Global Agenda: Waiting for the cavalry

By PINCHAS LANDAU
October 26, 2007 00:24

There is no justification for putting any kind of optimistic gloss on the state of the American economy.

4 minute read.



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There is no justification for putting any kind of optimistic gloss on the state of the American economy. It, therefore, must be admitted that last week's column, which sought to present the situation as still being "a matter of belief" - between those prepared to accept at face value the data and projections of the big American commercial and investment banks regarding their own businesses and the wider economy, and between those claiming that the banks were detached from reality - was just whitewash. There are no two sides and nothing to debate, any more than there is a debate with two opposing sides as to whether the Earth is flat, or the moon is made of green cheese. There is only reality and make-believe. In the world of reality, the situation is deteriorating relentlessly, in line with the axiom proposed here a couple of months ago, namely IKGW - it keeps getting worse. This week brought a deluge of IKGW news: the biggest ever month-to-month fall in sales of existing homes, a quickening rate of decline in house prices and other horrors from the housing front. On the banking front, in addition to more banks announcing large write-downs, Merrill Lynch came back just three weeks after pre-announcing a $5 billion write-down of subprime mortgage losses, to say that actually it wasn't $5b. in the third quarter, but rather, er, $8b. - and that no one should think that's the end of the story, because the crisis, losses and write-downs will continue in the fourth quarter and into 2008. Nomura, the biggest Japanese brokerage, also took its subprime medicine and, like Merrill, ended up with its first quarterly loss in several years. In the wider economy, durable goods orders fell again and unemployment claims stayed high - both defying predictions of an improvement from miserable data in the previous month. There was more of the same from the US, while data from Europe showed that the EU economy is also slowing and the banking sector there is cutting back on lending even more sharply than the Americans. Given this bleak picture and even bleaker outlook, it seems extraordinary that most share markets around the world are still at or near record highs. This phenomenon becomes even more remarkable in light of the rapid rise in government bond prices in the US and Europe and the consequent fall in yields. Normally, a rush to buy government bonds reflects a desire to get out of riskier assets and into the least risky financial asset available. If so, one would expect share prices - and, for that matter, commodity prices - to fall, but exactly the opposite is happening. Most equities and most commodities are rising, in many cases sharply. So what gives? A simple way of seeing what's going on would be to trace what happened in the US markets on Wednesday. The day began with a hefty dollop of woe, most notably the Merrill Lynch second-round write-down noted above. Then came a sharp fall in weekly data on inventories of crude oil and distillates, although the expectation had been for a small rise. This latter sent oil prices soaring, after they had pulled back from last week's record price of $90 a barrel to around $85. Merrill, plus oil inventories, plus some lesser items caused the share market to plummet after it had recovered on Monday and Tuesday from Friday's heavy falls. By early afternoon, the Dow Jones Index was off some 200 points - about 1.5% - with the Nasdaq and other broader indices falling by as much as 2.5%-3%. Commodities were mostly weak and the dollar gained against all currencies except the yen. However, by the time the session closed, the Dow was flat and the Nasdaq had retrieved most of its earlier loss. Commodity prices had partially recovered and the dollar had given up most of its gains. What happened to turn things round? The substantive answer is - nothing. The unsubstantive answer is that rumors started flying that the Federal Reserve would cut interest rates even sooner than its next meeting (scheduled for next week!), and/or would cut rates by one-half percent rather than one-quarter percent, as was universally expected. This was sufficient basis for everything that happened in the morning to reverse itself in the afternoon. It should be stressed that almost all economists accept that even if the Fed cuts rates sharply, ot will not solve any of the big problems connected with the subprime crisis or prevent much of the corporate and consumer pain that is being increasingly felt. It should mitigate the severity of all the problems and might perhaps prevent the economy sinking into a general recession, or at least make any recession shorter and shallower than it would otherwise be. In other words, for the real economy, interest rates are an important, but distinctly secondary factor. But for the financial or money economy, interest rates are still the dominant factor. If rates fall, that means the Fed is pumping more dollars into the economy. This extra money should generate more economic activity, but it will first and foremost find its way to the financial markets. There its immediate impact will be to push share prices higher (a rising tide...), but the fall in dollar interest rates relative to other currencies will cause the dollar to weaken and dollar-denominated commodity prices to rise. So the mere rumor that the Fed might cut rates sooner, or by more, than is anyway expected acted like the sound of bugles heralding the arrival of the cavalry to save the besieged wagon train from the blood-thirsty savages. In the world of make-believe, rumors are enough to deliver salvation - at least temporarily. In the world of reality, nothing less than the physical arrival of the cavalry, in large numbers, can save the situation - and even that's far from certain. landaup@netvision.net.il


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