Macrobuddies - Economic Insight and Analysis

Cave Theory, continued…

2010-12-03T12:42:00.002-05:00

"When the entire world is running into their caves, the country with the best cave wins." – Farrokh Langdana

Shomail Malik (REMBA ’12) brings our attention to the following article on Bloomberg:

Dollar Rises Most in 3 Months on Concern at European Debt, Korean Conflict

Shomail writes:

A perfect example of no matter how bad things get in the global economic landscape, "our cave is still better than they other guys' cave". Europe's debt and tensions in Korea causing people to run to the dollar. Although on the surface it would seem that we have reached the point of unsustainability, the rest of the world still views the U.S. as a "safe haven".

The US Dollar Index provides illustration:

US Dollar Index (DXY) September-December 2010

Europe staggers, the Koreas simmer, warships steam at battle speed in Asian seas....and we have Flight to Safety. Cave Theory [click link for earlier post] still holds.

The US still has the best cave - for the moment...

Pegs on Fire!

2010-11-25T13:09:00.000-05:00

Two recent articles brought to our attention the currency peg stress being experienced by the Hong Kong Dollar (HKD):

Sinking Feeling for the Hong Kong Dollar, Craig Stephen, Marketwatch, October 17, 2010
QE2 pressures Hong Kong asset markets, Craig Stephen, Marketwatch, November 7, 2010

(H/T Martin Wagner)

Basically, HK has a "hard" peg with the US Dollar. This means that its currency must always be locked to the USD. To ensure this, HK's central bank MUST do exactly what the Fed does with its interest rates. If the Fed increases M (Money Supply), HK must too, no matter what the consequences for HK. If it does not, then the interest rates in the US would dip below those in HK and capital would rush into Hong Kong thus making the HKD stronger and thus violating the hard peg.

So now, HK MUST increase M to match the Fed's crazy increase in M - - it must lower its interest rates too. As it increases its M, it will put further pressure on its SAPs, and since its interest rates drop, the HK dollar will weaken against the Yuan and against other currencies, as it has been.

The HK peg is on fire, and one wonders how long it will last.

Farrokh Langdana, Ph.D.
Rutgers Business School

QE2: Will it work?

2010-11-15T03:23:00.007-05:00

The market shot up 200+ points the day following the news that the Fed was printing money ($600 billion) like there was no tomorrow. What happened?

Investors expect that this huge dose of monetary growth, "M", by the Fed on the order of $600 billion, will shift the AD to the right over a Keynesian Aggregate Supply (AS) curve and propel the economy to a nice Stage 2 recovery (at AD2 below)—or who knows, maybe even overheating in the future (at ADoh)! Hence, the rush back into stocks and into commodities which (in their thinking) will undoubtedly put commodities (rubber, copper, oil, silver, rhodium, etc.) in great demand.

Current state of Economy:

Economy suffering from weak Aggregate Demand (AD1)

Increased Aggregate Demand from Monetary stimulus:

AD2: Demand has increased, leading to recovery in GDP

ADoh: Demand has been pushed too far, leading to Overheating

AD3: Severe inflation due to Overheating.

What's with the hike in precious metals prices?

The expected Stage 2 and overheating will be inflationary, thus warranting a nice inflation hedge such as precious metals. Investors want to get-in on this expected run-up in prices in commodities and precious metals and they jump into these markets today, thus driving up the prices even further and faster.

These investors are typically Keynesians who believe that in this last-gasp Keynesian fling of massive spending and monetization, the Obamists have pulled off a last-minute macro recovery.

Gold Prices Jan-Nov 2010

Regarding precious metals, there is another group that also loves them. These are the "inflation-vigilantes" who understand well that the increase in money growth M is simply a gigantic monetization of government debt and dubious mortgages (yes, billions are still around).

They know that monetization is ALWAYS followed by very big inflation---the only reason we do not see the inflation now (according to this group) is that depressed housing and jobs markets have crushed consumer and investor confidence. This is why (they would point out) the "long end" of the yield curve is very steep—the "smart money" is expecting inflation in the future.

These investors are largely non-Keynesians. They are not buying that large "wasteful" doses of government spending or simply printing of money to finance the deficits will jump-start the economy.

These are mainly supply-siders who are insisting that until taxes and government regulation come down, and until investors and businesses see tangible rewards to absorbing more risk, they will not increase capital investment and employ any additional workers.

In our language, until their C-bar and I-bar (consumer and investor confidences) increase, we are not going anywhere. All that we will get (according to this group) is more inflation.

The Wealth Effect

The Fed is also seeking to increase Aggregate Demand through another channel: The Wealth Effect.

Bernanke's statement last week that he is targeting stock prices raised many eyebrows:

"…And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."

Here Chairman Bernanke is referring to the "Wealth Effect", by which consumers and investors who feel their wealth increasing will be more likely to spend and invest.

Recall that Consumer Spending is a function of C-bar, Output, and Wealth:

The Consumption Function: C = C-bar + bY + dW

By inflating "W", Chairman Bernanke seeks to "help increase confidence", boosting consumption and investment.

Positive Wealth Effect: Increase in Wealth boosts Confidence

With Ben Bernanke now playing the role of Dick Whitney, investors must surely be wary of betting against the Federal Reserve!

However, we must also remember Mr. Whitney was only able to stave off disaster temporarily, as the market's decline resumed two days later, with a vengeance.

Dick Whitney
Staved off disaster on Black Thursday, October 25, 1929
by loudly buying huge blocks of shares

It is interesting to see that in the days following the initial burst, the market has lost some ground.

Source: Yahoo! Finance

However, the full effect of QE2 on Stock prices must be measured from the time it was first anticipated, starting earlier this year. The run-up is impressive.

Source: Yahoo! Finance

So who is right, the Keynesians or the Supply-Side skeptics?

We should know by early next year!

Farrokh Langdana, Ph.D.
Rutgers Business School

QE2: All Aboard!

2010-11-05T20:01:00.003-04:00

The Queen Elizabeth II

The Federal Reserve made its long-expected announcement earlier this week regarding "QE2", the name investors have given to his program of buying assets other than short-term Treasuries in an attempt to spur economic growth.

What is "QE2"?

The "QE" stands for "quantitative easing", and the "2" denotes that this is the second (the first being in late 2008-early 2009) round of the Fed implementing this type of policy.

Traditionally, the Federal Reserve attempts to manipulate short-term interest rates by buying and selling short-term Treasury Securities, in it's Open Market Operations:

When the Fed wants to reduce interest rates, it buys short-term Treasuries, which puts cash into circulation and pushes their price up and interest rates down. This policy is known as monetary "easing", and is seen as a catalyst to spur economic activity.

Conversely, when the Fed wants to raise interest rates, it sells short-term Treasuries, which removes cash from circulation and pushes their price down and interest rates up. This policy is known as monetary "tightening", and is seen as a brake on potential economic overheating which would lead to inflation.

Breaking out our graphs, the increase in the Money Supply is intended to work as follows:

The Fed applied traditional Monetary stimulus as the financial crisis proceeded, culminating on December 16, 2008, when the Fed dropped its target interest rate to zero (0 to 0.25%), where it has been ever since.

Once rates are near-zero, the Fed's traditional policy tools are of no use, as rates have nowhere to go down from zero. [For an interesting discussion on why, see this post from Greg Mankiw].

If the Federal Reserve believes that economic conditions warrant further action, it has many rarely used tools at its disposal, designed primarily to encourage economic activity by bringing down longer-term interest rates. Here is where non-traditional policy comes into play.

Ben Bernanke
Federal Reserve Chairman

Chairman Bernanke presciently outlined his playbook on this in a 2002 speech before the National Economists Club. Highlights (the entire speech is well worth reading):

"Because central banks conventionally conduct monetary policy by manipulating the short-term nominal interest rate, some observers have concluded that when that key rate stands at or near zero, the central bank has "run out of ammunition"--that is, it no longer has the power to expand aggregate demand and hence economic activity."

"However... a central bank... retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is zero.'

"To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys."

On November 25, 2008, the Fed announced that it would purchase $100 Billion in GSE debt, and up to $500 Billion in Mortgage Backed Securities.

NON-TRADITIONAL POLICY

This was a significant departure from traditional policy. Prior to the financial crisis, the vast majority of the Fed's Assets (which on its balance sheet support its Debt – which is the currency in circulation) were shorter-term Treasuries.

However, this was not the first instance of new and unusual actions by the Fed – these began with Liquidity-related actions as the Financial Crisis unfolded starting in the Spring of 2008. A summary of these actions follows, by way of background:

EMERGENCY LIQUIDITY POLICIES – A SUMMARY

The first radical departures from traditional policy related to Liquidity – providing credit for otherwise-solvent* institutions which found themselves holding assets that were hard to sell during a crisis. (*This description of Citibank, et al. as otherwise-solvent at the time may be questioned; we are simply describing the Fed's policy).

During the financial crisis, the Fed undertook a number of controversial actions and instituted a number of unusual emergency lending programs to provide liquidity to financial institutions.

Federal support programs as of November, 2008
Federal Reserve Programs at top of chart
[Click chart to expand]

These included:

* The guarantee of $30 Billion of Bear Stearns' (BSC) worst assets, provided to J.P. Morgan as incentive for it to acquire BSC. This pool remains on the Fed's balance sheet as "Maiden Lane I".

* TSLF (Term Securities Lending Facility) – created in March, 2008 to support Primary Dealers with $200 Billion in Mortgage-Backed and other securities

* Loans to AIG collateralized by (at par value):- $40 Billion in RMBS (Residential Mortgage-Backed Securities), under "Maiden Lane II"- $60 Billion in CDO's (Collateralized Debt Obligations), under "Maiden Lane III"

* CPFF (Commercial Paper Funding Facility) – designed to bail out companies (primarily GE) who rely heavily on Commercial Paper for their financing, with a commitment theoretically in excess of $1.5 Trillion, instituted in the Fall of 2008

* ABCPMMMFLF (yes, that's Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility – thankfully shortened to AMLF in common usage) – supporting Money Market Funds which were threatened by a run in September 2008 with the collapse of Lehman, a commitment theoretically exceeding $1 Trillion

* TALF (Term Asset-backed securities Loan Facility) – the purchase of securities backed by consumer loans (such as credit cards and auto loans) designed to revive the stagnant market for these securities in November, 2008, a commitment of up to $200 Billion

* Foreign Currency swaps exceeding $700 Billion with Central Bank counterparties at the height of the crisis in the Fall of 2008

* Nearly $150 Billion credit extended through the Primary Dealer Credit Facility in the Fall of 2008, which extended the Fed's Discount Window to all qualifying Financial institutions (not only the Primary Dealers who normally are the only entities which may access the Discount Window)

* Guarantee of up to $300 Billion to support Citibank's toxic Tier III Asset portfolio.

* Guaranteeing over $100 Billion of Merrill Lynch's (ML) assets to support Bank of America's September 2008 purchase of ML

The total liquidity commitments ran into the several trillions by early 2009, and the Fed's balance sheet ballooned with a hodgepodge of unusual assets (including, among other things, empty shopping malls).

These actions were designed to stave off what the Fed saw as the imminent collapse of the Financial system itself.

We discussed these actions in earlier articles, click to link:

What's that Smell? September, 2008
The Garbage Barge October, 2008
The Garbage Mega-Ship February, 2009

The Mobro, the original "Garbage Barge", in 1987
Did the Fed's balance sheet become the new Garbage Barge?

These policies do not fall under a narrow definition of "Quantitative Easing", as their purpose related to the emergency provision of liquidity, but we outline them to give a sense of the Fed's willingness, prior to its initiation of Quantitative Easing, to embark on bold and unusual policy initiatives.

NON-TRADITIONAL MONETARY POLICY

At the height of the crisis, with interest rates already at zero, the Federal Reserve perceived that the "real economy" (as opposed to its financial plumbing, which was addressed through its liquidity measures) was in danger of a severe and deep contraction.

As noted above, with rates already near-zero (during the crisis, rates actually fell below zero as terrified investors around the world scrambled to hold Treasuries, the one asset considered universally safe), the Fed found itself without access to the policy levers it normally uses to prod economic activity (the purchase of short-term Treasuries to lower short-term rates).

QE1 (and QE 1.5)

The RMS Queen Elizabeth, launched in September 1938

QE1 - The November 2008 announcement of $600 Billion in GSE and MBS securities indicated that the Fed would now target interest rates further out on the yield curve – that is, it would attempt to encourage economic growth by lowering medium- and long- term interest rates through the purchase of large quantities of longer-dated bonds. This is the "quantitative" in "quantitative easing": the injection of quantities of money into the economy that takes place through the process of buying longer-term bonds and securities.

QE1.5 - The November 2008 announcement was followed in March 2009 by the announcement of massive ($1.2 Trillion) additional purchases of:

* Up to $750 billion of additional agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion

* Up to $100 billion of additional agency debt bringing the total up to $200 billion

* Up to $300 billion of longer-term Treasury securities

The March 18, 2009 Federal Reserve statement included the dismal report that:

"Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment. U.S. exports have slumped as a number of major trading partners have also fallen into recession. And despite almost two years of near-zero interest rates, economic conditions have remained poor."

By way of explanation for its now $1.8 Trillion quantitative-easing program, the Fed stated that;

"In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability."

And so it did!

The effects of QE1 are controversial, but if it is true that "Bonds Don't Lie", the effects are visible in the path of the yield curve leading up to and after QE1, but are more muted after QE1.5:

Treasury Yield Curve May 2008 - December 2009
Source: Mish's Global Economic Analysis, August 2010

QE2

A year and a half after the last round of QE1, with the economy still in the doldrums, the Federal Reserve has determined to take additional action with a new round of Quantitative Easing.

Citing ongoing adverse economic conditions:

"…the pace of recovery in output and employment continues to be slow. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts continue to be depressed."

The Fed has determined to:

* Purchase $600 Billion in longer-term Treasury securities, and

* Reinvest what analysts indicate is approximately $300 Billion additional from principal repayment on existing securities held by the Fed into the purchase of new securities.

The total Quantitative Easing between QE1 (and QE1.5) and QE2 thus falls in the range of $2.8 Trillion. For perspective, going into 2008, the Fed's balance sheet consisted of between $800 and $900 Billion of Assets, primarily short-term Treasury Securities.

The recent and projected expansion of the Fed's balance sheet is illustrated by the following graph, from Zero Hedge:

Past & Projected Federal Reserve Balance Sheet
Source: Zero Hedge

WILL QE2 "WORK"?

To answer this question we must go back to the question of whether QE1 "worked".

+ THE POSITIVE ARGUMENT

Certainly the yield curve responded across the board at a time coincident with the original policy, and it is not unreasonable to assign causation to the Fed's actions.

This allowed homeowners facing rate resets to refinance at more beneficial rates than would otherwise have been the case, and also permitted companies to refinance their existing debt also at favorable rates, perhaps ameliorating an incipient funding crisis.

- THE NEGATIVE ARGUMENT

However, there are several criticisms which must be considered:

* It is reasonable to note that the real economy has only returned to anemic growth, which may or may not be ascribed to Monetary policy, and of late has stalled and remains below the threshold at which employment can stage a meaningful recovery.

Data Source: Bureau of Economic Analysis

Real economic activity remains below the level of three years ago, with the only increase among the components of GDP (aside from a small reduction in the trade deficit) being Government Spending:

Real GDP and components, Fourth Quarter 2007 versus the most recent Third Quarter 2010
Data Source: Bureau of Economic Analysis

One criticism aimed at Monetary Policy as a means of stimulus is that it does not, in fact, promote real economic growth at all.

If business conditions are such that firms are unwilling to expand, then there will be no demand from "Main Street" for the excess funds provided by the Federal Reserve to the banks.

However, these funds must go somewhere.

Where have they gone?

* The lack of demand for credit from businesses can be seen by the large buildup of bank reserves during this period. While the Fed can make credit available, it cannot force unwilling entrepreneurs to take risks by borrowing.

* The yields on Junk bonds have shrunk to levels generally last seen near their peak prior to the crash. Money is obviously flowing to these higher-yielding, and risky, assets instead of its intended target of business expansion, as investors who are facing negligible returns on Treasuries chase higher yields. The chart of Barclay's junk bond ETF (NYSE: JNK) illustrates the effects:

Barclay's high-yield bond fund (NYSE: JNK) Nov 2008 through Nov 2010

* One also must note that the Stock market bottom roughly coincided with QE1.5 in March 2009. Here also, one might reasonably conclude that the money not being borrowed by individuals and businesses is instead inflating a risky asset class.

SO, QE2…

Evidence that the excess money will inflate asset bubbles rather than real economic growth has accumulated in advance of and immediately following QE2:

* Stock prices surged through the fall in anticipation of, and accelerated in the two days following, the Fed's November 3 announcement

S&P500 ETF (NYSE: SPY) Aug-Nov 2010

* Commodity prices have skyrocketed, with Gold reaching all-time highs, and many other basic commodities up 30% or more year-over-year

Gold Prices Jan-Nov 2010

* Emerging market economies are facing hot capital inflows – as evidenced, by way of one example, by the boom in Indian equities. The financial officials of these countries have expressed concerns.

The India Fund (NYSE: IFN) 1-year Nov '09 through Nov '10

In a remarkable moment of candor for a Central Banker, Federal Reserve Chairman Ben Bernanke actually confirms that it is targeting Stock prices (emphasis ours):

"…And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."

Here Chairman Bernanke is referring to the "Wealth Effect", by which consumers and investors who feel their wealth increasing will be more likely to spend and invest.

There are two poignant counterarguments (among many) that may be offered against this notion:

1) The "Wealth Effect"

The most recent manifestation of the "Wealth Effect" led to homeowners using their houses as ATM's, withdrawing home equity to spend on consumer items and actually saving at a negative rate (why save when your home value is growing by leaps and bounds?).

This did not end well.

The Wealth Effect works both ways - on the way up, and, in reverse on the way down.

2) Stock prices

Consider a share of IBM stock. A share is essentially a claim on a company's long-term stream of cash flows. These cash flows are determined primarily by industry conditions, the company's competitive position, and its sales, marketing, operating, and financial policies.

Fundamentally, a share is "worth" only the present value of its long-term stream of cash flows.

The price of the share, however, is determined entirely by investor sentiment. If you bought a share of IBM in August at $125, and today, thanks in large part to easy Fed policy, the bid is $146, Chairman Bernanke would like you to feel more wealthy and spend some of that extra $21 on… well on pretty much anything except your savings account or your credit card bills.

However, while the price of the share has changed, IBM's long-term stream of cash flows have changed not at all. The fundamental drivers of IBM's long-term success are the same as they were. The share still represents the same claim that it did before.

All that has changed is that there is more money chasing risk – driving the premium for risk down (and the price of stocks and high-yielding bonds, up).

Post-crash, investors are painfully aware of the potential for a reversal. And so with many analysts already viewing share prices as overvalued by fundamental metrics, encouraging them higher may reasonably be questioned as a proper goal of the US Federal Reserve.

Is QE2 a dangerous and potentially hyperinflationary "Monetization"?

This concern has been articulated loudly by many critics.

The answer is: Yes and No.

Yes, the Federal Reserve is directly buying Treasury securities, which is the definition of Monetization.

No, in that the Monetizations that precede Hyperinflationary episodes generally occur when the Central Bank buys Government Debt that no-one else will buy. The Fiscal authorities go to the Central Bank as a last resort when their creditors desert them, which leads to a hyperinflationary spiral. This was the case in Weimar Germany, post-war Hungary, and most recently, Zimbabwe.

Hyperinflation in Zimbabwe, 2008

In the case of today's Federal Reserve, the Central Bank is purchasing the debt with the explicit goal of lowering interest rates and deliberately triggering some level of inflation. There has yet been little evidence of a serious slackening of demand for US Government securities among the usual buyers (although concerns have been expressed).

And, the Fed has repeatedly indicated confidence in its ability to ultimately withdraw the excess Money Supply from circulation in an orderly manner. (This claim also has come under criticism.)

CONCLUSION

Some have argued that QE2 amounts to a deliberate, competitive debasement of the currency with the goal of manipulating a change in the USA's current account imbalances (by increasing exports), and/or an attempt to inflate away the value of the national debt. We take the Federal Reserve at its word that these are not its deliberate intentions.

But the question remains: Will QE2 create the inflation desired by the Federal Reserve, and will this inflation spur economic growth?

Both parts of this two-part question are subject to a high degree of uncertainty.

Will QE2 create the inflation desired by the Federal Reserve?
Fine-tuning the transmission of Monetary growth to inflation is a risky enterprise. Very often, inflationary forces build up for a period of up to two or more years unseen, only to explode with a vengeance – too late to put the Monetary genie back in the bottle.

If so, will this inflation spur economic growth?
And the question of whether inflation spurs economic growth was in the United States most recently answered "no" in the 1970's Stagflation episode.

So what should the Fed do to spur growth?
"What is do be done?", you ask?

Lenin asked: "What is to be done?" in his seminal 1902 pamphlet

This is the eternal question raised by bureaucrats, central planners and central bankers of all stripes ever since the rise of the modern state. The underlying premise, of course, is that something must be done – the question precludes the notion that doing nothing is an option.

Here, several schools of economists diverge:

* Keynesians would argue that something must indeed be done, and would support precisely the sorts of Monetary policies that the Federal Reserve is undertaking (indeed, they are currently running the show), as an increase in Money will boost economic growth.

* Supply-siders would concur that something must be done, but would argue that Monetary policy is ineffective at promoting real growth and instead only creates inflation, and that Fiscal and (De-)Regulatory policies to encourage business activity are the way to go.

* Classical Economists would follow the advice of President Hoover's Treasury Secretary Andrew Mellon, whose counsel on what to do about the Great Depression was:

"Let the slump liquidate itself. Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate... It will scourge the rottenness out of the system. High costs of living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people".

* Austrian Economists might suggest that instead, doing nothing is indeed an option, and that the best thing the Federal Reserve can do (besides disband!) is to simply preserve the value of the currency, providing some certainty to businesses and individuals as they make economic decisions.

Andrew Mellon: Liquidate Everything!

The results of QE2 will unfold over time, although as with all economic policies, the extremely complex nature of the system will likely allow advocates of all points of view to plausibly claim vindication. Such is the nature of the "dismal science"!

In any event, QE2 is underway. "ALL ABOARD!"

[Click here to play]

- Peter T. Murphy, November 5, 2010

Keynes… Vindicated!

2010-10-14T02:36:00.010-04:00

No, we're not talking about the economic theory which bears his name – Keynes' vindication this week comes with the news that the 'Huns' have finally paid off their war reparations, ninety-two years after the armistice.

Halt the Hun!
Poster for WWI Liberty Bonds

John Maynard Keynes represented the British Treasury at the Paris Peace Conference in 1919.

As a first-hand participant, Keynes saw the promise of a just peace with, in President Wilson's words "no annexations, no contributions, no punitive damages…" transformed into a brutal, Carthaginian regime of precisely annexations, contributions, and punitive damages.

The Paris Peace Conference, 1919

Keynes' reflections on the conference, including his recommendations for a rational and lasting settlement, were published in book form as The Economic Consequences of the Peace, published in November, 1919, as the Reparations Commission was still formulating its policies.

The work is an unsung masterpiece of 20^th Century literature – unsung perhaps because it does not neatly fit into a category: its masterful prose demonstrates Keynes' worthiness as a leading light among the Bloomsbury set (particularly in his cutting descriptions of the main participants), while at the same time, it is essentially a comprehensive and highly detailed macroeconomic report, replete with figures and tables, on the productive capacity of Germany and Europe as a whole.

Keynes outlines how any chance for a generous peace was corrupted from the outset.

The Paris Peace Conference

David Lloyd George
British Prime Minister

In Britain, an ill-advised early election call by Prime Minister David Lloyd George backfired as he found himself hemmed in by his opponents and forced to follow public opinion, egged on by the tabloid press, in demanding impossible and brutal terms.

Georges Clemenceau
French Prime Minister

The French, who then viewed (and may someday again…?!) their relationship with Germany as an eternal, Manichean struggle, defined only by the balance of power between two irrevocably hostile foes, would have salted every inch of ground from the Rhineland east if they were so permitted.

Keynes characterizes Clemenceau's position:

"… the German understands and can understand nothing but intimidation, that he is without generosity or remorse in negotiation, that there is no advantage he will not take of you, and no extent to which he will not demean himself for profit, that he is without honor, pride or mercy. Therefore you must never negotiate with a German or conciliate with him; you must dictate to him."

U.S. President Woodrow Wilson
returns from Paris, 1919

And Wilson, to the surprise of many (remember, this was 1919 - international travel at this time was by steamboat and there was no television!) turned out to be, contrary to the hyped expectations invested in him by the welcoming crowds of Europeans, completely out of his depth. He was outmaneuvered easily by the far more cunning British and French negotiators, his grand ideas for a world of post-war harmony left in tatters.

Again, we turn to Keynes' description:

"There can seldom have been a statesman of the first rank more incompetent than the President in the agilities of the council chamber."

"The Old World's heart of stone might blunt the sharpest blade of the bravest knight-errant. But this blind and deaf Don Quixote was entering a cavern where the swift and glittering blade was in the hands of the adversary."

Proposals for reparations exceeding $100 Billion were bandied about prior to the conference by various officials quoted in the British and French press; meanwhile, Keynes calculated in exacting detail that a high-end estimate of the actual economic damage incurred against the allies during the war would be in the range of $10.6 Billion.

"The Economic Consequences of the Peace"

Keynes, disgusted with the proceedings as they moved inexorably toward a cruel victor's justice, quit the conference and returned to England to write his treatise, which became a surprising best-seller.

Keynes' brilliance was to base his case not on the moral injustice of the draconian terms being imposed, which given the tenor of the times would have fallen on deaf ears, but rather on a straightforward economic argument: there exists a figure that Germany can pay, and any amount exceeding this simply will not be paid.

"There is a great difference between fixing a definite sum, which though large is within Germany's capacity to pay and yet to retain a little for herself, and fixing a sum far beyond her capacity… The first leaves her with some slight incentive for enterprise, energy, and hope. The latter skins her alive year by year in perpetuity…"

Keynes' key insight was to understand the interconnectedness of global trade: by devastating Germany economically the victorious powers would eliminate a huge market for their own goods (as well as a major source of imports), the consequences of which would boomerang upon themselves.

Among the many figures and tables in the work is this one, showing annual German imports and exports by country – clearly the destruction of this major trading partner would deal a crushing blow to the world's economy:

Keynes then set out to determine the highest amount that might be reasonably extracted from the vanquished. He assembled an inventory of the pre-war and post-war assets and productive capability of Germany and its neighbors, looking at Europe as a whole. He determined that that the absolute maximum that Germany could bear to pay, without destroying the global economy, was on the order of $8.5 to $10 billion.

Keynes' recommendation for reparations was the sum of $7.5 Billion ($10 Billion less $2.5 Billion credit for assets and territory already transferred), paid without interest at $250 million per year for thirty years. He also called for mitigating some of the more severe territorial and in-kind appropriations, and establishing a Free Trade Union in Europe (another prescient idea…).

Ignoring Keynes' warnings, the final terms dictated by the Reparations Commission in 1921 were for $32 Billion in reparations, plus draconian appropriations of productive assets.

Less than 1/8^th of the total sum would be paid before a new German Chancellor, risen to power on the resentment universally felt by the German people to the injustice of the treaty and the economic cataclysm which it created, suspended payments outright in 1933.

The long-term consequences of the terms
of Reparations included the election in 1933
of a new German Chancellor

So, with reparations now paid in full, 92 years after the Armistice, we salute the genius of John Maynard Keynes, whose policy prescriptions, if not ignored in 1919, may have forestalled the worst of the 20^th century's savagery.

The Contrarian Brilliance of Lord Keynes

Keynes' hallmark was to challenge the conventional wisdom – to take the facts as they are and look at them from new, unexplored directions.

This was characteristic of his next work on policy: A Tract on Monetary Reform, published in 1923, where he argued for the abandonment of the gold standard (another set of recommendations that would be ignored, but in this case belatedly thrust upon the major economies by the force of events in the coming years).

Likewise, Keynes' 1920 A Treatise on Probability was a thorough, 480-page exploration of the cutting-edge of probability theory at the time, which Keynes brings to life with his characteristically original criticisms and insights.

And in 1936, Keynes published his magnum opus, The General Theory of Employment, Interest, and Money, which challenged the conventional economic models of the time.

His object was:

"…to contrast the character of my arguments and conclusions with those of the classical theory of the subject, upon which I was brought up and which dominates the economic thought"

'Keynesianism' Today

We have earlier explored the limits of Keynesian policy as applied to our present world, and have concluded that Keynes is Tired.

In fact, today, the view widely held by all but the most rabid Keynesian dead-enders is that 'Keynesian' fiscal and monetary policy has failed to perform as advertised:

- $1 Trillion of Stimulus spending has failed to dent the unemployment rate or spur any economic activity outside of "G" (Government), as "C" (Consumer Spending) continues to retrench and "I" (Investment) is hibernating.

- Legislative acts intended to spur lending have instead increased business uncertainty, and have focused solely on credit supply, ignoring the fact that this supply is being met with little demand as businesses remain loath to expand.

- $Trillions in an alphabet soup of Fed Support programs, near-zero interest rates for 2+ years and counting, an unprecedented expansion of the Fed's Balance sheet, 'Quantitative Easing' have failed to spur economic activity or even to create monetary velocity, as bank and corporate cash reserves have reached record levels.

Keynesian High Clergy: Christina Romer, Alan Blinder, Paul Krugman, and Joseph Stiglitz

And yet, opining from deep in their epistemic bunkers, proponents of 'Keynesianism' continue to insist that our problem is that we need more fiscal and monetary stimulus:

"The only surefire ways for policymakers to substantially increase aggregate demand in the short run are for the government to spend more and tax less."
- Economist Christina Romer, speech to the National Press Club, 1-Sep 2010

"The urgent need is for government to replace the lost purchasing power of the unemployed and their families and to employ other tax-cut and spending programs to boost demand."- Alan Blinder, Joseph Stiglitz, and other Economists, Daily Beast, 19-July 2010

"Everything is pointing toward the need for more spending."- Paul Krugman, New York Times Columnist, on CNBC, August 31,2010

"…the key problem with economic policy in the Obama years: we never had the kind of fiscal expansion that might have created the millions of jobs we need."
-Paul Krugman, New York Times Columnist, October 13, 2010

Meanwhile, economists not bound to old paradigms, doing new research, are coming out with intriguing findings.

Alberto Alesina, Harvard University

In particular Alberto Alesina of Harvard University has determined that credible and significant budget cuts are often more effective at spurring economic activity than fiscal stimulus:

"Many even sharp reductions of budget deficits have been accompanied and immediately followed by sustained growth rather than recessions even in the very short run. These are the adjustments which Alesina's have occurred on the spending side and have been large, credible and decisive."

His findings provided support for European policymakers' moves toward fiscal restraint earlier this year.

Would Keynes be a 'Keynesian'?

So, with Keynes' vindication on the defining policy error of the 20^th Century, we find ourselves wondering… would Lord Keynes even subscribe today to that set of policies which bear his name?

John Maynard Keynes

'Keynesianism' as broadly conceived today consists of applying the principles outlined in the General Theory to current economic challenges – in particular, spurring sagging Aggregate Demand through fiscal and monetary stimulus.

Would one of the most gifted, creative thinkers of the past hundred years dogmatically cling to policies conceived in response to a specific set of conditions some seventy years ago? Or, would he survey the economic landscape, and develop new and original prescriptions based on his observations of facts on the ground?

From a thorough reading of Keynes' body of work, and his biography, we are led to believe that were J.M. Keynes to return for policy consultation today he would be operating at the cutting-edge of economic theory, perhaps expanding on Alesanio's work, or, more likely, coming up with completely new and unconventional paradigms of his own. The idea that this man, especially, would rigidly follow a long-dead economists' prescriptions issued for a specific set of circumstances, in a specific time long past, is highly questionable.

Perhaps it's time to reclaim the word 'Keynesian' from the High Priests of Orthodoxy of a 70-year old set of theories, and inject the word with meaning that Keynes himself would, perhaps, have preferred.

Here is our humble suggestion:

Keynes-i-an [keyn-zee-uhn]
-adjective

bold, original, unorthodox
brilliant (as in an idea); contrarian, critical of prevailing paradigms
prescient

-noun

a bold, original thinker who challenges conventional models with new theories based on observation of current facts

- Peter T. Murphy, 8-October, 2010

Disclaimer!: The above may or may not represent the views of Dr. Langdana, who, on the question of Keynesians vs. Supply-siders remains officially neutral, inscrutable, and enigmatic!

Recommended reading:

The Economic Consequences of the Peace, John Maynard Keynes, 1919

Large changes in fiscal policy: taxes versus spending. Alberto Alesina and Silvia Ardagna, August 2009, Revised: October 2009

Fiscal adjustments: lessons from recent history. Alberto Alesina, April 2010

BASEL III: Does it address the roots of BASEL II's problems?

2010-10-06T15:03:00.001-04:00

by Francis Rodriguez, M.B.A.

The Basel Accords are a set of international banking regulations which were created by the BASEL Committee, made up of members of the Group of 10 (G10) nations to provide regulatory consistency and stability for banks worldwide.

BASEL I was triggered by the collapse of two major banks in 1974, Franklin National Bank and Bankhaus Herstatt. The first BASEL accords were published in 1988 and enactred in the G10 in 1992. This coherent, unified regulatory code increased confidence and transparency for banking across borders and promoted competition by ensuring similar requirements across the globe. The BASEL committee does not possess any direct regulatory authority; it is up to individual nations to enact and enforce the BASEL standards. In the US, for example, the recent financial reform legislation contained language to automatically adopt the requirements of BASEL III, which is being negotiated currently.

One of the most important and highly debated issues in the current BASEL III negotiations is capital requirements. Capital requirements are regulations controlling the ratio of a bank’s capital to its risk weighted assets. This basically means banks much be able to absorb the unexpected loss of value to risky assets (think subprime mortgage loans, MBS’s, etc) with cash or highly liquid, non-risky assets they have. To be more specific:

“To be adequately capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 4%, a combined Tier 1 and Tier 2 capital ratio of at least 8%, and a leverage ratio of at least 4%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels.

To be well-capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 6%, a combined Tier 1 and Tier 2 capital ratio of at least 10%, and a leverage ratio of at least 5%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels.”

- Wikipedia.org - http://en.wikipedia.org/wiki/Regulatory_capital

Tier 1 capital, or "core capital", refers to shareholder equity, retained profits, and may include preferred stock.

Tier 2 capital, or "supplemental capital", consists of undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt.
The big problem with the current capital requirements as defined by BASEL II is that it just doesn’t cover lots of risky assets. These assets are called “off balance sheet”. This was apparently partially adressed in BASEL II but not implemented in the US till 2007, after the bubble was built on the back of overleveraged banks and other financial institutions with short term financing (often as short as overnight on REPO markets). But even after 2007, there remained the possibility to hide risky assets in off-balance sheet entities. Here’s an excerpt from a research paper explaining how a bank could take securitized MBS’s and hide them to circumvent the capital requirements, thus increasing leverage and risk for the institution and increasing the possibility of default and bankruptcy:

“One way to understand where and why possible frictions might have occurred is to consider an idealized securitization transaction whereby the originator, bound by capital adequacy rules, sells a pool of assets to an off-balance-sheet entity. What is of critical importance, however, is the issue exactly what kind of an off-balance sheet entity takes control over the assets.

It may be a special purpose vehicle (SPV), i.e. what Gorton and Souleles (2005) call a bankruptcy remote, “robot firm,” with no employees, no physical existence, and no capacity to make substantial economic decisions. SPVs typically carry out predefined tasks of tranching pools of receivables obtained from the originator into asset-backed securities which are then sold on the market in much the same way as described above.

Alternatively, the originating bank could set up an offbalance-sheet conduit called a structured investment vehicle (SIV), a physically existing, managed and leveraged financial company whose purpose will be to undertake arbitrage by buying long-term fixed-income assets from its sponsors to fund them with short-term liabilities such as asset-backed commercial paper (ABCP).

As Shin (2008) astutely observes, the critical difference between SPVs and SIVs stems from the fact that selling a loan is entirely different from issuing liabilities against it. While the former – to the extent that loans are indeed passed down the chain – contributes to spreading credit risk around the whole economic system, the latter keeps it concentrated around the very bank that originates the loans and only hides it from the regulators.

As recognized by the IMF (2008, p. 69) in one of its latest reports on global financial stability:

…SIVs and commercial paper conduits, are entities that allow financial institutions to transfer risk off their balance sheet and permit exposures to remain mostly undisclosed to regulators and investors; to improve the liquidity of loans through securitization; to generate fee income; and to achieve relief from regulatory capital requirements.”

- http://www.ijesar.org/docs/volume2_issue1/impact_basel.pdf

So banks don’t want these requirements because it limits their ability to leverage and take risk and thus make tons of money. The biggest banks in particular believe they will not be allowed to fail and even if they are, the executives will likely keep their jobs, increase their compensation, and help write the next round of watered-down regulations - while shareholders and taxpayers take it on the chin.

And, unsurprisingly, the latest news is that the latest draft of BASEL III is watered down, weak tea:

“Early reports suggest that the final draft accord — agreed to by everyone except Germany so far — largely caved in on its definition of capital, which will allow banks a lot more leeway to skirt the new rules. It also, as expected, allows a long transition period before the new rules take effect. In return, it mandates a minimum leverage ratio. This would be great news except that the new minimum is 3%, or 33:1”
- http://motherjones.com/kevin-drum/2010/07/are-bankers-winning-again

Lehman's leverage ratio in June 2008? 33.7 - to - 1.

UPDATE: BASEL III's standards may be tightening as the process unfolds:

http://blogs.reuters.com/felix-salmon/2010/09/07/will-basel-iii-really-deliver/

Francis Rodriguez, M.B.A.

A Primer on Gold

2010-07-22T15:25:00.000-04:00

A rise in gold prices is basically a “thumbs down” for the economy, right?

Not necessarily. A rise in gold prices could be signaling positive news or very negative news.

So when do rising precious metals prices imply positive news?

Source: Macroeconomic Policy: Demystifying Monetary and Fiscal Policy, Chapter Five, 2nd Edition, Farrokh Langdana, Springer Press, 2009.

In the figure above, the vertical axis, "P", is "inflation", and the horizontal axis, "Y", is "national output".

In the traditional case, illustrated above, we see the economy’s total demand (Aggregate Demand, denoted AD) shifting rightward (growing) due to some combination of government spending (fiscal stimulus), monetary easing (lower interest rates), tax cuts, or a huge surge in consumer and business confidence. As the AD shifts to the right and approaches the maximum possible output at full employment, (Y max) the economy is said to be “overheating”. Inflation rises to Phigh, and dangerous bubbles in housing, stocks, or commodities could develop here.

Prudent investors see this coming, and at point "X" in the figure, for example, they start buying gold and precious metals. Why? As inflation is expected to rise in the future (by the time the economy overheats, at point "2"), it erodes savings along with the purchasing power of cash. Consequently, gold becomes a good store of purchasing power in inflationary, strong-growth climates.

This is one scenario in which rising gold prices go hand-in-hand with the expectation of robust economic growth and rising inflation in the future.

Aha! So this is the link between stock prices and gold?

In the scenario just described, we would typically see broad-based rallies in the stock market at point "X", accompanied by growth in gold and precious metals prices.

Conversely, if the AD curve were to start shifting to the left, due to say a collapse in confidence, then this shift would imply disinflation (or deflation) in the future. In this case, investors would unload their gold holdings, thereby causing drops in gold prices. As the AD drifts to the left, one could expect to see simultaneous drops in stock prices and in gold. In fact, in June 2010, the toxic combination of declining job growth here in the US, dropping housing prices, expected hikes in taxes, turmoil in Europe, and even greater government regulation caused a sharp drop in consumer confidence in the US. This, in turn, threw the AD to the left leading to expected declines in future inflation, growth, and jobs.

The spectre of future lower inflation accompanying a possible “double-dip” recession had investors unwinding their gold holdings—hence the drop in gold prices. Stocks fall along with gold as economic growth looks bleak.

So when do rising gold prices imply “very negative” news?

A typical scenario is an economy in which its budget deficits have become nonsustainable. Here, the government has spent more than it can borrow. Domestic and foreign lenders have no more interest or risk-tolerance for any more government bonds sold by this country; they will not lend to this country any more.

The government then has only one recourse—the wholesale and indiscriminate printing of money, known as the “monetization” of their debt. This eventually leads to macroeconomic disaster in the form of severe inflation, or even hyper-inflation. In the latter case individuals lose all confidence in the domestic currency which quickly becomes worthless, and they desperately convert all their assets and savings to gold (or foreign currencies).

Please note that it need not always be a nonsustainable deficit that leads to no-confidence in the domestic currency. Other reasons could be civil wars, natural disasters, and a collapse of government.

This is then similar to the ‘overheating’ case, right? Gold in both cases is a hedge against inflation.

Technically, yes, gold is being used as a hedge against inflation in both cases, but keep in mind that inflation in an overheated economy could be 7 to 30%, while a hyperinflation, such as the Hungarian Hyperinflation of 1945-46 had a price increase of 24x10^28 in just one month!

What else affects gold prices? What about “follow-along” investors?

Recently, many non-institutional investors have indeed loaded up on gold ETFs and have indulged in profit-taking to relieve their debt burdens (tuition payments, mortgages). This, in turn, has aggravated the slide in gold prices. But the big gold players are institutional (central banks, for example) and the big gold moves are typically episodic. Even though gold has significantly less industrial application than silver, it gets hammered by events such as miners strikes in South Africa, the Russians selling their gold reserves to try and shrink their deficits, Indians buying gold in anticipation of more overheating in the near future, China trying to divest out of US dollars and into gold, Zimbabweans switching to gold following the Mugabe-driven collapse and hyperinflation…..

Gold comes with a lot of “baggage”. It is indeed the ultimate store of value, but it is not for everyone. Investors need to do their homework.

Farrokh Langdana is grateful to his son and gold guru, Christopher, for expert advice in drafting this article.

Pegs explained, implications for the Yuan

2010-07-07T10:38:00.001-04:00

With the recent relaxation of China's peg to the US dollar, this is an opportune time to present a primer on exchange-rate pegging.

A. Why do countries peg (lock) their currencies to the US dollar?

This is done for basically two reasons:

(i) To "import" monetary discipline

Country B locks (pegs) its currency to country A (say, the US). This is accomplished by mimicking US monetary policy. If country A raises its interest rate, B must too, and vice versa. By ensuring no spread in interest rates, capital is precluded from flowing to and from A and B on the basis of interest rates alone (the "carry trade"), and hence B's exchange rate with respect to A's currency remains fixed.

This technique allows central bankers of B to attain some form of monetary discipline by letting rogue fiscal policy makers (in B) know that simply printing money in B to fund pet government projects, is now no more an option. B's money growth is now driven by A, and if A is an economy with great macro discipline, then B may be able to "import" this discipline vis-a-vis the peg.

Pegging of this nature occurs often in the aftermath of a hyperinflation or sovereign default, as a country attempts to restore confidence.

(ii) The other reason for pegging is to minimize fluctuations in domestic exchange rates, and hence in exports

Economies with relatively large export sectors (Singapore, Hong Kong) are prime examples.

Obviously severe swings in exchange rates will dramatically affect the price of county B's exports to country A. For an export-led economy, such swings can be destabilizing.

B. How is the exchange rate locked (pegged)?

Every day, the country B's central bank buys and sells foreign exchange (country A's currency) in the global currency markets to maintain the peg.

For example, if 10 of B's currency is to be locked to be equal to 1 of A's, and if the market is driving the rate to be 9 of B = 1 of A, then B's central bank will quickly buy A's currency in exchange for its own currency, to artiificially weaken its currency and quickly bring the exchange rate back to 10 of B = 1 of A.

C. So what was China doing--what were the claims of China "managing" its exchange rate?

Lets say that the endogenous (natural, market-driven) exchange rate for the Chinese Yuan and the US$ is 6 yuan = 1 US$. China was not allowing that to happen--the main reason was to keep exports cheaper, and to reduce the trauma on its export sector that has already been weakened by the global downturn. Every day the People's bank of China would buy huge amounts of US$ and sell huge amounts of Yuan to artificially weaken the Yuan (and artificially strengthen the US$) to force the rate to be say, 6.86Yuan = 1US$.

D. So why did they allow the yuan to finally start getting stronger (to appreciate) recently?

Pegging has a huge cost--keeping one's currency artificially weaker. China was flooding its economy with yuan to keep the currency deliberately weak. This massive increase in yuan was making its way to the banks and to the housing sector and the stock market.

The bubbles in China were being fueled, in part, by the rampant increase in the supply of domestic yuan resulting from the attempt to keep the yuan artificially weak. The recent move to "loosen the peg" (to allow a modicum of market-driven adjustment) is simply an attempt to slow down money creation and, in turn, to gently bring down the extremely dangerous real estate market bubble in China.

E. What effect has this adjustment had so far?

The graph tells the story, although the vertical scale makes the change appear to be more severe than it is - the Yuan has appreciated some 0.7% against the USD in the roughly two weeks since the change. Is this the endogenous market rate? Or is this the limit to what appreciation the PBC (People's Bank of China) will allow?

The PBC is not the most forthcoming of institutions regarding its activities. However, don't succumb to the temptation to single out China's inscrutible institutions for special criticism.

The PBC is operating under the same principles as the US Federal Reserve, and indeed as have all Central Banks from time immemorial: To a Central Banker, opacity is a feature, not a bug.

F. Where will the USD-Yuan exchange rate be in a year?

Most prognosticators expect further Yuan appreciation (H/T Himanshu REMBA '10).

Keep in mind, however, that most prognosticators looking ahead from January 2008 expected the S&P 500 to end the year at around 1300-1400+. (To cite one example, subscribers to Business Week must have been particularly disappointed with the S&P's near-miss, closing 2008 at 903.25 versus their projection of 1520).

Speculating on the outcome for the Yuan involves a twofold prediction: (1) the endogenous rate, and (2) the PBC's stance.

Place your predictions in the Comments! On the one-year anniversary of the PBC's loosening (June 20, 2011) we will provide the winner with (#1) a $25 gift certificate to Wal-Mart (who will quickly send a good portion of these dollars back into China!) [generously sponsored by John Giorgi, REMBA 2010!], and (#2) a forum to explain how the fulfillment of your prediction was the result of exceptional wisdom and brilliance (rather than sheer luck).

Dr. Farrokh Langdana, Ph.D.
Rutgers Business School

Milton Friedman was… WRONG?!

2010-03-31T11:07:00.013-04:00

"HERESY!!!" you cry…

Indeed. And yet…

"Inflation is always and everywhere a monetary phenomenon"

-Milton Friedman, A Monetary History of the United States, 1963

We simply cannot reconcile the monetarist position as elucidated above, with these two graphs:

Adjusted Monetary Base

Inflation

According to the Quantity Theory of Money, an near-tripling of the money supply should result in a dramatic rise in prices.

Yet despite an explosion of base money supply, and, as we've mentioned previously, a severe deterioration of the quality of the assets which (theoretically) back up the Fed's liability of Dollars in circulation, there is no inflation to speak of whatsoever. Why?

Basically:

You can give a bank lots of money, but...

...You can't make it lend.

While the Federal Reserve can create money, it can push this money only as far as the Banks. From there, the Fed is powerless.This graph tells the story:

Excess Reserves at Depository Institutions

Excess Bank reserves have grown just as fast as money supply. Basically, the extra M is just sitting there. Two forces conspire to create this scenario:1) Bank balance sheets, though gradually repairing, are still in poor shape. And, a wave of Option-ARM resets, created during the final, peak stage of the housing bubble, are just starting to hit now. Banks are happy to have big piles of cash under these circumstances.

And, equally important, but less-discussed, is the question of:

2) Who wants to borrow? Does the present economic environment make you feel like taking out a loan to grow your business? Does the government's current attitude toward investors and businesses make you eager to expand or take risks? Are you ready now to take out a mortgage to buy that second-home? Or a home-equity line to remodel your kitchen? Borrow a couple month's salary to take that vacation you've been putting off? You get the point…

The "money multiplier" refers to the multiples of $1 that are created in the economy with every dollar of base money created. This happens as the initial $1 of base money is lent out, spent, invested, lent out again, etc. This effect is also known as the Velocity of money.Banks, who provide the Supply of credit, are only one party to the transaction. There has to be a borrower. So, even a bank eager to lend will find no takers if businesses and individuals don't want to borrow.

With Confidence still in the doldrums, DEMAND for credit (or anything, come to think of it…) remains low.

M1 Money Multiplier

For the past year, a dollar in extra base money has actually created less than a dollar in the economy!

Thus, without strong motivation on the part of the lenders AND borrowers, the Federal Reserve can create all the money in the world (as it has been doing for the past two years) and inflation will not result.

What, then, can create Inflation in today's environment?

Throughout history, the biggest culprit behind every major inflation event have been the FISCAL (not Monetary) authorities. That is: GOVERNMENT SPENDING.

Stay tuned...

-by Murph 31-Mar 2010

The Dollar: Rumors of its death are greatly exaggerated

2009-10-21T23:54:00.001-04:00

There has been much discussion this year over the possible development of a new global reserve currency which would displace the dollar.

In an essay in March 2009, People's Bank of China governor Zhou Xiachuan had outlined a plan to expand the use of Special Drawing Rights (SDRs), a basked of currencies used by the IMF and its member countries as an accounting construct, to basically begin the process of phasing out the prevalence of the US$ as a global reserve currency. This essay has generated significant attention and in fact, has done damage to the greenback.

However, fears of a dollar-replacing SDR currency may be misplaced.

1. About 65% of China's ahrd currency reserves, earned since China opened its doors to world trade in 1987, are in US assets. Any precipitous drop in the US$ would be calamitous for China's "savings". And one thing is certain, which I can say having taught in and studied China since 1993, China's macro policy, so far, has been brilliant. They will not push for anything that will be deleterious, or destabilizing, to their economy.

China's reserve growth 2000-2009 (Source: Brad Setser)

2. So why this talk of SDR's coming from China?

Simple. China sees the US running nonsustainable deficits and if growth gains traction in the US, they see rapid inflation which will erode away the dollar (and hence the real value of their savings). The SDR rhetoric is simply a short across the US macro bow that says "Hey, you macro-guys in the US, you'd better watch that deficit, and the impending inflation that will come with it. And keep in mind that this humongous amount of money that you are printing cannot be easily withdrawn!"

3. It is true that we have been monetizing like crazy, but why can't we simply vacuum the excess money back in to prevent inflation, when the economy picks up?

This is because of the rampant monetization that has been done by buying toxic sub-prime assets from malfeasant lenders. To "undo" the monetization, these assets, persumably now non-toxic, would have to be sold back to investors. The probability of them becoming "non-toxic" is not significantly large (less than their becoming more toxic as time progresses) - hence the worries of inflation if the economy gains traction.

4. So coming back the SDR challenge to the reserve-currency status of the US dollar - what is the final word?

We hold currency for two major reasons: As a store of value, and as a medium of exchange. It is the first one - the store of value - that is vitally important. And "value" is endogenous. A currency is awarded value by the world community. A currency becomes a reserve currency because the rest of the world is comfortable holding on to it, and accepting it in lieu of exporting goods and services. Reserve currencies are earned and not announced. It is like respect - you earn it, you do not command it or negotiate for it. So yes, the SDRs may be a decent unit for accounting (another basic function of "money") purposes, but will only be as strong as their weakest member countries' economies.

Keep in mind, that the largest component of the SDR today is still the US$ (at 44%), followed by the Euro (34%), the Japanese Yen (11%), and then the British Pound (11%). So the SDR, were it to gain acceptance, would still have to have the US$ as its main ingredient. But if the Eurozone or the UK or Japan were to tank, then this would undermine reliance on the SDR.

In summary - don't sell your US$. Yes, the dollar is under siege, and has been mauled, but, given the state of the global economy and the extraordinary resilience of the US, the dollar will continue to be awarded the status of the planet's reserve currency by the world community.

Dr. Farrokh Langdana, Ph.D.
Rutgers University Business School

.

Monetization Demystified

2009-10-16T07:19:00.012-04:00

There is a lot of talk (finally) about how the Fed is simply "printing money" to pay for the unprecedented increases in spending and deficits. Economists are going on about how Bernanke's monetizing the deficit. Is this is the same as "printing money"? And, how is this different from borroing by Uncle Sam via the Treasury?

Here is a Monetization primer that will hopefully clarify exceptionally important issues - especially given the US is well into non-sustainable deficits.

The Treasury

When the Treasury borrows from domestic and foreign (Chinese) lenders, it issues new government debt: Treasury bonds and Notes. This borrowing used to be done at four large auctions every year - now they are almost a weekly feature. This borrowing finances "G" - government spending.

If the Treasury finds no lenders - or insufficient lenders - it has to simply "sell" these new government bonds to the Federal reserve which "pays" for these by simply creating money out of this air. This is known as "monetization" of government deficits and is extremely dangerous. On a large scale - as it inevitably is - this leads to hyperinflation. Note: Since President Nixon closed the "gold window" in 1971, there is no more gold anchor. Since 1971, there has been nothing restricting the creation of money by the Federal Reserve.

The Fed

To increase money for normal operations (i.e. not for monetizing the deficit), the Fed simply buys previously issued (not new) Treasury bonds from local banks and creates money to increase the growth of the monetary base and to lower short-term interest rates known as the Federal Funds Rates. To shrink money in circulation and to raise the short-term rates, the Fed sells government bonds to local banks - it reverses the process. These are Open Market Operations, not to be confused with Monetization.

Since Fall 2007, the Bernanke Fed has bought Trillions in toxic debt (rotten mortgages) from financial institutions, etc. Including, by way of example, this empty shopping mall in Oklahoma City (yes, believe it):

Empty Shopping Mall in Oklahoma City owned by the Federal Reserve

This process has been labeled the great "Stealth Monetization" by the Fall 2007 Rutgers EMBA class.

This monetization went largely unnoticed, and most important, this is a "toothpaste" monetization. Like toothpaste, this money is easy to print and impossible to put back. When the time comes to shrink the monstrous amount of money created by the Fed - unprecedented in human history - we will be unable to"vacuum back" this money creation. Who will buy back the toxic debt? Certainly not the same financial institutions that were delirious when the Fed took it off their hands at above-market value. This is the new and more insidious monetization that has cropped up since 2007.

Hopefully this clears up the confusion between Government spending, Open Market Operations, and Monetization - both conventional and stealth.

Farrokh Langdana, Ph.D.
Rutgers University Business School

.

Playing Chicken with Trade

2009-07-02T10:55:00.021-04:00

"China is expected to ban imports of US Chickens in coming months", reports the WSJ.

This move is, in part, retaliation for the 2008 U.S. ban on imports of processed chicken from China, but is also part of a broad global trend toward protectionism - which is being led by the US.

Repaying organized labor for their massive political support in the most recent election cycle, Congress inserted the notorious "Buy American" provision into the stimulus bill in February. Three weeks later, Congress banned Mexican Trucks from entering the U.S., in a clear violation of the NAFTA treaty.

These protectionist moves have led directly to harmful consequences for the USA, for example:

* China has begun to enforce "buy Chinese" requirements for investment related to its own RMB 4 Trillion stimulus package.

* Mexico, in addition to suing the US over the trucking ban (which will have no effect as the US consistently ignores unfavorable WTO rulings), has retaliated by "imposing tariffs of 10 to 45 percent on dozens of U.S. exports ranging from fruit and wine to washing machines".

* Canada's national and local governments are considering retaliation for the "Buy American" provisions.

This takes place as world trade continues to collapse as a result of the economic crisis:

http://www.cpb.nl/eng/research/sector2/data/trademonitor.pdf

Meanwhile,

* The Doha round of world trade talks languishes because of the intransigence of developed nations on their farm subsidies.

* The US continues to support ethanol mandates and subsidies, regardless of the effect on food prices (which cascades down to affect the poorest nations of the developing world).

* Fully negotiated US bilateral trade agreements with South Korea and Colombia gather dust and remain unratified due to the political influence of organized labor.

* The climate bill passed by the US House of Representatives last week includes provisions to impose tariffs on goods imported from countries that don't match U.S. carbon-dioxide restrictions". China and India (against whom these provisions are clearly designed) are already objecting strongly.

Simple self-interest dictates that the US forcefully advocate for free and open trade. The US is by far the biggest trader of goods and services in the world, accounting for 11% of world trade and exceeding both Germany and China, its nearest rivals, by 30%.

The dynamics of local and regional politics dictate that legislators will almost always put provincial politics ahead of the national interest when it comes to trade. For this reason, only strong leadership by the US Executive can stop the global slide into Trade Protectionism.

To-date, this leadership has been absent. The best that President Obama has mustered so far does not exactly qualify as a ringing defense of open trade: “I think we have to be very careful about sending any protectionist signals out there.” (NYT, June 29 2009).

The US is far beyond sending mere "protectionist signals". It has in fact put itself on a collision course with its largest trading partners over trade issues of its own making.

In a global trade game of chicken, nobody wins.

-Peter T. Murphy, 2-July 2009

Credit creation versus Debt relief

2009-06-30T09:06:00.006-04:00

Increased savings is a symptom of the ongoing debt-deflationary condition of the economy, argues the author in this article, courtesey of Lincoln Rowley, REMBA'09: Debt Deflation in America – What the Jump in the U.S. Savings Rate Really Means by Michael Hudson.

Michael Hudson makes an important point:

"The trillions of dollars that the Bush and Obama administration have given away to Wall Street would have been enough to buy a great bulk of the mortgages now in default – mortgages beyond the ability of many debtors to pay in the first place."

The Government has committed Trillions of dollars (over $12 Trillion and counting) to bail out institutional Creditors (Banks) rather than Debtors (Citizens), in the misguided belief that we need more lending. "Hair of the dog" may be an effective pallative for a hangover, but a crisis caused by overindebtedness is unlikely to be cured by creating additional debt.

Hair of the Dog
Photo Source: http://www.housepetmagazine.com/dog_events_newyork.htm

There are two sides to a loan - the lender, and the borrower. Unfortunately for the Government's strategy, no matter how much "liquidity" is provided to lenders to support the supply of credit, the appetite among borrowers to take on more debt (the demand for credit) has disappeared. This shift in attitude is evidenced by the soaring savings rate, and, is unlikely to be temporary.

Data Source: http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=75&Freq=Month&FirstYear=2009&LastYear=2009

"It is wrong to squander the taxes of ordinary citizens and put a burden of indebtedness on our children in order to protect the bondholders of careless and poorly-managed financial institutions" - John Hussman, Ph.D.

John Hussman has written cogently on what would have been a more proper use of taxpayer resources to address the heart of the problem - falling real estate prices which continue to drive a chain reaction of defaults throughout the financial system.

The concept is that the Treasury would administer a program whereby lenders write down the underwater portion of a distressed mortgage, and transform the written-down portion into an equity position in the property (a "Property Appreciation Right", or "PAR"). These "PAR"s would be pooled and administered by the Treasury. This solution deals directly with debt relief, rather than credit creation.

Read the article at http://www.hussmanfunds.com/wmc/wmc090223.htm

A point made in both articles is that government aid to financial institutions, rather than directly to distressed debt relief, has been misguided. Dr. Hussman makes the point that equity and bondholder capital in the banking system was, and remains, more than sufficient to cover bank losses on distressed debt. The various bailouts to-date have simply transferred wealth from present and future taxpayers to bank bondholders.

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Cave Theory

2009-06-02T10:23:00.004-04:00

"When the entire world is running into their caves, the country with the best cave wins."
- Langdana Cave Theory (paraphrased)

In the global flight to safety last fall, the dollar, which had been in decline for years, rallied strongly as the world rushed to what was perceived as the safest asset, relative to others, on the planet.

Mike Shedlock's article today in Minyanville discusses the current pessimism about the US dollar, due to all the debt being issued - and the fact that the pessimists are ignoring the fact that the entire world is engaged in the same deficit-spending activity.

Here's the link to the article:
http://www.minyanville.com/articles/CHINA-dollar-euro-FXI-UDN-CMC/index/a/22892

Dollar bears: beware !

- Peter T. Murphy, 2-Jun-2009

"GAME OVER"? Perhaps not...

2009-05-18T17:08:00.017-04:00

“During a recession of this severity it is important, as I explained, for the government to step in and fill the hole in demand that was created by consumers and by businesses, to get the economy kick-started.

But the long-term deficit and debt that we have accumulated is unsustainable. We can't keep on just borrowing from China, or borrowing from other countries -- (applause) -- because part of it is, we have to pay for -- we have to pay interest on that debt. And that means that we're mortgaging our children's future with more and more debt, but what's also true is that at some point they're just going to get tired of buying our debt."

- President Obama, speaking at New Mexico town hall meeting, 14-May 2009

SUSTAINABILITY

The Dornbusch model of the sustainability of bond-financed budget deficits is the benchmark for gauging deficit sustainability.

Generally, if the ratio of Fiscal Budget Deficit - to - GDP is less than 5%, the bond-financed budget deficits in mature economies such as the US, Japan, and Western Europe, are said to be "sustainable". That is, they can be perpetually financed by "rolling over" the debt.

In the Dornbusch model, this 5% coincides with the real (inflation-adjusted) interest "lost" on government debt being less than the growth rate of the economy. In other words, as the size of the economic pie grows faster than the interest paid on government bonds, all will be well.

NON-SUSTAINABILITY

Over 5%, well, that's another story. Here the budget deficit becomes "nonsustainable". Domestic and foreign lenders refuse to lend Uncle Sam any more $ -- they refuse to buy any more of our Treasury bonds-- and a mind-numbing inflationary monetization becomes inevitable. Unable to finance its budget shortfall by borrowing, the Government will simply print money. For the non-economists: We then have to print money like crazy and we basically go into hyperinflation.

At that point, our collective ATM dispenses only two words: “GAME OVER”!

THE SITUATION TODAY

So how are we right now in May, 2009? The 2008 deficit/GDP ratio was 3.2%, well under the 5% limit established by the Dornbusch model, but by December 2009, thanks to the massive spending of the Obama plan, we will be at 13% (this estimate directly from the Congressional Budget Office) !

The US has not seen levels like this in 60 years. (war-time deficits, as seen in the graph, are generally temporary, and can be manageable - if your side wins!).

Source: usgovernmentspending.com

REASON FOR HOPE

We're clearly well-past the 5% Dornbusch limit. But wait! Is this the end? How dangerous is this? There is hope---there may be some mitigating circumstances.

This time, with the whole planet in recession, there is no other safe haven. Even at 13% deficit/GDP ratio, the US economy is still the world's most resilient. Where will the Chinese send their savings? Europe? Not likely. Furthermore, US reliance on foreign lenders may be abating, as domestic savings continues to rise.

So as long as global contagion causes the recession to be a worldwide phenomenon, we may dodge the deficit bullet after all, and still manage to confound Dornbusch and be sustainable at 13%.

If I am wrong, buy gold--the real thing, the shiny metal. And a safe.

Dr. Farrokh Langdana, Ph.D.
Rutgers University Business School

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"You don't need banks and bondholders to make cars"

2009-05-12T02:27:00.025-04:00

- Obama Administration official (WSJ, 11-May 2009)

This is certainly an interesting proposition. If only Chrysler, GM, and Ford had known this earlier - all their recent trouble could have been avoided!

For those readers who might be entertaining doubts -let's briefly review a few of the modern wonders of the world that have been produced where the greedy hand of the Kapitalist has been kept at bay:

Lada Riva

The Lada Riva. Soviet engineering at its mightiest: take a Fiat design, double the weight, install rock-hard manual steering and aluminium drum brakes incapable of effecting a stop, and you've got a true car of the people. Banned in Western countries for safety reasons in the 1990's, enthusiasts can still obtain a version produced under license in Egypt today.

Moskovitch 408

The Moskvitch 408. For those with a family, the 1970's Moskvitch 408 was the first Soviet production car to include safety features - including: seat belts(!). Manual drum brakes were also standard. Top speed is unknown but we've seen video of this 50-horsepower monster doing upward of 40mph.

Zaporozhets 968

The ZAZ 968. For those who fantasize about rear-engine sportscars, the dream can be realized with the Ukranian-made rear-engine ZAS 968. An optional 70hp motor (available on the ZAZ 968-A) was available for the most adventurous thrill-seekers. Originally designed as a "people's car", the notoriously unreliable ZAZ became known as the go-to vehicle for "pensioners and intellectuals"...

Wartburg Knight (Touring model)

The Wartburg Knight represented the best of (East!) German engineering right up until those greedy bankers and bondholders stormed through after the wall came down in 1991. Its 2-stroke one-liter (well, close enough at 992cc) engine was upgraded to a full 1300cc's in 1988 in its last iteration, bringing it to parity with most heavy lawn equipment in the United States.

Trabant 601 (...and it's 'green'!)

The Trabant 601, also a product of East Germany, generally required customers to wait 15 years or more for delivery. No such problems for party members, for whom the rules, in people's republics such as ours (like paying income taxes), don't apply. The Trabant, the most popular car in East Germany, achieved 60mph in 21 seconds with all 26 horses of its 2-cylinder, 2-stroke engine in full gallop. Another casualty of the cold war victory of Kapital over Labor, the last Trabant creaked off the assembly line in 1989.

And, let's not forget the Polish-made Polonez (luxury model shown here)...

Polonez (Poland)

Or the Russian Zil, available in armor-plated models capable of withstanding land-mine explosions and a direct hit from an RPG...

Zil (Russia)

And finally, not to leave out our comrades to the East, the classic Red Flag, Chairman Mao's favorite mode of transport and every bit the equal in armor and armaments to the Zil...

Red Flag (China)

Sadly, for those eager for vehicles produced without the exploitation of the proletariat, these cars have all been discontinued. However, options do exist - nuclear weapons technology and counterfeit US currency aren't North Korea's only exports...

Pyeonghwa Motors, North Korea - no bankers or 'speculators' here...

Service could be a problem, however, as the North Koreans do not at this stage have distribution in the US...

But - Not to worry! Capitalism-free cars will be coming soon to one of 3300 dealerships near you in the USA!

We do have a suggestion for the new proletariat-and-state-owned Chrysler as it seeks to produce the President's "fuel efficient cars of tomorrow". Don't listen to the naysayers (probably those same greedy banks and bondholders) who claim that it will take many years and many billions of dollars to create the "next generation" of vehicles - plenty of fuel-efficient, popular designs were available for years to comrades across the People's Republics, and could easily be ramped back up... we could start with the Trabant 500 (last produced in 1989):

Don't let the sexy looks fool you - this bad boy gets 34 Mpg!

- Peter T. Murphy, 12-May 2009

The case for Inflation: "G", not "M"

2009-04-24T00:38:00.006-04:00

The runaway increase in the Monetary base over recent months is often cited as an inflationary development.

The fact is, however, that historically, there is a weak relationship between base money and inflation. The graph below shows the growth of the Monetary Base (green, left scale) and CPI-U inflation (blue, right scale)

The explosion in base money over the past year has been accompanied by a steep fall-off in prices.

"G", not "M"

Thus, the relationship between "M" and inflation is ambiguous at best.

There is, however, a historic relationship between government spending ("G") and inflation. US Government debt as a percentage of GDP from 1970 to the 2010 (projected) is shown below.

Source: usgovernmentspending.com

The dramatic increase rise in government debt currently underway, some of which is being presently monetized, presents serious potential for future inflation...

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Inflation? Not anytime soon...

2009-04-16T00:23:00.006-04:00

For those who are concerned about the speed at which Ben Bernanke is operating the printing presses, consider the following:

Going back to 1967 (actually earlier, although we only have data back to this point), Inflation has been correlated with Capacity Utilization.

Both are dropping precipitously.

The Federal Reserve reported today that "The capacity utilization rate for total industry fell further to 69.3 percent, a historical low for this series, which begins in 1967".

This was accompanied by the Bureau of Labor Statistics' Consumer Price Index release, which noted that "The index has decreased 0.4 percent over the last year, the first 12 month decline since August 1955.

Despite the Fed's massive increase in base money, Capacity Utilization and Inflation are at multi-decade lows. Historically, inflation has not gained traction until Capacity Utilization exhibits recovery.

The prospects that Industrial production might ramp up significantly any time soon are weak, as:

- With Consumer Confidence also at abysmal levels, Consumers are not interested in durable goods or discreationary goods & services...

- A significant portion of the production base must be re-allocated, as certain industries grew out of all proportion during the previous expansion (Home builders, Automobile manufacturing, Financial services...). This takes time...

Deflation, which has arrived for the first time in 54 years, will be the story for the near and mid-term.

Wage Deflation

2009-03-27T09:36:00.038-04:00

Photo Source: NJ.com (AP/Mike Drerer)

Yesterday, Newark Mayor Corey Booker announced furloughs and pay cuts for the city's employees, joining a significant, and unusual, trend which has taken shape over recent months...

In December, a 'blip' on our macroeconomic radar (Fedex' pay cuts for 36,000 workers) caused us to ask: What Shape is Your Supply Curve?

That 'blip', which has now become a siren, is something which the US has not seen for decades. In addition to layoffs and plant closings, which accompany any recession, the new and unusual feature of this downturn are the wage reductions for those who still have a job.

These are taking the form of either outright wage cuts, or mandatory unpaid leave. [One unpaid furlough day per month is equivalent a 4.6% pay cut, as 1 day / ((52 weeks * 5 days) / 12 months) = 4.6%.].

Since our December warning, anecdotal evidence of downward pressure on wages has been accumulating. Consider this sampling, taken from headlines during this period:
(click the links for the original articles)

Dec-08
Fedex: -5% for 36,000 employees (and more announced March 2009)
Agilent Technologies: -10% for 20,000 employees
Atlas Van Lines: -5%, 373 employees
AK Steel Holdings: -5%, 1500 employees
Hutchinson Technology: -5%, 4500 employees
Micron Technologies: -5% for 22,000 employees

Jan-09
Caterpillar: -5% to 15% for 25,000 employees
Gymboree: -10% to 15%, 4700 employees
Advanced Micro-Devices: -5% to 20%, 11,000 employees
YRC Worldwide (Trucking): -10% wage cuts for 50,000+ employees
Kulicke & Soffa Industries, PA: -10% to 20% for 2400 employees
Kemet Corp, NC: -10% wage cuts for 450 employees
MBH Architects: -25% to 50% cuts for 60 architects
City of Detroit: -10% proposed wage cuts for 15,000 city employees
Microchip, AZ: -10% (20% for executives), 4800 employees

Feb-09
Microsoft: -10% rate cuts for 40,000 contracted temps
HP: -5% worldwide wage cut affecting 112,000 employees
Conway Trucking: -5% pay cut (10% for managers), 26,000 employees
Modanock Hospital, NH: 2.5% to 5% wage cuts, 200 employees
General Motors: -3% to 10% pay cuts for 26,000 employees
Wynn Resorts: -10% to 15% cuts for 9,500 employees
Galveston TX: -3% across-the-board cuts, 700 workers
State of California: -9% cuts through 2 day/month furloughs, 200,000 workers
Columbus Components Group: -5% wage cut, 400 employees
Acco Brands: -10% (6 weeks at -47%, 12 wks at -20%), 2000 employees
American Axle: -10% cut for 17 executives

Mar-09
New York Times: -9% through 5% wage cuts & 2 week furloughs, 2000 employees
Indianapolis Star (Gannet): -15% wage cut affecting 200 employees
Oregonian Newspaper: -5% to 10% wage cuts, 1200 employees
Morris Communications: -5% to 15% wage cuts, 6000 employees
Anchorage Daily News: -2.5% to 10% cuts, 200 employees
Sacramento Bee: -3% to 5% pay cuts, 200 employees
Atlanta Symphony Orchestra: -5% to 7% cuts, ~100 employees
University of Iowa Hospital: -5% pay cut for 40 managers
Visit Florida (FL Tourism Bureau): -2% through 5 furlough days, 115 employees
Vail Resorts: -2.5% to 10% pay cuts, 3500 employees
American Reprographics: -5% wage cut, 4500 employees
Charlotte NC Fire Department: -3% cut in two stages, 239 firefighters
Fort-Worth Star Telegram: -2.5% to 10% cut, 1000 employees
Pittsburgh Glass Works: -3% to 15% cuts, 305 employees
Cleveland Orchestra: -5% to 25% pay cuts, ~110 employees
Orlando Orange County Expressway: -5% to 10% cuts, proposed, 50 employees
Dewey & LeBoeuf: ~80% reduction for 66 law partners
Burton Snowboards, VT: 0% to 15% pay cuts, 663 employees
Grill Concepts, Walnut Creek, CA: -10% cuts for 12 senior executives
Global Lingust Solutions: -40% pay cuts for 2,000 military-contract Arab translators
Lincoln Paper & Tissue, ME: -15% pay cuts or 1-day/wk furloughs, 350 employees
State of Minnesota: -8% through 1 month furlough/yr (proposed), 30,000 employees
State of State of Pennsylvania: -9% through 2 furlough days/mo. (proposed), 78,000 employees
Principal Financial Group: -2% to 10% pay cuts, 16,000 employees
City of Newark, NJ: -4.6% to 6.6% through 1 furlough day/month, 2000 employees

How unusual is this trend? Investopedia's definition of sticky-down notes that "attempting to reduce wages is something that has historically been so unsuccessful that it is almost never attempted anymore".

Last Friday's BEA release of Personal Income and Outlays for Feb 2009 provides data which confirm early warning signals of wage deflation.

Nominal, seasonally-adjusted private-sector wages declined by 0.4% from the previous month, continuing a six-month pattern of zero or negative growth.

As the US piles on Keynesian fiscal and monetary stimulus, it is critical to keep in mind that the Keynesian model absolutely depends on downward wage stickiness.

If wages are not 'sticky-down', the Keynesian model, with its supply curve derived from this assumption, falls apart. The classic, positively-sloped supply curve is what gives Keynesian stimulus its power. By increasing "G" (Government Spending) or "M" (Money Supply), Output (GDP) can be increased, with some trade-off for inflation. If wages are downward-flexible (wages fall by as much or more than prices), the supply-curve is vertical, and stimulus has no effect on output:

We noted last week that Keynesianism is Tired... with several conditions particular to today's crisis likely to render the traditional Keynesian levers ineffective.

At a much more fundamental level, anecdotal evidence as well as emerging data raise serious questions regarding the applicability of the Keynesian model to today's circumstances.

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Keynesianism is tired

2009-03-24T13:54:00.045-04:00

At 73 years of age (dating from the publication of Keynes' General Theory), the economic model that is Keynes' namesake is showing signs of weariness.

Keynesianism holds that fiscal and monetary policies can be fine-tuned to stimulate an economy in order to jump-start growth.

To push Demand, the Keynesian model relies on three policy levers:

1) Increase Government Spending ("G")
2) Increase Money Supply ("M")
3) Lower Taxes ("T")

Pull these levers in just the right way, and the economy responds accordingly.

Unfortunately, given today's conditions, these policy levers are unlikely to yield meaningful results:

1) "G" is unlikely to be effective

The 407-page, $800 Billion Stimulus Plan was intended as a Keynesian "jump-start" on a scale never before tested.

However, there are several problems:

a) The 'Stimulus' is not 'Stimulative'

Only a small fraction (the WSJ estimates $90 Billion, or 12%) of the "G" being deployed acqually qualifies as stimulus, as defined by an item which might concievably have a multiplier (such as fixing and building bridges and highways, developing broadband access, etc.).

For every bridge to somewhere in the plan, there are many bridges, and transfers, to nowhere (where is Sarah Palin when we actually need her?).

These include (to name but a few):

$50 billion for the National Endowment for the Arts
$1 billion for nutrition programs
$650 million for digital tv switching coupons
$400 million for global-warming research
$150 million to the Smithsonian Institution
$100 million for school-lunch programs
$250 million for domestic violence programs
$250 million for farm loans and grants
$225 million for assistance to Indian tribes

Any of these items may be worthwhile expenditures on their merits, however, none of them qualifies as "stimulus".

For the elegance of the manner by which they combine simplicity with profligacy, we especially admire the stimulus grants, with no other details specified, of:

$400 million for, simply, "Science" (quotation marks in the original bill - see page 17),
$150 million for "Aeronautics", and
$400 million for "Exploration"...

b) Someone must buy all the debt which is being issued to fund all this "G"! But whom?

The biggest buyers of US Government (and Agency) debt, for the past several years, have been China, Japan, and the Oil States.

However, the supply of loanable funds among these entities from which the US can borrow is drying up.

China's current-account surplus, the source of the funds for its Treasury purchases, has dropped precipitously as the global economy has contracted over the past several months.

Japan, another major buyer of Treasuries over recent years, is now posting trade deficits for the first time since the early 1970's. This current account deficit, combined with a significant fiscal shortfall and planned issuance of $33 Trillion Yen ($340 Billion USD) in government debt this year, means that Japan will be, in effect, competing with the US for funds, rather than lending to us.

And, the oil-exporters are in no shape to be buying anything right now, as oil prices have collapsed since last summers $147/barrel peak. Russia is busy selling foreign exchange to prop up its currency.

Brad Sester of the Council of Foreign Relations reports that foreign demand for long-term treasuries has faded, and notes, ominously, that "global reserves aren't growing". (Brad Sester's article, linked above, is highly recommended).

c) The FUNDAMENTAL difference between the original Keynesian plan in the 1930s and the Obama Keynesian version today is that back then, we had "idle loanable savings" in the US. Today, after 25 years of a declining savings rate, we have no savings--idle or otherwise, to deploy (although, the savings rate is increasing, finally).

Source: CalculatedRiskblog.com

Today the "G" must be funded by foreign capital inflow--there is no other way for the math to add up. This is a BIG difference in the funding of the fiscal deficit. And the implications thereof.

Fiscal deficits have traditionally been viewed to be 'sustainable' at a maximum level of 3% to 5% of GDP. (At this level, GDP growth is sufficient to maintain total debt at a servicable level). The European Union's Stability and Growth Pact actually requires member countries to maintain deficits of <= 3% of GDP. Will foreign creditors, who are already calling for the replacement of the US Dollar as the world's reserve currency, continue to fund US fiscal deficits as they race from 3% of GDP up to 13% (this year), 10% next year, and beyond...?

2) Pushing "M" in today's circumstances is ineffective

Despite the Federal Reserve's unprecedented increase in Money Supply over recent months, Aggregate Demand has not budged.

Fed Chairman Ben Bernanke is, famously, a student of the history of the Great Depression, and is determined not to repeat the Fed's mistakes of the 1930's.

However, the monetary problem at that time was one of illiquidity in otherwise-solvent institutions, resulting in bank runs which decimated the banking landscape and perpetuated the deflationary spiral.

Anna Schwartz, the economist who co-authored the seminal Monetary History of the United States with (Rutgers-educated!) Milton Friedman, wrote in the WSJ several months ago that today's bank problem is not illiquidity, but insolvency.

Let's review the definitions, in case Ben is reading:

The fundamental problem with today's banking system is that the major banks are insolvent, and are sitting on hundreds of billions (possibly trillions) of dollars of loans which are not worth anything near the value which the banks claim.

Recognition of this fact was the reasoning behind the TARP plan, whatever its merits, which was rolled out in its latest itiration this week (the Geithner plan), as a scheme to leverage taxpayer money to buy these bad assets. [Actually, the plan uses taxpayer money to (a) pay the banks more for the assets than they worth, (b) transfer any upside to private bankers and investors, and (c) transfer the losses to you, the taxpayer.]

Regardless, the problem cannot be solved by printing money. Nevertheless, the Federal Reserve last week announced plans to expand its balance sheet to more than $4 Trillion, with purchases of up to $300 Billion in long-term Treasuries (starting tomorrow), along with $850 Billion in mortgage-related bonds and securities...

The bigger picture is that the United States is at the beginning stage of a debt unwind of historic proportions. While the Fed's expansion of base Money appears astoundingly large when looked at in isolation...

... it nevertheless pales by comparison to the debt imbalances which must be worked off in the economy as a whole.

The charts below illustrate the scale of the issue facing Mr. Bernanke as he attempts to reflate. US private debt is more than 300% of GDP. This is twice the historical average. Reversion to the mean implies, ultimately, that there will be a debt unwind of some $25 Trillion in today's dollars.

As GDP is the denominator in the Debt/GDP equation, falling GDP, as we are experiencing now, exacerbates the problem.

If GDP falls by 5% during the current recession, this means that private debt must be retired (or monetized?) by $2 Trillion, just to hold the Debt/GDP ratio at 300%!

Here is long-term chart showing Money Supply and total private credit. The left-scale is in Billions ("$40,000" = $40 Trillion).

Base Money is represented by the red line at the bottom of the chart. Clearly, debt monetization of even $1 Trillion by the Fed barely even registers when compared to total private credit.

Unless Mr. Bernanke plans to expand, exponentially, the number of presses he is operating, he is tilting at windmills.

Finally, with regard to Policy Lever #3...

3) Taxes

While this lever has been deployed in the past with some effect, at this point in time, for better or worse, reducing taxes is not on anyone's radar. In fact, indications are that this lever will soon be pushed hard into reverse...

And so, there it is.

As policymakers desperately pull the Keynesian levers, we find that Keynes' beautiful model sadly offers little to help us at this juncture.

As Nobel-prize winning economist Gary Becker noted in a recent interview:

"Keynesianism was out of fashion for so long that we stopped investigating variables the Keynesians would look at such as the multiplier, and there is almost no evidence on what the multiplier would be." He thinks that the paper by Christina Romer, chairman of the Council of Economic Advisors, "saying that the multiplier is about one and a half [is] based on very weak, even nonexistent evidence." His guess? "I think it is a lot less than one. It gets higher in recessions and depressions so it's above zero now but significantly below one. I don't have a number, I haven't estimated it, but I think it would be well below one, let me put it that way.

Unfortunately, pulling the wrong policy levers is not only ineffective, but harmful. With each additional expansion of the Fed's balance sheet, each additional hundred billion in non-stimulative spending, and each new attempt to avoid the painful but necessary corrections in the economy, full recovery is further delayed.

It is time for Lord Keynes to take a breather, and rest up until conditions are more felicitous for the economic model which bears his name.

John Maynard Keynes... is tired.

Dr. Farrokh Langdana, Ph.D.
Rutgers University Business School

...is not tired!

For further information, see:

What Shape is Your Supply Curve? For a further exploration of the Keynesian model's application to today's conditions...

What's That Smell?, The Garbage Barge, and The Garbage Mega Ship, regarding the Fed's unprecedented balance-sheet expansion...

Don't Count on us to Bail You Out!, and Warnings from China regarding US fiscal and monetary policies, and...

Deflation Blues, for a discussion of Deflation and its implications.

Hair of the dog...

2009-03-24T13:28:00.003-04:00

AIG got itself (and us) into trouble, very simply, by selling insurance (CDS contracts on bonds) for far less than it was worth.

AIG underpriced the risk-protection it was selling, and, in the end, the taxpayers were (are) stuck with the losses.

The WSJ reports that AIG's competitors are indicating that the company is now leveraging its taxpayer-financing to sell insurance (of all types) for far less than market prices, offering discounts of more than 30% in some cases, in order to fend off rivals.

So, today...

AIG is underpricing the risk-protection it is selling, and, in the end, the taxpayers will be stuck with the losses.

(And this time, it is putting its competitors out of business in the process.)

"Skilled Workers Need Not Apply"

2009-03-11T10:15:00.012-04:00

Two pieces in the WSJ today, one from Deans Danos, Slaughter, and Hansen from Dartmouth's Tuck School of Business ("It's a Terrible Time to Reject Skilled Workers"), and one Review & Outlook editorial ("Turning Away Talent") bring attention today to an insidious provision (one of many) in the stimulus package, which makes it harder for foreign highly skilled workers to come to the USA on H-1B visas.

As the US Citizenship & Immigration Services website explains, H-1B's enable 'specialty' workers with "theoretical and practical application of a body of specialized knowledge along with at least a bachelor’s degree or its equivalent. For example, architecture, engineering, mathematics, physical sciences, social sciences, medicine and health, education, business specialties, accounting, law, theology, and the arts are specialty occupations."

The H-1B visa program has allowed US companies over the past several years to bring talented knowledge workers in from all over the world, which has helped them grow and succeed in global marketplace where national borders mean less and less (what Thomas Friedman characterized as 'Globalization 3.0').

In a US workforce of 154,000,000+, singling out 65,000 foreign knowledge workers for special discrimination is simply an exercise in xenophobia reminiscent of some of the ugliest periods in American history.

And, it harms America.

Economist Robert Mundell demonstrated that trade in "inputs" (e.g. laborers, or production machinery) and trade in "outputs" (goods and services) are, in some sense, interchangeable.

The Mundell hypothesis illustrated that trade with, for example, Mexico, allowed the US to "import" Mexican labor in the products which were produced in Mexico and transported to the USA. Mexican workers put their labor into the products when they make them, and, this labor comes to the USA in this form. Free trade between the USA and Mexico (enabled by the NAFTA Agreement) thus mitigates, to a degree, the movement of actual laborers from Mexico to the USA (which would be greater without free trade).

The important corollary to the Mundell Hypothesis here is that when the USA restricts the movement of a certain type of laborer - in this case, highly skilled international knowledge workers, it will still import their work, but in the form of the outputs (goods and, particularly in this case, services) which they will now produce abroad.

By barring these workers from entering, America is speeding up the development of production capabilities in the areas in which these workers specialize, outside America's shores... If the workers can't come to America, then, their outputs (services and products) will, one way or another.

Some US companies are big and geographically diverse enough to establish footprints in the places where these workers can be found, and in other cases, local foreign competitors will further expand their capabilities.

Regardlesss, the US is tossing an important comparative advantage aside in order to satisfy a primal and ugly impulse.

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"It would have been the end of our economic system and political system as we know it."

2009-02-10T10:31:00.005-05:00

Rep. Paul Kanjorski gives C-SPAN what we believe to be the first public glimpse into what exactly transpired back in September that so spooked Secretary Paulson and government authorities:

Rep. Kanjorski: $550 Billion Disappeared in "Electronic Run On the Banks"

Transcript (starting at 2:20):

"On Thursday [Sept 15, 2008] at about 11 o'clock in the morning, the Federal Reserve noticed a tremendous draw down of money market accounts in the United States to the tune of $550 Billion dollars, was being drawn out in a matter of an hour or two. The Treasury opened up its window to help, they pumped about $105 Billion in the system, and quickly realized that they could not stem the tide. We were having an electronic run on the banks. They decided to close the operation, close down the money accounts, and announce a guarantee of $250,000 per account so there wouldn't be further panic out there, that's what actually happened. If they hadn't done that, their estimation was that by 2 o'clock that afternoon, $5.5 Trillion would have been drawn out of the money market system of the United States, would have collapsed the entire economy of the United States, and within 24 hours the world economy would have collapsed... It would have been the end of our economic system and the political system as we know it."

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Macro trumps Micro

2009-02-04T20:12:00.028-05:00

Reader Vito asks a question which is on the minds of many over these past few months - the working individual who cannot pore over financial statements all day must trust finance professionals (who are in fact paid to pore over financial statements all day) for the information they will rely on to manage their portfolio. Yet, these professionals, in general, utterly failed to forecast the present crisis. How can these people be so badly wrong?

Here are the forecasts of the major investment banks for the year-end 2008 S&P 500, per Bloomberg (last updated August, 2008):

The S&P closed out 2008 at 903. The experts were -40% off-target.

Here, the venerable Goldman Sachs puts its clients into an investment which will return -80% (that's negative 80%!) in 6 months:

Goldman did manage to call the peak of the Russian stock market to within one week. The RTS index, from its all-time high of 2,487 on May 19th, is at about 500 today.

While we're on Goldman, let's not forget their May call for $200 per barrel oil by the end of 2008. Goldman's knack for piling on near the top was no less in evidence here, as oil peaked in July around $143 per barrel before collapsing to close out 2008 at around $40.

Vito mentions his banker in Hong Kong suggesting several months ago that he move into Australian dollars. Thanks to timely 'macro-intervention', Vito held off. Here's how his investment would have fared:

The Australian dollar has lost more than 30% against the USD since the summer.

So how do these august institutions, and their well-educated, well-paid professionals get it so wrong ?

Goldman Sachs Headquarters in New York. Nice offices. Lousy forecasts.

The simple reason can be summed up as "Macro trumps Micro".

Investment analysts generally spend their time looking over financial comparisons of companies within an industry, or comparing industries and sectors, to determine who will be the strongest performers. In a generally growing economy, most firms are growing, so, as long as the professionals can keep away from the garbage, they'll look ok.

However, macroeconomic factors by definition affect the entire economy. A macroeconomic crisis will affect every firm to one degree or another, and, in a major crisis like the current one, can affect every asset class.

All the time spent comparing the relative strengths of dry bulk shippers Dryships (DRYS), Ocean Freight (OCNF), and Eagle Bulk Shipping (EGLE) mean nothing when global trade grinds to a halt and freight rates look like this:

Virtually every shipper has seen their share prices collapse, and has slashed their dividend.

The same holds for banks, home builders, and to a greater or lesser degree, every sector in the economy.

And, when macroeconomic adjustments occur, they can wipe out generations of savings and investment overnight.

The good news is that these events are NOT as unpredictable as the talking heads on CNBC would have you believe.

Long before the current crisis peaked, warnings were sounded by many who were looking at the bigger picture. In retrospect, as is always the case, the signs are obvious.

Take US Debt - to - GDP as an example - even in early 2006, total US Debt - to - GDP had reached ratios not seen since the Great Depression:

Other data were giving similar signals...

Here is aggregate owners' equity as a % of home values. Clearly families were taking on more mortgage debt than ever before, especially as seen in the near-vertical drop over the past three or four years:

Source (the full, excellent article is recommended): Contrary Investor

Here is housing Price-to-Household Income, from Calculated Risk:

The price-to-earnings level of the stock market is another indicator:

Always at the height of a boom, stratospherically high price-to-earnings levels are justified because "things are different now", or "it is a new era".

While the financial industry and its cheerleaders in the financial press would have us believe that the collapse of 2008 was a complete surprise, not everyone missed the boat.

- Nouriel Roubini of NYU warned in 2006 of the coming crisis, and its severity, early.

- Oppenheimer Analyst Meredith Whitney was well ahead of the curve on the banking crisis.

- Kevin Depew of Minyanville called predicted today's deflation at a time when mainstream economists and finance professionals were mostly concerned with inflation.

- Fund manager John Hussman issued an urgent warning to readers (and clients) to 'examine all risk exposure' precisely at the October 2007 market peak.

- And, our own Dr. Langdana warned of 'stealth monetization' more than a year ago, as the Fed's balance sheet expansion was in its infancy.

What did these people have in common? They were all looking at the larger macro picture and keeping it in perspective.

The first part - seeing the macro picture, is easy once you've educated yourself on general macroeconomic principles and simply take a look at the widely available data.

The second part - keeping it in perspective - is the challenge. This is particularly true in the midst of a speculative asset bubble (SAP).

Who did not know of someone making easy money "flipping" houses over the past few years, and wonder if they should get in on it? How many people saw their no-good bum of a brother-in-law buying a McMansion and figure if he can do it, why can't I? Going back to the late 1990's, who didn't know of day traders who claimed to be making a mint in the stock market in their underwear ?

Social mood is contagious. If you are not participating in the bubble-building activity, you are bound to feel somehow 'left out'.

This effect works upon even the brightest among us:

"Stock prices have reached what looks like a permanently high plateau... I expect to see the stock market a good deal higher within a few months" - Irving Fisher, pioneer of our modern understanding of interest rates, Oct 17th 1929, days before the Crash...

"We will not have any more crashes in our time" - John Maynard Keynes, 1927...

Both these economic giants lost their fortune in the crash. Being personally invested, along with everyone else, very likely clouded their ability to see the obvious...

And, alas, trends never peak predictably - that is, you can never 'call' the peak of a bubble with any accuracy. Particularly if you are early in spotting the imbalances, as time wears on, the chiding from your friends and colleagues about your 'pessimism' can wear you down.

Many of those who lose the most in a speculative bubble are those who hold out until the very end, until they are finally persuaded that perhaps, after all, "this time it's different", and plunge in exactly at the precipice.

So: Keep your own Macro Engine Room running by paying attention to the data (not what the talking-heads on TV say about the data!), and do not let the prevailing fad to distract you from what you know, from clear analysis, to be the facts. When you have a clear picture of the Macro situation, knowing if, when, and in what to invest becomes much easier.

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"Free Shipping!"

2009-02-04T14:47:00.011-05:00

Photo source: UK Telegraph

Normally offered as an incentive by mail-order retailers, "Free Shipping!" has now spread to... the Shipping Industry.

At the UK Telegraph, Ambrose Evans-Pritchard reports that shipping rates from Asia to Europe have hit zero, as "Idle ships are now stretched in rows outside Singapore's harbour, creating an eerie silhouette like a vast naval fleet at anchor."

Reportedly, Singapore is accepting no more ships into long-term anchorage.

Photos of idle ships at anchor in Singapore Harbor,

Courtesy of Mitchell Rona, Rutgers EMBA 2010.

Overall rates for Dry Bulk and Container shipping have dropped precipitously since last summer, a direct indication of the severity of the slowdown in global trade.

The Baltic Dry Bulk Index, a measure of shipping rates for bulk cargo (such as coal and other raw materials), is off -90%:

Harper Petersen's HARPEX, a measure of container shipping rates, has also fallen drastically:

Note that for the HARPEX, which currently stands at 505, a value of 1,000 indicates the break-even price of shipping (cost of capital and operation).

Neither of these shipping indices are traded, so the rates reflect the actual contracted rates in the market.

With a slew of new 'mega-ships' scheduled for delivery over the coming year, shipping rates may remain depressed for a long time even when the eventual recovery is underway...

The Garbage Mega-Ship

2009-02-03T13:32:00.008-05:00

It is time we checked back in on the Fed's Garbage Barge.

Last time we looked in, the Federal Reserve had expanded its negligible 'non-standard' assets (assets other-than USG and Agency securities) from 4% of total assets in September 2007 ($38 Billion out of $893 Billion) up to 60% of total assets in October 2008 ($906 Billion out of $1.5 Trillion).

Like the original Garbage Barge, the Fed's scow continues to drift, with no final port of call in sight...

Today we find 'non-standard' assets of $1.4 Trillion accounting for a whopping 72% of the Federal Reserve's total assets ($1.9 Trillion, as of January 28th).

This $1.4 Trillion includes the alphabet-soup of funding facilities (TAF, TSLF, CPFF, MMFF, ABCPFF, etc.), as well as the toxic waste dumps 'Maiden Lane' I (Bear Stearns) and 'Maiden Lane' II & III (AIG), and 'Other Loans'.

(Keep in mind that these 'Assets' are what supports the Fed's Liabilities - the green pieces of paper in your wallet).

In a related article, the WSJ reports that ultra-large Mega-ships are putting additional stress on an industry already suffering from over-capacity. The MCS Daniella, carrying 13,800 containers, is the first of a wave of such gargantuan ships to be scheduled for launch in the coming months.

With harbors filling with surplus ships, and shipping rates at their lowest levels in years, the Federal Reserve may want to take the opportunity to book a mega-ship or two to carry its growing cargo...

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"We will make money"

2009-01-19T18:12:00.005-05:00

- Treasury Secretary Hank Paulson, Nov 17 2008 interview with Erin Burnett of CNBC

A few days earlier, the Secretary told Jim Lehrer "this is money the taxpayer will get back; these are investments. These are preferreds in these banks are well-protected and I believe that will be a good investment."

The idea that taxpayers might earn positive returns from the 'investments' made under TARP was a selling point during the rushed deliberations in late September and early October.

The speed with which AIG, Citigroup, and Bank of America came back for "Bailout Round II" did not provide much by way of comfort...

Finally, a bright light is now being shed by the aptly named Robert A. Sunshine, Director of the Congressional Budget Office, in the CBO's first mandated report on the results of the TARP 'investments'.

For the first quarter of operations, covering the period to December 31, 2008, TARP 'investments' amounted to $247 Billion.

As of December 31, the risk-adjusted present value of the assets held had dropped by $64 Billion, or 26% of the total amount 'invested'.

The CBO reports the loss in market value as the value of the "subsidy", because this is the amount which ultimately impacts the Federal budget as an expenditure.

Not content with -26% quarterly returns, the government's latest idea for the remaining $350 Billion of TARP funds is to create an "Aggregator Bank" which will directly buy the banks' "troubled assets".

Of course, if "troubled" meant "temporarily undervalued and likely to generate long-term returns", investors would already have swoooped in to pick them up.

Three Things are now clear:

1) As private investors have NOT come in to buy these assets, they are not "troubled", but, "worthless".

2) Banks have no incentive to clear these assets off their books at a price private investors would be willing to pay, when they can instead wait for the government to come in and overpay.

3) The -26% quarterly return will look downright fantastic compared to the returns taxpayers will realize from buying up all this toxic garbage.

Deflation Blues

2008-12-19T11:48:00.022-05:00

Prof. Farrokh Langdana, Ph.D., Rutgers Business school, EMBA Program

With Inflation at its lowest in 61 years (December 17, 2008), the Deflation Specter looms large on the radar screen of most analysts. Here, my macrobuddies and I attempt to focus on vital aspects of the oncoming deflation.

Initially deflation may appear to be a beneficial thing, as in, “Shouldn’t falling prices be great for consumers?” or “Hey, what’s wrong with lower prices?”

[From WSJ 12/19: Retailers Drop Prices to Avert a Flop ]

The truth is that deflation, while initially and outwardly attractive, is really symptomatic of a serious collapse in across-the-board aggregate demand. It is equivalent to the falling body temperature of a patient that is hanging on to life.

Deflation has game-theoretic implications: sellers are reluctant to sell at the current low prices and buyers refuse to buy at the prevalent prices, in the expectation that prices will drop even further. For example, housing markets from the US to China have seized up as both parties refuse to approach the table. (Credit concerns factor-in too, but lets just focus on the delftion here).

This update focuses on a feature of deflation that is not included in most of the prevailing deflation literature---the role of the Fisher Effect and of real interest rates in a deflationary environment.

The Fisher Effect is: (Nominal Long-term Interest Rates = [ Real Interest Rates ] + [ Expected Inflation (Deflation) ]

Rewriting, we have: Real Interest Rates = [ Nominal Rates ] - [Expected Inflation (Deflation) ]

The real rates are simply the real interest earned by savers (in terms of actual purchasing power) and simultaneously, the real interest “lost” by borrowers.

If we have deflation in the future, at say -2.5%, and if Fed Chairman Bernanke has interest rates down to 0.1% (for example) then we get real rates as:

r = 0.1% - (-2.5%),

or,

r = 0.1% + 2.5% = 2.6% !

In other words, despite near-zero nominal interest rates, we have positive real rates. This encourages savings, and strongly discourages borrowing. It simply makes sense to save. Even if CDs pay low rates (the nominal rates) the accompanying deflation results in a high effective real rate! It “makes sense” to park your money, and not to borrow.

The Fisher Effect also illustrates how the real cost of any and all debts grow as a result of Deflation.

By way of example, say that with real-estate significantly off from its recent highs, you decide that your dream-house is finally within reach.

Being a responsible borrower with good credit, you put 25% down today and qualify for a 30-year $200,000 mortgage at 6%.

After a year of making timely payments at $1200/month, in December 2009 your principal amount is down to $197,544. So far, so good.

However: if the rate of Deflation is 2.5%, the real value of this debt in today's dollars is $202,482. Despite doing everything right, your debt has grown and you owe more in real dollars than you did when you started!

Knowing this, private and business borrowers everywhere focus their energies on saving and paying down debt wherever possible, rather than consuming or expanding, which exacerbates the drop in Demand, further accelerating the rate of Deflation. Bankruptcies follow for individuals and businesses who cannot pay the ever-increasing real value of their debts, and prices continue to fall.

To this potent mix must be added declining wages, evidence of which is growing.

Source: http://online.wsj.com/article/SB122960669336617899.html

Aside from outright pay cuts, many companies have announced massive layoffs, unpaid leave, and wage & benefit freezes.

The downward movement of wages and employment adds yet more pressure on the already falling Aggregate Demand.

All of these factors can potentially add up to the classic Deflationary Spiral, where falling prices, defaults, bankruptcies, and falling wages reinforce each other in a continuous cycle.

Getting out of a Deflationary Spiral is notoriously difficult (as Japan has learned over the past decade and a half).

The severe depression following the Panic of 1873 subsided only after exhausting itself through massive liquidation, but is considered by many to be simply the start of the Long Depression, which lasted for more than twenty years, until the late 1890's.

The economy did not fully recover from the Great Depression, and ensuing downturn, until America's entry into World War II.

These are the two major severe Deflationary episodes in the US over the past 150 years. Unfortunately, other than liquidation, and war, policy prescriptions to escape a Deflationary Depression are purely theoretical.

Our economic policymakers are well aware of this, which is why everything including the kitchen sink is being thrown at the growing crisis:

By comparison with past crises, the level of Federal Commitment is staggering. Here is how the present $8.5 Trillion commitment (so far) compares with other historical Government commitments, in constant 2008 dollars:

Data source: http://www.ritholtz.com/blog/2008/11/big-bailouts-bigger-bucks/

The incoming administration promises an additional $775 Billion (or more) in additional stimulus aimed at spurring economic recovery.

All of this firepower being brought to bear on the crisis is sure to have significant effects, some positive, hopefully fewer negative, and, certainly, many unintended.

- Farrokh Langdana, Ph.D.
Rutgers University Business School

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What shape is your Supply-Curve ?

2008-12-18T12:47:00.020-05:00

John Maynard Keynes (1883-1946)

Keynesian Stimulus is the order of the day.

President-Elect Obama's proposed Government Stimulus package currently stands at $600 Billion and is rapidly approaching $1 Trillion with still more than 30 days to go before his innauguration.

The Federal Reserve's aggressive actions over recent months, and its December 16th Statement, have made clear that it will pour Money into the economy to spur growth: "The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level."

In times of crisis, it is comforting to know that we can do something. The Supply-Side models of "Augmented Expectations", and "Rational Expectations", promise modest and temporary effects (if any) from fiddling with the "G" (Government Spending) and "M" (Money Supply) policy levers.

The Keynesian model, by contrast, demonstrates that increasing "G" and "M" can both induce economic activity. In times of crisis, Keynesianism offers the ability to do something to change the situation. Adjust "G" and "M" and the stage is set for recovery.

A key assumption underlying the Keynesian model - THE key assumption, in fact, is the "downward stickiness" of wages. At a very basic level, this means that a downward shift in the price level is not matched by a downward change in wages.

This is what gives the Keynesian AS (Aggregate Supply) curve its positive slope and allows for Demand-side stimulus.

In the above illustration of the Keynesian model, increasing "M" or "G" will push Aggregate Demand to the right, generating an increase in "Y" (Output), [with some accompanying inflation].

The following headline is of crucial importance and should give us pause as we race headlong into various Keynesian stimulus efforts:

FedEx To Cut Salaries 5%, Suspend Bonuses, Freeze 401(k) Contributions

This change affects 36,000 employees, who will all see their wages cut by 5% (or more). We cannot recall, in recent times, a similar example of an across-the-board reduction of wages on such a broad scale.

A recent WSJ article noted that "By 42, the average American will change jobs 11 times.". Such labor-market dynamism implies aggregate wage-level flexibility, both upward and downward.

If the underlying assumption of "downward wage stickiness" is inapplicable to today's environment, then, the entire Keynesian paradigm is subject to question.

In the early 1970's, the government was frustrated in its attempts at similar Keynesian stimulus, as increases in "M" and "G" produced only inflation. That is what happens when your supply curve, rather than positively-sloped, is vertical:

In the above Supply-Side model illustration, pushing Aggregate Demand with "G" or "M" stimulus will only produce inflation.

No economic model always reflects an accurate picture at all times. Entering the Great Depression, policymakers' economic model assumed a vertical supply curve similar to that depicted above - which Keynes would later prove was inaccurate.

The Keynesian model served policymakers well from that time until.... it didn't. Stagflation resulted from attempting Keynesian stimulus in an economy that looked like the "Rational Expectations" model.

Today, we face a new situation, and, it is unclear what the paradigm actually looks like.

There is growing evidence that the absolutely crucial Keynesian assumption of "downward wage stickiness" does not reflect the facts on the ground today.

The Supply-Side model focuses on pushing out the Supply curve (rather than pushing out the Demand-curve), through deregulation and tax cuts. These policies, which were effective coming out of stagflation (high inflation and high unemployment, with an artificially-elevated AD), are unlikely to be implemented in today's political environment. However, even if they were magically put into place, does pushing out the Supply curve work in a deflationary environment ? Nobody knows - we've never been here before!

Andrew Mellon (1855-1937)

Andrew Mellon, Treasury Secretary from 1921 to 1932, has been harshly criticized for many decades for his seemingly hard-hearted "let them eat cake" prescription during the Great Depression seventy-five years ago:

"Let the slump liquidate itself. Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate... It will scourge the rottenness out of the system. High costs of living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people".

Mellon based his "liquidationist" position on his observations of the Panic of 1873 and ensuing Depression, which was nasty and brutal, but relatively short in duration.

Doing nothing, while apparently callous, is clearly better than doing the wrong things. A recent paper by John Taylor of Stamford University spells out the various ways in which "government actions and interventions caused, prolonged, and worsened the financial crisis."

If you offered a Mellonian-style "liquidation" to Japanese officials in 1990, of, say, a 50% drop in asset values and severe output decline over 12-18 months, they'd have laughed you out of the room.

Were you able to provide those same Japanese officials of 1990 with a glimpse of their economic future, with the Nikkei sliding 78% over 18 years, from 38,900 to 8,600 (today), persistent deflation, and stagnant growth, good old-fashioned Mellonian Liquidationism would have seemed like a pretty decent alternative.

Regardless, such a "hands-off" approach will not be the choice of today's policymakers, who are under pressure to act, and, it is unclear whether such a policy would even be appropriate in today's situation...

What is clear is that we are in uncharted territory.

Keynesian stimulus cannot have the predicted effect if its core underlying assumption is inoperative. Supply-side policies, even if implemented, have never been tested in a deflationary environment.

Times of great economic crisis are when new paradigms emerge. Unfortunately, these models are generally discovered looking backward, rather than forward, as data only emerges after-the-fact. The prescriptions based on these models are often developed too late to prevent a prolonged and severe period of hardship.

Whatever new model(s), and accompanying policy prescriptions, emerge, recovery for the economy can only begin when the process of asset erosion and debt default has run its course, and finally, confidence is restored.

As Todd Harrison of Minyanville often reminds us, ultimately, the only true economic pallatives are "time, and price".

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"Do you know who I am? I'm Moe Greene!"

2008-12-02T10:32:00.007-05:00

Michael: My credit good enough to buy you out?

Moe Greene: Buy me out? [Fredo laughs nervously]

Michael: The hotel, the casino. The Corleone Family wants to buy you out.

Moe Greene: The Corleone Family wants to buy me out? No, I buy you out, you don't buy me out.

Michael: Your casino loses money, maybe we can do better...
[continues...]

Moe Greene: Sonofabitch! Do you know who I am? I'm Moe Greene! I made my bones when you were going out with cheerleaders!

--------------------------------------------

Old Moe tried to drive a tough bargain with the Corleones, and found out the hard way who was really in charge.

Reading Hank Greenberg's opinion piece in the WSJ today, one wonders if he has any relation to Moe.

Hank is upset that AIG didn't drive a harder bargain with the Feds in their bailout deal.

Huh ???

AIG was hours away from insolvency, where it had arrived by writing hundreds of billions in uncovered CDS bets (which began under Mr. Greenberg's tenure), and due to its size, threatened to drag down the entire financial system with it.

That was the point at which the Government came in to save the pathetically-run business, making AIG "an offer it couldn't refuse", extending a loan at a punative interest rate, and taking warrants for 79.9% of the company's equity.

Ideally, this would force AIG into an orderly liquidation (rather than a default, fire-sale, and financial system contagion) to repay the loan.

However, Hank Greenberg sees things differently. He applauds Citigroup for "insisting" on a better deal and suggests another do-over for AIG on even more favorable terms than last month's initial, lenient do-over.

In Hank's words, "The role of government should not be to force a company out of business, but rather to help it stay in business so that it can continue to be a taxpayer and an employer."

We've double-checked our copy of the US Constitution and cannot find the section that covers keeping mismanaged zombie insurance behemoths afloat with the hard-earned income of ordinary taxpayers.

"It's a National Treasure"

- Hank Greenberg re: AIG, September 16, 2008

The idea that the Government, rather than AIG's utter irresponsibility, forced AIG into its present situation is ludicrous. As is Mr. Greenberg's view of AIG - "a National Treasure", as he twice put it in a September 16 CNBC interview. During that interview, Greenberg also asserted that AIG "is not an insolvent company", and that it only needed a "bridge loan" from the Government to address a short-term liquidity problem.

Ten weeks, a further 50% decline from already-low September 16th $3.82 market price, and $150 Billion of taxpayer money later, it is safe to say that very much like Moe Green, Mr. Greenberg severely overestimated the strength of AIG's position. From the tone of his editorial today, he continues to do so.

No bailout for Moe Green.

Obama's New New Deal

2008-11-25T09:20:00.000-05:00

President-Elect Barack Obama will face a daunting set of challenges when he takes office in January—similar, in many ways, to the systemic problems that confronted Franklin D. Roosevelt when he assumed the presidency in 1932 during The Great Depression. Will President Obama put forth a vision, and possess the leadership and legislative moxie, to pursue an aggressive economic stimulus package to stanch the crises in the banking and financial-services industry, energy dependence and global warming, mortgage foreclosures, job losses, health care, and the auto industry? How should he do it? And what should be his priorities? What would be the practical ramifications of a stimulus package, short- and long-term?

The systemic problems that confront President Obama are indeed similar to those that confronted FDR in 1932. Asset prices were run-up in the Roaring Twenties, fueled by greed, easy credit and lax regulation, much as they were in the current sub-prime crisis.

The ensuing Crash of 1929 deteriorated into the Great Depression primarily due to four humongous macro-policy mistakes:

(1) A misguided wage floor that exacerbated unemployment,

(2) Drastic tax increases that demolished business and consumer confidence,

(3) The Smoot-Hawley tariffs that precipitated a global trade war, and

(4) The inactivity of the Fed that led to a shocking liquidity crisis

It appears likely that President Obama may indeed be listening to reason and history, and backing away from switching to the higher pre-Bush taxes on incomes and capital gains, etc. Tax increases deal confidence a crippling blow that might take generations to recover, as evidenced in Japan over the last ten years. Memories of the tax increases of 1932 loom large today as we face similar asset-price collapses—in 1932 the highest tax bracket jumped from 25% to 63%, and corporate taxes went from 12% to 13.75%. By not raising taxes, Mr. Obama will have scored a just-in-time victory in the battle to rebuild consumer confidence (already at its lowest ever reading in November 2008) as well as business confidence.

Mr. Obama cannot afford a trade war. The Smoot-Hawley tariffs of 1930 slapped a tax of 45% on US imports in 1930, and were increased to 60% by 1933. These taxes precipitated countervailing tariffs on our exports, and the ensuing trade war basically shut down global trade.

Data Source: http://www2.census.gov/prod2/statcomp/documents/CT1970p2-08.pdf

While many economists attribute the global depression to our Smoot-Hawley tariffs, this time around, unbelievably, the stakes are even higher! Since the 1980s, the US has been running large trade (current account) deficits, with foreign economies accumulating the equivalent US dollars. These dollar deposits have been promptly invested back in the US in the form of foreign purchases of US government debt (Treasury bonds), businesses, real estate, and more recently, and much to their chagrin, foreigners have bought vast amounts of mortgage-backed securities issued by Fannie Mae and Freddie Mac. The point is that without this massive capital inflow--the “flip side” of the US trade deficit--Uncle Sam goes broke. Before the financial meltdown in September 2008, we needed about $2.4 billion in capital inflow every work day to stay afloat. These inflows—mainly from China, Japan, followed by Brazil and OPEC, funded most of our government spending and served to keep interest rates low.

Data source: www.treas.gov/tic/s1_99996.txt

At the present time, with bailouts galore (currently up to $7.76 Trillion, according to Bloomberg!), and more infrastructure spending planned, it is imperative that there be no disruption in these inflows. A trade war would demolish capital inflows, which in turn would render us insolvent.

The Obama stimulus plan is as yet not fully articulated, but is likely to be on the order of some $500 billion or more over two years. The responsible way to fund government spending is by borrowing from domestic and foreign investors (issuing Treasury bills and bonds). How long can this go on? Is there an upper limit to the borrowing? Past research has indicated that when the Federal budget deficit/GDP ratio exceeds 5%, bond-financed deficits become non-sustainable—domestic and foreign investors stop lending to Uncle Sam. At this point, the Fed has to resort to a mind-numbing monetization to “finance” the deficit, and this is, of course, the road to hyperinflation. The US ratio of fiscal deficit -to- GDP is projected to exceed 5% next year, but there is hope. This time around, given the global contagion, with virtually all major economies in recession, there is no other "safe haven" competing for global capital, and this may allow the US to be able to borrow more than conventionally thought possible. Technically, this may lead to a sustainable maximum deficit/GDP ratio of perhaps, 8-9%, and may place some timely fiscal ammunition within Mr. Obama’s reach.

Finally, Mr. Obama has to resist the urge to roll back the Reagan deregulation. In the wake of the financial malfeasance of the last few years, and the Enron debacle, the country is in a regulating mood. And, smarter and in some cases more strict regulation of previously un- and under-regulated financial instruments and practices may be warranted. But Mr. Obama should not throw out the baby with the bath-water. Innovation, R&D, venture capital inflows, and explosions in productivity all spring from a free-flowing creative environment, uncluttered by invasive government regulation. Our greatest strength lies in our ability to bounce back as a country, time and again, from seemingly hopeless situations. This applies to innovation and business too. Just when we “lost” automobiles to the Japanese, we invented minivans and SUVs. Just when we lost computers to foreign competition, we invented the internet and the browsers. And when the Japanese and Koreans made semiconductor chips better and cheaper, we invented microprocessors. Once again, the US needs to bring the world the “next big thing”, funded by the venture capital—by the global “smart money” and not by US taxpayers. While Government stimulus-investment is a helpful prescription at the present time, Government spending is a blunt instrument, unsuitable for allocating resources to emerging technologies. By retaining the incentives and friendly environment for private innovation, private capital will naturally flow to those areas of the US economy (biotech, nanotech, and whatever else comes next) which offer the highest potential.

With low regulation, low taxes, gifted leadership, American creativity, and the undeniable “Obama dividend” we can make it happen. The world is waiting.

-Farrokh Langdana, Ph.D.
Rutgers University Business School

Turnaround Tuesday?

2008-11-25T09:19:00.001-05:00

** UPDATE (5:34pm): Tuesday Nov 25 saw the S&P 500 close at 857.39, up from yesterday's close by 5.58. This is only the 2nd time in 6 months (out of 27 Tuesday sessions) in which a Monday rally was followed up by positive action on Tuesday ***

Since late Friday afternoon, markets have staged the strongest rally since 1987, with the S&P closing yesterday at 851.81, from a low-point Friday of 741.02.

Todd Harrison of Minyanville frequently refers to "Turnaround Tuesday", the effect whereby Tuesday seems to consistently reverse Monday's equity market action.

We reviewed the past six months of data, and found the facts support Todd's characterization, with Tuesday reversing Monday's action 18 out of 26 times over the past six months.

In fact, only once in 26 Tuesday sessions (July 1) has Tuesday continued an upward Monday rally.

Given this, any upward close today may be an indicator of changing sentiment.

Rutgers Symposium: The Financial Meltdown and You

2008-11-24T16:55:00.004-05:00

Rutgers University held an economic symposium on November 18th in New Brunswick, NJ (click link for details): "The Financial Meltdown: The Impact of the Financial Crisis on You"

Key takeaways:

Money Manager Mitchell D. Eichen: While things seem (and by nearly any measure, are) really bad right now, remember - we've been through tough times before, and we'll get through this as well...

Finance Professor Ben Sopranzetti: CASH IS KING! Following a massive deleveraging of debt, look to firms with cash to be the survivors who ultimately swallow up those surviving on debt.

And from Farrokh Langdana: American resilience and ingenuity have been transformative catalysts which have repeatedly led the world out of crises and into a brighter future, and now, the world looks to American again. American creativity and innovation will again transform the world economy, in ways that we may not even imagine just yet...

as Dr. Langdana put it:

"We always come up with the next best thing".

Corporate Event Planning for SOE's

2008-11-12T12:08:00.015-05:00

When we think of SOE's ("State Owned Enterprises"), we tend to think of huge inefficient Soviet-era tractor factories and steel mills.

That was yesterday. Today, SOE's are all around us (especially those of us who live or work near Wall Street): AIG, Fannie Mae, Freddie Mac, Goldman Sachs, Bank of America, and a growing list of others, soon perhaps to include auto-makers and credit-card issuers, are all partly owned by the State.

The problem is, having come begging to the Government to take an equity stake, these enterprises are yet to acclimate to their new SOE incarnations.

Take as an example a recent story relating to AIG.

Representative Elijah Cummings (D., MD) is calling on the Chief of AIG to resign, after learning of a $343,000 Corporate marketing event held in Phoenix last week. AIG CEO Edward Liddy defended the conference saying “it provides the kind of communication we must conduct with the people who sell our products if we are to be successful and repay the U.S. taxpayer." Liddy notes that 90% of the cost was paid for by sponsors and the independent financial planners who attended.

CEO Liddy is operating under a serious misapprehension: AIG still thinks that it is a business. AIG ceased being a business several years ago when it decided to become a betting house, taking the wrong side of uncovered CDS derivative bets to the tune of half a trillion dollars or more. It should have formally ceased being a business several weeks ago when it ran out of money. Today, however, as nobody (kids’ soccer teams, college students, and especially poorly-run financial firms) is allowed to “fail”, AIG has become a ward of the state.

AIG’s top executives had better get with the program if they want to continue to enjoy their salaries, bonuses, and travel accounts.

What does this mean?

Very Simply: Forget about profits, shareholders, “stakeholders”, and other outdated concepts. Your business now exists solely for (a) the benefit of its Executives, and (b) to pay homage to and be fleeced by Politicians. Fannie Mae and Freddie Mac learned this lesson long ago and their executives prospered famously.

And don’t get hung up on the idea of “repaying the U.S. Taxpayer”. It’s probably hopeless and your Congressional overlords don’t really want that anyway (they’d lose their hold on you!) – they want to be deferred to, enriched in power, and occasionally, to berate you (don’t take it personally, it helps their populist image).

And regarding those Corporate Events which Rep. Cummings is chiding you about, we recommend that you, and all other recipients of Government largesse who are planning upcoming Corporate Events select their event locations more carefully.

To assist with this, we’ve assembled a helpful guide with some suggestions:

California District 30: Rep. Henry Waxman
69-Year old 33-year veteran of Congress, and powerful Chairman of the House Committee on Oversight and Government Reform.Representative Waxman’s district includes beautiful Santa Monica, Beverly Hills, and Malibu. Conference Hosts might consider the world famous Beverly Hills Hotel, where rooms are available from $505 to $1025 per night.

California District 6: Speaker Nancy Pelosi
You can’t find a more powerful congressperson than the Speaker of the House – who represents one of the most beautiful, if most expensive, urban centers in the United States. But then, when you’re pumping dollars into the Speaker’s district, no expense should be spared.

AIG and others with billions of taxpayer money to burn might consider the Ritz-Carlton, in prestigious Nob Hill, where rooms are available for bargain-hunters starting at $419 per night.

Wisconsin District 7: Rep. David Obey
Forty years in Congress allows one to accumulate a lot of clout, and no-one has more than the man holding the purse-strings: 70-year old David Obey, Chairman of the House Appropriations Committee. Representative Obey’s district is largely rural and remote, perfect for those who prefer the rustic outdoors and open air.

Conferees visiting the coastal towns of Washburn, Bayfield, or Ashland might visit the Apostle Islands National Lakeshore, a beautiful series of undeveloped islands on Lake Superior.

Massachusetts District 4: Rep. Barney Frank
Attention Financial Companies receiving government aid: Spend generously on this man and in his district! Fannie Mae and Freddie Mac, (who understood long ago that they were not really in business for anyone but their executives), were able to avoid any meaningful oversight by lavishing contributions on the powerful Chairman of the Financial Services Committee, 68-year old Rep. Barney Frank, now in his 29th year in Congress. Frank’s District winds its way from the posh suburbs of Boston down through New Bedford, providing a variety of choices for Event Planners.

Home to a number of elite Country Clubs, including the storied Brae Burn Country Club near Beacon Hill, corporate golf enthusiasts will find plenty of opportunity to spread their wealth around.

New York District 15: Rep. Charles Rangel
The 78-year old Charlie Rangel, serving in his 38th year in Congress, runs the powerful Ways & Means Committee, and represents a district which runs from the Upper West-Side, through all of Harlem up to Marble Hill. Former President Bill Clinton knew was savvy enough to locate his offices smack dab in the middle of Rangel’s district, and Conference Planners looking for the most bang for their Congressional-District buck could do worse than New York District 15.

(Note: Executives facing indictment for their financial shenanigans who expect a short jail term of a year or less should bear in mind that Rep. Rangel’s district includes the Riker’s Island Correctional Facility).

Rep. Rangel’s personal real-estate holdings include property in the Dominican Republic, we are not certain of his policy on letting these out for Corporate Events.

Maryland District 7: Rep. Elijah Cummings
A relative newcomer among his long-serving Committee Chairman peers (with ‘only’ 14 years’ experience in the House), Rep. Cummings knows how to get headlines. Rep. Cummings sits on several committees, including the Joint Economic Committee. His district includes much of Baltimore and the surrounding area, offering Event planners a variety of options.

The Baltimore area offers any number of options for entertainment, and the brand-new 757-room Hilton Baltimore Hotel and Convention Center is a perfect location from which to spend money in Rep. Cumming’s district.

South Carolina District 5: Rep. John Spratt, Jr.
For those who prefer a slower pace, and don’t have the platinum-level expense accounts of an AIG, the rural South Carolina district of 25-year Congressional Veteran John Spratt, Jr., Chairman of the important Budget Committee, offers just the ticket. His constituents will certainly appreciate Conferees turning out for sport fishing on beautiful Wateree Lake.

These suggestions are only a partial and incomplete list - certainly with 535 Representatives and Senators, the Corporate Event Planners of our new SOE's can identify scores of other potentially appropriate sites for their upcoming Conferences.

A final note: During the Soviet era, a "Corporate Event" at an SOE would more often than not consist of a six hour long harrangue given by the factory's Party propoganda officer.

Clearly this would be far too much time away from the golf links in today's environment - however, AIG and other of today's SOEs could do worse than to open their events with a ten minute presentation on the wonderful things which Representative [X] has done for the industry and the nation.

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Biting the hand that feeds you...

2008-11-01T07:26:00.013-04:00

Senator Obama this week accused China of currency manipulation. In a letter to the National Council of Textile Organizations (who knew there were any left?), he states:

Highlighted Excerpts:

"The massive current account surpluses accumulated by China are directly related to its manipulation of its currency’s value."

"China must change its policies, including its foreign exchange policies, so that it relies less on exports and more on domestic demand for its growth. That is why I have said that I will use all diplomatic means at my disposal to induce China to make these changes."

China immediately took note of the Senator's statement, as foreign ministry spokesperson Jiang Yu stated that "The yuan exchange rate is not the cause of the U.S. trade deficit."

We do not doubt the Senator's good intentions, but, care in dealing with this sensitive issue is warranted.

China is the largest creditor of the United States. Without massive capital flows from the Chinese, fueled by their exports which Senator Obama decries, the US would be unable to fund its fiscal deficit, which may soon approach $1 Trillion.

There is a clear message in reviewing the pattern of Chinese lending to the USA.

Throughout many and varied political disagreements the USA has had with China over the past several years, from the collision of the US and Chinese military planes in April 2001, to our arms sales to Taiwan, to human-rights protests, etc., China has continued to accumulate US Treasury and Agency debt.

There was only one month out of the past eight years in which China meaningfully decreased their net US debt (total of Treasury and Agency) holdings. That was August 2007.

What happened that month ?

Treasury Secretary Henry Paulson visited China during the first week of August 2007, during which he conveyed the US’s desire for China to allow its currency to appreciate. A few days before his trip, the Senate passed legislation which would require the Treasury Department to identify countries with “fundamentally misaligned” currencies, a move clearly aimed at China, given the timing.

The Chinese responded within days of Paulson’s return to the US, with two key officials delivering “alarming and unambiguous” threats that China may liquidate its dollar holdings if the US were to threaten trade sanctions or apply pressure for Yuan revaluation. Their message was apparently reinforced by their selling $23 Billion of US Treasury Securities (which represented precisely 5% of their total UST holdings) during that month. (The net UST sell-off was $14 Billion, after counting $9 Billion in purchases, their largest single-month net sell-off ever, more than 3 times the previous $4 Billion record in June 2000).

Much else was happening in August 2007, which dates the onset of the credit crisis.

However,

We believe that the Chinese were sending us a clear message - they will tolerate just about anything politically, BUT: DO NOT MESS WITH THEIR CURRENCY !

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Hyperinflation

2008-10-27T10:14:00.007-04:00

We all remember the stories of Weimar German hyperinflation in the 1920's - shopping carts full of money just to buy a loaf of bread, families using currency as fuel for their furnace...

For us, it's just another one of those things that happend in the ancient, grainy black-and-white world of yesteryear, like the 1929 Stock Market Cr-..., um... anyway...

Here is a newsflash: Hyperinflation is deadly, it is real, and it is happening in the world right now.

These images from Zimbabwe, posted on a Russian website, courtesey of our Stan Podolski, are a must-see for anyone who things of hyperinflation as something hypothetical.

Click to link: http://www.gustaff.ru/post88103014/

The reslience on display, in the faces of the people in the photos is amazing.

As our Monetary authorities have clearly made the decision to fight Deflation at all costs, the prospect that their actions may trigger the flip-side of Deflation must be contemplated.

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Q: What's black and white and deep in the red ?

2008-10-26T23:14:00.008-04:00

A: US Newspapers

A posting by John Hempton discussing the decline of the New York Times (in light of its recent downgrade to junk-status by Standard & Poor's), piqued our curiosity about the 'Grey Lady'. Just how poorly is the New York Times performing compared to other newspapers ?

As an examination of Bloomberg's newspaper index shows - relatively speaking, the Times' performance is not much different from its overall industry:

Blue Line: Bloomberg Newspaper index
Green Line: New York Times
Share Price Change% 2004-2008

The entire US newspaper industry may be in need of redefining just what business it's in - Newspapers ? Or - - - Information ? Entertainment ? Deforestation ?

The industry's product requires a significant investment of its customers' time to consume, and at the current pace of events, it is outdated by the time it arrives on your doorstep.

Characteristics which we would suggest the New York Times, and its industry competitors, examine, would include:

1) The homogeneity of subject matter (story selection) from one newspaper to another.

2) The trend toward narrative framing of stories, and away from basic reporting of facts (who-what-where-how-when).

3) The consensus editorial viewpoint which pervades the major newspapers and colors their reporting from the masthead to the back page.

4) The provinciality of US newspapers - one cannot read the Times, or any major US newspaper, on any given day and get any understanding of what is going on in the rest of the world.

To summarize, newspapers are selling a product which is obsolete by the time the customer receives it, and which is: undifferentiated, uninformative, and predictable.

Should their continuing decline be any surprise ?

note: Thanks to Mark Thoma's blog for alerting us to John Hempton's article

State of the US Economy

2008-10-26T22:28:00.003-04:00

Beacon Economics, a California-based consulting firm, has put together an informative report on the current and projected state of the US Economy, packed with interesting information - we recommend it:

http://www.beaconecon.com/products/Presentations/CSSA08.pdf

HT to CR (calculatedrisk.blogspot.com) for the original link.

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A world of trouble...

2008-10-24T13:40:00.003-04:00

by Jennifer Singleton

As I am trying to keep up with all the wonderful macroeconomics I saw this article today: China Slows, World Feels the Pain WSJ, 21-Oct

In Keynsian fashion, the Chinese govt has been moving the AD (Aggregate Demand) curve around. The articles speaks about the incredible growth rates China has experienced in previous year (10%) but that it has fallen slightly in the third quarter (9%) and likely to continue to drop.

As the rest of the world is experiencing the financial crisis, China's trade sector is beginning to suffer. "Though China's financial system remains largely insulated from the credit crunch, 'everything is moving in the wrong direction in terms of sustaining growth,' says Nicholas Lardy, senior fellow at the Peterson Institute of International Economics." Confidence is down and the long term outlook is expecting further decreases in inflation.

From the paragraph "One area Chinese...this year.", it sounds like the AD was steadily moving right and the govt was worried about overheating and a housing SAP bubble. So they "put on the brakes" which should have worked well but with the global financial crisis it seems to have moved the AD too far left.

In the paragraph "China's leaders, keen... infrastructure construction.", the govt is attempting to jump start the economy with an increase in "G", some specific cuts in "t", and a push for increased "I".

I hope their economy regains speed and is able to weather our crisis.

If not we are in a world of trouble.

Confidence

2008-10-24T12:42:00.004-04:00

We have discussed the importance of Confidence (click to link) and the failure to this point of our leaders to deliver it.

Thanks to Nacho Vijil-Cabrera for alerting us to the following articles:

We Need Confidence, Not Just Action WSJ, 10/20

The Government is Contributing to the Panic WSJ, 10/11

Investors and Consumers are increasingly taking each new Government intervention as a sign that things are indeed very bad - driving Confidence down even further and largely defeating the purpose of the interventions....

As Nacho further notes, in this case, the Europeans have been more direct in addressing the core issue of Confidence in the banking system:

Suddenly, Europe Looks Pretty Smart NYT, 10/18

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America wants to help !

2008-10-24T12:29:00.003-04:00

We encourage anyone who has not yet read the Langdana Rebuilding America Plan to do so (by clicking the link).

A key element of the plan is to go directly to "Mom and Pop America" inviting Americans to participate directly by buying Rebuilding America Bonds.

Strong evidence that this can be successful comes from our Brian Melgaard, who notes the strong demand for California bonds following a "marketing campaign targeted to individuals".

Here is the Bloomberg article: http://www.bloomberg.com/apps/news?pid=20601109&sid=aYgvqAjTESfo&refer=home

Poof!

2008-10-16T20:52:00.019-04:00

On Tuesday, the Treasury announced its plan to invest $125 Billion into nine of the largest US financial institutions.

On Wednesday & Thursday, three of these banks reported their quarterly earnings.

By our count, more than half of our "investment" has already gone down the black hole of their balance sheets, disappearing between write-downs, losses, charges, and newly added loss reserves:

We can take solace, however, that these captains of finance, who gave us the credit implosion, will effectively employ what's left of our money to re-start our economy.

Here's an example of the brilliance and foresight which these august institutions bring to the table:

May 12, 2008, Goldman Sachs recommends Russia:

On May 12, with the Russian RTS index at 2,321, Goldman urged told investors that "Russia is currently one of the best global investment opportunities" and urged them to "avail themselves of the current mispricing opportunity in Russian equities".

One week later, on May 19, the Russian market peaked at 2,487.

Today it stands at 713.

If you followed their recomendation you lost 69% of your investment in 5 months.

We have a better idea than giving more money to the same people, with the same poor judgment, running the same institutions, that have already failed us.

It's time for Americans to take matters into their own hands and REBUILD AMERICA .

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REBUILDING AMERICA

2008-10-15T17:39:00.078-04:00

The President of the Federal Reserve Bank of San Francisco remarked today that "The U.S. economy appears to be in a recession". With a Central Bank that has such acute powers of observation and such impeccable timing, and one that has created about $1400 Billion of new dollars all for nothing, why should we worry?!

Our government's response to the crisis has involved one market intervention after another. One day we are "providing liquidity", the next day we're "buying troubled assets", and the next day we're "injecting equity into financial institutions".

With all the new acronyms created over the past several months ("TAF", "TSLF", "TARP", "EESA", etc.), our financial Scrabble board has run out of letters..

As we intervene in the market, endogeneity in asset pricing--the vital cog that keeps our pricing mechanism alive and the bulwark that holds up our free market economy--is destroyed. We resort then to being a few guys in a small room with a naked bulb, cigars, etc., determining prices.

It is no wonder that investors are choosing to sit on the sidelines rather than try to out-guess the next move of the Government's 'Plunge Protection Team'.

The market has now voted on the current plan - twice. The first time, from the 1:30pm passage on October 3, the market plunged for the worst week since the Great Depression. The votes are in for the most recent version:

We need to go in a new, bold direction. One that does not attempt to manipulate the market (a futile endeavor in any event, which should be clear by now). One that ignites, rather than interferes with, the free market's engine of growth.

Here is our plan:

REBUILDING AMERICA

1) Stop the presses

Literally. No more liquidity to be created. No more bailouts. The current plan, to buy bank shares is doomed to failure. In macroeconomic history, there has never -- NEVER -- been a time when institutional intervention to shore-up prices / wages / exchange rates has managed to defeat the endogenous power of the market. NO MORE GOOD MONEY AFTER BAD.

2) Jump-start the economy by rebuilding American infrastructure to again be the best in the world

Spend on bridges, airports, trains, education, power-grids, broadband access, etc.

The Confidence of both Consumers and Investors is currently at rock-bottom.

Consumers used a high proportion of the recent "stimulus checks" to pay down debt.

Likewise, banks are likely to use a high proportion of the recent capital injections to fill the massive holes made by the toxic Level 3 Assets on their balance sheets.

Attempting to "flow" money through either consumers or lenders, in the current environment, is doomed to fail. In rare situations, where confidence is totally lacking, direct Government spending is the best and fastest way to achieve a jump-start.

A massive program of infrastructure spending and investment, with the goal of re-establishing American infrastructure as the best in the world, is urgently needed today.

3) Enlist prominent, respected Americans to voluntarily market these REBUILDING AMERICA BONDS to the American public.

The faces of this effort should be Americans who have earned the universal respect of their countrymen. If willing, these would include luminaries such as Warren Buffet, Tiger Woods, Paul Volcker, Bill Cosby, Rudy Giuliani, Clint Eastwood, Oprah Winfrey, Bill Gates, and others of similar stature. No-one in the current leadership has any credibility, and as such should not be seen as the "face" of this project.

4) Borrow the funds from Mom & Pop America

From the time of our country's Founding, Main Street America has never refused the call to service. After 9/11, in a moment when Americans were eager to serve in a common purpose, our Government asked them simply to shop. Certainly consumer spending was helpful, but many have argued that this was a missed opportunity.

We must seize on the can-do spirit and natural patriotism of the American people and invite them join in rebuilding America.

Speaking with many "Main Street" Americans, a clear theme as emerged: Angry as they are with the situation, and disgusted as they are with current leaders, Americans want to help the economy get back on track! Rather than go back to the well with foreign lenders, market this issuance first and foremost to Americans.

And, importantly: Not one penny more would be spent than is voluntarily subscribed by purchasers of the REBUILDING AMERICA BONDS.

5) The REBUILDING AMERICA BONDS would pay a coupon which is indexed to inflation (much as "TIPS"). The bonds would pay a regular coupon, and the interest rate paid would be adjusted every six months. In this way investors can't lose from the effects of inflation.

6) Total Transparency, unlike any Government program before, would be a central component

a) We tell lenders exactly where the money will go on a state-by-state basis -- for example, residents of New Jersey will be told which specific airports, school districts, power grids, and university programs are being funded.

b) Websites will show where the money is being spent and the services provided and the amounts transacted, for any bondholder to see.

7) We must not subsidize alternate energy research.

Let the venture capital--the smart money--bring the new ideas to fruition. Once this happens, we must then nurture the infant alternate power industry to maturity by giving real tax breaks. This approach will ensure that the innovating companies are not forced to spend scarce resources hiring expensive lobbyists to compete for a fat share of federal subsidies, but instead, will be able to direct their resources to hiring real research scientists. The same applies to biotech, nanotech, or any number of other promising new industries.

Government spending is a blunt instrument - successful development in emerging technologies requires much more deftness and finesse than can be applied through any government-run program.

8) Tax cuts for all--for the next year at least.

One of the biggest mistakes that led to the Great Depression was a savage increase in taxes. This is no time to repeat that mistake. This applies equally to taxes on capital and income - as both investors, and consumers, are needed once the REBUILDING AMERICA program gets the economy moving.

9) Capital will flow back to the American economy.

Once foreigners see that we are reinventing America again, the global money will flow back in. No-one will want to be left out on the sidelines as America becomes the hottest emerging economy on the planet.

America is at her best under adversity. She has shown this time and time again. Our friends love this quality about her; our enemies have repeatedly discovered this quality at great cost. It is time to show the world what we can do.

-Farrokh Langdana, Ph.D.
Rutgers University Business School

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"All-in"

2008-10-13T20:36:00.014-04:00

Last week, we talked about the circle being drawn around certain favored financial institutions in "OH MY GOD THE BOAT IS LEAVING US!".

We observed that a lifeboat had been constructed, into which the Government was hoisting certain banks, which included Bank of America (BAC), JP Morgan Chase (JPM), Goldman Sachs (GS), and Morgan Stanley (MS).

Citigroup (C) and Wells Fargo (WFC) were fighting over the pieces of Wachovia (WB).

At the time, the Bailout Plan (originally, the "Troubled Asset Relief Program") consisted of the Treasury buying 'troubled assets' from banks.

A lot can change in a week these days...

The focus of the Bailout Plan, now the "Emergency Economic Stabilization Act", has changed in a direction recommended by many leading economists.

The Wall Street Journal reports this evening that the Treasury will directly inject equity capital in the form of preferred shares into nine large financial institutions.

These "lifeboat" banks are:

JP Morgan Chase (JPM): $ 25 Billion
Bank of America (BAC), including newly acquired Merrill Lynch : $ 25 Billion
Citigroup: $ 25 Billion (made it into the lifeboat)
Morgan Stanley: $ 10 Billion (this will comfort their friends in Tokyo)
Goldman Sachs (GS): $ 10 Billion
Bank of New York Mellon (BK): $ 3 Billion
State Street Bank (STT): $ 3 Billion
Wells Fargo (WFC): $ unknown at the time of this writing

The WSJ notes, interestingly, that some banks did not want to take the money, largely because of the stigma attached to any perception that they might have needed a bailout.

We would assume these might include Bank of New York Mellon (BK) and State Street Bank (STT), who are receiving the least at $ 3 Billion each, and were the only two US financial institutions of signficant size to avoid the over-leverage and improper risk which drowned everyone else.

If true, this means that Treasury has apparently decided that allowing a healthy bank to swim on its own is not to be permitted, as it would stigmatize those banks who have so mismanaged themselves that they desperately need the capital.

Thus have prudent banking practices and effective risk-management been devalued. (Who needs risk management anyway when the Government is guaranteeing everything ?)

Nevertheless, with the Government's pro-active and strenuous actions, borrowing and lending may resume and a systemic global meltdown may well be averted.

However, as can be seen from the below chart, this injection alone does not instantly turn around the balance-sheet problems for the seven worst offenders.

"Level 3" Assets are the "illiquid" assets which have no market price and so cannot be readily valued. These were generally mortage-related debt instruments which banks were buying, repackaging, and selling at a rapid pace.

When the housing and credit-bubble music stopped playing, the banks were left holding these things.

All the banks holding these know that theirs are not worth what they are listing them for on their balance sheets. And, they suspect that everyone else has the same problem. This is a big reason why banks do not trust each other's financial strength enough to want to lend to each other.

The Level 3 Assets - to - Equity ratio, a key measure of how badly the toxic assets are dragging down the institutions, is helped, but not cured, by this injection.

The more important aspect of the action is of course the Confidence injection, whereby the Government has made clear that it will support these institutions, and will not allow them to fail.

At this point, the Government has effectively gone "all-in".

Should the credit markets not respond positively, there are few options remaining. It is not a very great step from here to full nationalization of the banking system.

While unthinkable only a few months ago, it is a growing possibility.

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UXB: LEH

2008-10-09T23:19:00.012-04:00

During and for a long time after WWII, the danger from Unexploded Bombs (UXB) was a serious problem in London and all over Britain. (As recently as this June, a bomb was discovered near Bromley-by-Brow Station).

A UXB can can be anything from a 1,000 lb. 68 year-old Nazi TNT bomb to a modern anti-personnel landmine in the border regions of Eritrea, to an Iranian-made roadside IED in Iraq. It is a severe problem in many corners of the world. A multibillion dollar industry has emerged to deal with it.

This morning, in New York, as Rachael Baldwin of VOX EU has noted, an attempt will be made to defuse another UXB which has the potential to cause financial devastation on an unprecedented scale.

The munition in question is the aggregate total of the Credit Default Swaps (CDS) and related instruments to which the now-bankrupt Lehman Brothers [LEH] is a party.

What is a CDS? A Credit Default Swap is insurance against a default on a bond. If you own Ford bonds, and are concerned that Ford might go bankrupt and that your bonds will be worthless, you can buy a CDS to hedge against that loss. A CDS today for a Ford bond might cost you $3 million to protect against $10 million in bonds for five years. Should the bonds default, you'd be due the $10 million face value (less what you recover on the bonds). In normal times, the CDS for a healthy company would sell at a fraction of $1 million for 5-year protection on $10 million of bonds.

How is Lehman involved? Lehman bought and sold CDS contracts for hundreds of billions of dollars worth of bonds. There are also CDS contracts out for Lehman bonds, which have defaulted.

What is the problem? Here are the basics:

(a) Any CDS contracts that Lehman wrote are now basically worthless as they cannot be honored. So anyone who bought a CDS written by Lehman now finds themselves without the protection they thought they had. If you, with your Ford bonds, had bought a CDS from Lehman to protect against loss, you now find that Lehman no longer exists, and you have no protection!

(b) Financial companies who write CDS contracts expose themselves to a significant loss if the underlying bonds default. For this reason, these companies have generally tried to offset their exposure so that for any CDS contract they wrote, they also bought an ofsetting one. This way, if a bond defaults, they have no net exposure as they will pay out but also collect on a CDS contract. (Their profit in this sort of trade would come from the slim difference between the price of the CDS they sold and the cost of the CDS they bought.)

(c) Because CDS instruments were totally unregulated, financial companies began several years ago to start writing, buying, and selling them against bonds they did not even own. The CDS market became, basically, a betting market on the creditworthiness of public companies. Ultimately the CDS market grew to some 50-times the notional value of the bonds being insured, reaching $62 Trillion. This is greater than the sum value of all the world's stock markets.

(d) Because a CDS is only contracts between two companies ("counterparties"), nobody is sure just who sold, bought, and now owns or is liable for how many contracts on what companies of what value. CDSs are "dark matter" in our financial system.

(e) Further complicating the matter is the extremely sloppy execution of CDS contracts between parties. Poorly written contracts returned with illegible notations are not uncommon.

(f) The CDS market has a very limited number of originators.

Add all this together. An unknown number of CDS instruments to which Lehman is a party must now be untangled. Financial companies who had matched their sale and purchase of CDS contracts now find themselves exposed to unexpected risk with no hedge, during a time when corporate bond defaults are elevated.

It has been estimated that the total exposure involved is $400 Billion, although, because of the opaque nature of the CDS market, the total may be anywhere from $150 Billion to $1 Trillion.

Further, it is completely uncertain how all this exposure, of an unknown total in the hundreds of billions of dollars, will "net out". Many of the contracts may "offset", netting out to zero. No-one has any idea what percentage of the total this will represent. Thus, nobody has any idea what the final "net" payouts will be, by whom, to whom.

Three hundred fifty-eight companies are listed as "Adhering Parties", implying that they in some way have a stake in the outcome.

The "Participating" firms in the auction are:

Banc of America Securities LLC
Barclays Bank PLC
BNP Paribas
Citigroup Global Markets Inc.
Credit Suisse Securities (USA) LLC
Deutsche Bank AG
Dresdner Bank AG
Goldman Sachs & Co
HSBC Bank USA, National Association
JPMorgan Chase Bank, National Association
Morgan Stanley & Co. Incorporated
The Royal Bank of Scotland PLC
UBS Securities LLC

It has been hypothesized by many that a major reason that the credit markets have remained tight over the past many days in the fact of massive efforts of Central Banks and Governments worldwide is that banks are hoarding cash in the face of Friday morning's uncertainty.

The auction begins with opening bids and offers submitted from 9:45 to 10am, a summary of those published at 10:30am, final Bids submitted between 12:45 to 1pm, and the results published at 2pm.

It is likely that news will leak out throughout the day. Credit and Equity markets will be watching closely. A huge net exposure by one or more already weak counterparty financials will provide fuel to an already out-of-control financial fire. A relatively modest net exposure, on the other hand, may greatly ease the credit markets.

Whatever the real effect, perception is reality and the markets are watching intently.

The participants might think about calling in these guys just in case:

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Confidence...

2008-10-09T12:09:00.005-04:00

We quoted FDR's advisor Ray Moley recently, who spoke about the "...vital part that public confidence had in assuring solvency".

The UK Telegraph (and others) report: Financial crisis: Hank Paulson warns that more banks and businesses will fail

In his talk, Paulson identifies the four key challenges in our economy today as "Confidence, Capital, Systemic Risk, and Liquidity".

We agree with the Secretary, and Ray Moley, that Confidence is #1. We thus find it unsettling that Secretary Paulson went on to say (emphasis added): "One thing we must recognize - even with the new Treasury authorities, some financial institutions will fail."

Dartmouth, Harvard MBA, Investment Banker... hasn't this guy ever heard of a euphemism ? Confidence is all about the glass being half-full, or, perhaps in this case, one-quarter full... rather than three-quarters empty.

While certainly a true statement (financial institutions fail every year, even during booms), perhaps "may fail", "still face difficult challenges", "have a hard road ahead", etc., would have served Priority#1 better than damning "some institutions" to oblivion and leaving investors to sort out which ones he's talking about.

Taking no chances in this environment, and assuming the Secretary of the Treasury knows more than themselves, market participants' safest bet is to get the heck out of the way and watch from a safe distance... Not the best way to bring capital into the financials.

After seeing Mr. Paulson's recent performances during Congressional testimony, a frantic press conference after the first failed bailout vote, and yesterday, we suggest that Hank move into the background in any further public appearances and that a new 'Undersecretary for Confidence' be appointed.

We have the perfect candidate:

Billy Mays, Pitch-man extraordinaire

Bonds Know Best

2008-10-08T19:52:00.010-04:00

Headlines today heralded the global 1/2 point rate cut by the world's central banks, which has now been joined by Taiwan and Hong Kong.

The Treasury also is doing its best to help liquify the credit markets and ease the tight grip with which banks have been holding on to safe US Government securities.

Today, for the first time in many days, intermediate-term yields rose (the price of the bonds decreased), which may be viewed as either

(a) success,
(b) inflation concerns, or
(c) simply a sloppy auction.

The $66 Billion in Treasury debt which was auctioned today included an emergency re-opening of $20 Billion in "off-the-run" 10-Year notes. These are previously issued securities which are being auctioned at their stated maturity - in this case, 6-years (May 2015).

The expected yield was, according to Bloomberg 2.91 percent, but the bonds were auctioned instead at a yield of 3.31 percent.

By our calculation, this means that the Treasury realized $400 Million less than expected from the re-issuance of these bills. (Bloomberg quotes an analyst who puts the shortfall at $ $345 Billion, we'll say we're close enough for government work.)

The inflation argument is advanced by the fact that the 10-Year note closed at 3.65%, up from 3.51% a day before, the first significant easing in two weeks. 30-Year yields were also up slightly at 4.05%.

However, John Jansen points out the fact that the auction was hastily arranged, as dealers were given only one hour's notice to prepare for the $20 Billion surprise offering, which CNBC's Rick Santelli referred to as a "drive-by auction". This may have contributed to the poor result.

Mr. Jansen also suggests that the hasty time-frame may have been deliberate, to put those hoarding paper on notice that the Treasury may act at any time. The poor price may incentivise hoarders to loosen up and start trading.

Yields, along with the Libor and the TED Spread will tell us if global Central Bank and Government actions over the past several days are having the desired effect of easing the credit markets.

Libor is the rate at which Banks borrow from each other. The elevated levels of late indicate that banks are basically refusing to lend cash to other banks.

The TED Spread is the difference between the 3-Month T-Bill and 3-Month Libor. An elevated TED Spread, as is the case now, indicates a higher perceived risk, as investors seek the safe haven of US Government debt and shun corporate debt.

Some historical perspective on the TED Spread and previous crises:

Libor and TED may be monitored at Bloomberg:

Libor: http://www.bloomberg.com/apps/quote?ticker=US00O%2FN%3AIND

TED: http://www.bloomberg.com/apps/quote?ticker=.TEDSP%3AIND

At the time of this writing (October 9, 9:44pm), Bloomberg reports that Asian credit markets remain tight but show signs of easing...

A master plan for China to bail out America

2008-10-08T06:48:00.011-04:00

Arvind Subramanian, writing in the Financial Times, has adopted Farrokh Langdana's idea of a Chinese bailout - we reprint the entire article here as it is worthy of close analysis:

A master plan for China to bail out America
By Arvind Subramanian, senior fellow, Peterson Institute for International Economics and Center for Global Development, and senior research professor, Johns Hopkins University
From the Financial Times October 7 2008 19:34

"The financial rescue plan passed by the US Congress is viewed as flawed but necessary to head off panic in financial markets and loss of confidence in the economy. It seems a holding operation, a Plan C or D that might need augmentation via a Plan A.

A vital component of a Plan A is likely to be additional money. For one thing, there is suspicion that the amount of toxic assets is considerably greater than the rescue plan provides for. For another, more money may be required to address the problem in the housing market by providing relief to subprime and marginal borrowers. And finally, further fiscal stimulus could become necessary if recessionary forces take hold.

Where will this additional money – perhaps as much as another $500bn – come from? The US taxpayer is wary. Joe Six-Pack has ponied up a lot already, and done so with no great confidence that the money was for a worthwhile cause or that it will be well spent.

Enter China. Ken Rogoff of Harvard cheekily characterised the vast Chinese accumulation of US Treasury bonds over the past five years as the biggest foreign assistance programme in history. Why not push that further? Here is a thought experiment.

The Chinese government could offer to lend up to $500bn (from its current stock of $1,800bn) to the US government for the rescue of its financial sector. Its previous assistance – buying US bonds – was indirect and unconditional. Not so in this case.

China’s loan offer would be direct to the US government to be spent in the current financial crisis. More important, it would come with strings attached. Tied aid, the preferred mode of operation of western donors since the postwar period, would now be embraced by China.

What would be the nature of the strings – or “conditionality” as the US Treasury, a longtime practitioner of this art, has called it? Conditionality as imposed by the World Bank and International Monetary Fund was underpinned by an ideology that favoured markets and globalisation. But there was also an assumption that either borrowing third world governments did not understand their benefits or the reformers there needed a “spoonful of sugar” to help overcome any internal opposition.

China would impose two conditions. First, it would declare that the offer of money was conditional on the US government’s adopting a particular approach to rescuing the banks, namely to favour in the next round the use of government money to recapitalise the banks. Europe has been using this approach and evidence suggests it is the most effective way of dealing with large-scale financial crises.

The US government – like third world governments in the past – has been unable to adopt the most efficient course of action. This stems from an ideological obsession against “socialising” banks or because inducement is necessary to overcome any domestic opposition to it.

The second condition would relate to “social safety nets”, which had become standard embellishments to World Bank/IMF adjustment programmes. China would stipulate that monies be devoted to cushioning the impact on vulnerable homeowners, so that they would not be forced into forgoing the American dream of home ownership. Chinese conditionality on this front would achieve an outcome that several economists on the left and right have argued for on grounds of fairness, and also to address the fundamental problem in the housing market.

For China, this offer of help would have three virtues. First, it would be riding to the rescue of a situation partly created by its own policies of undervalued exchange rates, which led to lax global liquidity conditions. Second, its economic interest would be served because successful US efforts at rescuing its financial sector could help avert an economic downturn, protecting China’s exports, its growth engine.

Perhaps most important, it would seal China’s status as a responsible superpower willing to deploy its economic resources for the sake of protecting the world economy. And if the means for achieving that are by providing the current hegemon with the largest aid package the world has ever seen with a healthy dose of sensible conditionality, well, what could be more statesmanlike than that?"

-------------------------------------------------------------

Our own Randy Klein, writing from his vantage point in Shanghai, explores this idea below ("Don't Count on us to bail you out"). Having been burned several times already, will China really want to come back for more ?

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"Don't count on us to bail you out!"

2008-10-07T09:12:00.013-04:00

by Randy Klein, randy.klein@Heraeus.com

In reference to Bailout Questions – Answers from the Engine Room, it’s worth noting China’s recent public announcement regarding greater diversification away from the USD appears meant to send the message to the Fed: 'Don’t count on us to bail you out' It doesn’t look likely monetization (M) through (G) can come any other way than cranking up the output at the Mint!

With the long-running devaluation of the USD vs. RMB there was great pressure to achieve better returns on China’s USD foreign reserve investment beyond that of treasury notes.

Against China’s typically conservative approach, they followed other countries such as Norway and Russia and create last year a $200Bn Sovereign Wealth Fund through CICC (China Investment Corp).

This was lesson #1 in USD investment for China, as the fund took a beating after investing in Blackstone and 10% of Morgan Stanley.

Lesson #2 for China came when ¼ of China’s $2 Trillion foreign exchange reserves, held in Freddie Mac and Fannie May debt, had to be backstopped through the US Government's effective nationalization of the two GSEs.

Ha J iming from CICC recently said, “The crisis has made Chinese officials realize it’s a bad idea to put all their eggs in one basket and will likely lead to greater diversification of foreign exchange reserve investments. It is likely to reduce the portion of reserves in dollar assets from the current 60 percent by purchasing more non-dollar assets with new reserves.” This public announcement by Ha, a departure from China’s private nature regarding financial policy, was made the Friday before the recent run-up in gold prices resulting in the greatest single day gold price increase in history. China will continue to move away from the USD and diversify with a larger percentage of reserves in gold and other currencies.

Finally, it’s inevitable, (M) must increase through (G) of some form and we will pay inflation consequences down the road.

A few questions:

1) Has there been enough discussion regarding how to add (M) and (G), rather than the debate of if to add (M) and (G)?

2) Is the urgency of dumping liquidity into the system so much that a 'dump and let’s wait and see approach' is justified?

3) How close are we to a liquidity trap? If we are close or already there, is this short term approach of adding liquidity by lending money to banks destined to fail?

4) Why does it appear the Fed is averse to pursuing more covert ways of adding liquidity such as reducing the risk of commercial papers through a federal insurance plan? [ UPDATE 7-OCT - The Fed seems to have listened to our advice - WSJ: FED TO PURCHASE COMMERCIAL PAPER IN NEW PLAN BACKED BY TREASURY ]

5) Why is the Federal Government averse to other stimuli which would spur activity and add jobs such as subsidizing state and local municipality deficits or direct investment in new technologies and infrastructure?

Comments are invited...

"MY GOD, THE BOAT IS LEAVING US!"

2008-10-06T23:15:00.009-04:00

The 65 souls aboard lifeboat#8 were desperate. They had taken to the boat as the passenger ship Vestris sank, two days out of Hoboken on November 12th, 1928. Their leaky craft had filled with water as the night wore on, and was on the verge of breaking apart in the rough water. Spotting lifeboat#1 not far away, they maneuvered close enough to yell over for help. Some began to swim.

However, seeing all those desperate people, the survivors on lifeboat#1 kept their distance. Those who approached by swimming were pushed away with oars.

As lifeboat#1 pulled away, passenger Clytie Raphael was heard to exclaim “MY GOD, THE BOAT IS LEAVING US!”. Mrs. Raphael, and most of those on lifeboat#8, were lost at sea.

It has become clear over recent months that the Federal Government has been at the helm of its own lifeboat, into which it is hoisting certain banks and financial institutions to safety, while leaving others to their fate.

Over the past seven months, the US Government has stepped in to rescue Fannie Mae (FNM), Freddie Mac (FRE), and AIG (AIG).

It also, very conspicuously, allowed Lehman Brothers (R.I.P.) and Washington Mutual (R.I.P.) to fail.

In Congressional testimony today, Dick Fuld (Lehman’s CEO) was asked why he thought that Lehman was allowed to fail while others were saved. “I will wonder about that until the day they put me in the ground”, was his answer, “I do not know why we were the only one.”

Indeed.

Not a few others are wondering just what, exactly, the standard for rescue is.

For financial institutions, it is a matter of survival.

For investors, it is a matter of allocating capital and risk.

For everyone involved, the stakes are high.

So, who are the “Lifeboat Banks” ?

Clearly the list includes JP Morgan Chase (JPM), to whom the Feds handed the remains of Bear Stearns (R.I.P.) and Washington Mutual, as well as Goldman Sachs (GS) and Morgan Stanley (MS), who climbed aboard with their government-encouraged reclassifications as ‘Bank Holding companies’.

Bank of America (BAC), given its size, and relative balance-sheet strength (at least to others), secured its status through its acquisition of Merrill Lynch (MER).

And, until last Friday, Citigroup (C) was assumed to be OK as well.

Simply by virtue its sheer size and global footprint, Citigroup was assumed to be 'safe'. Further proof came with its announcement last Monday that it would, with the assistance and intervention of the FDIC, acquire Wachovia’s (WB) operations and balance sheet. Investors cheered as Citibank shares rose 20% from $19.54 to $23.50 by early Thursday.

With the news Friday morning that Wells Fargo (WFC) had snatched Wachovia away for itself, Citigroup shares plummeted. The shares finished today at $ 17.41, off 26% in two days, and off 11% from last week’s open.

Was the Wachovia acquisition so essential to Citigroup's prospects that the business itself is significantly impaired without it? No. There are plenty of regional bank candidates which can provide the type of footprint that Citibank is looking for.

Investors had taken the government-assisted deal on Monday as a sign of Citibank’s membership in the lifeboat club. They ran for cover when Wells Fargo’s deft action Friday called that status into question.

Citigroup and its shareholders were left to exclaim, as did Mrs. Raphael - “MY GOD, THE BOAT IS LEAVING US!”

Whatever happens with the Citigroup – Wachovia – Wells Fargo mess (the government is trying to mediate), we are clearly now in a world where the decisions and actions of bureaucrats and regulators mean more to the market than business fundamentals.

Citigroup, and others intent on survival, do have one advantage going forward that Mrs. Raphael and her fellow passengers didn’t…

They can hire lobbyists.

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Steering the Fed Funds rate...

2008-10-05T21:46:00.011-04:00

We admit to being nostalgic, sometimes, for the big, loose steering of American Cars from days of old, like that of our 1980 Oldsmobile Custom Cruiser. Making a 90-degree turn involved spinning the wheel like a frisbee.

The Federal Reserve Open Market Committee's steering wheel is starting to feel like that 1980 Olds...

Yesterday we pointed out the difficulty the Fed has had in maintaining short-term rates close to its 2% Target over recent weeks.

As we know, the Federal Reserve does not "set" interest rates by fiat. It sets a Target rate, and attempts to keep rates at that level through its open market operations, in which it buys ("loosens", to lower rates) and sells ("tightens", to raise rates) Treasury securities to member banks.

The New York Fed maintains daily data on rates, including the Standard Deviation, a measure of variance indiating how narrowly the actual rates are adhering to the Target.

Traditionally, the Fed has had little difficulty keeping rates close to its target through its open market operations, especially over periods of several weeks at a time, with a Standard Deviation averaging less than 0.1.

A look at the rolling average over the past several years paints a startling picture. Starting at August 10, 2007, as the first ripples of the credit crisis came to be widely felt, the FOMC (Federal Reserve Open Market Committee) has found it extremely difficult to manage rates.

The Fed smelled trouble, as, on that day it issued an unusual press release, which included the statement "In current circumstances, depository institutions may experience unusual funding needs because of dislocations in money and credit markets. As always, the discount window is available as a source of funding."

Rates have been difficult to manage since that day. The variance has become especially remarkable over the past three weeks:

Following the passage of the US Bailout plan on Friday, Central banks and governments across Europe have scrambled over the weekend to calm the credit markets.

- The German Central bank guaranteed all deposits

- The German Central bank stepped in to save the bailout of Hypo Real Estate ($50 Billion+)

- BNG Paribas is taking over certain operations of Fortis NV ($15 Billion)

- The Netherlands nationalized Fortis' Dutch operations

- Italy's Unicredit will raise capital ($3 Billion)

"Confidence" is the term one hears most often from the various authorities discussing these issues, and confidence will be the key to whether the system stabilizes.

As the variance in the Fed Funds Rate has tracked closely with the credit crisis since its inception, an indicator of confidence returning will be the degree to which the Fed can manage rates toward its target.

Eyes on the road...

* Excellent further information can be found at Brad Sester's Follow the Money, which inspired the above research.

Rate Cut ? The market has already voted.

2008-10-05T01:10:00.004-04:00

Some attention has been focused on whether the Federal Reserve Open Market Committe will vote to lower its target rate from 2%, perhaps even proir to the next FOMC meeting.

The Federal Reserve's data tells the story.

The market is already voting. It is saying

(a) That the Fed is not in control.

(b) That the rate will be lowered.

The Garbage Barge

2008-10-02T19:30:00.030-04:00

On March 22, 1987, the barge 'Mobro' left Islip, Long Island, on what was to be a short trip hauling waste to a southern landfill. The voyage, however, did not go as planned...

The "Garbage Barge", as it came to be known, and its 3,186 tons of baled trash, would ultimately travel more than 6,000 miles, being turned away by North Carolina, Florida, Louisiana, Alabama, Texas, and New Jersey, as well as Cuba, Belize, and, at one point, the Mexican Navy. Nobody wanted the barge's cargo.

On Monday, December 17, 2007, the Federal Reserve embarked on a journey of its own, opening a new "Term Auction Facility", providing $20 Billion of Fed Funds for a 28-day term, and accepting a "wide variety" of collateral. This was one of many innovations the Fed has instituted over recent months to address tightening credit and liquidity.

The Fed's balance sheet has grown, and changed in composition, significantly since that time, as we noted Monday. The level of non-traditional loans and assets held on the Fed's balance sheet, at $906 Billion, is greater than the entire sum of the Fed's assets ($893 Billion) only ten months ago.

Over the past week alone, this amount has grown by +$283 Billion, now accounting for 60% of the Federal Reserve's total holdings.

Under the bailout plan, the Treasury is planning to launch its own $700 Billion scow, taking on unwanted refuse from financial institutions and holding them until such time as they can be sold at or above their purchase price.

When, or perhaps whether, a market for those assets will materialize is an open question...

As for the original Garbage Barge ?

In the end, after failing to find anyone to accept its unwanted cargo, it finally returned right back to its starting poing at Islip, where its trash was burned.

Photos: http://www.jconoverjr.com/g-barge.htm

What's that smell ?

2008-09-29T23:47:00.019-04:00

Dr. Langdana has compared bundles of questionable financial assets to sacks of Oranges, into which the grocer (the investment bank, in the case of Mortgage-backed securities) packs as many bad ones as possible down in the bottom of the bag, hoping you won't notice...

In light of the Fed's announcement today that it will be expanding its Term Auction facility by $300 Billion (of a total $630 Billion liquidity injection), we thought we'd take a look at the sack of oranges backing up our money at the Federal Reserve.

First, some basics about our currency. Every piece of US paper currency includes the phrase "FEDERAL RESERVE NOTE":

What does this mean ?

It means that the Federal Reserve stands behind the money. How ? At any time, you may actually redeem your dollar of Federal Reserve currency for... another dollar of Federal Reserve currency !

...which makes the value of the currency entirely dependent on the faith which those using it for exchange have in the Federal Reserve, the US banking system, and the U.S. Government which stands behind them.

Getting back to our oranges - The Federal Reserve supports the money in circulation (its liabilities) by holding certain Assets (its 'bag of Oranges') on its balance sheet.

Over the past year, the Fed's bag of oranges has grown significantly in size, and, one might say that a certain odor is starting to emerge from the bottom of the bag:

The detail is available at the Federal Reserve, here is our summary:

Federal Reserve (Combined) Assets, $Millions

The data can be found at:
http://www.federalreserve.gov/releases/h41/Current/
http://www.federalreserve.gov/releases/h41/20070927/

So where does this leave us? Today, the lack of credit and liquidity which the Fed is desperately fighting is the paramount challenge facing the global financial system.

What seems certain is that, at the end of this process, it will be left holding a much bigger, and much more pungent, bag...

UPDATE - OCTOBER 2, 2008: The Fed's balance sheet has grown massively over the past week, as the institution continues to attempt to provide liquidity to global credit markets -

The total of 'non-standard assets' ("Yuck!", in our table) now exceeds the total size of the Fed's balance sheet a year ago.

Think $700 Billion is a lot? How about $800 Billion in 90 minutes...

2008-09-29T16:25:00.000-04:00

Heading into the 1pm Bailout vote, US equities were off roughly 2 -3% and trading flat...

In just 90 minutes following the 228-205 "NO" vote on the $700 Billion plan, US equities dropped by a further 5%, representing a decline in market capitalization of more than $800 Billion...

Investors looking for reassurance will need to look other than to Treasury Secretary Hank Paulson, who came out for a brief Press Conference at 4:30pm, appearing as one who is certain that the sky is about to fall in...

Click here to play video

Eyes now turn to the overseas equity, and especially, credit markets...