China's Gold

Needless to say, throughout the turmoil of the last year, the forecasts for most asset classes have been bearish. However, many speculators have been bullish on China and gold, largely because of what’s happening in the rest of the world. Indeed, many of those who predicted the crash—such as Jim Rogers and Peter Schiff—argue China and Gold are the only safe assets to hold over the next couple years. Maybe the futures of these two are more related than it seems.

China seems to be doing great. The latest economic figures on housing, auto sales, and commodities are quite good. Goldman Sachs recently upgraded growth forecasts for 2009 to 8.3% from 6% and, for 2010, to 10.9% from 9%. And, best of all, new loans in March were 29.8% higher than a year earlier!

I wrote in my last post on the question whether, “horses will drink,” a reference to the question whether increasing the money supply will increase the velocity of money. China doesn’t have that problem. While the US can encourage banks to lend and use TARP money to make loans (most haven’t), China only needs to say the word, and it’s done—one of the benefits of an authoritarian government.

But is this really a benefit? It seems so in the short run, but in the long run it can mean losses from sloppy lending, especially in a country with crony capitalism. A lot therefore depends on the much-asked question whether China can survive without strong exports. Economists are divided on the issue. There is data that shows only 8% of China’s workforce is involved in export industries. Either way, it is hard to imagine how China could keep up its growth without external demand and capital at current levels of domestic spending. For that reason, much depends on Chinese consumer spending. James Kynge wrote in his famous book China Shakes the World in early 2006 that Chinese consumer spending should “hit us in two or three years.” The world, as well as the largest shopping mall in the world in Dongguan—nearly empty, is still waiting.

People’s Bank of China governor Zhou Xiaochuan recently gave a speech on China’s “superior system advantage.” In it he argued the country’s low interest rates, stimulus, and new medical system will boost domestic spending and bring China, and the world, out of recession. The health service plan is seen as a key part of boosting consumption. Chinese generally save at much higher rates than the rest of the world. Many think the higher savings rate is a result of uncertainty about the future, and that a social safety net would greatly increase consumer spending. While this may be so, China’s new health care system will not function for many, many years. So of these three variables Zhou Xiaochuan mentioned, only one has a substantial effect of raising consumer demand and it will not be in effect for years.

The government must, therefore, rely on itself. It must spend its way to economic growth, and though its reserves are vast, it may be more limited than it seems. Zhou Xiaochuan has been in the news recently after calling for a new reserve currency from the IMF, echoing Premier Wen Jiabao’s call for guarantees on China’s dollar holdings. And for good reason: China is in a sticky situation with its dollar assets. In the short term, selling treasuries would drive down the price of treasuries, raising interest rates and hurt Chinese exports even more by raising the value of its currency. In the long term, inflation in the US could wipe out their value. China is treading a thin line between stimulating its consumers and hurting its exports. For that reason, China needs a new reserve strategy.

One option is gold. In fact, the FT reported a few days ago China’s gold reserves had jumped drastically to 1,054 metric tons. The dramatic shift is evident in the graph below, which is from before its acquisitions were public. China's true holdings should be around those of Switzerland.

Of course, gold could never replace the dollar as China’s main reserve asset. China is a lot more important to gold than gold is to China. Gold has been struggling to stay high after the fear frenzy of the stock market crash burned down. If China decides to put more emphasis on gold, which is likely considering its problem of holding too many dollars, gold could rise above $1,000 per oz, much like China did for copper earlier this year.

Will the Horses Drink?

Policymakers’ strategy to fight the recession and credit crunch has been to make vastly more funds available through fiscal stimulus, low rates, and quantitative easing. Ironically, to get the country back on track requires encouraging the exact behavior that got us here in the first place. It is not possible to delever all at once because of what PIMCO’s Paul McCulley calls the “Paradox of Deleveraging”—deleveraging causes asset prices to fall thus increasing debt to equity. It is hard to imagine how recovery can occur if the consumer delevers as this would mean a fall in consumption—70% of GDP. The government has made massive amounts of funds available, the question is how will people behave. Just taking a horse to the watering hole doesn’t necessarily mean it will drink.

The question is one that goes back to an intellectual dispute between economists Milton Friedman and Irving Fisher about the Great Depression. Friedman argued the Fed could have prevented the Great Depression by increasing the money supply. Fisher argued once a credit bubble has burst, deflationary pressures will be so strong consumer behavior changes no matter if credit conditions change. Easy money or “candy floss money” increased asset prices in the “forward Minsky journey” until the Minsky Moment, when assets and debt deflate. Easy money has to be repaid with precious hard money. The question is whether the government can reinflate or whether consumer behavior has changed to the point where this is impossible.

This question largely depends on asset prices. Personal savings to personal income was around 10% in the 60s, 70s, and 80s, though ever since the rapid increase in asset prices during the 90s it has fallen to almost 0%. This article illustrates this trend. As asset prices fall, personal savings as % of personal income should increase, especially since incomes will fall as well. We've already seen an increase in the savings rate.

Remember the macroeconomic equation MV=PQ. The money supply (M) is increasing but the velocity of money (V) is decreasing. If the velocity of money doesn’t pick up, it will have a negative effect on production (Q) and price (P). If consumers and businesses don't retrench to far, the velocity of money will pick up and Milton Friedman will have been correct. (If it increases close to 2007 levels it will mean massive inflation.)

There are also non-behavioral impediments to the velocity of money. For example, massive downgrading from ratings agencies or perceived counterparty risk. Another example is Obama’s new restrictions on credit card rates. One reason for these high rates is because companies need to charge these rates to cover their huge default rate. These new rules will mean credit card companies offer less loans since they can’t charge a return high enough to compensate for the risks. We already saw revolving consumer credit fall at a 9.7% annualized rate in February. Politically motivated policies like this one (or Barney Frank calling for TARP repayments) can push the velocity of money even lower, feeding the deflationary spiral.

Financial Services and Innovation

In my last post, I mentioned the City Hegemony Thesis of Britain’s economic decline. Today, I will compare a few main ideas from this theory with trends in the US. The CHT argues Britain’s global expansion in the 19th century created a large and powerful financial services industry (the City) which ultimately damaged domestic development. London was at the center of an empire which, especially after WWII, maintained its influence mostly through finance. As a result, the City flourished and gained significant influence over the government, using this influence to insure favorable free trade and laissez-faire policies. The UK went from being a center of economic innovation to one of financial innovation.

Economists have questioned whether the free market policies pushed by the City were the best policies for the UK. These policies meant capital moved efficiently to where it received the highest return with the lowest risk. Though this benefited global economic development, it hurt industry because capital was moving to sectors that did not facilitate real growth within the UK.

Here in the US, a similar thing has happened. We have lost the true purpose of the financial services industry. The main purpose of financial services, the reason these firms exist, is to provide financing and allocate capital. Financial services have built a completely new business model. If one includes the financing arms of industrial companies like GE and GM, financial earnings have represented 40% of recent S&P earnings (before 2008)! Capital is no longer a driving force of innovation but a method of speculation and arbitrage.

In the UK, the City’s allocation of capital neglected domestic industry and innovation. In the US, capital pushed mortgages and housing prices rather than innovation. Ever since the dotcom bubble, fund raising for private equity (top) and venture capital (bottom) has diminished.

Same trend for IPOs:

But Hedge Funds have boomed:

That’s not to say the growth of the financial services sector is necessarily a bad thing. Even financial product innovation can be a positive force if they were traded on exchanges rather than OTC. The most negative development has been the structural innovation. Financial firms should return to their core competencies and stay there. Investment banks should do less speculating and more underwriting. Commercial banks should do less investment banking and return to borrowing at 3, lending at 4, and golfing at 5. Speculation should be the business of hedge funds; their systemic risk is much lower since they aren’t too big to fail. (Some would argue LTCM was an exception, but what made LTCM a systemic risk was the action of its counterparties, the investment banks.)

Financial services need to recognize they have a responsibility beyond their shareholders. For example, the Lex column this Wednesday displayed a graphic showing the differences between financial recessions and normal recessions.

Bigger Booms and Bigger Busts

One theory of Britain’s decline called the City Hegemony Thesis argues the City’s vast influence over the government prevented the UK from making effective economic policies. One hypothesis of why power was accumulated in the City—the UK’s financial services industry—is that the government relied on the financial sector to prop up Sterling since other countries held more in Sterling than the Bank of England could ever pay (a remnant of the British Empire). To prop up Sterling, the City needed to keep a high interest rate, thus harming industry at home.

One enabling factor for the City’s influence was organization of the UK government. As a part of the Westminster model, monetary and fiscal policy was determined by the Chancellor of the Exchequer. Much like fiscal policy is used in the US, this structure has led politicians to use monetary policy to give themselves a boost before an election. (Harold Macmillan set the precedent in 1959 when he used inflationary monetary policy to achieve a 21% swing in public opinion)

In 1997, then Chancellor of the Exchequer Gordon Brown took action against this trend by granting the Bank of England’s Monetary Policy Committee the power to set interest rates with little oversight. He declared, “For 40 years our economy has an unenviable history, under governments of both parties, of boom and bust…ten years ago and for decades before, Britain’s stop go economy was also held back by chronic underinvestment.” This phrase—the end of boom and bust—became Gordon Brown’s rallying call (one that will surely hurt him in the next election). The following is from a conservative blog:


Until recently, the “end of boom and bust” idea bought Brown enormous political capital. It was seen by many as a success because interest rates went down without increasing inflation.


Now, the idea seems ludicrous. Low rates, incredibly “light touch” regulation, and a giant financial sector can never mean the end of booms and busts, only bigger booms and bigger busts.

Greenspan's Risk-Based Monetary Policy

A new book by economist John Taylor called Getting Off Track assigns the cause of the current financial crisis to monetary policy errors starting in the early 2000s rather than “any inherent instability of the private economy.” This argument is a direct attack on Greenspan’s account of the crisis, who argues the cause was not low rates but misguided ideology. Taylor argues Greenspan should have never strayed from the Taylor Rule (Fed funds rate=1.5*(inflation rate) + ½(gap btwn actual and trend GDP)+1). Greenspan set the fed funds rate significantly below the Taylor Rule only three times: during the ‘87 crash and S&L crisis shortly after attaining office, during the Asian/LTCM financial crisis of 1998, and after the dotcom bubble as shown below.

None of his previous deviations were nearly as severe as the one from 2001-2005. This is by no means a new criticism. Greenspan has taken a lot of heat for these policies since as far back as 2005.

In the early 80s, when Paul Volcker had just started on his onerous task of tackling inflation, there was a debate among economists what policy he should follow. Milton Friedman advocated a non-activist, strict rules approach. However, Volcker and Greenspan both followed a rules-based approach with discretion. What this translates to is a rules-based policy except during crises. Taylor argues strict policy gets better results because Greenspan and Volcker's approach surprises economic agents or leaves them guessing about what the government intends.

Greenspan’s response to Taylor in a recent post on the FT’s economist’s forum is, “Taylor and others derive their simulations from model structures that have been consistently unable to anticipate the onset of recessions or financial crises. This suggests important missing variables. Counterfactuals from such flawed structures cannot form the basis for policy.” Greenspan's response stresses the uncertainty involved in economics and the need as a policymaker to incorporate these risks into policy.

It’s too easy to criticize Greenspan after the fact as many have done. Greenspan’s loose monetary policy was based on a “risk-based” approach. In the early 2000s, the “lost decade” of the Japanese hung heavily over Greenspan’s head. Greenspan saw how a failure to act promptly by monetary policymakers to remove deflationary expectations sent the country into a ten-year malaise. After the dotcom bust, Greenspan recognized a small possibility this could occur in the US. Though the risk was small, the huge negative effects this would have on the country was worth the inflationary policies. In this way, Greenspan created a black swan to protect from another one.

If Greenspan is to be criticized, it is for what he calls his “ideology,” his unflinching belief in free markets. Greenspan had the power to regulate Wall Street, derivatives, and mortgage lenders. The Gramm-Leach-Bliley Act (the one that repealed Glass-Steagall) made the Fed the “umbrella supervisor” of financial holding companies, giving Greenspan all the power he needed. Paul Krugman said, “(Greenspan’s) rate cuts helped make the bubble possible, but I’m not sure there was an alternative…What Greenspan did not do was listen to warnings about subprime. The Fed had substantial regulatory and moral-suasion power. They could have done a lot to limit the excesses.”

Greenspan’s deep skepticism of the abilities of regulators and strong belief in the self-regulatory effect of communal self-interest caused him to ignore the apparent excesses in these industries. Testifying recently on Capitol Hill, Greenspan conceded, “I made a mistake in presuming that the self-interest of organizations specifically banks and others was such that they were best capable of protecting their own shareholders…Loan officers of those institutions know far more than…our best regulators at the Fed were capable of doing.” This “solid edifice” of free markets broke down.

It is puzzling to me how Greenspan could have looked at the Case-Shiller Housing index and not realized it was a dangerous bubble. Greenspan probably thought the increase in asset prices was a good thing. He said in a speech at the Federal Reserve Bank of Kansas City in August 2005, “Lowered risk premiums—the apparent consequence of a long period of economic stability—coupled with greater productivity growth have propelled asset prices higher. The rising prices of stocks, bonds, and more recently, homes have engendered a large increase in the market value of claims, which, when converted to cash, are a source of purchasing power. Financial intermediaries, of course, routinely convert capital gains in stocks, bonds, and homes into cash for businesses and households to facilitate purchase transactions. The conversions markedly have been facilitated by the financial innovation that greatly has reduced the cost of such transactions.”

The problem with this theory was that as asset prices grew, consumers started saving proportionally less since they viewed themselves as wealthier. Now that this wealth has come crashing down, Americans are worse off than before. Therefore, by hedging against deflation with loose monetary policy, Greenspan unknowingly created even more risk of deflation by decreasing consumer purchasing power.

In the context of rules vs. risk-based monetary policy, it is interesting to look at the distinctly different ways with which central banks have handled the current crisis. With its aggressive rate cuts and use of quantitative easing, the Fed and Bank of England have embraced a risk approach. The ECB on the other hand, has been much more cautious, lowering rates to only 1.25%. In a recent interview with the FT, Trichet alluded to how “excessive pessimism” after the dotcom bubble pressured central banks to lower rates too far - a clear reference to Greenspan's low rates.

Naturally, Trichet also faces a different political situation since the Eurozone can’t implement a fiscal stimulus. But there is a strong argument for quantitative easing. Paul McCulley in a recent speech posted on the PIMCO website said, “What intrigues me the most right now is the concept of global Competitive QE, rather than competitive tariff hiking or competitive currency depreciation. If all countries, or most major countries anyway, “go QE,” then the global game changes from fighting for bigger slices of a too-small global nominal aggregate demand pie to actually correlated efforts to enlarge the nominal pie…There need not necessarily be any explicit coordination between countries, because those that choose not to play will likely experience a rise in their real effective exchange rate, a deflationary impulse to their underutilized economies. Thus, there need not be an explicit enforcement mechanism to propel Competitive QE, merely individual countries acting in their own best interest. This is the best kind of cooperative behavior, explicitly because it need not be coordinated, but rather brought about by, you guessed it, Adam Smith’s invisible hand!” QE has gotten a lot more attention recently in the financial media; central bankers should do as well in a global economy beset with deflationary risk.

More Mortgage Carnage Still to Come

Forget subprime, the new problem child of the mortgage industry is payment option ARMs (Adjustable-rate mortgages). A payment option ARM (POA) is a type of mortgage that was especially popular from 2004 to 2007. POAs give borrowers options for each monthly payment: they can either pay the interest plus amortized equity, only the interest, or less than the interest. If a borrower chooses to pay less than the interest the amount of interest not paid is added to the total debt. This is called “negative amortization” because it keeps current mortgage payments artificially low by increasing future payments (mortgage lenders called it the “I’ll worry about it tomorrow option”).

There were $500bn POAs originated in 2006 and 2007 (a strong upward pressure on housing prices). These mortgages are a looming disaster because after a few years of negative amortization these mortgages are reset so homeowners have to pay a rate that amortizes the loan over the rest of the 30-year period. For many homeowners this means their monthly payments will double after their reset date.

Also, the borrowers of these loans were qualified at the starting low rates of 1-3%. Mortgage lenders weren’t worried about their qualifications because as long as housing prices kept increasing they had little risk of loss. Not surprisingly, mortgage research found that roughly 75% of these borrowers chose the negative amortization option. The real breaking point for these borrowers is going to be when their mortgages are reset and they have to pay enormous monthly fees. Considering these borrowers were never qualified to begin with and unemployment is increasing, it is not hard to imagine how it will affect defaults. The following chart from the IMF (via Credit Suisse) indicates the carnage ahead:



All financial institutions will be affected by this, but mostly Bank of America. Countrywide (which Bank of America acquired in January 2008) was the largest POA originator. Angelo Mozilo, Countrywide’s CEO, wanted these loans so badly he paid a 3% premium for them from brokers, further encouraging quantity over quality. When Countrwide was acquired, it held $98 bn of these mortgages on its balance sheet under the asset class “held for investment” so they wouldn’t have to write them down. From Chain of Blame, a detailed account of mortgage lending, “for $4 billion Bank of America was buying a potential black hole.” That is, of course, assuming Bank of America can’t get rid of its bad assets to the PPIP.

It was very depressing seeing the chart above for the first time today. It’s more evidence that the current optimism about the financials is overdone.

Pirate Struggle Underscores Importance of Gates' Defense Budget

The extended pirate standoff that finally seems to have come to an end today with the freeing of Captain Phillips underscores the prudence of Secretary of Defense Robert Gates’ new defense budget. Gates plans to shut down many expensive projects like the F-22 and the presidential helicopter in favor of unmanned aircraft and other weapons more apt at fighting insurgency warfare.

In his press conference, Gates said his budget will “reshape the priorities of the American defense department.” He said, “Every defense dollar spent to over-insure against a remote or diminishing risk or in effect to run up the score in a capability where the US is already dominant, is a dollar not available to…improve capabilities in areas we are under-invested and potentially vulnerable” Therefore, Gates is preparing the US for both conventional warfare (in which the US is by far the leader) and insurgency warfare. As Politico points out, a foe like Iran would use both types of warfare.

The Somali pirate situation is another example of how guerilla type fighting is replacing conventional warfare. The US military needs to be more flexible--unmanned aerial vehicles and increased intelligence is a step in this direction. The Somali pirate situation is similar to when Iran sent small, quick warships to swarm a US navy squadron in the Strait of Hormuz in January 2008. The Iran speedboat and Somali pirate situation are reminiscent of the Battle of Salamis during the Greco-Persian Wars when a Greek fleet of small, nimble ships destroyed a far superior Persian fleet of larger ships. The effectiveness of such strategies underscore the need to develop a new kind of weapons.

Bonds for the Long Run?

A recent article by Rob Arnott of Research Affiliates called “Bonds? Why Bother?” published in the Journal of Indexes shows how the risk premium of stocks over bonds (20 year treasuries) is not the accepted 5% but rather 2.5%. He writes, “Over this full 207-year span (1802-2009), the average stock market yield and the average bond yield have been nearly identical. The 2.5 percentage point difference in returns had two sources: inflation averaging 1.5% trimmed the real returns available on bonds, while real earnings and dividend growth averaging 1.0 percent boosted the real returns on stocks. Today, the yields are again nearly identical.”

As the chart below shows, at current market levels bonds even outperformed equities the last 40 years—so much for stocks for the long run!

As John Mauldin points out in his book Bulls Eye Investing stock performance depends almost entirely on when you buy in and how long your holding period is. Logically, if you buy closer to a peak and sell closer to a bottom your returns will be much lower, possibly even negative. In his book, Mauldin stresses the importance of assessing market valuations for asset allocations.

I disagree with this article in its assertion that “Mr. Arnott’s article is shocking stuff!” Arnott’s research cannot be considered especially surprising considering the definition of a risk premium. Increased reward naturally correlates with greater risk, whether short-term or long-term. Statistically, it makes perfect sense. But is the increased risk of stocks worth the extra 2.5%? Arnott’s chart above clearly shows that for the last 20 years and even 40 years this was not the case.

However, at the same time, Mauldin’s principle of stock valuations and timing applies to bonds as well. Bonds only outperform stocks if one sells stocks and buys bonds at a very precise moment in time. Bonds may have outperformed equities 1929-1949; however, buying bonds only four years earlier would have earned a lesser return than stocks even through the entire Great Depression. For example, buying bonds instead of equities at current market prices is a terrible idea (remember with bonds I mean 20-year treasuries). Not only are bond yields low but with loose monetary policy and excessive debt, inflation is a significant risk.

If there is anything the chart above shows it is not the superiority of bonds but the predictable boom-bust gyrations of equities caused by what Keynes called our “animal spirits.” If an investor can avoid buying equities for the long-term when the market is clearly brimming with irrational exuberance then stocks should outperform bonds. A good indicator of this is the fear index at marketpsych.com. In general, I would not buy equities while this fear indicator is at its low.

This adds a new dimension to "be greedy when others are fearful."

Dotcom Outliers

I recently finished Malcolm Gladwell’s new book Outliers, in my opinion his best book yet. I was especially interested by what he said about birth year being a strong determinant of success. He used the birth dates of successful computer and Gilded Age entrepreneurs to support his conclusions. The evidence is compelling. Intuitively it makes sense as well. You have to be born at a certain time to be able to take advantage of a wide open field or a “blue ocean” as they say in the business world.

I was curious to see if this is true for Internet entrepreneurs as well. I did some quick research and came up with the following data:

There’s a few interesting trends I noticed. First, you can tell the strong divide between original internet companies like Yahoo! and Google and Web 2.0 companies like Twitter and YouTube. One difference between these two groups is not only the date founded but how they were educated. Web 2.0 entrepreneurs were much more self-educated while original internet entrepreneurs studied computer science at Stanford. The internet probably enabled self-education and made a degree from Stanford less important.

Also, these entrepreneurs were very similar in age when they started their respective companies. On average, these entrepreneurs were 29 years old, with a coefficient of variation of .136 implying very little variance from the mean.

The most interesting trend from this data, however, is the similarity in ages of partners. The success of these companies was very dependent on teamwork. Though ages of the entrepreneurs in general vary, the partnerships were always very close in age. Not a single sample of partnerships has a coefficient of variation more than .08. This also makes intuitive sense since people are more likely to become close friends and start a company together if they are the same age.

Reading about these enormously successful though very young entrepreneurs makes me think, what is the next new thing? The consensus seems to be alternative energy, but who knows.

The End of Cramerica (Hopefully)

I’m sure many of you, like me, have followed the Jim Cramer/Jon Stewart spat with relish. I’ve never been a big fan of his show, though he is entertaining in an O’Reilly, Hannity, Chris Matthews sort of way. However, my reasons for not being a “Cramerican” have little to do with his infamous Bear Stearns and Wachovia stock picks, but with his disingenuous and misleading rhetoric. I have to agree with Ben Stein that you can’t condemn someone for bad stock tips, no matter how stupid they might be (NYT).

The first I ever heard of subprime was Cramer’s August “meltdown.” In this segment of Mad Money, Cramer raves that Bernanke and Bill Poole have “no idea” what’s going on in the market. He yells: “I have talked to the heads of almost everyone of these firms in the last 72 hours, and they have no idea! My people have been in this game for 25 years and they are losing their jobs! The Fed is asleep!”

There is so much ironic about this segment I don’t know where to start. First of all, he blames Bernanke and Bill Poole when it is his “people” that are the problem. (Especially his good friend Angelo Mozilo who frequently appeared on Mad Money promoting Countrywide) Secondly, he starts the segment criticizing Bear Stearns’ for disrupting the market by calling fixed income market worst of 22 years; however, in calling financial markets “Armageddon” he does the exact same thing. Third, while he is raving about the problems financial institutions are having, the subtitles on the screen say “Bear Stearns: leveraged finance positions manageable, well-hedged, prudently funded.” This final example is why I can’t stand Jim Cramer.

On a later CNBC show, as a guest commentator, Cramer goes on a rampage about how the individual investor is getting screwed. He calls financial institutions “disingenuous,” saying they are taking advantage of Main Street. This is especially ironic when one considers how Cramer made money as a hedge fund manager. In a private interview that was never intended for the public, Cramer describes how he disseminated false information and manipulated markets, feeding information to WSJ journalists. He also fervently promoted the site TheStreet.com on Mad Money, of which he is the majority shareholder. He is just as disingenuous as the institutions he criticizes.

The problem is not Jim Cramer, it is CNBC and financial media. He should never have been slated to give investment advice. He is not even an investor. He is a lawyer or a trader not a security analyst. He calls more bulls than a cattle rancher. The only reason he has his job is he is loud. And that is how financial media works, whoever yells loudest is listened to. Before the crisis got too bad, CNBC would bring on bears like Nouriel Roubini and Nassim Taleb and laugh at their prognoses. Bulls rule CNBC, that is why I do not watch it.

And this isn’t even Cramer’s first big bust. His first bust was during the dotcom bubble. He started a dotcom (TheStreet.com) that reached up to 60 a share before falling to 6. Described as one of the loudest voices of the internet bubble (big surprise), he said afterwards on the Today Show, “and I can tell you, that it’s a sobering and humbling experience. I feel I went from being, you know, top of the game to pretty humiliated. Yeah it’s over. The gold rush is over…What’s next for me? It’s called coaching fifth grade soccer. There I can accomplish everything I want in life. I can make everybody happy at home and have something to show for it in the end. I’m done with the material stuff” (Clement Schonfeld, “High Price of Research” Fortune magazine).

He should have kept his word.

Obama, NATO, and Soft Power

This summer while living in Berlin, I watched Barack Obama give his historic speech at the Siegessäule in the Tiergarten. Apart from getting a nasty sting from a bee outside the Chancellor’s apartment, it was a great experience especially after being scorned by Germans for the last eight years for being an American. My close relatives would disparage American “imperialism,” even though it was often clear they did not fully understand the situation. For this reason I was surprised that the crowd’s cheers didn’t die down when Sen. Obama called for increased European involvement in Afghanistan.

It is almost a year later and Obama has reiterated his call for increased European support in Afghanistan, but this time as President. Even though Germany and Europe as a whole hold Obama in high regard, their commitment of 5,000 extra troops and trainers is nothing in comparison to the US’ 21,000. In a press conference after the summit, Obama expressed satisfaction with the number, calling it a “down payment.” However, Politico reported the outcome represented a limit on Obama’s diplomacy. The article argues European adulation of Obama does not translate into new policies.

I do not agree with Politico’s conclusion. Obama might yet see dividends from his diplomatic efforts. In fact, I would be very surprised if he doesn’t. The main barrier for European support in Afghanistan is domestic political sentiments. Before the election in an interview with Bill O’Reilly, Obama said the reason Europeans won’t fight is because of a strong anti-Iraq attitude in Europe. When O’Reilly sarcastically asked if Obama was going to change this with his “magic wand,” Obama replied he would engage in “deliberate diplomacy” and change policy in Iraq. So far he has stuck to his word. He has shifted troops from Iraq to Afghanistan and stuck to his diplomatic attitude.

There is a distinct difference between US diplomacy with the EU and countries like Russia and China. The EU seem much more genuine. Their policy positions are based on domestic situations within their countries, while Russia and China use diplomacy more as a game to further their interests. During the G20, the European position against a coordinated stimulus was based on the economic situation within their borders. Their demographic situation means large government debt is particularly precarious—that is not diplomacy that is a reality. During the NATO summit, European leaders do not have the political capital to send troops to Afghanistan. European public opinion needs more time before it will accept this. Sarkozy already took a big step rejoining NATO. Merkel needs to wait for this year’s elections before attempting any such move, especially while her CDU is gradually losing votes to the FDP. Maybe that is what Obama meant when he called NATO’s decision a “down payment.”

Now compare that to Russia and China. A few days before G20, Medvedev and Hu met to discuss an alternative global reserve currency. STRATFOR considers much of Russia’s actions, such as their response to the US’ planned ABM system in Poland, to be diplomatic huff intended to draw concessions. About China and its recent calls for a new global reserve currency, STRATFOR writes, “None of this amounts to anything substantial, and China knows it — the purpose is to put the United States in a defensive position ahead of the summit, thus pre-empting potential criticism aimed at China from any direction. In truth, China wants to protect the value of the dollar to maintain the worth of its own dollar-denominated investments. Deep down, China sees the U.S.-centered global system as essential, and does not wish to stir up bad feelings with the United States, which would only postpone global economic recovery.” The Europeans might be stubborn, but at least they are honest.

At first I was hoping Obama would resurrect the United States Information Agency as McCain had pledged during the campaign. I no longer think this is necessary. Obama does a good enough job interacting with foreign media that there is no need for it. Consider his interview with Al-Arabiya, his town hall meeting in Strasbourg, or even small gestures such as allowing foreign media to ask him questions during press conferences. Obama has embraced soft power and eventually this will protect him from more than shoes at an Iraqi press conference.

Risk Regulators and Risk Accountants

The news today that KPMG is being sued over its audit of New Century Financial, the collapsed mortgage lender, especially grabbed my attention. Not that it was surprising. Auditors have not caught a break all millennium, being first blamed for Enron and then having to completely re-organize the industry in the wake of Sarbanes-Oxley. If the allegations of the plaintiff, the liquidating trust of New Century, are even somewhat true, it represents the further inability of auditors to remain independent from its clients.

The plaintiffs make some bold claims. They blame KPMG for neglecting their role as a watchdog. In their view, if KPMG had correctly audited New Century’s loan reserves then New Century would not have disseminated subprime loans like rabbits in Australia.

This claim makes little sense to me if one considers the operations of New Century, but it brings up an interesting comparison. Regulators and auditors perform a similar role in the economy. Both operate in the public trust and provide functions crucial for a healthy economy. Both must avoid falling under the sway of industry and both have a long list of failures under their belt. Regulators are as liable for New Century’s failure as its auditors. As Sec. Geithner said before the Financial Services Committee the other day, “Lax regulation also left too many households exposed to deception and abuse when taking out home mortgage loans.” From Chain of Blame, a recent book about the origins of Subprime, “New Century largely depended on owners treating their homes like ATMs, withdrawing cash as…their equity expanded.”

With re-regulation one of the G20’s biggest goals and Geithner calling for “new rules of the road,” why doesn’t accounting change as well? Just like the US regulatory system, the current US accounting system is malfunctioning. We can do bettah!

My accounting professor described financial statements as a “portrait of an entity’s resources, claims against those resources, and changes in those resources over time.” But that’s easier said than done. Financial innovation and securitization have greatly increased the difficulty of assessing a firm’s economic performance. Not only have the individual assets and liabilities become more complex, their interactions have become increasingly important and unpredictable. Consider a credit default swap. By itself it has an NPV of 0. Whether the CDS turns into an asset or liability depends on the credit markets. We’ve already seen how hard some of these assets are to value. Consider how far our valuations must be removed from their intrinsic value when a loosening of mark-to-market is expected to increase earnings by 20%.

One of the key attributes, perhaps the overarching principle in the FASB conceptual framework, is the idea that financial statements must be useful to its users. How can financial statements be useful when they provide little indication of a Banks’ true value. Financial statements are not globalized yet in the sense that they do not assess systematic and counter-party risk.

Goldman Sachs CEO Lloyd Blankfein wrote in the Financial Times a couple weeks about the need for this forward looking risk management.

“Given the size and interconnected nature of markets, the growth in volumes, the global nature of trades and their cross-asset characteristics, managing operational risk will only become more important.”

One interesting suggestion he has is for “dynamic regulation” where regulators adjust their regulatory involvement according to market moves, much like the Fed increases interest expenses during times of excess. Another interesting suggestion is his support for completely independent risk managers at financial institutions. This idea reminds me a lot of the emphasis on internal controls after Enron and WorldCom. As systemic risk increases, so does the importance of corporate governance.

Blankfein thinks regulators and internal risk managers should have more information on systemic risk. Why stop there? Accountants could be the public’s window into the risks of these institutions.

In today’s FT there is a great article by Andrew Lo of MIT called “Mind the GAAP” where he advocates such an approach. He argues accounting is inherently backward-looking when it should be forward-looking, assessing risk.

In his article, Lo mentions that in 1995 Robert Merton and Zvi Bodie pointed out the need for a new branch of accounting called “risk accounting.” When trying to find more information on this subject I stumbled across a more recent paper of theirs from 2006 called, “A New Framework for Analyzing and Managing Macrofinancial Risks of an Economy.” Here is a short excerpt from the abstract:

“The high cost of international economic and financial crises highlights the need for a comprehensive framework to assess the robustness of national economic and financial systems. This paper proposes a new comprehensive approach to measure, analyze, and manage macroeconomic risk based on the theory and practice of modern contingent claims analysis (CCA). We illustrate how to use the CCA approach to model and measure sectoral and national risk exposures, and analyze policies to offset their potentially harmful effects. This new framework provides economic balance sheets for inter-linked sectors and a risk accounting framework for an economy.”
http://www.hbs.edu/research/pdf/07-026.pdf

Back to Andrew Lo’s article:
“By viewing future values of accounting concepts as random variables, the well-developed framework of probability and statistics can be used to quantify the impact of events such as credit crunches, flight-to-quality, and volatility spikes on corporate balance sheets and income statements.”

I hope this is the direction accounting is headed. As globalization and financial innovation continues, systemic risk will become an even more important variable for the global economy. Plus it would make the industry a heck of a lot more interesting, and I think we can all agree accountants deserve a break.