Editor’s Note: The following is a guest post by John C.K. Daly.

The good news is that on 8 November the International Energy Agency released its 2011 “World Energy Outlook.” While it will cheer nuclear advocates, overall the report makes for grim reading. Pulling no punches, the report states at the outset, “There are few signs that the urgently needed change in direction in global energy trends is underway.”

Stripped of its cautious language, the IEA report essentially noted that should present trends continue, the world’s governments through a lack of progressive initiative embracing alternative energy sources would continue to rely on ‘tried and true” fossil fuels, resulting in increased pollution, more fossil-fuel dependency and increasingly upward energy prices. For environmentalists, this is all good news, but the report contained a caveat virtually anathema to all green movements, that accordingly, governments should reconsider their reluctance to embrace nuclear power, as it does not generate greenhouse gases.

Dollars, Cents and Reliable Energy Production

Like many discussions in Western economies since 2008, when the global recession first began to draw blood, the issue of reliable energy production ultimately comes down to dollars and cents issues. The grim reality for environmentalists is that no single renewable energy resource, from wind power to solar energy through biofuels, has remotely become competitive with kilowatt hours of electrical energy generated by coal or oil-fired power plants. The debate pits those opposed to a transition to greener technologies to those considering the bottom line, despite greenhouse gas emissions.

Even worse for the environmentalists, the IEA report advocates that as a short-term solution, governments ought to reconsider nuclear power, as it produces zero CO2 emissions. Projecting into the future the report notes, “A low-nuclear future would also boost demand for fossil fuels: the increase in global coal demand is equal to twice the level of Australia’s current steam coal exports and the rise in gas demand is equivalent to two-thirds of Russia’s current natural gas exports. The net result would be to put additional upward pressure on energy prices, raise additional concerns about energy security and make it harder and more expensive to combat climate change. The consequences would be particularly severe for those countries with limited indigenous energy resources which have been planning to rely relatively heavily on nuclear power”

But while sketching out a bleak scenario should governments remain largely disengaged to the larger issues involved in energy production, the IEA report nevertheless ends on a cautiously optimistic note, with its authors concluding:

“International concern about the issue of energy access is growing. The United Nations has declared 2012 to be the ‘International Year of Sustainable Energy for All’ and the Rio+20 Summit represents an important opportunity for action. More finance, from many sources and in many forms, is needed to provide modern energy for all, with solutions matched to the particular challenges, risks and returns of each category of project. Private sector investment needs to grow the most, but this will not happen unless national governments adopt strong governance and regulatory frameworks and invest in capacity building. The public sector, including donors, needs to use its tools to leverage greater private sector investment where the commercial case would otherwise be marginal. Universal access by 2030 would increase global demand for fossil fuels and related CO2 emissions by less than 1%, a trivial amount in relation to the contribution made to human development and welfare.”

Most notable about the IEA report are two things:

1. Energy options beyond dependence on traditional fossil fuels such as coal and oil not only exist, but are available in significant amounts to make a serious contribution.
2. As Germany’s experience in weaning itself off nuclear energy is showing, the alternatives are more expensive than current power production modes.

According to the IEA’s scenarios then, the issue of global power production over the next two-three decades depends upon two major issues:

1. Cost: undoubtedly an uphill struggle for many governments seeking to meet the population’s rising energy demands, who will be loathe to endure increasing energy bills.
2. Global Warming: the impact of traditional fossil fuel-fired power plants belching vast amounts of CO2 into the atmosphere.

While even the most diehard proponents of traditional power plant electrical generation do not deny that their facilities emit significant amounts of carbon dioxide, they denigrate the concerns of environmentalists as ‘fuzzy science.” So, at the end of the day, the two fundamental issues facing the world’s nations seeking to satiate their population’s demand for reliable and inexpensive power come down to cost and scientific projections.

We’ll leave the final word to the IEA, which laid out three scenarios, ranging from best- to worst-case – “The wide difference in outcomes between these three scenarios underlines the critical role of governments to define the objectives and implement the policies necessary to shape our energy future.” Accordingly, the major question is whether global governments will have both the cash and political will “to shape our energy future” to the best possible ends.

Source: IEA-Report Calls-for Governments to Embrace Nuclear Power

By: John C.K. Daly of oilprice.com

Do you think governments will be able to adopt the policies necessary to ensure that sustainable and cost-effective sources of energy are available for future generations?

Related posts:

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2. Goal Setting: My Report Card
3. When the Levee Breaks

Even nectar is poison if taken to excess.

~Hindu Proverb

If low interest rates are good for the economy, it should be booming by now. After all, rates have basically been falling for 30 years. Over the last 10 years or so, short term rates have been held low by central banks. Just a few weeks ago, the U.S. Federal Reserve announced Operation Twist, which will keep rates at the longer end of the curve low as well.

Yay. Soon we’ll all be basking in the glow of a red hot global economy. So why does it sound like so many governments and pundits are preparing for perdition rather than prosperity? Why isn’t the low interest rate elixir working its magic?

10 Reasons Low Interest Rates Aren’t Helping – And May Be Hurting

Lower rates are supposed to stimulate the economy by encouraging business investment, home buying and consumer spending. Operation Twist is supposed to accomplish more of the same. As John Mauldin points out “in a normal business-cycle recession such a policy might work. But in a normal business cycle, it has never been necessary.” Here are 10 ways low interest rates are inhibiting a healthy economy:

1. Savers Are Suffering

Low interest rates mean meagre returns for retirees and risk averse investors who can’t or won’t or shouldn’t have very much of their money at risk in the markets. This means they need to spend less, find a way to earn more income, or move farther out the risk spectrum. Mauldin aptly asks “Do we really want retirees increasing their risk by seeking more yield?”

2. Artificial Boost to Other Asset Classes

I’ve lost count of the number of times I’ve heard low interest rates given as a good reason to jump headlong into stocks and commodities. A lot of investors did just that in 2009 and 2010 when it looked like the Fed would be able to engineer an economic recovery. That’s great for people invested in those vehicles, but the average consumer, many of whom do not own stocks or commodities, is now stuck with a rising cost of living, a slowing economy and a deteriorating employment picture.

3. Lower Real Returns

Real returns are what you earn after factoring in inflation. With CPI in Canada and the U.S. running over 3% and many fixed income investments yielding under 2%, it’s not hard to see that real returns are negative. While many advocate buying stocks as a remedy for this, it’s important to remember that stocks can offer negative returns on their own via capital losses and that capital gains should be converted to real returns as well. If your stock portfolio is up 3% on the year and inflation is running at 3%, your real return is zero. (Dividends can help cushion the blow with regular distributions. )

4. Increasing Debt Loads

Many young people have become accustomed to very low interest rates. Folks in their 20s and 30s find it hard to imagine that mortgage rates could go as high as 7%, never mind 12% as they were as recently as the early 90s. This tendency to presume low rates will persist as far as the eye can see has prompted many consumers, businesses and sovereign countries to take on astounding amounts of debt. Keeping rates artificially low does little to ameliorate our debt problem.

5. Decreasing Net Interest Margins for Banks

While central banks held short term rates down, global financial institutions made a lot of money borrowing short and lending long. So while they’re paying you less than 1% on your cash deposits, they’re charging you multiples of that amount for your mortgage. Heaven knows they needed a capital boost after the subprime debacle of 2008. But now the Fed is sitting on the long end of the yield curve as well, so that spread and its attending profit margins are quickly disappearing.

6. No Help for U.S. Housing

Interest rates have been low for over a decade now. Some would argue that this a major precipitating factor in the 2008 U.S. housing crash. Since then, rates have gone even lower but we have yet to see any measurable improvement in the housing market south of the border. The problem is not that rates are too low, but rather that inventories are too high and prices are still falling.

7. No Help for Businesses

John Mauldin points out that the latest NFIB (National Federation of Independent Business) survey shows that most small businesses are not suffering from a lack of lending, but from a dearth of sales. So lower rates are fine for carrying an existing line of credit, but there’s no need to take out a large business loan if the sales aren’t there to support expansion.

8. No Help for Consumers

Most consumers are trying to deleverage, so lower rates can help keep interest costs down. Still, there’s still a segment of consumers who will take the Fed’s promise to keep rates low for an extended period of time as an invitation to take on even more debt. With debt levels at or near record highs in many countries that doesn’t seem like a prudent course of action. And with sovereign sources of bailout funds struggling to keep up, it could be a recipe for disaster.

9. It Didn’t Work for Japan

Japan has maintained interest rates near zero for decades now and the result has been an ongoing deflationary depression. The Nikkei peaked around 37,000 in 1990 and hasn’t even come close to regaining that level over the past 20 years. Today it trades below 10,000. That doesn’t necessarily mean North American equity markets will follow the same path, but it’s got to at least be on the radar screen for investors.

10. Pension Funds and Insurance Companies Hurting

As recently as Monday, Sun Life Financial, generally considered to be a Canadian blue chip company, warned profits would fall well below estimates. Much of the miss can be blamed on sagging equity markets and pitiful returns on interest-bearing investments. That in turn led Moody’s to consider downgrading the insurer’s U.S. subsidiary. Sun Life is not alone. Analysts expect most insurers and pension plans to struggle to meet their benchmark returns, especially in light of Operation Twist.

Insurers and large pension funds depend on “safer” investments like bonds and term deposits to cushion their portfolios against market risk. Most of them have not modeled interest rates this low into their projections. With equity markets flat to lower over the past decade, insurance companies aren’t getting the returns they planned on and many pension plans are underfunded by a wide margin. If market conditions don’t improve, pension contributors and employers may be required to fill the gap.

Do you think record low interest rates are positive or negative for the economy and financial system?

Related posts:

1. Where Are Interest Rates Going?
2. Interest Rates: 2010 Mid-Year Review
3. Why Are Mortgage Rates Rising?

If you are neutral in situations of injustice, you have chosen the side of the oppressor. If an elephant has its foot on the tail of a mouse and you say that you are neutral, the mouse will not appreciate your neutrality.

~ Bishop Desmond Tutu

“In the wake of the global financial crisis, politicians and regulators assuaged public outrage by promising reforms that would prevent such a crisis from occurring again. But not much has improved. We haven’t even managed much of a regime change. Many of the bankers, regulators and politicians who drove the policies that led to the crisis are still in their chairs. Many of the big banks are even bigger. Too big to fail is still a major systemic threat.” I made this comment over 8 months ago as the civil unrest in Egypt was boiling over.

At the time, I wondered how long it would take before citizens in other parts of the world would grow tired of the income disparity that seems to have become a global epidemic: “How much longer will the American public tolerate government-subsidized success for large corporations while many are running out of unemployment benefits and over 40 million Americans are on food stamps? There has to be a tipping point somewhere.”

From Arab Spring to Autumn in America

The protests this spring in the Middle East seem to have given way to widespread – albeit mostly peaceful – demonstrations in more than 1500 cities across the globe this fall. Most are taking place under the auspices of the Occupy Wall Street movement. I read all the time that the movement lacks a coherent message. That may be true, but many people can identify with the pervasive sense that there’s something rotten in the halls of power worldwide, that capitalism isn’t functioning as it should and that the middle class has somehow been handed the bill for mistakes made by both ends of the political spectrum while CEOs of failed banks walked away with millions.

One OWS spokesman summed it up this way: “Does anyone really not know what the basic message is of this protest: that Wall Street is oozing corruption and criminality and its unrestrained political power—in the form of crony capitalism and ownership of political institutions—is destroying financial security for everyone else?” The chart at the top of this article illustrates just one of the reasons Wall Street protesters are angry: The top 1% of American wage earners are taking bigger percentage of the country’s total pre-tax income than at any time since the late 1920s. Their share of the national income, in fact, is almost twice the long-term average!

Josh Brown, otherwise known as the Reformed Broker, added a lot more detail in his open letter to the banks that don’t seem to get why people are mad. Incidentally, Josh is part of the 1%. He works in finance and I’m guessing he’s doing alright. That’s the thing about Occupy Wall Street. Some of its most ardent supporters actually work there, or used to. Check out the story of Josh’s encounter with Suzanne, a former Wall Streeter and current member of the 1%.  She’s down in Zuccotti Park personifying the fact that not all Occupy Wall Street sympathizers are “stoners, losers and fringe elements.”

MSM Missing in Action

It’s worth pointing out that the mainstream media (especially financial networks like CNBC) have been slow to cover the Occupy Wall Street protests. When they do, they usually throw in a few winks, nods, and sarcastic jabs about the legitimacy of those involved. It’s so far been left to blogs, social media and online publications to bring the real issues to light. (Today’s chart is from online news aggregator Business Insider.)

Documentaries like the Oscar winning Inside Job offer a lot of details on how and why crony capitalism helped spawn the 2008 financial crisis. Why have none of the MSM outlets with the budgets to support it not sent armies of investigative reporters out there to find out what really happened? Maybe it’s because they didn’t know any better. Or maybe it’s because they would never again get an interview with the business and political heavyweights that draw the big ratings. Or maybe it’s because they are owned by the crony capitalists in question.

Either way, it seems like a good idea to get your information from a variety of sources. If you’re relying on the mainstream media alone, you may only be getting one side of the story. It still amazes me how some of the folks who looked so guilty in Inside Job are regularly invited to express their views in the financial media.

Middle Class Uprising?

Occupy Wall Street is often viewed as a left wing movement. Given that many powerful labour unions joined the protests this past weekend, I suppose it makes sense to think so. Many would like to write off the nascent organization as just another extremist group of wing nuts and rabble rousers. If the Tea Party is the crazy uncle of the political right, maybe Occupy Wall Street is just the crazy aunt of the political left.

I’m not sure what the right answer is, but it strikes me that this movement is trying to represent the masses in the middle. These are the folks whose taxes helped bail out the banks as well as the auto companies. These are the folks who work in the private sector, where cushy pension and benefit plans are nonexistent. They earn less than their unionized counterparts and just a fraction of the income many in the financial industry take home.

Like the classic psychological portrait of a middle child, the middle class feels overlooked, underappreciated and a little exploited. They are, by nature, more diplomatic and therefore more prone to defuse rather than invite conflict. Perhaps this is why it’s taken so long for the middle class to pipe up and have its say. Perhaps it’s also why the demonstrations have thus far been mostly peaceful.

It seems the middle class is less interested in tipping the scales to the left or the right than in simply restoring some sense of balance to our society. They’re hoping that they can avoid the violence that so often accompanies social change. Who knows? Maybe they can do it. After all, these imbalances have grown slowly and almost silently for decades. Let’s hope we can correct them without too much upheaval as well.

What do you think of Occupy Wall Street? Have we hit a tipping point?

Related posts:

1. Nightmare on Wall Street II
2. Book Review: The Weekend That Changed Wall Street
3. Egypt: Financial Lessons and Tipping Points

Growth for the sake of growth is the ideology of the cancer cell.

~Edward Abbey

Although I visit the grocery store at least once a week, lately I’ve had the feeling that I’m in a different place – and that’s not just because we recently moved. I sometimes can’t believe the prices I’m seeing on staples like milk, cheese, or sugar and I can’t help but notice that my cart doesn’t have to be very full in order to rack up a pretty big bill.

My shopping trips highlight several economic trends I’ve been noticing over the past few years. These trends are having a direct effect on our finances, and I’m curious to know whether others are finding the same thing. Here are 5 of the most salient trends that seem to be affecting our personal finances:

1. Less for More

Not only do the large cheese bars we buy regularly cost almost ten bucks at regular price, they are only a fraction of the size they were a few years ago. I’m sure most folks can come up with many other such examples. More recently, I noticed that Minute Maid reduced the size of their cans of orange juice – not that we’ve been buying the brand names for a while now. The price just keeps going up and we only buy it if it’s on sale.

This trend is not limited to the grocery aisles. Energy prices have risen and that feeds into pricing for all kinds of goods and services. Have you noticed that services that used to be free or included with your purchase have gone the way of the dinosaurs? It seems that so many transactions nowadays come with a service charge, administration fee, or surcharge. When we moved, just about every utility or agency that sent us a bill included some kind of exorbitant “service change” fee even if we remained with the same company. Either way, I can’t escape the feeling that my pocket is being picked repeatedly.

2. Biflation

Less for more seems to be a natural by-product of the biflation trend I highlighted early this year as one of the major factors affecting your money in 2011. In spite of a lacklustre economy and pervasive unemployment, commodity prices have risen, mostly as a result of the monetary machinations of central bankers. It will be interesting to see whether the recent slide in commodities brings any relief in the inflation half of the biflation equation.

What about the deflationary component of biflation? That usually means falling interest rates and housing prices. It can also mean lower prices for gadgets. The U.S. housing market has yet to recover. Interest rates have remained low and have fallen even further during the latest round of economic malaise emanating from the Eurozone. It looks like the trend will continue until we can find some kind of resolution to the global debt problem.  And that brings us to trend #3.

3. Debt Boom

I won’t spend too much time on this one since I’ve written so much about it already. The global debt problem has been building for decades. The 2008 financial crisis brought it to the forefront and the solutions provided by governments and central banks have made it worse. Consumers and sovereign entities alike have taken on huge amounts of debt and we are now struggling to understand whether it will ever be repaid. We covered some of this in Monday’s article on principal vs. principle.

4. Growth at Any Price

We live in an economic system that values growth above all else. Growth isn’t necessarily a bad thing – unless we take it too far. Many would agree that we’ve done just that. Pushing growth at any price has led to the debt boom and many of the misguided solutions to our problems. Barry Ritholtz had an excellent commentary on the idea that we’ve repeatedly ignored a key trading axiom: Take the Loss. Late last year I wondered What Happens When the Glass Is Too Big? Almost a year later, we’re seeing some of the results.

Monetary and political authorities have been reluctant to allow institutions to fail for fear that falling stock prices and derivatives implosions would bring down the financial system. Perhaps those fears are well-founded – all the more reason to fix the system so that failure is once again a key component. Regular recessions are part of the business cycle. Bankruptcy is part of capitalism. Both allow for rebirth and real growth based on sound economic fundamentals rather than bogus backstops.

5. Wealth Disparity

It’s hard for the average middle class family to be successful when unemployment is stubbornly high, the cost of living is rising, and interest rates are so low that saving for the future seems fruitless. Jeremy Grantham recently pointed out some of the stats:

“The top 10% of U.S. workers currently receive about half of the nation’s total income, with half of that going to the top 1%. The last time this country saw a wage gap so extreme was just before the 1929 stock-market crash and the Great Depression. By comparison, in the late 1970s the top 1% garnered about 9% of all earnings.”

Say what you like about class warfare or picking on bankers, this is not a good scenario for future economic prosperity – for anyone. As Grantham observes “You can’t run the economy on BMWs alone.” While the statistics he uses focus on the U.S., we are seeing a similar dynamic play out in many other parts of the globe as well.

What Does It Mean?

All of this will affect each of us a little differently depending on our age, income level and job security. For us, it means waiting for sales on items like cheese, cereal and orange juice before we buy. It means holding off putting any more money into GICs until rates rise. (Right now, a savings account at Ally pays 2% while many 5-year GICs are only yielding about a half a percentage point more.) It means we’ll use the ultra-low mortgage rate we just received to pay down the principal as quickly as possible. It means limited participation in the stock market until that mortgage principal is a lot lower.

Have you noticed similar trends? What do they mean to you?

(Photo Credit: Shutterstock/Shkurd)

Related posts:

1. Revenge of the Dumb Money
2. Our Money Story: Part I
3. RRSPs: Taking Money Out

Wisdom is knowing what to do next; virtue is doing it.

~David Star Jordan

It’s funny how rather complex issues can sometimes become a little more clear by accident. One of the spelling riddles I sometimes come across when I’m writing is the difference between principal and principle. Unlike other words like favourite and favorite, this is not simply a matter of unique international spelling conventions. Principal and principle actually have completely different meanings.

Principal vs. Principle: What’s the Difference?

According to my trusty dictionary, principal can refer to:

1. a school administrator
2. something or someone of first rank or importance
3. capital bearing interest

Principle, on the other hand, is:

1. a fundamental truth, or doctrine on which others are based
2. rules of conduct or ethical behaviour

Who Cares?

I’m sure some of you can already see where I’m going with this. It’s not about spelling trivia. It’s about the global economic pickle we seem to have landed in. The markets have reflected the uncertainties we face by alternately surging and plunging. The last few trading sessions have obviously leaned pretty heavily toward the plunging side. Even the precious metals complex, considered by some to be a safe haven, has been hammered. At one point on Friday gold was down over $100.

These manic-depressive tendencies reflect the uncertainties surrounding the mountains of debt that have been piling up in the Eurozone, the United States, and even China. While China’s massive stimulus programs helped us out of the 2008 economic ditch, there’s growing concern that they may have inadvertently thrown themselves into it along with us. So it seems China may not be able to come to our rescue again.

The recent market gyrations are simply a continuation of the financial crisis that began in 2008. I’ve written quite often about the idea that the root causes of the crisis were never addressed. I am by no means the originator of that assessment. The measures taken in 2008 and 2009 only served to rescue the financial sector with taxpayer money. Now taxpayers are tapped out, governments are tapped out, and we have even more debt on global balance sheets than we did in 2008.

While the problems facing us seem quite complex at times, we can probably boil it all down to 6 simple words: too much principal; not enough principle.

Too Much Principal

Obviously, we are dealing with an unmanageable quantity of “capital bearing interest” worldwide. We are very close to the terminal stages where the interest owing alone is causing many debtors to incur more debt just to pay the interest charges. Forget about the principal. No one seems to be able to comprehend making a ding in that at all. We have put ourselves into survival mode where we are just trying to tread water, buying time (on credit of course) and hoping for a miracle solution.

Creditors do not want to acknowledge that the debt will probably not be repaid, but they don’t want to take the haircuts that go with that reality. It’s time to face the music. It’s unfortunate that we didn’t do it sooner.

One of the major reasons governments and creditors have been reluctant to allow debtors to default is the exponential effects of credit default swaps. If a large financial institution or sovereign nation were to default on its debt, bondholders would suffer, but so would anyone who wrote CDS on those bonds. It’s widely acknowledged that the amount of CDS out there vastly outnumbers the capital in the financial system. In other words, the folks who insured the debt can’t pay up.

We’ve had a few years to figure out a solution to the CDS conundrum. How can we allow failed institutions to default without bringing down the global financial system? Instead of taking a serious stab at curtailing the size and influence of the financial sector, we gave them more money. Exposure to derivatives has reached new highs.  Now the rescuers need rescuing.

Not Enough Principle

It’s not hard to look at the global leadership vacuum and see that one of the major problems confronting us is a lack of principle. I don’t know a single soul who isn’t completely exhausted and/or disgusted by watching the political brinkmanship play out across the globe with progressively poorer results. We seem to be getting better at calling each other names, but worse at addressing the mounting problems that confront all of us.

A second major problem might be a pervasive failure to recognize the fact that some of the principles we’ve embraced over the past few decades may not have been of the highest calibre. Consumerism, growth at any price and short-termism have undermined our economy. We’ve listened to Alan Greenspan, Henry Paulson, and a host of others who are either revered or reviled depending on whom you ask. They have been the alleged champions of free market capitalism.

Now I’m a big fan of capitalism. But the last time I checked, capitalism is supposed to allow for failure. That’s one of the things that makes it great.

We can have a great idea about how to solve a problem or provide a service. We can develop and bring that idea to market. If our idea takes off, we will likely reap financial rewards commensurate with that success. If it doesn’t, we close up shop and go back to the drawing board, hopefully richer in experience, if poorer in cash.

Failure is an essential component of capitalism. It can’t work without it. Unfortunately, the version of capitalism under which we are currently operating is more like Gore Vidal’s idea of “socialism for the rich and capitalism for the poor.”

Who would have thought that a simple spelling puzzle could help define the financial crisis? I realize that defining the problem does not automatically lead to a solution, but it strikes me that reducing principal and redefining principles might be a good place to start.

What do you think?

Related posts:

1. 5 Economic Trends Affecting Your Money
2. Financial Spilled Milk: Macbeth Meets Ponzi

I am more afraid of an army of one hundred sheep led by a lion than an army of one hundred lions led by a sheep.

~Charles Maurice, Prince de Talleyrand-Périgord

When the financial crisis erupted in 2008, many questioned the leaders and regulators in place at the time. How could the global financial system be humming along one minute and completely bankrupt the next? Clearly, those in charge either made some very questionable decisions or failed to inform the public of the potential consequences of those decisions. Most likely it was both.

When it came to constructing solutions for the crisis, however, we continued to listen to and implement the ideas of the same people who brought us to the brink. In turn, those people followed policy prescriptions similar to the ones that got us into trouble in the first place. Were there no other options available? There were. They were simply ignored. And what role did we the public play? Were we willing sheep, helpless dupes, or both?

While I’ve been thinking and writing about this exasperating situation for some time now, the reality of it hit home once again this past weekend as Joe Nocera published an excellent exit interview with outgoing FDIC chairwoman Sheila Bair. Ms. Bair added a refreshingly candid piece in the the Washington Post. I highly recommend reading both.

Notes from the Exit Interview

Here are a few points that stood out to me from Nocera’s article:

• “Not long after she took charge in June 2006, Bair began sounding the alarm about the dangers posed by the explosive growth of subprime mortgages, which she feared would not only ravage neighborhoods when homeowners began to default — as they inevitably did — but also wreak havoc on the banking system. The F.D.I.C. was the only bank regulator in Washington to do so.”
• “Just a few months ago, she went so far as to send a letter to Standard & Poor’s, the credit-ratings agency, suggesting that its ratings of the big banks were too high because they reflected an expectation of government support. If a too-big-to-fail bank got into trouble, she wrote, the F.D.I.C. would wind it down, not bail it out.”
• “the last female financial regulator to be labeled difficult was Brooksley Born, the head of the Commodity Futures Trading Commission in the mid-1990s. Fearful that derivatives were becoming a threat to the financial system, Born wanted to regulate them but was stiff-armed by Alan Greenspan and Robert Rubin.” I had the same sense of déjà vu. (If you get a chance, watch the PBS documentary called The Warning that I wrote about in Market Integrity Should Not Be an Oxymoron.)
• “She favored “market discipline” — meaning shareholders and debt holders would take losses ahead of depositors and taxpayers — over bailouts, which she abhorred. She didn’t spend a lot of time fretting over bank profitability; if banks had to become less profitable, postcrisis, in order to reduce the threat they posed to the system, so be it. (“Our job is to protect bank customers, not banks,” she told me.)”
• Ms. Bair felt the authorities should have let Bear Stearns fail: “Banks and bank-holding companies are in the safety net. That’s why they have deposit insurance. Investment banks take higher risks, and they are supposed to be outside the safety net. If they make enough mistakes, they are supposed to fail. So, yes, I was amazed when they saved it. I couldn’t believe it.”
• The FDIC was the lone regulatory agency that foresaw and tried to stem the toxic impact of subprime mortgages. The responses of the Fed, the Office of the Comptroller of the Currency and the Office of Thrift Supervision “were at best tepid and at worst hostile.”
• As head of the FDIC, Sheila Bair also fought against U.S. adoption of the Basel II accords. Already taken up by most European countries, Basel II “would allow banks to hold capital on a “risk-weighted” basis, meaning that assets with lower risk would require less capital. (As it turned out, triple-A-rated mortgage bonds stuffed with bad subprime mortgages were considered very low risk under the Basel proposal. That is why so many banks loaded up on them in the years leading up to the crisis.) To make matters worse, the Basel II accords, as they were called, permitted banks to evaluate their assets with their own internal risk models.”

It turned out that Bair’s approach, often labeled “difficult” by bankers and fellow regulators, left U.S. banks in a slightly better position than their European counterparts when the credit crisis hit. If they had listened to her ideas with regard to tightening capital requirements and regulations in the first place, however,  perhaps the crisis could have been averted.

In Her Own Words

I can remember watching media coverage of the financial crisis as it unfolded in 2008 and 2009 and wondering what some of the key players were really thinking behind the spin and the rhetoric. Sheila Bair’s Washington Post article on Short-Termism and the Risk of Another Financial Crisis provides a glimpse into what she feels is the primary cause of our economic and financial problems. Given that many of the “solutions” employed continued the policies of short-termism that she abhors, it’s easy to see how frustrating that period of time must have been for the FDIC chairwoman.

Bair begins her op-ed with an incredulous observation that we have quickly returned to “the same untenable business practices that brought [the financial system] to its knees less than three years ago.” She notes that “too many industry leaders, as well as some government officials, compare the crisis to a 100-year flood. ‘Who, us?’ they say. ‘We didn’t do anything wrong. Nobody saw this coming.’ ”

In reality, plenty of people saw this coming. They did the best they could to try to stop it, but no one at the political or public level was listening:

“The truth is, some of us did see this coming. We tried to stop the excessive risk-taking that was fueling the housing bubble and turning our financial markets into gambling parlors. But we were impeded by the culture of short-termism that dominates our society. Our financial markets remain too focused on quick profits, and our political process is driven by a two-year election cycle and its relentless demands for fundraising.”

Just as she did back in 2006, Sheila Bair wants to “sound the alarm again.” The problems created by short-term thinking are “actually getting worse, not better.” Will we listen this time?

I once wrote that strong leadership is one of the missing links in our current, distorted version of capitalism. If so, the only way to change that is to find a way to better educate the public about the long term consequences of short-termism – no small task given our “gotta have it now” society.

(There’s a lot more to both of these articles, so I would urge you to go and read both in their entirety.)

Should we have listened to Sheila Bair and others who warned of the longer term consequences of a lack of market discipline? Why are we still ignoring them?

Related posts:

1. Egypt: Financial Lessons and Tipping Points
2. Financial Spilled Milk: Macbeth Meets Ponzi
3. The Financial Sector: Capitalist Bastion or Corrupt Oligarchy?

Investors have very short memories.

~Roman Abramovich

Today’s U.S. Nonfarm Payroll Report was a huge disappointment by any measure. Paraphrasing some reaction to it (mostly from economists who got it wrong):

• catastrophic
• severely disappointing
• no redeeming qualities whatsoever
• Stop looking for the silver lining. There is none.

Now most of you know that I have a fairly bearish view on the economy due to the global debt burden. So I’m doing an I-told-you-so happy dance right now, right? Not so much. While I did add to my tiny HIX position today, I’ll be out of it again quickly if the market changes its mind, as it’s wont to do regularly.

Attention Deficit and Hyperbole

Why so sanguine in the face of data that is, by all accounts, unexpectedly and extremely negative? Because years of following the markets have taught me two key things:

1. Markets have a very short memory.
2. Anything can happen.

It’s not wise to cling to a single idea, data point, or theme. The markets are full of too many variables for that kind of strategy to be successful. Markets, and the traders who drive prices, tend to be prone to both hyperbole and attention deficit disorder. The news of the moment is often blown out of proportion – until the news of the next moment takes over. How many times have we seen a premarket bomb turn into an afternoon delight?

ADP vs. BLS

Markets jumped on Thursday due to a better than expected employment report out of ADP. Many economists raised their estimates for today’s BLS report as a result of that report. Obviously, the BLS report looks that much more disappointing in light of those elevated expectations.

ADP is slammed regularly for missing the BLS nonfarm payroll number, sometimes by a wide margin. To me, this misses the point. It seems like it might be more productive to ask which report is more accurate. What if the ADP report is actually presenting a more accurate view of the U.S. employment picture? I’m not sure whether that’s the case or not, but I’d love to know the answer.

Potentially Positive Catalysts

So what are some of the catalysts that could trigger my stop? Any of the following could cause an upward mood swing for traders:

• The ADP number could be catching an uptick in employment before the BLS. Future economic data may look better.
• While many other data points have been negative, there have also been some positives: rail traffic has increased in both the U.S. and Canada, corporate earnings have been rising, and retail sales recently beat expectations.
• Those who say the recent soft patch is mainly due to the supply chain disruptions caused by the Japanese disaster may turn out to be correct.
• Earnings season is upon us. We may see some upside surprises. (For a much more cynical take on earnings beats, take a look at the latest note from Albert Edwards via Zero Hedge.)
• If the data continues to be negative, we could see another Jackson Hole miracle toward the end of the summer as Bernanke dangles the QE3 carrot and causes another short squeeze/asset price liftoff.
• The U.S. government comes to an agreement on the debt ceiling. While this wouldn’t solve the long-term debt problems facing our neighbours to the south, it would likely provide some support to the markets.

If I sat here a little longer, I could probably come up with a few more ideas. And there are always those white swans to consider too. You never know when some completely unanticipated event will move markets one way or the other. In the end, none of us knows what will happen next. Even if we have some insightful hypotheses, they may not play out according to the timeline in our heads. Best to remember that anything can happen.

By the way, I could come up with an equally long list of negative catalysts, but I’ll leave that for another time. For now, I see the NFP number as concerning, but not necessarily catastrophic. I would be much more concerned if things started to unravel on the European sovereign debt front, or if more rumblings of trouble with Chinese debt began to surface.

Off Topic: Thanks

I just wanted send a note of thanks out to those who have wished my son well following the recent surgery on his leg. Your kind thoughts are much appreciated. He’s feeling much better now, although it will be months before this whole process is complete. Luckily, lots of experience on crutches has him operating pretty independently now that he is over the initial trauma of the surgery itself.

We will be out of town every couple of weeks visiting his specialist for follow-up. When you add that to all of the stuff that goes with moving to a new city, things will be pretty busy for the next couple of months. I appreciate your patience as my posting schedule will be inconsistent at best during that time period. I hope to resume more regular writing in the fall. In the meantime, thanks for reading and for sticking with Balance Junkie.

Do you think the U.S. payrolls report was a harbinger of weaker economic data, or just a temporary blip?

Related posts:

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2. Goal Setting: My Report Card

Truth is after all a moving target
Hairs to split,
And pieces that don’t fit
How can anybody be enlightened?
Truth is after all so poorly lit.

~Neil Peart, Turn the Page

The following is an excerpt of an article that was originally published on Seeking Alpha as premium content. You can read the entire article there.

I read two fascinating articles this week that shed a little light on the opaque workings of our global financial system. One used recently declassified documents to show that foreign banks were the greatest beneficiaries of the Federal Reserve’s efforts to quell the financial crisis. The second elucidated a recent BIS report that revealed the relative exposure of U.S. versus European financial institutions to a PIIGS default. The former article posited that the data provides the grounds for Ben Bernanke’s impeachment. The latter offers some information on why that might not necessarily be the case – at least not for one of the reasons given.

Read the full article at Seeking Alpha . . .

Related posts:

1. What Happens After QE2?
2. Balance Junkie Joins Seeking Alpha
3. Is This a Good Time to Invest in Banks?

Nothing is more desirable than to be released from an affliction, but nothing is more frightening than to be divested of a crutch.

~ James Baldwin

This is an excerpt of an article that was originally published on Seeking Alpha as premium content. You can read the entire article there.

There’s been no shortage of potentially market-moving news for investors to digest so far in 2011. From major geopolitical strife in the Middle East to the sovereign debt crisis in Europe to the multilevel Japanese catastrophe, markets have been remarkably resilient so far. Perhaps that’s because these types of events aren’t what’s driving the markets.

The only news items that seem to have any lasting impact on the stock and bond markets these days are those that pertain to monetary policy, particularly that of the US Federal Reserve. David Rosenberg recently pointed out that there has been an 86% correlation between the Fed’s balance sheet and the S&P 500 over the last 2 years. So it seems logical that the biggest question facing investors these days relates to the possible next steps for Ben Bernanke and company. Specifically, investors and analysts are speculating about what happens when QE2 ends in June.

Read more about the QE Quartet at Seeking Alpha . . .

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If it keeps on rainin’, levee’s goin’ to break . . . Cryin’ won’t help you, prayin’ won’t do you no good.”

~ Led Zeppelin, “When the Levee Breaks”

Having taken some time off over the past week, I have yet to comment on the latest wave of crises buffeting the global financial system. I’ll throw my two cents into the mix today.

When subprime mortgages started to unravel in 2007 and 2008, I couldn’t get the Zeppelin classic “When the Levee Breaks” out of my head. I have the same feeling again as I watch global leaders try to minimize, juggle and contain a growing collection of economic threats.

The markets had been rallying relentlessly throughout the dawn of 2011 in spite of growing civil unrest across the globe, particularly in the MENA (Middle East North Africa) region. In fact, many parts of the global economy were showing genuine signs of improvement. Even the lethargic U.S. employment figures were beginning to exhibit some signs of revival.

And yet the threats to the stability of the global financial system continued to mount as European countries faced renewed downgrades of their debt ratings, inflation became a worry for those of us who buy food and fuel, and China began to tighten monetary policy. Our 2011 theme of bifurcation was going strong as countries with relatively low debt levels struggled to avoid the fallout from those with intractable debt and deficits. Citizens across the globe became increasingly restless and intolerant of shouldering the burden of austerity while the financial sector that necessitated such measures recovered and thrived.

3 Phases of Contemporary Crisis Management

This latest series of crises appears to be playing out much like those we’ve witnessed over the past decade:

Phase 1: Denial

Many continue to deny that excessive debt levels, inflation, or even destruction on the massive scale we’re seeing in Japan could possibly slow the global economy. Capitalism will make the appropriate adjustments and we’ll soon be back to business as usual. Nothing to see here folks.

Phase 2: Acceptance

OK, so maybe widespread nuclear contamination combined with massive global debt loads, nascent inflationary pressures, civil unrest and oil supply disruptions aren’t a good thing. Maybe this thing isn’t as contained as we thought.

Phase 3: Intervention

When the forces of capitalism actually start to price in reality, central banks and governments intervene to thwart the much-needed cleansing. We saw this last week as the Dollar-Yen currency pair cracked key support levels and briefly entered free-fall. Central banks across the G7 responded by capping the Yen appreciation and punishing those pesky speculators.

Nuclear Options

So here we go again. We’re told that all is well and that things aren’t as bad as they seem. When the situation turns out to be worse than we thought, we throw free market capitalism under the bus and sweep reality under the rug. Markets are not allowed to perform their cathartic function and the charade continues. But for how long?

Central banks have been willing to throw printed money at any and all crises over the past couple of decades. It’s their answer to every question and the solution to all problems. If you’ve seen the movie My Big Fat Greek Wedding, it’s like Gus believing that “every ailment from psoriasis to poison ivy can be cured with Windex.” Quantitative easing is monetary Windex, or the quintessential nuclear option – choose your metaphor.

The term “nuclear option” usually refers to a solution of last resort. It’s the proverbial red button – to be used only in the most dire emergency. Many accepted the Fed’s use of extreme, unconventional monetary policy measures during the financial crisis, but it seems as though the nuclear option has now become standard operating procedure, the cure-all for everything from a mild GDP hiccup to an actual nuclear disaster.

So far, many think it’s worked. Maybe it has. All Mr. Bernanke has to do is whisper the “Q” word and the shorts are wiped out by a sea of charging bulls. Don’t fight the Fed.

Cracks in the Levee?

Central banks have, for the most part, been able to stave off the overdue financial reckoning for quite some time. How much longer they are able to do so is anyone’s guess. This, however, presents investors with a very difficult dilemma.

Given the simultaneous crises that confront us, any one of which could cause massive financial dislocations on its own, it seems like avoiding or shorting equities and/or bonds might be the way to go. This approach over the past few years, however, would have lost a lot of money. Each time governments intervene in the markets, we get very powerful rallies. The fact that they are based on market manipulation is irrelevant. If you trade against them, you lose.

So is a long-only, long-always approach the better plan? It depends, of course, on your individual circumstances, risk tolerance, and all of the other factors we talk about all the time. It also depends on how long the Fed’s “Windex” keeps working. No one knows the answer to that question.

Perhaps the best approach is to simply acknowledge that we have been, and continue to be, in an era of elevated volatility where huge swings in either direction are possible at any moment. If you can’t stomach the volatility and have a history of selling into panics, perhaps it’s time to dial down the risk a little by boosting your cash allocation. If you’re an experienced trader, you can take advantage of the swings by profiting from larger moves and implementing stricter risk management measures. When all else fails, reduce your position size.

Ready for Anything

There are definitely cracks in the levee. Whether or not it holds remains to be seen. Now is a good time to think about how you would react in a variety of scenarios and prepare a plan of action for each of them:

• What if the levee breaks and we are faced with an economic, currency, and/or bond market crisis? Are your finances water-proof – or at least water-resistant? Do you have the cash reserves necessary to capitalize on the opportunities presented by oversold markets and panic sellers?
• What if the levee holds and we’re able to avert a major breach? Are you ready to step in and capitalize on the opportunities presented by a crisis averted and a recovering economy?

Having lived through several financial disruptions over the past couple of decades, a few lessons stay with me:

1. Don’t assume the levee will hold.
2. Don’t assume it won’t.
3. Be ready for either scenario and as many of the possibilities in between as you can.

The events unfolding today reflect my long term economic forecast, which included increased volatility and elevated unpredictability. They also fit in with the longer cycle Kondratieff winter I wrote about at the end of 2010. One of the big questions I’ve been wondering about lately is whether the March 9th, 2009 market lows will prove to be the low for this economic winter, or whether that levee will be breached to the downside. Many believe that those March lows were in fact generational, and that they will hold.

While I certainly don’t think a break is inevitable, I’m not sure it’s impossible either. The market action over the past week once again reminded us that investors are a fickle lot, and that sentiment can change on a dime. If you can’t be bothered to follow this economic and financial stuff all the time, you might try a less active approach like Valuation Informed Index Investing. (My thanks once again to Rob Bennett for fleshing out some of the details of this strategy last week.)

What do you think? Will the levee hold or not? For how long?

Related posts:

1. On the Move
2. Postcards from 2009
3. Economics: Your Personal Finance Weather Forecast

So long as all the increased wealth which modern progress brings goes but to build up great fortunes, to increase luxury and make sharper the contrast between the House of Have and the House of Want, progress is not real and cannot be permanent.

~Henry George, Progress and Poverty, 1879

The civil unrest in Egypt over the past couple of weeks has generated a lot of discussion in the economic community. Aside from the more immediate and obvious concerns over human rights, debates have arisen over whether central bank policy has contributed to the food inflation and income inequality that are cited as instigating factors for the uprising. Further questions have centered around whether or not what’s happening in Egypt is so different from what’s happening in North America and Europe.

I’m not sure how all of this will play out, but I have noticed three themes that have surfaced as the crisis in Egypt has unfolded that could have parallel implications for those of us who are feeling smug about the economic and political stability in our own part of the world. If any of these factors start to worsen in our domestic economies, the markets will quickly come off of their QE-induced high.

Income Disparity

According to the OECD, the gap in prosperity between the rich and poor has been growing over the past two decades. This fits in with the major 2011 theme of bifurcation that I wrote about as the New Year dawned. It should seem obvious that this type of trend can only continue for so long before those getting the short end of the stick decide that they’ve had enough. Although the general standard of living in Egypt falls far below that of North America, income inequality in the U.S. is actually worse than it is in Egypt.

There’s a list of income inequality by country that is put out by the CIA World FactBook. It ranks countries according to something called the Gini Coefficient. If you give the country with the worst inequality a ranking of 1, Egypt comes in at number 92 while the U.S. is up at 42. So income disparity is worse in America. Incidentally, Canada comes in at 100 and the U.K. at 92. At 133 and 134 respectively, Norway and Sweden have the least income inequality of those on the list.

Contagion

The problems in Egypt demonstrate how quickly a simmering pot can suddenly come to a full boil and make a huge mess of things. Seemingly isolated protests in Tunisia, which resulted in the overturn of the government there, somehow morphed into mass riots and an economic shutdown in Egypt. Before we knew it, governments in Jordan, Qatar, Syria, Yemen, Saudi Arabia and Israel were on high alert for spreading violence and/or collateral damage.

There were even reports that China was blocking news from Egypt via internet searches to avoid parallel protests which would dwarf those in the Middle East to date. Many took this to mean that the Chinese authorities are paying attention to the events in Egypt and are at least a little worried that their own citizens may try to bridge the income gap by force as well.

The financial crisis of 2008 taught us that we are all connected. Global finance is more interconnected than ever, and small ripples in one corner of a market can sometimes produce a tsunami that affects us all. The funny thing about tsunamis is that you often don’t see them coming. They can happen on the most beautiful days and they occur in places that are usually nowhere near the epicenter of the earthquake that spawned them.

Get at the Roots or the Weeds Will Keep Growing

It’s probably safe to say that most of us support democracy and admire the protesters who are trying to achieve it as peacefully as possible in Egypt. Who wasn’t moved by the images of demonstrators dropping everything to pray together? There were even reports of Muslims pledging to protect Christians on their holy days and vice versa. If only our political leaders could show the same poise.

Still, a brief report by STRATFOR, which I read courtesy of John Mauldin, pointed out that we don’t yet know how all of this will turn out. Other insurgencies that began with pro-democracy movements were successful in ousting the incumbent regime only to cede power to more radical movements later. The peaceful protesters do the hard work of clearing out the old regime only to provide entrée to factions that may be even worse. STRATFOR emphasizes that we need to find out who is really behind the unrest before we can figure out how it will end.

In the wake of the global financial crisis, politicians and regulators assuaged public outrage by promising reforms that would prevent such a crisis from occurring again. But not much has improved. We haven’t even managed much of a regime change. Many of the bankers, regulators and politicians who drove the policies that led to the crisis are still in their chairs. Many of the big banks are even bigger. Too big to fail is still a major systemic threat.

For all of the protests we saw in the streets, and in the courtrooms and Congressional hearings, not much has changed. The “heads I win tails you lose” compensation game is still going strong on Wall Street. Many worry that another financial crisis is inevitable, only this time we will have exhausted all of our options for fighting it.

Tipping Points

While the situation in Egypt is different enough from our own that we can’t draw direct comparisons, some of the parallels above are worth noting. How much longer will the American public tolerate government-subsidized success for large corporations while many are running out of unemployment benefits and over 40 million Americans are on food stamps? There has to be a tipping point somewhere.

Will it be a rise in bond yields, another flash crash, a sovereign debt crisis, or spreading geopolitical unrest? Maybe. But it could also be something as simple as a seemingly innocuous news item about a family struggling to make ends meet or a new round of bonuses on Wall Street.

When will the tipping point occur? We have no way of knowing that either. It could be a month, a year or 5 years from now. What we do know is that unsustainable trends can persist much longer than we think, that they always end eventually and that it’s really messy when they do. The lesson for investors is simply that complacency is not healthy for bulls or bears and that there are some seismic rumblings out there that bear watching.

What are your thoughts as you watch the events in Egypt unfold?

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Think left and think right and think low and think high. Oh, the THINKS you can think up if only you try!

~ Dr. Seuss, Oh, the Thinks You Can Think

Update: This article was included in the Umpteenth Weekly Carnival of Wealth at Control Your Cash. Thanks!

John Mauldin’s weekly e-letter is a must read for me. His yearly economic outlook letters, even more so. The second part of this year’s outlook came out on January 15th. In it, Mr. Mauldin is Thinking the Unthinkable, and that makes it a perfect subject for the first Friday Food for Thought of 2011.

For new readers, Friday Food for Thought is just an occasional feature at Balance Junkie where I devote a Friday post to an article I found interesting or thought-provoking. Sometimes I’ll choose a longer, more complex article and summarize it here for the time-challenged. Today’s offering is such an article. There’s a lot more to it than I’m writing about here, so I encourage you to go and read the whole thing. While you’re at it, you might want to check out the first part of John’s outlook as well: Forecast 2011: Better than Muddle Through.

The Fed’s Third Mandate

John Mauldin, like many of us, was less-than impressed to hear Fed Chairman Ben Bernanke confirm something that many conspiracy theorists and market watchers have long speculated but never thought the Fed would admit. Apparently, the Fed is indeed targeting stock prices through QE2. Should boosting the stock market really form the third component of the Fed’s mandate?

For the record, the Fed has only two official mandates:

1. Keep prices stable.
2. Create an economic climate for low unemployment.

In a recent interview, Chairman Bernanke was asked how QE2, which was ostensibly supposed to lower interest rates, could be considered a success in light of the recent rise in rates. He responded that QE2 is a success because stock markets have risen. Really?

Now I suppose you could argue that facilitating higher stock prices is one way to improve the economic climate. Higher stock markets create a wealth effect that makes consumers feel ready to spend and employers, confident enough to hire – or so the thinking goes. One is left to wonder, however, what becomes of the free market if stock prices are manipulated higher every time there’s a glitch in the economy? And what about unintended consequences? (See rising commodity prices and global food riots.)

John sums it up as follows:

“Understand, I am not against a rising stock market. But that is not the purview of the Fed. And certainly not a reason to add $600 billion to the balance sheet of the Fed when we clearly do not understand the consequences. If it looks like they’re making up the rules as they go along, it’s because they are.”

A Fisher Fan

Mr. Mauldin views Dallas Fed President Richard Fisher as “a rational voice” on the FOMC committee. He quotes at length from a recent speech in which Mr. Fisher points out that the Federal Reserve is “purchasing the equivalent of all newly issued Treasury debt through June.” He worries that the Fed will be “viewed as an accomplice to Congress’ fiscal nonfeasance.”

Mr. Fisher goes on to observe:

“The entire FOMC knows the history and the ruinous fate that is meted out to countries whose central banks take to regularly monetizing government debt. Barring some unexpected shock to the economy or financial system, I think we have reached our limit. I would be wary of further expanding our balance sheet. But here is the essential fact I want to emphasize today: The Fed could not monetize the debt if the debt were not being created by Congress in the first place.”

Two Unthinkable Thinks

If you’re familiar with John Mauldin’s writing, you know that he usually has a reasonably long list of worries. European sovereign debt and European banks are at the top of his list right now. Although he is relatively optimistic about the economy this year, he, like many of us, realizes that trouble in Europe could throw a really big wrench into the recovery – if not this year, then perhaps next.

Here are a couple of the potential problems emanating from Europe:

• Italy, Spain, Portugal, Belgium, Greece and Ireland: Collectively, these countries will need to raise about $1 trillion this year to cover rollover debt and new borrowing. It can probably be done, but at what interest rates?
• Spotlight on Belgium: Total debt is about to eclipse 100% of GDP and the country is deeply divided politically. John sees this as a story that has the potential to be an issue a few years down the road.

But a potentially larger problem coming out of Ireland is Mauldin’s first unthinkable think.

Will Ireland Go Icelandic?

During last year’s crisis, Ireland guaranteed both the deposits and the debt of its banks. At 30% of GDP, the debt they had to take on do so will be extremely onerous. A greater portion of tax revenues will be necessary to service the debt, leaving a lot less for public services. The bank bonds that the current Irish government has agreed to guarantee are mostly held by German, French, and British banks.

The first unthinkable think goes something like this: A populist backlash from the Irish electorate leads to a new government that decides it will not back the bank debt after all. Iceland did something similar, leaving some in Britain quite angry.

If Ireland chose to tell the ECB, IMF and EU to “pound sand” when asked to bear the burden of Irish bank debt, “Irish bank bondholders could face a haircut of some 80% or more, which is more like a leg amputation than a haircut.” But that “would get their total debt-to-GDP down to a still-high but manageable 100%. Not good, but something they can grow out of over time.”

What If China Slows a Little?

The second unthinkable think challenges the current assumption that China is somewhat immune to the ravages of a normal business cycle. What if China’s growth hits a snag this year due to increasing inflation? “Official inflation is in the high single digits. Unofficial inflation may be running closer to 20%.”

Mr. Mauldin quotes Simon Hunt, who notes that the significant increase in China’s minimum wages suggests that inflation is running a lot hotter than the official figures would suggest. Apparently, minimum wages rose about 20% last June and were hiked another 21% after Christmas.

Anecdotally, Mr. Hunt noted that: “In Shanghai gas prices to the home have risen by some 600% in two years and electricity by over 300%.” Is it possible for the Chinese to engineer a soft landing with inflation levels like this? Mr. Mauldin is not sure whether a Chinese recession will be a reality this year. Rather, he’s pretty sure that they will have one at some point and that “the rest of the world will feel it” when they do.

So a European default and a Chinese recession are two unthinkable thinks that John Mauldin went ahead and thought about anyway. They seem like the two top concerns for many market observers, although, like Mr. Mauldin, no one is able to pin down the timing of either event. They’re just a couple of key concerns to keep in the back of your mind for the coming year.

Do you have any unthinkable thinks on your radar for 2011?

No related posts.

If inflation continues to soar, you’re going to have to work like a dog just to live like one.

~George Gobel

This is an excerpt of an article that was originally published yesterday as exclusive content on another site. You can read the whole thing on Seeking Alpha.

The Food Crisis of 2011 (Excerpt)

Our overview of 2011 What Ifs concentrated on the concepts of bifurcation and biflation. Those themes are already playing out just a couple of weeks into the New Year. Inflation in all types of commodities has ramped up even further, leaving countries like China, India, Brazil, Thailand and South Korea to deal with more than their fair share of these inflationary forces. Meanwhile, easy monetary policy in the U.S. and Europe just adds fuel to the inflation fire.

The United Nations food agency (FAO) kicked off 2011 by announcing that December of 2010 saw food prices eclipse the record levels hit during the 2008 food crisis, which triggered riots in Egypt, Cameroon, and Haiti at the time. The current spike in food prices has already caused violent food riots in Algeria, Tunisia, Morocco, Yemen, and Jordan.  . . .  Continue reading on Seeking Alpha . . .

The article goes on to look at just how much commodities have risen, as well as some of the weather events, financial issues, and demand factors that are driving the rise in prices and the resulting food crisis. Have a look and feel free to comment here, or on Seeking Alpha.

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“Nobody…nobody…knows for sure what it going on,” said he. “On the one hand, there are plenty of excesses and bad investments in China. There must be. We’ve been growing so fast. And there must be a lot of bad debt hidden in the banking system, for example.“But on the other hand, China is booming. There have never, ever been so many people working so hard to make money. It’s a bit like the US probably was a hundred years ago. Only bigger. Faster. And with more government involvement.”

~ Chinese businessman, quoted in The Daily Reckoning

Today we wrap up our 3-part series on China. So far, we’ve looked at the bear case and the bull case. Today, we’ll look at some of the basic similarities and differences between what’s happening in the Chinese economy and what’s happening in Western economies.

Today’s opening quote comes from an article by Bill Bonner of The Daily Reckoning. It was apparently taken from a conversation he had with a businessman from China. I chose it because it seems to aptly represent the polar opinions that characterize the China debate.

If you’re a regular Daily Reckoning reader as I am, you wouldn’t have been surprised to detect Mr. Bonner’s disdain for government meddling. In fact, he goes on in the same article to predict: “They will control too much…and then they will lose control.”

I had a distinct feeling of déjà vu when I read that article, and not just because I’ve heard Mr. Bonner (and many others) express the same sentiment regarding the US government. As a matter of fact, there were a few familiar themes in much of the material I read to prepare for this short China series. Let’s take a look at some of the basic factors that make China’s economy unique, and some that might seem uncomfortably familiar.

China Is Different

I won’t spend a great deal of time on these, as we’ve covered them in the first two parts of this series. You’ll recall that there are a few main characteristics that make China’s property market unique:

1. Size: China is huge in terms of both area and population. What’s more, it has a long way to go before the majority of the potential for growth and development is realized.
2. Government Efficacy: As Byron Wien pointed out in part two of this series, the Chinese have far fewer political hurdles to jump in light of the fact that they do not operate within the trappings of democracy.
3. Less Leverage: The Chinese are voracious savers and tend to buy hard assets with little or no credit.

These factors do separate the Chinese property market from some of the recent markets that have experienced bubbles and subsequent busts like those in the US and Japan.

. . . Or Maybe Not

And yet I found a few recurring themes in my reading that seemed to indicate that China’s markets face some of the same challenges as those in the Western Hemisphere. See if any of these ring a bell:

1. Government Meddling

Many critics complain that the Fed’s quantitative easing programs and the government’s generous bailouts of select companies constitute a level of interference that should not be part of a capitalist economy. I suppose you could argue that, while not ideal, more government interference is to be expected in China’s economy. For a while, it seemed to be helping. They have so far managed to stave off any potential crises.

But the Chinese need to avoid social unrest in order to maintain control of the country, and runaway inflation is something they want to avoid at all costs. The Telegraph article cited in part one of this series observed that, while China’s officially-reported inflation rate hovers around 5%, the price of vegetables has risen 20% in a month. This is reminiscent of the ex-food and energy inflation readings that the Fed uses. Official core CPI readings may not be very elevated, but those of us who frequent gas stations and grocery stores know otherwise.

2. Hidden Liabilities

Jim Chanos warned that, although there doesn’t seem to be a lot of debt in the Chinese property market on the surface, much of it is hidden in local financing vehicles and kept off balance sheet. In fact, the Royal Bank of Scotland recently recommended buying CDS on China’s 5-year debt as a top trade for 2011. (See the Telegraph article mentioned above.) It’s not that they see a sovereign default in China’s future, but they do see a risk that efforts to cool inflation may trigger a hard landing in the property market and the economy as a whole.

A rise in interest rates due to  inflationary pressures would cause the cost of servicing the debt on fractionally-utilized infrastructure to rise above the income these projects produce. A Zero Hedge recap of the HSBC report on China observed that the “Wuhan to Guangzhou bullet train, which started operating earlier this year, was running at less than half its capacity and would never make enough money to pay off the loans used to finance it.” One can only imagine that this dynamic is not restricted to this one project, and that its effects would be exacerbated by rising interest rates.

Of course, hidden liabilities are not exactly rare in the Western banking system either, especially since FASB suspended mark to market accounting. Off balance sheet items remove the transparency from markets. So in that respect, our financial system is not much better than China’s.

3. Vested Interests Control the Rules

We touched on this in part one of this series as well. While the central government tries to institute changes to cool the property market and economy, some of these measures are not being carried out on the ground. Special interest groups negotiate favourable arrangements at the local level and the bubble continues to inflate. So Mr. Wien may be correct in his assertion that it’s a little easier to get things done in China, but there seem to be a few signs of crony capitalism creeping into Communist China.

Similarly, the powerful financial and energy lobbies have been the subject of criticism for quite a while in the US. There are accusations that they have had an outsized influence on policy and that this influence has caused irreparable damage to the global economy: GM killed the electric car and then resuscitated it years later to pull itself out of a taxpayer-subsidized bankruptcy process. Goldman Sachs got a sweet deal on its AIG CDS. The financial lobby successfully watered down the financial regulation bill. Numerous banks committed fraud in the foreclosure process. All of these accusations have been leveled, but not yet proven, and certainly never prosecuted.

These are just observations that occurred to me. I don’t know what impact they will have on how all of this turns out. I would, however, welcome your thoughts. Am I just seeing things or do some of these themes seem rather familiar?

What Can We Conclude?

With all of the information we’ve looked at over the past week, what can we conclude about China and the prospect of a property bubble there? I’m afraid we’re still left with many questions that only time can answer. Further, any answer has to come with a time frame. Most people (bears and bulls) seem to acknowledge China’s long-term economic advantages.

If, however, China is experiencing a true bubble, it will pop at some point. The trade for that scenario would be to short commodities and watch for collateral damage, especially in markets like Brazil, Australia and Canada. If China’s growth story can continue without a severe correction, then the trade is the opposite, and the entire global economy (especially other strong emerging market economies like India and Brazil) would likely benefit.

The Chinese may or may not have a lot of leverage in their property market, but the market players betting on the Chinese miracle most certainly do. If that crowded trade rolls over, it will likely be more swift and violent than the subprime liquidation. It may also represent a unique long-term buying opportunity.

Do you think China’s unique position will allow it to cool its property market, or are they subject to the same influences as the rest of the world?

Related posts:

1. China: The Bear Case
2. China: The Bull Case