Slump Starting to Hit Luxury Goods

Even the rich are feeling the pinch of this downturn a bit. Some of it is that even the wealthy cut back in bad times (if nothing else, conspicuous consumption becomes a tad unseemly), but in addition, the rich are more levered generally speaking than heretofore, so some may also have good reason for caution.

From the Financial Times:

Inflation in luxury goods and services has dropped sharply in the past year, suggesting even the wealthy are feeling the effects of the downturn.

The Stonehage Affluent Luxury Living Index ....has almost halved to 3.3 per cent in the year to April.

Its London index was running at 6 per cent in 2006-07.... the figure is now more in line with the traditional Consumer Price Index which stands at 3.8 per cent.

Stonehage, the wealth management group which compiles the index, said even ultra-high net worth families appeared to be cutting their discretionary spending on luxury goods and services as the global economy slows.

Deflation was notable in some of the index’s items, including cars and watches...

John Selvadorai of Grange Aston Martin, a car dealer in Brentwood, Essex, said: “We’ve had to sharpen our pencil because we’ve had less people walking through the door.”

Customers “don’t want to be perceived to be spending the money when they’re having to lay people off or not pay people bonuses”.

Darren Street, sales manager at RSJ Sports Cars in Slough, Berkshire, which specialises in Porsches, said: “We get a lot of City customers and people who own their own businesses and I think everyone is affected.”

Property rental prices have also been flat compared with the previous five years which saw luxury rentals rise by 25 per cent.

Robby Hilkowitz, executive director of Stonehage, said: “At the top end, it is a money-oriented population that is well attuned to the markets and so they do tighten their belts even earlier than average consumers.”

However, items in limited supply continued to exhibit big price rises. A case of Lafite Rothschild 2000 wine was up 45 per cent to £13,415, while the global art price index was up 37.6 per cent....

Standing between the egg-shaped Alexander McQueen Empire Bag, retailing at £29,350, and the £43,000 one-off Steiff bear, made of cashmere and gold lamé, is a surprisingly relaxed Paul Kelly.

The credit crunch may be biting at the heels of some of Selfridges’ competitors, but it has yet to make its presence felt in Mr Kelly’s shopping halls...

Meanwhile, Myla, the lingerie maker, says it is still enjoying underlying sales growth in the double digits and is planning on its biggest Christmas yet after opening its fifth standalone store in London this year.

The lower end of the luxury market, however, does appear to have begun feeling the pinch.

“Just in the last few weeks we can see it slightly fraying at the edges,” says Robert Ettinger of the eponymously named leather goods designer and manufacturer, whose wallets typically sell for about £120. “Up to that point I was very optimistic.”

FOMC Member Gary Stern Calls For Interest Rate Increase

The Bloomberg report on Minneapolis Fed president Gary Stern's hawkish views noted that he has a more sanguine view of the health of the financial system than other FOMC members do.

From Bloomberg:

The Federal Reserve shouldn't wait until financial and housing markets stabilize to raise interest rates, central bank policy maker Gary Stern said.

``We can't wait until we clearly observe the financial markets at normal, the economy growing robustly, and so on and so forth, before we reverse course,'' Stern, president of the Federal Reserve Bank of Minneapolis, said in an interview today. ``Our actions will affect the economy in the future, not at the moment.''

The comments by Stern, a voter on the rate-setting Federal Open Market Committee this year, reinforced traders' forecasts for a rate increase by year-end. Stern indicated that Treasury Secretary Henry Paulson's rescue plan for Fannie Mae and Freddie Mac will help prevent a deeper housing and economic slump.

I'm not sure I buy that logic. Making it clear to Congress that guarantees to housing have a real economic cost, which is what the rescue does, may constrain their efforts to launch more housing initiatives. The rescue of Fannie and Freddie do not improve the fundamentals of the housing market.

Back to the story:

Traders' estimates of a rate increase in October rose to 64 percent after Stern's remarks were published, from 58 percent earlier today....

``This is a very challenging policy environment,'' Stern said today. ``I don't think we ought to pretend that'' an end to the credit crisis ``won't take some time,'' he said.

Merrill: US May Face "Financing Crisis"

Ambrose Evans-Pritchard appears to be trying to corner the market in apocalyptic financial news. But his sources aren't evangelicals, survivalists, or even goldbugs. The experts he cites are with respected financial firms, meaning they don't sound alarms casually. Even more significant, the terms they are using to describe what might be coming are uncharacteristically dire.

The latest bad tidings in that the Fannie/Freddie turmoil may lead our favorite foreign credit sources to dial down their purchases of Treasuries and agencies a tad. We've become so dependent on foreign credit that a mere tightening of the spigot would have significant consequences.

Tim Price, a UK based investment manager, gives a long-form treatment of a theme I've mentioned: we are way way outside known historical patterns. That is troubling to anyone, but it is particularly unnerving to the order-liking mindsets of analysts and central bankers:

That stock market price action has been so consistently dreadful with such little evidence of a sustainable floor despite flurries of ostensibly positive news (Santander / Alliance & Leicester; some form of formal pastoral care for Fannie Mae and Freddie Mac) could be interpreted as a sign that many investors remain trapped at the “denial” stage of this particular market disaster. Or perhaps many investors, institutional and individual alike, are now mulling their deliberative options. And some, presumably, have already reached the decisive phase, and already pulled the plug on much of their market exposure and initiated the dash for cash. This may or may not prove to be the prudent strategy; only time will tell. It certainly seems to show the merit in the advice that if you’re going to panic, panic early. We would merely hazard the following suggestion: the current market environment is flushing out those investors (supposedly “professional” and individual) who are congenitally unsuited to be making substantial portfolio allocations to the equity markets. The fiendish difficulty for those who decide to be out of the market entirely will be when to decide to get back in.

Classic Buffettology advises us to get greedy when others are fearful. This would ordinarily be sound advice, if somewhat difficult psychologically to execute. But if that blanket exhortation proves to be deficient or at least premature this time around, it will be because the nature of the problems facing financial markets, central banks and commercial banks is off the charts. It feels difficult because many of us have never been here before: only part-way through the historic bust of an extraordinary credit boom, only part-way through a property market correction that could yet last for months if not years, and only part-way through probably the gravest systemic crisis facing the banking system since the 1970s, if not indeed the 1930s. What accelerates and amplifies the downwave in stock markets is the state of our brave and newly inter-connected world where all investors are effectively neurons firing in a vast collective brain. And the global investment brain has suffered a stroke, an ischemic shock triggered by a sudden catastrophic lack of confidence mixed with heady deleveraging.

Now to Evans-Pritchard (hat tip reader Dwight):

Merrill Lynch has warned that the United States could face a foreign "financing crisis" within months as the full consequences of the Fannie Mae and Freddie Mac mortgage debacle spread through the world.

The country depends on Asian, Russian and Middle Eastern investors to fund much of its $700bn (£350bn) current account deficit, leaving it far more vulnerable to a collapse of confidence than Japan in the early 1990s after the Nikkei bubble burst. Britain and other Anglo-Saxon deficit states could face a similar retreat by foreign investors.

"Japan was able to cut its interest rates to zero," said Alex Patelis, Merrill's head of international economics.

"It would be very difficult for the US to do this. Foreigners will not be willing to supply the capital. Nobody knows where the limit lies."

Brian Bethune, chief financial economist at Global Insight, said the US Treasury had two or three days to put real money behind its rescue plan for Fannie and Freddie or face a dangerous crisis that could spiral out of control.

"This is not the time for policy-makers to underestimate, once again, the systemic risks to the financial system and the huge damage this would impose on the economy. Bold, aggressive action is needed, and needed now," he said.

Mr Bethune said the Treasury would have to inject up $20bn in fresh capital. This in turn might draw in a further $20bn in private money. Funds on this scale would be enough to see the two agencies through any scenario short of a meltdown in the US prime property market.....

Yves here. The problem is that the Treasury lacks statutory authority to do so, and despite going to the trouble to announce a plan on a Sunday before markets opened in Asia, there is no sign that anything concrete has been done to advance the ball.

Roughly $1.5 trillion of Fannie and Freddie AAA-rated debt - as well as other US "government-sponsored enterprises" - is now in foreign hands. The great unknown is whether foreign patience will snap as losses mount and the dollar slides.

Hiroshi Watanabe, Japan's chief regulator, rattled the markets yesterday when he urged Japanese banks and life insurance companies to treat US agency debt with caution. The two sets of institutions hold an estimated $56bn of these bonds....

But the lion's share is held by the central banks of China, Russia and petro-powers. These countries could all too easily precipitate a run on the dollar in the current climate and bring the United States to its knees, should they decide that it is in their strategic interest to do so.

Mr Patelis said it was unlikely that any would want to trigger a fire-sale by dumping their holdings on the market. Instead, they will probably accumulate US and Anglo-Saxon debt at a slower rate. That alone will be enough to leave deficit countries struggling to plug the capital gap. "I don't see how the current situation can continue beyond six months," he said.

Merrill Lynch said foreign governments had added $241bn of US agency debt over the past year alone as their foreign reserves exploded, accounting for a third of total financing for the US current account deficit....

Global inflation is now intruding with a vengeance as well. Much of Asia is having to raise rates aggressively, drawing capital away from North America. This may push up yields on US Treasuries and bonds, tightening the credit screw at a time when the US is already mired in slump.

Russia's deputy finance minister, Dmitry Pankin, said the collapse in the share prices of Fannie and Freddie over the past week was irrelevant because their debt has been effectively guaranteed by the US government under the rescue package.

"We don't see a reason to change anything because the rating of the debt of those agencies hasn't changed," he said.

Foreign policy experts doubt that the picture is so simple. Russia is likely to use its $530bn reserves as an implicit bargaining chip in high-stakes diplomacy, perhaps to discourage the US from extending Nato membership to the Ukraine and Georgia.

Vladimir Putin, now Russia's premier, has stated repeatedly that his country is engaged in a new Cold War with the United States. It is clear that Moscow would relish any chance to humiliate the United States, provided the costs of doing so were not too high for Russia itself.

China is regarded as a more reliable partner, with a greater desire for global stability....

Yves here. Partner maybe, only in the way Ambrose Bierce defined it in the Devil's Dictionary:

When two thieves have their hands so deeply plunged into each other's pocket that they cannot separately plunder a third party.

If we think China is a friend, we will be disappointed.

Brad Setser, from the US Council on Foreign Relations, said the Chinese have a stake in upholding Fannie and Freddie, not least to ensure that their loans are "honoured on time and in full".

David Bloom, currency chief at HSBC, said fears that regional banks could start toppling after the Fed takeover of IndyMac last week were now the biggest threat to the dollar.

"We have a pure dollar sell-off," he said. "It's a hating competition: at the moment the markets hate the dollar more than they hate the euro, even though German's ZEW confidence indicator was absolutely atrocious."

Oil Collateral Damage: $100 Billion of Aircraft Orders at Risk

It's a no-brainer that as airlines are cutting service, slapping on new fees and surcharges, and raising prices in increasingly desperate efforts to achieve profitability, the last thing they need to do is strain their cash flows further by buying new aircraft. A Times story assesses the magnitude of the cutback in orders.

From the Times:

More than $100 billion (£50.2 billion) of aircraft orders could be cancelled or postponed in the next couple of years as the high price of fuel drives airlines into bankruptcy or forces them to cut spending.

Analysts estimate that 20 to 30 per cent of the $530 billion order backlog held by Boeing and Airbus, the aircraft manufacturers, could be cancelled or delayed as the aviation industry heads towards a winter of turmoil. These cancellations would have a significant impact on aerospace suppliers such as Rolls-Royce, the engine maker.........

Pessimism over the future of the airline industry is expected to lead to a muted Farnborough Air Show, which starts today. A few large orders are expected, including a possible $20 billion order from Etihad, the Abu Dhabi-based carrier, but the bonanza that has marked recent air shows is unlikely to be repeated.

The high price of fuel has already forced more than 20 airlines worldwide out of business and many more are expected to enter bankruptcy this year as their costs rise and passenger demand drops because of the economic slowdown in the United States and Europe. According to the International Air Travel Association (IATA), every $1 rise in the price of oil increases the fuel costs for the global airline industry by $1.6 billion.

Fears about a drop in aircraft orders come as Boeing and Airbus have a competitor in the trillion-dollar, shorthaul aircraft market for the first time in over a decade after the announcement yesterday that Bombardier, the Canadian engineering group, is to build a new passenger jet, the C-Series...

At a presentation on Saturday, EADS, the owner of Airbus, outlined its plans to cut costs further to cope with the rising value of the euro, which makes it more expensive to operate in Europe.

Airbus has already introduced a costcutting and restructuring scheme, called Power 8, which is intended to save €2.1billion (£1.68 billion) and eliminate 10,000 jobs. Louis Gallois, the chief executive of EADS, said that the company would extend this project with Power 8+ in order to achieve further savings.

Branson: "Spectacular Casualties" Coming to Airlines Soon

We've said that if oil prices don't retreat significantly before year end, airlines will be asking for bailiouts. One travel agent who is a wholesaler tells me that premium seats (business and first class) are seriously undersold. That's a major blow in combination with skyrocketing fuel costs.

From Reuters (hat tip reader Saboor):

There will be "spectacular casualties" in the airline industry over the next 12 months, billionaire Richard Branson, the owner of Britain's No. 2 long-haul airline Virgin Atlantic, was quoted as saying on Saturday.

The U.S. airline industry -- including Virgin America -- has been battered by soaring fuel costs that are pinching even the healthiest airlines.

"The financial state of the world is just about the worst I've ever known it," Branson told The Times newspaper in an interview. "It's getting perilously close to being worse than the 1990s.

"You have the perfect storm -- you've not only got the banking crisis and the housing crisis, you've got the soaring fuel prices as well. One of the big American carriers will almost definitely go."

Does M1 and M2 Contraction Signal Debt Deflation?

Ambrose Evans-Pritchard in "Monetarists warn of crunch across Atlantic economies" in the Telegraph points to a troubling development: a fall over last few months in M1 and M2 in the US, UK and EU.

Many have criticized the Fed for "printing money" of late. But the evidence suggests otherwise. First, all of the cash injections that the central bank has undertaken via its alphabet soup of new lending facilities have been met with roughly equal withdrawals though open market operations. Thus the new facilities themselves have not led to monetary expansion.

Second, critics like to point to the Fed's negative real interest rates as lax monetary policy. In the dot-bomb environment, which was not a credit crisis, that charge is accurate, and that policy helped create our current mess.

But we now have credit contraction. Deleveraging is deflationary. Somewhat loose monetary policy is appropriate. Unlike 2002, banks or securities firms are not going out to create new debt, which is the mechanism by which low interest rates lead to inflation or asset bubbles. Mortgage lending has become dependent on the Federal government via Freddie, Fannie, and the FHA (and the future of that support is now in question). Consumer credit of all sorts is being reined in. Dow Chemical had to go to Warren Buffett to borrow to acquire Rohm & Haas because it could not get funding from banks. Our credit intermediation system is barely functioning.

And oil is now playing a role that is weirdly parallel to gold in 1931. England abandoned the gold standard, which was tantamount to a devaluation. The US stayed on it at that juncture and raised interest rates even though the economy was very fragile. Countries that stayed on the gold standard in 1931 on average suffered a 15% fall in real GDP in 1932.

But gold was not an essential economic input. Oil is, and thus constrains the Fed's ability to lower rates further (not that it has much leeway at 2%, since most economists regard going below 1% as risking falling into the zero interest rate trap that has enmeshed Japan).

From the Telegraph:

The money supply data from the US, Britain, and now Europe, has begun to flash warning signals of a potential crunch. Monetarists are increasingly worried that the entire economic system of the North Atlantic could tip into debt deflation over the next two years if the authorities misjudge the risk.


The key measures of US cash, checking accounts, and time deposits - M1 and M2 - have been contracting in real terms for several months. A dramatic slowdown in Britain's broader M4 aggregates is setting off alarm bells here.

Money data - a leading indicator - is telling a very different story from the daily headlines on inflation, now 4.1pc in the US, 3.7pc in Europe, and 3.3pc in Britain.

Paul Kasriel, chief economist at Northern Trust, says lending by US commercial banks contracted at an annual rate of 9.14pc in the 13 weeks to June 18, the most violent reversal since the data series began in 1973. M2 money fell at a rate of 0.37pc.

"The money supply is crumbling in the US. There was a very sharp lending contraction in the second quarter lending. If the Federal Reserve is forced to raise rates now to defend the dollar, it would be checkmate for the US economy," he said.

Leigh Skene from Lombard Street Research said the lending conditions in the US were now the worst since the Great Depression. "Credit liquidation has begun," he said.

The Fed's awful predicament does indeed have echoes of the early 1930s when the bank felt constrained to tighten into the Slump in order to halt bullion loss under the Gold Standard. Investors - notably foreigners - dictated a perverse policy. Over 4,000 US banks collapsed. This time a de facto "Oil Standard" is boxing in Ben Bernanke. Benign neglect of the dollar has started to backfire. It is pushing up crude, with multiple leverage.

The monetary picture is highly complex. The different measures - M1, M2, M3, M4 - have all given false signals in the past. Each tells a different tale, and monetarists fight like alley cats among themselves.

The Federal Reserve stopped paying much attention to the data a long time ago. It has abolished M3 altogether. The US economic consensus is New-Keynesian (dynamic stochastic general equilibrium model). Delving into the money entrails is derided as little better than soothsaying.

That attitude, retort monetarists, is the root cause of the credit bubble. The money supply almost always gives advance warning of big economic shifts. Those who track the data are now calling on central banks to move with extreme caution. If the rate-setters overreact to an inflation spike caused by oil and food - or confuse today's climate with the early 1970s - they may set off an ugly chain of events.

"The data is pretty worrying," said Paul Ashworth, US economist at Capital Economics. "US lending is shrinking dramatically in real terms, and we know from the Fed's survey that banks want to tighten further. People are clamouring for higher rates but we think deflation is now the biggest threat. The idea that the Fed should tighten with unemployment soaring is preposterous," he said. The jobless rate jumped from 5pc to 5.5pc in May.

In Britain, the Shadow Monetary Policy Committee - hosted by the Institute for Economic Affairs, and a refuge for UK monetarists - issued its own alert this week. The focus is on "adjusted M4", which covers loans to "private non-financial corporations" and may offer the best insight into the health of British business.

The growth rate has dropped from 16.1pc a year ago to minus 0.5pc in April. It is the suddenness of the decline that matters most. The data reeks of recession. Professor Patrick Minford from Cardiff Business School called for an immediate rate cut, arguing that the credit crunch is a more powerful and long-lasting force than the oil inflation.

Professor Tim Congdon from the London School of Economics said the UK was lurching from boom to bust. "Real money growth is virtually nil. The British economy is taking a thrashing and it is going to get worse. Corporate money balances have contracted 3pc over the last three months, which is double digits on an annualised basis. This is a serious squeeze for companies," he said.

Mr Congdon warned three years ago that surging M4 would lead to a "dangerous" bubble, which is what occurred. He now fears the MPC will react too late as the process goes into reverse.

Roger Bootle from Capital Economics said Britain could be facing a "real economic crisis and a financial collapse. The MPC does not have the luxury of waiting until all is absolutely crystal clear. By that time the bird will have flown."

The eurozone is at a later stage of the credit cycle. Even so, house prices are collapsing in Spain, and falling in Germany and France. German industrial orders have dropped for the last six months in a row. A joint IFO-INSEE survey said eurozone growth had stalled to zero in the second quarter.

"Consumer lending has fallen off a cliff. It is contracting in real terms," said Hans Redeker, currency chief at BNP Paribas. Core inflation has fallen from 1.9pc to 1.7pc over the last year.

Unlike the Fed, the European Central Bank keeps a close eye on money data (though not on real M1, now shrinking). It looks at the broader M3 figures. There is a raging debate in Europe over the signals now being sent by this indicator.

The M3 growth is still 10.5pc, down from 11.5pc in January. However, the data has been badly distorted by the closure of the capital markets. Firms have been forced to draw down existing credit lines from banks, which shows up as M3 growth. (It is the same story with America's M3 since the collapse of the Commercial Paper market).

"The credit lines are expiring. Companies cannot roll over loans. We are going to see the entire private credit multiplier go into a slowdown," said Mr Redeker.

Jean-Claude Trichet, the ECB's president, said last week that the M3 data "overstates the underlying pace of monetary expansion". The ECB nevertheless pressed ahead with a rate rise to 4.25pc, setting off a storm of protest. This may go down as one of the most unwise monetary decisions of modern times.

The strain on eurozone banks is growing by the day. They bid a record $85bn (£43bn) at the ECB's last auction for dollars. Only $25bn was available. The spreads on Euribor interbank lending are still at extreme stress levels.

Few disputes that "global inflation" is taking off. Over 50 countries now face double-digit price rises. Ukraine (29pc), Vietnam (27pc), and the Gulf states are out of control, with Russia (15pc), and India (11pc) close behind. China (7.1pc) is on the cusp. Interest rates are still below inflation across much of the emerging world. This is the driving force behind spiralling commodity prices.

The oil spike is already squeezing real wages in the Atlantic region. The debate is whether the Fed, Bank of England, and ECB should squeeze them further, trying to off-set energy rises with a deflationary bust in the rest of the economy. If and when oil peaks in this cycle, they may find inflation crashing faster than they dare to imagine.

The 9th Circle in Dante's Inferno - starring Judas and Brutus - is a frozen lake. Cold can be more frightful than heat. "Blue pinch'd and shrined in ice the spirits stood," (Canto XXXIII). Such awaits the victims of debt deflation.

Will Japan's Lost Decade Become the Norm?

Blomberg columnist William Pesek plays out a line of thought that may have occurred to some readers: what if the resolution of the credit crisis and global imbalances isn't a nasty recession or punishing inflation but Japan-like protracted low growth, with stagnant to deteriorating living standards?

This idea may not be as much of a stretch as it sounds. Policy makers, in trying to avoid the depression/entrenched inflation extremes, may steer themselves into the Japan solution.

In the US, despite the brave talk of free markets, we have been socializing losses right and left and trying to shore up plummeting asset values. Although inflation is running at high rates in many countries, it is the product mainly of commodities price increases due to developing economy demand. If the banking system in the US, UK and Europe are in as bad shape as I think they are, demand for imports will slacken further, which will reduce growth, and in some cases, reduce consumption. Reader DownSouth reminded us that from 1979 to 1983, oil consumption fell from 67 million barrels per day to 58 million bpd. And high fuel price act as a tariff, again hurting exporters. We have already discussed that factories near Hong Kong are being shuttered at a rapid pace, and this is before the expected post-Olympics slowdown.

Similarly, the strain on food prices is due to biofuels, increased consumption of meat in third world, and poor harvests in Australia, have put pressure on foodstuffs. Biofuels subsidies may get undone (one can only hope) and similarly, higher food costs will have us all, not just people in developing countries, being more sparing of our meat consumption. A near-global slowdown will intensify that trend.

And there is the bigger question of whether we really have reached a crisis of capitalism, whether a system whose raison d'etre is growth and increasing standards, can adapt to a world of resource constraints. The optimists at the Milken Institute Global Conference felt that technology would provide and answer. But new technologies take time to be developed and implemented, particularly on a broad scale, while the needs appear urgent.

From Bloomberg:

Count Hong Kong real-estate mogul Ronnie Chan firmly among those who think Japan's 1990s experience is highly instructive. The reason: Lost decades may become the rule, not the exception.

``What if the lost decade in Japan becomes the global norm?'' Chan, chairman of Hang Lung Properties Ltd., said at the Asia Innovation Initiative conference in Fukuoka, Japan, on July 8. ``Can you imagine that? Perhaps we should. Perhaps people should get used to slower growth, or no growth.''

It's not that Chan, who runs Hong Kong's fourth-largest real-estate development company by market value, is a pessimist. Property developers don't often relish 10 years of lost growth here and 10 years of declining asset values there. Chan sees a rare confluence of economic and demographic trends that bode poorly for a global rebound.

No one should be surprised by the rapid pace of economic expansion after World War II.... It began from a low base, following the devastation of economies in Europe and parts of Asia. Next came rapid population growth and a boom in innovation. Then there were new social and institutional paradigms as democracy spread and organizations such as the United Nations and the World Bank offered support.

Today, the picture looks vastly different. As everyone tries to stabilize growth, things are hardly at a low base. Population growth is fueling demand for commodities, driving up inflation and increasing poverty rates. Innovation may slow as investment dries up. And institutions such as the International Monetary Fund hardly seem up to today's challenges.

Oddly, one of Asia's potential failures is democracy, Chan says. It simply isn't proving to be the panacea that leaders in the U.S. and Europe promised. Poverty rates remain stubbornly high in many Asian democracies, and so does corruption. The former is often a result of the latter.

It's certainly not that democracy is bad. Yet there's something to be said about what Chan calls ``premature democratization'' in Asia.

Elections matter only when nations build strong institutions such as independent courts, ministries, a free press, credible central banks and ample systems of checks and balances. Their absence means many governments don't operate as transparently or successfully as expected.

Yves here. That is not a trivial point. My Communist college roommates would remind me that Russia and China were the only economies to industrialize in the 20th century (for the record, I was apolitical then and previously had a someone who appeared in the Ivy League Playboy issue and later a brilliant but highly wound poet as roommies).

Similarly, Japan with its one party system is not exactly a Western-style democracy. Singapore, an island with just about nothing going for it, and some serious disadvantages at the time of its independence, prospered under a far sighted nation-builder who bordered on being a benevolent dictator, Lee Kwan Yew. Yew in particular was concerned about corruption, and early on created tough watchdog agencies and implemented the policy that top bureaucrats would earn the same level of pay as top private sector professionals, both to make sure the government would attract good people and reduce the incentives to cheat.

Back to Pesek:

All this may be a problem for the region as it tries to avoid the worst of the credit-market crisis. Chan wonders if the type of prosperity during the decade before the 1997 Asian crisis will be more unusual in the future.

``Those 10 golden years of rapid growth and high returns may well have been an aberration,'' Chan says.

The combination of surging energy and food prices will challenge economies with political rifts, such as Thailand and Malaysia. Nor does it bode well for high-poverty ones such as Indonesia and the Philippines, or those trying to compete amid China's boom -- South Korea, Singapore and Taiwan, for example.

Slower growth is absolutely necessary, of course. Economists, including Kenneth Rogoff of Harvard University, argue that accelerating inflation is a clear sign the global economy needs to cool to let commodity supplies and fuel alternatives catch up. Yet a sharp slowdown in Asia may be devastating.

Take China, which needs to expand about 10 percent annually to raise the living standards of 1.3 billion people. Slowing growth will place dangerous pressure on Asia's second-biggest economy. For a nation at China's level of development, 5 percent growth is essentially a recession...

Policy makers are merely putting off the inevitable and treating the symptoms of what ails the global economy. If they aren't careful, Japan's experience during the 1990s will become a familiar one.

``It's not a scenario many expect for the West or for Asia,'' Chan says. ``But I'm not sure it can be ruled out.''

Lehman, Deutsche Bank Strategists Predict Best 6 Months for S&P Since 1982

Since I seldom am the bearer of upbeat news, I thought I'd pass along the cheery forecast from market strategists at Lehman and Deutsche Bank, namely, that the Standard & Poor's 500 index will have its best six months since the second half on 1982 in the second half of 2008.

I happen to remember that period. The markets had been though a grinding loss of faith in securities, not just stocks. Philip Brothers, a commodities broker, had bought the storied Salomon Brothers; Goldman had done a reactive deal, a purchase of a commodities trader, J. Aron, which turned out to be a horrifically bad deal on any cashflow analysis (commodities went promptly into retreat shortly after the deal was concluded; J. Aron was soon hemorrhaging cash and pink slips) but in the very long term helped Goldman's strategic position. The few fixed corporate bond deals being done were at coupons of over 15%. Similarly, very few equity issues were being done (who would want to sell stock at such low multiples?).

It on a specific day in August that thinks turned, I think August 12, that word went through Goldman like wildfire that the bear market was over. Sadly, I don't recall the trigger for this change in sentiment (it preceded Volcker's relenting on his dose of high interest rates, which occurred in October 1982).

The Bloomberg piece is skeptical of these forecasts, as am I based on my recollections of the reference period. Markets and sentiment are no where near as ground down as they were then. The S&P 500 earnings multiple was around 10. And given how weak the economy had been, there was ample room for both earnings improvement as well as multiple expansion (click to enlarge).



But hey, I could be all wet. And another Bloomberg story points to a bullish indicator: record short interest. High levels of shorting means an improvement in stock prices can gain strong momentum from short covering.

From Bloomberg:

Deutsche Bank AG, Lehman Brothers Holdings Inc. and UBS AG say the Standard & Poor's 500 Index will gain the most in 26 years during this year's second half. That isn't going to happen, if history is any guide.

The S&P 500 will rise 18 percent by January, according to the consensus projection of 10 U.S. strategists surveyed by Bloomberg. The forecasts are based partly on estimates that profits will jump 50 percent in the fourth quarter after falling for the past year.

Even if that happens, it may not be enough. In 2001, the last time profits fell as much, they then had to climb for three straight quarters before stocks rebounded. Analysts' earnings estimates for this year still represent a decline from 2006 levels, making the strategists' optimism harder to justify, investors say.

``If they're accurate, I'll give them a big kiss,'' said Randy Bateman, who oversees $15 billion as chief investment officer at Huntington Bancshares Inc. in Columbus, Ohio. ``I don't think those are very realistic figures.''

The S&P 500 dropped 1.2 percent last week to 1,262.90, coming within a percentage point of a ``bear market,'' defined as a 20 percent plummet from its peak in October. Based on the index's closing price of 1,280 on June 30, the average strategist forecast of 1,515 by year-end calls for the biggest rally of any second half for the S&P 500 since Ronald Reagan was in the White House in 1982....

Strategists at Deutsche Bank, Lehman Brothers and UBS are the most bullish and expect the benchmark for American equities to climb to a record in the second half. Binky Chadha, Deutsche Bank's New York-based chief strategist, says the S&P 500 will end the year at 1,650, up 29 percent from June 30.

Ian Scott, Lehman's global strategist, is predicting an advance of 27 percent to 1,630, while David Bianco at UBS says the index will increase at least 25 percent.

The S&P 500's rebound ``is going to be one of the greatest roars we've seen,'' Bianco said. ``The market has way too many fears baked into the valuation right now. The fear out there is the earnings are about to collapse and interest rates are about to surge on inflationary fears. Neither is going to happen.''

Strategists' annual forecasts have been off by an average of 14 percentage points since 2000, according to data compiled by Bloomberg. They haven't projected an annual decline in at least eight years

At the start of the year, strategists told clients to expect an average 11 percent advance in the S&P 500 in 2008 to 1,634, Bloomberg data show. The measure has dropped 14 percent so far.

``A monkey with an abacus is probably better at the end of the day,'' said Peter Sorrentino, a Cincinnati-based senior money manager at Huntington Asset Advisors, which oversees $16.7 billion. ``To read the strategists' input is intriguing and thought-provoking, but at the end of the day, you'd better have your own tools. We're nowhere near as optimistic as some of the forecasts.''...

Abhijit Chakrabortti, chief global equity strategist at Morgan Stanley, wrote in a report today that the S&P 500 is still too high relative to earnings and may decline as much as 8.9 percent to 1,150 if inflation accelerates. Merrill Lynch & Co.'s Richard Bernstein expects the index to rise to 1,400 in the next 12 months, according to a July 3 note to clients...

Profits at S&P 500 companies fell for three straight quarters and are estimated to have dropped 11.2 percent in the second quarter, according to data compiled by Bloomberg. Four consecutive periods of declines would be the most since the last recession in 2001....

``Earnings in a lot of sectors should look good,'' said James Swanson, Boston-based chief investment strategist at MFS Investment Management, which oversees $204 billion. He expects the S&P 500 to gain 23 percent to 1,580 by Dec. 31. ``Financials should be making money again. There's certainly a lot of wreckage now, but there are bargains out there.''...

Shares may still drop even after earnings recover, which is what happened during the last recession. The S&P 500 lost 13 percent during the five quarters of profit declines between 2001 and 2002. In the last three quarters of 2002, when earnings increased again, the index fell a further 23 percent.

``There's always going to be ebbs and flows in the economy, but we believe that this is a start of a significant bear market,'' David Tice, founder of the $1.2 billion Prudent Bear Fund, said on Bloomberg Television. ``We are going to pay the price for it with much lower stock prices.''

Wolfgang Munchau: Maybe the Economists Are to Blame After All

Wolfgang Munchau, in his latest Financial Times comment, "Recession is not the worst possible outcome" takes up a theme near and dear to our and many readers hearts: that policies to avoid recessions do more damage in the long run than letting slumps run their course.

Munchau is hard on economists, but not the purely academic type, but policymakers who endeavor to road test theories. A central element of Munchau's piece is that central bankers rely heavily on the so-called "dynamic stochastic general equilibrium model" which as he discusses at some length, fails to incorporate elements many observers would regard as important.

Note Munchua's Eurointelligence co-blogger (and fellow FT contributor) Paul De Grauwe gave a longer-form treatment of this topic recently. However, another FT writer, John Dizard, noted late last year that Bernanke discussed the Fed's efforts to improve its DSGE models and indicated that the Fed does not rely solely on them. Nevertheless, Dizard seemed underwhelmed by its choice of alternatives (Dizard later argued that the Fed's efforts to improve liquidity in banking markets were a departure from DSGE, but doomed to fail).

Munchau therefore advocates remedies that sound straight out of the IMF's playbook circa 1997. Let housing fall as far as it needs to, raise interest rates high enough so that real rates are positive (horrors!), permit some banks to go bust (that's gonna happen regardless, but I think Munchau means a big bank or two), plus some sensible longer-term policy remedies.

I can tell you with 100% certainty this will never happen. The mere idea of letting housing find its natural level (which Munchau thinks is 40% to 50% below peak prices) is politically unacceptable, so a great deal of effort and government resources will be expended to attenuate the inevitable. And per the 1997 analogy, Munchau may not appreciate what an unadulterated dose of his medicine might mean. We've remarked more than once that the America's situation very much resembles that of Thailand or Indonesia circa 1997, except we have the reserve currency and nukes. In this case, the reserve currency is the more important element, for when the IMF's harsh remedies were imposed, the rapid depreciation of local currencies meant that foreign currency denominated debts increased greatly in cost. Many businesses failed due to the rise in the debt burden. Now a currency depreciation won't affect US borrowing costs to anywhere near the same degree, but consider nevertheless: Indonesia's GDP fell by 13.5% in 1998. Would the US tolerate a fall of even 1/3 that much to get its economy back on track? Not voluntarily.

From the Financial Times:

If this had been a mere financial crisis, it would be over by now. The fact that we are suffering its fourth wave tells us there might be something at work other than merely financial euphoria and bad regulation. Maybe this is not a Minsky moment after all. Hyman Minsky, the 20th century US economist, formulated the long forgotten, and recently rediscovered, financial instability hypothesis, according to which capitalist economies, after a long period of prosperity, end up in a vicious circle of financial speculation. The Minsky moment is the point when what economists call this “Ponzi game” collapses.

But there might be better explanations. As the Bank of International Settlements said in its latest annual report, subprime might have been the trigger for this crisis, but not the cause. We do not have a full understanding yet of what happened but the BIS suggested that fast expansion of money and credit must have played a role. I would go further and say this is not primarily a crisis of financial speculation, but one of economic policy. Its principal villains are therefore not bankers, but economists – not in their role as teachers and researchers, but as policy advisers and policymakers.

So who are they? I recall a wonderful episode told by Jagdish Bhagwati in his book In Defense of Globalization when he quoted John Kenneth Galbraith as saying: “Milton’s [Friedman’s] misfortune is that his policies have been tried.” In fact, this is not the worst that could happen. The worst is for economists to try out their own theories themselves. This happened to several highly respected academics who have since become central bankers or finance ministers. If, or rather when, they turn out to be wrong, they risk a double reputational blow – as policymakers and as academics. So do not count on them to change their mind when the facts change.

Several of them have been leading proponents of an economic theory known as New Keynesianism. It is, in fact, probably the most influential macroeconomic theory of our time. At the heart of the New Keynesian doctrine stands the so-called dynamic stochastic general equilibrium model, nowadays the main analytical tool of central banks all over the world. In this model, money and credit play no direct role. Nor does a financial market. The model’s technical features ensure that financial markets have no economic consequences in the long run.

This model has significant policy implications. One of them is that central banks can safely ignore monetary aggregates and credit. They should also ignore asset prices and deal only with the economic consequences of an asset price bust. They should also ignore headline inflation. An important aspect of these models is the concept of staggered prices – which says that most goods prices do not adjust continuously but at discrete intervals. This idea lies at the heart of some central bankers’ focus on core inflation – an inflation index that excludes volatile items such as food and oil. There is now a lively debate – to put it mildly – about whether an economic model in denial of a financial market can still be useful in the 21st century.

So when economists tell us that we need to keep real interest rates negative, just as we did for long periods in the past 15 years, or that we now need to bail out homeowners and banks and raise our national debt in the process, or ignore any considerations of moral hazard while the crisis is raging, we might want to question whether the recipes that got us into this mess are also most suited to get us out again.

If we believe, as the BIS does, that a rapid expansion of money and credit has either caused, or significantly contributed to, the build-up of asset price bubbles and higher inflation, the opposite policy conclusions might be more appropriate.

Under this setting, the priority might be not to impede the fall in asset prices. Real house prices in the US, the UK and several other economies might end up falling by some 40-50 per cent, peak-to-trough, in the downward phase of this cycle. Let this happen and do not implement policies to prevent this fall – such policies might alleviate some pain in the short run for some people but will make the adjustment last a lot longer.

Second, monetary policy should be geared towards price stability first and foremost. When inflation expectations rise, real interest rates should be positive. This would necessitate a large interest rate increase in the US and further interest rate increases in the eurozone as well.

Third, allow some defaulting banks to go bust.

Fourth, implement long-term policies designed to reduce volatility. Among these are: a change in the monetary policy framework to take explicit account of asset price developments; the removal of pro-cyclical incentives in the banking sector; stricter regulation of mortgages, such as the encouragement of fixed-rate loans and the imposition of maximum loan-to-value ratios; more exchange-rate flexibility in countries with fixed or semi-fixed exchange rates and, of course, the development of alternative energies to reduce our reliance on oil.

We might run a greater risk of a recession in the short term. But a recession is not the worst possible outcome. The worst is for this crisis to go on and on, for Minsky’s moment to become an eternity.

"Oil price shock means China is at risk of blowing up"

The headline above, which comes from an article in the Telegraph by Ambrose Evans-Pritchard, might benefit from a better image. "Blowing up" doesn't seem the right image to describe an economy at risk of a sudden drop in growth. But something more fitting, like engines going into stall, might have taken too much space.

Aside from that quibble, the article provides further anecdotal evidence that high oil prices are hitting China hard. The country's export-driven strategy depended on cheap shipping, which has become a thing of the past. We had noted that Hong Kong businesses may shutter 20,000 factories out of 70,000 in the neighboring province Guangdong. Similarly, the article mentions furniture manufacturing returning to the US. A friend who was a senior officer there said there was no reason for the US to send high end furniture building overseas (many of the woods used are domestic in origin) but at Ethan Allen, the analysts wanted it and the CEO was eager to comply.

The second factor is that China has started rolling back domestic subsidies of fuel prices. The government has realized a bit late that its energy inefficiency (amount of energy required to produce one unit of GDP) puts it at a competitive disadvantage, so ending the subsidies is seen as necessary to force businesses to become more efficient energy users. But that adjustment process will be painful.

Update 7/7/08, 2:00 AM: Further confirmation of the Telegraph's thesis comes from a weekend Reuters story, "Asia's exporters suffering as global demand weakens" (hat tip Russ Winter):

Deutsche Bank estimates some 20 percent of China's low-end exporters will go belly-up this year.

From the Telegraph:

The great oil shock of 2008 is bad enough for us. It poses a mortal threat to the whole economic strategy of emerging Asia.

The manufacturing revolution of China and her satellites has been built on cheap transport over the past decade. At a stroke, the trade model looks obsolete....

Asia's intra-trade model is a Ricardian network where goods are shipped in a criss-cross pattern to exploit comparative advantage. Profit margins are wafer-thin.

Products are sent to China for final assembly, then shipped again to Western markets. The snag is obvious. The cost of a 40ft container from Shanghai to Rotterdam has risen threefold since the price of oil exploded...

Energy subsidies have disguised the damage. China has held down electricity prices, though global coal costs have tripled since early 2007. Loss-making industries are being propped up. This merely delays trouble.

"The true impact of the shock will only be revealed over time, as subsidies are gradually rolled back," he [Stephen Jen, currency chief at Morgan Stanley] said. Last week, China raised internal rail freight rates by 17pc.

BP 's Statistical Review says China's use of energy per unit of gross domestic product is three times that of the US, five times Japan's, and eight times Britain's.

China's factories "were not built with current energy levels in mind", said Mr Jen. The outcome will be "non-linear". My translation: China is at risk of blowing up.

Any low-tech product shipped in bulk - furniture, say, or shoes - is facing the ever-rising tariff of high freight costs. The Asian outsourcing game is over, says CIBC World Markets. "It's not just about labour costs any more: distance costs money," says chief economist Jeff Rubin.

Xinhua says that 2,331 shoe factories in Guangdong have shut down this year, half the total.

North Carolina's furniture industry is coming back from the dead as companies shut plant in China. "We're getting hit with increases up and down the system. It's changing the whole equation of where we produce," said Craftsmaster Furniture.

China is being crunched by the triple effects of commodity costs, 20pc wage inflation, and sagging import demand in the US, Canada, Britain, Spain, Italy, and France.

Critics warn that Beijing has repeated the errors of Tokyo in the 1980s by over-investing in marginal plant. A Communist Party banking system has let rip with cheap credit - steeply negative real interest rates - to buy political time for the regime.

Whether or not this is fair, it is clear that Beijing's mercantilist policy of holding down the yuan to boost exports share has now hit the buffers.

Foreign reserves have reached $1.8 trillion, playing havoc with the money supply. Declared inflation is just 7.7pc, but that does not begin to capture the scale of repressed prices, from fuel to fertilisers. "There is a lot more bottled-up inflation in this economy than meets they eye," says Stephen Green, from Standard Chartered.

Inflation merely steals growth from the future. It defers monetary tightening until matters get out of hand, which is where we are now. Vietnam has already blown up at 30pc. India is on the cusp at 11pc, so is Indonesia (11pc), the Philippines (11pc), Thailand (9pc) - leaving aside the double-digit Gulf.

Of course, oil prices may fall again. They plunged to $50 a barrel in early 2007 after the Saudis raised production. The scissor effect of slowing global growth and extra crude later this year from Brazil, Azerbaijan, Africa, and the Gulf of Mexico may chill the super-boom.

The US Commodities Futures Trading Commission is on an "emergency" footing, under orders from the Democrats on Capitol Hill to smash speculators. If it is really true that investment funds have run amok, we will soon find out.

I suspect that the energy markets have fallen prey to their own version of the "shadow banking system" that so astonished regulators when the credit bubble burst.

I also suspect that Hank Paulson and his EU colleagues have a surprise up their sleeve for the late-cycle über-bulls. Those who claim that derivatives (crude futures) cannot drive spot prices have overlooked a key point. The Saudis and others use the IPE Brent Weighted Average of futures contracts as their pricing mechanism. Futures now set the spot price.

But even if oil comes down for a year or two, the mid-term outlook of the International Energy Agency warns that crude markets will be tighter than ever by 2012. Call it Peak Oil, or just Peak Non-Cooperation by the dictatorships that control most of the world's remaining 5 or 6 trillion barrels (Mankind has used one trillion so far).

Come what may, globalisation has passed its high-water mark. The pendulum will now swing back from China to America. The mercantilists will have to reinvent themselves.

Are Trichet's Rate Hikes 1930 All Over Again?

Readers have taken to throwing brickbats when I post material that suggests that raising interest rates (at least in advanced economies) might not be a good move right now.

We've said before that the reason the Fed kept rates too low too long was it looked at inflation as strictly a domestic phenomenon and ignored the inflation-suppressing effects of cheap imports. That process has gone into reverse due to high oil prices and rising import prices. Remember, the reason high interest rates kill inflation is by slowing economic activity. That's already happening, and I am highly confident things will get worse all by themselves if the Fed and ECB merely stand pat.

The problem is inflation in emerging economies, particularly China. The Chinese stock market (not a perfect indicator, to be sure) says growth is slowing big time. We noted in a post yesterday that there are other indicators, such as significant factory closings, that say Chinese growth may be about to downgear fast. We've noted in passing, and reader Independent Accountant noted longer form, that an increase in fuel prices is having the same effect as tariffs. Hello, Smoot Hawley?

And as painful as high oil prices are, if you believe they are the result of supply and demand, a runup this fast is producing considerable demand destruction. We've seen it already in the US based on April results, and oil was only $110 to $120 a barrel then. The effect of cuts in fuel subsidies in China and India have only started to work their way through the economy. The blunt instrument of monetary policy is not the answer to high fuel prices.

Note we are not applauding Bernanke's moves to date. We think he cut too deeply, too quickly, and left the Fed with no maneuvering room. It would be better if the Fed funds rate were, say, 100 basis points higher. But increasing it to that level would wreak so much havoc on banks that you'd get (in the end) such massive fiscal stimulus that it could more than undo whatever benefit there might be via a modest rate increase.

Yes, negative real interest rates normally lead to speculative investment. But pray tell who is getting credit in the US now? Consumers most certainly aren't, businesses have it tough, the mortgage market depends on Federal guarantees, and by all accounts, the credit markets are having liquidity issues in many sectors. We saw a different version of this phenomenon in the S&L crisis: the prime rate wasn't all that bad, but it was irrelevant because just about no one could borrow in any meaningful size.

Now if you don't think the credit crisis has further to run (credit contraction is deflationary), then raising rates is in order. But based on what I see, things are plenty fragile. I'd rather have the central bankers simply sit tight and do nothing for a quarter and try to get a better handle on the fundamentals.

We'll admit that in a solvency crisis, there is not much a central banker can do. But raising rates now, particularly in pursuit of a dubious notion like inflation targeting, is in its own way as precipitous as Bernanke's 75 basis point cuts.

First, some comments from Banque AIG market strategist Bernand Conolly (hat tip reader Scott, no online source). The subtext is that he sees no pretty way out of the mess of massive US debt overhang, but efforts to force US rates up now could produce a particularly devastating resolution:
[

W]hat we are seeing in the world is a breakdown of international economic consensus. In its place is what the literature calls “strategic behaviour”, marked by threat strategies and an underlying feeling of every man for himself....

Our main concern today, though, is with the damage that will be done to the world economic and financial system if the US gives in to threat strategies, whether from the ECB, from europols or from elsewhere in the world. If one looks at the Saudi position, for instance, it is very understandable indeed that the Saudi authorities should be seriously concerned about the erosion of their country’s purchasing-power over rest-of-the-world resources as the dollar has depreciated. But that simply restates the impossibility of achieving a fundamental equilibrium in the US. As we argue in some detail in our note, “Central Banks, Asset Prices, Risk Premia, Money and the Macro Paradigm: Where Does It All Point?” of 19 February 2007, the US current-account deficit has been a Ponzi game: market pricing has implied that holders of claims on the US economy will see the value of those claims (in terms of command over future US resources) go towards zero as time goes towards infinity. There is an agent-principal problem here that relates to the possibility of a self-fulfilling equilibrium with an inefficient outcome: those in charge today of managing their countries’ claims on the US have an incentive not to inflict realised losses on their principals by sparking a dollar rout, even though, in the limit, not bailing of claims on the US now may mean that future generations will find those claims worthless.

But the Saudis, at least, now seem to have understood at least one aspect of the problem. Unfortunately, a combination of Saudi pressure on the US to stem dollar depreciation and europol pressure on the US to try to do that by forcing US rates up could bring disaster. Recall the analysis of the relevant part of our note of 19 February last year. The scale of real effective dollar depreciation required for the US to be able to respect its intertemporal budget constraint without a devastating US
recession was simply not reflected in real-interest-rate differentials. That left two possibilities. One was that the Ponzi game would be allowed to run on indefinitely: the US would not respect its transversality constraint and the rest of the world would not meet its transversality condition. The other was that the US current-account deficit would indeed adjust but, without the support to net exports from a massively-depreciated dollar, that adjustment would take place in conditions of devastating recession. But in that scenario US credits would deteriorate dramatically; yet that, too, was not incorporated in market pricing.

The horrible prospect is that the europols are trying to subject the US to the constraints that EMU has imposed on the euro-area cads. In EMU, currency risk (for individual countries, though not of course for the area as a whole) is transformed into credit risk. But if that happens to the US, via attempts to “stabilise” the dollar, the catastrophic impact on US credits will – given that the dollar has been essentially a credit story in the present decade – lead to very severe downward pressure on the dollar as foreigners are forced to try to bail out of claims on the US. That vicious circle would be broken, no doubt, either by a decision by the US authorities to let the dollar go – in chaotic circumstances recalling the end of the Bretton Woods system but probably with even more profound geopolitical consequences – perhaps after intervention/exchange controls on one side or the other.

Ambrose Evans-Pritchard of the Telegraph is largely on the same page.

Sadly, we are witnessing the sort of strategic errors that turned the recession of 1930 into a global catastrophe.

The European Central Bank is now hell-bent on a course of action that will have a knock-on effect across the world and risk a dangerous implosion of the credit system.

The ECB's Jean-Claude Trichet told Die Zeit today that "there is a risk of inflation exploding."

Let me put it differently: there is a grave risk of social and political disorder "exploding" if the logic of his argument is followed to its grim conclusion, that is to say if the ECB charges ahead with a string of rate rises through the autumn after its near certain move to 4.25 per cent on Thursday.

The ECB mantra is that Europe and the world is on the cusp of a wage-price spiral along the lines of the 1970s...By taking this militant 1970s line, he is in effect kicking Bernanke in the teeth. Or put another way, the ECB is trying to pressure America into a tighter monetary stance. Regrettably, this has in part succeeded. The Fed badly needs to cut rates further -- probably to 1per cent. It cannot do so because the ECB keeps threatening to pull the plug on the dollar.

This is madness. It is the mirror image of the early 1930s, when the Federal Reserve (cowed by the Chicago liquidationists) precipitated the collapse of 4,000 banks, and transmitted their fervour to rest of the world through the Gold Standard. This time there is no Gold Standard. But the globalised capital and currency markets -- egged on by Trichet -- are playing much the same role.

Yes, eurozone inflation reached 4 per cent in June. But what on earth does that tell us, unless you are an inflation-target totemist? It takes two years or so for the full effects of monetary policy to work through the economy, and by then Europe will be an entirely different place.

The ECB was too loose in the early part of this decade (in order to help Germany), keeping rates at 2 per cent until December 2005. That is the underlying cause of the rapid credit growth in the eurozone up to the onset of the credit crunch, and a key cause of silly property bubbles in Club Med and Ireland. The ECB was negligent in 2004, 2005, and 2006, (as were the US Federal Reserve and the Bank of England -- this is not to absolve Anglo-Saxon central banks at all. They all botched royally.)

We are now in the eye of the post-bubble, debt-deleveraging, deflation storm. The ECB's rate rise tomorrow will do nothing whatever to deal with the current oil and food spike, which is in any case causing a dramatic squeeze in real wages. It will merely make the downturn worse. I suspect that the ECB will be cutting frantically to undo the damage from its own ideological excesses soon enough, just as the Fed had to do after its fatal rate rise to 5.25 per cent last year...

If the rate rise pushes the euro higher against the dollar, it will merely push oil higher as well -- since oil is trading as inverse dollar with seven times leverage. Eurozone "inflation" -- that treacherous term -- will get worse. Brilliant.

Ben Bernanke -- despite his own "helicopter" baggage -- has had the courage to ignore the shrieking punditocracy and slash rates by 325 basis points, looking beyond the oil spike to the deflationary risks that lie beyond. This is statesmanship of the first order....

Perhaps Germany now needs higher rates as unemployment tumbles to a 16-year low. It has gained 30 per cent to 40 per cent in unit labour competitiveness against Italy and Spain since the currencies were fixed, and 20 per cent against France.

It is conquering market share across Club Med. As chief supplier to booming Russia, it is enjoying a (positive) asymmetric shock. But Germany is not the euro-zone.

The unspoken truth -- and now the source of so much poisonous policy-making -- is that Europe signed an implicit political contract with Germany in the 1990s that monetary union should never lead to a recurrence of German inflation. The euro must be as hard as the old D-Mark, and not a Lira-Peseta.

The system is now being bent to comply with this contract. Indeed, one senses that Buba chief Axel Weber has a near maniacal urge to press the point, like Shylock cutting his `Pound of Flesh', -- even if such a course of action has become inherently destructive, especially for Germany's strategic interests....

As the BIS and others have warned, the eurozone is already in the grip of an incipient credit crunch. Distressed companies are drawing down existing loans from banks because the securitisation market is shut.

The result of monetary overkill is already evident in parts of system. Ireland's GDP contracted at an annual rate of 1.5 per cent in the first quarter. It will get a lot worse. Investment fell 19.1 per cent. House prices have fallen for fifteen months in a row.

Spain's house prices have fallen 6.2 per cent since July (4.3 per cent this year alone) according to Facilisimo.com. This hardly surprising. Euribor used to price floating rate mortgages (98 per cent of the total in Spain) has risen 120 basis points since the crunch began.

Unemployment has risen by 425,000 over the last year, a faster rate of increase than during the recession of the early 1990s. Monetary policy has been tightened into a severe downturn.

HSBC expects French house prices to fall 10 per cent over the course of this year and next.

Yes, inflation has run amok in Asia, the Mid-East, and Russia. They will have to slam on the brakes. Some are doing so already. This will hit just as the effects of the ECB's squeeze bites harder.

It has become fashionable to talk of "global inflation". There is no such thing. A large number of countries have let their money supplies surge out control by refusing to let their currencies revalue against the dollar. They are now paying the price.

The Western states with collapsing property and asset markets (the Anglo-Saxons, Club Med) or demographic implosions (Germany) have the opposite problem. Confusing one with the other will take us straight into a slump.

Job Market Now Forecast to Worsen Into 2009

The report Tuesday of worsening conditions in the auto market has led to a deepening of gloom on the employment front. Many private sector forecasters now expect workplace conditions to weaken well into 2009.

In fact, these forecast might prove to be optimistic. Housing will probably not bottom before 2010 at the earliest, and given that Alt-A and option ARM resets run at high levels through 2011, it's an open question how long it will be before we see improvement on that front. My view is we are not likely to see much pickup in the economy until housing has at least stabilized.

From the New York Times:

Joblessness has accelerated, and employers have slashed working hours even for those on their payrolls, shrinking the size of paychecks just as workers need them the most.

Now, add to that unsavory mix the word from automakers that sales plunged in June — by 28 percent for Ford, 21 percent for Toyota and 18 percent for General Motors — a sharp sign that consumers are pulling back, making manufacturers more likely to cut production and impose more layoffs. Until recently, the weak labor market has been marked more by the reluctance of employers to create new jobs than by mass layoffs...

“It’s a slow-motion recession,” said Ethan Harris, chief United States economist for Lehman Brothers. “In a normal recession, things kind of collapse and get so weak that you have nowhere to go but up. But we’re not getting the classic two or three negative quarters. Instead, we’re expecting two years of sub-par growth. Growth that’s not enough to generate jobs. It’s kind of a chronic rather than an acute pain.”...

Mr. Harris expects tepid economic growth and a shrinking labor market to persist through the fall of 2009....

Goldman Sachs forecasts that the unemployment rate will peak at 6.4 percent late in 2009 before the picture improves, meaning that the painful process of shedding jobs may be only half-way complete..

On Thursday, the Labor Department will release its snapshot of the job market for June. Economists generally expect the report to show 60,000 more jobs lost, marking the sixth consecutive month of decline.

But many anticipate the unemployment rate will nudge down a little bit, swinging back from an abrupt climb that could have been exaggerated by survey glitches in the previous month, when the rate jumped by half a percentage point — the sharpest one-month spike in 22 years.

If the unemployment rate were to hold steady or rise, that would likely spook markets, underscoring the impact of the economic slowdown....

Recent indications lend credence to the view that the job market is in the grip of a sustained downturn. Three weeks in a row, new unemployment claims have exceeded 380,000, a level generally associated with recession. Construction spending fell in May. The University of Michigan Consumer Sentiment Survey, which tracks attitudes about business and personal finance, has dropped to a depth last seen in 1980.....

With job losses growing and working hours shrinking, many paychecks are eroding, prompting millions of families to cut their spending. Soaring prices for food and gasoline are overwhelming modest wage gains for most workers, leaving households with even less money to spend. All of which deprives struggling businesses of sales, prompting them to shed more workers, sending the cycle down another turn. Starbucks announced on Tuesday that it would close stores and eliminate up to 12,000 jobs, about 7 percent of its work force.

The fear of a downward spiral prompted the Bush administration to unleash $100 billion worth of tax rebates...Economists expect the rebates will continue to help retail sales through the summer...

Many experts expect the economy to then be pulled back into the weeds by the same forces that have led the downturn — declining home prices, tighter credit and leaner paychecks.

“It’s going to be very hard to overcome those headwinds,” said Mr. Harris, the Lehman economist.