Economic Dreams - Economic Nightmares

James Galbraith on the 'Collapse of Monetarism'

Hyman Minsky, John Kenneth Galbraith and John Maynard Keynes take center stage as James Galbraith throws down the gauntlet to contemporary mainstream economists. Speaking at the 25th Annual Milton Friedman Distinguished Lecture at Marietta College, Marietta, Ohio, Jamie Galbraith asks Fed Chair Ben Bernanke and a host of others to embrace the " intellectual victory of John Maynard Keynes, of John Kenneth Galbraith, of Hyman Minsky." — else to explain "why not". We will search and update on any "why nots" if and when they surface. To Galbraith:

The Collapse of Monetarism and the Irrelevance of the New Monetary Consensus [PDF], by James K. Galbraith, March 31, 2008 : … I come to bury Milton [Friedman], not to praise him. But I would like to do so on the terrain that he favored, where he was strong, and over which he ruled for many decades. This is monetary policy, monetarism, the natural rate of unemployment and the priority of fighting inflation over fighting unemployment. It is here that Friedman had his largest practical impact and also his greatest intellectual success. It was on this battleground that he beat out the entire Keynesian establishment of the 1960s, stuck as they were on a stable Phillips Curve. It was here that he set the stage for the counter-revolution that has dominated academic macroeconomics for a generation, and that – far more important — also dominated and continues to influence the way in which most people think about monetary policy and the fight against inflation.

What was monetarism? Friedman famously defined it as the proposition that "inflation is everywhere and always a monetary phenomenon." This meant that money and prices were tied together. But more than that, Friedman believed that money was a policy variable — a quantity that the Central Bank could create or destroy at will. Create too much, there would be inflation. Create too little, and the economy might collapse. There followed from this that the right amount would generate the right result: stable prices at what Friedman came to call the natural rate of unemployment.

The intent and effect of this line of reasoning was to defend a core proposition about capitalism: that free and unfettered markets are intrinsically stable. In Friedman's gospels government is the lone serpent in Eden, while the task of policy is to stay out of the way. Just as this was the vulgar lesson of "Free to Choose" so it turns out it was also the deep lesson of the larger structure of Friedman's thought. Friedman and Schwartz's Monetary History for all its facts and statistics carried a simple message: the market did not fail; the government did.

Friedman succeeded because his work was complex enough to lend an aspect of scientific achievement to his ideas, and because the ideas played to the preconceptions of a particular circle. As Keynes wrote of Ricardo:"The completeness of [his] victory is something of a curiosity and a mystery. It must have been due to a complex of suitabilities in the doctrine to the environment into which it was projected. That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely…to do more harm than good, commended it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority."

Friedman's success was similar to Ricardo's but not in all respects. Yes he also explained away injustice and supported authority. But the logical superstructure was not vast and consistent. Rather Friedman's argument was maddeningly simple, yet slippery. He would appeal to short run for some effects and to the long run for others, shifting between them as it suited him. … His money growth rules promised stable employment without inflation. Their promise was not austere, but happy. Ricardo was Scrooge. Friedman was more like the Pied Piper.

Short take on MuCulley at the Hyman Minsky Conference

I've been meaning to post up a cut-down version Paul McCulley's recent assessment of our current plight: "Reverse Minsky Moment" interview with Kathryn M. Welling, but haven't yet. So yesterday I was glad to see Floyd Norris do a spot on McCulley's talk at the Hyman Minsky Conference for the NY times, titled Ponzi Squared:

… Minsky argued there were three levels of investment as the cycle progresses. First comes hedging, in which investments are made to reduce risk. Then comes the speculative phase, and finally the Ponzi phase, in which the investment can be justified only by the assumption that prices will keep rising, not by the expected income.

Paul McCulley of Pimco, the big bond manager, gave an interesting speech in which he said the recent subprime mortgage fiasco proceeded to a fourth level — one that he called "Ponzi-squared" — before it collapsed.

At the end, he said, the marginal subprime loan was:

No money down
No documentation of income
Initial below-market teaser interest rate
Negative amortization

That is not a loan, he said. Instead, it amounted to giving the home buyer a call option to buy the house at the current market price, coupled with a put option to sell the house back at that price.

If house prices kept rising, the "buyer" could make the small interest payments to keep the option open, and eventually sell the house. That happened for a time, and led to the conclusion by rating agencies that such borrowers were good risks.

But when prices went down, the "buyer" would suffer no loss if he exercised the put and gave the house to the lender. That is just what happened.

As Paul Simon wrote in 1975, said Mr. McCulley, the strategy became:

Drop off the key, Lee,
And set yourself free.

Here is the written version of McCulley's April 17 talk at the Minsky Conference. Oddly, the "Drop off the Key" remarks are not included, although they are in the longer, Welling-McCulley rendition above. Some tidbits:

… [I]n what I call a "Reverse Minsky Journey" … Ponzi Units evaporate. Then many Speculative Units morph into Ponzi Units and are shot. Surviving Speculative Units are only those with explicit liquidity support from banks, who have explicit liquidity support from the Federal Reserve. Hedge Units, of course, remain standing tall, fundamentally sound, though cheaper in price, providing an excellent long-term buying opportunity.

This has been precisely the process in place since almost a year ago, and particularly since last August, when the shadow banking system — defined as any levered lender who does not have access to (1) deposit insurance and/or (2) the Fed’s discount window — experienced a modern-day run, with asset-backed commercial paper holders refusing to roll over their paper. It has not been fun. It has not been pretty. And it is not over.

Along the way, policy makers have slowly recognized the Minsky Moment followed by the unfolding Reverse Minsky Journey. But I want to emphasize "slowly," as policy makers, collectively, still suffer from more than a thermos full of denial. Part of the reason is human nature: to acknowledge a Reverse Minsky Journey, it is first necessary to acknowledge a preceding Forward Minsky Journey — a bubble in asset and debt prices — as the marginal unit of debt creation morphed from Hedge to Speculative to Ponzi.

That is difficult for policy makers to do, especially ones who claim an inability to recognize bubbles while they are forming and, therefore, don’t believe that prophylactic action against them is appropriate. Nobody likes to admit they were blind, dumb, or asleep at the switch. Or all three. …

That's not to say that Minsky had confidence that regulators could stay out in front of short-term profit-driven innovation in financial arrangements. Indeed, he believed precisely the opposite:

"In a world of businessmen and financial intermediaries who aggressively seek profit, innovators will always outpace regulators; the authorities cannot prevent changes in the structure of portfolios from occurring. What they can do is keep the asset-equity ratio of banks within bounds by setting equity-absorption ratios for various types of assets. If the authorities constrain banks and are aware of the activities of fringe banks and other financial institutions, they are in a better position to attenuate the disruptive expansionary tendencies of our economy."

Minsky wrote those words in 1986! Twenty-two years later, we can only bemoan that his sensible counsel was ignored. …

Minsky's insight that financial capitalism is inherently and endogenously given to bubbles and busts is not just right, but spectacularly right. And when the financial regulators are not only asleep but actively cheerleading financial innovation outside their direct purview, a disaster is in the making, as the last year has taught us. We have much to learn and relearn from the great man as we collectively restore prudential common sense to bank regulation — both for conventional banks and shadow banks.

Cecchetti on Recent Fed Policy Changes

(Via David Beckworth at Macro and Other Market Musings, April 11:

Previously I discussed how much of what you learned in your money and banking class is now outdated given the many policy innovations by the Federal Reserve since last summer. Stephen Cecchetti now has a nice summary of these innovations that can be found here (shorter version) or here (longer version). Read these updates and you will be current on the workings of the Federal Reserve.

I too find Cecchetti to be a good go-to source on where things stand and where we may be heading—barring bad politics, too-intense lobby pressures, and host of other interferences that seem to get in the way of "Economics Dreams".

Speaking of Money and Banking "learning" being outdated, consider this from Kevin Quinn at Econospeak, April 9

It is scandalous that nowhere in what passes for mainstream macroeconomics will you find anything that helps you understand what Hyman Minsky called "financial fragility" - the inherent instability of the credit system - and the implications for the real economy. No models - nothing!! - Nothing in a macroeconomics textbook that would aid in understanding the current crisis, and countless previous cises in the history of capitalism….

Butier Responds to Greenspan's Latest Attempt to Rewrite History

{Updated, April 9}
At maverecon Willem Butier counters Alan Greenspan's latest claim the he and the US Fed not be held responsible, in large part, for our current mess. Butier's eight policy "tragedies":

1. The Greenspan Fed (August 1987 - January 2006) did indeed contribute, through excessively lax monetary policy, to the US housing boom that has now turned to bust.
2. The Greenspan-Bernanke put is real. It is an example of an inappropriate monetary policy response to a stock market decline.
3. The Greenspan Fed focused erroneously on core inflation, rather than using all available brain cells to predict underlying headline inflation in the medium term.
4. The Greenspan Fed failed to appreciate the downside of the rapid securitisation during the first half of this decade and acted exclusively as a cheerleader for its undoubted virtues.
5. The Greenspan Fed displayed a naive faith in the self-regulating and self-policing properties of financial markets and private financial institutions.
6. The Greenspan Fed, by enabling the rescue of Long Term Capital Management in 1998, acted as a moral hazard incubator.
7. The failure of the Greenspan Fed to press, before or after LTCM, for a special insolvency resolution regime with prompt corrective action features for all highly leveraged private financial institutions that were likely to be deemed too big and too systemically important to fail, demonstrates either bad judgement or regulatory capture.
8. During his years as Chairman of the Federal Reserve Board, Mr. Greenspan's statements reflected a partial (in every sense of the world) understanding of how free competitive markets based on private ownership work. This partial understanding guided his actions as monetary policy maker and financial regulator. Mr Greenspan's theories have been comprehensively refuted by the financial crises of 1997/98 and 2007/08.

Butier elaborates on each. We will bring forward only one, dealing with possibilities for moral hazard. But before we do, I just found Martin Wolf's counter-balancing position, Ft.com, April 8, still praising Greenspan, while fearing that over-zealous regulatory reform spaned by a Greenspan "blame game" will kill the "good" that free-er (my word, Wolf uses "free) market mechanisms bring. Whereas Butier lists eight "tragedies" of Fed policy/practice, Wolf highlights two: (1) regulators should have been "tougher", in subprime and elsewhere, and (2) monetary policy should have been tigher, not looser — to lean against prevailing winds of excess instead of leaning with them.

David Beckworth, via Macro and Other Musings, adds insight into why Butier's critique is on target:

… [T]he Federal Reserve is a monetary hegemon. It holds the world's main reserve currency and many emerging markets are pegged to dollar. Thus, it's monetary policy is exported across the globe. This means that the ECB, even though the Euro officially floats, has to be mindful of U.S. monetary policy lest its currency becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. The Fed's loosening, therefore, of monetary policy in the early-to-mid 2000s triggered a global liquidity glut that set the stage the subsequent housing boom-bust cycle. This is not to say the 'saving glut' and financial innovation had no role, but rather that loose monetary policy was a key factor behind the boom. …

Back To Butier:

The Greenspan Fed: a tragedy of errors, Willem Butier, maverecon:Financial Times, April 8: Mr Greenspan's apologia pro vita sua in the Financial Times of Monday, April 7 2008 fails to convince. …

Everyone Hates Treasury Secretary Paulson's Reform Proposal

{Updated April 1, 2}

Ok. Some are cheering, if softly. But not among folks I read regularly. Clearly Robert Reich hates Secretary Paulson's self-proclaimed reform proposal, concluding: "Hank Paulson's discussion paper – it's not even meant to be enacted under the Bush Administration – is not broad, it's not an overhaul, and heaven forbid, if we're facing another Great Depression, it will do absolutely zilch to head it off."

More dissent:
Not "Calculated Risk" or Paul Krugman.
Not Clive Crook
Not Willem Buiter
Not Barry Ritholtz or Michael Mandel

Last but not least:

Stephen Cecchetti, soon to be Economic Advisor to the Bank of International Settlements, in a 19 min. Bloomberg audio podcast with Tom Keene says "Paulson Proposal isn't right first move". Included are good insights into much-needed regulatory reform, particularly w/r/t leverage and the troubling phenomenon of investment banks, hedge funds etc. moving where-ever around the world to avoid any specific country's regulatory requirements.

A few tidbits from Crook:

The new Treasury blueprint for reforming financial regulation is not really a blueprint at all. (The full document is here; or see a Treasury summary of it here.) It says some sensible things and has some good ideas, but for the most part it is an agenda for discussion rather than a detailed plan. Given that the Treasury has been working on this thing at least since March 2007, it is surprisingly thin.

Moreover, it is concerned exclusively with the structure of the regulatory system. I think that getting this right is more important than Paul Krugman does—he calls this the Dilbert strategy—but Paul is surely right to complain that a better structure will get you only so far. It is a question of form and content. What the rules say matters more than which regulators are responsible for enforcing them, and the so-called blueprint does not go into that. …

At least there is some agreement that "Something should be done." Duh! AND: It's about time. But 'not yet', of course it's an election year! Next year the excuse will be something else.

Here is CNNMoney Good plan, bad plan - Reaction to Paulson, demonstrating that mainstream media will always find opposing views, no matter how far and wide the search.

Still, I'm a wee bit hopeful, as is Paul McCulley, that we may at least avoid a Depression and get some needed financial regulatory reform as well—but it will take time and much deliberation, and perchance more pain felt by stock and bond fund holders as well as by taxpapers in general. Here's Paul McCulley's latest perspective [PDF] on the general financial/economic landscape—not specifically on Paulson's proposal. I think McCulley nails it! What do others think?

Fed's 'Historic Steps' into Uncharted Waters

Unless I'm mistaken, the Fed just took a first step toward Thomas Palley's suggested solution to our current mess:

Central Bank Offers Loans To Brokers … Historic Steps, Greg IP, WSJ, March 17: … It took a unanimous vote by the Fed's five governors yesterday to invoke a Depression-era clause in the Federal Reserve Act to waive the usual prohibition on Fed loans to nonbanks. A Fed official told reporters today's circumstances couldn't have been envisioned when the Fed was created, and noted newer central banks like Europe's have many of these powers. But these steps also take the central bank into uncharted territory with new and potentially troublesome risks.

Those risks include the possibility that with the credit crunch showing no sign of lifting, the Fed will be called on to lend to other troubled firms and end up a major creditor of Wall Street, even if at present the risk of any substantial loss appears small. Another risk is that while the Fed used a loophole yesterday in the Federal Reserve Act to expand its lending to nonbanks in "unusual and exigent" circumstances, it has in effect expanded the federal safety net with no political debate. However, the Fed sought and received agreement over the $30 billion loan from Treasury Secretary Henry Paulson, who informed President Bush.

Bigger Test

For now, though, the bigger test will be how the markets greet the initiatives today: with relief at the bold steps taken to shore up the financial system, or with alarm at how unstable the financial system had to be to invite such action.

Officials appear to hope the initiatives will restore enough confidence to markets to allow a smaller rather than larger rate cut tomorrow, but they acknowledge it will depend partly on how markets evolve over coming days.

On Wall Street, there is likely to be some relief that the Fed has finally opened the discount window to securities dealers, something they have long clamored for. The Fed has been reluctant because the move was outside its explicit mandate. "This is a five-vodka event," said a senior executive at one big brokerage firm that previously didn't have access to this funding source. "Liquidity is no longer an issue."

Federal Reserve Bank of New York President Timothy Geithner told reporters: "This is designed to help get liquidity to where it can help play an appropriate role in helping address the range of challenges" in the markets, especially in the mortgage-backed securities market.

Mr. Paulson said in a statement, "I appreciate the additional actions taken this evening by the Federal Reserve to enhance the stability, liquidity and orderliness of our markets."

For all their creativity, the Fed moves are also an acknowledgment that its previous steps have failed to stem the collapse in investor confidence, forcing it to abandon many of its original principles, such as not favoring particular firms or market sectors and sticking within its explicit statutory authority.

Last Tuesday, it announced what Wall Street called its most creative initiative yet: It lent up to $200 billion of its much-sought Treasurys to investment banks starting March 27 in return for a like amount of now-shunned mortgage backed securities for up to 28 days. The announcement led to a huge rally in stocks. But within days dealers were telling the Fed it didn't go far enough. They wanted longer term, more immediate funding against a broader range of collateral.

It also came too late to save Bear Stearns. On Thursday evening, Bear Stearns informed the Securities and Exchange Commission and Fed that it had experienced a dramatic loss of cash reserves and now saw no option other than to file for bankruptcy protection Friday morning. Fed officials at that point saw just two options. They could try to wall off the rest of the financial system. If the environment had been less tumultuous they might have chosen that option.

But in the current period they feared that a failure by Bear to make good on billions of dollars of contracts could severely dislocate critical markets, especially garden-variety repo loans -- overnight loans secured by various collateral that are the grease of the credit markets.

Too Interconnected

Officials grimly concluded that while Bear Stearns wasn't too big to fail, it was too interconnected to be allowed to fail in just one day. They spent Thursday night going over Bear's books and huddling with the SEC and Treasury. By Friday morning it had settled on its second option: a 28-day secured loan via J.P. Morgan to give time for a sale or wind up of the firm.…

Krugman: Fed Lacks Tools to Deal with Crisis

Paul Krugman says Nouriel Roubini was right: We are in the worst financial crisis since the Great Depression. AND, The Fed probably lacks the tools to deal with it. Then Krugman muses, "Who ya gonna call?", The White House? Greenspan? To Krugman:

Who ya gonna call? Paul Krugman, March 17:

Um, on second thought

Nouriel is right: this is the worst financial crisis since the Great Depression, and the Fed, with the best will in the world, probably lacks the tools to deal with it. Broader action is necessary.

But then comes the question: who ya gonna call?

The Gang That Couldn't think Straight still holds the White House; no good ideas will come from that quarter. Worse, Incurious George would probably veto any sensible plan from Congress, even if said plan could get past a filibuster.

Hey, here's an idea! Let's create a nonpartisan expert commission, headed by Alan Gr …. oh, wait. He's part of the problem. In fact, is there any way we can repossess his book royalties?

Seriously, it's very hard to see who can take charge.

Things fall apart, and the center doesn't exist.

PS. Most of what I dig up and find "most interesting to share", I now distribute via Google Reader on my Econ Dreams - Nightmares sidebar.

US Fed Caught Between Rock and Hard Place

At Economist's View, Tim Duy tries to sort out Bernanke and Co.'s next moves. In short the Fed risks a dollar collapse on one horn of its dilemma and a systemic banking crisis on the other. Which path will they choose? Or is there some way to steer clear of a near-term-future in which the ever-vocal, times-past market cheerleader Alan Greenspan says we will see many banks failing (Financial Times, March 17). Here's Duy:

Fed Watch: Anything and Everything is On The Table, Tim Duy, March 17: … [P]olicy may soon be dangerously close to the having to choose between a collapse of the Dollar and a more generalized banking crisis. Another description of this tradeoff comes from Fed Chairman Ben Bernanke in a 1995 paper, The Macroeconomics of the Great Depression: A Comparative Approach:

A particularly destabilizing aspect of this process was the tendency of fears about the soundness of banks and expectations of exchange-rate devaluation to reinforce each other (Bernanke and James 1991; Temin 1993). An element that the two types of crises had in common was the so-called "hot money," short-term deposits held by foreigners in domestic banks. On one hand, expectations of devaluation induced outflows of the hot-money deposits (as well as flight by domestic depositors), which threatened to trigger general bank runs. On the other hand, a fall in confidence in a domestic banking system (arising, for example, from the failure of a major bank) often led to a flight of short-term capital from the country, draining international reserves and threatening convertibility. Other than abandoning the parity altogether, central banks could do little in the face of combined banking and exchange-rate crises, as the former seemed to demand easy money policies while the latter required monetary tightening.

To be sure, Bernanke is describing the Fed's tradeoff during the Great Depression, when it was constrained by gold standard. Still, the basic problem remains. Tight policy would accelerate and intensify the pain in the banking system, but loose policy could destabilize the Dollar, causing capital to flee the US and also undermining the banking system. And, to make matters worse, a collapse in the banking system due to tight money could then trigger a currency collapse.

I think it is safe to describe this as a no-win situation, which means an ugly choice has to be made. And, with this in mind, perhaps the Fed only offered 25bp on the discount rate in hopes they could avoid a greater than 25bp cut in the Fed Funds rates. At this point, that does not look like an acceptable domestic policy choice, and if they ultimate cut 50bp or more, they have accepted the risk of destabilizing the Dollar.

I have to imagine that global central banks are ready to intervene at the drop of a hat, and would not be surprised by some action when New York opens Monday. If there is an intervention, it will be interesting to see if the Fed participates. Could the Fed credibly buy the Dollar one day while cutting rates 75bp or more the next? And what are the odds of a successful intervention if the monetization option looks increasingly viable in the weeks ahead?

[N]othing but tough policy questions at this juncture. …

Bottom Line: An aggressive cut in the Fed Funds rate seems likely, with 100bp certainly on the table. Still, one has to ponder why this was not part of the Sunday policy package. Could it really be as simple as not being able to contact enough FOMC members to have a teleconference? Or was it hope that a bigger than 25bp Fed Funds rate cut might not actually be necessary? Or has the Fed come to believe that their policy actions might trigger a destabilizing fall in the Dollar? At this point, I anticipate a cut larger than 50bp, with even odds on 75 and 100. The greater the cut, the more the Fed is willing to risk a Dollar collapse.

Financial 'Meltdown Moment': Thomas Palley Suggests a Solution

Everyone paying attention to our current financial mess seems to be scratching their head, wondering just what might get us out. Paul Krugman threw up his hands earlier today. Thomas Palley to the rescue! Palley suggests simply that the Federal Reserve "open its term auction facility to all publicly traded financial intermediaries rather than just deposit taking institutions." Sounds reasonable to me, but I only watch from the sidelines.

I suspect that such a move would have some banks trembling in their boots, since they would have to play on a more level playing field than they are used to. I'm sure that some libertarians will scream, perchance for good reasons, that this is getting us one step closer to dreaded big-brother land. It will be interesting to see if Palley's suggestion garners favorable response, and from whom. To Palley:

Meltdown Moment: What Must be Done: … In today's crisis environment the problem in financial markets is not the level of interest rates, or even the size of the Fed's term auction facility. The problem is getting liquidity to those links in the financial chain that are most stressed. Reliance on the normal channels of distribution does not work when confidence has evaporated and markets have seized-up.

There is a very simple and fair solution to this problem. That solution is for the Federal Reserve to open its term auction facility to all publicly traded financial intermediaries rather than just deposit taking institutions. That means giving access to insurance companies, mortgage investment trusts, mutual funds, and hedge funds. These firms would be subject to the same borrowing terms as banks, and would have to post collateral of identical quality.

Such a change would level the playing field in financial markets and remove the unfair subsidy to banks. Most importantly, it would tackle the problem of credit market seizure that is afflicting all financial institutions. In a world where distinctions between financial intermediaries have become increasingly blurred, broadening access to the term auction facility is the logical and correct policy.

The Federal Reserve's current policy is failing because it is structured for the world of the past in which depository institutions dominated lending. Thus, current policy restricts access to emergency liquidity to deposit taking institutions, ignoring how lending has become detached from deposit taking. The challenge of the day is preventing a meltdown that destroys sound lenders and sound assets. That calls for widening access to temporary emergency liquidity. Afterward, there will be time to visit the question of regulatory reform and more permanent policy change.

Marc Faber Takes Fed to Task

Worth Watching: 15 Minutes with Marc Faber

Click for Video

Bloomberg News Video, March 5
Hat Tip: The Big Picture

Early this year I began to pay less attention to bearish views than for the past several years. Marc Faber is, of course, the king of the bears—but not the only bear I've drawn inspiration from. Most likely the fact that I'm now discounting hyper-bear rhetoric is a signal that investors should run for cover. Still, the US dollar plumbs new depths each day, and US exports surge providing some hope that we can indeed work our way out of our mess. Yes, US consumers are, on average, "in over their heads." And there are signs of US recession at every turn. And yes, the world is not highly decoupled from the US. Still, there are reasons to at least be hopeful. Just as there are reasons to believe that financial derivatives time bombs may still detonate.

Faber begins with a declaration that the US is already in a recession. Then follows with "gloom and doom", i.e. world markets being positioned for a bust, following 76 months of boom.

Faber follows up with a shot across the bow of the US Fed, and blames both Greenspan and Bernanke for the mess we are now in. So have I, in earlier musings. But Faber goes further and suggests that Bernanke will destroy the US dollar. I disagree. I believe that Bernanke and other major league central bankers are just trying to keep the world's currency markets solvent. Bernanke's next steps will be telling — or not — since if we are in a liquidity trap the Fed is pretty much impotent in any case.

Faber then goes on to talk about markets. Faber believes that Gold may go higher. But he really likes sugar. I'm not into commodity trading — or trading generally — so I'll leave that for what it may be. Besides, I missed this Gold rush early on, and will likely leave it alone now.

Faber also thinks Google, Apple, and RIM [Research in Motion LTD, (Nasdaq: GS:RIMM)] will all see at least a 50% reduction from their recent highs. Maybe. If so I might even take a bite of Google, as I did long ago with Apple (minor personal disclosure). {Update: Here is Fortune, Mar 7, on Apple v. RIM's Blackberry going forward.}

Faber also notes, importantly, that the US S&P 500 is not pricey in terms of Euros, indeed the S&P 500 is down 50% from its peak in 2000. Question is, What next for international currencies?

Faber believes that dollar devaluation will likely continue and we will see the imbalances work out there rather than in "asset declines in nominal terms measured in US dollars." China and India stock markets, by contrast may correct 30% to 40%. Finally, US Long Term Bonds, are, in Faber's opinion a "disaster waiting to happen", as are Long Term Treasuries.

Finally, Faber also says he hopes to see a major bank in the US fail, if only to see some discipline rebuilt into the US financial system. I want to see such discipline too, and suspect it will not be forthcoming short of more pain felt in the banking community that brought us to the brink of the abyss.

Minsky Moment and Trillion Dollar Meltdown: What might Help?

George Magnus, UBS Senior Economic Advisor, widely credited for popularizing the "Minsky Moment" phrase a year ago, once-again invokes Hyman Minsky and suggests that we are likely facing a Trillion dollar financial meltdown when all eventually gets added up. And he says that "fixing the problem" goes way beyond simple Monetary Policy fixes. Legislative and regulatory fixes will need to accompany monetary policy fixes.

Magnus believes that Ben Bernanke sees the crisis in proper perspective and believes that the US Fed is doing what is necessary, although not sufficient to stem the worst outcomes from this crisis. Here is a link to three-part video (3 minutes per part, Feb 25) featuring Magnus as interviewed by Financial Times Gillian Tett. In part three, Magnus predicts a Credit Crisis Bailout (by the US Government and others) by October.

Meanwhile, US Treasury Secretary Henry Paulson is in full attack mode as to a Credit Bailout. And Allan Meltzer suggests (Feb 28) that, far from doing what appears proper and necessary, the Fed is repeating the mistakes of the 1970s.

Of the three, I think Magnus is more likely correct.

P.S. I'm wandering off for a few days skiing in the Utah mountains.

Bill Gross: Mr. Bernanke - we have a problem

Bill Gross's Feb 1 Investment Outlook is worth a look. Echoing Paul Krugman, Gross suggests that we now need some deep Keynesian stimulus, not the 'Stimulus Lite' fare being bandied about by the Bush Administration and the Congress. Implicitly, but without any real plan to make it happen, Gross also suggests we need to return to earlier fundamentals of honesty and thrift, abandoning the 'quick fix' mentality that has at once encouraged speculation and outright financial fraud and buried the American middle classes under mountains of debt. Soundbite: "[T]he U.S. economy and its somewhat coupled global companion will sleep walk for some time and a resumption of prosperity as we knew it will be dependent on reforms of monetary and fiscal policy resembling the 1930s more than our past decade." Here's more:

Bill Gross, Better Late than Never, Feb 1: … Paul Krugman, …, proposing revolutionary solutions for the Japanese recessionary malaise of the 1990s and writing a book in 1998 entitled The Return of Depression Economics … referred to the fact that the crucial task of future policy would be to bolster demand as was the case in the FDR-driven 1930s as opposed to encourage supply which has been the case since the Reagan revolution. Although Krugman doesn't comment, in my opinion, it's not that Reagan was wrong — he was in fact brilliantly correct and timely in his supply-side revolution.

Iverson aside: I can't go along with Gross here. I find the very idea that Reagan "was brilliantly correct" repulsive. I believe that Reagan helped to mislead the US, and helped jump-start a 30+ year-long "irrational exuberance" party that is now unwinding badly. Back to Gross:

That pendulum, however, appears to have swung too far in the direction of the private market. But Krugman (and yours truly) was a tad early in his forecast for reversal I think, because of the failure to recognize the potency and the inventiveness of modern finance.

Until recently, U.S. and therefore global demand has been driven by the ability to lower interest rates and extend credit to an increasing majority of Americans. Mortgages, auto finance, and credit cards were offered on increasingly liberal terms and continually lower yield and risk spreads because of Wall Street ingenuity and — importantly — the naïve endorsement of their black magic by rating services willing to sell AAAs for a fee. … Demand, as Krugman would likely retrospectively recognize, was bolstered and supported by innovative, securitized finance which in turn was nurtured by lax regulation and a belief that things could not go wrong — and if they did — that policy makers, both monetarily and fiscally oriented, would make things right. The repair, if needed, was labeled the "Keynesian compact" and it made for a deal with the American public: it would be OK to have free markets because policymakers know enough to prevent another Great Depression. Demand could always be stimulated with a combination of easy money/budget deficits. Prosperity in effect, was guaranteed.

Well "probably" guaranteed — but the historic growth rate of that prosperity may now be threatened. Because demand in the form of consumption has been artificially and fictitiously stimulated in recent years by financial engineering run amuck, there is a legitimate question as to whether its black hole imploding destructiveness can be totally countered with another dose of lower yields and deficit spending packages. The $150 billion "return to sender" deficit plan advanced by Bush and the Congress, for instance, amounts to just 1% of GDP and is labeled temporary. It will be of marginal benefit to long-term prosperity. To understand why, consider that the productivity of our economy ultimately depends on its ability to 1) innovate, and 2) save and invest, and that there is little of either in this stimulus package. Some have even suggested — and with my somewhat grudging concession — that this package will help the Chinese economy more than ours. Americans will use the rebates to buy Chinese imports offered at Wal-Mart and the $150 billion will then wind its way inevitably back to Asian coffers. The U.S. needs a Krugman "demand-based" fiscal package alright, but a $300-$500 billion permanent one, in addition to the proposed temporary package, because as mentioned in last month's Outlook [Pyramids Crumbling], as the system of modern day levered shadow finance slows to a crawl or even contracts at the edges, its ability to systemically fertilize economic growth must be called into question. But government writing checks for American consumers which then flow to foreign central banks is not the permanent solution; it only makes sense in the short-term as a life preserver. To provide a stable recovery path, government spending needs to fill the gap — not consumption. Public works programs, badly needed infrastructure repairs, as well as spending on research and development projects should form the heart of our path to recovery. Assistance for homeowners? That too — figure out a fiscal/regulatory way to stop the slide in housing prices and foreclosures but please — no traffic jams at the Wal-Mart checkout counter in 2009 and beyond.

Approaches to monetary policy must change as well. 1% short rates were so effective 5 years ago that they not only bolstered demand but created a housing bubble of Frankensteinian proportions. Those days, however were influenced by the creation and implementation of adjustable-rate mortgages (ARMs) that were priced at the short end of the yield curve. Millions of ARMs were issued at 2% and 3% teaser rates, many with terms of up to 5 years before their inexorable adjustment upwards. Surfeits of houses were bought at artificial prices because of these generous terms and billions in home equity loans were taken out — both driving demand and the economy forward. But adjustable-rate mortgages are a dying relic. Originators will no longer offer them except on onerous terms. No more teasers or pleasers of that ilk; there are regulators to deal with, and lawyers on the prowl with class action lawsuits in their briefcases.

And so the monetary attempt to halt housing's — and therefore the economy's — downward slide rests on the shoulders of the 30-year mortgage. If so, then Mr. Bernanke — we have a problem. First of all these 6-7% 30-year mortgages now require a significantly higher down payment than in prior years. 20% down? Say what? Where does a 30-year-old couple get that kind of money? Secondly, however, and just as important, what motivates a future homeowner to pay 6%+ interest for an asset that is going down in price? It was an easy decision to pay subprime yields of that and then some when housing prices were accelerating at double-digit annual percentages; the benefit was obvious. Now however, with prices in negative territory, the risk/reward is tilted towards the renter.

My point is that Chairman Bernanke must recognize the reduced benefits and obvious dangers of a déjà vu trek to 1% short rates. Those yields produced 5% 30-year mortgage rates to the homeowner for a 2-3 month period in 2003 and they could do so again, but bubble creating, inflation inducing damage to the U.S. dollar would be the likely result now. Best to stop far short of 1% and at the same time encourage reforms in FHA government assisted programs that would permit subsidized mortgage rates with minimal down payments.

An artificially low, 1% short-term interest rate was an elixir during the days of a burgeoning shadow banking system. It cannot be the solution now.

In combination, a well constructed, more than temporary fiscal/monetary stimulus plan is what is required to rejuvenate a U.S. economy reeling from a low punch delivered by a private market economy gone too far. Its "Rosemary's Baby" took the form of a shadow banking system based on leverage and the fateful conclusion that a finance-based economy alone can deliver prosperity. It cannot. As Keynes theorized and then Krugman affirmed, when private demand falters, it becomes the responsibility of government to fill the breach. Because it likely will not do so effectively until after a new Administration is elected in late 2008, the U.S. economy and its somewhat coupled global companion will sleep walk for some time and a resumption of prosperity as we knew it will be dependent on reforms of monetary and fiscal policy resembling the 1930s more than our past decade. Better late than never.

Dean Baker: More Transparency, Accountability Needed from Fed

Dean Baker recommends that the media and the American people need to hold the Fed accountable as part of US Government, rather than allowing it to act as a mostly-owned subsidiary of Wall Street banks. Sounds reasonable to me. Here's Baker:

Profit motive, Dean Baker, Feb. 5: Much of the policy elite hold the view that the Federal Reserve's conduct of monetary policy is best carried through in the dark, far way from political debate. This is a profoundly anti-democratic attitude, since the Fed's monetary policy is likely to have far more impact on the economy than anything the politicians spend their time screaming about as the elections roll around.

And we all know that the Fed has done an absolutely atrocious job in managing the economy in the last decade. First, Alan Greenspan adopted the view that financial bubbles are cute and decided to let the stock bubble expand until it had created nearly $10 trillion in wealth. Its collapse gave us the 2001 recession. While Greenspan was confident that he could easily deal with the fallout from a stock bubble recession, the fact is that we did not regain the lost jobs until the very end of 2004.

Furthermore, Greenspan relied on the growth of another bubble, in housing, to escape the damage from the stock bubble. This bubble is now bursting, giving us yet another recession, which promises to be much longer and deeper than the last one. This track record suggests that the Fed is in need of some very real oversight.

Unfortunately, the media still treat the Fed as being above the political realm. They never question whether its policies are designed to serve the economy or special interests, such as the major Wall Street banks.

If the media did apply serious scrutiny to the Fed's conduct of monetary policy, they might well be asking about the motives for the most recent round of rate reductions. There can be little doubt that the economy is in serious trouble and badly in need of stimulus, but it is not clear that the recent rate cuts will provide a boost to growth. …

There is one route through which lower interest rates will boost the economy. They should help push down the value of the dollar. This will help to boost exports and reduce our trade deficit, although the cost will be somewhat higher inflation, which is undoubtedly one of the factors explaining the jump in long-term interest rates.

It may be that Fed chairman Ben Bernanke is consciously pursuing a lower dollar as the best way to stimulate the economy, but it would be useful if he explained this policy. An explicit commitment to a low-dollar policy is likely to help bring about the goal of a lower dollar, since the statement will affect investors expectations.

It would also be helpful if Bernanke would explain his policy because there is an obvious alternative, less benign, explanation. When banks borrow money they pay the short-term rate. They mostly lend money at the long-term rate. Fed actions that increase the spread between long-term and short-term rates directly increase bank profits. Those with a suspicious mindset might think that the Fed is more interested in beefing up the profits of banks that are rolling in bad debt than in boosting the economy.

Along these lines, the special "term auction facility" that the Fed created to allow banks to borrow money in secret also raises serious questions. The Fed claims to have established this mechanism because it was worried that financial markets attach a stigma to borrowing from the Fed. Whether or not the financial markets are right to attach a stigma, the TAC creates a group of insiders that know about bank borrowing and a group of outsiders who remain clueless.

The country did not get into the current crisis because of too much transparency. There seems little reason to depart from the Fed's longstanding practice of publicly disclosing bank borrowings from the Fed.

It is impossible to know the motivations of Bernanke and the other Fed governors, but there are certainly grounds for suspicion that they may hold the interests of the major Wall Street banks above the interests of the general public. The Fed is an arm of the government, and it is long past time that its conduct of monetary policy received the full scrutiny of the media and Congress.

Financial Crisis: '20 Years in the Making'

Doug Noland tells us — preaching to the choir, since no one else will listen — that the stage for the mess now unfolding was built on a foundation laid over 20+ years by US Federal Reserve policy, cheerled by Wall Street finance. Noland says, "The unfolding financial and economic crisis has been more than 20 years in the making. It's a creation of flawed monetary management; egregious lending, leveraging and speculating excess; unprecedented economic distortions and imbalances on a global basis. And I find it rather ironic that Wall Street is so fervidly lambasting the Fed. For twenty years now the Fed has basically done everything that Wall Street requested and more." Here's more:

More than 20 Years in the Making, Doug Noland, Credit Bubble Bulletin, Jan. 25: … When the junk bonds, LBOs, S&Ls, and scores of commercial banks all came crashing down beginning in late-1989 to 1990, the Greenspan Fed initiated an historic easing cycle that saw Fed funds cut from 9.0% in November 1989 all the way to 3.0% by September 1992. In order to recapitalize the banking system, free up system Credit growth, and fight economic headwinds, the Greenspan Federal Reserve was more than content to garner outsized financial profits to the fledgling leveraged speculator community and a Wall Street keen to seize power from the frail banking system. Wall Street investment bankers, all facets of the securitization industry, the derivatives market, the hedge funds and the GSEs never looked back — not for a second.

In the guise of "free markets," the Greenspan Fed sold their soul to unfettered and unregulated Wall Street-based Credit creation. What proceeded was the perpetration of a 20-year myth: that an historic confluence of incredible technological advances, a productivity revolution, and momentous financial innovation had fundamentally altered the course of economic and financial history. The ideology emerged (and became emboldened by each passing year of positive GDP growth and rising asset prices) that free market forces and enlightened policymaking raised the economy’s speed limit and increased its resiliency; conquered inflation; and fundamentally altered and revolutionized financial risk management/intermediation. It was one heck of a compelling — alluring — seductive story.

But, as they say, "there's always a catch". In order for New Age Finance to work, the Fed had to make a seemingly simple — yet outrageously dangerous — promise of "liquid and continuous" markets. Only with uninterrupted liquidity could much of securities-based contemporary risk intermediation come close to functioning as advertised. Those taking risky positions in various securitizations (especially when highly leveraged) needed confidence that they would always have the opportunity to offload risk (liquidate positions and/or easily hedge exposure). Those writing derivative "insurance" — accommodating the markets' expanding appetite for hedging — required liquid markets whereby they could short securities to hedge their risk, as necessary. There were numerous debacles that should have alerted policymakers to some of New Age Finance's inherent flaws (1994's bond rout, Orange Co., Mexico, SE Asia, Russia, Argentina, LTCM, the tech bust, and Enron to name a few). Yet the bottom line was that the combination of the Fed's flexibility to aggressively cut rates on demand; ballooning GSE balance sheets on demand; ballooning foreign official dollar reserve holdings on demand; and insatiable demand for the dollar as the world's reserve currency all worked in powerful concert to sustain (until recently) the U.S. Credit Bubble — through thick and thin.

Despite his (inflationist) academic leanings and some regrettable ("Helicopter Ben") speeches as Fed governor, I do believe Dr. Bernanke aspired to adapt Fed policymaking. His preference was for a more "rules based" policy approach of setting rates through some flexible "inflation targeting" regime, while ending Greenspan’s penchant for kowtowing to the markets. Today, it all seems hopelessly naïve. Inflation is running above 4%, while the FOMC is compelled to quickly slash the funds rate to 3%. And never — I repeat, never — have the financial markets been more convinced that the Federal Reserve fixates on stock prices while is permissive when it comes to inflationary pressures. Today, the contrast to the ECB and other global central banks could not be starker. The Fed has climbed way out on a limb, and it is difficult at this point to see how they regain credibility as inflation fighters or supporters of the value of our currency. It is not only trust in Wall Street-backed finance that is being shattered.

The greatest flaw in the Greenspan/Bernanke monetary policy doctrine was a dangerously misguided understanding of the risks inherent to their "risk management" approach. Repeatedly, monetary policymaking was dictated by the Fed's focus on what it considered the possibility of adverse consequences from relatively low probability ("tail") developments in the Credit system and real economy. In other words, if the markets (certainly inclusive of "New Age" structured finance) were at risk of faltering, it was believed that aggressive accommodation was required. The avoidance of potentially severe real economic risks through "activist" monetary easing was accepted outright as a patently more attractive proposition compared to the (generally perceived minimal) inflationary risks that might arise from policy ease. As it was in the late 1920s, such an accommodative ("coin in the fuse box") policy approach is disastrous in Bubble environments.

The Fed's complete misconception of the true nature of contemporary "inflation" risk was a historic blunder in monetary doctrine and analysis. To be sure, the consequences of accommodating the markets were anything but confined to consumer prices. Instead, the primary — and greatly unappreciated — risks were part and parcel to the perpetuation of dangerous Credit Bubble Dynamics and myriad attendant excesses. Importantly, the Fed failed to recognize that obliging Wall Street finance ensured ever greater Bubble-related distortions and fragilities — deeper structural impairment to both the financial system and real economy. In the end, the Fed's focus on mitigating "tail" risk guaranteed a much more certain and problematic "tail" — a rather fat one at that.

Fundamentally, the Greenspan/Bernanke "doctrine" totally misconstrued the various risks inherent in their strategy of disregarding Bubbles as they expanded — choosing instead the aggressive implementation of post-Bubble "mopping up" measures as necessary. They were almost as oblivious to the nature of escalating Bubble risk as they were to present-day complexities incident to implementing "mop up" reflationary policies. "Mopping up" the technology Bubble created a greatly more precarious Mortgage Finance Bubble. Aggressively "mopping up" after the mortgage/housing carnage in an age of a debased and vulnerable dollar, $90 oil, $900 gold, surging commodities and food costs, massive unwieldy pools of speculative global finance, myriad global Bubbles, and a runaway Chinese boom is fraught with extraordinary risk. Furthermore, the Fed's previously most potent reflationary mechanism — Wall Street-backed finance — is today largely inoperable. …

It is also as ironic as it was predictable that Alan Greenspan — Ayn Rand "disciple" and free-market ideologue — championed monetary policies and a financial apparatus that will ensure the greatest government intrusion into our Nation’s financial and economic affairs since the New Deal. Articles berating contemporary Capitalism are becoming commonplace. I fear that the most important lesson from this experience may fail to resonate: that to promote sustainable free-market Capitalism for the real economy demands considerable general resolve to protect the soundness and stability of the underlying Credit system. …

Finally Sir Alan, Have You No Sense of Decency?

Just days after Mark Thoma asked for a moratorium on Fed bashing, Yves Smith finds himself pushed over the edge by a Financial Times story exposing Greenspan's latest antic: becoming an advisor to hedge fund Paulson & Co., noted for making a killing during last fall's credit squeeze. To Smith:

Ooh, I am ill. … In keeping with Greenspan's tutelage at the knee of Ayn Rand, he has exercised his right not to be constrained by propriety or other rules that govern little men and has gone and sold himself to what is no doubt the highest bidder, Paulson & Company. …

It's one thing for Greenspan to sell books and give speeches to try to salvage his reputation. Nixon did that too, with more success and less profit. It is quite another for him to benefit in a far more direct fashion from the devastation he created, by hooking up with the fund that scored the biggest kill from the worst aspects of the negative real interest rates that Greenspan put into effect.

Overly cheap credit always and inevitably leads to bad investments, And Greenspan of all people should have known that. How he can rationalize his actions then and now is beyond me. But I forgot. Objectivism means never having to say you're sorry.

Actually, it is worse than that. More than 50 years ago, this country could be awakened from its nightmare of Joe McCarthy-led Communist-in-every-closet witch hunting by the exposure of McCarthy's methods in the first nationally televised Congressional hearings. The pivotal moment occurred when a Boston lawyer, Joseph Welch, rebuked McCarthy with the now-famous phrase, "Have you no sense of decency, sir, at long last? Have you left no sense of decency?"

But decency and propriety mean nothing in America these days. What used to be recognized as corruption is now shrugged off as business as usual. When a nation loses its moral compass, it also loses its soul. …

I'm with you Yves. Still Mark's points are, as usual, well taken. In particular Thoma notes:

Market participants didn't properly account for risk -- they had too much confidence in the ability of the Greenspan Fed to insulate the economy and financial markets from large fluctuations.

That's why they got so exuberant. They gave the Fed too much credit for the "Great Moderation."

If current market troubles wake these participants up to the risks they face, not because they think the Fed is incapable, but because they now get the risky nature of their environment, that will put a damper on the self-feeding financial frenzies.

And that would be a healthy development for us all.

I continue to give Bernanke and Co. the benefit of the doubt. But that benefit is not granted to Greenspan!

Deconstructing 'Recession 2008?'

I spent an hour yesterday listening to three economists (Brad DeLong, Mike Mandel, and William Beach) discuss our current plight. I found their insights compelling. Areas of agreement, included:

• Don't look to the US Government for effective Fiscal Policy Help — particularly in an election year
• Don't look to the Fed to ease much pain since they are pretty much helpless in the face of a faltering US housing market (See Krugman too)
• Best we can do is to see both borrowers and lenders share the pain, with some pain (how much?) shared by the rest of us

The forum was hosted by Dave Iverson (a different, more erudite Dave Iverson) and aired on KQED, NPR, San Francisco. It's well worth an hour of your time, if only to get better acquainted with Brad DeLong's longer-than-a-post reflections (but skip the questions and answers). From Delong's Grasping Reality…

KQED | Forum: Recession 2008? [Jan. 11]

http://www.kqed.org/.stream/anon/radio/forum/2008/01/2008-01-11a-forum.mp3

Host: Dave Iverson

Guests:

• Brad DeLong, professor of economics at UC Berkeley
• Mike Mandel, chief economist for BusinessWeek
• William Beach, senior economist and director at the Center for Data Analysis at the Heritage Foundation

Catching up on Financial 'Interesting Times'

Let's begin with Paul Krugman's Dec 14 Authors@Google Series video on how we got into our current financial mess and some "mysteries" on how we might get out of it this side (or the other side) of a 'hard landing.' In this very good hour with Krugman, he covers the previous Long Term Capital Management induced mess, the Nasdaq "tech bubble", the housing bubble, the Fed, "financial innovation", and more. Good insights for we who don't spend 24/7 dealing with matters financial:

Krugman believes that the housing mess is with us for about the next six years, guessing, based on early '90s S. California housing bust, with an average 30% price drop (in "real" dollars) from "bubbleicious" peaks. In a blog post today, Unknown Housing Territory, Dec 19, Krugman gives us more:

… The bubbles in the most bubbleicious areas were bigger than anything we've ever seen — and there's every reason to think that the required fall in prices in those areas will be much bigger than anything we've seen since the Great Depression. …

In the video, Krugman admits being surprised by the enormous impacts of the housing and related credit crunch have on the "financial system". He highlights how the Fed has been 'behind the curve' on dealing with this latest crisis, naïvely believing that the same medicine that 'solved' the LTCM mess years ago would suffice here. Since that medicine didn't work this time, Krugman gives us glimpses of the newer approaches central bankers are trying to put into play.

One Highlight: Glassman's law, as a correlary to Stein's law (also from Bubble Denial, Dec 10 on Krugman's blog):

… [B]ack in 2005, when I started writing about the housing bubble — it didn't take much to see that something was way out of whack.

So how come the housing crisis has come as such a surprise to so many people?
Part of it was the usual bubble psychology. Economists like to cite Stein's Law: "If something cannot go on forever, it will stop." I think it needs to be paired with another law — let's call it Glassman's Law — along the lines of "If something unsustainable goes on for a while, there will be people claiming it can go on forever."

According to Krugman, everybody looks to the 1998 'fix' for the Long Term Capital Management debacle as a model for this episode. Problem is, that strategy doesn't seem to be working this time. The 'fix' as applied last August, seemed to work for awhile, but 'trouble' is now welling up again. So the Fed and other Central Bankers are now trying hard to funnel short- to medium-term liquidity into the system.

Krugman is hoping this latest, belated effort from central bankers will work, although he suggests there are no 'quick fixes' to this mess — adding that we still don't even know the size and extent of the mess. "Steve Cechetti is hopeful but has his doubts", says James Hamilton in his Monetary Policy Using the Asset Side of the Fed's Balance Sheet, Dec 16. Whatever you read from these extended hyperlinks, don't miss Cechetti's The Art of Crisis Management: Auctions and Swaps, Dec 16.

Noruiel Roubini is even less sure that even this latest easing will help , although he has been advising central bank "easing" for some time. See Roubini: First, Central Banks Are Getting Desperate in Dealing with the Liquidity Crunch …, Dec 18, and second, Why Monetary Policy Easing is Warranted Even in the Current Insolvency Crisis, Dec 15

Finally, Michael Shedlock (as an interesting member of the Libertarian Right) is apoplectic, not only at what he considers continuing mis-steps by the Fed, but also since Roubini, whom he admires as a forecaster, doesn't buy Shedlock's particular brand of 'free market fundamentalism': asking for the Fed to be abolished and for a return to the gold standard and private banking. See Shedlock's Missing the Boat on Monetary Easing, Dec 18.

Quite a bunch of interesting stuff out and about! Mostly I just sit back and read from the really good commentators I track on my sidebar (and my Google Reader). I don't pretend to be in the same league as they are on matters of finance and geopolitics. But I do like to try to sort out some of it, second hand. Ocasionally I even help others in their own sorting, and that makes this little hobby of mine worthwhile.

Happy Holidays to those who are celebrating such during this season.

Doug Noland: Tight "Money"

Noland's excellent Fed-Watch commentary continues. This week Noland argues that "the Fed is in the midst of another of its aggressive loosening cycles", and that "loosening" may not play out as in recently-earlier times because "trust" has been squantered:

Tight "Money", Doug Noland, Credit Bubble Bulletin, Nov 30: … Between June 30, 2004 and June 29, 2006, the Federal Reserve raised rates from 1% to 5.25%. During this period of significant Fed "tightening", "money" became progressively looser. More accurately, Credit and Financial Conditions loosened in the face of rising short-term interest rates. Today, the Fed is in the midst of another of its aggressive loosening cycles. Credit Conditions are today tight, and there is the distinct possibility that they will remain taut or possibly tighten further.

The Fed receives too much Credit for the "efficacy" of past easing cycles. Going all the way back to the then extraordinary rate slashing from the early-nineties (23 straight cuts!), it was actually the burgeoning power of Wall Street Finance providing the brut force behind Fed "reliquefications" and "reflations." The evolving securitization markets and government-sponsored enterprises were the key mechanisms driving system Credit expansion when the banking system was severely impaired back in 1991/92. By 1993, the blossoming leveraged speculating community had become a major force, taking highly leveraged positions in U.S. (and Mexican!) debt securities, in the process significantly augmenting system Credit Availability and Marketplace Liquidity. By the time of the "Asian Contagion" and then Russian/LTCM crisis, leveraged speculation throughout the (global) debt markets had become a prevailing source of system Credit and liquidity creation.

Having first nurtured "Wall Street finance" to buck the banking system "headwinds" early in the nineties, by the end of the decade Fed accommodation had fashioned the most powerful "reflationary" tool in the history of central banking. Simply tinker with rates or signal lower prospective market yields and the enterprising speculators would quickly lever up on risky debt instruments on demand. Never had it been so easy for a central bank to incite "animal spirits" and stimulate Credit and liquidity. The hedge funds, Wall Street firms and, increasingly over time, myriad global financial players forged both the Maestro's "genius," the American economic "miracle", and synchronized global asset and economic booms. In any case, the leveraged speculating community has been the force behind U.S. Bubble Economy Dynamics including $800bn Current Account Deficits, negative savings rates, destabilizing asset Bubbles, and so-called economic "resiliency."

I'll be quite surprised if this easing cycle lives up to market expectations. Most importantly, Wall Street Finance self-destructed over the past few years. Trust will not be returning anytime soon to "structured Credit products", meaning the securitization and derivatives markets are for quite some time impotent to play their usual "reflationary" role. This has been a momentous development, one certainly compounded by the role our major financial institutions came to play in structured finance and their resulting problematic Credit and market exposures. … [emphasis added]

Earlier in his "post", Noland provides an interesting picture of the California housing market:

California Watch:
November 28 - California Association of Realtors (C.A.R): "Home sales decreased 40.2% in October in California compared with the same period a year ago, while the median price of an existing home fell 9.9% … California's statewide median price was down $33,720 to $497,110, putting the two-month decline at a remarkable $91,860. …

New blog: "Economic Principles"

I just discovered economicprinciples.com. It's good. Here is a sample:

Greenspan Shrugged, David Warsh, Nov 25: … [I]f Greenspan was so prescient, why did permit the housing bubble to get so out of hand, before retiring as chairman of the Federal Reserve Board in 2006?

Suppose, as my friend expects, that the credit crunch is just beginning, that the worst is yet to come. Suppose that Bernanke is still in the throes of finding out just how great is the mess that had been left him by his predecessor, the Maestro. Suppose, too, that Greenspan is working overtime to protect his reputation, and is scarcely a disinterested source of information and commentary.

Suppose, in other words, that Greenspan had been right when in December 1996, when he raised the specter of "irrational exuberance;" right, too, in facilitating the remarkable boom of the late 1990s; but wrong in thinking that central bankers don't have to worry about preventing asset bubbles. …

[T]he S&P soared 31 percent in 1997 (after a famous Business Week cover story asserted that Greenspan now believed that the US economy had entered a "new era" of enhanced productivity; 26 percent in 1998, and 20 percent in 1999. In March 2000, the market peaked. By January 2001 the economy was sliding into a recession. Congress cut taxes; the Fed cut rates to as low as 1 percent in 2003. The recession proved to shallow and relatively short-lived.

But those record low interest rates kindled the housing bubble. …

The question of the moment is not so much one of rampant banker greed -- Fortune asked the other day "What Were They Smoking?" -- as one of failed regulation. As recently as April 2005, Greenspan himself was touting the rapid developments in securitization that permitted US banks to write nearly a trillion dollars of subprime mortgages and sell them in impenetrable packages to financial institutions around the world.

Today hardly anyone knows with any precision who owns what, much less what particular assets, once rated triple- and double-A, are worth today. Estimates of the necessary write-downs run as high as $'200 or even $300 billion. The situation is reminiscent of the savings and loan crisis of the late 1980s, except that then it was decentralized S&Ls and the developers to whom they lent who bore the brunt. This time the biggest banks are at risk, some of them of outright bankruptcy; pension funds, here and abroad, will report substantial losses; and, of course, tens of millions of individual homeowners will feel the pain. Only a fraction will lose their homes to foreclosure.

The darkest possibility was hinted at last week by Paul A. Samuelson, of the Massachusetts Institute of Technology, at 92 still the greatest public policy economist of the age, writing in the International Herald Tribune:

All through the years of the Great Depression, Wall Street publicists and President Herbert Hoover would repeatedly declare: 'Recovery is just around the corner.' They were wrong. And history repeats itself.…. …

Noland Debunks Greenspan's "No particular regrets" remarks

While I'm not yet ready to throw verbal rocks at Ben Bernanke, I certainly share Doug Noland's disdain for Alan Greenspan's behavior during the last decade and more. Here, with a few highlights, is Noland's latest view or where we stand and how we got here—cheerled by the US Fed:

No Regrets, Doug Noland, Credit Bubble Bulletin, Nov 23: November 23 – Bloomberg (Robin Wigglesworth and Craig Stirling): "Former Federal Reserve Chairman Alan Greenspan said he has 'no particular regrets' about his time at the central bank, adding that the deepening U.S. housing-market slump isn't result of his policies. 'Markets are becoming aware of the fact that the decline in house prices is not stopping,' Greenspan said… I have no particular regrets. The housing bubble is not a reflection of what we did, as it is a global phenomenon.'"

November 18 – Bloomberg (Anthony Massucci): "Former Federal Reserve Chairman Alan Greenspan said the dollar's decline hasn’t affected the global economy and is a 'market phenomenon.' 'So long as the dollar weakness does not create inflation, which is a major concern around the globe for everyone who watches the exchange rate, then I think it's a market phenomenon, which aside from those who travel the world, has no real fundamental economic consequences'…"

I don't know which of the two above quotes this week from Alan Greenspan I find more astounding. They are somehow equally despicable. The Greenspan Fed's fingerprints are all over the housing Bubble — at home and abroad. And they're everywhere when it comes to heightened global dollar and currency market tumult. Our much revered former Fed Chairman is making a fool of himself, a spectacle not all too supportive of confidence in our policymakers, Credit system, or currency.

Whether he will admit it or not, mortgage Credit inflation was central to the Federal Reserve's post-tech Bubble reflationary strategy. It really was a "Great Experiment" in inflationist monetary policy and, predictably, it failed miserably. The Fed and some notable Wall Street "strategists" feigned a system-wide "price level" that the Fed was obligated to adeptly manipulate to ensure that that evil “deflation” was not allowed to take root. What a crock. The risk was, then as it is now, U.S. Credit Collapse — and certainly not a somewhat deflating price level. Accommodating history’s most reckless Credit expansion over the past six years then ensured that the risk of collapse grew significantly greater while countermeasures turned increasingly unavailing.

I'll assume that the Fed simply lost control of mortgage Credit excesses. And as the risk of a devastating housing bust escalated, the Greenspan/Bernanke Fed became more ideologically intransigent in their opposition to pricking asset Bubbles. In this regard, Dr. Bernanke was Greenspan’s ideal surrogate. Unfortunately, we’re about to experience the consequences of the fundamentally flawed policy of ignoring Bubbles while they are inflating, choosing instead to wait for post-Bubble "mop up" duties. It was Greenspan himself decades ago that placed responsibility for the Great Depression on the Fed for repeatedly inserting "Coins In the Fusebox" during the Roaring Twenties. How differently would the world look today had the Fed not cut rates to 1% and left them at ultra-low levels for several years? How different would it be if the GSEs had kept their power dry, retaining financial resources to assist the mortgage market during this downturn instead of shooting all their bullets and more perpetuating the fateful Mortgage Finance Bubble? How differently would it be today if the dollar were fundamentally strong, instead of a currency carelessly debased to perpetuate an Economic Bubble?

As gatekeeper for the world's reserve Credit system and currency, to pass off our unfolding housing and financial messes as "global phenomena" would be laughable if it weren't so serious. "No particular regrets" Somewhere along the line the Federal Reserve lost sight of its fundamental mandate and responsibility — to protect the soundness and stability of our financial system and economy. Doubling our entire stock of mortgage debt in just over six years is certainly not consistent with price stability, financial stability, or economic stability — no matter what the reading on "core" CPI. And $800bn Current Account Deficits are an abomination and talk of a global "savings glut" shameful economics.

Moreover, it was our Credit system that led the world in the proliferation of securitizations, derivatives, leveraged speculation, Credit guarantees/insurance and highly tangled debt structures. And throughout his 18-year reign, Mr. Greenspan was the most vocal proponent of "Wall Street finance." He was the head cheerleader for securities-based risk intermediation, derivatives, dynamic hedging strategies, leveraged speculation and, generally, Credit Bubble Turned Global Financial Fiasco. If he were any kind of statesman, he would today at least be willing to admit where mistake were made.

U.S. mortgage excesses blighted the world. Credit systems around the globe adopted Wall Street securitization and derivatives practices, while incorporating uniform "risk management" strategies. Wall Street cut loose leveraged speculation to overrun financial systems around the world, while our Current Account Deficits were often "Recycled" back to high-yielding "structured products." And while not commonly recognized, U.S. mortgage Credit excesses and attendant Current Account Deficits concurrently debased the dollar while unleashing Credit systems globally. A complete lack of discipline — evolving into outright recklessness — at the "Core" nurtured rampant Credit and speculative excesses at the "Periphery". Bad "money" for the "reserve currency" equated to bad "money" proliferating throughout. And, let there be no doubt, monetary toxicity has progressed to the point where it has severely affected global Economic Structures. The situation will not be rectified by central bankers and an even greater bout of Credit inflation.

It is no coincidence that Greenspan made such ridiculous comments this week. As it has become increasingly apparent to the world that U.S. mortgage finance and the dollar are impending fiascos, our former Fed chairman is compelled to disavow responsibility. The housing Bubble is a "global phenomenon" and dollar weakness a "market phenomenon" with "no real fundamental economic consequences." It's stunning, and I can only contemplate how such nonsense sits with central bankers at the ECB, The People's Bank of China, The Reserve Bank of New Zealand, other European central banks, in the Middle East, and in Asia.

Outside of radically shifting financial, economic and geopolitical power away from the U.S. to the rest of the world, perhaps our policymakers' neglect of our currency hasn’t been of real consequence. Historians will look back at this period and have difficulty comprehending how a nation could have so indecorously squandered the benefit and privilege associated with reigning over the world’s reserve unit of exchange. Especially when it comes to energy resources, dollar devaluation has had momentous real consequences. Our vulnerabilities have been further exposed, while the standing of our competitors has been enhanced and our enemies empowered. Worse yet, the leading beneficiary of U.S. inflationism has been, not coincidently, the most unstable tinderbox region of the world. It is precisely these types of momentous inflation and economic consequences that manifest into financial and economic upheaval and calamitous global conflicts.

It was a short but eventful week. The Credit disaster unfolding at the GSEs came into clearer focus with the release of earnings from Freddie Mac. Agency debt and MBS spreads widened markedly. The mortgage implosion was at the brink of a major turn for the worst, with liquidity concerns spurring significantly wider Credit default swap prices for Rescap, GMAC, Countrywide, the Credit insurers, and financial institutions generally. The dominoes are lined up. Yet it is this type of acute stress that has always in the past extorted aggressive policymaker action. The Fed's traditional tool box, however, is woefully deficient to deal with impending Credit Collapse. I can only assume they're now diligently at work crafting new implements. [emphasis added]

Stiglitz on Greenspan's Mess

Greenspan 'Made a Mess' and U.S. Risks Recession, Stiglitz Says, Reed V. Landberg and Paul George, Bloomberg, Nov 16 … "Americans have been taking money out of their houses to finance a consumption binge," [Nobel-prize winning former World Bank economist, Joseph Stiglitz] said. … [The U.S. faces] "a very major slowdown, maybe recession."'

"Alan Greenspan really made a mess of all this,'" Stiglitz said. "He pushed out too much liquidity at the wrong time. He supported the tax cut in 2001, which is the beginning of these problems. He encouraged people to take out variable rate mortgages. That helped create the subprime crisis."

Can Structured Finance Survive?

That is this week's question from Prudent Bear's Doug Noland. As for me I have decided to take a "wait and see" attitude—since I don't have faith in anyone's ability to know the future— and since my long-term approach of living frugally, saving some small sums (in part by investing a bit in things I hope offer a bit of an "asset inflation" hedge), and staying debt free for the last 20 years will MAY allow us to weather whatever storms may be on the horizon. Too many others, however, ought to be rightfully much more worried than I am by Doug Noland and others' gloom and doom forecasts. Here is a shortened form of Noland's latest:

Structured Finance Under Duress, Doug Noland, Credit Bubble Bulletin, Oct 26: The market may be been perfectly content to brush it aside. It was … a brutal week for "contemporary finance." Merrill Lynch, a kingpin of structured Credit products, shocked the marketplace with a $7.9bn asset write-down — up significantly from the $4.5bn amount discussed just two weeks ago.… Street analysts have already warned of the possibility for an additional $4bn hit. Merrill is not alone.

Also hit by sinking CDO fundamentals, Credit insurer Ambac Financial reported a third-quarter loss of $361 million — it's first-ever quarter of negative earnings. The company posted a $743 million markdown on its derivative exposures, "primarily the result of unfavorable market pricing of collateralized debt obligations." Credit insurance compatriot MBIA also reported its first loss ($36.6 million), on the back of a $352 million "mark-to-market" write-down of its "structured Credit derivatives portfolio." …

MBIA and Ambac combine for about $1.9 Trillion of "net debt service outstanding" — the amount of debt securities and Credit instruments they have guaranteed, at least in part, to make scheduled payments in the event of default. Throw in the Trillions of Credit insurance written by the mortgage guarantors and you’re talking real "money." Importantly, the marketplace is beginning to question the long-term viability of the Credit insurance industry, placing many Trillions of dollars of debt securities in potential market limbo.

With recent developments — including the monstrous write-down from Merrill Lynch, the implosion in the mortgage insurers, and the losses reported by the "financial guarantors" — in mind, I'll revisit an excerpt from a January article by the Financial Times' Gillian Tett: "…Total issuance of CDOs…reached $503bn worldwide last year, 64% up from the year before. Impressive stuff for an asset class that barely existed a decade ago. But that understates the growth. For JPMorgan's figures do not include all the private CDO deals that bankers are apparently engaged in too. Meanwhile, if you chuck index derivative portfolio numbers into the mix, the zeros get bigger: extrapolating from trends in the first nine months of last year, total CDO issuance was probably around $2,800bn last year, a threefold increase over 2005. These startling numbers will certainly not shake the world outside investment banking. For, as I noted in last week's column, the CDO explosion is occurring in a relatively opaque part of the financial system, beyond the sight — let alone control — of ordinary household investors, or politicians."

Subprime and the SIVs are peanuts these days in comparison to the gigantic global CDO and Credit derivatives markets. CDOs may lack transparency, trade infrequently, and operate outside of market pricing ("mark-to-model"). Nonetheless, CDO exposure now permeates the entire global financial system — exposure that regrettably mushroomed in the midst of the most reckless end-of-cycle mortgage excesses imaginable. Rumors this week had major insurance companies suffering huge CDO losses. To what extent the big insurance "conglomerates" have exposure to CDOs and other Credit derivatives is unclear today, but there is no doubt that the global leveraged speculating community is knee deep in the stuff. Importantly, as goes the U.S. mortgage market, so goes the CDOs. I'm not optimistic.

I don't want to place undue weight on one month's data, but the California statewide median home price sank $58,140 over the month of September (down 4.7% y-o-y to $530,830). This was by far the largest monthly decline on record and the first year-over-year fall "in more than 10 years." September California sales were down 39% from a year earlier. Weakness was statewide ….;

We've definitely reached a critical point worthy of the question: Can "structured finance," as we know it, survive the California and U.S. mortgage/housing busts? I don’t believe so. For one, the historic nature of the Credit Bubble virtually ensures the collapse of the Credit insurance "industry" (companies, markets, and derivative counter-parties). The mortgage insurers are now in the fight for their lives, while the "financial guarantors" today face an implosion of their "structured Credit" insurance business. Worse yet, major problems in municipal finance (certainly including California state and municipalities) are festering and will emerge when the economy sinks into recession. It is worth noting that California revenues were $777 million short of expectations during the first fiscal quarter ….

Returning to the vulnerable CDO market, some key dynamics are in play. With California now at the brink, uncertain but huge losses are in the pipeline for jumbo, "alt-A," and "option-ARM" mortgages — loans that were for the most part thought sound only weeks ago. The market began to revalue the top-rated CDO tranches this week, a process that should only accelerate. "AAA" is not going to mean much. If things unfold as I expect, a full-fledged run from California mortgage exposure could be in the offing. And as the dimensions of this debacle come into clearer market view, the viability of the Credit insurers will be cast further in doubt … with ramifications for Trillions of securities and derivatives. General Credit Availability would suffer mightily.

With global equities markets in melt-up mode, it might seem absurd to warn that a troubling global financial crisis is poised to worsen. But Structured Finance is Under Duress. The entire daisy-chain of liquidity agreements, securitization structures, Credit insurance and guarantees, derivatives counterparty exposures and, even, the GSEs is increasingly suspect. Trust has been broken and market confidence is not far behind.

The big global equities and commodities surge over the past few months certainly has been instrumental in counteracting what would have surely been a problematic "run" from the leveraged speculating community. How long this spectacle can divert attention from the unfolding mortgage/CDO/"structured finance" debacle is an open question. I can't think of a period when it has been more critical for stocks to rise — and rise they have. Yet I suspect recent developments will now encourage the more sophisticated players to begin reining in exposure.

The nightmare scenario - where the market abruptly comes to recognize that the leveraged speculating is hopelessly stuck in illiquid CDO, ABS, MBS, derivative and equities positions - doesn’t seem all that outrageous or distant this week. [emphasis added]