What Part of the Global Economy Should We Laugh At First

Oh, where to begin!

We read the news and confront our first challenge - choosing what to laugh at first!

Consumer confidence is near a five-year high. What to make of it? We don't know.

It must be because of the 'savings glut' that U.S. Federal Reserve Chairman Ben Bernanke believes is boosting prices of assets - especially U.S. Treasury bonds - all over the world.

Ha…ha…a 'savings glut'…what a sense of humor. Get it? All this cash and liquidity - created out of thin air - he calls 'savings'!

Meanwhile, the Dow went up yesterday, and unless something remarkable happens today, it will end January barely higher than it began it. The 'January Effect' is taken seriously by some. It says that as the year's first month goes, so go all 12 of them. Which wouldn't be bad…stock investors would end the year about where they began it.

The big risks are 'receding,' says Deputy IMF chief John Lipsky. The man believes the world is in better shape now than it was a few months ago because U.S. residential real estate seems to have stabilized…and the price of oil has come down.

On both scores, it could turn out that Mr. Lipsky is wrong. Yesterday, crude oil jumped to almost $57. And in our opinion, the U.S. housing market remains in a state of suspended animation. No one is sure in which direction it will go when it comes back to life.

But that is the condition of the entire world economy. Whether it will go up or down is not apparent to anyone. What is clear is that huge amounts of liquidity have been added. As near as anyone can tell, this new liquidity - cash and credit provided by central banks and the ever-innovative financial industry - is still increasing at a record pace. And this new liquidity is what gives the financial world the impression of stability…and consumers the confidence that they currently exude.

Which brings us to our second challenge - trying to make sense of it. And we are not the only ones thinking about it. In Davos, Switzerland, the great financiers, economists, and bluffers of our time gathered to try to explain it. The aforementioned Mr. Lipsky was only one of many. All wondered about the effect of new financial instruments - trillions of dollars' worth of them - on the stability of the world.

The Financial Times takes up an important little piece of the discussion:

"It is widely acknowledged, for example, that mathematical models of risk, which are used to stress-test derivatives, give too much weight to the low volatility of recent times. In other words, they use the recent past as a guide to predicting the future. In financial markets this is the one sense in which history is bunk, since financial shocks have a habit of coming from unexpected quarters."

The average man - even the average economist - is cowed by the complexity of it. What exactly is the effect of a souped-up, high-tech, optimized financial world, he wonders? Do hyper-sophisticated financial instruments dreamed up by MIT Ph.Ds. in mathematics and to speculators, banks and hedge funds all over the world really disperse risk…making the foundations of the world financial system more solid? Or do they merely increase the risks overall? No one really knows.

And the longer this new Titanic Credit Expansion sails along with no major mishap, the more people settle down into their comfortable deck chairs or order more drinks at the bar. Why worry about it? Why take out insurance or check out the lifeboats? Nothing has gone wrong, so far, they say to themselves. Nothing ever will.

But the reason nothing has gone wrong so far is merely because the tide of liquidity is still in flood mode. The world is awash in moolah…dinero…dough…bread. Nothing is too absurd. Roman Abramovich, one of London's richest men, is building a new yacht for $400 million. Blackstone has upped its bid on Equity Office Properties to $38 billion. And a property in Montana that hasn't even been built yet will be the most expensive spec house ever put up. Tim Blixseth is putting up a house that will be sold for $155 million - a new world record, we believe. The place will be located near Bozeman at the Yellowstone Club, a private ski resort that Mr. Blixseth developed.

Pretty daring move for Mr. Blixseth. But who can lose with so much money around? So far, people who have made bad bets - whether in industry, speculation, or in private finance - couldn't go belly up. Lenders wouldn't let them. Except for a couple extreme cases - such as the hedge fund Amaranth - whenever speculators or homeowners began to run short, new cash and credit were offered, on new and better terms. Asset prices rose, giving them more to borrow against.

 Again, the Financial Times:

"Academics such as Harry Kat of the Cass Business School at the City University in London have produced evidence that many hedge funds are, in fact, pursuing trading strategies that can be relied on to produce positive returns most of the time as compensation for a very rare negative return. They are encouraged to do this by a fee structure that does not require the fund managers to pay back their earlier profit share to investors if an extreme event strikes and wipes out the fund.

"At the same time, big financial institutions have no incentive to incorporate the potential costs and risks to the system of their own collapse in their market pricing. They prefer others to incur the costs of providing the 'public good' of financial stability, while under-insuring against the risk of failure and under-investing in systems to enhance financial stability."

In other words, when the inevitable end comes…neither the hedge funds nor the big financial institutions will be able to absorb the losses.

The real test won't come until the credit cycle turns. Then, we'll see how good these new risk-reducing, profit-enhancing wonders really are. Then, we'll see how many people really want a $155 million ski chalet. Then we'll see which of the hedge funds is still hedging.

It should be interesting. Of course, we don't want to give away the plot…but we already have a little soupcon of how it will turn out.

Bill Bonner
for The Daily Reckoning Australia

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