The Fed Failed Basic Economic Thought

Today's FT has an article by Henry Kaufman on "How Libertarian Dogma Led the Fed Astray" He writes:

"..... Its failure to spot the importance of changing financial markets and its commitment to laisser faire economics were big mistakes and justify a fundamental overhaul of the Fed.

The first of these shortcomings was its failure to recognize the significance for monetary policy of structural changes in the markets, changes that surfaced early in the postwar era. The Fed failed to grasp early on the significance of financial innovations that eased the creation of new credit. Perhaps the most far-reaching of these was the securitisation of hard-to-trade assets. This created the illusion that credit risk could be reduced if instruments became marketable."

Last October, Kenneth Arrow wrote in the Manchester Guardian:

"There have been two developments in the economic theory of uncertainty in the last 60 years, which have had opposite implications for the radical changes in the financial system. One has made explicit and understandable a long tradition that spreading risks among many bearers improves the functioning of the economy. The second is that there are large differences of information among market participants and that these differences are not well handled by market forces. The first point of view tends to argue for the expansion of markets, the second for recognising that they may fail to exist and, if they do come into being, may fail to work for the benefit of the general economic situation."

I would like to add this definition of the Theory of the Second Best from Wikipedia:

"The Theory of the Second Best concerns what happens when one or more optimality conditions are not satisfied in an economic model. Canadian economist Richard Lipsey and Australian-American economist Kelvin Lancaster showed in a 1956 paper that if one optimality condition in an economic model is not satisfied, it is possible that the next-best solution involved changing other variables away from the ones that are usually assumed to be optimal.

This means that in an economy with some unavoidable market failure in one sector, there can actually be a decrease in efficiency due to a move toward greater market perfection in another sector. In theory, at least, it may be better to let two market imperfections cancel each other out rather than making an effort to fix either one. Thus, it may be optimal for the government to intervene in a way that is contrary to laissez faire policy. This suggests that economists need to study the details of the situation before jumping to the theory-based conclusion that an improvement in market perfection in one area implies a global improvement in efficiency."

The Fed's role in creating the current mess is writ large. Greenspan, Bernanke, Poole, Mishkin, Yellen, et al all fell victim to an ideological group think that monetary policy should be run as if we live in a market economy with perfect information. We don't and at the same time, borrowing a bit more from Arrow's work, the Fed's central bank counterparts aren't voting for the same pareto optimal solution. For the Fed to manage policy and its regulatory stance as if all this were true is astounding considering all those high SAT scores sitting on the FOMC. And these are the same leading lights engineering the recovery? Considering how Bernanke et al are still pinning all the blame on the banks I have to agree with Henry, some major changes are in order.

Krugman on Wall Street Comp -- "Money for Nothing" ; Well Not Exactly

Paul Krugman, in his op-ed article today, is outraged that Wall Street pay is reportedly returning to pre-crisis levels. His outrage may be understandable but like so many others he is blaming the consequences for the cause of our problems. He writes --

"All of which explains why we should be disturbed by an article in Sunday’s Times reporting that pay at investment banks, after dipping last year, is soaring again — right back up to 2007 levels.

Why is this disturbing? Let me count the ways.

First, there’s no longer any reason to believe that the wizards of Wall Street actually contribute anything positive to society, let alone enough to justify those humongous paychecks."

If pay and contribution to society had any relationship then elementary school teachers would be earning more than Mr. Krugman for writing his column. After all, of what value does Mr. Krugman have to society? His pay, even his bully pulpit at the Times exists because the newspaper believes that people want to read what he has to say and will pay the NYT for the privilege. If more people are buying the paper or hitting the NYT website to read Mr. Krugman the more money the paper earns. Mr. Krugman would certainly want his share of the marginal revenue and the Times will certainly want to miminize his contribution to circulation so as to profit more from his articles. All of this is how business and wage setting works and has nothing to do with contributions to society.

Compensation is a tricky subject fraught with populist notions and high-horse orations, but if firms are paying a lot then they are making a lot -- be it newspapers, baseball teams or banks. As for Wall Street wizards, their big paychecks, and their contribution to society, let's get to the basics of what the financial sector does and the role of innovation.

The financial sector intermediates funds between lenders and borrowers and charges a handling fee priced in basis points. The more funds there are to intermediate the more absolute cash is generated by those basis points. Because of technical innovations, less people are needed to move this money about so the revenue is spread amongst fewer people. If a trader earns a few hundred million in profits for the firm, how much should he be paid? That is up to the firm, but I can tell you it will be a lot more than minimum wage. And if increasing sums of money are looking for yield what should the financial system do, turn it away? Of course not. Someone figures out how to manufacture the yield the cash is looking for and that someone and someones who now create lots of revenue for the firms to the tune of hundreds of millions should get paid what? As close to marginal revenue as Mr. Krugman would want to earn at the NYT.

The underlying problem is the policies of the world's central banks and their creation of all this capital flowing through the system. Innovation is a way for banks to handle huge flows relative to their capital base, innovation doesn't create flows. Run a monetary policy that constrains the growth of credit and hence the leverage of the U.S. economy and that will take care of bankers pay and inflation.

Policy is instead flooding the system with public money to replace private debt in order to get the economy back to running at some too high of a multiple of debt. At the same time the government and assorted pundits want banks to earn less profit from handling renewed capital flows because these firms were saved by government and are trading off of government capital. The government should then demand a bigger dividend on its shares, common or preferred, but of course that is why the banks want to hand back the TARP money ASAP.

Bankers are far from guiltless in the current debacle, and the firms that mismanaged and misread their profits should have gone out of business. The broader societal function filled by MER, AIG and others would have been picked up by someone else. Government has instead been trying to keep firms in business rather than manage the implosion from the loss of several players. To now ask bankers to play nice as the funds start flowing again is, well, good luck to that.

Yen / Dollar -- A Technical Look

The $/Yen chart and momentum indicators suggest that the dollar bounce against the yen is ending if not over -- no guarantees as you know and any bets you make are your own responsibility. The dollar should broach the lows set in the mid 1990s but the ultimate downside is as yet indeterminate. Because the forwards are pretty flat relative to spot, thanks to effective zero interest rates in both the U.S. and Japan the spot and the forward are pretty close making it less expensive to bet on a dollar decline than it used to be. To see Yen rally past 80 by September might be a fundamental shock to some (not me) but not a technical one.

Milken, Capital Structure, and The Future Of Banking

In today's WSJ, Mike Milken discusses how proper management of a firm's capital structure through a business cycle sharply raises the odds of survival. In discussing the evolution of capital raising options since the mid 1970s he writes (italics mine) --

"The accessibility of capital markets has grown continuously since 1974. Businesses are not as dependent on banks, which now own less than a third of the loans they originate. In the first quarter of 2009, many corporations took advantage of low absolute levels of interest rates to raise $840 billion in the global bond market. That's 100% more than in the first quarter of 2008, and is a typical increase at this stage of a market cycle. Just as in the 1974 recession, investment-grade companies have started to reliquify."

Since the mid 1970s banks have been financially innovated into a marginal existence when it comes to supplying capital to premier corporations. A good many of these innovations arose out of the need for firms to have continued access to capital when regulatory restraints shut down banks as an avenue for funds. As the prime rate began to mean something less than prime when classifying the borrowers the overall credit quality of any given bank's clientele declined as well. Most of the restructuring moves made by banks since then have been to 1) Attempt to recapture these premier clients by breaking down the regulations that kept them out of the capital markets as direct players; 2) Replace C&I loans with mortgage lending; 3) Increase lending to leveraged players in the capital markets such as hedge funds and dealer desks.

The Government is chastising the banking system for its transgressions and rightfully so in many regards. To me, the bank's biggest faults lie not in the businesses they went into, they seemed like rational choices at the time, but how they managed these forays. Quality of bank executives aside, the point is that lest banks become permanent wards of the state so that ROE is forever less important than sustaining a liquid balance sheet, the government should be careful about the regulatory restraints they are creating. Those that need to borrow capital will find a place, in this country or elsewhere, and a way -- regardless of the regulations in place.

Given the results, we should resurrect Glass-Stegall and again prevent commercial banking and investment banking from operating under one roof. This is better than the good bank / bad bank splitting being proposed. If these institutions are split into commercial bank and investment bank and either fails, so be it, because neither will be too big to do so. As for the future role of commercial banks, management will have a choice. A boring, steady ROE or they can opt to become investment banks instead and chase riskier profits. But now if they do, they must know that they are no longer playing with a net.

Feldstein Targets Inflation Risk -- And Misses

In the FT today Prof Feldstein writes an Econ 101 piece tying inflation risk to the monetization of the fiscal deficits. In his words:

"Whether this larger fiscal deficit leads to an increase in prices depends on monetary conditions. If the fiscal deficit is not accompanied by an increase in the money supply, the fiscal stimulus will raise short-term interest rates, blocking the increase in demand and preventing a sustained rise in inflation."

It is hard to know where to begin with his analysis since he makes no mention of the internationalization of the dollar and that Asian nations are essentially running as dollar-based economies. There is a reason why no one stands around any more waiting for weekly money growth numbers and why the Fed stopped publishing targets for M's. No one really knows how to read money growth in the current era.

While his basic economics is obviously right Prof. Feldstein fails, in my humble opinion, to grasp the signposts indicating inflation ahead by ignoring international capital flows. We do not live in a closed economy. He also confines inflation to the cost of goods and services and hence makes the same mistake Greenspan/Bernanke did in ignoring accelerating prices of assets. The claim that bubble management is beyond the scope of the Fed (What is beyond its scope today?) is true only in the narrow definition of management. What the Fed has the scope and obligation to do is keep credit growth from growing too rapidly. Until that becomes the Fed's focus, keeping the policy eyes on inflation indexes of dubious value will get us back into the same soup we are in now -- especially if our major trade deficit countries sustain current dollar policies.

Credit Collapse and The Tale Of Two Recessions

All the talk about comparing the current downturn with the Depression makes for scary bedtime reading. But as liquidity slowly returns to the capital markets and profits to financial institutions there is also now lots of chatter about green shoots and so my thoughts run to the 1980-82 recession (see chart). Actually that period was officially two recessions. The first ran from January 1980 to July 1980, the second ran from July 1981 to November 1982. That these were two recessions not one is exactly why I believe the comparison with the current downturn is valid.




The ferocity of the downturn in the first recession was created by credit controls. The second one was created by more traditional means – the Fed allowed the funds rate to get to 19% and the yield curve inverted a lot and stayed that way for some time. For the point of historical accuracy, the Fed did raise the funds rate during the first downturn and reversed quickly when everyone got scared at how fast the economy imploded.

One could say that that was an era of extraordinary inflation and that is not the case today. It’s not if you are only counting the price of good and services but it is if you decide to look at asset prices during the current decade.

At that time credit was deliberately collapsed by government fiat in order fight inflation (from a Time magazine article at the time) –

The Federal Reserve will tell banks and other lenders that, if they expand their lines of credit beyond the totals outstanding last week, they will incur a penalty: they will have to deposit a sum equal to 15% of the additional amount into a special reserve drawing no interest. How to stay within this requirement is entirely up to the lenders. They can refuse to extend additional credit to consumers, cancel the unused portion of existing credit lines, or go ahead and offer more credit, pay the penalty, and pass the cost along to the borrowers. "Secured" loans—those taken out to buy houses, cars, refrigerators and other appliances—will not be affected at all.

Also, the Federal Reserve will be empowered to extend its reserve requirements to banks that are not members of the Federal Reserve System; these banks hold 30% of all deposits. The effect will be to tighten the Fed's control of lendable funds throughout the economy. Fed Chairman Volcker will also undertake, in Carter's words, "a voluntary program, effective immediately, to restrain excessive growth in loans by larger banks." That sounds like more federal jawboning to get banks to stop making loans for unproductive purposes, such as financing mergers or speculative inventory increases.

The more things change…….

This time around the credit machine collapsed from the capital market imploding on itself. Regardless of how we got there, the reaction of real GDP growth is eerily similar and so is the reaction by the Fed and the President.

Once credit controls were lifted and monetary policy eased, the economy snapped back quite nicely. So it is perhaps a good percentage bet, based on returning liquidity and the math of quarterly data, that we get an upturn in the third quarter. And then?

In 1980-82, another recession took hold because Volcker was determined to squeeze inflation out of the economy. That recession brought about lots of comparisons to the Great Depression at the time and kicked off the hollowing out of this nations industrial core. You can look it up, but I will save it for another blog. In the end, at some real high costs, inflation was gone.

Do Obama, Geithner, and Bernanke have the political will to squeeze asset inflation out the economy by driving down the overall leverage in the economy. If they do, 2010 will witness a downturn just like what occurred in the 1980-82 recession. If they don’t, TIPS are cheap.

Bank CDS Spreads Narrow -- C Still On The Hot Seat

As the accompanying chart reproduced from Bloomberg illustrates, the news about bank earnings in the first quarter have narrowed CDS spreads from their recent wides at the end of March but they are still wide. JPM, priced as the best of the bunch, is at 174bp in from 216bp on Mar 30 but still quite a bit wider than the 111bp spread on Feb 9 -- its narrow for the year. C, the perceived weakest bank, was at 262bp at the beginning of Feb, widened to 666.6bp on Apr 1 and has since narrowed to 568bp. WFC, the big profit earner for Q1 is at 241.4bp from a wide of 312.5bp on Apr 1 but its projected earnings have not brought the spread back to its narrow of 128.8bp on Feb 9.

Equity prices for banks have performed better than the default spreads in recent weeks. One could argue that the equity valuations got too pessimistic and were ahead of the debt markets and this is a bounce back. Perhaps we can call CDS and equity prices in line today, perhaps not, but we can say that the all the talk of Q1 earnings and passed stress tests still has the market plenty worried about default, and worried about C most of all.

WSJ On Goldman, Subsidies & Too Big to Fail -- Firms Are Not Industries

In today's WSJ editorial on Goldman's desire to return TARP funds and get out from under the yoke of "Federalism" --

"The point is that Goldman and other banks can't have it both ways. If they want taxpayers to save them, then they have to take fewer risks and become smaller. Either that, or we need a new financial resolution or bankruptcy process that lets these companies fail while protecting the larger banking system. We're glad Goldman wants to flee Barney Frank's embrace, but it's still only half way back to the promised land of capitalism -- which includes the freedom to fail."

Saving an industry does not require saving any one firm. Policymakers seem to have forgotten this principle from their Industrial Organization classes. The memory lapse has created a lot of hand wringing and a rush to save firms from collapse -- lest the whole of western civilization would fail because GM stopped making cars and Citibank stopped making loans.

If GM were to stop producing cars tomorrow some firm would manufacture and sell the cars GM sold because the demand is still there. I would imagine Ford and the domestic factories producing Japanese cars would shift into overtime or at least back to full time.

When Lehman went under the impact on risk pricing was enormous and there was probably a better less disruptive way to shut the firm down. Lehman was a mismanaged firm but it was filling an economic need in the financial industry. Hence the firm is gone but the broker/dealer still operates as Barclays in the U.S. and as Nomura in the rest of the world, the Neuberger-Berman asset management arm is under new management, etc. Some of Lehman is gone forever because the demand for CDO structurers and traders is less than it was.

The financial industry exists to intermediate funds between lenders and borrowers so the overall economy can expand. There will be lots of firms filling that role in the years to come because there is a lot of profit in it. The names of the major players may be different as smaller healthier banks step up in class, foreign banks take more active roles, and new broker/dealers and M&A boutiques are formed. Today's boutiques and small shops can very well become tomorrow's Goldman's and J.P. Morgan's.

Government has a role in making sure the financial system continues to function but it is has no role in determining who the major players are going to be. There is a difference and, of late, it is a difference policymakers seem to have forgotten. Next time let Goldman fail -- the Government's only job is to make sure a firm's failure will not and does not take the financial system with it.

Retail Sales -- Not So Bad

A quick glance at what the Fed calls "control retail sales", sales ex autos, auto parts, gasoline stations, and building supply stores, shows a picture of why Bernanke and others suggest that the economy is show some signs of stabilizing.



To me, stabilization means the data turn positive. There is enough volatility in the data that the rate of change of the rate of change will give a lot of false reads. Even though the sharpest contraction in the economy does appear to be past, the economic risk going forward is that we are shifting from a liquidity crisis to a solvency crisis -- the full impact of the contraction in the nonfinancial sector has yet to be felt. The economy might not contract at quite the same pace, but it can still contract all the same.

Bernanke Asks The Four Questions, But His Answers Prove He Is No Rabbi Hillel

Fed Chairman Bernanke speaks today at Morehouse College in Atlanta asking the "Four Questions About The Financial Crisis." He mirrors the Passover Seder ritual where the youngest asks four questions to understand the why and how of Passover. The answers Bernanke offers for the current credit collapse of near biblical proportion proves a wisdom far less than the Rabbinic sages whose answers are repeated at the seder. Bernanke fails to note the Fed's passivity in the face of foreign saving inflows that "drove down the returns available on many traditional long-term investments, such as Treasury bonds, leading investors to search for alternatives."

If the Fed invoked credit growth instead of a single focus on inflation as a reason to adjust policy, as the Rabbinic sages would have had the wisdom to do, those returns never would have been driven so low as to so distort domestic investment and saving. If the Fed started tightening sooner and more aggressively policy would have effectively done what the FX market was not doing -- raising the cost of domestic credit so that domestic investment and saving could move towards balance.

Here is a paragraph from his talk:

Mortgage markets were not the only ones caught up in the credit boom. The large flows of global saving into the United States drove down the returns available on many traditional long-term investments, such as Treasury bonds, leading investors to search for alternatives. To satisfy the enormous demand for investments both perceived as safe and promising higher returns, the financial industry designed securities that combined many individual loans in complex, hard-to-understand ways. These new securities later proved to involve substantial risks–risks that neither the investors nor the firms that designed the securities adequately understood at the outset.

By failing to note that the Fed's myopic attention on flawed inflation indexes was complicit in creating the situation, the Fed risks creating the same situation all over again. Bernanke concludes with

. . . the Federal Reserve is committed to working to restore financial stability as a necessary step toward full economic recovery.

If that is to be true, the Fed must focus on credit growth and put aside inflation targeting. The next collapse will not find the Federal government as underleveraged as it was this time. Between now and the next crisis, however, the management of monetary policy suggests a period of tremendous profit for financial institutions. Yet again. This is no way to, as Paul Krugman wrote, "make banking boring again".

Shrinking Trade Deficit & Implications For Policy

Census reported on monthly trade in February and not surprisingly the deficit is a lot smaller than it used to be because import demand is quite a bit lower (see chart). The non-oil trade deficit has been shrinking since March 2007 and the turn in trend coincides with the beginning of the implosion in securitized products. The two events coincide but it is no coincidence (see chart of non-oil trade deficit vs two-year swap spread – my proxy for bank credit stress).

The flip side of a shrinking trade deficit is reduced foreign capital inflows to finance the deficit. Once the growth in the bid for these instruments ebbed, supply exceeded demand and traders and investors knew that these instruments were no longer going to be priced against the momentum of surging demand but against now weakening fundamentals – the rising tide of subprime mortgage defaults. Existing holders of these securities recognize a depreciating asset when they hold one and when they tried to sell it the “Street” showed no bid – no surprise. And we all know how the story unfolded from there.



The non-oil trade deficit is now shrinking even faster but the two-year swap spread has narrowed and seems relatively stable around levels generally consistent with recessions. The sum of the efforts by the Fed and Treasury to reliquefy markets is apparently working. In truth, they have been effectively replacing diminished foreign demand with government capital.

In the past several months the sharply narrower trade deficit reflects a sharp collapse in import demand (all of this is looking at non-oil trade flows). Recessions do that and do it fast when consumption drops off as rapidly as it has. It is no surprise that the economies of our trading partners turned sour at the same time – although it was a surprise to the FOMC based on the minutes released yesterday.

The drop in imports and narrowing trade deficit are why there is a huge ongoing adjustment in the U.S. capital markets and in nations manufacturing our imports. Moving forward is where policy gets tricky if a sustainable recovery is to be engineered. Policy needs to accept and manage the deleveraging of the U.S. economy. If economic policy instead focuses on supplanting private credit with government funds and keeping the dollar strong then policymakers here and abroad are just trying to put humpty dumpty back together and back up on that wall. By doing that policy is setting up humpty dumpty for another fall.

FOMC Minutes -- What was mentioned and why the dollar wasn't

Given the way in which financial events and new programs to reliquefy markets unfold, the minutes are a bit less newsworthy than they used to be in the sense that there isn't much surprise when it comes to knowing what the Fed is thinking. Still, there is always a tidbit or two that makes for interesting reading and ready comment.

This passage in the minutes qualifies (italics mine):

Several participants said that the degree and pervasiveness of the decline in foreign economic activity was one of the most notable developments since the January meeting. In light of this development, it was widely agreed that exports were not likely to be a source of support for U.S. economic activity in the near term.

Were they thinking in January that the export markets would hold up? When I read this and then looked back at policy these past several years it seems as if the FOMC doesn't quite understand just how interconnected the world is and how Fed policies can set off a domino effect of reactions around the globe -- not always to the good (see the recent run up in oil and food prices).

I have to believe the Committee members know better than this expression of surprise in the minutes indicate. Giving them this poetic license with the language in the minutes, my inclination focuses on what wasn't said -- or at least reported in the minutes (they are not necessarily one and the same).

There was only one mention of the dollar's FX value, and that to only point out dollar appreciation against the yen and how the dollar is doing against the major currencies. Considering the amount of debt being issued and the extent of foreign participation in the U.S. capital markets (China, for one) I would think some mention of the dollar and foreign holdings would be warranted. Perhaps it will be mentioned in the next meeting, which will be post G-20 and the hub-bub regarding China's concern about the value of its dollar holdings.

The minutes also contained this:

Several expressed concern that inflation was likely to persist below desired levels, with a few pointing to the risk of deflation. Even without a continuation of outright price declines, falling expectations of inflation would raise the real rate of interest and thus increase the burden of debt and further restrain the economy.

Those several are absolutely right. The Fed recognizes the obvious danger of deflation and wants positive inflation expectations, not too hot but not too cold either, and they are clearly committed to keeping these expectations warm.

Summing up everything being done to revive the credit markets, the economy, and to keep inflation from dropping below target, and then add in the lack of comment regarding dollar FX and foreign ownership of U.S. Treasury debt, I find it near impossible to come away with any conclusion other than that the dollar will fall and the Fed really isn't particularly concerned (see my 4/2 blog).

The Fed funds futures market is pricing a 50bp funds rate by the end of the year and a 75bp funds rate in spring 2010 and 1.25% by the fall.

Redressing the imbalance in the value of the dollar is necessary, though not necessarily sufficient, to restore economic growth.

Citibank Disconnect -- Is This Big Shoe Still Going To Drop?

The disconnect between the bond and equity markets can be startling at times and this one is worth noting, considering that banks are in the midst of remarking positions and conducting stress tests. The chart below, from Bloomberg, shows that the CDS (credit default swap) for C has been widening from the pack since Mar 9, the widest CDS for these banks.




Yet in terms of equity price performance since Mar 9, C is up 183%, BAC is up 94%, JPM is up 72% and WFC is up 51%. Considering that CDS for C is wider now than it was when C was trading under $1, I have to wonder whether the equity market got a bit too optimistic on C surviving.

Being a bond guy, meaning I tend to see the glass as half empty, my inclination is to believe the increased betting on Citibank defaulting.

Caveat emptor

Soros Weighs In, Talks His Book, The Dollar Is Going Down, And What Is Policy?

In an interview with Reuters Financial Television, George Soros opined on the U.S. banking system, how its "zombied" state will slow the economic recovery, and on his favorite topic -- the dollar:

"I think the dollar is now under question and I think the system will need to be reformed, so that the United States will be subject to the same discipline as is imposed on other countries," said Soros, whose famous bet against the British pound earned his Quantum Fund $1 billion in 1992.

"Being the main issuer of international currency, we have been exempt and we have abused that because we have effectively consumed 6.5 percent more than we have produced. That is now coming to an end."

Soros said there was a risk of a "tipping point" for the dollar which would see it slump, triggering higher interest rates and choking growth.

"This leads you to what used to be stagflation -- stop, go. And I think that is what's probably in store, rather than... hyperinflation. . . .

. . . . U.S. consumer spending has to fall to 60 percent of gross domestic product, compared two-thirds now, he continued."

Here is a man who knows how to talk his book -- he wants a strong dollar and reduced consumption. If a strong dollar reduced consumption the Chinese and other Asian exporters wouldn't have been propping up the dollar against their currencies despite a growing trade surplus. They wanted their export driven economies to continue to boom. To think they were lending us the capital out of largesse is wrong. If U.S. consumption did drop to 60% of GDP, as he suggests it should, and investment spending failed to pick up the slack that would be one heck of a downward adjustment to overall activity in the U.S. and globally.

For the dollar to have stayed strong in light of a growing trade deficit meant either the Fed had to raise interest rates or our trading partners, those with whom the U.S. has a big trade deficit, were willing to hoard dollars. Dollar hoarding won the day and the U.S. lost because the Fed, blinded by low inflation, kept interest rates too low. That meant credit was priced too cheap and that distorts activity just the same as high inflation expectations. That is what we got and that is why we are in the mess we are in. It was the Fed's misread of the economy, not financial sector abuses, that allowed those inflows of foreign capital hunting for yield to keep growing.

Mr. Soros knows that one of many steps to get the U.S. out of this mess is for the dollar to depreciate. We should really think of it as no longer allowing our trading partners to keep their currencies too cheap. Letting the dollar depreciate will also steepen the curve and give some real profit out of having zero carry. A dollar adjustment is not the cure all but it is a step in the right direction and even the Fed recognizes (see earlier post) that letting the dollar fall is far from the end of the world for this economy.

In truth, I am no longer sure what our policy is given all the zigs and zags since the summer of 2007. FASB has been bullied to change its rules so banks can again mark assets to their models but at the same time PPIP lets PIMCO and others bid for these assets with government leverage and a government guarantee against loss. If you are the bank, why sell them now that they are marked at 90 instead 40 -- I would imagine they would be buying instead. Or, more to the point, swapping their own legacy assets for others thereby picking up the free leverage and the guarantee against loss. I am not sure that this is what the Fed and the Treasury had in mind.

It is tough getting somewhere if you don't know where you are going. First one road looks good, then another, and before you know it you are in the same place where you started but out of gas. Policy is either going to manage the deleveraging of the U.S. economy through a lower dollar and higher real rates or it is going to try to restore the leverage by replacing private credit with public credit. Geithner said on "Meet the Press" a few weeks ago that a more sober economy will emerge while also saying that lower mortgage rates now give homeowners the opportunity to refinance and spend -- and they should do just that.

If in the end all we get is a public/private debt swap with a strong dollar policy aided and abetted by the nations where the U.S. has its biggest trade deficit then we are only delaying the inevitable adjustment.

Baseball Opening Day & The NY Yankees

In honor of opening day, thought I would share this photo of mine taken during the last game played at the old Yankee Stadium. Eco/markets thoughts to come.

Bernanke Set To Let Dollar Crumble

If you want to find out what the Fed is really thinking, thumbing through the titles of their working papers and reading some abstracts is a darn good way to find out. In the past few years a number of us have found that the papers reveal the direction of policy when a Fed official can't. Bernanke is at heart an academic and if he is going to take policy in a new direction he wants the underpinnings of good research. And the economists at the Fed are capable for producing excellent research.

Among the Fed's International Finance Discussion Papers is the paper "Currency Crashes in Industrial Countries: Much Ado About Nothing?" by Joseph E. Gagnon (2009-966) Feb 2009. Here is the abstract (bold is mine):

Sharp exchange rate depreciations, or currency crashes, are associated with poor economic outcomes in industrial countries only when they are caused by inflationary macroeconomic policies. Moreover, the poor outcomes are attributable to inflationary policies in general and not the currency crashes in particular. On the other hand, crashes caused by rising unemployment or external deficits have always had good economic consequences with stable or falling inflation rates.

When you add up all the policies, fiscal and monetary, and the economy it is hard to come to any conclusion other than that the dollar is going to weaken. Key though is not the dollar/euro or dollar/pound exchange rate -- it is the rate with those countries where the U.S. has big trade deficits. Eco 101 teaches us that, and now Bernanke has confidence that we have nothing to fear of the outcome. There is a geopolitical aspect to it, considering the dollar is the world's reserve currency, and you can bet that this subject came up when Obama and Hu got together yesterday for their one-on-one.

U.S. & China -- The G 2 That Count

Obama and Hu got together in a side room yesterday to, as reported in the FT

" . . . work together to renew world economic growth, strengthen the financial system, and establish a ”strategic and economic dialogue” group that would first meet in Washington later this year. . . "

China staked out its position as being upset over the amount of dollar debt they own but didn't own up to the manufacturing boom and sharp rise in employment and incomes that their "cheap yuan" policy had yielded. Everything has a cost. What we will never know for certain is whether the economic relationship between the U.S. and China these past number of years came out of a geopolitical arrangement to help China find employment for all those young men leaving the farms to seek their fortunes or at least a paying job in the cities. Young men are a powder keg waiting to explode when they have nothing to do but hang around street corners while on the dole.

Later in the article --

While talk of an emerging “G2” ignores the increasingly multilateral basis of financial diplomacy, it does reflect the reality that on a growing range of international issues, little can happen without agreement between the US and China.

It wasn't so long ago that stable global economic growth meant conversation and cooperation between the U.S. and Japan. If Japan wants to get back into the lead of shaping the world to come, look for Japan's financial institutions to aggressively eclipse European and U.S. global banks as the lead source of capital to finance the next upturn and buy some of the damaged banks as well.