If you haven’t been awake the past week, you might not have noticed the soap opera-like tale of the now former head of the International Monetary Fund, Dominique Strauss-Kahn (or DSK as he is known). DSK used to be a very powerful individual. One who would meet with heads of nations as an equal. His fiefdom, the IMF was a major supranational organization which doled-out billions to nations needing credit. Now, DSK is sitting in a luxurious apartment in Manhattan under house arrest awaiting trial on charges of sexual assault.
He was compelled to quit his gig as IMF Managing Director. He was widely considered a viable candidate to compete with Nicholas Sarkozy to be the next president of France. And, maybe that avenue won’t entirely be blocked if he gets acquitted and fast. The French seem to have a somewhat different view of these things than the typical American response. But, even our response isn’t what it once was. (There is a widely held belief in the DSK camp that this whole affair is one very well constructed political attack on him by Sarkozy and his party.)
So, why would a powerful man with dreams of running France risk that for a tussle with a maid in his New York hotel room? Why indeed. The only person who knows that is DSK himself. But why are so many powerful people, mostly men but powerful all, feel they can do anything they want? Likely, because they always have. It emerges that DSK has had other brushes with sexual misconduct, but those all got quashed instead of leading to legal entanglements. When you get away with things often enough, you probably don’t view the risk/return assessment quite the same way.
Bill Clinton left plenty of accusations in his wake. Arnold Schwarzenegger, Eliot Spitzer and Mark Sanford come immediately to mind. The list is too long to bother with here, but power corrupts it seems. Or maybe it is just that the people attracted to power have related personality issues. This could easily diverge into another rant on professional politicians, but we really wanted to discuss the IMF and its role in the world financial system, especially now that it holds the financial lifeline for much of Europe.
The IMF was created shortly after World War II. The world’s financial system was in chaos and needed rebuilding. The IMF was created to help countries manage their balance of payments with other nations and build free international markets. After the massive development seen in the 1950s and 1960s it was thought the IMF had done its job and could be wound-down. But, then came the petro-crises of the 1970s, the Latin American debt mess in the 1980s and finally the LDC debt debacle in the 1990s. It seems there was always something for the IMF to do. Now, they are knee-deep in the peripheral European debt crises. The IMF has put together debt management plans for Greece, Ireland and Portugal so far. It has extended billions upon billions in cash to these nations in hopes of patching-over their debt troubles so as to avoid destroying their economies and governments. It might work, but then it might not.
The IMF is owned by the member countries and controlled by a board of directors representing many of the members. The voting on policy issues is done by the weight of the funding that has been contributed by each member. The US holds almost 17% of the votes, about as much as the next three largest members, Japan, Germany and Great Britain. European nations hold roughly 30% of the total votes.
What is important today is that the IMF is electing a new Managing Director. Currently, an American economist, John Lipsky, is the acting Managing Director. Historically, a European has held the post (by a gentleman’s agreement the US holds the presidency of the World Bank as a quid pro quo). Many of the now more powerful emerging nations would like to see a non-European run the IMF. The Europeans argue that now it is more important than ever to have a European at the helm as many of their most pressing problems are in Europe. The emerging market bloc could argue – why wasn’t a Latin American chosen to run the bank in the 80s or an Asian to run it in the 90s when the critical issues of the day were in those regions?
For that matter, many are now saying that the IMF is far more lenient to Greece, Portugal and Ireland than they ever were toward Thailand, Malaysia or Argentina in their day. There might be something to that.
The IMF has taken on the role of financier of last resort to nations that can’t handle their own finances. That argues that someday, we’ll need the IMF here as well, when we lose control of our own future, either to foreign creditors or domestic demands or whatever. As the world evolves with more supranational agencies telling countries what to do, there may be a bigger role for the IMF than ever before. That makes it all the more important who runs the outfit.
The leading candidate today is Christine Lagarde, currently finance minister in the French government. But, there are many other able candidates. Former British Prime Minister Gordon Brown would like the job, any job, to keep his name in the headlines. The Germans would like one of their own to run the bank, since according to them the bank is spending mostly their money. But, there are a whole lot of people from emerging countries who could do the job, if given the chance. Odds are good that Lagarde will win based only on the idea that between the Europeans and Americans they have about all the votes they need to elect the next Managing Director. But, by the time this Managing Director serves their five-year term, the emerging states may have even more clout than they have now and that could mean they could elect the next one.
Issue of the Week
The issue du jour remains the debt limit and what we are going to do about it. No less an authority than Warren Buffett has argued that we will not have a debt crisis. He may be right. Long-term bond yields on US Treasuries are still only 4%-plus. Look no farther than Portugal to see what debt costs when you have a crisis. Their 10-year bonds yield 9%, ours barely over 3%.
Buffett may have a point that most folks refuse to acknowledge, when you are the safe haven, nothing can really go wrong, for now. What happens when there is a crisis in the financial markets? Usually, the huge crowd of hedge funds and other trend followers jumps out of risky assets like stocks, commodities and the like and into Treasury bonds. We’ve seen this work lately as the Euro has slumped on renewed Greek crisis talk. The dollar goes up, Treasuries go up, gold tends to go up and everything else goes down. So, what happens when the crisis is in the dollar or Treasuries? Well, so far that same script plays-out with stocks, commodities and other currencies falling while Treasuries and the dollar go up. (Think about the weird reaction when Standard and Poor’s threatened to downgrade the Treasury.) So, a dollar crisis, or a US Treasury debt crisis leads to a dollar rally and a Treasury rally? Weird, but likely what will happen. Are we insane? Well, duh.
We have been harping on this ‘world’s reserve currency’ topic for a long time as to why the dollar is special and why it is our ace in the hole when it comes to handling the numerous crises that have arisen. Our mistake has been to believe that someday the crises would stop and normalcy would return with a dollar declining and Treasury yields rising. With the seemingly unending capacity of the markets ginning-up new crises to keep the dollar and bonds in their safe haven mode, we could be in this mode for a long, long time.
The beauty of the situation we’re in is that the Treasury market isn’t the weakest link in the chain and some other link will show the strain long before the Treasuries do. If we have a rising tide of concern over Treasury debt, the dollar might bend first, then stocks and commodities. Long before we get to the real crisis in Treasuries, we’d have to respond to the crisis somewhere else, which again drives a lot of people into Treasuries and out of nearly everything else. We also get a political response that might be all we really needed in the first place.
Long ago, we wrote a piece in one of these missives talking about the four ways we could respond to our fiscal excesses. The four options are: reduce spending, increase taxes, some combination of those first two, or inflate our way out of it. Inflation has the beauty of raising tax revenue quietly, without raising anyone’s rates. It also has a way of raising, not lowering spending, but by softly applying the brakes on the spending side, we can create a gap in the mix that will not allow spending to increase any faster than taxes. But, the real kicker is that we will pay-off all this massive debt with dollars that are worth only a fraction of the value they have today. The bondholders will provide cheap, possibly negative real cost, financing. Bless the bondholders.
If we combine more inflation with a cheaper dollar, we also get our foreign creditors to pay more than their share in our fiscal remodeling. Bless the foreign bondholders especially.
The long and the short of it is we have a very slow burning issue on our hands, not one that will necessarily flare-up all of a sudden. But, when it does flare-up, it will be a doozy.
Housing starts dropped in the US in April to a level of 523,000 at an annual rate. Economists were expecting a small rise, which actually came about due to revisions to the March numbers. It gets kind of confusing, but the March number was originally reported as 549,000 and economists were forecasting 575,000 for April. But, March was revised to 585,000, stealing all the possible growth from April. Weird, but that’s the way economics goes. The drop from the higher, revised number is still rather disappointing. Many economists believe we are on the cusp of a modest uptick in housing due to the long period of very low production, but they have been disappointed once again by housing.
Industrial production was essentially unchanged in April from March. This was another disappointment as the economics fraternity had expected a modest rise in industrial production. Much of the slack in production can be explained by the after-effects of the Japan earthquake/tsunami and its impact on the auto and technology sector due to supply chain disruptions. When even the smallest part of a large computer or automobile isn’t available, the whole production line stops. Yeah, that’s why we used to carry inventories.
Capacity Utilization was essentially unchanged in April. Gains in utilization have been hard to come by in recent months as the economy has slowed. But, increases in mining and utilities will continue to push this series higher.
Existing Home Sales were disappointing. While most forecasters had expected a modest rise from last month’s report, we actually got a very small decline from March. We are still at a very disappointing pace of roundly 5 million homes at an annual rate. Prices for homes fell to a post-housing boom low of $163,700.
Leading Indicators were down in April. Only four of the ten indicators rose while six fell on the month. We have seen a rash of weaker than expected economic numbers lately, sort of like we saw last spring. Some of these likely reflect weather-related effects or are linked to effects of the Japanese earthquake and tsunami, but others are just a softening in growth. The Conference Board, who maintains the leading indicators, argues that the recent numbers for the indicators signals ‘choppy’ outlook over the summer.
Japan has slid back into recession according to their statistics agency. The impact of their massive earthquake and tsunami caused sufficient disruption to reduce economic growth in the first calendar quarter on top of the lull in the winter quarter. Many now expect the April to June quarter to also show a decline; though there is hope that reconstruction in Japan’s battered northeast could offset any decline.
Another rough week for equity markets around the world. There were exceptions: Canada, Mexico, Australia, Singapore and the United Kingdom were higher, but there were so few it was easier to list them than to describe them. Most of Europe is suffering from a recurring issue with debt and how to handle it. The need to finance the ongoing deficits is straining their financial system.
Many Asian markets were lower on fears that attempts to slow China’s economy may work altogether too well. A survey of Chinese business leaders had its most bearish reading in several years. By comparison, US markets were relatively safe and sane.
Bonds were generally stronger in most markets as risk-off overpowered the lurking negatives in bonds. The comments above may explain this better but if you didn’t get that part, then the fact that most of the issues are far more concerned with bondholders than stockholders yet when the crisis jumps back to the front page from page nine it is stocks that get whacked tells it all.
Currencies have seen a lot of action recently with the Euro first climbing and now falling versus the dollar. The dollar had gotten as high as $1.25 to the Euro at the height of the financial crisis in early 2009. Then it fell as the world’s governments started stimulating the heck out of their economies, falling to $1.50 to the Euro by late 2009. Then the buck rallied again until it hit new highs against the Euro below $1.20 by mid 2010 as their debt crisis was in the news. It has since fallen back toward $1.45 give or take in recent weeks. You can see the whole move in terms of risk level, where as risk rises so too does the dollar and when risk eases so too does the dollar. This is the safe haven trade we speak of from time to time. (If you have a hard time wrapping your mind around the currency movements, look at a chart of the dollar at http://finance.yahoo.com/q/bc?s=EURUSD=X+Basic+Chart .)
Real estate securities were largely higher last week across the globe. This is unusual as financial stocks were among the weaker areas of the market last week and REITs often follow the financials. But, foreign real estate was very strong on the week and that helped US REITs hold onto gains.
Commodities were mixed with energy prices mostly down, grains mostly up, precious metals down and the averages nearly unchanged. We saw some huge moves in grains as US Department of Agriculture estimates of crop acreage were released. Flooding in the Midwest and South will limit crops this year as will droughts in Texas, Oklahoma and Kansas. All this will mean fewer acres and lower output. Watch as the American farmer will react to what nature has thrown him and come back with much bigger yields than now expected.
Have a great week.
Karl Schroeder, RFC, CSA
Investment Advisor Representative
Schroeder Financial Services, Inc.