Is Inflation Happening Now?  Walmart Says…

Yes.

The hope and aim of the Fed Chairman, Ben Bernanke, is that all of the liquidity that’s being injected into the system will cause prices to rise as inflation takes hold.  The fear of many is that he’ll succeed and the general public is now catching up with the econophiles as they try to determine if this is going to happen.  After hearing friends comment about how this or that went up in price, I went ahead and started the PracticalDad Price Index to publicly follow the course of prices amongst a market basket of 47 items.

It seems that Walmart has been keeping its own internal survey of about 86 items and the Walmart purchasers are expecting prices to rise in the coming months.  Apart from the intellectual exercise of trying to stretch the family dollar even further, people should be concerned because these prices will be concentrated amongst the major producers of items that are composed of commodities such as wheat and sugar.  These are precisely the commodity items that have been the recipients of a significant portion of the funds that the Fed has injected into the economy via the financial system.  As quantitative easing kicks in over the coming months, more funds will be funneled by the financial sector to commodities that in turn sends the price up further. 

If I read the article correctly, the prices haven’t actually hit the shelves yet so shoppers are safe.  But they’re coming and we’ll be following them publicly on a monthly basis.

Stay tuned.

PracticalDad Price Index:  November 2010

Because there are questions as to whether inflation is really going to accelerate, I began a simple price index – the PracticalDad Index –  with the market basket priced at three local and unrelated grocery stores.  The basket consisted of 47 items covering basic food categories such as dairy, meat, produce, staples, baby items and health/beauty products.  The pricing will occur during the first several days of each month and the results posted during the second week.

Listed below are the items, with store and average prices, that compose the market basket.  The average cost of the basket is $178.39 with a basket range from $174.37 to $181.42 and whenever possible, the items sampled were store brand.

PracticalDad Price Index – November 2010

Item Size Category Store A Store B Store C Average
hot dog rolls, store brand (count) 8 bread 1.09 .99 1.19 1.09
loaf, white bread, store brand (oz) 20 bread 1.19 1.19 .99 1.12
spaghetti, store brand (oz) 16 bread .99 1.09 1.25 1.11
children cereal, sugar flakes, store brand (oz) 17 cereal 2.99 2.10 2.50 2.53
cereal, rice chex, store brand (oz) 12.8 cereal 2.59 2.59 2.89 2.69
oatmeal, one-minute, store brand (oz) 42 cereal 3.19 2.99 3.19 3.12
milk, 2% (gal) 1 dairy 3.54 3.54 3.54 3.54
butter, unsalted (lb) 1 dairy 3.79 3.29 3.59 3.56
vanilla ice cream, store brand (qt) 1 dairy 1.71 1.71 2.13 1.85
grated parmesan cheese, store brand (oz) 8 dairy 2.99 2.99 2.99 2.99
American cheese (lb) 1 dairy 5.99 6.99 4.58 5.85
peanut butter, store brand (oz) 28 grocery 2.99 2.89 2.99 2.96
grape jelly, store brand (oz) 32 grocery 1.99 1.69 1.79 1.82
kidney beans, dark, store brand (oz) 15.5 grocery .85 .83 .89 .86
can green peas, store brand (oz) 15 grocery .89 .89 .89 .89
can diced tomatoes, store brand (oz) 14.5 grocery .99 .95 .89 .94
can cut green beans, store brand (oz) 14.5 grocery .89 .89 .89 .89
can corn, store brand (oz)

15.25

grocery .89 .89 .89 .89
spaghetti sauce, store brand (oz) 26 grocery 1.07 .89 1.42 1.13
cola, store brand (L) 2 grocery .88 .89 .89 .89
caffeinated coffee, store brand (oz) 13 grocery 3.19 2.99 2.69 2.96
diapers, size 3 (count) 100 baby 16.82 18.41 16.82 17.35
formula, Enfamil (premium Lipil) (oz) 23.4 baby 23.19 22.59 23.02 22.93
child ibuprofen, OS, store brand (fl oz) hlth/bty 4.49 4.69 4.89 4.69
adult ibuprofen,caplet, store brand (ct) 100 hlth/bty 7.69 7.69 4.99 6.79
shampoo, Suave brand (oz) 22.5 hlth/bty 1.69 1.65 1.89 1.74
pads, long, Poise brand (ct) 42 hlth/bty 15.99 15.99 16.29 16.09
bath soap, Dial brand (ct) 8 hlth/bty 5.39 5.39 5.39 5.39
aluminum foil, store brand (sq ft) 75  hshold 2.99 2.92 2.79 2.90
kitchen trash bags, store brand (ct) 26 hshold 4.24 4.46 3.63 4.11
paper towel, 2-ply, store brand (rolls) 8 hshold 8.19 4.99 8.59 7.26
hot dogs, meat franks, store brand (oz) 16 meat 3.0 2.69 1.69 2.46
ground beef, 80% lean, per lb (in bulk) 5 meat 2.99 2.99 3.09 3.02
eggs, large (doz) 1 meat 1.49 1.79 1.59 1.62
lunchmeat, ham (lb) 1 meat 5.29 6.79 4.59 5.56
chicken, roaster (lb) 1 meat 1.69 1.39 1.49 1.52
fish sticks, Gortons (ct) 44 meat 7.99 7.59 7.49 7.69
tuna, water packed, store brand (oz) 5 meat .79 1.29 .79 .96
banana (lb) 1 produce .59 .59 .55 .58
apples, Red Delicious, bag (lb) 3 produce 3.49 3.99 3.49 3.66
carrots (lb) 2 produce 2.19 1.89 1.99 2.02
orange juice, original, store brand (oz)

64

produce 2.89 2.59 2.49 2.66
potatoes, Russet (lb) 5 produce 3.99 3.49 3.99 3.82
sugar, store brand (lb) 5 staple 3.19 2.99 3.19 3.12
flour, all purpose, store brand (lb) 5 staple 1.89 1.89 2.09 1.96
canola oil, store brand (oz) 48 staple 2.99 3.39 2.99 3.12
rice, white, long-grain (lb) 2 staple 1.59 1.99 1.49 1.69
             
total     181.42 179.39 174.37 178.39
             

As time progresses, the November 2010 average will serve as the basis index level of 100.

We’ll see.

Is Inflation Happening Now?

Now that we’re cruising aboard the QE2, everybody wonders whether we’ll reach the promised destination of a return to economic normality.  The cost of this return however, is the value of the dollar and whether we’ll be able to afford anything at all after we’re done.  There’s been growing concern about the validity of the economic data coming from the Federal Government, especially in terms of consumer prices.  The Federal Reserve has kept interest rates at all-time lows under the mantra that the Consumer Price Index is .1%, exclusive of food and energy.  Apparently the Fed believes that the rest of us don’t eat and don’t have to buy gas, so we can stay home on our extreme diets.  I’ve heard people say that food prices are rising, and I believe that they will if they aren’t already, but nobody can seem to say how much.

So we’re going to put it to the test and track the prices of commonly used household items in the PracticalDad BOG (Boots on the Ground) Index.  The BOG Index will measure, monthly, the prices of selected grocery items in a  simple, straightforward format.  What do we actually buy and what’s happening to the price?  It’s actually not difficult to do provided that you have some rules in place at the outset and then follow them scrupulously; the key is to keep it simple and consistent.

B(oots) O(n the) G(round) Index Rules

  1. The Index will be calculated by following prices on a monthly basis at three different grocery stores in my vicinity.  These stores comprise a mix:  a locally owned grocery; an American owned Grocery chain store; an internationally owned grocery chain store.  I don’t pretend that there aren’t regional differences but we’re looking at the price changes in totality, not pricing by region.
  2. The items are those that would be purchased by a family with children.  The item list will not change and the items will be consistent from store to store in package size and comparability.  A five pound package of ground round (80% lean) will be the same item priced at each of the three stores.  If an item is no longer available at one of the stores, then the best-fit alternative will be used.
  3. Because one of the concerns about pricing is "stealth inflation", in which prices remain the same but package size changes, the package size of each item will be consistent.  In the event that the package size of an item changes, I will adjust the price recorded to reflect the change by recalculating the item on a per ounce basis.  This will then be carried forward as we move along.
  4. If the stores do not have identically sized packaging for the item in question, the price for the item will be calculated at the base unit price (per ounce, per count, etc.) and equalized amongst the three in a common size.
  5. Pricing will not allow for BOGO or other such specials so that price movements aren’t distorted.  Likewise, there will be no allowance for coupons.
  6. As much as practicable, the BOG Index will concentrate on generic items.  If generic items aren’t available, such as diapers, then a brand name will be used.
  7. Pricing will always occur during the first week of each month and the prices as of November 2010 will constitute the base level of 100. 

It’s going to be a work in progress but with a little time, the question of whether there’s price inflation – and the extent to which it exists – will become apparent. 

The results of this month will be posted next week.

My Kids and the Coming Economy

A large part of my paternal job is to keep tabs on the world and how it affects my family.  What’s happening and what must I do to adapt?  More importantly, how do I help prepare my children for the world in which they’re going to live?

Parental roles are slowly blending and blurring as fathers take on childcare and mothers expand into the workforce.  But each still has a certain impact upon the kids and for dads, it’s how the child perceives and interacts with the outside world.  Research has shown that it’s a father’s input that helps spur vocabulary and language skills in small children.  When fathers were actively involved, the language skills of a three year-old were higher at a statistically significant level.  More recent research finds that a dad’s horseplay and interaction with the kids encourages exploration and self-confidence; this helps them meet and cope with the larger outside world.  It’s simply part of our job to prepare our children to survive and be productive in the world.

But our times are significantly different than our own parents’ and the economic challenges facing our children will make ours pale in comparison.  If we’re going to prepare them, we have to first get a handle on what they’ll be facing in the future.

Through A Glass, Darkly

Stroll through the internet’s economics offerings and you’ll find the full gamut of opinions on what’s going to happen and unless you live in Chile or Norway, little of it is good.  Views are offered by economists, investment strategists and advisers, pundits and even the odd economic astrologer.  This opinion spectrum ranges from stagflation and economic depression to Japan-style deflation and hyperinflation; to paraphrase one economics blogger, we really have no idea what will happen.

The short-term future is fuzzy at best but statistics and anecdotal evidence make the long-term outcome pretty certain.

  • The quoted unemployment rate (U-3) is stuck persistently at 9.5%+ but the more realistic rate of U-6 is closer to 17%.
  • The gap between the wealthiest Americans – the top 1% of wage-earners – and the rest of the country has widened to a level not seen since the days just prior to the Great Depression.
  • We remain an oil-based economy with an oil-based infrastructure, reliant upon foreign suppliers who often don’t like us and only tolerate us for our military and our currency; unfortunately, you can’t field a military without a viable currency.
  • Precious metals prices – an indicator of fear and instability – are at global 30 year highs as individuals and institutions purchase them to counter the continuing devaluation of the dollar and other fiat currencies.
  • Within the past several weeks, 25 nations have piled into what the Brazilian Finance Minister openly calls a "currency war".  Even Peru bought $12M in order to drive up the dollar versus whatever they call their currency.
  • The US Federal Reserve System will again engage in further quantitative easing, effectively flooding the economy with even more cash and liquidity.
  • The financial markets are largely broken.  The pervasive use of High Frequency Trading has led to a market-wide "flash crash" with multiple smaller flash crashes amongst individual stocks, most notably Apple Computer.
  • Through unfettered lobbying and campaign contributions, the financial system has corrupted the legal/political system to a degree unmatched in our nation’s history.  In 2009, Senator Richard Durbin (IL) told an interviewer that on Capitol Hill, banks "own the place".  The attitude of lenders has become so cavalier regarding such bedrock legal principles of title and property-ownership that in 23 states, large mortgage lenders have suspended foreclosure proceedings when the courts found that cases brought didn’t adhere to basic principles and in some cases, the bank had no actual financial interest in the property.  Additionally, mortgage servicers hired by lenders have been caught presenting counterfeit court summons attesting that foreclosure notices were delivered when they really were not.  Most disturbingly, Reuters news recently reported that advance notes of the Federal Reserve Open Markets Committee meetings are being provided to paying clients by a former Federal Reserve System governor in advance of their release to the general public.
  • Our elected representatives are failing in their most basic duties as they leave for a pre-election recess without having yet passed an actual budget.

Viewing even only this partial statistical and anecdotal evidence, our nation really does sit on the cusp of huge structural challenges that haven’t been faced in generations.

The Long-Term Upshot

Whether it happens hard or easy in the near-term, the long-term outcome for our children is difficult.  There is real risk that the American Middle Class will be largely eliminated as the political and financial elites sacrifice the common good for their own personal power and benefit.  Our children will be marginalized to an underclass forced to subsist in lower-wage jobs with little hope of real prosperity, their earnings spent meeting the debt payments on a societal-wide model based upon the company town model of the 19th/20th century coal fields.  Their freedoms will be likewise jeopardized as those in positions of power continue to consolidate and maintain their grasp on the levers of government, twisting the screws even further as they bleed the future underclass.

So what can any typical father do?  There are no magic tricks to suddenly undo what’s been in the making for decades and it’s doubtful that there will be any call for great acts of heroism or civil disobedience.  The great changes will have to be made at the family level and it’s our job as fathers to expose them to the wider world as we do with our words, language and horseplay.

 

What Exactly is Monetization?

One of the things that people might be hearing from the economics blogs is the question of whether – and to what extent – the Federal Reserve System is gaming the system.  What is meant by quantitative easing and what does it mean to say the Fed is Monetizing the Debt

The above link is to an article in a business/economics site entitled Zerohedge.  The site is like many other economics sites in which the writer (here the pseudonymous Tyler Durden) has a particular point of view as to how things will turn out in the world of money.  In this case, Durden espouses the case of monetary collapse and hyperinflation, which is a particularly scary outcome arising from our economic difficulties. 

The reality is that times are truly tough and no one knows what’s going to happen as a result of these policies and actions.  But the article does a decent job of explaining what it means when you hear talk of monetizing the debt and walking through the essential pathways of how it happens, so I thought it might be of some benefit to folks.  As an additional treat, follow the comments thread for an eye-opening look at what some others believe and the opinions and arguments that they make.  It makes for fascinating, eye-opening and occasionally hilarious reading.

I have no final idea of what’s going to result from the policies and actions of our leaders and central bankers.  But follow enough and you’ll learn that neither does anybody else, so we’re all even.

Fiat:  A Car and a Currency

Fiat Currency.  Global Reserve Currency.  Gold Standard.

You’ve heard terms like these on the news and in the paper, but what exactly do they mean?  How does the mess in Greece and Europe relate to what’s happening here and why should I even care?  We’re going to spend some bytes in the next several articles laying out the basics of the ongoing financial crisis – no, it never actually went away – and what it means to us.

But first, let me share a true story.

My father once bought a third car because his eldest child, my sister, was now driving.  Since he was having what I now recognize as fully blossomed mid-life crisis, he pulled into the driveway one evening in a sporty, low-slung, forest green convertible, proud that he thought he’d bagged a two-fer.  This car was a 1973 Fiat Spyder and it looked fabulous, the best that he could afford with the money available.

We soon learned the joke that Fiat was an acronym for "Fix It Again, Tony" and it was a car that demanded unrelenting vigilance and discipline, more than any other vehicle we’d owned.  It was a mechanically unforgiving auto and if it wasn’t assiduously maintained it would wind up at the shop.  There were still times that it was in the shop despite my father’s best efforts.  Because the engine didn’t like the Pennsylvania climate, he kept it in the garage and covered the engine itself with a canvas tarp in cold weather.  so the morning routine was the enter the garage, lift the hood and remove the tarp, recite a Hail Mary and then turn the ignition.

This car remained in the family until one winter morning when Mom needed to drive it.  She was running late, so she drove the Spyder for a quick run to the local bank.  She sat waiting in the drive-thru lane when she noticed the window teller banging on the glass and yelling at her while pointing furiously at the hood.  Mom glanced ahead to see that smoke was billowing out from under the hood where the tarp – which she hadn’t removed – was burning.  After the tarp caught fire, the engine soon followed and in a quick few minutes, there was a toasted Fiat blocking the bank’s drive-thru lane.

Fiat:  A Currency As Well As A Car

The dollar, as are all of the world’s currencies, are fiat currencies;  it isn’t an acronym, but actually the Latin term for "faith".  Each is considered a fiat currency because it is backed by the globe’s faith and confidence in the ability and will of that particular country to support it in terms of competitive ability, resources and capacity to service its debt.  That faith is demonstrated in the daily global transactions involving the buying and selling of the various currencies.  All manner of entities engage in currency transactions – companies, banks, hedge funds, individuals and central banks – and it’s the number at which buyers are willing to pay versus what sellers will accept that the valuation occurs.  And with world-wide networked computers, valutation occurs quickly and globally.  Because the Norwegian Krone is used by a country with solid governmental finances and an oil exporting economy, the world demonstrates its respect by valuing that currency higher than the Argentina’s, whose government burned international investors by defaulting on its debt.  It takes far more Argentinian Pesos to buy one Krone now than it did ten years ago.

And that’s the key to my father’s Fiat and today’s currencies.  Fiat currency is based, to a significant degree, upon the perception and faith of others.  Maintaining that faith and supporting that perception requires self-discipline and vigilance on the part of the owner to assure that it continues to be deemed worthwhile by others.  If a country’s currency gets a poor reputation, like the Italian car, then the global economies vote against it by valuing it less than other currencies.

How Did We Get To a Fiat Currency?

For most of our history, the dollar – like all of the other currencies – was backed by gold and silver and its control was mandated in our Constitution.  What that literally meant, after paper notes were issued, was that somebody who held a dollar was able to go into a bank and trade that paper dollar for a fixed amount of metal, either silver or gold.  People learned to accept the dollars because the amount of the metal was fixed and also because it was simply easier to carry paper bills than deal in gold.  Because the dollar bill was backed by the metal for which it could be exchanged, it had a steady store of value that buoyed the people’s confidence in it as a currency.

This gold standard was a staunch enforcer of discipline upon the international markets.  For instance, if America purchased more from England in 1866 than England purchased from America, then England could take all of the dollars that it had received and return them to the US Treasury for an equivalent amount of gold from the American government’s vaults.  Consequently, the US government would have less gold than could support the number of its own dollars in circulation, running the risk of default should enough citizens trade paper for bullion.  Dollars would have to be withdrawn from circulation and the result would be less money around for the citizenry.  So countries had to live within their means or develop new ways to garner wealth.

We’re not finished with the gold standard yet, but we need to cover something else first that makes the final days of the gold standard understandable.

What’s a Global Reserve Currency?

Many live by the rule that simpler is better and that runs to international financial transactions as well.  To keep from having to constantly recalculate the value of one currency to another in these transactions, banks and merchants long ago opted to assure that international transactions were usually handled in one currency only.  This is referred to as the Global Reserve Currency (GRC) and it’s a role presently held by the dollar because it serves as the medium of exchange for almost all international business transactions.

The status of GRC is bestowed by the world upon that currency which, it is view, is the steadiest and best able to weather the various storms – political, economic, natural – that occur.  The dollar became the GRC at the end of the Second World War after a meeting of allied financial ministers at Bretton Woods, after which the subsequent agreement was named.  At that time, the US was literally the last country standing after a second global war which devastated dozens of nations and exhausted the country with the existing GRC, Great Britain.  It was agreed that going forward, all international transactions would be handled in dollars.

Remember something.  The dollar was now the GRC but it was still backed by gold.  The dollar’s status as the "anointed one" was only peripherally related to its backing and it had not yet become a fiat currency.  At that time, the US had roughly 20000 tons of gold in the government’s vaults.

This system lasted for almost thirty years.  And in that time, the country began to persistently run trade and government deficits so that we were sending more dollars overseas than we were bringing in from elsewhere.  Our standard of living rose dramatically and we dreamed big dreams and tackled big projects but that meant that periodically, our gold flowed out of Fort Knox.  Financing the Vietnam War, the Great Society and Apollo took huge sums of money and those dollars printed were returned by foreigners for gold. 

And this was where the gold standard ran into problems.

Gold to Fiat

Somewhere around 1969, the government acknowledged that the US was going to run out of gold if things weren’t brought under control.  There was yet another meeting of international finance ministers and they hashed out what’s now referred to as Bretton Woods II.  The dollar – still the biggest kid on the block – continued as the GRC but it was agreed that all of the currencies would "float" in valuation against one another.  Gold would no longer be used to back the store of value as it once had.  Those valuations would be set by tracking transactions within the global markets and updated by computer, which now made this possible.  The dollar’s value now floated against other currencies, which was good because we’d lost over half of our gold reserves in the preceding thirty-odd years. 

The flip side was that if our country didn’t pay attention, exercise discipline and maintain our fiat, it would eventually become toast as others punished it in the global marketplace.

So What Do You Need To Remember Going Forward?

  • The dollar is a fiat currency with a value based solely upon the willingness of people to accept it.  That means that perceptions, beliefs and biases play a major role in how well it holds value – especially to pay for things like oil.
  • The dollar is the Global Reserve Currency, which means that almost all of the world’s business transactions occur in the dollar.  It also means that the dollar’s value is determined not just by folks in this country, but by others throughout the world.
  • Financial systems can change and if there’s a pressing enough reason, change relatively quickly.  We went through two major changes – Bretton Woods I and II – within a thirty year period.  It might seem like a long time personally, but it’s a blink of history’s eye.
  • Covering a Fiat with a tarp is ultimately bad for the Fiat.

Coming Soon:   Rising Debt – I Have To Repay This? 

Thanks to Jesse at Jesse’s Cafe Americain for reviewing this article.  All errors are mine and mine alone.

Thanks also to Kay, Molly and Burt for their input.

PracticalDad’s Guide to Following the Economic Issues

(Writer’s Note:  I apologize that this article was posted half-finished.  Life intruded…and the article is now complete)

What’s happened in the financial sector of the Economy  is a tangled knot of various issues that have come together in what some refer to as a Perfect Storm.  It can appear mind-numbing to the average person who’s looking at it for the first as he or she sifts through the rubble of the 401k statement.  Since much of it arises from the quantitative mathematics of Ph.D mathematicians, mind-numbing is about right.

With a college degree in Administration and a minor in Economics, I started digging in 2005 when basic economic principles no longer seemed to match the reality that I had learned and with which I’d grown up.  With the internet, I encountered dozens of sites – literally hundreds are there – and sifted through them to come to the ones that I go to regularly.  Some are on the wonkish side and others are more visceral in terms of tone.  But the key is to find a few good ones and then not only link the referenced articles, but also read the comments and start to pull your understanding together.

I’ll take a few moments to note my top choices.

If you need a general outline of the Economics/Personal Finance arena, then I would recommend www.kiplingers.com.  It is the digital equivalent of the old Kiplinger Newsletter but the articles are straightforward and written towards the layman.  If you find yourself getting further into investing, then I suggest that you try www.morningstar.com for a wider variety and analysis of investment opportunities.  They even go so far as to provide their own criteria for selection of mutual funds.

An insightful view of the finance and investment developments can be found at www.nakedcapitalism.com and is penned daily by Yves Smith.  She is a retired investment banker who started the site after noting the disconnect between what she was reading in the Main Street Media (hereafter MSM) and what she knew was actually happening.  She explains developments well and remains connected to peers within her former profession.

My personal favorite, and source of great insight, remains www.calculatedrisk.blogspot.com, hosted by CR and Tanta.  CR is apparently an independently wealthy investor who also started the site in 2005 when he noted the growing disconnect between reality and economics/finance.  He was subsequently joined by Tanta, the pseudonym for a retired mortgage banker who posts wonkish or scathing articles, depending  upon her ability to suffer fools gladly.  The key to this site however, apart from CR’s well thought out and executed "chart porn", is the collection of individuals who post regularly.  The commentary is pithy, intelligent and depending upon the subject matter and poster, exceptionally educational and insightful.  Even if you choose not to post – and I lurked for close to a year before posting – the education is superb. 

www.londonbanker.blogspot.com is a new and increasingly favorite blog from an English central banker.  His posts are infrequent as yet but they are beautifully written and provide incisive behind-the-scenes glimpses of the workings of the macro-level economic landscape.  It does presume a certain level of understanding, but even if you have a thin knowledge base, the use of the English language is excellent.

A good look at general economic trends and developments is www.econbrowser.com.  It was created by two Economics professors, James Hamilton of UCSD and Menzie Chinn of University of Wisconsin/Madison.  Their content is topical and provides a grounded overview of the Economics developments.  And while their "chart porn" isn’t always up to CR’s standards, they will readily correct and adapt them if it’s appropriate.

Finally, I tend to wander regularly to www.maxedoutmama.com for a ground level view of the situation.  It’s penned by a woman with an interest in Economics and has a "boots on the ground" feel to what’s occurring.  It’s thoughtful and if some nowadays consider her too political, then I simply acknowledge that everything happening now has political overtones.  Bear that in mind as you read and you’ll still find useful information.

Finally, am I a proponent of Jim Cramer?  Uh, no.  His schtick is good for everyday trading, but the present circumstances are far from everyday and make his approach simply too dangerous.

Next up…so how does a PracticalDad approach today’s environment?

The PracticalDad Guide to the Credit Crunch

The speed of the financial and economic changes in the past decade reached a crescendo this week when the credit system came to a startling and terrifying halt.  The Federal Government, in its infinite wisdom and hope for a miracle, has approved a massive bailout with no clear idea as to whether it will even work.  What exactly has happened and what does it mean?

Let’s start by looking at what the credit market is.  The typical person looks at the Stock Market/Dow Jones Industrial Average as an indicator for the health of the economy.  That’s natural since the large majority of the 401k retirement options pertain to stocks; there might be a single bond option in addition to a money market fund, and these are both members of the credit market.  It’s this credit market – with huge daily flows of money siphoning through the system – that provides the daily operating funds for financial and non-financial firms to operate.  Simply put, firms borrow the everyday/short-term funds for their daily operations – paying vendors, taxes, employees…and it’s this particular item that has everybody spooked.  Firms will have cash on hand, but it’s simply never going to be enough to meet all of the obligations.  Consequently, you could think of credit as the oil that keeps the gears of the grand economic engine turning smoothly, pistons pumping on all cylinders.

And what happens when you don’t check the oil?  Geez, how can the economic pistons wind up thoroughly jammed?

It all comes down to debt.  Debt in and of itself isn’t a bad thing.  The average person would never be able to afford a home without borrowing the principal, and the same goes for cars, and so on.  But in the course of the past several decades, debt has gone from being a useful financial tool to a mechanism to satisfy every consumer’s wildest fantasy.  It has become acceptable and even encouraged – think all those rebate credit cards – to use credit to pay for anything you might want, let alone need.  Mortgage programs were made available that encouraged people to buy beyond what they could reasonably afford by the use of teaser introductory rates; some were even allowed to borrow large sums based solely on what they said they earned.  These were the no-document  NINJA – No Income No Job/Assets – loans.

And at the same time, genius financial engineers with mathematics degrees were learning to create financial instruments for sale, and these instruments were packages of those same mortgages bundled together.  The cumulative payments from the homeowners were the cash flow on which the value of the instrument was based.  These instruments were called MBS for Mortgage Based Securities.  This appeared to work so well at first that other asset classes were constructed on the same premise – credit card payments, auto notes, you name it.  And the collective group was named CDO, for Collateralized Debt Obligations.  These became so popular that they were sold throughout the global economy.  A Chinese bank can conceivably own a bond backed by an apartment building in Poughkeepsie, New York.  It is a small world, after all. 

So they combined a very loose lending policy with a vehicle for spreading this loose policy throughout the global financial system.  This sounds suspiciously like a communicable disease with a virus encapsulated in a vehicle for faster spread.  And this is the point at which people remember that geniuses frequently have a very poor grasp of the real world.

Lax lending, overfed consumerism and a virus-like financial package meant that this chinese bank owned a bond back by an apartment complex that simply didn’t have the cash flow to support the mortgage payments.  Now multiply this by hundreds of thousands, if not millions, of like products.  And in the course of a decade, there isn’t a country which hasn’t had these products flood throughout their system.

So how does this get to a credit crunch?  Remember that all of these banks lend to other banks and also non-financial companies.  The notes of the non-financial firms are the basis for something called commercial paper, or very short-term debt; it is this debt that serves as the bulk of the assets held by the deemed-safe money market funds.  Well known disasters like Bear Stearns, Lehman and AIG simply exposed that many institutions are supported by financial instruments backed by failing assets, like house values.  And with firms not willing to divulge what they have in their books, trust amongst the firms and banks has collapsed.  Over the last week, this was demonstrated by the increasingly higher rates that firms and banks had to pay one another for the commercial paper.  As of yesterday, October 2, the rates were meaningless as banks simply refused to lend to anyone else as they hoarded the money to rebuild their own MBS-depleted books.

So what does this mean?  Simply put, that if this continues for several more days, businesses of all sizes will be unable to obtain the money necessary to meet their obligations.  Vendors aren’t paid and this ripples through the economic fabric, and ultimately, employees are laid off for lack of funds to pay them.  It amounts to a replay of the Depression of 1929.

The Paulson Plan is simple and akin to a plague city worker.  The intent is to remove the dead or dying assets from sick institutions via purchase and replacing them with healthy capital, think Treasury Notes.  If the government purchases the bad assets for more than Fair market value, then the institution can use the excess proceeds to rebuild their assets and hopefully spur lending again.  Will it work?  The scarily interesting part is that no one knows.  There’s simply no guarantee that impaired banks will resume lending instead of just taking the assets onto their books and hunkering down for the duration.

This is economic terra incognita.  And like the old maps said, "here there be monsters."

Next…how does this affect me as a father?