I am a big fan of Kyle Bass. He is one of the few guys that seems to be able to take a 30,000 foot view of the world’s economy. He then breaks it down into very common sense and 8th grade math. His viewpoint is we are mathematically screwd.

Bass lays out the case that Japan will be next on deck after Europe blows (and it will). Rather than get into the stats, just watch the two videos. It is well worth your time.

Here is a news piece from ABC discussing how jobs sent to China previously are returning to America. The news piece cites increasing wages in China, transportation cost savings by building in America, and productivity of American workers. These are huge pieces of why jobs will continue to return. As China’s capacity utilization grows, the employees will be able to demand higher wages since employees are harder to find. Capacity utilization is best described by looking at a factory. If the factory can produce 100,000 widgets a year, and it is currently producing 80,000 per year, then its capacity utilization is 80%. If the capacity utilization on the macro level is high, then employees can ask for higher wages.

http://news.yahoo.com/video/us-15749625/overseas-jobs-come-home-26850542.html

America also has an enormous advantage currently compared to China: property rights and the rule of law. If I was to build a factory, I am taking a big risk by building it in China. The Chinese government could shut me out at a moment’s notice , and I would have no recourse. In the US, we respect property rights, and corporations have recourse in our court system if these rights are violated. Our bankruptcy laws also promote entrepreneurship, which is another enormous advantage for job creation.

If we really want to see the jobs flow home, we need to make two more changes. One, is the tax policy. Our 35% corporate income tax is way too high. Many emerging countries like China have low taxes, but it isn’t just emerging countries. Ireland, which also sports a solid legal system and property rights, has a 12% rate as well as competitive wage and productivity rates. If I am debating between Ireland or America to build a factory, it probably makes more sense to do so in Ireland. We are competing with nations for jobs. We need to entice companies to put jobs here. The tax rate is a huge determinate. Many folks will argue we need more taxes, and that the wealthy businesses should open up their wallet to pay their fair share. All I can say is if we lower the corporate tax rate, the middle class will see more jobs. Isn’t that the bottom line here? Additionally, we would get 10% or 12% of something instead of 35% of nothing – not to mention the savings from no longer paying unemployment and food stamp benefits.

Secondly, we need to lessen the regulations to get business off the ground, especially the environmental regulations. We have too many hoops to jump through to get a business started. I hear cries for infrastructure spending, but it takes 3-10 years to get any infrastructure project approved after dealing with local government boards, the EPA, state and federal regulations. It should take 3 years tops even for sophisticated projects like bridges, tunnels and overpasses. The EPA is out of control. The people harkening for infrastructure jobs point to the Hoover Dam as a project we should be undertaking during these challenging times. A Hoover Dam project would never get approval from EPA today due to some fury or slimly critter like a horned frog or grey mouse. As an example, my hometown, Flint, Michigan, just demolished the Buick plant. I inquired why they didn’t just offer a company the plant at little to no cost in an effort to entice a company to relocate. I was told that the EPA deemed the area hazardous, requiring a $6 Million clean up process first. That $6 Million would prevent any corporation from relocating to the Buick plant, especially a start up. Today, we have an empty lot, and the hazardous clean up will never be done because the local and state government can’t afford the $6 Million price tag. How does this make sense in any way? Rather than having a company use the plant, but not getting the cleanup, we have no plant or jobs without the cleanup. Bravo, EPA, Bravo.

I am not implying that we should become a dumping ground for toxins like China allows. However, we need to relax the ridiculous rules in place today. Besides, the court system is in place to provide retribution if a company harms others through pollution.

So I expect to see more jobs leak back into the US as the third world demands higher wages and transportation costs rise, but that leak could become a stream if we altered our high tax rates and cumbersome regulations.

Here is an article from Bloomberg describing the amounts received as loans from the Federal Reserve during the market blow up in 2008 and 2009. While taxpayers were enraged, and rightfully so, with the TARP bailout, which provided $300 billion to troubled banks, automakers, and other companies with strong lobbying arms, taxpayers should really be up in arms at the Fed, who provided $1.2 Trillion to the banks during the same time.  The reason this information is only coming out now is Bloomberg won a Freedom of Information Act (FOIA) lawsuit against the Federal Reserve who was not going to release this information.

This shows the secret, shady workings of the Fed along with the sole purpose the Fed exists: to help the banks. We need to end the Federal Reserve because it shows the government is working to help the banks, not the taxpayer. Rather than taking over the banks, writing down the assets, and then re-launching the banks, we, the taxpayers, will pay for this bailout with taxes and higher prices. Why higher prices? When the Fed prints this money to give to the banks, it causes the price of commodities, goods and services to rise. We pay more to live. Had the government taken over the banks like Sweden did during its banking crisis, the banks’ shareholders and bondholders would have lost their investment, but the taxpayer would have been spared. Even more importantly, we would be done with the liquidity mess. As it stands now, the banks will probably face another crisis when the European debt situation finally blows up.

Hat tip: The Big Picture

I am a huge fan of Steve Keen. One might say I have a man crush on him. He leans towards the Austrian school of economics, but he isn’t afraid to slap those ideas around as well. He just loves to tear apart neo-classical economics though. He has a book out that dispels the truths from that economic school. It is called “Debunking Economics.”

Anyway, below is a video of Steve Keen, and it is well worth your time to watch even if you aren’t an economics junkie. He lays down the truth on how banks are the main reason we are in this economic funk, and how we will continue to be in this funk until we “put them in a box.” h/t Investment Postcards from Cape Town

Here is a recent analysis from Moody’s chief economist, Mark Zandi. Zandi gives good interview as he is a polite, articulate, handsome guy, but he epitomizes the Constanza principle if anyone ever has. On the Big Picture blog, Barry Ritholtz has done a great job of laying out the case against Zandi. I won’t even try to replicate it, just link over to get a feel.

I see short and long term headwinds for the economy. The short term headwind will be the end of government stimulus that hits this summer. The $830 billion stimulus package from 2009 winds down, especially the benefits to state governments. This means further cutbacks at the state level. Don’t get me wrong – I am not nor was I in favor of the stimulus (see the broken window fallacy again for reasons why), but it will be a drag on the economy unless other parts of the economy step up. Second, the recent round of Quantitative Easing ended on June 30th. Again, this was a useless maneuver that holds back the free markets, but it was an influx of cash that will disappear. As I have stated previously, the end of any Quantitative Easing program results in a deflationary environment as witnessed last summer when QEI ended as well as the several rounds of QE in Japan.

So I don’t see any short term boom for the economy. My larger concern is the long term trend. The reason we have and will continue to see sub-par growth in the US and many other developed economies is the debt levels. Below is a chart from Ned Davis Research showing the total Debt to Gross Domestic Product (GDP). As you can see, we have $3.5 for every $1 in economic activity. At the height of the Great Depression, we were still under $3 to $1. A healthy ratio is 175% Debt to GDP. This means we need to shed about half of our $52,ooo,ooo,ooo,ooo ($52 trillion) in debt. This produces some serious headwinds for the economy longer term. So maybe Zandi will finally be right, and the economy will pick up steam in the second half of the year, but I bet it would be a short term boost. Eventually, we need to deleverage, and that usually means slower economic growth.

Great video from the Financial Times where Russell Napier is interviewed. Napier is a thoughtful analyst, historian and money manager who understood the problems of 2008 and called the 2009/2010 rally – so one is wise to listen to him. In this video, he explains why he sees the S&P 500 falling to 400 from its current 1300 level. Napier uses two valuation methods: the Price to Earnings based on rolling 10 year earnings and the Q Ratio. As an aside, I am putting out my newsletter which will explain these metrics further.

Napier says that the 2008/2009 bear market only took us to reasonable valuations. Usually, true secular bottoms exhibit extremely cheap valuations. We never got close. Napier even discusses how secular bottoms are met with apathy from investors. He claims in 2009 we had fear – even extreme fear – but it was not apathy. He believes when no one believes in stocks anymore we will be through the secular bear, and stocks will be a fantastic investment.

Even scarier than a 900 point drop in equities, Napier still prefers stocks to bonds. That speaks volumes to me.

http://video.ft.com/v/946244201001/Long-View-Historian-sees-S-P-fall-to-400

Here is a video from Tech Ticker featuring Martin Wolf. Wolf is a writer for the Financial Times, and he really knows Europe. Essentially, he is saying that the Greek default is inevitable as Greece’s debt is 160% of its Gross Domestic Product (GDP) and the market is already pricing the event as short term rates in Greece have skyrocketed.

For me, I was alarmed at Wolf’s belief that a default won’t cause a greater crisis. His theory is strong, but I am not sure reality matches theory. If Greece defaults on its debt, many European banks will face substantial write-offs. These write-offs could freeze credit and possibly cause a panic like we saw in 2008. Wolf believes that the European banks have to see this coming and have been reducing their risk by selling their Greek debt to hedge funds, central banks, and other outside buyers. Again, I agree that this is the path banks should be following, but it doesn’t mean that they are. The banks knew the risks with subprime lending, yet they got caught with their pants down when it finally blew up.

Further, I think banks might hold off on reducing risk in hopes that a bailout will save them. This is the problem with the previous bailouts. It created a moral hazard. Banks don’t have as much incentive to reduce risk. Why sell the Greek bonds that are paying a higher rate when you can maximize the gain and have the taxpayers pay for any losses.

My thinking is we will look back upon these sovereign defaults and wonder how we didn’t see it coming, just like we did with subprime.

Greece may end up in default not by choice, but by necessity. It appears that the appetite for the healthy countries to bail out Greece and its PIIGS partners (Portugal, Ireland, Italy, and Spain – Greece is the G in PIIGS) is waning. Finland’s recent election is proof positive. The head of the FINN party, which won enough votes to be one of the two controlling parties in Finland, released an op-ed in the Wall Street Journal recently claiming Europe must purge itself of this debt. The taxpayers should not prop up insolvent banks and governments. From the article (courtesy Credit Writedowns):

When I had the honor of leading the True Finn Party to electoral victory in April, we made a solemn promise to oppose the so-called bailouts of euro-zone member states. These bailouts are patently bad for Europe, bad for Finland and bad for the countries that have been forced to accept them. Europe is suffering from the economic gangrene of insolvency—both public and private. And unless we amputate that which cannot be saved, we risk poisoning the whole body.

The official wisdom is that Greece, Ireland and Portugal have been hit by a liquidity crisis, so they needed a momentary infusion of capital, after which everything would return to normal. But this official version is a lie, one that takes the ordinary people of Europe for idiots. They deserve better from politics and their leaders.

To understand the real nature and purpose of the bailouts, we first have to understand who really benefits from them. Let’s follow the money.

At the risk of being accused of populism, we’ll begin with the obvious: It is not the little guy that benefits. He is being milked and lied to in order to keep the insolvent system running. He is paid less and taxed more to provide the money needed to keep this Ponzi scheme going. Meanwhile, a kind of deadly symbiosis has developed between politicians and banks: Our political leaders borrow ever more money to pay off the banks, which return the favor by lending ever-more money back to our governments, keeping the scheme afloat.

In a true market economy, bad choices get penalized. Not here. When the inevitable failure of overindebted euro-zone countries came to light, a secret pact was made. Instead of accepting losses on unsound investments—which would have led to the probable collapse and national bailout of some banks—it was decided to transfer the losses to taxpayers via loans, guarantees and opaque constructs such as the European Financial Stability Fund, Ireland’s NAMA and a lineup of special-purpose vehicles that make Enron look simple. Some politicians understood this; others just panicked and did as they were told. The money did not go to help indebted economies. It flowed through the European Central Bank and recipient states to the coffers of big banks and investment funds.

Further contrary to the official wisdom, the recipient states did not want such “help,” not this way. The natural option for them was to admit insolvency and let failed private lenders, wherever they were based, eat their losses.

The Finns should know about default and turnarounds. In the 1990s, Finland defaulted on its debt. Back then, it was the only country facing default so Finland never received (or was considered for) a bailout. Certainly, the short term consequences were painful for Finland, but it cured its ills and know is one of the healthier nations (financially) in Europe. The pain from the default caused a positive change in behavior. Their government started acting like an adult again and got its fiscal house in order. This goes for the private sector as well. Look at GM. Many believe it was the government bailout that saved them. It wasn’t. GM turned around when it was able to discard billions in debt and contract obligations through bankruptcy.

So let’s get on with the default, and let Greece start to heal itself.

Here is another humorous post featuring the rapping Keynes vs Hayek. Both are advocates of different views of economics. Keynes looks for more intervention in the economy from the government or central banks while Hayek, a student of the Austrian School of Economics, believes markets should be allowed to function without political interference.  I posted the original video previously, but I included both of them here again. The first video is the new one so if you haven’t seen these before start with the second one.

And the original

Today, the Federal Reserve Chief, Ben Bernanke, will hold a press conference to detail what the Fed’s plan is once the second round of Quantitative Easing ends. Some think they will let the plan end with the stipulation that the Fed stands ready to jump back in if needed while others believe that Quantitative Easing III will be announced. I really think it is totally anti-capitalist to have a cartel of 13 bankers control so much of our economy and markets, but that is where we are. I decided to write a letter to Uncle Ben, and I put it here first. Also, after the letter, I have some thoughts on how this decision should drive your investments.

Dear Chairman Bernanke:

Today, you will alert the markets to the Federal Reserve’s decision about extending QEII, implementing QEIII, or letting the markets function on a more normal basis. I do hope you choose the latter. Unlike most Americans, I realize that you actually work for the banks (since the Fed is owned by its member banks) and not the government (or its citizens) so I understand the banksters would be upset with you if QEIII doesn’t happen. Providing the banks with all that fresh liquidity has helped them make a fortune in the stock and commodity markets. I do feel for the banksters if you don’t do QEIII, I really do. I know this will probably mean that the banksters won’t be able to afford the newest Lamborghini. They would be forced to settle for the Mercedes S class. While this is a step down, I hear the S Class is awfully nice. In fact, I was driving my 1995 Jeep (saving up for a used Hyundai) on the highway the other day, and I was cut off by an S Class. As I drove into the ditch, I remember thinking the S Class maneuvered superbly. So I hope that you agree an S Class is an acceptable mode of transportation for the banksters.

If that doesn’t convince you to halt any attempt at QEIII, I hope you will look at the price of most commodities. Since the announcement of QEII, prices for staples like oil, grains, livestock, and industrial metals have increased around 50%. I do realize that the world is demanding more commodities as China, India and other emerging markets develop their economies, but I suspect the underlying demand hasn’t increased 50% in six months. I know you deny publicly that QEII caused any commodity inflation, but I know that you know that I know that you know (to quote Eddie Murphy) QEII is causing commodity prices to rise. Being the ever optimist that I am, I guess I could deal with a continued spike in commodities. Maybe it will allow me to shed those last, stubborn 10 pounds I have been trying to burn off since I won’t be able to afford as much food.

If you still aren’t convinced, I will make a desperate plea by reminding you that our nation became great with a market based economy. While we never had true capitalism, it was as close to a capitalist society as was ever seen. Maybe if we start to move towards the principles, upon which we were founded, we could correct our inefficiencies and malinvestment and start to grow again. I know – silly, isn’t it. I am so naive to believe in things like principles. If you find my thoughts humorous, I ask you don’t share them with the banksters. They may attempt to read it while driving their new Lamborghinis and run me off the road (as they laugh their tails off). I can’t afford to repair another front end to my Jeep, and I haven’t saved enough for that Hyundai either.

Sincerely,

Kirk Kinder

I know, I know. I am being too much of a smart ass. I just find sarcasm soothing when I am in an uncontrollable situation. I do think that the Fed’s decision is a critical step though. It will have a dramatic effect on your wallet so we need to understand how.

The reason it will be such a big decision is the fate of the dollar rests in the Fed’s hands. If they undertake more Quantitative Easing, the dollar will drop even further than it already has. To put it in perspective, the dollar is around the low last seen in 2008 before the crash. If it breaks this trend, the drop could be severe. This means inflation will be even more painful than it has been for the past six months. If QEIII is announced, then it would be wise to think about investing in commodities, especially gold and silver, along with stocks. I would also look at parking cash in foreign currencies. Everbank has FDIC backed CDs denominated in foreign currencies.

If the Fed halts its Quantitative Easing program in June, I expect commodities and stocks to slowly lose value as money moves to Treasuries. Last summer, the stock/commodity markets were tanking and Treasuries/the US dollar was doing quite well. Then QEII was announced, and the opposite happened. The general consensus of most is Treasuries will get hammered if the Fed stops buying them through its QE program. Bill Gross, the manager of the largest bond fund in the world, has sold all his Treasuries expecting rates to rise and bond prices to fall once QE ends.

As mentioned previously, most market pundits agree. I am certainly a contrarian here, which I like. I always remember that the market attempts to provide the most pain to as many people as it can. I do feel a bit relieved in that Jeff Gundlach shares my view. He has outperformed Bill Gross’ bond fund for the past decade or so.

I still believe the natural tendency of the economy is to deflate. We have way too much debt as a nation that must be reduced through repayment or default. Without massive amounts of money printing, liquidation will begin, and investors will move to the dollar or Treasuries as it is seen as a more guaranteed return than commodities or stocks. Long term, Treasuries are doomed, but a guaranteed payment – even if it loses value due to interest rates rising – is better than an unguaranteed return from stocks/commodities.

Please take a moment to read my disclaimer and remember I am not advocating you invest in any particular way. I am just throwing out ideas for you to ponder. So ponder away and watch out for those Lamborghinis and Mercedes S Classes. They will drive you right off the road. :^)

Hat tip to Paul Kedrosy who found this article from Michael Lewis, the author of the Blind Side and the Big Short (one of my favorite books dealing with the Wall Street/real estate crash of 2008).

If you have ever read any of Lewis’ work, you will want to read this article. He makes mundane, financial stories interesting. More importantly, he lays out ways an earthquake in Japan would affect the world’s markets…and this was in 1989. Here are six shocks he points out from 1989:

1. The initial quake causes uncertainty in the Japanese stock markets and spreads to other countries. We are already witnessing this.

2. Stock and bond markets continue a decline once Western insurance companies sell stocks and bonds to cover Japanese insurance claims. Japan has always had a requirement that Japanese insurance companies reinsure with companies, usually outside the Land of the Rising Sun.

3. Japan starts liquidating foreign investments to cover the cost of rebuilding.

4. US interest rates skyrocket as Japan stops borrowing. Currently, Japan is the second largest purchaser of US government bonds. What happens when they stop buying and actually start cashing in those bonds? Either rates will rise or the Fed will print more money. Either way, inflation is on its way.

5. High rates cause US consumer prices and housing costs to rise while the US economy shrinks.

6. Tokyo exchange reopens with a 4% rise while other nations face years of declining growth.

These shocks are still as applicable today as they were in 1989. I would also add another shock that could be even more dangerous to our economy: banking crisis.

Entire villages have been wiped out…literally. These people are not paying their mortgage (or won’t be) on homes that do not exist. This could be exacerbated if the nuclear plant goes Chernobyl, and these regions are uninhabitable for years to come.

So the Japanese banks will now face a severe crisis. I always point out that one reason the Great Depression was worse than our situation today (and why we won’t see as bad of an economic downturn) is the fact that US banks were devastated by the droughts from Oklahoma to Maryland. The US economy was still very agriculturally driven with 25% of people living on the family farm. The drought caused numerous family farms to default, which demolished the small banks throughout that agricultural region. The earthquake will cause a similar dislocation in Japan.

As the banks face failure due to home defaults, this will spread to the rest of the world, particularly the US banking sector. Why? The shadow banking system holds more derivatives than the entire size of the world’s economies or Gross Domestic Products (GDP). This was one reason for the 2008 debacle, and it hasn’t been dealt with appropriately. Think of the derivatives like insurance. Let’s say a Japanese bank writes a mortgage for a Japanese family. The shadow banking system allowed that bank to put down 5 or 10% of the total replacement cost of the home and buy insurance (in this case a derivative). The insurance or derivative was issued by another bank, not an insurance company. As you can imagine, the banks didn’t put aside enough collateral to cover the potential loss. The bank just collected the derivative premium. Again, this derivative market exceeds all the world’s economies combined. We have no idea who was backing the Japanese banks and mortgages because it is a shadow system with no transparency.

This could be another risk that hammers the banks further.

Suffice to say, an earthquake and potential nuclear fallout like this in the world’s third largest economy is going to have a big impact on the world. The question is how big.