China

Hopefully, all of you believe, as I do, that a prosperous China, integrated with the world economy is the best hope for peace and economic growth. However, I've been reading an article in the latest Foreign Affairs Journal about China's environmental problems; and they are manifest. As the author went on about the various horrors, she concluded that the real solutions won't be forthcoming until China reforms some relevant portions of its government. Point taken.

But, I will take it further. I'll say this is a worrisome confirmation of a point that Milton Friedman made. He argued that capitalism and freedom went hand in hand. That capitalism maintained the means of freedom outside of governmental control. For instance, he pointed out that it was very difficult to exercise free speech if the government controls all the radios, televisions, and printing presses.

Recently, it has become a fashionable thing to write that this is a one way street. Freedom may lead to capitalism, but the opposite is not necessarily true. Russia and China are used as the two greatest examples of a society that seems to be embracing an authoritarian, as opposed to democratic, capitalism. And, it has seemed that these two countries have experienced rapid economic growth and improvements in the average person's material standard of living while personal political freedoms remain, or are even further, curtailed.

But, this article on Chinese environmental matters points to what I think is a hidden truth. A capitalist, free market economy is one of the most powerful, dynamic, and unpredictable forces on the earth. And where people have argued that technology developed by such a system just makes it easier to monitor people and restrict their freedoms, I argue that the opposite is the case as well.

A legal system, or a bureaucracy, is a complex and rigid thing, and is even more so when it is not routinely held accountable in elections that vent popular unrest. It may be strong, but it is also brittle. China's environmental problems, as an example, would never have occurred under the former communist economic model, simply because that model was not capable of unleashing the current amount of activity. In this area, and many others, we are now finding that a government of repression is not well suited to adapt to the dynamic needs of a free market. And, further, as the free market enriches the citizens, and technology expands the capabilities of a single individual, the means to seize and exercise political freedom are more and more available.

Here lies the worry: can China survive a revolution? Would it be a velvet one? Or would the government destroy all that has been accomplished to preserve its power? And, if China were derailed, what would happen to a world economic system that has become deeply tied to it?

It's ironic to be worried about democracy, no?

Some Sunshine

The last several posts have probably painted a fairly bad picture of the markets, and indeed if you've watched the stock market over the past three weeks or so, it has been extremely volatile. But, there are reasons not to be too concerned (and I, in fact, am not overly concerned):

1. The global economy has never been so strong. There are always risks (including environmental collapse in China among other things), but all things considered, things are really good out there.
2. American profits have been at record levels as a percentage of GDP.
3. The economy is stronger than many thought. The second quarter's GDP was revised up to 4.8%, which is a great rate of growth. I think everyone would be thrilled with a consistent 3.5%.
4. Only a fraction of 1% of all homes have a subprime mortgage attached to them. Heck, about one in three homes is owned outright.
5. We are not yet witnessing a collapse in asset values, the housing prices around the country have been coming down, and inventory is certainly building up, but prices have only dropped marginally. For instance, in Orlando prices have recently begun to tick down a few thousand dollars, but over the last five years, prices are still up about 95%.
6. The Federal reserve bank seems determined not to let a panic set in for the commercial paper markets, but rightly, I think, they also seem determined not to bail out people who made poor decisions.
7. People aren't stupid, and therefore people are getting out of their adjustable rate mortgages that are resetting to higher interest rates for a fixed 30-year mortgage, which a qualified buyer can still get for around a 6.5% interest rate - which really isn't bad.
   

This whole scenario might just be one of those great "walls of worry" that disciplined investors hope for. And, hey, you might end up being able to buy that vacation home you've always wanted on the cheap if prices do drop.

Credit Woops - Part 5

So, who bought all these asset backed securities? Lot's of people, but most notably, hedge funds. Hedge funds are just like mutual funds, except they usually require large amounts of money to join, have relatively few investors involved, and don't have to say up front what their investment strategy is (in other words, they can do pretty much whatever they think will make money). They play an important role in the financial system, but they often times swing for the fences since the hedge fund manager can be paid a percentage of the assets gained - double $300 million dollars for investors, and a 5% commission is looking pretty good.

Hedge funds, pension funds, and foreign banks all bought various flavors of these asset backed securities for their varying mixes of risk and reward. Those institutions that bought too much of the bad stuff are going to have to take a hit. And that's how the mortgage in Miami can give a bank in France some nervous moments.

There is one other side to the whole story, and that is that a similar liquidity boom was happening with respect to loans to companies, also called the "commercial paper" market. The same story pervades there. Quickly, typically when a bank makes a loan to a company, it requires "covenants", which are simply benchmarks it requires the borrower to maintain. These requirements help the lender know that their borrower is sound, and will be able to make interest payments. But, in all the hubbub, new "covenant-lite" loans were issued, and companies didn't have to show how they could pay it back. One telling quote I read recently was a lending manager saying that he didn't meet with a borrower over a $25 million loan because "it wasn't worth the meeting time". Not good.

As a result, lenders are now nervous about the loans they have already made, and don't really want to make many new ones. And here is the serious problem: without freely available credit our economy doesn't function, because many companies take loans to make large investments that keep their businesses running. If they can't make those investments, they can't hire people, they can't compete as well, and they can't meet demand.

Put the rising defaults on mortgages which are now connected to the world financial system with the lock-up in the commercial paper markets, and a lot of people are very worried.