Tuesday, January 29, 2008


The lead article in the current issue of New Yorker Magazine is about economic bubble after economic bubble. The article explains how in current times we seem to go from bubble to bubble instead of a broad economic boom to a broad economic bust. No one seems to be able to understand why these bubbles keep occurring. A lot of finger pointing has been directed at Federal Reserve Officials, at members of Congress and at the Bush administration. Alan Greenspan expressed the frustration of the most economically astute by saying that the current situation is a "conundrum". What is not fully appreciated is that in order to have a bubble, you have to have an anti-bubble and a new anti-bubble has surfaced.

At the heart of the "conundrum" is the fact that the real GNP continues to grow at a much faster rate than would be predicted by the rate of the 10 year treasury bond. Last quarter, the numbers defied belief with the inflation adjusted GNP at 4.9% while the 10 year was falling hard below 4%. The 10 year currently trades for 3.6% but how can it be that corporate profits are coming in at much higher rates -- AGAIN!

For old timers in the market, they just cannot get over the price of gold soaring to over $900 while the long bond also has soared in price. How can it be that we have high inflation and low inflation at the same time? During a time of confusion, the markets have not known which way to turn.

The news media, those guys who always try to make a mountain out of a mole hill, are in never never land. They have help to convince the American public that a heck of a recession is here. This morning, the numbers have once again upset the apple cart. Durable goods orders show that the economy is actually in a boom time. The world just does not seem to fit together the way it once did.


I have given the answer here many times before but I can identify with the profit who cried out in the wilderness. If my words were more widely disseminated then it would not be just the market insiders who are buying stocks. The words I am referring to are the words about how extremely low inflation rate.

I think my readers and indeed most of the population appreciates that when a person pays $3.95 to watch a pay per view movie, versus driving to the video store to rent the movie for $3, he is actually saving. The total cost of the rented movie must include the cost in time and expense to drive to the video store twice. I have written dozens of times about how this and trillions of other daily activities is lowering the cost of living. Everyone seems to understand that the electronic down loading of a movie or document is far more efficient than the physical delivery of the same movie or document. What is not appreciated is that the substitution of the inexpensive alternative represents a subtraction from the inflation rate.


For 25 years, China has been exporting dis-inflation in manufactured goods to the rest of the world. A slowdown in this exporting occurred last year because China temporarily ran out of energy. China could not continue to find more goods to make when it did not have enough energy to employ the hundreds of millions of people lined up to take the next products forward. This is no longer the case. China is averaging adding a new power plant every fourth day! The environmentalist can whine all they want about how much more coal is being burned but the result in the near term is that more and more goods can be made in China where the labor costs are low. As an aside, I would remind the environmentalist of two things, 1) Kuznets Curve is at work here and the environment will ultimately improve as a result of bringing China into the developed world 2) Cleaner alternatives would be used for power if the environmentalist were not standing in the way.

Anyway, the fact remains that 135 million people were lifted out of extreme poverty in the past 5 years while the rest of the world enjoyed lower priced goods. As the good folk at GaveKal Research have written, "The End is Not Nigh". The Chinese have the electric power to put another 100 million people to work over then next few years. As a result, the cost of manufactured goods will continue to fall.


The continuing movement of the poor into manufacturing jobs combined with the continuing incredible advance of rapid transmittal of information is a powerful combination. The net effect is that "real inflation" (ha ha, that is a funny term), is almost negative!

With the GNP running at an average of better than 3% and the 10 year bond selling for significantly less than 4%, where is the inflation? Put another way, inflation is a measure of change and the big perceived change is in oil. However, the US only uses slightly more oil today than it did 35 years ago, Japan uses less. At the same time, we are using billions of times as much digital storage space but the cost of it has falling by factors exceeding 100,000 times.

Robert Solow's Nobel Prize in Economics.

Robert Solow won his Nobel Prize in 1987. A long time for knowledge to be known but not appreciated. Solow showed us a couple of things. One is that "backstop resources" are unlimited. I have written and written about the power of substitution. Substitution is frequently nothing more than using backstop resources when the supply of the "normal resource" is scarce. To beat a dead horse, there is an unlimited amount of substitutes for oil. Once the quantity of oil is truly in the scarcity stage, the only question will be, "what is the lowest cost substitute for oil?" By understanding that man can eventually find a substitute for any good, Solow understood that 2) economic growth is determined mostly by technology.

Indeed, Solow calculated that 80% of economic growth is a function of technological development. In the "old days", economist said that growth came from the expansion of labor and capital. For the past 20 plus years, others have argued against Solow's "high" figure of 80% due to technology but it seems to me that the number is even higher. The compounded effect is that one worker does the work of many as a result of technology and $1 goes a very long way compared to the distance it would travel 20 years ago.

The other day, I wrote about GPS guided tractors plowing 40,000 hectare farms. This example was used because the image of a tractor plowing day and night on without the presence of a human is powerful. In the same e-letter, I mentioned Dover Elevator as being a beneficiary of the massive immigration to the city. The elevator is a super efficient people mover. I don't have the numbers handy but I know that a car is very inefficient relative to an elevator. Put another way, all of the developed countries have seen a dramatic slow down in the use of energy per person as electricity has grown to become the primary source of individual power usage.


As of Monday, 20 of 24 S&P Technology Companies had reported surprisingly good earnings. The headline in most papers was that new home sales were at the lowest level in 25 years. A short term figure was used to continue to exaggerate the severity of the "bad housing story". The median price of the average sale continues to make the news without any hint that the average sales price of the average sized house has not fallen. Yes, when times are tough, people may choose to buy a slightly smaller house but it does not mean that the economy will fall apart as a result.


The democrats continue to paint themselves into a corner. The markets will get a huge boost if it becomes clear that the "tax increaser's" are not going to sweep the house senate and presidency. An article by Charles Krauthammer offers a good illustration of how twisted many of the democratic positions have become. His article highlights the John Edwards gyrations but Hillary and Obama will either be fighting for the hearts of Americans from the extreme left or they will be forced to confront themselves at every turn the way of John Edwards.

The following is a quote from Russ Feingold as posted in the Krauthammer article.

"The one (presidential candidate) that is most problematic is Edwards, who voted for the Patriot Act, campaigns against it. Voted for No Child Left Behind, campaigns against it. Voted for the China trade deal, campaigns against it. Voted for the Iraq war.... He uses my voting record (Feingold's) exactly as his platform, even though he had the opposite voting record."

Krauthammer ends his article with the following statement: "It profits a man nothing to sell his soul for the whole world. But for 4 percent of the Nevada caucuses?

Now that the Kennedy establishment has fallen in behind Obama, the democrats are more and more the party of the extreme left. The war is wrong no matter what the results. The fact is that war is sometimes necessary. I wish it were not true but it is. McCain is looking stronger and stronger because he understands how to win a war. The war in Iraq and Afghanistan is not over but the majority of the terrorist are now holed up in the high mountains of Afghanistan and Pakistan. More than 1,000 years ago, one of the greatest terrorist of all times hid out in those mountains and occasionally came down to wipe out entire villages. He picked his targets carefully and raided cities from India to Turkey. He survived because he would raid and then relax. By the time the Indians were almost ready to join forces with the Persians or the Turks to go after him, he was no longer a threat worth the trouble. The average person thinks that it would be a cake walk for American forces to go into the mountains and find Osama bin Laden. It would not.

It is actually a good thing for some to have "gotten away". America needs to keep its guard up. We enjoyed too much the "peace dividends" after War War I and after the Cold War. America went soft on defense during the Clinton administration. Clinton was a great president in that he and the congress passed a lot of significant reforms. Reforms that helped the economies of America and the rest of the world. Clinton did not maintain our military strength and the result was an embolden enemy.

Going into the mountains or sequestering the terrorist in the mountains is a choice that will have to be made by the new president most likely. While great pressure is on the Pakistanis to allow US troops to go after the terrorist in the mountains, the situation in Pakistan is almost as complicated as any other in the Middle East. Pakistan is currently divided into four "states" and the northern "state" is controlled by radical Islamist. These radicals are members of various tribes and religious sects. If the rest of Pakistan can continue to move into the "modern world", these tribes will eventually be absorbed into the greater community (eventually is a long term word). Republicans win votes by being willing to protect the world from the growth of terror. Wiping it out is nearly impossible. Winning the presidency could come down to who is "for the war and who is against".

Believe it or not, the percentage of the world that is experiencing armed conflict continues to decline. People who are enjoying good food and good times are not inclined to go to war. From the Carpe Deim web site I read that 135 million people escaped poverty in the past 5 years. Prosperity is "breaking out" around the globe. In America people are about as anxious as they could possibly be because even the "experts" do not understand why there is one "bubble" after the next. The anti bubble is a good thing. The anti bubble means that interest rates are very low, which means that the discounting of income streams yields soaring asset prices. The price of homes soared like never before from 2002 to 2005. Since that time the prices have fallen back a tiny little bit relative to the prior climb. With interest rates back down, the tiny decline is over. Home prices and other asset prices are ripe for another big run.