Monday, August 31, 2009

The Recovery in the US - The View from the UK

All this talk about the recovery of the economy is tiring. Car sales are up do to government stimulus. Home sales are up in part due to the season and in part due to the $8,000 tax credit (government stimulus). In the meantime foreclosures continue to run at high levels, retail sales continue weak, unemployment remains high, and capacity utilization is low. We may have an economic recovery in the second half of the year, but with no underlying strength. So as the debate in the US continues about how good things are going to be, I thought an opinion from across the Atlantic might be informative. Text in bold is my emphasis. From the UK Telegraph:

Never in modern times has there been such a flat contradiction between the euphoria of markets and the stern warnings of officialdom at central banks and financial watchdogs.

Corporate credit has seen the steepest rally in almost a hundred years, according to Morgan Stanley. Hedge funds are reviving the final bubble play of early 2007, writing put options on long-dated "volatility" contracts to wring out extra profit.

It is as if the Great Contraction – as the Bank of England now calls it – was just a random shock, as if we should naturally expect "V-shaped" resurgence to take us back to where we were. Yet that is what precisely we are being told will not and cannot happen.

The current financial crisis is unlike any others," says the Bank for International Settlements. Lasting damage has been done. The "cumulative output loss" is likely to reach 20pc of GDP in the major economies.

The message is the same at the International Monetary Fund. "The world is not in a run of the mill recession. The crisis has left deep scars. In advanced countries, the financial systems are partly dysfunctional," said Olivier Blanchard, the Fund's chief economist.

Mr Blanchard said an IMF study of post-War banking crises led to an unpleasant finding. "Output does not go back to its old trend path, but remains permanently below it."

Then the sting: we are exhausting the limits of fiscal stimulus. "The average ratio of debt to GDP in the G-20 economies was high before the crisis, and is forecast to exceed 100pc in the next few years".

We cannot add debt, so the IMF says we must draw down our future pensions and future health spending to keep today's economy afloat. "A modest cut in the growth rates of entitlements can buy substantial fiscal space for continuing stimulus."

Shouldn't bulls be sobered that the bastion of hard-nosed orthodoxy feels the need to talk in such terms, or that White House officials are preparing the ground for another round of emergency spending even as it reveals that fiscal deficits will reach $9 trillion over the next decade. This is $2 trillion worse than feared in March, and based on rosy growth assumptions.

It has certainly alarmed US retail tycoon Howard Davidowitz. "As a country we are out of control, we're in a death spiral," he said.

All that has happened over this crisis is that huge private losses have been dumped on society: but the losses are still there, smothering the economy. Taxes must rise. Debts must slowly be purged. "As long as economic growth relies on the state, you cannot talk about durable recovery," said European Central Bank member, Yves Mersch.

Nobel Laureate Paul Krugman said the US needs another fiscal blast for "political reasons", alluding to the Great Depression. It was Phase II from late 1931 to early 1933 that tipped half Europe into fascism and brought America soup kitchens. Although such a fate has been averted this time by government action, the Atlanta Fed says the true rate of US unemployment is already 16pc (not 9.4pc), worse than early 1931 levels. Official youth unemployment is 34pc in Spain, 28pc in Latvia, 25pc in Italy, 24pc in Sweden, Hungary, and Greece.

I have some sympathy with the Krugman view, but entirely disagree over methods. The key is to prevent a debt deflation trap – note that producer prices have fallen 8.5pc in Japan, 7.8pc in Germany, and 6.8pc in the US. The least dangerous medication is Quantitative Easing a l'outrance (ie printing money), as the Bank's Mervyn King clearly thinks. This does not add debt. It prevents the real value of existing debt from rising.

Mr Krugman undermined his case by citing Italy as a country that faced public debt of 118pc of GDP in the early 1990s without disaster. Actually, it has caused disaster, even if it has taken this recession to expose the damage. Debt will rocket to 125pc next year (IMF forecasts), and then -- one fears – off the charts.

We know what caused this crisis. The West kept short-term interest rates too low for a quarter century, luring society into debt: and the East held down long-term rates by flooding bond markets as a side-effect of their mercantilist strategy (ie suppressing currencies to gain export share).

The outcome was over-investment, excess capacity, and too much debt among those supposed to buy the goods. Has any of this changed? No. Have we cleared the excess plant? No.

Jeff Wenniger from Harris Private Bank says an army of baby-boomers have seen their old age plans shattered by the housing bust. Their nightmare is here. They will have to spend less, and save more. "Generational destruction of a society's balance sheet down not rectify itself in a matter of months".

How about a quarter century?

Wednesday, August 5, 2009

The Fed and Inflation

The biggest problem the US economy faces in addition to what the recovery will look like is how the Fed will go about soaking up the huge increase in the money supply done late last year to stabilize the markets and banking industry. The Fed has at least three problems: 1) how much of the excess money supply to soak up, 2) when to start and 3) changing monetary policy is not an exact science. The second issue is particularly problematical because most changes in monetary policy take 24 months to work there way through the system. Combine that with the last issue concerning policy lags and all of sudden monetary policy looks more like a stone axe when a scalpel is needed. Stopping inflation is going to be a tought one. You either choke off the economy early to forestall inflation or you choke it off later to kill an inflationary spiral. Text in bold is my emphasis. From the WSJ:

Federal Reserve Chairman Ben Bernanke assured readers of this page (“The Fed’s Exit Strategy,” July 21) that he has the tools to prevent the huge reserves he’s pumped into the banks from generating an inflation that would abort an economic recovery.

But does the Fed have the guts to use those tools? Will it risk censure from Congress and the Obama administration if it tightens money at the crucial juncture when inflationary omens accompany a reviving economy? Mr. Bernanke signaled the probable choice by writing that “economic conditions are not likely to warrant tighter monetary policy for an extended period.”

The Fed’s past record of judging when and how to use its tools for regulating the money supply is not impressive, particularly in times of economic distress. Its financing of large federal deficits in the mid-1970s sent inflation up to an annual rate approaching 15% before Jimmy Carter repented in October 1979 and installed Paul Volcker at the Fed with orders to kill the monster.

More recently, the Fed’s continued easing of interest rates during the 2003 economic recovery created the credit bubble that collapsed last year with such devastation.

The Fed’s difficulties in getting money policy right stretch back to its creation in 1913. In 1930 it starved the banks, creating a string of failures that worsened the effects of the 1929 stock market crash. In 1937, it starved them again, contributing to a prolongation of the Depression that had been manufactured in Washington by the clumsy taxation and interventionist policies of Herbert Hoover and FDR.

To be sure, the Fed has had its good years. It financed the 20-year period of low-inflation growth and prosperity that began in 1983 when the Reagan tax cuts became fully effective.

But because of its often self-contradictory double mandate to promote both monetary stability and full employment—plus the rap it has taken from economists like Mr. Bernanke for stinginess in the 1930s—it often overreacts to recessions with excessive generosity. With its federal-funds interest rate target at near zero, the spigots are now wide open. And as Mr. Bernanke promises, they will likely remain that way for an “extended period.”

Quite apart from the question of the Fed’s will, there is another large issue. Mr. Bernanke’s assurances to the contrary, there can be doubts about whether his tools are really adequate to deal with the powerful inflationary pressures the politicians are in the midst of creating in the form of a mountainous and rising federal deficit.

Mr. Bernanke showed that he is well aware of that danger when, in his semiannual report to Congress on July 21, he pleaded with that body to bring the deficit under control. The federal budget deficit is projected at an incredible $1.8 trillion for the fiscal year ending Sept. 30, almost half of proposed federal spending. The Treasury’s financing needs will be even higher than that when you count in the various “investments” the government has made in auto, housing and other dubious ventures.

But the day after he issued that plea, President Barack Obama was pleading with the American people to support his nationalized health plan. This plan would yet add hundreds of billions more to the deficit.

The Fed has been financing a significant part of the government’s profligacy, and it is riding a runaway horse. Even if it has the means to cope with present financing needs, will it be able to do so when, and if, the economy actually recovers and it has to finance both a recovery and a spending-crazed government?

Martin Hutchinson, a former merchant banker who blogs as “Prudent Bear,” wrote in May that the German Weimar Republic was monetizing 50% of government expenditure when it brought on the ruinous hyperinflation that destroyed the mark in the early 1920s. The Fed in May 2009 had monetized 15% of federal expenditures over the preceding six months—well short of the rate that destroyed the German economy, but not negligible.

The Treasury (and Congress) has been depending on the Fed’s massive buying of Treasury bonds to keep the government’s financing costs within reasonable bounds—as weakening international demand puts downward pressure on bond prices and upward pressure on the interest rate the Treasury must pay. The yield on the 10-year Treasury bond is below where it was a few weeks ago but well above early this year when investors world-wide were seeking the safety of U.S. Treasurys. Even massive Fed support hasn’t been enough to prevent slippage in bond prices this year.

The Fed has more than doubled the size of its balance sheet in the last year to over $2 trillion. As of July 30, it held $695 billion in Treasurys, up $216 billion from a year earlier. In addition, it has added nearly half a trillion of mortgage-backed securities it purchased to keep Fannie Mae and Freddie Mac, now wards of the government, afloat.

Adjusted reserve balances of member banks exploded in late 2008, soaring to $950 billion from $100 billion in four months as the Fed has pumped liquidity into the banking system. They peaked at nearly $1 trillion in May. The reserves provide banks with a shield against runs but they also are high-octane fuel for bank lending, which means they can touch off another credit bubble, and the accompanying inflation, when credit demand picks up again.

In his Journal op-ed, Mr. Bernanke listed ways he can keep this monster in check. The Fed can pay interest on the bank reserves it holds. This would lessen the incentive of banks to find private borrowers and keep some reserves out of the credit stream, damping inflation potential. But the net effect would be to add still more liquidity to the system, which would run counter to the longer-term goal of mopping up liquidity.

He said that the Fed could also sell securities to the banks with an agreement to repurchase them, but these “reverse repos” would only mop up liquidity temporarily.

The standard way for the Fed to soak up liquidity, mentioned last on Mr. Bernanke’s list, is to sell Treasurys to the banks. That would draw down bank reserves and reduce their inflationary potential. Under the Basel I international banking rules, Treasurys are zero-risk investments and don’t have to be matched at 8% of their value with additional capital, as does private lending.

With the huge volume of Treasury financing coming down the road, the Fed will have plenty of bonds to sell (it already has, in fact). But the Fed buys Treasurys primarily by creating new money, or in other words by inflating the money supply. Will it have the nerve or even the capacity to “sterilize” inflation by reselling the bonds to soak up bank liquidity? Again, there are those political pressures. Will the Fed’s admittedly bright money managers be able to strike a balance between warding off inflation and leaving the banks with sufficient liquidity to finance an economic recovery?

As to that huge volume of mortgage-backed securities the Fed is now holding, what is to be done with them? They are “toxic,” which is why the Fed bought them as a means of keeping Fannie and Freddie solvent. They are “guaranteed” by Fannie and Freddie, which means they now are guaranteed by the U.S. Treasury. So they are yet another liability to add to all the other liabilities being piled on the Treasury. The Fed already has financed them once; will it have to finance them again when they come up for redemption?

In short, there are very good reasons to doubt that the Fed can cope with the political problems of avoiding inflation. The technical problems don’t look very easy either.