September 16, 2014

US Corporate Executives to Workers: Drop Dead

The Washington Post has a story that blandly supports the continued strip mining of the American economy. Of course, in Versailles that the nation’s capitol has become, this lobbyist-and-big-ticket-political-donor supporting point of view no doubt seems entirely logical.

Three years ago, Harvard Business School asked thousands of its graduates, many of whom are leaders of America’s top companies, where their firms had decided to locate jobs in the previous year. The responses led the researchers to declare a “competitiveness problem” at home: HBS Alumni reported 56 separate instances where they moved 1,000 or more U.S. jobs to foreign countries, zero cases of moving that many jobs in one block to America from abroad, and just four cases of creating that many new jobs in the United States. Three in four respondents said American competitiveness was falling. 
Harvard released a similar survey this week, which suggested executives aren’t as glum about American competitiveness as they once were… 
Companies don’t appear any more keen on American workers today, though. The Harvard grads are down on American education and on workers’ skill sets, but they admit they’re just not really engaged in improving either area. Three-quarters said their firms would rather invest in new technology than hire new employees. More than two-thirds said they’d rather rely on vendors for work that can be outsourced, as opposed to adding their own staff. A plurality said they expected to be less able to pay high wages and benefits to American workers. 
The researchers who conducted the study call that a failure on the part of big American business. They say the market will eventually force companies to correct course and invest in what they call the “commons” of America’s workforce. “We think this mismatch is, at some fundamental sense, unsustainable,” Michael Porter, one of the professors behind the studies, said in an interview this week. 
But what if it’s not? 
Why, if you were a multinational corporation, would you feel a need to correct that mismatch? Why would you invest in American workers? Why would you create a job here? 
At what point does it become a rational business decision for American companies to write off most Americans?
It’s hard to know where to begin with this. First, Harvard Business School is hardly a bastion of socialist thinking. Porter and his colleagues are correct to call out short-sightedness in the incumbents of C-suites. And there’s nary a mention of the role of the long-overvalued dollar, thanks to the lessons that China and the Asian tigers learned in the wake of the 1997 Asian crisis: keep your currency pegged low, run a big trade surplus so you have such a large foreign exchange warchest as to never again be subject to the tender ministrations of the IMF.

But second, and more worrisome, is a vastly larger intellectual failure on the part of the Washington Post and even the Harvard investigators. They’ve completely lost sight of whose interests are at work. The HBS grads are looting the American economy for their own personal profit. Making better products and developing new markets is hard and it takes time for that effort to pay off. Cutting costs is easy. Getting a pop in the price of your stock due to investors’ belief that offshoring and outsourcing will lower costs is even easier.

It’s far from a given, particularly at this juncture, that more outsourcing and offshoring is good for anyone aside from top executives, well-placed middle managers, and the various intermediaries in the outsourcing industry (yes, there is such a thing). We’ve been writing for years that even in the 1990s, we were hearing from executives at companies that sent operations overseas that the business case was weak, but they went ahead regardless to please Wall Street. Chief investment officers have said flatly that outsourcing is overrated as a cost saver.

In the early 2000s, we heard regularly from contacts at McKinsey that their clients had become so short-sighted that it was virtually impossible to get investments of any sort approved, even ones that on paper were no-brainers. Why? Any investment still has an expense component, meaning some costs will be reported as expenses on the income statement, as opposed to capitalized on the balance sheet. Companies were so loath to do anything that might blemish their quarterly earnings that they’d shun even remarkably attractive projects out of an antipathy for even a short-term lowering of quarterly profits.

And even when these projects actually do lower costs (as opposed to transfer income from lower-paid workers to middle managers, who need to do more coordinating, and senior executives), there are hidden costs in terms of extended supply chains, lost flexibility, and ceding the opportunity to develop expertise to vendors. In other words, even when profits improve, it’s typically achieved by making the company more fragile.

This unwillingness to invest represents a failure of capitalists to do their job on a massive scale. US-style short-termism has become all too common around the globe. As yours truly and Rob Parenteau wrote for the New York Times in 2010:
For instance, IMF and World Bank studies found a reduced reinvestment rate of profits in many Asian nations following the 1998 crisis. Similarly, a 2005 JPMorgan report noted with concern that since 2002, US corporations on average ran a net financial surplus of 1.7 percent of GDP, which contrasted with an average deficit of 1.2 percent of GDP for the preceding forty years. Companies as a whole historically ran fiscal surpluses, meaning in aggregate they saved rather than expanded, in economic downturns, not expansion phases. 
The big culprit in America is that public companies are obsessed with quarterly earnings. Investing in future growth often reduces profits short term. The enterprise has to spend money, say on additional staff or extra marketing, before any new revenues come in the door. And for bolder initiatives like developing new products, the up front costs can be considerable (marketing research, product design, prototype development, legal expenses associated with patents, lining up contractors). Thus a fall in business investment short circuits a major driver of growth in capitalist economies. 
Companies, while claiming they maximize shareholder value, increasingly prefer to pay their executives exorbitant bonuses, or issue special dividends to shareholders, or engage in financial speculation. They turn their backs on the traditional role of a capitalist – to find and exploit profitable opportunities to expand his activities. 
Some may argue that lower investment rates are the result of poor prospects, but the data does not support that view. Corporate profits have risen as a share of GDP since the early 1980s, reaching unprecedented levels right before the global financial crisis took hold. Even now, US profit margins are nearly two thirds of the way back to their prior cyclical high, despite a subpar recovery.
More than four years later, those sorry trends have continued, with profits now at a record share of GDP. But the top brass has been handsomely rewarded for its sorry behavior. They’ve discovered that the more they squeeze workers, both here and abroad, the more they can keep for themselves.

And in a bit of unintended irony, the Washington Post shows a headline for another way they’ve succeeded in making the greater public subsidize their profits: How the Postal Service subsidizes cheap Chinese goods. As readers know, the sources of corporate welfare are legion. Walmart’s super low wages are subsidized by $6.2 billion a year in public assistance, a significant portion of its $17 billion in reported 2013 profits. And that’s before you factor in the value of state and local tax breaks that Walmart gets by pitting communities against each other when it is planning new store locations. These concessions are particularly dubious given that Walmarts don’t create jobs, but do a combination of destroy them (by putting smaller retailers out of business) and steal them (by syphoning retail sales and hence other jobs) from neighboring communities.

While Walmart is the poster child of subsidized profits, the Bentonville giant has plenty of company, including large financial firms (so heavily subsidized and backstopped as to not be properly considered private companies), Big Pharma (a huge beneficiary of decades of NIH-funded research) and Big Auto (which has played the “pit communities against each other” game as adeptly as Walmart in securing subsidies for moving plants into union-hostile Sunbelt states).

Unfortunately, Porter appears to have characterized the problem accurately when he depicts the attitude of these self-serving executives as a looting of the commons of labor, meaning much of America. And the precursor of the early industrial period show that this can be a sustainable strategy until workers finally rebel. The Bolshevik revolution, which was actually a peasant revolt, was more than a century after the enclosure movement began its successful program to turn independent yeoman farmers into desperate factory wage-slaves. So while history suggests that capitalists will push workers beyond their breaking point, that rupture can be a very long time in coming. 

September 15, 2014

The U.S. National Debt Has Grown By More Than A Trillion Dollars In The Last 12 Months

The idea that the Obama administration has the budget deficit under control is a complete and total lie.  According to the U.S. Treasury, the federal government has officially run a deficit of 589 billion dollars for the first 11 months of fiscal year 2014.  But this number is just for public consumption and it relies on accounting tricks which massively understate how much debt is actually being accumulated.  If you want to know what the real budget deficit is, all you have to do is go to a U.S. Treasury website which calculates the U.S. national debt to the penny.  On September 30th, 2013 the U.S. national debt was sitting at $16,738,183,526,697.32.  As I write this, the U.S. national debt is sitting at $17,742,108,970,073.37.  That means that the U.S. national debt has actually grown by more than a trillion dollars in less than 12 months.  We continue to wildly run up debt as if there is no tomorrow, and by doing so we are destroying the future of this nation.

The chart that I have posted below shows the exponential growth of the U.S. national debt over the past several decades.  Anyone that would characterize this as "under control" is lying to you...

National Debt 2014

This is the greatest government debt bubble in the history of the world, but very few people seem to have any desire to do anything about this anymore.  We are literally gorging on debt, and most Americans seem to think that it is just fine and dandy.

Perhaps that it is because we have never really experienced any serious consequences for going into so much debt yet.

But when it comes to running up debt, a day of reckoning always comes eventually.
Just ask Greece.

And the absolutely insane spending policies of this administration and this Congress are hastening the day when our day of reckoning will arrive.

Consider the following facts...

-The U.S. national debt has increased by more than 7 trillion dollars since Barack Obama has been in the White House.  By the time Obama's second term is over, we will have accumulated about as much new debt under his leadership than we did under all of the other U.S. presidents in all of U.S. history combined.

-The U.S. national debt is now more than 5000 times larger than it was when the Federal Reserve was first established in 1913.

-If the U.S. national debt was reduced to a stack of one dollar bills it would circle the earth at the equator 45 times.

-Right now, the United States already has more government debt per capita than Greece, Portugal, Italy, Ireland or Spain.

-In August, the average rate of interest on the government’s marketable debt was 2.028 percent.  In January 2000, the average rate of interest on the government’s marketable debt was 6.620 percent.  If we got back to that level today, we would be paying well over a trillion dollars a year just in interest on the national debt.

-At this point the U.S. government has accumulated more than 200 trillion dollars of unfunded liabilities that will need to be paid in future years.  In other words, we have made more than 200 trillion dollars worth of promises that we do not have money for yet.

Thomas Jefferson once said that "the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale."

What we are doing to future generations is absolutely unconscionable.  We are stealing trillions upon trillions of dollars from our children and our grandchildren, and we are willingly consigning them to a lifetime of debt slavery.

I have said this before, but it bears repeating.  If future generations get the chance, they will look back and curse us for what we have done to them.

And shame on anyone that would dare to suggest that we should continue to run up more debt that future generations will be expected to repay.

But government debt is far from the only massive debt bubble that we are dealing with as a country.

40 years ago, the total amount of debt in our nation (all government debt plus all business debt plus all individual debt) was sitting at a grand total of about 2.3 trillion dollars.

Today, that total has grown to 59.4 trillion dollars.

As the chart posted below shows, our total debt bubble is now more than 25 times larger than it was just 40 years ago...

Total Credit Market Debt 2014

If you were to take all forms of debt in our country and divide it up equally to each person, the average family of four would owe approximately $735,000.

This is not anywhere close to being sustainable, but most Americans don't seem to care.  They just continue to recklessly run up even more debt.

However, there are signs that we are starting to hit a wall with all of this debt.

For example, an astounding 35 percent of all Americans have debts that are so overdue that they have been referred to collection agencies.

Our nation has become an ocean of red ink from sea to shining sea, and the only way to keep the bubble from bursting is for the total amount of debt to continue to grow much faster than the overall economy is growing.

Obviously this cannot happen indefinitely, and when this house of cards comes crashing down it is going to be absolutely horrific.  For much more on all of this please see my previous article entitled "The United States Of Debt: Total Debt In America Hits A New Record High Of Nearly 60 Trillion Dollars"

The big question is how long our "bubble economy" can keep going before it finally collapses.

It has gotten to the point where even some of the biggest banks in the world are admitting that what we have been doing is completely and totally unsustainable.  Just consider the following excerpt from a recent article by Joshua Krause...

Recently, strategists for Deutsche Bank released a startling study in regards to government debt. They decided to investigate whether or not the bond market is currently in a bubble. What they found was, unlike previous eras, the past 20 years has seen no lag between economic booms and busts:
It has long been our view that over the last couple of decades the global economy has rolled from bubble to bubble with excesses never fully being allowed to unravel. Instead aggressive policy responses have encouraged them to roll into new bubbles. 
This has arguably kept the modern financial system as we know it a going concern. Clearly there have always been bubbles formed through history but has there been a period like the last 20 years where the bursting of one bubble has consistently led directly to the formation of the next?
Essentially, our current system has been dying a very slow death. It’s running out of steam.

Sadly, most Americans have no idea that we are living in a giant debt-fueled bubble that has a limited lifespan.

Most Americans just assume that since the politicians tell them that everything is going to be okay that they don't need to be concerned about any of this.

But every single day our debts get even larger and our long-term financial problems get even worse.

Someday this bubble is going to burst and then all hell will break loose.
It is just a matter of time.

September 12, 2014

The Fed Fails, Um, Does Irony

In a speech in 2002, Bernanke said that the Fed would prevent the US from experiencing a Japan-like outcome.

However, the US has experienced a pattern of economic and policy developments that parallels developments in Japan.

Japan experienced a financial bubble and crisis. The Japanese authorities took actions to support asset prices and prevent insolvent businesses from failing. The growth of the Japanese economy remains so anemic that almost two decades after their financial crisis, the authorities are still introducing new stimulative measures and packages.

The US has also experienced a financial bubble, a crisis, a recession and a very slow recovery. The Fed and the Treasury took unprecedented measures to support asset prices and have prevented or helped to prevent the failure of insolvent firms. Despite the Fed’s opportunity to learn from the Japanese experience and all Fed’s efforts to promote the growth, per capita growth in the US has been slower than in Japan.

In short the US economy has experienced exactly what Bernanke said the Fed could and would prevent, save outright deflation.

In the same speech, Bernanke also said that the Fed could call on other government agencies for help should a financial crisis occur.

Despite Bernanke’s statement that the Fed would be part of a multi-pronged, multi-agency, counter-cyclical response to a serious economic downturn, the Fed has been the only macroeconomic policy game in town. There was no sustained fiscal stimulus, and supporters of the use of fiscal stimulus have argued that the package that was adopted was too small to be effective. Fed-Treasury cooperation during the crisis was limited to the Fed financing the Treasury’s de facto nationalization of AIG. This allowed Treasury to avoid going to Congress for the funding and a debate about the appropriateness and terms of the take-over.

Recently, Bernanke said that monetary policy is no panacea. However, the Fed still insists that a recovery based on monetary stimulus alone is forthcoming.

Again, there is dramatic divergence between what the Fed says or expects on the one hand and actual outcomes on the other.

Before the crisis, the Fed denied the existence of a bubble in residential real estate.

Unfortunately, there was a massive bubble. When the bubble popped, it crippled the financial system and ushered a recession with a slow recovery, high unemployment, and the pain of foreclosures.
The Fed had bet on heads only to have tails come up.

The Fed asserted that a rules-based policy regime was better than one based on discretionary decision making.

However, the rule/discretionary dichotomy has proved to be a false one. Policy makers have exercised discretion when they chose the 1) type of rule, e.g., the Taylor rule versus a nominal GDP target; 2) the variant of the rule employed, e.g., the use of CPI (as favored by Taylor) or forecasts of the PCE deflator (as favored by the Fed); and 3) the sensitivity of policy to deviation of targeted variables from targeted levels.

A truly rules-based, no-discretion-allowed regime would also have rules for when and why the rule should be ignored, as well as a rule that would govern if, who and when the rule can be changed, e.g., from the Taylor rule to nominal GDP targeting. The current regime does have any such rules.

However, the Fed did set interest rate policy in accordance with a variant of the Taylor-Rule. The adoption of this rule-based policy was supposed to insure the continuance of the Great Moderation. Prior to the crisis, FOMC members frequently gave speeches in which they took credit for the Great Moderation. Post the crisis, all we heard from them in effect was: “It cannot be our fault. We were following the rule.” A framework that was supposed to impose discipline and to enhance accountability on policy makers became an alibi for a policy failure.

Again the actual outcomes were the opposite of the outcomes and the goals that the Fed set for itself.

Prior to the crisis, the Fed promoted the idea that a rule-based, inflation-focused policy would make policy design and implementation purely technical problems. This, in turn, would insulate the Fed and its policy from political pressures and insure its independence.

The Fed has not enhanced its independence from political meddling and interference far from it. There is an unusually large amount of political pressure and interference aimed at the Fed and its independence. There are efforts in Congress to 1) require audits of the policy design process, 2) impose a quota system on the Board of Governors of the Federal Reserve System requiring that a seat on the Board be allocated to a community banker, and 3) require the Fed to adhere to a Taylor Rule framework for policy design.

The Fed also opened the door to political meddling when it financed Treasury’s de facto nationalization of AIG and the bailout of AIG counterparties, as well as when it decided to engage in a massive re-distribution of wealth and income via ZIRP.

Once again, the outcome – increased politicalization – was opposite of the desired result.

Prior to the crisis, the Fed said it would not comment on or interfere in the design of fiscal policy in yet another attempt to stay above the partisan political fray.

However, in pursuing ZIRP and QE, the Fed is actively engaged in fiscal policy. ZIRP and QE have lowered the Treasury’s cost of borrowing. The decline in interest rates paid by the Treasury directly affects its outlays and the fiscal deficit. Hence QE has a fiscal policy dimension. It may seem benign today, but when ZIRP and QE are ended the rates paid by the Treasury will rise. Other things equal the fiscal deficit will increase as a result of the policy stance and the Fed will be in a political hot seat.

The Fed is more deeply involved in fiscal policy than ever before. Yet again, the Fed has achieved the opposite of the goal it set out for itself.

The Fed promised to be more transparent than in the past.

In some cases, the Fed is no more and probably less transparent than in the past. The Fed releases numerous point estimates of economic variables, including the staff forecast, the forecasts of individual members of the FOMC, forecast ranges, and central tendencies. In short, a series of often inconsistent forecasts with no confidence limits attached, none of which caught the crisis or the recession and all of which have continuously over-estimated the strength of the recovery. On the other hand, the Fed does not divulge one set of numbers that it knows with certainty and that are of interest to the markets, i.e., the vote tallies at FOMC meetings. If transparency is a goal, why not report the exact vote tallies instead of characterizing the votes as “few, some, many”?

In some cases, the Fed is less transparent. The Fed has never released the rationales for targeted rates of asset purchase under the QEs, nor has it released the rationale behind the pace of tapering of the QE purchases. Policy now emerges from a black box. In addition, the Fed has not specified exactly what the expected goals of the ZIRP and the QE programs was/is. Hence the public has no way of evaluating the success of the programs.

Policy transparency is down and not up.

Prior to the crisis, the Fed attached very little if any importance to its regulatory function. As a result, it failed miserably as a financial regulator.

Despite 1) its failure as a regulator, 2) the fact that its chosen model of the economy (DSGE) does not even contain financial institutions or markets, 3) the policy rule that it employed prior to the crisis as well as the leading alternatives do not reflect financial market developments, and 4) the fact that it only pays lip service to financial stability when setting policy, its regulatory reach was expanded.

The Fed now acknowledges that regulation is important. This is precisely the opposite of what the Fed had assumed. The expansion of the Fed’s regulatory reach is the opposite of what the Fed would have argued was necessary, as well as the opposite of what the record suggests is appropriate. Alternatively, one could argue that after resisting changes the Fed has suffered a de facto loss of regulatory authority, even as its regulatory reach outside the banking sector has been expanded.

In its role as a financial regulator, the Fed presents itself as having expertise in risk management.

When ZIRP did not work to the Fed’s satisfaction, the Fed doubled down with QE1. When QE1 did not work to the Fed’s satisfaction, the Fed doubled down with QE2. And when QE2 didn’t work to the Fed’s satisfaction, it doubled down with QE3. This despite a running debate on exactly and to what extent QE has stimulated the real economy.

Furthermore, the Fed says that it should not lean against asset price bubbles because it can never be certain there is an asset price bubble. However, the Fed cannot know with certainty that there isn’t an asset price bubble either. Nonetheless, it sets policy as if an asset price bubble does not exist or are of no concern.

With a sustained satisfactory rate of growth still illusive, signs of excesses in the capital markets, no agreed upon plan to shrink the size of its balance sheet and with the Fed already in a political hot seat, society and the Fed have more on the table than they can afford to lose. The Fed has demonstrated all the risk management acumen and discipline of the London Whale.

The Fed asserts, based on its expertise and knowledge of the economy, that the markets, financial institutions and society as whole should base their behavior on its forecast for the economy, interest rates and inflation.

However, better-credentialed individuals (former full professors at prestigious universities with Nobel Prizes in economics to boot) running a fixed income portfolio at LTCM managed to make errors that threatened the US financial system in 1998. This occurred despite all the credentials and the fact that managing a fixed income portfolio is a trivial problem compared to setting and implementing macroeconomic policy.

Given that episode, the Fed’s failure to foresee the financial crisis, and the repeated incorrect calls for acceleration in growth a few quarters out, why does the Fed assume that economic agents will treat its forecast as gospel and alter their behavior beyond the impact of the interest rate stance?

The Fed employs models that assume rational expectations and efficient markets, but its assertion that current policy pronouncements can manipulate expectations implicitly assumes that economic agents do not remember or learn from the recent past.

The economic and financial systems are complex and dynamic. The fact that the Fed did not achieve all the goals that it set out for itself is not surprising. However, is more than just ironic that the Fed made decisions and pursued policies which resulted in it achieving the opposite of its stated goals and forecasted outcomes.

September 11, 2014

Goldman Declares The "End Of The Iron Age"

Back in the summer of 2008, when crude seemed poised to take out $150, Goldman decided to declare the start of a commodity supercycle and boosted its oil price forecast to $200. Shortly thereafter crude cratered, plunging to the low double digits, and causing many to scratch their heads whether Goldman was merely taking advantage of the pre-Lehman panic to sell into the euphoria. The same questions, but inverted, will likely follow today's just as seminal note, one which this time calls for the end of a supercycle, this time of iron, with "The end of the Iron Age."

While intuitively this makes sense considering iron ore prices have tumbled nearly 40% YTD and were at multi-year lows at last check with the demand picture going from bad to atrocious, the reality is that a protracted period of deflation in this key commodity will have very adverse implications for not only China, where CapEx amounts to over half of GDP and will likely force the transition to a consumer-driven economy - something the Politburo has been delaying for years - but for the rest of the commodity suppliers countries, with the most negative impact hitting Brazil and Australia. Worse, for a country like China which has thrived on commodity oversupply and overcapacity, the collapse in the equilibrium price driven largely by demand, will mean thousands of suppliers will be left out in the cold and forced to liquidate with massive ripple effects through the fabric of the Chinese economy.

To be sure, for the time being local governments, banks and other SOEs, and the central bank, have been successful in isolating the assorted pockets of deflation that has hammered China in the past several years, but if Goldman is correct and if indeed a iron (and other commodities) are shifting from the "Investment Phase" to the "Exploitation Phase" as Goldman calls it, then watch out below not only China, but the rest of the world as well.

So what exactly does Goldman say?  Let's dig into their latest note:

The end of the Iron Age

Producers and investors have enjoyed a long period of supply tightness, cost inflation and above trend profitability; in our reports we have referred to this period as the Iron Age. In our view, 2014 is the inflection point where new production capacity finally catches up with demand growth, and profit margins begin their reversion to the historical mean; in other words, the end of the Iron Age is here.
Iron ore has entered a new exploitation phase

As we have previously argued3, a period of overinvestment in production capacity has ended, giving way to an exploitation phase where supply growth comes mainly from more efficient utilization of existing capacity. Production volumes grow with a certain time lag behind the investment decision; the lag in the mining industry between investment approval and production at full capacity is typically between 5 and 10 years. Based on historical trends, we believe that many market dynamics are reversed in the shift from investment to exploitation, and the current exploitation phase in iron ore could last for a decade (Exhibit 20).

On the demand side, lower prices for iron ore and steel are unlikely to boost demand in a material way. Instead, the day when steel production in China will peak gets  ever closer. In the past decade, the Chinese economy added steel to its economy at a rate three times faster than the US did during the 20th century. On a per capita basis, the average household in China is accumulating steel at a rate equivalent to the purchase of a new car every 8 months (without disposing of its older cars). In other words, the volume of steel stock in China is racing towards the US level of 13 tonnes per person (Exhibit 21). If China is to converge towards the US level, steel consumption will eventually have to stabilize and steel recycling will play a larger role.

On the supply side, the capital stock of the iron ore industry in Australia, Brazil and China increased by US$180 billion during the period 2003-12; this will fuel production growth for years to come (Exhibit 22). Now that the market has transitioned to an exploitation phase we expect new approvals for capital intensive projects to become increasingly rare, largely because the economics of greenfield projects will be challenging in an oversupplied market. However, projects approved in the later stages of the investment phase will support production growth in the years ahead, and low cost brownfield expansions at Tier 1 producers will remain attractive.

Can prices recover once marginal supply is gone? We don’t think so

In principle, the displacement of marginal producers should eventually lead to a balanced market with a high level of concentration among the top 4 miners, raising the prospect of a price recovery further down the road. In practice, we believe that market fundamentals will continue to see supply growth outpacing demand growth by a ratio of 3 to 1 over our forecast period. Not only is the growth pipeline set to deliver several large projects over our forecast period (Minas Rio, Roy Hill, Serra Sul as well as large expansions at Rio Tinto and BHP Billiton), but the supply side will also have many idled mines waiting on the sidelines and ready to resume production should prices recover.

Moreover, iron ore markets went through a 20-year period of declining prices in real terms during the previous exploitation phase that ended in 2004. The iron ore price in 2003 was the same as in 1983 in nominal terms; this is equivalent to an annual deflation rate of 3% in real terms (Exhibit 23). In our view, iron ore prices will display a similar trend of cost deflation in the current exploitation phase.

Cost curves become flatter via the loss of marginal supply and they shift downwards via rising productivity and weaker commodity currencies. Commodity currencies have started to depreciate relative to the US dollar; the weighted average across five of the largest seaborne exporters has lost 16% since January 2011 (Exhibit 24). Given that a majority of production costs are denominated in local currency, this has a direct impact on the level of marginal production costs. On the productivity front, the increased focus on efficiency and the ramp-up of production has already resulted in a modest decline in unit costs among some producers; we expect this trend to continue.

Many moving parts but China remains the key question

The veil on Chinese iron ore production and the level of cost support it would provide to seaborne prices was supposed to be lifted as the market moved into surplus during 2014. But instead of a clear answer, recent data from China only raise further questions regarding the scale of the supply response low prices. In the seaborne market, the delivery of new projects in Australia and Brazil more than offsets the closure of marginal producers. Meanwhile, slower growth in low grade ore supply should see grade discounts normalise.

Chinese riddle: making sense of production statistics

The Chinese iron ore sector is highly fragmented and the data on supply trends is rather limited, but official statistics on price and volume have been roughly consistent in the past: high domestic prices coincided with growth in raw ore production, while market corrections in 2H 2012 triggered production cuts among marginal miners. On that basis, the recent decline in domestic concentrate prices should have led to another deceleration or even contraction in raw ore volumes. Instead, NBS statistics suggest that volume growth has accelerated (Exhibit 3). We find this highly counterintuitive. First, media reports from Platts and other sources indicate that many small mines stopped production from Q2 2014 onwards. Second, a rising volume of domestic ore would be inconsistent with the reported statistics on steel production and iron ore imports which show high growth in Fe supply but low growth in Fe consumption (Exhibit 4).

What does this all mean? We consider the following hypotheses:
  • Official statistics do not reflect actual iron ore production. Provincial governments may set GDP or tax revenue targets at the start of the year, and set iron ore production estimates accordingly.
  • Official statistics only capture some production. The smallest miners may slip through the cracks if they fall below the threshold used in data collection, preventing the closure of small private mines from appearing in official statistics.
  • Production can cut at the concentrator rather than the mine. Mines may choose to suspend sales to concentrators but continue to operate in order to minimize disruption to their operations.
In our view, a combination of these factors could be responsible for the muddied picture, forcing us to look for alternative ways to assess current trends in Chinese iron ore supply. One option is to calculate the implied production of iron ore from statistics on crude steel production and iron ore imports. Taking into account the changes in iron ore inventory and the modest variations in the grade of imported ore, this analysis suggests that Chinese iron ore production on a 62% Fe basis grew during Q1 (partly reflecting limited disruption from a mild winter) before contracting in the following quarter; implied production in the year to July is down 11% yoy (Exhibits 5 and 6). Importantly, the timing of this contraction coincides neatly with the decline in the price of domestic concentrate in Hebei.

Industry sources also suggest that some Chinese supply has been displaced. The MySteel survey shows that utilization rates began to drop in May 2014 when the domestic price of concentrate was heading towards Rmb900/t, with the smallest mines reporting the lowest rates of utilization (Exhibit 7). Meanwhile, the consensus view at a recent conference on Chinese iron ore was that many private mines had indeed closed, even if the aggregate impact on production was limited due to their small size. However, producers also indicated that efforts to expand domestic production are ongoing, as implied by the volume of investment in the sector (Exhibit 8).

Given this wide range of sometimes conflicting indicators, we assume that future Chinese iron ore production would remain roughly stable before mine closures, as new projects and depletion at existing mines offset each other. We continue to assume that the average grade mined in China will remain stable at c. 20% Fe based on a) the reported grade of new projects and b) the fact that closures are likely to affect mines with below-average grades the most. After factoring in mine closures, we forecast domestic production to decline by c.9% per year on a Fe adjusted basis.

September 10, 2014

A Historic First: Bank Of Japan Monetizes Debt At Negative Rates

First, Europe infamously shifted to a NIRP and now Japan has begun NIRP monetization. As WSJ reports, Tuesday marked another milestone in the topsy-turvy world of monetary easing in Japan: The Bank of Japan bought short-term Japanese government debt at a negative yield for the first time. In the understatement of the decade, one Japanese bank strategist noted, "The BOJ probably didn't expect this would happen, and T-bill rates staying negative should be a cause of concern for them." The BoJ's decision to scoop up these negative-yielding bills appears to confirm they will meet the QQE-buying demands no matter what the cost (to the Japanese people). The bottom line, the Bank of Japan is now implicitly issuing debt to the Japanese Treasury.

The BOJ scooped up some of the three-month No. 477 Treasury bill, which has traded at a negative yield for the past two trading days amid strong demand, the market participants said.

Traders said the bank wanted to show the market that it would meet its asset purchase goals–literally at whatever the cost.

Market participants say the bank probably didn’t foresee buying Japanese debt at negative yields. But the European Central Bank’s easing has created demand for short-term Japanese debt from European investors, to the extent that interest rates have turned negative.

“The BOJ probably didn’t expect this would happen, and T-bill rates staying negative should be a cause of concern for them,” said Shogo Fujita, chief Japan bond strategist at Merrill Lynch Japan Securities Co.
So, in summary, normally, people who buy debt expect to get their money back plus some interest. Negative yield means the buyer gets back less than he or she puts in.

In other words, the Bank of Japan is now ISSUING debt TO the Japanese Treasury.

September 9, 2014

Losing Credibility – The IMF’s New Cold War Loan to Ukraine

In April 2014, fresh from riots against the kleptocrats in Maidan Square and the February 22 coup, and less than a month before the May 2 massacre in Odessa, the IMF approved a $17 billion loan program to Ukraine’s junta. Normal IMF practice is to lend only up to twice a country’s quota in one year. This was eight times as high.

Four months later, on August 29, just as Kiev began losing its attempt at ethnic cleansing against the eastern Donbas region, the IMF signed off on the first loan ever to a side engaged in a civil war, not to mention being rife with insider capital flight and a collapsing balance of payments. Based on fictitiously trouble-free projections of the ability to pay, the loan supported Ukraine’s currency, the hryvnia, long enough to enable the oligarchs’ banks to move the money quickly into Western hard-currency accounts before the hryvnia plunged further and was worth even fewer euros and dollars.

This loan demonstrates the degree to which the IMF is an arm of U.S. Cold War politics. The loan terms imposed the usual budget austerity, as if this would stabilize the war-torn country’s finances. The financings obviously were devoted mainly to rebuilding the army. The war-torn East can expect to receive nothing even nothing even though its basic infrastructure has been destroyed for power generation water, and hospitals. Civilian housing areas that bore the brunt of the attack are also unlikely to profit from the IMF’s uncharacteristic generosity.

A quarter of Ukraine’s exports normally are from eastern provinces and sold mainly to Russia. But Kiev has been bombing Donbas industry and left its coal mines without electricity. Nearly a million civilians are reported to have fled to Russia. Yet the IMF release announced: “The IMF praised the government’s commitment to economic reforms despite the ongoing conflict.” No wonder there was almost no comment in the news or even the business press!

The loan is bound to create even more infighting among IMF staff economists than broke out openly at their October 2013 annual meeting in Washington. Dissension over the disastrous IMF $47 billion loan to Greece – at that time the largest loan in IMF history – prompted a 50-page internal IMF document leaked to the Wall Street Journal. Acknowledging that the IMF had “badly underestimated the damage that its prescriptions of austerity would do to Greece’s economy,” IMF staff economists blamed pressure from eurozone countries protecting their own “banks [that] held too much Greek government debt. … The IMF had originally projected Greece would lose 5.5% of its economic output between 2009 and 2012. The country has lost 17% in real gross domestic output instead. The plan predicted a 15% unemployment rate in 2012. It was 25%.

The IMF’s Articles of Agreement forbid it to make loans to countries that clearly cannot pay, prompting its economists to complain at their Washington meeting that their institution was violating its rules by making bad loans “to states unable to repay their debts.” One official called its Debt Sustainability Analysis, “‘a joke,’ a [European] commission official described it ‘a fairy tale to put children to sleep’ and a Greek finance ministry official said it was ‘scientifically ridiculous.’” In practice the IMF simply advanced however much a country needed to pay its bankers and bondholders, pretending that more austerity would enhance the ability to pay, not worsen the debt trap, while Kiev also used the loan for military expenses to attack the Eastern provinces.

This raises the question of whether the IMF’s loan is legally an “odious debt,” being made to a military junta and stolen by government insiders. John Helmer’s Dances with Bears calculates that “of the $3.2 billion disbursed to the Ukrainian treasury by the IMF at the start of May, $3.1 billion had disappeared offshore by the middle of August.”

Unlike the IMF’s most recent disastrous loan to Cyprus, the IMF did not reveal its reasoning. But it made it clear that the National Bank of Ukraine (NBU) – its central bank – was simply turning money over to the kleptocrats who ran the country’s banks as part of their conglomerates, and funding the government’s military attack on the East: “The proportion of government securities and loans to banks increased from 28 percent of NBU total assets at end-2010 to 56 percent at end-April 2014.” The financial situation was getting worse. Facing rising insolvency risks, Ukraine’s leading banks were reported to need another $5 billion over and above the IMF’s $17 billion commitment.

In preparation for October’s scheduled elections, the eastern provinces are in no condition to vote, and the junta has banned the Communist party and also banned TV and media reporting that it does not like. The leading pro-war parties are polling very low even in the West (as of early September). There are warnings of a coup by the Right Sector and allied neo-Nazi Ukrainian nationalists, headed by the oligarch Ihor Kolomoyskyy, who has fielded his own private army. From Johnson’s Russia List* (no online version):
A defeat in war frequently leads to regime change. The spectre of a coup is once again roaming the streets and squares of Kyiv. Surviving National Guard fighters are threatening to turn their weapons on Poroshenko. A third Maydan [Independence Square protest movement] is taking shape, which is to sweep aside the present regime. The instigators of this Maydan are militants from the punitive battalions created with Kolomoyskyy’s money. It is obvious that the oligarch is playing his game against Poroshenko. Subordinate to him Kolomoyskyy has quite a strong private army capable of carrying out a coup.

IMF- and US-backed Privatization Plans for Ukraine

Ukraine’s main problem is that its debt is denominated in dollars and euros. There seems only one way for Ukraine to raise the foreign exchange to repay the IMF and NATO creditors rounded up to help Westernize the economy: by selling its natural resources, headed by gas rights and agricultural land.

Here the shadowy figure of Kolomoyskyy resurfaces, with support from the United States. Recent Senate Bill 2277 “directs the U.S. Agency for International Development to guarantee loans for every phase of the development of oil and gas” in Ukraine, Moldova and Georgia.

Vice President Biden’s son, R. Hunter Biden, recently was appointed to the board of Burisma, a Ukrainian oil and gas company registered in Cyprus, long a favorite for post-Soviet operators. The firm has enough influence over Kiev politics to make prospective gas fracking lands a military objective. From the PEU, citing an Economic Policy Journal report**:
Ukrainian troopers help installing shale gas production equipment near the east Ukrainian town of Slavyansk, which they bombed and shelled for the three preceding months, the Novorossiya news agency reports on its website citing local residents. Civilians protected by Ukrainian army are getting ready to install drilling rigs. More equipment is being brought in, they said, adding that the military are encircling the future extraction area.
The Western press has failed to convey Ukraine’s East/West hostility to the gas and agricultural issues, but one report notes: “The people of Slavyansk, which is located in the heart of the Yzovka shale gas field, staged numerous protest actions in the past against its development. They even wanted to call in a referendum on that subject. … Countries like the Czech Republic, the Netherlands and France have given up plans to develop shale gas deposits in their territories. Not only them but also all-important Germany, which two weeks ago announced it would halt shale-gas drilling for the next seven years over groundwater pollution concerns.” U.S. and IMF backing seems intended to help reduce European dependence on Russian gas so as to squeeze its balance of payments as part of the New Cold War deterrent.

But it has involved a potentially embarrassing U.S. alliance with Kolomoyskyy as reportedly the major owner of Burisma through his Privat Bank. Robert Parry points out he “was appointed by the coup regime to be governor of Dnipropetrovsk Oblast, a south-central province of Ukraine. Kolomoysky also has been associated with the financing of brutal paramilitary forces killing ethnic Russians in eastern Ukraine.”

The other natural resource to be sold off is farmland. Already there is heavy Monsanto investment in genetically engineered grain. A recent report by the Oakland Institute, Walking on the West Side: the World Bank and the IMF in the Ukraine Conflict, describes pressure to deregulate Ukrainian agricultural land use and promote its sale to U.S. and other foreign investors. In particular it notes that “IFC advised the country to ‘delete provisions regarding mandatory certification of food in the listed laws of Ukraine and Government Decree,’” and “to avoid ‘unnecessary cost for businesses’” by regulations on pesticides, additives and so forth.

What makes this so puzzling is that neither Russia nor many European countries accept genetically engineered foods. It would seem that the only way Ukraine can export this food is if U.S. diplomats pressure Europe to drop its anti-GMO labeling. This threatens to drive yet another wedge between the United States and European NATO members.

It will be expensive to restore power and water facilities that have been destroyed by the Kiev forces in Donetsk, which faces a cold dark winter. Kiev has stopped paying pensions and other revenue to the Eastern Ukraine, all but guaranteeing its separatism. Even before the Maidan events the local population sought to prevent gas fracking, just as Germany and other European countries have opposed it. Also opposed is the appropriation of land and other properties by Ukrainian kleptocrats and especially foreigners such as Monsanto for genetically modified seeds – again, just as Germany and other European countries have opposed crops produced by GMOs.

U.S. Stratagems to Save Ukraine from Having to Pay Its Debts to Russia

The “inner contradiction” in the IMF loan is that Ukraine owes the entire amount to Russia for gas arrears and current needs as winter nears, and also for the euro loan by Russia’s sovereign wealth fund on strictly commercial terms with cross-defaults if Ukrainian debt rises above 60 percent of GDP. Yet U.S. Cold War strategy is to minimize payments to Russia out of IMF and NATO “reconstruction” lending.

In the wake of the New Cold War confrontation in mid-2014 after Russia re-absorbed Crimea, the Peterson Institute for International Economics, floated a proposal by former Treasury official Anna Gelpern to deprive Russia of legal means to enforce its claims on Ukraine. “A single measure can free up $3 billion for Ukraine,” she proposed. Britain’s Parliament might pass a law declaring the $3 billion bond negotiated by Russia’s sovereign wealth fund to be “foreign aid,” not a real commercial loan contract worthy of legal enforcement. “The United Kingdom can refuse to enforce English-law contracts for the money Russia lent,” thereby taking “away creditor remedies for default on this debt.”

The problem with this ploy is that Russia’s sovereign wealth fund lent Ukraine euros with strict financial protection aimed at limiting the country’s overall debt to just 60 percent of its GDP. If debt rises above this level, Russia has the right to demand full immediate payment, and this may trigger cross-default clauses in Ukraine’s foreign debt.

As recently as yearend 2013, Ukraine’s public debt amounted to just over 40 percent – a seemingly manageable $73 billion. But in view of the fact that Ukraine had only a B+ rating – below Russian sovereign fund normal limit of requiring at least an AA rating for bond investments – Russia seems to have acted in a prudent financial way in inserting protection clauses precisely to distinguish its investment from general purpose aid.

Waging civil war is expensive, and Ukraine’s currency is rupturing. The black market exchange rate already is reported to have plunged by one-third. If recognized officially (once the kleptocrats have moved their money out at IMF-supported hernia rates), this would raise the country’s debt/GDP ratio to the 60 percent threshold making the debt to Russia payable immediately. Unlike foreign aid, Russia’s loan gives it “power to trigger a cascade of defaults under Ukraine’s other bonds and a large block of votes in any future bond restructuring. This is because all of the government’s bonds are linked among themselves. When one bond defaults, the rest can do the same.”

What the U.S. Government classifies as foreign aid also typically takes the form of loans to be repaid, and insists on matching funds in local currency, e.g. for Public Law 480 food exports. Congress insisted already during the Kennedy Administration that the U.S. balance of payments, and specifically its farm exports, must benefit from any such “aid.”

Reviewing the possibilities of how to prevent IMF and NATO credit from being paid to Russia for its bondholdings and gas arrears, Prof. Gelpern points out that “governments do not normally sue one another to collect their debts in national courts.” If this should occur, the pari passu rule would prevent some debts from being annulled selectively. She therefore raises another possibility – that Ukraine may claim that its debt to Russia is “odious,” addressing the situation where “an evil ruler signs contracts that burden future generations long after the ruler is deposed.” She suggests that “Repudiating all debts incurred under Yanukovich would discourage lending to corrupt leaders.”

The double standard here is that instead of labeling Ukraine’s long series of kleptocratic governments odious, she singles out only Yanukovich, as if his predecessors and successors are not equally venal. But an even greater danger in declaring Ukraine’s debt “odious”: It may backfire on the United States, given its long support for military dictatorships and kleptocracies. Ukraine’s sale of bonds to Russia’s sovereign debt fund and its contracts signed for gas purchases were negotiated by a democratically elected government, at prices that subsidized domestic industry and also household consumption. Unlike the case with Greece, there was no removal of a national leader to prevent a public referendum from taking place over whether to approve the loan or not. If this debt is deemed odious, what of Eurozone loans to Ireland and Greece or U.S. loans to Argentina’s generals installed under Operation Condor?

Gelpern acknowledges that Ukrainian refusal to pay the bonds by invoking the odious debt principle “is fraught with legal, political and market risks, all of which would play into Russia’s hands.” This leaves the most promising solution to hurt Russia to be the above-mentioned ploy for Britain’s Parliament to pass a sanctions law invalidating “the Yanukovich bonds.” Such a sanctions law would reduce Russia’s “ability to profit from selling the debt on the market” simply by denying Russia legal rights to grab Ukrainian assets.

Gelpern concludes her paper by suggesting a universal principle: that contracts “used to advance military and political objectives … should lose their claim to court enforcement.” This opens a can of worms in view of the fact that “[t]he United Kingdom and the United States have both used military force in the past to collect debts and influence weaker countries. Is it legitimate for them to punish Russia for doing the same?” Are not the vast majority of inter-governmental debts either military or political in character? On this logic, shouldn’t most inter-governmental debts be wiped out? Do not Gelpern’s arguments cited for not paying Russia serve even more to provide a legal basis for nullifying Ukraine’s debt to the IMF and subsequent NATO loans on terms that force it to forfeit its natural resource rights for gas and land to foreign investors?

The legal review ostensibly seeking reasons to isolate Russia economically thus has the seemingly ironic effect of showing the legal and political difficulties in trying to achieve this. If Ukraine borrows from the IMF and/or EU, and then breaks up – with the East becoming independent – who will be obliged to pay? Certainly not the East, attacked by the military coup leaders.

So we are brought back to this month’s financial news in preparation for next month’s IMF annual meeting: Where then does the Ukrainian loan leave the IMF’s credibility?

September 8, 2014

If The Economy Is Recovering, Why Is The Labor Force Participation Rate At A 36 Year Low?

Should we be concerned that the percentage of Americans that are either working or looking for work is the lowest that it has been in 36 years?  In August, an all-time record high 92,269,000 Americans 16 years of age and older did not "participate in the labor force".  And when you throw in the people that are considered to be "in the labor force" but are not currently employed, that pushes the total of working age Americans that do not have jobs to well over 100 million.  Yes, it may be hard to believe, but there are more than 100 million working age Americans that are not employed right now.  Needless to say, this is not a sign of a healthy economy, and it is a huge reason why dependence on the government has soared to absolutely unprecedented levels.  When people can't take care of themselves, they need someone else to take care of them.  If the percentage of people in the labor force continues to decline like it has been, what is that going to mean for the future of our society?

The chart below shows the changes in the civilian labor force participation rate since 1980.  As you can see, the rate steadily rose between 1980 and 2000, but since then it has generally been declining.  In particular, this decline has greatly accelerated since the beginning of the last recession...

Labor Force Participation Rate

We have never seen an extended precipitous decline of this nature before.  But instead of admitting that we have a very serious problem on our hands, many mainstream economists are dismissing this decline as "structural in nature".  For example, check out the following excerpt from a recent Reuters article...
A paper published on Thursday by the Brookings Institution, a Washington-based think tank, suggested the decline was primarily due to an aging population and other structural factors, and concluded the labor force would continue to shrink.
But there is a major flaw in this analysis.  It turns out that older Americans are the only group for which employment numbers have actually been going up.  I really like how Zero Hedge made this point the other day...
Well that's very odd, because it was only two months ago that the Census wrote the following [5]: "Many older workers managed to stay employed during the recession; in fact, the population in age groups 65 and over were the only ones not to see a decline in the employment share from 2005 to 2010 (Figure 3-25)... Remaining employed and delaying retirement was one way of lessening the impact of the stock market decline and subsequent loss in retirement savings."
Figure 3-25
Yes, Baby Boomers are hitting retirement age.

But that does not explain why the labor force participation rate numbers for younger groups have been going down.

Each month, the U.S. economy has to add somewhere between 100,000 and 150,000 jobs just to keep up with population growth.  Since job creation has been tepid at best in recent years, the only way that the government has been able to get the official unemployment rate to steadily "go down" has been to remove millions upon millions of Americans from the labor force.

According to the official government numbers, since 2007 768,000 jobs have been added to the economy, but a whopping 13 million Americans have been added to the numbers of those "not in the labor force".

As a result, the official unemployment rate has magically been "declining".

But the truth is that our employment crisis has not been solved at all.

And it isn't just the number of jobs that we need to be concerned about.  We are also dealing with a multi-year decline in the quality of our jobs.  In fact, the Wall Street Journal just reported that 34 percent of all U.S. workers are "freelancers" now...
More evidence that this isn’t your parents’ labor market: Roughly one in three U.S. workers is now a freelancer. 
Fifty-three million Americans, or 34% of the nation’s workforce, qualify as freelancers, according to a new report from the Freelancers Union, a nonprofit organization, and Elance-oDesk Inc., a company that provides platforms for freelancers to find work. These individuals include independent contractors, temps, and moonlighters, among others.
In other words, about a third of all workers in the country are "temps" at this point.
I don't know about you, but to me that is an extremely alarming statistic.

If the economy really was recovering, this would not be happening.

And as millions upon millions of Americans are being forced out of the official labor force, an increasing number of people are turning to the underground economy.

For example, in some of our major cities we are witnessing a rise in the number of street vendors.  The following is an excerpt from a recent Los Angeles Times article entitled "More Angelenos are becoming street vendors amid weak economy"...
Sitting at her street vending booth with products arrayed neatly on a sequined purple tablecloth, Jackie Lloyd reflects nostalgically on the days when she had a steady salary and regular hours. 
That was four years ago, before the 39-year-old was laid off from her job as an elementary school cafeteria worker and mounting bills forced her to venture into self-employment. 
Now the Pico-Union resident hops from location to location, selling body oils, shea butter, soap and incense. She moves when nearby businesses complain or she feels unsafe. 
Some days, her sales bring in $150. Others, they don't break $20.
In order to have a strong middle class, we need middle class jobs.

If our labor force participation rate continues to fall and the quality of our jobs continues to decline, the middle class will continue to shrink.  For much more on this, please see my previous article entitled "30 stats to show to anyone that does not believe the middle class is being destroyed".

But our authorities never seem to want to admit what our real problems are.

Instead, they love to come up with alternative theories for our economic struggles.

One of the latest theories being put forward by the Federal Reserve is that the economy is not moving along like it should because ordinary Americans are "hoarding money"...
One of the great mysteries of the post-financial crisis world is why the U.S. has lacked inflation despite all the money being pumped into the economy. 
The St. Louis Federal Reserve thinks it has the answer: A paper the central bank branch published this week blames the low level of money movement in large part on consumers and their "willingness to hoard money."
This seems completely absurd to me.

From what I can see, most families are just doing their best to survive from month to month these days.

I certainly don't see a lot of people "hoarding money".

What about you?

What do you think?