Video embedded below.

See also Democratic Rep. DeFazio Calls for Geithner and Summers to Be Fired – Yves Smith

Related posts:

• Geithner testifies before Congress on financial reform
• Weekend Video: A Conversation with Tim Geithner at CFR
• Geithner is open to suggestions
• Did Tim Geithner blow it?
• How did economists get it so wrong (parody version)?

Hat tip Rolfe Winkler.

Related posts:

• Steve Keen and the spectre of terminal debt
• Steve Keen: On the Edge with Max Keiser
• Bloomberg News is still after the Fed for more disclosure
• Dilbert on the asset-based economy
• What does Mises say about trying to stimulate the economy out of recession

This excerpt comes from the blog News from 1930 which gives us a day-to-day account of what was being reported in 1930 before the worst of the Great Depression hit.

“The unemployment situation in New York is critical. Unless it is speedily met, we face a winter of hunger and distress for families whose bread-earners are without work and without funds. The great majority of family men now unemployed are asking not for charity, but for a job. In the richest city of the world, where the vast majority are at work, it is unthinkable that anyone should be permitted to starve. The Emergency Employment Committee is composed of New York business and professional men, formed at the request of experienced welfare organizations of the city. It is raising funds which will be used by these organizations to give temporary work to heads of families and to relieve distress caused by unemployment without regard to race, creed, or color.” Followed by endorsement from Pres. Hoover and appeal for funds.

Sen. Smoot denies tariff is retarding business recovery, says it has saved thousands of jobs and helped maintain wages and preserve farm purchasing power; points out only one country has increased its tariff since US adopted revisions; says question now is whether tariff is high enough, not whether it is too high.

I find the parallels to present day frightening to say the least. Let’s hope for some serious divergence.

Related posts:

• Black humor on Wall Street circa 1930
• Unemployment: U-6 data versus the Great Depression
• Food insecurity: alternative measure of economic distress skyrockets
• “That’s what happens when a town full of broke people gets a whiff of free money”
• When is the next panic?

The US Department of Agriculture highlights how the United States in the last decade, despite increased aggregate wealth, slid back significantly in terms of food insecurity as measure of poverty. With everyone now focused on the unemployment situation, it bears noting that even before the downturn in the economy there had been a large surge in food insecurity nationwide.

The Guardian says:

Food insecurity – defined by the USDA as when "food intake … was reduced and their eating patterns were disrupted at times during the year because the household lacked money and other resources for food" – afflicted 14.6% of Americans in 2008. ie, some 50 million people were too poor to guarantee being able to put food on the table.

The table below, also from the Guardian, shows where food insecurity is highest. While much of the distress is concentrated in the South, there are plenty of states in the Southwest and West as well. Maine has the highest food insecurity in the Northeast.

My interpretation of the data goes to income inequality. I see this as evidence that the last decade of growth in the U.S. has not been beneficial for poorer Americans. However, I would go further in saying that the downturn in the U.S. and rising unemployment, bankruptcy and foreclosure in the middle class has made plain that the middle class has also been left behind. While distress amongst poorer Americans is plain from these numbers, the diminished position in the middle class was masked by a surge in debt. This was made plain only as a result of a drop in asset prices.

At present, U.S. policy makers are trying to make this problem go away by reflating an asset bubble, but continued high unemployment is the elephant in the room which higher asset prices can not make disappear.

As for the poor, a related Guardian article gets to the heart of things:

The report said 6.7 million people were defined as having "very low food security" because they regularly lacked sufficient to eat. Among them, 96% reported that the food they bought did not last until they had money to buy more. Nearly all said they could not afford to eat balanced meals. Although few reported that this was a permanent situation throughout the year, 88% said it had occurred in three or more months.

Nearly half reported losing weight because they did not have enough money to buy food.

The number of children living in households where there were shortages of food at times rose by nearly one-third to 17 million. The report says that most parents who did not get enough to eat ensured their offspring received sufficient food but that more than 1 million children still suffered outright hunger.

The worst affected states are in the south with Mississippi having the largest proportion of its population enduring shortages of food followed by Texas and Arkansas. More than half of those affected are minorities, principally black people and Hispanics.

Millions more Americans do not go hungry only because they are so poor they receive government food stamps or rely on handouts from food banks such as Feeding America. In some states, such as West Virginia, one in six of the population is on food stamps.

This is certainly the stuff of depressions more than V-shaped recoveries. The first Guardian article has links to the data for downloading.

Source

Hungry America: food insecurity, state by state – Guardian

Record numbers go hungry in the US – Guardian

Related posts:

• News from 17 November 1930: “we face a winter of hunger and distress”
• If you can’t afford food, steal it: lessons from Japan
• “That’s what happens when a town full of broke people gets a whiff of free money”
• Massive U.S. job loss of 598,000 in January
• 467,000 jobs lost in the U.S. in June 2009

Hong Kong’s leader Donald Tsang has come out with a scathing criticism of U.S. monetary policy, comparing it to Japan’s which he believes contributed to 1997’s Asian crisis. This is the most direct and strident criticism of the U.S. Federal reserve’s monetary policy from a major international politician yet.

Bloomberg reports:

The Federal Reserve’s policy of keeping interest rates near zero is fueling a wave of speculative capital that may cause the next global crisis, Hong Kong’s leader said.

“I’m scared and leaders should look out,” said Donald Tsang, chief executive of the city, said in Singapore today. “America is doing exactly what Japan did last time,” he said, adding that Japan’s zero interest rate policy contributed to the 1997 Asian financial crisis and U.S. mortgage meltdown…

“We have a U.S. dollar carry trade at the moment,” Tsang, 65, said in a speech where leaders of the Asia Pacific Economic Cooperation forum are gathering for a weekend summit. The carry trade is where investors borrow cheaply in one currency and use the funds to invest in other currencies.

“Where is the money going — it’s where the problem’s going to be: Asia,” Tsang said. “You can see asset prices going up, not only in Korea, in Taiwan, in Singapore and in Hong Kong, going up to levels that are incompatible or inconsistent with the economic fundamentals.”

Tsang’s criticisms are sure to draw attention as it comes during the APEC summit in Singapore, which is a cross-Pacific economic and political group now being used to show Asian-U.S. cooperation and harmony. Tsang has an especially painful memory of the Asian Crisis as he was Hong Kong’s financial secretary at the time and was forced with the central bank to spend $15 billion to defend Hong Kong’s currency peg as speculative capital fled Asian markets en masse. Depression ensued across wide swathes of Asia, leaving a psychological scar that reverberates today.

As for the comparisons of America to Japan, I find them very well placed.  Yesterday I posted an article in which Marshall Auerback and Fox’s Brian Sullivan discussed parallels between the two. Nouriel Roubini fears that a U.S. dollar carry trade is building which is being used to help inflate assets outside of the U.S. in a global financial bubble.

This is certainly what the Japanese had done in the 1990s. Last August, before the Lehman collapse and panic I wrote that Japan was an enabler of the tech bubble of the late nineties:

the Bank of Japan did not realize the limitations of monetary policy. It could provide easy money, but it could not control where that money ended up. So, ultimately it ended up in the carry trade and helped supply the fuel for the tech bubble.

Was the BOJ responsible for the Tech Bubble? That’s a question that cannot be answered. But, what is true is that the Japanese government and monetary authorities were very instrumental both in the late 1990s and earlier this decade in providing free money to global investors via the carry trade.

Tsang is saying that Japan’s easy money policy also infected Asian markets, helping to inflate an unsustainable bubble which led to collapse and depression. In a macabre repeat of economic history, he sees the same re-occurring now as the U.S. tries desperately to ward off deflation.

Source

Fed May Cause Next Crisis, Hong Kong’s Tsang Suggests – Bloomberg

Related posts:

• Japan’s easy money policy was the trigger for the tech wreck
• Is the U.S. dollar carry trade replacing the one in Japanese yen?
• Depression in Japan
• Asia is de-coupling
• Big Mac Index: Europe overvalued, Asia undervalued

I have said on a number of occasions that a sovereign nation that issues debt in its own fiat currency cannot default involuntarily.  The case most people point to as a counterfactual is Russia in 1998.  I mentioned Russia in a recent post:

Countries that have gone bust, Russia, Mexico, and Argentina were borrowing in foreign currency because of interest rate differentials. No sovereign nation which prints and issues debt in its own fiat currency can ever involuntarily be made insolvent.

I was on a trading desk that was dealing in synthetic GKOs before Russia defaulted in 1998, so I remember the incident quite clearly. Russia’s was not an involuntary default by a country which issues debt in its own fiat currency. Russia was a perfect example of a voluntary default due to huge foreign currency debt and foreign exchange reserve losses (see Wikipedia for a pretty accurate and thorough account on the events of the 1998 Russian financial crisis).

Marshall Auerback summed it up well in an email to me as we discussed this case in view of his post refuting chatter about Japan defaulting. Not the underlined words.

Russia didn’t have to default.  As a point of logic, the concept of ability to pay being inherently revenue constrained is not applicable to the issuer of a currency. Any such constraints are necessarily self-imposed (including various ‘no overdraft’ legislation in some countries for the Treasury at the Central Bank). The issuer can always make payment of its currency by crediting the appropriate account or by issuing actual paper currency if demanded by the counter party.

An extreme example is Russia in August 1998. The rouble was convertible into $US at the Russian Central Bank at the rate of 6.45 roubles per $US. The Russian government, desirous of maintaining this fixed exchange rate policy, was limited in its willingness to pay by its holdings of $US reserves, since even at very high interest rates holders of roubles desired to exchange them for $US at the Russian Central Bank. Facing declining $US reserves, and unable to obtain additional reserves in international markets, convertibility was suspended around mid August, and the Russian Central Bank has no choice but to allow the rouble to float.

All throughout this process, the Russian Government had the ability to pay in roubles. However, due to its choice of fixing the exchange rate at level above ‘market levels’ it was not, in mid August, willing to make payments in roubles. In fact, even after floating the rouble, when payment could have been made without losing reserves, the Russian Government, which included the Treasury and Central Bank, continued to be unwilling to make payments in roubles when due, both domestically and internationally. It defaulted on rouble payment by choice, as it always possessed the ability to pay simply by crediting the appropriate accounts with roubles at the Central Bank.

Why Russia made this choice is the subject of much debate. However, there is no debate over the fact that Russia had the ability to meet its notional rouble obligations but was unwilling to pay and instead chose to default.

Russia defaulted voluntarily, an event which the geniuses at Long-Term Capital Management failed to model correctly. Moreover, the immediate stress on Russia was not the rouble-denominated debt but the mountain of foreign currency obligations via an unrealistic currency peg which were draining reserves. Similar events unfolded in Argentina a few years later as their currency board crumbled and the Peso was devalued by three-quarters.

Again, the point is that a government can always make good on its own fiat currency obligations if it chooses to do so. The real question is why a country might voluntarily default on its own currency debt or involuntarily on foreign currency debt.  The answer usually has to do with taxes.  In Argentina and Russia, the government was unable to prove that its taxation policies were benefitting its citizens, creating rampant tax evasion, especially in the monied classes. Capital flight took form as many dodged taxes. Capital flight eventually turns into currency revulsion which creates the pre-conditions for depression, as Latvia, Estonia and Lithuania learned most recently.

The relationship these examples from the Baltics, Argentina and Russia have with Japan and the United States is taxes. When taxes seem unfair or excessive, the citizens evade taxes and eventually revolt; you end up with a situation like Russia circa 1998, Argentina circa 2002 or Zimbabwe circa 2007.

Related posts:

• Russia devalues currency again as foreign reserves plummet
• Latvia – the insanity continues
• The Age of the Fiat Currency: A 38-year experiment in inflation
• Argentina faces potential collapse
• Russia cuts Europe off completely from its gas

The following is a re-print of the latest monthly newsletter from Niels Jensen of Absolute Return Partners, published with the express permission of the author. Visit www.arpllp.com to learn more about Absolute Return Partners. You can reach the firm by email at info@arpllp.com.

This post on taxes and budget deficits should remind one of three recent posts here which take varying views of the fiscal position in Japan. See "Marshall Auerback’s "Japan does not demonstrate the failure of stimulus" and “The new Japan, domestic consumption, and the neo-liberal thought machine “ and my “Japan: stimulus without reform leads to a policy cul de sac.”

While I am personally no fan of supply-side economics or Arthur Laffer (actually, in full disclosure, I have to admit to being generally anti-Reagan/Thatcher as well – in large part due to a lax regulatory environment on both counts and some heinous racial politics in Reagan’s case), I do favour lower taxes as a way to stimulate the economy (through a payroll tax cut, for example).

“The only thing worse than rescuing the system would have been not to do so.”   – Martin Wolf

Welcome to the third letter in our four letter series about major trends defining the future of the world we live in. I kicked off back in September with a piece on energy supplies and last month I took a closer look at the demographic outlook. This month my focus will be on government and why our leaders need to think outside the box to solve the crisis we find ourselves in. I have found this topic particularly difficult to handle – probably because I am somewhat outside of my comfort zone. I sincerely hope you enjoy it anyway.

Let me introduce the main characters: First, the banks which are veering out of control (again!). Next, our central bankers and regulators who are doing a better job than broadly perceived; however, they lack the political support to tackle a financial system which thrives on excesses. And, just to complete the picture, we are up against a political system which is institutionally corrupt and politicians who are hopelessly narrow-minded and unable to look beyond the next election.

Less means more

Since the early 1980s, we (or at least those of us living in an Anglo-Saxon country) have lived in a world where less has carried the meaning of more. Reagan and Thatcher both genuinely believed in small government. Fundamentally, they shared the view that people respond to economic incentives, but it was not only about tax. The public sectors in both countries were slimmed down and much red tape removed. Even the City of London underwent drastic transformation – the so-called Big Bang. The economy reacted favourably in both countries and stock markets began a journey which lasted more than two decades and delivered the most powerful bull market of all times.

But, as we all know now, it ended in tears. Like children in a candy shop, we couldn’t control ourselves. Greed took over and whatever control mechanisms there were in place failed miserably when we needed them the most. It is therefore perfectly understandable that both regulators and politicians want more control. I just wish that our elected leaders would put their self-interest to the side for once and do what is right for the country. Unfortunately, that is about as likely as the sun not rising tomorrow morning.

Too big to fail or…?

Central to the discussion is the role of our banks. Are some banks really too big to fail or are they just too politically connected to fail? Following last year’s near Armageddon, most banks desperately need fresh capital and our monetary authorities – with plenty of encouragement from our Government – have created an environment which has handed banks a license to print money. In a budget constrained world, such a policy was always considered a more palatable way to re-finance the banking sector than the alternative – pumping more hard earned tax payer money into the banking system. So far so good.

Unfortunately, little seems to have been learned from the excesses of recent years. As we have seen time and again, easy money leads to carelessness, paving the way for future bubbles, and why should it be any different this time? A system where profits are privatised and losses socialised is destined to fail. It is the old moral hazard argument all over again and it encourages extreme risk taking. It is nevertheless the system which is being practised all over the world at the moment. And if politicians believe they can solve the problem by capping bonuses, they are less intelligent than even I thought.

In a recent article in the Financial Times, Willem Buiter made some interesting observations on this subject:

Will things be different during the next boom/bubble?  The next credit and asset market boom will generate massive profits and generous tax revenues.  The same phalanx of lobbyists will again descend on regulators, legislators and members of the executive branch of government.  New and exciting financial instruments – superprime lifegages perhaps – will be demonstrated by highly paid hirelings from academia to have unprecedented potential for diversifying, sharing and extinguishing risk.  It will be different from every other boom in the past.  It will be a truly sustainable euphoria – a high for humanity.  And the regulators/supervisors will be convinced, seduced, intimidated or co-opted.

Bank of England Governor Mervyn King recognises the problem:

It is important that banks in receipt of public support are not encouraged to try to earn their way out of that support by resuming the very activities that got them into trouble.

As a possible solution, King has proposed a re-introduction of the rules which used to be in place, prohibiting retail and investment banking activities under the same roof. For speaking his mind, he was publicly reprimanded by the Prime Minister, who deemed such a policy response “simplistic and out-of-date”. Perhaps I should mention that banks are amongst the largest contributors to the political parties in this country. So much for integrity.

It is time to move on

A friend of mine attended an investment conference recently, where one of the speakers was the CEO of a world famous investment bank. When the talk turned to bonuses, the CEO stated flatly that “it is time to move on” (no prizes for guessing which bank). Perhaps it is time to move on, but not in the direction he wants to go. When US tax payers were forced to cough up $185 billion last year to save AIG which in turn saved an entire industry bar Lehman Brothers, the man on the street would be forgiven for expecting a touch more humility and sensitivity from those running our banks.

I am not for one second arguing that bonuses should be regulated. It is simply the wrong way to address the problem. But society is faced with a much broader problem when bankers carry on living in their ivory towers whilst the canyon between them and the rest of society grows bigger and bigger. “Take risks and you will be amply rewarded; fail and the tax payer will bail you out” is about the only lesson they seem to have learned from the past two years. The solution? Force banks to take less risk. It is absurd that many of our banks are still levered 30, 40 and some even 50 times. With less risk, their profits in good times will be much lower (and their losses in bad times correspondingly smaller), and the reduced profits will automatically drive down bonuses.

Here in the UK, two banks (Royal Bank of Scotland and Lloyds Banking Group) are being forced to break up their businesses. If you are too big to fail, you are too big to exist, seems to be the philosophy. However, the government deserves little or no credit for that decision. It is in fact the EU Commission which is forcing the government to take this draconian step. Who said nothing good comes out of Brussels? It is a much more constructive move than the pathetic focus on bonuses, but it doesn’t address the basic problem – banks must reduce their gearing.

The Laffer curve

Regulating banks more effectively is only half the story, though. As already alluded to, governments all over the world are faced with rising debt, threatening to bankrupt many countries. Several political leaders have already stated publicly that taxes will have to rise, but is that really the appropriate policy response to a dire fiscal outlook? Let’s turn our attention to the so-called Laffer curve. The Laffer curve simply states that there is always a revenue optimal tax rate. The Laffer curve does not provide any evidence as to what that tax rate actually is. As illustrated in chart 1 below, not surprisingly, when the tax rate is zero, the tax revenue is also zero; likewise when the tax rate is 100%. Somewhere in between, the optimal tax rate is to be found. The obvious implication of this relationship is that, over and above a certain point, the tax revenue falls once the tax rate is increased.

Behind the relationship between the tax rate and tax revenues lies the simple notion that a change in the tax rate has an arithmetic as well as an economic effect on tax revenues. The arithmetic effect of a tax hike is always positive whilst the economic effect is always negative due to the effect it has on output, employment, consumption, etc. In other words, the two effects always move in opposite directions.

  Chart 1:  The Laffer Curve

Source:

http://www.heritage.org/research/taxes/bg1765.cfm

It was this basic idea which drove President Reagan to lower tax rates in 1981, yet he was by no means the first US president to do so. In the early 1920s Presidents Harding (1921-23) and Coolidge (1923-29) had reduced the top rate from a whopping 77% to 25% and, in the early 1960s, President Kennedy had also introduced massive tax cuts. The top rate had peaked at 94% (!) by the end of World War II and he brought it down to 70% (see chart 2).

Chart 2:  US Marginal Tax Rates

Source: http://www.heritage.org/research/taxes/bg1765.cfm

Compelling evidence

So how did these tax cuts actually affect tax revenues and overall economic growth? The evidence is quite compelling (see table 1 below). During the four years prior to 1925 (the year in which the 1920s tax cuts were fully implemented, US tax revenues declined by 9.2% per year. In the following four years, tax revenues rose 0.1% per annum. The Kennedy experience was equally convincing. In the four years prior to the 1965 tax cuts, tax revenues rose by 2.6% per annum. In the following four years, revenues rose by 9.0% per year. Finally, in the Reagan years, tax revenues declined by an annual rate of 2.6% during the four years leading up to 1983, whilst revenues grew by 3.5% annually during the subsequent four year period.

Table 1:  US Tax Revenues around Major Income Tax Cuts

Source:  http://www.heritage.org/research/taxes/bg1765.cfm.

All numbers are inflation-adjusted.

Furthermore, in all three instances, economic growth accelerated following the tax cuts. For example, between 1978 and 1982, US GDP growth averaged 0.9% per year in real terms. Between 1983 and 1986, the economy grew by 4.8% in real terms, so the case in favour of tax cuts appears to be pretty compelling.

Other factors to be considered

It is not always one-way traffic, though. In his first term as President Clinton actually increased taxes in 1993 and what followed? One of the biggest economic booms of all times. Other factors impact tax revenues as well. In the case of Clinton, he presided over an economy which benefited immensely from globalisation and an IT boom, the likes of which had never been seen before.

Here in Europe, total tax revenue as a % of GDP is, on average, much higher than it is in the United States (chart 3). Whilst European growth rates have, admittedly, been modestly below US growth rates in recent years, there is no evidence to suggest that the higher tax rates have done significant damage to European growth. If that were the case, Denmark and Sweden should suffer the lowest growth rates amongst developed nations. In fact, the two Scandinavian countries have enjoyed comparatively high economic growth in recent years.

Also, corporate earnings have been as strong here in Europe as is the case in the US, and European stock markets have actually vastly outperformed the US market in recent years. So it is hard to drive the argument that lower taxes always lead to higher economic growth and stronger stock market performance. However, it is noteworthy that, in the United States, 3 major income tax cut programmes have been implemented in the last 100 years. In each and every case, tax revenues have grown, GDP growth has accelerated and there has been significant job creation. Can you ask for any more than that?

The canary in the coal mine?

One thing is sure, though. Given the rapidly rising public debt all over the OECD area, economic growth must be secured at any price. Anything else will be devastating longer term. Japan stands out as the black sheep with public debt-to-GDP reaching 218% this year. Japan has tried many things to drag itself out of the quicksand but to no avail.

Chart 3:  Total Tax Revenues as % of GDP (2006)

Source: OECD

Its stimulus programme has been very Keynesian with a multiple of public spending projects over the past couple of decades, most of which have been a terrible waste. Now, 20 years later, Japan is falling into the precise trap our economic adviser Woody Brock is warning so vehemently about. GDP growth is slow or non-existent. Debt continues to grow rapidly and sticky deflation makes an already difficult situation almost impossible to deal with.

So far, Japan has just about gotten away with it because they have had easy and cheap access to credit. But what will happen if (when) that changes? It is no longer inconceivable that Japan will default on its sovereign debt at some point over the next decade. Ambrose Evans-Pritchard has written an excellent piece in the Daily Telegraph recently about Japan’s predicament, which you can read here.

Woody Brock did a study earlier this year where he pointed out the danger of allowing public debt to grow much faster than GDP for an extended period of time. As is evident from chart 4, should the United States (or any other nation for that matter) fall into that trap, the implications could be very dire indeed. Think Zimbabwe. Therefore, given the large escalation of public debt, policy makers should aggressively pursue a pro-growth policy. Anything else could have fatal consequences.

Chart 4:  US Federal Debt Outlook

Source: www.sedinc.com

Cut income taxes! 

Empirical evidence suggests that recessions destroy tax revenues; tax cuts don’t. And increased tax revenues are precisely what we need to solve our fiscal crisis. It is therefore tempting to argue that now is the time for a reduction in income tax rates. Unfortunately, and true to form, our politicians will most likely do exactly the opposite. And the Swiss will be laughing all the way to the bank as more and more disenchanted people in this country flee Britain and Gordon Brown’s strait jacket to start a new life in Switzerland.

Niels C. Jensen

© 2002-2009 Absolute Return Partners LLP. All rights reserved.

This material has been prepared by Absolute Return Partners LLP ("ARP"). ARP is authorised and regulated by the Financial Services Authority. It is provided for information purposes, is intended for your use only and does not constitute an invitation or offer to subscribe for or purchase any of the products or services mentioned. The information provided is not intended to provide a sufficient basis on which to make an investment decision. Information and opinions presented in this material have been obtained or derived from sources believed by ARP to be reliable, but ARP makes no representation as to their accuracy or completeness. ARP accepts no liability for any loss arising from the use of this material. The results referred to in this document are not a guide to the future performance of ARP. The value of investments can go down as well as up and the implementation of the approach described does not guarantee positive performance.  Any reference to potential asset allocation and potential returns do not represent and should not be interpreted as projections.

See other posts I have published referencing or presenting Niels’ analysis.

• The emerging markets crisis – Nov 2008
• Do BRICs (and Germans) Eat PIGS? – Feb 2009
• Europe on the ropes – Mar 2009
• The Fake Recovery - Apr 2009
• Green Shoots or Smoking Weed? – May 2009
• Make Sure You Get This One Right – Jul 2009
• The Hamster on the Wheel – Sep 2009
• A Country for Old Men and a Bit of Samba – Oct 2009

Related posts:

• Japan does not demonstrate the failure of stimulus
• Obama takes middle road on stimulus and taxes that leads nowhere
• Are US corporations feeding at the trough of low taxes?
• Japan: stimulus without reform leads to a policy cul de sac
• A note on Japan’s experiment with quantitative easing

This article by Peter Tasker, a well-regarded financial analyst in Asia, comes via the Financial Times (hat tip Marshall). He sees an enormous bubble forming in China – and parallels to Japan circa 1987:

Emerging markets, it seems, have had a good crisis. In contrast to the debt-ridden G7 economies, they have quickly resumed their growth trajectory. No surprise, then, that US emerging market mutual funds are experiencing record inflows. The stellar performance of the Brics markets – Brazil, Russia, Indian and China – is due to continue into the distant future.

Such is the narrative now forming among investors. To anyone who has lived through the rise and fall of the Japanese bubble economy, it should set off alarm bells.

Remember that it was in the years following the 1987 "Black Monday" crash that Japanese assets went from being expensive to absurdly overvalued and the Nikkei’s dizzy rise to 39,000 forced the bears to throw in the towel…

But what you saw was decidedly not what you got. The crisis, far from leaving Japan unscathed, exacerbated its structural problems and laid the groundwork for a far greater disaster…

Interest rates have been far too low for far too long. If the natural interest rate is, as the Swedish economist Knut Wicksell posited, around the level of nominal GDP growth, then China’s interest rates should have been close to 10 per cent for most of this decade. Alan Greenspan, former chief of the US Federal Reserve, has been criticised for holding interest rates too low and setting off a housing and credit bubble in the US. But if US monetary policy was wrong for the US, it was even more wrong for the high-growth countries that "imported" it. The result could only be a massive misallocation of capital…

At the 2008 peak, the price-to-book ratio of the Shanghai stock exchange was over seven times, well above the five times achieved by Japanese stocks in 1989. After the turbulence of the past 18 months, the ratio has fallen to 3.3 times, still the world’s second highest after India, and residential real estate trades at multiples of income that make the US housing boom look tame…

What is scary is that the current frothiness of emerging markets, centred on China, may be only a taste of what is to come.

There is a lot more in the original article. Link below.

Source

China rushes towards a Japan-style bubble – Financial Times

Related posts:

• China: reflation play spells trouble for rest of the world
• Subprime housing bubble timeline
• Marc Faber: China’s numbers are fake
• Hong Kong: “America is doing exactly what Japan did last time”
• Huge property bubble in China

This comes via the NYTimes:

To the Editor:

Re “Volcker’s Voice, Often Heeded, Fails to Sell a Bank Strategy” (front page, Oct. 21):

As another older banker and one who has experienced both the pre- and post-Glass-Steagall world, I would agree with Paul A. Volcker (and also Mervyn King, governor of the Bank of England) that some kind of separation between institutions that deal primarily in the capital markets and those involved in more traditional deposit-taking and working-capital finance makes sense.

This, in conjunction with more demanding capital requirements, would go a long way toward building a more robust financial sector.

John S. Reed
New York, Oct. 21, 2009

The writer is retired chairman of Citigroup.

Interesting.

Related articles

John Reed on Glass Steagall: Then & Now – Real Time Economics

Related posts:

• Was repealing Glass-Steagall the cause for the present Depression?
• How globalisation led to universal banking in America
• More on why big capital markets players are unmanageable
• Obama caves to pressure on consumer financial protection
• Is Citi being forced to downsize by Obama?

Nouriel Roubini seems to think so. In remarks quoted via Bloomberg, he called the enormous increase in asset prices “the mother of all carry trades.”

Investors worldwide are borrowing dollars to buy assets including equities and commodities, fueling “huge” bubbles that may spark another financial crisis, said New York University professor Nouriel Roubini.

“We have the mother of all carry trades,” Roubini, who predicted the banking crisis that spurred more than $1.6 trillion of asset writedowns and credit losses at financial companies worldwide since 2007, said via satellite to a conference in Cape Town, South Africa. “Everybody’s playing the same game and this game is becoming dangerous.”

If you recall, this is the same trade the world’s punters were putting on via the Japanese yen when the Japanese were pumping out huge amounts of liquidity earlier in this decade.  The yen’s real effective exchange rate only hit post Plaza Accord trade-weighted lows in 2007 when the carry trade was all the rage and just when all hell was breaking loose in subprime.

Reuters said then:

The yen’s real trade-weighted value slipped in October as the Federal Reserve’s interest rate cuts gave a boost to global stock markets and prompted investors to sell the Japanese currency in carry trades.

Bank of Japan data on Friday showed its index of the yen’s real effective exchange rate fell 1.9 percent in October to 96.7 JPYEEXR=J.

The retreat in the BOJ’s REER index took it closer to a 22-year low of 92.8 hit in both June and July, when the currency was sliding as carry trades flourished.

That was the weakest since the September 1985 Plaza Accord in which the five biggest industrialised countries agreed to depreciate the dollar against the German mark and the yen via intervention, aiming to correct the giant U.S. trade deficit at the time.

For the year the yen’s real value has lost 3.6 percent despite periodic bouts of strength as the credit market crunch this year and worries about the U.S. economy prompted market players to unwind risky carry trades.

The yen has suffered in the past few years from carry trades in which investors use the low-yielding Japanese currency as a cheap source of funds to buy higher-yielding currencies or rising assets, such as stocks or commodities.

My view has been that the Japanese yen carry trade was a major contributor to asset bubbles globally as the Bank of Japan’s excess liquidity found its way to other asset markets via the carry trade.  Last August, in my post “Japan’s easy money policy was the trigger for the tech wreck” I also pointed to the yen carry trade as a major factor in the Internet bubble. And I certainly see it as a major factor in this decade’s housing bubbles.

Now the U.S. dollar is the carry trade currency of choice, with zero percent interest rates funding asset purchases globally. This play is certainly pumping up all manner of asset prices. But as with the yen carry trade before it, I do not see this ending well.

Roubini takes a similar tack:

The risk is that we are planting the seeds of the next financial crisis,” said Roubini, chairman of New York-based research and advisory service Roubini Global Economics. “This asset bubble is totally inconsistent with a weaker recovery of economic and financial fundamentals.

Source

Roubini Says Carry Trades Fueling ‘Huge’ Asset Bubble – Bloomberg

Related posts:

• U.S. Bailout: the mother of all carry trades?
• Japan’s easy money policy was the trigger for the tech wreck
• Hong Kong: “America is doing exactly what Japan did last time”
• The carry trade unwinds and it’s not pretty
• Reverse carry trade borrowing is deadly

Bill Gross has a must-read piece out for his monthly Investment Outlook called “Midnight Candles.” He begins the piece with allusions to his advancing years (Gross is now 65) and the mortality he feels because of it – pretty sobering stuff. gross then abruptly segues into his investment outlook, leaving one with the distinct impression he is suggesting there is something ephemeral in the global financial system’s status quo ante.

To solve the problem, Gross suggests continuing artificially low interest rates to maintain pumped up asset prices. This is a perverse conclusion I reject categorically. But his analysis leading up to this is right on the money. And the line he takes to make the transition to his thinking is right out of Credit Writedowns’ playbook.

I’ll jump straight into a discussion of why in a New Normal economy (1) almost all assets appear to be overvalued on a long-term basis, and, therefore, (2) policymakers need to maintain artificially low interest rates and supportive easing measures in order to keep economies on the “right side of the grass.”

Let me start out by summarizing a long-standing PIMCO thesis: The U.S. and most other G-7 economies have been significantly and artificially influenced by asset price appreciation for decades. Stock and home prices went up – then consumers liquefied and spent the capital gains either by borrowing against them or selling outright. Growth, in other words, was influenced on the upside by leverage, securitization, and the belief that wealth creation was a function of asset appreciation as opposed to the production of goods and services. American and other similarly addicted global citizens long ago learned to focus on markets as opposed to the economic foundation behind them. How many TV shots have you seen of people on the Times Square Jumbotron applauding the announcement of the latest GDP growth numbers or job creation? None, of course, but we see daily opening and closing market crescendos of jubilant capitalists on the NYSE and NASDAQ cheering the movement of markets – either up or down. My point: Asset prices are embedded not only in our psyche, but the actual growth rate of our economy. If they don’t go up – economies don’t do well, and when they go down, the economy can be horrid.

This, my friends, is the dreaded asset-based economy. It is the same financial model which has led us to mountains of debt and repeated bubbles and extreme financial instability.  I have said in the past that aggregate debt levels as measured by ratios like debt to nominal GDP should remain constant to the degree that the capital used to generate that growth is efficiently allocated. However, we have seen a ballooning in debt, which suggests that we need far more capital to generate a unit of growth than we did a generation ago.  Gross makes similar arguments, focusing instead on assets instead of debt (liabilities).

First of all, assets didn’t always appreciate faster than GDP. For the first several decades of this history, economic growth, not paper wealth, was king. We were getting richer by making things, not paper. Beginning in the 1980s, however, the cult of the markets, which included the development of financial derivatives and the increasing use of leverage, began to dominate. A long history marred only by negative givebacks during recessions in the early 1990s, 2001–2002, and 2008–2009, produced a persistent increase in asset prices vs. nominal GDP that led to an average overall 50-year appreciation advantage of 1.3% annually. That’s another way of saying you would have been far better off investing in paper than factories or machinery or the requisite components of an educated workforce. We, in effect, were hollowing out our productive future at the expense of worthless paper such as subprimes, dotcoms, or in part, blue chip stocks and investment grade/government bonds.

Again, these themes echo something i recently posted on, namely the hollowing out of America’s middle class from downsizing and outsourcing. See my post “A conversation with Stephen Roach on Charlie Rose “ in which the juxtaposition between a Stephen Roach interview circa 1996 and one from this past week makes plain the long-term problem.

Gross comes to a very different conclusion to all of this than I come to.  He says, faced with a potential collapse in nominal GDP growth, the answer is to feed the patient more of the asset price elixir to wean him off his drugs. Cold turkey would lead to depression (i.e. death – that makes the tie to his lead in plain).

This is where it gets tricky, however, because policymakers, (The Fed, the Treasury, the FDIC) recognize the predicament, maybe not with the same model or in the same magnitude, but they recognize that asset prices must be supported in order to generate positive future nominal GDP growth somewhere close to historical norms. The virus has infected far too many parts of the economy’s body, for far too long, to go cold turkey. The Japanese example over the past 15 years is an excellent historical reference point. Their quantitative easing and near-0% short-term interest rates eventually arrested equity and property market deflation but at much greater percentage losses, which produced an economy barely above the grass as opposed to buried six feet under. The current objective of global policymakers is to do likewise – keep the capitalistic patient alive through asset price support, but at an “old normal” pace if possible, six feet or 6% in U.S. nominal GDP terms above the grass.

My conclusion is different. I have said before that I also think cold turkey would lead to disaster (see my post “Confessions of an Austrian economist), but I am under no illusion that we need to keep supporting the asset-based economy indefinitely.  Our goal should be to use government stimulus as cover to eliminate malinvestments and downsize bloated sectors of the economy like financial services. This is one reason I am in favor of introducing a comprehensive too-big-to-fail (TBTF) resolution process to allow big banks to fail and breaking up TBTF financial institutions.

Going back to Gross, he concludes that his policy preference for maintaining is supportive of asset prices in the medium-term but not so supportive that we are going back to the gold rush of yesteryear.

If policy rates are artificially low then bond investors should recognize that artificial buyers of notes and bonds (quantitative easing programs and Chinese currency fixing) have compressed almost all interest rates. But while this may support asset prices – including Treasury paper across the front end and belly of the curve, at the same time it provides little reward in terms of future income. Investors, of course, notice this inevitable conclusion by referencing Treasury Bills at .15%, two-year Notes at less than 1%, and 10-year maturities at a paltry 3.40%. Absent deflationary momentum, this is all a Treasury investor can expect. What you see in the bond market is often what you get. Broadening the concept to the U.S. bond market as a whole (mortgages + investment grade corporates), the total bond market yields only 3.5%. To get more than that, high yield, distressed mortgages, and stocks beckon the investor increasingly beguiled by hopes of a V-shaped recovery and “old normal” market standards. Not likely, and the risks outweigh the rewards at this point.

While I disagree with Gross, his is a very good piece if you want to know which way the wind is blowing. I have linked to it below.

Enjoy.

Source

Midnight Candles – Bill Gross, Pimco

Related posts:

• Bill Gross: Fed on hold through 2010
• Gross isn’t buying corporates, high yield or equities even with zero rates
• Bill Gross: “Stop the decline in asset prices”
• Bill Gross: the new normal means investors should shun risk
• Bill Gross: “Staying Rich in the New Normal”

Steve Horwitz had an interesting read last week on Friedrich von Hayek, the Nobel Prize winning Austrian School economist. Von Hayek is best known for his 1944 Libertarian call to arms “Road to Serfdom” and is generally considered one of the fathers of the free market ideology.

In Horwitz’s piece, he points out that Hayek was not a ‘liquidationist’ and he uses the title quote to demonstrate that Hayek saw deflation as destructive. Was this an evolution in beliefs? it’s hard to say.

Horowitz goes on to say:

Those Austrians who think deflation is always and everywhere a good phenomenon strongly overlap with those Austrians who wonder whether Hayek is really an Austrian (or a even a classical liberal) anyway, so I’m doubtful this will convince them of the claim that a concern with monetary deflation has been, and should be, a core part of Austrian monetary and macro theory.  However, it does, in fact, bolster the case for a monetary equilibrium reading of Hayek.

The question, of course, is if price stability is the ultimate goal of monetary policy, how does one achieve that in a deflationary environment?

Source

Hayek on Deflation and the Great Depression – Steve Horwitz

Related posts:

• The inflation-deflation debate
• Forget Inflation, debt deflation is the real threat
• Credit deflation and the Japanese problem
• Goldman says fund managers expect deflation
• The inflation – deflation debate redux

This morning, I ran across a post by Prieur du Plessis, which linked out to a Stephen Roach interview on Charlie Rose.

Roach is the head of Morgan Stanley Asia and has been a voice to listen to when trying to discern where China is headed and how its relationship with the United States will develop. That was the topic of conversation between Roach and Rose. Through the links on that post I happened upon a 1996 Roach interview on Charlie Rose of a very different sort where he talked about the hollowing out of America and his concern for the future. I want to link those two below.

In the transcript of the recent China interview on Rose’s website, Roach marvels about the progress made in China:

CHARLIE ROSE: You left Wall Street to go live in China.

STEPHEN ROACH: I did. About three years ago, your friend and mine, John Mack, called me up and said, 25 years as an economist, a long time, good job. How would you like to do something different and be the chairman of Morgan Stanley’s business activities in Asia? And I told John I thought he was nuts. I had the best job. I wasn’t going to leave it. He said, "Think about it."

And, you know, John, when he says, "Think about it," there’s a fair amount of emphasis there. I did think about it. And I’d built fabulous relationships in Asia over the years, Charlie. I was passionate about the region. I thought I knew it well, but I knew in my gut that it would be a lot different from the inside than from the outside, and I said, yeah, I’m going to go for it.

And I’ve been out there now about two and a half years. And I have no regrets. I love it. I have learned an awful lot about Asia, and I thought it was time to put it down in a book and get it out there when the world is very focused on Asia, its own challenges and its role in the global economy.

CHARLIE ROSE: What do you love and what have you learned?

STEPHEN ROACH: What I am most passionate about in terms of Asia is what they’ve done, especially in China, over the last 30 years. You know, big celebration, 60th anniversary of the People’s Republic of China. But the first 30 years were pretty awful and the next 30 years have been spectacular. And the difference is they have really put huge focus on transitioning this economy from one that was owned by the state to one that is more of a market-based economy. They’ve taken huge risks in terms of reforms, layoffs, building market structures, building companies that we’ve never seen before. And to be on the inside and watching, watching that risk taking up close is a pretty fascinating experience for anyone. And I love every bit of it.

They go on to talk about the outlook there as well as how the government is dragging its heels on increasing domestic demand and shoring up a porous social safety net among other things. I definitely suggest you read the full transcript here. It makes for a better understanding of China. A snippet of the video is embedded below.

However, what was equally interesting to me was that Roach and Robert Reich were talking to Rose about concerns over the hollowing out of America’s workforce through downsizing (off-shoring had not yet gathered full steam).

Roach says:

“What has changed for me is my appreciation for what it has taken to get from point A to point B over the last ten years. It would be one thing if these productivity gains were built on the back of a more talented, skilled, educated, dynamic work force, but it’s another thing altogether if these productivity or efficiency changes were built on the basis of strategies that are hollowing out our companies, hollowing out our workforces, stagnating real wages – tactics in the end that can really lead to industrial extinction.

I’m sure you see the connection. If not, watch the video below in the context of the more recent video and your knowledge of what is happening in the global economy. I will say this: Roach was right about the dichotomy between the benefits to the owners of capital and the benefits to labor that these corporate strategies created.

Where I think his view could be tweaked looking back 13 years is in terms of what it has meant for Corporate America.  The hollowing out of America’s workforce and lack of investment domestically has not meant a hollowing out of Corporate America. Those companies that did downsize American workers in a ‘short-term’ play for next quarter’s earnings are many of the ones which have outperformed for the last 13 years because they have gone global. And the impressive leaps forward in China are testament to the gains made in places like China due in part to that move. It’s called ‘global labor arbitrage’ and it is what I see as the defining element of globalization as practiced.

In the end, however, a day of reckoning will come – not for the managers of the companies who have profited over the time span between these two interviews because they are going to keep their bonuses.  The day of reckoning for America will come in terms of the growth and dynamism of its middle class. Whether the U.S. then moves toward a Latin American style economic structure of a few rich at the top, a weaker middle class, and everyone else at the bottom or back to a more equal income and wealth distribution depends on the reaction by the ‘body politic,’ not on Wall Street.

Related posts:

• Stephen Roach: Downturn in Asia less severe, but recovery later
• Stephen Roach and Jim Grant: Video of credit crisis thoughts
• Stephen Roach is still bearish, no recovery until 2010
• Stephen Roach sees a W-shaped recovery for China
• Stephen Roach is talking double dip again

Remember the iconic Depression-era movie “Mr. Smith Goes to Washington, in which Jimmy Stewart plays the wholesome young man in Washington out to do good? Well, Mr. Smith could just as easily have been your friendly banker at Washington Mutual. Unfortunately, Mr. Smith lost his way and turned predatory lender – and that’s the subject of the second part of a Seattle Times expose on the rise and fall of WaMu.

I posted yesterday on part one, which you should definitely read to get a sense of how WaMu culture changed. Now comes part two – also a must-read.

The lead-in says it all:

For decades, Washington Mutual lived up to its image as a staid, straight-laced Seattle institution. Its motto: "The Friend of the Family."

By the time WaMu made history last year as the nation’s biggest bank failure, it bore no resemblance to this homey image.

What few people knew was that bank executives crafted a radical new business strategy in 2003 that was intended to boost profits. The new WaMu used huge sales commissions and misleading marketing to hawk risky and overpriced loans to borrowers.

In short, WaMu became one of the nation’s biggest predatory lenders.

 

Here are a two quotes from the article:

• WaMu lured borrowers with a very low interest rate of about 1 percent. But this "teaser" rate was good only for one month. After that, the option ARM could have far higher interest rates than conventional 30-year fixed-rate loans. With each minimum payment, unpaid interest piled up. Once the debt grew too large, WaMu canceled the minimum-payment option. You could suddenly get a new bill for two or three times what you had been paying.
• "I always felt like I worked for a really honest industry that cared for the borrowers they dealt with," she said. The corporate culture changed to: "We just want to do the most we can to make money for the bank."
• The 1 percent interest rate Houk thought he was getting was only good for the first month. It had reset to 7.4 percent, nearly 3 percentage points above his previous WaMu loan. This was buried in the fine print in a sheaf of legal documents he had signed. "Who in their right mind would give up a 4.6 percent loan?" Houk said. "I felt totally duped."

The overall gist of the article (in conjunction with the previous one) is of a company whose CEO was obsessed with the share price as validation of success.  As a result, the company morphed from an institution worthy of Mr. Smith to just another profit-oriented bank. 

The key changes came in crisis after profits were devastated by the recession of 2001 and the jobless recovery afterwards. WaMu was forced into huge layoffs.

It is often said true character is shown in crisis and at WaMu it would be no different.  Instead of accepting a temporarily lower share price and reduced earnings from its bread and butter mortgage products, WaMu went all-in, wading into sub-prime and option-ARM products which were not its mainstay. That is when the predatory lending began, ultimately setting the firm up for failure.

More here.

WaMu: Hometown bank turned predatory – Seattle Times

Related posts:

• Anecdotes on reckless lending at WaMu from the Seattle Times
• WaMu on the brink of disaster: has agreement with regulators
• JP Morgan Chase buys WaMu out
• Is the new affordable FHFA loan program predatory lending?
• How refinancing helps the likes of Bank of America and Wells Fargo

I just came across a post on Zero Hedge called “An Overview Of The Fed’s Intervention In Equity Markets Via The Primary Dealer Credit Facility.” Now, that’s a mouthful. As far as I can discern, the post’s purpose is to expose alleged equities market manipulation by the Federal Reserve. However, I found the argument rather conspiratorial. And despite claims of an alleged smoking gun, there is no evidence in the post that that Federal Reserve is manipulating anything except interest rates. And the Fed made clear that that was what it intended to do.

Let me break down the argument made by Zero Hedge’s Tyler Durden and give a few remarks of my own on how I read the situation.

The junking of the Fed’s balance sheet

In March 2008, the Federal Reserve established the Primary Dealer Credit Facility (PDCF) to provide liquidity to the financial sector after Bear Stearns collapsed. Overnight funding had become a key source of liquidity for banks looking for cheap money (short-term rates are lower than long-term rates).

But when crisis hit, the liquidity in overnight interbank markets dried up leading to collapse at Northern Rock in October 2007 and then Bear Stearns in March 2008, institutions which were recklessly overexposed to overnight funding. This was a market failure. The Federal Reserve, therefore, stepped forward, effectively taking the entire wholesale banking market onto its balance sheet. That is what all of the Fed’s liquidity provisions are about.

The problem most of us have with this and similar facilities is the PDCF’s collateral terms. In the past the Fed accepted treasuries. Now it was accepting a lot more (including some so-called toxic assets):

The PDCF will provide overnight funding to primary dealers in exchange for a specified range of collateral, including all collateral eligible for tri-party repurchase agreements arranged by the Federal Reserve Bank of New York, as well as all investment-grade corporate securities, municipal securities, mortgage-backed securities and asset-backed securities for which a price is available.

By April 2008, when David Einhorn questioned Lehman’s earnings report, people were asking if they were going the way of Bear Stearns (see my June 2008 post “Is Lehman the next Bear Stearns?”). When Lehman did collapse, acceptable collateral expanded. In some instances it included equities as well. The Fed’s press release expanding collateral said:

The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities. The collateral for the Term Securities Lending Facility (TSLF) also has been expanded; eligible collateral for Schedule 2 auctions will now include all investment-grade debt securities. Previously, only Treasury securities, agency securities, and AAA-rated mortgage-backed and asset-backed securities could be pledged.

You’ll notice nowhere in the press release does one see the term equities. This is obviously by design because the Fed was under fire for bloating its balance sheet with junk. This process – what I call qualitative easing – was meant to be opaque.

With the panic now over, things have settled down and these facilities are likely to end. The Fed is issuing its own research to give intellectual cover to these activities. But, outrage remains nonetheless. The Fed’s own Charles Plosser, the President of the Philadelphia Fed, has said he wants to see qualitative easing end sooner rather than later. And Bloomberg News is suing the Federal Reserve under the Freedom of Information Act to reveal who it is lending money to against this dubious collateral.

That sums things up in a nutshell.  The key to note here is that the PDCF is an overnight lending facility, the TSLF is a 28-day lending facility and another program, the TALF, is a third longer-term lending facility I haven’t discussed. (See more on the TALF here and why it is a bailout).

Tyler Durden’s beef: the Plunge Protection Team

Tyler’s history of events in his post is largely consistent with what I just presented. Where his history diverges from mine is when he goes into the section headed “Implications,” saying “the Federal Reserve has now managed to singlehandedly take over the entire capital market.” At some point, he goes as far as to say:

The bolded text is all you need to know to find the smoking gun for any and all allegations of "plunge protection" or however one wishes to frame the invisible market bid.

Those are pretty strong words and I believe these claims are unsubstantiated in the post.  Why not leave it at the lesser claim that the Federal Reserve is running a loose monetary policy that encourages excessive risk – something that, while subject to interpretation, is a valid criticism?

Posts like this are exactly why I expressed concern when Bloomberg fecklessly expunged a Tyler Durden interview in August amid media hoopla over his identity:

Zero Hedge is a site replete with copious information on finance and the economy and is often a necessary voice of scepticism in the blogosphere that keeps the mainstream media honest.  We need outlets like that.  And Tyler was on Bloomberg Radio in the first place because he has something to say that is different, interesting and adds value. However, the hyperbole, tone, anonymity and confusion as to which writer is using which pseudonym at Zero Hedge has long become a liability which reduces the credibility of the site.

The claim of equity market manipulation strikes me as hyperbole.  There is no smoking gun whatsoever. It is a theory that I don’t buy into and that is not substantiated by the evidence in the post. Otherwise, Tyler and I are on exactly the same page.

I do have a few other points of disagreement.

• Why talk about the Primary Dealer Credit Facility when it is an overnight facility? The haircut is usually reset daily. How much manipulating can the Federal Reserve really do with an overnight facility? As I see it, the real problem with the Fed’s balance sheet is the loans under longer-term facilities like the TALF.
• What about the haircut on other asset classes, namely investment-grade and non-investment grade asset-backed securities and collateralized debt obligations. Forget about the plunge protection team conspiracy. To my mind, this is the real story here. The Fed says it accepts only securities “for which a price is available” as collateral. Is that really true? I am sceptical, one reason I would like to see who is getting these loans and what kind of collateral they are using.

Somehow you get the feeling there is a reason these facilities are still around, namely that some institutions need them because their capital base is so impaired right now that they would fail without the Fed taking those toxic assets off their hands.

In the end, Charles Plosser, Tyler Durden and I all agree: the Fed needs to end these programs as soon as possible.

Expect more on this issue soon via Marshall Auerback.

Update: This phrase, "PDCF usage declined, reaching zero in mid-May 2009," suggests the PDCF is not being used to goose equities. The quote comes from page seven of the following PDF document at the New York Fed from August: "The Federal Reserve’s Primary Dealer Credit Facility."

Related posts:

• Will banks exiting TARP take back their toxic waste now?
• TALF: A bailout if one reads the fine print
• A few words from a reader on TALF mechanics
• Understand the Fed’s balance sheet
• Bloomberg News sues the Fed under Freedom of Information Act

The Seattle Times has a must-read piece on Washington Mutual today which reveals a lot of the fine detail on how the company was run and what led to its demise (hat tip calculated Risk).

As with many of the other busted financial giants like Northern Rock and Lehman Brothers, indications that something was amiss were apparent long before their ultimate demise.  However, in an environment of easy money and lax regulatory standards those signs were overlooked as share prices kept rising.

Here are a few of the verbatim quotes from the article which I found most telling.

• In its headlong pursuit of growth, WaMu systematically dismantled or weakened the internal controls meant to prevent the bank from taking on too much risk
• WaMu’s riskiest loans raked in money from high fees, but because the bank skimped on making sure borrowers could repay them, they eventually failed at disastrously high rates.
• WaMu’s subprime home loans failed at the highest rates in nation. Foreclosure rates for subprime loans made from 2005 to 2007 — the peak of the boom — were calamitous. In the 10 hardest-hit cities, more than a third of WaMu subprime loans went into foreclosure.
• By the summer of 2004, nearly 60 percent of the loans WaMu was making were the riskiest sort — option ARMs, subprime mortgages and home-equity loans.
• Talk to people who worked with Killinger, and the same phrases and adjectives keep coming up. Ambitious. Quick study. Smartest guy in the room. And always, always optimistic. "He’s a cockeyed optimist to the nth degree," one former associate said. "He always thought he could get out of whatever trouble he was in." But Killinger also is repeatedly described as avoiding confrontation and uninterested in the nuts-and-bolts details of WaMu’s business.
• And even more than most chief executives, insiders say, Killinger was focused on WaMu’s stock price as the company’s — and his — primary gauge of success. "Kerry’s view of himself was tied to a constant increase in the stock price," Chapman said. "He was fixated on it."

This article is the first of two parts. The link to the article is below. It is a good read and documents fairly extensively how all-encompassing the originate-to-sell model of securitization was at WaMu and how this relaxed internal controls and risk management, leading to its demise. What tipped me off to what was happening was the change in Washington Mutual’s lending profile as it rushed headlong into option ARMs. The whole episode is rather sad because WaMu was a great company with an amazing brand. And from most anecdotes I hear, Killinger was a brilliant man as well.

But, smarts are not enough when you are taking on too much risk, thinking you have somehow magically hedged yourself against those risks. No, you do not have to dance, if the music is playing. Given the bubbles now building again and the likelihood of a nasty end to this particular episode as well, this is something that bears remembering.

Source

Reckless strategies doomed WaMu – Seattle Times

See also “A Giant Downfall” from Portfolio.com last month. It documents WaMu’s last days and demonstrates that WaMu was the subject of a bank run – the major reason it was seized by regulators.

Related posts:

• WaMu: Mr. Smith goes to Washington and turns predatory
• WaMu on the brink of disaster: has agreement with regulators
• AIG down; Lehman and WaMu looking to be sold
• JP Morgan Chase buys WaMu out
• Consolidation through merger over bankruptcy

Watch the hour-long retrospective which aired tonight on PBS’s Frontline.  It should be very enlightening in regards to the seeds of the bubble and meltdown.  It examines who the players in the 1990s and 2000s were, what their attitude to regulation was, and how lax regulation created a bubble and a bust.

Also see the following posts for more background:

• 1987
• Freshwater versus saltwater circa 1988
• 1995
• Deregulation efforts from the late 1990s were blocked
• FRONTLINE: Inside the Meltdown of Sept. 18, 2008

(video embedded below; runs just under one hour)

Related posts:

• FRONTLINE: Inside the Meltdown of Sept. 18, 2008
• Greenspan: financial crisis ‘will happen again’
• Ms. Watkins, why does Charlie have lit dynamite?
• Deregulation efforts from the late 1990s were blocked
• Ten lessons from financial crisis investors will soon forget

This is a cross-post from an article I wrote at the finance site New Deal 2.0, a one-stop-shop for current news, sharp analysis and potential solutions of the country’s fiscal crisis. Edward linked to this in this morning’s links, saying “I don’t agree 100% but this is a good overview” – tied to the Austrian business cycle theory as he is!

He asked me to post this here as well. I hope this will help identify some of the flaws in conventional economic orthodoxy.

Fears about the falling dollar are stoked by neo-liberal money myths that harken back to the gold standard system.

It seems there isn’t a day that goes by without more commentary on the demise of the dollar and the concomitant risk of a collapse of the world’s reserve currency. Again, the reasoning here appears largely to be based on the tyranny of orthodox neo-liberal economics. Orthodox economists view dollar depreciation as an imminent danger which raises the relative costs of imports, and imparts an inflationary bias to the economy. Moreover, they argue that depreciation leads to expectations of further depreciation and fuels the run out of the currency.

So, in the logic of this view, there may be no interest rate that is high enough to counter expectations of losses due to depreciation and possible default, which means that there will be no alternative but to urgently restore reserves of foreign currency either through renegotiation of foreign debt obligations, international donor assistance or default, especially given our supposedly “reckless” and “irresponsible” government spending, which is supposedly robbing future generations of growth and prosperity.

Large deficits are not the problem

Let’s all take a deep breath here: Whilst the dollar index has fallen some 15% from the high sustained earlier this year, it is still above the lows sustained at the height of the credit crisis reached about a year ago. Secondly, there seems to be a fear that the current fall in the dollar could well engender inflation, and create a panicked response from policy makers where the Fed actually does raise rates and the Treasury begins to reduce government spending. Given high prevailing debt levels and the weak state of the consumer’s personal balance sheet, this would be an unmitigated disaster.

It is true that excessive government deficit spending can be inflationary, and could therefore cause some impact on exchange value of dollar. But this can’t be viewed in some sort of vacuum. The size of the deficit is irrelevant in itself. There is no meaning in the terms ‘large deficit’ or ’small deficit.’ You have to relate them to the extent of labor and capital underutilization, which is a human measure of the aggregate demand deficiency. The fact that labor underutilization is now in excess of 16 per cent in the US (combined unemployment, underemployment and hidden unemployment) and capacity utilization is in the 60-65 per cent range rather than 90 per cent range sends one very clear message – the deficit is not large enough.

So the correct policy response is to spend until we get to full employment. That is the only consequence of excessive deficits — insolvency is not possible. Your social security check will never bounce in a country issuing debt in its own freely floating non-convertible currency.

The size of our government deficit is endogenously determined, which is to say that it has no external cause; it is a function of internal, domestic phenomena. Today, the deficit is largely a function of weaker spending power and concomitantly lower economic growth. (”Good government spending” more or less seeks to fill private output gaps; “bad government spending” is a consequence of government not taking responsibility for filling the spending gap and instead letting this occur via the automatic stabilisers). So the scenario of ever-increasing deficits is unlikely because as economy heats up, deficit shrinks and turns to surplus (as during the Clinton years and also the 1920s).

The orthodox interpretation of a nation with a declining currency and a large current account deficit appears to indicate that the nation concerned is “living beyond its means” — with excessive domestic demand that boosts imports; the excessive demand also fuels inflation that restricts exports. The presumption is that the resultantly large deficit must be “financed” by flows of foreign reserves, which, for the most part, must be attracted by high returns and a stable political, economic, and social environment.

From the US perspective, this means that if America cannot continue to attract these needed reserves, it must raise rates to attract new foreign capital, which in turn will slow its growth to reduce imports; lower prices and wages could also encourage exports. The obvious portent of the default on foreign debt obligations is then used to argue in favour of restricting government spending. Thus, both monetary and fiscal policy ought to be tightened to encourage such capital flows even as this reduces the need for them. In other words, an emerging markets’ crisis writ large.

Deflation or inflation?

But the reality is not so much that the US is inflating, so much as that the rest of the world is deflating relative to the dollar. Import prices are still generally falling, inflation remains quiescent and private credit growth is now contracting. These are hallmarks of deflation, not inflation. Additionally, the US is not borrowing in a foreign currency (in contrast to Iceland or Latvia or the Asian countries during the 1997/98 emerging markets’ crisis), so it does not face an external funding constraint.

What about China? True, there may be some indications that there is some shifts in terms of private portfolio preferences. Perhaps the Chinese don’t want to buy as many dollars as they did before. Perhaps hedge funds are now laying on a big “short dollar” trade in the markets. These are one-off portfolio preference shifts and it seems inadvisable for US policy makers to respond to every single vicissitude of changing market sentiment. That way leads to Latvia and economic implosion.

It’s hard to believe that a nation with 10% official unemployment and likely double that when one factors in underemployment is actually “living beyond its means.” It is even crazier to suggest that we should scale back government spending and private consumption, when there is substantial unused capacity and under-utilised resources (particularly labour). In those circumstances, the nation could not possibly be living beyond its means.

What about those terrible “global imbalances” that we are told must be rectified, what I call “the cult of zero imbalances”?

Well, let’s consider that as a possible policy response.

Policy fables

According to the G20 communiqué, those countries running current account deficits, most notably the U.S., would have to define ways to boost savings. Nations running surpluses – China, Germany and Japan, among others – would detail how they propose to reduce any reliance on exports. The U.S. would likely need to commit to a sharp deficit reduction by government. Europe would need to commit to improving competitiveness. That could mean introducing “labour market reforms” (an interesting choice of language here), which generally is code for being able to sack workers and destroy the power of trade unions.

The collective impact of these measures? We want more domestic led consumption in Asia and the EU (especially Germany), but then the two largest economic areas (the US and Europe) would have to deflate their economies. The former, by reducing the public net spending which would thwart the goal of “boosting” saving, and the latter, by widespread shedding of workers and the resulting collapse in consumption (and rising deficits via the automatic stabilizers as welfare payments and crime rose).

These, of course, are the traditional “remedies” proposed by the IMF — and we can see what a great job this organisation has done. Just ask any Argentinean. Neo-liberal-based policy recommendations almost invariably make things worse. We have ample examples of this in Asia, Russia and Brazil during the 1997/98 emerging markets and more recently in Iceland and the emerging market economies of Eastern Europe.

Goldbug mentality still dominates

It is important to understand that much of the economic orthodoxy is still dominated by the “gold standard paradigm”.

Under the Gold Standard, the leading economies of the world, through their monetary authorities, agreed to maintain the “mint price” of gold fixed by standing ready to buy or sell gold to meet any supply or demand imbalance. Further, the central bank (or equivalent in those days) had to maintain stores of gold sufficient to back the circulating currency (at the agreed convertibility rate). The currency was strictly convertible into gold at the fixed parity. So this was a convertible, fixed exchange rate system.

Gold was also considered to be the principle method of making international payments. Accordingly, as trade unfolded, imbalances in trade (imports and exports) arose and this necessitated that gold be transferred between nations (in boats) to fund these imbalances. Trade deficit countries had to ship gold to trade surplus countries. Money literally did “flow” between countries (which is why we still speak in terms of “capital inflows” and “capital outflows” even though the reality of current modern monetary operations is that we electronically credit and debit bank accounts).

This inflow of gold into surplus countries allowed them to expand their money supply (issue more notes) because they had more gold to back the currency. This expansion was in strict proportion to the gold-currency parity. The rising money supply would push against the inflation barrier (given no increase in the real capacity of the economy) which would ultimately render exports less attractive to foreigners and the external deficit would decline. The trade deficit country would lose gold reserves and this would force their government to withdraw paper currency which drove up unemployment and drove down the price level. The latter improved the competitiveness of that economy. The two adjustments – for the surplus and deficit countries — helped to resolve the trade imbalance. But it remains that the deficit nations were forced to bear rising unemployment and vice versa as the trade imbalances resolved.

So under the Gold Standard, the government could not expand base money if the economy was in trade deficit. It was considered that this constraint acted as a means to control the money supply and generate price levels in different trading countries which were consistent with trade balances. The domestic economy, however, was forced to make the adjustments to the trade imbalances.Monetary policy became captive to the amount of gold that a country possessed (principally derived from trade).

In practical terms, the adjustments to trade that were necessary to resolve imbalances were slow. In the meantime, deficit nations had to endure domestic recessions and entrenched unemployment. So a gold standard introduces a recessionary bias to economies with the burden always falling on countries with weaker currencies (typically as a consequence of trade deficits). This inflexibility prevented governments from introducing policies that generated the best outcomes for their domestic economies (high employment). Ultimately the monetary authority would not be able to resist the demands of the population for higher employment.

We no longer have this currency system, but traditional economic thinking and modelling is still based on it, which is why notions of “affordability” and “sustainability” still dominate our economic discourse. But given that we operate under a fiat currency system (where government declares money to be legal tender), we face no operational constraint per se, or issues of national solvency.

So, in regard to the dollar, what is our advice to Lawrence Summers, Tim Geithner, and Ben Bernanke? Do nothing. In the words of the English poet, John Milton, “They also serve, who only stand and wait”.

Related posts:

• The dollar is rising against floating currencies
• The Cult of Zero Imbalances
• Hyperinflation, national bankruptcy, dollar crash and other exaggerations
• Japan does not demonstrate the failure of stimulus
• Japanese defend dollar’s status while China tears it down

Remember when Paul Krugman asked aloud “How Did Economists Get It So Wrong?” He had a very well-received answer.  But he left out something.

The elephant in the room was debt.  No one seems to have been noticing.

Below is a British video parody version asking economists and political leaders the same question (in a slightly more graphic version). Warning : this video is hilarious but graphic.  Don’t play it at work. I warn you.

Hat tip Yves Smith.

Related posts:

• Doubling down at AIG
• Tim Geithner defends himself before Congress
• Paul Tudor Jones: Trader – Flashback to 1987
• Bloomberg News vs. Fed: Judgment against Fed attached
• Wassup 2008

In my last post, I presented you with a bunch of data on debt levels broken down by sector of the economy (see “A brief look at the Asset-Based Economy at economic turns”).  I found it interesting that a secular pattern seemed to be at play when looking at the household debt charts.

Notice the three areas boxed in red on the chart to the right.

The chart measures the differential between the year-on-year change in household debt and nominal GDP.

The three areas show three distinct periods of household debt accumulation.

1. 1951-1966. The first shows household debt changes generally outstripping nominal GDP by a wide but decreasing margin. This period coincided with a secular bull market in equities.
2. 1966-1982. This second period is more volatile, but with the overall numbers lower.  In general, debt was accumulated less rapidly compared to the growth in nominal GDP. And when recession hit in 1970, 1974 and 1980, it induced a retrenchment (at least relative to nominal GDP growth). This period coincided with a secular bear market in shares.
3. 1982-?. This last period shows an enormous increase in debt growth relative to GDP growth during the 1980s followed by minor retrenchment after the 1990-91 recession and strangely also in 1997 (could this be a butterfly effect to the Asian Crisis?). But after that it was off to the races right through the 2001 recession until mid-2007.  This period coincided with a secular bull market in equities.

The pattern seems to indicate that there is a relationship between debt build-up in the household sector and stock prices.  The build-up in debt relative to nominal GDP troughed in Q3 2008 at -0.4%. As of Q2 2009, the number was +1.2%.

I see this as evidence of the so-called Wealth Effect. The data suggest that the secular bear market may not have begun in 1998 or 2000 as I have generally believed. And they also suggest that, despite the recent rise in shares, a new secular bear market may have just started in 2007. I will be curious to see what the data look like for the second-half of 2009.

Source

Z1 Data Series – Federal Reserve

Related posts:

• Americans are not increasing savings
• A brief look at the Asset-Based Economy at economic turns
• Chart of the day: household debt vs. savings
• Consumer credit falls 4.4% from year ago levels
• Data on past consumer deleveraging during recessions

This morning I again wanted to challenge my somewhat bullish medium-term outlook but bearish longer-term view on the US economy – this time by looking at the data on debt. What follows is going to be a very numbers-heavy post.  So, I apologize in advance if you are not a numbers jockey like me. But, do bear with me; I think you will find the analysis useful.

Now, as I write this paragraph, I have compiled the data, but have not yet dissected it. So I approach this without any definitive conclusions at the outset (although I must admit the last time I saw the data last year, they supported my thesis). Let’s see if the data still support my beliefs .

The Asset Based Economy View of America

My pre-conceived thesis is as follows:

1. The U.S. has been living beyond its means for a generation as reflected in the increase of debt to GDP across a wide-spectrum of sectors of the economy.
2. This increase has not been worrying to policymakers because they have only been watching debt service burdens, to the degree they have been tracking debt.
3. Because of “the Great Moderation,” interest rates have fallen, permitting a secular increase in debt to GDP levels without increasing debt service burdens.
4. The Federal Reserve has a dual mandate to support economic growth (through full employment) while maintaining low consumer price inflation (through price stability). Cognizant that debt services burdens were not acute and consumer price inflation was low, the Federal Reserve was able to target asset prices through lowering the Fed Funds Rate as a mechanism for reviving the economy when cyclical downturns occurred.
5. As a result, the Federal Reserve under Sir Alan Greenspan followed an asymmetric monetary policy of only increasing interest rates slowly in the face of large levels of asset price inflation but reducing those rates very quickly to stem asset price declines.
6. The result has been a belief that the Fed would save the economy when it ran into trouble, the so-called Greenspan Put. This has increased the appetite for risk in the financial sector and, most crucially, has meant that debt levels always increased after a brief downturn. The heroic actions of the Bernanke Fed have only increased this belief in the Fed as economic savior, sowing the seeds of the next asset bubble.
7. This Asset-Based Economic Model can last through several business cycles – but will eventually collapse when debt service burdens become too large.

So, in sum, I believe that we are now poised to either a) collapse under the weight of debt only if debt service burdens are too much to bear or b) continue apace in the Asset-Based Economy until these burdens do eventually become crushing. I see b) [this originally said a) erroneously. A reader caught the mistake. Freudian slip?] as the more likely outcome during this cycle. Whether that crushing level of debt eventually comes as the result of a decline in incomes not matched by a decline in debt burdens (deflation) or via an increase in interest burdens not matched by an increase in incomes (inflation) is a question for another day.

What I want to look at here is the narrow issue of how debt burdens have moved at turns in the economic cycle. Specifically, I am about to examine the debt to GDP levels of specific sectors of the economy as presented by the Fed Flow of Funds right around recessions. And then I will compare these levels to the growth in nominal GDP and draw conclusions based on the data (debt cannot grow more than nominal GDP for long or it is a clear sign that growth is predicated not on sound investment and productivity but on leverage). 

So, this is not an exercise in crunching the numbers to fit a conclusion, but rather a look-see at whether the data supports my thesis.

The Numbers: Federal Reserve Z1 Data Series

The Federal reserve releases a data series called Z1 every quarter.  This is the basis of my analysis (link at the bottom). The Z1 series shows debt from the following sectors of the economy:

1. domestic nonfinancial sectors credit market instruments, excluding corporate equities liability
2. households and nonprofit organizations credit and equity market instruments liability
3. households and nonprofit organizations home mortgages liability
4. households and nonprofit organizations consumer credit liability
5. nonfinancial business credit market instruments, excluding corporate equities liability
6. nonfarm nonfinancial corporate business credit market instruments liability
7. state and local governments, excluding employee retirement funds credit market instruments liability
8. federal government credit market instruments liability
9. total finance credit market instruments, excluding corporate equities liability
10. rest of the world credit market instruments, excluding corporate equities liability

My pre-conception is that the sectors I want to key in on are the mortgage market (3), the household sector (4) and financial services sector (9)

Total Debt

What should be abundantly clear from the two charts below is that the U.S. has been growing in an unsustainable way since the recession of 1982.  There was a brief period during the 1990-91 recession when the change in nominal GDP outstripped increases in debt levels, but that’s it  (note, I use year-over-year change levels throughout). This is completely at odds with the preceding period in which every recession induced declines in debt to nominal GDP comparisons.

Debt levels at the end of Q2 2009 are 357% of GDP, a massive increase from the 160% that prevailed in 1982. The data clearly demonstrate that since 1982 the U.S. has relied on an increase in debt, even during recession, to avoid downturns. My thesis of policy asymmetry is, therefore, confirmed.

Government Debt

This chart is fairly benign when you look at aggregate levels as a percentage of GDP.  Pundits forecasting an imminent increase in U.S. interest rates because of too much government debt have obviously not looked at these data. However, what is striking is the huge and unprecedented surge in debt as a percentage of GDP since the latest downturn hit.  This discrepancy to nominal GDP cannot go on indefinitely.  My general conclusion is that deficit spending can indeed continue for a long time without stoking an increase in interest rates given the low level of government debt as a percentage of GDP. This is bullish for U.S Treasuries in a muddle through economic scenario.

Household Debt

There is less here than I anticipated.  One thing is clear: the household sector has breezed through the recessions in 1990-91 and 2001 without decreasing debt significantly.  As a result, the increase in debt levels in the household sector are pretty astonishing. In 1952, it began at 24% of GDP, rising to around 40% by 1960, where it remained through the Ford presidency. Afterwards, it shot up again to its present 97%, four times the level a half-century ago.

Mortgage Debt

This pattern is largely the same as the previous one.

Consumer Credit Debt

Consumer Credit seems to be much more volatile than mortgage credit.  You can see the fluctuations in comparison to nominal GDP are greater.  And the absolute amounts are much less than in the mortgage market. The conclusion I draw from this is that, to the degree household debt levels have increased unsustainably, it is mortgage debt which is to blame.

Non-Financial Business Debt

There is a lot more volatility in capital spending as reflected in non-financial business debt levels as well.  Nevertheless, there has been a secular increase in debt levels of the business sector, from 30% in 1952 to the present 78%. The one thing to notice on the chart on the right is how short business cycles were pre-1982.  It is more striking in that chart because business debt levels always adjust during recession.

State and Local Government Debt

Since the 1960s, state and local government debt levels have been basically flat as a percentage of GDP. There is not much to say here except to note the huge spike in the mid-1980s relative to nominal GDP.  Can someone explain this for me?  I think that area circled in red is quite intriguing.

Federal Government Debt

This chart looks basically the same with the total government debt charts as Federal Government debt dominates.  What you should notice is that debt levels are lower now than they were in the 1950s and have just passed the post 1950’s high-water mark in 1993 of 49%. Again, this does suggest there is ample room for deficit spending without an increase in interest rates.  The data are more favorable for treasuries than I had anticipated.

Financial Services Debt

This is probably the key damning piece of data confirming the asset-based economy thesis.  The data are much worse than I expected.  Not only do Financial Sector debt levels rise from negligible to percentages well over 100% of GDP, but the entire post-1982 period sees zero decline compared to nominal GDP until last quarter.

What conclusions can one draw here?

1. The financial services sector is six times more important than in 1982 when its debt is measured as a percentage of GDP.
2. The financial sector protected the American economy since 1982 by increasing its debt burden relative to nominal GDP even during recession.
3. The financial services sector contracted in Q2 relative to GDP for the first time since 1982.  If this is a rear-view mirror view, that means recovery could continue. However, if this is a canary in the coalmine, that is negative for the U.S. economy. This number bears watching.

Foreign Debt

There was an absolutely massive decrease in foreign debt relative to GDP when the economy was falling. Q4 2008 saw a gap of -12.4% between the change in foreign debt and the change in nominal GDP.  The year-over-year differential has diminished as Q1 and Q2 2009 saw foreign debt increase, albeit to a level much lower than in Q3 2008.

Conclusions

Most of my basic beliefs regarding the asset-based economy are still intact.  What now seems clear to me is the degree to which the post-1982 period is a departure from the one which preceded it. Moreover, the data on the financial services sector was surprisingly stark. I would go as far as to say that the US economy depends on leverage in the financial services sector to continue growing.  I come out of this thinking it is the financial services sector more than the household sector dictating the course of events. And as the financial sector just began to really deleverage in Q2, it bears watching how this proceeds.

As for the household sector, aggregate debt levels are not decreasing substantially – not in mortgages or consumer credit. This may have changed in Q3 but given the fact that the worst of the recession was in Q4 2008 and Q1 2009, the data suggest that the consumer will not deleverage.  If deleveraging doesn’t occur in the mortgage market, the household sector will not be the cause of a double dip.  So, not having looked at debt service levels yet, I am not anticipating an imminent downturn in consumption demand or a further increase in savings – although this could change based on the data.

In the end, my somewhat more bullish medium-term outlook is justified by the data. Here, I am not talking about longer-term sustainability but the prospects of a multi-year recovery. Watch debt levels in the financial sector as a contrary indicator.

Source

Z1 Data Series – Federal Reserve

Related posts:

• U.S. unemployment claims rise sharply
• GDP: imports, inflation and local government are the story
• Kill All The Storytellers
• If the UK economy is still in recession, why are London house prices hitting new records?
• ISM: September manufacturing data disappoint; market sells off

Hank Paulson and Ben Bernanke told us when the Troubled Asset Relief Program (TARP) was launched that they were not concerned about the health of our banking system.  In fact, this was not the case. They were concerned about specific institutions and the overall health of the system. The U.S. financial system was much weaker than we were led to believe as I indicated at the time.

Now the TARP Special Inspector Neil Barofsky is telling the American people what many of us knew all along. Listen to what he says in the video below with MSNBC’s Dylan Ratigan. His contention that these false premises undermined the credibility of TARP and subsequent government economic policy rings true. Even today, we don’t know what the banks are doing with their TARP funds.  If they are loaning it out, why is the unemployment rate 9.8%?

By the way, I love D-Rat. This is a guy who likes to talk – god bless him. Sometimes he goes on way too much, but I like his approach.

Related posts:

• US Bancorp CEO makes his case on TARP repayment
• Some banks not paying TARP dividends
• TARP dividends are killing bank profits
• Should foreign companies get TARP funds?
• Crony capitalism in U.S. banking bailout should end

Marshall Auerback sent me a link to a recent Simon Johnson missive about Goldman Sachs. I had already seen and liked this article, but his e-mail prompted me to write this post. My question is: Why is Goldman a bank holding company?

Goldman becomes a bank

The reason Goldman became a bank to begin with is because it was on the verge of collapse after the Lehman Brothers failure. Andrew Ross Sorkin has a good write up on this in Vanity Fair:

Due to disastrous bets on Lehman paper, the giant Reserve Primary Fund had broken the buck a day earlier, causing an investor run on the money-market funds. Between that, Geithner thought, and billions of dollars of investors’ money locked up inside the now bankrupt Lehman Brothers, that meant only one thing: the two remaining broker-dealers—Morgan Stanley and Goldman Sachs—could actually be next.

Just in case it’s not obvious, Goldman Sachs was a major beneficiary of the government’s bailout of the financial services industry, not only through the bailout of AIG but also through its ability to fall under the regulatory umbrella as a bank holding company* (technically Goldman became a financial holding company but the distinction is relatively minor. see definition here). – something which made it eligible for debt guarantees and other government backstops.

Late last year, every financial services company on earth wanted to become a bank and line up for the handouts coming from Washington – American Express (a credit card company), GE Capital (basically a hedge fund), GMAC (a car financing company), Genworth Financial (an insurance company), Aegon (a Dutch company), even Willem Buiter, a former central banker, wanted to become a bank.

This is why Goldman became a bank too. Now, Goldman was in a more precarious position than bank holding companies because of the vulnerabilities of being a broker-dealer. Nouriel Roubini warned repeatedly before Leman’s collapse that the large full services broker-dealer model was broken.  Here, just before Lehman failed, he talks about Goldman, Morgan Stanley and Merrill’s demise if Lehman collapses:

I also argued in follow-up pieces that, in a matter of two years, no one of the remaining independent broker dealers (Lehman, Merrill Lynch, Morgan Stanley and Goldman Sachs) would survive as: 1. their business model is now impaired (securitization is semi-dead); 2. they will need to be regulated like banks given the PDCF support and thus have lower leverage, higher liquidity and more capital that will erode their profitability; 3. Their severe maturity mismatch – borrowing very short term and liquid, leveraging a lot and lending and investing in more long term and illiquid ways – makes them very fragile – in the absence of deposit insurance and in the presence of only limited LOLR support by a central bank – to bank like run that are destructive even of illiquid but otherwise solvent institutions. Thus all such broker dealers need to merge with larger financial institutions that have a commercial banking arm and thus access to stable and insured deposits and to true LOLR Fed support. That process of unraveling of independent broker dealers started with Bear Stearns; now it is moved to Lehman; tomorrow Merrill Lynch will be on line; and Morgan Stanley and Goldman Sachs will be next. No one of them can and will survive as independent entities. So, the Fed and Treasury should advise them all to start finding a large international partner (international as almost no domestic partner is now sound to take them over) and merge with such partner before we get another Bear or Lehman disaster.

I happen to think Goldman is a well-run institution, but that is neither here nor there. They were vulnerable. 

And, apparently, policy makers heeded Roubini’s words as all the broker-dealers were immediately made into banks.  Government went so far as to try and merge Goldman with the bankrupt Wachovia (now a problem for Wells Fargo), but thought better of it because of the conflicts of interest for Hank Paulson and Robert Steel:

In an excerpt from his forthcoming book, Too Big To Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System—and Themselves, Sorkin reports that the deal, which was nearly consummated, would have merged Goldman Sachs and Wachovia. Henry M. Paulson, the Treasury secretary and former C.E.O. of Goldman, was deeply involved in the process, contacting both Lloyd Blankfein, Goldman’s current C.E.O., and a Wachovia board member, and strongly urged both to consider it. Wachovia’s C.E.O., Robert Steel, was a former vice-chairman at Goldman Sachs and Paulson’s former number two at the Treasury Department.

Sorkin reports that Warren Buffett was also contacted about investing in the merged company, but told a banker at Goldman that it would never happen. “By tonight the government will realize they can’t provide capital to a deal that’s being done by the former firm of the Treasury secretary with the company of a former vice-chairman of Goldman Sachs and former deputy Treasury secretary,” Buffett said. “There is no way. They’ll all wake up and realize, even if it was the best deal in the world, they can’t do it.”

Goldman gets to game the system

These conflicts of interest has everyone up in arms about Goldman, dubbed “Government Sachs” by its haters (see here, here, and here). That is why the face-sucking squid polemic by Matt Taibbi was a zeitgeist piece. 

I think eyes should be focused firmly on the government’s responsibility and not Goldman when it comes to these issues. Which is why the issues that Simon Johnson raises are important. They go to the core of the regulation of banks.

Here are four questions we should be asking regulators:

1. Why is Goldman Sachs allowed to maintain leverage ratios significantly higher than the large legacy bank holding companies like Wells Fargo, Bank of America, JPMorgan and Citigroup?
2. Why is Goldman allowed to operate like a private equity company, holding large stakes of foreign non-financial corporations? (I should note that Financial Holding Companies do have ten years in which to sell their stakes)
3. Why is Goldman (and other large banks) allowed to operate like a hedge fund and take outsized risks with capital via large proprietary trading operations.  Most of Goldman’s profits are coming from this area. At least Deutsche Bank has offloaded these bets onto hedge funds in which it invests. Given the fact that the large too-bog-to-fail financial institutions have received a large backstop from the taxpayer, the fact that they are loading up in prop trading shows that regulation in the U.S.  is non-existent.
4. Why is Goldman allowed to have an interest in the failure of other financial firms? We now hear that Goldman has an interest in the failure of CIT, a major lender to small-and medium-sized businesses. These perverse incentives are everywhere in the derivatives world and were an enabler of the financial meltdown and the principal reason AIG was bailed out with taxpayer money.

Clearly, regulators are not serious about regulating or they would correct these problems.  MarketWatch reported on this as far back as July and nothing has happened.

When Goldman switched to a bank holding company, such big profit seemed unlikely as analysts worried the firm would face stricter regulatory oversight from the Federal Reserve, with limits on risk-taking and higher capital requirements. See story Wall Street changes.

But almost 10 months later, nothing much appears to have changed, some analysts said in the wake of the firm’s second-quarter results.

After two quarters as a bank holding company, Goldman is still "not reporting like a bank and not acting like one either," said David Hendler, Baylor Lancaster, Pri de Silva and Kristine Lanspa, analysts at CreditSights, an independent fixed-income research firm.

Given Goldman’s spectacular results so far this year, "the company has basically been given a green light to continue operating in a ‘business as usual’ fashion," they wrote in a note to investors after Goldman’s latest earnings report. "Bank regulators have their hands full with other deteriorating bank situations and, for the time being, seem content to let Goldman do what it’s always done."

Tier 1

Goldman still doesn’t report quarterly results like other large bank holding companies. For instance, the firm doesn’t disclose a full balance sheet in its earnings release or provide detailed information on revenue and valuation marks on exposures, the analysts noted…

"Our sense is that Goldman’s switch to bank holding company status was basically a security blanket in the worst of last fall’s troubles, and the company would be happier today if it could let it go," they added. "We also sense that Goldman Sachs many not yet have the same level of regulatory scrutiny that many banks routinely live with."

And CreditSights is right. Goldman have no intention of changing anything at all.

“Our model really never changed,” Goldman Sachs Chief Financial Officer David Viniar said yesterday in an interview. “We’ve said very consistently that our business model remained the same.”

Plus ça change.

The excerpt in this article from the RGE Monitor is copyrighted and re-published with the express permission of Roubini Global Economics LLC.

Related posts:

• Let Goldman fail next time
• Goldman and Morgan Stanley are now banks
• Goldman looking to buy a bank
• Goldman loses $2.1 in the third quarter
• Banks: are mergers in the offing?

In light of recent comments made by both living former Federal Reserve Chairmen, I thought it appropriate to look back 22 years to the succession from Volcker to Greenspan.  What follows is a blurb from a New York Times article circa 1987, which highlights the appointment of Alan Greenspan as Chairman of the Federal Reserve Board of Governors and the failure to re-appoint Paul Volcker.

I have bolded the key points and follow the blurb with comments and links to the rest of the article as well as to Volcker and Greenspan’s recent remarks:

President Reagan brought to a close today Paul A. Volcker’s stewardship as one of the most powerful economic policymakers in the nation’s history, nominating Alan Greenspan to succeed him as chairman of the Federal Reserve Board.

Economists and other analysts said Mr. Greenspan, in taking a job that is sometimes described as the second most influential in the nation, was unlikely to pursue a policy markedly different from Mr. Volcker’s.

Mr. Greenspan shares the free-market views of the White House and has long been an important presence both in Washington and the Wall Street community. Still, the news stunned the financial markets, which had come to regard a third term for Mr. Volcker as highly probable. Bonds finished with one of the biggest losses on record, and the dollar tumbled.

Efforts Seen as Minimal

The President’s selection of Mr. Greenspan followed a letter from Mr. Volcker saying he did not wish to be reappointed after eight years in the job. But it appeared that White House efforts to persuade Mr. Volcker to remain were minimal.

It is understood that Mr. Volcker would have accepted a reappointment to the post if the President himself had urged him to do so. But no such effort was made.

It was also understood that Mr. Volcker felt that the Administration was looking for a way to avoid an outright rejection and that it asked him to meet with Howard H. Baker Jr., the President’s chief of staff, who was said to have made no serious attempt to urge him to remain.

‘Reluctance and Regret’

President Reagan, in a short appearance at the White House briefing room, said he had accepted Mr. Volcker’s decision ”with great reluctance and regret” and Treasury Secretary James A. Baker 3d said later that someone ”at my level” had urged Mr. Volcker to ”give some reconsideration” to his inclination to leave.

”After eight years as chairman, a natural time has now come for me to return to private life as soon as reasonably convenient and consistent with an orderly transition,” Mr. Volcker said in a letter he carried to the White House Monday afternoon for a meeting with the President. ”Consequently I do not desire reappointment.”

Mr. Volcker, who recently denied reports that he had turned down the presidency of Princeton University, said today he had ”not the vaguest idea” about his future employment.

The main philosophical difference between Mr. Volcker, a Democrat, and Mr. Greenspan, a Republican, appears to be in their views of the structure and regulation of the banking system. Mr. Volcker has tended to resist deregulation of banks while Mr. Greenspan is more favorably disposed to it.

Analysts noted that Mr. Volcker was considered almost a national hero for chopping inflation from an average rate of 12.8 percent in 1979 and 1980 to less than one-third that level for each of the past five years, while Mr. Greenspan’s anti-inflation credentials have not been tested in practice.

Seeking to reassure skeptics, the President said Mr. Volcker had ”indicated his strong support” for Mr. Greenspan and added that his own ”dedication to the fight to hold down the forces of inflation remains as strong as ever.”

Looking back at this article today, what is abundantly clear is that Greenspan’s appointment ushered in a period of ‘free market’ ideology, which had been gaining strength in academic and policy circles.  This belief in market forces as efficient and unerring was a rejection of so-called ‘fine-tuning’ that gained sway in the 1960s and 1970s. and The rift between Saltwater and Freshwater economists was won by Freshwater economists.

Below are video clips of both Alan Greenspan and Paul Volcker putting their spin on recent economic events.  Notice how Greenspan points to asset prices and liquidity i.e. the Asset Based economy, while Volcker focuses on government support.

Source

Volcker Out After 8 Years As Federal Reserve Chief; Reagan Chooses Greenspan – NYTimes

Related posts:

• Volcker warns how serious things have become
• Should the Fed have a dual mandate?
• Obama to re-appoint Bernanke
• Paul Volcker: Obama’s other economic advisor
• Popping bubbles

Marshall Auerback pointed out a statement from Dallas Fed Chief Richard Fisher today that is not getting a lot of attention despite its importance.  He said:

I expect that when it comes time to tighten monetary policy, my colleagues and I will move with an alacrity that, if needed, will be equal in speed and intensity to that with which we pursued monetary accommodation.

This is extremely hawkish language from Fisher. If true, it would be an upward move more akin to 1993-1994 than to 2004-2007. If you recall, the Fed Funds rate bottomed at 3% in May 1993. The Fed then aggressively raised rates to 6% in the next two years. This was not the ”measured” interest-rate hike campaign that the Federal Reserve followed after the Dot.com bubble.

The mid-nineties rise in rates led to a major bust at investment banks which were long treasuries like Goldman Sachs and also led to the so-called Tequila crisis (see my write-up on this in a post called “1995.”). This was the first full blown financial crisis of the Greenspan era and it seems the lesson the Fed took from the event was that it needed an asymmetric monetary policy in which rate cuts are more aggressive and quicker than hikes.

We have seen the folly in this policy, euphemistically known as ‘the Greenspan Put’ as gigantic asset bubbles ballooned out of control following cuts in 1998-1999 and 2002-2003. Fisher, a well-known inflation hawk, might be speaking for himself.  Or he might be signaling there will be no Bernanke Put.

Source

Fisher Sees Limit to Fed’s ‘Life Support’ for Housing – Bloomberg

Related posts:

• Quote of the day – Richard Fisher, head of the Dallas Fed
• The unkindest cut: the BoE got it wrong
• The Fed leads a global rate cut by central banks
• BoE dilemma highlights difficulty of turning points
• Is the Fed just jawboning?