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”

I pick up Bill Gross where I left him on Friday.  He said in his monthly newsletter that the Fed is going to keep interest rates at zero percent through 2010. But, he is not willing to stick his neck out in a liquidity seeking return kind of way even though this is what reflation is all about. He advises lower risk assets over higher risk ones cognizant that this could mean under-performance.

What I found interesting is that Gross highlighted only two bits in his piece. That should lead you to believe these are the most important points he makes.  The first bit is the rationale behind why he thinks the Fed is on hold through 2010:

The Fed is trying to reflate the U.S. economy. The process of reflation involves lowering short-term rates to such a painful level that investors are forced or enticed to term out their short-term cash into higher-risk bonds or stocks. Once your cash has recapitalized and revitalized corporate America and homeowners, well, then the Fed will start to be concerned about inflation – not until.

This is what’s called an asset-based recovery and is exactly the same model we followed in 1992 and 2002. the Federal reserve lowers rates so much that the cash in your pocket burns a hole in it. Grandma may be stuffing her dollars in a mattress, but investors judged against an investment benchmark get fired if they don’t seek returns.  how did Chuck Prince put it: When the music’s playing…

If you are an insurance company, you have a ton of money invested expecting 6-7% nominal returns.  But, in a deflationary environment you have to be smoking something if you think you’ll get that return in low risk assets. So everyone is running the liquidity-seeking-return play. 

The Wall Street Journal mentioned this today:

Though insurers continue to buy bonds, the rally does "make it challenging in terms of getting yield," Steven Kandarian, chief investment officer at MetLife Inc., told analysts in an Oct. 30 earnings call.

Life insurers have long been one of the nation’s biggest bond buyers, currently holding about $1.78 trillion in corporate debt, or 16% of the total outstanding, according to industry group American Council of Life Insurers.

Their frustrations in finding investment opportunities signal how far and fast the bond market has recovered from the dark days when markets were frozen and insurers were diverting almost all incoming premiums and investment income into cash accounts.

But, it sounds like Gross is having none of this.  He asks a rhetorical question about overpriced assets in nearly every asset class:

Do you buy the investment grade bond market with its average yield of 3.75% (less than 3% after upfront fees and annual expenses at most run-of-the-mill bond funds)? Do you buy high yield bonds at 8% and assume the risk of default bullets whizzing at you? Or 2% yielding stocks that have already appreciated 65% from the recent bottom, which according to some estimates are now well above their long-term PE average on a cyclically adjusted basis?

Answering his own question is the only other part he highlights in his essay – one doubting the elevated price of risk assets. He says:

In a low growth environment, it seems to me that a company’s stock should yield more than its less risky debt, and many utilities provide just that opportunity.

Gross goes on to recommend high dividend safe stocks like utilities.  But, I did get the sense he was talking out of both sides of his mouth.  For months now, Gross has been advocating reflation as an economic policy. He has advocated massive deficit spending too.  Back in June of 2008, he was the first one I knew who was talking about deficits in the trillions. Yet, here he is cautioning us about inflated asset prices.  Well, zero rates and inflated asset prices go hand in hand. And I’m sure Bill Gross knows this.

Source

Anything but .01% – Bill Gross, Pimco

Related posts:

• Bill Gross: Sell equities and buy Treasuries
• Bill Gross: the new normal means investors should shun risk
• High yield is back in business in Europe
• Another take on the treasuries bubble
• Bill Gross: “almost all assets appear to be overvalued on a long-term basis”

Max Keiser certainly has a way with words. In one of his latest TV appearances, using the colorful analogy of “Warren Buffett’s toilet paper,” he calls the U.S. dollar worthless.

He goes on to say that China is addicted to this worthless paper because they are using it to stimulate their domestic economy. In another memorable analogy, he labels this an “opium” addiction which will cost the Chinese dearly.

While the Chinese (and the Indians) are increasingly turning to gold as a currency alternative, it is fairly clear that China will have to eventually take an enormous haircut on its holdings of U.S. paper assets. One reason the Chinese are refusing to revalue the renminbi is their desire to forestall this eventuality – and with good reason. Last year, the Chinese central bank needed to go cap in hand to the Finance Ministry because the central banks U.S. dollar paper assets had so depleted the central bank of capital.

Keiser has a lot more to say. Very entertaining. Below is the video. It runs just under 5 minutes.

Related posts:

• China “serious about the plan to internationalise” Yuan
• China launches retaliatory investigation into U.S auto subsidies
• Japanese defend dollar’s status while China tears it down
• Quote of the day: China hopping mad about GSEs
• China wants to get rid of the dollar

Nouriel Roubini, writing in the New York Daily News , said on Sunday that “unemployed Americans should hunker down for more job losses” given the likelihood of a job less recovery. This was as gloomy a piece as I have seen from Roubini in the past few months. He has clearly become more downbeat about the long-term picture for the U.S. economy.

The article begins:

Think the worst is over? Wrong. Conditions in the U.S. labor markets are awful and worsening. While the official unemployment rate is already 10.2% and another 200,000 jobs were lost in October, when you include discouraged workers and partially employed workers the figure is a whopping 17.5%…

…we can expect that job losses will continue until the end of 2010 at the earliest. In other words, if you are unemployed and looking for work and just waiting for the economy to turn the corner, you had better hunker down. All the economic numbers suggest this will take a while. The jobs just are not coming back.

This sounds dire. As a result, Roubini goes on to call on the Obama Administration to take direct action on jobs. Extending unemployment benefits is not going to cut it.  Roubini says we need:

a bold prescription that increases the fiscal stimulus with another round of labor-intensive, shovel-ready infrastructure projects, helps fiscally strapped state and local governments and provides a temporary tax credit to the private sector to hire more workers. Helping the unemployed just by extending unemployment benefits is necessary not sufficient; it leads to persistent unemployment rather than job creation.

With statistics showing that the rate of long-term joblessness is at the highest since the Great Depression, Roubini joins an increasing number of economists who are calling on the Obama Administration to take the employment situation more seriously.

Paul Krugman has said that we are now in a liquidity trap. Therefore, we need to subsidize jobs and promote work sharing as Germany is doing.

I have made similar arguments about quantitative easing for the past year. Monetary policy is effectively useless – and is merely creating bubbles.

The Obama Administration is moving into deficit hawk mode at the wrong time as this will only worsen the jobs situation and lead to a double dip recession. Instead, I have called for a payroll tax cut or a job subsidy.

Randall Wray, a professor at the University of Missouri-Kansas City, has also offered a unique job solution.

All of this is urgent, as Roubini indicates:

Based on my best judgment, it is most likely that the unemployment rate will peak close to 11% and will remain at a very high level for two years or more.

The weakness in labor markets and the sharp fall in labor income ensure a weak recovery of private consumption and an anemic recovery of the economy, and increases the risk of a double dip recession…

The damage will be extensive and severe unless bold policy action is undertaken now.

The Obama Administration is taking an ‘indirect’ approach. They do so for three reasons. First, they are afraid of being boxed in politically by taking more direct measures. They also see a need to defend their previous policy decisions.  But, Mark Thoma thinks part of the resistance to more direct measures is ideological.  In a post earlier today, he says:

Growth policy is an attempt to make the economy grow faster, and stabilization policy attempts to keep the economy as close as possible to that trend, i.e. to avoid business cycles.

When Republicans had the political microphone, they emphasized growth policy (because it allowed them to argue for what they really wanted, lower taxes, growth policy was simply the vehicle that allowed them to get there), and this was supported by academic work from people such as Robert Lucas who claimed that, from a welfare perspective, stabilization was of second order concern, growth policy was where policymakers should focus their effort if they wanted to enhance welfare. Summers’ remarks reflect this type of thinking.

The Obama Administration’s approach of focusing on deficit reduction without enough direct job measures is sure to keep unemployment elevated. In looking at the politics of economics I said recently:

I see jobs as the first area for Obama to attack. The question is whether he does this directly via some modified private-sector controlled W.P.A.-type program or indirectly via something like a payroll tax cut. After jobs comes foreclosure. Personal income and taxes are the least important area going forward (especially as any tax cuts will either increase deficit spending or have to be made up by tax increases elsewhere).

The Obama Administration is doing the opposite. They seem to have received the ‘deficit reduction comes first takeaway’ from recent state elections in Virginia, New Jersey, and New York instead of the ‘jobs come first takeaway.’ That is bad news for Democrats and it is also bad news for the hopes of a sustained recovery.

Source

The worst is yet to come: Unemployed Americans should hunker down for more job losses – Nouriel Roubini, NY Daily News
Job Losses Mount, Enduring and Deep – Floyd Norris, NY Times (the long-term unemployment image is also from this story)

Related posts:

• Comprehensive unemployment rate is 17.5%
• 467,000 jobs lost in the U.S. in June 2009
• 651,000 jobs lost but unemployment rate at 8.1% in U.S.
• 10.2% unemployment, 190,000 jobs lost
• Unemployment rate to 9.7%, 216,000 jobs lost

On the eve of U.S. President Barack Obama’s visit to China, a major Chinese official has criticized U.S. monetary policy in unusually harsh language. Liu Mingkang, China Banking Regulatory Commission chairman said the zero interest rate policy of the U.S. Federal Reserve posed a “new systemic risk.”

Liu, using language reminiscent of warnings by NYU economist Nouriel Roubini and speaking at a financial forum in China’s capital Beijing, said:

This situation has already encouraged a huge dollar carry trade and had a massive impact on global asset prices… It is boosting speculative investment in stock and property markets and will pose new, insurmountable risks to the global recovery and, particularly, to the recovery in emerging markets.

In my view, this is pure political posturing by the Chinese in order to defuse any U.S. criticisms of Beijing’s currency peg. Call it a pre-emptive strike. The U.S. has seen the unemployment rate rise to 10.2% and the trade deficit rise quite dramatically as well. Many are blaming the Chinese and their currency peg to the U.S. dollar.

When Barack Obama visits China this week, the Chinese expect him to focus on the yuan dollar peg. His administration will find it increasingly difficult to hold protectionist pressures at bay given the yuan’s firm peg to the U.S. dollar even while the dollar has plummeted.  To prevent the U.S. from successfully painting the Chinese peg as the sole major risk to the global economic recovery, the Chinese must therefore point to the destabilizing effects from measures taken by the U.S. to reflate its domestic economy.

The Chinese have shown success thus far. Last week, Tim Geithner penned an Op-Ed in the Wall Street Journal along with the Finance Ministers of Indonesia and Singapore which pointed a critical finger at China by asking for “market-oriented exchange rates.” Yet when the APEC (Asian Pacific Economic Cooperation) summit in Singapore ended that same language was cut from the final commiunique.

On the other hand, there has been little change in the prospects of a revaluation of the yuan peg.

Reuters reports:

Chinese Vice Commerce Minister Chen Jian on Sunday played down talk of a shift in the central bank’s currency policy as well as mounting expectations of a rise in the yuan’s exchange rate.

Speculation that China might let the yuan resume its climb after a 16-month pause swirled after a change last Wednesday in the long-standing wording used by the People’s Bank of China to describe its currency stance.

In its third quarter monetary policy report, the central bank failed to refer to keeping the yuan "basically stable at a reasonable and balanced level" when discussing the outlook for the exchange rate.

Asked whether the PBOC was heralding a return to the gradual appreciation of the yuan against the dollar seen from July 2005-July 2008, Chen told Reuters: "I don’t think the central bank meant to say that."

And all indications suggest that we are now returning to the same unbalanced pre-crisis growth model – but with the global economy in a considerably more fragile state. In this climate, the issues of the yuan currency peg and low interest rates in the U.S. will continue to be front and center for some time to come.

Related posts:

• Chinese to start settling trade in Yuan
• China issues bonds to “promote the RMB in neighbouring countries”
• US angling to get Chinese to revalue renminbi
• China slams U.S. profligacy
• Is China avoiding using US dollars?

Bill Gross of Pimco spoke on Bloomberg with Tom Keene and Ken Prewitt. He thinks the U.S. is entering a new normal of low nominal GDP growth. However, financial bets have been made on 6-7 percent nominal GDP (think pension liabilities).  Unless we get 5-6% nominal GDP growth debt deflation and deleveraging dynamics (the D-process)will take hold, Gross says.

This is not a bullish scenario for equities as revenue growth is based on nominal GDP, meaning profit growth must come from trimming expenses and a secular increase in already high profit margins. Lower interest rates are the only other way to improve the net present value of future profit streams.

Pimco is dipping a toe into equities, however.  Gross remains cautious on high yield, which he sees as fully priced (buyer beware) a.k.a. overvalued. Mortgage backed securities are also overpriced in his view.  That leaves you emerging markets, corporates, and treasuries in the bond area.

So the Fed will be on hold because they need to see at least 4-5% steady nominal GDP growth, something unlikely to occur before the end of 2010, Gross says.

Video below.

Se also: Bill Gross Says Value Diminishing in Credit Markets – Bloomberg

Related posts:

• Gross isn’t buying corporates, high yield or equities even with zero rates
• Bill Gross: Sell equities and buy Treasuries
• Bill Gross: the new normal means investors should shun risk
• Bill Gross: Government intervention in markets will last
• The $1 trillion deficit: has Bill Gross gone crazy?

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

Bloomberg reports:

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

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

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

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

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

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

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

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

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

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

Source

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

Related posts:

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

Columbia University Professor and former Federal Reserve official Frederic Mishkin wrote a much-discussed Op-Ed in the Financial Times yesterday. In it, he asks

Are potential asset-price bubbles always dangerous?

He answers this question with a no, noting that some asset bubbles are more dangerous than others because of their connection to debt and credit. I agree with his delineation and assertion that some asset bubbles are more dangerous than others. But, his conclusion that the non-credit variety of asset bubble — what he calls the “pure irrational exuberance bubble” — is not dangerous is false. This is the same blinkered thinking which led to Nasdaq 5000 and its crash. Experience demonstrates that all asset bubbles are dangerous, some asset bubbles are more dangerous than others. Think Animal Farm: All bubbles are equal, but some bubbles are more equal than others.

The real question Mishkin attempts to answer is whether the Federal Reserve (where he once worked) or any other central bank should target asset prices so as to prevent bubbles from taking form.

Because the second category of bubble does not present the same dangers to the economy as a credit boom bubble, the case for tightening monetary policy to restrain a pure irrational exuberance bubble is much weaker. Asset-price bubbles of this type are hard to identify: after the fact is easy, but beforehand is not. (If policymakers were that smart, why aren’t they rich?) Tightening monetary policy to restrain a bubble that does not materialise will lead to much weaker economic growth than is warranted. Monetary policymakers, just like doctors, need to take a Hippocratic Oath to “do no harm”.

Are we to take this seriously?  Even Alan Greenspan is showing more realism in the wake of our latest bubble.  This man is outright dangerous.  Don’t be fooled; his piece is a plant. We have some serious asset bubbles forming right now and he is looking to give intellectual cover to the watch-the-bubble-and-clean-up-after-the-mess policy we saw on display in the late 1990s. Yves Smith thinks there is a connection between his statement and likely Federal Reserve policy.

What I find interesting is how the Federal Reserve under Greenspan had an explicit policy of targeting asset prices as a means of reflating the economy. Yet, Mishkin is saying they should not target asset prices as a means of deflating the economy. This is what is called monetary policy asymmetry, otherwise known as the Greenspan Put. It’s not about targeting asset prices but looking for excess credit growth, which was certainly on display in the Nasdaq boom as well.

In effect, Mishkin is arguing for us to continue with business as usual. This is one of the more loathsome pieces of prattle I have witnessed since the financial crisis began. I hope no one takes this man seriously. I am ashamed that he is a professor at the business school I attended.

I would be remiss if I didn’t point out his equally absurd piece of research on Iceland’s economy before it collapsed. he wrote a piece called “Financial Stability in Iceland” with Tryggvi Herbertsson which stated:

Our analysis indicates that the sources of financial instability that triggered financial crises in emerging market countries in recent years are just not present in Iceland, so that comparisons of Iceland with emerging market countries are misguided.

No, Mr. Mishkin your analysis is misguided. It was with Iceland and it is here again. See below for a real analysis on Iceland from Willem Buiter and Anne Sibert which we can take seriously.

As I have been saying, you can get wildly different conclusions from two people based on the same facts and largely the same analysis. It goes to philosophical predisposition.  What this FT article by Mishkin demonstrates is that no amount of real world evidence of the havoc that bubbles wreak will dissuade these ivory tower ideologues from supporting failed economic policy.

Sources

Not all bubbles present a risk to the economy – Frederic Mishkin, FT

Financial Stability in Iceland (pdf) – Icelandic Chamber of Commerce

The collapse of Iceland’s banks: the predictable end of a non-viable business model – VoxEU

Central Banks Can Do Better Than Just Mopping Up – Caroline Baum, Bloomberg

Related posts:

• Popping bubbles
• Federal Reserve’s Fisher says tightening will be aggressive
• Japan’s easy money policy was the trigger for the tech wreck
• Quote of the day: William White and inflation
• Bank leverage: forever blowing bubbles part two

That’s all you need to know.

Source

FOMC statement – Board of Governors of the Federal Reserve System

Related posts:

• The Federal Reserve bails out AIG
• No Fed cut
• The Fed leads a global rate cut by central banks
• Bloomberg wins Freedom of Information lawsuit against Fed
• Don’t underestimate the power of printing money

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

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

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

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

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

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

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

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

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

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

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

Related posts:

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

The power grab at the Federal Reserve is a topic I first broached back in February when the Federal Reserve was creating its alphabet soup of liquidity programs to pull us back from the brink of financial disaster. I was troubled about Fed policy then and I am still troubled today.

I am equally disturbed by what is happening in shift in the balance of power to the executive branch. The Obama Administration seems to be following in the footsteps of the Bush Administration and making its own power grab and Congress has only just begun to wake up to this and start to push back.

At the risk of making this post overly broad, I want to make a few general comments about how executive power in government operates before I take on the specifics of the cases at hand. Everyone who has studied political science is aware that dictators and oligarchies use crises to invoke fear that allows them to usurp power using the cloak of ‘national security’ as a Trojan horse to consolidate power.

I would argue, this is what has just happened in the U.S. post-9/11 and again after the Panic of 2008. I see these developments undermining Americans’ faith in the political process and I hope an appropriate restoration of the checks and balances laid out in the Constitution can be restored. Having made my editorial statement, let me move to the specifics.

Executive Branch power grab

In September, after Lehman Brothers failed, US Treasury Secretary Hank Paulson asked for and received a blank check to disburse $700 billion to former colleagues and rivals in the financial services industry as he and his staff saw fit. In a brilliant act of cunning, Paulson had gotten approval to do anything he wanted from a gutless Congress more interested in loading the bill with sweeteners. This bill was not unlike the Patriot Act, passed after the 9/11 attacks, in that it increased the executive branch’s ability to intervene in the economy as they saw fit. I called it the Economic Patriot Act.

Originally, the Economic Patriot Act was about marking to market. However, once Gordon Brown started recapitalising Britain, Paulson made an about-face and proceeded to dispense the money in a similar fashion (albeit with much fewer strings attached than in the UK).

When the Obama Administration came to town, the modus operandi were not much different. Other support programs were forthcoming and bailouts at Citi and BofA ensued.

With the economy and banks on sounder footing and much of the money returned to taxpayers, the Obama Administration has turned to regulatory reform – and, what do you know – they are looking for a blank check again to do as they please in resolving too big to fail institutions that run into trouble. Again, as with Bush in 2002, if Congress gives the executive branch any blanket authority, it will be used and Congress will be cut out of the process. This is NOT how the American system of government is supposed to be run.

The Fed is grasping for the brass ring too

Enter the Federal Reserve. The Fed has been engaged in a policy of acting in concert with the Executive Branch in a non-arms length fashion since this crisis began. All of the liquidity programs and backstops the Fed has implemented are not just about liquidity, they are subsidies that lower the cost of capital and increase profits in the banking sector. As such, these subsidies are actually a part of America’s fiscal policy – stimulus, if you will. It is a clear no-no for the Federal Reserve to inject itself into fiscal matters. And to top it off, the Fed is refusing to be transparent about the process. Why would we make it the Systemic Risk Regulator?

Willem Buiter says it best so I will just quote him verbatim from his article, “Should central banks be quasi-fiscal actors?”:

Any action going beyond that, such as the recapitalisation of insolvent banks through quasi-fiscal subsidies, ought to be funded by the Treasury.  The central bank should be involved only as an agent of the Treasury – an expert assistant.  It should not put its own conventional or comprehensive balance sheet at risk.

The two arguments against the central bank acting as a quasi-fiscal agent are, first, that acting as a quasi-fiscal agent may impair the central bank’s ability to fulfil its macroeconomic stability mandate and, second, that it obscures responsibility and impedes accountability for what are in substance fiscal transfers.  In the US such actions subvert the Constitution, which clearly states in Section 8, Clause 1, that the power to tax and spend rests with the Congress: “The Congress shall have Power to lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States; but all Duties, Imposts and Excises shall be uniform throughout the United States.”.

If, as happened in the USA on a vast scale, the central bank allows itself to be used as an off-budget and off-balance-sheet special purpose vehicle of the Treasury, and refuses to provide to the Congress some of the information essential for the quantification of the fiscal transfers it has made, the central bank not only subverts the constitution.  By attempting to hide contingent commitments and to disguise de-facto subsidies by not divulging relevant information on the terms on which the central bank has offered financial assistance, it undermines its own independence and legitimacy and impairs political accountability for the use of public funds – ‘tax payers’ money’.  It is surprising that a country whose creation folklore attributes considerable significance to the principle of ‘no taxation without representation’ would have condoned without much outcry such a blatant violation of the equally important principle of ‘no use of public funds without accountability’.  This indeed amounts to a quiet usurpation of the power of the legislature by the central bank.

Qualitative easing, or whatever you call it, must end.  With the FOMC starting its two-day meeting tomorrow, and with the Reserve Bank of Australia having already hiked twice, it will be interesting to see if the Fed retracts its “extended period” language as many of us expect. While I think it premature in regards to the robustness of the economy, the Fed needs to show it is an independent actor.

Once lost, independence will not be easily restored.

Related posts:

• The Federal Reserve bails out AIG
• Plosser: The Fed must stop qualitative easing
• Geithner testifies before Congress on financial reform
• Bush: ever the opportunist, lifts oil drilling ban
• Geithner and Summers consolidate power

The Norwegian central bank has hiked rates 25 basis points, making it the third central bank and first European central bank to do so since the global recovery process started.

The Financial Times says:

Norway’s central bank increased its key interest rate by a quarter point to 1.5 per cent on Wednesday – Europe’s first monetary policy tightening since the global economic crisis bit hard last year.

Norges Bank said it would gradually continue more rises, holding with its main rate at between 1.25 and 2.25 per cent until the next monetary policy report in late March.

Analysts believe the central bank seeks to keep rates around the mid-point of the range, signalling another 25 basis point rise.

Israel and Australia have also raised rates, with the Australian rate rise coming somewhat unexpectedly.  Australia and Norway are particularly geared to commodities exports. As such, it is hard to say that these rate hikes have any significance for the rest of the developed world. At a minimum, they show that interest rates are not going lower; interest rate risk is now clearly to the upside.

Of particular note, should be the fact that the central bank cited asset prices as a driving motivation behind the increase in rates. Norges Bank head Svein Gjedrem recently warned that house prices were back to their summer 2007 peak and that the market risked overheating.

Related posts:

• Reserve Bank of Australia lifts rates again
• The ECB cuts rates 50 basis points to 2 percent
• BoE makes a dramatic 1 1/2 point cut
• Paul Krugman: Liquidity trap makes future ‘more or less speculation’
• Roubini: How to avoid the horrors of ‘stag-deflation’

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

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

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

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

Reuters said then:

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

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

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

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

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

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

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

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

Roubini takes a similar tack:

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

Source

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

Related posts:

• China slams U.S. for inflating global asset prices via carry trade
• U.S. Bailout: the mother of all carry trades?
• Hong Kong: “America is doing exactly what Japan did last time”
• Japan’s easy money policy was the trigger for the tech wreck
• Chart of the day: Aussie – Yen cross

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

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

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

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

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

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

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

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

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

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

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

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

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

Enjoy.

Source

Midnight Candles – Bill Gross, Pimco

Related posts:

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

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

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

Horowitz goes on to say:

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

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

Source

Hayek on Deflation and the Great Depression – Steve Horwitz

Related posts:

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

Marshall Auerback here with a few thoughts on money, the Federal Reserve’s balance sheet, and the alphabet soup of emergency liquidity facilities.

The expansion of the Fed’s balance sheet has been widely misunderstood within the economics profession, because it has been viewed through the lens of a pre-existing debate about the monetary transmission mechanism. Those who emphasized the importance of the money supply (on nominal spending) saw the expansion as quantitative easing, and warned about eventual inflationary consequences. Those who emphasized the credit channel (as Bernanke) saw the expansion as providing credit that was temporarily unavailable in the private market. The fact that the balance sheet expanded on both sides, and in both cases with the private sector as counterparty, tells us that something else was going on.

I would argue that the Fed’s actions after Lehman should be understood as moving the wholesale money market onto its own balance sheet. Banks with surplus funds lent them to the Fed by holding excess reserve balances, and banks that needed funds borrowed them from the Fed through the discount window. Foreign banks that needed dollar funding got it through their own central bank, which got it from the Fed through the liquidity swap facility. Banks that were short of collateral eligible for discount borrowed directly through the new commercial paper facility. Shadow banks that could not deposit in the Fed instead bought Treasury bills, and the Treasury deposited the proceeds at the Fed.

Once we think about the Fed’s balance sheet expansion in this way, the doubling seems in fact rather small. After all, the wholesale money market is much larger than the mere trillion or so that Fed took on. Deleveraging provides one answer why the expansion was not even larger. But the deeper answer, I think, comes from an appreciation that the Fed was acting as lender of last resort, and in doing so supporting continued lending in the private money market that would otherwise have frozen. In effect the Fed was offering a standing facility at prices away from market prices, so only those who most needed it took advantage. Simply knowing it was there made others willing to deal privately at more reasonable prices.

Thus, the commercial paper lending facility expanded and then contracted as private lending recovered. The central bank liquidity facility has followed a similar course. The important thing to realize is that, as these temporary liquidity facilities have wound down, the Fed has ramped up additional facilities, now aimed at restarting the securitized lending system more generally.

Related posts:

• Chart of the day: Fed Balance Sheet
• Fed is buying money market fund assets
• Will banks exiting TARP take back their toxic waste now?
• Flooding the system with money?
• Why is Zero Hedge claiming the Fed is intervening in equities markets?

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

In January, Ben Bernanke gave a very important speech at the London School of Economics where he laid out the Federal Reserve’s strategy in fighting the forces of deflation and market illiquidity (see post with videos here).  His was a strategy that took the Japanese variant of quantitative easing one further – toward what I call qualitative easing.

Earlier this decade the Japanese faced deflation in the wake of the recession after the Tech Bubble.  Interest rates were already zero percent (they conducted a never before tried Zero Interest Rate Policy – ZIRP, but this proved inadequate in the face of massive deleveraging). With the recession, outright deflation was sure to follow as interest rates could be cut no more. As a result, the Japanese started quantitative easing, a technobabble term for printing money.  The goal was to flood the economy with money which created inflation as the mountains of debt in Japan meant deflation could cause a downward spiral.

Fast forward to 2009 and we see Bernanke embarking on the same path. The twist however is that he has focused on the asset side of things. So while the Fed balance sheet has ballooned in both assets and liabilities, the mix of assets has changed considerably from almost all Treasuries to a bunch of Treasuries and a lot of assets of more dubious quality as well. (This chart, courtesy of Zero Hedge, shows the change). Clearly, this should leave you with a sense of unease as it is the collapse in value of these same assets which was largely responsible for the global panic last year.

One Fed President, Philadelphia’s Charles Plosser, is fed up with this and wants change.

Bloomberg reports:

Federal Reserve Bank of Philadelphia President Charles Plosser said the central bank should limit the securities on its balance sheet to Treasuries and create a policy for serving as lender of last resort.

The Fed’s emergency-credit programs and inconsistency in bailout decisions created confusion and showed the central bank “lacked a well-communicated, systematic approach,” Plosser said yesterday in a panel discussion at Palo Alto, California. Policy rules “would yield better economic outcomes for both monetary policy and financial stability policy,” he said.

Plosser’s comments rank him among the strong internal critics of the Fed’s efforts to stem the worst financial crisis in seven decades. The Fed “strayed into credit allocation” that should be the purview of fiscal authorities, not the central bank, he said at Stanford University.

“Developing such a systematic approach is not easy,” Plosser said at a forum hosted by the Stanford Institute for Economic Policy Research.

“Making a credible commitment to stick to such a lending policy in good times and bad is even more difficult,” he said. “Nevertheless, that is what we must tackle if we are going to achieve better results the next time a crisis arises.”

In effect, Charles Plosser is saying that the Federal Reserve become the handmaiden of the executive branch, conducting fiscal policy on its behalf. This is a clear no-no and the major reason the federal reserve has received so much scrutiny.

In my July post “Is quantitative easing really inflationary,” I said the following:

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.

I gather Plosser agrees with this assessment given his recent remarks. If the Fed wants to remain independent, or at a minimum resist the legislative branch’s desire for greater oversight, it needs to get rid of these toxic assets and stay out of fiscal policy for good.  How the Fed disposes of these junk assets is the $1.25 trillion question.

Related posts:

• Is quantitative easing really inflationary?
• Credit conditions
• Don’t underestimate the power of printing money
• Pushing on a string and similar notions on monetary policy ineffectiveness
• Is Japan next on the road to quantitative easing?

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:

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

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

The Asset Based Economy View of America

My pre-conceived thesis is as follows:

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

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

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

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

The Numbers: Federal Reserve Z1 Data Series

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

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

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

Total Debt

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

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

Government Debt

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

Household Debt

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

Mortgage Debt

This pattern is largely the same as the previous one.

Consumer Credit Debt

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

Non-Financial Business Debt

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

State and Local Government Debt

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

Federal Government Debt

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

Financial Services Debt

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

What conclusions can one draw here?

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

Foreign Debt

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

Conclusions

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

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

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

Source

Z1 Data Series – Federal Reserve

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The Reserve Bank of Australia unexpectedly raised rates by 25 basis points to cool down its economy. It will “gradually reduce stimulus” in anticipation of sustained recovery. Australia has probably been the major economy least affected by the global economic slowdown, so one would expect the RBA to be the first major central bank to increase rates. However, the question now is whether other central banks will follow.

In the U.S., Donald Kohn and Richard Fisher have made fairly hawkish statements suggesting that the Federal Reserve is going to be more anti-inflation now than in the Greenspan era.  However, New York Federal Reserve Chairman William Dudley obviously didn’t get the memo about jawboning the market in a hawkish way.  Yesterday, he indicated that the U.S. Federal Reserve is likely to keep rates very low for a prolonged period for fear of choking off a tenuous recovery.

So while the RBA is raising rates, the Fed and the ECB may not follow anytime soon. That is certainly supportive of the Australian dollar.

Below is a CNBC video that gives you a chance to see the real-time reaction to the RBA’s decision and another with some commentary on the Aussie dollar.

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Below is a wide-ranging interview with Marc Faber over four videos on CNBC TV18 in India explaining view on inflation, currencies, commodities, stocks and more.

Asset-based economy. In general, he thinks we are in an inflationary environment, whereas I think that deleveraging is secular and means any inflation is only cyclical. But he shares my belief that zero interest rates induce money balances to move into consumption or into higher yielding assets. He believes this is a boon over the medium-term (if not the short-term or long-term) for financial assets, whether they be stocks, bonds, commodities, real estate or art. And it is something that will continue, he says. Faber believes Bernanke will be loath to raise rates aggressively given his prior statements and writings.

Currencies. Faber takes the view with which I agree that the Fed’s easy money policies after 1998 flooded the global economy, especially emerging economies with liquidity. This has led to asset bubbles.  Hong Kong residential real estate is one example he cites.  As a result, Faber thinks the U.S. dollar is no longer overvalued at present levels. A snapback rally for the dollar resulting from oversold levels would be bearish for asset markets. But, longer term, Faber thinks the dollar is weak.

Equities. There has been a huge rally everywhere.  He says he is not a buyer at these levels. However, as central banks are going to continue to print money, stocks could continue higher – but he would not bet on a blow off rally from these levels.

Commodities. Faber thinks zero rate levels makes it extremely difficult to value anything.  Pose the question: which would you rather own – the “US dollar at zero interest rates or a ton of gold or a ton of copper or a ton of crude oil?” Of course, commodities are supply constrained, whereas dollars are not, so there is a justification for buying them. But, he anticipates the commodity hoarding by China is about to end and that is bearish for industrial commodities as well as precious metals. As with other commodities, he thinks the huge run up in oil could induce a setback. Long run, he is an oil bull because of limited supply.

 Financial Crisis. He is disturbed by the fact that a crisis caused by excessive debt growth, especially as a result of Federal Reserve policy has been allowed to pass with the same players in control. He says enjoy the ride for now. Longer-term, this necessarily means the same bad policies will follow and it will lead to a system-wide financial collapse.

India. Faber is bullish longer-term. Short-term, there could be a correction. India is one of the best protected countries because of less vulnerability to the export sector. He also believes the Reserve Bank of India has one of the best monetary policies in the world – supervise the financial system closely, relatively tight, and mindful not just of core inflation but other price levels like asset prices.

(videos embedded below)

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

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

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

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

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

Efforts Seen as Minimal

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

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

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

‘Reluctance and Regret’

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

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

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

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

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

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

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

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

Source

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

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

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

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

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

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

Source

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

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