2008 – Page 9 – The Aleph Blog

Eight Notes and Comments on the Current Crisis

Posted on 27 October 200827 October 2008 by David Merkel

1) Greenspan — what a waste.? A bright, engaging man becomes a slave to the Washington political establishment.? Now he gives us a lame apology, when he should be apologizing for his conduct of monetary policy, which encouraged parties to take on debt because of the Greenspan Put.? Now the debts are too big to be rescued by the Bernanke/Paulson Put, where the Government finances dodgy debts.

On a related note, Gretchen Morgenstern is right when she calls the apologies hypocritical.? I would only add that Congress also needs to apologize; they did not do oversight of the Administration properly.? Many members of the oversight committees are not economically literate enough to do their jobs; they can only score political points.

2) I found this post highly gratifying, because it points out the disconnect between macroeconomics and finance, which I have been writing about for years.? When I was an economics grad student, I felt economics had gone astray by trying to apply statistics/mathematics to areas that could not be precisely measured.? In this case, if your models of macroeconomics can’t accommodate the boom/bust cycle, you don’t deserve to be an economist.

3) You want accounting reform?? Start with accounting that disallows gains-on-sale in a financial context.? WIth modern life insurance products, gain from sale is not allowed under SFAS 97, and I would modify SFAS 60 to be the same way.? No profits at sale.? Profits are earned in a level way over the life of the business as risk decreases.? Let other financial firms use something akin to SFAS 97, and many business problems would be solved.

4) What freaks me out about this article is that Taiwan is refusing the full faith and credit of the US Government, which stands behind GNMA securities.? Don’t bite the hand that feeds you; who knows but that you might be traded for the elimination of Kim Jong Il.

5) It figures that the moment the PBGC buys the specious arguments of a pension consultant that the equity markets crash.? Whaat makes it worse is that the PBGC tended to buy long Treasury debt which has been one of the few securities rallying? recently.

Given all the furor over investing in long duration bonds for pensions versus equities, it is funny that the PBGC rejected the growing conventional wisdom that DB plans should invest in safe long bonds.? Once they reject their current pose, the equity market could rally.

6) Is the economy weak?? Well, look at the states.? If their tax receipts are going down, so is the economy.? We are in a recession, and maybe a depression, given the lack of strength in the banks.

7) Do we need a new system for managing the global economy?? The Chinese certainly think so.? They finance the US and don’t get much in return.? Perhaps China could host the new global reserve currency?? I don’t think so.? Their banking system isn’t real yet, and they still want to subsidize their exports.? The global reserve currency role will flow to the largest economy allowing free flow of capital.? Now, who is that?? Japan?? Too small, but the world now recognizes that their banks may be in better shape than many other countries.? Plus, they have been through this sort of crisis for a while, and may be closer to the end of it than the rest of us.? The alternative is that Japanese policymakers still don’t have the vaguest idea of what to do, much like the rest of the world now.

Thing is, we don’t have a logical alternative to the US Dollar as the global reserve currency.? The Euro is a creation of an alliance of nations untested by economic crisis.? Perhaps the rest of the world should consider the possibility of no global reserve currency, or keep the US Dollar, or, move to a commodity standard like gold or oil.

For now, though currencies will follow the path of panic, as carry trades unwind, as countries that had too much borrowing see loans repaid (Japan, Switzerland), and countries with high interest rates see a demand for liquidity, which perversely will push rates higher.? (Isn’t everything perverse in the bust phase, just as everything is virtuous in the boom phase?)

8 ) On the bright side, some boats are rising.? After seeming irrelevant, the IMF has found a reason to exist again with loans to Iceland, Hungary, and Ukraine, with more to come.? The small/emerging markets once again learn that they were at the end of the line in this economic game of “crack the whip.”? That said, the developed market banks financing them will get whipped too.? This is truly a global crisis.

And given that it is a global crisis, I wonder how willing the developed nations will be to add more funds into the IMF when they have crises at home to deal with?? I’m skeptical, as usual.? Perhaps the Treasury can send them a raft of T-bills.? The IMF can ask the Fed for contact info.

(more to come)

NOT Born and Bred in the Briar Patch

Posted on 24 October 2008 by David Merkel

Originally, I was not a fan of Bernanke, but the more I read about him, the more I liked him.? Still, my main fear that I wrote about at RealMoney at the time of his nomination has largely been realized in my mind.

		David Merkel
		Why I Don’t Like Bernanke as Fed Chairman
		10/24/2005 12:09 PM EDT

From my post on April 4th:

“I’m not crazy about Ben Bernanke being selected chairman of the Bush administration’s Council of Economic Advisers. This is not because I think he’ll do a bad job there; odds are, he’ll do fine. It’s kind of a nothing job, anyway. I just suspect that this is a stepping stone to becoming the next Fed chairman. Bernanke is too much of a dove on inflation for me, and too seemingly certain of his own opinions. If we have very placid economic conditions, he could do fine as Fed chairman. If we have crisis conditions, the last thing I want is a dovish idealist as Fed chairman.”

Greenspan was more of a political operative than an academic, and as such, fairly pragmatic as he threw liquidity at every crisis, creating a climate of moral hazard. Investors lose fear of loss, because monetary policy will bail them out in a crisis.

Academics think they understand how monetary policy affects the economy, and in my opinion, have a higher degree of confidence in their views than say, a banker in a similar position would. When models of the world are imperfect, a false certainty can do a lot of damage. Bernanke is a bright guy, but bright doesn’t mean right.

Position: None

Bernanke spent a lot of time studying the Great Depression as a grad student, and I did not.? As an academic, there is the bias that says, “Yes, but we have learned from the past, and know what to do next time.? We have the game plan to fight Depression II set.”

I think the wrong lessons were learned by Dr. Bernanke, and many academic macroeconomists.? They look at the ineffective remedies at the time: negative monetary growth, Smoot-Hawley, and lack of stimulus, and they conclude that if they can stimulate a lot more, they can avoid Depression II.

Depressions occur because market actors take on too much debt, including financial institutions, and at the tipping point, cash flow proves insufficient to service the debt, starting a self-reinforcing bust cycle going the opposite direction of the prior self-reinforcing boom.? Once the self-reinforcing bust starts, I’m sorry, but there is little that can be done.? Liquidation of bad debts must happen to clear the system.? In the absence of that, we can have a Japan-style scenario where rates go to zero, and we stay in a funk, or we could inflate the mess away, harming savers and pensioners.

The boom-bust cycle is normal to Capitalism and should be enjoyed, rather than avoided by policymakers.? A lot of smaller busts are better than one big bust when national debt to GDP levels are at record levels.

At this point, stimulus merely slows down the inevitable.? We aren’t liquidating debts as much as transferring them to the government.

I am waiting for the first Treasury auction failure.? They won’t call it a failure, and they may reschedule it.? When that happens, we will have a statement that shifting private debts to the US Government is not appreciated by the creditors of the government.

We also could have semi-failures, where the market clearing rate at the auction is well above the average bid.? A few of those, and the yield curve could be at record wide levels.

I view the Federal Reserve and Treasury as being a bunch of amateurs here.? That’s not an insult.? Take me, James Grant, or any number of bright critics of the Fed and Treasury, and if they were in charge now, they would be amateurs also.? There is nothing in their training that prepares them for dealing with the credit equivalent of nuclear winter.? Nor should there be.? These abnormal periods happen every 40-80 years whether we like it or not, once we forget the lessons of building up too much leverage under a fiat money system.

Should they be blamed for not bailing out Lehman?? That was the inflection point for this crisis as it is manifesting now.? Yes and no.? Yes, since they took it upon themselves to be the guardians of the whole financial system.? Yes, since they bailed out Bear and AIG, two institutions that they had no business bailing out.? Both were bailed out for reasons relating to systemic risk, and both were politically unpopular.? But though Lehman may have posed less systemic risk than AIG, it certainly posed more risk than Bear.? Yes, because they jolted expectations.? No, because they couldn’t have known the full chain of events that allowing Lehman to fail would touch off.

A hidden cost here is that activism begets more activism, or, at least, a demand for more activism.? If the Federal Government and the Fed are now the lenders of first resort, it is no surprise that many will come-a-beggin’.? Once you are willing to lend to support one critical area of the economy, my but many areas will deem themselves critical as well.? Where does it stop?? At this point, I think it might have been better to let Bear, Fannie, Freddie, and AIG fail, but with some sort of expedited bankruptcy process that quickly disposes of equity rights, and converts all debt claims into varying degrees of new equity.? This extinguishes debt claims, and accelerates the healing of the economy.? This would be true reform.

Looking Forward

Now, suppose for a moment that the monetary and fiscal stimulus programs work in the short-run, and bring down rates.? What happens when the Fed tries to exit?? My guess is that they can’t exit.? In paying interest on reserves, the Fed is slowly replacing the Fed funds market with its own lending.? If the Fed leaves, the crisis reappears.? But even apart from that, the government ends up with more debt, and that has to be serviced in some way.

In providing guarantees to money market funds, buying top-rated CP, and helping financial firms finance paper of varying quality, the Fed replaces markets that ceased to function for a time.? The Fed sets yields and prices for credit, but with little to guide their decisionmaking.? Set the price too high, and there are few takers.? Too low, and there are many takers.? Beyond that, with so many programs, what is a bureaucrat to do to figure out which programs are offering the most relief?? I’ll tell you, it is not possible to figure that out.? The money going out is certain, but the benefits are not.

Now, as Greenspan mumbles, wondering about how this crisis could have come about, those of us that are more aware (or intellectually honest), look at the increase in total debt levels and say, “It’s pretty amazing that the system held together for so long.”? It’s an ugly situation, but it is worth asking whether the current actions of our government might harm the future well-being of our nation.

It’s almost never a good idea to sacrifice freedom for security.? But the Federal Reserve has done that.? They are now tied to the Treasury Department, and any policy independence they had is gone.? Book-smart Bernanke has been co-opted by the street-smart Paulson.? Bernanke is a bright guy, but he was not “Born and bred in the briar patch,” as was Paulson, who learned the ropes on Wall Street.? (Do I have to say that Wall Street produces harder characters than academia?? No?? Good.)

In this case though, we are beyond normal, even for seasoned veterans of Wall Street.? There are no comparables any more.? This is more severe per unit time than 1973-4 or 2000-2.? Only the Great Depression remains as a benchmark, and that era grins at us as we think we can beat the process of delevering through government action, of which they had much.

I’m not grinning here.? We are looking at tough times.? May the Lord help us.

When What Cannot Happen Happens, More Surprises Likely Await

Posted on 24 October 200824 October 2008 by David Merkel

After not feeling well for a few days, I am back to writing.? Let me start with a blast from the past from RealMoney, during happier times:

		David Merkel
		Swap Curve Inverts a Teensy Bit, for a Moment
		2/17/2006 12:29 PM EST

Nothing big here, but the swap curve briefly inverted twos to tens a few minutes ago. There is no reason to panic here; I’m just pointing out something that is highly unusual in the bond market. Having successfully traded bonds 2001-2003, I can say that strangeness tends to beget more strangeness. If this inversion gets larger and persists, I will have a post on the topic, but for now, this is just a curiosity.

Position: none, but the swap market affects us all in a wide number of quiet ways…

		David Merkel
		The Deepening Inversion
		2/22/2006 11:06 AM EST

I did not expect the inversion in the Treasury curve to get so deep so quickly. At present, the Treasury curve is inverted 15 basis points from twos to tens. Does this mean the market is falling apart? No, only the economics of spread-based lenders.

Whoever taught me (way back when) that the swap curve can’t invert deserves a few whips with a wet noodle. It’s small, but swaps are inverted two basis points twos to tens. What will I see next? Inverted corporate curves for BBB bonds? I can’t imagine what that would imply for the economy. It would deepen my feeling that we are in uncharted waters in a low nominal world.

On the CPI, it is an advantage for TIPS buyers that the bond market focuses on the core CPI, when TIPS buyers get paid off of the unadjusted CPI. It allows us to get more yield off of our TIPS.

Inflation is higher than the core CPI indicates for a wide number of reasons, but the simplest one is that they exclude food and energy, whose prices have risen at faster than everything else for the past 10-20 years.

Eventually the long end of the Treasury curve will react badly when market players revise their long run inflation expectations, which in my opinion are too low. But for now, international flows dominate because US yields are higher than those in most other countries, and pension fund flows dominate because of a need to fund long liabilities. Until those factors quit, we will continue to live in a weird bond market, with uncertain implications for GDP and the equity markets as a whole.

This doesn’t make me change any of my strategies yet, but it does leave me uneasy.

Position: long long-dated TIPS, bank floating rate loan funds

Back then the yield craze was upon us, and credit risk forgotten.? The swap curve was theoretically never supposed to invert on a yield basis.? That was then, this is now.? A new yield craze is upon us, where credit risk is omnipresent, even in securities of the highest quality.? It reads, “I don’t care about the yield, just give me guarantees for a long time, and keep me safe.

That is manifesting in (at least) three ways right now:

Failure to deliver in repurchase markets. (Alea, Jesse’s Cafe Americain)
Swap spreads going negative on the long end of the curve. (Across the Curve, FT)
What bond deals are getting done for investment grade names are getting done at amazing spread levels.? (Baker Hughes, Pepsi — in 2002, spread levels for single-A names never got this wide, though some cyclical BBBs got that wide.)

The grab for safety is relentless, and the efforts of our Government are small relative to the size of the economy.? The yields of the investment grade bond market are a truer measure of the troubles, because no one is fiddling with it yet.? Even so, the fiddling may not turn even the manipulated markets around.

PS — As a final note, a kind word for the CDS market — their netting procedures work admirably, as pointed out by Alea (numerous times), and Derivative Dribble (a valiant start for a new blog).? Here’s a wild thought: we need the same thing on a broader and more complex scale, allocating the embedded losses in our financial system to their rightful recipients, wiping out common, preferred equity, and subordinated debt as needed, and forcing the conversion of debt claims to equity, delevering the system in a colossal way.

CDS netting does that in a flash for synthetic debt exposures, but how do you do it for a wide number of assets at once?? I’m not sure it can be done.? My question is this: do the present actions of policymakers genuinely help, as they shift debts from private to public hands, or do they merely delay the inevitable?? I hope the former, but I think it is the latter.

Full disclosure: long PEP

The Collapse of Carry Trades

Posted on 24 October 2008 by David Merkel

In his usual brief style, jck at Alea displays the collapse of carry trades through the appreciation of the yen.

Put on your peril-sensitive sunglasses before viewing.? When I was at RealMoney, I wrote a lot about carry trades, and how the end would be ugly.? We are experiencing that now.

		David Merkel
		The Craving for Yield, Part 2
		2/6/2007 2:55 PM EST

If you hang around bond investing long enough, you run into the phrase “carry trade.” It’s a simple concept where one borrows at a lower rate, and lends at a higher rate, just like any bank would do.

Free money, right? Yes and no. People make money in these trades often enough to make them popular, but there are often points where they blow up. The simplest example is when the Treasury yield curve is very steep, like it was in late 1993, or mid-2003 right after Alan Greenspan finished his last contest of “How much liquidity can I provide?” At that point, it seemingly paid to borrow short and buy longer dated Treasuries, clipping the interest spread. That works well when interest rates are falling, or when the FOMC is on hold at the bottom of the cycle, but once the hint that the first tightening might occur, it doesn’t work well until the first loosening is hinted.

Carry trades can involve other factors as well. Some creditworthy entity can borrow cheaply, and invest in less creditworthy or more illiquid paper, capturing a spread. That trade also goes in cycles; good to do it when everyone is scared to death, as in late 2002. Bad to do it in late 1999-2000, as the negative side of the credit cycle kicks in.

Carry trades can involve different currencies. Borrow in the low interest rate currency (Yen, Swiss Francs, Offshore Yuan), and invest in the high interest rate currency (US dollars, NZ dollars, Australian dollars, Korean Won, Indian Rupee, etc.) Again, it all depends where you are in the cycle, as to whether this is a good trade or not. The weak tendency will be for low interest rate currencies to appreciate versus high interest rate currencies, but in the short run, currency movements are somewhat random.

What fascinates me in the current environment is the size and variety of all the carry trades being put on at present. CDOs of all sorts. Borrowing in developed markets and investing in emerging markets currencies. Levering up nonprime commercial paper. Borrowing offshore in Yuan. Borrowing short to finance paper with short embedded call options. Corporate, RMBS, CMBS and ABS spreads are tight.

When I think of all of the different risks that can be taken in bonds (duration, convexity, credit/equity, illiquidity, currency, etc.) they are all being taken now, and at relatively high levels. There is an exception. Duration risk is not being taken because of invested yield curves. (But who is borrowing long to lend short? Not many I hope.)

The danger here is not immediate. As with most topping processes, it is just that, a process. Bubbles pop when cash flow proves insufficient to finance them. Cash flow is still sufficient now. Banks are still growing their balance sheets faster than their central banks. Petrodollars and Asian surpluses are still being recycled. Wealthy investors are still for the most part bullish. We’re not to the point of no return yet; the sun is shining amid large cumulus clouds. But as those clouds cumulate, we should prepare for rain. Okay, snow.

Position: none

Alas, but the boom has given way to a bust, and “All the king’s horses and all the king’s men, Couldn’t put Humpty together again.” Sad times these, but they had to come. There was too much leverage in the the system, and now leverage is collapsing, and the value of assets whose prices were artificially high due to the temporary additional purchasing power that leverage afforded.

Have a wonderful day amid the chaos, and be grateful if you have food, shelter, clothing, family, friends, and peace with God.

Neomercantilism and Sloppy Central Bankers

Posted on 22 October 2008 by David Merkel

When I wrote for RealMoney, one of my continuing themes was that the Federal Reserve was less relevant because neomercantilistic nations like China (and perhaps OPEC nations) had reasons for promoting exports to the US that were less than economic.? As such they would buy US fixed income in order to facilitate their exports.? What could be sweeter?? You send goods; we send promises, denominated in our own currency.

With that, I want to point to a short post from Marginal Revolution.? Like me, he takes the “modified Austrian” view that the bubble was caused not only by the Fed, but also by the neomercantilists, both of which I fingered in my “Blame Game” series.? Buying longer dollar-denominated debt stimulated mortgage rates more than the Fed could, because under normal conditions the Fed can only affect the short end of the yield curve.

PS — What a long day, to NYC and back.? I appeared on Fox Business News show “Happy Hour.”? They said I did very well.? If I get video I will post it here.? As I have said before, time on live television goes fast.? The four minutes seemed like the blink of an eye.? At the end, Liz asked me for a third stock, and I blanked out, so I said Assurant, a company that I love, but don’t currently own.? I will own it in the future.? I meant to say Pepsico, but it just didn’t come to mind.

I also had dinner with my friend Cody Willard after the show.? Though our rhetoric is different, we basically agree that the actions of the government in the bailout offer much possibility/potential for favoritism.? Also, that it is easy to start a bailout, and hard to end one.

Let the government chew on this: Pepsico issued $3.3 billion of corporate debt yesterday.? For a company with recession-proof products and a Aa2/A+/AA- balance sheet, for them to pay 4%+ over Treasuries is astounding.? Liquidity?? What liquidity?? If financing needs are outside the A-1/P-1/F1 CP box, there is no help.? Not that there should be help, but the corporate bond market is a truer indicator of our stress than the money markets, which still aren’t in great shape.

Full disclosure: long NUE PRE PEP

Survive, survive…

Posted on 20 October 2008 by David Merkel

I’m traveling, so no significant post this evening.? I would merely point you to the interview with Anna Schwartz suggesting that the Fed is fighting the last war, and is not fighting the solvency crisis, as they consider it a liquidity crisis.

As for me, with the total level of debt in the economy relative to GDP being so high, bear markets in credit should persist until that ratio is significantly reduced.? I am not a bull here on credit.? Focus on companies that can survive without external financing for three years.

I have made changes to my portfolio that reflect this.? More on that in the next few days.

Picking Some Stocks to Survive the Market

Posted on 18 October 200819 October 2008 by David Merkel

I have not done well in the markets for the last six weeks.? Here is why:

Overweight in Life Insurers.? Yes, they are in better shape than the banks, but that only means they got hit later, not that they would not get hit.
Too much economic sensitivity.? I felt that global demand would hold up better than US demand, but that only means they got hit later, not that they would not get hit.
I suspect that hedge funds have been blowing out my positions.

I’ve ben talking about stock survivability lately.? What does that mean?

Low levels of short-term debt.? Few major debt maturities coming in the next three years.
Low levels of total debt relative to tangible capital.
Still earning money and producing free cash flow, even in a tough environment.
If a company is cyclical, it has slack assets, particularly cash equivalents.? High current and quick ratios.
If not a financial, trading at a historically low price to sales ratio.? If a financial, trading at a historically low price to book ratio.
Good accounting quality and corporate governance.
A leader in their industry.? It would be difficult to lose them.

With a little work on my side, I came up with 80+ names to consider, that I think fit the above criteria, mainly:

AAPL ABX ADBE ADP AFG AHL ALL APA AXS BBOX BHE BHI BHP BWA CAS CB CF CHV CINF CLF CMI CRH CSL CTSH EBAY ENH FCX FDS FSR GD GPC GWW HANS HAR HCC HMN HON IBM ITW LNT LOW MHP MMM MRO MSFT MTW NKE NOC NOV NUE NVDA ODP OKE ORCL OXY PC PEP PL PRE PTP RE RHHBY RIO ROC ROCK RTN SHLM SIGI SYK T TEX TMO TRV TYC UTR VCLK WAG WBC WDC WRB Y ZMH

This is a portfolio that I think will do well even in tough environments.? I will be buying some of them on Monday, and let you know what I did.

Blame Game III

Posted on 18 October 200819 October 2008 by David Merkel

I went on a shopping trip today to buy a desk for my two youngest children (10, 6), both girls.? As I drove, I listened to radio C-Span, because it is “guilt week” for the NPR stations in the area.? In hindsight, I would have rather listened to the begging from the NPR affiliates than what I heard on C-Span.

The program that I heard was hearings on the financial crisis.? All of the testimony fell into the bucket of “not me, there are evil people who tricked us.”? My daughters must have found my negative commentary to be funny.

We have the government that we deserve.? Congress listens to self-interested loonies, rather than seek out those with intelligence that don’t have an axe to grind.? When I wrote the pieces, Blame Game, and Blame Game, Redux, what I tried to express is that there are a lot of parties to blame in our current crisis, and that everyone should ‘fess up their culpability.

With that, I want to add on a few more responsible parties:

29) FICO srcoring enabled loan underwriting to decouple from the local bank investigating the character of the borrower.? There is something lost when the underwriter does not explore the qualitative aspects of the borrower.

30) The fools who wrote that said that it is easy to make money in stocks or real estate.? They always show up near the end of the cycle.

31) Dojo suggests the Prime Brokers — How about the Prime Brokerage business model followed by most banks and investment banks which allowed their speculative clients to go ?nuclear? in any marketplace as long as they had a credit facility and a cell phone. A $10 million hedge fund run out of a basement in Westchester County NY or Orange County CA could control $1 Billion worth of goodies in many cases. Yikes!! A bit severe, but there is some validity there.

32) dlr suggests the FDIC — The bank regulators at the FDIC. It was their JOB to maintain oversight of the banking industry. Every regulator who allowed the banks they were monitoring to giving liar loans, or pick a rate loans, or zero down payment loans, and didn?t call a halt, should be fired for malfeasance. The regulators who had oversight of Washington Mutual and Indy Mac should be fired. And their BOSSES should be fired. Right up to Shiela [sic] Blair. I think that all of the banking regulators deserve blame here, plus the Bush administration, who encouraged malign neglect.

My main point is this: if you are defending your core constituency in this crisis, you are at least partially wrong.? There are so many culpable parties, that few are blameless.

Final note: in many ways, this is a proper comeuppance to US policy that encourages home ownership.? Policy was trying to push home ownership to 70%+, when reality should have said “be happy with a stable 60%.”? Home ownership is not an unmitigated good.? Many cannot truly afford it, and the government tricks them into buying what they cannot afford with reasonable probability.

The Dependent Federal Reserve

Posted on 17 October 200817 October 2008 by David Merkel

There was a great hoo-hah made in the ’90s and early 2000s over the grand importance of having an independent central bank, one that the politicians could not mold to their own ends.? This was largely during the Greenspan era, where the party line was independence, but Greenspan did what the administration wanted, no matter who was president.? Volcker was a better example of what an independent central banker was like, and as such, he was shown the door by Reagan.? Much as I liked Reagan, we would have been better off with Volcker, and better off with someone other than Greenspan.? (Ron Paul for Fed Chairman, baby. 😉 )

I could talk about the social or political aspects of the Fed that makes it less independent of the Government:

They have worked together in other roles.
They are grateful for their cushy sinecures.
The Fed has a too-large employment base that they don’t want to draw attention to.
There is an aspect of mutual back-scratching.
No one wants to take abuse from Congress or the Treasury.? Best to go with the flow.
News coverage always favors loose monetary/credit policy in the short run.

But I’m going to take another approach tonight, one that is more data-driven.? Here’s chart number one of the asset side of the Fed’s balance sheet:

My, but look at how Treasuries owned by the Fed and not sold to them by the Treasury have disappeared.? The most common asset (maroon) has disappeared, and has actually gone negative.? Here’s a simpler version of the graph:

Without the Treasury selling the Fed Treasury securities, the Fed would have run out of Treasuries with which to support its market intervention programs.? They are economically dependent on the Treasury.? That may have impact on their future decisions, not that the Treasury would want to ruin the Central Bank, after all they take care of the extra-constitutional stuff that the Treasury can’t.? Besides, it allows the Treasury to finance the government cheaply by issuing the Treasuries to the Fed.? The relationship is symbiotic.? What could be happier?

I’ve made the comment before that we are heading down the path of Japan with a few differences.? The differences are summarized in my pieces Liquidity for the Government and no Liquidity for Anyone Else, and Inflation for Goods Prices, Attempted Inflation for Housing-Related Assets, but Sorry, No Inflation for Wages.

Where we vary from Japan’s path of quantitative easing is that the money created from government credit in Japan was pumped into the banking system as a whole. In the US, it is pumped into the Fed’s plans to fix various lending markets. This article from The Economist has a good discussion of the similarities and differences.? Whether that will result in fixing those markets, or result in the Government/Fed becoming the one sole counterparty for those “markets” (with a difficult disentanglement) remains to be seen.

In a financial crisis, there are no good solutions.? The good solutions existed 7-20 years ago when orthodox central banking was replaced with tinkering, through oversupply of liquidity in minor problems that should not be called crises, which allowed investors to build up the level of leverage, because the Fed always came to the rescue.? Also, many Fed Chairmen of the past (in the 50s, 60s, and Volcker) stood up to the Adminstration and Congress, and did not enable their policies.? The economy was healthier as a result in the intermediate-term.

I’ve also said that Fed policy works through stimulating healthy parts of the economy, and that pulls the sick parts of the economy out eventually.? Well, because of the overleverage of the past, there are no healthy parts of the economy to work with.? I wish I could be more optimistic here, but given the path that the government is taking, I see the explicit debt of the US Government going to 100%+ of GDP before the system stabilizes, just in time to leave us overleveraged for our entitlements crisis.? At least the debt is denominated in US dollars. :(? How long will our lenders continue to honor that?

We face painful choices over the next 20 years partly as a result of the policies of the last 20 years.? 20 years of pain… hmm… that sounds like Japan as well.? Let’s pray for a better outcome.

Our Monetary Policy is not an Asset

Posted on 16 October 2008 by David Merkel

It is an interesting academic question for Dr. Bernanke.? “Perhaps we should consider asset prices in our monetary policy after all?”? Nice to be considering that idea now, when it is too late.? The Fed has toyed with the idea in the past, often obliquely through the wealth effect, and how asset price inflation affects the creation of credit in banks.? Consider this post from RealMoney:

		David Merkel
		The Media Overstated Greenspan’s Point
		8/26/2005 1:36 PM EDT

Tony, you probably have more experience than me in this, so if you disagree after I write this, I defer to you.

I’m not sure the media didn’t get Greenspan’s point, but merely cast it in the most sensationalistic way. That the FOMC uses asset prices in making decisions is nothing new; the 1999 transcripts indicated how they used them with respect to the wealth effect.

Secondarily, though they haven’t stated it as plainly, when asset markets have an effect on depositary institutions, the Fed has a responsibility to protect the depositary institutions; the only real debate is whether it should be done through regulatory or monetary policy means. Cramer prefers regulatory means (boost regulatory capital held against risky loans), and I would agree, except that the Fed for political reasons doesn’t like to hold a smoking gun. That’s why they didn’t raise margin rates during the Nasdaq bubble, and why they are conducting a very quiet campaign through the bank examination process to put the fear of God into bank CEOs.

Where the media errs is that the FOMC would focus on assets solely. It’s just one criterion among many for a FOMC that has been notably elastic in their decision-making process (and monetary policy) during Greenspan’s tenure.

Partly, I see Greenspan’s comments as partly about the past to the present, but also pointing the way he would go in the future, if he had the opportunity. That said, barring unusual circumstances (i.e. a dilatory President Bush) he only has three FOMC meetings remaining … what Greenspan thinks about the future conduct of monetary policy is irrelevant, if the new Fed chairman thinks differently.

Position: None, but all of the likely successors to Greenspan worry me, and that is saying a lot…

I’ve argued in the past that both asset and goods/services price inflation should influence monetary policy.? I’m no great fan of fiat money, but if you are going to have fiat money, you must regulate the growth and nature of credit in order to make the system work in the longer-run.? Better we should move to a gold standard (after the crisis) or something like it.

Get the government out of the money and credit business.? They have not done well at it.? We would have more recessions/panics, but they would be shorter and sharper, but much easier for the system as a whole to recover from.? Under a gold standard, we could not build up the kind of leverage that we have done now, or at the Great Depression.

So, Professor Bernanke, that’s a really interesting academic point about asset prices and monetary policy, but there are no bubbles to avoid now, and it is not possible to reflate a bubble, short of massive monetary inflation, leading to price inflation of real assets.? Monetary policy works through stimulating healthy sectors of the economy; unhealthy sectors face credit spreads so large that moves by the Fed are useless, unless they themselves lend to or buy bad debt from the damaged sectors, with losses getting washed to taxpayers through reduced/negative seniorage.

And, if I may say it plainly… I think the governments and central banks of the developed world are going to find out that they are smaller than the size of the credit problems, which will lead to:

A severe credit-driven recession, and/or,
Significant socialization of the financial system (much more than what has been done so far), and/or
Insolvency of several major developed country governments.

The problems of excess leverage can be shifted, but they can’t be eliminated by government action.? I am repositioning my portfolio into companies that can survive the worst (hopefully), largely because I don’t think the present government policies will work in the intermediate-term.