Monday, November 19, 2007


The Chinese government has given the countries banks an ultimatum, "No more loan growth this year"! Banks have been told that October 31 was the high point. I'm starting to wonder if Jimmie Carter has taken control of the Chinese economy. Gas lines, odd and even license plate days for cars and now we have credit controls.

If you remember the credit card controls imposed by Jimmie Carter, you remember the days of malaise. Ronald Regan was able to get a lot of political mileage by creating the "misery index". This index, computed by adding the unemployment rate to the inflation rate topped out in June of 1980 at 21.98%. To be fair to Jimmie Carter, the index hit 17.68% during the Ford term and Ford's response was Whip Inflation Now buttons. The BusinessWeek Magazine dated November 26, 2007 includes an article titled, "Stagflation Lite", the article is about stagflation in the current US economy. What a joke?

When Ronald Reagan took the price controls off oil, the free market did its thing and solved the "energy crisis". The price of a barrel of domestically produced oil soared but exploration flourished and power plants started switching from fuel oil to coal. It took 6 years for the price of imported oil to fall from record levels to $9 per barrel! You would think that the US would have learned the lesson of avoiding government manipulation of supply, demand and price. This time around, the government has spent billions of dollars in subsidies to corn farmers while billions of barrels of oil lie within easy reach. The most sad fact is that billions of pounds of fertilizer, pesticides, and coal dust have been dumped into the environment as a result of government policy.

Eventually, the politicians of this age will learn that the market should be as free as possible so that the most efficient solutions can be found. The WIN buttons and credit controls of Ford and Carter did not repeal the law of supply and demand.


When Carter slapped on partial credit controls, they certainly did have an effect. In short order, a recession was at hand. Indeed, the US "enjoyed" back to back recessions in 1980 and 1982. The recessions were worse than they needed to be. Had the slowdown been caused by allowing the price of "things" to reach their natural level, some very worthwhile loans would have been made. When a government rules that no loans can be made at any price, the good deals get thrown out with the bad.

China is not anywhere near a recession. The GNP has recently grown by an incredible 11%. The economy is overheated. Reserve requirements and interest rates have each been raised multiple times in the past couple of years in the hopes of cooling down the economy. Once again, the world has seen a demonstration of why the government should set the frame work and allow the free market to function. Americans have believed that the Chinese have been hurting America by pegging their currency to ours. The fact is that if anyone was hurt it was the Chinese. They are the ones who have sold and sold and sold goods to us for extra low prices. Had interest rates and currencies been allowed to float, the growth in China might have been more moderate but also more sustainable.

The government of China is working hard to be ready to showcase the country during the 2008 Olympic Games. I am reminded of getting ready for a Christmas party to be held at my house. The closer we get to the date of the party the more frantic the activity at the house. There might be a big let down after the party but there is little chance of a great slow down before the party. The credit controls were set to last only 3 months. I expect the growth rate in China will slow to 5 or 6%. Many a country would love to experience such a level of "slow growth".


Eisenstein taught us about relativity. Eisenstein was "the master" of the physical world but late in life he applied his thoughts to other areas, including religion. The thing that was missed by Ford, Carter and the Chinese is that interest rates are relative.

The prime rate is currently at a higher level than the rate of growth in corporate debt. This was not the case during the days of Nixon, Ford and Carter. As you may recall, prior to Nixon, the US embarked on the "great society program" of Lyndon Johnson. Johnson attempted to do the impossible. He tried to fight the Vietnam War and dramatically expand spending on domestic programs without paying for the programs with increased taxes or increased interest rates. The inflation explosion of the 1970's was a direct result of the Johnson administration and the price control response of the Nixon administration. Ford and Carter continued to battle inflation by artificial measures, including price controls.

Paul Volcker and Ronald Reagan took the country back to its roots. Volcker allowed the free market to work in regard to interest rates and Reagan allowed the price of goods to float. The prime rate stayed well above the growth rate of corporate debt for most of the years since and US corporations now have, on average, the best balance sheets in more than a life time. Believe it or not, US corporations are net savers! Consumers have gone the other direction but once again because of government policy. Consumers are paid by Uncle Sam to finance as much money as they can against a home and second home. The influence of the depression babies has waned. The great majority of the baby boomers have learned to take advantage of the home loan subsidy and the Y generation knows nothing else. Citizens of the US are approaching the extreme opposite extreme that lived in the 1950's. In the 1950's, many a family lived in a small shack or trailer while they saved for the day when they might buy a home. The clearing "price" was reached in 2003 when even poor credit risk citizens were allowed to buy homes with no money down.

The people of China need the availability of credit. Young people always need credit and the Chinese population is relatively young. However, the situation in China is extremely volatile. The median age of the population is rising quickly as a result of restrictions on births. Agricultural economies are savers by necessity but 100's of millions of Chinese are leaving the farm and becoming urban consumers. As is typical of government controlled economies, individual needs of consumers and businesses cannot be anticipated and filled as well by fiat as they could be in a free economy. As was demonstrated by Johnson, Nixon, Ford and Carter, even a "free economy" can be hijacked by restrictive government policy.

Like Johnson, Nixon, Ford and Carter, the Chinese administrators have refused to allow interest rates to rise above corporate growth rates. The inflation spiral that we witnessed in America was about to be repeated in China. The move by China to cut off credit growth is not the Whip Inflation Now button of Ford. The Chinese are taking a meat cleaver to a bone-in chicken and the chicken does not have a chance.


We do not know how this story will end but a few events seem likely. Hot money is likely to leave China to be invested elsewhere. A good candidate for those investment dollars is the USA because US assets are as cheap as they have been in 12 years. The crunch to Chinese based stock markets is likely to be a significant "correction". The Chinese people are all the more likely to spend some of their new found wealth as the turn away from putting all they can into soaring Chinese stocks. Of course, the wealth effect could offset some of the spending as losing money on investments is always a depressing event. The Chinese government could use the slow down to allow the Yuan to float more freely. The Yuan has been allowed to rise about 10% against the dollar over the past year. All those investments in US Treasuries, have lost value in the past year. If you remember the Carter days you know it is no fun to get paid on savings at less than half the rate of inflation. The Chinese people are in the boat of having lots of savings but watching those savings decline in value. The "in country" inflation rate has been around 6% which is less than the GNP growth but if I recall correctly the amount China has saved in US Dollars is in Trillions of Depreciating Dollars! (The wealthy oil countries are complaining about the same problem but it is false to believe that pricing oil in Euro Dollars would have a positive effect. If a have only hundred dollar bills and a store says it will not take hundreds, you will have to go get your money changed but you will still buy the same goods at the same price.)


The forces of "the turn" are natural economic forces. Like other natural laws, these are powerful forces. Like the locks in a canal, the water will only go so low until it is time for the doors to let the big ship slide through. The Chinese and oil barons hold trillions of US dollars. They have an excess supply. The law of supply and demand has caused the price of those dollars to fall. Hit the dumbest of mules with a two by four enough times and he will learn to move. People are not dumb as mules but they deal with "mindsets". In John 9, John told the story of Jesus. When Jesus performed miracles on the Sabbath day, some people were amazed at the miracles and others were amazed that the rules against work on the Sabbath had been broken. When the depression babies witnessed their children buying homes on credit, they thought they had lost their minds. Later when the undisciplined file for bankruptcy to avoid excessive debt it is easy for the those who remember the depression to say, "I told you so". The old saw is true that the only constant is change. When it is time for the leaves to change, there is not much you can do other than enjoy the view or worry that winter is on the way. The change over from small cap value to large cap growth is well under way. You cannot stop it. You can enjoy it or not but you cannot stop it and neither can the Chinese.

"News" and "Brief Comment"

GM is offering 60 month zero interest loans on various models. "Where there is a will there is a way".

Hillary has a secret file on Obama. "No news here, the pattern of the past is upon us, cases of FBI files in the bedroom?"

Thirty-year mortgage rates off .6 from the peak. "Just a little bit more and 10 months worth of unsold homes will disappear in a hurry."

Prices of goods continue to fall, core CPI low. "Inflation is present in 'rich man services" such as tuition at top universities and elective surgeries. Inflation is down in 'every man goods', electronics, home furnishings, clothing, and communication services".

Signs of slower growth around the globe. New unemployment claims rise in USA. "Peter Dag offers a good list of 'connected economic variables'. The list is composed of three groups that 'trade together'. The first group is 1) Stock Market 2) Money Supply 3) Yield Curve 4) Dollar. The second group is 1) ISM Indexes 2) Inventories 3) other Coincidental Economic Indicators. Group three includes 1) Commodities 2) Inflation 3) Interest rates. Because each business cycle only rhymes with the prior cycle and is different in any number of ways, one cannot expect the groups to 'trade' exactly the same each time. Besides, if there were perfect correlations there would be no business cycle. One of the things that can be said about the cycle is that by the time interest rates are in 'full retreat' it is time for the stock market bottom. The mid cycle interest breaks came in September of 1984, in November of 1995 and June of 2007. These were the breaking points of treasury bills which normally precedes the first cut in the Fed Funds Rate. For example, the November 95 break in t-bills was followed by the first cut in Fed Funds in February of 1996. By the time of the November 1996 election, the stock market had soared. One might note that the stock market did well in 1995 and 1996 but there was a huge rotation in the type of stocks that soared. Charts of broad indexes hardly show a bump during the mid 1990's turn. The turn this cycle is a bit more like the 1980's turn but even if it is more like the 1970's turn, the big growth stocks will ultimately gain strength. In all cases, stocks joined bonds in the rally long before commodities hit the next bottom. The peak in industrial metals occurred in April of this year. Stocks will outperform commodities for the next couple of years or more.


This time may be like the 1970's in terms of the need for massive construction. In the long run, economics always wins. A mega watt of power now costs about $60 when produced with natural gas. A coal mega watt only cost about $20. A mega watt of nuclear power cost only $4. The difference between this time and the 1970's is that the world markets are much more free than then. As a result, the price of oil has been allowed to rise to its market level. In the 1970's, price controls held down the price until the pressure was too great. The artificially low price encouraged excessive consumption and discouraged exploration. The law of substitution was not allowed to work.

If you really believe in inflation, please tell me how much higher the price of oil will go. It is currently trading at $94, do you really believe the direction is up substantially from here?

Yes, $4 nuclear power will "elbow out" coal and natural gas power eventually. The only question is "How long will it take"? So far, I have not found a completion schedule for coal or nuclear power plants or for refineries. I have read that China is completing coal electricity plants at the average rate of one per week and that it will complete 40 nuclear plants within the next 10 years.

One of the "great upside downs" is that profit growth will slow during the next several years while growth stocks out perform. Small stocks that grow the fastest over long periods of time will grow slower during the time for growth stocks. The slow down in world growth will be the "pause" that allows "infrastructure to catch up". Many a new energy project will come on line over the next several years. Profits will still be made but growth will be hard fought and the little guys of the world will get squeezed -- except for those who bring forward exciting new innovations.

Out of the turn gates, the little and the big will jump. The big will continue to climb. Buy now, the jump will be fast and hard.