This is a post I just wrote over at Yves Smith’s site Naked Capitalism in response to a reader request. Marshall Auerback has already written a reply as well and I will post this later today.

A reader at Naked Capitalism asked us to respond to a recent article from the Christian Science Monitor asking Does US need a second stimulus to create jobs?

Marshall Auerback has already done some heavy lifting. He says emphatically yes. Now I want to take a crack at this. My short answer is no. But before I go into this, as an aside, I wanted to mention Marshall’s new smiling, happy picture up at the great blog New Deal 2.0 where he now writes.  Earlier, when Credit Writedowns was hosted at Blogger, he used a picture best described as a mug shot in his profile, but he has changed that one too (although he smiles there a little less). He thinks we haven’t noticed this sleight of hand.  Well I have! Once upon a time, Marshall wrote with a man I called all bearish, all the time this summer. Take a look at that post; you don’t see him smiling now do you? We have Lynn Parramore, New Deal 2.0’s editor to thank for making Marshall Auerback into an optimist.

Different policy choices

But all teasing aside, I do want to take the opposite side of this trade.  You see I too was a deficit hawk. And while I may have been backing fiscal stimulus, I have felt conflicted for doing so. Here’s how I see it. 

You have four options:

1. No stimulus. Let the chips fall where they may. Yves Smith calls this the ‘Mellonite liquidationist mode.’ The thinking here is that trying to avoid the inevitable bust only makes it that much larger. And the economic policies during recessions in 1991 and 2001 seem to bear that out. The Harding Recession of 1921 is commonly seen as gold standard response.
2. Monetary stimulus only. Quantitative easing mania. My understanding is this is what Ambrose Evans-Pritchard has been advocating.   The thinking here is that the flood of money and the low rates will eventually jump start the economy. No deficit spending needed.
3. Monetary and fiscal stimulus.  Full tilt Keynesian. This is the Krugman view. The thinking here is that one needs to credibly commit to higher inflation and close the output gap to avoid a deflationary spiral. If that is insufficient, then one needs to go full bore on fiscal stimulus aka deficit spending. And if that doesn’t work, subsidize jobs. The New Deal is commonly seen as the gold standard response.
4. Fiscal stimulus only. Deficit spending. I have been talking up this view. The thinking here is that we need to both close the output gap to prevent a deflationary spiral and revive private sector savings in order to promote deleveraging.

There is no magic bullet here.  We are living through a situation unique in time with few historical precedents. And there are a lot of competing ideas being tossed about. So policy makers are groping around, desperately seeking the holy grail of depression-busting economic policy.  In that regard, I don’t envy them. They are certainly going to make a lot of mistakes. It may seem at times that I don’t realize this given the harshness of my critiques, but I do.

Deficit hawks are misguided

However, there are some policies which could work and others which are flat out wrong.  One policy which is flat out wrong is the concept that we need to reduce deficit spending in order to avoid a double dip recession. This flies in the face of basic economics which says that more spending and less taxes equals greater demand and recovery/boom. More taxes and less spending equals less demand and recession/depression.

Now, it’s not as if we didn’t see this line of argument coming. As far back as November 2008, I heard the chatter (see my post here). So you knew this we-have-to-stop-or-we’ll be-bankrupt nonsense was coming. The problem is it’s just not true.  Here are a few data points:

• Private sector debt (incl. financial firms) was 292% of GDP as of Q2 but public sector debt (incl. state and local municipalities) was 67.2%. Who’s more indebted – the private sector by a factor of 4.
• Adding unfunded liabilities to any public debt number when talking about spiking treasury rates is inaccurate and artificially inflates the number. A lot of people do this to make the public debt scenario look worse. The issue at hand is whether a supply/demand imbalance in Treasury securities spikes interest rates. Unfunded liabilities have absolutely nothing to do with this.
• Cash and bonds are fungible. They are both obligations of the federal government to be repaid in full with a specific sum of fiat money. The Treasury could literally stop issuing government debt altogether and just start crediting accounts electronically to ‘fund’ its purchases. There is no operational constraint to government spending. The U.S. government is not going broke involuntarily. See my post here.

The real issue with deficits causing a double-dip has to do with inflation and overheating. If inflation increases because the economy begins to overheat, interest rates spike and the Fed raises rates to choke off inflation. That’s not going to happen any time soon – although it may be a problem down the line.  The issue at hand now is deflation not inflation. At least Morgan Stanley understands this when they take a deficit hawk position.

And as for the Chinese, they are not going to pull the plug on Treasuries unless they want to tank their export boom. The reason they must buy Treasuries is the dollar peg; they must re-invest in U.S.-based assets in order to prevent their currency from appreciating. This has caused a huge rise in their U.S. dollar reserves. If they changed the peg, their currency would almost certainly rise and this would choke off exports.

No more stimulus, just jobs

I have said my piece about the need for stimulus in the past. So I won’t repeat it here. If you are interested, see my December 2008 posts “Confessions of an Austrian economist,” “What does Mises say about trying to stimulate the economy out of recession,” and “A brief philosophical argument about the role of government.”

But, on the whole, I look at long-term deficits in a dubious light. There are practical constraints to deficit spending – and they lead to inflation, currency depreciation and lower standards of living. This is not national bankruptcy, but it is what Murray Rothbard called default by inflation and it makes you and me less well off.

This, of course, is over the long-run. In the short run, it is the spectre of a deflationary spiral we care about. Stimulus was important to stop this. I said in February that Obama was making a big mistake with his stimulus measures.

My view here is that Obama is forging a middle path that leads to a dead-end. The stimulus is not nearly enough by half to get the job done. The proposed deficit reduction measures for 2013 are outright scary as they risk repeating a mistake from the 1930s. And the banking sector and mortgage plans, both of which I failed to mention, are dubious half-measures as well. One needs to act aggressively and proactively or not at all.

If you are going to deficit spend you need to do it in a big way. You need to stop the deflationary spiral.  That means hitting the reset button by promoting private sector savings and deleveraging and purging all built-up malinvestments. The risk in addressing the situation this way, of course, is replacing the imperfect invisible hand of markets with the imperfect hand of politicians and legislative fiat.

This is a risk I no longer see as worth taking. I have bailout and deficit fatigue just like most Americans. It is abundantly clear that this Administration has absolutely zero intention of purging any malinvestment or promoting any deleveraging. All they want to do is continue business as usual and go back to the asset-based economy that caused this mess. This is why we have seen bailout after bailout coupled with easy money. It makes for record profits on Wall Street but it does nothing for the unemployed.

Moreover, the political process in the U.S. is such that any stimulus money will be diverted to pet projects and used to pay off political constituents. While this may increase aggregate demand, it does so at the risk of serious social unrest as the outrage will certainly spill over into populism.

So I say no to a second (third) stimulus package.  What the President needs to focus on is jobs. The reason Obama’s poll numbers are shrinking is because he now owns this economy.  And people are not benefitting from this fake recovery.  They are angry at the bailouts and distrustful of government – and with good reason.

Cut payroll taxes, subsidize job creation, divert some military spending to direct job creation by ending the foreign wars. But stop the madness.

Related posts:

• Japan does not demonstrate the failure of stimulus
• Don’t underestimate the power of printing money, part 2
• Inflation: The strategy that dare not state its name
• The inflation-deflation debate
• Barack Obama: “if we keep on adding to the debt… that could actually lead to a double-dip”

Morgan Stanley’s piece on Treasuries Priced for Perfection…for Now! is pretty bearish. The basic gist is that while the ten-year represents fair value today, because inflation expectations have become unanchored, Morgan Stanley expects the yield to rise from 3.3% to 5.5%. That’s a disaster of 1994 proportions. Obviously, given some of my recent comments, this is not what I expect to happen, but be well aware of the risk; in this economic environment, it would be fatal.

Here’s an excerpt of what Manoj Pradhan had to say (emphasis added):

Fed Chairman Bernanke’s speech on Monday could not have been better tailored to keep bond markets happy. The commitment to keep policy rates "exceptionally low" for an "extended period" and the benign outlook for inflation were both very well received by bond markets, as well as other risky assets… Our proprietary model, MS FAYRE, shows a current fair value of 3.3% for the US 10-year Treasury yield – bang in line with actual yields…

Priced for perfection… MS FAYRE generates its fair value estimate using the real fed funds rate, 1-year ahead CPI inflation expectations from the SPF conducted by the Philadelphia Fed and the 5-year rolling standard deviation of inflation as a proxy for inflation volatility (for more details on the MS FAYRE model, see Fairy Tales of the US Bond Market, July 26, 2006). With the fed funds rate at 12.5bp, core PCE inflation tracking at 1.3% and the 4Q09 number for 1-year ahead CPI inflation expectations from the SPF coming in at 1.6%, MS FAYRE produces a fair value of 3.3% for 10-year bond yields, which is exactly where the 10-year yield is now (interested readers should contact us for a user-friendly spreadsheet for simulating the FAYRE model). Forward-looking bond markets thus seem to be pricing in altogether too rosy a scenario for the foreseeable future.

…for now: With actual bond yields bang in line with our fundamental fair value estimate, investors seem to be receiving no compensation for macroeconomic or fiscal risks..

Our forecasts look for bond yields to rise in 2010: Our US economics team expects bond yields to rise to 5.5% by the end of 2010 – an increase of 220bp that outstrips the 137bp increase in the fed funds rate expected over the same horizon (see Don’t Fear the Double-Dip, October 6, 2009). Our US interest rate strategy colleagues suggest that this bear steepening of the curve in 2010 may well be preceded by slightly lower 10-year yields in 2009 (see Liquidity Aplenty but Rising Sensitivity to Rates, October 22, 2009)…

Inflation expectations don’t seem to be anchored… The SPF measure of long-term CPI inflation expectations in the US has indeed remained stable, as claimed, since the median expectations have held steady for nearly a decade now. However…

…our conversations with clients also suggest a split into two fairly distinct camps. A smaller set of clients are bearish on the economic outlook and believe that inflation will be extremely low or even be outright negative for the next few years. The rest believe that inflation risks, and probably inflation itself, will rise within a year or so as the recovery becomes sustainable. The important point here is that it is difficult to find investors who believe that inflation over the medium-to-long run will be precisely in line with central bank targets. Both pieces of evidence do not support the argument that inflation expectations are anchored.

Obviously, Morgan Stanley is bullish on the economy because they are talking about a bear steepener across the Treasury curve. Their thinking on Treasuries is one reason you see Barack Obama talking about reeling in deficit spending. He obviously believes that an increase in interest rates would trigger a double dip recession.

My thinking goes more to bull flatteners where the two-year – ten-year spread decreases as expectations of a fed rate hike are countered by weak economic fundamentals.  This dichotomy points out some very real risks in the bond market right now.

Bill Gross his on the record expecting Treasuries to rally because he is cautious on the economic environment.

Gross has been talking about a “new normal” of deleveraging, deglobalization and reregulation. In his view, this means weak consumer demand counterbalanced only by heavier government intervention, leading to slow growth for the foreseeable future (See my post ‘Gross: The new normal for “the next 10 years and maybe even the next 20 years”’).  In essence, he sees a scenario that is bullish for bonds (especially longer duration types like the 10-year and the 30-year) but not particularly bullish for shares.

But we know that Gross loves to talk his book and he made billions from the Fannie/Freddie bailout doing so.  You have to make your own call here. It’s Morgan Stanley on one side of the trade and Pimco on the other.

Realistically, if rates spike to 5.5%, it would be a blood bath for insurers, and probably for pension funds (and hence municipalities as well). Mortgage rates would skyrocket and this would stop any housing recovery dead in its tracks. That sounds like double dip and depression to me; this is not an early 1990s economic environment. 

Ironically, 5.5% rates would sow the seeds of future 3.3% rates or lower. If you hold – and do not sell at the bottom – I don’t see how this induces a capital loss.

Related posts:

• Morgan Stanley: Recession will ‘end by mid-to-late summer’
• Morgan Stanley sees U.K. downturn worse than Great Depression
• Financial Alchemy at Morgan Stanley: Greywolf A3 CDOs now Aaa bonds
• Another take on the treasuries bubble
• Bill Gross: Fed on hold through 2010

When I read Ed’s recent piece “Japan: stimulus without reform leads to a policy cul de sac,” I couldn’t help but think he is wrong about Japan.

Supporting aggregate demand

The problem is taxes. In Japan, taxes are too high relative to the desire for spending and savings. Policy makers need to stop taking so many yen away from working people, so that they are able to buy all of the output which they can produce at full employment levels.  

The Japanese should have gone for domestic demand-led growth instead of export-led growth. When export growth reversed, the economy went into depression. Even Richard Koo, who has often spoken of a balance sheet recession and has the right approach on Japan, never imagined that such a thing would happen.  But it’s easy enough to resolve; simply support domestic incomes with the right tax cuts to sustain domestic demand at desired levels to sustain output and employment.

One can always sustain domestic demand by altering the fiscal balance.  In truth, it is as simple as debiting and crediting accounts on the Bank of Japan’s master yen account spread sheet.

Again, a fiscal adjustment can restore domestic demand immediately.

Savings in Japan

The savings rate in Japan is down as a consequence of falling net exports and what was until recently a falling budget deficit. The deficit trend is now reversing in a very ugly way- falling revenues and increased transfer payments.  True, private sector savings have fallen which means that Japanese policy makers have run out room for error.  I would contend that the vast scale of private savings allowed them to continue to screw up for so long by, for example:

• hiking the VAT in 1996
• introducing ‘fiscal consolidation’ in 2001 (and finally relenting in 2003 when the economy finally started to grow again, until this latest fiasco). 

Issuing one’s own fiat currency debt

But, the notion that the country is in a ‘debt trap dynamic’ as Ambrose Evans-Pritchard suggests is ludicrous.  Debt is serviced by data entries by the BOJ- debits and credits to securities accounts and transactions accounts at the BOJ. The BOJ can spend/credit accounts at will.  It’s just data entry.  Spending is not constrained by revenues (this is fiat currency, not a gold standard). In a worst case, ‘over-spending’ causes inflation. But, that happens to be what they are trying to accomplish. Getting some inflation would be considered a success.  Moreover, it can easily be reversed by tightening fiscal policy if it comes to that.

It’s really that simple.

Related posts:

• Japan: stimulus without reform leads to a policy cul de sac
• Do the personal income data demonstrate unbalanced reflation?
• Unrealized gains in wealth
• South Korea going gangbusters in contrast to UK
• Depression in Japan

Former Morgan Stanley economist Andy Xie joins other famed prognosticators like Nouriel Roubini in worrying about an incipient asset bubble. The Rosetta Stone Advisors board member sees the huge increase in money supply created by central banks as fuel to an asset bubble fire. He even goes so far as to call the central banks ‘arsonists.’

The financial crisis exposed gross inefficiencies in the massive amounts of money financial institutions received from central banks. Supplying so much money to the same people who caused the crisis — and with the same incentives — does not feel right. The argument in favor of this policy is that, when the house is on fire, you have to do whatever to extinguish the fire and find the culprit later. The problem is that, in this case, the arsonists have been asked to put out the fire. How can we be sure they won’t start another fire?

Most argue that the answer is not to limit the money supply but to reform the financial system. In this way, future demand for money would be efficient. But so far, no corrective reforms have been implemented in response to the financial crisis. Why? Because the global financial system became so big over the past decade that it has co-opted central banks, legislators and entire governments. Any reforms that do come will not address the main factors leading to the current crisis.

Even the best reforms will never resolve a problem based on the fact that financial professionals generally risk other people’s money: They get big rewards when bets go right and don’t have to pay when bets go wrong. The problem with this incentive system suggests the global financial system is structurally biased toward taking on more risk than what would be taken in an efficient market. The only way to counter this is for central banks to limit money supplies. Asset inflation over the past 10 years and the catastrophe incurred when it burst lend credibility to this argument.

Xie sees stagflation as a threat and a double dip coming, as a result. He warns bond market speculators, “you’ll want to run for your life” when the bond market tanks.

A word of caution for all would-be speculators: You’ll want to run for your life as soon as the bond market takes a big fall. And the case for a double dip in 2010 is already strong. Inventory restocking and fiscal stimuli are behind the current economic recovery, and when these run out of steam next year, the odds are quite low that western consumers will take over. High unemployment rates will keep incomes too weak to support spending. And consumers are unlikely to borrow and spend again.

Many analysts argue that, as long as unemployment rates are high, more stimuli should be applied. As I have argued before, a supply-demand mismatch rather than demand weakness per se is the main reason for high unemployment. More stimuli would only trigger inflation and financial instability.

The post is very entertaining, if scary. (“monetary growth is being used to support leverage, mostly in the financial sector.”) While I am not in the stagflation camp, I agree that money supply growth is fuelling unsustainable increases in asset prices globally. Xie concentrates on China where retail investors dominate the equity markets, operating under the assumption that government will not let assets prices fall. My view is that prices must eventually fall if they are too high relative to the income streams that underpin that price. The resultant crash in prices will be deflationary. Xie believes that this discrepancy between price and value will be closed via inflation.

However, you see it, I recommend reading this article. It asks some very important questions for investors, businesspeople and economists alike, the most important of which is a variation on theme of the Stephen Roach article:

While workers and businesses struggle, asset players are reaping substantial paper profits again. As the central bank’s monetary policy is behind the asset boom, we should ask whether the policy is achieving its goal by helping the real economy, or whether it is just helping speculators and hoping they have something left over for the real economy.

Much, much more here.

Related posts:

• Quote of the day: William White and inflation
• The inflation – deflation debate redux
• Inflation: The strategy that dare not state its name
• Central banks will face a Scylla and Charybdis flation challenge for years
• Is this the way to fight inflation?

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

Morgan Stanley has an interesting piece out this morning called Debtflation. In the past, they have raised alarm bells over what they see as embedded inflation in the loose monetary policy presently being followed by most central banks.  This particular piece focuses not on a general potential for inflation, but the possibility that central banks will explicitly target higher inflation in order to reduce high debt burdens – a policy advocated by Kenneth Rogoff.

The recent downturn has called many of the old certainties into question. In the world of central banking, a prominent victim of the downturn is the – previously orthodox – view that central banks should neglect asset prices when conducting monetary policy. Yet more recently, another major tenet of central bank doctrine is being challenged – the view that monetary policy should not be used to help out governments under debt pressure. We think that the risk of independent central banks creating some amount of (controlled) inflation going forward cannot quite be dismissed out of hand.

We have flagged inflation as a major long-term risk going forward: if the recovery is as tepid as we expect, central banks will be inclined to err on the side of caution when it comes to withdrawing the unprecedented conventional and unconventional monetary stimulus. But we believe that there will be a familiar additional source of inflation risk – the mounting public debt burden.  There is no doubt that, last winter, with the global economy slumping, central bankers welcomed the help they got from hugely expansionary fiscal policy. However, the result has been a massive increase in developed countries’ public indebtedness – the extent of the debt build-up in some countries resembles the consequences of wars. Historically, developed economies have escaped high debt by growing out of it rather than inflating it away or defaulting (with the notable exception of Germany and Japan). Growth after World War II for example was fast, not least because war-ravaged economies were rebuilding their capital stocks.

This time around, however, eroding the debt through faster growth may not be an option. Instead, growth in many developed countries is likely to slow significantly going forward as labour forces shrink due to the demographic transition. Worse, population ageing will impose added pressure on public expenditure through higher pensions and healthcare costs. If outgrowing the debt is unlikely, and if governments lack the resolve to cut spending and/or raise taxes sufficiently, the remaining options are default and inflation. No policymaker in the developed world – and, by now, few in the developing world – would want to countenance default as an option. This leaves inflation. The question is familiar: could central bankers be forced to engineer inflation – ‘monetise the debt’? Almost all developing world central banks are independent from an institutional point of view. Indeed, one of the main reasons for setting up independent monetary authorities is precisely to avoid pressure from governments to inflate away the debt. So, central banks cannot be forced by their governments to generate inflation (unless governments were prepared to change the statutes of their monetary authorities; this would in most cases require going to the legislature).

With governmental coercion being unfeasible, is there a possibility that independent central bankers might generate inflation out of their own volition? If nothing else, they would take a big gamble with their hard-won credibility. And history teaches us that the reason behind most, if not all, episodes of very high inflation has been monetary expansion to finance government expenditure or reduce debt (see "Could Hyperinflation Happen Again?" The Global Monetary Analyst, January 28, 2009).

Morgan Stanley is saying in effect that it fears central banks inflating away private and public debt burdens by printing more money. It is not clear that quantitative easing really is inflationary (at least in the short-term). For this policy to actually produce inflation in an environment that is geared more toward deleveraging, we will need serious asset price inflation to spill over into the real economy – and this would require increases in asset prices that would be extremely destabilizing when the inevitable bust occurs. Most likely an asset bubble bursting would tip the global economy back into deflation. This is the Scylla and Charybdis problem I outlined in June. So, I am not sure central banks could pull this off even if they wanted to.

More from Morgan Stanley at the link below.

Source

Debtflation – Morgan Stanley

Related posts:

• Quote of the day: William White and inflation
• Are central banks independent actors?
• Stephen Roach: Downturn in Asia less severe, but recovery later
• The inflation – deflation debate redux
• Emerging Markets will be tested by inflation

Wolfgang Munchau of the Financial Times wrote a very important comment piece in today’s Financial Times. In it he said that central banks are targeting asset prices to avoid the brunt of cyclical downturns. This policy is inducing asset bubbles and creating a more volatile real economy with unpredictable negative consequences.

I want to expand upon his comments here because his analysis fits well with a number of macro points I have made in the past.  First a quote from the Munchau piece:

We did not need to wait until the Dow Jones Industrial Average hit 10,000. It has been clear for some time that global equity markets are bubbling again. On the surface, this looks like 2003 and 2004 when the previous housing, credit, commodity and equity bubbles started to inflate, helped by low nominal interest rates and a lack of inflation. There is one big difference, though. This bubble will burst sooner…

The single reason for this renewed bubble is the extremely low level of nominal interest rates, which has induced people to move into all kinds of risky assets. Even house prices are rising again. They never fell to the levels consistent with long-term price-to-rent and price-to-income ratios, which are reliable metrics of the property markets’ relative under- or over-valuation…

…there is danger no matter how the central banks react. Successful monetary policy could be like walking along a perilous ridge, on either side of which lies a precipice of instability.

For all we know, there may not be a safe way down.

The argument Munchau is making should be familiar to you as ‘the asset-based economy’ (which I will now retroactively add as a tag to prior posts).  To date, the best outline I have provided for you was in a post earlier this month called,”A brief look at the Asset-Based Economy at economic turns.”

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.

But, given Munchau’s comments, I want to add a few of my own to flesh out what is happening here. First, this is not just an American phenomenon.  The post I wrote on London house prices earlier today shows that asset prices are being targeted as a vehicle for economic reflation in Britain as well.  The US and the UK are far from alone as nearly every major central bank has been using an extremely accommodative monetary policy to prevent a deflationary bust.

Munchau invokes Hyman Minsky’s model of financial instability to help explain how this sets us up for a volatile future because traditional macroeconomic theory is inadequate for understanding what got us to this point. In essence, the idyllic state of economic and price stability we know as “the Great Moderation” is really just a financialization of the economy. However, a large financial sector leads to excessive dependence on asset prices to fuel growth, which in turn leads to an accumulation of debt.

The financialization leads to both a widening gulf of income in society as the monied class profits (look no further than record financial sector bonuses during a weak recovery for roof). I believe it also leads to regulatory capture and crony capitalism. The debt buildup precipitates asset price deflation during busts — and the potential for a deflationary spiral in the real economy. As a result, central banks flood the economy with money to prevent this outcome. This flooding of the economy with liquidity in bad times, therefore, has the unintended consequence of making monetary policy asymmetrical.

The asymmetry results in extreme volatility in asset price.  All the while, debt keeps accumulating. Clearly, this increases the likelihood of a major bust and depression. Hence Stability (the great Moderation) creates Instability (a pronounced Boom-Bust cycle).

The question is: where does this all lead?  Munchau asks this question at the end of his post and suggests that “there may not be a safe way down.” His discussion about likely policy responses evokes memories of my “Scylla and Charybdis” post. Here is the key part from it:

So, you have a huge amount of excess reserves, hard to sell assets on the Fed’s balance sheet.  Add in the fact that the Federal Reserve is going to be loathe to choke off an incipient recovery and you have the makings of inflation when recovery takes hold.

Moreover, there is a rise in commodity prices which is adding inflation to the pipeline.  Much of the recent decrease in headline inflation numbers is due to the collapse in commodity prices.  But, Copper is near a seven-month high. Oil is near a seven-month high.  And all of the agricultural and industrial commodities are taking off again.  As China ramps up its economic stimulus, the recent increases in the ISM manufacturing data in the U.S. and elsewhere point to an increasing demand for industrial commodities, and this is inflationary.

In sum, any pickup in the economy is going to be met by a host of inflationary forces.  This is one reason that bond yields have been increasing and the spread between the two-year and 10-year U.S. government bond is near a record.

Scylla and Charybdis

So, how do I see this push and pull of deflationary and inflationary forces playing out?  There are two outcomes I am looking for.

Outcome Number One

• No policy traction. This is a sluggish muddle-through Japanese scenario where the Richard Koo thesis of the balance sheet recession comes into play. You would see an output gap and below-trend growth for an extended period. Most pundits would say it is the lack of lending that is creating the problem.  However, what if it is the lack of borrowing which is at fault?  Then, we are going to see no traction from monetary policy.

Outcome Number Two

• Start-Stop economy. I believe Bernanke would prefer this outcome. This is one in which the Federal Reserve allows the economy to recover by keeping interest rates low.  The result is a rise in inflation. We could see inflation rising to 3 percent inflation and then to 5 to 7 and 10 percent. An example would be animal spirits coming back in 2010. And leading to 3 percent inflation followed by 7 percent including $100 oil and then interest rate hikes and another recession at which point the deleveraging begins again in earnest. Followed by more easing and on it goes. But, of course, the problem with outcome two is it is unstable and that it invites an aggressive policy response which risks situation one as an ultimate outcome.

Neither of these scenarios is one in which asset markets are likely to benefit, one reason I see the latest uptick in share prices as nothing more than a bear market rally.

What you should draw from this is the following:

1. The Great Moderation is revealed as an illusion once we reach the zero bound, where interest rates are near zero.  At this point the asset-price reflation can no longer rely on interest rates alone, but must also use increasingly heavy-handed tactics to get the economy going.  This is where we now are.
2. Terminal Debt is fast approaching. Steve Keen believes we are at a Terminal Debt stage, where no more debt can possibly be accumulated to revive growth.  However, I have presented you with evidence that this is not necessarily the case (see posts here and here). Nevertheless, it is fast approaching.
3. The central bank is damned if it does and damned if it doesn’t. This was the takeaway of the Scylla and Charybdis post: All roads lead to a W-style Japanese depression or a deflationary bust because deflation is secular (Terminal Debt) while inflation is cyclical (asset prices). An inflationary scenario will invite a policy response which kills the recovery.
4. This is good for government bonds but not for risky assets.  Longer-term, this is a good environment for government bonds. They are the risk-free asset in an environment of secular deflation. Shares are not a good investment in this situation despite huge rallies.  Remember, we saw huge bear market rallies after 1929 and again in Japan after 1990.

I believe we are in the reflationary period of a longer-term depression right now. As a result, there is substantial downside risk for the economy going forward. Like Munchau, I don’t have any magic bullet solution to this dilemma – although I do have a number of ideas.  Feel free to chime in with your thoughts on the way forward.

Related posts:

• Quote of the day: William White and inflation
• Liquidity trap of a different sort
• Morgan Stanley warns of a new inflationary period
• ECB rate hike likely as wages in Germany spiral upward
• No Fed cut

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

Earlier today I wrote a post featuring comments by Marc Faber as I like to do from time to time.  In this particular case Dr. Faber was waxing prosaically about an eventual bankruptcy of the U.S. government.  His money quote was:

“Next station is when the U.S. government goes bust.”

I love this guy. Quite frankly, the man is a quote machine.  He makes a lot of outrageous statements that get him noticed.  Here are a few that I have featured in the past:

• Oct 2009 – “Monetary policy in the United States will stay expansionary”
• Sep 2009 – “The future will be a total disaster, with a collapse of our capitalistic system as we know it today, wars, massive government debt defaults and the impoverishment of large segments of Western society.”
• May 2009 – “I am 100% sure that the U.S. will go into hyperinflation”
• Mar 2009 – “The feds poured the gasoline and lit the match. Now they’ve joined the fire department”
• Nov 2008 – “I advise every American to hold his gold outside of the United States”
• Mar 2009 – “Don’t underestimate the power of printing money.”

The last one is my all-time favorite.  And there are many more available on this site and elsewhere.  Dr. Doom is very entertaining indeed – which is why I quote him so often.  But, is he right?

That’s a good question – one I will take up indirectly by introducing the latest piece by Martin Wolf, another author I have featured here from time to time. You may have seen me tweet this earlier today. I had intended to add it to the links for tomorrow, but Niels Jensen, who I also feature here often, convinced me to write it up as an ‘antidote’ to Faber.

Here’s how Wolf begins his article:

It is the season of dollar panic. These panic-mongers are varied: gold bugs, fiscal hawks and many others agree that the dollar, the dominant currency since the first world war, is on its death bed. Hyperinflationary collapse is in store. Does this make sense? No. All the same, the dollar-based global monetary system is defective. It would be good to start building alternative arrangements.

This is exactly what the Chinese are doing. They are preparing themselves for a non-dollar future. This is why the Chinese are buying gold. This is why the Chinese are settling trade in Yuan. And this also why the Chinese are getting a bunch of other countries onside.  But they are not looking for a dollar crash as I indicated last week.

Then, there is the part about Dollar weakness being a sign of inflation. Here’s what Wolf has to say about this idea:

The dollar’s correction is not just natural; it is helpful. It will lower the risk of deflation in the US and facilitate the correction of the global “imbalances” that helped cause the crisis. I agree with a forthcoming article by Fred Bergsten of the Peterson Institute for International Economics that “huge inflows of foreign capital to the US facilitated the over-leveraging and underpricing of risk”.* Even those who are sceptical of this agree that the US needs export-led growth.

I hope this argument sounds familiar because it is one I made when I asked is the Fed just jawboning? The U.S. wants – it needs a lower dollar to avoid deflation. Quantitative easing is not solving the deflation question. The U.S. government wants a strong dollar? Well, policymakers say one thing and wish for another. The U.S. insistence on focusing on global imbalances at the G-20 should tell you what policy makers really want. This is why the dollar is falling. 

The problem of course is that the dollar’s recent rout is not necessarily helping the U.S. because the dollar is overvalued vis-a-vis a host of pegged currencies. And while those currencies are under pressure to drop the peg, they are resisting because they do not want to move toward a more re-balanced global growth paradigm unless forced to do so.  Unless these countries (read China) do something on the currency front, expect more of this, this and this – protectionism.

Then, the question arises, if everyone hates the dollar, what are they moving to? Wolf says:

Finally, what can replace the dollar? Unless and until China removes exchange controls and develops deep and liquid financial markets – probably a generation away – the euro is the dollar’s only serious competitor. At present, 65 per cent of the world’s reserves are in dollars and 25 per cent in euros. Yes, there could be some shift. But it is likely to be slow. The eurozone also has high fiscal deficits and debts. The dollar will exist 30 years from now; the euro’s fate is less certain.

This view may be too complacent. The danger of a collapse of the dollar is small and of its replacement by another currency still smaller. But a global monetary system that rests on the currency of a single country is problematic, for both issuer and users. The risks are also growing, particularly since the emergence of “Bretton Woods II” – the practice of managing exchange rates against the dollar.

I liken this argument to George Soros’ comments on dollar weakness: "The dollar is a very weak currency except all the others." Right now, there is no alternative to the dollar.  Some people are fleeing U.S. assets if they can. But the alternatives are limited and this limits how far the dollar will fall. And this is unfortunate because the monetary system now in place is in need of change.  Without it, we are likely to see nationalistic policy responses to economic weakness, which will induce conflict.

Wolf says:

I arrive, by a somewhat different route, at the same conclusion as Mr Bergsten: the global role of the dollar is not in the interests of the US. The case for moving to a different system is very strong. This is not because the dollar’s role is now endangered. It is rather because it impairs domestic and global stability. The time for alternatives is now.

Apropos alternative monetary systems, we might start with Paul Davidson’s ideas, which I first highlighted here in November.  So there is no hyperinflation, no U.S. national bankruptcy, and  no dollar crash coming. But, the financial crisis demonstrates we are living on borrowed time and need a new monetary system. The time is now.

Source

The rumours of the dollar’s death are much exaggerated – Martin Wolf

Related posts:

• Marc Faber: “U.S. dollar weakness is a symptom of inflation in the system”
• China to diversify out of U.S. dollars
• Japanese defend dollar’s status while China tears it down
• The latest dollar rout revealed
• Hayek: “I am not only against inflation but I am also against deflation.”

Below are two videos from Marc Faber’s recent interview on Asia Confidential.  In it, he takes questions from user emails in regards to the U.S. dollar, economic decline in the U.S. and gold as an investment.

He sees a need for the U.S. to borrow increasing amounts of money going forward – not less. As a result, what was a crisis in finance in 2008, resulting in the nationalization of Fannie Mae and Freddie Mac will become a national bankruptcy. The U.S. will borrow and print money. The dollar will fall precipitously. Then, “next station is when the U.S. government goes bust.”

Edward here. This might make for good headlines on Bloomberg, but it is patently false.  The United States is not now or ever going bust. A sovereign government which borrows in its own currency in a fiat currency system can never go bust. An entity which borrows and prints its own money does not have the same constraints that, say, California or Ireland have. How prices are affected is another issue altogether.

That’s where gold comes into the picture. Here, there are many questions.

• Is it overvalued?
• Is it a good inflation hedge?
• How does gold perform in deflationary environments?
• How does it perform against equities over the longer run?
• What about silver?

Faber takes on all of these.

On the whole, he is an inflationista and does not believe the U.S. will suffer deflation. When asked how gold might perform in a significant deflationary environment, he responds “first of all, I would like to make a very clear statement. I will believe in deflation once we have a significant period of U.S. dollar strength. U.S. dollar weakness is a symptom of inflation in the system.”

He goes on to say that gold outperforms other asset classes in a deflationary environment and is therefore a good hedge against fiat currency revulsion whether one expects deflation or inflation.

My own view is similar. However, I would differentiate between consumer price inflation, which will remain non-existent while industrial capacity and employment levels are at depressionary levels.  The inflation in the system will manifest itself first in asset prices – with industrial and food commodities or oil being the transmission mechanism into consumer prices.  Secular consumer price inflation will not return until the slack in the system is purged. 

I would add that this is one principal reason that the Great Moderation occurred despite enormous money printing in Japan and extraordinarily loose monetary policy in the U.S.  After China, India and Eastern Europe joined the capitalist system, the enormous increase in labor – both skilled and unskilled – acted as a check on inflation of the consumer price variety.

Alan Greenspan was fooled by this and kept monetary policy too loose. The result was asset bubbles again and again.  Going forward, it would comforting to see central banks target asset prices not just to gain policy traction through reflation but in order to cool the economy through deflation.

Related posts:

• China to diversify out of U.S. dollars
• Quote of the day: William White and inflation
• The inflation – deflation debate redux
• Morgan Stanley warns of a new inflationary period
• Bernanke is responsible for the market meltdown

The U.S. dollar is getting crushed again today.  I have been waiting to see if and when it hits parity with the Swiss Franc. Today’s action brings us that much closer. The dollar is losing ground against the dollar bloc (Kiwi, Aussie and Loonie) as well as against the Franc and Euro.

What gives? Allegedly, a plot by central banks to dump the dollar, according to British daily the Independent.

In the most profound financial change in recent Middle East history, Gulf Arabs are planning – along with China, Russia, Japan and France – to end dollar dealings for oil, moving instead to a basket of currencies including the Japanese yen and Chinese yuan, the euro, gold and a new, unified currency planned for nations in the Gulf Co-operation Council, including Saudi Arabia, Abu Dhabi, Kuwait and Qatar.

Secret meetings have already been held by finance ministers and central bank governors in Russia, China, Japan and Brazil to work on the scheme, which will mean that oil will no longer be priced in dollars.

The plans, confirmed to The Independent by both Gulf Arab and Chinese banking sources in Hong Kong, may help to explain the sudden rise in gold prices, but it also augurs an extraordinary transition from dollar markets within nine years.

Let’s call this dollar revulsion.  Now, I am sceptical about the authenticity of all of this revulsion.  But, it is having an affect on currency markets.  While I see the U.S. dollar as a weak currency, I am not convinced that anyone (except maybe Iran or Venezuela) thinks it is in their best interest to provoke a disorderly depreciation. The Chinese, with their $1 trillion in reserves, have a vested interest in preventing a disorderly move away from the U.S. currency.

Nevertheless, people are talking. FT Alphaville reports Jim Grant taking this very seriously:

This is not new news of course, for such a change from dollar pricing to some other methodology has been discussed, rumoured, tossed about for months, but this time we note that Japan and France are involved in the meetings and that changes the tenor of the rumours entirely. Too, the addition of the Saudis and the Emirates AND Kuwait to the meetings adds further importance and seriousness to the threats…

The article in The Independent becomes quite serious in that The Independent has not been given to such rumours in the past. This is not The Sun, nor the NY Post.

Is it curtains for the U.S. currency?  Maintain a healthy dose of scepticism.  But, I will say this: if the dollar does decline, Bernanke and the gang will be high-fiving it up and down the corridors of Washington because the dirty little secret is the U.S. wants currency depreciation. Policy makers in America want inflation.  This gets them out of a policy cul-de-sac and certainly helps the U.S. to increase savings without government deficits via an invigorated export sector.

Who hates this: the Swiss especially (see here and here).

Stay tuned.

See also: Plans to Move Away From Dollar Pricing of Oil – Naked Capitalism

Related posts:

• Japanese defend dollar’s status while China tears it down
• Mea culpa on the need for a new currency
• The weak dollar trade regains momentum
• China to diversify out of U.S. dollars
• Is China avoiding using US dollars?

I just received notice that the FDIC Board has approved the phase out of the Temporary Liquidity Guarantee Program (TLGP) in a first clear sign that the U.S. Federal Government has started policy normalisation.

The FDIC Board today adopted a Notice of Proposed Rulemaking (NPR) that reaffirms the expiration of the debt guarantee component of the Temporary Liquidity Guarantee Program (TLGP) on October 31st, 2009. Under the NPR, the Federal Deposit Insurance Corporation will seek comment on whether a temporary emergency facility should be left in place for six months after the expiration of the current program.

“The TLGP has been very effective at helping financial institutions bridge the uncertainty and dysfunction that plagued our credit markets last fall,” said FDIC Chairman Sheila C. Bair. “As domestic credit and liquidity markets appear to be normalizing and the number of entities utilizing the Debt Guarantee Program has decreased, now is an important time to make clear our intent to end the program. It is also important to note that the FDIC has collected over $9 billion in fees associated with this program. The FDIC will be using some of this money to off set resolution costs associated with bank failures.”

I view this announcement as confirmation that the Obama Administration sees the financial crisis as over and is declaring victory.  I would anticipate other policy announcements from the Administration and/or Federal Reserve to reflect this view.

Just yesterday Zero Hedge reported that the money stock is now falling, another clear sign that the excess liquidity about which inflation hawks have been concerned is being drained. In the main, one should take this premature ‘tightening’ bias as bearish for equities and bullish for government bonds.

While I had anticipated the Fed and the Obama Administration would be loath to cut the recovery short and would maintain accommodative fiscal and monetary stances, this announcement is the first contrary indicator.

More here.

Related posts:

• More signs of liquidity withdrawal, now from the U.S. Treasury
• FDIC Chairman Sheila C. Bair Statement on the Legacy Loans Program
• Should GE be a AAA company?
• Liquidity
• How will the Fed withdraw all that liquidity?

Refining margins have been absolutely decimated, especially for refiners of heavy, sour crude like Valero Energy (VLO) and Tesoro Petroleum (TSO).  This is taking a toll on profits in the oil and gas sector, with both oil majors highly leveraged to downstream operations like ConocoPhillips (COP) and independent refining outfits showing steep falloffs in operating margins.  I see this as a proxy for the underlying economic demand in the U.S. economy.

Refiners

Refining is a cyclical business and this same pattern has been repeated for decades. When times are good, refining margins are high.  But, margins crash down at a moment’s notice, leaving some flat-footed and generating the waves of oil-sector busts of yesteryear. The desire of large firms to move away from Refining and Marketing reflects their desire to be insulated from these swings.

Independent refiners like Tosco, Valero, Premcor, Tesoro, and Giant grew up because of this vacuum left by the majors. Because the world’s refineries are leveraged to light sweet crudes like West Texas Intermediate (WTI), heavy and sour crudes like Maya and Alaska North Slope (ANS) normally sell for large discounts on the spot market. This generated a demand for complex refining capacity capable of processing these crude varieties and offers the independents a natural area of competitive advantage.

Refiners as a proxy

However, this cycle has been especially severe for refiners leveraged to heavy, sour crudes, with WTI-Sour Crude margins averaging $1.34 a barrel for all of 2009. Valero, the largest independent refiner had never had layoffs until now. Below is the beginning paragraphs of today’s VLO press release.

Valero Energy Corporation (NYSE: VLO) announced today that the company is continuing to take action to improve its profitability by rationalizing underperforming operations. As a result, the company’s subsidiary, The Premcor Refining Group Inc., intends to shut down the coker and gasifier complex at the Delaware City refinery. The coker is expected to be idle at least until the outlook for coking economics improves, while the closure of the gasifier complex is for an indefinite period. The company also noted that the plant-wide shutdown of the Valero Aruba refinery is now expected to be for an extended period, and, as announced earlier this year, the shutdown of a coker and a fluid catalytic cracking unit at the Corpus Christi refinery continues, and that cokers at certain of its refineries would run at reduced rates until coking margins improve.

The company expects that these decisions will reduce headcount at the Delaware City refinery by at least 150 employees and 100 contract workers. Valero has notified its employees and contractors along with the appropriate regulatory agencies and union officials. At the Aruba refinery, the company expects that more than 700 contract workers will be released in September.

I imagine this was a hard decision for Valero, a company that was #3 on the list of best companies to work for in America as recently as 2006 and prides itself on taking care of its employees. It is now #91.  But, this is the reality of the refining business in 2009 and it doesn’t speak well to underlying demand in the U.S. economy.

Back in July of 2008, before oil prices collapsed, I saw the reduction in refining margins as a telling sign of weak demand.  The fact that margins remain weak despite incipient signs of recovery suggests that underlying U.S. consumer demand remains weak.  In the last business cycle, margins did not improve materially until 2004 when the employment market picked up and underlying demand growth improved.

Related posts:

• Refiners as a canary in the coalmine
• Largest U.S. refiner Valero now permanently shutting capacity
• Valero crushes earnings: I was wrong
• Stocks pummeled as value plays increase
• Oil down below $138

Over the past week, America’s banks have had a bumper earning season, in part courtesy of the Federal Reserve’s accommodative monetary policy. Even before this week, a number of market pundits (including me) began to wonder aloud whether the Fed had any strategy with which to remove all of the excess liquidity it has created to deal with the credit crisis. Finally, Ben Bernanke delivered the goods in an Op-Ed in today’s Wall Street Journal, signalling a decent overall strategy (including paying interest on reserves which I outlined here in “S.F. Fed chief Yellen tells inflationistas to pipe down”).

Most of the chatter started after yields on long-dated US treasury securities began to rise, with the 10-year hitting levels over 3.7%. I first mentioned this in my post “How will the Fed withdraw all that liquidity?” after Morgan Stanley’s David Greenlaw made some interesting comment in that regard.  As to the specific tools the Fed intends to use, here’s how Ben Bernanke put it (I have added emphasis to the most important bits):

First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Second, the Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline.

The Treasury has been conducting such operations since last fall under its Supplementary Financing Program. Although the Treasury’s operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury.

Third, using the authority Congress gave us to pay interest on banks’ balances at the Fed, we can offer term deposits to banks—analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market.

Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.

Each of these policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

Given the “if necessary” label of the fourth item listed, you should expect Bernanke gave the list in exactly the order of which tools he would prefer to use. But, it should be clear to anyone that the Fed will err on the side of accommodation because it will be loathe to sink any incipient recovery given the dire economic misadventures of the past two years.  And since monetary policy acts with a significant lag, inflation is likely to result.  Of course, there’s always the pesky problem of all those risky assets now on the Fed’s balance sheet. But, let’s not quibble.

Bonds rallied today because market participants were relieved to find that the Fed had a coherent strategy to deal with the situation.  Bernanke’s position as Fed chair is looking a lot more comfortable these days.

Source

The Fed’s Exit Strategy – Ben Bernanke, WSJ

Related posts:

• How will the Fed withdraw all that liquidity?
• Don’t underestimate the power of printing money
• Obama to re-appoint Bernanke
• Plosser: The Fed must stop qualitative easing
• Inflation: The strategy that dare not state its name

On numerous occasions you will have heard me use the term ‘monetizing debt’ to describe what happens when the central bank creates money out of thin air in order to increase reserves in the banking system. The central bank is certainly increasing the monetary base in this regard, but are they really monetizing the debt being issued by the federal government?  Let’s examine the issue to find out.

Fiscal and Monetary Authority

The crux of the issue here is whether the US or the UK central governments can deficit spend to their hearts’ content in order to prop up their respective domestic economies and whether this spending will be financed by printing money at the central bank.

In both cases, a small budget deficit in good times has turned into monstrous deficit reaching double digits in percentage terms. Moreover, the two countries have a monetary authority (the central bank) and a fiscal authority/backer of legal tender (central government) which is at the same level.  This is not true in, say, Spain, where the ECB and the Spanish central government are at different levels.

So what happens then?

Printing money

Let’s first turn to the central bank.  The central bank, looking to increase bank reserves in the system, buys assets (usually federal government debt) with previously non-existent money that it electronically prints out of thin air. This money printing is known as quantitative easing or QE. QE increases bank reserves in the system when the seller of the assets deposits the new funds at her bank and the bank then holds some of these funds in reserve at the central bank as it is mandated to do.

The hope is that the seller’s bank will then go out and lend the non-mandated funds, thus increasing credit in the system.  However, what has generally happened is that the bank has deposited these funds at the central bank as excess reserves without lending it out, receiving only the base rate of interest for doing so – almost zero.

The reason excess reserves are piling up in the UK and the US has as much to do with the demand for credit as it does with the impairment of banks’ balance sheets.  Banks are under-capitalized on a mark-to-market basis, and are, therefore fearful of making new loans when they need to increase their capital base.  But, companies and individual, fearful of their enormous debt burdens in a world of asset price deflation, show no demand for credit.  The lack of credit and the build-up of excess reserves is, therefore, due to constraints on both the supply and demand sides of the credit process.

But, this is a situation which cannot continue ad infinitum because those reserves are assets on the bank’s balance sheet earning near zero interest.  That means the bank’s profitability is lower than it would be had it lent out those funds or purchased assets with those reserves.  Right now, that is acceptable because banks are earning a lot of cash due to high interest spreads, but eventually, these excess reserves are going to become painfully unprofitable.

So, eventually, the bank will be forced to buy some treasuries in order to increase profitability. Obviously, treasuries would be the asset class of choice for financial institutions fearful of making loans while their capital base is impaired. This makes those lenders wiling buyers of federal government debt and financiers of the burgeoning supply of the government’s spending spree.  In essence, the central bank has caused the private sector to prefer bonds over reserves by pushing the overnight rate to zero. That is what is meant by monetizing debt.

Whether the seller is domestic or foreign, the net effect is the same in increasing reserves unless a foreign seller converts the money into a foreign currency without eventual re-conversion back into the domestic currency.  In this case, QE has actually increased reserves in the foreign baking system instead.

By the way, monetizing debt is a central issue in the debate over Federal Reserve independence.  Because the Federal Reserve has been acting in concert with the executive branch since the credit crisis began, many are beginning to question its quasi-fiscal role in supporting the wider financial system with bailouts, subsidized borrowing, guarantees and liquidity. Add in the QE and a ballooning Fed balance sheet as the central government deficit spends and you have an organization that seems to be acting on behalf of the executive branch.

Is this inflationary?

It all depends on net private savings as to whether this stokes inflation in the short-term. The reason that the Federal Government is deficit spending to begin with has to do with the loss of consumption in the private sector due to increased deleveraging and savings.  In the U.S., we have seen the savings rate rise from negative territory (i.e. saving nothing and spending even more by drawing down accumulated wealth) to almost 7% in a few years’ time.  This behavorial change is a positive for America as it is a recognition of the excess consumption that an asset-based economy created. It puts America in a much better position on its current account and helps to reduce debt from unsustainable levels.

But, it is also responsible for much of the decline in the US economy.  So, to prevent a deflationary spiral, the federal government has stepped in to fill the void.  But, if the increase in net government spending (with the improvement in the current account balance) is less than the increase in net private consumption (both via individuals through lower consumption and companies through reduced capital spending), then the net effect of the spending will not be inflationary.  In that case, the net consumption of individuals, businesses and government (C + I + G +(EX-IM) for you economics fans) is lower than it was before the negative consumption shock.

Over the longer-term, the money printing is problematic.  When demand for borrowing is restored, the extra reserves in the system will be lent out. Moreover, the excess reserves can always be invested in higher yielding assets by the banks in order to increase profitability. Therefore, this sequence will engender rises in either asset or consumer prices, depending on how much excess capacity is in the system.  This is why it is imperative that the Fed outline how it plans to withdraw all of the excess liquidity it created when it expanded its balance sheet by twofold.

And since capacity utilization is incredibly low right now, my bet is on asset price inflation rather than consumer price inflation. So when Marc Faber says don’t underestimate the power of printing money, this is what he means.  That is how and why an asset bubble can inflate even in the face of poor fundamentals and why the present bear market rally can sustain itself longer than one might think.  Eventually, all of this comes to an end and the fundamentals re-assert themselves. When that is, is the $23.7 trillion question.

Related posts:

• Connecting Fed cuts with credit writedowns and quantitative easing
• Quantitative easing: printing money like mad to ward off deflation
• Chart of the day: Excess Reserves
• China warns that the west’s quantitative easing is inflationary
• Don’t underestimate the power of printing money, part 2

I have highlighted comments by famed Columbia University economist Jagdish Bhagwati before (see “Jagdish Bhagwati: Obama is a protectionist”).  Bhagwati has since gotten with the program and sees Obama in a much more favourable light.  However, he is sceptical because Obama has not said boo about free trade.

Now Bhagwati is turning his attention away from trade, his specialty and talking inflation.  He’s not saying he’s 100% sure the U.S. will go into hyperinflation like some pundits.  But, in talks with the Financial Times Deutschland, he did make clear that he is worried about inflation. Nevertheless, he too warns of a 1937-style Armageddon if stimulus is withdrawn too quickly.  He goes into a lot of other topics as well, including the cozy relationship between Wall Street and Washington (singling out Tim Geithner in particular) and the lack of regulatory reform.

My translation of the German-language article is below.

The world renowned Economist Jagdish Bhagwati is not worried about financial markets – but he is worried about the risk of inflation.

The world renowned economist Jagdish Bhagwati has warned the governments in Germany and the United States about an erroneous assessment of inflation risks in their respective countries. Angela Merkel’s fears are "excessive", while the Americans have been reckless regarding the future risk of rising prices, said the Columbia University professor and Globalisation guru to FTD. "In the U.S., they underestimate the inflation threat: There are enormous amounts of money in circulation, but there have been no announcements for a clear exit strategy."

The Indian is world renowned for his defence of free trade and globalisation. Following the crisis, he argued that globalization in trade was a success, but, in the financial markets, it had failed.

Germany tends to be too cautious when it comes to supporting the economy, said Bhagwati. It is certainly "too early, now or in the next few months," to roll back stimulative measures just because medium inflation risks are present. A premature withdrawal would have disastrous consequences, according to Bhagwati, as we have seen in the past. "For a reversal, 18 to 24 months seems an appropriate time frame."

Bhagwati classified it as basically correct that Merkel is reacting to the fears of the population. "In the U.S., a concrete plan of how the stimulus will be taken back is completely lacking," the economics professor criticised. Even if the date for the withdrawal cannot yet be set, the government should demonstrate how they will proceed "as concretely as possible.”

The macro-economist showed scepticism about a third stimulus package. Laura Tyson, a key adviser to U.S. President Barack Obama, among others, has called for such a program. "As yet, not even all the money from the first package has been spent," said Bhagwati. Thus, spending more makes little sense. "The next delayed instalment of the first package will act like a third stimulus." The discussion underscored the lack of sensitivity to inflation risks. Much of the spending would be appropriated wrongly anyway, and corruption would creep in, the Columbia economist criticized. "The bulk of the money will be wasted."

The U.S. economic measure are less reason for hope for the world economy, according to estimates given by Bhagwati, than the recent signals from Asia: "In China and India huge bottlenecks in the infrastructure provide for substantial additional demand," said Bhagwati. That would help the rest of the world out of the crisis, including the United States. "In this respect I am optimistic that the crisis will no longer last for years."

In regards to the financial markets, the economist now has no more worries: "I would not step onto an aircraft carrier and declare that the war was over like George W. Bush once did – but I think we are on the right track."

Nothing has changed, in Bhagwati’s view, regarding the close link between Wall Street and politics. There is a lack of critical distance, which was one of the main causes of the financial crisis. "The reform of rating agencies is, thus, an urgent need," said Bhagwati. Moreover, he again called for the establishment of a financial market supervisory body of independent experts. Possible candidates [to head the body] would be Harvard economist Kenneth Rogoff, Fed Chairman Ben Bernanke and Deutsche Bank Chief Economist Norbert Walter.

Therefore, Bhagwati was critical about the new U.S. Treasury Secretary Timothy Geithner. He is considered closely allied with Wall Street. "I was not too excited about this staff selection," said the economist.

Source

"USA unterschätzen Inflationsgefahr" – FTD

Related posts:

• Jagdish Bhagwati: Obama is a protectionist
• GDP: imports, inflation and local government are the story
• Kasriel: ‘greater risk for the global economy…is inflation’
• Does the US need a second stimulus package?
• Morgan Stanley warns of a new inflationary period

Of late, there have been a lot of worries about he potential for inflation in the U.S.  Marc Faber is the most noted pundit in this regard. Over-the-top comments he made back in May about hyperinflation in the U.S. may have been a catalyst for all of the inflation talk. See my post Marc Faber: “I am 100% sure that the U.S. will go into hyperinflation” for more on Faber’s comments.

But Janet Yellen, the Chairman of the San Francisco Fed and a potential successor to Ben Bernanke, is having none of this.  She gave a speech yesterday at the Commonwealth Club, which was widely followed – in part due to talk about her succeeding Bernanke. There, she was very dovish on inflation, at least over the near term. In her view, the deflationary risks associated with this downturn will keep the Fed’s bias toward policy accommodation.

Here is the crucial passage in her speech (emphasis added):

Let me now turn to an issue that has lately garnered a great deal of attention—inflation.  Just a short time ago, most economists were casting a wary eye on the risk of deflation—that is that prices might drop, perhaps falling into a downward spiral that would squeeze the life out of the economy. Now, though, all I hear about is the danger of an outbreak of high inflation.

I’ll put my cards on the table right away. I think the predominant risk is that inflation will be too low, not too high, over the next several years. I take 2 percent as a reasonable benchmark for the rate of inflation that is most compatible with the Fed’s dual mandate of price stability and maximum employment. This is also the figure that a majority of FOMC members cited as their long-run forecast for inflation, according to the minutes of the committee’s April meeting.
First of all, this very weak economy is, if anything, putting downward pressure on wages and prices. We have already seen a noticeable slowdown in wage growth and reports of wage cuts have become increasingly prevalent—a sign of the sacrifices that some workers are making to keep their employers afloat and preserve their jobs.  Businesses are also cutting prices and profit margins to boost sales. Core inflation—a measure that excludes volatile food and energy prices—has drifted down below 2 percent.  With unemployment already substantial and likely to rise further, the downward pressure on wages and prices should continue and could intensify.  For these reasons, I expect core inflation will dip to about 1 percent over the next year and remain below 2 percent for several years.

If the economy fails to recover soon, it is conceivable that this very low inflation could turn into outright deflation. Worse still, if deflation were to intensify, we could find ourselves in a devastating spiral in which prices fall at an ever-faster pace and economic activity sinks more and more.  But I don’t view this as likely. The vigorous policy actions of the Fed and other central banks, combined with sizable fiscal stimulus here and abroad, have sent a clear message that deflation won’t be tolerated.

On the whole, I would agree with this point of view. And Reuters does a good job of summing up the main takeaways from her speech (article linked at the bottom). But, I would make a few caveats.  First, just because deflation is the primary risk at present, does not mean that we shouldn’t be worried about eventual inflation.  The Fed should be devising exit strategies away from policy accommodation because it is unclear that they have one.  That said, the fact that the Fed can now pay interest on reserves is a often overlooked new tool in the Federal Reserve’s arsenal.  I could see the Fed using this as a means to keep all of the excess reserves now in the system from being lent out as it sells off assets to soak up liquidity.

Bu, it is clear that Yellen thinks the Fed should err on the side of accommodation. The mantra: ‘Don’t fire monetary policy bullets until you see the whites of inflation’s eyes.’  To me, this means that eventual inflation risk is real despite Yellen’s present fears of deflation.  In early June, I said in my post “Central banks will face a Scylla and Charybdis flation challenge for years”:

So, you have a huge amount of excess reserves, hard to sell assets on the Fed’s balance sheet.  Add in the fact that the Federal Reserve is going to be loathe to choke off an incipient recovery and you have the makings of inflation when recovery takes hold.

Moreover, there is a rise in commodity prices which is adding inflation to the pipeline.  Much of the recent decrease in headline inflation numbers is due to the collapse in commodity prices.  But, Copper is near a seven-month high. Oil is near a seven-month high.  And all of the agricultural and industrial commodities are taking off again.  As China ramps up its economic stimulus, the recent increases in the ISM manufacturing data in the U.S. and elsewhere point to an increasing demand for industrial commodities, and this is inflationary.

In sum, any pickup in the economy is going to be met by a host of inflationary forces.  This is one reason that bond yields have been increasing and the spread between the two-year and 10-year U.S. government bond is near a record.

While yields have eased of late, this dynamic is still at work. Yes, deflation should be the Fed’s primary concern right now because the economy is still very sick.  However, when the economy does rebound, inflation is going to be a real challenge.

Sources
President’s Speech: Presentation to the Commonwealth Club of California, San Francisco, CA (pdf version here) – San Francisco Fed website
Yellen says Fed should not rush to reverse policy – Reuters

Related posts:

• U.S. CPI: Lowest since 1954 – deflation here we come
• Pimco sees inflation in America’s future
• The Fed is on the easy money trip
• One on One with David Rosenberg, Chief North American Economist at Merrill Lynch
• Roubini: How to avoid the horrors of ‘stag-deflation’

The real worry right now should be deflation, as we have not yet beaten back all of the ill deflationary effects of the financial crisis.  Nevertheless, a growing number of market participants see inflation as a longer term worry.  With unemployment high, a cost-wage push will not be part of that equation.  Nevertheless, increases in food, oil and commodity prices could create problems down the line as this Bloomberg News video on milk prices attests – they are talking about a doubling in milk prices in 2010.

And, remember, before 2007, $70 was an unheard of, recession-inducing price for a barrel of oil.  Yet, in the midst of a deep, deep global recession, we have $70 oil.  What does that tell you about likely prices in a recovery?  Is it too early to worry about inflation?

Sources
Dairy-Cow Kill to Double Milk Price on Biggest Slump Since 1980 – Bloomberg

Related posts:

• George Soros warns UK on economy, oil and inflation
• Oil to sink to $100
• Oil breaks out above 2009 high
• Quote of the day: William White and inflation
• Oil down below $138

It seems a Q3 recovery is the new consensus of professional economists.  First, we hear Paul Krugman saying this, now Richard Berner and David Greenlaw are singing the same tune.

The deepest post-war recession likely will end by mid-to-late summer, a bit sooner than we’ve been expecting.  The improvement in financial conditions and incoming data has outpaced expectations, and the backdrop for global growth is less daunting.  Recessions are protracted declines in output, employment, incomes and sales, and all seem likely to stop declining within the next several months.  Thus, for the second month in a row, we’re slightly boosting our near-term economic outlook: We are raising 2Q-4Q09 estimates for the change in GDP by half a point, netting to a decline of 1.5% over the four quarters of 2009, compared with an expected 1.9% contraction a month ago.  However, we strongly believe that the recovery will be gradual.  Despite the ongoing benefits of monetary and fiscal stimulus, the economy faces several headwinds that seem likely to limit the growth pace through the end of 2010.

I have been conservative and talking Q4 or Q1 here (and have been criticized as too optimistic), even though the data has been suggesting Q3 since at least April (see my posts “The Fake Recovery” and “Are jobless claims peaking?”). So Morgan Stanley now has a very bullish view which more or less makes Robert Gordon look on the money. Have a look at the rest of the Morgan Stanley research piece, it makes for interesting reading.  Here are the key section headers

• There’s no mistaking the rapid improvement in financial conditions.
• Incoming economic data have also improved faster, if only slightly beyond expectations.
• More important, however, we think that both the logic and evidence for a gradual recovery remain intact.
• Sharply rising energy prices are fueling a pick-up in headline inflation, but slack in the US and global economy is exerting downward pressure on ‘core’ inflation.
• In this environment, the Fed faces a number of important challenges.
• Against this backdrop, financial markets have priced out the adverse tail risk of prolonged recession and deflation.

Related posts:

• Morgan Stanley expects 10-year yields to rise 220 bps in 2010
• Morgan Stanley: Bullish, but not revising estimates for Euroland
• Morgan Stanley warns of a new inflationary period
• Looking beyond the fake recovery
• Philly Fed survey points to manufacturing rebound

Nearly a month ago, back on May 5th, I highlighted some testimony by Federal Reserve Chairman Ben Bernanke before congress in a post labelled, “Bernanke expects recovery later this year“.  In his testimony, Bernanke used the phrase ‘Scylla and Charybdis’ to describe the Federal Reserve’s policy challenge regarding deflationary and inflationary forces.  I would like to highlight this characterization because I believe it goes to the core of the debate as to how the global economy and asset markets will fare over the next 5-10 years.  In my view (and apparently in Bernanke’s), both inflationary forces and deflationary forces will be at work for some time to come. This will present policy makers with a problem as the reflation trade comes good, and the resulting policy responses will have serious implications on the medium term outlook for the economy and asset markets.

Deflationary forces

The problem is this: we have just witnessed one of the most serious asset bubbles in history. In fact, I would call the great housing bubble an ‘echo bubble’ that was merely a continuation of the bubble forces that created the technology bubble of the late 1990s.  So, the world saw asset price inflation of the most severe kind for over a decade – from the mid 1990s when Alan Greenspan first voiced concern about ‘irrational exuberance”’ to 2007 when the housing bubble imploded.  What results from the implosion of such a significant bubble is deflation.

Actually, more crisply put, what results is ‘the D-process,’ an outcome highlighted by Ray Dalio of Bridgewater Associates (see my post “A conversation with Bridgewater Associates’ Ray Dalio” for more detail).  This process involves the three D’s of deleveraging, deflation and depression (outlined in my post “We are in depression“).

Richard Koo goes further in his book “The Holy Grail of Macro Economics.”  Here, he argues that the unwind of great bubbles suffers from what he labels a ‘balance sheet recession.’  In essence, companies go from maximizing profits, as they had done in normal times, to a post-bubble concern of reducing debt. Regardless of how much priming of the pump monetary authorities do, the psychology of debt reduction will limit the effectiveness of monetary policy as a policy tool.

In my view, the catalyst for this change of psychology is the ‘debt revulsion’ that ushers in the panic phase of an asset bubble collapse.  (Charles Kindleberger highlights the various stages of a bubble and its implosion in his seminal book “Manias, Panics and Crashes”). In this particular bubble, debt revulsion began post-Lehman Brothers.  What we have seen, therefore, is a reduction in leverage and debt as the most leveraged players have gone to the wall.  But, more than that, the household sector has gotten religion about debt reduction as the savings rate has increased dramatically since Lehman. In fact, I would argue that companies learned their lesson about debt from the aftermath of the tech bubble.  It is the household sector in the U.S. (and the U.K.) which is heavily indebted. Therefore, if the psychology of a balance sheet recession does take form, it will be the household sector leading the charge.

In sum, the psychology after a major bubble is very different than the psychology before its collapse.  The post-bubble emphasis becomes debt reduction and savings, making monetary policy ineffective, not because financial institutions are unwilling lenders but because companies and individuals are unwilling borrowers. These are forces to be reckoned with for some to come.

Inflationary forces

Meanwhile, inflation is going to be a problem too.  Why?  Two principle reasons come to mind: commodity prices and money supply. Now, just yesterday in my most recent post “Kasriel: ‘greater risk for the global economy…is inflation’,” I highlighted Paul Kasriel’s view that there are several inflationary forces, both secular and cyclical which will impinge upon the economy. I want to bear down on just the two forces of commodity prices and money supply.

First, let’s look at money supply.  The Federal Reserve and other central banks have been pumping a lot of money into the financial system in an attempt to add reserves to the system and to take on the intermediation role the wider banking system normally serves.  Nevertheless, this money is not being lent out and excess reserves are piling up at the Federal Reserve.  Last April, there were only $1.8 billion in excess reserves i.e. reserves against which loans were not being made. According to figures just released by the Fed on May 28th, this April that figure has soared to $824.4 billion, a surge of 447 times in one year. If you want to know what is wrong with the American economy, you should start here.

But, what happens when the economy returns to an environment in which those excess reserves start to be lent out?  Inflation.  And this is an inflation that will not be so easy to control because the Federal Reserve has embarked on a policy of ‘qualitative easing’ by buying up non-treasury assets, transforming its balance sheet from one dominated by treasury assets to one in which Treasury assets are in the minority.  So, as the Fed has intervened and bloated its balance sheet, an increasing amount of the assets it has with which to withdraw the excess liquidity in the system is hard to sell.

So, you have a huge amount of excess reserves, hard to sell assets on the Fed’s balance sheet.  Add in the fact that the Federal Reserve is going to be loathe to choke off an incipient recovery and you have the makings of inflation when recovery takes hold.

Moreover, there is a rise in commodity prices which is adding inflation to the pipeline.  Much of the recent decrease in headline inflation numbers is due to the collapse in commodity prices.  But, Copper is near a seven-month high. Oil is near a seven-month high.  And all of the agricultural and industrial commodities are taking off again.  As China ramps up its economic stimulus, the recent increases in the ISM manufacturing data in the U.S. and elsewhere point to an increasing demand for industrial commodities, and this is inflationary.

In sum, any pickup in the economy is going to be met by a host of inflationary forces.  This is one reason that bond yields have been increasing and the spread between the two-year and 10-year U.S. government bond is near a record.

Scylla and Charybdis

So, how do I see this push and pull of deflationary and inflationary forces playing out?  There are two outcomes I am looking for.

Outcome Number One

• No policy traction. This is a sluggish muddle-through Japanese scenario where the Richard Koo thesis of the balance sheet recession comes into play. You would see an output gap and below-trend growth for an extended period. Most pundits would say it is the lack of lending that is creating the problem.  However, what if it is the lack of borrowing which is at fault?  Then, we are going to see no traction from monetary policy.

Outcome Number Two

• Start-Stop economy. I believe Bernanke would prefer this outcome. This is one in which the Federal Reserve allows the economy to recover by keeping interest rates low.  The result is a rise in inflation. We could see inflation rising to 3 percent inflation and then to 5 to 7 and 10 percent. An example would be animal spirits coming back in 2010. And leading to 3 percent inflation followed by 7 percent including $100 oil and then interest rate hikes and another recession at which point the deleveraging begins again in earnest. Followed by more easing and on it goes. But, of course, the problem with outcome two is it is unstable and that it invites an aggressive policy response which risks situation one as an ultimate outcome.

Neither of these scenarios is one in which asset markets are likely to benefit, one reason I see the latest uptick in share prices as nothing more than a bear market rally.

Sources
H.3 Aggregate Reserves of Depository Institutions and the Monetary Base, current release – U.S. Federal Reserve website
H.4.1 Factors Affecting Reserve Balances, current release – U.S. Federal Reserve website
Copper Falls From 7-Month High on Speculation Gains Too Rapid – Bloomberg.com
Soybeans Advances to 8-Month High, Corn Gains to 7-Month Peak – Bloomberg.com
Oil Falls From Seven-Month High on Signs OPEC Output Climbing – Bloomberg.com

Related posts:

• Is quantitative easing really inflationary?
• The next crisis is already under way
• Debtflation
• Morgan Stanley warns of a new inflationary period
• Plosser: The Fed must stop qualitative easing

So we can put a check by Paul Kasriel’s name for inflationistas because he has come out today with a report saying he believes it is inflation over the medium term which is the greatest risk to the economy.

I will not keep you in suspense. I believe that the greater risk for the global economy in general and the U.S. economy in particular is inflation, not deflation. I arrive at this conclusion both on secular and cyclical grounds.

For the record, I believe deflation is the greater risk right now.  However, when the reflation play takes hold (and I believe it will do by Q4 or Q1 at the latest), inflation will be the real threat. So I agree with Kasriel.  Think $100 oil or higher for starters.  Commodities are going to be a good play all around.   Kasriel identifies secular and cyclical reasons inflation is a problem over the medium-term.  Secular reasons would include a higher Fed Funds rate, disappointing productivity growth, and higher defence spending.  Cyclical concerns for the U.S. include the positive relationship between the output gap and inflation, and the exchange rate correlation to inflation. There are other factors too like the re-emergence of Japanese consumer demand and the rising levels of government debt. 

The global markets are on to this trade as the dollar has sold off massively as have U.S. government bonds.  I do think these moves are pre-mature because disinflationary or deflationary forces (household de-leveraging, the destruction of shadow banking, and the implosion of real estate valuations, both commercial and residential) still have the upper hand in the U.S. economy.  Nevertheless, inflation is coming. It’s only a question of time.

Source

Greater Risk over Next Five Years – Inflation or Deflation? (PDF) – The Econtrarian, Paul Kasriel, Northern Trust

Related posts:

• Deflation has already arrived
• The inflation-deflation debate
• Pimco sees inflation in America’s future
• Inflation or deflation?
• Central banks will face a Scylla and Charybdis flation challenge for years

You have to hand it to Marc Faber; he knows how to grab your attention. Earlier this year, I posted a video of him saying “don’t underestimate the power of printing money“, a quote that has become mantra for me.  Basically, he believes a rising tide of quantitative easing is going to buoy stock markets globally and the global economy (at least for the medium-term). This is a view I agree with and one reason I have taken a more bullish tack at Credit Writedowns.

Earlier today, I also posted a video of Faber talking about Nouriel Roubini and the pressure not to overstay a bearish call and miss the turn which I found rather interesting (Here’s a video of Roubini sounding rather bullish – for him).  However, later in that same interview, Faber makes his most quotable statement yet: “I am 100% sure that the U.S. will go into hyperinflation.”  That is a very bold claim.

Just last week, I made similar comments in my post, “More thoughts on the fake recovery.”

In my view, the Federal Reserve has effectively demonstrated it is willing to risk hyperinflation in order to beat back the deflationary forces.

But I was using hyperbole.  Faber, however, is dead serious.  It is the secret desire of the Fed to want inflation that has U.S. government bond yields going bezerk.  But, most people are not expecting hyperinflation in the United States ever.

The video of Faber is below.  Is this headline-seeking exaggeration or serious punditry?

Source

U.S. Inflation to Approach Zimbabwe Level, Faber Says – Bloomberg.com

Related posts:

• Marc Faber: “it’s very tough for a forecaster who was ultra-bearish to stay bearish”
• Marc Faber makes bullish comments on Bloomberg
• Marc Faber: China’s numbers are fake
• Marc Faber on CNBC: bearish on oil and India
• Marc Faber: "I don’t think that you’ll see gold below $1,000 per ounce probably ever"

For the time being, I am more worried abut the potential inflationary effects of quantitative easing than about the deflationary impact of deleveraging.  But, the latest news from Ireland shows us that deflation is alive and well. This comes via the Irish Independent:

Consumer prices recorded a second annual drop in April as the cost of energy, clothes and food declined amid a deepening recession.

Prices based on a European Union measure dropped 0.7 percent from a year earlier after falling at the same rate in March, the Cork-based Central Statistics Office said today. The decline in March was the first annual drop since the data were first collected in 1996. Prices rose 0.1 percent in April from the previous month.

Crude oil has dropped around 60 percent since reaching a record $150 a barrel in July. At the same time, waning consumer demand as unemployment rises has prompted stores to cut prices.Tesco this month said it will reduce prices at some Irish stores by as much as 22 percent.

Rising unemployment and tax increases have “heightened consumers’ reluctance to spend,” Lynsey Clemenger, an economist at Ulster Bank in Dublin, said in an e-mailed note today. “Prices have further to fall, as the consumer strike continues.”

The EU measure excludes mortgage interest payments. Based on an Irish gauge, prices fell 3.5 percent in April from a year earlier, the biggest decline since 1933.

In my opinion, the ECB’s recent announcement that it was getting into the covered bond market has a lot more to do with Spain and Ireland than it does with Germany.  Spain and Ireland suffer from their joining the Euro to escape the impossible trinity of free exchange rates, independent monetary policy and free capital movement.  Having sacrificed monetary policy for a fixed exchange rate, the Spanish and Irish are seeing some horrific debt deflation dynamics.  The ECB seems to have awoken to this and is now engaged in quantitative easing via the covered bond market (although Trichet denies this). See Edward Hugh’s take on this from a Spanish perspective.

So, Ireland has joined the deflation camp along with Spain, the U.K., Switzerland and China, to name a few.  If you think this deleveraging cycle is too powerful for the money printers to override, you’ll see the increasing number of countries with deflationary numbers as a bad harbinger.  However, if like me, you are equally concerned about the upturn in commodity prices and the steepness of the yield curve, you will also see inflation as a looming threat.

To be continued.

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The following is an excerpt from Murray Rothbard’s excellent book, “A History of Money and Banking in the United States.”  The passage outlines how the gold standard prevented governments from using inflation as a device to manipulate their currencies, something of great concern to China now in 2009.  However, Word War I brought that to an end as expenditures during the ‘Great War’ resulted in massive wartime spending throughout Europe.  When the war ended, a jerry-rigged and bogus new gold standard was created which went into effect in 1925 with the U.S. dollar and the British pound at its core.  However, the inherent flaws in this system were to have fatal repercussions made plain in 1929 and during the Depression.

The prewar monetary order was genuinely “international”; that is, world money rested not on paper tickets issued by one or more governments but on a genuine economic commodity – gold – whose supply rested on market supply-and-demand principles. In short, the international gold standard was the monetary equivalent and corollary of international free trade in commodities. It was a method of separating money from the State just as enterprise and foreign trade had been so separated.  In short, the gold standard was the monetary counterpart of laissez-faire in other economic areas.

The gold standard in the prewar era was never “pure,” no more than was laissez-faire in general. Every major country, except the United States, had central banks which tried their best to inflate and manipulate the currency. But the system was such that this intervention could only operate within narrow limits. If one country inflated its currency, the inflation in that country would cause the banks to lose gold to other nations, and consequently the banks, private and central, would before long be brought to heel. And while England was the world financial center during this period, its predominance was market rather than political, so it too had to abide by the monetary discipline of the gold standard…

The advent of the World War disrupted and rended this economic idyll, and it was never to return. In the first place, all of the major countries financed the massive war effort through an equally massive inflation, which meant that every country except the United States, even including Great Britain, was forced to go off the gold standard, since they could no longer hope to redeem their currency obligations in gold. The international order not only was sundered by the war, but also split into numerous separate, competing, and warring currencies, whose inflation was no longer subject to the gold constraint. In addition, the various governments engaged in rigorous exchange control, fixing exchange rates and prohibiting outflows of gold; monetary warfare paralleled the broader economic and military conflict.

At the end of the war, the major powers sought to reconstitute some form of international monetary order out of the chaos and warring economic blocs of the war period. The crucial actor in this drama was Great Britain, which was faced with a series of dilemmas and difficulties.On the one hand, Britain not only aimed at re-establishing its former eminence, but it meant to use its victorious position and its domination of the League of Nations to work its will upon the other nations, many of them new and small, of post-Versailles Europe. This meant its monetary as well as geral political and economic dominance. Furthermore, it no longer felt itself bound by the old-fashioned  laissez-faire restraints from exerting frankly political control, nor did it any longer feel bound to observe the classical god-standard restraints against inflation.

While Britain’s appetite was large, its major dilemma was its weakness of resources. The wracking inflation and the withdrawal from the gold standard had left the United States, not Great Britain, as the only “hard,” gold-standard country. If Great Britain were to dominate the postwar monetary picture, it would somehow have to take the United States into camp as its willing junior partner. From the classic prewar pound-dollar par of $4.86 to the pound, the pound had fallen on the international money markets to $3.50, a substantial 30-percent drop, a drop that reflected the greater degree of inflation in Great Britain than in the U.S. The British then decided to constitute a new form of international monetary system, the “gold-exchange standard,” which it finally completed in 1925. In the classical, prewar gold standard, each country kept its reserves in gold, and redeemed its paper and bank currencies in gold coin upon demand. The new gold-exchange standard was a clever device to permit Britain and the other European countries to remain inflated and to continue inflating, while enlisting the United States as the ultimate support for all currencies. Specifically, Great Britain would keep its reserves, not in gold but in dollars, while the smaller countries of Europe would keep their reserves, not in gold but in pounds sterling. In this way, Great Britain could pyramid inflated currency and credit on top of dollars, while Britain’s client states could pyramid their currencies, in turn, on top of pounds. Clearly, this also meant that only the United States would remain on a gold-coin standard, the other countries “redeeming” only in foreign exchange. The instability of this system, with pseudo gold-standard countries pyramiding on top of an increasingly shaky dollar-gold base, was to become evident in the Great Depression.

But the British task was not simply to induce the United States to be the willing guarantor of all the shaky and inflated currencies of war-torn Europe. For Great Britain might well have been able to return to the original form of gold standard at a new, realistic, depreciated parity of $3.50 to the pound. But it was not willing to do so. For the British dream was to restore, even more glowingly than before, British financial preeminence, and if it depreciated the pound by 30 percent, it would thereby acknowledge that the dollar, not the pound, was the world financial center. This it was fiercely unwilling to do; for restoration of dominance, for the saving of financial face, it would return at the good old $4.86 or bust in the attempt. And bust it almost did. For to insist on returning to gold at $4.86, even on the new, vitiated, gold-exchange basis, was to mean that the pound would be absurdly expensive in relation to the dollar and other currencies, and would therefore mean that at current inflated price levels, Britain’s exports—its economic lifeline— would be severely crippled, and a general depression would ensue. And indeed, Britain suffered a severe depression in her export industries—particularly coal and textiles—throughout the 1920s. If she insisted on returning at the overvalued $4.86, there was only one hope for keeping her exports competitive in price: a massive domestic deflation to lower price and wage levels. While a severe deflation is difficult at best, Britain now found it impossible, for the new system of national unemployment insurance and the new-found strength of trade unions made wage-cutting politically unthinkable.

But if Britain would not or could not make her exports competitive by returning to gold at a depreciated par or by deflating at home, there was a third alternative which it could pursue, and which indeed marked the key to the British international economic policy of the 1920s: it could induce or force other countries to inflate, or themselves to return to gold at overvalued pars; in short, if it could not clean up its own economic mess, it could contrive to impose messes upon everyone else. If it did not do so, it would see inflating Britain lose gold to the United States, France, and other “hard-money” countries, as indeed happened during the 1920s; only by contriving for other countries, especially the U.S., to inflate also, could it check the loss of gold and therefore halt the collapse of the whole jerry-built international monetary structure.

In the short run, the British scheme was brilliantly conceived, and it worked for a time; but the major problem went unheeded: if the United States, the base of the pyramid and the sole link of all these countries to gold and hard money, were to inflate unduly, the dollar too would become shaky, it would lose gold at home and abroad, and the dollar would itself eventually collapse, dragging the entire structure down with it. And this is essentially what happened in the Great Depression.

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Marshall Auerback here with a few thoughts about the monetary policy end game.

Bernanke has to continue to make hawkish comments about inflation so as to avoid a complete blow out in bond yields, but the the dirty little secret is that inflation is the way out of the debt trap, along with dollar weakness. Both reduce the real cost of debt servicing.

But Bernanke is in a real policy cul de sac of his own making since he initiated Fed purchases of longer dated Treasuries. Low yields on bonds introduce a high risk of capital loss to investors if yields return to historical norms (think McCauley duration), and if investors cannot be sure they will hold the bond to maturity. The private sector will wish to raise their holdings in government bonds only if they perceive risk adjusted returns elsewhere are less attractive – yet this is antithetical to the very purpose of quantitative easing, which is to break the high liquidity preference of private investors by “trashing cash” and lowering the yield on default free government bonds. In other words, even before we get to the day when quantitative easing is removed, when investors face the likely renormalization of policy rates and the removal of implicit ceilings on government bond yields, there is a glaring inconsistency in the QE approach which no one seems to have noticed..

If government yields back up, either because private sector portfolio preferences are shifting toward riskier assets as central banks trash cash and suppress government bond yields, or because fiscal stimulus is helping “green shoots” take root and thereby encouraging riskier portfolio exposures, then mortgage rates are likely to back up as well, confounding any stabilization in housing sales.

Alternatively, if central banks step in to buy Treasuries and thereby contain the back up in Treasury yields, more professional investors are likely to conclude “monetization” is underway and they will try to increase their exposure to inflation hedges. The net result would be a likely rise in the relative prices of energy, precious and industrial metals, “commodity” currencies, and ag products and ag land – all of which, as inputs to final products, would tend to represent an adverse supply shock to the economy. In addition, raising the price of essentials like food and energy is more likely to crowd out consumer spending in discretionary items. Neither of these supply and demand effects are particularly supportive of an economic recovery.

Over to you Ed!

Edward Harrison here.  Basically, the Fed wants to inflate our way out of this depression – that’s the dirty little secret.  There is really no other policy choice because the mountain of debt in the United States is immense.  And I think Bernanke, Geithner and Summers have proven they are willing to do anything to reflate this economy and avoid debt deflation dynamics.

The problem with this inflationary policy response is that it invites a currency and asset revulsion.  Why do you think the Chinese have been talking so much about inflation in the west?  They are pretty unhappy about the prospect that quantitative easing will depreciate the value of their U.S. dollar assets. So they are looking to apply some pressure on the U.S.

But, policy makers are going to say one thing in public and to the Chinese and do another thing altogether different.  Hence, the hawkish talk by Bernanke in Washington this week about withdrawing liquidity.  Their hope is that the U.S. economy can right itself enough BEFORE the inflation becomes apparent and yields start marching upward.

But, the appetite for risk is fully manifest in U.S. markets, causing yields to back up and this is going to require an increasing “monetization” of the U.S. debt, making the inflationary policy that much more transparent.  While Marshall has already mentioned the flight to commodities and real assets as a likely response, you can expect the dollar to lose value in this scenario.

What the Chinese response will be is the $1 trillion in dollar reserves question.

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