World Markets and News

Top 30. Jan 27, 2005 9:04 AM

» Normxxx - China Loses Faith in Dollar Stability

AP: Economist: China Loses Faith in Dollar Stability

01.26.2005

China has lost faith in the stability of the U.S. dollar and its first priority is to broaden the exchange rate for its currency from the dollar to a more flexible basket of currencies, a top Chinese economist said Wednesday at the World Economic Forum.

At a standing-room only session focusing on the world's fastest-growing economy, Fan Gang, director of the National Economic Research Institute at the China Reform Foundation, said the issue for China isn't whether to revalue the yuan but "to limit it from the U.S. dollar."

But he stressed that the Chinese government is under no pressure to revalue its currency.

China's exchange rate policies restrict the value of the yuan to a narrow band around 8.28 yuan, pegged to $1. Critics argue that the yuan is undervalued, making China's exports cheaper overseas and giving its manufacturers an unfair advantage. Beijing has been under pressure from its trading partners, especially the United States, to relax controls on its currency.

"The U.S. dollar is no longer - in our opinion is no longer - (seen) as a stable currency, and is devaluating all the time, and that's putting troubles all the time," Fan said, speaking in English.

"So the real issue is how to change the regime from a U.S. dollar pegging ... to a more manageable ... reference ... say Euros, yen, dollars - those kind of more diversified systems," he said.

"If you do this, in the beginning you have some kind of initial shock," Fan said. "You have to deal with some devaluation pressures."

The dollar hit a new low in December against the euro and has been falling against other major currencies on concerns about the ever-growing U.S. trade and budget deficits.

The U.S. currency came under some pressure Wednesday, drifting lower versus most currencies including the Japanese yen and the euro, as dealers mulled the Chinese official's statements.

Fan said last year China lost a good opportunity to revalue its currency, in July and October.

"High pressure, we don't do it. When the pressure's gone, we forgot," Fan said, to laughter from the audience. "But this time, I think Chinese authorities will not forget it. Now people understand the U.S. dollar will not stop devaluating."

Asked how speculation about revaluation could be curbed, he noted that China imposed a 3 percent tariff on Chinese exports.

Some Chinese experts say that perhaps inflation can be reduced this year, "but I'm not that optimistic," Fan said, noting that fuel prices keep rising.

"So maybe China (will) have 4-5 percent inflation in 2005," he said.
Fan, whose nonprofit institute specializes in analyzing the Chinese economy, stressed that the country's development is a long-term process that will take decades, maybe a century.

Since China's economic modernization began over a decade ago, 120 million rural laborers have moved into cities, but another 200 million or 300 million people need to move into the cities from the countryside to spur development, he said.

"The income disparity is huge, and income disparity will stay with us for a long time, as long as those 200 to 300 million rural laborers stay in the countryside," Fan said.

Nonetheless, William Parrett, chief executive of Deloitte Touche Tohmatsu, told the panel that Chinese companies are making significant progress in becoming global giants, led by state-owned companies.

"It's probably at least 10 years before the objective of the government of 50 of the largest 500 companies in the world being Chinese" is achieved, he said.

The content of this letter/report does not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

-- posted by Normxxx

Top 31. Mar 16, 2005 1:17 PM

» Normxxx - MELTDOWN BEATS WARNINGS

MELTDOWN BEATS WARNINGS
http://www.sky.com/skynews/article/0%2C%...

Kilimanjaro: As it was-- but no longer!

The snow-capped summit of Mount Kilimanjaro has melted away to reveal the tip of the African peak for the first time in 11,000 years.

The glaciers and snow which kept the summit white have almost completely disappeared.

Although scientists had predicted the melt would happen, it is 15 years sooner than they had predicted.

The white peak of the 19,340ft mountain has long formed a stunning part of Tanzanian landscape, not least because it is only 200 miles south of the equator.

The photograph is part of the NorthSouthEastWest exhibition by The Climate Group, a book of which will be presented to ministers at the G8 energy and environment summit in London.

Steve Howard of The Climate Group said: "Climate change is real. So are the solutions, which are practical, affordable and in many cases, profitable.

"This exhibition shows us that a low-carbon economy is the only sustainable future for our planet."

The G8 meeting comes a day after the WWF warned Himalayan glaciers are receding at among the fastest rates in the world because of global warming.

The environmental group warned that the melting could result in water shortages for millions of people who rely on rivers supplied by the glaciers in China, India and Nepal.

[Normxxx Here: Invest in the stocks of water companies! ]

-- posted by Normxxx

Top 32. Mar 24, 2005 2:16 PM

» Normxxx - COPPER-- A Bubble Too Far?

COPPER-- A Bubble Too Far?

By Australasian Investment Review-– (AIR) | 24 March 2005

You don’t have to be a hardcore pessimist these days to conclude that spot fuel and commodity prices have run too far ahead of market fundamentals, increasing the risk that reality will come with a bang.

All it takes is not believing in the super cycle thesis.

Resources analysts at National Australia Bank aptly pointed out this week at the fact that promoters of the super cycle thesis are still by far outweighed by the rest of the market. This means that, in the light of current record or near record spot prices for the likes of crude oil and copper, there are many experts out there who simply cannot believe current market prices are sustainable, let alone fundamentally justifiable.

With markets and market participants transmitting mixed signals, the situation is unlikely to become any clearer in the near term.

Apparently, China hasn’t even started building up its long muted strategic oil reserve, now expected to start impacting the market from the second half of calendar 2005 onwards.

Traders in copper, on the other hand, seem to find it more difficult selling the product as their clients are holding back in light of record high price levels. In China, it is said, a whole sector of small producers of household goods has been forced to close down simply because they had no margin left to work with.

Meanwhile, official market calculations and estimates by leading consultants and industry bodies seem to offer few conclusive benchmarks, with every update followed up with adjustments and amendments by the likes of Macquarie (as regular readers of our daily news stories will have witnessed).

But that’s not necessarily how the skeptical majority sees things.

ABN Amro Morgans analysts ran into Chilean copper producer Antofagasta CEO Marcelo Awad recently, and they soon found common ground in renouncing the super cycle thesis.

The analysts report that Antofagasta views the copper market as moving towards demand-supply balance during 2H05 as global copper consumption growth slows and the producers’ supply response gathers pace. Apparently, Awad noted that, reflecting the flood of copper concentrates, TCRCs (treatment and refinery costs charged by smelters) had risen over the past year from historical lows to historical highs.

But, "mindful of a turn in the copper price", the company had recently decided to start buying puts to hedge its higher-cost mines. One such put option had a strike of US121c/lb, as well as a floor at US120c/lb and a cap at US160c/lb, the analysts report, while adding: "We wonder how many other miners, and not just of copper, are busy putting downside price protection in place?"

Antofagasta uses US90-100c/lb real long-term prices for planning purposes while US90c/lb is considered a "good" price. The analysts note this is 40% lower than the current spot price (still above US$140c/lb). So much for the myth that metals producers have higher price expectations than financial analysts for the coming years?

ABN Amro Morgans is not a big fan of the super cycle-super prices theory and copper is seen as one of the outstanding examples where fact and fantasy are deeply intertwined, leaving the market confused, unable to determine what’s "real".

The analysts cite stories of major players, both funds and banks, hovering up physical metal and "squirreling it away off-warrant".

The big play, they explain, is to "squeeze the market to exhaustion before coming to an abrupt halt, making even more money as the price cascades". And this is all possible because reported London Metals Exchange inventories remain dismally low. "For example, LME stocks of around 50,000t are worth just US$165m".

As fundamentalists we’re more interested in "evidence" of an inflection point occurring, ABN Amro Morgans states, adding the critically low inventory position for copper and other metals has now become "rather academic".

To clarify their point, the analysts use the analogy of the flooding of the Serengeti: "It starts with the drought; the rivers dry up, the wildlife begins its migration to still green pastures; and then, when all seems lost, the storm clouds gather.

Down comes the rain and still nothing happens. Then the first trickle, then another and the water is at first soaked up, then fills up all the crevices and potholes before becoming a flooding torrent."

Expect the same process for copper. ABN Amro Morgans finds the copper concentrate market is clearly "long". Treatment and refining charges have leapt above US$180/t and shipments so desperately sought this time last year are now being rescheduled or even turned back.

Copper refinery utilisation rates have already risen sharply from around 75% in 1Q04 and are estimated by industry analysts CRU to reach 83% by end 2005. "As this concentrate is turned into metal, it too will at first refill the pipeline, then fill the nooks and crannies before finally appearing in reported inventory."

Once the tide turns, the market is likely to witness as inexorable a rise in copper inventory as was the handsome decline from record highs of 2002, the analysts believe.

What really got them worried is the steady decline in apparent Chinese copper consumption since 2000-2001 (see table).

"For the industrial metals this looks more like a bloated cycle than a super cycle. We wait to see the magnitude and intensity of the supply-side response before we perform a Road to Damascus style turnaround", the analysts conclude.

ABN Amro Morgans is far from the only one who suspects that speculators and banks are playing mind games through an artificially constructed pricing bubble – one that is ready to pop once the divergence between market fundamentals and pricing levels has become too apparent to sustain current record levels.

Commodity bulls such as the experts at GSJB Were, however, remain unperturbed and maintain the game is still about Chinese growth and Chinese demand and, having just returned from a trip through Asia, they report sign, after proof, after signal that the "stronger for longer" scenario remains healthy and undamaged.

With regards to copper, for instance, GSJB Were believes Chinese demand in recent months appears lower because of massive de-stocking as a result of the government’s credit tightening measures. As this process is now believed to have run its course, copper demand should again pick up throughout the rest of the year.

In order to accurately gauge China’s overall demand for copper units, GSJBW believes it is necessary to monitor trade in copper raw materials and China remains a massive importer of both concentrates and scrap. The analysts point out that in the first two months of 2005 Chinese imports of concentrates were 35% above a year ago, while scrap imports were up by 27%.

Moreover, GSJBW analysts seem to have brought back their own distinction between fact and fantasy; between what the Chinese authorities are trying to achieve and the real impact of their actions.

More than 50% of copper consumption in China is currently estimated to go into the power industry, the analysts point out, adding this will continue to be the major source of growth in demand for copper in 2005.

To this point in time, power shortages remain a key issue in China, and despite constant government attention to the matter, "the situation is little, if at all, improved from 12 months ago".

-- posted by Normxxx

Top 33. Apr 21, 2005 3:17 PM

» Normxxx - Iran Plans To Attack Israel

Sharon Tells Bush Iran Plans To Attack Israel.

By Dr. Joe Duarte, | 21 April 2005

Israeli Prime Minister Arial Sharon has reportedly repeatedly told President Bush that Iran in planning to attack Israel, once the United States leaves Iraq.

[Normxxx Here: Not a problem, since Bush never intends to leave Iraq! ]

The World Tribune.com, a conservative web site that has a fairly good record of reporting stories before the mainstream media noted: Israel has relayed its concern to the United States of the rising prospect of a Middle East war in 2006. U.S. officials said Israel has determined that the expected U.S. withdrawal from Iraq in 2006 would raise tensions in the region that could lead to a Middle East war. The officials said the Israeli assessment asserted that Iran would either lead or play a major role in any future war against the Jewish state.”

The Tribune added the following: “Officials said Sharon has raised this issue with President George Bush, Vice President Richard Cheney and leaders of the U.S. intelligence community. They said Sharon and Defense Minister Shaul Mofaz have assessed that an Iran emboldened with nuclear weapons and intermediate-range missiles was seeking to form a coalition against Israel for a war that could take place after a U.S. withdrawal from Iraq.”

According to the report, during Sharon’s recent visit to Crawford, Texas, he showed President Bush satellite photos of Iran. Sharon then told President Bush and Vice President Cheney, reportedly in the context of the photographs “that Iran has nearly reached the point of indigenous nuclear weapons capability. He said Iran still had several technical obstacles to overcome.”

No Agreement Reached

According to the report, the U.S. intelligence community is not totally in agreement with the Israeli assessment of the situation. “Sharon was also said to have urged Bush for military support to ensure that Israel would receive the supplies and weapons required to deter or fight any Middle East war in wake of the unilateral withdrawal from the Gaza Strip and northern West Bank. Officials said the prime minister asserted that Iran was encouraging Palestinian insurgency groups and Hizbullah to increase tensions along the southern and northern Israeli borders. But officials said most of the U.S. intelligence community does not share the Israeli assessment of either an imminent Iranian nuclear threat or the prospect of a regional war in 2006. They said U.S. intelligence does not envision an Iranian nuclear bomb until at least 2010.”

[Normxxx Here: They must have got the data on Iraq and Iran mixed up! ]

Instead of agreeing, at least publicly with Sharon, the U.S. continues to push diplomacy when dealing with Iran. “The U.S. priority in the Middle East, officials said, was for Israel's withdrawal from the Gaza Strip and the northern West Bank as well as the establishment of a Palestinian state. During his meeting with Sharon, officials said, Bush asserted that the establishment of a Palestinian democracy would result in regional stability.”

The contents of this letter/report does not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

-- posted by Normxxx

Top 34. Apr 22, 2005 4:56 PM

» Normxxx - ONLY 5 SHORT YEARS AGO

ONLY 5 SHORT YEARS AGO
Gold and Stock Market Update

By Steve Saville | 24 April 2000

Overview

Bonds - absent a boost from flight capital seeking a safe haven, bond prices are likely to move lower from here.

Stocks – last week's rally should continue during the coming week (after some weakness on Monday).

Gold - strength in the US Dollar is turning the short-term outlook negative.

The Euro Crisis

In the 18 months leading up to the 1987 stock market crash, US Government Bonds in terms of the Dmark lost more than 40% of their value. It was the steady erosion of US debt in terms of other major currencies, combined with a panicky attempt by the Fed to stem the decline in the Dollar and quell rising inflationary pressures via the hiking of official interest rates, that precipitated the large-scale liquidation of US assets and an equity market crash.

In the 18 months leading up to the present time, German Government Bunds in terms of the Dollar have lost about 30% of their value.

Whilst the entire world keeps an eagle-eye on the US stock market, pondering when the decisive break will occur, perhaps the collective gaze should be directed towards Europe for the source of a possible global financial shakeout. The Euro has been declining relentlessly since its inception due to a gradual ebbing of confidence. As confidence diminishes investment capital leaves in search of greater stability, thus putting downward pressure on the currency and causing a further reduction in confidence.

A steady downwards trend in the Euro-Dollar exchange rate, low Euro interest rates (compared to Dollar equivalents), and European officialdom who appear to be unwilling to take any firm action to arrest the decline in their currency, are the perfect ingredients for a Euro carry trade. As the Euro's slide progressed over time with no meaningful response from the ECB, it is likely that the speculative short position in the Euro mushroomed. Enormous quantities of Euros have no doubt been borrowed in order to finance higher-yielding Dollar-denominated investments.

So, while much of the world is focussed on the high valuations of US technology stocks we have a potential Euro-crisis in the making. In order to make a guess at how the various markets will be affected, let's summarise what we think we know.

There is an interesting parallel between the current time and 1987 in that the European markets of today are, in one important respect, strikingly similar to the US market of 1987.

When huge speculative positions are accumulated based on the belief that a particular trend will continue indefinitely, that is, when a trade is perceived to be a one-way bet, a dramatic reversal is inevitable. The Asian crisis of 1997, the panic unwinding of the Yen carry trade in 1998, and 1999's gold price surge are examples of such reversals.

The fortunes of the world's financial markets are inter-twined. A sudden upheaval in one part of the world will reverberate throughout the globe.

The value of any fiat currency is based purely on confidence. At the moment, confidence in the Euro is low and confidence in the Dollar is high.

As long as confidence in the US Dollar remains relatively high, any crisis that occurs outside the US will likely cause an acceleration of capital flow into the US.

Our view is that the Euro-crisis has two possible outcomes. The first is that an event occurs that causes the urgent unwinding of the Euro carry trade. The event could be an unexpectedly-large rise in official Euro interest rates, or dislocations in other markets that necessitate an across-the-board de-leveraging. In this case the Euro would probably move lower into 'the event' and then explode upwards as per the Yen in 1998. The effect of such a sudden and extreme reversal in the Euro-Dollar exchange rate would almost certainly be a sharp (and most likely short-lived) sell-off in global equity markets as assets were liquidated in a haphazard manner to cover losses from wrong-way currency bets. US Treasuries would benefit initially from flight-to-safety buying, but would reverse course soon after as central banks add liquidity to the markets at a frantic pace. The second is that the Euro will maintain a downward path towards an eventual demise, punctuated by the occasional sharp short-covering rally. In this case both the US and Japan would continue to be the recipients of large and increasing capital inflows.

It is almost inconceivable that the Euro would be permitted to fall substantially below current levels since such an outcome would not be in the interest of any of the major financial powers. However, an attempt to support the Euro with higher interest rates could potentially backfire (as per the US experience in the 3rd Quarter of 1987). It will be interesting to see if the ECB takes the higher interest rate route (the next ECB meeting is April 27). If they do, then short-term equity market risk will increase on both sides of the Atlantic.

At this stage we are not sure how the Euro-crisis will end, but we suspect it will come to a head soon (within the next 6 weeks). Although we are unsure what the primary effects of this unfolding currency crisis will be (Will the equity markets crash? Will capital seek out the perceived safety of US bonds? Will the gold price drop or rise?), we can quite confidently forecast an important secondary effect. As it always does, the US Fed would react to such a crisis with hyper-stimulative monetary policy.

The US Stock Market

Current Market Situation

The US market reached its peak on March 24. It then began a slide that culminated in a washout on Friday April 14. During the first 2 weeks of this correction bullish sentiment, as indicated by the put/call ratio, was not significantly dented. In fact, as recently as April 10 the CBOE Equity Put/Call Ratio was 0.33 (revealing an extraordinarily high level of bullish complacency considering the market's volatility). This told us that the market would likely fall much further before meaningful support would be found. As downside momentum progressively increased during the week ending April 14, an escalation in the level of fear and a consequential sharp rise in the put/call ratio finally occurred.

The market greeted the first two weeks of the current correction with disbelief that it could be anything other than a blip in an on-going up-trend. Similarly, last week's rally was regarded with complete skepticism. It seems that even the bulls are expecting at least a re-test of the April 14 low before a sustainable rally gets underway. The current uneasiness can be seen in the Equity Put/Call Ratio which, despite an impressive rebound in the major indices over the past week, was a very high 0.68 on Thursday (indicating that traders are anticipating another fall and are seeking to protect themselves through the purchase of put options).

Last week we made the comment that "sentiment is certainly bearish enough at this time to suggest that a strong rebound will commence on either Monday or Tuesday of the coming week". This statement is equally applicable to the week commencing April 24. With Microsoft making some cautionary statements in its conference call after the close of trading last Thursday we will most likely see a weak market on Monday morning. However, with the majority doubting the veracity of the recent rally we expect the market to continue upwards for at least a few more days following the initial MSFT-led sell-off.

Crash Update

Last week we outlined a typical crash sequence. We said: "If the market is going to crash, with March 24 giving us the major high on the S&P500, then we are probably just completing step b) in the sequence [the initial drop of 10-20%] and should see the market move up over the next two weeks. If it then turns around and begins heading back down towards the current lows (or a lower level reached during any follow-through selling early in the coming week), then a crash becomes possible around May 15-22".

Nothing has changed in the past week to negate the possibility for a May crash. However, with so many technical analysts anticipating a re-test of the April 14 lows in order to confirm that a bottom has been put in place, the probability that we will never re-visit those levels becomes greater. We do not think the market will be so accommodating as to put in a successful re-test and thus let everyone know, in no uncertain terms, that a low is in place and it is now safe to buy.

The wildcard in the whole process is the Euro. Whilst we don't completely ignore the possibility that the US market could crash of its own accord at some point this year, the probability of such an event occurring is very small. However, we can see that a financial crisis brought about by an eroding Euro could well be the catalyst for a worldwide equity sell-off.

Further to the above, we see little chance that a successful re-test of the April 14 lows will take place – there will either be no re-test (the market will find support at a higher level during the next downwards move) or there will be an unsuccessful re-test (the market will fall to a much lower level, most likely as a result of a currency crisis centered on Europe).

Gold and Gold Stocks

Last week we noted that the US Dollar requires net investment inflows of more than $30B per month just to offset the current account deficit and thus maintain its relative value. These inflows will not be sustainable if there is a loss of confidence in US financial markets. A diminution in confidence would see the foreign exchange value of the Dollar fall and lead to an increase in the investment demand for the Dollar's major competitor – gold. The corollary of this is that if the US continues to attract sufficient investment to maintain Dollar strength, then the investment demand for gold is unlikely to grow. The pre-requisite for a sustainable gold rally is a loss of confidence in the Dollar and Dollar-denominated assets.

By now we had expected that stock market instability would have taken its toll and slowed the flow of investment capital into the US. However, with the Dollar Index having hit a new high during the past week this is clearly not happening. We must therefore re-examine our premise.

Declining confidence in the Euro is encouraging the mass departure of capital from Europe. Increasingly large net capital outflows are, in turn, putting further downward pressure on the relative value of the Euro. The Dollar is currently being buoyed by this flight capital from Europe.

It seems that gold is being caught in the Euro-Dollar crossfire. As Euro weakness enhances the relative value of the Dollar, the US Dollar gold price falls (or is prevented from rising). As such, a gold rally is not likely to occur until we see a definitive reversal in the Euro-Dollar exchange rate. With speculators having piled into the short-Euro/long-Dollar trade, when a reversal does finally occur it will probably be violent.

Unfortunately, it probably won't be possible to just wait for the Euro to reverse course before going long gold because the re-valuations of both the Euro and gold versus the Dollar will likely take place very quickly. While waiting for the reversal to occur investments in gold stocks should be maintained at a level that satisfies the "sleep test", that is, they should not be so large that sleep is lost worrying about the price of gold.

As discussed earlier in this Update, we suspect the Euro-crisis will come to a head during the next 6 weeks. Unfortunately, there is no telling how far the Euro will fall before the inevitable sharp reversal occurs.

The contents of this letter/report does not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

-- posted by Normxxx

Top 35. May 12, 2005 5:17 PM

» Normxxx - The Cyclical Endgame

Asia/Pacific: The Cyclical Endgame

By Andy Xie (Hong Kong) | 12 May 2005

The global economy has experienced a synchronized business cycle since 1998, led by Anglo-Saxon consumption and Chinese investment. The cycle is aging and running into intensifying headwinds. The biggest are high oil prices and large US current account deficits. The former puts pressure on central banks to tighten despite slowing growth, and the latter increases instability in currency markets.

Is it possible for the global economy to have a soft landing? If not, would the cycle end with a hard landing in Anglo-Saxon consumption and/or Chinese investment? The politics over China’s currency are increasingly about the outcome for the global economy.

If China’s investment were to experience a hard landing, the US current account deficit would drop sharply on lower prices of oil and other raw materials, and the inflationary pressure in the US economy would disappear. The US Federal Reserve could cut interest rates again, and the dollar would likely remain strong. This would indeed be a favorable outcome for the US.

Three interest groups in Washington are putting pressure on China. First, some economic experts want China to shoulder a big share of the growth deceleration in the business cycle. A significant revaluation would cause hot money to leave China and, hence, its property and investment to crash. Second, uncompetitive industries (e.g., textile, auto) appear to be targeting China as the reason for their business failings. Third, some strategic thinkers consider China’s growth a strategic challenge and want to slow China down. China’s currency peg has become a rallying point for these interest groups.

China has to stay the course to reform its financial system to increase immunity against external pressure, in my view. China can live with the external pressure on its currency. The resulting inflow of hot money complicates China’s monetary policy, but the scope for sterilization has not been exhausted. The rise in its foreign exchange reserves could enhance China’s clout in international financial markets and provide a monetary cushion when the trade cycle turns down and the hot money stops flowing in.

Trade sanction threats by the US seem mostly rhetoric, as sanctions could cause a hard-landing scenario for the US economy before China’s economy is affected. While some specific interest groups could be vociferous in the US policy dialogue with China, they would not be powerful enough to push the US government to take actions that could seriously harm the US economy. In my view, a major trade protectionist bill would have severe implications for the US stock and property markets, pushing the US economy into recession.

With a massive stock of foreign exchange reserves, China could sustain its investment strength even if there is a temporary trade disruption. China has more leverage than the US in the cyclical endgame, in my view. It is in China’s interest that this cycle turns down with burdens shared by all major economies, not just China and commodity exporters.

China and the US Have Opposing Cyclical Interests

The global economy is witnessing an unusual conflict of interest between China and the US in a business cycle. A ‘normal’ business cycle runs into headwinds when labor markets are tight and wages begin to rise to cause inflation. The headwinds in this business cycle are inflation from rising prices of oil and other commodities, and the large US current account deficit.

The big US current account deficit and the high prices of oil and other raw materials are closely related. The US is the world’s largest importer of energy products. The increased import bill for crude alone accounted for 30.9% of the expanded US trade deficit between 2002 and 2004. Higher import prices in general accounted for half of the increase in the US trade deficit during the same period.

Furthermore, commodity-based economies that are benefiting from high commodity prices suffered foreign debt and balance-of-payment problems in the past and have been using the high export revenues to repair their balance sheets. Hence, their good fortune has resulted in the global savings rate increasing. The consequent reduction in real interest rates has encouraged the Anglo-Saxon consumer to spend more, which, I believe, accounted for the remaining increase in the US trade deficit.

The large US trade deficit has increased the supply of dollars in the global economy. As China’s currency is pegged to the dollar, the increased dollar supply has triggered a property boom in China. The Chinese economy is experiencing overheating as a result, and this is attracting speculation in the currency. The hot money inflow has made the economy even more overheated and pushed up prices of raw materials further. The US trade deficit, hence, continues to expand. From China’s perspective, the best solution is for the US to raise interest rates to cool its consumption, which would end the inflow of hot money into China. This would be the best scenario for China to achieve a soft landing.

The US, however, is already worried about growth rates being too low and may be seeking to lower the trade deficit. A hard landing for China’s investment could serve this purpose nicely. If China’s investment were to crash, I estimate the lower import prices for the US could bring its trade deficit down by one-third. The inflationary pressure on the US economy would also likely dissipate. The dollar would strengthen, similar to what occurred during the Asian Financial Crisis. The Fed could cut interest rates, which would prolong the US housing bubble. In short, a hard landing for China would lower consumption costs for the US and boost its asset prices, similar to the impact of the Asian Financial Crisis of 1997-98 on the US economy.

It is in China’s interests for the US to raise interest rates, while it is in the interests of the US to see a hard landing from China’s investment boom. This pretty much summarizes the opposed interests of the two.

Pressure on China’s Currency Is a Strategic Game

The intensifying pressure on China to change its currency regime should be viewed in the context of the conflicting interests between China and the US on how the business cycle should end. If the Fed raises interest rates to lower the US current account deficit, China could enjoy relatively good growth rates at the bottom of the cycle, while the US could experience growth rates significantly below 3%. If China were to suffer a hard landing, the US could enjoy high growth rates at the bottom of the global economic cycle, as during the Asian Financial Crisis.

In addition to opposing cyclical interests, there are two other groups involved in putting pressure on China to revalue. Some US industries are under severe pressure and are lobbying against China; the textile industry is a typical example. Some strategic thinkers in Washington view China’s growth as a strategic challenge to the US. They advocate a ‘containment’ policy. Attention has been diverted from China because of Iraq, but as the situation there stabilizes, the focus is turning back to China.

These three interest groups seem to believe in the vague concept that a major revaluation of the Chinese currency would slow China and diminish the problems in the US. This is why ‘flexibility’ is merely a codeword to get China to move. The endgame for these interest groups is for the Chinese currency to move up significantly.

A China hard landing would serve the US’s short-term interests. Like the Asian Financial Crisis, it would result in the rest of the world subsidizing the US economy through lower prices and more surplus savings. However, this would merely prolong the US asset bubble and create a bigger problem for the future. At least in the short term, the US could benefit from a China hard landing.

A significant chunk of the US manufacturing industry is under severe pressure. Light manufacturing and autos are the most important examples. Light manufacturing is shifting to developing economies across the world. Europe and Japan are experiencing the same outflow. The auto sector is a telling example of US competitiveness. It represents one-fifth of the US trade deficit, and this is mainly with economies with more expensive currencies (Germany and Japan).

There is no doubt that China’s economy is becoming bigger relative to others, because China is industrializing from a low base and, hence, is experiencing faster productivity gains than those of mature economies. This catching-up process could make China the biggest economy in the world in another three decades due to its population size. Such a dramatic shift, of course, would have strategic implications for the United States.

China and the US Can Have a Productive Relationship

The above are negative forces in the China-US relationship. There are considerable positive forces, however. Otherwise, China and the US would not have developed such close economic ties. First, China’s open-door approach to economic development is in the US’s economic interests. US multinational companies dominate the modern consumer sector in China, where domestic demand is already a significant source of profits for corporate America. China’s importance in US corporate earnings should only rise.

Second, corporate America has taken advantage of China’s cheap labor to lower prices of consumer goods. The availability of cheap Chinese products has led to massive wealth creation in marketing and branding in the US corporate sector. China’s low-cost production and the US’s marketing creativity appear to be a winning combination. Many, if not most, high-profile corporate successes in the past few years could be attributed to this.

The biggest winner in the China trade is the American consumer. Cheap Chinese goods have lifted living standards among low-income US households, who have been experiencing income stagnation. The China trade has thus made a beneficial contribution to US society.

Third, Americans and Chinese appear to interact well on a personal level. While China and the US have very different cultures, they share an individualistic approach to economic activity. Americans and Chinese often collaborate to create businesses in China. The number of Americans living in China is rising rapidly. I think that the good relations on a personal level offer the best hope for a friendly relationship between the two countries.

China Has Enough Staying Power

The immediate challenge for China is how to respond to the pressure on its currency. Stalling is the best approach, in my view. As the Fed continues to raise interest rates, the global business cycle could cool and prices of oil and other raw materials decline. The global economy could bottom in a scenario favorable to China.

There could potentially be noise from some quarters in Washington; but what would be the practical consequences?

The implementation of trade sanctions is the stick that many in Washington are waving at China. I believe that this threat is not credible. Ten million workers in the US may be associated with China trade, and 15% of the profits of the S&P 500 companies may come from markups on Chinese products. A serious disruption to China trade would be quite damaging to the US economy. Indeed, the confidence crisis from a protectionist bill could have severe negative implications on both the US stock and property markets.

There is an argument that some in Congress could push for a protectionist bill even though it would do serious damage to the US economy. I do not buy this. The Smoot-Hawley protectionist bill helped send the US economy into the Great Depression. When it comes to trade, the US government would not make such a mistake again, in my view.

The increased hot money inflow is another consequence for China as speculators listen to the US government. But should it be such a big problem? China still has scope to sterilize the inflow, as its renminbi yields are lower than those on the US dollar. Its inflationary effect on the property market could be handled through administrative measures like a capital gains tax. The enlarged foreign exchange reserves would give China more clout in international financial markets. I do not believe that the hot money is an insurmountable obstacle.

The contents of this letter/report does not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

-- posted by Normxxx

Top 36. May 13, 2005 2:16 PM

» Normxxx - Is there a "New Economy" ???

Is there a "New Economy" ???

By Marc Faber | 13 May 2005

In the late 1990s, numerous economists and strategists distinguished between the "old economy" and the "new economy". Old economy companies were companies that made some money, had reasonable stock market valuations, and a relatively high earnings visibility. "New economy" companies, on the other hand, were engaged in new and unproven industries, in which were the pace of technological innovation was extremely rapid and, therefore, also obsolescence. Moreover, all the profits and some more had to be reinvested in research and development. New economy companies were also characterized by very high valuations (in March 2000, NASDAQ at 5000), and almost no earnings visibility. Well, we now know what happened to the then popular buzzword "new economy", but to be fair, there is indeed a new economy in the world. It is just different than what the visionaries had anticipated. The new economy is characterized by the rise of China, India and to some extend also Russia as global economic and geopolitical players.

Out of the blue and certainly totally unexpected to the American visionaries that spent their days counting irrelevant eyeballs in order to value Internet stocks, China has overtaken the US in many markets such as for steel, iron ore, copper, not to mention in the production of appliances and consumer electronics. But more importantly the "newest economy" is characterized by seemingly endless bubbles, courtesy of the man who has done more to destroy the value of paper money than any one else in the 200 year history of capitalism: Mr. Alan Greenspan.

The destruction of paper money as a store of value - the most important quality paper money should have - occurs only in one way and that is through increasing the quantity of paper money at a higher rate than real GDP growth. At times this "excessive" money supply growth will lead to real wages rising strongly, such as in the 1960s, or to commodity and consumer prices soaring, such as in the 1970s. But, excessive money supply growth can also lead to the most dangerous form of inflation and this is asset inflation, which at times will boost equity prices to lofty levels (Kuwait in 1980, Japan in 1989, Taiwan in 1990, NASDAQ in 2000, etc) and on other occasions boost the value of real estate into cuckoo-land (Tokyo in 1990, Hong Kong in 1997, and now in the Anglo Saxon countries).

The reason asset inflation is so dangerous is that central bankers - usually unemployable in any other capacity - not even as waiters - only pay attention to consumer price inflation. Therefore, when consumer prices do not rise much, for example because of international competition (as is now the case), they print money like water. So, with the entry of China and India into the global economy we had low consumer price increases around the world - although higher than the statisticians in the US are under political pressure computing, calculating and doctoring - and this led Mr. Greenspan to create, after he fueled the NASDAQ investment mania with easy money, another gigantic bubble: the housing bubble! There are many ways to recognize a bubble. One of the most reliable indicators that an investment mania is underway is always very high volume. In the case of US housing it is the number of home sales as a percentage of households that show how speculative the market has become (see figure 1).

FIGURE 1: US Home Sales as a Percent of Number of Households
<img src="http://www.gold-eagle.com/editorials_05/...">
Source: Bridgewater Associates

As can be seen from figure 1, annual home sales as percent of households is now at all time high. I am not suggesting that US housing cannot get even more over-heated but very clearly we are in housing not near a low such as was the case in 1971, 1982, and 1992. Moreover, from figure 2, we can see that since 1994, housing stocks rose actually more than the NASDAQ had risen between 1994 and 2000.

FIGURE 2: NASDAQ and HOME-BUILDING STOCK
<img src="http://www.gold-eagle.com/editorials_05/...">
Source: Elliott Wave International

Now, there are several interesting development in the housing markets. In Britain home prices are no longer rising and turnover is down. In Australia, in many markets home prices are already down and in the US, on record home sales in March, stocks of homebuilders failed to make a new high (see figure 3).

FIGURE 3: Lennar Corp, 2004 - 2005
<img src="http://www.gold-eagle.com/editorials_05/...">
Source: www.DecisionPoint.com

Usually if a new high in a physical market is not confirmed by the stocks in the respective sector - that is if there is a divergence in the performance between physical and financial market we call it a non-confirmation. If the non-confirmation occurs following a long term up or down trend it frequently leads to a very sharp reversal whereby an uptrend is followed by a collapse in prices and a downtrend is followed by an explosive upward move. There is another reason to be negative about US homebuilding stocks.

As can be seen from figure 3, homebuilding companies have traced out a Head and Shoulders top, which is an important reversal pattern. I must stress that there are occasions when prices break out on the upside from a Head and Shoulders formation, but usually they will not rise significantly above the "Head" of the Head and Shoulders pattern. Thereafter, they reverse very quickly and break down almost vertically. But there is another reason I am inclined to think that the housing boom is nearing its end. From figure 4, we can see that international liquidity (FRODOR) has been diminishing.

FIGURE 4: Foreign Official Dollar Reserves and CRB Metals Prices
<img src="http://www.gold-eagle.com/editorials_05/...">
Source: Ed Yardeni www.yardeni.com

FRODOR is a creation of my friend Ed Yardeni and stands according to him for "Foreign Official Dollar Reserves of central banks" and is "the sum of U.S. Treasury and U.S. Agency securities held by foreign central banks. It is probably the best available measure of world liquidity because foreign central banks tend to transmit and to amplify U.S. monetary policy globally. The yearly growth rate of FRODOR is extremely pro-cyclical. It tends to rise during global economic expansions and to fall during recessions." When FRODOR expands asset markets including stocks, commodities and real estate tend to perform well while the US dollar tends to decline. Conversely, when FRODOR growth decelerates, asset markets come under pressure while the US dollar strengthens. From figure 4 and figure 5, we can see that commodity prices and oil demand correlate very closely with the rate of change in FRODOR.

FIGURE 5: Foreign Official Dollar Reserves & Crude Oil Demand
<img src="http://www.gold-eagle.com/editorials_05/...">
Source: Ed Yardeni, www.yardeni.com

Since the takeoff in commodity prices in 2000 coincided with the takeoff in homebuilding stocks I assume that shrinking global liquidity will not only have a negative impact on industrial commodity prices - including oil - but also on other asset markets such as housing. Now, I admit that it is always possible that Mr. Greenspan will ease once again massively - if the economy weakens. That should almost certainly be the case if home prices begin to weaken since housing inflation was driving consumption or, more appropriately put, over-consumption in the last few years.

But this might be one of the rare moments in financial history where "printing money" becomes totally ineffective because any easing move now would hurt the bond market. Why would that be so if the economy weakens? Because commodity prices would soar and the US dollar tumble as investors would once and for all recognize that paper money under the guardianship of central bankers is no longer a store of value but a recipe for impoverishment due to paper money's loss of purchasing power. Needless to say that if the Fed engages one more time in "printing money" the decline of the US dollar will lead to soaring import prices, accelerating consumer price inflation and higher interest rates. Hardly a favorable environment for the highly priced and highly leveraged US stock and real estate markets!

I do admit that my expectation, a month ago, of an April stock market rally was plainly wrong (there was a rally but it only lasted for one day and pushed the Dow up by 200 points). Still, stocks around the world remain from a near term point of view somewhat oversold and rallied in the first few days of May. I believe that a better shorting opportunity will arise in the course of this rebound, which may extend into May 10th to May 15th.

However, I strongly feel that for the most stock markets new 2005 highs will be very difficult to achieve. For the S&P 500 there is strong resistance between 1195 and 1230 and numerous stocks have already broken down and inflicted serious technical damage to the entire market. So, I would use any strength to liquidate stock positions around the world. The risk reward ratio remains unfavorable. Moreover, based on the deceleration of growth in FRODOR I would avoid all industrial commodities including oil.

Lastly it will be fascinating to watch whether the "newest economy", which is characterized by bubbles everywhere and was the creation of the destructor of the value of paper money, Mr. Alan Greenspan, will last for much longer than the "new economy of the late 1990s!

Marc Faber
Editor and Publisher of "The Gloom, Boom & Doom Report"

The contents of this letter/report does not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

-- posted by Normxxx

<img Width="520" src="http://www.safehaven.com/images/conrad/3097_b.gif">
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Top 37. May 21, 2005 10:38 AM

» Normxxx - Japan and China Stop Buying

Japan and China Stop Buying US Debt. Is Caribbean Take-Over Safe?

By Bud Conrad | 21 May 2005

I have been analyzing interest rates because they can affect all the rest of our investments. The lynchpin to the projection of US rates is how foreigners handle our US trade deficit, which is often described "unsustainable". It is the subject of this article to closely examine the latest data to see how the cross border flows of capital may affect rates, which will affect our economic system.

Under a resource based gold convertible dollar system, as we had for most of our nation's history, the kinds of trade deficits we now enjoy could not occur. When trade imbalances occurred, delivering gold to make up the difference would balance the books. As gold was drained from a deficit country, the currency would be devalued, making imports too expensive, and thus stopping the trade deficit. But in a fiat dollar based system, these limits are removed. To see how far we have come from such a gold based system, just look at the size of the current imbalance: The US government claims to have about 261M oz of gold, which is worth about $110B at today's market prices. Our annual trade deficit is running about $660B per year. Using gold to pay off this trade imbalance would use up the entire stash of gold in 2 months. That assumes that the gold on our books is really there and that the accounting is accurate, that may also be questionable, as there has been no audit in decades. As a relative size comparison note, the Federal Reserve has issued $755 B of paper money called Federal Reserve notes. If this currency were backed by gold at 100%, the gold price would be $2,892. From the above we see that the US is in no position to return to a gold standard anytime soon, despite protestations of many of us that we need a more reliable store of value than Fed paper.

We need to understand how this new system has worked so well for the US. The counter parties to our trade deficit have managed the system to allow this extreme condition to continue. At the risk of oversimplification, what they are doing is providing a massive Vendor Finance program for their exports. They literally loan us the money to buy their goods. They have been doing this for decades, but have expanded greatly as we have expanded our high living by purchasing so much with our paper currency. This is patently "unsustainable" because at some point foreigners may decide they have enough of our dollars, forcing the whole system to fall apart. The dollar would devalue, and then we wouldn't be able to buy as many things we want from foreigners, like energy to drive our cars. But this feared calamity has not occurred. The US dollar has dropped some but stabilized, and US interest rates are not soaring.

The system may appear stretched, but nothing has broken, so we have been lulled into believing that it may not really be a problem. Some argue that catastrophe can't happen. These optimists point out that the foreigners who have loaned us the dollars to maintain our life style, are freely doing so and are now locked in a deadly embrace where they would hurt themselves so much that they will continue extending us credit. (I'm not so sure, but I'll get to that later.) They go on to point out that the situation is almost like the Mutual Assured Destruction of the cold war, where the Soviets and the US were locked in a fearful embrace of world potential destruction: Neither side would initiate all out attack on the other, because the result would be worse for everyone.

The problem for the Japanese and Chinese is that they hold so much of our debt, that if they tried to cash it in, (sell off their holding of US Treasuries) they would drive Treasuries down, interest rates up, the dollar down and be left holding big losses on their balance sheets. The proponents of this status quo like to talk about how owing the bank $100 is my problem, but owing the bank $1 million becomes the bank's problem. Again, I question that conclusion. Let's look at the numbers: Japan has $700B of accumulated Treasuries, and China $200B. They could afford to let them crumble to worthless because these levels of losses could be absorbed by these economies.

On a relative basis the damage to the US would be worse. That is not a likely course, but it should be providing fear as an overhang to the value of the dollar. It is more likely that they will keep the flow supported at some level because they want to continue to keep their workforce busy producing goods for us for trade. That is a bigger deterrent to their pulling out of the vendor finance program than the potential loss on their Treasury holdings.

All that background is to set the stage as to why looking at the details of this imbalance of trade is so important. The imbalance has not produced disaster because of how the foreigners have handled our deficits. So key to predicting the future is to determine if there is any change in the Vendor Financing policies of our foreign partners. So now I turn to reading the tea leaves of the latest cross border flows to see what is unfolding. China, Japan, India, and Korea have all made comments that they may need to consider re-balancing their portfolio of foreign assets. By this they mean to decrease the percentage of their holding that are denominated in dollars.

Despite these pronouncements, the dollar has held up well in the last 5 months. The highest level question is whether foreign reinvestment is keeping up with our purchases. So far investment is continuing. Total cross border investment flow is still strong. Foreign long-term investments of foreigners buying our Treasuries, Agencies, corporate bonds and equities, minus our purchases of their bonds and equities is still up. In March there was a slowing from $90B to $45B but with trade deficits around $50B to $60B this does not appear alarming, as several months of being over the trade level has left a balance between these flows.

But we need to look at the components of the figures to see if there are underlying causes for worry. First, are the biggest acquirers of our government debt, China and Japan still continuing to do so? Here is a picture of purchases of Treasuries since the beginning of 2005 by the biggest holders:

The surprise here is that China and Japan are doing what they said they would do, even selling off some of their holdings. If Japan and China are not buying the government debt, who is buying? The little islands of the Caribbean stand out. Obviously, they are not wealthy nations with the wherewithal to by such quantities for their own natives who are harvesting coconuts. They are acting on behalf of investors from other nations who are passing money through the banks of the Caribbean to make their purchases. Unfortunately, the US Treasury is unable to capture the true source of this money since they only know the first party of their transactions. The most cynical observers offer a theory that the US government itself might be behind these off shore operations to prop up the dollar. They have no evidence, and we are unlikely to ever know.

Another component of the expansion of purchase of US Treasuries is that London has purchased large amounts of our debt. This includes British investment, but I suspect that a large percentage of this flow is indirectly from other countries using London money center banks to make transactions for them. In this case I look to OPEC countries using London as their broker, who may be recycling the increased oil revenues.

There is another shift in the composition of the purchases of Treasuries: Central Banks are buying less and the rest of the public is buying more. In the month of March the central banks actually sold off $15B from their holdings, which was the second highest rate ever. The only bigger month was during the Russian default and the LTCM collapse of August 1998. This shift is also consistent with the stopping of Chinese and Japanese purchases, as they use official institutions to carry out their actions.

<img Width="520" src="http://www.safehaven.com/images/conrad/3097_c.gif">
Click Here, or on the image, to see a larger, undistorted image.

The other component is the purchases by non-official sources, which was at a record:

<img Width="520" src="http://www.safehaven.com/images/conrad/3097_d.gif">
Click Here, or on the image, to see a larger, undistorted image.

Here are a couple of other observations: US purchases of foreign stocks was close to a high at $14.4B, reflecting US attitude becoming more positive for foreign investments. This is growing just as Foreigners have slowed their buying of US stocks from the time of our stock bubble. The combination is an additional headwind for cross border balance.

<img Width="520" src="http://www.safehaven.com/images/conrad/3097_e.gif">
Click Here, or on the image, to see a larger, undistorted image.

Separately and inexplicably Norway cut its holdings of Treasuries in half to $16.9B from $33.8B, without any news to explain their actions.

What does all this mean? These warning details do not yet constitute cause for immediate alarm. The US was able to attract foreign investment from the Caribbean and London to cover the loss of support from Japan and China. I expect future deficits to continue large as the dollar stays weak and foreign purchases continue. But I question the strength of the structure of the Vendor Financing as described here. I see a shift in the composition of foreign purchases that looks to be built on a less stable base. Who these Caribbean investors really are is a mystery. To give some explanation, one could imagine US hedge funds using these instruments as offshore conduits. They could ply their trade of leverage to attain positions of safety in the face of plight for concern about risks of already too low rates being offered for junk and emerging debt.

But Hedge fund rumors of calamity don't leave me with comfort that this is a reliable source of deficit funding. The London money center may be funneling OPEC oil money that would gain more anonymity with resulting protection from the US possibly freezing assets, as was done with Iran when politics turned confrontational. My conclusion is to read these tea leaves as saying that the hands holding our Treasuries look weaker and less long term committed than the traditional Japanese and Chinese central bank holdings. I consider it weakening of underpinning, not yet a break. The only sure comment is that this bears continued watching.

The contents of this letter/report does not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

-- posted by Normxxx

Top 38. Jun 10, 2005 4:34 PM

» Normxxx - It’s The Euro, Stupid!

It’s The Euro, Stupid!

By Anatole Kaletsky | 10 June 2005

European policymakers want to believe that European business will continue as usual after the French and Dutch referendums, but they know in their hearts that this cannot be. Nobody should be surprised about this state of denial. Politicians are usually slow to understand the significance of truly historic events, especially when they involve economics. Remember John Major after Black Wednesday; Britain had not been ejected but “temporarily suspended” from the ERM! Politicians often behave like actors who find it impossibly difficult to deviate from their rehearsed scripts, even when the theatre is on fire.

But why should we care what Europe’s leaders are saying or thinking? After all, Schroeder and Chirac have completely lost the plot and are on their way out. There is, however, one important European leader who still has a decent chance of re-election. Significantly, he is the one European leader with a personal feel for business (and, above all, show-business) and he has found a new story line to offer the voters of Europe. Its catch-phrase, boiled down and translated from Italian into English, amounts to “it’s the euro, stupid”.

The idea that the euro is mainly responsible for the breakdown of Europe has recently been floated by so many Italian politicians allied to Silvio Berlusconi that it is losing what Richard Nixon used to call “deniability”. The anti-euro claims are partly designed to shift blame for Italy’s problems onto Romano Prodi, the former Commission President who is now Berlusconi’s main political opponent. But more importantly, the anti-euro rhetoric is weakening the euro on the foreign exchange markets and may well force a change in policy regime at the European Central Bank. These are exactly the right objectives for Europe’s politicians – and they bring us back to the comparison between Britain after Black Wednesday and Europe today.

The first lesson of White Wednesday (as I have always perversely called this day of national salvation), was that a country that gives up its currency loses control of its economic destiny. The second lesson was that interest rates, used boldly, are a uniquely powerful tool for stimulating job-creation and growth. These lessons are hugely relevant to Europe today. The euro is the essential cause of Europe’s “democratic deficit” because it prevents different countries adopting the variety of social and business models that voters demand. A currency is to national economic management what a border is to political sovereignty: with floating currencies, each country can choose its own style of economic and social organisation, with fixed currencies they can’t.

If France or Italy wants generous social safety nets, they can keep their business costs down by devaluing their currency. Of course, devaluation may lower living standards for consumers, but if people want to pay this price to preserve their social traditions that is what democracy is for.

It is only when a country with high social costs loses control of its currency, that the burden becomes intolerable, destroying jobs and decimating investment. According to traditional economics (which most European politicians and central bankers still believe in) an overvalued currency is not a long-term economic problem, since it leads to a decline in exports, which in turn brings the currency back into equilibrium. But in a world of abundant capital flows, this is not how things work.

An overvalued currency leads not to a loss of exports but to mass unemployment and collapsing investment. For a long period, these deflationary conditions may actually “improve” the balance of payments by reducing consumer imports and redirecting industrial production into exports. Eventually, of course, the collapse of export-oriented investment will cause an overvalued currency to fall back to earth, but this is a process which can take many years or even decades, especially in a modern industrial economy where businesses can hedge their foreign exchange risks and continue to export from their high-cost factories simply on the basis of sunk-costs. In the intervening period, the economy suffers from mass unemployment, falling investment and a hemorrhage of enterprise.

This is exactly what has happened in the euro-zone since 2001. After 9/11 and the Iraq War the euro began to rise for essentially non-economic reasons. Politicians who are unable to control this kind of currency upsurge, in principle, have five possible options to protect their countries from the economic dislocation caused by overvaluation.

The first option is to dismantle their social model and bring welfare costs into line with those of the cheapest economies at similar levels of development – not necessarily China, but Japan, America and perhaps South Korea.

The second is to achieve higher productivity growth than leading competitors. This worked in the 1960s and 1970s, when Europe was catching up, taking advantage of US technology, capital and management methods, but it is no longer feasible, now that US (and Japanese) productivity growth have accelerated, while free trade and free capital flows have made leading-edge technology and abundant capital available to the world as a whole.

A third approach is to maintain the social model, but to cut labour costs, either by slashing wages or by increasing working hours. This is what Germany has recently been trying to do, with benefits to profits but disastrous effects on consumer confidence and government popularity.

A fourth is to find niches in the global economy not too exposed to global competition. This has worked well for Ireland and Denmark, but it is not feasible for large economies.

The final option is to keep the social model and preserve wages, but to devalue the currency until it is so cheap that jobs and investment revive. This is essentially how Italy and France became Europe’s fastest growing economies in the ‘60s and ‘70s, with generous welfare and enviable life-styles but ever-falling currencies.

If the euro did not exist, European politicians would not be driven to such desperate, even suicidal, measures. Each country could make its own decisions about the balance between social protection, wages and currency strength. France and Italy could have rising social protection and a falling currency. Germany could have a strong currency combined with falling wages. Ireland could have a strong currency and rising wages, but low taxes and social protection. Unfortunately, today, these trade-offs must be decided for the euro-zone as a whole.

Since European voters are unwilling to accept wage cuts or abandon their social model, the rational choice is for the euro-zone as a whole to adopt the policies that worked so successfully for Britain (and to a lesser extent in Italy) after White Wednesday: to devalue the euro and stimulate economic growth by slashing interest rates to 1% or less. This “White Wednesday policy” would almost certainly create a strong cyclical recovery lasting a few years – enough time to conduct a serious debate on the balance Europe really wants to strike between wages, social protection and living standards. Of course recovery might simply make Europeans complacent and allow them to dodge the choice between a hard currency and a traditional welfare state. But that in itself would be a democratic choice – if France, Italy and Germany opted for high social costs and a soft currency, nations which objected, such as Holland or Austria, could simply leave.

There is, however, a practical objection to this logical response to the wishes of European voters. Euro-zone monetary policy is controlled by central bankers, not politicians. And why should the ECB cooperate with a democratic approach? The polite answer is that the ECB is first and foremost a European institution, run largely by ex-civil servants and ex-politicians with strong personal commitments to the ideal of “ever-closer union” which is now under threat. Indeed, Jean-Claude Trichet, the quintessential French enarque who is currently ECB President, has already started to hint at the possibility of rate cuts, having said the opposite only two weeks ago.

But what if M. Trichet and his colleagues were simply too obstinate for the intellectual gestalt-shift which White Wednesday brought to the UK? Europe’s politicians could call for their resignation and threaten to remove their independence when they rewrite the European treaties. But they could also try a tougher approach. The ECB is legally charged to “support the general economic policies in the European Community, with a view to contributing to the achievement of the objectives of the Community", including a "high level of employment" and "sustainable, non-inflationary growth". This is something the ECB’s policy is now manifestly failing to do.

If Trichet and his colleagues refuse to comply with their legal mandate, they could be sued and impeached. In this connection, Berlusconi might want to draw their attention to a news item which appeared last week in Singapore’s Business Times: “A Thai court has fined a former central bank governor, Rerngchai Marakanond, 186 billion baht or US$4.6 billion. The ruling, which effectively pinned the blame for starting Asia's 1997/98 crisis on one man, found Rerngchai guilty of gross negligence. Now he could lose everything he owns.”

Might this approach appeal to Sr. Berlusconi? Like Thaksin Shinawatra, the Prime Minister of Thailand who also happens to be a controversial billionaire, Sr. Berlusconi is a tough businessman who knows what it feels like to face a billion-dollar lawsuit. After more than a decade of abysmal economic performance, it is tempting to conclude that Europe’s policymakers will never get anything right. The politicians may indeed be incompetent and self-deceiving. The central bankers may be arrogant and narrow-winded. But they now have their backs to the wall and cannot afford any more errors.

Or, as Dr. Samuel Johnson expressed it succinctly: "when a man knows he is to be hanged in a fortnight, it concentrates his mind wonderfully."

The contents of this letter/report does not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

-- posted by Normxxx