Barbary Apes & the Art of Central Banking

Anyone who's visited the UK lately can see that London is bubbling and frothing. House prices are, once again, vaulting upwards, restaurants and airports are jammed, and all manner of high-end product or service retailer are replacing the tired bookie on the high street. Even the ubiquitious corner shops are being remodeled replete with a zillion watts of halogen, uncluttered aisles more akin to Waitrose than Londi's. Vertical tower cranes adorn the London skyline as new skyscrapers dwarf the once-dominant Centrepoint Tower, whilst rents are increasing smartly too, according to CB Richard Ellis's latest report. Housing affordability? Ha! It'd so unaffordable that few Brits outside hedgies and merchant bankers own (or even live) with the Congestion Zone. So the Bank of England has raised rates, and rightfully so. Granted, London can be deemed pseudo-idiosyncratic since it does prey upon the rest of EC by generously allowing tax refugees to live there without paying Inland Revenue. And Hedge Funds are popping up and multiplying like mushrooms in a cow pasture after a spring rain due to the lack of the SEC, and a subtler, more level-headed approach to fighting terrorism. Most major metropli share the feel-good of London. New York is the same. As is Tokyo, Moscow, Rio, Khartoum, as are Dubai, Mexico City, and Caracas. In fact the whole world - save Zimbabwe, Mogadishu, North Korea, Dresden, and yes, Detroit - is booming and building.

The ECB has been raising rates, though they remain comparatively and historically low. And despite jawboning by the Trichet, higher VAT in Germany, and higher energy prices, European real estate is rising, unemployment is falling, speculative building continues apace, and estate agents and stock brokers are more ubiquitious than engineers or machinists. Liquidity is growing. And it it growing significantly. Assets of all types are being sold by old long-standing owners to new owners, and used as collateral in this transfer of ownership. It leaves the old owners with paper, while the new owners put up a bit of equity and borrow the rest, often collateralized by the assets themselves, the newly collateralized and rated paper that then is used as equity, near-equity or faux-equity for creation of further credit. But while there IS indeed real growth in eastern europe, and encouraging recovery in old europe, this boom, it would seem to me, is decidely financial. And this has been rewarding for owners of assets, and doubly so for owners that are geared. But make no mistake: the feel-good is the result of leverage and debt. And the source of such funds and the ease with which one can borrow them - i.e. the grease - is I suspect still coming from "liquidity" created by loose fiscal policies (deficit spending) of what's been 3% of GDP in the EU, 4%+ or so in the US (taking into account SS and other OBS obligations), and 4 or 5% in Japan, on top of still-easy money in the EU, very cheap money from Switzerland, and still almost free money from Japanese ZIRP, now, (called nearZIRP in my lingo). Asian savings, and GCC petrodollars further enable it. And with still-easy money, and the dollars from US nearZIRP of 02-to-05 still sloshing about unspent by the neo-mercantilst trade financiers excepting US TBills, Bonds & MBS, and the deficits continuing to add many zeros to the cumulative figures, speculators have, to say the very least, been emboldened.

So emboldened have they become, that everyone has become a spec. Whether individual home buyers in America using floating, IO mortgage product, or formerly staid folk that traded on connections and information (like Carlyle), professional specs are now seizing everything in site, whether alone or through consortia. TPG, KKR, CINVen, GS, and a hundred others all borrowing to buy assets. And Morgan Stanley, manager of the largest levered real estate fund no longer is content or satified by buying buildings. It's appetite has gotten so big, and apparent bullishness on assets so whetted, it's taken to feasting upon entire listed REITs, swallowing them whole with some equity and a lot of debt. Where is all this money emabring upon leveraged asset acquisition pecadilloes coming from??!? Is the market THAT ineffficient, that it's got the prevailing price so so wrong? Are the debt-to-equity ratios of companies that ineffciently underleveraged? Or is there something more nefarious going on? Have smart people simply figured out how to manufacture paper money at low cost in order to buy very real assets and things? Probably, the answer is "No", "No", "Yes", and emphatic "Yes". And the culprits are a combination of globalization, open-capital flow, large differentials in interest rates, and a purgatory-like stasis that is preventing adjustment in the relative value of currencies. If in fact it is so, is this bad? And If so, what is to be done?

"Why?" is still the nagging question I ask myself this question every day. And that "Why?" implies, "Why are not participants afraid of the effects of policy shifts, recession, uncertainty in their risk equations determining the pricing of risk?? Is it that one has magically found the keys to the printing press, and they are raking it in and converting it assets as quickly as possible, OR is it perhaps that the world is so awash with liquidity that delegated agent portfolio managers have it, and must use it or lose it, even if valuations are not attractive, cap rates on real estate are low, or the risk vs. reward of changes inimical to the realization of profits for investors at the end of the trade, poor. In either case asset values are rising, and price signals in both the real and financial economies are being distorted. There is no silver lining in this round of leveraged private equity as there was when Oliver Stone's Wall St. Villain shook up the sleepy New England family manufacturing firm to ostensibly make them more competitive and efficient. These buyouts are not about running the companies better, or realizing value for shareholders, whatever the rhetoric. It is about borrowing to take something private with other people's money, stripping it, and flipping it back out sans assets and with pathetic capital structures, having pried loose untoward management fees, success fees, incentive fees, directors fees, refinancing fees, handshakes, parachutes, and all manner of other freebies, goodies, consultancies, etc. before selling it back out to the public market saps. The early deals have been home-runs for investors and structurers alike, but one must wonder now with a deal-or-two-a-day being done, what the outcome of these will be. Either way, the signals and competitive incentives for the market and the immediatre future prospects for the workers and communities where these enterprises dwell is rather grim. For as leverage goes up, so all accounting conservatism goes to proverbial pot: R&D & ad spending are slashed. All but the most urgent & necessary capital expenditure is torpedoed. Working capital pared to the bone. Anything that can be levered, factored or securitized is so encumbered. Employees are laid off. Benefits and wages cut. Extra-responsiblities heaped upon non-eexecutive, non-buy-out affiliated salaried employes that are fortunate enough NOT to be fired. Good for capital. Bad for labour. Good for competitor firms, for the new owners will be in the midst of a Sherman-style march that will see the enterprise, in all likelihood marginalized and handicapped for years to come, as their competitors and nearest-neighbors invest, whistle-dixie and take "the long view".

But hey, this is capitalism, and a free market. Why should we care? And if we should care, what should we do? I think we should care because the result is inequality and further imbalance enroute to economic serfdom and marginalisation of anyone NOT already a large owner of assets or king of Wall Street. Like it or not, this will have economic, political, sociological and psychological consequences that will floor a generation, for skill-sets and compeititve market positions, once yielded, are most difficult to recapture. I am not talking central planning. I am a fan of the market, and think capitalism the lesser of evils. But I think that perverse incentives to accumulate that are granted to a limited few at the expense of the many is simply wrong, ethically speaking, for will have political manifestations, make no mistake. And when the hordes become meaningfully disenfranchised, and no longer believe the rules of the game are fair, then all manner of turn-the-world-upside-down becomes possible.

More immediately, what's to be done? The prime enablers are globalization and free movement of capital, coincidental to dramatically different national interest rates, combined with the neutering of market signals by surplus nations systematically and persistenly accumulating debtor nation reserves. The first allows "the carry trade". The second enables large imbalances - trade deficits - to persist without immediate or tangible consequence. Both of these spawn perverse outcomes and dangerous consequences to national economies and the international monetary system alike.

Now, some will say hard money is the answer. And here, I must admit to being philosophically sympathetic. BUT practically speaking, politically speaking, this is extreme, and at once difficult, at least as far as true hard money solutions go. And I will further admit to secretly having sympathy with Vickrey & discisples who mourn the social costs of lost output, as well as those who highlight the stickiness of prices on the downside, and therefore argue that cautionary erring on the side of looseness is better than erring on the side of being too scrooge like. In this sense, I am no radical. BUT I do believe that there is great moral hazard in income inequality, and in selectively giving the keys to the press to some, with a put option, and that this will cause rgeat distortion like housing bubbles, and wholesale raping of enterprises for short-term parochial gain at the expense of enlightened social policy, a balanced economy and longer-term competitiveness. This is unconscionable in a world that itself is, day-by-day becoming more competitive, and is something communities all across America and Europe will come to regret when the look back should they persiist in substituting leverage and consumption for investment, balance, a long-term view. All, which to say, in the most long-winded way that I believe, we must end the carry trade, and adopt fiscal, energy and macro policies that encourage longer-term competitiveness, balance, and fortitude and equality.

For the carry trade is the lifeblood of the Spec. There is no problem with investors from one nation desiring to invest, in another. There IS a problem with investors in one nation conjuring up financial liquidity to parasitically profit off of another while at the same time preventing it from confronting the financial issues and problems that are most pressing, like trade and current account deficits. I believe of course that our trading partners are NOT helping, and are disingenuous. ZIRP is a sham, and even if Japan experiences further disinflation or deflation (mild as it would be), they SHOULD, since they are running persistent surpluses, are demographically stagnant, undergoing dramatic producitivity increases, and situated adjacent to the largest deflationary force the world has ever seen. But leaving the cynical self-interest of MITI, MoF and BoJ, the USA can take matters into its own hands, for its own self-interest, and should NOT passively let itself be exploited for the narrow interests of transnationals, banks & finance houses benefitting most directly from the one-direction of trade and continuation of status quo and the great sucking sound that it is producing in the domestic economy.

So what specifically should do we do, since open capital flows are a cornerstone of globalisation and the international monetary system? Like many things that go awry incrementally, policy correction to fix the problem need not be intractable or even difficult. A simple statement that the speculative leveraged carry trade will not be tolerated any longer will go a long way. For this situation of the Central Bank and hordes of mischievious and clever speculators reminds me of one of my favorite anecdotes from when I visited Gibraltar some years ago. Aside from being strategically important at the mouth of the Med, and the foot of Europe, it is the home of a large troupe of barabry apes. They run wild around the place, live in caves up the side of the rock (the one now notorious by Prudential), and frequently descend upon the populated town to steal pies from the windows of old ladies, and picnic boxes from small children. Ocassionally they run amok and can truly cause chaos and mayhem, during full moons for example.

But fortunately there is a solution to help civil man and beast live side-by-side. You see, the first thing that the leader of the British garrison does when there is a leadership change in Gibraltar's British squadies, is meet with the apes, mano-a-ape-o. As the story goes, they manage to round up a great number of them into a cave, with the new British Commander. The Officer rolls up his starched sleeves. Stares the alpha Barbary male down, and proceeds to wrestle the alpha male ape down to the ground, and beat the pulp out of him thus establishing dominance. Once the Commander is ensconced atop the Barbary Ape hierarchy, he is the law, so that whenever the apes run amok, the garrison leader need only show up and tell them to "shove off" for them to run off with their tails between their legs, without screaming fuss, a fight, or tossing of bottles. Understand, that it is not out of sadistic pleasure that this is done, just as a Central Banker should take no pride in generating volatility, uncertainty, and occasional liquidation in financial markets. But, it must be understood that it IS for the greater good, else the mischievious little buggers will run amok with no apparent recourse....