From the New York Times, September 4, 2005

Connect the Dots. Find the Fees.
Gretchen Morgensen

TO many investors, the collapse of the Bayou Group - a hedge fund company and brokerage firm run by Samuel Israel III - may seem like just another financial mishap, and a calamity only for those who had the bad luck to invest with Mr. Israel or to be steered his way by advisers they were wrong to trust.

But actually, the mess at Bayou, which federal prosecutors are now calling a $300 million fraud, should be a clarion call for caution among the many investors who have been throwing money at hedge funds recently. This is especially true for institutions - endowments and public pension plans - that have flocked to hedge funds with the hope of increasing their returns. Because many of these institutions are having financial difficulties - low interest rates are cutting deeply into their returns - they are too often captivated by investments that seem to promise outsized gains with little risk.

"Our unique multifactor risk model acts as a road map for navigating risk and provides investors with alternative routes to reach their investment summit," Steve Henderlite, a co-founder and principal of Trail Ridge Capital L.L.C., said in a press release from October 2003. Trail Ridge Capital is a hedge fund and fund-of-funds company that had clients in Bayou. Mr. Henderlite did not return a phone call seeking comment.

Trail Ridge is also an adviser to a new investment fund, the Undiscovered Managers Spinnaker Fund, offered to wealthy individuals by the investment unit of J. P. Morgan Chase. The fund, which started last November and had $7.3 million in assets as of March 31, held $662,602 in Bayou. J. P. Morgan says it has written that investment down to zero.

Central to the Bayou story, and to almost every other financial disaster of recent years, are conflicts of interest. At Bayou, these conflicts began in its brokerage unit, which executed trades for the hedge funds. Because the brokerage unit, Bayou Securities, was wholly owned by Mr. Israel, he was able to profit personally from the rapid-fire trading conducted by the funds he oversaw.

But some Bayou investors who got into the funds on the recommendation of investment consultants were confronted with another layer of conflicts. That is, the consultants who recommended the hedge funds to their clients and the funds of funds that bought Bayou shares for their investors often received compensation from Bayou for sending assets its way.

While some investors may not find fault with such an arrangement, institutional investors who have a fiduciary duty to their beneficiaries should definitely steer clear of the deals.

"In my view, if a hedge fund manager wants to pay a particular level of fees to a marketing agent, that's their business," said Orin Kramer, chairman of the New Jersey Investment Council, the oversight board for the state's pension system. "But as a fiduciary, I would be very uncomfortable dealing with a gatekeeper who is being paid on both sides of the trade."

Unfortunately, not all fiduciaries know where these conflicts lie. They are often well hidden.

"Pension consultants frequently have undisclosed financial arrangements with hedge fund managers that create a conflict of interest," said Edward A. H. Siedle, president of Benchmark Financial Services, in Ocean Ridge, Fla., a company that works for pension funds to investigate possible wrongdoing among outside money managers.

Mr. Siedle says the nature of these deals varies. Sometimes the payments come in the form of commissions on trades steered by a hedge fund to a brokerage firm that is affiliated with the consultant; in other cases the payments are fees paid by the fund based on the assets the consultant brings in. In one case, Mr. Siedle said, he found that a pension consultant received a partnership interest in the hedge fund to which it was steering clients.

SUCH payments were a part of the picture at Bayou. According to materials provided by the fund to a prospective investor in 2003, Bayou had several outside marketers that it paid either as a percentage of assets raised or through commissions to the promoters' "designated broker/dealer."

One of the firms that Bayou listed as an external promoter at that time was the Consulting Services Group of Memphis. Bayou also gave prospective investors the name of E. Lee Giovannetti, chief executive of Consulting Services, as a reference and as an institutional investor in Bayou.

Joe Meals, a spokesman for Consulting Services, said that the firm did act as a reference for Bayou in 2003 and that it had recommended Bayou funds to clients. But, he said, "We became uncomfortable with the operations at Bayou and made recommendations to all our clients that they redeem their accounts, and they did so long before any of these issues came to light." He added that Bayou "may have executed commissions through our affiliated broker dealer at one time, but not recently."

Consulting Services did the right thing in advising its clients to exit Bayou before the debacle. Others weren't so lucky.

In coming weeks, federal and state investigators will try to sort out what happened to the money that investors entrusted to Bayou. Because Bayou's minimum-investment requirement of $250,000 was smaller than that of most hedge funds, the firm unfortunately attracted a lot of individual investors. The United States attorney in New York is seeking the forfeiture of all of Bayou's assets, including $100 million seized by authorities in Arizona last May. How much Bayou's investors ultimately get back is anybody's guess.

Larger investors, especially those who are fiduciaries, should take a lesson from the losses at Bayou. Conflicts of interest in the financial world are often hard to uncover. But refusing to do the necessary digging is downright irresponsible.


Copyright 2005 The New York Times Company

From the New York Times, September 4, 2005
By David Leonhardt and Edmund Andrews

The broad American economy has largely withstood the early effects of Hurricane Katrina, even as residents of the Gulf Coast suffer through a regional economic disaster with few equals.

The flooding has displaced about one million workers in the Gulf Coast region, many of whom will not be able to resume their jobs anytime soon. While some employees of large companies are still receiving paychecks, Wal-Mart stopped paying workers in the area four days after shutting its stores, and McDonald's and UPS have not paid regular wages to idled employees since the storm hit.

The hurricane has also bottled up grain shipments on the Mississippi River, hurting farmers and grain exporters, and saddled households with even higher energy costs.

The effect of the damage to oil rigs and refineries in the gulf is the greatest uncertainty. But contrary to early fears, the nation's transportation network has not become overwhelmed so far, and despite spot shortages drivers have generally been able to buy gasoline. The price of crude oil fell 2 percent on Friday - to $67.57, up only $1 from a week ago - as a large importing terminal off the coast of Louisiana reopened and the International Energy Agency announced that it would release emergency oil supplies.

As corporate executives scrambled to get in touch with employees who lived in Katrina's path, most said they had seen little overall effect on their businesses.

"It's a little too early to tell," said Fred Beljaars, an executive vice president of DHL, the shipping company. "But the first indications are that there is no real impact on trade."

Apple Computer, Intel and National Semiconductor all reported that their operations were running normally. So did Harley-Davidson and Whirlpool. Nissan halted production Monday morning at a plant in Canton, Miss., that builds Titan pickup trucks, but reopened it Wednesday.

Economists said that the storm and its aftermath had raised the risks of a downturn. One major question is whether the damage to oil refineries aggravates what had already been a growing burden caused by soaring energy prices.

No forecaster knows how consumers will react to seeing gas lines reminiscent of the 1970's and hearing the president urge people to drive less. If oil production or refining does not return to pre-storm levels for months, a spike in energy prices could prompt households to cut their spending and cause other hardships.

"The difference with this disaster is that we have an energy shock," said Laurence H. Meyer, a senior economist at Macroeconomic Advisers, a forecasting firm.

But the most likely outcome, according to forecasts that Wall Street firms revised after the storm, is a slowdown in growth during the rest of this year and a pickup next year, as New Orleans and southern Mississippi are rebuilt.

"Clearly, this will be a challenging time for the economy," Treasury Secretary John W. Snow said on Friday after meeting with Alan Greenspan, the chairman of the Federal Reserve, to discuss the storm's impact. But, Mr. Snow said, "The normal pattern is that after the negative consequences, we get into a rebuilding mode, and that rebuilding mode takes you to higher G.D.P. levels."

In a sign that the recovery could make the sprawling construction sector even busier than it has been during the recent housing boom, the price of lumber jumped last week.

"Personally, I'm loading up on everything," said Bruce Scanlon, manager of Boulder Lumber, a Colorado store that sells the bulk of its supplies to building contractors. "No one is taking any chances."

The fast economic recovery from the Sept. 11 attacks showed that traumatic events often have a relatively small economic impact. On the day of the attacks, the economy had been shrinking for about six months; it was growing again by the end of the year, at least outside of the New York area.

There is a major difference this year, however: the Fed and the Bush Administration have less in their arsenal to fight economic weakness today than they did in 2001.

A soaring budget deficit makes it harder for the White House to propose tax cuts than it was four years ago. Mr. Snow dismissed suggestions last week from the House Republican whip, Roy Blunt of Missouri, that Congress take up a stimulus package that goes beyond money for reconstruction.

And the Fed has been raising its benchmark interest rate since the start of last year to ward off inflation, a policy that Anthony M. Santomero, president of the Philadelphia Fed, said last week would probably continue.

But Katrina complicates the Fed's job.

"The problem, and every Fed official is fully aware of this, is that every recession since 1971 has been preceded by two things: higher oil prices and an increasing Federal funds rate," said Richard Yamarone, chief economist at Argus Research. If Katrina leads to a sustained increase in oil prices, Mr. Yamarone said, the Fed could have to "navigate between skyrocketing prices and stagnating economic growth."

Consumers also have less of a cushion than they have had at many other points. In July, the nation's savings rate fell below zero, to its lowest level on record, the Commerce Department said last week, suggesting that households have little ability to absorb higher oil prices without cutting other spending.

But the forces supporting growth might be just as strong. Katrina's aftermath caused a fall in long-term interest rates, potentially prolonging the housing boom, which has been showing signs of slowing.

Americans have also been unwilling to change their driving habits, despite oil prices that had doubled between early 2004 and last month.

"You still have to get from Point A to Point B," said Paul Noonan, a 41-year-old engineer from Boston, while stopped at a rest stop in upstate New York on his way to Minnesota last week. People talk about traveling less, Mr. Noonan said, but he did not think they were really doing so.

But the economy has been growing at a healthy clip in recent weeks, and few forecasters think it is close to tipping into recession.

"Fortunately, this happened in a strong economy," said Henry A. McKinnell Jr., chief executive of Pfizer, the world's largest drug maker and the chairman of the Business Roundtable, a lobbying group of chief executives. "But I don't think anyone would say it will be positive."

Even if the economic impact ends up being narrow, the storm has still created a challenge unlike any other the country has faced recently. A local economy that employed a million people has suddenly shut down.

Some of those people have been able to continue working elsewhere. Of the several thousand Wal-Mart employees from the 36 stores that were still closed on Friday morning, four have relocated to Pensacola, Fla., and are working for the company there, said Melissa O'Brien, a spokeswoman. Wal-Mart is also giving emergency grants, typically of about $250, to some employees.

UPS is helping Gulf Coast workers put in for holiday time or unused vacation so they could continue to be paid, said Norman Black, a company spokesman. Walt Riker, a McDonald's spokesman, said the chain was trying to locate workers and considering ways to help them financially.

DHL, Pfizer and Starbucks all said they were continuing to pay employees who were unable to work because stores and offices were flooded or destroyed. Other people - many employees of small businesses, for example - were not so fortunate.

At a church shelter in Houston, Paula Sanchez, 52, slowly cried as she said she was trying to locate her 24-year-old daughter. Ms. Sanchez, an immigrant from the Dominican Republic who worked as a pipe insulator at Avondale Shipyard in New Orleans, also wondered whether she could start over in Texas. "I hear there is industry here," she said. "I hope there's something here for me. I'm ready to do almost anything."

The recovery in New Orleans is likely to take longer than it will in southern Mississippi, where there is much less flooding. About 600,000 of the region's 1 million workers are in New Orleans, according to Economy.com, a research company.

Outside the immediate area, the biggest economic problems have come along the Mississippi River corridor. The Port of New Orleans is the nation's fifth busiest, and its closure has left barges in the Midwest with nowhere to go.

River/Gulf Grain, a shipping company in Davenport, Iowa, sent only one barge of corn and soybeans down the Mississippi last week and planned to send none next week, compared with the four or five it usually sends this time of year, said Erol R. Melik, the company's president. With no way to get the corn and beans on their way to Asia, the company would not hire the extra four workers that it did last year during harvest season.

"We're just taxing our infrastructure in a way we could never envision," Mr. Melik said. "It's going to be a quagmire for a long time."

Manufacturers have been calling ports from Houston to Philadelphia to ask about their ability to accept steel, rubber and other goods that usually go to New Orleans. On Thursday in Houston, stevedores finished unloading 3,000 tons of rubber and timber from the Indotrans Flores, a freighter diverted from New Orleans and Pascagoula, Miss., after the shipping lanes there had closed.

"There are alternatives," Donald C. McCrory, executive director of Port of Memphis, said.

Still, the other ports will not be able to handle all of the New Orleans traffic easily, and many companies expect weeks of bottlenecks. The potential that those bottlenecks might worsen is one of the new risks facing the economy.

No matter how the hurricane had affected them, people outside the disaster zone said financial issues were not their biggest concern.

"We're not feeling sorry for ourselves," said Mr. Melik of River/Gulf Grain. The human tragedy of the storm was far bigger than any economic problems, he said.

David Leonhardt reported from New York for this story, and Edmund L. Andrews from Washington. Motoko Rich, Charles V. Bagli and Louis Uchitelle contributed reporting from New York, Micheline Maynard from Toledo, Ohio, Simon Romero from Houston, Susan Moran from Boulder, Colo., Danny Hakim from Buffalo, and Laurie J. Flynn from San Francisco.



Copyright 2005 The New York Times Company

As we're just starting to get a sense of the human tragedies and the horrific damage where the hurricane hit, we're also getting a glimpse of possible implications for the rest of the country and the world.

First is the energy shock to the US economy. The WSJ explains:

The best-case scenario, says Nariman Behravesh of forecaster Global Insight, is that oil, natural gas and gasoline supply are cut by only about 5% for several weeks. Oil prices rise to $75 a barrel, and then slip back to the low $60s. Gasoline prices go above $3 for a couple months and then fall back to $2.50 by year's end. That would shave economic growth by between half a percentage point and one full point later this year.

The worst case is that energy supply is reduced twice as much, and oil prices soar to $100 before sliding back to $70 by year's end and gasoline prices average -- ouch! -- between $3 and $3.50 a gallon for four to six months. That would cut GDP growth by as much as three percentage points, and bring the economy dangerously close to recession by year's end.

So which scenario is the most likely? "We're certainly not at the best case," Mr. Behravesh said yesterday. "There been quite a bit of damage. We're creeping towards the worst case -- but we're not there yet."

Unfortunately, as the NYT explains, the President's announement that the government will release reserves won't help the refinery and pipeline problems.

As many as 10 refiners have formally requested or informally contacted the government about using oil from the Strategic Petroleum Reserve, which currently holds about 700 million barrels of crude, according to Mr. Stevens, the Energy Department spokesman. He declined to identify them until their requests had been approved.

But one company whose loan was accepted on Tuesday evening rescinded its request yesterday afternoon. The problem is that no active refiners are in a position to increase their production to make up for the lost output from storm-damaged refineries.

"It doesn't matter that the government opens the strategic reserves because there is very little slack in the refining business," said Craig Pennington, the director of the global energy group at Schroders in London.

The WSJ provides a rough inventory of preliminary reports on widespread damage or outages due to power disruption to production, crude oil supply to refineries, fuel pipelines and terminals, and refineries. The impact won't necessarily be limited to the US economy and consumer confidence as they pay higher prices or wait in gaslines, as the FT reports:

Fears of an international energy crisis mounted on Wednesday as the scale of human and economic devastation caused in the southern US by Hurricane Katrina became fully apparent.
[...]
Some analysts cut US growth forecasts, saying soaring petrol prices would hurt consumer spending. “US [petrol] prices are now in the process of the most dramatic spike ever seen,” said Kevin Norrish, an analyst at Barclays Capital. “It is now appropriate to talk of a major energy crisis.”
[...]
With nine Gulf Coast refineries closed, US wholesale petrol prices hit a closing record of $2.65 per gallon, up 34 per cent since the storm, and supplies ran short in some areas. Chevron said it had started rationing gasoline across the south-east, a move analysts said could lead to panic buying, particularly ahead of the Labor Day weekend. US consumers have not seen shortages since the petrol station line-ups that followed the 1973 Arab oil embargo.

“We recognize that prices are high,” said Mary Rose Brown, spokeswoman for Valero, a top US refiner. “The market is responding to the overnight lossof almost 2m barrels per day of domestic production. Since the US is already dependent upon 1m BPD of imports to meet demand, there is a real fear ofshortages in the near-term. Pipeline outages due to power losses have exacerbated an already challenging situation.”
[...]
Governments have begun to worry that a looming US petrol shortage could affect their economies. Europe could see strong competition for limited refinery products. Wholesale petrol prices in Europe rose by 10 per cent. “If the assessment of the damage shows a severe crisis in the petrol sector, the crisis will not be limited to the US it will be a global one,” said Claude Mandil, executive director of the International Energy Agency, the consuming nations' watchdog.

The emerging markets are also likely to suffer, not only directly from rising energy costs but also from the knock-on effects of slower US and European growth. Even some of the oil exporting nations will feel the hit from rising prices. As Brad Setser noted last week before Katrina was a clear threat to New Orleans, some big exporting countries like Nigeria and Iraq, and even well-managed Malaysia, import large quantities of gasoline, which is then heavily subsidised at the pump.

The Economist offers this roundup of the possible ripple effects:

It would also be bad news abroad, where many nations, particularly in Asia, are already heavily dependent on robust American demand for their exports. Those countries are also being hit by higher oil prices. Indonesia's central bank was forced to tighten the money supply sharply on Tuesday, raising interest rates by three-quarters of a point and increasing banks’ reserve requirements, to stem a near-10% drop in the rupiah. Partly thanks to lavish fuel subsidies, Indonesia’s oil imports, financed in dollars, have touched off fears of a balance-of-payments crisis, driving the currency sharply downwards. On Wednesday, Indonesia's president, Susilo Bambang Yudhoyono, said that the government would need to curtail its fuel subsidies in order to stave off a currency crisis. While rich countries are much less dependent on oil than they used to be, thanks to increases in fuel efficiency and a shift from manufacturing to services, middle-income countries are still big energy guzzlers: India and South Korea use more oil per dollar of GDP today than they did in the 1970s.

There are also fears that Europe’s recovery could be choked off in its infancy by the steady upward march of prices for petrol and heating oil. That would weaken another of Asian exporters’ main markets and leave the world economy looking vulnerable. If Katrina has damaged America’s capacity to pump and refine oil, forcing Americans to shop abroad for more fuel to feed their appetites, it could be a long cold winter for everyone.

cross-posted at Liberals Against Terrorism

Gene Sperling has penned the best simple explanation I've read of how a pension and disability system should be structured, and where private accounts would fit into such a system. His pre-obituary for the bamboozlepalooza, "Bush Private Accounts Are Dead Shark" (HT Woody Allen), will be read mainly for its assessment of GOP and Dem tactical maneuvering. But it is actually a tidy little essay on the principles of a "three-legged stool," which should underpin the logic of any scheme if it is to be supported by Democrats and reasonable Republicans.

Sperling expresses far more succinctly the key points I made more than three months ago, when last I took up the dreaded Social Security topic.

Social Security is simply the wrong vehicle for pushing the worthy and important goal of increasing ownership and savings among working Americans. In our three-legged retirement system [government benefits, employer-based pensions, personal investments]... Social Security is the only leg free of market and economic risk.

When communities were devastated by corporate scandals or bankruptcies in 2001 and 2002, many families saw not only their pensions dissipate, and retiree health benefits evaporate, but even their housing values decline as their hard-hit neighborhoods spiraled down.

The only part of their financial package that didn't join this spiral was Social Security. With privatization, those families would have seen their Social Security benefits drop, as well. That is why those of us who support new investment incentives like Universal 401(k)s should be the ones most adamant about the importance of keeping the Social Security leg of our retirement system completely risk-free.

Sperling then proceeds to outline why it's important for the three legs to be kept separate and distinct.

The second substantive rationale for a hard "no" on privatization is that virtually every private-account plan is designed to make Americans undervalue the social-insurance benefits of Social Security and overvalue their private accounts.

To see why, imagine a father who decides to invest $5,000 in the market and $5,000 in a combination of fire insurance, life insurance, and auto insurance. After one year, he happily notes that his market investment has risen 6 percent. Yet, because he neither died, saw his house burn down nor experienced a serious auto accident, he concludes he got a negative annual return on his $5,000 insurance investment and, therefore, cancels all of his insurance policies.

Of course, this father would be a fool. No rational person measures the value of insurance by an annual return. Yet, when Bush tells Americans to compare the return on their private account with the return they get with a Social Security system -- which provides valuable insurance against poverty, devastating disability, and the early death of a provider -- he encourages exactly that foolish comparison.

And here's the pernicious effect over time of Bush's political "optics" in action:

Bush leads Americans to ignore the value that goes to the recipients of survivor and disability insurance -- almost a third of all Social Security beneficiaries -- and the almost 100 percent of workers who can go to bed knowing that if such misfortune occurs, Social Security will help their families maintain a modicum of economic dignity.

Bush's plan is designed to even further exacerbate this false comparison. By requiring borrowed funds for private accounts to be paid back not from the accounts themselves but by reducing Social Security benefits, his plan is designed to make private accounts seem deceptively large and Social Security benefits appear deceptively small.

This absurd design serves only one purpose: to encourage the healthy and the well-off to misconstrue Social Security as a bad deal.

Now, you may say, it may or may not be a bad deal for the healthy and well-off. But isn't the real point that the current program is more than is necessary to provide a safety net to keep folks from really falling through the cracks. Wouldn't it do the trick to provide a means-tested small safety net for everyone, with a bigger private investment portfolio portion that varies for each individual by the size of his or her contributions? And I would respond, that depends what's happening with the other legs of the stool -- not merely from the vantage of individuals but for the overall structure of the economy.

We need to take Sperling's analysis one step further -- to what's happening with the second leg of the stool, employer-based pensions. This is the story of the rapid demise of the defined-benefit system. Business has been shifting to defined-contribution plans at an accelerating rate, leaving the financial risks with the employees. According to Business Week:

The number of defined-benefit pension plans has plunged from 112,000 in the mid 1980s to fewer than 30,000 today. The tally of workers earning a pension has fallen more slowly, but their ranks now total just 17 million, down from 22 million 20 years ago.

Where defined-benefit systems have survived, they are increasingly endangered species. Many plans are experiencing crises in funding, and they remain most common in "legacy" industries like the older airlines and autos. These industries simply cannot continue their previous levels of employee benefits and stay in business.

The result has been a growing crisis at the Pension Benefit Guaranty Corporation, where it is rapidly losing its ability to fund its liabilities from premiums. To compound the difficulty, as the GAO just reported this week, the government's current pension accounting rules allow companies to use techniques that can mask significant funding shortfalls. Any "cure" for the PBGC's own balance sheet will undoubtedly accelerate the move away from defined-benefit plans, even as the mopping up of old problems grows more expensive by the year.

Give the Bush Administration credit in one sense -- they have proposed to address the PBGC issue head-on rather than continue to temporize, despite screams from many industries. The PBGC problem is frequently described as an "S&L crisis" in the making, and the Bush Administration seems to have taken the lesson from the S&Ls to heart. Continuing to tinker with the rules to accommodate an arrangement that no longer makes much economic sense is simply running up the costs while delaying the inevitable. The PBCG isn't going to "grow out of" its dilemma any more than the S&Ls did. And make no mistake about it -- the outcome will be the same in both cases -- the disappearance of a type of financial service that has lost its economic logic as the structure of US competition has shifted. The only question is when, at what cost, and who will bear those costs.

The Bush Administration's approach to the PBGC is an implicit acknowledgment that global competition has made defined-contribution arrangements -- those that shift financial risk to employees -- the only realistic option for most individual employers. But when we look at this shift in financial risk from the view of American business as a whole, the picture is becoming far less attractive. A system without predictable levels of retirement income is a system in which a considerable portion of the consumer confidence and spending power of the American middle class would be subject to the volatility of investment portfolios. In three-legged stool terms, over the past few decades one of the legs of the stool has started to change length frequently and is coming loose -- making for a rather wobbly stool.

Now why would we compound this financial uncertainty, exacerbate business cycles, and reinforce financial crises, by cutting the size of the one leg that is fixed and steady? This is one of the reasons why most captains of industry and finance (other than the sell-side guys in the brokerage firms) have been noticeably missing in action on the score of privatizing Social Security. They understand that the health of the American economy and American business depend on a secure, confident middle class. They know full well that over the past decades financial risks have been shifting from business to individuals. Few but the true-believers see much virtue in shifting more risk onto individuals from a widely-accepted, easily administered government program.

Shouldn't Democrats, as well as US business and labor together, be supporting policies that strengthen both legs of the stool?

For the employer-based-leg of the stool, it's time to face up to the fact that defined-benefit plans are going to be phased out over the coming years. The costs to both individual employees and taxpayers may be extremely high if corporations and unions persuade Congress to delay the day of reckoning. Shouldn't we be pushing for the orderly conversion of existing defined-benefit plans to defined-contribution plans in the private sector?

And as the financial security of the employer-based-leg of the stool decreases, shouldn't we be strengthening, not weakening, the Social Security leg of the stool?

[Cross-posted at Liberals Against Terrorism]

Praktike points us to some China-related comments from Chairman Greenspan today. The China remarks appear in a column by Greg Ip (WSJ) -- see prak's post -- who reported on comments that weren't in the Greenspan statement (which was all budget process), Ip characterizes Greenspan as "the latest U.S. official to turn up the volume on China."

Ip is far more experienced at Greenspan-ology that I, but I have a decidedly different take on today's comments. Seems to me Greenspan's telling folks to cool their jets. That a revaluation of the yuan is going to happen when it's in China's interest and they're not going to be pressured into it. Pressure is, if anything, counter-productive because it produces cross-the-board tensions that are really quite unncessary.

Greenspan indicated, and I agree, that the Chinese know full well that it's -- sooner or later (and increasingly sooner) -- going to be necessary to revalue. They've been openly trying to prepare for it for some time -- especially in their financial system (which as we all know isn't the strongest, to put it politely). In fact, as Greenspan seems to have noted according to Ip, one of the main pressures for revaluing is increasingly the strains on their financial system from the hot money they can't sterilize and the asset bubbles and over-investment in some regions and sectors. All that is undermining many of the benefits they're trying to extract from the current exchange rate as well as their ability to manage macro policy.

I'd expect that Greenspan's real audience for the comment about the revaluation sooner rather than later is the markets -- there are a lot of concerns about too rapid a readjustment, the impact on global growth, and a hard landing. For the masochists among us, Brad DeLong has been keeping a running inventory of "hard landing" fretting and commentary over the past few days (from David Altig, Bruce Barlett, and Krugman & Setser).

I read Greenspan's China remark as similar to his comment about oil prices a couple of weeks ago -- that they'll work their way through the global economy in a fairly orderly adjustment of supply and demand. So Greenspan's trying to keep everybody calm.

I think he's also signaling to Congress that their impatience is both unnecessary and not doing the markets any good. American business is concerned about all the trade war noises. A big tariff increase may make "good politics" domestically, and it may seem to some not materially different from an exchange rate adjustment in macroeconomic theory. But in practical terms, it sure doesn't make American businesses who actually have to produce and sell stuff happy to hear about big unilateral tariffs against a key trading partner, and it shouldn't make their employees happy either.

As The Economist notes today in a piece on Congress' new-found love-affair with protectionist noisemaking, even the National Association of Manufacturers isn't keen on the tariff games.

Nobody in Congress, alas, seems to care about breaking WTO rules. The aim is to be seen to be bashing China loudly. Mr Bayh is holding up the confirmation of Rob Portman, the new trade representative, until his bill is voted on. Meanwhile, in the House of Representatives, Duncan Hunter, a conservative Republican, and Tim Ryan, a Democrat, have cooked up a law that allows American companies to use “exchange-rate manipulation” as a reason for demanding protection under America's trade laws. And the Congressional China Currency Action Coalition has filed a Section 301 petition asking the Bush administration to file a formal case to the WTO complaining about the yuan.

In the 1980s, a rising trade deficit—at that time with Japan—fueled protectionist pressure in Congress. Ronald Reagan introduced the notorious “voluntary export restraints” on Japanese steel and cars. The Reagan team also abandoned its laisser-faire attitude to currency markets and, through the Plaza Agreement, engineered a sharp drop in the dollar.

The current bout of China-bashing is not a replay of the 1980s. Back then, large American firms, particularly the Detroit car giants, led the clamour for protection. Now big business, which relies heavily on Chinese inputs, is quieter. The shouting comes from smaller American suppliers. And even the noisier business groups, such as the National Association of Manufacturers, are relatively nuanced. Though the NAM wants Beijing to revalue the yuan, it does not support the Schumer bill.

I just love how every time the chickens start coming home to roost from the pursuit of bad (or non-existent) US policy, the US politicians (of both parties I might add) all run to blame somebody else. Doesn't strike me that Greenspan is falling into that old bad habit. But it's pretty disgusting when it comes from the profligates who have been at least titularly in charge of conducting US economic policy like Snow, and I don't have much more patience for grandstanding from folks who should know better like Schumer and Bayh.

If Democrats want to turn up the volume, let's start with making noise about the ridiculous energy bill that's actually being voted on in the House but that could, if enough Senators got behind some of the more sensible proposals out there, be changed in the Senate with, I might add, some White House support. (The House bill's so bad even Bush bashed it this week.) Hey, and where was the volume on the estate tax or bankruptcy bills that really mean something directly to people? Nah, it's easier to blame somebody else for the consequences of the consumer-spending and debt binge we've enjoyed for years. Sheesh!

BTW -- Just to respond to Roubini's remark that prak quotes in his post on Greenspan. I disagree with the emphasis by Roubini and many others on the loss of value of foreign reserves as one of the major pressures on the Chinese to revalue early. Hey, it's only money. The Chinese have humongous problems they're trying to grow their way out of -- e.g. SOEs, banking system, labor mobility, development in inland regions. 16% of one year's GDP doesn't look like all that outrageous a price tag when you look at things from their perspective.

UPDATE re the reserves losses discussion: For more on the impact of losses on reserves held by the PBoC (Peoples Bank of China), see this post from Brad Setser yesterday. He concludes:

The PBoC may still have a positive cash flow, but it is sitting on a large expected valuation loss on both its dollar and its euro reserves. Diversifying out of dollars does not help much; the best way for the PBoC to reduce its prospective loss is to stop adding to their reserves. And in any case, it might want to start provisioning against that future loss now ...

The real debate here is not whether the losses are "just paper" losses or not -- the losses from a revaluation would be very real, though they could be partially offset by the PBoC's ongoing profits from issuing renminbi cash. The real question is whether these mounting losses are a worthwhile price to pay to sustain China's rapid export growth for a while longer.

And as I suggested, at least until recently when some of the downside of an overvalued currency started undermining the gains, the answer from the Chinese has clearly been "It's worth it." I see them in quite a different position from other Asian central banks who are being forced to digest a lot more dollars than they'd like.

In the comment thread Brad also helps sort out some of the confusions that are common in discussions of the risks of revaluation to China's banking system. Worth a read.

Amidst a flurry of interesting posts on the decline of the dollar and what it all means, Brad Setser patiently lays out the risks of diversifying by buying Iraqi dinars:

[A]nyone considering making an interest free loan to the Iraqi government (that's what buying dinars as an investment implies) ought to understand the risks. The dinar is not exactly a candidate to be the world's next reserve currency.

1) If you are buying dinars, you are betting on real appreciation through nominal appreciation of the currency -- that is to say betting that the way the purchasing power of Iraqis will increase is through a rise in the dinar's value. If the currency appreciates in nominal terms from 1460 dinars to the dollar to say 1000 dinars to the dollar, an Iraqi that makes say 10,000 dinar a day would be able to purchase $10 rather than @$7 of the world's goods.

2) You lose if the nominal exchange rate goes down, obviously, for whatever reason -- civil war, lower oil prices, etc. You also lose -- or at least don't win -- if Iraq's dinar stays stable in nominal terms but the currency appreciates in real terms because of inflation in Iraq. In that case, our Iraqi's salary would go up to 15,000 dinar a day rather than 10,000 dinar, but the exchange rate would stay around 1,500 dinar per dollar. The Iraqi could then buy $10 of the world's goods even though the exchange rate stays constant. Iraqi citizens are richer, those holding its currency abroad are not. This is not an entirely unrealistic scenario.

3) Iraq's government has fairly strong incentives to keep the currency stable -- it is one of the few signs of political and economic stability the government can point to. It also has some incentive to resist letting the Iraqi dinar rise in real terms. A stronger currency makes imports cheaper and any Iraqi production (to the extent there is Iraqi production) relatively more expensive. Not exactly the best way to solve Iraq's unemployment problem. The Iraqi government, one presumes, does not want Iraqi wheat production, for example, to be uncompetitive with imported wheat.

4) Oil alone does not make betting on Iraq's currency a slam dunk, to paraphrase George Tenet. With production @ 2.5 mbd (November seems to have been a bit lower) and with oil at $50, Iraq is getting a fairly solid revenue stream -- nearly $2 billion a month -- from its oil right now. Even if the security situation stabilizes and, over time, Iraq can bring more oil production on line, it may do so in a less robust world economy with lower oil prices. So Iraq may make less money from selling a larger amount of oil than it does now ...

So ... how many war supporters are willing to put their life savings in dinars?

I don't mean to ruin Nadezhda's silver lining, but ...

We're Congressional Republicans are spending $2,000,000 taxpayer dollars so that George W. Bush can have a Presidential Yacht?

(Edited: credit where credit is due)

Ah, cotton subsidies:

The Bush administration yesterday formally appealed a World Trade Organization ruling that subsidies paid to U.S. cotton farmers violate global trade rules.

Now, I'm generally in favor of conservation-oriented subsidies. We have to preserve our prime agricultural soils. But programs like Step 2 are bad news, primarily because they make it harder for developing countries to compete.

And helping cotton growers in the developing world ought to be a vital component of a comprehensive war on terrorism. Nearly half of the Pakistani labor force works in agricultural industries, and cotton is the country's top agricultural commodity. While Pakistan has basically eradicated opium poppy production by launching a vigorous crop substitution program in the Northwest Frontier Provinces, Afghanistan's opium production has exploded, particularly in Helmand province, a stronghold of the Taliban. Al Qaeda is said to be hip-deep in the heroin business. Drug money goes to buy AK-47s and explosives that kill Americans.

I'm by no means certain that cotton is an economically viable alternative to poppies. It requires more intensive irrigation and better soil conditions, and the price it fetches may not be high enough at present to meet a family's needs. But despite these problems, Afghanistan still exports cotton somehow. It's clear that cotton works in some areas of the country. Wouldn't we like to give those Afghanistan's farmers who are at the margin every possible incentive to switch?

Why is the Bush administration undermining the War on Terror?