Of course, there may be rallies, but the near-term trajectory of the market now seems downward. What we are experiencing is a reversal of the “flight to risk” that underlay the rally since March. As I mentioned in earlier posts, every risky asset class shared in the inflation in value, from commodities, to high risk bonds, to speculative currencies, to the most volatile stocks. In the last few days, all of this has come to a sudden and sharp end. Every asset class that was rising has dropped sharply in the last four trading days.

I am not much of a technician (one who reads the tea leaves of past market action to predict the future), but even skeptic that I am, the technical signals seem convincing that a significant downturn is at hand. The analysts and commentators that I have been following most of late are unanimous in their opinion that the market is more likely than not to head downward.

Marc Faber, who continues to amaze me with the correctness of his outlooks, had this to say in his “Boom, Gloom, and Doom” letter of July 1:

Personally, I would not be surprised to see for a while renewed deflationary fears
developing with bonds rallying (as mentioned in last month’s report), the US dollar rebounding and commodities and equities coming under renewed pressure. [emphasis in original]

Mr. Faber is referring to Treasuries when he says “bonds,” and these have rallied sharply over the last month and continue to rise. The dollar is rebounding, and commodities across the board (and notably, oil) have declined sharply, along with equities. Once again, Mr. Faber, you get a 5-star rating.

Dave Rosenberg, of Gluskin Sheff, minced no words after last Thursday’s market drop:

The S&P 500 is clearly struggling and on Thursday closed below its 50-day moving average and is barely hanging on to its 200-day m.a. As we have said before, the bounce in the market was a two-month wonder that looks to have been completed in early May and what is ironic is that most of the street strategists turned outright bullish after the complete move had already been made. But the volume has not been there, the green shoots are fading (with both auto sales and employment disappointing in June) and it may be important from an “all the good news is priced in” standpoint that since the stress test results were announced the broad market has done little more than move sideways.

The CRB is also struggling now at both the 50-day and 200-day m.a.’s. The U.S. dollar has bounced back despite the weak economic data and the reason for that is because heightened risk aversion, which is what we are seeing now, tends to occur alongside a shift towards liquidity preference, and many investors may not like the greenback for a whole host of reasons, but liquid it is. [July 3, Brunch with Dave]

Mr. Rosenberg has been pointing his finger at all of the negatives for quite some time, and just before the latest drop in the market, he expressed his concerns succinctly:

“When all the experts and forecasts agree, something else is going to happen.”

During my 22 years in the business, I have rarely seen such a lopsided recommended asset mix from street strategists as is the case today. So, we have a lot of groupthink on our hands. From my lens, we had Armageddon priced out in March, the recession priced out in April, and since early May, the S&P 500 has been flat. At this stage, no recovery may bring on a 2002 type of relapse, which nobody believes will happen, or a full-fledged recovery may bring on a 2003 type of rebound. We are at a critical juncture right now but I still think at this stage the market is fully priced and the history of post-bubble credit collapses is that recoveries prove elusive and fragile and deflation risks can linger for years. [Emphasis added. Breakfast with Dave, 6/30/2009]

Finally, I cite Dennis Gartman, whose very expensive daily market letter I’ve been reading on a trial basis for a bit less than a month. I’ve learned in this time that Mr. Gartman is a quintessential chart trader. He has his views of the underlying economy and finance, but he never lets his personal views override the message of market action. When I started reading his newsletter, he was continuing to add to his speculative currency positions (ones that benefit from the carry trade, such as Australian and Canadian dollars), and taking more risk in stocks (though hedged). On this Monday, he completely reversed his investment stance.

… the inflation trade seems to be ending; the deflation trade seems to be rising and in that light being long of the “commodity” currencies is wrong… in so many ways. We want out… immediately.

Well add another unit to the short side [of the general market] this morning, skewing the trade to the short side.

Note that we were stopped out of our short position in bonds on the close last Thursday, Those not out should get out immediately.

[The Gartman Letter, July 6, 2009]

You can be sure that after the market drop of 2% today, with commodities also falling and bonds rising, he will be stronger in his view tomorrow that the market is moving toward less risk, with all its concomitant implications.

For those who have remained fully invested throughout the collapse and rally, this would be a good time to reconsider whether they want to reduce their market exposure. Mr. Rosenberg thinks that ten-year Treasuries are good investments for the next year. This might be an alternative to consider.

If we were to continue the path of the Great Depression, real economic activity would have still a lot further to fall, and the stock market, though it has fallen a lot this time, would still have another 50% decline to go. Still, if the Great Depression is a guide, the stock market now is well below the level it was at the same relative point in time.

To me, the real question that these charts raise relates to the effectiveness of the fiscal and monetary measures that have been taken this time. Here are some comparison charts:

Clearly, short-term interest rates were lower initially and have since been pushed down to unprecedented levels.

The money supply, which is another indicator of monetary policy, is shown starting 4 years before the downturn (unlike the prior charts):

The authors comment on this chart:

Figure 5 shows money supply for a GDP-weighted average of 19 countries accounting for more than half of world GDP in 2004. Clearly, monetary expansion was more rapid in the run-up to the 2008 crisis than during 1925-29, which is a reminder that the stage-setting events were not the same in the two cases. Moreover, the global money supply continued to grow rapidly in 2008, unlike in 1929 when it levelled off and then underwent a catastrophic decline.

Fiscal policy, as represented by government surpluses or deficits, is shown again starting 4 years before the downturn.

While monetary policy is wildly different than following 1929, fiscal policy is much less radically different. If we look at year 5 (2009), the fiscal deficit is about 2% of GDP. In 1930, it was zero; but 2% of GDP is not very significant. In 2010, the deficit is projected to be much larger, over 5%, compared to still zero in 1931.

The burning question is whether these differences are enough to push the world economy onto a different, more positive path than occurred in the 1930’s. There are certainly skeptics, especially followers of the Austrian school of economics. The current prevailing view, though, is that these measures, plus more that will be tried if these seem inadequate, will succeed. This seems overly sanguine to me. Rather, I think it is best to view us as in the midst of a grand economic experiment on the largest scale ever tried. Experiments, by their very nature, have uncertain outcomes.

We have already seen one part of the policy armada begin to come apart: the pushing down of long-term interest rates in order to make mortgages cheaper and house purchases more affordable. In the last month, the market has turned sour on US Treasuries. Yields on ten-year Treasuries have risen remarkably this year. The yield on the benchmark 10-year Treasury due May 2019 ended last week at 3.83 percent, up from the low this year of 2.14 percent on Jan. 15 (Bloomberg). Rising long term Treasury yields have pushed up mortgage rates from a low of 4.75% just a little over a month ago to a current 5.45%.

The rise in Treasury yields is being attributed to the massive deficits (the flip side of the economic stimulus). The federal government is going to need to sell $2 trillion of bonds to cover the deficit. There is skepticism in the market that this amount will be saleable at current yields, especially given the concern that all of the monetary measure will lead to inflation. Clearly, not everything is under the control of central government policy makers.

I would hesitate now to rush to implement his investment recommendations (see Will the Rally Ever End). His analysis is best viewed as a basis for long-term strategy, not for short-term trading. In general, by the time that big investors publicly announce their strategies, they and their colleagues have already acted on them.

Investment Outlook

Bill Gross | June 2009

Staying Rich in the New Normal

…

The current annual deficit of $1.5 trillion does not even address the “pig in the python,” baby boomer, demographic squeeze on resources that looms straight ahead. Private think tanks such as The Blackstone Group and even studies by government agencies, such as the Congressional Budget Office, promise that Federal spending for Social Security, Medicare, and Medicaid will collectively increase by 6% of GDP over the next 20 years, leading to even larger deficits unless taxes are increased proportionately. Collectively these three programs represent an approximate $40 trillion liability that will have to be paid. If not, you can add that present value figure to the current $10 trillion deficit and reach a 300% of GDP figure – a number that resembles Latin American economies such as Argentina and Brazil over the past century.

So the rather conservative U.S. government debt ratio shown in Table 1 will likely be anything but in less than a decade’s time. The immediate question is who is going to buy all of this debt? Estimates suggest gross Treasury issuance of up to $3 trillion this calendar year and net offerings close to $2 trillion – almost four times last year’s supply. Prior to 2009, it was enough to count on the recycling of the U.S. trade/current account deficit to fund Treasury borrowing requirements. Now, however, with that amount approximating only $500 billion, it is obvious that the Chinese and other surplus nations cannot fund the deficit even if they were fully on board – which they are not. Someone else has got to write checks for up to $1.5 trillion additional Treasury notes and bonds. Well, you’ve got the banks and even individual investors to sponge up some of the excess, but a huge, difficult to estimate marginal supply will have to be bought. The concern is that this can be accomplished in only two ways – both of which have serious consequences for U.S. and global financial markets. The first and most recent development is the steepening of the U.S. Treasury yield curve and the rise of intermediate and long-term bond yields. While the Treasury can easily afford the higher interest expense in the short term, the pressure it puts on mortgage and corporate rates represents a serious threat to the fragile “greenshoots” recovery now underway. Secondly, the buyer of last resort in recent months has become the Federal Reserve, with its publically announced and near daily purchases of Treasuries and Agencies at a $400 billion annual rate. That in combination with a buy ticket for over $1 trillion of Agency mortgages has been the primary reason why capital markets – both corporate bonds and stocks – are behaving so well. But the Fed must tread carefully here. These purchases result in an expansion of the Fed’s balance sheet, which ultimately could have inflationary implications. In turn, nervous holders of dollar obligations are beginning to look for diversification in other currencies, selling Treasury bonds in the process.

The obvious solution to both dollar weakness and higher yields is to move quickly towards a more balanced budget once a sustained recovery is assured, but don’t count on the former or the latter. It is probable that trillion-dollar deficits are here to stay because any recovery is likely to reflect “new normal” GDP growth rates of 1%-2% not 3%+ as we used to have. Staying rich in this future world will require strategies that reflect this altered vision of global economic growth and delevered financial markets. Bond investors should therefore confine maturities to the front end of yield curves where continuing low yields and downside price protection is more probable. Holders of dollars should diversify their own baskets before central banks and sovereign wealth funds ultimately do the same. All investors should expect considerably lower rates of return than what they grew accustomed to only a few years ago. Staying rich in the “new normal” may not require investors to resemble Balzac as much as Will Rogers, who opined in the early 30s that he wasn’t as much concerned about the return on his money as the return of his money.

William H. Gross
Managing Director

Regular readers will have noticed that I have made few posts the last few weeks. This is because I have been caught up in a combination of tax preparation nightmares and working on my major occupation — trying to bring sense and sensibility to the management of Jackson Forest, a state-owned 50,000-acre redwood forest near where I live. The former time sink was a  short-term frustration. The latter is turning into a lifetime occupation. For those interested in knowing more about my involvement with Jackson Forest, visit JacksonForest.org and Jackson Forum.

What is Going to Happen?

Of course, no one knows what is going to happen, even in their own life, let alone in the economy and financial markets, but we still a lot of time trying to figure it out.

The Stock Market

We had a major rally in the stock market in the last month (25%). Is this the beginning of a new bull market, or as I asked in the midst of the rally, is it a "sucker rally?" The answer depends on whether the wave of optimism that is pushing the market upward is well founded. Ulli G. Niemann (thanks to reader Rita Crane) expressed it well in his weekly review of the market:

So why is the market rallying?

Wall Street in its infinite wisdom does not look at current
data but has an anticipatory view in that traders look ahead
some 6 months and evaluate as to what the conditions might
be then. There has been much talk of an economic turnaround
later on this year, and even the Fed Chairman has supported
that view. In other words, the rally is based on nothing but
hope that we will be, economically speaking, in a better
place 6 months from now than we are right now.

As we’ve seen with the tremendous ups and downs over the
past 6 months, economic assumptions can change in a hurry
and with it the short-term direction of the market. In other
words, if that Goldie-locks-turn-around scenario, which many
on Wall Street envision, does not come to pass in a few
months, or is delayed, this rally will be history, and we
may very well revisit the March 9 lows.

The Financial Picture

The Obama Administration has thrown its full weight behind the Treasury and Federal Reserve efforts to bail out the biggest financial institutions, to transfer toxic assets from the banks to taxpayers, and to prevent bondholders and shareholders from having to bear the losses of their bad investments. This has been great for financial stocks and bonds.

Does it mean the banks are out of the woods and that now is the time to invest in the financial sector?

A great analysis of both the banks’ market and fundamental prospects is given by Meredith Whitney, justly famous for having foreseen the collapse of the banks. I highly recommend watching the video interview all the way through.

As you will hear, Ms. Whitney is optimistic about the very short-run prospects for banks, but has a sobering longer-term outlook not only for the banks but for the economy. She, in particular, has been pointing out for some time the cutting back of credit card companies on credit maximums to consumers. She expects credit lines to be cut by $800 billion, with corresponding impacts on consumer spending. She also expects housing prices to fall by about 30% from their current level.

The Bailout

The Obama Administration bailout has been dismaying to me on many levels — not the least of which is having to reassess my sense of trust in Obama’s instincts. No matter how I turn it over in my mind, the best interpretation of Obama’s backing of Geithner’s plan is that he has been badly misled by the advisors that he (mistakenly) trusts. The more straightforward interpretation is that Obama is a closet supporter of the big financial institutions. This I am not ready to believe.

What I do believe is that Obama has bought into the intellectual construction that says that a large, vibrant financial sector is key to economic prosperity and in his practical way is willing to get into bed with them to a very big degree in order to "turn the economy around." 

I am wondering now, though, whether he may be having second thoughts about the "Geithner Plan," now that people are pointing out the extent of the taxpayer abuses to which it is likely to lead. It has already been widely pointed out that its plan for private/public financing to buy toxic assets is a giant sweetheart deal for the private investors (restricted to hedge funds and big banks). Lawrence Kotlikoff and Jeffrey Sachs writing in the Financial Times have pointed out that the biggest banks with the most toxic assets can participate in the bailout (through special purpose subsidiaries), selling their worst assets to the subsidiary at an inflated price, while only putting up 7.5% of the purchase price (us taxpayers putting up the rest).

The authors give a hypothetical example for $1 bn face value of toxic assets owned by Citigroup, now with a true market value of 360 million. Citigroup could make a huge profit by using the government program (TARP) to bid the full face value for the assets! Citi bank could do this by setting up its own Public Private Investment Fund (CPPIF) under TARP to bid for its toxic assets.

… The CPPIF will bid the full $1bn in face value for its own toxic assets!

To see this, note that on a bid of $1bn by the CPPIF, Citibank would finance $71m in equity of the CPPIF, the Treasury would add another $71m in equity, and the FDIC would add $857m in loans to the CPPIF. The CPPIF will either break even (20 per cent of the time), or go bankrupt (80 per cent of the time). The CPPIF is therefore a washout – with no chance of profits, yet also zero liability.

On the other hand, Citibank gets a sure boost of $1bn minus $360m, or $640m in net worth, for which it pays $71m. Citibank’s gain from the CPPIF’s overbidding is $569m, which exactly equals the taxpayer’s expected loss that is incurred by the FDIC loan and Treasury equity…

It’s possible that some fine print of the GASP [Geithner and Summer's Plan] would try to preclude explicit hyper-self-dealing of the type just described. But when there is free money on the ground, Wall Street will figure out ways to pick it up. For example, Citibank could arrange to overpay Bank of America for some unrelated securities in exchange for having Bank of America do its bidding at the auction. Indeed, Citibank, Bank of America, and other toxic asset owners might join together in a consortium to finance an “arms-length” PPIF on favorable terms with the proviso that the PPIF bid for the toxic assets of the consortium. Business Week has reported that “Administration officials confirm Treasury may allow such seller financing. [Emphasis added.]

In commenting on the above analysis, Paul Krugman concludes:

If there’s a mechanism to police such deals, it isn’t clear. And the sense that the administration is just too close to Wall Street continues to grow. [Emphasis added.]

For me personally, the sense of dismay goes well beyond feelings about the administration’s financial policies, because they indicate that Obama’s mind is captive of mainstream (corporate-centric) economic thinking. This is bad news for those of us who feel that fundamental reform is needed to create a nation of the people and for the people.

Act Now to Oppose the Bailouts!

There is something you can do to oppose the bailouts. I will put this in a separate post, but you can take action now if you believe as I do that the public needs to:

Tell Obama and Congress: "If it’s too big to fail, it’s too big to exist. Dismantle the power of the financial elite and make policies that keep a new crop from springing up. We want our economy and politics restored for the public."

A New Way Forward is organizing the public to protest the Geithner policies. You can sign on easily. Join our voices together!

The Economy

I can find no better way to give a quick sense of the perilous state of the world economy than to refer you to today’s "Eurointelligece Briefing". This is just picked out as a topical, random sample of what is being reported but being largely ignored (or actively dismissed by those in government attempting to instill "confidence" in the economy). Here are the headline summaries, but I urge you to read the expanded version with links and charts. It should open your eyes.

IMF to raise forecast for toxic asset write-offs to $3.1 trillion for US originated paper, and  almost $1 trillion for European and Asian originated paper;

A Deutsche Bank report suggests that US junk bond default rate will rise to 53%;

Lawrence Kotlikoff and Jeffrey Sachs says the Geithner is even worse than they thought, as it allows banks to set up vehicles to bid for the bank’s own toxic assets; Paul Krugman compares this to a legal form of insider dealing;

Barry Eichengreen and Kevin O’Rourke have found that global trade, industrial production and stock markets are falling faster now than during the Great Depression;

Brad Setser has produced a striking chart about the fall in global financial flows -quite scary;

The euro area’s policy establishment condemns the leaked IMF proposals for fast track CEE euroisation as unrealistic;

Jean-Pisani Ferry gives a moderately optimistic assessment of the G20 meeting, arguing that it constitutes a small step in the direction of global economic governance.

Reuters

Wed Dec 17, 2008 7:08am EST  — John Kemp is a Reuters columnist. The views expressed are his own —

Fed unleashes greatest bubble of all

By John Kemp

Like the sorcerer’s apprentice, Federal Reserve Chairman Ben Bernanke and his predecessor Alan Greenspan have unleashed a series of ever-larger asset bubbles they cannot control.

Now the Fed’s decision to cut interest rates to between zero and 0.25 percent, coupled with a promise to  keep them there for an extended period, and the threat to conduct even more unconventional operations in the longer-dated Treasury market risks the biggest bubble of all, this time in the U.S. government debt.

THE ASYMMETRIC EXPERIMENT

Bubble mania is no accident. It is the direct consequence of the Fed’s asymmetric response to shifts in asset prices. Pressed to "lean against the wind" and adopt counter-cyclical interest rate and credit policies in the asset market, senior Fed policymakers have repeatedly demurred.

Led by Bernanke and Greenspan, officials have argued it is too hard and subjective to identify bubbles until afterwards, and not the Fed’s job to second-guess asset allocation decisions of professional investors.

Even if bubbles could be identified, they argue, pricking them would require swinging rate rises that would inflict widespread damage on the rest of the economy.

Far less damaging to allow asset markets to follow their natural cycle and stand by to cut interest rates sharply, supply liquidity and contain the fallout when the bubble bursts.

But the Fed’s asymmetric policy response to rising and falling asset prices (colloquially known as the "Greenspan/Bernanke put") directly led to much of the excessive risk-taking which has humbled the financial system over the last eighteen months.

More importantly, the Fed’s decision to respond to the collapse of the technology and stock market bubble by lowering rates to 1 percent and holding them there for an extended period is now widely accepted as a mistake that contributed to the bond bubble and subsequent housing market boom in the middle of the decade.

If the low-rate strategy was a mistake, it was a conscious one. In testimony to the UK Parliament last year, former Bank of England Governor Eddie George admitted the bank had deliberately sought to stimulate the housing market and house prices to support consumption during the downturn. Greenspan, Bernanke and Co seem to have adopted a similar approach in the United States.

The real mistake, however, was not creating one bubble to offset the collapse of another, but believing they could control what they had wrought.

When the Fed did eventually start to raise short-term interest rates in 2004, long rates remained stubbornly low for a year, and then rose much more slowly than anticipated, a development the puzzled Fed chairman and his able assistant Dr Bernanke described as "the Great Conundrum."

Even as rates eventually rose, the alchemy of securitization ensured the real cost of credit remained far too low until the subprime bubble finally burst in late 2007.

The second mistake is a basic design flaw in the Fed’s "risk-management" approach to setting monetary policy. Risk management is a nice idea, but not terribly useful. As engineer will explain, risk management involves trade offs and is not cost-free.

The Fed has struggled to formulate a response to "low probability, high impact" events such as the threat of deflation in the early 2000s. Its response has been to cut rates aggressively to ward off the danger of extreme downside events, a strategy officials liken to taking out an insurance policy.

That’s fine, but when these low risk events have not in fact occurred, as was never statistically likely, the resulting policy settings have proved far too loose, and the central bank much too slow to change it.

Concentrating on theoretical but small risks such as deflation has too often blinded the Fed to much larger risks near at hand of bubbles and asset inflation.

INTO THE UNKNOWN

Even as officials recognize policy has played a role stimulating an endless series of bubbles, the Fed finds itself trapped with no way out. Following the collapse of much of the modern banking system, the risk of pernicious deflation is now very real–more so than in the early 2000s.

So like the sorcerer’s apprentice, the Fed has cranked up the Great Bubble Machine for what policymakers hope will be one final time.

The Fed’s "unconventional" monetary strategy comes in four parts:

(1) Cutting interest rates to near-zero to lower the cost of borrowing.

(2) Injecting short-term liquidity into the financial system in the form of bank reserves (quantitative easing).

(3) Trying to pull down yields on longer-dated Treasury bonds through a combination of the jawbone (promising to keep short rates low for an extended period) and the threat to intervene in the market directly by buying longer-dated paper.

(4) Trying to reduce credit spreads above the Treasury yield for other borrowers, and increase the quantity of credit available, by buying mortgage-backed agency bonds for its own account, and financing other market participants to buy securities backed by other consumer credits, auto loans and student loans.

Most attention has focused on the zero-rate policy and quantitative easing at the short end of the curve. But the real significance lies in the unconventional operations targeting Treasury yields and eventually credit spreads at the long end.

Operations at the short end are designed to bolster the banking system and restart lending. But the Fed knows the banking system is not large enough to replace the much more important sources of credit from securities markets.

Operations at the long end are designed to get bond finance and securitized credit flowing. Short-end interest rates and quantitative operations are significant because they help shape the whole term structure of interest rates embedded in the curve.

ONE LAST SUPER-BUBBLE

The strategy has already succeeded in halving yields from over 4 percent in mid October to just 2.25 percent now.

By convincing investors interest rates will remain ultra low for a long period, the Fed has made them willing to lend to the U.S. government for up to ten years for what is a paltry return.

There are two risks. First, the massive rise in bond prices and compression of yields has come in the secondary market. The U.S. Treasury has not yet succeeded in placing much of its massively expanded debt and new requirements for next year at such low levels. But given the panic-driven demand for default-free assets, officials should not have too much difficulty.

The bigger one is that the Fed is misleading investors into the biggest bubble of all time. Bernanke is making what learned economists call a "time-inconsistent" promise to hold interest rates at ultra low levels for an extended period.

The problem is that if the unconventional monetary policy works, and the economy picks up, the Fed will come under pressure to "normalize" rates and reduce excess liquidity to prevent a rise in inflation. The resulting rate rises will inflict massive losses on anyone who bought bonds at today 2.25 percent rate.

Bizarrely, Bernanke and Co are in fact inviting investors to bet the policy will fail, the economy will remain mired in slump for a long period, deflation will occur and interest rates will remain on the floor, as Japan’s have done since the 1990s.

Buyers of real estate and subprime securities have recently been lampooned for foolishly overpaying at the top of the market. Bernanke and Co are gambling memories will prove short and investors will prove just as eager to pay top prices for long-term government and private debt even though the downside is large.

Let us have one last bubble, and when it collapses, we promise not to do any more in future…honest.

© Thomson Reuters 2009 All rights reserved

"Why should I care?" would be an understandable response to this topic. Inflation/deflation seems pretty far removed from concerns about economic and/or financial collapse. In truth, though, they are very central to the policies being pursued by the Federal Reserve. As you are likely to be aware, Mr. Bernanke has been anything but restrained in expanding the debt of the Federal Reserve and taking other measures aimed at expanding the money supply and keeping interest rates low. He has been explicit that much of his motivation is to avoid deflation, a falling off of prices. In his view, deflation is a specter so fearsome as to be avoided at all costs.

Why, you may wonder, is deflation such a bad thing? I have wondered the same thing myself. The underlying reason, it turns out, is the same reason that we are having a financial/economic crisis — the huge over-expansion of debt. As the economy contracts, many of those debt holders become hard pressed to pay back their debts. If prices decline, the burden of debt becomes even larger, because one needs to pay back with dollars that are harder to earn. Conversely, inflation has the opposite effect.

Consider, if inflation goes on at 3% per year, each year, one’s profits will increase by 3% per year just as a result of the inflation (leaving aside possible real effects on profits). In 10 years, due to compounding interest, $1 million of debt today will be able to be paid back in ten years for $750,000 of today’s dollars (which will increase due to inflation to the $1 million owed). Conversely, if prices decline by 3% per year, $1 million of debt today will take $1.34 million of today’s dollars to pay back ten year’s hence.

If deflation sets in, it makes outstanding debt burdens more onerous, and it also discourages taking on new debt for investment because the deflation effectively raises the interest rate. The Federal Reserve can’t lower interest rates below zero; so monetary policy is limited in its scope. Less investment will contribute to pushing the economy downward, which can then contribute to further deflation — and so on.

Mr. Bernanke believes that the deflation cycle was one of the major contributors to making the 1930′s depression so severe, explaining why he is so dedicated to preventing its recurrence.

Not everyone is so sure Mr. Bernanke is right or that he will achieve his goal of preventing deflation. Perhaps an even larger number believe that even if he is able to prevent deflation, he is doing so only at the cost of creating an unavoidable much larger inflation in the future. Mr. Bernanke answers such critics by saying that when the time comes, when the economy begins to expand, he will "mop up" all of the excess money in the system so that inflation won’t occur.

Who is right about this is not just an academic question. The huge increase in Federal Reserve debt, plus the huge increase in Treasury debt to finance the big federal deficits, are not matters of debate. They are fact. These create pressures toward higher interest rates for government bonds. However, the Federal Reserve to date has succeeded (or had "good fortune") to have very low interest rates for Treasury bonds.

If we have deflation, Treasury interests rates, although low, may persist or fall further, making Treasury bonds a good investment. Conversely, if serious inflation occurs, interest rates will follow suit and the price of such bonds will fall substantially. Whether bond prices will rise or fall in the future is a key question for all of those who now own the $6 trillion of publicly held U.S. debt.

As The Federal Reserve’s policies are official policy, they receive a great deal of media coverage of the rationale for them. Less coverage is provided to opposing views. I, therefore, concentrate on providing space for opposing, and to me very credible, critiques.

The first one in the series is from Reuters’ columnist John Kemp on the inherent contradiction of the Federal Reserve’s current efforts to push down and keep down long-term government bond interest rates.

[I hoped that] Obama would bring a fresh perspective to managing our economy, one that would provide for rebalancing the economy as well as the distribution of income. It is not just who get the money (although this needs to change), but what as a nation we choose to produce and consume. To make changes in the latter, we need to redistribute political and economic power. In Obama’s actions on the financial crisis, there is no evidence that he saw it as an opportunity to accomplish some of this redistribution. This is not encouraging for the future.

Since writing this, I watched Obama on the Jay Leno Show and on 60 Minutes. If you haven’t watched these, and have the time to spare, both of these provided very worthwhile insights into Obama’s understanding and approach toward addressing the financial economic plight.

What stood out for me were the following:

Obama spent most of his time on educating viewers about the origins and magnitudes of the crisis — and on the constraints and limitations the administration faces in attempting to resolve them. He made a good case for the approach taken in the Geithner-Obama plan — though he never really explained why the failing banks were not allowed to go into a restructuring process that would have lessened taxpayer risks.

Obama stated very directly that the bloated financial sector size and profits are not good for America.

He mentioned the unreasonable compensation of top people in the financial companies. He noted how in 1980, they earned 20 times average compensation, not the 200 times of recent years. The higher number is clearly unreasonable, he said. He said that the problem goes beyond the bonuses paid but to the excessive level of compensation in general (and perhaps, though I don’t recall exactly, he extended this beyond financial firms to corporations in general).

Further, it is not in our long-term interest to have all of the brightest people training for Wall Street. It would be better if they trained to become scientists, engineers, and others who would help the "real" economy.

He specifically mentioned that the financial sector didn’t produce "real" goods that people need, such as housing, automobiles, etc., and that we need to rebalance the economy away from the financial sector.

Obama’s understanding of the situation and his statement of values about what counts were reassuring. Though I still have issues with the latest bailout plan, I am more optimistic that he will address the problems of the disproportionate influence of the financial sector, and that he will work to move our economy toward types of production that will be to the long-term benefit of the people.

Even more redemption occurred when Geithner addressed Congress and laid out the regulatory reform requests of the Administration. This will be a major, fundamental reform in regulation of financial firms. For the first time, the government would have strong powers over firms such as AIG and other insurance firms. Hedge funds will no longer be able to operate in obscurity. The infamous unregulated derivatives will be regulated. Financial tax havens, such as the Cayman Islands, where big financial firms have operated outside of public scrutiny and government oversight, will no longer be exempt from government efforts to gain control.

In his appearance before the Banking and Oversight Committee, Geithner was strong and direct. He first summarized and acknowledged the failure to prevent the financial crisis. He then said,

To address this will require comprehensive reform. Not modest repairs at the margin, but new rules of the game…

We need much stronger standards for openness, transparency, and plain, common sense language throughout the financial system. And we need strong and uniform supervision for all financial products marketed to consumers and investors, and tough enforcement of the rules to ensure full accountability for those who violate the public trust.

Financial products and institutions should be regulated for the economic function they provide and the risks they present, not the legal form they take. We can’t allow institutions to cherry pick among competing regulators, and shift risk to where it faces the lowest standards and constraints. [This is a major, current regulatory failure, where financial institutions incorporate in states or countries with minimal regulation. Roylat]

And we need to recognize that risk does not respect national borders. We need to prevent national competition to reduce standards and encourage a race to higher standards. Markets are global and high standards at home need to be complemented by strong international standards enforced more evenly and fairly. These are global markets and challenges. Building on these principles, we want to work with Congress to put in place fundamental reforms that create a stronger, more stable system, with much stronger protections for consumers and investors, and a more streamlined, consolidated, and simple oversight framework.

Geithner went into detail in each of these areas. His entire testimony reinforces the messages of the summary.

Taken together, Obama’s communications and the proposed regulatory reforms, demonstrate that the financial companies are not going to simply be re-inflated and allowed to return to their predatory ways — at least until memories of 2008 and 2009 fade away. Let’s hope that is a very long time in the future. At least for the near future, the prospect seems good that the power of the financial sector is going to be seriously downsized.

By now, almost everyone must know that in the last week the Federal Reserve and the Obama Administration fired coordinated bombshells at the financial crisis.

First, last Thursday the Federal Reserve announced major increases in asset purchase programs, adding $1.150 trillion to the total. The total included purchase of up to $300 billion of long-term Treasuries. The Fed also expanded the list of the type of assets it would purchase under its Term Asset-Backed Securities Loan Facility (TALF).

Before the financial community and the public had a chance to catch its breath, on Monday, the Treasury unveiled the next blockbuster. Both the FDIC and Treasury would combine with private investors to purchase toxic assets from banks.

In the FDIC program, the government would put up 92.5% of the money and private investors would put up 7.5% — but, here’s the catch, private investors would get 1/2 of potential profits from their 7.5% investment and be liable for no more than their investment. Who is responsible for additional losses? The FDIC, which in theory is underwritten by the banking sector — though if there are big losses, it seems likely that you and me, the taxpayers, will end up paying.

In the Treasury program, the government and private investors would put up equal amounts of initial capital, and then the government would lend the entity twice its initial investment. The entity would then bid for troubled assets from banks. The kicker here is that, once the entity has purchased assets, it will able to borrow against them from the Federal Reserves expanded TALF program; then turn around and buy more troubled assets, and so on. The private investor again may get to leverage its initial sum by 6 times or more, with losses limited to its initial investment. Who is responsible for additional losses? You know who. You and me, the taxpayers.

A key part of the plan is to amend the TALF, which was initially a Federal Reserve initiative aimed at purchasing new loans, with the objective of expanding new lending. The amended plan allows loans against existing securities that were “originally AAA rated.” Of course, many of those AAA mortgage backed securities are, as we are well aware, now junk. You can be sure that these are the ones the new rescue partnerships are going to pledge to the government first.

[Nouriel Roubini's RGE Monitor has provided an excellent summary and brief analysis of the Geithner plan.]

Wall Street Wins!

The response of Wall Street, with a one-day rise on the Monday of the plan’s announcement of 7% in the S&P 500 and 18% in the S&P Financials indices, was ecstatic. The big bond investment firms fell over themselves with praise. This was what the financial community has been looking for, but almost giving up hope of getting: for the government to step in and buy all of the crappy loans on their books. The common estimate is that their are two trillion dollars of such junk held by banks. The government programs, not coincidently, have potential purchasing power of about $2 trillion.

If it works, and the street is currently betting it will, the plans will get the toxic debt out of the zombie banks, making them live once again, to the great benefit of the stockholders and option holders of the banks. Of course, the debt will go into the hands, primarily of the government; so if the plan doesn’t work, the economy doesn’t recover, and all of those bad mortgages, auto loans, and credit-card securities decline further in value, you and I will be left holding the bag.

And, of course, the big investment firms love the plan because they are going to be allowed to participate in buying up the bad debt with only small risk and big profit potential — to say nothing of getting to transfer their lousiest assets to the government. Bill Gross of PIMCO, the worlds largest bond company, has called it a “win-win” plan. It is a win-win plan for the investment community.

You Lose!

The Obama-Geithner plan is a lose-lose plan for you and me. We lose, first, because we as taxpayers are having to pony up almost all of the money to buy up the crappy assets that the financial community sold at very great profit to itself. The shareholders and bondholders of the financial community are getting the BIG bailout at our expense. If the plan fails, we are left holding the bag. Of course, the big financial firms will probably be forced into failure, too, but only after having transferred most of the bad privately-held securities into the hands of the willing government. This is bad public policy on multiple counts, not the least of which is the blatant inequity of it all.

But, what if the plan succeeds, as Geithner has clearly succeeded in convincing Obama that it will? You lose. The government will have succeeded in revitalizing the financial sector with the same players in charge. It will have turned the economy around by once again expanding leverage and debt, raising the burden of debt that for years has been depressing our real economic performance and individual well being. The chance will have been lost for transforming our economy away from pursuit of capital gains and financial aggrandizement toward focusing on meeting the real needs of our population and of the planet.

Obama Fails!

The current crisis, caused by financial excesses, offered the opportunity for us as a country to take away the dominant power of go-go finance and corporate exploiters. Instead of fundamentally rethinking and restructuring the political-economic management of our country, Obama has chosen to side with the entrenched power interests.

There are no outsiders in the inner circle of economic and financial advisors. All apparently come to their task with a mindset that big finance and big business are essential to the future of our country. Geithner was protégé of Larry Summers and Robert Rubin, both instrumental in the deregulation legislation that set the stage for the current crisis.

I am disheartened by this latest episode in the unfolding crisis not so much because of the unfairness of the latest plan but because of what it reveals about Obama’s core beliefs. The pressure that has been building around the financial meltdown has certainly required Obama to search within himself for the right answer.

There was no shortage of voices recommending that the failing banks be allowed to fail, to be restructured with government assistance, and the shareholders and bondholders be required to bear the results of their poor investment judgment. I have published many of these voices here. It seems highly likely that Axelrod, Plouffe, and Emanuel would have seriously challenged Geithner’s plan. Yet, in the end, when Obama had to decide, he supported a plan that is designed to make the financial sector as whole as possible, at huge cost to the government and, ultimately, us taxpayers.

From this episode, I infer that in matters of economics, Obama operates within the mindset of the prevailing economic paradigm of prosperity through continued growth in output, with little concern about what makes up that output.

For me personally, this is very sad. I had hoped, I realize now with little evidence, that Obama would bring a fresh perspective to managing our economy, one that would provide for rebalancing the economy as well as the distribution of income. It is not just who get the money (although this needs to change), but what as a nation we choose to produce and consume. To make changes in the latter, we need to redistribute political and economic power. In Obama’s actions on the financial crisis, there is no evidence that he saw it as an opportunity to accomplish some of this redistribution. This is not encouraging for the future.

James Galbraith has made another effort to get this message across — interestingly in the European media rather than the New York Times, where it properly belongs. The beginning of the Der Spiegel article is below, with a link to the entire article.

US ECONOMIST JAMES GALBRAITH

Financial Crisis Caused by a ‘Culture of Complicity’

While the world talks about new ways to save struggling banks, there are a handful of economists who think some banks shouldn’t be saved at all. American economist James Galbraith told Manager Magazin that it might make more sense to break them up and start over.

Manager Magazin: Professor Galbraith, you suggest that banks that suffer from bad assets should simply be declared insolvent, instead of rescuing them with taxpayers’ money. Why?

What should be done with the world’s ailing banks?

James Galbraith: We need a correct assessment of the degree of losses suffered by a bank which is functionally insolvent. But as long as the old management is in place, there are no incentives to cooperate in the evaluation you need to make. That’s the first problem.

The second problem is: When a bank is insolvent, the incentives for normal banking practice disappear. They become perverse. The incumbent management has good reason to gamble excessively and to make capital losses. This is because it appears that the regulators could soon close down the bank.

Beyond that, if the situation for the bank is truly hopeless or if the management is truly corrupt, then the incentive is to loot the institution, to take as much money out of it — e.g. in the shape of bonuses and dividends — before the true state of the books is discovered.

More

The Wall Street Journal story goes into depth. For those that can follow it, it provides a fascinating education on how these supposedly sophisticated organizations badly mispriced risk, and how other predatory financial concerns took advantage to reap billions in profits (which would not be realized if the government had not stepped in with taxpayer money to make the bets good).

I can see no public justification for making whole gigantic gambles on the failure of the U.S. economy. When gamblers are dealing with gamblers, caveat emptor should certainly apply. Bailing out the losers so they can pay the winners provides no public benefit.

Here is the article in full. It is worth trying to work your way through it.

Hedge Funds May Get AIG Cash

Some Bailout Money Is Set Aside to Pay Firms That Bet Housing Market Would Crater

By SERENA NG

Some of the billions of dollars that the U.S. government paid to bail out American International Group Inc. stand to benefit hedge funds that bet on a falling housing market, according to people familiar with the matter and documents reviewed by The Wall Street Journal.

The documents show how Wall Street banks were middlemen in trades with hedge funds and AIG that left the giant insurer holding the bag on billions of dollars of assets tied to souring mortgages. AIG has put in escrow some money for at least one major bank, Deutsche Bank AG, whose hedge-fund clients made bets against the housing market, according to a person familiar with the matter. The money will be released to the bank if mortgage defaults rise above a certain level.

In essence, while the U.S. government is busy trying to prop up the housing market — by trying to limit foreclosures, among other things — it is simultaneously putting up cash that could be used to pay off investors who bet housing prices would tumble and many mortgage holders would default.

It’s unclear how much government money might eventually flow to hedge-fund investors. Overall, the government has committed up to $173.3 billion to bail out AIG. Of that amount, AIG’s housing-related bets have cost U.S. taxpayers some $52 billion.

The investment strategies involved are perfectly legal maneuvers. Still, the losses show how AIG strayed from its core business: selling standard insurance policies to businesses and individuals to protect against everything from fires to lawsuits. "AIG’s financial-products division went heavily into the business of speculation, and its gambling debts are what taxpayers are paying off right now," said Martin Weiss of Weiss Research, an investment consultant in Jupiter, Fla.

 European Pressphoto Agency

An AIG spokeswoman declined to comment, as did a spokesman for the Federal Reserve Bank of New York.

The transactions worked like this: Investment banks such as Goldman Sachs Group Inc. and Deutsche Bank sold financial instruments to hedge funds letting them bet that mortgage defaults would rise. These instruments were credit default swaps, a form of insurance that pays out in the event of a debt default.

It is not known which hedge funds made those bets with specific banks. However, several large funds made big, ultimately profitable, wagers that mortgage defaults would increase.

Many of the assets AIG insured were tied to subprime mortgages. The deterioration of those high-risk mortgages, along with AIG’s own financial woes, forced the insurer to put up billions of dollars in collateral, mostly to the banks that were its trading partners. AIG sold protection on securities backed by physical assets, as well as on positions almost entirely backed by other financial bets.

Some of the U.S.-government exposure traces back to the hedge funds that spotted problems in the U.S. housing market in 2005. They wanted to "sell short" — or bet against — securities backed by mortgages to questionable borrowers. These hedge funds entered into trades with investment banks. The banks then used a complex set of financial maneuvers to pass on some of the risk of those trades to AIG and other insurers.

The transactions meant that AIG was wagering that the U.S. housing market would remain robust. With housing markets now in free fall, the hedge funds stand to collect money from their bank counterparties. AIG is, in turn, compensating the banks.

The banks that had sold credit default swaps to the hedge funds wanted to turn around and hedge their own risks. But finding that protection wasn’t easy.

So at Deutsche, the German bank’s securities arm created a handful of offshore companies known as collateralized debt obligations, or CDOs. These companies carried a series of exotic names, according to securities filings, mostly based around the moniker "START," short for STAtic ResidenTial CDO. They allowed Deutsche to neutralize its exposure to the hedge funds’ bets by buying swaps from START on the same securities its clients were betting against.

START held assets from a hit parade of lenders closely linked to the subprime crisis, including Bear Stearns, Countrywide Financial and New Century Financial, according to documents reviewed by the Journal.

In 2005, Deutsche found a willing taker for a chunk of the mortgage risks held by START: AIG Financial Products. The derivatives arm of AIG agreed to pay out up to $1 billion under two of the START vehicles, if underlying assets deteriorated or the insurer’s own credit rating fell below a certain threshold. AIG stood to earn a fraction of a penny each year for every dollar of protection it sold, according to securities filings, meaning it made less than $10 million annually on the $1 billion in insurance.

Up until AIG exited the market in 2006, "AIG was by far the single largest ultimate taker of risk in the [subprime mortgage] CDO space," says a senior investment banker whose firm bought credit protection from the insurer.

Last fall, after AIG’s credit rating was cut, the insurer paid roughly $800 million to START, according to two people familiar with the matter. Much of the money is being held in escrow and will be used to pay off Deutsche’s swap contracts if mortgage defaults in the portfolio rise above a certain level. Some of that money could go through Deutsche to its hedge-fund clients.

 

Click to See Full Chart

If the housing market improves, AIG could recover some or much of the cash it transferred to START. But that outcome won’t be known for years. The portions of START to which AIG is exposed were originally rated triple-A by Standard & Poor’s. They’ve since been downgraded to "junk" status by the ratings firm.

The START CDOs share some similarities with mortgage pools created by Goldman named "Abacus" and also insured by AIG Financial Products, according to people familiar with the matter.

These pools were made up of credit-default swaps tied to individual mortgage securities. AIG had to post collateral to Goldman when the assets dropped in value. Some of this money, too, could go to hedge-fund clients of Goldman.

From mid-September to the end of last year, AIG and the government paid $5.4 billion to Deutsche and $8.1 billion to Goldman under credit default swap contracts the insurer had written.

A spokesman for the German bank said, "Our exposure to AIG was well-collateralized and hedged." A Goldman spokesman also said his firm’s exposure was collateralized and hedged.

Write to Serena Ng at serena.ng@wsj.com

Printed in The Wall Street Journal, page A1

Copyright 2008 Dow Jones & Company, Inc. All Rights Reserved

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