China focused hedge funds don't deserve hefty fees

 

 

China Hedge Funds Post Big Gains,
But Are They Worth Hefty Fees?

 

The latest year-to-date performance numbers from hedge funds that invest in China's red-hot market appear impressive. But stumbles by some funds in November raise questions about whether they are worth the heavy fees.

The average China-focused hedge fund is reporting a double-digit percentage gain for the 11 months ended in November, with a few up more than 100%.

788 China Fund, managed by Heritage Fund Management of Switzerland, was up 104%. Golden China Fund, managed by China-based Greenwoods Asset Management, was up 100%, while several other funds were up 30% or more, according to performance data reviewed by Dow Jones Newswires.

Anyone Could Have Scored?

But the numbers belie a worrisome performance picture for some funds. Chinese stocks have been a guaranteed moneymaker this year, so investors could have made impressive returns without paying hedge-fund fees. The Shanghai Composite Index returned 82% during the same time period, while the Hang Seng returned 44% -- better than returns at some hedge funds.

A number of hedge funds took hits last month when Chinese stocks tumbled, raising questions about their ability to weather volatility. The Golden China Fund, for example, lost 9.3% in November, while the more recently launched Golden China Plus Fund, which focuses on high-growth companies and private equity, dropped 13%, bringing its year-to-date return to 30% at the end of November, according to performance data reviewed by Dow Jones Newswires.

Officials from Greenwoods Asset Management didn't return a request for comment.

A China-focused hedge fund run by Ginger Capital Management in Hong Kong, meanwhile, lost 17% last month, bringing its annual return to 40%. Officials from Ginger Capital Management didn't return a request for comment.

"What investors want to be looking for is risk-adjusted returns," said Christopher M. Schelling, director of strategic research with Thomson Corp. "I wouldn't be surprised if these Shanghai indexes give back a big portion" of their recent gains in coming months, he added.

One Winning Fund

One fund that seems to have weathered the November storm is 788 China Fund, which was up 2.4% last month despite a drop of 9% in the Shanghai Composite Index. Karim Daou, deputy manager of Heritage Fund Management, said the fund invests based on a macro strategy, moving in and out of sectors depending on their broader performance outlook.

"One of the main objectives is to protect the assets, then to beat inflation and interest rates, then to make performance," Mr. Daou said. "We're not benchmarked [to an index], so we have the flexibility needed to protect the portfolio."

While it isn't clear what exactly was behind losses in some funds, Veryan Allen, who advises institutional investors in Japan on investments including hedge funds, said the drops are a "red flag," suggesting the managers are "very long" and not managing risks well enough.

"One of the myths about China is that you can't go short," said Mr. Allen, adding that there are lots of ways to hedge, including shorting U.S.-listed American depositary receipts.

Investors who want only long exposure to China's growth can just as easily skip the hedge funds and their heavy costs, Mr. Allen said. He recommends investors take a look at China exchange-traded funds, which invest in baskets of stocks like mutual funds but trade on an exchange like stocks.

An investment in the iShares FTSE/Xinhua China 25 Index Fund ETF, for example, would have returned 72% through the end of November.

"We can all make money when the sun is shining," Mr. Allen said. "If for whatever reason you think China's going up, you might as well go with the simplest and cheapest and most direct product."

--
**************************************
Paul D. Deng
Department of Economics
Brandeis University
IBS, MS 032
Waltham, MA 02454
www.pauldeng.com

inside China's Morgan deal

a good piece from WSJ.

 

 

Morgan's Helping Hand in China

Ardent Mack Aide From Beijing Lends Stature, Local Ties  

BEIJING -- Morgan Stanley's landmark deal to sell a $5 billion stake in itself to China marks a bold move by Chief Executive John Mack. If it pans out, it also will owe some of its success to the long experience and local ties of Wei Sun Christianson, Mr. Mack's steadfast lieutenant and point woman in China.

The surprise deal, announced Wednesday, gives the state-owned China Investment Corp., or CIC, a stake of as much as 9.9% in Morgan Stanley at a time when the U.S. investment bank is staggering under a multibillion-dollar write-down. While initiated by Mr. Mack, the agreement also helps solidify Ms. Christianson's status as one of China's premier deal makers, and perhaps the country's most prominent female investment banker.

The 51-year-old Ms. Christianson, born in Beijing, hails from a pioneering generation of Chinese who went abroad to study in the early years of China's economic overhauls and later returned to help reshape the country's financial system. Among the fellow Chinese she met in New York while studying at Columbia University School of Law in the late 1980s was Gao Xiqing, a Duke University-trained lawyer who later helped found China's stock markets. Mr. Gao today is president and chief investment officer of CIC, which was founded in September to manage $200 billion of China's $1.4 trillion in foreign-exchange reserves.

It isn't clear precisely what role Ms. Christianson and Mr. Gao, both of whom were in New York for Wednesday's announcement, played in the deal. Ms. Christianson declined to comment, and Mr. Gao couldn't be reached. But their involvement in the tie-up reflects the rising profile of their generation of Chinese in global finance, as China becomes an important force in world markets.

The CIC investment could prove a boon to both CIC and Morgan Stanley, although it also risks feeding suspicions among some U.S. politicians that the Chinese fund is seeking to obtain control of strategic assets -- something CIC officials have long denied. For Morgan Stanley, it provides an infusion of capital, while for CIC the bet could prove lucrative if the U.S. investment bank is able to successfully emerge from its current woes.

CIC's strategy under Mr. Gao and his boss, Lou Jiwei, a former Chinese vice minister of finance, appears to be a mix of opportunistic big bets and more restrained portfolio investment. Mr. Gao and his colleagues have shown an appetite for prominent deals with the Morgan Stanley stake and a $3 billion stake in Blackstone Group LP earlier this year.

Ms. Christianson has spent much of her career working with Mr. Mack, following him when he left Morgan Stanley in 2002 to join Credit Suisse Group, departing from Credit Suisse when he was ousted in 2004, then rejoining Morgan Stanley in early 2006 after Mr. Mack's return there. In between, she spent 14 months as Citigroup Inc.'s lead investment banker in China.

Ms. Christianson didn't set out to be a banker. Growing up during the Cultural Revolution, a period of chaos from 1966 to 1976 when much of China ceased to function, she was unable to go to college until the late 1970s. When she could, she enrolled at a language institute in Beijing to study English and was on track to become a translator at the foreign ministry.

Eager to attend graduate school, she jumped at a chance to go to the U.S. in the 1980s. She graduated with honors in 1985 from Amherst College in Massachusetts, becoming the school's first China-born graduate, before attending Columbia's law school on a scholarship. It was at Columbia that she met her husband.

New York at the time was home to a small and tight-knit group of Chinese students studying law and finance -- subjects almost completely alien to a generation that had grown up with Maoism. Mr. Gao, who had graduated from Duke in 1986, was working at the now-defunct law firm Mudge Rose Guthrie Alexander & Ferdon.

"At the time, most Chinese going overseas were aiming to study science," said Li Xiaoming, a friend of Mr. Gao's who graduated from Duke's law school in 1990 and is now managing partner of White & Case's Beijing office. "There were probably about ten Chinese lawyers then at Wall Street firms, making it a close group." Ms. Christianson and Mr. Gao remained friends as she climbed the investment-banking ladder and he rose through the ranks of China's bureaucracy.

After helping found the stock markets, Mr. Gao became vice chairman and chief executive officer of Bank of China's investment-banking arm and later served as vice chairman of the country's securities regulator and its national social-security fund.

Ms. Christianson briefly served as a regulator at the Hong Kong Securities and Futures Commission. After her third child was born, she decided she wanted a career switch and jumped into finance. Morgan Stanley gave Ms. Christianson her first break in 1998. "I was willing to try and ready to fail," she said in an earlier interview.

Today, Ms. Christianson, Mr. Gao and others of their generation are perpetuating the tradition they helped establish, by recruiting Chinese talent from overseas. CIC, for example, recently hired Li Yingru, a young Chinese who studied in the U.S. and had spent about a year and a half working at the California Public Employees' Retirement System.

 

 

 

Recession or not?

With recent econ stats all looking (surprisingly) good, why people still fuss about recssion? Here included are some heated debates on the topic: 3 videos from CNBC's Kudlow and one quant piece from Jim Hamilton.

http://www.cnbc.com/id/15840232?video=612803140
http://www.cnbc.com/id/15840232?video=613298026
http://www.cnbc.com/id/15840232?video=613298033

The bears must wait another quarter

by James Hamilton

Currently available data on consumer spending make it very unlikely that we'll see negative real GDP growth for the fourth quarter.

The BEA reported on Friday that seasonally adjusted real consumption spending grew at a 6.5% annual rate between October and November. As Calculated Risk has noted in the past, this takes much of the guesswork out of predicting what the fourth-quarter numbers will turn out to be. The quarterly consumption component of real GDP is just the average of these monthly numbers, so we now have two of the three months that will go into 2007:Q4 consumption spending.

Following CR, blue bars in the graph below represent the growth rate of the average real consumption during the first two months of a quarter relative to the average real consumption over the first two months of the previous quarter; (my numbers differ slightly from CR's in that I've measured growth rates from changes in the natural logarithm, which correspond to continuous compounding and make the algebra a little simpler). Green bars in the graph report the actual growth rate for the quarterly consumption component of real GDP. The October and November 2007 data imply an estimate of the growth rate of real consumption spending of 3.2% during the fourth quarter of 2007.

The two-month estimate has an R² of 80% in predicting the actual quarterly numbers, and a root mean squared error of 80 basis points. The latter can be used to construct a 95% confidence interval for the 2007:Q4 forecast. The 3.2% estimate for 2007:Q4 implies a confidence interval between 1.6% and 4.8%. That Normal confidence interval can also be bootstrapped, by the way-- only 4 out of the 69 errors since 1990:Q3 exceed 160 basis points in absolute value.

With 2007:Q4 real consumption growth in the ballpark of 3%, it's extremely unlikely that we'll see the negative real GDP growth for 2007:Q4 that some analysts had been predicting before the strong November retail sales figures came in.

--
**************************************
Paul D. Deng
Department of Economics
Brandeis University
IBS, MS 032
Waltham, MA 02454
http://www.pauldeng.com/

My strong critic toward sovereign wealth funds (SWFs) was buttressed by Becker's recent piece that explains its fundamental flaws.


Why Sovereign Funds?
by Gary Becker

The growth of large government managed funds during the past few years has been spectacular. These funds are estimated to manage between $2-3 trillion, and their assets are increasing rapidly. Sovereign funds have grown mainly because of the run-up in fossil fuel and other commodity prices, although China is creating a large fund with the capital earned from its trade surplus in goods. If present energy and commodity prices continue, sovereign funds could have over $10 trillion in assets within a few years. I do not believe that the scale of these funds is a healthy development for these countries.

The largest fund is that by The United Arab Emirates, which is thought to have assets of about $900 billion. Next in size are the funds from Singapore, Saudi Arabia, Norway, and China: each has capital of about $300 billion. Following these giant government funds are another 20 or so funds with much smaller amounts of capital. Oil producing countries have about two thirds of the capital of all sovereign funds. The aggregate assets of sovereign funds greatly exceed the approximately $1.5 billion invested in hedge funds.

During the past couple of years, sovereign funds have begun to invest more aggressively in international companies. For example, the Abu Dhabi Investment Authority recently gave cash infusion of $7.5 billion to Citigroup to help replace bank capital that had been depleted due to the credit crunch. China's State Foreign Exchange Investment Corp invested in the IPO of the large private equity company, Blackstone, and was embarrassed after the stock declined greatly from the issuing price. Sovereign funds have made other investments in private companies, and many more are expected.

With only a few exceptions, such as the fund of the Norwegian government, sovereign funds are secretive and not at all transparent. Lack of transparency is a major obstacle to citizens of countries with secretive sovereign funds in determining whether the money that automatically flows to the funds is being well spent. Even estimates of the total assets of most sovereign funds have to be arrived at through guesswork, and except for an occasional well-publicized transaction, their asset allocations are kept private. While private equity and hedge funds have also been criticized because they are little regulated- I do not share this criticism- they are paragons of voluntary disclosure and good governance compared to the vast majority of sovereign funds. Private equity and hedge funds voluntarily disclose information mainly because they compete vigorously for funds, whereas sovereign funds automatically get their resources because of government ownership of oil producing and other commodities.

Compounding the adverse effects of the extreme secrecy is that managers of these funds, being government employees on fixed salaries, have only limited financial incentives to try to achieve higher returns for given risk. Even when those in charge of sovereign funds hire private managers for some of their capital, there is still what economists call a principal-agent problem because government officials choose the managers. As a result, one would expect that the management of these funds would be excessively conservative to avoid investment blunders and bad publicity, or that managers would be tempted toward corruption by companies that want to attract investments from these funds. Or governments will use the funds for other government purposes, such as the just announced unwise decision by Brazil to create a sovereign fund to intervene in the foreign exchange market to shore up that country's currency. Given that little information is available, it is very difficult to discover whether a fund is managed too conservatively, or whether corruption affects investments in a significant way.

A major reason behind the growth of sovereign funds is the desire by oil producing and other countries to avoid what happened during previous booms in commodity prices. Vast revenues in the past were spent with little concrete results to show later on. Countries now recognize that the enormous boom in their export prices, such as oil close to $100 a barrel, is not likely to last. That makes it prudent to save rather than spend most of the revenue that is being collected. The desire to save the surplus is commendable, but that consideration alone does not imply that governments rather than households should do the saving.

Central banks and fiscal agencies should accumulate assets during years with high oil and other commodity prices, or what are in other ways unusually good times, in order to protect against the adverse effects of bad times on fiscal and foreign trade deficits. However, the Abu Dhabi fund and the other large funds, and many smaller ones, have far more assets than is necessary for cyclical management of government portfolios. Instead of government funds retaining the excess assets, they should be distributed as national dividends, or as reductions in taxes.

One advantage of distributing most of a funds' assets as dividends, or reduced taxes, is that since families at different stages of the life cycle have very different investment needs, they would invest such a dividend in ways that best suit their individual needs. Younger couples that are investing in children, and actively accumulating wealth, will spend their dividends on buying homes, cars, and other consumer durables, saving for the education of their children, and investing in mutual funds and other financial intermediaries. Since older persons with adult children already own their homes and other durables, they would spend their dividends mainly on conservative financial instruments.

To be sure, countries accumulating some of the largest funds are not at all democratic, so that any national dividend would only go to a relatively small fraction of the total population. But so too are any benefits from the investments of sovereign funds, so a national dividend would not be any worse in this dimension.

People's Investment Company
January 29, 2007; Page A16, WSJ

For Wall Street, the big news out of China this month is that the country will "actively explore and expand the channels and methods for using foreign-exchange reserves." The Communist Party might hive off a big chunk of its $1 trillion stash and invest abroad on behalf of its citizens, a la Singapore's Government Investment Corporation. That may be a boon for bankers, but it's not necessarily a smart idea for China.

This is yet another scene in the Party's balancing act between economic liberalization and state control. China's exchange-rate policy -- the catalyst for its huge foreign-exchange reserves -- is at the heart of the debate. By more or less pegging the renminbi to the dollar, Beijing accumulates foreign-exchange reserves when it mops up the incoming greenbacks. The policy has spurred an enormous boom, giving Chinese and foreigners the confidence to invest without worrying about price volatility.

This has also bought time for China to reform its broken financial sector -- a task that's far from finished. At the same financial conference at which the government investment idea was floated, Premier Wen Jiabao kicked off the reform of the Agricultural Bank of China, more than half of whose loan portfolio is rumored to be non-performing; it will take perhaps $100 billion or more to bail it out.

So why hive off foreign-exchange reserves into a Singapore-style fund? For one, China's policymakers may be frustrated that their efforts to encourage money to flow abroad aren't working quickly enough to offset the tide of incoming capital. The so-called Qualified Domestic Investor Initiative scheme, which lets Chinese investors buy bonds abroad, has attracted only a few billion dollars so far.

But there are good reasons for that. Today, Chinese investors see better prospects at home. The Shanghai stock market is up more than 110% over the past 12 months, and property prices are still healthy. Chinese investors probably aren't turned on by buying U.S Treasury bonds. If the Party were serious about opening their capital markets, they'd let investors buy General Electric on the New York Stock Exchange, or a vacation home in Thailand.

It's more likely that Beijing likes the GIC-like setup because it would keep the Party's hands on the money. Singapore's fund hasn't released public accounts since its founding in 1981; its stated total under management, at $100 billion, hasn't changed in years. But at least Singapore has a reputation for clean governance; the same can't be said of China's bureaucracy.

Beijing's policymakers could also make political hay domestically by telling citizens that they will get more return for their renminbi -- which could then be invested in, say, education or health care. This is the "negative carry" argument -- the idea that foreign investors are receiving double-digit returns on their dollars, while China's central bank receives single-digit returns when it invests renminbi in U.S. T-bills.

But that's not the way it really works. Foreign-exchange reserves are liabilities on a central bank's balance sheet, not found money. Up to a certain point, reserves assure foreign investors that a country has ammunition to fight an attack on its currency, such as during the 1997-98 financial crisis. Once reserves accumulate beyond that point, more fundamental questions about government policy have to be raised. Instead of creating an opaque government institution to manage reserves, China would do better to tackle the root problem: the need for more capital freedom.

A Revisit of Chinese Stock Market: Was I Wrong?


01/04/2007

In early 2005, I predicted bearish Chinese stock market in the medium term. Back then, the Shanghai Composite Index was only around 1000. Nobody quite understood how this could happen with the economy soaring every year at double-digit rate. Now, the index stands high at 2650, a 165% jump from 1000. If just count from October to December last year, the index jumped 800 from 1800, almost 45% increase. One word: unbelievable!!!

The bear market I predicted was out of two reasons. For one, there will be huge piles of state-controlled non-circulating stocks waiting be to put into the market, creating an oversupply. Two, China is working toward floating her capital account (sooner or later), domestic investors will want to invest overseas seeking better return instead of earning pity banking interest. This will create a shortfall of demand. Both forces drive down the market in the medium term. Supply and demand work like magic. Is it that simple?

It turns out the supply side of the story was right. But the privatization of state controlled non-circulating stocks completed sooner than expected. The demand side's just totally opposite. Instead of a shortfall, we had a huge surge.

Several events contributed to the flip of the demand.

First, Chinese government announced appreciation of the yuan in the first half of 2005. And with continuing pressure from the U.S., yuan is expected to appreciate further. This contributed a huge inflow of speculative capital, part of it flowing into the stock market. This is the most important factor in this round of stock rally.

Second, with IPOs of monster big Chinese state banks, and with backings of the prestigious Investment banks such as Goldman Sachs and RBS (in return for favorable access to Chinese banking business), the market psychology turned to Chinese stock holders' favor.

Third, Chinese government took a gradual approach on freeing its control on capital account. Although the state, in replacing individuals, begins to invest abroad, the process is too slow. The expected outflow of capital did not happen.

Is the huge outflow of domestic capital ever gonna happen? I don't think so. Here is why? 1) Chinese investors are relatively poor informed about the foreign markets. They do not have experience investing abroad. Simply too much uncertainties out there. 2) The financial institutions in China are still backward. Institutional investors, like mutual fund and pension fund, are inexperienced either.


Now here is the tough question: With Renmingbi expected to rise further, will China suffer similar boom-and-bust in Japan since early 90s? At least, this is what economists like R. McKinnon are worrying about.


Read on, next time...


-Paul

In Memory of Milton Friedman


Here I compiled a list of comments and interviews of Milton Friedman, as a special tribute to the greatest economist of the 20th century, and my most admired one.

For some of us who came to the States from those non-free regimes (former and now), his half-century fight for economic&political freedoms is especially inspiring. He will certainly be missed.

In memory of him, PBS will broadcast a special TV program called "The Power of Choice: the life and idea of Milton Friedman", on January 29, 2007. To get a preview clip of the program, please go to: http://freetochoosemedia.org/production/POC/press.php


Now here is the list...

From Friends and Foes:

Gary Becker: written in 2002, on the influence of Friedman's ideas
http://home.uchicago.edu/~gbecker/Businessweek/BW/2002/07_01_2002.pdf

Thomas Sowell: his former student, now at Hoover Institution, previously at UCLA
http://www.opinionjournal.com/forms/printThis.html?id=110009268

Greg Mankiw:
http://gregmankiw.blogspot.com/2006/11/milton-friedman.html

Brad Delong (kindof foe, but still admires him):
http://www.salon.com/news/feature/2006/11/17/milton_friedman/
On Uncle Milton
http://www.j-bradford-delong.net/movable_type/2003_archives/001309.html
some excerpt: "Friedman... how great an influence on my thought? Let me think who has had more... Smith, Keynes, Summers, Shleifer... I would put Friedman fifth: only four other economist have had a greater influence on how I think... I'm not atypical at Berkeley in finding myself moving under the influence of the intellectual field generated by Milton Friedman--at least, I don't think I am... "

Paul Krugman (real foe):
I wish he had written one. Maybe he will, as he did for James Tobin.



In-Depth Interviews:

PBS: Charlie Rose on Friedman, Nov. 17, 2006, about 1 hour
http://video.google.com/videoplay?docid=-921891628093252478&q=milton+friedman

PBS: Charlie Rose interview with Friedman, Dec. 2005, about 1 hour
http://video.google.com/videoplay?docid=-2963837673813979186&q=milton+friedman

Friedman on PBS, many years ago:
http://video.google.com/videoplay?docid=6813529239937418232&q=milton+friedman



From professional papers:

WSJ:
http://online.wsj.com/article/SB116369744597625238.html?mod=hps_us_at_glance_most_pop
if you don't have access to wsj, read it from here: http://www.pauldeng.com/pdf/in%20memory%20of%20milton%20friedman.pdf

Economist Magazine:
http://www.economist.com/daily/news/displaystory.cfm?story_id=8190872&top_story=1

BusinessWeek:
http://www.businessweek.com/print/bwdaily/dnflash/content/nov2006/db20061117_169299.htm


From major newspapers:

New York Times:
http://www.nytimes.com/2006/11/17/business/17milton.html?ex=1321419600&en=a0db578046e72e19&ei=5088&partner=rssnyt&emc=rss

Washington Post:
http://www.washingtonpost.com/wp-dyn/content/article/2006/11/16/AR2006111601779_pf.html


For more info about Friedman, please go to: http://www.freetochoose.net/


-Paul

Congestion Pricing

Yesterday the Journal had an interesting article (attached below) on traffic pricing: a dynamic-pricing system in which drivers where charged different amounts depending on the time of the day.  It's William Vickery's theory of "'congestion pricing" in practice.
 
 
Relating to this, another Nobel Laureates R. Selten recently presented a paper on his experiment on day-to-day driving route choice behavior. People who are interested in experiment, behavior and dynamic game might be interested in reading this paper:
http://www.wior.uni-karlsruhe.de/LS_Puppe/Personal/Papers-Kube/route.pdf
 
 
 
Stockholm's Syndrome
Hostages to Traffic, SwedesWill Vote on High-Tech Plan To Untangle Snarls With Tolls
By LEILA ABBOUD and JENNY CLEVSTROM August 29, 2006; Page B1 
Soren Astrom, a 40-year-old advertising executive in Stockholm, spent the first half of this year working later than usual, beginning his drive home after 6:30 p.m. each night. But it wasn't his boss keeping him chained to his desk. He was avoiding the extra tolls charged to drivers using city streets during peak hours.

From January through July, Stockholm tested one of the world's most sophisticated traffic-management systems as part of a plan to reduce gridlock, lower smog levels and improve quality of life in the city. Unlike most other traffic-control plans in place in cities such as London and Rome, Stockholm used a dynamic-pricing system in which drivers were charged different amounts depending on the time of day. If Mr. Astrom, for example, left the city center at the busiest time of the afternoon rush, from 4 to 5:29, he would have paid the equivalent of $2.76. But by waiting until 6:30 (image placeholder)p.m., he traveled toll-free. "People changed their habits," he said.

The project is essentially a giant behavior-control experiment designed to distribute traffic more efficiently throughout the day and to spur more people to take public transportation. The approach, known as "congestion pricing," first gained attention in the 1950s through work by Nobel-prize winning economist William Vickery. He theorized that billing drivers for driving at peak hours would give them an incentive to modify their routines. Because even small declines in the volume of cars on the road can have a huge impact on the flow of traffic, some economists believe pricing could eliminate some of the worst snarls.

The Stockholm system, implemented by International Business Machines Corp. in a contract with the Swedish national government, used small transponder boxes, laser detectors and a network of cameras to track the path of every car in the city.

Each time a car passed through one of 23 tolling points, the system identified the car either from its transponder or by reading its license plate. It then checked it against vehicle-registration information and calculated the appropriate fee depending on the time of day and location.

Drivers using a windshield-mounted transponder, similar to the E-ZPass in the U.S., had the tolls deducted automatically from their bank accounts.

The Stockholm plan is an experiment in democracy as well as technology. One of its key elements, say urban planners, is how the city government is getting drivers to back the program. Now that the trial period has ended, the city has scheduled a referendum next month to let residents decide whether to continue the system. If the referendum fails, city officials promise to scrap the $525 million project. But they hope it will pass, and will lead to reduced congestion and smog. A poll done in June found that 52% of voters favor the plan.

Urban planners and city officials from as far away as Bangkok and New York traveled to Stockholm during the trial to review how it might be adapted to their own cities. Dublin and San Francisco are planning similar projects, and Prague and Copenhagen have the plan under consideration.

Preventing traffic tie-ups is one of the great urban puzzles of physics and economics. Solving it is more than an academic question; the time people spend stuck in traffic is essentially wasted economic productivity. "We'd love to see a Stockholm-style demonstration project in the U.S.," said Tyler Duvall, the assistant secretary for policy at the U.S. Department of Transportation.

Mr. Duvall said the referendum approach might help implement an effort in the U.S., where higher tolls are seen as politically unpalatable. "I think people would be willing to pay more if they could see that congestion was meaningfully reduced and that their quality of life improved," he said.

During the Stockholm trial, the city collected data on how the system affected air quality, parking and bus ridership. The results showed that traffic passing over the cordon decreased 22%, while traffic accidents involving injuries fell by 5% to 10%. Exhaust emissions, including carbon dioxide and particles, decreased by 14% in the inner city and by 2% to 3% in Stockholm County.

Greater Stockholm has fewer than two million people. It is made up of an archipelago of islands connected by several bridges, with a single road encircling the center. That makes the central area prone to traffic jams, despite an extensive public-transportation system. (image placeholder)

Before the trial, a drive into the city during morning rush hour used to take almost triple the time of a nonpeak trip. By the end of trial, the morning rush was just over double the time of an off-peak ride.

The Stockholm trial produced another insight into a vexing traffic-reduction programs: getting people to use public transportation. Before the trial began, Stockholm spent about $180 million on improvements to public transportation. It bought about 200 new buses, and added rush-hour trains, express bus routes and more park-and-ride lots. But the changes had little impact on the number of people who left their private cars at home. In spring 2006, however, during the trial, use of all forms of public transportation jumped 6% and ridership on inner-city bus routes rose 9%, compared with a year earlier.

In the trial, about half of the drivers opted for the transponders; cameras checked the others' license plates. People without transponders also could pay at convenience stores, which were connected to the network. Anyone trying to evade payment had their bill sent to the Swedish tax authorities for collection. Taxis, cars licensed in foreign countries and environment-friendly cars were exempt.

Putting the system in place took four months. Construction teams fanned out at night to build 23 metal archways over the roads at each charging point. The cameras and lasers had to be perfectly calibrated to identify cars as they sped by. "You have a few milliseconds to identify each car," said Johan Westman, a technical architect at IBM who worked on the project.

Mr. Westman worried that the system wouldn't be able to identify cars in the harsh Stockholm winters because of all the salt, snow and dirt on the roads and vehicles. But the trial period went smoothly and the cameras functioned well in the winter months. IBM's customer-service center, which anticipated 30,000 calls a day, fielded just 2,000 a day; and few appeals of charges were filed to the tax authorities. (image placeholder)

Some Stockholmers argue that the whole plan to reduce emissions can backfire. Lars-Inge Svensson changed the route he drove to his job at the postal service to avoid two tolling points. His new way to work was three miles longer, but he avoided about $8.40 in tolls. "I let out the same amount of exhaust fumes, or more, but at different locations," said Mr. Svensson.

Some of the biggest beneficiaries, however, weren't drivers, but cyclists and bus riders. Astrid Ericsson, a 32-year-old who lives in the city center, said her 35-minute bicycle ride to work in the morning was much less stressful during the trial. She found fewer cars and more bikes on her route. On rainy days, she took the bus, which got to the office 15 minutes faster than usual. "I will vote for it," she said of the referendum.

If Stockholm residents vote against the referendum, it could set back efforts to try congestion pricing elsewhere. "Sweden is a pretty environmentally oriented place and it has good public transport," said Hani Mahmassani, professor of transportation engineering at the University of Maryland. "If congestion pricing isn't accepted by people there, many other places will balk."
 
 
-Paul

Feldstein on current state of the economy

Tomorrow Fed's interest rate decision will be one of the
most important ones in recent years. Will Bernanke pause
as the market expected (80% bet so in futures market)?
Or will he surprise the market again (partly damage his own
reputation) by tilting the delicate balance between
inflation and growth?

The latter was suggested by Feldstein as should-be-done
(see his article below), who was the No. 1 competitor to
Bernanke's job before he was nominated.

Steve believes the rate should be at least 6% in order to
get current inflation under control, but do it gradually
(see his recent inflation update).


The Fed's Difficult Task
By MARTIN FELDSTEIN
August 7, 2006; Page A13, WSJ

A soft landing is a natural aspiration for any central bank confronting an unacceptably high rate of inflation. For today's Federal Reserve, that means bringing inflation down to less than 2% without the fall in output and employment that would constitute a recession.

The Fed governors and Reserve Bank presidents appear to believe this will happen. Their "central tendency" economic projections, summarized in the July Monetary Policy Report, state that the Fed's favored measure of inflation, the PCE price index excluding food and energy, will decline from the 2.9% rate in the most recent quarter to between 2% and 2.25% in 2007, presumably on its way to Ben Bernanke's "comfort zone" of 1% to 2% in 2008. They project this to occur with real GDP growing above 3% and the unemployment rate remaining under 5%. Indeed, not a single one of the 19 FOMC members projected growth of less than 2.5% in 2007 or an unemployment rate above 5.25%.

Although this optimistic outlook is possible, experience suggests that it is unlikely. A mild slowing of economic growth is generally not sufficient to reverse rising inflation. That generally requires a sustained period of excess capacity in product and labor markets, with GDP growth falling significantly or even turning negative.

The Fed's projected combination of strong growth and declining inflation requires either a rise in the rate of productivity growth that slows the rise in unit labor costs, or some favorable spontaneous decline of the external drivers of inflation that is unrelated to unit labor costs. Neither seems likely. Productivity growth appears to be slowing, and external drivers are pointing to a continuation of high or rising inflation.

The official estimates of productivity growth showed a gradual decline of productivity growth in the nonfarm business sector from 3.9% in 2003 to 3.4% in 2004 and 2.7% in 2005. The result of the slower productivity growth and rising compensation per hour (from a 4% rate in 2003 to 5.1% in 2005) caused the increase in unit labor costs to accelerate from 1.3% in 2003 to 2.1% in 2004 and 2.8% in 2005. Taking the new GDP estimates into account is likely to lower the calculated productivity growth rates and cause estimated unit labor costs to have risen faster than 3% in the most recent quarter. There is no reason to anticipate a favorable productivity surprise of the type that contained inflation in the 1990s.

The rapid rise in the overall cost of living creates wage pressures that make it harder to limit the rise in unit labor costs. The CPI in June was 4.3% higher than a year ago. Since wages and salaries have not kept pace, real wages were actually declining over the past year. That came to an abrupt end in June when they jumped at a 5.7% rate.

The external drivers of inflation imply that actual inflation is likely to rise even more rapidly than the unit labor cost numbers would otherwise imply. The doubling of the price of oil is being reflected in transportation costs and in the costs of goods that use petrochemical inputs. The gap between the sharp rise in real-estate prices over the past few years and the much smaller rise in rents is now causing a catch-up in rents, and in the implicit rental prices that the government statisticians impute to owner-occupied housing. The decline of the dollar in the past year, and its likely further decline in the year ahead, will boost the prices of imports and of domestic goods that compete in global markets. The expected rate of inflation implied by comparing the yields on Treasury Inflation Protected Securities and ordinary Treasury bonds has increased during the year to 2.6%.

But while a decline in the core inflation rate may not be compatible with the FOMC's "central tendency" growth projections, the interest rate hikes of the past two years could soon cause a significant and sustained economic slowdown, bringing down future inflation without the need for further rate hikes. Although it is too soon to tell, some FOMC members may oppose a rise in the interest rate at tomorrow's meeting because of this possibility, and because of their fear that another rate increase could lead to an unnecessarily deep economic decline.

The published forecasts of the FOMC members do not capture the full range of each individual's views. While stating that the most likely growth is 2.5%, an FOMC member may also believe that there is a risk that the growth and employment picture could be substantially worse than his or her forecast. As Alan Greenspan emphasized, monetary policy is a balancing of risks and cannot be made on the basis of the most likely projections alone.

The consequences of the past interest rate hikes are difficult to predict. The fall in the real level of house prices has caused residential construction to plummet, with housing starts off 14% from 12 months ago. The combination of lower housing wealth and a sharp fall in mortgage refinancing may cause the household saving rate to return to a positive level, bringing down consumer spending. Business expenditures on equipment and software slowed sharply in the most recent quarter. So a much sharper slowdown than the central tendency forecasts is certainly possible.

While this risk provides a rationale for a pause at tomorrow's meeting, it would be wrong to focus just on this downside risk. The probability that inflation will rise above the FOMC forecast is at least as great. The unemployment rate of 4.8% still represents a tight labor market. Waiting for more data before deciding to raise rates is not costless. If the Fed does not act and core inflation continues to rise, expected inflation may rise further. Higher expected inflation would cause faster increases in wages and prices. If the core PCE inflation rate rises above 3% in 2007, it would take a very substantial slowdown and a large loss of GDP and employment to bring it back under 2%.

In assessing the current interest rate decision, the FOMC members should recall that during the Volcker and Greenspan years the Fed pushed the fed funds rate to 8% above the concurrent rate of CPI inflation in the early 1980s, to 4% in 1989 and to almost 3% in 2000. That measure of the real fed funds rate is now less than 1%.

The Federal Reserve has a difficult task ahead. It is understandable that it would like to achieve the soft landing of low inflation with continued solid growth. But that may not be possible. And if the Fed wants to convince the markets that inflation will be contained in the future, it must show that it is willing to take the risk of tightening too much.

Mr. FELDSTEIN, professor of economics at Harvard, was chairman of the Council of Economic Advisers under Reagan.


-Paul
ps: you can bet on interest rate on hedgestreet.com.

Some opposite view in contrast to market's reaction last week on Bernake's comments. Also attached is a link to Cecchetti's view on current state of inflation. I happened to believe also the Fed raised the interest rate too slow back in 2003-05.


The Fed's Logic
appeared on wsj

Every investor likes to believe that the bad news is behind him, so stocks understandably soared yesterday on Fed Chairman Ben Bernanke's allegedly dovish testimony to Congress on the future course of interest rates. For our money, however, yesterday's bigger and less reassuring news was the Commerce Department's June inflation report.

The June consumer price index proved, if more proof were needed, just how big a monetary policy mistake the Fed made from late 2003 through 2005. The government's price indices operate on a lag, often as long as 24 months, and they are now showing a marked inflation revival that too many economists and pundits, including more than a few Fed Governors, have been reluctant to acknowledge.

Overall prices rose in June by 0.2%, a deceptively low number since it included a big decline in energy prices for the month; the real signal is that inflation has set in across the breadth of the U.S. economy. For the last 12 months prices have climbed at an annual rate of 4.3%, and for the last three months by 5.1%. So-called "core" inflation -- sans food and energy -- rose 0.3% in June and is now well above the 2% annual rate that the Fed says is at the top of its tolerable range. For the last three months, "core" inflation is up a scary 3.6%.

So when Mr. Bernanke declared in his testimony yesterday that "Inflation has been higher than we had anticipated in February," he was understating things by a good measure. The Fed has been wrong for a lot longer than February; it has merely taken the conventional price indices this long to make some people believe it.

One striking, and perhaps worrying, part of Mr. Bernanke's testimony yesterday was his implicit logic that real economic growth will soon slow down, therefore we don't have to worry about inflation as much, ergo interest rates may not have to keep rising. Mr. Bernanke is too good an economist to actually believe this . Real GDP growth (defined as growth less inflation) can decline even as prices are rising fast and nominal growth continues to roar. What the Fed should be watching is less real GDP than real prices, and this is where the Fed took its eye off the ball by staying too loose for too long.

Mr. Bernanke is still scrambling to catch up, and the danger looking ahead is that the Fed will have to raise rates more than if it had tightened money faster and earlier in the final years of the Alan Greenspan era. Investors in stocks were betting yesterday that the interest-rate increases are almost over, though we wouldn't bet our own mortgage on it. Stocks were also perhaps oversold last week due to Middle East worries. More price increases are baked in the cake in coming months, and those will surely test whether the Fed can make its much-ballyhooed "pause" in raising rates at its August meeting -- and for how long.

Our own belief is that the Fed has substantially increased the chances of a recession in the next year or two by failing to blunt inflationary expectations early enough. Let's hope the economy's current supply-side momentum, led by very strong business investment, and stronger global growth will offset the impact of higher rates and $75 oil. Monday's Fed report of a big 0.8% jump in June industrial production was an encouraging sign that business spending and manufacturing remain strong.

One question for the Fed, and especially for its staff, is whether its inflation mistake will lead to any policy introspection. Mr. Bernanke is surely right, as he said yesterday, that "monetary policy makers operate in an environment of uncertainty." But those policy makers also continue to downplay, or even dismiss, the relevance of such real-time inflation signals as a weak dollar and the soaring price of commodities including gold. Those prices have been warning the Fed about future inflation for a long time. Some policy reflection can be good for the soul, and even better for the economy.

Link to Steve's most recent inflation update: http://people.brandeis.edu/~cecchett/pdf/inf_current.htm


-Paul