Debt Rattle, May 27 2008: Where is this going?

Dorothea Lange House Call October 1939.
Farm Security Administration camp unit at Merrill, Oregon.
The camp nurse introduces doctor to mother of sick baby

Ilargi: Prices dropped 14% from a year ago, but that looks benign compared to the 6.7% decrease in the first quarter from Q4 2007, for an annual percentage of 26.8%. The monthly drop in March was 2.2%, February saw 2.6%. Last week, we saw prices in California fell 32% from a year ago.

Where is this going?

I told you where: peak to trough, prices will go down 80%. Or more.


Case-Shiller: House Prices Fall 14%

The S&P/Case-Shiller home-price indexes, a closely watched gauge of U.S. home prices, saw prices fall further in the first quarter amid the continued deterioration of home prices as the subprime-loan meltdown weighs on the sector.

Meanwhile, new-home sales rose in April but failed to meet expectations because the government revised lower the level of demand for the previous month. In the first quarter, the Case-Shiller indexes showed home prices across the country fell 14% from a year earlier, representing the largest drop in the 20-year history of the indexes. From the fourth quarter, prices fell 6.7%.

"The steep downturn in residential real estate continues," David M. Blitzer, chairman of S&P's index committee, said. He added, "There are very few silver linings that one can see in the data. Most of the nation appears to remain on a downward path." According to the indexes, released by ratings firm Standard & Poor's, home prices in 10 major metropolitan areas fell 15% in March from a year earlier and 2.4% from February.

In 20 major metropolitan areas, home prices dropped 14% from a year earlier and 2.2% from February. Charlotte and Dallas managed to avoid March-over-February drops in prices, with Charlotte eking out 0.2% growth and Dallas posting a 1.1% increase. Charlotte also reported a 0.8% rise year-over-year, as -- for the third month in a row -- it remained the only city to post annual growth.

Las Vegas was the weakest market, posting a 26% drop in March from the prior year, followed by 25% and 23% drops in Miami and Phoenix, respectively. Las Vegas and Miami had been the weakest markets in January and February. Las Vegas and Miami also were the biggest decliners month-on-month, posting 4.4% and 4.5% drops, respectively.

According to a separate measure released last week by the Office of Federal Housing Enterprise Oversight, home prices fell an average of 1.7% nationwide in the first quarter from the final three months of 2007. The decline was the largest in the index's 17-year history. The index differs from the Case-Shiller index in several ways; notably, Ofheo data excludes homes with jumbo mortgages.

Earlier this month, the Commerce Department offered the latest sign that the struggling U.S. housing market may hold back economic growth for much of the year. While home construction unexpectedly jumped 2.5% in April follows months of bad weather that held back many builders, permits declined 8.9% from March to an annual rate of 1.43 million, marking the largest percentage drop since a 24% tumble in February 1990. Permits are now down 41% from their 2005 peak.

Housing permits, which are down 28% from a year ago, predict the market's direction better than housing starts. Meanwhile, the National Association of Home Builders also said earlier this month that home builders' confidence has fallen substantially, to match the lowest point in the latest economic cycle. The meltdown in subprime loans is expected to continue weighing on the sector, and high inventories will need to be worked off.

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U.S. consumer confidence hits 16-year low in May

Soaring gas prices and weakening job prospects made shoppers gloomier about the economy in May, sending a key barometer of consumer sentiment to its lowest level in almost 16 years.

The New York-based Conference Board said Tuesday that its Consumer Confidence Index dropped to 57.2, down from a revised 62.8 in April. Economists surveyed by Thomson Financial/IFR had expected a reading of 60.

The May reading marks the fifth straight month of decline and is the lowest since the index registered 54.6 in October 1992.
Economists closely watch sentiment readings since consumer spending accounts for more than two-thirds of the nation's economic activity.

“Weakening business and job conditions coupled with growing pessimism about the short-term future have further depleted consumers' confidence in the overall state of the economy,” Lynn Franco, director of the Conference Board's Consumer Research Center, said in a statement.

Ms. Franco said consumers' worries about inflation, fueled by increasing prices at the pump, are now at an “all-time high” and are likely to rise further in the months ahead. She added that based on consumers' outlook on the economy, she believes there's little likelihood of a turnaround in sentiment in the next few months.

The Conference Board's index that measures shoppers' current assessment of economic conditions declined to 74.4 in May from 81.9 in April. The index that gauges their outlook over the next six months declined to 45.7 from 50.0 in April.

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Back to the 1970s, or the early 1920s?

As readers know, we Austrians are not yet convinced by claims that inflation is spiralling out of control - though it obviously is in Eastern Europe, the Gulf, and much of emerging Asia. I suspect that headline CPI inflation in North America and Europe will peak soon as the commodity spike short-circuits, and then fall hard as recession/slowdown bites deeper.

It may even turn negative late next year if central banks misjudge the “feedback loop” of debt deflation. So let me post the counter-view by Joachim Fels, joint-head of research at Morgan Stanley and one of the best minds in the City. His latest report - “Stagflation, More Than Just A Scare” - hits the nail on the head. He sees “scary parallels with the 1970s”.

“What was still a threat six months ago has become reality in the US, and is likely to arrive in Europe soon.  The current stagflationary phase will turn out to be longer and more serious than most people believe.  “Easy money is the culprit. On the surface, the rising demand in emerging market economies such as India and China for energy and higher-protein food is pushing commodity prices and headline inflation higher.

But beneath the surface lies a very expansionary monetary policy stance in many of these economies. Weighted global interest rates stand at 4.3 per cent, while global inflation is running above 5 per cent. The real policy rate in the world is negative. On a global scale, central banks are both fuelling and accommodating the rise in food and energy prices.”

Among the parallels with the 1970s:

• Fiscal policy in many countries looks likely to be loosened in order to cushion the economic downturn.
• US monetary policy is being exported to many countries pegged to a weakening dollar, stoking inflation pressures in these countries.
• Productivity growth has slowed, meaning a lower speed limit for growth and upward pressure on unit labour costs.
• The competitive pressure from Japan and Korea in the 1970s gave rise to protectionist pressures in the US and Europe.
An anti-capitalist mood in western societies favoured government intervention and regulation. Similar pressures have emerged in response to China. Re-regulation is inherently stagflationary.”
• Of course history never repeats, but it rhymes. Sluggish growth is likely to prevent most central banks from fighting inflation.
This is bad news for most asset classes. Equities and credit should struggle. Bonds should sell off because inflation is not in the price. Inflation-linked bonds should do relatively well.”

To those who think the slowdown will create enough “slack” to contain inflation - as it has in recent episodes -- Dr Fels has a warning.

• This time will be different. The Fed policy stance has been less restrictive going into recession, and is now more expansionary than it has been at similar stages of previous recessions”
• During the past three recessions, the global trend was disinflationary. Now inflation is on a rising trend almost everywhere.
• Global factors are a more important driver of inflation nowadays. The underlying reason for persistent pressures is a very lax global monetary policy.

My apologies to Dr Fels for a little condensation of his points here and there. He may well be right. He usually is. My schema is a little different. We could see a reply of the early 1920s, when the world system split in half as they faced the policy ructions following the Great War.

Germany, France, Belgium, and Poland (I believe, I write from memory) all opted for varieties of hyperinflation, either because it was the lesser of evils or because the political pressures were overwhelming (Germany had little to gain from discipline: the hyperinflation was unanswerable proof that the Versailles reparations were unpayable).

The US, the British Empire, Italy, and (I think) the Scandies, opted for various levels of deflation linked to pre-war Gold Standard parity. The contrast was extraordinary. Could this divergence occur in a modern global economy with (mostly) floating currencies? The emerging world inflates into the stratosphere; the Atlantic economies and Japan go into a deflationary slide? I will make tentative bet that this can indeed occur. Tentative, mind you.

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Hedge funds: the credit crunch's enigma

Breathe in. Breathe out. You can relax now. The worst of the credit crunch, and the liquidity crisis it spawned, is over, we are told. It's getting slightly easier to borrow money. True, the banks are still taking writedowns, but the pace is slowing. Banks and insurers are replenishing their capital at a furious pace, as AIG did this week, when it raised a cool $20-billion (U.S.) rather than the $12.5-billion it had announced earlier. No other big securities firm seems on the verge of Bear Stearns status - that is, toast.

Whatever you do, do not - repeat, do not - think about the hedge funds. If you do, your breathing might become quicker. Your blood pressure might rise. That's because the hedge funds are opaque. No one knows what's in them. They might be fine. But they could blow up too, the proverbial next shoe to drop in the credit crunch's (allegedly) waning days.

By now, we know the banks are not run by CEOs and their flunkies. They are run by accountants. The bean counters are just no fun any more, even when you fill them with spiked Shirley Temples. They insist that the financial instruments on the books - a futures contract, a share - be valued at what it's worth right now, not what it might be worth in nine months or on your aunt's birthday.

In today's markets, that means a string of writedowns even if the bank is convinced the asset in question might be worth five times as much once liquidity and confidence return. Not so the hedge funds. Private and largely unregulated, the hedgies don't have a strict mark-to-market burden. Their valuation requirements are flexible. If the instrument is, in effect, worthless because it doesn't trade, big deal.

It will just be held at par until the price rises to the point that another truckload of management fees can be collected. That could happen in three days, three months or 12 months. The luxury of time, it appears, has kept the hedgies off the front pages (only a few have blown up, like Peloton Partners' $2-billion ABS fund). But time can't stay on the hedgies' side forever.

At a certain point, a dud instrument or investment has to be written down or blown off the books, bank style. The credit crunch started nine months ago, in August. Might the moment of truth be coming for the hedgies? The hedge funds' big potential danger, of course, is leverage, piled high and deep like cheap pasta. If they go, they could go with a great thundering crash, spreading destruction near and far. Leverage is used to amplify returns - you load up with debt to ramp up your return on equity.

Bear Stearns's leverage rate was 26 in 2005, that is, the total assets were 26 times the value of the shareholders' equity. By last year, the figure had climbed to about 33. All you have to know is that leverage works both ways. Leverage is one potential time bomb. The other is the monster credit default swap (CDS) market, whose notional value is estimated at more than $60-trillion. The swaps are a form of insurance. They are used by owners of debt to hedge, or insure, against defaults.

The hedge funds are obviously exposed to this market. How much isn't known. Remember, the hedgies don't have to tell you what's inside the black box. What is known is that the default rate on corporate bonds is rising as various economies slow down or go into recession (the United States, Canada, Britain, Ireland, Spain, Italy, to name a few). Any hedge fund that sold these protection products has to be worried. Buyers of the products would be doomed if the sellers collapse. The buyers would bear the full brunt of the credit losses.

What will prevent disaster for the hedge funds, and no small number of private equity funds, which bought huge companies at the top of the market with heaps of borrowed money, is a broad-based economic upturn. Well, good luck. House prices in the United States could easily take another tumble; already, they are about 15 per cent below their mid-2006 peak. A fall of another 15 per cent would eliminate trillions of dollars of household wealth, with predictable effects on the economy.

Europe seems in better shape, thanks to the German export juggernaut, but the eurozone is not immune to what's happening in North America and Britain. On Friday [May 23], the eurozone purchasing manager's index showed that economic growth had slowed to its weakest level since July, 2003. Jobs were added at the slowest rate since early 2006. You can assume the hedge fund managers are on tenterhooks. Relax while you can because the next few months could be horrific in Hedgeville.

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Ilargi: Jeff Rubin says that globalization is reversible. I don’t think he’s thought too much about it. Our manufacturing base is gone, it’s been razed to the ground, and it can’t be brought back on any realistic level in any realistic timeframe. What is reversible about that, Mr. Rubin?

High energy costs will bring dramatic changes in trade: CIBC World Markets

The rising price of oil is making international trade of heavy cargo prohibitively expensive, and acting as an incentive for importers to find products such as steel closer to home, new research by CIBC World Markets shows. For heavy products, rising shipping costs are eroding the low-wage advantage of China over North America, say chief economist Jeff Rubin and senior economist Benjamin Tal.

If oil prices continue to rise, the soaring cost of global transport will act like a major tariff barrier and lead to a substantial slow down in international trade, they argue. “Globalization is reversible,” they state.

Oil passed $133 (U.S.) a barrel on Monday, and Mr. Rubin forecasts the price will average $106 this year, $130 next year, $150 in 2010 and $225 by 2012. These days, the cost of oil is the equivalent of imposing a tariff rate of about nine per cent on goods coming into the United States. At $150 a barrel, transport costs act like a tariff of 11 per cent. And at $200, all the trade liberalization efforts of the past 30 years are reversed, Mr. Rubin said.

Oil prices now account for about half of total freight costs, and for the past three years, for every $1 increase in world oil, there has been a corresponding one per cent increase in transport costs. “Unless that container is chock full of diamonds, its shipping costs have suddenly inflated the cost of whatever is inside,” Mr. Rubin said.

“And those inflated costs get passed onto the Consumer Price Index when you buy that good at your local retailer. As oil prices keep rising, pretty soon those transport costs start cancelling out the East Asian wage advantage.”

Persistently high oil prices will also cause many commuters to consider moving to the city, reversing the allure of the suburbs, he said. And it could also force a change in eating habits, as foreign food becomes too expensive to ship. “It means forget about that 50-mile commute from Cooksville to Toronto, and also forget about that avocado salad in January.”

More fundamentally, the soaring oil price will prompt a major rethinking of how production is organized, Mr. Rubin argues, and could even lead to a revival of North American manufacturing. Already, U.S. imports of Chinese steel are declining dramatically, while domestic production is rising at rates not seen for years, they say.

China's steel exports to the United States are falling at a 20-per-cent annual pace, while U.S. domestic production has risen by 10 per cent in the past year. That makes sense, the economists say, because Chinese steel producers need to import iron ore from the likes of Australia and Brazil, then turn it into steel and then pay huge and rising freight costs to send the hot-rolled steel to the United States. Regional trade looks much cheaper in comparison, they say.

As oil prices continue to climb, shipments of furniture, footwear and machinery and equipment are likely to meet the same fate, the economists say. “In a world of triple-digit oil prices, distance costs money,” they say in a paper released Tuesday. “And while trade liberalization and technology may have flattened the world, rising transport prices will once again make it rounder.”

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Ilargi: Karl Denninger provides a badly needed counterweight against all the empty gibberish about speculation and energy prices. Mind you, that same gibberish is the topic du jour in parliaments the world over.

Tremors on Tuesday?

The crooners and screamers are out again over the weekend decrying "speculation" in oil futures. Rick Santelli did a pretty good job of destroying that argument this morning on CNBC, surprisingly enough. He brought up the "inconvenient truth" that on the last day of a given contract, as the day winds down, all speculation must (by definition) cease on that contract, as anyone holding a long at the bell must take delivery, and anyone short at the bell must provide delivery.

He's right of course, but don't expect people to pay attention to the inconvenient thing called "facts" when emotion rules the political landscape. See, here's the bottom line - if speculative distortions were the "primary drivers" of price, then we would see tremendous distortions in the price of the front month .vs. longer contracts on that last day. $10, 20, 30 or more.

That is, if the "actual delivery price" of oil is really $100/bbl, and the speculative premium $30, one minute before the bell on expiration day only those people who will deliver (or take delivery) have open contracts. That last trade is going to take place at the actual delivery price - it simply must, by definition, as these contracts do not cash settle - they settle with actual barrels of oil changing hands for money!

Now is there a "speculative premium" in oil? Well, yes and no. The $250 billion in excess liquidity that is flying around has found a "safe haven" in oil and other commodities. But this is not "speculative premium" in terms of market manipulation or "evil people", it is people buying oil and oil products as a stable store of value!

And what, pray tell, is wrong with this? We've got Bernanke running around literally shredding The Fed's balance sheet, deprecating US Treasury Bonds as a safe place to hide. He has turned what were pristine credit instruments into used toilet paper with wild abandon, stuck in the Ivory Tower world having made his speeches that "The Fed has a device called a printing press and can always arrest a deflation by using it."

Well Ben? This reminds one of Greenspan's speech when asked about FDIC insurance many years ago, when he said that "we can guarantee that you will receive your dollars, but not what they will be able to purchase."The truth is that The Fed has not been hyperinflating anything. Liquidity is a loan, not a gift nor printing. Loans have to be paid back, with interest. But - credit quality is credit quality, and at the end of the day the question for the markets comes down to asset allocation.

Since Bernanke has shown his willingness to shoot off his mouth with statements that call into question his sanity, in which he has stated outright that he will protect insolvent institutions and homeowners by destroying the credit quality of The United States, we should not be surprised if the market, over which Bernanke in fact has no control (his delusions of grandeur notwithstanding), decides to allocate assets away from those things which he has and can wipe his butt with!

So if you're talking about "distortions" and who's to blame, go talk to Bernanke. He has single-handedly created this mess and the responsibility lies with him. You cannot blame people for allocating assets in a way that they perceive as safe.

You cannot fault market participants' perception that US Treasury instruments are fundamentally unsound when your own Central Bankers make public statements and take actions that demonstrate their willingness to destroy the credit quality of same!

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2007 Worst-Ever Vintage for US Subprime, Alt-A RMBS

Early reviews of the 2007 vintage of Subprime, Alt-A and Prime Jumbo residential mortage-backed securities indicate it will be the worst ever in terms of delinquencies, judging from Standard & Poor’s latest assessment. The delinquency rate on Alt-A RMBS, for example, is four times as high as the 2006 vintage at the same stage of seasoning.

As of the April 2008 distribution date, total delinquencies for subprime RMBS transactions were 36.79%, 37.11%, and 25.87% of the current aggregate pool balances for the 2005, 2006, and 2007 vintages, respectively. This is an increase of approximately 2% for the 2005 vintage, 4% for 2006, and 6% for 2007 when compared with March 2008 according to S&P.

Serious delinquencies (90-plus days, foreclosures, and real estate owned) for the 2005, 2006, and 2007 vintages were approximately 26.60%, 26.61%, and 17.33% of the current pool balances, up 3% from March for the 2005 vintage, 5% for 2006, and 9% for 2007.

The 2007 issuance year continues to be the worst-performing vintage in terms of cumulative losses. After 12 months of seasoning, cumulative losses for transactions issued in 2007 represent 0.49% of the original aggregate pool balance, which is 69% higher than the 0.29% recorded for the 2006 vintage at the same level of seasoning.

For Alt-A RMBS, backed by mortagegs that are less than prime but better than subprime, total delinquencies were 13.10%, 17.34%, and 10.88% of the aggregate pool balances for the 2005, 2006, and 2007 vintages, respectively, up 7.03% for the 2005 vintage, 6.32% for 2006, and 6.77% for 2007 since March.

Serious delinquencies were approximately 8.47%, 11.48%, and 6.64% of the current aggregate pool balances, respectively, up 10.00% for the 2005 vintage, 8.61% for 2006, and 10.85% for 2007.

Cumulative losses for Alt-A transactions issued in 2007 represent 0.04% of the aggregate original pool balance, which is four times the amount recorded for the 2006 vintage (0.01%) at the same level of seasoning.

For Prime Jumbo RMBS total delinquencies were 2.85%, 3.31%, and 2.50% of the current aggregate pool balances for the 2005, 2006, and 2007 vintages, respectively, up 5.2% for the 2005 vintage, 5.4% for 2006, and 9.2% for 2007 from March.

Serious delinquencies were approximately 1.49%, 1.70%, and 1.16%, respectively, up 8.0% for the 2005 vintage, 9.0% for 2006, and 20.8% for 2007. For all vintages but 2007, cumulative realized losses of 0.01% or more of the original pool balances haven’t started to appear until 24 months of seasoning.

The 2007 vintage, represented only by the deals issued during January through April (which have had 12 months of seasoning), has cumulative realized losses of 0.01% after only 12 months of seasoning. Transactions issued in 2006 have now performed the worst, with 0.03% in cumulative realized losses at month 24 (but only four months of issuance have reached that seasoning level), compared with 0.02% for 2001.

HELOC and Closed-End Second-Lien RMBS delinquencies also increased in April.

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Ilargi: I was going to leave this lousy article alone, but since I see people taking its main point seriously, I’ll expose its retarted lunacy. To think that rising oil prices (will) have more impact on our lives than the credit crisis, one really needs to have grave problems with numbers.

In the UK, where this was published, real estate is in collapse, no matter what cooked upbeat cheerleading "reports" from the lending industry say. The reality is that home sales are expected to fall by 30% this year in the UK, which means a 10% drop in prices is the very minimum. If the average home price is £200.000, the average home will lose $40.000 in value, and that’s just the start.

And that is supposed to have, to quote the article ”relatively little conspicuous impact on the lives of the average Joe”? That’s a full year’s salary for Joe Average, you geniuses. So tell me again, what will Joe spend extra on gasoline?

What’s happening here is the media following and creating fads. The credit crisis has had its 15 minutes of fame, time for the next Idol. Truth be damned.

Credit crisis was crude compared with this oil price surge

Now you see it. For most of the last year, the world has been living through an invisible crisis. The ravaging of the banking system, painful though it has been for shareholders in the grandes dames of Wall Street and banks beyond, has had relatively little conspicuous impact on the lives of the average Joe.

The principal exception to that rule has been the dearth of credit available to British homebuyers: a serious issue, to be sure, and one which because of the dithering of our Government has had draconian consequences. I would hazard a guess, though, that once the credit crisis is fading to black, the reality of $135 oil will make today's trauma feel like a minor inconvenience.

Where the banking meltdown has largely been confined to the paper-based hinterlands of structured debt products and banking writedowns, the ongoing surge in the oil price is very much a real-economy issue. Whether you subscribe to the view that the world has sufficient oil for another 50 or 200 years is immaterial.

Amid surging demand from emerging economies - and undoubtedly an element of the froth that speculation has brought to the party - there is little reason to suspect that crude prices are going to experience a serious correction anytime soon.

Not so long ago, let's not forget, oil industry analysts and investors were adjusting to a new reality where prices were nudging the $25 mark. Talking to executives last week at companies large and small, across industries, they all wanted to make the same point: that a protracted run of oil priced above $100 a barrel, and possibly as high as $200, is inevitable.

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Estate agents: Crisis? What crisis?

Property sales are stabilising despite shaky consumer confidence and the widening gap between supply and demand, according to estate agents. Recent reports on house prices have been universally downbeat.

But a National Association of Estate Agents (NAEA) report, published today, says that in April the number of agreed sales, the number of pre-sale viewings and the average difference between the asking and selling prices all levelled off, belying alarmist predictions that the market is heading into freefall.

"What people need to remember is that the market is stable and we are not seeing massive price drops," Chris Brown, the president of the NAEA, said. "There are still strong economic factors at play, such as high employment and low interest rates, and sales are still taking place. Moreover, people need places to live and property purchase remains a good long-term investment."

Buyers are being cautious, says the NAEA. But the number of viewings before a sale stayed level at 14, only two higher than the same time last year, and the average difference between the price tag and the eventual payment was also stable last month at 4.7 per cent. Although the number of buyers on agents' books dropped by 12 to 237 in April, the number of sellers is on the rise, with 84 properties on average available in April, compared with 76 in March.

Actual sales have remained level since January – with the average agent closing seven deals per month – but have dropped significantly since the highs of 13 in April, May and June last year. First-time buyers are the worst affected by the current credit conditions, with the numbers buying down from 8.3 per cent in March to 7.7 per cent in April, continuing the precipitous drop from 13 per cent in December and 14.5 per cent in January.

But reports from elsewhere in the housing sector make grim reading. The Hometrack survey published yesterday said May was the eighth consecutive month of falling prices, caused by the falling number of buyers as more properties go on the market. Building companies are also feeling the pinch.

Last week, the chairman of the Home Builders Federation said sales of newly built houses have "fallen off a cliff", while Taylor Wimpey, the UK's biggest homebuilder, announced plans to close 13 offices and lay off 600 staff. Persimmon has seen sales drop by 24 per cent this year, and Bovis Homes by 30 per cent.

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Will our central banks make a Freudian slip over their illusory control of price stability?

Are we finally seeing The Future of an Illusion? Sigmund Freud's essay on the nature of religion focused, as you might expect, on religion's psychological importance.

Freud – not the world's biggest believer – thought that, as science revealed truths which previously had been shrouded in religious mystery, people would eventually have to recognise their own irrelevance in a universe that was, in truth, devoid of spiritual life. Would they be able to cope? How would they be able to reconcile their inflated egos with the essential meaninglessness of life?

Freud defined an illusion in terms of wishes. We wish religions to be true because we cannot tolerate the consequences of their being false. We're afraid of death, we fear anarchy and we're terrified of loneliness. Religions claim to provide answers for all these worries. We wish, therefore, that religions are true. A world in which religious "truth" is destroyed is, therefore, too frightening to contemplate (unless, of course, you're Richard Dawkins).

Central bankers, too, depend on an illusion. They are, if you like, the high priests of money. Their success depends entirely on their ability to persuade the rest of us that, come rain or shine, they are able to deliver price stability. Our dislike of inflation means, in turn, that we wish the illusions the central bankers create to be true.

This is a beautiful self-fulfilling arrangement. Why, after all, would any of us demand an inflationary pay increase if the central bank is proved, time after time, to be right in its pursuit of price stability? The central bank, though, only gets it right because we don't demand those inflationary pay increases. This is a circle not of logic but, instead, of faith. In Freud's eyes, then, it's not much more than an illusion. Central banking, in this sense, thrives on the placebo effect.

This illusion, though, is in serious danger of crumbling, going the same way as the many religions which were unable to stay the course (few of us have the opportunity these days to pop down to the local mithraeum, and most of us don't typically choose to offer a prayer to Thor).

The threat is obvious. As oil and other commodity prices rise into the stratosphere, there is an increasing sense that our inflationary destiny no longer lies with our central banks. They, too, understand the problem. The Federal Reserve last week revised down its forecasts for US economic growth but, at the same time, revised up its forecasts for inflation.

Meanwhile, the Bank of England continues to warn of difficult times ahead, with Mervyn King skippering a ship that's heading all too quickly towards the inflationary rocks. The problem can be simply stated. The prices of the individual things we buy on a regular basis are not determined by our central banks. Indeed, central bankers would be horrified were they to be accused of trying to influence the price of, say, bread, spring onions or shoe polish.

All they're interested in is the price level as a whole or, put another way, the value of money. The value of money is determined in relation to a hypothetical basket of goods and services which we call a price index. If, within this price index, some prices rise, it follows that other prices must fall to ensure that the price level as a whole doesn't stray too far from the path implied by the inflation target. That way, the value of money is preserved.

Within the price index, however, is a mixture of prices some of which are easier to influence through monetary policy than others. Moreover, even those which can be influenced are only affected with a lag. Like Steve Austin, the Six Million Dollar Man, central bank policy works only in slow motion.

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U.S. housing crisis takes a toll on the auto industry

The American auto industry is getting side-swiped by the country's housing crisis. Auto lenders and banks have tightened their wallets, preventing hundreds of thousands of consumers from getting the financing they need for a car.

Home equity loans, used in at least one of every nine deals, are no longer a source of easy money for many prospective buyers. And used car prices have fallen nearly 6 percent as repossessed cars and gas-guzzling trucks and SUVs flood auction lots. Those forces, on top of the softening economy, are putting enormous pressure on the U.S. auto industry as it faces what may be its worst year in more than a decade.

About 14.95 million vehicles are expected to be sold in 2008, down from 16.2 million last year, as sales reach the lowest levels since 1995, according to the marketing firm J.D. Power & Associates. The impact on the broader U.S. economy could be profound. Not only is the car a consumer's second biggest purchase after the home, but the auto industry remains one of the country's most important economic engines.

With less money available to fuel the industry's growth, the businesses that support it are also facing the prospect of a sharp slowdown. "It is a bleak picture, and it all hinges on the availability of financing," said William Ryan, a financial analyst at Portales Partners who has followed the auto business for years. "The whole universe related to the auto industry is touched in some way - parts suppliers, manufacturers, salespeople, trucking people, the paint and metals industries. Even semiconductors."

Within the auto sector, problems stemming from the ongoing tightening of credit have already started to spread. Auto lenders like Chase, Capital One and GMAC are finding it harder and more expensive to obtain money for loans. Profits also look dimmer as the lenders absorb losses from defaults and pull back from making new loans.

Car dealers and manufacturers will likely face months of weaker profits as they offer more incentives to sell new vehicles. Luxury car sales, which provide outsize profits for auto companies, are off 13 percent from last year, according to the Autodata research firm. And consumers, facing potentially higher mortgage payments and $4-a-gallon gas, are delaying purchases of midmarket cars.

"The housing crisis, defined with the credit crisis, has really knocked consumers back on their heels," said Michael Jackson, the chairman of AutoNation, the largest automobile retailer. But the auto industry may not suffer the same dramatic bust as the housing sector. One reason is that auto lenders have long issued loans expecting that vehicles, as collateral for the loans, start to lose value as soon as they are driven off the lot.

Meanwhile, auto lenders have struggled to find investors willing to buy packages of new loans. Just as in the mortgage markets, a sterling credit rating - the bond insurer's seal of approval - is no longer trusted. "It's a challenge, but it's not a crisis," said William Muir, president of GMAC, the finance arm of General Motors.

As the pool of money available to auto lenders has dried up, they have cut back on making new loans. Subprime auto lenders have been forced to pull back the most. AmeriCredit, a big subprime finance company, said it would issue about $3 billion in new auto loans this year, compared with $9.2 billion in 2007. That translates into around 340,000 fewer vehicles being financed this year.

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Oil crisis triggers fevered scramble for the world's seabed

A fevered scramble for control of the world's seabed is going on - mostly in secret - at a little known office of the United Nations in New York. Bemused officials are watching with a mixture of awe and suspicion as Britain and France stake out legal claims to oil and mineral wealth as far as 350 nautical miles around each of their scattered islands across the Atlantic, Pacific, and Indian oceans.

It takes chutzpah. Not to be left out, Australia and New Zealand are carving up the Antarctic seas. The latest bombshell to land on the desks of UN's Commission on the Limits of the Continental Shelf is a stack of confidential documents from the British Government requesting an extension of UK territorial waters around Ascension Island, St Helena and Tristan da Cunha.

The three outposts between them draw big circles in the Mid and South Atlantic, covering unexplored zones that may one day offer deep reserves of crude oil and gas. A similar request has already been made for eastward expansion from the Falklands and South Georgia - much to the fury of Argentina. "If the British do not change their approach, we shall have to interpret it as aggression," said President Nestor Kirchner, before he handed power to his wife Cristina.

Ascension Island - famed for its enormous green turtles - is a dusty cluster of 44 volcanoes, covered with cinder. It is barely big enough to host America's "Wideawake" airfield and a tracking station for Ariane 5 space rockets. First garrisoned by the British in 1815 to keep an eye on Napoleon, it now boasts 1,100 hardy souls. St Helena - the "Atlantic Alcatraz" - is yet more remote, if greener.
 
The forgotten relics of the Empire make Britain a player in the marine race. There are the waters off the Falkland Islands and South Georgia, already home to a clutch of oil exploration companies; the Pitcairn Islands in the Pacific; Diego Garcia in the Indian Ocean; and a string of outposts such as Montserrat, the Caymans, the British Virgin Islands, the Turks and Caicos, and Bermuda.

The French "Outre-Mer" is a bigger network - from the Isles Crozet to Saint-Paul and Kerguelen in the southern seas, to Clipperton off western Mexico. They too have been busy at the UN, requesting an extension of their zone off French Guiana and New Caledonia. All the maritime powers are nibbling gingerly at the edges of Antarctica, though the Antarctic Treaty bans fresh claims on the world's last pristine landmass.

The two-page summary of Britain's submission to the UN gives little away. It merely notes that the UK is providing information on the limits of shelf "beyond 200 nautical miles", adding that there will be further requests. A Foreign Office spokesman said the motive was to "protect the environment".

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Spain's drought: a glimpse of our future?

Barcelona is a dry city. It is dry in a way that two days of showers can do nothing to alleviate. The Catalan capital's weather can change from one day to the next, but its climate, like that of the whole Mediterranean region, is inexorably warming up and drying out.

And in the process this most modern of cities is living through a crisis that offers a disturbing glimpse of metropolitan futures everywhere. Its fountains and beach showers are dry, its ornamental lakes and private swimming pools drained and hosepipes banned. Children are now being taught how to save water as part of their school day.

This iconic, avant-garde city is in the grip of the worst drought since records began and is bringing the climate crisis that has blighted cities in Australia and throughout the Third World to Europe. A resource that most Europeans have grown up taking for granted now dominates conversation. Nearly half of Catalans say water is the region's main problem, more worrying than terrorism, economic slowdown or even the populists' favourite – immigration.

The political battles now breaking out here could be a foretaste of the water wars that scientists and policymakers have warned us will be commonplace in the coming decades. The emergency water-saving measures Barcelona adopted after winter rains failed for a second year running have not been enough. The city has had to set up a "water bridge" and is shipping in water for the first time in the history of this great maritime city.

A tanker from Marseilles with 36 million litres of drinking water unloaded its first cargo this week, one of a mini-fleet contracted to bring water from the Rhone every few days for at least the next three months. So humbled was Barcelona when prolonged drought forced it to ship in domestic water from Tarragona, 50 miles south along the Catalan coast, 12 days ago, that city hall almost delayed shipment and considered an upbeat publicity campaign to lift morale and international prestige.

The whole country is suffering from its worst drought in 40 years and the shipments from Tarragona prompted an outcry from regions who insist they need it more. For now the clashes are being soothed by intervention from Madrid, and plans to ship water from desalination plants in parched Almeria in Andalusia are shelved until October.

But there is little indication of a strategy to deal not just with an immediate emergency but an ongoing crisis. Buying water on an epic scale from France has given the controversy an international aspect as French environmentalists question whether such a scarce natural resource should be sold as a commodity to another country.

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The 'fiction of affluence' has Greeks uneasy

With its Mediterranean sun and incomparable history, Greece delights the tourists who bake on its beaches and stroll through its ruins. But Greeks themselves, struggling with an increasingly obsolete economy, worry that tourism may be all they're left with if nothing changes.

The government of Prime Minister Kostas Karamanlis likes to point to decent economic growth and ebbing unemployment as signs that the country is thriving. With the euro as its currency, Greece is at the heart of European integration, the argument goes.

But many quarters take a more critical line, saying that the euro gave Greece only temporary respite from disaster by obscuring some of the structural deficiencies common to European countries: bloated state-owned companies, a wallet-busting pension system and old-fashioned, ossified state universities.

"What we have in Greece is the fiction of affluence," said Stefanos Manos, a former Greek finance minister and harsh critic of the current government. "That is going to disappear in five or 10 years if we don't do anything." The upcoming 10th anniversary of the start of Europe's grand experiment in a common currency is already providing fodder for a round of self-congratulatory speeches from European politicians and central bankers, many of whom helped introduce the euro on Jan. 1, 1999.

But along Europe's southern border, nearly a decade of the euro is an occasion for soul-searching as much as celebration. In Greece, Italy, Spain and Portugal, the euro provided a major burst of low-cost credit as previously high interest rates plummeted to unheard-of lows.

In Greece, the euro fueled brisk household spending and a lot of home building, creating headline numbers for economic performance that did not look too bad, despite debt levels that rose by 30 percent annually and a huge trade deficit. Economic growth has reached 4 percent in the past few years, and unemployment has fallen slightly.

"Participation in the euro zone has been beneficial for Greece, despite the fact that Greece entered the euro zone relatively unprepared," George Alogoskoufis, the Greek finance minister, said during an interview. Though stable since then, Greece is widely viewed as the weakest of the 15 euro-zone economies. Nicholas Garganas, the governor of the Bank of Greece, has been increasingly outspoken about the dangers the country now faces if it does not find the will to change.

"The challenge for Greece is to maximize the benefits of participation in monetary union" - that is, the euro - "by making further progress on the path of structural reform," Garganas said. Calls like these invite scorn from ordinary Greeks, who accuse the euro of bringing inflation after coins and bills were introduced on Jan. 1, 2002.

Years later, Greek newspapers still scream with headlines about the euro's inflationary effects, while the popular Lonely Planet guidebook warns that Greece is "no longer a cheap place." Over the past year, the cost of bread, flour, fresh poultry, butter and cheese have exploded by double-digit rates, feeding grudges against the euro despite evidence that the rise is caused by greater demand from Asia. (Few Greeks take heart that one staple, olive oil, has actually fallen in price over the past 12 months.)

The experience with the euro fosters a general sense of foreboding in Greece these days, a feeling that the country will give up what the ancients started with thousands of years ago: land. Manos, an independent member of the Greek Parliament, says many Greeks on the island of Tinos, where his daughter lives, are selling small parcels of property, typically to wealthier Europeans.

They live off the proceeds to make ends meet - and then sell some more. "If you switched off the sun, we would go bankrupt in a few days," Manos said. "What we have in Greece is the sun and the sea."

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Health care fees trouble Eastern Europe

In the Czech Republic, a patient can now see a doctor for about $1.85. This is not cause for celebration. For Czechs, who visit their doctors more often than anyone in Europe, it has led to outrage. In fact, the idea of charging anything at all for health care can generate significant controversy, not to mention abrupt about-faces in policy, here and in other Central European countries.

The theory is to cut waste and abuse from the health systems to strengthen and modernize them. But the backlash can be powerful.In Hungary, health care fees were resoundingly defeated in a nationwide referendum in March, which resulted in the firing of the health minister. Here in the Czech Republic, which began imposing the fees at the start of the year, the prime minister himself was dragged before the constitutional court in Brno to testify as the court weighs overturning them. It is scheduled to rule Wednesday.

Countries rich and poor struggle with how best to provide affordable health care to their citizens without breaking the bank. In places like the Czech Republic, the difficulty is sharpened by the clash between the rapidly rising expectations for the latest and best treatments and the long-ingrained habits of Communist-era unlimited, free health care on demand.

There is a sense of betrayal, because the state once took care of them, but also a justified fear for those left behind in the recent years of growth and change. Even in Prague, known as the golden city, newfound wealth for some has meant only higher prices for those trapped with low salaries or fixed pensions.

For healthy people with jobs, the fees are literally pocket change, usually paid with the same 10 and 20 koruny coins as streetcar tickets in Prague ($1 is worth about 16 koruny). Affluent Czechs will acknowledge privately that they spend far more on veterinary care for their cats and dogs than their own medical care, even with co-payments for some medications.

But many Czechs see it as a matter of principle that health care should be free, along with a strong sense of solidarity for the poor. "The only analogy I can think of in our political culture is primary schools," said Marc Roberts, a professor of political economy at the Harvard School of Public Health who has worked in Central Europe. "Most people in the United States believe that primary education should be free and open to all and that it shouldn't be subject to market principles."

The region has been a living laboratory of health care reform in recent years. The effort has been spearheaded by free-market advocates from booming Slovakia, which has a flat tax and scorching economic growth - more than 10 percent last year. Slovakia introduced modest payments for doctor visits and hospital stays in 2003. But, as would later happen in Hungary, the fees did not last. The leftist government that came to power in 2006 rolled them back later that year, within just a few months of taking office.

"What we want to achieve in the health system is a higher individual responsibility, making the consumers more responsible for what they consume," said Peter Pazitny, executive director and one of the founding partners at the Health Policy Institute in Bratislava, Slovakia, and formerly the principal advisor to the Slovakian minister of health.

The need for a health care overhaul in the region, Pazitny said, is obvious. Statistics from the Organization for Economic Cooperation and Development show that the Czech, Slovak and Hungarian health care systems rank at or near the bottom of all member countries in life expectancy, as well as mortality rates for strokes, heart disease and cancer.

The Czech government was receptive to the Health Policy Institute's input, and even employs another of Pazitny's partners in Prague. But the opposition would prefer that their former countrymen left them - and their health care system -  alone. "I would understand if these Slovak boys would do it as a paper for their seminar at university, but here they are introducing it into real life," Michal Hasek, leader of the Social Democratic caucus, the largest opposition party in Parliament, said in an interview in his office.

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Foreign banks play ball on ABCP

The $32-billion restructuring of Canada's asset-backed commercial paper market could be back on track by the middle of this week after a group of key foreign banks backed down on a threat to scuttle the deal rather than bow to concessions demanded by a judge.

Germany's Deutsche Bank AG and other big foreign banks, whose co-operation is crucial for the plan to swap the frozen ABCP for new bonds, are in talks to create a system by which investors stuck with ABCP can try to bring fraud claims, sources said.

Allowing fraud claims is a big concession from the banks, which had previously said they would back the plan only if they had broad legal immunity, including from allegations of fraud. In Ontario Superior Court hearings, the banks warned the deal could collapse if the judge tried to force them to deal with fraud claims.

But Mr. Justice Colin Campbell said that he didn't want to approve a plan that took away investors' right to recompense for fraud. That left the banks with a stark choice - play along or follow through on their threat to pull their support, a move that would lead to massive losses for ABCP holders and a torrent of litigation.

The banks "are playing ball," said one person familiar with the talks. "All parties are working very hard at coming up with something sensible that will satisfy Judge Campbell." A compromise with the foreign banks means the restructuring deal is likely to be brought before the judge by midweek. Should the plan satisfy the judge and assuming there are no appeals, investors could begin to get their money back this summer.

That would be almost a year since the ABCP market froze in August of 2007, after investors fled amid concern about links to securities backed by U.S. subprime mortgages. Since then, a committee led by lawyer and veteran restructuring specialist Purdy Crawford has been seeking a solution.

The plan is to swap the old paper for new longer-term bonds that should trade freely. But given the continuing credit crunch, the bonds are likely to sell in early days at a substantial discount to par value.

Because of that, corporate holders of ABCP have pushed in court for the right to pursue legal claims, arguing that since they may lose money in the restructuring they should keep the right to sue. The likely outcome of the talks will be a system giving investors a short window of time to bring forward allegations of fraud, sources said.

The negotiations now revolve around how to define fraud, the sources said. If the definition is too narrow, or the corporate challengers are unhappy with being able to press claims for fraud only because of its high bar for proof, a settlement may be further delayed by appeals even if Judge Campbell signs off.

"It will fly with Judge Campbell, but won't avoid appeals," said Colin Kilgour, an adviser to corporate holders of ABCPs. He pointed out that many of the corporate challengers wanted to be able to sue for more than just fraud. "Where I think we need to see some progress is by having a way to deal with things like misconduct and misrepresentation."

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