Fed Policy – Page 55 – The Aleph Blog

In Large, Red, Friendly Letters it Reads, “Don’t Panic!” (GSE Edition)

Posted on 11 July 2008 by David Merkel

want to tread a fine line this evening.? I am going to argue that a government takeover of Fannie and Freddie would not be as costly as some imagine — it would likely be more expensive than the S&L bailout, but not in inflation-adjusted terms.? My post is driven by the New York Times article, as cited by Barry Ritholtz, and Yves Smith (as I was drafting this).

The first thing to say is that conservatorship may not happen.? The GSEs have many powerful political friends, and they won’t give up without a fight.? I rate the odds of conservatorship as less than 50/50 in 2008, and the next President/Congress may have a different opinion.

I want to rule out the idea that the Federal Reserve could save the GSEs.? Unlike Bear Stearns, the Fed is too small to materially affect the situation.? Sure, it can buy the senior paper of the GSEs, but that would not be enough to absorb more than 10% of the total senior financing base for the GSEs at maximum.

But suppose conservation of Fannie and Freddie takes place.? What then?

Most mortgages insured by Fannie and Freddie are good quality already.? They financed smaller loans, reasonable down payments, tilted away from the high cost areas that are under the most pressure.? For loans prior to 2006, losses should be small.? Also, Fannie and Freddie have been careful, even with pressure from politicians.

But some loans were done with mortgage insurance because of low down payments, and the mortgage insurers are in bad shape now.? True, and though Fannie and Freddie may not get full payment, they should get 80% payment on the 20% or so of the loan that was insured.? Mortgage insurers are worth something, even if not full value.? My scenario implies 4% losses on a small portion of their mortgage book.

Now the GSEs will continue to receive guarantee fees, and they still have embedded margins from the loans on their balance sheets.? Now, WIlliam Poole says that Freddie is insolvent on a fair value basis, and Fannie might be.? Still, the losses are small compared to the S&L bailout at present.

Thus, I argue that a guarantee of senior obligations of the GSEs would not be horrendously costly.? Let the preferred and common equity be wiped out.? Let the subordinated bondholders sweat.? The losses at the senior level should be small.

The benefits of such a guarantee would be big, though.? Who invests in Fannie and Freddie direct and guaranteed paper? Banks, insurers, stable value funds, foreign investors, and more.? Do we want a “domino effect” that might lead to further financial failures?? I think not.? Arresting the losses at the senior level, and eventually folding Fannie and Freddie into GNMA preserves many other financial institutions.

Two notes on the politics here: the Bush Administration wins, and loses.? Wins, because they end the dominance of the GSEs in a bigger way than they ever could have imagined.? Loses, because they can’t use them to support the mortgage market any more.? Can the FHLB pick up the slack without them?? I doubt it, at least not fully.? The FHA isn’t big enough either.

So, be careful here.? There are too many variables and political angles to make decisions easy.? I think I understand what is most likely here, but I would assume a conservative posture, unless the cost of achieving that posture was too high.? We are close to that “too high” level now.

PS — As a bond manager, aside from mortgage bonds, I rarely bought agency bonds because the spreads were too small to bother with.? I have a rule for avoiding small bond yield spreads; they are too narrow to waste time over, and the present distress illustrates why.? At present a barbell of Treasuries and high yield bonds is more attractive than agencies.

(These are my opinions, and not those of my employer.)

Federal Reserve, Tend to Your Own House

Posted on 9 July 2008 by David Merkel

I am not in favor of the Federal Reserve as a greater regulator over the financial system.? Why?? They can’t even do their own job right, or use the tools that they have today effectively.

Is the stock market too frothy?? Let them adjust margin ratios.

Are they worried about the solvency of investment banks?? Let them increase the level of capital that needs to be held against investment banks.? Hedge fund worries?? Same drill.

There should be a bright line distinguishing the regulated from the non-regulated financial companies.? Capital requirements on loans from the regulated to the non-regulated shoul be very high, forcing the non-regulated entities to be mainly equity-financed.

Beyond that, the Federal Reserve has enough of a hard time with their existing mandate, balancing inflation, unemployment, and the health of the banks that they regulate.? Adding additional balls for them to juggle will make their paralysis greater.

Better we should consider giving the SEC some real teeth, and funding it appropriately to do it.? Let the next President put forth a good proposal to make it happen.

Ten Notes on Crude Oil: The Fixation

Posted on 14 June 200815 June 2008 by David Merkel

In different economic eras, different things attract the attention of the media, investors, politicians, etc.? Today a leading attention grabber would be crude oil, and the energy complex.? It is a honeypot for conspiracy theorists and unscrupulous politicians (not quite an oxymoron).

1)? Fuel is subsidized across much of the world, particularly in countries where there is a large state owned oil company.? Current high prices are making it difficult to maintain those subsidies, so countries like Egypt and Indonesia are reducing subsidies.? Yet subsidies are not being eliminated everywhere yet.

2) Speculators — perhaps they need a new name, and a branding campaign.? Risk bearers, maybe.? I don’t know.? But discouraging speculation by raising margin requirements will not necessarily decrease the cost of crude — those who are short crude also face margin requirements.

Now, many commodities have no futures contracts.? On average their prices have increased more than those that have futures contracts recently. ? That indicates to me that those that have futures contracts are not in a bubble.

Some look at the dollar change in prices and think that speculation must be high.? Bespoke does a good job in breaking it down into percentage terms, which indicates that the oil market has been more volatile more than half a dozen times in the past.

Do speculators include the ordinary shmoes like you and me who use ETFs?? I’ve used currency and stock and bond index ETFs, but not commodities so far.? Amazing how the trading interest on commodities has grown through ETFs — here’s another good chart from Bespoke.

As I have commented before, I think the run-up in the price of oil is fundamental, not manipulation.? Ignore the futures, and just look at spot prices — it is hard to affect where the real buyers and sellers trade in a global commodity.? If prices get too high, like the last move of OPEC in the 1979, where they overshot, and supply eventually overwhelmed their too high price.

3) We could be in overshoot mode now; it’s hard to tell.? As I have said before, sustained high prices are necessary to create the investment in alternative technologies that save energy and produce energy
more cheaply.? I don’t think that it will happen quickly though… in the early 80s, oil prices edged down, and then came down rapidly in the mid-80s.? It took a while for the new supply to be developed, and for conserving technologies to be created and deployed.

If you want a current example, think of the new big oil field found off the coast of Brazil.? It will be three years or so until we see new production there.? Another example is that it is hard to ramp up additional production from existing fields.? If you try to force more oil out more rapidly than is prudent, you can destroy the long-term viability of the oil fields.

4) But, there are dissenting voices, whether wishful ones like this one from a Japanese Vice Minister, or this article from Fortune which is more nuanced.? His arguments sound like mine, but on a faster timetable, with less consideration for future depletion.? This article from the Dallas Fed is similar; though it says that it will be difficult for oil to stay over $100/barrel in 2008 dollars, they have a ten-year horizon on that forecast.? Hey, even I think that oil will drop below $100/barrel within 10 years.

5) Now, there is demand destruction.? We are already seeing it in the UK.? We are not seeing it in China, yet.? Part of the difference has to do with China subsidizing gasoline, which blunts the market effect.

From this article, within a year gasoline demand is pretty inflexible with respect to price.? Beyond one year, people adjust their behavior.

And, it is worth noting that OPEC thinks demand in the US and globally is shrinking.? They are probably right, though the effect on price is problematic, because many oil producers can’t produce what the used to — Mexico, Venezuela, Indonesia…

6) Now, this article indicates that changes in demand for oil have been more significant than changes in supply.? Whether that will be true in the future remains to be seen, but as the rest of the world gets better off, they will demand more energy.? A wealthy life is energy-intensive.

7) Inventories are light compared to average, but I’m not sure that is as big of a factor as many indicate.? At the edges when inventory is close to capacity, or when it is close to running out, that has a big impact, but in the middle zone, the impact should be modest.

8) When I read this summary of a speech by Donald Kohn, I concluded a few things:

The Fed is stuck.
Because the Fed is stuck, it will let things drift for a while.
A certain amount of idealism is waning inside the Fed, with a creeping suspicion that they aren’t wizards, but only sorcerer’s apprentices.

9) It has been a long term theme of mine that the oil that is easiest to refine would get relatively more scarce.? This article from Naked Capitalism is another demonstration of that.? And, for those who want a stock pick, that favors Valero, which can refine the heavy and sour crudes.

10) A large part of the US current account deficit is the increase in the price of crude oil.? Eventually, the decline in the US Dollar will stimulate exports, but for a while, the J-curve effect remains in place, and the Dollar takes a beating.? That beating isn’t happening at this instant, but it has gotten hit over the past several years.? I’m not sure that this recent rise is the reversal, but there will come a time when the current account normalizes.? Hopefully other nations will liberalize trade; that would do it in its own.

Full disclosure: long VLO

PS — I am market weight in energy stocks.

As The Yield Curve Moves

Posted on 13 June 2008 by David Merkel

My, but haven’t we had interesting times in the short end of the yield curve lately. Have a look at this graph:

This covers the period from the final aggressive 75 basis point move by the FOMC, where there were expectations of a 1% fed funds rate by year end 2008, to now, where the rate at year end is between 2.5-3.0%.? Now look at this chart, which summarizes the yield curve moves:

The graphs and numbers tell a story.? My four datapoints represent:

3/17 – The sharpest point in the loosening cycle, prior to going to 2.25%.
4/25 – Anticipation of the end of the loosening cycle.
6/6 – FOMC jawboning that we must support the dollar and fight inflation.
6/12 – Now.

Let’s describe the moves, period by period.? In Period 1, the transition was from maximum FOMC accomodation to the end of the loosening cycle.? What happened?? Investors required more yield to invest for two years versus cash instruments, because they concluded that short rates would not go near record low levels.? The long end of the curve flattened, because inflation expectations were under control.

In period 2, things were quiet.? Three month rates rose to reflect the new consensus that the FOMC was on hold after the 4/30 meeting for the foreseeable future.? The rest of the curve did nothing.

In period 3, members of the FOMC began beating the inflation drum, particularly the hawks, including Plosser, Lacker, Fisher, and Bernanke.? The belly of the curve (twos to fives) rises the most, anticipating tightening moves by the FOMC, leading the long end to flatten, and the short end to steepen.? This implies that inflation will remain under control in the long run, an idea borne out by the TIPS market, where you can buy 20+ year inflation protection at a real yield of 2.3% — a pretty good bargain for investors that must own Treasuries and other high quality debt.

I’ll give the FOMC this.? In the last four trading days, they helped create the biggest move in the 2-year note yield that we have seen in a long time.? They managed to push up 30-year mortgage yields around 35 basis points, close to the move in the 10-year note.

Now, (to the FOMC) is that what you wanted?? Go ahead.? Start tightening monetary policy in August or September.? See what that does to the investment and commercial banks.? See how that affects weakening employment.? Do it during an election year, when politicians in 2009 might say, “Central bank independence hasn’t helped the nation.? Let’s clip the wings of the Fed.”

I see the FOMC tightening, and then abandoning the tightening early, and reverting to a weak policy, accepting more inflation for the sake of growth in the real economy, and leniency to banks that are facing tough market conditions.

Declaring Victory Too Soon

Posted on 10 June 200810 June 2008 by David Merkel

The last few months have seen a change in expectations of FOMC policy. The next expected move is a tightening, while some incremental loosening was expected 2-3 months ago.

One of the reasons for this is that the Fed has managed to calm the short term lending markets. They have also managed to defuse a possible crisis among derivative books by bailing out Bear Stearns with the aid of JP Morgan. Also, GDP growth hasn’t gone negative yet, at least the way the Government calculates it. As a result, Ben Bernanke feels that the risk of a substantial downturn has receded, and so, the next focus of the FOMC will be inflation.

Now, I don’t think the answer for the Fed is that simple. That said, there are many that would welcome a tighter FOMC policy.

China is importing our lax monetary policy, and they are unsuccessfully trying to fight the implications of the policy, because they won’t raise their exchange rate. They will have to eventually, perhaps after the Olympics, but a tighter US monetary policy relieves some of their stress.
Europe would welcome a tighter US monetary policy, because it would relieve pressure on the rising Euro. As it is, the ECB with its single mandate is moving to fight inflation. Even the Bank of England is not loosening aggressively, and their housing problems may be proportionately greater than those in the US.
The Gulf States would like a stronger US Dollar to help arrest the inflation that they are importing.
Savers in the US might like higher rates.

But the trouble is that there are still weak spots that might cause the Fed, which has a dual/triple mandate to not tighten monetary policy. (Dual — inflation and unemployment. Triple — financial system solvency, inflation and unemployment.)

The Fed is not out of the woods yet on real estate related credit. I commented many times at RealMoney that Home Equity Lending would be a big problem, back in 2006. I also warned on option ARMs. Well, both are looming problems now.
This will lead to problems in the regional banks. Many of them are exposed.
I still expect residential real estate prices to fall further.
The correction in commercial real estate prices has only begun.
Also, investment banks are still delevering and taking writeoffs. Lehman is the most recent poster child there, but other investment banks could still be affected.
Beyond that, we have defaults rising in speculative grade credit, which will do damage directly, and through the CDOs that they are in.
Places like the Philippines may be canaries in the coal mine — they may be experiencing outflows of hot money at present.

I think the Fed has less freedom to act than is commonly believed. As Yves Smith has commented at his blog, the Fed may have painted itself into a corner. I think the risks from inflation, unemployment, and financial system weakness are fairly well balanced. As it stands, the Fed has adopted the following policy:

Don’t let the monetary base grow. Sterilize all new lending programs.
Allow the banks freedom to expand their lendings; informally relax regulations for now.
Bail out any significant systemic risks.
Work out kinks in the short term lending markets through new programs.

The Fed may make some of those new programs permanent, but then they will need to find a new policy equilibrium involving greater tightness elsewhere in their policy tools. They will also need to decide what to do regarding investment bank leverage, both direct and synthetic. They will also have to figure out what comes first if there is a broader banking solvency crisis, and/or significant shrinkage of real GDP with a rise in unemployment.

It is my guess that Dr. Bernanke is talking a good game today, but that the Fed’s policies will be loose toward inflation, should systemic risk or unemployment prove to be more difficult problems than currently advertised today. They are not out of the woods yet.

Everyone is a Critic!

Posted on 6 June 200822 June 2017 by David Merkel

It’s bad enough that nobodies like me criticize the Fed, but what do you do when members of the FOMC criticize?? Two hawks, Lacker and Plosser, criticize the recent efforts to alleviate difficulties in the lending markets because of the potential for moral hazard.? In this case, moral hazard means to banks: “Don’t worry about bad lending as a group.? If you make mistakes, the Fed will rescue you.”

Give Bernanke some credit, because unlike Greenspan, he lets the members of the FOMC speak their minds.? Hopefully the disagreement will sharpen the Fed, and not lead to paralysis or confusion.? For more background on the individuals who are part of the FOMC, please refer to my piece, A Social View of the FOMC.

I agree the the moral hazard is a live issue here.? The real question is whether growing weakness in the lending markets can be tolerated, which might be worse than moral hazard.

Facilitating the Dreams of Politicians

Posted on 25 May 2008 by David Merkel

I’m a life actuary, not a pension actuary, so take my musings here as the rant of a relatively well-informed amateur.? I have reviewed the book Pension Dumping, and will review Roger Lowenstein’s book, While America Aged, in the near term.

First, a few personal remembrances.?? I remember taking the old exam 7 for actuaries — yes, I’ve been in the profession that long, studying pension funding and laws to the degree that all actuaries had to at that time.? I marveled at the degree of flexibility that pension actuaries had in setting investment assumptions (and future earnings assumptions), and the degree to which funding was back-end loaded to many plan sponsors.?? I felt that there was far less of a provision for adverse deviation in pensions than in life insurance reserving.

I have also met my share (a few, not many) of pension actuaries who seemed to feel their greatest obligation was to reduce the amount the plan sponsor paid each year.

I also remember being in the terminal funding business at AIG, when Congress made it almost impossible for plan sponsors to terminate a plan and take out the excess assets.? Though laudable for trying to protect overfunding, it told plan sponsors that pension plans are roach motels for corporate cash — money can go in, but it can’t come out, so minimize the amount you put in.

The IRS was no help here either, creating rules against companies that overfunded plans (by more than a low threshold), because too much income was getting sheltered from taxation.

Beyond that, I remember one firm I worked for that had a plan that was very overfunded, but that went away when they merged into another firm which was less well funded.

I also remember talking with actuaries working inside the Social Security system, and boy, were they pessimists — almost as bad as the actuaries from the PBGC.

But enough of my musings.? There was an article in the New York Times on the troubles faced by some pension actuaries who serve municipalities.? For some additional color, review my article on how well funded most state pension and retiree healthcare plans are.

Pretend that you are a financial planner for families.? You can make a certain number of people happy in the short run if you tell them they can earn a lot of money on their assets with safety — say, 10%/year on average.? Now within 5 years or so, promises like that will blow up your practice, unless you are in the midst of a bull market.

Now think about the poor pension actuary for a municipal plan.? Here are the givens:

The municipality does not want to raise taxes.
They do want to minimize current labor costs.
They want happy workers once labor negotiations are complete.? Increasing pension promises little short term cash outflow, and can allow for a lower current wage increase.
A significant number of people on the board overseeing municipal pensions really don’t get what is going on.? It is all a black box to them, and they don’t get what you do.
You don’t get paid unless you deliver an opinion that current assets plus likely future funding is enough to fund future obligations.
The benefit utilization, investment earnings, and liability discount rates can always be tweaked a little more to achieve costs within budget in the short run, at a cost of greater contributions in the long run, particularly if the markets are foul.
There are some players connected to the pension funding process that will pressure you for a certain short-term result.

Even though I think pension plan funding methods for corporate plans are weak, at least they have ERISA for some protection.? With the municipal plans, that’s not there.? As such, more actuaries and firms are getting sued for aggressive assumptions, setting investment rates too high, and benefit utilization rates too low.

The article cites many examples — New Jersey stands out to me because of the pension bonds issued in 1997 to try to erase the deficit they had built up.? They took the money and invested it to try to earn more than the yield on the bonds — the excess earnings would bail out the underfunded plan.? Well, over the last eleven years, returns have been decidedly poor.? The pension bonds were a badly timed strategy at best.

Now, like auditors. who are paid by the companies that they audit, so it is for the pension actuaries — and there lies the conflict of interest.? One of my rules says that the party with the concentrated interest pays for third-party services, so it is no surprise that the plan sponsor pays the actuary.? I’m not sure it can be done any other way, unless the government sets up its own valuation bureau, and tells municipalities what they must pay.? (Now, who will remind them about Medicare? 😉 )

The suits against the pension actuaries and their firms could have the same effect as what happened to Arthur Andersen.? These are not thickly capitalized firms, and many could be put out of business easily.? For others, their liability coverage premiums will rise, perhaps making their services uneconomic.

Finally, the flat markets over the last ten years have exacerbated the problems.? Partially out of a mistaken belief that the equity premium is large (how much do stocks earn on average versus cash), actuaries set earnings rates too high.? The actuarial profession offers some guidance on what rate to set, but the reason they can’t be specific is that there is no good answer.? With all of the talk about the “lost decade,” well, we have had lost decades before, in the 30s and 70s.? Even if the statistics are correct for how big the equity premium is, equity performance comes in lumps, and in the 80s and 90s, when we should have taken the returns of the fat years and squirreled them away for the eventual “lost decade,” instead, politicians increased benefits as if there was no tomorrow.

The states and smaller government entities have dug a hole, and they will have to fill it somehow.? Lacking the ability to print money, they will raise taxes as they can, and borrow where they may.? We are seeing the first pains from this today, but the real crisis is 5-10 years out, as the Baby Boomers start to retire.? You ain’t seen nothin’ yet.

Half a Dozen Thoughts on Monetary Policy

Posted on 3 May 20084 May 2008 by David Merkel

1) If you are looking for an article that describes how the Fed’s new lending facilities work, look here.? It shows the effects on the Fed’s balance sheet of each program.

2) Well, I guess the Fed is willing to further risk its balance sheet in order to force LIBOR down.? Now, this may have knocked 10 basis points off of the TED spread in the short run, but I am not sure what it will do long term.? It may do nothing, because the LIBOR lending markets are so much larger than the Fed.? As is noted in this piece:

Still, RBS Greenwich Capital chief economist Stephen Stanley cautions that adding AAA-rated asset-backed debt may not do the trick. ?This is not likely to be a major change, as the highest quality ABS were getting financed without too much difficulty already,? he wrote in commentary.

3) As I have noted before, the Fed cannot, and should not solve every lending problem.? There is a tendency for the financial system to adjust to monetary laxity and ask for more.?? This is just another aspect of the way our government operates, absorbing many medium-sized crises at the risk of an eventual run on the Dollar.

4) Should the Fed pay interest on reserves?? At present, the Fed has banks lend to each other through the interbank market; if the Fed paid interest, the Fed funds market could become an explicit market where banks loan money to the Fed, rather than to each other.? Now for the Fed to issue debt would allow them more flexibility in their balance sheet, but at a price.? We would have a central bank with additional liabilities beyond the currency, and that would have an impact on their ability to do monetary policy.

5) Funny how the Republicans grab for something unusual — pointing a finger at the Fed for commodity price inflation.? The Fed does have a small role there, but the bigger factor is the development of China, India, Brazil, and many other placesthat need raw materials in a way they did not previously.

6) Though I disagree with this paper, it is worth a read.? I am not a monetarist, I am more of an Austrian economist.? I acknowledge that economic systems are not stable, and that is a good thing in the intermediate-to-long run.? In my opinion, the main weakness of monetarism is that it fails to recognize asset inflation.? When the money supply is growing too rapidly, the money goes somewhere.? If savers predominate, it goes to assets, if spenders, to goods and services.? We mismeasure savings in the US — it is higher than commonly believed.? As such, growth in the money supply boosted asset prices.? But as the Baby Boomers gray, that balance will tilt as they draw on assets to finance consumption.

What is needed is a willingness for central bankers to stand in the way of investment/lending booms, and raise rates to deflate investment/lending bubbles before they deflate themselves, with large consequences to the economy.? That’s not coming anytime soon.

One Dozen Notes on Markets Around the World

Posted on 3 May 20084 May 2008 by David Merkel

1) Desperation and the Dollar. In mid-March, pessimism over the US economy and monetary policy were so thick that people were considering the old Greenspanian rate of 1% Fed funds as possible. Well, times change, at least for now. The orange line above is the 2-year Treasury yield which gives a fair read on expectations of monetary policy, which bottomed in mid-March. It took the Dollar a little longer to move along, but the present course of dollar is up in the short-term (consider the Euro). That doesn’t address the possibilities of a wider lending problem, or the overly aggressive fiscal policies that will be employed by the next President. (Deficits don’t matter, until they are big enough to matter.)

2) I’ve talked about the US Dollar and the five stages of grieving. I think the G7 got to the second stage, anger, in threatening action recently. I think they get a respite from fear because of the bounce in US monetary expectations. My guess is that they would intervene when the Dollar gets to $1.70/Euro. Neither the threats nor the intervention will have much impact in the long run, though. This will only change when foreigners stop buying our bonds, and start buying our goods and services.

3) Another thing that correlates with the shift in expectations of US monetary policy are yields in long government bonds around the world. Surprise, as the anticipated future financing rates rise, the willingness to try to clip a spread off of long bonds declines.

4) So what could replace the Dollar as the global reserve currency? The Euro, maybe? The Yen and Pound are too small, and everything else is smaller still. The Yuan might be ready in 15 years when their financial markets are developed. It takes a long time for the reserve currency to shift.

5) So, why not the Euro? I’m still a skeptic that the EU will hang together without political union. Also, a strong Euro is testing the monetary union in places where credit markets are weak, and export markets are weakening because the US is getting more competitive with the weak Dollar. That said a persistently weak dollar raises the incentives for other countries to look for a new reserve currency. Leaving aside the potential instability of the EU (unlikely in the short run) the Euro is probably the best alternative.

6) This piece by Felix Salmon helps point out why why Iceland is the canary in the coal mine. They are the smallest economy with a floating currency. It seems like they are successfully defending their currency at present, at the cost of 15% interest rates.

7) Is the UK economy just a miniature version of the US economy?

Cutting Central Bank lending rates
Bailout plans for the banks (and here)
Many homeowners with negative equity, and all of the problems that brings

8 ) Why is Chinese inflation rising? Loose monetary policy, and an undervalued Yuan, at least versus the Dollar. Now, maybe the Chinese will start buying Euro-denominated bonds, and sell more to the EU than they buy. (Note that I am not the only skeptic on the Euro’s survival.)

9) What of the Gulf States? What will they do with all of the dollars that they have? Along with China, their huge depreciating Dollar reserves are fueling inflation. Personally, if I were in their shoes, I would buy US corporations quietly, perhaps through the purchase of ETFs. But the huge accumulation of dollars threatens to create the same “white elephant” development schemes that they experienced in the early 80s, when the socialist Gulf governments had too many Dollars, and too few places to use them.

10) Inflation is rising in the OECD. This is a “sea change” in terms of economics. Policymakers have enjoyed falling inflation rates for so long that perhaps they aren’t ready for the degree of monetary tightening necessary to squeeze out inflation.

11) Development isn’t easy after a point. It reveals shortages, as India is experiencing in semi-skilled and skilled labor. This will eventually work out, but in the short run, it makes infrastructure and construction projects difficult. Bodies aren’t enough; skills are needed, and many better skilled Indians work abroad, where they can make more.

12) A rice cartel? Everything old is new again. I remember in the 1970s when the US talked about a wheat/corn cartel, in response to the new strength of OPEC. Personally, I don’t think it would be effective. Agriculture is too flexible for cartel-like schemes to work in the intermediate-term. But, let them try. It will be interesting to see what happens.

Is This What You Wanted?

Posted on 2 May 20082 May 2008 by David Merkel

In my blogging, in my other research and in investing, I gain some degree of comfort from being criticized by both bulls and bears. Worst of all would be no criticism; it would mean that I am not saying much. Criticism from both sides means that I am probably not blindly taking a partisan view, or talking my own book.

Briefly this evening, I want to point out some of the costs of our current monetary policies. Now, some things are going well, and the Fed might want to take some credit.? But the costs are soft costs, ones that are preferable to systemic financial collapse. That said, there are smarter and dumber ways to do bailouts. When I criticized the Bear Stearns bailout, I tried to point out how there have been better ways of doing bailouts from history, and that the Fed should have known this. I understand that the Fed may have felt rushed at the time, leading to a suboptimal decision, but they should be better read on economic history. Bailouts should be very painful for those bailed out, or else others line up for them.

Well, now that there has been one bailout, why not more? Other shaky areas of the economy could use a bailout… student lenders, homedebtors, home lenders, etc. Are they less worthy than Bear Stearns? Ignore the student lenders, because they pose little systemic risk. If housing prices fall another 20%, the systemic risk issues could be severe. Consider there two quotes from the article:

“There is no way to put the genie back in the bottle,” Minneapolis Fed President Gary Stern said in an interview with Fox Business Network on April 18. “What worries me most about where we wind up is that we will have an expansion of the safety net without adequate incentives to contain it.”

and

Richmond Fed chief Jeffrey Lacker and policy adviser Marvin Goodfriend wrote in a 1999 paper that central bank lending creates ever-expanding expectations. “The rate of incidence of financial distress that calls for central bank lending should tend to increase over time,” they wrote. That “creates a potentially severe moral-hazard problem.”

We’re on that slippery slope now. Should the Fed bend monetary policy even more to compensate for areas of lending where they have inadequate control? To the extent that you believe in central banking, central banks should deal with the big issues, and leave the little ones alone. Lend at a penalty rate during a crisis; don’t try to make things normal. Where there is systemic risk, stand behind the core but not the fringe; defend debt claims, and wipe out equity claims.

Or, consider the second order effects that our monetary policy creates: the weak dollar and the responses that foreign governments must follow: let their export sector wither, or follow US policy down, and accept more inflation. It will take a long time for the US to lose its reserve currency status, but we are on that path. Here’s to the day when we have to borrow in the currencies of oil exporters, or China. (Please no. 🙁 )

Or, consider the troubles that the states are in, since they have to run balanced budgets, unlike the Federal government, which can borrow in dollars, and inflate the currency as needed. I follow state tax revenues; it is an excellent coincident read on the economy. Well, sales tax revenues are falling. Also, some states are considering one of the “dumbest ideas ever” — pension bonds (borrowing to fund pension plans, relying on clever investing to beat the rate paid on the bonds). New Jersey lost big on their last attempt at pension bonds. Far better to consistently fund municipal pensions through general revenues. For those that have read me before on municipal pensions, their claim to fame is that they make private sector funding look good.

Finally, to end on a less sad note, is Iceland looking better, or , is it just part of an overall bear market rally?? (What of Argentina?) ? My guess is the latter, but maybe they have successfully defended their currency. Then again, we can look at Brazil, which is now investment grade on one side (from S&P). Good news follow good policies, and Brazil has been on the right track — they have become a net creditor, unlike the US. Hey, maybe the Real should be a reserve currency.