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Crafty_Dog:
Let's Not Panic and Ruin the World
By BRIAN S. WESBURY
December 7, 2007; Page A17
WSJ

You can't move these days without bumping into an economic pessimist. "Recession in America looks increasingly likely," said the Economist magazine on Nov. 17. Two days later, in the International Herald Tribune, Nobel Prize winner Paul A. Samuelson brought up the specter of the Great Depression. And then, on Nov. 26, former U.S. Treasury Secretary Larry Summers wrote in the Financial Times that, "the odds now favor a recession that slows growth significantly on a global basis."

The pressure on policy makers to do something is intense. Not only is there a desire to see the government get even more involved in the housing loan market -- witness the Bush administration's plan to freeze starter rates -- there is also tremendous pressure on the Fed to make another large 50 basis-point rate cut in attempt to alleviate credit-market problems.

 
This desire for government intervention to fix problems that grown adults have created for themselves is dangerous. Constantly counting on the government to save the economy undermines confidence in free markets, conditions people to believe they don't have to live with bad decisions, and creates a willingness to take imprudent risk. Actions to stabilize the economy in the short term can destabilize it in the longer term, and set the stage for even more intervention to fix the new problems at a later date.

Moreover, all this pessimism makes serious economic problems less likely. If it really happens, a recession in the next year could be the most anticipated ever. That fact alone makes it improbable. Recessions usually surprise the consensus. When a recession is expected, the odds of rapidly rising inventories, excessive investment, or a surprise drop in new orders are reduced.

In the past, when manufacturing was a larger share of the economy and inventory control was less exact, recessions often began abruptly, sometimes on the heels of very strong growth. Today, with services a larger share of the economy, and technology speeding up information flow, the economy tends to glide more gently into recession. Given this, all the doom and gloom seems unnecessary.

Real GDP in the U.S. grew 4.9% at an annual rate in the third quarter, and has averaged 4.4% in the past two quarters. While real growth in the current quarter will slow (our forecast is 1.5% to 2.0%), this is more of a payback for the past two quarters of strong growth than it is a new direction for the economy. Average annualized growth in real GDP from March to December will be roughly 3.5%.

In addition, nominal GDP, or total spending, has accelerated from a 3.6% annual growth rate in the second half of 2006 to 6.2% in the past two quarters. This is an excellent signal that Fed policy is still accommodating. When the Fed is tight, the growth rate of nominal GDP, or aggregate demand, does not accelerate.

Despite all of this, many believe that credit-markets problems have increased economic risk dramatically. Mr. Summers argues that "levels of the federal-funds rate that were neutral when the financial system was working normally are quite contractionary today." "Speculative markets will not stabilize themselves," wrote Paul Samuelson. For Messrs. Summers and Samuelson, only Fed action can save the world.

But this argument confuses money and credit. It is increases in the money supply that drive total spending (or aggregate demand), not increases in credit. Many people confuse the idea of a "money multiplier" with money creation. They believe banks can create money. This is not true: The Fed is the only entity in the world that creates new dollars.

In a fractional reserve banking system, the money multiplier works as banks lend out part of their deposits and keep some in reserve. Then the next bank, which receives deposits as a result of the first bank's loan, lends out part of the money again. This is repeated over and over so that every dollar of the monetary base is "multiplied" into many more dollars of lending or credit.

Despite problems at many major financial institutions, this process is not breaking down. The Fed is not behind the curve. When the Fed buys bonds to inject new liquidity into the banking system, that money doesn't go into a black hole. Even if a bank has had its capital eroded by large write-downs, it must invest the new cash. Some banks are putting the cash right back into Treasury bonds, which is one reason Treasury yields are so low. Banks need less capital to hold Treasury bonds than they need to hold loans to the private sector.

But, contrary to popular belief, when a bank buys Treasuries, the money mechanism does not stop. For every debit there must be a credit, and this continues endlessly. In fact, it may be that banks are buying those Treasury bonds from foreign holders, say the Abu Dhabi Investment Authority, which just made a huge investment in Citibank. In this case, the money came right back into the U.S. banking system.

There are an infinite number of paths that the monetary transmission mechanism can take. The only time it breaks down is when investors expect deflation, as in the Great Depression. This is when hording cash makes sense. But this is not the case today. Consumer prices are up 3.5% versus last year. As a result, as long as the Fed is accommodative, money will find its way into the financial system and the multiplier process will continue.

This does not require massive money center banks such as Citibank. It can happen through any well-capitalized institution. For example, tens of thousands of community and regional banks made few or no subprime loans and have large amounts of excess capital. They are in fantastic shape. However, because the cost of funds for banks does not fall quickly, and adjustable rate loans reset immediately, a rate cut can hurt these banks' earnings. In addition, with uncertainty about the economy elevated, forcing banks to lend at lower rates doesn't make sense. Widening spreads between Treasury and private-sector bond yields are a signal that the federal-funds rate is too low, not too high. This helps explain why many regional Federal Reserve Bank presidents sound hawkish.

Hedge funds, private equity firms and nonfinancial corporations also have trillions in cash that is already being put to work. Citadel, a hedge fund, bought at-risk loan pools from E*Trade, and increased its investment stake by $2.5 billion. The French parent of CIFG Services Inc., a major bond insurer, injected $1.5 billion of new capital to shore up its balance sheet. Bank of America invested in Countrywide and HSBC brought its high-risk loans back onto its balance sheet.

The only real problem is that these "fixes" are not cheap. Citibank is paying 11% to Abu Dhabi. E*Trade reportedly sold its problem loans to Citadel for 27 cents on the dollar, a price many think is well below the true value. Institutions with cash and capital will make huge profits in this environment, while those without these two things will fight to survive. While not everyone is happy about it, the market is healing itself.

Some say that we can't risk a spillover of credit problems into the economy as a whole, but that ignores two things. First, outside of housing-related businesses and financial institutions that invested in subprime securities, the economy is in good shape. Despite many months of fearful forecasts and an erosion in consumer confidence, the economy remains resilient. Early holiday shopping data have been strong, car and truck sales rose in November and manufacturing continues to expand.

Second, more Fed rate cuts risk a weaker dollar, rising inflationary pressures and a new round of lax lending standards. Don't forget that similar arguments were used between 2001 and 2004 to justify a 1% federal-funds rate that was designed to ward off the significant and serious risk of deflation. That policy helped create the subprime lending crisis in the first place.

To top it off, as long as the Fed allows the market to believe more rate cuts are coming, the greater the incentive to put off business activity. An investor who wants to buy distressed property or debt, a potential home buyer, or a hedge fund looking to make a leveraged investment may choose to wait for lower interest rates before taking action. This delays the self-healing process of the marketplace.

All of this argues for a much more laissez-faire approach. Attempting to offset the problems caused by a few (i.e., a bailout), actually creates larger risks for the economy as a whole. The very act of saving the world puts it at greater risk.

Mr. Wesbury is chief economist for First Trust Portfolios, L.P.

DougMacG:
Wesbury is right on the money IMO. While I like low interest rates and as an exporter I like a weak dollar, taking the Fed rates to artificially low levels for economic stimulus would be to repeat a pattern that causes them to go up later to punitive levels and risk future stagflation.

The government has other stimulative tools available, not just free money.  Legalize energy production comes first to mind. Introduce market reforms into health care.  Make the previous tax rate cuts permanent, stable and predictable, not just stimulative.  Cut corporate tax rates.   At the state level, stop taxing capital gains that include inflationary gains as ordinary income!

The Fed's primary function is to maintain a stable value of the currency, not to attempt to tweak out all the minor ups and downs in the economy.  Other than energy, health care and government costs, none of which are dollar-caused problems, price stability has been good.

Stable interest rates are a secondary, but VERY important goal as well.  It is bad for the economy to have homebuilding, for example, alternate in boom and bust modes instead of to flourish as an ongoing, profitable industry employing millions. 

The Fed was painted into a corner last time when it lowered its rate to 1%.  The only step down from there would have been to just give money away.  They were out of policy options and admitted later that they don't want to be in that situation again.

Wesbury didn't like the last rate cut and I like rates right where they are now.  Let's start solving other problems.   - Doug

p.s. Here is a link to Wesbury's weekly column.  He posts every Mondays afternoon from what I have seen.  http://www.ftportfolios.com/Retail/Commentary/CommentaryArchiveList.aspx?CommentaryTypeCode=MMO&CommentaryCategoryCode=ECONOMIC_RESEARCH 

Crafty_Dog:
The Roots of the Mortgage Crisis
Bubbles cannot be safely defused by monetary policy before the speculative fever breaks on its own.
WSJ
BY ALAN GREENSPAN
Wednesday, December 12, 2007 12:01 a.m. EST

On Aug. 9, 2007, and the days immediately following, financial markets in much of the world seized up. Virtually overnight the seemingly insatiable desire for financial risk came to an abrupt halt as the price of risk unexpectedly surged. Interest rates on a wide range of asset classes, especially interbank lending, asset-backed commercial paper and junk bonds, rose sharply relative to riskless U.S. Treasury securities. Over the past five years, risk had become increasingly underpriced as market euphoria, fostered by an unprecedented global growth rate, gained cumulative traction.

The crisis was thus an accident waiting to happen. If it had not been triggered by the mispricing of securitized subprime mortgages, it would have been produced by eruptions in some other market. As I have noted elsewhere, history has not dealt kindly with protracted periods of low risk premiums.





The root of the current crisis, as I see it, lies back in the aftermath of the Cold War, when the economic ruin of the Soviet Bloc was exposed with the fall of the Berlin Wall. Following these world-shaking events, market capitalism quietly, but rapidly, displaced much of the discredited central planning that was so prevalent in the Third World.
A large segment of the erstwhile Third World, especially China, replicated the successful economic export-oriented model of the so-called Asian Tigers: Fairly well educated, low-cost workforces were joined with developed-world technology and protected by an increasing rule of law, to unleash explosive economic growth. Since 2000, the real GDP growth of the developing world has been more than double that of the developed world.

The surge in competitive, low-priced exports from developing countries, especially those to Europe and the U.S., flattened labor compensation in developed countries, and reduced the rate of inflation expectations throughout the world, including those inflation expectations embedded in global long-term interest rates.

In addition, there has been a pronounced fall in global real interest rates since the early 1990s, which, of necessity, indicated that global saving intentions chronically had exceeded intentions to invest. In the developing world, consumption evidently could not keep up with the surge of income and, as a consequence, the savings rate of the developed world soared from 24% of nominal GDP in 1999 to 33% in 2006, far outstripping its investment rate.

Yet the actual global saving rate in 2006, overall, was only modestly higher than in 1999, suggesting that the uptrend in developing-economy saving intentions overlapped with, and largely tempered, declining investment intentions in the developed world. In the U.S., for example, the surge of innovation and productivity growth apparently started taking a breather in 2004. That weakened global investment has been the major determinant in the decline of global real long-term interest rates is also the conclusion of a recent (March 2007) Bank of Canada study.

Equity premiums and real-estate capitalization rates were inevitably arbitraged lower by the fall in global long-term interest rates. Asset prices accordingly moved dramatically higher. Not only did global share prices recover from the dot-com crash, they moved ever upward.

The value of equities traded on the world's major stock exchanges has risen to more than $50 trillion, double what it was in 2002. Sharply rising home prices erupted into major housing bubbles world-wide, Japan and Germany (for differing reasons) being the only principal exceptions. The Economist's surveys document the remarkable convergence of more than 20 individual nations' house price rises during the past decade. U.S. price gains, at their peak, were no more than average.





After more than a half-century observing numerous price bubbles evolve and deflate, I have reluctantly concluded that bubbles cannot be safely defused by monetary policy or other policy initiatives before the speculative fever breaks on its own. There was clearly little the world's central banks could do to temper this most recent surge in human euphoria, in some ways reminiscent of the Dutch Tulip craze of the 17th century and South Sea Bubble of the 18th century.
I do not doubt that a low U.S. federal-funds rate in response to the dot-com crash, and especially the 1% rate set in mid-2003 to counter potential deflation, lowered interest rates on adjustable-rate mortgages and may have contributed to the rise in U.S. home prices. In my judgment, however, the impact on demand for homes financed with ARMs was not major.

Demand in those days was driven by the expectation of rising prices--the dynamic that fuels most asset-price bubbles. If low adjustable-rate financing had not been available, most of the demand would have been financed with fixed rate, long-term mortgages. In fact, home prices continued to rise for two years subsequent to the peak of ARM originations (seasonally adjusted).

I and my colleagues at the Fed believed that the potential threat of corrosive deflation in 2003 was real, even though deflation was not thought to be the most likely projection. We will never know whether the temporary 1% federal-funds rate fended off a deflationary crisis, potentially much more daunting than the current one. But I did fret that maintaining rates too low for too long was problematic. The failure of either the growth of the monetary base, or of M2, to exceed 5% while the fed-funds rate was 1% assuaged my concern that we had added inflationary tinder to the economy.

In mid-2004, as the economy firmed, the Federal Reserve started to reverse the easy monetary policy. I had expected, as a bonus, a consequent increase in long-term interest rates, which might have helped to dampen the then mounting U.S. housing price surge. It did not happen. We had presumed long-term rates, including mortgage rates, would rise, as had been the case at the beginnings of five previous monetary policy tightening episodes, dating back to 1980. But after an initial surge in the spring of 2004, long-term rates fell back and, despite progressive Federal Reserve tightening through 2005, long-term rates barely moved.

In retrospect, global economic forces, which have been building for decades, appear to have gained effective control of the pricing of longer debt maturities. Simple correlations between short- and long-term interest rates in the U.S. remain significant, but have been declining for over a half-century. Asset prices more generally are gradually being decoupled from short-term interest rates.

Arbitragable assets--equities, bonds and real estate, and the financial assets engendered by their intermediation--now swamp the resources of central banks. The market value of global long-term securities is approaching $100 trillion. Carry trade and foreign exchange markets have become huge.

The depth of these markets became readily apparent in March 2004, when Japanese monetary authorities abruptly ceased intervention in support of the U.S. dollar after accumulating more than $150 billion of foreign exchange in the preceding three months. Beyond a few days of gyrations following the halt in purchases, nothing of lasting significance appears to have happened. Even the then seemingly massive Japanese purchases of foreign exchange barely budged the prices of the vast global pool of tradable securities.

In theory, central banks can expand their balance sheets without limit. In practice, they are constrained by the potential inflationary impact of their actions. The ability of central banks and their governments to join with the International Monetary Fund in broad-based currency stabilization is arguably long since gone. More generally, global forces, combined with lower international trade barriers, have diminished the scope of national governments to affect the paths of their economies.





Although central banks appear to have lost control of longer term interest rates, they continue to be dominant in the markets for assets with shorter maturities, where money and near monies are created. Thus central banks retain their ability to contain pressures on the prices of goods and services, that is, on the conventional measures of inflation.
The current credit crisis will come to an end when the overhang of inventories of newly built homes is largely liquidated, and home price deflation comes to an end. That will stabilize the now-uncertain value of the home equity that acts as a buffer for all home mortgages, but most importantly for those held as collateral for residential mortgage-backed securities. Very large losses will, no doubt, be taken as a consequence of the crisis. But after a period of protracted adjustment, the U.S. economy, and the world economy more generally, will be able to get back to business.

Mr. Greenspan, former chairman of the Federal Reserve, is president of Greenspan Associates LLC and author of "The Age of Turbulence: Adventures in a New World" (Penguin, 2007).

Crafty_Dog:
The Global Money Machine
By DAVID ROCHE
December 14, 2007; Page A21

Robert Graves defined hell as "words repeated endlessly until they all but lose their meaning." "Liquidity" is one such word from the financial lexicon. Yet, properly defined, it is the clue to the potentially disastrous outlook for the global economy and financial markets.

 
It is a no-brainer to say that the credit crunch is making liquidity scarce. It is less clear why central banks are powerless to do anything to stop it contracting, and why this shrinkage will sabotage economic growth as economies fall prey to the credit drought in places as far-flung as the Baltic states to China, as well in the OECD countries.

But to back up for a minute, what is liquidity? Two years ago, when confronted with financial-sector balance sheets and asset prices that were growing at a multiple of GDP and money supply that wasn't, we at Independent Strategy found our answer. At the time, there was precious little correlation between money and financial-asset prices. That seemed strange. Unless return on assets, measured by corporate return on capital, was rising exponentially, there was no justification for asset prices to be doing so.

Further research indicated that what was driving asset prices was the supply of copious and cheap credit with which to buy them. This type of asset money or credit was not counted in the traditional definition of liquidity, which is simply broad money, made up of central-bank money and bank lending.

The reason for the exponential growth in credit, but not in broad money, was simply that banks didn't keep their loans on their books any more -- and only loans on bank balance sheets get counted as money. Now, as soon as banks made a loan, they "securitized" it and moved it off their balance sheet.

There were two ways of doing this. One was to sell the securitized loan as a bond. The other was "synthetic" securitization: for example, using derivatives to get rid of the default risk (with credit default swaps) and lock in the interest rate due on the loan (with interest-rate swaps). Both forms of securitization meant that the lending bank was free to make new loans without using up any of its lending capacity once its existing loans had been "securitized."

So, to redefine liquidity under what I call New Monetarism, one must add, to the traditional definition of broad money, all the credit being created and moved off banks' balance sheets and onto the balance sheets of nonbank financial intermediaries. This new form of liquidity changed the very nature of the credit beast. What now determined credit growth was risk appetite: the readiness of companies and individuals to run their businesses with higher levels of debt.

No longer could central banks determine how much debt was created. They used to do that by limiting the amount of central-bank money they supplied, which formed the base of all loans, and then obliging commercial banks to make reserves for every loan. This made lending capacity finite. Now that the loans didn't stay on banks' balance sheets, this control mechanism was ineffective. Lending capacity became almost infinite -- for a while. Indeed, central banks didn't even control the price of money very well any more; again; risk appetite set how risk was priced and central-bank rates held very little sway over the outcome. Yield curves, which were inverting at the time, had the effect that when central banks raised rates, long-term credit markets reduced them.

The credit tide is now ebbing. Since August, the credit system has been frozen solid. Debt issuance for all sectors of the economy has plummeted. Banks don't trust each other's balance sheets (and they alone know how bad their assets are). The rates at which they lend to each other show the same levels of risk premium as at the outbreak of the crisis, despite central banks' efforts to inject liquidity into markets.

For these reasons the Federal Reserve this week announced joint actions with central banks around the world to ease liquidity conditions. The Fed said it will initiate a series of auctions under the Term Auction Facility (TAF) that will inject funds to a broader range of participant depositary institutions against a broader range of collateral. The minimum rate of interest charged will be the expected fed-funds rate over the term of the loan. The auctions start on Dec. 17 for an amount of $20 billion to be lent for 20 days. Other auctions are planned for Dec. 20, Jan. 14 and Jan. 28. At the same time, the Fed set up bilateral swap agreements with the Swiss National Bank and the European Central Bank, so that these central banks could also borrow U.S. currency to fund dollar liquidity needs among their own banks.

These measures are an extension of what central banks were doing anyway: substituting central-bank money for funds normally lent and borrowed between banks in the interbank market. The funds themselves are not a "net" addition to liquidity, because they are paid back when the loan becomes due. The Fed's additional TAF auctions will help fulfill the responsibility of the central bank to ensure the proper functioning of financial markets by providing temporary liquidity. But they are not an additional easing of monetary policy or a bailout of banks' bad assets.

Therein lies the problem: The auctions address a liquidity shortage -- caused by the banks' refusal to lend and borrow from each other due to mistrust of each other's balance sheets -- but cannot address the solvency problem inherent in the balance sheets themselves.

Moreover, much of the leverage that fuels the economy is downstream from the banks, and on the balance sheets of nonbank financial intermediaries (such as brokers, hedge funds and investment banks) in the form of securitized debt and derivatives. Neither these entities nor many of the assets they own are eligible for central bank loans.

It was excessively optimistic risk appetite and consequent mispricing of risk that created this leverage problem. The reversal of risk appetite is now driving the deleveraging process. Just as the central banks were powerless to control the expansion of liquidity in the expansionary phase, it is unlikely that they can control its contraction and its economic consequences.

The deleveraging process will be ugly. First, the junk assets that the banks moved off balance sheet will have to be financed by the banks, and a lot of them will have to be moved back onto banks' balance sheets. As this happens, bank lending capacity gets used up. Second, re-intermediated junk assets will have to be written down. This destroys bank capital and further reduces lending capacity.

Finally, future bank lending practice is going to be changed. Much more lending will be kept on banks' balance sheets. When loans are securitized, banks will remain responsible for the quality of the credit and have to make prudent reserves against it. All this means lower liquidity expansion, particularly of asset money, and lower economic growth.

In a globalized system, no one is immune. The big shock of 2008 will be that the China bubble pops. After all, where would China be without excessive global liquidity flooding into its domestic markets over a quasi-fixed exchange rate and excessive household borrowing stoking U.S. consumer demand for China's goods? We are about to find out.

Mr. Roche, president of Independent Strategy, a global investment consultancy based in London, is the author of "New Monetarism" (Independent Strategy, 2007).

Crafty_Dog:
Money Illusions
December 17, 2007; Page A20
Groucho Marx once asked, "Who are you going to believe, me or your own eyes?" Too bad Groucho doesn't work at either the Federal Reserve or on Wall Street, where economists have been predicting that slower economic growth would lead to a slowdown in inflation. They should have believed their own eyes.

As any American who has shopped for groceries or gasoline can tell you, prices are rising. That was confirmed last Friday in the official figures for November, with overall consumer prices jumping 0.8% from a month earlier. That was the largest monthly gain in two years, and 4.3% higher than a year ago. The report for producer prices was equally as alarming a day earlier, rising 3.2%. The producer price index is up 7.7% in the past 12 months, on a seasonally adjusted basis.

Some analysts continue to ignore all this and focus on so-called "core" inflation, which excludes food and energy. That is cold comfort to Americans who devote increasingly larger chunks of their monthly budget to -- food and energy. One lesson of the past few years is that relying too much on core inflation data, as the Fed has done until recently, can be a dangerous mistake. We couldn't help but notice that former Fed Chairman Alan Greenspan, a longtime "core" watcher, was quoted last week as saying it is now a less reliable guide to monetary policy.

Not surprisingly, equity markets fell Friday on the inflation news -- the same markets that only a week earlier had been begging for easier money from the Fed. Anyone who recalls the 1970s understands that inflation is very bad for stocks in general, though of course price-sensitive shares like commodities can do very well for a while. If nothing else, the inflation figures should remind us that there is no free lunch for Wall Street in continuing its cheerleading for easier money.

It should also remind us once again that inflation doesn't rise or fall along with economic growth. Inflation is a monetary phenomenon and reflects the supply and demand for currency created by central banks. We learned in the 1970s that rising prices can co-exist with slower growth, and we learned in the 1980s, or should have, that rapid growth can co-exist with falling levels of inflation.

Those are lessons too many people seem to have forgotten this decade, which is why the Fed now has both less credibility and less leeway to ease money amid the housing recession and mortgage mess. If politicians want to help the economy, they'll stop relying on the monetary delusion and instead focus on fiscal policy -- specifically, a tax cut.


WSJ

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