Slouching Towards Wall Street… Notes for the Week Ending Friday, 6 May 2011
Inflacion, Inflacionismo, Inflacionissimo!
Like a BRIC to the side of the head, Brazil has taken the lead in inflationary economic policy. We are not sanguine about what it bodes for the world.
Speaking in 1951, Ludwig von Mises demonstrates how consumer behavior derails government economic policies. In his talk, “Inflation: An Unworkable Fiscal Policy,” von Mises posits a housewife who, contemplating current price inflation, defers her purchase of a new frying pan, reasoning that the elevated prices are an anomaly, and she will make her purchase once prices retreat. But, says von Mises, “the housewife discovers that the government expects to go on inflating and that consequently prices will continue to rise more and more.” Von Mises says the government’s policy of driving inflation will succeed as long as it encourages individuals to defer purchases, increasing their bank balances so that “prices in the market do not rise in proportion to the inflation.”
But once his hypothetical housewife determines that the government intends to go on inflating the economy, she will not only buy the frying pan now — to avoid paying a much higher price later — she will buy other things now on the speculation that she may one day need them, and that prices will be much higher when she does. This behavior being widespread in an economy, the vicious inflationary cycle is firmly in place. This leads to a “flight into real values” where, fearing that their cash will become corrupt, people hasten to convert it into gold and silver bars, and oil and gas ETFs.
America’s banks continue to cooperate by not spending their TARP-induced hoard. But investors and fearful consumers have been converting their 401K’s into gold faster than you can say “Glen Beck.” Von Mises says a protracted policy of inflation is the death knell of the nation’s currency regime. “Continued inflation inevitably leads to catastrophe.” Now, we recognize that (unlike us,) (and unlike Treasury Secretary Geithner) von Mises is an economist. Or should we say “merely” an economist? And his thought experiments are subject to the challenge of history. But to our layman’s ear the word “inflation” means filling something with air. And while air may be a fertile subject for a microbiologist, an entomologist, a physicist or a meteorologist, we are left wondering how economic growth can be built on air.
Testifying before Congress earlier this year, Chairman Bernanke bridled at the suggestion that the US’ weak dollar policy was exporting inflation to less developed nations. Bernanke retorted that developing nations were growing and their inhabitants demanding more in the way of goods and services. It was this “demand pull” effect that was causing inflation across the developing world, rather than the fact that their currencies were appreciating out of control as the dollar continued to fall.
We believe the Fed’s inflation is contagious. Indeed, it appears that Chairman Bernanke’s inflationism is catching too. Earlier this year Brazil’s new central banker, Alexandre Tombini, announced that the bank was deferring its inflation targeting policy because it would prove too costly to rein in inflation in 2011. Confident that the country will attain its 4.5% inflation goal by the end of 2012, Tombini said inflation will fluctuate within the rather broad “target range” of plus-or-minus two percentage points. This permits Brazil’s rate of inflation to fluctuate between 2.5% annually and 6.5% without officially being out of control. This means the bank can miss its target rate of inflation by 44% to either side and still claim victory, enlisting statistics to prove the efficacy of the bank’s not very efficacious policies. Chairman Bernanke take note.
This week, Brazilian finance minister Guido Mantega testified before his nation’s Senate finance committee and made the remarkable statement that Brazil is experiencing a form of inflation that has never been cited in economic literature: “High and Controlled Inflation.” Saying that high inflation does not pose a threat to the economy, as long as it is controlled, Mantega expressed his comfort with the present state of affairs, much to the displeasure of members of the congressional committee, who accused him and Tombini of falling down on the job. Unlike Secretary Geithner, and unlike your humble Scrivener, Minister Mantega is an economist and may know something we don’t.
Both Tombini and Mantega stated this week that current inflation levels might exceed the ceiling of their target rate, but that it would be no cause for concern, so sanguine are they about achieving the 4.5% target by next year. No sooner did they issue their statements than April’s 12 month cumulative consumer price index inflation was reported at 6.51%, which is 0.01% above the top of the target range. For us lay folk, a miss is as good as a proverbial mile.
Undaunted by reality, Messrs Tombini and Mantega have launched a PR blitz. Tombini, the top economic appointee of President Rousseff’s Labor Party, reached out to the party’s core constituency of labor unions in a plea to forego wage increases in the upcoming round of contract negotiations. His argument is that the central bank will surely achieve its 4.5% target next year, thus the inflation indexed wage increases routinely sought in contract negotiations would be a distortion.
Finance Minister Mantega is making the same argument to Brazil’s industrialists and manufacturers, saying it would distort the inflation picture if they proceed to pass increased costs of labor and raw materials on to the consumer. Tombini and Mantega are asking Brazil’s housewives to believe that inflation is “really” 30% below the reported figures, and to defer buying those skillets until “normal” prices reassert themselves — by the end of next year. As Groucho Marx said, “what are you going to believe — me, or you own eyes?”
Among the questionable statements to come out of the pair charged with running Brazil’s finances are Tombini’s categorical insistence that the bank has complete autonomy, and that the Rousseff government will never interfere with its policies. And in his congressional testimony, Mantega said inflation was not the government’s fault. He said the developing world is experiencing an “outbreak of inflation” with food prices going up because “major food producers did not notice that people were eating more” and thus failed to anticipate demand.
Chairman Bernanke’s inflationism is being given a run for the money by our mighty southern neighbor. We are not an economist — nor are we a housewife — but policies of out-inflating the inflationists clearly disadvantage those at the lowest reaches of the Great Chain of Being. A party balloon, a pig bladder, a basketball or a truck tire all can be inflated to a certain capacity; beyond their maximum level, they will burst. We humbly propose that a society is no different. Not a “rush to value” nor a “flight to safety,” but widespread and extensive social unrest is the predictable outcome of extended inflationism, as those at the bottom of the high-low society become increasingly aware that it is the government, and not God, who has decreed their fate.
Von Mises reminds us of the Latin American phenomenon known as the cacerolazo — literally a “beating of the pots” — practiced by outraged housewives in Argentina to protest out of control food prices. Spontaneous public demonstrations consist of armies of common folk parading through major cities to the accompaniment of a cacophony of cookware. Past demonstrations resulted in trashing and even occupying banks and government buildings, and some turned violent. The cacerolazo caught on, and Icelanders turned out in 2008 in “the kitchenware revolution.”
Will America, too, go to pot? One thing is certain, those who sow the inflation shall reap the whirlwind.
If this age should urinate in a bottle Time’s physician would know its ailment.
Speaking of a bag full of air, we note items this week relating to the valuation of Facebook. The Wall Street Journal quotes reports (2 May, “Facebook Numbers Feed IPO Outlook”) that the company “is on track to exceed $2 billion in earnings” this year — above the numbers provided by the company for the Goldman-led investment. The article quotes “people familiar with the company’s recent finances” saying Facebook could boast a $100 billion valuation on IPO. A rather pretty virtual penny.
While not writing directly about Facebook, the Financial Times (2 May, “Investor Warns On Rush For Web Stars”) reports on what some think is clearly a bubble as investors rush to get in on internet offerings, “accepting weaker ownership rights than in the dotcom bubble” in the process. The article quotes one internet investor expressing concern, not merely over the valuations bubble, but more over the lax process surrounding these investments. Investment decisions are being made in haste. In their panic to not miss the virtual boat, investors are settling for plain old common equity and no board representation. We note a related article in the Journal (2 May, “Buying Stocks Before They Go Public”) discussing mutual funds which own shares in private companies. Presumably no mutual fund investor will argue with their fund holding shares in Facebook or Zynga, but it is not yet possible to predict what valuation these companies will carry once they are public. More important, we wonder which mutual funds have taken positions in less well-known private firms, perhaps sacrificing good corporate governance in the process, in hopes of not being left out of the Next Big Thing. Following the rule that the value of publicly available information should be reflected in the stock price, we get the argument that these holdings may be good investments today. But that is just an argument. The final determination will be made by the marketplace, not the economists.
We do not know how many mutual funds have holdings in non-public companies, and we wonder what kind of valuation process a mutual fund management team goes through when deciding to buy into a private firm — or how well that process is disclosed to the investors. With the SEC behind schedule on creating Dodd-Frank-mandated rules, items that had once been considered priority are being left to languish. It would not surprise us if the SEC permitted mutual fund boards to shunt off the responsibility for valuation of private equity to the bankers from whom they buy it. And since the “IPO spinning” moratorium, which expired in 2008, has not been followed up by a regulatory rule, the SEC will have no one to blame but itself when the lion’s share of the hot Facebook IPO finds its way into the hands of the wealthiest investors.
Thus does regulatory neglect contribute directly to the high/low divergence in our society. It incentivizes the wealthy to game the system and reinforces the powerlessness of the rest, leading some observers to wonder whether anyone on Wall Street or in Washington has ever read a history book.
Which brings us to today’s quote. Al-Jibarti was an Egyptian cleric who lived through and chronicled the invasion of Napoleon, the rise to power of Muhammad Ali, and the deterioration of Ottoman rule. He believed, as did many other thinkers of his age, that the study of history is required training for those who would live effectively in the present.
In America when someone say’s “that’s history” they mean it’s no longer relevant. Attitudes and behaviors they have transcended — or wish they had. “Time to move on,” they mean. “I’d rather forget about that.” And we all know what it means when our employer — or team coach, or lover — says “You’re history!” When preparing to stagger out of a group swill of a Saturday night, many a wag has been heard to announce “I’m history.” But for a culture that thrives on statistics, Wall Street appears obtusely indifferent to the lessons of history, a pose that has served both Wall Street and Washington exceedingly well. They paint themselves as History’s victims. “How could we have known?” they tearfully plead. How often have we read the words “Perfect Storm” in relation to what is still being described as a “financial crisis”? How many times have how many financial leaders testified before how many committees, been interviewed on how many television programs, been quoted in how many financial articles saying “we didn’t see it coming — no one could have seen it coming.”
A historian would correct them. Or any speaker of English. A “crisis” is a moment, an inflection point. Not a process. Those who speak of “Crisis” would have us believe there is no way to control what is going on. In fact, history has been caught with its pants down.
Ace Greenberg, the legendary Chairman of Bear Stearns and a student of history, predicted in the early days of the bull market that the staggering rise in stock values would attract incredibly bad people. An example of how prescient he was came to light in December 1998, when the US Attorney for the Eastern District of New York released a slew of criminal charges relating to stock manipulation and money laundering, and alleging Wall Street ties to leading organized crime families. Instructively, the individuals caught up in the probe were brought down, not because they pumped and dumped securities on the unsuspecting public, and not because of their string of naked short sales, but because of their involvement with organized crime.
This is the crux of today’s history lesson: it was not the illegitimate business that brought down the Bad Guys. It was their involvement with Even Worse Guys. Anyone from the Neighborhood can tell you that you don’t defecate where you eat. Our society maintains its increasingly obtuse High / Low character by maintaining the myth of Good Market versus Bad Human Nature. Adam Smith’s invisible hand has been enshrined as a benevolent divinity. Known to common lay folk through its earthly avatar, the Efficient Market Hypothesis, the market is seen as benevolent nature incarnate, while human actors are often wicked.
The benevolent power of the market is seen as so potent that it does not require the intervention of government (a creation born of human wickedness). Regulation is cast as a perverse attempt to force human control (inherently flawed) on a natural process (inherently perfect). Government’s job is seen more properly as protecting individuals’ property from the depredations of social misfits, allowing the market’s bounty to trickle down to the lower reaches of society.
Thus does our social philosophy imprison the one who filches the loaf of bread, while lionizing the one who pilfers millions. Millionaire drug dealers are called “scum,” millionaire stock scammers are called “robber barons.” Go figure.
Financial industry rules and regulations were written to protect brokers, bankers and traders. (Anyone who believes the rules are written to protect the customer may wish to subscribe for “Brooklyn Bridge Partners LLC,” an offering to be launched by the investment firm of Dewey, Cheatham & Howe.) How stupid does someone have to be to bring actual criminals into the workplace? This behavior ruined a perfectly good scam for lots of people.
We agree with Al-Jibarti: the study of history is highly instructive, and the history of the scam brokerage firms of the early 1990’s contains lessons for those charged with regulating the markets today.
Many a small brokerage firm integrated their scamming by becoming a manufacturer-distributor. They launched Initial Public Offerings. At their garden variety worst, OTC firms would issue stock in a company that had a minimal business. The principals of the company had to look good, both on paper and in their numerous appearances at the dog-and-pony show to woo investors prior to the IPO. These due diligence meetings were often more notable for the quantities of free alcohol absorbed by the stockbrokers than for any financial information or management insights shared by the company. Often, managements delivered absolutely nothing — which mattered not at all to the brokers or their firms, because once the IPO had been filed, they had Inventory. And since the firm offering the stock was frequently the only firm marketing it or trading it, the market price was determined by how much of a profit the firm wished to make on a given day.
The 1998 SEC filing describes one such stock called Transun International Airways, ticker symbol TSUN. The SEC says TSUN “purported to be a chartered airline; however it never owned or operated any planes…” leading the wag who penned the press release to refer to TSUN as a “fly by night company.” The brokerage firm that brought TSUN public and then dominated and controlled the public market for its stock was charged with “artificially inflating” its price. (We are not sure what constitutes “non-artificial” price inflation — perhaps Brazil’s finance minister could instruct us.) The crew then pumped and dumped more than $8 million of worthless stock onto investors. We note that “worthless” stock is defined after the fact, when the price collapses, leading us once again to contemplate the old saw about those who know the price of everything, but the value of nothing.
The unholy alliance of the Greed Guys with the Goodfellows came to a head with the 1995 collapse of brokerage firm Hanover Sterling, the alleged Vatican of organized crime on Wall Street. While those who talk don’t know, and those who know don’t talk, Hanover Sterling was allegedly controlled by the Genovese crime family, which supposedly also had links to Hanover’s clearing firm, Adler Coleman. One version says the Hanover Sterling brokers inflated the prices of the firm’s worthless underwritings, while Gambino-controlled associates executed massive naked short sales of the same securities. Thus, it was a war of the naked. The customers were the naked longs, who owned worthless actual shares. Arrayed against them were the naked shorts, who sold nonexistent shares that actually were worth something, because they were able to cash them in. The crush of illegal naked short sales in all Hanover Sterling’s stocks ultimately put Adler Coleman out of business. Clearing firms’ financing is dependent on the value and liquidity of the stock they hold for their client brokers. The knock-on effect of the Adler Coleman collapse was that some six or eight other clearing firms went out of business immediately, all having large positions in Hanover Sterling stocks.
Al-Jabarti observed a fundamental inability on the part of the French to grasp the essence of the Egyptian mind, nor did they seem to care, so convinced were they of their own superiority. The Europeans came as colonizers. It never occurred to them that they should learn the background of the Arab peoples. As our government aids and abets the colonization of our investment markets by the Napoleons of our age, they may wish to look to the lessons of history.
Adler Coleman had to fall, because it was the repository for worthless securities. The relentless barrage of short selling resulted in Adler holding many more shares of stock than actually existed — and paying out on the trades, pending deliveries that never came. Any time real money changes hands in exchange for some good that does not exist, there is the risk of collapse. This was true in the mortgage-backed markets, where Fannie and Freddy starred in the role of Adler Coleman. It is true in muni bond markets where there is no revenue stream to pay the bondholders. It is true in the Treasurys market if the government printing press runs out of ink. Doesn’t anyone think this mess needs to be regulated? Oh, we forgot — the market is virtuous, and human meddling will ruin our way of life.
Things aren’t going to get any better any time soon. Get out your pots and pans, ladies and gentlemen.
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