China's trade surplus is shrinking faster than expected. I told one of my graduate students last year  when China moved to allow flexibility of its currency it was more likely to allow for devaluation not appreciation.(Shout out to Benny!)

Pettis raises the issue in a recent post.

"The slowdown in growth is worrying an awful lot of people in Beijing and with all this concern, of course there is a lot of attention on trade policy.  Will the RMB appreciate or depreciate in 2012?   Within China many are going to argue that the rapid decline in the trade  surplus, coupled with unmistakable evidence of flight capital, means that the  PBoC should devalue the RMB.  Others within China will argue that debt levels  and domestic imbalances are so worrying that the RMB should continue  appreciating in order to speed up the pace of rebalancing.

If this were the whole extent of debate, it would be pretty easy to guess that the former side would win, but of course there is also international pressure.  Foreigners are going to argue that  China’s maintaining a trade surplus will simply subtract from foreign growth, and given higher unemployment and lower growth in the US, Europe, and much of the developing world, China has no natural right to insist on a trade surplus at their expense.


With the trade environment getting worse all the time,  I suspect that international pressure is ultimately going to decide the issue. If China depreciates it will almost certainly set off furious retaliation – and remember, surplus countries always lose trade wars.  Deficit countries often win, at least in the near term."

In early December, I wrote about that the bottom line for Europe is they need a plan to reverse trade flows and generate employment. Here is a post by Pettis which echoes my words.

"Europe’s underlying problem is not budget deficits or even unsustainable debt.  These are mainly symptoms.  The real problem with Europe is the huge divergence in costs between the core and the periphery – in the past decade costs between Germany and some of the peripheral  countries have diverged by anywhere from 20% to 40%.  This divergence has made  the latter uncompetitive and has resulted in the massive trade imbalances within  Europe."

Last month Brazil imposed a 30% import tariff on vehicles without at least 65% local content. The move is seen as a way to protect its labour force from Chinese imports.

Structural unemployment is the biggest issues facing economies of the West. Protectionism will become more and more prevalent over the course of  the next decade as countries seek to find ways to allow employment for the least educated and skilled in their society.

An import tariff is a lot cheaper than educating people. The Brazilian President is an Economist; she knows full well the trade-offs of what  she is doing.

The  award – winning HBO television series ‘The Wire’ opens with a bleak view of an inner city neighborhood. At first glance a viewer might be mistaken in thinking the location is war torn Sarajevo; however it is soon revealed to be drug infested, dilapidated west Baltimore. Detective, James McNulty, interviews a youth about a shooting homicide. The witness confides that the victim,  player at the weekly dice game, would regularly attempt to abscond with mone being wagered. When the detective asks why the victim was allowed to continue his participation despite continual attempts to rob the game, the witness responds “Got to. This (is) America, man.”  This scene is a metaphor for one of the program’s recurring themes – that despite repeated examples of rampant abuses and systematic gaming, institutions seem resistant to meaningful change.  

“The  Wire” is a poignant meditation on “the game” of life and how the rules of the game influence behavior in institutions. It dramatizes the manner in which weaknesses in market design, individuals chasing statistics for personal gain, and game playing within institutions often lead to tragedy and a tremendous waste of resources. The evolution of the global financial crisis is replete with examples of individuals and corporations gaming the financial regulator framework.

A  housing bubble is fueled by short term interest rates that are kept too low for too long in the wake of September 11, 2001. US consumers through home equity refinancing begin to use their homes as ATMs.  Individuals game the system by taking out loans they can not afford.

As the housing boom matures and most good quality borrowers have either bought or refinanced, the market looks for ways to keep the housing boom going. Credit standards weaken.  At a retail  level, mortgage originators fail to verify income. Since mortgage originators do  not keep mortgages on their books but instead sell them to financial institutions they are able to game the system by not having proper lending standards. 

At  the wholesale level, financial institutions buy mortgages from originators and  in turn repackage them as derivatives, mortgage back securities (MBS), and  resell the mortgages in pieces. Rating agencies fail to properly rate MBS products because they depend on the revenue of the financial institutions that issue them. In retrospect, it is not surprising that a MBS issue comprised of  80% subprime mortgages was given the highest possible investment grade rating. Investment banks game the system by shopping for ratings and selling paper that they know is substandard. 

In order to curry favor with Wall Street and voters, Congress and the Federal Reserve promote homeownership and financial innovation at the expense of Financial system stability. Financial institutions successfully lobby to have leverage restrictions relaxed -allowing them to shift from 10-12 times leverage to 30 to 40 times leverage. Products such as subprime mortgages and adjustable rate mortgages allow weaker borrowers to access the mortgage market. Quasi government entities, such as Fannie Mae and Freddie Mac, become some of the largest holders of MBS portfolios. Credit levels in the private US economy balloon to a multiple of 2.5 times average levels. 

The over-the-counter (OTC) derivatives market, with hundreds of billions of dollars of notional exposure, is left completely unregulated and opaque. AIG, the world’s largest insurance company, is allowed to sell tens of billions of dollars of OTC derivatives and credit defaults swaps (CDS) –insurance on MBS, without being required to allocate any capital as a reserve. The individuals within AIG game the system by selling insurance products whose claims they can not pay.

Then, in the fall of 2008, in the space of a few weeks, the entire global financial system unravels. A system wide bailout, the Troubled Asset Relief Program (TARP), is implemented. Financial institutions and individuals that took enormous risk, issued “toxic waste” products, and profited from gaming the system in good times, are now allowed to socialize their losses.
  
 In response to the crisis Congress passed the Frank-Dodd financial reform bill that is seen by many market observers and participants as not being a substantive modification of the regulatory framework.  David  Einhorn, president of Greenlight Capital, a hedge fund with $7 billion dollars in assets under management, recently talked about the reforms on Charlie Rose.
He characterized the measures as Washington letting Wall Street off the hook with the understanding that Wall Street would let Washingtonoff the hook. “And so I think that the reform -- it doesn’t go after any of the obvious issues  that were identified in the crisis.” Among other changes, Einhorn believes credit rating agencies should  be abolished and reserve capital requirements need to be imposed on CDS.  

The lack of regulation of OTC derivatives market is a case of “déjà vu  all over again”. In the mid nineties, Brooksley Born, a Clinton appointee to chair the Commodity Futures Trading Commission, attempted to regulate the opaque market. The financial sector lobbied strongly against regulation. Robert Rubin the Secretar of Treasury, Arthur Levitt chairman of the Securities and Exchange Commission, Deputy Secretary of the Treasury Larry Summers, and Alan Greenspan chairman of the Federal Reserve, went to congress and successfully lobbied to remove her statutory ability to regulate the market. Shortly thereafter Born resigned her post. Even after the financial crisis, provoked by Long term Capital Management  in 1999, the OTC market was left unregulated. 
 
The Brooksley Born saga is reminiscent of a scene in “The Wire” where police  officers gather on both ends of a desk and attempt to move it through a door. They struggle mightily to no avail finally giving up - convinced that the desk just doesn’t fit. A moment later it becomes evident that they had been trying to push the desk in opposite directions. Born’s experience is representative of another major theme of “The Wire”. Institutional champions trying to affect  meaningful change often find themselves thwarted by those who benefit from  maintaining the status quo.     

The  recent global financial crisis is an example of life imitating art. The lack o fappropriate OTC regulatory response, despite two financial crises in the space of a decade, places us in the shoes of The Wire’s Detective McNulty. We are left to ask “why do we let the financial institutions play the same game, an unregulated OTC market, if it repeatedly leads to financial crises?” 
 
Several  lessons emerge. Markets are not self regulating. If the “market” is not correctly designed, individual and institutional optimization will be to the detriment and even collapse of the system as a whole. Absent proper changes to market design, market failures will follow a predicable repeating pattern. 
 
The  regulatory response to the financial crisis transferred a lot of private debt to  public balance sheets. It has sown the seed for the most likely next global crisis – sovereign debt. Furthermore, absent meaningful reform, it is only a matter of time before we will have another crisis sparked by the opaque unregulated OTC derivatives market. 

It  was not by accident that the Canadian financial system weathered the global financial crisis better than almost any other developed nation. Canadian  consumers or bankers are not intrinsically more ethical or risk adverse than their American counterparts. Also, one need only look to the case of  Icelandto see that being a small  country does not guarantee that markets will be more appropriately designed and  regulations more easily implemented. We were spared not by intrinsically superior virtues, but rather by the markets we designed and manner in which we regulated them.

In  the words of Omar, one of ‘The Wire’s’ most memorable characters: “I'll do what I can to help y'all. But, the game's out there, and it's play or get played. That simple.” 

I have had several friends ask me “which way is the market going  in 2012?”My answer has been - it depends on how the debt crisis is handled. Last fall, we had a Greek debt restructuring and the US FED (covertly and perhaps illegally) bailed out European banks.

Much of the Euro zone, the US and Japan have unsustainable debt trajectories, on top of which they have banking systems which themselves are  impaired with bad loans. Kyle Bass, hedge fund manager at Hayman Capital Management LP, calculates that when sovereign debt + size of banking system> 5X government revenues - the government loses the ability to bail out the  banking system.

There are two primary options that can be used to address a  sovereign debt crisis, one is a default; the other is the central bank can print  money and diminish the real value of the debt. The former option is deflationary, the latter is inflationary.

The question for the individual investor, risk manager and portfolio manager is which market effect is likely to dominate? Deflation is  bad for commodities like gold but good for US treasuries, vice versa for inflation.

Moreover, as was the case last fall, it isunlikely that all countries would have uniform responses. For example, debt restructuring could dominate the Euro zone and the US response could be inflationary. Ray Dalio, of Bridgewater Associates, also sees a non-uniform response.

"Dalio believes that some heavily indebted countries, including the United States, will eventually opt for printing money as a way to deal with their debts, which will lead to a collapse in their currency and in their bond markets. “There hasn’t been a case in history where they haven’t eventually printed money and devalued their currency,” he said. Other developed countries, particularly those tied to the euro and thus to the European Central Bank, don’t have the option of printing money and are destined to undergo “classic depressions,” Dalio said.
 
We are in a new age of volatility. The central banks, particularly the FED, have been managing the market levels, providing accommodation that may have short term benefits but serves to increase systematic risk and volatility in the economy. This means all asset managers are now risk managers.

As suggested a few days ago, direct confrontation between the US and Iran is unlikely. Instead, we are likely to see acts that are viewed by the other as state sponsored terrorism, as evidenced by the third, recent, assignation of an Iranian nuclear scientist.

Correlation is not necessarily causation, but, I do expect that when the story is finally told on the Chinese misallocation  of capital, a lot of it will be due to overinvestment in real estate. According to the first link, India is also overindulging.

The tendency of regulators to advance commercial interests in favour of the public interest is known as regulatory capture. Matt Taibbi,of the Rolling Stone, outlines such a case in which lawyers for the SEC were shredding evidence of illegal activity by banks.
Here is a link to massive overbilling of Medicare by a US Hospital chain -according to the report as much as 20% of all claims to medicare are estimated to be fraudulant.(Notice it was PBS and a watchdog group that brought these charges to light -not the government regulators)
 
Healthcare and Financial Services are two industries where this type of behaviour is often demonstrated.