Politick

GM's Delphi Gambit is Working

In chess, a gambit is the sacrifice of a pawn or piece to gain the initiative and attack. Delphi was until recently a part of GM, and the spinning off of Delphi in 1999 followed by it first going into bankruptcy can be seen as a gambit by GM to test Labor. As they say, Labor blinked, and has now offered a deal to cute wages and benefits, primarily by changing from a defined benefits program to a defined contribution. In a sense, this is karma, as Labor stiffed GM back in 1999 by a lengthy strike at Delphi, and GM blinked. Market reaction to GM's moves today is mixed. GM will still have to sell a controlling part of its cash cow, GMAC, in order to lower GMAC's costs of borrowing. This unwinding of the social compact will continue. The news today should inspire other old-line companies to begin their chess moves, while Labor is compliant.

Postscript to The End of GM

We noted how GM was in its endgame, and would soon follow the airlines into bankruptcy to remove the burden of high wages, generous pensions and layers of medical benefits. The first shot across the bow of Labor is the bankruptcy of its parts supplier, Delphi. Until a few years ago, Delphi was part of GM. Now it will serve as the stalking horse for the bigger bankruptcies to follow: GM, Ford and other old-line industrial powerhouses. A flood of analysis has noted how this is the end of the unskilled middle class in America. It reflects the unwinding of the social compact since the New Deal, where Government and Labor would layer benefits, wage increases and pensions onto the great engines of American prosperity. In a global economy, with the loss to China and India of the comparative advantage from the Industrial Revolution, the First World will now have to retool. Look for a tumultuous ten years. And for the Democratic Party, the friend of Labor, to remain on the defensive. At least they have an issue to fight for, even if it puts them on the wrong side of history.

Peak Oil Redux

Katrina and Rita have changed the dynamics of Peak Oil.  Before the two hurricanes, Yelnick posted a summary of the Peak Oil risk, and said it was at least a few years away.   Tonight at the Commonwealth Club in SF, longtime oil Cassandra Richard Heinberg (author of The Party's Over: Oil, War and the Fate of Industrial Societies) explained why this window until the peak has now seriously shrunk.

Peak Oil

On the companion stock market blog, Yelnick has been running a series on the uber-bears crying Wolf! Wolf! too often and losing their following.   Eventually, they will be proven right, but their followers will be tapped out by then.  Something similar may be occurring in the oil patch. 

The NYT Sunday Magazine ran a great piece on Peak Oil today.  Peak Oil is the bumper sticker for what happens when we hit max production out of current oil fields.  It doesn't mean we are running out of oil.  It means we can't get any more output from the wells.  Consequently, the marginal price of oil - what increasing demand will pay for the oil that we can no longer extract - will skyrocket well above the average price of oil, locked in by long-term contracts. 

Implication is we need a new fuel source ASAP.  The problem is that we have had at least five prior moments when some oil-industry Cassandra yelled Wolf! Wolf! and the Peak Oil problem abated.  Hence it is very difficult to get political momentum around doing anything about it, until it occurs.

Demographic Demise and the Real Deficit Problem

Today United was approved in being able to dump its pension obligations on the Federal government.  This could open the floodgates for GM, Ford and others to run through bankruptcy and strip out their excessive benefit and pension plans.  Should we be concerned?  Is there a limit to have much obligation can be assumed by the US government? 

Yelnick noted a while ago of the declining birth rates in the West and how it would lead to shrinking populations and lower growth, sparking a global scramble for yield. The scramble has already begun, as we sit in the low yield environment of the Kondratieff Winter. Now the mainstream punditry is picking up on this theme.  The first week of May, the Wall Street Journal ran a first page column on retiring boomers withdrawing from growth stocks and moving their wealth (what they can hang on to) into income producing properties, depressing the stock market. McKinsey has also completed a study of The Demographic Deficit: How Aging Will Reduce Global Wealth.  Their core message is that aging populations will save less and spend more, and governments will be pressed to fund all those welfare programs to support the aging, further reducing private investment.  What these analyses have so far overlooked is the other side of the story: in a low return environment, how to pay for all of the unfunded obligations we have assumed? How to pay it back?

Long Dead Economists and the End of GM

Today's story that GM debt is now rated as junk bonds should make us sit back and ask what is going on.  Much of the reason for GM's fate lies in pension and medical benefits obligations.  How we got here is one of the great delusions of our age, that we layer benefits and obligations on the private sector and still manage our way to prosperity.  Where did this come from, this illusion that wealth was just out there and we could take a bit here and a bit there and things would work out? 

It comes from a long dead economist, John Maynard Keynes, who once opined that we were all living in thrall to the theories of some long dead economist.  He succeeded beyond even his wildest imagination. His theories during the Great Depression gave justification for massive government intervention in the economy.  At first they were resisted. For 150 years the US Constitution had been interpreted to grant economic rights as a bedrock of a free society: protection of property, enforcement of contract and so forth, not to be removed without due process of law.  The Constitution itself specifically limited the powers of the Federal government.  During the Great Depression, the Supreme Court overturned many of FDR's interventionist acts.  Frustrated, the President attempted to 'pack the court' to change these decisions.  A key Justice backed down, and the floodgates opened.  Now almost any Federal law is allowed to intervene in economic affairs, and the Welfare State has us in thrall. 

Keynesian justification for action is so pervasive that it is like the air we breathe in debating political issues.  We argue over whether the government is the problem, and is too big, without even recognizing the extent to which we allow coercive political meddling in almost every aspect of economic life.  The issue is not its larger size but our smaller freedom.

Keynesian economics have failed repeatedly.  They did not lift us out of the Depression; we fell back into it in 1937-8 and did not escape until a war intervened.  They got us into the mess of stagflation in the '70s, after President Nixon famously said, "We are all Keynesians now."  They have justified piling layer after layer of unfunded liability onto the public, to the extent of estimates as high as $89T (that is trillion) or 8x our current GDP, half of which is government spending in any event - so an incredible 15x the private sector.  GM was saddled with all sorts of obligations that have now reduced it from the premier industrial giant of the US economy to a rustbelt relic with excess capacity that makes almost all its cash flow on finance not manufacturing. 

Keynes' other most notable quote is: "In the long run, we are all dead." How right he was again.  This is the epitaph we can put on GM.

Demographic Destiny and the Global Scramble for Yield

We are entering a one time event in human history - population will peak and then drop in our lifetimes.  The demographics are clear - in developed nations, birthrates are below replacement, and in developing nations, they are plummeting towards below replacement.  The primary cause seems to be the education of woman, who then see much more to life then being barefoot & pregnant.  (Just in case anyone has any doubts, I find the liberation of women to be the a GOOD thing, the seminal achievement of this era.) 

One consequence is a radical change in investment.  We all tend to believe in regression-to-the-mean, so if rates are low, they will rise; or if bonds are high, they will fall.  The demographic trend may lead to a one-time direction that should last 40 - 50 years, and the fact it doesn't change will catch everyone by surprise. 

Another consequence is grave risk of the Japanization of developed countries - decades of slow growth or modest decline.  One massive driver of growth are the Tweeners - twenty-somethings who enter the workforce and buy their first car, house, appliances, etc.  Subsequent purchases tend to be trading up or trading in.  Without the Tweeners, economies grow much slower.   (Hence the wisdom of consumer credit - fuels the Tweeners, is paid back when they begin saving in their 40s and 50s.)   The Birth Dearth means the Tweener growth engine sputters. 

(As a policy implication, it may be time for the US to open the immigration spigot, particularly for the best & brightest Tweeners from around the world.)

Economists at CSFB have assessed the inevitable demographic trends and made five predictions.

The Kennedy Republican Tax Cut

Art Laffer, the scion of supply side, proffered a perfect tax proposal for Gov. Schwarzenegger to fix California's fiscal problem: a radical simplification down to two taxes: 6% on business net sales, and 6% on personal income less the normal  middle class deductions (mortgage, charity, and -   significantly - rent). This would match current California tax revenues and would replace ALL other taxes, including sales, property, capital gains,   etc.  Laffer's insight is that a complex tax scheme raises too much money  during boom times, which governments overspend; and raises too little in bad   times, which causes crises like the one behind the Recall.  This simple tax would smooth revenue to the state, as well as make California look like the promised land to business once again.

Can the Fed Stop Deflation?

Prechter's EWI site has posted their primary deflation analysis. Worth studying.

Prechter defines deflation as follows: "Just as inflation is an expansion in the supply of money and credit, deflation is a contraction in the supply of money and credit. Deflation is not falling prices. Falling prices are a consequence of deflation. It is dangerous to confuse the two ideas because prices can fall without deflation." PC prices are an obvious example of this.

Is deflation impossible because the Federal Reserve Bank can just print money? Prechter says no, since the Fed primarily 'prints' money by fostering the expansion of credit. Banks create money by lending. The volume of bank money dwarfs the volume that the Fed could sensibly create on its own. Hence the Fed has to weave its magic by trying to manage credit markets.

Currently credit markets for business ("Main Street") are not working well - another way of saying that it is hard to get venture capital, or go public, or get commercial loans at reasonable rates and terms. It is virtually impossible in certain segments, such as dot-coms, or new telecom companies.  During the Great Depression, banks simply stopped lending, and the levers he Fed used to change behavior did not work. This was called the liquidity trap' since the Fed made credit available to banks but the banks did not make it available to borrowers. The psychology had to be broken before banks lent. Speeches about fear, big government deficits, government job programs, Fed pump priming, cheapening the currency, failed to do so then, just as they have failed for Japan more recently. It took WWII to break the psychology.

(A fascinating validation of Prechter's point of view can be seen in WWII movies. Some of the most commended early movies about WWII are actually about the Depression; watch From Here to Eternity or In Harm's Way. These movies start with people being bored, and when the war comes, it is welcomed, as a way to escape the psychology of the Depression. More recent WWII movies, such as Saving Private Ryan or Pearl Harbor, completely miss this context, as they were made during the social mood of the '90s.)

Three credit markets have been working in lieu of Main Street: Muni's, Mortgages and Margin, although the window on two of them appears to be closing. Given the sorry state of California, muni borrowing is approaching its limit. Given the recent jump in mortgage rates, after a final rush to borrow, the real estate boom is likely to end. That leaves the stock market. As Yelnick has reported, it appears the Fed has used any significant event (9/11, Iraq War, blackout) to pump credit into equity markets and keep the stock markets afloat without creating a dysfunctional reaction from naked credit pumping.

Greenspan's strategy is use credit in these ancillary markets to keep the economy afloat long enough for Main Street to return to normal. This means the Fed is primarily trying to manage social mood and psychology, not more mechanistic targets such as money supply growth.

Prechter's point is that the Fed is running out of arrows in its quiver to affect credit market psychology, and when there is no more it can do, the negative social mood may overwhelm all that it has tried to do, and send us into a deflationary spiral and subsequent depression. The marker for when the 'herd' recognizes this point of no return is a severe stock drop, or even crash. If it happens, it will be said after that the crash caused the subsequent depression, or 'discounted' it, when in fact, the crash only reflects a collective "Oh, $#!@" reaction as investors head for the exit, not knowing what may follow.