Obama's Economic Policies Are Not About Big Government

Below is an excellent op/ed piece in the WSJ by Robert Reich discussing Obama's overall economic policy. An economy only has two components to drive economic growth capital and labor. The only thing that is uniquely American is labor. Capital can move any where in the world at the push of a button. Obama's economic policy concentrates on improving human capital. Text in bold is my emphasis.

Twenty-eight years ago, Ronald Reagan used the severe economic downturn of 1980-82 to implement an economic philosophy that not only gave force and meaning to a wide range of initiatives but also offered a way back to sustained economic growth. Is there a similarly powerful animating idea behind Obamanomics?

I believe there is -- and it's not a return to big government.

The expansive and expensive forays of the Treasury and the Federal Reserve Board into Wall Street notwithstanding, President Barack Obama's 10-year budget (whose projections may prove wildly optimistic if the economy fails to rebound by early next year) presents a remarkably conservative picture. In 10 years, taxes are expected to fall to around 19% of GDP, a lower level than the late 1990s. Spending is expected to drop to around 22.5% of GDP, about where it was under Ronald Reagan -- including nondefense discretionary spending at about 3.6% of GDP, its lowest since data on this were first collected in 1962.

The real distinction between Obamanomics and Reaganomics involves government's role in achieving growth and broad-based prosperity. The animating idea of Reaganomics was that the economy grows best from the top down. Lower taxes on the wealthy prompts them to work harder and invest more. When they do so, everyone benefits. Neither Reagan nor the apostles of supply-side economics explicitly promised that such benefits would "trickle down" to everyone else but this was broadly understood to be the justification.

Reaganomics surely marked the beginning of one of the longest bull markets in American history and generated enormous gains at the top. But its benefits were not widely shared. After the Reagan tax cuts, growth in the median wage slowed, adjusted for inflation. After George W. Bush's tax cuts in 2001 and 2003, the median wage dropped. Meanwhile, an increasing share of total income went to the top 1% of income earners. In 1980, before Reagan took office, the highest-paid 1% took home 9% of total national income. By 2007, before the economy melted down, the richest 1% was taking home 22%.

Obamanomics, by contrast, holds that an economy grows best from the bottom up. The president proposes to increase taxes on the highest 2% of income earners starting in 2011.

Those tax increases will fund more Pell grants allowing lower-income children to attend college, better pay for teachers that show they're worth it, broader access to health care, improved infrastructure, and more basic research. These and related expenditures are designed to help Americans become more productive. You might think of it as "trickle up" economics.

The key is public investment. Reaganomics did not view any public spending as an investment in the future except when it came to spending on the military. Hence, since 1980, federal spending on education, job training, infrastructure and basic research and development (apart from defense-related R&D) have all shrunk as a proportion of GDP. And apart from a modest expansion of health insurance available to poor children, there has been no significant attempt to make health insurance broadly affordable to Americans.

Obamanomics is premised on the central importance of public investments in the productivity of Americans. The logic is straightforward. Capital no longer remains within the borders of a nation where it is saved. It moves to wherever around the globe it can get the best return. Some of it flows as highly liquid investments that slosh across borders at the slightest provocation, as we're witnessing in the current financial crisis. But much takes the form of direct investments in new plants and equipment, telecommunications systems, laboratories, offices and -- most important of all -- jobs. Such capital goes to nations that can deliver high returns either because labor is cheap and taxes and regulations low or because labor is highly productive: well educated, healthy and supported by modern infrastructure.

In this way, every nation faces an implicit choice of whether its strategic advantage will lie in low costs or high productivity. For the better part of the last three decades America's job strategy has tended toward the former. But this inevitably exerts downward pressure on the real wages of a larger and larger portion of our population.

Only those Americans whose parents can afford to give them a high-quality private education and health care, and who can situate themselves in locations with excellent infrastructures of telecommunication, transportation, public health and safety, have been able to link up with global capital on more positive terms. But not even they are entirely secure economically, because they face growing shortages of talented people they can rely on within easy reach, and can't entirely avoid the disadvantages of a deteriorating public infrastructure, such as ever more congested roads and airports.

Obamanomics recognizes that the only resource uniquely rooted in a national economy is its people -- their skills, insights, capacities to collaborate, and the transportation and communication systems that link them together. Public investment is the key to attracting long-term private investment so that a nation's people can prosper.

Bill Clinton understood this but failed to do much about America's deteriorating public investments because he came to office during an economic expansion, when the major worry was excessive government spending leading to inflation. Mr. Obama comes to office during the biggest downturn since the Great Depression, and his plan represents the largest commitment to public investment in 30 years.

Regulation, done correctly, is also a form of public investment because it enables consumers and investors to be confident about what they're receiving, and ensures that the side-effects of trades don't harm the public. Reaganomics assumed that deregulated markets always function better. They do in many respects. But when they don't, all hell can break loose, retarding economic growth.

Energy markets were deregulated and we wound up with Enron. Food and drug safety has been neglected, resulting in contaminated products that have endangered consumers and threatened whole industries. Financial markets were deregulated and we now have a global meltdown. Obamanomics, by contrast, views appropriate regulation as an essential precondition for sustainable growth.

Under Reaganomics, government was the problem. It can still be a problem. But a central tenet of Obamanomics is that there are even bigger problems out there which cannot be solved without government. By building the economy from the bottom up, enhancing public investment, and instituting reasonable regulation, Obamanomics marks a reversal of the economic philosophy that has dominated America since 1981.

China and the IMF

I am no expert on China, but it is clear to me that China is interested in playing a larger role in international economics and finance. It is now interested to playing a larger role in the IMF, which will re-direct the institution and its policies. The Americans and Europeans better get used to the fact that the world is not going to go back to way it was and other people now want a seat at the table. Text in bold is my emphasis. From the WSJ:

China is showing more willingness to aid organizations like the International Monetary Fund, reflecting its desire for a stronger voice in global economic affairs. But as leading economies prepare for a summit, Beijing's push for clout to match its financial resources is creating friction with rich countries.

The European Union's commissioner for external relations, Benita Ferrero-Waldner, said Monday during a visit to Beijing that the G-20 summit is "not the right moment" to negotiate IMF votes, which are set to be updated by January 2011. She also called China's proposals for dealing with the global financial crisis "imprecise."

Over the past week, Beijing officials have said China, with nearly $2 trillion in foreign-exchange reserves, is willing to add funding for the IMF to increase the lender's ability to help countries hurt by the crisis. An agreement on putting more money into the IMF could be one of the most concrete achievements of this week's summit of the Group of 20, a gathering of the world's major economies.

The IMF is aiming to boost its war chest to at least $500 billion from $250 billion, and is already close to that goal. Japan has lent $100 billion, and the EU has committed €75 billion ($100 billion). Countries such as China and Saudi Arabia are being asked to help come up with tens of billions of dollars more to make up the difference. The U.S. is looking to chip in nearly $100 billion, but wants it as part of a separate kitty the IMF can tap in emergencies.

Beijing wants something in return for new funding. "China sees this as a good opportunity to increase its influence," said Jun Ma, China economist for Deutsche Bank. China doesn't want to miss out on the chance to help rewrite the rules that will govern global finance for coming decades. "China is more actively contributing their thoughts. This is very different from 10 years ago, when China was much quieter and more low profile," said Mr. Ma, who previously worked for both the IMF and the Chinese government.
China wants more IMF voting rights in exchange for any new funding, which most countries agree makes sense given its weight in the global economy. Chinese officials have also said the country could contribute in ways that don't require an immediate overhaul of the organization, for instance by buying bonds issued by the IMF.

An increase in China's IMF voting power would likely come at the expense of smaller European nations.

A stronger Chinese role at the IMF could also mean the institution might start going along less frequently with the U.S. and Europe. Because the current crisis originated in developed countries, China says the IMF should be able to more openly criticize their policies. "Under the current situation, we feel that the IMF particularly needs to strengthen its surveillance of the economic and financial policies of the major reserve-currency-issuing nations," deputy central bank governor Hu Xiaolian said last week.

China seems to want to strengthen and redirect the IMF, not undermine it. Central bank governor Zhou Xiaochuan's proposal last week for a new global reserve currency would give the IMF even greater clout. Mr. Zhou was a member of an outside panel of current and former officials who last week called for a "re-energized" IMF, concluding that "the world needs a multilateral institution at the center of the world economy to help anchor global financial stability."

The interest in bolstering the IMF is perhaps surprising given the sometimes rocky relationship China has had with the fund. The organization's reputation within Asia is poor, as many governments say the IMF gave bad advice during the regional financial crisis of 1997-98. Though China hasn't had to borrow from the IMF, many within China see the IMF as a tool the U.S. has used to criticize Beijing's currency and economic policies.

China has stepped up its participation in other international agencies. In January, China formally joined the Inter-American Development Bank, contributing $350 million to fund the agency's lending in Latin America and the Caribbean.

Incorporating China into institutions that have long been dominated by the U.S., Europe and Japan is bound to alter what has been "the fairly predictable context" for decisions on international economic policy, said Angel Gurria, secretary-general of the Organization for Economic Cooperation and Development. "We have been producing consensus among ourselves in a generally like-minded community of countries which are very used to working with each other and talking to each other," he said in an interview in Beijing.

But China's positions have gained more credibility internationally because of its aggressive response to the economic downturn: Its stimulus plan is one of the biggest in the world.

Obama and the Auto Industry - More Details

Below is an article from today's WSJ outlining the position that bankruptcy could play with GM and Chrysler. I find it very interesting that the Obama Administration has really taken the bull by the horns on this issue and demonstrated considerable leadership. If I were an executive at a bank or on Wall Street I would be nervous.

I don't know if you have noticed but so far this month the Fed agreed to buy US Treasury securities, the Treasury outlined a plan to buy toxic mortgage assets, and China warned the US about the value of the dollar. Now the government is in the auto industry in a big way. Forget the stimulus package and bail-out plan, they are not the big news. Text in bold is my emphasis.

The Obama administration, wading deeply into the U.S. auto industry, is weighing a fix for General Motors Corp. and Chrysler LLC that would divide their "good" and "bad" assets and send the auto makers into bankruptcy to purge their biggest problems.

The potential move would transform two companies that have helped define U.S. industrial power over the past century. Following the ouster of GM Chief Executive Rick Wagoner, it would represent one of the biggest-ever government incursions into private enterprise.

And it would be fraught with political risk and controversy for the Obama administration, now that it is becoming clear that government involvement in the operations of GM and Chrysler will dwarf that of any other company receiving U.S. aid.

Among other things, a bankruptcy filing could hurt GM's unionized work force, angering a key Democratic constituency. The plan also exposes the administration to criticism that it is being tougher on GM and Chrysler than the banks that have repeatedly gotten government cash.

Sending GM and Chrysler into bankruptcy isn't a done deal. But both the government and the auto makers are planning for such an eventuality, barring dramatic, 11th-hour concessions from bondholders, unions and others.

The administration would like to see the "good" GM, comprising brands such as Chevrolet and Cadillac, remain an independent company, according to an administration official. Equity in the "good" Chrysler, meantime, would be sold to Fiat SpA, assuming that proposed deal goes forward, this person said.

President Barack Obama on Monday warned GM and Chrysler that they couldn't depend on unending taxpayer loans and gave the companies a brief window to craft plans -- 60 days for GM and 30 for Chrysler -- that would justify fresh government support. But he also pledged to do all he could to save the industry.

"We cannot, we must not, and we will not let our auto industry simply vanish," Mr. Obama said at the White House.

The remarks came a day after the administration forced Mr. Wagoner's departure and rejected the restructuring plans that GM and Chrysler had hoped would lead to another infusion of government loans. The administration also is set to remove the majority of GM's board of directors. One senior administration official said the aim was to restart GM "with a clean sheet of paper."

GM's stock fell 25% on the news, down 92 cents to $2.70 in 4 p.m. New York Stock Exchange composite trading.

The administration's interventions struck a new tone of seriousness amid the recent uproar over executive bonuses at financial companies receiving big government loans. With the auto makers, the government has laid down stringent terms for new support and raised, in the case of Chrysler, the possibility the company could be left to collapse.

All the same, the administration's new plan is sure to ignite a battle over the government's role in the economy, what sacrifices will be required of labor unions, and whether it makes sense for U.S. taxpayers to assist a foreign company, Fiat, in an alliance with a U.S. company, Chrysler.

As part of their proposed pact, Fiat and Chrysler agreed over the weekend to scale down the Italian auto maker's initial stake in Chrysler to 20% as a condition of the Treasury Department's bailout. Fiat earlier this year struck an agreement to take a 35% stake in Chrysler initially, and up to an additional 20% at a later date.

Many hot-button issues remain unresolved, above all the fortunes of about 140,000 members of the United Auto Workers union and the health-care plan for the group's hundreds of thousands of retirees.

President Obama argued Monday that the U.S. auto industry -- and, by default, its largest component, GM -- was unique in its centrality to the U.S. economy. "This industry is, like no other, an emblem of the American spirit," he said. "It is a pillar of our economy." He went on to insist that the government had no intention of running GM.

His auto team's dissection of what ails GM, on the other hand, underscores how deeply the administration plans to plunge into the finer points of the company's business plan. In a five-page analysis of GM's viability, the team critiqued GM's marquee next-generation project, the electric-powered Chevy Volt, as "too expensive to be commercially successful in the short-term." It notes that much work needs to be done to boost the overall fuel-efficiency of GM's fleet of cars and trucks.

With GM, the Obama administration is interested not just in preserving jobs, but in pushing other policy prescriptions, in particular creating a "company of the future" with clean and energy-efficient vehicles, a frequent campaign theme during Mr. Obama's quest for the presidency.

The auto plan came packaged with several new government initiatives whose price tags remain unclear. The government said it would guarantee the warranties for all new GM and Chrysler cars until the two companies return to health. It also plans to speed up government fleet purchases, and to support a congressional bid to offer large tax incentives for new-car purchases, with money for the program coming out of the $787 billion stimulus package. Mr. Obama also said that the Internal Revenue Service was creating a new tax benefit for car buyers.

Auto executives and Obama aides cautioned that the bankruptcy route is not preferred or in anyway preordained. The two car makers could avoid that outcome if they manage in coming weeks to strike tough bargains with debtholders, creditors and the union. But concessions on that front have so far proved largely elusive, giving the bankruptcy option a much higher likelihood of success.

"We have significant challenges ahead of us, and a very tight timeline," said new GM Chief Executive Fritz Henderson. In a conference call with reporters, Mr. Henderson acknowledged that bankruptcy was very much a possibility. "There are ways to do this out of court, but we're getting ready to do in court if necessary," he said.

The Journal's John Stoll says that with billions in taxpayer money on the line, the Obama administration needs to work closely with GM to forge a more dramatic restructuring.

GM and Chrysler have had bankruptcy attorneys devising plans to split their companies in two for several months. Mr. Obama's task force has told both companies that the administration prefers this route as a way to reorganize the two auto makers, rather than the prolonged out-of-court process that has so far frustrated administration officials, people familiar with the discussions said.

GM looks increasingly like it will be forced into filing for bankruptcy protection, sometime in mid-to-late May, and that the surviving "new GM" will retain select brands and some international operations, said several people familiar with the situation.

Stakes in this new GM could be given to creditors. It is also possible the new company could be sold whole or in parts to investors or its shares sold in an initial public offering. The UAW's retiree health-care fund would likely get either some shares or proceeds from the sale of the stock.

A key ingredient in acting on this plan is getting the UAW to agree to an entirely new contract, including major reductions in health-care benefits, said several people involved in the matter. "That's the No.1 wild card here," one of these people said Monday.

Under the plan, the "good" GM wouldn't be expected to hold the tens of billions of dollars in retiree and health-care obligations that hurt the auto maker in recent decades. Instead, those obligations would be transferred to an "old GM," made up of less-desirable brands such as Hummer and Saturn, and underperforming plants and other assets.

This part of GM would likely sit in bankruptcy much longer while a buyer is sought for the parts or it is wound down. Proceeds from the sale of old GM would go back to pay claims to various creditors.

"That is the plan, to the extent it comports with the bankruptcy laws," said one person familiar with the matter.

On the first day in bankruptcy, people familiar with the matter said, GM would transfer the valued assets to new GM. Then it would launch a marketing and advertising campaign, aiming to comfort consumers about warranties on new and existing vehicles, the resale value of their vehicles and the ability to buy replacement parts.

The "new GM" would have a less-burdened balance sheet than GM currently has. But one debt that would stay with new GM is the $20 billion or so the federal government has lent to it, say these people.

Mr. Wagoner had participated in the plan's development, along with Mr. Henderson, turnaround veteran Jay Alix and prominent bankruptcy attorney Martin Bienenstock. GM also has veteran bankruptcy lawyer Harvey Miller working for it.

At Chrysler, where Jones Day lawyers have been working on a plan, bankruptcy would be used to force new labor contracts and rework debt deals with secured creditors. People working on Chrysler's behalf say the approach is risky, because the company is still unsure it could survive even a short-term bankruptcy. Bankruptcy might be pursued to meet the Obama administration's demand that Chrysler's creditors agree to huge reductions in their expected recoveries on Chrysler debt.

GM and Chrysler's bankruptcy financing, called debtor-in-possession, would have to be funded by the government at a cost of tens of billions of dollars, say people familiar with the matter.

Democratic Rep. John Dingell of Michigan praised the package, but voiced one worry: "I have some concern that if these companies get into bankruptcy, how do they get out? I'm an old bankruptcy lawyer, and bankruptcies have a life of their own."

AIG Finances and the Health of the Insurance Industry

Below is an article on the finances of AIG and the health of the insurance industry as a whole. Most people do not understand the the average investment portfolio for an insurance company took quite a pounding last year so many of these companies could be weak. YOu may want to think this thorugh before signing up for an insurance company or an annuity. Text in bold is my emphasis. From the LA Times:

When insurance giant American International Group Inc. imploded last fall, the firm's problems were quickly blamed not on its core insurance business but on an obscure operation that traded exotic mortgage securities.

But as the economic crisis deepens, it has become clear that AIG's problems extend across most of its business lines, including its massive life insurance and retirement services operations, which reported a staggering $18-billion quarterly loss this month.

The company's situation is emblematic of problems across the life insurance industry, which is suffering deep losses on investments that underlie policies for millions of American families.

So far, some of the biggest companies have suffered sharp drops in their stock prices, and many of them are asking for federal assistance.

Industry conditions last year were the worst in memory and are expected to grow deeper this year amid credit rating downgrades, declining revenue and investment losses, according to credit rating firm A.M. Best Co.

The worst-case scenario is that a second financial crisis is looming if these life insurance companies come under too much stress.

"It was essentially a house of cards at AIG," said Donn Vickrey, a forensic accountant and co-founder of Gradient Analytics in Scottsdale, Ariz. "I would characterize other life insurers as suffering varying degrees of risk."

The financial problems, Vickrey said, may not be as serious as the disaster that swept over some parts of the banking industry, but insurers have not been subject to the same level of scrutiny as banks, and some experts say much remains unknown about their condition.

When the life insurance industry ultimately stabilizes, the financial landscape will be different, along with the once-dominant AIG.

Two key pieces of AIG's life insurance and retirement products operations are Los Angeles-based SunAmerica Inc., which sells retirement annuities, and Houston-based American General Life.

Last fall, AIG tried to sell off its life insurance and retirement products units with the idea of preserving its core business of property and casualty insurance.

But by March 2, AIG retirement services chief Jay Wintrob wrote to employees in an internal message that the sales were more or less on the back burner.

Wintrob is now considering a consolidation of SunAmerica and American General. Both operations say they are well capitalized and have many times the minimum required level of reserves to meet their obligations to their 17 million customers.

Credit rating agencies have cut their assessments of the firms, though they remain well above levels that would indicate vulnerability.

The companies' survival is due to a unique advantage: AIG is the only insurance company that is a major recipient of taxpayer bailout funds. The company has received commitments from the Treasury Department for $70 billion and lines of credit for tens of billions more.

"With the support and cooperation of the U.S. Treasury and Federal Reserve, AIG now has a new set of tools to reduce its debt, strengthen its capital base and enhance the value of its core business," Wintrob wrote in his message to employees.

Without that lifeline, all of AIG's operations -- and the welfare of its customers -- could be in a lot more trouble, according to securities analysts, insurance industry experts and credit rating agencies.

Other insurers are now asking the federal government for bailout packages, arguing that AIG has an unfair competitive advantage.

The Treasury Department and various oversight boards are uncertain how much of the taxpayer assistance went to AIG's retirement and life insurance operations. But credit rating firms say that without that assistance, there would have been a substantial downgrade to AIG's ratings.

Its current ratings reflect "our view that the U.S. Treasury and the Federal Reserve will continue their financial support of and commitment to AIG," said Kevin Ahern, an analyst who follows the company for Standard & Poor's Rating Services.

Ahern said the federal bailout of AIG kept the credit rating for AIG's holding company six notches higher than it would be otherwise, and without that support the company's credit would sink below investment grade.

AIG's loss of $18 billion in its life insurance and retirement businesses in the fourth quarter was about the same amount that the company lost in its financial services operation, which was trading in credit default swaps and other risky instruments.

The losses for the retirement and life insurance operations came on the falling value of investments that were being furiously sold and marked down as the stock market collapsed last year. The company said that if not for those investment losses, the operations would have been profitable.

SunAmerica, which has operations in Century City and Woodland Hills, sells variable annuities, which are retirement policies that provide a stream of payments, generally based on how well securities markets perform. The company has assets of $158 billion and nearly 6 million customers.

But those policies often have embedded guarantees, meaning that benefits can only drop so low before the company has to take a hit, said Joseph Belth, a nationally known insurance expert and retired Indiana University professor.

"Different variables have different embedded guarantees," Belth said. "But they all have one thing in common: The company takes on a risk if there is a dramatic decline in the stock market. And they no doubt never dreamed of the kind of stock market collapse like we have had.

"It seems to me that if AIG had not gotten the federal money, they would have had to declare bankruptcy," Belth said.

Belth said in a bankruptcy, state regulators would continue to operate the subsidiaries and maintain existing insurance policies.

Critics say the company brought some of its troubles on itself by engaging in risky securities practices. In some cases, it was betting against its own long-term interests.

"AIG investments were more aggressive, relative to other insurers, across all of their business, including life and casualty insurance," said Paul Newsome, an insurance analyst at investment banking firm Sandler O'Neill & Partners.

In a statement, AIG disputed that, saying their products carry about the average amount of risk for the industry.

"This claim is misleading and inaccurate," AIG spokesman John Pluhowski said. "The company has maintained a generally conservative, middle-of-the-road stance on living benefits for many years."

But other analysts go much further in criticizing the company's practices.

Overall, AIG made "the most egregious investment decisions I have ever seen," Vickrey said. "It was extremely high risk with very high levels of leverage and insufficient hedging."

AIG, along with others, began offering in recent years specialized variable annuities with guaranteed minimum death benefits, Vickrey said. The assumptions underlying these contracts turned out to be wildly optimistic, he said.

As a result, AIG is on the hook to deliver guaranteed benefits despite the fact that, even if it had invested prudently, it would not have earned a sufficient return to make good on the obligation, he added.

Sen. Richard C. Shelby of Alabama, the senior Republican on the Senate Banking Committee, said AIG's life insurance companies also played a very risky game of lending out long-term securities and investing cash collateral for those loans in securities backed by subprime mortgages.

When the mortgage market collapsed, AIG life insurance firms took a $21-billion loss, Shelby said at a Senate hearing this month. Only because those AIG life insurers were able to tap $17 billion in federal assistance were they able to meet policyholder claims, he said.

The Risk of Deflation

The debate about whether or not we will get inflation or deflation in the future continues with good arguments on both sides of the issue. Below is summary of a research note published by the Fed that argues against a deflationary spiral. It is short and easy to read. From the WSJ Real Time Economics:

Unemployment is rising, asset values are plummeting and some of the economy's most common products (beyond food and energy) have seen their prices tumble. The stage is set for a deflationary spiral. So why do professional forecasters put such low odds on a deflation scenario?

The Federal Reserve Bank of San Francisco, in a research note released today, concludes that forecasters are betting on aggressive central bank action. "Forecasters appear to be convinced that the Federal Reserve would not be content with sustained deflation and would take policy actions to restore a positive rate of inflation," writes John Williams, the San Francisco Fed's director of research. "This contrasts with the 1970s, when forecasters were concerned that the Fed would tolerate high rates of inflation."

Give the Fed a win (so far) for a successful communication policy on that front.
The Survey of Professional Forecasters puts the chance of core price deflation this year or next year at 1 in 20. The SPF sees core inflation (based on the price index for personal consumption expenditures, excluding energy and food) at 1.1% this year and 1.5% in 2010.

Mr. Williams dissects Phillips curve models of inflation and finds that one of them (based on the historical relationship between inflation and unemployment from 1961 to 2008) puts core PCE inflation at 0.3% in 2009 and a deflation rate of 0.8% in 2010.That puts the probability of deflation at 30% in 2009 and 85% in 2010.

The central bank can fight deflation by stemming slack in the economy and communicating its commitment to positive (but low) inflation rates, he writes. And the Fed is doing just that through its recent statements and its long-run inflation forecasts. "Such words, backed by appropriate actions, reinforce the anchoring of inflation expectations and reduce the chances of a deflationary spiral," Mr. Williams says.

George Soros on the Potential Global Economic Meltdown

Below are some comments about and from George Soros concerning the possibility of an economic meltdown. Text in bold is my emphasis. From the UK Times:

George Soros was 13 when the Nazis invaded his homeland of Hungary. As a Jew, he was forced to adopt a false identity and live separately from his parents in Budapest. Instead of being traumatised by the experience, though, he found the danger exhilarating. “It was high adventure,” he says, “like living through Raiders of the Lost Ark.”

Sixty-five years later, he still thrives on danger. He famously made $1 billion on Black Wednesday by shorting the pound, earning him the label of “the man who broke the Bank of England”. Last year, as the world tipped into financial chaos, Mr Soros pocketed another $1.1 billion by correctly predicting the downturn. “I’m an expert in crises,” he says.

The man who has a phobia about math has made his name as the philosopher king of economics – his book The Crash of 2008, out in paper-back next week, has been a bestseller on both sides of the Atlantic. Since 1944 he has believed in what he calls “reflexivity” – the idea that people base their decisions on their own perception of a situation rather than on the reality.

He has applied this both to investment and to politics: his skill has been to predict moments of seismic change by identifying a disjunction between perception and reality.

When everyone else was convinced that the markets would automatically correct themselves, the 78-year-old “old fogey”, as he calls himself, was one of the few warning of recession. He put all his chips on “the Barack guy” early on when all around him were still gunning for Hillary Clinton. It’s almost as if he has been waiting for the Great Recession for the past ten years. When we ask whether he prefers booms or busts, he replies: “I have to admit that actually I flourish, I’m more stimulated by the bust.”

This recession, he explains, is a “once-in-a-lifetime event”, particularly in Britain. “This is a crisis unlike any other. It’s a total collapse of the financial system with tremendous implications for everyday life. On previous occasions when you had a crisis that was threatening the system the authorities intervened and did whatever was necessary to protect the system. This time they failed.”

The financial oracle does not know how long it will last. “That depends on how it’s handled. Allowing Lehman Brothers to fail was the game-changing event. That’s when the financial crisis went over the brink.” We could end up with a depression. “Unless we handle it well then I think we would. The size of the problem is actually bigger than in the 1930s.”

The problem in Britain, he believes, is in many ways worse than in America or Germany. “American memory is seared by the Depression, the German memory is seared by hyperinfla-tion but Britain has a pretty serious problem in many ways worse than America because the financial sector looms bigger and the overvaluation of real estate is bigger than in America.”

He is not worried that an auction of government bonds failed this week – “that was a blip”, he says. He would still buy British bonds – “it depends on the price” – but he agrees with Mervyn King, the Governor of the Bank of England, that debt is a real problem. It will, he says, put people off investing in Britain. “I think it will have an effect, yes. It is a matter of worry because effectively the hole in the banking system is replaced by increasing the national debt.” There has been some talk that Britain might have to go cap in hand to the International Monetary Fund. “It’s conceivable,” Mr Soros says. “You have a problem that the banking system is bigger than the economy . . . so for Britain to absorb it alone would really pile up the debt . . . if the banking system continued to collapse, it’s a possibility but it’s not a likelihood.”

He refuses to say whether sterling has yet hit its lowest point. Has he shorted the pound recently? “I had shorted it last year, but I’m not shorting the pound now.” Is the euro under threat? “There is stress in the euro because of the differential in the interest rate that the different countries have to pay,” he replies.

Mr Soros is critical of the tripartite regulatory system set up when the Bank of England gained independence. “I have a different view on how the market operates than the prevailing view. I believe that the authorities have the responsibility to forestall, to counter the mood of the markets . . . I think that the problem was that the Bank of England didn’t have the supervisory authority.”

He does not, however, blame Gordon Brown. “He underestimated the severity of the problem, but then so did most people. Part of the perceived role of a leader is to cheerlead, so you can’t really blame him for that.”

From the day he was born, Mr Soros says, he was attracted to crisis. “It precedes me. I inherited it from my father.” His father had lived through the Russian Revolution and every day after school he would take his son swimming and talk about his experiences. “I sucked it in that way. And then when I was not yet 14, the Germans occupied Hungary, and I would have been deported to Auschwitz if my father hadn’t arranged for false papers. So that was a pretty profound crisis. I had to assume a false identity and live a different life.” He was separated from his parents. “We met occasionally in the swimming pool. But imagine you are 14 years old, you like adventure, and you have a father who seems to understand the situation better than others. It’s very exciting.”

He feels a similar thrill in an economic crisis. “On the one hand there’s tremendous human suffering, which is very distressing. On the other hand, to be able to handle the situation is exhilarating.”

He has always been something of an outsider. He thinks that this makes it easier for him to see through conventional wisdom. “I have always understood how normal rules may not apply at all times,” he says. In recent years he has been arguing against “market fundamentalism” – “the accepted theory was that markets tend to equilibrium”. He believes that the credit crunch has proved him right. “It reminds me of the collapse of the Soviet system, events are always exceeding people’s understanding. The situation is out of control. There’s a shortage of time to adjust to the change. Change is accelerating.”

Like Warren Buffett, he thinks that the complex financial instruments used by the banks were economic weapons of mass destruction. If anything he expected the tipping point to come earlier. “Everybody who realised that this was unsustainable expected it to collapse much sooner,” he says. “It is so devastating exactly because it took so long.”

The urgent task now, he says, is to realise that the system that collapsed was flawed. “Therefore you can’t restore it. You have to reform it.” He worries that politicians have not yet accepted the need for fundamental change and that “a lot of bankers have their head in the sand”.

H e was cast as the villain when Britain was forced out of the exchange-rate mechanism. “I didn’t speculate against sterling to benefit the public. I did it to make money,” he says.

He tells us that he has psycho-somatic illnesses – backaches and pains – that tip him off to changes in the market. “It’s as if you’re a jungle animal, and you see another animal facing you. You have to make a decision: fight or flight? Your hair stands up and you growl and you decide, ‘Am I going to attack because I’m stronger or am I going to run away because otherwise he’s going to eat me?’ You are very tense. And that’s the tension that gives you the backache.”

The G20 summit in London next week is, he says, the last chance to avert disaster. “The odds would favour that it fails because there are such differences of opinion. It’s difficult enough to get it right in your own country let alone with 20 governments coming together, but if it’s a failure I think then the global financial and trading system falls apart.”

If the G20 is nothing but a talking shop then he thinks we are heading for meltdown. “That could push the world into depression. It’s really a make-or-break occasion. That’s why it’s so important.” The chances of a depression are, he says, “quite high” – even if that is averted, the recession will last a long time. “Look, we are not going back to where we came from. In that sense it’s going to last for ever.”

Obama Makes Some Big Unprecedented Moves in the Auto Industry

As everyone knows President Obama made some big moves today in the auto industry. However, even with these big changes his popularity ratings did not change much. I suspect moves like this will become a pattern in the future. "If everyone could just please sit down and fasten your seat belts" will become a common expression going forward. Text in bold is my emphasis. From Yahoo News:

Some frustrated U.S. taxpayers cheered President Barack Obama's tough steps to shore up the reeling auto industry on Monday but critics called his decision to fire General Motors' chief a heavy-handed power grab.

Obama forced out General Motors chief executive Rick Wagoner, pushed Chrysler LLC toward a merger with Italy's Fiat SpA, and threatened bankruptcy for both, marking an escalation in Washington's involvement in rescuing the faltering economy.

Skeptics asked whether it was an early sign of a more activist administration or an isolated example. GM shares tumbled 30 percent on the news and the Dow Jones Industrial average sank nearly 4 percent.

Experts called it potentially the most significant presidential intervention in the private sector since Harry Truman tried to seize the steel industry during the Korean War in 1952, only to be rebuffed by the Supreme Court.

"I don't think the president should be running the economy. They should have let the company go bankrupt. The guy would have lost his job anyway," said Edward Prescott, a 2004 Nobel laureate in economic sciences.

As a candidate last year, Obama supported rescuing the financial sector, and since then he has shifted to attacking the bonuses and corporate jets for companies taking taxpayer money to pushing out a CEO and replacing members of the board of directors.

"Politics is certainly entering the process. GM should have gone into bankruptcy in the fall. We would be much further along with the workout by now," added Randall Filer, a professor of economics at Hunter College in New York.

Stephen Schork, editor of an industry report on the energy and shipping markets, feared Obama was trying to engineer a hasty conversion to green energy. "They are expressing abject hostility toward the hydrocarbon industry," Schork said.

At the same time, Obama's approval ratings have held firm above 60 percent in most public opinion polls. In a Cincinnati coffee shop, retiree Sharon Schmidt, 74, said she supported the decision to push Wagoner out.

"If GM is going to take a big bailout from the federal government, the people who brought it to this state should probably go," Schmidt said. "These bankers and so on are making million dollar bonuses? They should be gone, too."

In a Dallas suburb, accountant John Shaffer, 47, also approved. "I feel he was fired to force the unions and bond holders to seriously negotiate with the company. So I think it was good," he said.

Stephen Hess, a presidential scholar at the Brookings Institution, said Obama's action lacked any historical parallel because the circumstances of the financial crisis were unique and he could succeed because he seemed to have a good "internal gyroscope" on reading the mood of the public.

"So far people are with him," Hess said. "There will be a lot of people who say: At last somebody is doing something."

Opposition from Republicans in Congress was fast and fierce.

"With sweeping new power the White House will be deciding which plants will survive and which won't, so in essence, this administration has decided they know better than our courts and our free market process how to deal with these companies," said Republican Senator Bob Corker of Tennessee.

But in a sign Obama may find some support from the Republican minority, Representative Darrell Issa of California said Obama has "struck the right chord in seeking balance between supporting the American auto industry and calling for a much-needed restructuring."

Uemployment Rate by State

From the WSJ Economics Page:

The Labor Department issued its state unemployment report for February, and the data underlined a continuing deterioration in the jobs market.

The unemployment rate increased in February from the previous month in every state except Nebraska. But every state has seen significant increases in joblessness since the beginning of the recession in 2007.

Earlier this month, the Labor Department reported that the national unemployment rate for February stood at 8.1%. Overall, 13 states and Washington, DC, had significantly higher jobless rates than the national figure, with seven states showing double-digit numbers. (Double click to enlarge.)

Ever Heard of "A New Way Forward"?

Ever heard of A New Way Forward.org? This is a group of people that are trying to arrange a rally on April 11 to protest the current attempts to "fix" the financial system. Below is a statement of their Plan. Before you disregard this group out of hand, if memory serves me right the anti-war protests in the late 1960s started with anti-war demonstrations at the University of Wisconsin in 1964 with about 20 protesters and virtually no press coverage.

Just maybe the time has come for people to speak out. Trust me it is way overdue.

The Plan

DECENTRALIZE: Any bank that's "too big to fail" means that it's too big for a free market to function. The financial corporations that caused this mess must be broken up and sold back to the private market with new antitrust rules in place -- new banks, managed by new people.

As Wall St. corporations grew bigger and bigger until they were “too big to fail,” they also became so politically powerful that they led to distorted and unfair policies that served companies, not citizens.

Its not enough to try to patch up the current system. We demand serious reform that fixes the root problems in our political and economic system: excessive influence of banks, dangerous compensation systems, and massive consolidation. And we demand that the reform happen in an open and transparent manner.

This Weekend's Contemplation - Krugman's Market Mystique

Even if you just dropped in from Mars you would notice that there are at least 1,000 opinions out there on how to handle the economy and what to do next. Below is the opinion of Paul Krugman, which is worth a read. Please remember one thing the world is NOT going back to normal like it was 3 years ago. It is to early to tell what it is going to become, but the old world is gone and we should not try to re-establish it. From the NY Times:

On Monday, Lawrence Summers, the head of the National Economic Council, responded to criticisms of the Obama administration’s plan to subsidize private purchases of toxic assets. “I don’t know of any economist,” he declared, “who doesn’t believe that better functioning capital markets in which assets can be traded are a good idea.”

Leave aside for a moment the question of whether a market in which buyers have to be bribed to participate can really be described as “better functioning.” Even so, Mr. Summers needs to get out more. Quite a few economists have reconsidered their favorable opinion of capital markets and asset trading in the light of the current crisis.

But it has become increasingly clear over the past few days that top officials in the Obama administration are still in the grip of the market mystique. They still believe in the magic of the financial marketplace and in the prowess of the wizards who perform that magic.

The market mystique didn’t always rule financial policy. America emerged from the Great Depression with a tightly regulated banking system, which made finance a staid, even boring business. Banks attracted depositors by providing convenient branch locations and maybe a free toaster or two; they used the money thus attracted to make loans, and that was that.

And the financial system wasn’t just boring. It was also, by today’s standards, small. Even during the “go-go years,” the bull market of the 1960s, finance and insurance together accounted for less than 4 percent of G.D.P. The relative unimportance of finance was reflected in the list of stocks making up the Dow Jones Industrial Average, which until 1982 contained not a single financial company.

It all sounds primitive by today’s standards. Yet that boring, primitive financial system serviced an economy that doubled living standards over the course of a generation.

After 1980, of course, a very different financial system emerged. In the deregulation-minded Reagan era, old-fashioned banking was increasingly replaced by wheeling and dealing on a grand scale. The new system was much bigger than the old regime: On the eve of the current crisis, finance and insurance accounted for 8 percent of G.D.P., more than twice their share in the 1960s. By early last year, the Dow contained five financial companies — giants like A.I.G., Citigroup and Bank of America.

And finance became anything but boring. It attracted many of our sharpest minds and made a select few immensely rich.

Underlying the glamorous new world of finance was the process of securitization. Loans no longer stayed with the lender. Instead, they were sold on to others, who sliced, diced and puréed individual debts to synthesize new assets. Subprime mortgages, credit card debts, car loans — all went into the financial system’s juicer. Out the other end, supposedly, came sweet-tasting AAA investments. And financial wizards were lavishly rewarded for overseeing the process.

But the wizards were frauds, whether they knew it or not, and their magic turned out to be no more than a collection of cheap stage tricks. Above all, the key promise of securitization — that it would make the financial system more robust by spreading risk more widely — turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption.

Sooner or later, things were bound to go wrong, and eventually they did. Bear Stearns failed; Lehman failed; but most of all, securitization failed.

Which brings us back to the Obama administration’s approach to the financial crisis.

Much discussion of the toxic-asset plan has focused on the details and the arithmetic, and rightly so. Beyond that, however, what’s striking is the vision expressed both in the content of the financial plan and in statements by administration officials. In essence, the administration seems to believe that once investors calm down, securitization — and the business of finance — can resume where it left off a year or two ago.

To be fair, officials are calling for more regulation. Indeed, on Thursday Tim Geithner, the Treasury secretary, laid out plans for enhanced regulation that would have been considered radical not long ago.

But the underlying vision remains that of a financial system more or less the same as it was two years ago, albeit somewhat tamed by new rules.

As you can guess, I don’t share that vision. I don’t think this is just a financial panic; I believe that it represents the failure of a whole model of banking, of an overgrown financial sector that did more harm than good. I don’t think the Obama administration can bring securitization back to life, and I don’t believe it should try.

More Regulation of the Financial Markets is on the Way

I don't if you have have noticed, but the last few weeks has seen a flurry of new proposed legislation, regulation, etc. Whether we like it or not the US and the world is going to change significantly over the next few years. Below is a summary of the regulatory changes expected in the next round of legislation. Text in bold is my emphasis. From Yahoo News:

The Obama administration is proposing an extensive overhaul of financial regulations in an effort to prevent a repeat of the banking crisis last fall that toppled once-mighty institutions and wiped out trillions of dollars in investor wealth.

Officials said the administration will seek to regulate the market for credit default swaps and other types of derivatives and require hedge funds to register with the Securities and Exchange Commission.

Treasury Secretary Timothy Geithner was scheduled to outline the proposals in testimony Thursday before the House Financial Services Committee.

Administration officials provided details of the administration's plan before the testimony only on condition of anonymity.

The program the administration was presenting to Congress will also include a recommendation for creation of a systemic risk regulator, possibly at the Federal Reserve, to monitor risks to the entire system.

The plan also includes a measure that Geithner and Federal Reserve Chairman Ben Bernanke discussed before the committee on Tuesday to give the administration expanded powers to take over major nonbank financial institutions, such as insurance companies and hedge funds that were teetering on the brink of collapse.

That power was aimed at preventing a repeat of the problems surrounding insurance giant American International Group Inc., which sparked a furor last week when it was revealed the company had distributed $165 million in bonuses to employees of its financial products group. The unit specialized in trading credit default swaps, the instruments that drove the company to near-collapse last fall.

The administration, pushing Congress to act quickly on its reform agenda, sent Congress a 61-page bill dealing with the expanded powers to seize control of nonbank institutions late Wednesday. The House Financial Services Committee, chaired by Rep. Barney Frank, D-Mass., has indicated it could move on the measure as early as next week.

However, it was unclear how fast the rest of the financial reform agenda might move through Congress. Geithner was providing only a broad outline of the other proposals, with many thorny details remaining to be worked out.

Administration officials promised that the remaining issues would be hammered out in consultation with Congress with the goal of getting legislation approved as quickly as possible.

The administration is proposing that hedge funds and other private pools of capital, including private equity funds and venture capital funds, be required to register with the SEC if their assets exceed a certain size. The threshold amount has yet to be determined, officials said.

The proposal on credit default swaps and other derivatives would require the markets on which they are traded to be regulated for the first time, and for the buying and selling of these instruments to be conducted in ways that will foster greater oversight.

Credit default swaps, which trade in a $60 trillion global market without government oversight, are contracts to insure against the default of financial instruments like bonds and corporate debt.

They played a prominent role in the credit crisis that brought the downfall of investment banking giant Lehman Brothers Holdings Inc. last fall and nearly unraveled AIG, forcing the government to provide more than $180 billion in support.

Hedge funds, vast pools of capital holding an estimated $1.5 trillion in assets, operate mostly outside of government supervision. As the market crisis deepened last fall, hedge fund selling was widely cited as one of the reasons for increased volatility that pounded stocks and bonds. Hedge funds also suffered huge losses last year, notably from investments in securities tied to subprime mortgages.

The outline of the regulatory reform was being unveiled a week before President Barack Obama was scheduled to meet for discussions among the Group of 20 major industrialized and developing countries in London to assess what needs to be done to deal with the global financial crisis.

While the administration is pushing other nations to follow the U.S. lead in putting together sizable economic stimulus programs to jump-start global growth, many in Europe are resisting those calls and arguing that the United States needs to do more to toughen financial regulations. They believe the current troubles can be traced to lax regulation in the United States in such key areas as hedge funds and credit default swaps.

Requiring hedge funds to register would open their books to inspection by regulators. The SEC sought that authority several years ago but was stymied by a federal appeals court in 2006.
Hedge funds have grown explosively in recent years while operating secretively. They have lured an increasing number of ordinary investors, pension funds and university endowments — meaning millions of people now unwittingly invest in hedge funds indirectly.

China Calls for a New Currency

Many people knew that the current economic crisis would test the ability of the US dollar to remain the world reserve currency. China is calling for a new reserve currency, following in the footsteps of a proposal by Russia earlier in the month. The Bank of International Settlements (BIS) suggested the same thing several years ago. The point being that this may take a while to accomplish, but it is on its way. I personally consider this to be a news story as important as the Fed announcement last week to buy US Treasury securities. Text in bold is my emphasis. From the WSJ:

China called for the creation of a new currency to eventually replace the dollar as the world's standard, proposing a sweeping overhaul of global finance that reflects developing nations' growing unhappiness with the U.S. role in the world economy.

The unusual proposal, made by central bank governor Zhou Xiaochuan in an essay released Monday in Beijing, is part of China's increasingly assertive approach to shaping the global response to the financial crisis.

Mr. Zhou's proposal comes amid preparations for a summit of the world's industrial and developing nations, the Group of 20, in London next week. At past such meetings, developed nations have criticized China's economic and currency policies.

This time, China is on the offensive, backed by other emerging economies such as Russia in making clear they want a global economic order less dominated by the U.S. and other wealthy nations.

However, the technical and political hurdles to implementing China's recommendation are enormous, so even if backed by other nations, the proposal is unlikely to change the dollar's role in the short term. Central banks around the world hold more U.S. dollars and dollar securities than they do assets denominated in any other individual foreign currency. Such reserves can be used to stabilize the value of the central banks' domestic currencies.

Monday's proposal follows a similar one Russia made this month during preparations for the G20 meeting. Like China, Russia recommended that the International Monetary Fund might issue the currency, and emphasized the need to update "the obsolescent unipolar world economic order."

Chinese officials are frustrated at their financial dependence on the U.S., with Premier Wen Jiabao this month publicly expressing "worries" over China's significant holdings of U.S. government bonds. The size of those holdings means the value of the national rainy-day fund is mainly driven by factors China has little control over, such as fluctuations in the value of the dollar and changes in U.S. economic policies. While Chinese banks have weathered the global downturn and continue to lend, the collapse in demand for the nation's exports has shuttered factories and left millions jobless.

In his paper, published in Chinese and English on the central bank's Web site, Mr. Zhou argued for reducing the dominance of a few individual currencies, such as the dollar, euro and yen, in international trade and finance. Most nations concentrate their assets in those reserve currencies, which exaggerates the size of flows and makes financial systems overall more volatile, Mr. Zhou said.

Moving to a reserve currency that belongs to no individual nation would make it easier for all nations to manage their economies better, he argued, because it would give the reserve-currency nations more freedom to shift monetary policy and exchange rates. It could also be the basis for a more equitable way of financing the IMF, Mr. Zhou added. China is among several nations under pressure to pony up extra cash to help the IMF.

John Lipsky, the IMF's deputy managing director, said the Chinese proposal should be treated seriously. "It reflects officials' concerns about improving the stability of the financial system," he said. "It's interesting because of China's unique position, and because the governor put it in a measured and considered way."

China's proposal is likely to have significant implications, said Eswar Prasad, a professor of trade policy at Cornell University and former IMF official. "Nobody believes that this is the perfect solution, but by putting this on the table the Chinese have redefined the debate," he said. "It represents a very strong pushback by China on a number of fronts where they feel themselves being pushed around by the advanced countries," such as currency policy and funding for the IMF.

A spokeswoman for the U.S. Treasury Department declined to comment on Mr. Zhou's views. In recent weeks, senior Obama administration officials have sought to reassure Beijing that the current U.S. spending spree is a short-term effort to restart the stalled American economy, not evidence of long-term U.S. profligacy.

"The re-establishment of a new and widely accepted reserve currency with a stable valuation benchmark may take a long time," Mr. Zhou said. In remarks earlier Monday, one of his deputies, Hu Xiaolian, also said the dollar's dominant position in international trade and investment is unlikely to change soon. Ms. Hu is in charge of reserve management as the head of China's State Administration of Foreign Exchange.

Mr. Zhou's comments -- coming on the heels of Mr. Wen's musing about the safety of China's dollar holdings -- appear to be a warning to the U.S. that it can't expect China to finance its spending indefinitely.

The central banker's proposal reflects both China's desire to hold its $1.95 trillion in reserves in something other than U.S. dollars and the fact that Beijing has few alternatives. With more U.S. dollars continuing to pour into China from trade and investment, Beijing has no realistic option other than storing them in U.S. debt.

Mr. Zhou argued, without mentioning the dollar by name, that the loss of the dollar's de facto reserve status would benefit the U.S. by avoiding future crises. Because other nations continued to park their money in U.S. dollars, the argument goes, the Federal Reserve was able to pursue an irresponsible policy in recent years, keeping interest rates too low for too long and thereby helping to inflate a bubble in the housing market.

"The outbreak of the crisis and its spillover to the entire world reflected the inherent vulnerabilities and systemic risks in the existing international monetary system," Mr. Zhou said. The increasing number and intensity of financial crises suggests "the costs of such a system to the world may have exceeded its benefits."

Mr. Zhou isn't the first to make that argument. "The dollar reserve system is part of the problem," Joseph Stiglitz, the Columbia University economist, said in a speech in Shanghai last week, because it meant so much of the world's cash was funneled into the U.S. "We need a global reserve system," he said in the speech.

Mr. Zhou's idea is to expand the use of "special drawing rights," or SDRs -- a kind of synthetic currency created by the IMF in the 1960s. Its value is determined by a basket of major currencies. Originally, the SDR was intended to serve as a shared currency for international reserves, though that aspect never really got off the ground.

These days, the SDR is mainly used in the IMF's accounting for its transactions with member nations. Mr. Zhou suggested countries could increase their contributions to the IMF in exchange for greater access to a pool of reserves in SDRs.

Holding more international reserves in SDRs would increase the role and powers of the IMF. That indicates China and other developing nations aren't hostile to international financial institutions -- they just want to have more say in running them. China has resisted the U.S. push to make an immediate loan to the IMF because that wouldn't give China a bigger vote. Ms. Hu said Monday that China, which encourages the IMF to explore other fund-raising options, would consider buying into a bond issue.

The IMF has been working on a proposal to issue bonds, probably only to central banks. Bond purchases are one way for the organization to raise money and meet its goal of at least doubling its lending war chest to $500 billion from $250 billion. Japan has loaned the IMF $100 billion and the European Union has pledged another $100 billion.

Gold, the Central Banks and the IMF

Below is an article that gives a nice summary of the somewhat quiet world of gold sales and the central banks. According to the article many central banks are expected to reduce sales of gold this year. The article claims that this is being done because gold "supply and demand" or in balance. I wonder if the central banks are hedging their bets considering the condition of the economy. banks Text in bold is my emphasis. From Market Watch:

The world's major central banks, which hold more than 15% of global gold stockpiles, are expected to reduce their sales or lending of their bullion reserves this year, potentially restricting supplies and putting a floor under gold prices.

Several precious metals consultancies and the industry's main trade group anticipate total sales from major central banks such as France and Switzerland will decline again this year. One estimate projects sales could tumble to their lowest level in at least a decade.

Fewer sales mean gold supplies, which have been retreating in recent years as mining production has weakened, are likely to keep falling short of demand.

As long as investor appetite stays strong - and that's a big question mark, of course - this trend should support prices over the long term.

"Falling central bank sales have been a part of the gradual improvement in the overall balance between demand and supply in the gold market," said George Milling-Stanley, managing director of the official sector at the producer-funded World Gold Council.

"There are a whole bunch of reasons why the [gold] price has been going up, and I think that lower supply has been one of those reasons," he added. . . .

. . . . Analysts also anticipate official holders such as central banks will lend less of their reserves, keeping with a trend of recent years. Some analysts say central banks' loans of their reserves to mining companies and private banks contributed to a slump in gold prices in the second half of last year.

Another important milestone for the supply of official gold this year is the International Monetary Fund. The organization has said it plans to sell more than 400 tons of gold to diversify its revenue and strengthen its balance sheet.

Some investors are worried that the IMF sales could pressure gold prices, although the fund has said it plans to coordinate closely with central banks to minimize the impact of this large gold sale.

The IMF's plan could provide a boost in getting central banks to extend an agreement expiring in September to limit how much gold they will sell every year. That deal, called the Central Bank Gold Agreement, has helped restrain central bank gold supplies over the past decade. . . . .

. . . . Central banks sell gold to rebalance their reserves portfolio by reducing the portion of gold. By selling gold, a country can switch into assets with higher return and better liquidity.

For example, Switzerland, which had held the most gold reserves per capita in Europe in 1999, has sold more than 1,300 tons of its gold reserves. Other major sellers in the past 10 years included France, the Netherlands, and the U.K.

Countries like France, where monetary policy is now set by the European Central Bank, still maintains its own central bank. The U.S. hasn't sold gold.

In the past, abrupt selling has sometimes depressed gold prices. The Bank of England's announcement in early 1999 that it was selling part of its reserves helped gold prices slump to a 20-year low. Gold traded at just above $250 an ounce by the summer of that year.

But efforts to coordinate those sales have reduced those shocks. On Sept. 26, 1999, 15 European central banks, led by the ECB, signed the first CBGA to take concerted moves on gold sales.

The banks agreed that in a five-year period, they will cap their total gold sales at around 400 tons a year, with sales in five years not exceeding 2,000 tons. The CBGA was renewed in 2004 for another five-year period. The second CBGA raised annual ceiling to 500 tons and the five-year limit to 2,500 tons.

"There is a general consensus in the gold market that the two successive CBGAs have been a success for the whole market and for central banks in particular," said WGC's Stanley.

In the past 10 years, almost all the official gold sales have been from signatories of the CBGA. Their sales have fallen in recent years and are likely to fall further this year, analysts say.

VM Group, a precious metals consultancy based in London, estimated that selling under the CBGA will fall to 150 tons in the year ended Sept. 26. If realized, this will be the lowest number since 1999, when the first CBGA was signed.

The World Gold Council and CPM Group, a New York-based precious metals consultancy, also anticipate official gold sales will fall this year.

Central bank gold sales declined to 279 tons in the 2008 calendar year, more than 200 tons, or 42%, lower than a year ago, according to data collected by GFMS, a London-based precious metals consultancy.

The fall in official sales is a major contributor to the decline in global gold supply in 2008, GFMS data showed. Meanwhile, the portion of official sales in total gold supply also fell to 8% in 2008 from 14% a year ago.

"Central banks that wanted to reduce their gold holdings have sold most of the gold they wanted to sell by the middle of this decade," said Jeffrey Christian, managing director at CPM Group.
But further selling could come from countries that still hold a big portion of gold in their reserves, such as Germany and Italy, according to analysts at VM. Earlier this year, politicians in Germany were talking about selling gold to fund the country's stimulus package.

Aside from selling gold, some central banks also lend the metal to miners, big banks and funds. Miners borrow gold to sell forward in order to lock in their future revenue. Funds and banks sometimes sell borrowed gold to invest the proceeds in other markets.

Gold borrowed for these two purposes used to have a dramatic impact on the market because it was immediately sold in spot markets, said WGC's Stanley.

VM estimated that total outstanding balance of central bank gold lending was at 2,345 tons at the end of 2008. That's more than the year's total mining production, the major source of gold supply.

Nonetheless, this balance has shrunk consistently since the late 1990s, reducing its impact on the markets. The balance in 2008 fell almost 50% from 2004's more than 4,300 tons, according to VM.

"Gold mining companies have largely stopped selling production as a hedge, and the hedge funds have largely abandoned the practice of selling gold forward as a speculation," said Stanley.

Miners reduced forward sales by 1.54 million ounces in the fourth quarter, the smallest amount for the year, according to GFMS. Gold producers still had 15.52 million ounces left in hedging at the end of the year. . . . .

. . . . From last August, when the global credit crunch hit the financial industry, bullion banks borrowed "as much gold as was available and executed gold swaps to raise liquidity," VM analysts led by Carl Firman pointed out in a yearly report released earlier this month.

The activity had an "immediate and very marked affect" on gold by holding prices back, even in the wake of strong retail demand for physical metal, Firman wrote in a report.

Gold prices slumped nearly 30% from July's high to below $700 in November.

By lending gold, central banks can earn interest on it. Unless central banks can lend out their gold, it earns nothing, and the stockpile in fact is a cost in terms of storage and insurance, said VM's Firman in a telephone interview.

Despite some wild speculations, all evidence indicates that the U.S., the biggest gold holder, is not lending gold, said CPM's Christian.

"The people, the gold conspiracy theorists who claim evidence, twist the truth like Uri Gellar twists spoons," said Christian.

More than half of the 8,133.5 tons of gold held by the U.S. is stored in Fort Knox, Ky., according to the Treasury Department. Gold is also stored in West Point, N.Y., and Denver, Colo.

The second CBGA is expiring in September. Stanley said he expected a new agreement will be signed. William Lelieveldt, an ECB spokesman, declined to comment on the potential renewal of the agreement.

One of the beneficiaries of a third CBGA will be the IMF, which is considering coordinating with central banks to sell 403 tons of gold.

The fund, which holds more than 3,200 tons of gold, ranking the third in the world after the U.S. and Germany, is facing a widening deficit. With the majority of its income coming from interest payment of the fund's loans, the IMF has been looking for other revenue sources.

One of the plans is the creation of an endowment, with major financing for the endowment coming from the proceeds of gold sales.

The IMF acknowledged drawbacks of gold sales, but also said that the sales could "form part of a package approach" and should "subject to strong safeguards to limit their market impact," according to the plan.

The sales "need to be coordinated with the existing and possible future central bank gold agreements," the committee said in the report. By coordinating with the CBGA framework, IMF gold sales "should not add to the announced volume of sales from official sources."
The WGC's Stanley said the IMF is likely to help push through a third CBGA.

"The proposal was designed not just to plug the income gap, but also to put the IMF's finances on a more diverse, sustainable and stable footing for the longer-term, and less subject to the ups and downs of the world economy," wrote Matthew Turner, an analyst at VM, in a report.

Tough Times

A friend of mine sent me this. Unfortunately, I do not know the source.





























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A Sensible View About AIG

Below is an editorial from the NY Times that discusses the situation at AIG in a sensible and rational way, that is, what is best for the taxpayer (the primary shareholder).

Of special interest in the editorial below would be the formation of a "Pecora committee" for the current financial crisis. The original committee was formed in 1932 to understand the origins of the financial collapse in the Great Depression. A new committee would be the source of valuable information from which good policies could evolve. Besides at this time we need to dial down the rhetoric. It is time for the mob with the pitch forks to go into "time-out" for awhile.

With all that said, the taxpayer needs to believe they are: 1) being heard and 2) getting a fair shake. I think there is a high probability of a very contentious period (both in the streets and in the polls) if the taxpayer continues to be ignored except for the periodic witch hunt.

Text in bold or in color is my emphasis.

Can we all just calm down a little?

Yes, the $165 million in bonuses handed out to executives in the financial products division of AIG was infuriating. Truly, it was. As many others have noted, this is the same unit whose shenanigans came perilously close to bringing the world’s financial system to its knees. When Fed chairman, Ben Bernanke, said recently that AIG’s “irresponsible bets” had made him “more angry” than anything else about the financial crisis he could have been speaking for most Americans.

But death threats? “All the executives and their families should be executed with piano wire — my greatest hope,” wrote one person in an e-mail message to the company. Another suggested publishing a list of the “Yankee” bankers “so some good old southern boys can take care of them.”

Or how about those efforts to publicize names of individual executives who received bonuses — efforts championed by Attorney General Cuomo of New York and Barney Frank, chairman of the House Financial Services Committee. To what end?

How does outing these executives fix skewed compensation incentives, which have created that unjustified sense of entitlement that pervades Wall Street? No, it’s mostly about using subpoena power to satisfy the public’s thirst for blood. (In light of the death threats, when Mr. Cuomo received the list of AIG bonus recipients on Thursday, he promised to consider “individual security” and “privacy rights” in deciding whether to publicize the names.)

Then there was that awful Congressional hearing on Wednesday, in which AIG’s newly installed chief executive, Edward Liddy, was forced to listen to one outraged member of Congress after another rail about bonuses — and obsess about when Treasury Secretary Tim Geithner learned about them — while ignoring far more troubling problems surrounding the AIG rescue.

Oh, and let’s not forget the bill that was passed on Thursday by the House of Representatives. It would tax at a 90 percent rate bonus payments made to anyone who earned over $250,000 at any financial institution receiving significant bailout funds. Should it become law, it will affect tens of thousands of employees who had absolutely nothing to do with creating the crisis, and who are trying to help fix their companies.

Meanwhile, the real culprits — like Joseph J. Cassano, the former head of AIG’s financial products division— are counting their money in “retirement.” Nobody on Capitol Hill seems much interested in getting that money back. (And the bill does nothing about bonuses that were paid before 2009, meaning that most of those egregious Merrill Lynch bonuses, paid at the end of last year, will not be touched.)

By week’s end, I was more depressed about the financial crisis than I’ve been since last September. Back then, the issue was the disintegration of the financial system, as the Lehman bankruptcy set off a terrible chain reaction. Now I’m worried that the political response is making the crisis worse. The Obama administration appears to have lost its grip on Congress, while the Treasury Department always seems caught off guard by bad news.

And Congress, with its howls of rage, its chaotic, episodic reaction to the crisis, and its shameless playing to the crowds, is out of control. This week, the body politic ran off the rails.
There are times when anger is cathartic. There are other times when anger makes a bad situation worse. “We need to stop committing economic arson,” Bert Ely, a banking consultant, said to me this week. That is what Congress committed: economic arson.

How is the political reaction to the crisis making it worse? Let us count the ways.

IT IS DESTROYING VALUE During his testimony on Wednesday, Mr. Liddy pointed out that much of the money the government turned over to AIG was a loan, not a gift. The company’s goal, he kept saying, was to pay that money back. But how? Mr. Liddy’s plan is to sell off the healthy insurance units — or, failing that, give them to the government to sell when they can muster a good price.

In other words, it is in the taxpayers’ best interest to position AIG as a company with many profitable units, worth potentially billions, and one bad unit that needs to be unwound. Which, by the way, is the truth. But as Mr. Ely puts it, “the indiscriminate pounding that AIG is taking is destroying the value of the company.” Potential buyers are wary. Customers are going elsewhere. Employees are looking to leave. Treating all of AIG like Public Enemy No. 1 is a pretty dumb way for a majority shareholder to act when he hopes to sell the company for top dollar.

IT IS, UNFORTUNATELY, BESIDE THE POINT Even on Wall Street this week, I didn’t hear anyone condoning the AIG bonuses. They should never have been granted, and Mr. Liddy should have been tougher about renegotiating them. (A rich irony here is that any nonfinancial company in AIG’s straits would be in bankruptcy, and contracts would have to be renegotiated. The fact that the government is afraid to force AIG into bankruptcy, despite its crippled state, is the main reason Mr. Liddy felt he couldn’t try to redo the contracts.)

But there is a much bigger issue that has barely been touched upon by Congress: the way tens of billions of dollars of taxpayers’ money has been funneled to AIG’s counterparties — at 100 cents on the dollar. How can it possibly make sense that Goldman Sachs, Bank of America, Citigroup and every other company that bought credit default swaps from AIG should be made whole by the government? Why isn’t it forcing them to take a haircut?

What’s worse, some of those companies are foreign banks that used credit-default swaps to exploit a regulatory loophole. Should the United States taxpayer really be responsible for ensuring the safety of European banks that were taking advantage of European regulations?

The person who has made this point most forcefully is Eliot Spitzer, of all people. In his column for Slate.com, he wrote: “Why did Goldman have to get back 100 cents on the dollar? Didn’t we already give Goldman a $25 billion cash infusion, and aren’t they sitting on more than $100 billion in cash?” Mr. Spitzer told me that while “there is a legitimate sense of outrage over the bonuses, the larger outrage should be the use of AIG funding as a second bailout for the large investment houses.” Precisely.

IT IS DESTABILIZING How can you run a company when the rules keep changing, when you have to worry about being second-guessed by Congress? Who can do business under those circumstances?

Take, for instance, that new securitization program the government is trying to get off the ground, called the Term Asset-Backed Securities Loan Facility — or TALF. Although it is backed by large government loans, it requires people in the marketplace — Wall Street bankers! — to participate.

This program could help revive the consumer credit market. But at this point, most Wall Street bankers would rather be attacked by wild dogs than take part. They fear that they’ll do something — make money perhaps? — that will arouse Congressional ire. Or that the rules will change. “The constant flip-flopping is terrible,” said Simon Johnson, a banking expert who teaches at the MIT Sloan School of Business.

AIG offers another good example. Not all the employees who face the possibility of having their bonuses taxed out from under them work for the evil financial products division. Many of them work in insurance divisions. Very few of them pull down million-dollar bonuses, and none of them brought AIG to its knees. (And employees who bought the company’s stock are already hurting financially, having seen its value virtually wiped out.) They are the ones the company badly needs to keep if it hopes to sell those units at a healthy price. Taking away their bonuses — after they’ve already put the money in their bank accounts — hardly seems like the right way to motivate them. And demonizing them in Congressional hearings doesn’t help either.

In previous columns, I have been an advocate of nationalizing big banks like Citigroup. But after watching Congress this week, I’m having second thoughts. If this is how Congress treats AIG, what would it do if it had a bank in its paws?

What the country really needs right now from Congress is facts instead of rhetoric. Instead of these “raise your hand if you took a private jet to get here” exercises of outraged populism, we need hearings that educate and illuminate. Hearings like the old Watergate hearings. Hearings in which knowledge is accumulated over time, and a record is established. Hearings that might actually help us get out of this crisis. It’s happened before. In 1932, Congress established the Pecora committee, named for its chief counsel, Ferdinand Pecora. It was an intense, two-year inquiry, and its findings — executives shorting their own company’s stock, for instance — shocked the country. It also led to the establishment of the Securities and Exchange Commission and other investor protections. One person who has been calling for a new Pecora committee is Senator Richard Shelby of Alabama, a Republican and key member of the Senate Banking Committee.

“As we restructure our regulatory system, we need to be thorough,” he told me. “We need to understand what caused it. We shouldn’t rush it.”

Meanwhile, the House Financial Services Committee has scheduled a hearing on Tuesday featuring Mr. Bernanke and Mr. Geithner. The hearing has been called to find out only one thing: what did the two men know about the AIG bonuses, and when did they know it?

Is that Nero I hear fiddling?

BIG NEWS - The Fed to Buy US Treasury Debt

This is big news. They have been talking about for awhile, but it looks like they are going ahead. If the Fed can pull this off we will not need the Chinese to the extent previously estimated and the Fed has a better chance of controlling inflation. Text in bold is my emphasis. From Market Watch:

The Federal Reserve on Wednesday said it would buy $300 billion in longer-term Treasury bonds to help arrest a deepening slide in the U.S. economy, a surprise move that sent stocks soaring and triggered violent moves in other markets.

The Federal Reserve's move, one of several actions taken Wednesday aimed at making it less expensive to borrow money, signaled it will boost the size of its balance sheet to more than $4 trillion. Today's moves double the amount of money the central bank has poured into the economy to try to stimulate economic activity.

"The Fed has upped the ante on its policy actions, and in a big way," said Richard Moody, chief economist at Forward Capital LLC in Austin, Texas.

Following the Fed decision, gold futures and U.S. stocks rallied, while the dollar plunged against other major currencies. The Dow Jones Industrial Average rose 73 points, or 1%, to 7,464.

In the bond market, Treasury prices soared, sending yields plummeting by the largest amount since 1987. Yields on the benchmark 10-year note, which move in the opposite direction from their prices, declined 47 basis points to 2.54%, the biggest drop since the stock market crashed in October 1987.

Gold futures soared $51.20, or 5.8%, to $940 an ounce on Globex, as the dollar tumbled against its rivals, particularly the yen and the euro. Oil futures also rose, reversing earlier losses.

The Fed moves Wednesday will add $750 billion to its other credit-easing programs by committing to buy more mortgage-backed securities and agency debt and including more asset-backed securities under a new credit facility starting this week.

Most analysts had thought that the Federal Open Market Committee - the policy making arm of the central bank -- would keep the weapon of buying Treasurys in reserve as a last step in case the crisis deepened. The decision comes against a background of a worsening economic outlook, marked by falling housing prices and soaring unemployment, and follows a year of failed efforts to try to turn the economy around.

The Fed has already been very aggressive over the past year. It slashed interest rates to zero and started its credit easing program once it saw that its biggest fear - a self perpetuating downturn where a weak financial sector pushed down growth which would hurt the financial sector was coming to pass.

The Fed took special aim at the housing market.

"To provide greater support to mortgage lending and housing markets," the FOMC said it would purchase an additional $750 billion of agency mortgage-backed securities. This brings the total amount of agency mortgage-backed securities to $1.25 trillion.

The Fed said it would double its purchase of agency debt to $200 billion. In addition, many unspecified types of assets will be included in the newest Fed credit facility, the Term Asset-Banked securities.

The Fed was more pessimistic about the economic outlook, in a statement released after its two-day meeting, than Chairman Ben Bernanke was in the last several days. Officials removed language saying they expected the economy to recover later this year. The Fed repeated that deflation was a risk to the economy.

The Fed said the economy was "weak" and latest information only showed further contraction.

There was no mention of any "green shoots" of recovery that Bernanke mentioned seeing in his interview on Sunday with 60 minutes.

Economists expect that the economy is shrinking at a 4.8% annual rate in the first three months of this year. Growth fell 6.2% in the fourth quarter of 2008.

The Fed said that it still believed that the programs that it has put in place, combined with fiscal stimulus, would be able to pull the economy out of the ditch.

The vote on the day's moves was unanimous.

Shortly after the Fed statement was released, the New York Fed said it would concentrate its Treasury purchases in the 2-to 10-year range.

Economists said this focus made sense.

Lou Crandall, economist at Wrightson ICAP in a note to clients, said the Fed would not concentrate in the 20-30-year sector because it "is not a critical source of funding for private-sector borrowers."

There is more than one reason for the Fed to buy Treasurys.

The Fed concentrated on the fact that it would like to lower credit spreads on other loans.
But some of the regional Fed bank presidents may have supported the move because the purchases fall under the control of the full FOMC where the presidents have influence.

The other Fed credit programs are controlled in Washington by the Fed board of governors.
With interest rates at zero, economists said it is hard to even know exactly how stimulate policy is at the moment.

Morgan Stanley economists estimated that interest rates should be negative 5% if that were possible give the magnitude of the recession.

Before the meeting there was a clear sense that the economy is still spinning its wheels despite the huge expansion in the Fed's balance sheet already.

Today's announcement, combined with measures in the works, brings the size of the balance sheet to more than $4 trillion.

Even this might be too little.

Jan Hatzius, economist at Goldman Sachs, said the Fed might have to expand its balance sheet to $10 trillion to restore growth.

Some economists don't think it is a good idea to buy longer-term Treasury securities.

"In fiddling with the yield curve, the Fed is playing with fire," said Robert Brusca, chief economist at FAO Economics.

He cited many academic studies that said the Fed will have a hard time pushing yields down.
"It's not a good idea. If cutting short-term rates to zero has not brought longer rates down, there is a reason for that. Going out there and grabbing the yield curve by the neck and stomping on it is not likely to enhance market confidence in the Fed for doing the right thing," he said.

A View about Mr. Wen's Comments About US Debt

The Opinion below from the WSJ concerns the comments made by Chinese Premier Wen Jiabao concerning US debt. Mr. Wen's comments made last week caused quite a stir because the US is hoping that the Chinese, already the largest international holder of US debt, will be willing to buy more. Text in bold is my emphasis.

Chinese Premier Wen Jiabao created a useful stir late last week when he said he's a "little bit worried" about the safety of U.S. assets -- meaning the Treasury bonds his government owns. Whatever Mr. Wen's political motives, his concerns about the integrity of U.S. sovereign debt are timely and apt.

U.S. debt held by the public has now hit $6.6 trillion -- up from $5.3 trillion only a year ago. That doesn't count another $5.3 trillion in Fannie Mae and Freddie Mac liabilities that we now know also have a taxpayer guarantee. And it doesn't count the many ways that both the Federal Reserve and Treasury have guaranteed financial assets more broadly -- such as $29 billion in Bear Stearns paper, $301 billion in dodgy Citigroup assets, and hundreds of billions in Federal Housing Administration loans.

President Obama's stimulus plan and new budget will require an additional $3 trillion to $4 trillion in new borrowing over the next two or three years, and that's if the economy recovers smartly. Adding it all up, Federal Reserve Chairman Ben Bernanke last week estimated that U.S. public debt-to-GDP would reach 60% over the next few years, up from 40% before the financial panic hit -- and the highest level since the aftermath of World War II. He must be an optimist. As the nearby chart shows, Mr. Obama's budget anticipates a decade of outlays far above postwar spending and revenue averages. And even that assumes, implausibly, that most "stimulus" spending will be temporary.

That's a lot of T-bills to flog, and the world is taking note. Our colleagues at MarketWatch reported last week that the cost to buy insurance against U.S. sovereign debt default has surged in the past year. The spreads on credit default swaps for U.S. government debt hit 97 basis points last week -- or $97,000 to buy insurance on $10 million in debt -- nearly seven times higher than a year ago and 60% higher than the end of 2008.

Mr. Wen called on the U.S. to "maintain its credibility, honor its commitments and guarantee the safety of Chinese assets." Little wonder: China, like other trading nations, has a big stake in this fiscal free-for-all. Although it doesn't release detailed data, roughly two-thirds of Beijing's $1.9 trillion foreign-exchange reserves are likely parked in U.S. Treasury debt.

The Obama Administration revealed its sensitivity on the issue by responding quickly, with Presidential spokesman Robert Gibbs saying Friday "there's no safer investment in the world than in the United States." Mr. Obama added Saturday that "not just the Chinese government, but every investor can have absolute confidence in the soundness of investments in the United States."

The White House is almost certainly right that the U.S. won't default; the consequences would be too dire. But there are risks well short of formal debt repudiation. As the supply of U.S. debt increases, investors may demand a higher yield and interest rates would rise, reducing the tradable value of current Treasury bonds. The other temptation will be to inflate away the debt, which would also devalue dollar-denominated assets.

What Mr. Wen is really saying is that even the U.S. national balance sheet has limits. The dollar is the world's reserve currency, so the U.S. has the rare privilege among nations of being able to borrow (and then repay its debts) in its own currency. America also remains the world's main safe haven in a crisis, as the flight to the dollar and T-bills in recent months underscores.

But reserve currency status isn't a birthright and it can vanish when nations are irresponsible. Deficits are sometimes necessary to finance tax cuts and investments that promote economic growth. The tragedy of Mr. Obama's $787 billion stimulus and $410 billion 2009 budget is that they spend principally on transfer payments that have little growth payback. The U.S. received another foreign rebuke on this score this weekend, when German Chancellor Angela Merkel and other Europeans rejected Mr. Obama's calls for a comparable spending binge on the Continent.

Mr. Wen may have been trying to placate his domestic Chinese audience, which is suffering through its own economic slowdown. Or perhaps he was trying to repay Treasury Secretary Timothy Geithner for his nomination-hearing comments on Chinese currency "manipulation." Mr. Wen doesn't have much room to lecture the U.S., having done too little in his nearly six years in office to liberalize the Chinese economy.

But the Chinese Premier is right to warn the U.S. political class that the global demand for American debt will continue only if the U.S. runs economic policies that make U.S.-dollar assets worth the risk.

They are Finally Shining a Light on Financial Journalism

Last week I posted the video clips of Cramer vs. Stewart. An interview in which Jim Cramer seemed to just laydown under the questioning of Jon Stewart. This morning's WSJ had an interesting editorial piece resulting from the interviews, but more deeply explored the role of financial journalism in the market place. Is financial journalism finally under the bright lights? Text in bold is my emphasis.

"Listen, you knew what the banks were doing and yet were touting it for months and months," said "Daily Show" host Jon Stewart to CNBC superstar Jim Cramer in their much-discussed confrontation last week. "The entire network was, and so now to pretend that this was some sort of crazy, once-in-a-lifetime tsunami that nobody could have seen coming is disingenuous at best and criminal at worst."

The applause Mr. Stewart has received for his j'accuse is the sound of the old order cracking. We have turned on the financial CEOs, inducting them one by one into the Predator Hall of Fame. We have gone deaf to the seductive rhythms of the culture wars. We have tossed out the politicians whose antigovernment rhetoric seemed invincible for so long.

And now comes the turn of the bubble-blowers of pop culture, the army of fake populists who have prospered for years by depicting the stock market as an expression of the general will, as the trustworthy friend of the little guy buffeted by a globalizing economy.

We know -- or we think we know -- about the roles played by other culprits in the debacle. The government regulators, for example: How could they have ignored the coming disaster? Well, they were incapacitated by decades of deregulation. What about the market's own watchdogs? Well, from appraisers to ratings agencies the whole tough-minded system was apparently undermined by conflicts of interest.

But what about the syndicated columnists and the beloved stock pickers and the authors of personal finance best-sellers, the industry for which CNBC is the perfect symbol? How did they manage to miss the volcano under their feet?

Mr. Cramer, for his part, had the forthrightness to confess his errors and admit his limitations. "I'm not Eric Sevareid. I'm not Edward R. Murrow," he pleaded. "I'm a guy trying to do an entertainment show about business for people to watch."

But the larger problem won't go away. And it's not just a matter of people missing the biggest economic story of the last 20 years. It's a matter of those who minimized it and those who blew it off because it didn't fit their worldview continuing in their plum positions of authority. Mr. Stewart wasn't rude enough to ask it, but over all his inquiries there hung the obvious question: Why do you still have a job, Mr. Cramer?

If the world of financial infotainment can itself be described as a "market," it is a market where accountability does not seem to exist, where the heaviest of incentives seems to carry no weight, and where consumers, to judge by what they get, seem constantly to choose the lousy over the good. The old order discredits itself, but the old order persists nevertheless.

This needs to be repeated every time someone pleads, "Who could have known?" Plenty of people did see the disaster coming. Most of them were marginalized, however, laboring at out-of-the-way econ departments, blogs and B-list think tanks. They were excluded and even ridiculed because their larger understanding of the economy was not one that fit well with the sort of Wall Street worship preached by the likes of CNBC.

Nor is this a particularly liberal line of inquiry, despite Jon Stewart's well-known fondness for tormenting Republicans. It was a question that interested Milton Friedman, among others, who could be seen musing on the subject in a 1994 TV interview that C-Span chose to rebroadcast on Sunday.

The occasion was the 50th anniversary of the publication of Friedrich Hayek's "The Road to Serfdom." As he looked around him, Friedman marveled at the world's perverse refusal to learn certain lessons, even when history itself drove them home. Everyone had by then learned that government was too large, he said, but countries kept on growing government anyway.

Friedman may have misread the direction in which the world was moving in 1994, but the question he raised is still a good one. Bad ideas and clueless pundits often do get on top, and they stay there -- sometimes hailing incentives and accountability, even -- despite all manner of rebukes handed down by history itself.

The reasons the financial-entertainment biz failed us are many and complex, but they ultimately come down to this: In the marketplace to describe the marketplace itself, there is precious little competition. There is a single, standard product that comes in packaging that is alternately sultry, energetic or fun -- bitter, brainy or Cramer "crazy" -- but which rarely strays beyond certain ideological boundaries. Adversarial voices are few. Criticism is sacrificed for access. Advice sometimes shades over into simple propaganda. Even the worst prognosticators sometimes go on to jobs with presidential campaigns or prominent think tanks.

And the small investors whom the personal-financial industry claims so much to adore remain bystanders in a drama they neither understand nor control.

The Net Worth of American Households Dropped 18% in 2008

As one can imagine household net worth is under a great deal of pressure. It fell 18% in 2008 across the board, but is higher amongst higher income/net worth households. Text in bold is my emphasis. From the WSJ:

The wealth of American families plunged nearly 18% in 2008, erasing years of sharp gains on housing and stocks and marking the biggest loss since the Federal Reserve began keeping track after World War II.

The Fed said Thursday that U.S. households' net worth tumbled by $11 trillion -- a decline in a single year that equals the combined annual output of Germany, Japan and the U.K. The data signal the end of an epoch defined by first and second homes, rising retirement funds and ever-fatter portfolios.

Past downturns have been mere blips compared with the losses Americans faced last year, which set them back to below 2004 levels. "In the postwar period, we've never had anything other than very modest declines. That life experience led many people to think that houses were a one-way bet," says Douglas Cliggott, the chief investment officer of Dover Management LLC.

The decline in Americans' net worth, which was the first in six years, follows an extraordinary boom. Not accounting for inflation, household wealth more than doubled from 1990 to 2000, and then, after a pause, rose nearly 50% before the bust of 2008.

While the value of their assets was falling, Americans' total debt remained roughly flat. Total household debt increased by half a percentage point in 2008 as families faced tighter lending standards and many started trying harder to live within their means. After years of splurging with an eye on their rising assets, that phenomenon, known as the wealth effect, now cuts the other way, spurring frugality. . . .

. . . . Overall, the quarterly Fed report, known as the flow of funds report, underscores the new strain on the U.S. consumer: Mortgages and credit-card debt alone totaled $13 trillion, or 123% of after-tax income. In 1995, for instance, it was 83% of income.

Collectively, homeowners had 43% equity in their homes -- the lowest level since records have been kept. Amid foreclosures and tighter lending, the total amount of mortgage credit was down last year for the first time since the Fed started keeping track in 1945.

The recession that began in December 2007 has reversed a particularly long boom. "What's misleading about this being the biggest drop is that it was preceded by one of the biggest rises," says David Backus, an economics professor at the New York University Stern School of Business. "Even where it's come down to is not a low level compared to the last 50 years of history."

In all, the net worth of U.S. households stood at $51.48 trillion at the end of 2008, the Fed data showed. Besides being down 17.9% from a year earlier, it was down 9% just from the third quarter.

The net-worth figure encompasses all of families' assets -- housing, stocks, personal property -- minus their total debts.

Americans' assets have taken further hits in the first two months of 2009, a period not covered in the quarterly report.

Although stocks have risen for three straight days, they remain down roughly 16% since the fourth quarter, when Americans' portfolios of stocks and mutual funds were worth $8.76 trillion.

The national median home price, meanwhile, was $170,300 in January, down nearly 15% from a year earlier. . . .

. . . . Signs are emerging that Americans, in ways big and small, are pulling lessons from their collapsed empires. Of 46 economists responding to a recent Wall Street Journal survey, 43 predicted the new era of thrift will persist beyond the end of the recession.

The Case for Deflation

One concern that I have is that many of the people that called the crashes in housing, the stock market, and the credit markets cannot agree on the next stage of the economy. Many believe that we are in for a period of high inflation as the value of the dollar declines. However, others believe we are in for a period of deflation. Text in bold is my emphasis. From the WSJ:

While most investors fear deflation, Gary Shilling is looking forward to it.

The idiosyncratic economist manages about $100 million for clients from a small office here. For many, many years, he has predicted an era of falling prices that never arrived. Now, finally, it just might.

He has a batch of advice for investors on how to weather deflation: Don't expect your house's worth to rebound. Stash your money in apartment real-estate trusts and conventional Treasurys. Don't invest in companies that carry a lot of debt or in inflation-protected Treasurys.

The last time deflation appeared was in the Depression. U.S. prices slid 32% from 1929 to 1933. Suddenly, many observers these days fear that the popping of the housing bubble, along with the financial crisis, could be pushing the U.S. toward a new deflationary era. The consumer-price index including food and energy dropped 0.8% for December, year over year, and was flat for January. When the February CPI is reported on Wednesday, many expect it to be flat or negative again.

Mr. Shilling believes price drops of 2% to 3% yearly will persist long after this recession because of huge efficiencies driven by globalization and technology, plus retirement-panicked baby boomers curbing their spendthrift ways and pumping up their puny savings. That would echo similar deflationary spells during prosperous, high-growth times like the late 1800s and the 1920s.

Increasingly, Mr. Shilling is getting company from economists who think deflation may be on the way, notably New York University's Nouriel Roubini and Merrill Lynch's David Rosenberg. Of course, others such as Northern Trust's Paul Kasriel, argue that heavy federal spending by the Obama administration to jump-start the economy risks just the opposite, a vexing inflation.

Yet few go as far in seeing persisting deflation as Mr. Shilling, 71 years old, a Stanford Ph.D. in economics who once was Merrill's chief economist.

Deflation in the Depression was truly baleful because it fostered a falloff in demand, since consumers were leery to buy what would be cheaper in the future. And it punished debt holders, who had to pay fixed amounts even as the value of the underlying asset sunk. The same condition bedeviled Japan in the 1990s.

A frequent talking head on CNBC, Mr. Shilling sometimes comes across as an oddball with his chronic bearishness. "People say I'm always negative, and when I'm right, it's like the stopped clock being right twice a day," Mr. Shilling says. Indeed, in January 2004, he predicted a housing crash within the year. "I was early," he says.

Even Mr. Shilling's hobby is on the eccentric side: He keeps bees. At his Short Hills, N.J., home and a nearby property, he tends 80 hives. Mr. Shilling gives the honey away to friends in plastic bear containers with labels saying things like: "Our bountiful bees need no bailout."
Over the years, Mr. Shilling has devised a virtual deflationary handbook for investors.

Good ideas: Longer-term Treasurys and certificates of deposit, which will continue to pay interest in the low single-digits. If the CPI is down 2% and 30-year Treasurys yield 3.6%, as they do now, then you get an effective 5.6%.

The housing bust is showing Americans that a place to live is no longer a can't-lose investment, Mr. Shilling says. Hence, he forecasts a surge into rental apartments, which should boost now-flagging apartment REITs. In health care, Mr. Shilling thinks winners will be companies dedicated to cost containment, like pharmacy-benefit managers.

His expected victims of deflation? Auto makers (savings-minded consumers will hold onto their old cars longer) and sellers of other big-ticket goods like refrigerators. He also is down on mortgage-backed securities, linked to the plummeting housing sector.

Cramer v. Stewart - Cramer was a laydown and Stewart was serious. What are they up too?

The big debate between Jim Cramer and Jon Stewart occurred last night on the Daily Show with Jon Stewart. I was amazed how bombastic Jim Cramer wasn't. Normally he is an in-your-face, aggressive, ego maniac. On the other hand Jon Stewart is a quick witted, funny (I think he is funny), commentator who takes nothing seriously. Last night he was dead serious in in conversations with Jim Cramer. I wonder what these two guys are really up too? Below are the clips of the interview from the Daily Show with Jon Stewart:

The Daily Show With Jon StewartM - Th 11p / 10c

Jim Cramer Interview Outtake Pt. 1

Daily Show Full Episodes
Important Things w/ Demetri Martin

Political Humor
Jim Cramer

The Daily Show With Jon StewartM - Th 11p / 10c

Jim Cramer Interview Outtake Pt. 2

Daily Show Full Episodes
Important Things w/ Demetri Martin

Political Humor
Jim Cramer

The Daily Show With Jon StewartM - Th 11p / 10c

Jim Cramer Interview Outtake Pt. 3

Daily Show Full Episodes
Important Things w/ Demetri Martin

Political Humor
Jim Cramer

Foreclosures - The Beat Goes On

There is not much to add about foreclosures other than things are continuing as before. Also analysts are beginning to see the effects of higher unemployment on foreclosures. Text in bold is my emphasis. From Yahoo News:

U.S. home foreclosure activity resumed its upturn in February after a brief dip, despite numerous programs meant to quell the record pace of failing mortgages, RealtyTrac reported on Thursday.

Filings, which include notice of default, auction sale or bank repossession, rose 6 percent in February after slipping 10 percent in January, and leaped 30 percent from a year ago, the Irvine, California-based real estate data firm said.

One in every 440 households with loans drew a filing last month, RealtyTrac said. Nearly 291,000 properties in the U.S. got a foreclosure filing in February, the third highest monthly total since RealtyTrac began tracking the data in January 2005.

"The rate of foreclosure activity is increasing beyond the ability of even these types of moratoria to slow down," Rick Sharga, senior vice president at RealtyTrac, said in an interview, referring to major state and corporate moratoriums on foreclosures.

In Florida, where a 45-day voluntary moratorium ended at the end of January, filings jumped 14 percent in February, James J. Saccacio, RealtyTrac chief executive, said in a statement. Florida has one of the highest foreclosure rates in the nation.

President Barack Obama late last month unveiled a $275 billion housing stimulus plan, but the housing market is still contending with dire employment conditions and falling house prices.

The administration's housing rescue won't be enough to fix the rapid rate of foreclosure, though it is by far the best-constructed program to date, he contended. Many borrowers in the hardest hit states have mortgages far exceeding the value of their homes, and thus don't meet the criteria to refinance under the new federal program.

Three of the 10 states with the most foreclosure activity are fairly new to these ranks: Idaho, Illinois and Oregon.

"Everything we've been able to gather on those states suggests that this is the first wave of unemployment-related foreclosure problems," Sharga said.

One in every 54 U.S. households with mortgages got at least one filing notice last year, suggesting various temporary state programs to slow the process had little lasting effect.
Home prices began toppling in mid-2006, preventing many homeowners from selling or refinancing.

Prices have tumbled by more than 26 percent since peaking nearly three years ago, according to Standard & Poor's/Case-Shiller indexes.

Nevada, Arizona, California and Florida remained the states with the highest foreclosure rates and totals in February. All four had the biggest price run-ups and some of the most overbuilding in the nation before cratering.

Nevada had the top foreclosure rate, with one in every 70 housing units getting a notice in February. Filings on 15,783 properties meant activity ballooned by 9 percent from January and by 156 percent from a year earlier.

Las Vegas had the highest foreclosure rate for metropolitan areas with populations of at least 200,000 -- a rate more than seven times higher than the national average, RealtyTrac said.
Arizona and California had the second and third highest foreclosure rates in February, and California had the largest number of foreclosure filings., with notices up 5 percent from January and up 51 percent from a year ago.

Florida and Arizona were in second and third places for total foreclosure filings.

Florida's monthly foreclosure activity increase and 43 percent annual rise was driven mainly by a nearly 158 percent annual surge in auction sales notices and 128 percent jump in bank repossessions.

The Status of Credit Cards

Credit cards are the mainstay of consumer credit. In spite of all the hoopla about the quality of credit card account holders most accounts are in good shape. However, banks are cutting credit limits on those that struggle with their credit, do not use a large enough portion of the line, or live in the wrong zip code (i.e. house depreciation). This is being done mostly as a risk management tool with the added benefit that banks have to reserve for credit card exposure, so cutting lines is a good deal for banks all the way around. Regardless, based on the action of some banks, the consumer must soon realize that credit will not be as easily available as before, therefore, consumer spending is going to suffer. Text in bold is my emphasis. From the WSJ:

Few doubt the importance of consumer spending to the U.S. economy and its multiplier effect on the global economy, but what is underappreciated is the role of credit-card availability in that spending. Currently, there is roughly $5 trillion in credit-card lines outstanding in the U.S., and a little more than $800 billion is currently drawn upon. While those numbers look small relative to total mortgage debt of over $10.5 trillion, credit-card debt is revolving and accordingly being paid off and drawn down over and over, creating a critical role in commerce in America.

Just six months ago, I estimated that at least $2 trillion of available credit-card lines would be expunged from the system by the end of 2010. However, today, that estimate now looks optimistic, as available lines were reduced by nearly $500 billion in the fourth quarter of 2008 alone. My revised estimates are that over $2 trillion of credit-card lines will be cut inside of 2009, and $2.7 trillion by the end of 2010.

Inevitably, credit lines will continue to be reduced across the system, but the velocity at which it is already occurring and will continue to occur will result in unintended consequences for consumer confidence, spending and the overall economy. Lenders, regulators and politicians need to show thoughtful leadership now on this issue in order to derail what I believe will be at least a 57% contraction in credit-card lines.

There are several factors that are playing into this swift contraction in credit well beyond the scope of the current credit market disruption. First, the very foundation of credit-card lending over the past 15 years has been misguided. In order to facilitate national expansion and vast pools of consumer loans, lenders became overly reliant on FICO scores that have borne out to be simply unreliable. Further, the bulk of credit lines were extended during a time when unemployment averaged well below 6%. Overly optimistic underwriting standards made more borrowers appear creditworthy. As we return to more realistic underwriting standards, certain borrowers will no longer appear worth the risk, and therefore lines will continue to be pulled from those borrowers.

Second, home price depreciation has been a more reliable determinant of consumer behavior than FICO scores. Hence, lenders have reduced credit lines based upon "zip codes," or where home price depreciation has been most acute. Such a strategy carries the obvious hazard of putting good customers in more vulnerable liquidity positions simply because they live in a higher risk zip code. With this, frequency of default is increased. In other words, as lines are pulled and borrowing capacity is reduced, paying borrowers are pushed into vulnerable financial positions along with nonpaying borrowers, and therefore a greater number of defaults in fact occur.

Third, credit-card lenders are currently playing a game of "hot potato," in which no one wants to be the last one holding an open credit-card line to an individual or business. While a mortgage loan is largely a "monogamous" relationship between borrower and lender, an individual has multiple relationships with credit-card providers. Thus, as lines are cut, risk exposure increases to the remaining lender with the biggest line outstanding.

Here, such a negative spiral strategy necessitates immediate action. Currently five lenders dominate two thirds of the market. These lenders need to work together to protect one another and preserve credit lines to able paying borrowers by setting consortium guidelines on credit. We, as Americans, are all in the same soup here, and desperate times are requiring of radical and cooperative measures.

And fourth, along with many important and necessary mandates regarding fairness to consumers, impending changes to Unfair and Deceptive Acts or Practices (UDAP) regulations risk the very real unintended consequence of cutting off vast amounts of credit to consumers. Specifically, the new UDAP provisions would restrict repricing of risk, which could in turn restrict the availability of credit. If a lender cannot reprice for changing risk on an unsecured loan, the lender simply will not make the loan. This proposal is set to be effective by mid-2010, but talk now is of accelerating its adoption date. Politicians and regulators need to seriously consider what unintended consequences could occur from the implementation of this proposal in current form. Short of the U.S. government becoming a direct credit-card lender, invariably credit will come out of the system.

Over the past 20 years, Americans have also grown to use their credit card as a cash-flow management tool. For example, 90% of credit-card users revolve a balance (i.e., don't pay it off in full) at least once a year, and over 45% of credit-card users revolve every month. Undeniably, consumers look at their unused credit balances as a "what if" reserve. "What if" my kid needs braces? "What if" my dog gets sick? "What if" I lose one of my jobs? This unused credit portion has grown to be relied on as a source of liquidity and a liquidity management tool for many U.S. consumers. In fact, a relatively small portion of U.S. consumers have actually maxed out their credit cards, and most currently have ample room to spare on their unused credit lines. For example, the industry credit line utilization rate (or percentage of total credit lines outstanding drawn upon) was just 17% at the end of 2008. However, this is in the process of changing dramatically.

Without doubt, credit was extended too freely over the past 15 years, and a rationalization of lending is unavoidable. What is avoidable, however, is taking credit away from people who have the ability to pay their bills. If credit is taken away from what otherwise is an able borrower, that borrower's financial position weakens considerably. With two-thirds of the U.S. economy dependent upon consumer spending, we should tread carefully and act collectively.

Are We At A Point of Fundamental Change?

I find more and more people asking this question and I think it is worth pondering. From the NY Times. Text in bold is my emphasis.

Let’s today step out of the normal boundaries of analysis of our economic crisis and ask a radical question: What if the crisis of 2008 represents something much more fundamental than a deep recession? What if it’s telling us that the whole growth model we created over the last 50 years is simply unsustainable economically and ecologically and that 2008 was when we hit the wall — when Mother Nature and the market both said: “No more.”

We have created a system for growth that depended on our building more and more stores to sell more and more stuff made in more and more factories in China, powered by more and more coal that would cause more and more climate change but earn China more and more dollars to buy more and more U.S. T-bills so America would have more and more money to build more and more stores and sell more and more stuff that would employ more and more Chinese ...
We can’t do this anymore.

“We created a way of raising standards of living that we can’t possibly pass on to our children,” said Joe Romm, a physicist and climate expert who writes the indispensable blog climateprogress.org. We have been getting rich by depleting all our natural stocks — water, hydrocarbons, forests, rivers, fish and arable land — and not by generating renewable flows.
“You can get this burst of wealth that we have created from this rapacious behavior,” added Romm. “But it has to collapse, unless adults stand up and say, ‘This is a Ponzi scheme. We have not generated real wealth, and we are destroying a livable climate ...’ Real wealth is something you can pass on in a way that others can enjoy.”

Over a billion people today suffer from water scarcity; deforestation in the tropics destroys an area the size of Greece every year — more than 25 million acres; more than half of the world’s fisheries are over-fished or fished at their limit.

“Just as a few lonely economists warned us we were living beyond our financial means and overdrawing our financial assets, scientists are warning us that we’re living beyond our ecological means and overdrawing our natural assets,” argues Glenn Prickett, senior vice president at Conservation International. But, he cautioned, as environmentalists have pointed out: “Mother Nature doesn’t do bailouts.”

One of those who has been warning me of this for a long time is Paul Gilding, the Australian environmental business expert. He has a name for this moment — when both Mother Nature and Father Greed have hit the wall at once — “The Great Disruption.”

“We are taking a system operating past its capacity and driving it faster and harder,” he wrote me. “No matter how wonderful the system is, the laws of physics and biology still apply.” We must have growth, but we must grow in a different way. For starters, economies need to transition to the concept of net-zero, whereby buildings, cars, factories and homes are designed not only to generate as much energy as they use but to be infinitely recyclable in as many parts as possible. Let’s grow by creating flows rather than plundering more stocks.

Gilding says he’s actually an optimist. So am I. People are already using this economic slowdown to retool and reorient economies. Germany, Britain, China and the U.S. have all used stimulus bills to make huge new investments in clean power. South Korea’s new national paradigm for development is called: “Low carbon, green growth.” Who knew? People are realizing we need more than incremental changes — and we’re seeing the first stirrings of growth in smarter, more efficient, more responsible ways.

In the meantime, says Gilding, take notes: “When we look back, 2008 will be a momentous year in human history. Our children and grandchildren will ask us, ‘What was it like? What were you doing when it started to fall apart? What did you think? What did you do?’ Often in the middle of something momentous, we can’t see its significance. But for me there is no doubt: 2008 will be the marker — the year when ‘The Great Disruption’ began.”

Jon Stewart's Riff on CNBC

I am a big fan of Jon Stewart. Other than a particular interview every now and then I am not a fan of CNBC. I hope you enjoy this.

The Daily Show With Jon StewartM - Th 11p / 10c

CNBC Gives Financial Advice

Daily Show Full Episodes
Important Things With Demetri Martin

Political Humor
Economic Crisis

Why the Dollar May Be So Strong

According the UK Telegraph the strength of the US dollar lies not only on the last fall's flight to to "safety" by many investors, but also on a mismatch of borrowing by European banks. In the latter case banks would fund longer term dollar positions with short term local currency transactions. Now with all the turmoil in the markets as their short term positions roll over the banks are trying to move into dollars. I have heard of this before, but this is the first validation of the issue I have seen. If you are interested in the original article it is available at the BIS. Text in bold is my emphasis.

European banks face a US dollar “funding gap” of almost $2 trillion as a result of aggressive expansion around the world and may have difficulties rolling over debts, according to a report by the Bank for International Settlements.

The BIS said European and British banks have relied on an “unstable” source of funding, borrowing in their local currencies to finance “long positions in US dollars”. Much of this has to be rolled over in short-term debt markets.

“The build-up of large net US dollar positions exposed these banks to funding risk, or the risk that their funding positions could not be rolled over,” said the BIS.

The report, entitled “US dollar shortage in global banking”, helps explain why there has been such a frantic scramble for dollars each time the credit crisis takes a turn for the worse. Many investors have been wrong-footed by the powerful rally in the dollar against almost all currencies, except the yen.

British banks had accumulated a dollar "funding gap" of $300bn by mid 2007. The latest BIS data up to the third quarter of 2008 shows that this exposure has been trimmed by “deleveraging” but it still largely hanging over the UK financial institutions.

Swiss banks had a funding gap of $300bn at the onset of the credit crunch, an extremely high figure relative to Swiss GDP. German banks were $300bn short, and Dutch banks were $150bn short. Belgian and French banks were neutral.

The BIS said the total “funding gap” in dollars was around $2.2 trillion at the peak, when money market liabilities are included. This had fallen to around $2 trillion by the time of the Lehman Brothers collapse. The data is collected with a lag but it appears that there are still huge dollar liabilities to be covered.

Simon Derrick, currency chief at the Bank of New York Mellon, said the implications are obvious. “The global bullion of the last eight years was funded on dollar balance sheets, so the capital destruction we’re seeing leaves banks starved for dollars. Dollar is clearly going to appreciate a lot further,” he said.

Has the Economic Crisis Moved Overseas?

A few comments from my favorite author Ambrose Evans-Pritchard about the economic crisis in Europe. Text in bold is my emphasis. From the UK Telegraph:

As ordinary citizens with no power over the levers of policy, we watch from the sidelines, and weep. The whole global economy has tipped into a downward spiral. Trade and output are contracting at rates that outstrip the leisurely depression of the 1930s. Debt deflation has simply washed over the drastic measures taken by governments everywhere.

Judging by the latest Merrill Lynch survey of fund managers, investors have a touching faith that China is going to rescue us all and re-ignite the commodity boom. How can this be? Taiwan's exports to China fell 55pc in January, Japan's fell 45pc. These exports are links in the supply chain for China's industry. Manufacturing output in the Shanghai region fell 12pc in January.

My favourite China guru, Michael Pettis from Beijing University, is in despair – as you can see on his blog (http://mpettis.com) . The property bubble is bursting. Developers have built more offices in Beijing since 2006 than the entire stock in Manhattan. There is a 14-year supply glut. We have seen this movie before.

Factory output is collapsing at the fastest pace everywhere. The figures for the most recent month available are, year-on-year: Taiwan (-43pc), Ukraine (-34pc), Japan (-30pc), Singapore (-29pc), Hungary (-23pc), Sweden (-20pc), Korea (-19pc), Turkey (-18pc), Russia (-16pc), Spain (-15pc), Poland (-15pc), Brazil (-15pc), Italy (-14pc), Germany (-12pc), France (-11pc), US (-10pc) and Britain (-9pc). Norway sails blissfully on (+4pc). What do they drink up there?

This terrifying fall has been concentrated in the last five months. The job slaughter has barely begun. Social mayhem comes with a 12-month lag. By comparison, industrial output in core-Europe fell 2.8pc in 1930, 5.1pc in 1931 and 3.9pc in 1932, according to RBS.

Stephen Lewis, from Monument Securities, says we have been lulled into a false sense of security by the lack of "soup kitchens". The visual cues from Steinbeck's America are missing. "The temptation for investors is to see this as just another recession, over by the end of the year. But this is not a normal cycle. It is a cataclysmic structural breakdown," he said.

Fiscal stimulus is reaching its global limits. The lowest interest rates in history are failing to gain traction. The Fed seems paralyzed. It first talked of buying US Treasuries three months ago, but cannot seem to bring itself to hit the nuclear button.

As the Fed dithers, a flood of bond issues from the US Treasury is swamping the debt market. The yield on 10-year Treasuries has climbed from 2pc to 3.04pc in eight weeks. The real cost of money is rising as deflation gathers pace.

US house prices have fallen 27pc (Case-Shiller index). The pace of descent is accelerating. The 2.2pc fall in December was the worst month ever. January looks just as bad. Delinquenc-ies on prime mortgages were 1.72pc in September, 1.89pc in October, 2.13pc on November and 2.42pc in December. This is the trajectory eating away at the banking system.

Graham Turner, from GFC Economics, fears the Dow could crash to 4,000 by summer unless there is a "quantum reduction" in mortgage rates. The Fed should swoop in to the market – armed with Ben Bernanke's "printing press" – and mop up enough Treasuries to force 10-year yields down to 1pc and mortgage rates to 2.5pc. Monetary shock and awe.

This remedy is fraught with risk, but all options are ghastly at this point. That is the legacy we have been left by the Greenspan doctrine. We are at the moment of extreme danger in Irving Fisher's "Debt Deflation Theory" (1933) where the ship fails to right itself by natural buoyancy, and capsizes instead.

From all accounts, the Fed was ready to launch its bond blitz in January. Something happened. Perhaps the hawks awoke in cold sweats at night, fretting about Weimar.

Perhaps they feared that China and the world will pull the plug on the US bond market. If so, it is time for Washington to get a grip. America remains the hegemonic global power. The Obama team should let it be known – and perhaps Hillary Clinton did just that on her trip to Asia – that any country playing games with the US bond market in this crisis will be treated as an enemy and pay a crushing price.

Pacific allies already know that they cannot take the US security blanket for granted. As for China – and others pursuing a mercantilist strategy of export-led growth – they must know that the US can shut off its market and wreak havoc to their economy.

To Europe, they might make it clearer that unless the European Central Bank is brought to heel by the Continent's leaders (whatever Maastricht says) and forced to play its full part in emergency efforts to save the global economy, the NATO military alliance will wither and the region will be left to fend for itself against a revanchist Russia.

Should the main threat come from an exodus of private wealth, Washington may have to impose temporary capital controls. Never forget, America is the one country with enough strategic depth to go it alone, if necessary. The US is not going to let foreigners keep it trapped in a depression.

I doubt matters will ever come to this. Japan is already in dire straits. Exports crashed 46pc in January, year-on-year. The Bank of Japan may soon start buying US Treasuries for its own reasons – just as it did from 2003 to 2004 – in order to reverse the 30pc rise of the yen over the last 18 months. If it helps preserve the Sino-US defence alliance in the face of Chinese naval expansion, so much the better.

In any case, the storm has shifted across the Atlantic to Europe. Germany faces 5pc contraction this year (Deutsche Bank). The bill has come from the burst bubble in the ex-Soviet bloc. Europe's banks are on the hook for $1.6 trillion (£1.1 trillion). For the first time since the launch of monetary union, Europe's leaders are speaking openly about the risk of EMU break-up.

A run on the US dollar looks a remote threat as the euro drama unfolds. The Fed may soon have all the room for manoeuvre it needs. Small comfort.

This Weekend's Contemplation - When Will the Recession End

The following is from the NY Times and is a collection of opionions about the current "Great Recession" how it will go and when it will end. The comments are sobering, but realistic. Well worth the time.

James Grant:

“WHEN you stop asking,” was the exasperated reply of the broker to the pestering client who asked the same question over and over during the 1974 stock-market crash: When will it end?

Nobody knew, or could know. The broker, wiser than he realized, chose not to serve up the windy non-answer that fills so much cable TV time today: “Well,” he didn’t speculate, “the bear market will end when the Watergate crisis is resolved and the Federal Reserve gets its arms around the inflation problem and business activity shows convincing signs of a pickup.” Instead, he blurted the truth that bear markets end when investors give up hope.

Hope sustains life, but misplaced hope prolongs recessions. At the root of this paradox is the notion that booms don’t just precede booms, they cause them. Modern-day booms are the products of low interest rates and easy credit. People overborrow, overpay and overindulge. They love the things that borrowed money buys, but the debts become insupportable. Then the assets, or some of them, must go. A little selling — of houses, cars, companies, stocks — becomes a lot, and the next thing you know we’re talking about nationalizing Citigroup.

Wishing that this weren’t happening to them, hopeful business people and homeowners resist making necessary adjustments. Some refuse to sell the house they can’t afford. Others won’t think of selling the stocks for which they paid what seemed a reasonable price only last year but which are one-half of that reasonable price today.

Today’s low prices, painful though they may be, are the market’s own shovel-ready stimulus. Before you know it, the stock market, and the residential real-estate market, too, will be on their way back up again — just don’t ask when.

Stephen Roach:

It would be premature to declare an end to America’s recession at the first sign of a resumption of growth. After the unusually steep declines in the economy late last year and early this year, a statistical rebound in the second half of 2009 would hardly be shocking. It could be driven by the gyrations of the inventory cycle. Or it might reflect the first digs of the stimulus package’s “shovel-ready” projects.

But any such whiffs of growth are likely to herald a false dawn, because the consumer remains in terrible shape. American families have lived beyond their means for more than a decade by borrowing against their over-valued homes. With both the housing and the credit bubbles having burst, their stock portfolios down and their jobs threatened, consumers have been shocked into a new frugality. They are likely to be restrained for years to come. The consumption share of gross domestic product is still 71 percent — down from a peak of 72 percent but well above the 67 percent that prevailed from 1975 to 2000.

This points to an unusually anemic upturn, at best — not strong enough to keep the unemployment rate from rising to near 10 percent over the next year and a half. Since it’s hard to call that a recovery, it looks to me as if this recession won’t end until late 2010 or early 2011.

A. Michael Spence:

THE short answer is not soon.

The recession is global: exports, production and consumption are in high-speed descent. The headwinds are powerful because of excessive leverage, damaged balance sheets and the resulting tight credit.

Major financial institutions may be insolvent; their books are hard to assess. European banks have American-style problems with toxic assets and are also struggling because of their exposure to financial turmoil in Eastern Europe. Eastern Europeans borrowed in euros and Swiss francs. Capital exodus and depreciating currencies have caused these debts to rise. And the shadow banking system through which a substantial amount of credit had been provided is no longer working.

Global growth is approaching zero, and the economies of all the advanced countries are likely to shrink in 2009. The prices of stocks and real estate continue to fall, and thus it will take more time for consumers and companies to pay off debt.

These factors have led to, first, reduced consumption and then declining investment and employment. This has lowered sales, profits, credit quality and, completing the loop, asset values. This interacting spiral is what makes this recession exceptional.

Governments and central banks are the only major sources of credit, liquidity and incremental demand — private capital and sovereign wealth funds, having experienced losses, are largely sidelined. If governments are quick and clear in their intentions and intervene in a coordinated way in both the real economy and the financial sector, we will probably have an unusually long and deep global recession through 2010. If they don’t, it is likely to be worse than that.

Willian Poole:

THE fundamental causes of this recession, unique in the experience of the United States, were mortgage defaults and the consequent insolvency of major financial firms. These insolvencies, and especially fear of them, damaged normal credit mechanisms.

The self-correcting nature of markets will ultimately prevail. We should not underestimate the power of monetary policy; with the sharp increase in the nation’s money stock starting in September, monetary policy is now extraordinarily expansionary. I believe, though without great confidence, that the recession will end in the second half of this year.

Federal policy is damaging the economy’s prospects. It fails to provide the needed tax incentives for investment in factories and equipment, incentives that were central to efforts to revive the economy during the Kennedy-Johnson era and under Ronald Reagan. But government spending can’t lead the way to sustained recovery, because its stimulating effect will be offset by anticipated higher taxes and the need to finance the deficit.

Heavy-handed federal intervention into the management of companies from banks to auto makers will also delay recovery. And misguided efforts to help distressed homeowners by permitting courts to rewrite the terms of mortgages will cause banks to limit mortgage lending, which will prevent housing from contributing to the recovery.

The unrelenting anger across the country over bailouts of corporations and households that made unwise and even irresponsible financial decisions is influencing federal policy. Punitive measures, like forcing companies receiving federal dollars to cancel employee events, will increase uncertainty over where the government will strike next in its effort to deflect public outrage. Instead of more bailouts, we need a clear and consistent path to fundamental reform of our financial system.

George Cooper:

TODAY’S financial crisis is the biggest in recent history, when measured by its speed, the scale of its capital losses or its global reach. Yet viewed from another perspective the crisis is surprisingly ordinary, following the same path as dozens of previous bubbles.

While the details of each cycle differ, the core processes remain constant. In the expansion phase, asset inflation and credit creation form a woefully misnamed “virtuous cycle” that drives both asset prices and debt stock to unsustainable levels. Then comes the Minsky moment (named after the economist Hyman Minsky) when the virtuous cycle flips into a vicious one of credit contraction and asset deflation.

Let’s assume that the magnitude and duration of the credit correction phase will mirror that of the credit inflation phase. So when did the credit bubble begin? At one extreme we could point to the mid-1980s, when the American household savings rate began declining almost every year. If we concentrate only on the recent growth of mortgage lending and the shadow banking system, we could conclude the cycle began closer to the turn of the millennium.

If we go by the first measure we may see two or more decades of readjustment. If we go by the second, we are still probably in the early stages of the credit correction, meaning that while the technical recession could be over by the end of the year, the broader credit cycle will likely remain a significant drag on economic activity well into the next decade. Either way, we have a long way to go.

Niall Ferguson:

THIS recession, which began in December 2007, has already lasted longer than the average postwar recession. If it turns out to be as bad as the most protracted of the postwar downturns, we will touch bottom next month.

But my strong suspicion is that we are now in something more like a Great Recession. It won’t produce as steep a fall in American output as the Depression did, but it may prove to be as prolonged.

The depression that began in August 1929 did not hit its nadir until 43 months later. The one that started in October 1873 was shallower but lasted 65 months. If the economy were to keep shrinking for that long, we wouldn’t start coming out of this until after May 2013.

Is that possible? This is a crisis of excessive debt, the end of the Age of Leverage. It will take longer than a few more months to resolve bank and household insolvency, especially with asset prices continuing to fall so rapidly. Even with zero interest rates and huge deficits, Japan suffered a “lost decade” in the 1990s — and that was when the rest of the world was doing well. This recession is taking place as the rest of the world is doing even worse than the United States. The collapse of trade as measured by East Asian export data is petrifying.

So far in this recession, remember, we have had only two consecutive quarters of declining gross domestic product. At the moment, I find it quite easy to imagine two consecutive years of contraction. And I don’t rule out two more lean years after that.

Alan Blinder:

HERE’S the hard truth: Nobody knows when this recession will end. Economic forecasting is a dark art, and predicting when recessions begin and end is its weakest link. That said, my best guess is that growth will return in the fourth quarter of this year. Why?

First, recessions don’t last forever. If the economy continues to slide through the third quarter, as I anticipate it will, this will be the longest American recession since World War II. Housing must hit bottom at some point. For several years now, declining expenditures on homebuilding have subtracted roughly a percentage point from gross domestic product growth. The change from minus 1 percent to (at least) zero will add a full point to growth. Auto sales are also not likely to keep falling at recent rates. Second, Washington’s large economic stimulus should add more than 5 percent to real gross domestic product over two years.

Third, the price of oil plummeted from a peak of around $145 a barrel last summer to around $40 a barrel today. Since the $145 price was fleeting, let’s call the “true” decline from $100 to $40, which means the bill Americans pay for imported oil fell by about $300 billion dollars a year.

But here’s the rub. My forecast assumes that no other (big) shoes will drop. Sad to say, shoes have been dropping like rain.

Marcelle Chauvet and Kevin A. Hassett:

RECESSIONS end, and this one will, too. But the sad truth is, the probability of leaving a recession once you are in one is about the same each month — about 8 percent. It is as if God rolls two dice each month, and the recession ends when he rolls a 10.

We are without question in a deep recession. According to a model developed by one of us that draws on past recession experience and has proved quite useful, the chance that we will be in recession in March is 92 percent, in April 85 percent, and so on.

Many of the key indicators look similar to what we’ve seen before. The decline in employment is above average for past recessions, but smaller than in the downturns of 1960-61 and 1981-82. Industrial production and manufacturing and trade sales have also slowed more than average, but not nearly as much as during the 1973-75 recession, when they declined by 14 percent. And the drop in personal income has been below the average of previous recessions, and even trended up in the last quarter of 2008. So the history books give us cause for hope.

The good news is that the odds of this recession lasting into the fourth quarter of 2009 are below 50 percent. But the dice will be thrown each month, and we could get lucky and be out earlier — or unlucky and be stuck in the doldrums.

Carmen M. Reinhart:

WHEN our economic woes began, analysts took some solace that the longest American recession since World War II lasted 16 months, and that on average our recessions lasted less than a year. But as this contraction continues into its 15th month, we have been forced to look to more severe precedents.

Counting the months of decline, however, is a narrow gauge of distress. A better metric is the length of time it takes the economy to recover to the level of per capita income at its prior peak.
After the most severe banking crises around the world in the postwar period, the economy has taken an average of four years to return to its previous peak in personal income. After the Depression, it took the United States 10 years.

No doubt, the new stimulus package left much to be desired. But it was not a design flaw that the stimulus plan extends over several years, because the period during which the economy will remain below its earlier high-water mark will be protracted and efforts to speed recovery will prove welcome.

Nouriel Roubini:

LAST year, the debate over how long the recession will last was between those in the consensus who argued that it would be V-shaped — only about eight months long like those in 1990 to 1991 and in 2001 — and those like me who argued that it would last at least three times as long, 24 months, and be more than three times as deep as the previous two.

Today, as we enter the 15th month, it’s obvious that we are already in a painful U-shaped recession that has become global and will last at least until the end of the year — 24 months, the longest since the Great Depression. Even if the gross domestic product grows in 2010, it is likely to be no higher than 1 percent. And at that rate, with the unemployment rate rising toward 10 percent, we will still be substantially in a recession.

Even if appropriate aggressive policy actions were undertaken — monetary and fiscal stimulus, bank clean-up and credit restoration, mortgage debt reduction for insolvent households — the growth rate would not rise closer to 2 percent until 2011. So this recession may last 36 months.

And things could get worse. We now face a 1 in 3 chance that, if appropriate policies are not put in place, this ugly U-shaped recession may turn into a more virulent L-shaped near-depression or stag-deflation (a deadly combination of economic stagnation and price deflation) like the one Japan experienced in the 1990s after its real estate and equity bubbles burst.