Easy money
What’s Puffing up Profits?
Inflated fears, deflated hopes
Dollar dilemma
Corporate America : A Trying Year
Dow 12,000? Hmmm

Is America’s Federal Reserve running risks with inflation?

THE Federal Reserve left its key interest rate unchanged at 1% this week, and said it could still afford to be “patient” before raising rates. Although many economists do not expect the Fed to increase interest rates until next year, others argue America is now growing at such a clip that the Fed needs to touch the brakes to prevent inflation taking off again.

As growth has picked up, so has the talk about inflation. The explosive growth of the third quarter (8.2% at an annual rate) started the debate. The slower but more sustainable growth of 4% in the fourth quarter (according to figures released on Friday January 30th) will keep the issue alive. Booming commodity prices and a weakening dollar (which could push up import prices) also argue for a pre-emptive rise in interest rates.

But concerns that inflation is about to pick up are probably overdone. For one thing, inflation is currently too low. Over the past 12 months America’s core consumer-price index (ie, excluding food and energy) rose by only 1.1%, and the Fed’s favourite measure of inflation, the core personal consumption expenditure deflator, by only 0.8%—the smallest rise in the 45-year history of that index. This is well below most estimates of the Fed’s desired rate of inflation of 1.5-2%. So the Fed would be happy if inflation rose a bit.

On present trends inflation could even fall further. Inflation is not driven by the rate of growth, but by the amount of slack in the economy. When output is below its potential, inflation tends to fall even if growth is brisk. Goldman Sachs estimates that America’s GDP growth is still almost two percentage points below its potential.

There is more evidence of slack in the labour market, where weak demand for new workers is helping to hold down wage growth. Average wages have risen by only 2% over the past year and are unlikely to pick up by much until the unemployment rate, currently 5.7%, falls to 5%. Meanwhile, productivity has surged by 5% over the past year, resulting in a sharp drop in unit labour costs (see chart). This is another reason to expect inflation to edge lower over the next year.

The falling dollar is a risk, it is true, but it has yet to have an effect: import prices have been broadly flat over the past year. One reason is that, although the dollar has fallen sharply against the euro, its broad trade-weighted value has fallen by only 8% over the past 12 months. Movements in currencies also tend to have less impact on inflation in America than elsewhere, partly because it imports less. Nevertheless, a further sharp fall in the dollar would eventually feed through into inflation.

Prices, then, are in little danger of being pushed up by the cost of labour or of imports. Might they be pulled up by demand? The latest figures suggest not. With wages almost flat, consumers are relying on tax cuts to boost their take-home pay. The $14 billion-worth of child tax credits mailed out in July and August helped to boost third-quarter consumer spending by 6.9% at an annualised rate. But without this artificial stimulus, growth in consumer spending slowed to just 2.6% in the fourth quarter.

Ben Bernanke, a governor of the Federal Reserve, has argued that there is no need to raise interest rates until inflation starts to rise. He may be right about consumer-price inflation. But there is a big risk that the current “easy money” policy is spilling over into inflation in the price of shares and houses.

Not only does this risk creating another bubble, but rising asset prices are encouraging already over-indebted households to borrow yet more to invest in already-pricey assets. Total household debt rose by 11% in the year to the third quarter of 2003, more than twice as fast as incomes. In a new report Andrew Smithers, a London-based economist, argues that American share prices are at least 60% overvalued. House prices also look alarmingly high.

The debate about whether the Fed should worry about booming asset prices when inflation is low is therefore likely to hot up again in coming months. A big difference between today and the bubble of the late 1990s is that inflation is now even lower, so the risks of deflation are greater if the Fed gets monetary policy wrong.

The Fed’s dilemma is simple. It needs to keep monetary policy loose to prevent inflation falling. Yet by holding interest rates low it may be fuelling an asset bubble, which when it bursts could make deflation even more likely since there is much less room for fiscal and monetary stimulus than after the bursting of the previous one.

Monetary policy is extraordinarily loose. An old rule of thumb is that when interest rates are lower than the rate of growth in nominal GDP, monetary policy is expansionary. Nominal GDP has grown by 6% over the past year, well above the 1% rate of interest. A small rise in interest rates would still leave monetary policy very loose. But it would give a warning to investors in shares and houses that the good times cannot last forever.

UN agencies have appealed for funds to halt the rapid spread of a lethal strain of bird flu, which they fear could soon evolve into a deadly human disease. Is a global pandemic far worse than the SARS outbreak on the way?

THE great influenza pandemic at the end of the first world war is estimated to have killed up to 50m people worldwide—a far higher toll than even that of the war itself. Besides being highly contagious, flu viruses mutate rapidly, which means that new versions can quickly emerge, against which the body’s immune system may be powerless. Especially deadly are flu strains in birds and animals that have jumped the species barrier to become virulent human diseases, transmissible from person to person.

Now, three United Nations agencies fear that a strain of bird flu, known as H5N1, which has been spreading like wildfire across Asia and is already thought to have killed ten people, could become pandemic in humans if not stopped quickly. On Tuesday January 27th, the World Health Organisation (WHO), UN Food and Agriculture Organisation and the World Organisation for Animal Health jointly issued an urgent plea for funding to halt the new bird flu, which they said could quickly evolve into “an efficient and dangerous human pathogen”. And on Wednesday, an emergency summit on the outbreak was held in Bangkok, with representatives from 13 countries, the three UN agencies and the European Union (EU). On the same day, it was announced that the epidemic itself had arrived in the Thai capital from outlying provinces.

The summit’s host, Thailand’s prime minister, Thaksin Shinawatra, admitted that his government had made errors in handling the outbreak, but his officials denied accusations of a cover-up: last week Mr Shinawatra’s cabinet staged a lavish chicken lunch to reassure both locals and the foreigners who buy more than $1 billion-worth of Thai poultry a year. The two largest importers of Thai chicken, Japan and the EU, have since imposed temporary bans on it. The virus is believed capable of surviving for years in deep-frozen poultry but can be killed by cooking the meat thoroughly.

The countries represented at the summit pledged a co-ordinated fight against the disease and issued a declaration that mass culling of infected poultry flocks was the best way to control its spread. This prompted Indonesia to drop its earlier argument that it could not afford to compensate its poultry farmers for a mass culling.

There had been no recorded cases of bird flu infecting people until an outbreak of H5N1 among poultry in Hong Kong in 1997. Eighteen people suffered severe respiratory illness after contact with infected birds; six of them died. A decision was taken to cull Hong Kong’s entire poultry flock of about 1.5m birds in just three days. By denying the flu strain further opportunities to infect humans, this swift action may have prevented a pandemic, says the WHO.

The WHO has said that the current outbreak of H5N1 in birds started in South Korea in December. However, New Scientist, a British magazine, said experts had told it that the outbreak probably began a few months earlier in China. The Chinese government angrily denied the allegation of a cover-up. Whatever its origin, the disease has spread rapidly and is now believed to be affecting ten Asian countries.

As with the 1997 outbreak in Hong Kong, those people who have so far been struck by H5N1 seem to have picked it up from direct contact with infected birds. As yet, there is no evidence that the virus can pass from person to person. But flu viruses can swap genes with each other, so if someone carrying a human flu virus catches the new bird flu, the two strains could mingle inside the victim’s body, creating a new, highly contagious and lethal human plague. Fortunately, such a doomsday scenario is unlikely: none of the other recent outbreaks of avian flu resulted in human epidemics. But it is not impossible. Two flu pandemics (in 1957 and 1968) that caused large numbers of human deaths were caused by human and animal viruses mingling to form hybrids.

The alarming statements by the WHO and other UN agencies this week may in part have been prompted by a widespread feeling that health authorities in Asia failed to act quickly enough last year to contain the SARS virus, a hitherto unknown human infection. Eventually, the outbreak was largely contained, with about 8,000 people becoming infected, of whom about 800 died (though fresh cases have been reported in China this month). However, there were severe economic side-effects: the Asian Development Bank reckons SARS cost Asia $60 billion in lost revenues, with airlines and tourism especially hard hit.

SARS was a completely new disease in people, whereas any new, human version of H5N1 would be merely a new strain of an old enemy. This ought to be of help in combating it. Already, there are diagnostic tests for the flu strain and effective (though costly) antiviral drugs to treat it. Even so, says the WHO, it would take at least four months to create and start mass-producing a vaccine against a new, human-to-human version.

According to the WHO, public-health experts are agreed that another worldwide flu pandemic is “inevitable and possibly imminent”. But there is no need to panic, yet. Unlike at the end of the first world war, there is now a global disease-surveillance system which would sound the alarm if H5N1 showed signs of being able to pass from person to person. Even if it does, it may evolve into only a mild ailment that most healthy people would survive. Still, the spread of the disease, and the authorities’ response to it, need to be monitored carefully.

Investors are seeing what they want to see in the corporate-profits picture

THERE you are, trying to map-read your way to somewhere you’ve never been to, having already taken an unconscionably large number of wrong turns, and every other minute daughter number two asks how long it will be, exactly, until we arrive. And then, at last, there is a road that you recognise, and everyone is again wreathed in smiles. Buttonwood has been having similar troubles with the American stockmarket, with the added complication that not only is the map unfamiliar and difficult to read, but it keeps changing. It is not a market that he likes especially, though it is popular anyway for reasons that are largely unconnected with value. But the terrain is becoming familiar again: Buttonwood recognises irrational exuberance when he sees it.

Some 140 companies in the S&P 500 are due to announce their results this week. Doubtless they will be cheeringly good: those that have already done so have beaten analysts’ expectations by some 6%, and there is little reason to suppose that the rest have done worse. But then they will need to be good, so high are investors’ expectations. Stockmarkets have already climbed a long way from their lows in March of last year—the S&P is up by 44%, and Nasdaq by 69%; and judging by all the available indicators of appetite for risk, investors expect more of the same. A lot more, in fact. But how much will profits have to grow to drive stockmarkets still higher? And how sustainable is this surge in profits?

Investors are certainly gluttons for risk at the moment. There are any number of ways of measuring this. Most risk-appetite indicators look at the performance of risky assets, such as corporate or emerging-market bonds. These have flown, and risk indicators are correspondingly high. Perhaps the simplest way of discerning appetite for risk, however, is to ask fund managers how much risk they are taking. This is what Merrill Lynch has done in a monthly survey since the beginning of 1999. The latest results are striking. In the ten months since March of last year, when risk appetite among investors was the lowest the firm had recorded, appetite has climbed to the highest the firm has seen—higher even than during the euphoric months before the stockmarket bubble burst in March 2000. Buttonwood has said it before and he will say it again: if things can’t get better, they can only get worse.

There is certainly plenty of scope for disappointment. Investors have very little in cash; they hate Treasuries almost to a man (two-thirds of respondents think they are overvalued); and most think that shares are fairly valued, with prices likely to be propelled further upwards by higher profits. On this last question, a dose of scepticism is in order. Last week’s column looked at the astonishing profitability of American financial firms. Citigroup, to take one example, made more money last year than any company has ever made, and financial firms make up about a third of corporate profits, which is unsustainable. A bigger question is whether profits for non-financial firms are also being temporarily flattered, to which the answer is: most probably.

Profitability, it is true, seems to have been boosted by cost-cutting, which has allowed any growth in revenues to flow straight to the bottom line. There are, however, limits as to how much cost-cutting can drive future profit growth. To push profits up further, demand has to rise—in the jargon, companies need to boost top-line growth. In America, this is a problem. It requires the public to spend more than the huge amount it already spends. Yet America’s savings rate is anyway a niggardly 1.7%, and it seems unlikely that it can fall much further given how indebted Americans already are.

Perhaps demand would grow if job growth were not as anaemic as it apparently is, since more people would have money in their pockets. But if jobs do start to flow more freely, firms would presumably have to spend more to keep hold of treasured employees. Wall Street provides a nice example. Heartening though it was for its firms to have made record profits last year, this was at the expense (if that is the right word for an industry not known for its parsimony) of its employees. Were Wall Street’s finest to be paid more, profits would fall.

How about foreign demand? The fall in the dollar should clearly have been a boon, both by making exports cheaper and by increasing the dollar value of goods that American companies sell abroad in strengthening currencies. But the actual amount of goods that American companies are exporting has not risen that much—much of what America exports is not that sensitive to currency movements. And a rise in the dollar value of widgets can make foreign demand seem stronger than it is.

This is especially evident in the market for high-techery of one sort or another, shares in which are, to put it mildly, generously valued. In fact, IT spending around the world, though rising, is certainly not soaring, though it appears healthier than it is because of the effects on revenue growth of a falling dollar. In general, companies are making do with the technology they already have. Moreover, unless the dollar continues to fall, the effect on profits will fade. And the truly astonishing thing is that, despite the falling dollar, the anyway low proportion of profits earned overseas fell from 21% in 2001 to 14% at an annual rate in the third quarter of last year, according to the Commerce Department.

A much bigger (though much less talked about) source of profits has been a fall in the corporate tax rate. In the third quarter, according to estimates from Smithers & Company, a research firm, the rate was some 25%. From 1990-2000 it varied from 35-40%, but fell sharply after September 11th 2001, because companies were allowed to accelerate the depreciation of their assets for tax purposes. The mechanics of how all this works are complex, but the effect on profits is not: they have been hugely flattered. In the third quarter of last year, after-tax profits would have been a fifth lower at an annual rate had there not been this allowance and assuming a corporate tax rate of 40%. The allowance is due to run out at the end of this year.

As in the late 1990s, however, investors are seeing what they want to see. And what they want to see is their risk-taking rewarded and a nirvana in which corporate America, cleansed of wrongdoing and excessive debt, can get back to the business of making lots of money. Share prices reflect this—but there’s a long way to go yet.

The Chinese fear inflation; the Japanese long for it

WILL the year of the monkey be marked by economic mischief? The Chinese celebrated the lunar new year on Thursday January 22nd, gladdened by the news that the economy grew by 9.1% in 2003. But this heartening performance has stoked fears that the Chinese economy is overheating. It wouldn’t be the first time. During the last year of the monkey, in 1992, China’s then leader, Deng Xiaoping, made his famous tour of the south, urging the country to make the most of its new economic liberties. Liberty soon slid into licence, however, and within a year or two the economy was struggling to cope with rampant over-investment and inflation over 20%.

This year marks an equally troubling anniversary for China’s neighbouring economic giant, Japan. It was ten years ago that the economic superpower fell into a deflationary quagmire from which it has yet to escape. Core consumer prices registered a small increase in October, but fell again in November. The GDP deflator, a broader measure of prices, continues to fall by over 2% a year. While the Chinese authorities are acting smartly to head off inflation, the Japanese authorities are actively seeking it.

Inflation, said Milton Friedman, a Nobel prizewinning economist, is always and everywhere a monetary phenomenon. Maybe so. But Japan has phenomenal amounts of money, and inflation remains always and everywhere elusive. The Bank of Japan is pursuing a policy of “quantitative easing”. It cannot lower the price of money any further—nominal interest rates are already at zero—so it has boosted the quantity of money in the economy instead. Over the past two years, this policy has increased the monetary base by half. On Tuesday, the central bank surprised onlookers by increasing the money supply still further. It now aims to flood the banking system with reserves of ¥30 trillion-35 trillion ($280 billion-330 billion), up from its previous target of ¥27 trillion-32 trillion.

In China too, the money supply is increasing, though not with the central bank’s blessing. To maintain its currency peg, the People’s Bank of China has to create enough yuan to satisfy foreign demand for the currency at the going rate of 8.3 yuan to the dollar. As a result, it is losing its grip on the amount of liquidity in circulation. Broad money is growing by around 20% a year. Bank lending is expanding in step. Investment in plant, equipment and other capital assets is growing at rates not seen since the runaway years of 1993-94. Inflation has edged up, from negative territory a year ago to 3.2% now.

Even so, fears of overheating may be a little overdone. China’s modest inflation can be put down to a disappointing harvest, which raised food prices. There may be shortages in some sectors, such as electricity generation, but there is still much slack to be taken up in the rest of the economy. Labour in particular is never in short supply. Unemployment among those who have left the fields for the cities is thought to be quite high. Underemployment among those who work in loss-making state-owned factories is still higher. To keep the factory workers and peasants happy, China must mobilise labour on a grand scale. Economic growth of 9% or more is not surplus to requirements, because the country’s requirements are so stiff.

China is mobilising capital on an equally grand scale. According to official statistics, its investment rate is around 40% of national income and growing. The fear is that once mobilised, this capital will be mis-allocated. China’s state-owned commercial banks make over 60% of the country’s loans. Past history suggests they do not lend well. With marvellous understatement, the People’s Bank of China admits that the “mechanism of internal control” at these banks “still needs improvement”.

In the meantime, the Beijing authorities have taken to curbing, restricting or rationing the allocation of capital themselves. Investments in steel, cars, aluminium and luxury housing are all subject to new regulations. Last September, the central bank went a step further, raising the reserve requirements for banks in the hope of curtailing lending. The policy seems to be working for now. Bank lending in the final quarter of last year seems to have slowed.

If China’s problems stem from banks too willing to lend, Japan’s stem from banks unwilling to lend at all. Loans in Japan have fallen for 72 months in a row. Banks are reluctant to lend because the bad loans of the past still weigh heavily on their balance sheets; entrepreneurs are reluctant to borrow because demand for their products is weak and the price they can fetch for them falls every year; and, completing the vicious circle, households are reluctant to spend because goods will be cheaper next year. As a result, however much money the Bank of Japan creates, it is not being lent, borrowed or spent.

With spending at home flat, Japan relies more than ever on spending abroad. Indeed, the boom in nearby China may represent its best hope of escaping from its doldrums. Japan’s export-led recovery, now almost two years old, owes much to surging Chinese demand for its products. Morgan Stanley reckons that China accounted for no less than 66% of Japan’s export growth in the first nine months of 2003. In the space of a year, China has been transformed from scapegoat to saviour in Japan’s eyes. In December 2002, Japanese officials publicly rebuked China for exporting deflation around the world. Now, many recognise that it is helping their economy to reflate.

But Japan’s hopes may be thwarted by China’s fears. By taking steps to avert inflation in their own country, the Chinese authorities may halt the return of inflation to Japan. If the Chinese economy slows this year, its appetite for Japan’s exports will wane and its role as an engine of growth in the region will weaken. The Chinese believe that the year of the monkey is capricious and unpredictable. The Japanese may soon believe it too.

American banks are making very big deals and very big—nay record-breaking—profits. But for how much longer?

EVEN casual readers of the financial press will have noticed that another big banking merger was announced last week in America. This latest, between J.P. Morgan Chase and Bank One, will create America’s second-biggest bank by assets, which is to say a very big bank indeed, since the assets concerned amount to some $1 trillion or so. It follows on the heels of another megamerger, announced last October, between Bank of America and FleetBoston, which would have created the second-biggest bank had it not been for this latest deal. Most writers were swept along by the scale of the transaction and the undeniable human drama: Bank One’s boss, Jamie Dimon, was the protégé of Sandy Weill, the (apparently) former head of Citigroup, America’s biggest bank, before he was elbowed out by his mentor. Mr Dimon, it seems, is to come into a handsome inheritance after all, since he will become the chief executive of the new bank when Bill Harrison retires.

All good stuff. But what strikes Buttonwood is something else, albeit connected to this latest wave of coupling: America’s banks are astonishingly, jaw-droppingly profitable. Financial firms now account for a third of all corporate profits, compared with some 18% in 1988, their recent low. On January 20th, Citigroup announced that it made an astonishing $17.9 billion after tax last year—more than any financial institution has ever made—and a raft of other banks announced higher fourth-quarter profits on the same day. If the sector continued to make as much as it did in the third quarter, it would, according to figures compiled by Andrew Smithers, an independent consultant, rake in some $283 billion for the year as a whole—and this now seems a conservative forecast.

Why are the banks making so much money, and will they continue to do so? For those to whom reading this column is something of a chore, the answer to the second question is intimately connected to the answer to the first, and can be briefly summarised as “no”.

Banks, as Mr Smithers points out, essentially take two risks: credit risk—the risk that a borrower won’t pay the money back—and what is succinctly dubbed maturity-transformation risk—taking in short-term deposits and lending the money out for a longer term at a higher rate of interest to companies or the government (by buying government bonds). Historically, banks have not been very good at managing either of these risks, which is why there have been so many banking crises in America, and elsewhere, over the years.

But American banks have been especially vulnerable, because until the mid-1990s laws made it very difficult for them to expand across state boundaries. Banks were thus small, even the biggest ones, and undiversified. So a property crisis in New England, say, would have a dramatic (and often fatal) effect on banks that could largely operate only in that region. After the laws were scrapped, banks started to leap into bed with one another. At the end of 1993, there were 10,600 banks in America; by September last year, there were 7,875. This process has not only made banks more diversified and stable, but it has also allowed them to strip out masses of overlapping costs. Bank One grew in exactly this way.

But if banks have been more stable, the environment has also undoubtedly been much kinder to them of late. The fact that hardly any banks have gone bust in recent years (just two went under last year, neither big), even after the popping of one of the biggest stockmarket bubbles in history, is not just a matter of skill. Credit risk has been of fairly minor concern because few borrowers have gone bust. Although a few big, well-known companies folded after the stockmarket fell, banks have in fact had to write off very few bad loans. Charge-offs for corporate lending, for example, peaked in December 2001 at just over $6 billion and have halved since then. They are likely to continue falling, partly because corporate profits have soared, but also because of a renewed surge in investors’ appetite for risk, which has kept many a rocky company afloat. Moreover, consumers have kept spending, which has kept the economy buoyant and problem loans low.

For that, thanks goes mostly to Alan Greenspan and his colleagues at the Federal Reserve, for slashing interest rates to the bone and saying that they will keep them there. Low and falling short-term rates have been a bonanza for banks for another reason, too. The difference between short- and long-term rates, otherwise known as the yield curve, is close to historic highs, even though long-term rates have fallen remorselessly over recent years.

The result is that maturity-transformation risk has paid off handsomely: banks have snaffled up deposits and lent the money on at much higher rates. Better still, the value of the loans or securities in which they have invested (or most of them, anyway) has climbed as long-term rates have fallen. Mortgage-backed securities have been an especially profitable business. At the peak, commercial banks held some $400 billion of such paper.

In such conditions, in other words, bankers would have to be more than usually stupid not to thrive. Sadly, the wonderful times are unlikely to continue. Ten-year Treasury yields are now 4%, which is decidedly odd for an economy that is growing as fast as America’s. If growth peters out, bond yields will fall further but bad loans will rise and the difference between short- and long-term rates will narrow, since there is little scope for the Fed to push short-term rates down further than their current 1%. If growth continues to pick up, on the other hand, bond yields will rise, perhaps sharply, and so will short-term rates, perhaps even more sharply. Since much “restructuring” of corporate balance sheets has been flattered by low interest rates, it would not be entirely surprising if, to add insult to injury, bad loans mounted too.

Which is where the latest megadeal comes in. Bizarrely for a developed economy, banking has been a growth business in America over the past decade. Since 1995, the banking component of the S&P 500 has returned 240%, outperforming the overall index by almost 100 percentage points. But banks are having to run very fast indeed to boost profitability. Too fast, perhaps. J.P. Morgan Chase is about to embark on another merger, even though the one that formed it in 2000—J.P. Morgan’s marriage to Chase Manhattan—still looks decidedly uncomfortable. A benign, profitable environment makes most deals look magical, since banks can throw money at problems. Whether the deals will work when things are choppier is quite another matter. But to keep profits up, banks will continue to couple.

A dramatic cut in Shell's reserves has the oil world buzzing

HOW on earth can an oil company lose a fifth of its reserves overnight? And not any old oil company, but that very model of a modern oil major, Royal Dutch/Shell, which has long boasted of the excellence of its management.

On January 9th, Shell said that it was downgrading nearly four billion barrels of oil and gas—a whopping fifth of its total reserves—from “proven” reserves to “probable” or other, even less-certain, categories. As proven reserves are one of the main metrics used by analysts to value oil firms, investors were not pleased. Shares in the world's third-biggest oil firm promptly fell by 7%, amid fears of worse to come.

In some respects, Shell's shock news is not as bad as it seems. The firm has not actually lost any oil. Michael Lynch of Strategic Energy & Economic Research, an industry consultancy, explains that, under the oil industry's murky accounting practices, “shifting a project from proven to probable is like moving it out of a cash account to accounts receivable. It is still an asset, but not as valuable because of the lower certainty.” Shell still expects to bring most of the reclassified oil and gas to market eventually. It stresses that there has been no restatement of financial results, like at Enron or WorldCom—though it is surely undeniable that the firm has restated data of great importance to investors.

Still, this fiasco could yet lead to big changes, both at Shell and in the industry as a whole. The firm's boss, Sir Philip Watts, was never a favourite of investors, but now he faces intense pressure to go. He has long been seen as aloof and uncommunicative—an impression he reinforced this week by going to ground and leaving other executives to manage the bad news.

Now investors are questioning his competence. The revised figures suggest that, on Sir Philip's watch, Shell has performed far worse than previously thought on several important measures. Wood Mackenzie, a consultancy, calculates that in 1997-2002, the firm's rate of replacement of reserves—which are inevitably depleted as firms pump hydrocarbons out of the ground—was not 105% as previously thought, but an abysmal 57%, significantly below that of both BP and Exxon Mobil (see chart). Recalculated, Shell's “finding and development” costs in that period jump from an already relatively high $4.27 per barrel to $7.90 per barrel.

There is no evidence of criminal wrongdoing. And there is no precise legal standard or industry agreement on how to classify reserves. Under guidelines on what firms can call “proven reserves” issued by America's Securities and Exchange Commission (SEC), managerial discretion is allowed and reclassifications tolerated. Indeed, revisions—both up and down—are fairly common. What is uncommon is the breathtaking size of this reduction in reserves, the largest ever.

As has been widely noted, Sir Philip was previously in charge of Shell's exploration and production. That means that he knew, or should have known, how accurately the firm was booking new oil and gas discoveries. All eyes will be on him at Shell's fourth-quarter results presentation, due on February 5th—if he is there.

Shell's error may prompt an industry-wide move towards standardisation, and perhaps firmer regulation, of the booking of reserves, even though Shell's rivals are standing by their own numbers. Chevron Texaco and Exxon Mobil, for example, are Shell's partners in Australia's giant Gorgon gas project, which accounted for a big part of Shell's recent reclassification. But, unlike Shell, both firms say that they did not book Gorgon's reserves as proven.

The rewriting of Shell's history is so dramatic that the SEC is likely to investigate. It already has a small enquiry under way, triggered by questions about how firms were booking reserves in the deep waters of America's Gulf of Mexico.

Investors, too, may demand greater transparency. After all, if they can't be sure of trusty old Shell, how can they believe smaller, perhaps shadier, operators?

The most ironic suggestion now making the rounds is that the world's biggest oil companies should permit independent verification of reserves by outside consultants. Russian oil firms, with a well-deserved reputation for dodgy dealings, were forced to adopt that sensible if ego-deflating measure in order to satisfy the demands of western investors. How embarrassing it will be if the industry's proudest names are now put to the same test of transparency.

The uncertain promise of computing that is foolproof, invisible and everywhere

IT IS increasingly painful to watch Carly Fiorina, the boss of Hewlett-Packard (HP), as she tries to explain to yet another conference audience what her new grand vision of “adaptive” information technology is about. It has something to do with “Darwinian reference architectures”, she suggests, and also with “modularising” and “integrating”, as well as with lots of “enabling” and “processes”. IBM, HP's arch rival, is trying even harder, with a marketing splurge for what it calls “on-demand computing”. Microsoft's Bill Gates talks of “seamless computing”. Other vendors prefer “ubiquitous”, “autonomous” or “utility” computing. Forrester Research, a consultancy, likes “organic”. Gartner, a rival, opts for “real-time”.

Clearly, something monumental must be going on in the world of computing for these technology titans simultaneously to discover something that is so profound and yet so hard to name. What is certainly monumental, reckons Pip Coburn, an analyst at UBS, is the hype, which concerns, he says, “stuff that doesn't work yet”. Frank Gens at IDC, another tech consultancy, quips that, in 2004 at least, “utility” computing is actually “futility” computing.

Yet as a long-term vision for computing, what the likes of IBM, Microsoft and HP (and Oracle, Sun, etc) are peddling is plausible. The question is, how long will it take? Some day, firms will indeed stop maintaining huge, complex and expensive computer systems that often sit idle and cannot communicate with the computers of suppliers and customers. Instead, they will outsource their computing to specialists (IBM, HP, etc) and pay for it as they use it, just as they now pay for their electricity, gas and water. As with such traditional utilities, the complexity of the supply-systems will be entirely hidden from users.

The potential for a computing infrastructure such as this to boost efficiency—and even to save lives—is impressive. Irving Wladawsky-Berger, an in-house guru at IBM, pictures an ambulance delivering an unconscious patient to a random hospital. The doctors go online and get the patient's data (medical history, drug allergies, etc), which happens to be stored on the computer of a clinic on the other side of the world. They upload their scans of the patient on to the network and crunch the data with the processing power of thousands of remote computers—not just the little machine which is all that the hospital itself can nowadays afford.

For its nuts and bolts, this vision relies on two unglamorous technologies. The first is “web services”—software that resides in a big shared “server” computer and can be found and used by applications on other servers, even ones far away and belonging to different organisations. Mr Wladawsky-Berger's hospital would be getting the patient's info from his home clinic through such a web service.

The second technology is “grid computing”. This involves the sharing of processing power. The best-known example is a “search for extra-terrestrial intelligence” project called SETI@home, overseen by the University of California at Berkeley. Nearly 5m people in 226 countries have downloaded a screensaver that makes their computer available, whenever it is sitting idle, to process radio signals gathered from outer space. The aim is to find a pattern that may be from aliens. Mr Wladawsky-Berger's hospital would similarly crunch patient-data using the internet, or grid, as if it were a single, giant virtual microprocessor, but for a more earth-bound purpose.

Both technologies have made great strides recently. Web services, for instance, need common standards and protocols. Some basic standards already exist—awkward acronyms such as XML, SOAP and WSDL provide a rudimentary grammar to let computers talk to each other. But the sticking point, says Phillip Merrick, boss of webMethods, one of the pioneers in the field, has been the many other fiddly but necessary protocols for security, transaction certification, and so on. A breakthrough occurred in October, when the two superpowers, IBM and Microsoft, simply got up on a stage together and declared what protocols they will use. Dubbed “WS splat” by the geeks, this ought to speed up the adoption of web services.

Web services are currently most visible in the business model of so-called application service providers. These are firms that offer to host software applications and databases for customers for a monthly fee—an analogy would be for firms to do their e-mailing via Yahoo! or their buying via eBay. The most successful is Salesforce.com, a San Francisco firm that, as the name says, specialises in software for managing customer information and marketing leads. It says that it was poaching so much business from a more traditional seller of customer-relations software, Siebel Systems, that Siebel had to adopt the model itself. In October, Siebel teamed up with IBM and now also offers its software as a service over the internet.

Nonetheless, this particular form of web services is overhyped, says Rahul Sood of Tech Strategy Partners, a consultancy in Silicon Valley. Such services appeal mostly to small businesses and firms that do not need to customise their applications very much. For the grander vision—the on-demand, adaptive, seamless, ubiquitous, organic sort—a lot more needs to happen.

At the core of the vision is flexibility—a firm must be able to make its operating costs, and therefore its computing and information costs, totally variable so that they go up and down with business volumes. Firms can improve cost flexibility today, says Mr Sood, but only if they stick with one vendor, such as IBM, or if they make only one of their many computing functions (data storage, say) flexible. But for computing to be bought and sold as a utility, firms must be able to switch vendors, to do it for all their computing functions, and with meter-based pricing. All of this will take a few more years to get right.

And yet, though some years away, the very idea of utility-style computing is making waves today. IBM already describes practically every major corporate sale, whether of humdrum servers or of comprehensive consulting, as having to do with its “on demand” vision. This is forcing HP, its arch rival, to redouble its efforts to be seen less as a box-shifter and more as a provider of “solutions”. And software suppliers are preparing for a different revenue model: instead of chunks of licence fees at point-of-sale, monthly-usage fees will trickle in from their customers.

Still, it is tempting to conclude that the current marketing hype of the big computer firms is meant mostly to obscure the humdrum reality that overall tech spending will not regain the fizz of the bubble era any time soon. Instead, the new model of computing, says Halsey Minor, founder of Grand Central Communications, one of the many firms that are now working out the details of web services, is inevitable and important, but “sooo boring”.

Nobody has a good word to say about the dollar, which may augur well for the battered currency

ONE-WAY bets should be treated with the same healthy suspicion as racing certainties. In the same spirit of scepticism—no more—Buttonwood wonders whether the time has come to start making a few more encouraging noises about the beleaguered and, it seems, almost universally reviled dollar. Bearish sentiment about the greenback seems to have increased in proportion to the currency’s sharp fall, and if your columnist has learned anything about financial markets over the years, it is that when everybody thinks that assets can only go in one direction, the reverse often happens.

The dollar’s fall from grace, and the reasons for it, are well known. America lives beyond its means, which is to say that it saves too little and spends too much. The infamous twin deficits—its huge and growing budget and current-account shortfalls—are a reflection of this. With the current-account deficit running at an annual rate of some $550 billion or thereabouts, America now needs to borrow more than $1.5 billion a day from foreigners to finance its spending habits and keep the dollar at its present level. This is not, as they say, sustainable in the long term. To make American exports more competitive and (just as importantly) imports more expensive, the exchange rate needed to adjust, ie, the dollar needed to fall. The Bush administration understands this, though the cack-handed way in which it has handled market expectations has run the very real risk of a full-blown dollar crisis.

But the decline has been orderly so far. As a result, the Federal Reserve has been able to keep interest rates at a 45-year low since it doesn’t have to raise them to attract foreign capital or to stomp on inflation (which is low and falling). Since the dollar peaked in February 2002, it has fallen by a quarter in trade-weighted terms and the speed of the fall accelerated after the G7 countries “agreed” in Dubai last September that exchange rates should become more flexible. Much adjustment, in other words, has already taken place.

The odd thing about this adjustment, however, is how unbalanced it has been. The euro has risen by half against the dollar from its low of 83 cents in July 2001—and this a currency that was almost as universally hated as the dollar is now. The yen, on the other hand, has risen by less than a fifth over the same period. The main reason for this is that the Bank of Japan, the central bank of a country with a habit of setting economic records of all the wrong sorts, has intervened more heavily in currency markets than any country has ever done before to slow the yen’s rise. Last year, it spent ¥20 trillion ($187 billion)—around 4% of GDP—on buying dollars. And, thanks to a recent change of rules, it can now buy many, many billions more.

Japan’s foreign-exchange reserves now amount to $674 billion, more than any other country has ever amassed, and far more than could be needed to guard against the sorts of things that forex reserves are traditionally used for, such as having the wherewithal to pay bills in extremis to foreign creditors. No, the Bank of Japan, unlike John Snow, America’s treasury secretary, really does believe in a strong dollar policy and is prepared to put its money where its mouth is. As, indeed, have central banks almost everywhere in Asia, not least China’s. The region’s foreign-exchange reserves now amount to $1.8 trillion, a tidy sum. Together with Japan’s central bank, the People’s Bank of China financed half of America’s current-account deficit last year. But they are buying assets in a currency that is steadily losing its worth as a store of value, which should presumably be set against any possible advantages for their exporters.

This unprecedented situation is neatly described by David Bowers, a strategist at Merrill Lynch, as the “mother of all vendor-financing deals”. In essence, Asian central banks are lending Americans cheap money (via their purchases of Treasury bonds) to buy Asian products. Mercantilism, it is clear, is alive and well. Thus, in one sense, have Asian countries ignored the lessons of their financial crisis in 1997-98, which erupted in large part because they tried to peg their currencies to the dollar to keep exports strong—and damn the long-term consequences.

Those consequences are becoming increasingly clear, starting in China, which has a fixed exchange rate. All those Treasuries it has been buying have to be converted into the yuan, the local currency. This boosts the country’s money supply and causes inflation. Speculation in one form or another, notably in property, is rife—the last thing a country with an already shaky financial system needs.

As goes China, so goes the rest of the region. At what point does a healthy dose of reflation become another bubble? At some point, it will start to dawn on Asian countries that domestic demand and exports to one another are just as important as exporting to America, and they will stop intervening. That will probably mean that their currencies appreciate against the dollar—though that is far from certain.

What is certain, however, is that European policymakers are becoming increasingly irked at having to shoulder the adjustment alone. On Monday January 12th Jean-Claude Trichet, the president of the European Central Bank (ECB), and a decidedly cannier operator than his predecessor, said that European central bankers viewed the recent “brutal” currency movements as “not welcome and not appropriate”. The euro promptly fell a bit from another record high. For now, the European economy does not seem to be doing too badly, though Lehman Brothers reckons that every 5% rise in the trade-weighted euro shaves about a quarter of a percentage point off growth and inflation. Some economists now think that the ECB will cut interest rates further, to take some wind out of the euro’s sails. Meanwhile, European policymakers are starting to make very angry noises about Asian countries not doing their bit.

So there are a number of questions, to which Buttonwood has no ready answers. The dollar has already fallen a lot, but how much further does it need to fall to correct America’s imbalances? American assets are already a lot cheaper than they were, and thus, presumably, more attractive to foreign buyers. How long will European policymakers be content to see the euro rise so sharply when Asian currencies are not? Judging by comments from Mr Trichet and others, not that much longer, especially given that Europe’s recovery is a lot more fragile than America’s seems to be. And how long will Asian countries continue to spend money building up foreign-exchange reserves that earn next to nothing and carry the risk of currency losses, rather than use the money to invest in their own region, which seems set to grow an awful lot in coming years. Fund managers’ view of the dollar is at an all-time low—reason enough, one might have thought given their track record, for being a bit more bullish.

Corporate America starts 2004 in its sunniest mood for four years, with profits on the up and the latest scandal—Parmalat—reassuringly far away. But the allegations against Enron's Andrew and Lea Fastow and a slew of corporate trials will ensure that corporate misbehaviour remains in the headlines

THIS new year sees corporate America in a much brighter mood than many might have predicted last spring. In 2003, stockmarkets ended the year higher than they began for the first time since 1999. Economic growth, albeit aided by massive monetary and fiscal stimuli, has rocketed. And corporate profits have picked up. Moreover, a new mood of austerity appears to reign in America’s boardrooms. The Sarbanes-Oxley act of 2002, the most radical reform of corporate governance since the Great Depression of the 1930s, imposed tough new rules on companies—and harsh new penalties on wrongdoers.

After a tumultuous few years in which a series of corporate America’s best-known names admitted to wrongdoing of one sort or another—the roll-call includes Enron, WorldCom, Qwest, Aldelphia, Rite Aid, Tyco and Xerox—the focus shifted to Wall Street's banks and fund managers, giving industrial companies some breathing space. They are also relieved that the latest scandal—billions missing from Italy’s biggest dairy company, Parmalat—is unfolding thousands of miles away. However, the attempted plea-bargains by Enron's former finance chief, Andrew Fastow, and his wife, Lea, and a series of upcoming trials will ensure that corporate America's misbehaviour will remain in the spotlight this year.

Right now, the pack following the demise of one-time corporate titans is enraptured by the trial of Dennis Kozlowksi, former chief executive, and Mark Swartz, former chief financial officer, of Tyco. The group's shareholders were appalled by revelations of excess, including $6,000 spent on a shower curtain and over $100,000 on a mirror at a posh company apartment where Mr Kozlowski lived. Prosecutors have alleged that Mr Kozlowski and Mr Swartz stole $170m from the company, illegally gained $430m from selling stock, and used dubious accounting to hide their actions, allegations the men have denied. Tyco, which has admitted that $2 billion has been wrongly accounted for, sued both men. Mr Kozlowski, in turn, says it is the company that owes him money. The two men will face separate tax-evasion trials later.

Tyco may be the most farcical of the corporate scandals, but it is Enron that symbolises for most the downfall of corporate America, partly because the Texan group's fall from grace was so severe. Its chairman, Ken Lay, was a buddy of the Bush family. Its chief executive, Jeff Skilling, a former McKinsey consultant, won plaudits for designing the new concept of an asset-light energy company that would make money not by extracting stuff from the ground, but by trading it. Enron was at one point one of the most valuable Fortune 500 companies. Until now, the chief casualty of its collapse has not been any of the company’s most senior executives, but its auditor, Andersen, which collapsed after the partnership's American arm was found guilty of obstruction.

So far, of the senior Enron executives, only Mr Fastow has been indicted. The man who set up a series of offshore partnerships that disguised huge liabilities had pleaded not guilty to charges of fraud, money laundering and conspiracy to inflate Enron’s profits. However, he is currently reported to be in negotiation with prosecutors over a plea-bargain. His wife, also a former Enron employee, has been offered a deal under which she would plead guilty to a charge of filing a false tax return, though she has not been given any guarantee about the length of her sentence. It has been reported that any plea-bargain by Mr Fastow might help prosecutors to draw up indictments against Mr Lay and Mr Skilling, both of whom have denied wrongdoing.

The next big trial will be that of Martha Stewart, one-time arbiter of American domestic taste. Jurors are already being screened for what promises to be a media circus, beginning on January 20th. The authorities have alleged that Ms Stewart sold her shares in ImClone Systems, a biotech company, when tipped off by her broker, Peter Bacanovic. The Merrill Lynch broker also acted for Ms Stewart’s friend, Sam Waksal, ImClone’s co-founder and then chief executive. Prosecutors claimed that Mr Waksal told his family that ImClone's application for a supposed wonder-drug for colorectal cancer was about to be turned down. Mr Waksal was jailed for 87 months, fined $4m and banned for life from leading a public company after pleading guilty to charges including securities fraud.

Ms Stewart has denied any wrongdoing, though she has stepped down as boss of her media empire. She faces charges including obstruction of justice, making false statements to federal officials and perjury. If found guilty, she could face a $1m fine and up to ten years in prison. She is also facing a civil complaint from the Securities and Exchange Commission (SEC), America’s main stockmarket regulator.

February is scheduled to bring two trials, that of Scott Sullivan, former chief financial officer of WorldCom, and that of John Rigas, founder of Adelphia Communications, a cable television company. WorldCom is the holder of the record for the most deceptive accounts, to the tune of an estimated $11 billion over several years. Mr Sullivan is charged with masterminding the fraud, though he denies this. Two other accounting staff have pleaded guilty to securities fraud and other charges. Mr Sullivan's former boss, Bernie Ebbers, who created WorldCom out of a dazzling series of acquisitions, was accused of securities fraud in Oklahoma, irritating federal regulators who have yet to file charges. The Oklahoma charges were later withdrawn.

Mr Rigas, his sons Timothy and Michael, and two former executives have been indicted on fraud charges. Prosecutors allege that they defrauded Adelphia on a “massive scale”, and that the firm exaggerated its financial results. The government is seeking $2.5 billion from the Rigases. Adelphia is also suing them, and the SEC has filed a civil complaint. Both executives charged have pleaded guilty, and are helping the prosecution with its case. The Rigases deny any wrongdoing.

In March, the spotlight will turn on Wall Street’s involvement in the excesses of corporate America, with the retrial of Frank Quattrone, the one-time star technology banker at Credit Suisse First Boston. CSFB has already paid a fine of $100m to settle charges that it received excessive commissions from hedge funds in return for allocations of shares in newly floated companies, though the investment bank has not admitted any wrongdoing. Mr Quattrone was tried last year on charges of attempting to obstruct an investigation into the allocation of such shares, but a mistrial was declared after the jury failed to reach a verdict.

While the rash of scandals did subside somewhat in 2003, another of the best-known corporate personalities of the late 1990s fell from grace. Dick Grasso resigned as chairman and chief executive of the New York Stock Exchange after a furore erupted over his $140m pay packet (later revealed to have been $188m in total). The NYSE’s new interim chairman, John Reed, a former Citigroup boss, has passed a report into Mr Grasso’s pay, and the board's role in setting it, to both Eliot Spitzer, New York state’s attorney-general, and the SEC. Mr Reed said the new board recognised that “serious damage has been inflicted on the exchange by unreasonable compensation of the previous chairman and CEO, and by failures of governance and fiduciary responsibility.” The SEC said the investigation should not be seen as evidence that the law had been broken.

The continuing imbroglio over Mr Grasso, and the growing scandal over trading irregularities at mutual funds, are uncomfortable signs that American business is not as clean as it would like to believe. The optimists would like to see the trials as lagging indicators of poor corporate governance, providing a welcome contrast with the austerity of today’s boardrooms. This is a view that investors appear to be endorsing. It would be nice to think that they are right.

Some victories have been won in the West's war against al-Qaeda. But the danger persists

LIKE a pantomime villain, the man who is once again the world's most wanted fugitive has re-appeared on the global stage just when it looked as if the plot might be taking a turn for the better. Another taped rant against Crusaders, Zionists and apostate Muslim rulers, purportedly delivered by Osama bin Laden, reminded America and its allies that the enemy who preoccupied them before the war in Iraq remains bent on their downfall. The cancellation and delay of flights to the United States from France, Britain and Mexico has also helped to deflate the festive optimism brought on by Saddam Hussein's capture. Ditto this week's introduction of what in bygone times would have seemed draconian security measures at American airports, rows about whether planes should carry armed guards, and worries about “dirty” bombs. And from Iraq to Israel, Istanbul to Islamabad, growing numbers of people are blowing themselves up for fanatical ends (see article).

In fact, the ongoing disruption to international air travel contains good news as well as bad. It suggests that western intelligence services have a handle on the plots the terrorists are hatching. At the same time, the inconvenience caused to passengers, and the disagreement among governments that have resulted, point up the havoc that terrorists can cause, even if those plots are scotched or spectral. In a similar sort of way, the war against al-Qaeda as a whole offers both good and bad news, progress and peril. It is likely to stay that way: this is not a war that can be ended by toppling a statue.

With the pride that can go before a fall, George Bush's administration regularly and confidently asserts that it is winning the “war on terror”—and not without some justification. The invasion of Afghanistan denied al-Qaeda its sanctuary. More than two-thirds of its known senior leadership, say the Americans, have been captured or killed. Globally, more than 3,000 al-Qaeda operatives have been (as the Americans put it) “incapacitated”. Terrorist cells have been disrupted across Europe, and some previously recalcitrant countries seem finally to be co-operating in the hunt. In the case of Saudi Arabia, that is partly because, by targeting Muslim Saudis, Mr bin Laden's cadre has made what may turn out to be a strategic misjudgment. All of this has made it more difficult for al-Qaeda to move its men and cash around.

In America itself, chastened spies have pulled their socks up. Ports and borders are better protected than they were, and the emergency services better prepared to respond should the bomber (or germ-warrior) get through. So far, these precautions seem to be paying off. Since September 11th, al-Qaeda and its affiliates have struck repeatedly at “soft” (ie, civilian) targets in Turkey, Morocco, Kenya and elsewhere. But there have been no attacks on the catastrophic scale of the World Trade Centre, and none in mainland America or in America's key western allies. The erosion of a few civil liberties and a few cross airline passengers, Mr Bush might argue, are small prices to pay for this relative tranquillity.

But now imagine that you are Mr bin Laden. You may feel that you have just as many reasons to be cheerful. You have struck the hyperpower in its heartland. You have sown fear and discord in the West. True, you were put to flight in Afghanistan, but your friends are far from beaten even there. In Iraq, America has deposed an apostate, with a number of satisfying results. The infidels are leaving Saudi Arabia, answering your chief political grievance, a much more important one to you than the plight of the Palestinians—a cause, however, that you continue to exploit. America's popularity in the Muslim world has plummeted. Things may change if Iraq emerges as a model Arab democracy, but for now, in some Muslim countries, more people say they have faith in your conduct of world affairs than in Mr Bush's. Your associates can still raise and distribute more than enough money to fund their inexpensive operations. And neither you nor your most important aide, Ayman al-Zawahiri, has been killed or apprehended. You may be incapacitated and sometimes incommunicado, but you remain a powerful totem of jihadi resistance.

Perhaps skulking in a cave on the Afghan-Pakistani border, Mr bin Laden might also reflect that al-Qaeda enjoys two strategic advantages over its enemies. One is its diffuseness. Even before the loss of its Afghan base, al-Qaeda was not an organisation in a conventional sense: Mr bin Laden operated more like a venture capitalist than a CEO, sponsoring operations with varying degrees of control. Since then, the alumni of his Afghan camps—perhaps numbering in the tens of thousands—have dispersed across the globe, forming their own more or less autonomous units. Some of the bombings committed under the al-Qaeda banner may take little more than inspiration from Mr bin Laden himself. Nobody really knows how large that loose network is, nor whether it is growing or shrinking.

Al-Qaeda's other strategic advantage is its philosophy of time. As the typically obscure references in the latest tape illustrate, Mr bin Laden and his sort take a long view of history, lamenting the reconquest of Andalucia in 1492 as well as more recent “offences”. They are impatient for the advent of the global caliphate; but they can also wait. They plan meticulously and nurture their aspirations—such as the destruction of the World Trade Centre, and the use of planes as weapons—for years. Given that, the world should draw little comfort from the fact that it has so far been spared another September 11th.

Since al-Qaeda is less a concrete adversary than a movement or an ideology, any war waged against it must be equally subtle. “Incapacitation” has its place, but so do public diplomacy in the Muslim world and conflict resolution in the Middle East and beyond—both less in evidence. A “war on terror” in general makes even less sense. It suits Russia's Vladimir Putin and Israel's Ariel Sharon, for example, to portray their battles with Chechen and Palestinian terrorists as part of a global struggle; but these and many other campaigns involve mainly local issues. Most terrorists, moreover, still operate within self-imposed constraints, whereas Mr bin Laden regards the acquisition of weapons of mass destruction as a religious duty. Lumping these threats together under the general rubric of a “war on terror” makes them harder to address.

Another part of the anti-al-Qaeda strategy ought to be the education of western publics. Talk of a “war” itself encourages people to believe in a clear and not-too-distant victory, whereas the apocalyptic spirit of al-Qaeda may be around for decades. “Terror”—which is, after all, a technique rather than an army—will stalk the world forever. It is tricky for anyone not privy to the intelligence that informed the grounding of flights this week to assess whether it justified the alarm and inconvenience that were caused. But the public would be able to cope better with such trials if it understood that the al-Qaeda peril is one with which it will have to learn to live for the foreseeable future—and which, unfortunately, will occasionally inflict more than just inconvenience. Some phlegmatic European officials whisper that their American counterparts have become overly risk-averse, believing that they can see off every threat that may arise. That is unlikely to be possible.

A massive cash infusion for two of China’s largest state-owned banks is just the beginning of a much-needed overhaul of the sickly financial sector

CHINA’S newish prime minister, Wen Jiabao, is a geologist by training. So far, the conversion of his country’s financial system from swadeshi communism to global capitalism has moved at the kind of glacial pace only a geologist could appreciate. But on Tuesday January 6th, the Xinhua news agency announced a great leap forward. At the end of December, it said, the Chinese state injected $45 billion—one tenth of its foreign-exchange reserves—into the country’s two largest banks, dividing the funds evenly between Bank of China (not to be confused with China’s central bank, the People’s Bank of China) and the China Construction Bank.

These lenders are two of China’s “big four” state-owned banks, the other two being Industrial & Commercial Bank and Agricultural Bank. With 116,000 branches across China, these four hold 67% of the country’s deposits and make 61% of its loans. But not all of those loans are likely to be repaid. The government estimates that 23% of the big four’s loans are “non-performing”. Most independent analysts think the true fraction is a third or more. Big as last month’s cash infusion is, it is just a drop in a bucket of bad loans totalling more than 3.5 trillion yuan ($422 billion).

What kind of bank makes loans of which a third will not be repaid? The communist kind. Some of the banks, such as Bank of China, founded by the legendary nationalist Sun Yat Sen in 1912, predate the Maoist takeover, but none of them escaped its wholesale distortion of capital allocation. For decades they made loans based on bureaucratic, not commercial, priorities. Some funds served to prop up bankrupt state enterprises and the legions of workers who depended upon them. Others served social policy of a different kind—keeping cronies happy and palms properly greased. Wang Xuebing, former head of two of the big four banks, lost his job for making dubious loans and lost his liberty for taking bribes.

In a sense, the capital infusion announced this week simply shifts money from one state tentacle to another: $45 billion of foreign exchange, once under the custody of the state’s monetary authorities, is now under the custody of two of the state’s banks. But the Chinese government is hoping gradually to withdraw its tentacles from the banking system, and this latest injection of funds is a necessary part of that process. The state needs to clean its banks up in order to sell them off.

As a consequence, its funds have gone not to the banks in direst need, but to those most ready for the showroom. With a bit of tarting up, Bank of China and China Construction Bank will, it is hoped, make for an initial public offering (IPO) that investors (foreigners included) cannot refuse. Of the big four, China Construction Bank is in the best shape. A stockmarket flotation, perhaps as soon as this year, could raise between $5 billion and $6 billion, according to some investment bankers, who are already keenly offering their services as midwives to the deal. Bank of China, the country’s biggest foreign-exchange lender, which hopes to follow in 2005, could be even bigger. It already has some experience of going public, floating its Hong Kong operations on the territory’s stock exchange over a year ago.

The state will welcome these contributions to its coffers. However, its main purpose in selling the banks is not to raise money but to transform lending in China. The hope is that private banks run for the benefit of shareholders will lend more productively and more prudently than the big four have managed to date. They could hardly do worse. But although privatisation will undoubtedly help, privatisation without competition or regulation brings dangers of its own.

China’s people stash about 40% of their income in their nation’s banks. The big four do not have to chase deposits: deposits come to them. Privatising the banks will do little by itself to sharpen competition—a privately owned oligopoly is still an oligopoly. By the end of 2006, however, this cosy banking market will be shaken up by China’s commitments to the World Trade Organisation. Foreign banks will be allowed to do business in the Chinese currency with Chinese households. If the country’s banks, whoever owns them, do not learn how to compete for deposits, they may start losing customers to foreign entrants that do.

Complacent about the money coming in, China’s banks are also too free about the money going out. Lending by the big four grew by a fifth in the year to October, according to Goldman Sachs. Many economists fear that the Chinese economy is in serious danger of overheating. The central bank has raised reserve requirements in a bid to restrain lending, but to no great effect. Its job is greatly complicated by its desire to maintain a pegged currency: buying dollars at the fixed rate of 8.3 yuan creates a lot of extra liquidity that it then struggles to mop up.

Indeed, the Chinese authorities are caught in a bind. They cannot rein in their banks as long as they maintain their currency peg. But they cannot surrender their peg until the country’s banks are fit enough to live with a currency free to float and capital free to flee. It is a Gordian knot the Chinese state has only begun to unpick.

Dow 12,000? Hmmm

NEW year, familiar story: American shares are on the up. The venerable Dow again leapfrogged over 10,000 towards the end of last year (though in these less euphoric times traders did not sport “Dow 10,000” baseball caps) and is now closer to 11,000; and Nasdaq started this year by surging through 2,000, its highest level in almost two years. In the seemingly irresistible spirit that grips pundits at the start of every year, Buttonwood wonders whether the round numbers will continue to be breached—and in which direction. A self-confessed recovering bear, your columnist does not now treat every upward move with a snort of derision, and the market certainly seems to have the wind in its sails. But he can’t help feeling that headwinds aplenty loom on the horizon.

This is not a view held by most strategists at investment banks. Abby Joseph Cohen, Goldman Sachs’s stockmarket guru—dubbed “permabull” by those who treat her prognostications with a pinch of salt—thinks shares will rise again this year. Not, to be fair, as much as they did last year, when the S&P 500 rose by 26% and at the beginning of which Goldman Sachs thought the stockmarket a screaming buy. But given that (a) Ms Cohen thinks the market is still cheap and that fair value for the S&P at the end of this year will be 1,250, some 15% higher than now; (b) she describes her assumptions in calculating fair value as “conservative”; and (c) three-quarters of the ideal portfolio is devoted to shares, the permabull is snorting as loudly as ever.

It seems a stretch to describe America’s stockmarket as “cheap”. The S&P has a price-to-earnings (p/e) ratio of 29 or thereabouts, depending on how you calculate it. That is some way above its multi-year average of about 15. Ms Cohen and her like tend to decry high p/e ratios as misleading because the “e” is depressed, as it is in any recovery. In any case, she says, p/e ratios should be higher when inflation is low, as it is now, because profits are of better quality and the Federal Reserve is likely to be friendlier for longer. Which seems reasonable, except that such views are “rubbish”, says Andrew Smithers, a stockmarket consultant of independent mien. There is, he points out, no evidence that profits are of better quality now. Quite the opposite, indeed, thanks partly to the distortions produced by stock options. Mr Smithers thinks that the market is overvalued by at least 60%. Buttonwood tends to the Smithers view: shares are expensive.

For now, however, investors are flooding into the market for reasons other than valuations. A roaring economy is one of them. America’s GDP expanded by an annual 8.2% in the third quarter, and though economists expect that pace to slow, the forecasters polled by The Economist still expect the economy to grow by 4.2% this year. With a fast-expanding economy and some pretty savage cost-cutting have come bumper profits. Thomson Financial, a research firm, estimates that companies in the S&P 500 made some $474 billion in net profits last year—even more than the $445 billion they made in 2000, and almost two-thirds more than they earned in 2002. In short, earnings are far from depressed. The quarterly reporting season kicks off on Thursday January 8th.

Although just about everyone is agreed that the growth in profits will slow (to about 15-20% this year), they are divided as to what this means for the stockmarket. If you are a bull, the fact that profits are still growing is enough; if a bear, the best is already past. Moreover, analysts are quite probably still too optimistic about corporate profits, which are already above their long-term average as a percentage of GDP.

All of these arguments are rehearsed in a more heated way for a more heated market. Nasdaq, chock-a-block with technology companies, went up by 50% last year and is straining at the bit already this year. It is even more expensive than the S&P, with a p/e ratio of 36. Goldman Sachs has not provided fair-value estimates since 1998 because its models require positive earnings and cashflow, and too many of the companies had neither. Possibly, the profits of companies that do make money will rise fast enough to make buying them anything less than insanity. Certainly, technology companies as a group have slashed costs and would benefit hugely from any pick-up in tech spending.

On this, it is true, there are encouraging signs. For example, semiconductor sales rose for the fourth month in a row in November, and were a quarter higher than a year earlier. But most American companies seem to be doing very nicely with the technology they already have. Why would they want to buy a lot more of it? More fundamentally, the companies listed on Nasdaq are generally of a risky sort. Many will, quite probably, no longer exist in a few years. An old-fashioned view, perhaps, but shouldn't riskier assets be cheaper not more expensive?

Furthermore, there is a lot of risk about—quite apart from the geopolitical sort. Last year, America had strong growth, high profits, stable and low short-term interest rates, low long-term rates and a weak dollar (indeed, in euro terms the Dow rose by only 4%). This year, any number of things could upset that balance. Bond yields could rise sharply, especially if inflation started to climb, the dollar tanked or Asian central banks stopped buying American assets. Merrill Lynch, for one, thinks that ten-year Treasury yields will go up to 6%, from around 4.3% now. That wouldn’t be good for equities.

Equally, bond yields could fall. This is not as wild as it sounds. Disinflationary pressures are still strong, mostly due to excess capacity. A year ago, consumer-price inflation in America was 2.2%. In November, it was 1.8% and The Economist’s forecasters expect it to be only 1.5% this year. It might be lower still were American consumers finally to realise that they need to start saving for their retirement. Falling bond yields, falling consumption, strong disinflationary pressures. None of that would do much for equities either.