Economic Dreams - Economic Nightmares

Export Our Way Out of Debt?

Over at Fed Watch, Tim Duy reminds us to be keenly aware of the subtleties of international finance — and simpleton thinking that there are quick fixes. If everybody tries to export their way out of their finance problem all will lose. So too if even a bunch of countries try. It is one thing to be rightfully worried about Europe and the PIIGS, but we need also add in worries later this year about the USA and California, NY, and other states (also counties and municipalities). For those of us who have lived long enought to have assets, where do we find a "safe haven"?  Or do we? At Clusterfuck Nation, James Howard Kunstler believes that it is "over," meaning Western Civilization. Kunstler believes that we have finally pumped up the ultimate bubble, government debt pretty much worldwide, and that all bets are now off. We'll see!  To Duy, We Can't All Be (Net) Exporters 4/29:

The Greek crisis, which helped further extend the Dollar's uptrend in place since the beginning of the year, is a reminder that global imbalances are still with us - and, if not corrected, will eventually threaten the sustainability of the global recovery. Indeed, how sustainable can any recovery be if the vast majority of nations are pursuing an export oriented growth strategy? After all, clearly that is not a game all can play - there needs to be a net importer to offset the net exports. Who wants to fill that role? If the US is pushed into filling that role, we have simply come full circle over the past three years.

The Administration is clearly aware of this challenge, but concerns are growing that any action will fall short of what is necessary to bring about real change. From Sudeep Reddy at the Wall Street Journal:

President Barack Obama's goal of doubling U.S. exports over the next five years will be difficult to meet, business leaders and economists say, because of the lack of momentum on demolishing trade barriers and the shift by more American companies toward producing overseas.

U.S. exporters want Washington to put more pressure on trading partners to eliminate tariffs, crack down on intellectual-property violations and take a harder line on trading partners' currency policies. American firms say stronger action by the federal government could substantially boost prospects for U.S. exports.

Policymakers argue that it is far too early to admit defeat:

Christina Romer, chair of the White House Council of Economic Advisers, calls the administration's export target "an ambitious but reasonable goal."

"Going up 100% over a five-year period is not such a radical idea when you think about historical experience," she said, noting that exports increased more than 75% between 2003 and 2008. "It is going to be a gradual process. We are just starting the concrete steps in terms of what we can do to lower the fixed costs associated with exporting through trade promotion and commercial diplomacy."

… Am I the only one that finds the Administration's focus on doubling exports somewhat disingenuous? Economic growth depends on net exports - doubling exports is a fine goal, as long as import growth is contained, such that the net effect is positive. But with the economy bouncing back, will import growth remain contained? Recent signs are not supportive - the recovery so far has ended the improvement in the real trade gap….

[A]s the broad global financial crisis continues to fade, nations will increasingly attempt to withdraw fiscal support for their economies - even more so with the Greece example now so vivid - and attempt to rely on external growth to compensate. It is not a game everyone can win. But if it deteriorates into competitive devaluations, it is a game everyone can lose. 

Creeping hyperinflation anyone? As frightening as that prospect seems, Jim Kunstler spins it into something more immediately ominous. In And Chicks for Free, 5/10 Kunstler says:

[I]mbalances of global finance are so grotesque now that the whole money system is hanging together with nothing but spit and prayer. I get rafts of e-letters every week warning of a supposedly-coming global currency -- a companion idea to the notion of a one-world government. Both are idiotic fantasies. Events are taking the nations of the world in the other direction: towards break-up, down-sizing, down-scaling. Likewise, if major currencies such as the Euro and the dollar blow up, they're much more likely to be replaced by more local bank-notes backed by gold than by some hypothetical Amero or Globo-buck.

At seven a.m. Eastern time, the European stock markets were zooming, and Bloomberg even carried a wonderfully mysterious headline saying Greek Bonds Rally. That was especially rich -- like, who in the fuck is going to load up on Greek bonds now? Is there a pension fund somewhere run by such dimwits that they would sell their positions in the Goldman Sachs issued Timberwolf CDO in order to get in on the new bargain in ten-year Greek sovereigns? I hope those pensioners are prepared to spend what remains of their lives selling chestnuts from pushcarts on the streets of Oslo, because they sure won't be clipping coupons in front of any World Cup telecast.

As if life in the USA wasn't surreal enough last week. Once upon a time, the stock market was a  place where people with capital went to look for productive activity to invest in -- say, a company devoted to making soap flakes, an underpants factory. Now the market is a robot combat arena where algorithms battle for supremacy of the feedback loops.  Thursday's still-baffling fifteen-minute "crash" was an excellent demonstration of the diminishing returns of technology. People too-clever-by-half, aided greatly by computers, have now gamed the investment indexes so successfully that these markets no longer have anything to do with investment -- they're just about shaving micro-points of profit at high volumes by micro-milliseconds off mere differentials in... math! This is truly quant heaven, a place where only numbers matter and there is no correspondence to anything in the real world. In other words, last Thursday's bizarre action was a warning that the American stock markets have flown up their own aggregate ass.

So there you have it! If you find a safe place to hide assets, let me know. Goldbugs want you to buy gold. Rick Bookstaber (3/8) tells us that gold too is a bubble. According to Felix Salmon, 5/7, PIMCO's El-Erain is hyper-bearish and wants you to send money to them so they can out-compete all others.  So does Goldman Sachs.  Or maybe you are too small a fish for Goldman to bother with. In any case, Happy Tuesday.

Lingering question: Is there any way short of Jubilee (Jubilee Debt Coalition) to end this era of global imbalance? See, e.g.  Niall Ferguson: Bring on the debt jubilee!, 2/13/2009.

[End Note: I'm not a big fan of Debt Jubilee.  I believe people (and nation states) ought to be accountable for their debt. On the other hand I believe that institutions, e.g. financial institutions (government and private) ought to be accountable for setting up arrangements that are understandable to those who use them.  We have a big problem on our hands and seemingly no answers. This post is a bid dark, even for me.  Oh well, I categorized it under "irrational pessimism"--mine.]

Has the 2008 Bear Market Run Its Course?

Has this Bear played out? We'll see. But it does prove interesting to compare it — thus far — with earlier Bear Market runs. Here is a nice interactive chart (click on it to activate it) from the NYT on this Bear Market v. earlier ones:

Source:
How This Bear Market Compares
Amanda Cox, Xaquín G.V. and David Leonhardt
NYT, October 11, 2008
http://www.nytimes.com/interactive/2008/10/11/business/20081011_BEAR_MARKETS.html

HT: Barry Ritholtz

Soros: Financial Crisis Stems from Super Bubble

Like me, George Soros is no believer in "equilibrium economics". Rather he believes that sometimes we will see an equilibrium, but that it will be short-lived. Like Hyman Minsky, Soros argues that stability will itself sow the seeds of the next instability. Soros says we are in a unique place with our current crisis, experiencing both inflation and a recession at the same time. Hear/read more from Soros on today's NPR Morning Edition, Financial Crisis Stems from Super Bubble:

… Soros blames what he calls a "super-bubble" that started about 25 years ago. That's when a less-is-more philosophy became popular with economic regulators. That allowed Wall Street to invest increasing amounts of money in credit.

"The idea was that regulators always make mistakes, state interference in the markets just messes things up," Soros says. "And that was a false idea .... Regulators are human and bound to make mistakes, but markets are also human and they are also bound to make mistakes. Instead of markets always being right, they're actually always groping at trying to find out what the facts are. But they never get it right." …

Soros says there's a "super-bubble" in the economy that's bigger than just the recent housing crises, and he blames exotic financial instruments for helping cause it.

"The markets have introduced financial instruments with fancy names — CDOs and CLOs and all these strange instruments that are traded in very large volumes. And they were all constructed on the belief deviations are random.

Soros also has a new book out. Here is a snip from the introducion:

A New Paradigm for Financial Markets, Introduction, George Soros: We are in the midst of the worst financial crisis since the 1930s. In some ways it resembles other crises that have occurred in the last twenty-five years, but there is a profound difference: the current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency. The periodic crises were part of a larger boom-bust process; the current crisis is the culmination of a super-boom that has lasted for more than twenty-five years.

To understand what is going on we need a new paradigm. The currently prevailing paradigm, namely that financial markets tend towards equilibrium, is both false and misleading; our current troubles can be largely attributed to the fact that the international financial system has been developed on the basis of that paradigm.

The new paradigm I am proposing is not confined to the financial markets. It deals with the relationship between thinking and reality, and it claims that misconceptions and misinterpretations play a major role in shaping the course of history. …

Let me explain briefly how the theory of reflexivity applies to the [current] crisis. Contrary to classical economic theory, which assumes perfect knowledge, neither market participants nor the monetary and fiscal authorities can base their decisions purely on knowledge. Their misjudgments and misconceptions affect market prices, and, more importantly, market prices affect the so-called fundamentals that they are supposed to reflect. Market prices do not deviate from a theoretical equilibrium in a random manner, as the current paradigm holds. Participants' and regulators' views never correspond to the actual state of affairs; that is to say, markets never reach the equilibrium postulated by economic theory. There is a two-way reflexive connection between perception and reality which can give rise to initially self-reinforcing but eventually self-defeating boom-bust processes, or bubbles. Every bubble consists of a trend and a misconception that interact in a reflexive manner. There has been a bubble in the U.S. housing market, but the current crisis is not merely the bursting of the housing bubble. It is bigger than the periodic financial crises we have experienced in our lifetime. All those crises are part of what I call a super-bubble—a long-term reflexive process which has evolved over the last twenty-five years or so. It consists of a prevailing trend, credit expansion, and a prevailing misconception, market fundamentalism (aka laissez-faire in the nineteenth century), which holds that markets should be given free rein. The previous crises served as successful tests which reinforced the prevailing trend and the prevailing misconception. The current crisis constitutes the turning point when both the trend and the misconception have become unsustainable. …

Grizzly Times, Yet Some Hope on Horizon

Grizzly Bears roam the financial landscape: Doug Noland and Michael Shedlock here (or here) are ever-bearish, but so is Barry Ritholtz (Forbes video link). The "D" word is uttered ever-more-frequently. Yet I find myself thinking that just beyond this likely deep recession we are at the leading edge of a reformation: re-forming financial institutions—private and government—and bringing US and other banking "kicking and screaming" into the 21st Century.

In this I share hopes with Brad DeLong, Paul McCulley, Robert Shiller, and George Soros (or better still watch Soros: via the Financial Times in extended post). No one who is awake believes we will escape our current moment without at minimum a deep, prolonged recession. But some observers, like those just mentioned are less cynical than are they who believe that we are predestined to once-again repeat the tragedies of the recent past and earlier times—in particular to continue to reward speculative excess.

As per reform, Thursday's Senate Oversight hearings on the Bear Stearns mess (C-Span video link)) is almost 5 hrs. long, but worth watching to better understand where Ben Bernanke (Fed), Timothy Geithner ( NY Fed), Christopher Cox (SEC), and Robert Steel (Treasury) stand regarding hoped-for reregulation. (I recommend first panel: 3 hr. 40 min.)

It is by no means certain that we will indeed reregulate our system to once-again disallow the worst excesses of extended bouts of irrational exuberance and the irrational pessimism that must follow. But we might. We must! I've hoped for reforms too often in the past and been disappointed, but signs of hope are on the horizon at a time when moderates are beginning to take the reins of power in the US Congress away from borrow-and-spend neoCons on the far right and traditional tax-and-spend Democrats on the far left.

Let's not be eager to blame the Federal Reserve, the Treasury, and the SEC for this mess. NeoCons and "free market fundamentalism" are better targets for blame. And let's not forget that there was good reason for bringing the Federal Reserve system into being long ago—to curb the excesses of "boom and bust" cycles. The system worked reasonably well after the late 20s, early 30s debacle to disallow Hyman Minsky’s PONZI FINANCE moments. That is, it worked well until the so-called "Republican Revolution" dismantled regulatory functions of government here in the US.

I'm not naïve enough to believe that we could have weathered the storms brought about by recent financial and technological innovations without some pain, but the real tragedy I see is that "we the people" of the USA haven't yet figured out that we need good government to accompany good markets—and that neither can work effectively in isolation or without continued vigilance and oversight from citizens and the press (now fortified with internet commentary).

Government agencies and institutions must begin to wake up to realities that W. Edwards Deming, Peter Drucker, and many newer management writers have helped the best of our private-sector entities understand—that innovation and quality reform must be institutionalized into the fabric of agencies and institutions, to be ongoing and ever-vigilant of changes in external environment that must be incorporated into internal corporate and government cultures. Let's hope wider government reform begins with the Fed, the SEC, and the Treasury.

Doug Noland: 'Breakdown of Wall Street Alchemy'

In his latest Credit Bubble Bulletin, Doug Noland concludes that "GSEs are poised as the next shoes to drop — the next Dominoes in an Escalating Contagion. … Simplifying highly complex circumstances, the various risk models that empowered the greatest leveraging of risk in the history of finance no longer function as expected — or as required to maintain highly leveraged exposures to a multitude of escalating risks. And it was all just only a matter of time. The overriding flaw was to ignore that a runaway Bubble in market-based finance ensured that various market and Credit risks all coalesced into One Massive, Unmanageable, Highly Correlated, Unhedgable, Undiversifiable Association of Interrelated Systemic Risks. "

Although Noland's assessments continue to be bleak, I find them to be more 'on the mark' week-on-week than any other source I go to. Maybe I'm just hearing what I confirms my preconceived biases. Or maybe not? More from Noland (emphasis added):

The Breakdown of Wall Street Alchemy, Doug Noland, Feb 15: This week provided further confirmation of ongoing momentous Credit market developments. … Like the asset-backed commercial paper market that was popular with structured investment vehicles until last summer, auction-rate securities, a form of rolling short-term funding for long-term municipal commitments, have become fashionable in recent years."

"Auction-rate securities" has joined the beleaguered ranks of "subprime," "asset-backed commercial paper," "SIVs," and the "monolines" — financial structures that flourished during the prolonged Credit Bubble but no longer pass market muster in today's Post-Bubble Risk Revulsion Backdrop. This week's "unwinding" of the "auction-rate" market and the blowing out of Credit spreads should be seen as an escalation of the ongoing unwind of "Contemporary finance" and its many avenues of Risk Intermediation.

On numerous fronts, the markets and economy confront a Highly Problematic Breakdown in "Wall Street Alchemy" — the disintegration of key processes that had for some time transformed ever-increasing quantities of risky loans into perceived safe and liquid debt instruments that enjoyed insatiable demand in the marketplace. In the case of the “auction-rate securities,” it was a clever restyling of long-term and generally illiquid municipal debt (as well as student loans and other borrowings) into perceived liquid securities that could be easily sold at regularly recurring auctions (every one to a few weeks). With scores of flush corporate treasury departments and wealthy clients (managing huge Credit Bubble-induced cash-flows) keen to earn extra (after-tax) yield on "cash equivalents," the Wall Street firms had been diligent in ensuring (making markets for clients, when necessary) a highly liquid and enticing marketplace. Now, with the onset of Risk Revulsion and Acute Financial Sector Balance Sheet Pressures, investors are running for cover and Wall Street firms are shunning the use of their own capital to support this and other markets. Market liquidity has evaporated, confidence has been shattered, and we are witnessing yet another "run" on a previously popular risk market/asset class. The music has stopped for another game of musical chairs.

This week saw heightened systemic stress stampede toward the epicenter of the U.S. Credit system. It certainly didn't help that insurance behemoth AIG Group reported an almost $5bn writedown of its Credit default swap portfolio or that international securities dealer behemoth UBS reported massive losses on its U.S. Credit positions. Confidence was further shaken by huge losses reported by mortgage insurers, as well the twists and turns of the "monoline" bust turned apparent bailout. In the markets, various indices of investment grade Credits widened sharply to record levels. The key "dollar swap" (interest-rate derivative hedging) market saw spreads widen sharply. Agency spreads also widened significantly. Benchmark Fannie Mae MBS spreads widened a remarkable 20 bps against 10-year Treasuries, while agency debt spreads widened a noteworthy 12.5 basis points to 69.5 bps (high since November). The Breakdown of Wall Street Alchemy is now pushing the Credit Market Dislocation uncomfortably close to the core of our monetary system.

I'll return to financial aspects of this crisis, but I definitely feel the economic ramifications of the unfolding Credit Crisis are receiving short shrift in the media. This week saw parts of the municipal debt market grind to a virtual halt and the corporate debt market take another significant blow. Investment grade debt issuance has now slowed markedly after beginning the year at near record pace. At this point, the junk, CDO, ABS, "private-label" MBS, muni, and even investment grade debt markets are all somewhere between impaired, dislocated and completely dysfunctional. There is no mystery behind the recent string of abysmal economic reports.

The preliminary reading on February University of Michigan Consumer Confidence dropped 8.8 points to the lowest level since the 1992 recession. The Economic Conditions index sank and the Economic Outlook index plunged, while one-year Inflation Expectations rose from 3.4% to 3.7%. The Economic Outlook has sunk a remarkable 22 points since July. Falling national home prices are clearly wearing on confidence. This week, Dataquick reported that home sales throughout much of California have collapsed to more than 20-year lows, while home price declines accelerate. This is a huge unfolding issue/debacle for the MBS, agency, mortgage insurance, CDO, and Credit derivatives markets, not to mention the U.S. banking system and real economy. Countrywide Financial reported delinquencies on its $1.5 TN mortgage servicing portfolio had jumped to 7.47%, up from the year ago 4.32%. The New York "Empire" Manufacturing index sank to the lowest levels since April 2003.

The economy is now faltering badly and there is every reason to expect the downturn to gather pace — negative real interest rates compliments of the Fed and stimulus package compliments of the federal government notwithstanding. While fourth quarter data is not yet available, one can look to the first nine months of 2007 to gain important perspective. Despite the dislocation in the subprime mortgage market, Non-Financial Debt Growth accelerated from Q2's 7.2% to Q3's 8.9% (from the Fed’s Z.1 report). And while Household Debt Growth had slowed to a 6.9% pace, Business Borrowings accelerated to a blistering 11.9% annualized rate in the third quarter. This was the strongest corporate debt growth since the tech/telecom boom in the late nineties. Importantly, total (financial and non-financial) Corporate Debt expanded at an 11.1% rate during the first three quarters of 2007, followed by 9.3% growth in State & Local government borrowings. And while residential mortgage debt was slowing meaningfully, Commercial Mortgage Debt was expanding at an almost 13% rate.

Total (financial and non-financial) Credit expanded a seasonally-adjusted and annualized record $5.0 TN during the third quarter — as nominal GDP expanded at a 6% pace. While many trumpeted the "resiliency" of the U.S. economy in the face of mortgage and housing woes — more adept analysis would have focused on the massive Credit creation that had come to be required to sustain the Bubble Economy. Importantly, the faltering subprime market initially instigated only greater excesses throughout commercial real estate, municipal finance, M&A finance, and corporate lending more generally. The Credit Bubble was sustained at the great cost of heightened instability and weakened structures — especially throughout leveraged lending, state & local finance, and investment-grade corporate borrowings. Keep in mind that through the third quarter CDO issuance was actually running ahead of 2006's record pace. Until the fourth quarter, record Credit growth continued to fuel the finance-driven economy. This is all now coming home to roost.

Today, with bursting bubbles in corporate and municipal finance joining the mortgage bust, the U.S. Bubble economy has quickly fallen desperately short of sufficient Credit and liquidity. And the greater the Credit market dislocation and broad-based tightness of Credit, the bleaker become economic prospects and the more intense the Revulsion to Wall Street's Credit instruments. The days of free-flowing cheap finance for home buyers, state and local governments, LBO firms, commercial real estate speculators, college students, risky auto buyers, and high-risk Credit card holders are over — and they will not be returning for some time to come.

When I have previously underestimated the "resiliency" of the U.S. Credit Bubble and economy, it was in each instance a failure to appreciate the capability of Wall Street finance to expand to ever greater degrees of Bubble excess. Today, with "contemporary finance" mired in a historic collapse, I am confident that the Credit system is today only in a position to surprise on the downside. It is this framework that shapes my view of a rapidly escalating Credit crisis feeding an arduous economic adjustment period.

And while it could undoubtedly prod a highly speculative stock market, there is no resolution to the "monoline" dilemma that would meaningfully influence the trajectory of the unfolding Credit and economic bust. As we've been saying for awhile now, confidence in Wall Street finance has been irreparably shattered. Trust has been broken in "AAA" ratings, "mark-to-model," CDO structures, myriad risk models, Credit insurance, counter-party risk, and various instruments and vehicles for intermediating risk in the markets. Moreover, old fashioned lending will not come close to sufficing the demands of a highly imbalanced Bubble economy, especially with bankers nervous and retrenching. Again, we're witnessing nothing less than the Breakdown of Wall Street Alchemy — one that took a turn for the worst this week.

In a disconcerting development, recent market developments seem to confirm that the leveraged speculating community and the GSEs are poised as the next shoes to drop — the next Dominoes in an Escalating Contagion. Along with the "monolines" and mortgage insurers, the "Credit default swap market" and GSE mortgage Risk Intermediation were at the epicenter of the most egregious Systemic Risk Distortions and Accumulations. They are now quickly moving to the forefront of Current Acute Fragilities. Simplifying highly complex circumstances, the various risk models that empowered the greatest leveraging of risk in the history of finance no longer function as expected — or as required to maintain highly leveraged exposures to a multitude of escalating risks. And it was all just only a matter of time. The overriding flaw was to ignore that a runaway Bubble in market-based finance ensured that various market and Credit risks all coalesced into One Massive, Unmanageable, Highly Correlated, Unhedgable, Undiversifiable Association of Interrelated Systemic Risks.

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.

Timely, Temporary, Targeted Depression

While we wait for world market jitters to calm (whenever that may be). And while we wait to see if the US Congress gets a 3-T stimulus package together (as if that might help. We can all take some minor comfort in knowing that all Recessions (even those called Depressions) are Timely, Temporary, and Targeted:

• Timely: Recessions happen timed to events that suggest that "unbridled enthusiasm" is finally at an end—and confidence is lost.
• Temporary: All things come to an end, even Depressions. Some episodes just take longer to unwind than others.
• Targeted: Aimed to hurt most those who have over-extended themselves in debt or speculative frenzy. Aimed too to finally allow for responsible discussion of effective regulation, although there may be less-than-responsible discussion during initial panic—that hopefully will not get set into irresponsible policy.

After the bell:

Wall Street joins global equity plunge, Kristina Cooke, Reuters, Jan 22: NEW YORK (Reuters) - Stocks slid sharply on Tuesday [at the opening bell], joining a global equity rout on fears of a U.S. recession and pushing the Nasdaq into bear market territoryInvestors dumped equities even after the Federal Reserve cut interest rates by 75 basis points in a surprise intermeeting decision. The move from the U.S. central bank follows two days of sharp losses in Asia and Europe on worries a deteriorating U.S. economy would drag other regions down with it. …

The move from the U.S. central bank follows two days of sharp losses in Asia and Europe on worries a deteriorating U.S. economy would drag other regions down with it.

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

Thanksgiving Cheer: HERE'S ROUBINI!

With the stock markets increasingly jittery, and just in time for Thanksgiving, I can't resist leaving a little ray of sunshine BAG OF GLOOM at your doorstep: via FT Alphaville, Stand by for "generalized systemic financial meltdown", Helen Thomas, Nov 21 or straight to the source, HERE'S ROUBINI …

Nouriel Roubini, Nov 16: … I now see the risk of a severe and worsening liquidity and credit crunch leading to a generalized meltdown of the financial system of a severity and magnitude like we have never observed before. In this extreme scenario whose likelihood is increasing we could see a generalized run on some banks; and runs on a couple of weaker (non-bank) broker dealers that may go bankrupt with severe and systemic ripple effects on a mass of highly leveraged derivative instruments that will lead to a seizure of the derivatives markets (think of LTCM to the power of three); a collapse of the ABCP market and a disorderly collapse of the SIVs and conduits; massive losses on money market funds with a run on both those sponsored by banks and those not sponsored by banks (with the latter at even more severe risk as the recent effective bailout of the formers’ losses by theirs sponsoring banks is not available to those not being backed by banks); ever growing defaults and losses ($500 billion plus) in subprime, near prime and prime mortgages with severe known-on effect on the RMBS and CDOs market; massive losses in consumer credit (auto loans, credit cards); severe problems and losses in commercial real estate and related CMBS; the drying up of liquidity and credit in a variety of asset backed securities putting the entire model of securitization at risk; runs on hedge funds and other financial institutions that do not have access to the Fed's lender of last resort support; a sharp increase in corporate defaults and credit spreads; and a massive process of re-intermediation into the banking system of activities that were until now altogether securitized. …

As differentiated a wee bit by Yves Smith:

Naked Capitalism, Nov 17: … I agree with Roubini that there is the very real possibility of a financial horrorshow, However, I differ with him on some of the particulars. We are not going to see bank runs. We didn't have them in the late 1980s where S&Ls were actually failing and Citi nearly went under. However, we are already seeing institutional money getting very costly for Citi, and their tsuris have only begun. And we are seeing more examples of Citi-type behavior, where banks have what effectively were contingent liabilities (think, for example, of the guarantees and/or cash injections to keep affiliated money market funds from breaking the buck). These funding or liability demands are coming at precisely the time when bank equity is under strain, due to the need to increase loss reserves and writedowns. Look, for example, at asset backed commercial paper. The Financial Times reported today that banks have shown substantial balance sheet growth of late. But it isn't net new lending; it's credit commitments or actual drawdown related to ABCP.

I expect Citi to be in serious trouble in 6 to 12 months, and that specter will increase risk premia for many banks, and could push others towards the edge. So I anticipate a lot of near-failures, some gunshot marriages, and possibly even real bank collapses, but the mechanism will not be a run by retail depositors.

But I expect to see more serious damage among the "large complex financial institutions" of which Citi is one. There are 16 behemoths that have been deemed by the Bank of England as especially important to global credit intermediation. One is already in the process of taking a body blow. If we see damage to any others, it will lead to a contraction in the credit markets, both directly (shrinkage of their balance sheets) and indirectly (shrinkage of everyone else's balance sheets due to new found conservatism and sharply higher borrowing costs). The securitization market, absent government agency paper, is not functioning very well right now. It will really start laboring if conditions on Wall Street continue to deteriorate.

And if securitization looks less attractive because investors are far more stringent (and maybe no longer believe ratings) and Wall Street looks to have lost a couple of cylinders, then the banks need to step into the breech. Ah, but will they? Banks for the most part are no longer in the habit of keeping a lot of their own loans on their balance sheet. …

Fear Makes a Comeback

An old adage says markets are driven and balanced over time by greed and fear. This seems particularly true when markets get into their manic phases. Martin Wolf reminds us that the tide has now shifted from greed to fear, and brings Hyman Minsky to the forefront of our thoughts:

Fear makes a welcome return
by Martin Wolf
Commentary
Financial Times

"At particular times a great deal of stupid people have a great deal of stupid money. . . At intervals. . . the money of these people — the blind capital, as we call it, of the country — is particularly large and craving; it seeks for someone to devour it, and there is a 'plethora'; it finds someone, and there is 'speculation'; it is devoured, and there is 'panic'." Walter
Bagehot.*

Panic follows mania as night follows day. … Ours has been a world of … confidence, cleverness and too much cheap credit. This is not new. It is as old as financial capitalism itself. The late Hyman Minsky, who taught at the University of California, Berkeley, laid down the canonical model. The process starts with "displacement", some event that changes people's perceptions of the future. Then come rising prices in the affected sector. The third stage is easy credit and its handmaiden, financial innovation.

The fourth stage is over-trading, when markets depend on a fresh supply of "greater fools". The fifth stage is euphoria, when the ignorant hope to enjoy the wealth gained by those who came before them. The warnings of those who cry "bubble" are ridiculed, because these Cassandras have been wrong for so long. In the sixth stage comes insider profit-taking. Finally, comes revulsion.

In the latest cycle, displacement began with the huge cuts in interest rates in the early 2000s, which drove up prices in housing. The easy credit was stimulated by innovations that allowed those making the loans to regard their service as somebody else's problem. Then people started to buy dwellings to resell them, not live in them. Subprime lending was a symptom of euphoria. So, in a different way, was the rush of bankers into hedge funds and of the wealthy and big institutions into financing them. Then came profit-taking, falling prices and, last week, true revulsion.

This was what George Magnus of UBS bank calls a "Minsky moment". It was the moment when credit dried up even to sound borrowers. Panic had arrived.

The correct policy response is also well known. … The central bank must save not specific institutions, but the market itself. It must advance money freely, at a penal rate, on good security.

In providing money to the markets last week and this, the … central banks have been doing their jobs. Whether the terms on which they have done this were sufficiently penal is another matter.

Financial markets, and particularly the big players within them, need fear. Without it, they go crazy. Moreover, it is impossible for outsiders to regulate a global financial system riddled with conflicts of interest and dominated by huge derivatives markets, massive trading by highly leveraged hedge funds and reliance on abstruse mathematics and questionable statistical models. These markets must regulate themselves. The only thing likely to persuade them to do so is the certainty that the players will be allowed to go bust. …

The world has witnessed four great bubbles over the past two decades – in Japanese stocks in the late 1980s, in east Asia’s stocks and property in the mid-1990s, in the US (and European) stock markets in the late 1990s and, finally, in the housing markets of much of the advanced world in the 2000s. There has been too much imprudent finance worldwide, with central bankers and ministries of finance providing rescue at virtually every stage.

Unfortunately, there is every chance of repeating mistakes. A bail-out has already occurred in Germany. … More are likely. US legislators want Fannie Mae and Freddie Mac to bail out the mortgage markets.

The pressure on the Federal Reserve to cut interest rates will also grow. … The consequences [of this implosion] cannot be "ring-fenced", as those of LTCM were. Trust in counterparties and financial instruments has fled. The likelihood is a period of recognising losses, tightening credit conditions and deleveraging.

Such a period, desirable in itself, will lead to strong pressure for swift declines in interest rates, at least in the US, and so for another partial bail-out of a crisis-prone system. This pressure should be resisted as long as possible. …

*Cited in Manias, Panics and Crashes: a History of Financial Crises, fifth
edition. Charles P. Kindleberger and Robert Z. Aliber (Basingstoke: Palgrave
Macmillan, 2005)

[Note: This condensed version of Wolf largely borrowed from Mark Thoma, here.]

Andy Xie's perspective is similar. And Xie punctuates his own warning to the Fed, titled "It's time for central bankers to stop bailing out markets", Financial Times, Aug 14 [$] , with:

… If central banks try to bail out Wall Street, it would lead to high inflation for years. The inflationary effect of loose monetary policy of the past was offset by the deflationary effect of globalisation. Now China and other developing countries are experiencing high and rising inflation. Loose money will go straight into inflation. The vicious cycle of the wage-price spiral of the 1970s has not occurred as both labour and capital still believe in the inflation-fighting credibility of the central banks. If they loosen up again to bail out Wall Street, this credibility may be squandered. The ensuing wage-price spiral could ruin the global economy for years to come.

What is occurring is an opportunity for central banks to restore their credibility. Markets have been taking more risk than they should because they believe that central banks will come to their aid during times of crisis, like now. The penchant of Alan Greenspan, former US Federal Reserve chairman, to flood the market with liquidity during financial instability is the genesis of this "central bank put". As long as this expectation remains, financial bubbles will occur again and again. Now is the time to act. Let the crooks go bankrupt. Central banks should bury the Greenspan "put" for good.

So what's it going to be? Will Bernanke heed Xie's warning and attempt to restore faith in 'The Fed'? Or will he unleash the helicopters? Has he already?

I"m still willing to give Bernanke some rope. So far, I believe the Fed and other central bankers have done what they must in the wake of the recent crisis, although I wish they had done some things in advance, say mid-1990s.

If Bernanke moves to lower interest rates anytime soon, and if that indeed fuels fires of speculative frency once-again, then I'll join the ranks of the hounds, biting at the heels of the Fed. But not until/unless.