How Will Deflation Play Out?

I received the following question from "Suanny" on Silicon Investor" on December 29th.
Note: I cleaned up a few typos, punctuations, etc. to make the following a bit more readable.

Mish
I have been following your views on deflation for some time. You tend to limit the argument expansion and depletion of credit that defines more clearly the discussion so an individual will be able to follow. Trying to debate baskets of goods and their pricing would take the discussion all over the map. You make a great case, however it difficult for me to see how this will play out in the real world.

The inflation guys are just the opposite. They seem to be very sure how things play out but have difficulty explaining why or supporting their position. Although most of your positions are well supported I have difficulty understanding just how things will play out in your opinion and how policy or events might alter that view either in timing or severity. I think most of us especially me have a distorted view of what a modern day deflation would mean.

Mish technically you may be correct when you mention that the price an item which has just tripled, has fallen 10% is deflationary. As a consumer it feels like a temporary relief from inflation. I believe much the frustration in the inflation deflation debate stems from the inflationist clear vision of the future with rather cloudy evidence backing it up your solid arguments supporting a vague vision of what a modern deflation might look like. I for one would like to see more of your ideas what effect this credit contraction could have on various areas of our lives.

Suanny that was an excellent question and it also comes up time to time in responses to my blog as well. Before I answer your question as to how this will affect people's lives, let me reiterate my position once again as to what deflation is as well as clear up a couple of misconceptions that people have. Quite simply inflation is an expansion of money supply and credit. Deflation is the opposite, a contraction in money supply and credit.

How inflation starts and ends can be found in an Interview with Paul Kasriel with who I am in complete agreement.

Mish: How does inflation start and end?
Kasriel: Inflation starts with expansion of money and credit.
Inflation ends when the central bank is no longer able or willing to extend credit and/or when consumers and businesses are no longer willing to borrow because further expansion and /or speculation no longer makes any economic sense.

Mish: So when does it all end?
Kasriel: That is extremely difficult to project. If the current housing recession were to turn into a housing depression, leading to massive mortgage defaults, it could end. Alternatively, if there were a run on the dollar in the foreign exchange market, price inflation could spike up and the Fed would have no choice but to raise interest rates aggressively. Given the record leverage in the U.S. economy, the rise in interest rates would prompt large scale bankruptcies. These are the two "checkmate" scenarios that come to mind.

Predicting the end is extremely difficult especially as the powers that be are doing anything and everything to keep the bubble expanding. Three years ago would anyone have thought that neg-am "liar loans" would have become as widespread as they did or that people would be camping out overnight to get into a lottery to buy a Florida condo or that companies would be going into debt to buy back shares while insiders are bailing like mad and no one would care? But just as happened with Florida condos, supply of many things is destined to dwarf demand.

Yes I have been early and as such subject to taunts and ridicule. I have been even compared to Prechter who was at least 20 years too early in his call. It is an invalid comparison because I have only been talking about this for several years at most while Prechter clearly missed a massive disinflationary cycle boom led by increased productivity, the internet revolution, and falling energy prices. I also disagree with Prechter on what is going to happen to the price of gold. I am not attempting to trash Prechter as I find Ewave analysis itself quite useful. One must separate views of the person from use of the tools. Finally I believe peak oil will prevent a complete collapse in the price of energy. Yet economically and financially the conditions in the US are quite similar to those of 1929. You may wish to consider reading 1929 Revisited.

But just because economic conditions are similar to 1929 does not mean I am calling for a global depression. I have never called for such an occurrence although I admit it is possible. I also admit hyperinflation is possible even though I think it is extremely unlikely. Oddly enough I give more chance to hyperinflation happening (1-2%) than others who tell me that I am the one who is stubborn while at the same time telling me that deflation is "impossible". Go figure.

The main misconception I want to clear up involves these statement you made "Mish technically you may be correct when you mention that the price an item which has just tripled, has fallen 10% is deflationary." I have really never said any such thing. Perhaps you are mistaken because certain people attribute things to me all the time that I have never said. I have staunchly maintained what inflation and deflation are, and a 10% drop in prices is certainly not deflation.

Prices may be dropping as a result of deflationary pressures but it is important to understand cause and effect. For a discussion on cause and effect and putting the cart before the horse as most inflationists do, please consider Inflation: What the heck is it?

The internet and other massive productivity improvements kept a lid on prices and masked real inflation (an expansion of money and credit)as noted in my interview with Kasriel. But as long as the ability and willingness of businesses and consumers to take on additional credit is intact (especially consumers), inflation is nearly guaranteed to win out. The key then is finding the point at which "checkmate" occurs.

On occasion I do discuss prices. I try and make it perfectly clear that when I do I am discussing prices and not inflation or deflation per se. Some have asked me to start saying "price inflation" or "monetary inflation" etc but even if I don't it should by now be extremely clear as to what I am talking about. The primary reason for discussing prices is that every inflationist under the sun moans to high heavens every time the price of anything rises even as they ignore prices that are falling such as: copper, natural gas, crude, oil, lumber, home prices, prices at Walmart, prices at Circuit City, and prices at many restaurants.

Inflationists are also quick to point to recent movements in corn and grain prices ignoring the fact that prices are not much different than they were in the 1940's. More importantly corn and grains are both weather related as well as subject to ridiculous policy decisions by the government such as ethanol promotion and subsidies. Well the Fed can not control the weather nor can the Fed's interest rate policy solve peak oil problems nor can Fed policy do a thing about poor governmental decisions to promote inefficient use of ethanol. While on the subject of poor policies, consider some 300 programs designed to make housing affordable. At the top of that list would be the creation of Fannie Mae, and that policy has backfired in every way imaginable. Government programs attempting to do something usually accomplish the opposite.

That is a crucial point to understand. Interest rate policy can not in any way counterbalance poor government policies. That statement would hold true even if my some miracle the Fed actually managed to find the so called "neutral rate"!

Bad governmental policies make the Fed's job all the more difficult. In reality the Fed is attempting to micro-manage things much the same way that Russian central planners attempted to manage their economy and we all know how well that worked out.

We do not let the Fed set the price of orange juice even though that is probably far easier to do than set interest rates in a global economy. In short we would all be better off if the Fed simply absolved themselves and let the market set rates. We would still have government distortions but at least we would not have Fed distortions on top of government distortions.

How Debt Money Goes Broke

Before I answer your primary question let's first explore How Debt Money Goes Broke

Debt is self-liquidating when used to generate future income, from which interest is serviced and principal repaid. Used for any other purpose, it is non-self-liquidating and results in payment obligations with no countervailing source of income.

How does it end?

A debt-based monetary system has a lifespan-limiting Achilles heel: as debt is created through loan origination, an obligation above and beyond this sum is also created in the form of interest. As a result, there can never be enough money to repay principal and pay interest unless debt is continually expanded. Debt-based monetary systems do not work in reverse, nor can they stand still without a liquidity buffer in the form of savings or a current account surplus.

When debt grows faster than the economy, the burden of interest is bearable only so long as the rate of interest is falling. When the rate of interest reverses course, interest charges start rising faster than debt growth. This point was reached on 16 June 2003, the day the yield on the benchmark 10-year Treasury bottomed at 3.09%. Since then, debt grew from $32 trillion to $40 trillion, an increase of 25%. During the same period, annual interest charges rose by over 50%, from $1.28 trillion ($32 trillion at the prevailing average interest rate for debtors of 4%) to $2.0 trillion ($40 trillion at 5%). When interest charges exceed debt growth, debtors at the margin are unable to service their debt. They must begin liquidating.

Dipping into savings or running a current account surplus can offset liquidation for a time. The greater the pool of savings and the current account surplus, the longer an economy can endure liquidation at the margin without experiencing cascading cross-defaults. The US in the early 1930s and Japan in the early 1990s had such a liquidity buffer. In both cases, mobilizing domestic savings to increase government debt reversed the decline in total debt outstanding in two to three years and interest rates stayed low because savings financed the new debt. As a result, interest charges no longer exceeded debt growth and the need for marginal debtors to liquidate disappeared.

The US is now in a fundamentally different position than it was in 1930 or Japan was in 1990. Aside from a dearth of domestic savings, its vulnerability is compounded by a current account deficit. There is no buffer and no margin for error. Thus, when interest charges, now $2 trillion per year and accelerating, overtake annual debt growth, now $3 trillion and decelerating, liquidation will immediately trigger cascading cross-defaults. Without domestic savings to mobilize, the Fed cannot facilitate the expansion of government debt to fill the breach and simultaneously hold down interest rates. It cannot win the battle to keep debt growth greater than interest charges, the precondition for the viability of a debt-based monetary system. Once started, cascading cross-defaults consume all debt within an economy. The Fed has only two options: institute a new monetary system with a new currency or return monetary authority to the market and shut down.

As an adjunct to the above article let me repeat some comments made by
Professor John Succo on Minyanville in regards to Debating the Flat Earth Society.

As central banks rain liquidity (credit) down on markets, its long range effects eventually cause the very thing central banks are trying to avoid: deflation. The reason people don’t understand this is that it is cumulative: the accumulation of debt is in itself inflationary, but at a certain point it becomes unmanageable. Why is this?

Easy or free money (when central banks drive real interest rates below inflation rates) is irresistible. It wouldn’t be if people managed risk properly but they do not. Easy money causes competition for “projects” to increase: companies with free money take risk with it for less and less return. We are seeing deals getting done in LBO land and commercial real estate being built using very aggressive assumptions and low cap rates. With all that “money” out there rates of return drops dramatically. Everyone is starved for income.

At the very time that income and returns are dropping debt is increasing. Less income with more debt means that eventually it gets impossible to service that debt.

What does it all mean?

Finally! to answer your question.
What it means depends on several factors.

1. How much debt people have
2. How much people depend on home prices
3. How much people depend on the stock market

The coming deflationary downturn is clearly not going to affect everyone equally.

Those with little debt and few assets and high in cash are going to be huge winners. Cash and/or or gold will be king. Those leveraged in massive amounts of real estate lording it over on everyone else for the last 10 years are likely going to seriously regret that decision.

Relatively speaking the top 2-4% or so will not be affected much as a class (individual results will vary) as many in this group have more money than they know what to do with. They can ride out the storm outright if they are wealthy enough, and the second tier can ride it out as long as they keep their jobs.

In the next step down, baby boomers who thought they could retire by selling their houses will find themselves scrambling for supplemental income after retirement to maintain their lifestyle, or by cutting back on their standard of living or both. Retirement for many will be delayed. Those most affected will be those most dependent on the bubble in housing or stocks to maintain lifestyle. It will be a rude awakening for such folks and that awakening just might last for years.

Those heavy in stocks but light on real estate will be a lot more liquid. How those folks turn out will depend on how far down they ride the wagon. I suspect that many who need "just one more double" are not going to get it and instead will have 40% less than they have now 5 or 7 years from today.

Those overleveraged in stocks and real estate and relatively high in debt but not in the upper echelons of income will bear the full force of the downturn.

There is simply no reason we can not be following a Japanese style prolonged deflation. Housing prices fell in Japan for 18 straight years or so and that could happen here. More than likely a 5-10 year decline is reasonable. No doubt people will be chiming in "the US is not Japan" and yes they are correct. From a deflationary aspect our consumer debt makes things far worse. On the other hand our demographics makes things better (assuming we do not get as phobic about immigration as Japan did). Those are both major factors and for the sake of argument I assume they balance out.

Oddly enough those on the low end of the scale probably do alright compared to current conditions. They have tons of debt (relative to income), few assets, no house (or deep in debt on one), no stocks, no 401K, no medical insurance, and nothing to lose in bankruptcy. I expect many to take that way out and I will not blame them one bit if they do. Those with literally nothing to lose, obviously lose nothing.

Under the Democrats I expect to see some revisions in the bankruptcy laws as well as revisions in fees and interest rates on credit cards. If we do not get those revisions then expect far more bankruptcies. Heck, expect them whether or not we see those revisions. The result will be a forced reversion to the mean from the haves to the have nots (at least to the extent that bankruptcies wipes existing debt).

As far as prices go, deflation is not going to cure peak oil, shortages in natural gas, the China factor, bad government policies, or increasing demands for resources in emerging markets. On the other hand there is massive overcapacity everywhere that I have talked about many times. Overcapacity in the midst of a weakening economy has already put downward price pressures on places like Walmart, Home Depot, Circuit City, etc. Land and home prices have begun falling and will likely continue to fall for years. I expect to see demand for marginal services such as nail salons and yard work to plunge. Where there is overcapacity and falling demand expect to see layoffs and corporate bankruptcies. Lots of small businesses will likely go under. Unemployment will rise. That will further reduce demand for goods and services putting even more price pressures on suppliers. The process will continue until it plays itself out.

We must also consider how the Fed and Government will react to the downturn. This is by no means a given. Many think a "helicopter drop" will be invoked. I believe otherwise for reasons I have stated many times:

1. The government and Fed will not bail out consumers at the expense of banks and creditors.
2. The Fed can print but the Fed can not create jobs or determine how or even IF that money would find a use.
3. Hyperinflation if achieved would end the game at the expense of everyone, including the wealthy and the Fed itself. Deflation on the other hand allows the game to continue.
   

No doubt the Fed will attempt to inflate just as Japan attempted to inflate but those attempts failed. Likewise the Fed will fail. Their attempts to prevent deflation a few years back only succeeded in creating a bigger bubble that now will be deflated away.

Although we know the government will try things (most of them completely stupid), we do not know exactly what they will be. Will there be another Smoot Hawley Tariff? Are we going to start a war with Iran? Is so, how will China and Russia respond? Will we antagonize China into dumping treasuries or dollars in some sort of major international currency fight? How soon and how far will Japan rate hikes affect various carry trades? What happens to the AMT (alternative minimum tax) a year or so down the road and or to various tax credits that are set to expire?

We can speculate on answers to those questions but no one really knows. Yet, the answers to those questions may very well determine how fast or how slow the overall scenario plays out.

What we do know for sure is that the Fed and the government will attempt something, we just do not know exactly what at this stage. Oddly enough, even though we do not know what will be done, it is perhaps possible to see what one of the beneficiaries would be. Gold is a likely winner in this mess. Gold and money in general are historically trash in disinflation and hoarded in deflation. Unless it's different this time, gold and cash and treasuries will do well. In contrast those holding junk bonds, houses, stocks will see those values plunge.

Deflation will not be the end of the world for the US any more than it was in Japan, but it will cause a pronounced shift in consumer behavior and investment psychology.

Behavioral Psychology

• There will be shift away from consumption to saving
• There will be a shift away from risky assets to less risky assets (and lower returns)
• There will be changes in retirement plans
• There will be a shift in mentality from "have to have it now" towards some semblance of planning.

Those are good things actually and they will allow for replenishment of the pool of real savings that has now been completely exhausted.

Suanny, you asked what you might have thought was a simple question, but as you can see the answer was long and complex.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Open Skies & Virgin America

The US department of transportation (DOT) ruled on Dec 27th that the UK is a security risk and therefore British owned Virgin America Airlines is not allowed to fly within the US between San Francisco and New York. How flights originating in the US to other US destinations in the US posed security risks to the US was of course not explained (probably because the idea is ridiculous). They did not actually say "security risk" but what else could a law requiring 75% US ownership to fly within the US mean? The expressed concern was over "foreign ownership".

Bloomberg picked up the story in Virgin America's Bid to Start Flights Denied by U.S.

Dec. 27 (Bloomberg) -- Virgin America Inc., a startup airline partly owned by U.K. billionaire Richard Branson, won't be able to begin flights because of U.S. government concerns about foreign ownership.

Before it can start service, Virgin America must revise its corporate structure to show U.S. citizens own and control at least 75 percent of the company, the U.S. Transportation Department said today. Branson's closely held Virgin Group Ltd. put up 25 percent of the initial $177 million investment to start Virgin America, as well as a $53 million loan.

The decision is a victory for U.S. rivals that opposed the Virgin America bid as well as for organized labor, which feared job losses.

Broader Implications

The ruling may hurt U.S. efforts to open aviation markets worldwide to additional competition. Analysts have said Branson could use the denial to argue that the European Union shouldn't expand access to London's Heathrow airport, as the U.S. wants.

The Transportation Department, in reviewing the airline proposal, had to consider a law that limits foreigners to 25 percent of U.S. airline voting equity and bars them from "actual control" of a U.S. carrier.

U.S. rivals of Virgin America, including Continental Airlines Inc., AMR Corp.'s American Airlines, Delta Air Lines Inc. and US Airways Group Inc., have said in filings that the startup carrier doesn't meet the ownership test.

Continental said Aug. 2 that since Reid "was hired by, and is clearly beholden to, the Virgin Group" he cannot qualify as a citizen under U.S. law. Continental also argued that the Virgin Group conceived, financed and designed Virgin America, and hand- picked its fleet and key personnel.

The Virgin America case is sensitive for Transportation Secretary Mary Peters because her agency has urged opening markets for more aviation competition worldwide. The U.S. is pressing for an "Open Skies" agreement with the EU to lift decades-old curbs on where carriers can fly.

I sure wish they would let me toss out a few questions on these interviews.
It would go something like this.

Mish: Are you saying the UK poses a security risk to the US?
DOT: No that is not what we mean to imply.
Mish: Is Branson, the CEO of Virgin America, a security risk to the US?
DOT: Uh... No we are not saying that either.
Mish: Does the fact that Virgin America is British owned make it easier for contraband or weapons to be smuggled aboard flights originating in the US?
DOT: No
Mish: Are all international flights into the US majority owned by US citizens?
DOT: No. Many countries have plane flights into the US.
Mish: Is that a bigger security risk than Virgin America wanting to fly from San Francisco to New York?
DOT: Uh... I have to go now.

This is not a victory for US airlines, organized labor, free trade, taxpayers, or anyone else other than ISOH (International Society of Hypocrites), led by none other than the USA and EU. The stunning irony is impossible to miss. The U.S. is pressing for an "Open Skies" agreement with the EU to lift decades-old curbs on where carriers can fly.

Presumably Continental, Delta, American, etc and organized labor benefited from this action. That is the "seen" perceived benefit. The "unseen" consequence is hundreds of people who are denied a job, restaurants and hotels that do not benefit from increased travel, customers denied the benefits of increased competition, and fuel services and mechanics that do not benefit from servicing another airline. It would not surprise me in the least to see the EU to use this as an excuse to continue to fight "Open Skies". The odd thing is, the first to allow "Open Skies" would benefit even if the other didn't.

I can not think of a better post than this to encourage everyone to pick up a copy of "Economics for Real People - An Introduction to the Austrian School" by Gene Callahan. It is not a long winded rant about gold. In fact gold is only briefly mentioned a couple of times. Nor it is based on complicated formulas. Nor is it a book on any deflation/inflation scenarios. It is an easy and entertaining introduction to Austrian Economics with practical examples, some fictional and some recent real life economic examples. I was going to provide some excerpts from the book but I changed my mind. Just find or buy a copy, read it, and embrace the ideas presented.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Debating the Flat Earth Society (Part 2)

This is Part 2 in a debate with the Flat Earth Society.
Please read Part 1 first if you have not yet done so.

This debate came about when I informally responded to the Salt Lake Real Estate Blog on Silicon Investor. Salt Lake (SL) then sent out a "challenge" along with a rebuttal to my brief responses.

Part 1 of my response discussed Corporate Balance Sheets and Real Estate Appreciation.
Part 2 of my response discusses Building Costs and Rents.

My responses were broken in half simply because the amount of material supporting the notion that corporate real estate expansion is NOT about to pick up where residential real estate left of is massive. Even broken in half, each piece is lengthy. Part 2 now resumes with a discussion about Building Costs and Rents.

Building costs are coming down / Projects are being restarted

SL: With residential real estate waning, costs of building have come down to the point stalled building projects are being restarted.

Mish: There is a desperate need to finish stalled projects just to get rid of the carrying costs. Then what? Why is commercial capacity needed? It isn't is the correct answer.

SL: I didn’t say commercial projects were desperate. I said they had been stalled due to higher costs brought on by the residential boom. BusinessWeek’s blog said:

During the housing construction boom, homebuilders bid up the price of construction labor as well as building materials like copper and cement. Prices got so high that some non-residential construction projects became unaffordable, so developers put them on the back burner. Now, with residential construction slowing down, labor and materials costs are coming down, making non-residential projects affordable again.

This makes sense to me. How about you? Additionally, government construction rose to an all time high in October:

Public construction, namely government building projects, rose 0.8 percent to an all-time high of $273 billion. Federal construction saw an 11.6 percent boost in spending.

Most supportive of the theory residential construction jobs will be absorbed by commercial construction is the fact the hardest hit bubble areas including Denver and Los Angeles are seeing huge commercial growth.

Mish: Yes building costs dropped. That is called lack of demand.
In fact here are charts of Lumber and Copper.

Lumber



Copper



Exactly what is Dr. Copper and Lumber telling us?
To me it is obvious.
This economy is in trouble.

At any rate collapsing commodity prices is certainly NOT any indication of demand. It is an indication of weakness. What you are seeing is a mad scramble to finish some projects that were stalled due to costs. That real estate when finished will just add to additional supply.

But even as you state projects are being restarted you provide no examples while cancellations are everywhere. Here is a typical one. Please consider Developers rethink plans in slow market. Ok So Palm Beach is just one city. But projects are being canceled in Las Vegas, San Diego, Boston, Chicago and other places. Do a search. You will find them.

But let's zero in on some rock solid hard data: Builders are taking enormous writeoffs on land. If land was cheap or expansion was coming, builders would not be bailing hand over fist on land options, and/or taking other land writeoffs.

Here is a typical article on the subject: Homebuilders Take Another Hit.

Shares of industry players dipped Tuesday after Hovnanian posted a big quarterly loss on a hefty land write-off

Finally, just because some cheerleader states "labor and materials costs are coming down, making non-residential projects affordable again" does not really make it so, now does it? Even if it was so (from a construction standpoint) that does not make the projects viable from an overall economic point of view. Overall viability must be factored in and overcapacity is rampant.

Summary

• Falling materials prices are a sign of economic weakness not strength.
• Land writeoffs are an enormous sign of weakness.
• Projects are being canceled even as building costs are dropping.
• Expansion does not happen because building costs are coming down. Projects have to be viable before it makes sense to start them.
  

Rents are Up

SL: Rents have increased, so those in the apartment complex business are getting more apartment buildings online and refurbished. More potential homebuyers are sitting on the sidelines and renting. See the continued performance of REITs as evidence...many apartment buildings in those portfolios.

Mish: You point to a bubble in Reits as Zell and other vultures are selling as proof of something. It is like pointing to the bubble in the Naz in 2000 and saying everything is OK. There is ZERO fundamental reason for a continued strong commercial expansion.

SL: Rents for both commercial and residential functions have increased, making apartment buildings and commercial space more attractive to investors. On top of that, interest rates have leveled off and both companies and individuals are doing well financially. It makes sense for investors to continue to develop this sector of the economy.

The NAR reported just last month:

With healthy job growth, office market vacancy rates continue to fall in most major markets and are expected to average 13.0 to 12.0 percent in 2007 -- a steady downtrend since exceeding 16.0 percent in 2004. After falling in the first part of the decade, average office rents are projected to grow 7.5 to 8.5 percent next year...

Vacancy rates in the industrial sector should average 9.7 to 9.0 percent next year, a steady downtrend since early 2004 when they were close to 12 percent. Rents are expected to increase 3.5 to 4.0 percent in 2007...

The apartment rental market -- multifamily housing -- is strengthening as potential home buyers remain in rental housing. New supply is matching absorption, keeping vacancy rates fairly flat -- next year they are projected to average 5.2 to 5.3 percent. Average rent should rise 4.5 to 5.0 percent in 2007.

Retail vacancy rates are likely to rise to an average of 7.8 to 8.2 percent in 2007. After dropping about 1.5 percent this year, average retail rent is forecast to increase 2.5 to 3.0 percent next year...

Mish: Hmmm let's see. Do I want to believe what Zell is doing or the NAR is saying?
Please consider When Zell Sells, We Listen

Sam Zell built the largest publicly traded real estate firms in Equity Office Properties (EOP) and Equity Residential Properties (EQR). After years of acquisitions to build the portfolio, he is now cashing out just as many have called a peak in the real estate market.

For Mr. Zell, one of richest men in America and the owner of more real estate than Donald J. Trump, the sale is an opportunity to cash out of part of the empire he built while working from his office in the old Daily News Building in Chicago. But the sale by Mr. Zell, who made his first millions in the 1970’s buying distressed real estate, may also signal that he believes the market may have peaked.

Just last month, Ross L. Smotrich, an analysts at Bear Stearns, wrote in a note to investors: “REIT’s have outperformed the broader market in each of the past seven years, putting valuations at the high end of historical ranges.”

This guy was a real estate vulture and he is bailing. I am willing to stand up and take notice. Even in the article you quote I see "Retail vacancy rates are likely to rise to an average of 7.8 to 8.2 percent in 2007." History proves that the NAR underestimates every decline and overstates the smallest of bounces.

When it comes to rentals you are also ignoring condo towers everywhere. The supply coming online is enormous in Miami, Las Vegas, San Diego, Chicago, Boston, and many major cities. There is simply NO MARKET for condos right now except at absolute auctions.

I talked about this in Auctioneer's Perspective. Those towers under construction are hugely adding to future supply. At the same time demand is falling off. Nor is this just a "Florida Thing" says the auctioneer. Indeed if you do a search you will find examples of condos being converted back to rentals or condo-tels. Thus there is certainly no pent up need to build more rental towers. Nor is there any pent up demand for housing either. Crashing building permits should be proof enough.

Summary

• I believe what Zell is doing rather than what the NAR is saying. Is this even close?
• There is pent up supply of rentals with huge numbers of towers under construction in many major cities.
• Condos are only selling at absolute auctions.
• The idea of pent up demand in homes is laughable. Supply is easily overloading demand.
• Building permits (a leading indicator) plunged yet again.

Wrapup

I sit in amazement of the challenge:
I look forward to your responses Mish, hopefully supported by hard data. If you don’t respond within seven days, I will take that as a surrender.

For the record, I did not come close to meeting the deadline. I had other priorities than debating the Flat Earth Society. But what strikes me the most is a challenge to be supported by "hard data".

I provided hard data and/or charts on

• Permits
• Construction job employment
  
• Insider sales
• Auctions
• Leveraged buyouts
• Reits
• Charts on historical correlations (from CalculatedRisk)
  
• Building materials
• Land writeoffs
• Foreclosures
• Retail Stores
  

as well as an overall thesis backed up by logic. I also would like to point out at this time a massively inverted yield curve that is now pointing strongly towards a recession.

On the other hand, the only hard data point provided by SL was on the AIA, a point I agree is valid but whose timeframe is questionable. Otherwise all SL provided was supposition by the NAR and ideas that were 180 degrees twisted from reality such as corporate buybacks (a clear indication of unwillingness to expand).

Addendum:
I want to include a few comments from from Professor John Succo on Minyanville:

As central banks rain liquidity (credit) down on markets, its long range effects eventually cause the very thing central banks are trying to avoid: deflation. The reason people don’t understand this is that it is cumulative: the accumulation of debt is in itself inflationary, but at a certain point it becomes unmanageable. Why is this?

Easy or free money (when central banks drive real interest rates below inflation rates) is irresistible. It wouldn’t be if people managed risk properly but they do not. Easy money causes competition for “projects” to increase: companies with free money take risk with it for less and less return. We are seeing deals getting done in LBO land and commercial real estate being built using very aggressive assumptions and low cap rates. With all that “money” out there rates of return drops dramatically. Everyone is starved for income.

At the very time that income and returns are dropping debt is increasing. Less income with more debt means that eventually it gets impossible to service that debt.

These posts (minus the addendum) originally published in WhiskeyAndGunpowder.
This concludes my debate with the Flat Earth Society.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Debating the Flat Earth Society (Part 1)

One of the rules that scientists try and follow is to not debate the flat earth society. It simply lends credence to the idea that there is actually something to debate. For the same reason scientists will not debate creationism vs. evolution either.

Occasionally, however, a flat earth society theory actually manages to come into popular belief. This is one of those times. Right now there is a widely held belief in "goldilocks" and that corporate spending and construction will somehow pick up the slack where consumer spending and retail construction left off. Goldilocks is of course a fairy tale but to be fair, I did volunteer to rebut the goldilocks theory as presented on the Salt Lake Real Estate Blog.

This debate came about when I informally responded to the above link on Silicon Investor. Salt Lake (SL) then sent out a "challenge" along with a rebuttal to my brief responses. I was busy and failed to respond to the rebuttal in the required time. Shortly afterwards SL proclaimed victory. That notion will be put to rest now as we look at the main data points of his arguments (corporate balance sheets, real estate appreciation, building costs, and rents).

The amount of material supporting the notion that corporate real estate expansion is NOT about to pick up where residential real estate left of is massive. It was so massive that I had to break this rebuttal in half and each half is still lengthy. That of course is one of the reasons for the delay in responding. During the delay additional supporting evidence came in further increasing the length.

Part 1 of my response will discuss Corporate Balance Sheets and Real Estate Appreciation.
Part 2 of my response will discuss Building Costs and Rents.

Corporate Balance Sheets

SL: Corporate balance sheets are flush with cash. Companies have been reluctant to spend much since 911. You stock guys know this.

Mish: They have been wasting it on stock buybacks, mergers etc. There is no need to expand because there is overcapacity everywhere.

SL: And there's no denying record levels of cash on corporate balance sheets, or the tendency of the increasingly generous buybacks to force the stock market higher.

With all that cash on the books, companies are looking to invest it in places that will yield high returns. Their choice is in stock buybacks and merger opportunities because they are a good investment right now. The New York Times said, ” management says it is buying back shares because they are bargains.”

Companies are also expanding building. I’ll deal with the particulars in the next section because it will be more germane there.

Mish: Exactly what do mergers or buybacks or forcing shares higher have to do with expansion of commercial real estate? The answer is nothing. Exactly what do share prices supposedly being a bargain have to do with expansion either? The rebuttal is pure silliness and besides share prices are far from being cheap. If share prices were cheap corporate insiders would be buying shares not unloading shares at a record pace as they are doing now. Please consider Top-Level Insiders Selling Their Stock.

December 7, 2006 -- America's corporate chiefs are unloading their own stocks at one of the boldest paces in 20 years. In cases of the very rich, such as Microsoft's Bill Gates and Google's top brass, the executives are selling a whopping $63 for each $1 of stock they bought, says a report by Bloomberg. In November alone, leaders of public companies dumped $8.4 billion worth of stock they owned as insiders, most of it awarded as compensation, bonuses or other management incentives. Analysts say a take-the-money-and-run flight from their own companies signals a growing lack of confidence in the economy's future course.

Simply put if executives thought their stocks were cheap they would not be bailing at the fastest rate in 20 years. If they thought the future was promising their corporations would not be buying back shares but expanding their businesses. Stock buybacks suggest companies can not expand profitably so they buy back shares instead. Mergers typically result in duplication of services and that leads to firings not hirings.

Lets also look at leveraged buyouts. I discussed this aspect in Changing Priorities.

Casino giant Harrah's Entertainment Inc.'s debt load will nearly double and its priority will shift to paying it down instead of reinvesting in growth after one of the biggest leveraged buyouts ever, according to SEC documents filed Wednesday.

Harrah's historical priorities show two check marks beside "reinvest for growth" and "mergers and acquisitions," but only one beside "share repurchases" and "reduce debt." Under the new structure, only one check mark goes toward reinvestment and acquisitions, while two appear beside reducing debt.

While on the subject of corporate balance sheets please consider Remarks by
John C. Dugan Comptroller of the Currency on systemic risks to the financial system.

Also note that 2.2 Million Subprime Borrowers Face Foreclosure according to the Center for Responsible Lending. 2.2 million foreclosures will add to pent up supply would it not? Of course there is theory and there is practice. Let's look at some actual data.

Foreclosure activity surges in Massachusetts (up 300% from last year).
How about Georgia foreclosures jump 99%; rate is nation's 3rd highest.
What about Colorado Foreclosures?

Last month, 5,051 homes in Colorado - one new filing for every 362 households - entered some stage of foreclosure, up 88 percent from November 2005. "It's sort of the tip of the iceberg, and the problems are going to get worse before they will get better," U.S. Bank regional economist Tucker Hart Adams said. "I think we will see housing prices declining, sales down and new construction down for another year," Adams said.

I also see that California foreclosures surge 171 percent in Q3.

• National foreclosures increase 43 percent
• Colorado, Nevada and Florida have highest rates
  

More than 37,000 homes went into the foreclosure process in California in the third quarter, a 171 percent increase over the same period in 2005, according to RealtyTrac, an Irvine-based foreclosure information company.

The California number was up 35 percent from the second quarter of 2006.

Nationally, 318,355 properties entered some stage of foreclosure during the third quarter of 2006, a 17 percent increase from the previous quarter and a 43 percent yearly increase from the third quarter of 2005.

The nation had a foreclosure rate of one foreclosure filing for every 363 households during the quarter.

Those are massive rises in foreclosures that can no longer be blamed on Hurricane Katrina or changes in bankruptcy laws. Flat earthers will no doubt state that the rise is coming from a low level. Yes it is, but the rate of growth is staggering , GDP is slowing , and $1 trillion in mortgages are going to be reset in 2007. Those foreclosures pose a systemic risk to the financial sector.

Short summary

• Stock are not cheap as proven by insiders actions as opposed to their words.
  
• Stock buybacks happen when corporations have no better place to put their cash (expansion makes little sense).
• Mergers tend to lead to job cutbacks because of corporate duplication.
  
• Leveraged buyouts result in changing priorities from expansion to debt paybacks.
• 2.2 million households face foreclosure and foreclosures will add to supply.
• Actual data confirms massive increases in foreclosures on a national basis.
  
• Foreclosures pose a systemic risk to corporate balance sheets especially with lending institutions.
  

Commercial Real Estate Has Appreciated

SL:Commercial real estate holdings have increased in value. Appreciation has hit the commercial side as well. This is partially responsible for the better balance sheets.

Mish: So a bubble in real estate assets is going to cause them to expand more? For how long?

SL: Appreciation in real estate is causing increased profits, both in stock value and cash position. MSN Money reported last year:

Find companies with a lot of real estate on their books at rock-bottom prices because they bought it long ago. As these companies sell or develop that land and realize its value, shareholders should see big payoffs.

This has held true for other companies such as those in retail that have had real estate positions for many years as a function of doing business.

Companies are expanding as well. The NAR reported last month, “Commercial real estate sectors are on solid ground with generally tightening vacancy rates and sound fundamentals.”

Architecture firms confirm this data:

A monthly index of billings by architecture firms points to continued strength in U.S. nonresidential construction for the next nine to 12 months.

The index, which predicts construction spending up to a year ahead, has pointed to continued growth for four consecutive months, and suggests a healthy outlook throughout 2007, the AIA said. All regions except the U.S. Northeast saw growth in construction activity.

Mish: The argument that because commercial real estate has appreciated will lead to more expansion is complete silliness. So is the notion of shareholder profits. Businesses expand when they have legitimate reasons for expansions, not just because the value of their real estate went up or profits went up. As discussed in Corporate Balance Sheets (above) those argument are simply without merit. You are essentially presenting the same argument twice and it make no more sense the second time as it did the first.

Quoting the NAR "The Voice for Real Estate" as proof of the strength of real estate is the equivalent of asking the guy in the red suit and white beard at the shopping mall during Christmas season if he believes in Santa Claus. Of course he will say he believes in Santa Claus.

As for the AIA you actually presented your first valid argument. Indeed I see a Six Point Surge in Architecture Billings Index.

After consecutive months of very modest growth, the Architecture Billings Index (ABI) saw a considerable jump in November to its second highest reading of the year. The commercial / industrial sector recorded its best mark of the decade and while still reporting weak billings, residential architecture firms showed encouraging signs by posting the highest score in four months.

Key November ABI highlights:
• Regional averages: West (60.7), Northeast (58.0), South (51.1), Midwest (49.5)
• Sector index breakdown: commercial / industrial (62.9), institutional (54.6), mixed (50.6), residential (47.4)

I am not sure what to make of slight contraction in the Midwest, slight growth in the South, and decent growth in the West and Northeast. The questions here are several.

1. Was this an outlier?
2. What timeframe are we talking about?
3. Will this really pick up where residential left off?

Question 1 simply can not be answered until we see next couple month's numbers.
Question 2 was not discussed (unfortunately) but I presume to mean to be for the downturn cycle which I believe is in the early innings.
Question 3 is best answered by looking at past history of real estate busts, recessions, and time lags between residential real estate growth and non-residential real estate growth.

Attempting to address question 3 I point to Calculated Risk's analysis in Housing: Starts and Completions

Based on historical correlations, it is reasonable to expect Completions and residential construction employment to follow Starts "off the cliff". This would indicate the loss of 400K to 600K residential construction employment jobs over the next 6 months.

Not wanting to duplicate CalculatedRisk's work I ask that interested parties click on the link to see some very interesting graphs and analysis.

Here is additional analysis by CalculatedRisk that suggests that nonresidential construction historically follows residential construction. Please consider Has Nonresidential Construction Peaked?

Historically nonresidential investment (including nonresidential construction) has trailed residential investment by about 3 to 5 quarters. Since residential construction spending peaked in December 2005, and residential construction employment peaked in February 2006, it is about time for nonresidential construction to peak - if spending and employment follow the common historical patterns.

Once again the above link provides interesting charts and commentary suggesting the hit on commercial real estate is in front of us not behind us. Logical thinking would suggest why this is so: As subdivisions are built, services (grocery stores, strip malls, Home Depots, restaurants, etc follow with a lag). So as residential construction winds down commercial construction remains strong for possibly as long as 5-6 quarters. It will be the unwinding of commercial real estate that will provide the next leg down in real estate. Yes, that is supposition but it based on historical trends backed by logic as opposed to cheerleading by the NAR.

Enquiring minds might be asking if there is any hard data to support this conclusion.
Indeed there is. In November Jobs Report I provided the following chart and analysis.

Following is a chart of construction jobs (both residential and non-residential) for November 2006. Click on chart for an easier to read view.



Before discussing construction please note the red vertical oval. It shows that 40,000 goods producing jobs were lost. It also shows that of the 132,000 jobs that were created, 13.6% (18,000) jobs were government jobs. The last thing we need is more unproductive government jobs. Taking those two numbers into consideration, this was a fairly weak set of jobs numbers and supportive of the idea we are in an economic slowdown. The massively inverted yield curve also suggests that not only is a slowdown coming, but an out and out recession is coming.

It is simply illogical to assume that businesses would even want to keep expanding in the face of a consumer led recession. Even if they did, it is important to remember that consumer spending is 70-75% of the economy (and possibly higher in THIS economy). With that as a backdrop it is also illogical to expect that corporate spending can possibly pick up the slack even IF businesses were to keep expanding in the face of a consumer slowdown.

Nonresidential building has now shown a 4 month steady decline in jobs even as non-residential trade jobs are holding up over the same 4 month period. This divergence between trade jobs and building jobs is unlikely to hold. With an October to November decline in non-construction trade jobs it is possible that this divergence is now being resolved but we must wait and see if the data point on trade jobs is an outlier.

What we can see for sure is that huge cracks are starting to appear in the myth that "corporate expansion is likely to pick up where consumer spending left off". In the dotcom bust of 2000 strength in consumer spending did pick up when corporate spending was slashed, but it is simply illogical to expect the opposite to be possible.

When corporate expansion does crack it will be part of a "Second Wave Down" in construction and jobs and will have a far greater economic impact than the decline so far in residential construction.

Finally I would like anyone to address the following challenge that I made in Bernanke's Box when I asked ......

Can someone please tell me what we need more of?

Home Depots?
Lowes?
Pizza Huts?
Restaurants of any kind?
Strip Malls?
Furniture Stores?
Nail Salons?
Wal-Marts?
Office Supply Stores?
Grocery Stores?
Appliance Stores?
Auto Dealers?
Banks?
What? What? What?

Nothing is what. There is a veritable glut of every kind of store imaginable. The construction of all those places provided jobs. The staffing of all those stores provided jobs.

The bottom line is there is simply no need for businesses to expand into a consumer slowdown. It would not make economic sense to do so and that is arguably why corporate insiders are bailing at a record pace, even as stock buybacks continue unabated.

Given that overcapacity is a theory let's take a look at how some real companies are actually doing in practice.

Black & Decker Lowers Profit Forecasts on Sales Drop

Dec. 15 (Bloomberg) -- Black & Decker Corp., the second- biggest U.S. maker of power tools, cut its fourth-quarter forecast because of ``significantly' lower sales in the U.S. Fourth-quarter sales will probably decline 8 percent because of a slowing U.S. housing market and falling demand for goods such as power saws. Stanley Works, the biggest U.S. toolmaker, cut its sales forecast October 24.

YRC Worldwide Updates Earnings Guidance
[YRC is a trucking company]

"As widely reported by industry analysts, the economy has slowed significantly in the fourth quarter, resulting in lower volumes than we anticipated across all of our asset-based business units," stated Bill Zollars, Chairman, President and CEO of YRC Worldwide. "As a result of this economic slowdown, we are adjusting our earnings guidance."

"While the extent of the economic slowdown is uncertain, our business units are aggressively managing costs to create the best possible results for our shareholders," stated Zollars.

Herb Greenberg mentions YRCW and the markets in general and asks
Is it brains or a bull market?

In Bernanke's Box I also noted Home Depot Sales Falloff Kills Staff Increase Plan.

November 30, 2006 -- Home Depot abruptly shelved a much-touted plan to improve customer service by hiring more store-level employees - just a month after rolling it out. The about-face appears to be the result of a sales slowdown that is far more severe than the company anticipated, sources said. Rather than hiring additional employees, all stores - even those $40-million-plus high-volume locations - were told to cut staff hours by 200 per week because of falling sales.

The reason? Sales were falling short of internal projections, the result of a housing market that had stopped booming.

For Home Depot to go from hiring plans to firing plans in a single month, things must have gone to hell in a handbasket in a hurry. There is no other rational explanation.

I see that Circuit City Swings to Loss in 3Q

Consumer electronics retailer Circuit City Stores Inc. said Tuesday it swung to a loss in the third quarter as deep discounts on flat-panel televisions and computer hardware and software cut into profit margins. It also lowered its full-year sales outlook and shares fell more than 16 percent.

The nation's second biggest consumer electronics chain after Best Buy Co. Inc. reported a loss of $16 million, or 9 cents per share, in the three months ended Nov. 30. Analysts polled by Thomson Financial were looking for a profit of 5 cents per share.

Hmmm does that report say both Best Buy and Circuit City reported losses? Indeed it does. Is that too much competition for too few customers with too little demand? Yes again. Is that a sign of overcapacity? Why yes it is. Would it be rational for such businesses to go on an expansion binge? Of course not.

We talked about YRC, but inquiring minds might be wondering about UPS. I see that More Job Cuts Planned At UPS.

December 13, 2006 ATLANTA -- UPS Inc., the world's largest shipping carrier, is seeking more job cuts on top of 1,200 positions in its logistics unit that it previously said it would cut.

The Atlanta-based company has offered voluntary severance packages to about 650 employees at its headquarters and in its Supply Chain Solutions division in the United States.Since when do shipping companies announce layoffs at Christmas, typically the busiest time of the year? UPS and YRC suggest huge problems and Circuit City, Best Buy, and Walmart confirm the overcapacity problems in retail.

Commercial construction tends to lags residential construction simply because Walmart's, Pizza Huts, Home Depot's, Nail Salons, Best Buy's, etc, finish their buildout after residential areas are built. This is only logical, but the mantra being sung by Wall Street pundits is that somehow corporate spending will save the day.

Summary

• Commercial Real estate appreciation is not a logical argument for expansion.
• Corporate profits are not an argument for expansion when insiders are bailing like mad.
• Wishful thinking by the NAR is laughable.
• The diffusion index by the AIA is a valid point.
• Non-residential building jobs are down.
• Commercial real estate tends to follow residential real estate with a lag.
• UPS and YRC suggest huge falloff in shipping demand.
  
• Circuit City, Best Buy, and Walmart confirm the overcapacity problems in retail.
  
• Over capacity is stunning. We simply do not need more stores and profit margins are clearly being squeezed.

This concludes Part 1 of Debating the Flat Earth Society.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Global Savings Glut Revisited

Ben Stein hopped on the "global savings glut" bandwagon today in a New York Times article entitled The Hedge Kings Are Rich, but Will They Be Noble? Let's take a look.

HEDGE fund managers and traders make an astounding amount of money. This is now part of the lore of the nation. Young millionaires, young billionaires, all hunched over trading screens and manufacturing money while the rest of us toil for peanuts.

How did it happen? Why do they make so much more money than other people in finance do, or than people in industry in general? Do they deserve it? What will they do with it? And who makes it all possible?

These questions would take an entire book to answer. But I’ll just try to give a few answers that occur to me, and I invite anyone who knows more about this subject than I do to chime in.

First, the money is basically being made by “positive carry.” (By coincidence, this is also the name of a yacht owned by a supersmart, supersuccessful friend in finance named John Devaney.) That means the hedge funds can borrow money, invest it safely and make enough to repay the loan with interest and still have a profit. They can do this because the cost of money is so low these days.

Why is it so low? Because the Chinese people save about 40 percent of what they earn and use a lot of it to buy United States Treasury securities, keeping overall interest rates low. The Japanese do the same, and so do the immensely wealthy petro-states. So when the hedge fund managers cash their huge checks and sail their yachts and fly in private jets, they should thank people living carefully elsewhere. Savings in Guangdong, China, mean mansions in Greenwich, Conn.

Stein goes on to talk more about hedge funds, Warren Buffett, Andrew Carnegie, Andrew Mellon, Henry Ford, John D. Rockefeller, and philanthropy. I am stopping the post where I did because once again we see the idea presented that there is a "global savings glut" and that is the idea I want to focus on as well as refute. Before we get there, let's look a few previous articles on the subject.

In March of 2005 Bernanke proposed the idea of a "savings glut" in his speech The Global Saving Glut and the U.S. Current Account Deficit.

In July of 2005 BusinessWeek reported A global savings glut is good for growth -- but risks are mounting.

Look around the world, and extra money is piling up in all sorts of places. Japanese corporations are recording record profits, but not doing much spending. Chinese companies are on an investment tear, but the country is getting so much money from exports that it has billions to spare, including $18.5 billion that China National Offshore Oil Corp. (CNOOC) bid for Unocal. The surge in oil prices -- now about $60 a barrel -- is giving oil-producing countries such as Russia and Saudi Arabia far more money than they can use right away. And the aging workers of Europe are building nest eggs for an uncertain future.

The International Monetary Fund predicts that in 2005 the worldwide savings rate should hit its highest level in at least two decades.

A Jan. 31, 2005, article in BusinessWeek noted that a "global glut of savings" could explain low interest rates. Then, in March, Fed Governor Ben S. Bernanke -- now head of President George W. Bush's Council of Economic Advisers -- unleashed the flood gates with a speech on the "global saving glut."

In July of 2006 MacroBlog reported The Chairman Speaks: The Savings Glut Persists.

More from Chairman Bernanke's exchange with Senator Bennett during yesterday's testimony:

BENNETT: Do you still believe there's a global savings glut and that we can expect people to continue to want to put their money here?

BERNANKE: I think there still is a global savings glut. It may have moderated somewhat because of increased growth in some of our trading partners. But on the other hand, there's also been, of course, these large revenues that the oil producers are accumulating because of the high price of oil. They are not able to absorb - - use those revenues at home very quickly. So they are taking that money and putting it back into the global financial system. And so that's contributing to this overall global savings glut...

If you do a Google search of "Savings Glut" you will find over 400,000 hits.

Even articles attempting to refute the idea such as Investment dearth, not savings glut on Mises.org do not adequately explain exactly what is happening.

The simplest (and best) refutation to date of the silly notion that there is some kind of "Global Savings Glut" came today from Professor John Succo on Minyanville. In Response to Ben Stein, Professor Succo had this to say.

Dear Mr. Stein,

I have been running a hedge fund for almost seven years now and prior ran derivative trading at several wall-street firms. My fund trades derivative instruments with our $1.5 billion in capital.

In addressing your first assertion, that hedge funds make their money on positive carry, I would say that you are partially right. There are most likely many hedge funds borrowing low and lending high in “safe” investments, but the key word is “safe”. There are many likely scenarios where these safe investments would turn toxic quickly. It is not only hedge funds that are speculating in this way; you can say the same thing of Goldman Sachs and JP Morgan.

I disagree for the most part on your thoughts of where this cheap money is coming from: It is not coming from a high savings rate from Asian investors but from the creation of credit by all central banks.

The Federal Reserve creates credit through its open market operations like REPOS and coupon passes. If the Fed wants to inject liquidity (credit) into the system, they simply call up large broker dealers and buy some of their bonds with credit they create out of thin air (this expands their balance sheet). The dealer then passes this credit on to “the market” by making loans to mortgage companies or margin accounts or whatever. Because each layer of lender is only required to keep marginal capital on hand, a $1 billion REPO done by the Fed eventually creates as much as $100 billion in new credit to the consumer.

That credit creates the liquidity for additional consumption in the U.S., but these days we are buying our stuff from China (other countries too but we will just say China to make it easy). When a Chinese company receives dollars in trade, this normally would drive up U.S. interest rates: the company goes to the central bank of China to exchange Yuan for dollars; the central bank of China would normally sell those dollars into the currency market for Yuan thus driving up U.S. interest rates. But in our world of today these dollars are being sterilized: the central bank of China prints the Yuan to give to the company and takes the dollars and buys U.S. securities.

It is not the excess savings of Chinese investors that are buying U.S. securities. It is central banks creating credit themselves to buy those securities. The tick data that measure foreign inflows of money does not distinguish between private investors and central banks going through brokers to buy U.S. securities. We believe that as much as 90% of foreign money buying U.S. securities (not just Treasury bonds, but corporate bonds, mortgages, and yes, stocks) is not private investment, but central banks.

In order for other central banks like China’s to print the Yuan necessary, they too must create credit. Public debt in Asian countries is expanding as a result and creating worries: this is why Thailand came out essentially raising margin requirements to reduce speculation that is occurring as a result. Notice how they were quickly slapped down by their trading partners who do not want to rock the boat at this time.

This situation is very unstable in the long run. The Federal Reserves’ balance sheet this year alone has expanded by $30 billion in this way and created $3.5 trillion of new credit in the U.S. Public debt around the world is growing exponentially and total debt in the U.S. now stands at nearly 3.6 times GDP (1929 was 2.8 times).

My hedge fund’s position is the opposite of the carry trade you mention. There is coming (timing is unclear where it may be tomorrow or may be years away) a massive correction in debt and derivatives whose magnitude is only growing with time.

I invite you to visit and spend a few hours with me to discuss in depth hedge funds, their role and growth, and specific positioning and risk control we employ.

Best Regards,
John Succo

Key Points

• There is not really a savings glut in China.
• What people mistake for a savings glut is in reality a process in which the Chinese Central Bank prints Renminbi in exchange for US dollars and then has to figure out what to do with those excess dollars.
  
• In the long run the situation is very unstable.
• There is nothing "safe" about the massive carry trades in play.
• Public debt around the world is growing exponentially and total debt in the U.S. now stands at nearly 3.6 times GDP (1929 was 2.8 times).
• A massive correction in debt and derivatives whose magnitude keeps on growing with time is coming. Timing the event is difficult to predict.

A tip of the hat and thanks to both Professor Succo and Minyanville for exposing the myth of the global savings glut in a simple, easy to understand manner.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Was George Orwell Right?

This post is about RFID chips, video surveillance, and bluetooth wireless technology. Sometimes it is hard to tell sometimes where politics begins and economics leaves off and this post has aspects of both. Surveillance technology and chips of all kinds are big business. How that technology is used can be hugely political. But there is certainly no question that a huge trend is underway in regards to increasing use of such devices, and one of the as aspects of this blog is to look at trends. So here we are.

Bloomberg is reporting George Orwell Was Right: Spy Cameras See Britons' Every Move.

It's Saturday night in Middlesbrough, England, and drunken university students are celebrating the start of the school year, known as Freshers' Week. One picks up a traffic cone and runs down the street. Suddenly, a disembodied voice booms out from above: "You in the black jacket! Yes, you! Put it back!" The confused student obeys as his friends look bewildered.

"People are shocked when they hear the cameras talk, but when they see everyone else looking at them, they feel a twinge of conscience and comply," said Mike Clark, a spokesman for Middlesbrough Council who recounted the incident. The city has placed speakers in its cameras, allowing operators to chastise miscreants who drop coffee cups, ride bicycles too fast or fight outside bars.

Almost 70 years after George Orwell created the all-seeing dictator Big Brother in the novel "1984," Britons are being watched as never before. About 4.2 million spy cameras film each citizen 300 times a day, and police have built the world's largest DNA database. Prime Minister Tony Blair said all Britons should carry biometric identification cards to help fight the war on terror. .....

In Canada we see there are Eyes on Toronto Streets.

As Toronto gets its first police surveillance cameras, are we ready for our close-up?

The camera, at the corner of Gould, is one of three that have been installed on Yonge Street, in a police experiment that has drawn praise from some (including the Yonge Street business association), and condemnation from others, who see them as the first step toward a state where citizens are watched and controlled by Big Brother. .....

The market for surveillance cameras has boomed, according to Mr. Nilsson and other experts, with global sales estimated at up to $15-billion annually -- and demand is growing by 10 to 15 per cent every year. Mr. Nilsson's company has worked with a number of police forces (not including Toronto) on the installation of surveillance systems with capabilities that were once the realm of science fiction. For example, the Dallas police force has surveillance cameras that send a live video feed through a cellular uplink. Other cities have cameras that respond to motion or sound -- Chicago now has cameras with software that detects the sound of gunfire, and automatically trains the camera on its source. .....

"Privacy is sacred to our democracy, and this erodes it," says Varda Burstyn, a cultural critic and public policy consultant who is now working on a documentary about George Orwell. "Three cameras isn't a big deal. But the process is."

Critics of technology-based security systems believe the drawbacks far outweigh any benefits. The data collected could easily be misused, they say, and serious criminals can effortlessly evade electronic oversight.

"Cameras don't catch the big fish, only the small ones," Ms. Burstyn says. In her view, Western society has gradually slid toward the dystopian future predicted by Orwell through its increasing emphasis on technology and control. "There are always more cameras and more prisons," she says. "This is not the path we should be going down. What we should be focusing on is prevention and rehabilitation.

"Once you start down this road, it's hard to stop. You go from a dozen cameras to a hundred, from a hundred to a thousand, and from a thousand to a million." ....

Obviously there is big bucks for some firms in promoting this technology, but is it making anyone more secure? If it is, at what risk?

Please consider NSA Surveillance Data Led FBI To Dead Ends Or Innocent Americans.

In the anxious months after the Sept. 11 attacks, the National Security Agency began sending a steady stream of telephone numbers, e-mail addresses and names to the F.B.I. in search of terrorists. The stream soon became a flood, requiring hundreds of agents to check out thousands of tips a month.
Virtually all of them, current and former officials say, led to dead ends or innocent Americans.

F.B.I. officials repeatedly complained to the spy agency that the unfiltered information was swamping investigators. The spy agency was collecting much of the data by eavesdropping on some Americans' international communications and conducting computer searches of foreign-related phone and Internet traffic. Some F.B.I. officials and prosecutors also thought the checks, which sometimes involved interviews by agents, were pointless intrusions on Americans' privacy.

As the bureau was running down those leads, its director, Robert S. Mueller III, raised concerns about the legal rationale for the eavesdropping program, which did not seek court warrants, one government official said. Mueller asked senior administration officials about "whether the program had a proper legal foundation," but deferred to Justice Department legal opinions, the official said.

President Bush has characterized the eavesdropping program, which focused on the international communications of some Americans and others in the United States, as a "vital tool" against terrorism; Vice President Dick Cheney has said it has saved "thousands of lives."

The results of the program look very different to some officials charged with tracking terrorism in the United States. More than a dozen current and former law enforcement and counterterrorism officials, including some in the small circle who knew of the secret eavesdropping program and how it played out at the F.B.I., said the torrent of tips led them to few potential terrorists inside the country they did not know of from other sources and diverted agents from counterterrorism work they viewed as more productive.

"We'd chase a number, find it's a schoolteacher with no indication they've ever been involved in international terrorism - case closed," said one former F.B.I. official, who was aware of the program and the data it generated for the bureau. "After you get a thousand numbers and not one is turning up anything, you get some frustration."
......

Is this spying doing anyone any good? Does it make us safer or less safe? In the UK they are gathering information on chips about anyone of driving age. That means some 16 year old girls have their picture, eye color, age, height and birth all plugged into a chip that essentially any criminal can read. Of course prominent politicians and actors, etc, can file for an exemption for "security reasons".

So just how safe is this technology? What about RFID chips used in stores, passports, and even medical RFIDs implanted in the human body? Does this make it more or less likely for someone to steal your ID?

Some of the answers to those questions can be found in Suspect Nation.

I ask everyone to click on that last link and play the video in its entirety. It is fairly long (about 46 minutes) but well worth a play.

Perhaps it will scare some half to death, perhaps it will cause a lot of opinions to change, and perhaps it will cause some to look for ways to invest in the sector, or perhaps all three.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Vacancy Theory

I just received the following analysis on vacancies from a friend and would like to share it. Here goes, from Ramsey Su, with a study on San Diego vacancies:

The Study
Analyze all sales in SD, on a monthly basis, to determine the percentage of properties that are vacant at the time of marketing/sale. This study is based on all sales reported in the SD MLS from Jan 2004 thru Nov 2006.

The Theory
The occupant of an occupied property has to seek new shelter upon completion of the sale. This implies that they will be buying or renting something else, creating a positive chain of events for the market. Vacant properties, on the other hand, imply that the occupants had already moved into another dwelling. The sale of a vacant property is not likely going to add to the demand. Therefore, the higher number of vacant properties for sale and sold is an indication of weaker markets ahead (and vice versa).

The Results
The percentage of vacant properties was lowest during the summer of 2004, in the low 20% range. The resale market was strong and continued to be strong. Oct 05 clearly marked the turning point (see table below) of the San Diego real estate market with negative year to year comparisons for every month since then. The percentage of vacant properties sold also increased at that time. On a year over year basis, 27.4% of sales were vacant during 2004 vs 36.4% in 2005 and 44.5% in 2006 thru Dec 22nd, the last day that I downloaded data for the study. For the first 22 days of Dec 06, 50.5% of the 1,393 sales were vacant.

Looking ahead
There have been much debate about the pent-up demand vs the real estate crash ahead. The market will give us the answer soon enough.

Indicators supporting the pent-up demand theory:
1. New listings do not overwhelm the market after the holidays.
2. The percentage of vacant listings decline. Each sale should generate yet another sale.
3. Sales activities pick up at an equal or faster pace than new listings.

Indicators supporting the crash theory:
1. New listings spike up after the first of the year.
2. The percentage of vacant listings increases, especially in REOs.
3. Sales activities trail supply.

Ramsey Su Opinion

Owners of vacant properties should have a greater urgency to sell, therefore more willing to negotiate and will likely drive down the price in the process.

For the owners who can no longer support the debt service with no income or utility from living in the unit, it should increase the likelihood of foreclosures.

The public home builders have stated that the inability of buyers, who are under contract, to sell their existing homes as one of the major reasons for cancellations. The ones who are willing and able to buy a new home before selling their existing home might have already done so, resulting in a portion of the vacant properties listed for sale. The remainder may be either unwilling or unable to complete the purchase of a new home until their existing home is sold. Therefore, in order for the home builders to have a strong season during the traditional peak months of Feb and March, existing home sales must pick up immediately after the first of the year.

Support Data

Total number of sales and percentage vacant
When the market is strong, the percentage of vacant properties is low, and vice versa.






Active listings
As of Dec 22, 06, SD MLS has 17,384 total listings (single family and condos). Of the total, 6,404 or 36.8% are listed as vacant. As stated above, 50.5% of Dec sales so far are vacant. Does that imply owners of vacant properties are indeed more eager to sell?

Pendings
For the first 22 days of Dec 06, the MLS listed 1,616 properties as pending (in escrow). 870 or 53.8% of these listings are vacant. This indicates that the trend is heading toward higher vacant listings, not lower.

Expired listings
From Oct 1, 06 to Dec 22 06, there were 7,912 listings that expired. 2,438 or 30.8% of those listings were vacant. Does that imply owners of occupied properties are more willing to hold out for their dream price?

Thanks for sharing Ramsey.
This trend will be interesting to watch.

Given that it is Christmas Eve here is a story I would like to share.
Bus riders get gifts from Secret Santa

A woman hopped aboard buses, greeted passengers with "Merry Christmas" and handed each an envelope containing a card and a $50 bill before stepping off and repeating the process on another bus.

She did it so quickly that descriptions of the woman varied among surprised Spokane Transit Authority passengers on several routes Thursday, The Spokesman-Review newspaper reported Friday.

"She kind of kept her head down. I don't remember ever seeing this lady before," said bus driver Max Clemons.
"I had a young man in the back of the bus. He looked like he was going to start crying. He said in broken English, 'She don't know how much this will mean to me at Christmas,'" Clemons said.

Transit authority spokesman Dan Kolbet said efforts to identify the gift-giver were unsuccessful. Her generosity didn't appear to be part of a marketing gimmick, he said.

The woman gave envelopes to about 20 passengers, he said. Each was sealed with a sticker that said: "To a friend from a friend." The woman, accompanied by one or two young boys, pulled the envelopes out of a cloth satchel. The buses were pulling away from stops before riders even knew what happened.

Merry Christmas Secret Santa
Merry Christmas and a peaceful and prosperous new year to everyone here as well.
May 2007 will be your best year ever.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/