Signs of Life

In today's episode of the Daily Reckoning, we find the dashing Federal opposition leader in the Australian parliament making a defiant stand against the government's $42 billion jobs/recovery/schools/ plan. But to no avail. At 5:15 this morning the plan passed the House of Representatives and is on its way to the Senate. Its fate remains unknown.

And unknown it will remain for the rest of today's Daily Reckoning. The ins-and-outs of public policy are beyond the scope of this publication. So we leave the stimulus package to its own devices and push on to other issues in the world economy and financial system.

Bloomberg reports that the Baltic Dry Index "rose the most since at least 1985 in London as the number of idled capesizes fell to almost zero, indicating strengthening demand for iron ore." The BDI measures the cost of shipping bulk commodities.

"Capesize rates have risen more than ninefold from a record low of $2,316 a day on Dec. 2. Steelmakers may be replenishing stocks in China after they fell 22 percent by mid-January from a record in September. Producers abroad, faced with an oversupply of iron ore, may also be shipping ore to China for storage."

This restocking of Chinese inventories is what BHP's Marius Kloppers referred to earlier this week. It wasn't exactly a silver-lining to an otherwise disappointing report. But it did remind us: someday this crisis is going to end.

Today is still not that day.

BHP's first-half net income was down 57%. Qantas' was down 66%. And now Macquarie Group reports it will take another $900 million in write-offs and impairment charges in the second half of the year, on top of the $1.1 billion it took in the first half. GE Capital is firing workers in Melbourne and Sydney and its chief executive Steve Sargent told investors yesterday that, "Australia is going to experience its credit crunch in the first half of this year."

Yikes. Or, if you prefer, daloob.

You might have thought the poor earnings performance that's coming to light during reporting season would have already been factored into Aussie share prices. After all, stocks were down nearly 50% last year. They are already down 7.5% in 2009. But then, perhaps investors were not prepared for the financial crisis moving off the share market and on to Main Street.

It's not much better over on Wall Street. The Dow Jones fell below 8,000 and investors pondered what it means that the head of America's Executive Branch of government is now dictating the salaries of Chief Executive Officers on Wall Street. President Obama announced that heads of financial firms receiving government bailout money would have their salaries capped at $500,000. More on that in a moment.

What about inflation? Where is it hiding? Gary North makes a good point in his e-mail newsletter yesterday. Gary shows that the American monetary base has doubled. But that increase in the money supply has not, so far, made it into the economy where the money multiplier kicks in. Why not?

The huge increase in money supply went to banks, who then parked the money right back at the Federal Reserve as "Excess Reserves." The banks took the money but didn't make the loans, terrified of not getting it back from borrowers. Those excess reserves pay a measly one percent interest. Meanwhile, the banks are paying out interest to depositors at between 2-3%.

Do you see the problem here? It can't go on forever. The banks are losing money on the spread between what the Fed pays on excess reserves and what they must pay to depositors, who are saving more. It is death by a thousand cuts. And now you have Obama and Congress promising to mandate new bank lending.

It means we could reach a tipping point sometime soon where the increase in the monetary base actually begins to make it into the economy in the form of new bank lending. Whether the banks do it because they're losing money on the spread or because they have to do it doesn't matter. They will probably do it.

And it doesn't really matter who the borrowers are. It could be the U.S. Treasury, who then goes on a cash splurge. It could be households refinancing 30-year fixed rate mortgages at 6% into 40-year fixed rate mortgages at 2%. It could be corporations, commercial real estate, private equity, you name it.

But be warned: if the doubling of the monetary base is finally unleased from the excess reserves held by banks at the Fed onto the economy, the money supply in the real economy is going to rise very quickly. Inflation will spread like wildfire.

For now, we have continued asset deflation. But policymakers in Washington may be lighting the fuse that forces banks to lend all that pent up liquidity the Fed has provided into the economy. With an increase in the money supply, prices will rise. It could be asset prices. Or it could be commodity prices like oil, energy, and gold. The general price level will rise very quickly.

Ben Bernanke is always worried about avoiding another Great Depression. The Friedman school of thought holds that the Fed's waited too long to cut rates and a liquidity crisis ensued as banks across the country failed. Money supply shrunk and the price level fell.

This time around, there is no liquidity crisis. Banks have plenty of reserves provided by the Fed. But those reserves are compromised by bad assets. That's why this has always been a solvency crisis, where banks had heavily leveraged balance sheets. On those balance sheets you had a thin slice of equity capital supporting a massive edifice of debt-backed assets.

It's anyone's guess how the assets are going to be handled by Geithner and Obama. But it will probably be a one-two punch of some sort. First, the assets are sold to the "Bad Bank." Next, some form of bank recapitalisation with taxpayer money will include language that requires banks to lend (especially in the commercial paper and residential mortgage markets).

Whatever you choose to call the times we live in, they certainly aren't boring. They are, of course, absurd. Take the case of Washington assuming a morally righteous tone and lecturing New York about fiduciary duties. Gag.

Here's a thought: if Washington can set salary caps on Wall Street because taxpayer money is involved, why can't the rest of America set salary caps on American legislators? Those clowns get government money every single day. They even spend money they don't have by robbing from generations of unborn Americans. And they've run regular structural budget deficits for decades!

Congress, the Fed, the President and the Treasury have mis-managed their institutions even more than Wall Street mismanaged itself. The political class (the world over) now represents its own interests above the interests of the electorate. How could you change that?

We are not normally in the business of offering constructive solutions to political problems. But we'll have a crack at it today. How about a rule that no one in serving in Congress is allowed to make more than the median household income, as determined by the U.S. Census bureau, until the Federal Budget is balanced?

In this new era of accountability, shouldn't everyone be accountable for how they discharge their responsibilities? If CEOs can have their pay capped (something shareholders ought to have done via the compensation committee, if they really cared) then why shouldn't Congressmen and Senators be performance managed by the taxpayers?

Or think of it this way a 19-year old U.S. Marine deployed overseas to a combat zone earns a base salary of about $1,400 per month, according to the Department of Defense. He makes an extra $225 per month in "combat pay" while he's deployed. If he's married, he gets $250 in "family separation pay" each month, too. If he's in Iraq, he gets another $100 in "hardship duty pay". And while in a combat zone, he won't have any withholdings of federal income tax.

He still can't drink a beer, of course (and not just because he might be in a country where that's prohibited). And if we're weighing up his total compensation versus his salary, let's not forget he's not paying for his meals or accommodation, which are assuredly first-class and five-star. Still, assuming he's in Iraq for a year and married, his grand total for the privilege of putting his life on the line on behalf of his country is a whopping US$23,700.

That's about half the median household income of $50,000, using the Census Bureau's figures. But it's considerably less than the $174,000 annual salary paid to rank-and-file members of the U.S. Congress. House Speaker Nancy Pelosi does a bit better at $223,500 per year. But she's probably a lot busier than most Congresscritters.

So let's do the maths. A 19-year old serving his country in Iraq can max out his salary at $23,700. But the people who declined to fulfil their Constitutional duty and properly declare that war in the first place make $174,000. And while making this handsome salary, they run regular annual budget deficits, often fail to pay their taxes correctly, and lecture the American people on the need for sacrifice and how "patriotic" it is to pay taxes.

Can you see why trust in public institutions has reached an all-time low? From 1789 to 1885, anyone lucky enough to serve in public office in Congress received a per diem salary of $6 and nothing else. Perhaps if we made all 535 members of the U.S. Congress live in the same dormitory and eat the same cafeteria food they'd actually spend a lot less time in Washington.

It would be a huge improvement for the nation and the quality of its laws. And if elected officials could make no more than those who put a uniform on for their country and risk death each day, maybe elected office would cease being a lucrative career objective and resume being something you did because you cared about your country.

However that is probably too quaint and earnest a sentiment for this publication. In fact, we're already embarrassed to have written it. Almost as embarrassed as we are by the spectacle of public officials plundering the future while we all just sit there and take it.

Dan Denning
for The Daily Reckoning Australia

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