Tuesday, December 30, 2008

2009 Outlook

Pieter Breugel The Elder, The Blind Leading the Blind (1568),
Conservato alla Galleria Nazionale di Capodimonte, Naples

Humans seem innately clueless at predicting the course of their economies and financial markets, and most 2008 market predictions look pretty ludicrous now. Anyone looking to fellow mortals for clues to the financial course of 2009 should remember the parable: "Can the blind lead the blind? Shall they not both fall into the ditch?"

To avoid the ditch, consider the following list not as a New Year's prediction but as an attempt to identify important factors and trends for consideration when contemplating the course of US and world economies and markets in 2009:


The financial crisis is part of a long term process of change. Some of the adverse changes will correct, but slowly. Some of the changes are permanent.

The immediate crisis is one of too-easy credit and poor risk management. It took years to build up consumer and government debt, and it will take years to work through the crisis brought on by that debt. The process of credit recovery has not even started. Consumers are still in debt and losing their jobs. They are under water with their houses, prices are still declining, and houses are still not affordable. As for the availability of credit, price discovery for toxic assets is still a long way off, and the day of highly leveraged credit is over.

The change in consumer behavior is a generational event. Consumers can now see the folly of spending themselves into debt, and they are rueing the consequences. It is likely that their embracing of a more frugal lifestyle is permanent. When the pace of economic activity recovers in the US, it will be to a lower level than the nation has been accustomed to.

The credit crisis is only one part of a long-term process of change that is affecting the entire world and will continue to put pressure on the US economy. After World War II the US was the only large industrial nation in the world with its plant, equipment, and work force remaining intact. The advantage that this gave the US economically has eroded over time, first as Europe and Japan recovered, and then as the developing world took off.

The hollowing out of the US has gone on for decades. We have seen industry after industry leave these shores and set up where labor is cheaper and management is nimbler. I'm not talking about buggy whips and whale oil: Textiles, consumer electronics, auto manufacturing and many others are vibrant industries that generate money and are based on important technologies.

In the face of competition, US industry and wages did not keep up with the pace of change. Debt filled the lifestyle gap for many Americans until recently. Now that the credit bubble has burst, consumers can no longer maintain lifestyles by going into debt and going to the housing ATM. They can now see that they are poorer than they formerly thought. They can see that they do not have a birth right to luxury and a fine life style. Americans are part of the wider world, and competition for the good life is here to stay.

Industry after industry collapses in the US and prospers overseas. What are Americans to do when the last industry fails? Sell hamburgers to themselves? We can see how hollow the promise of a "service economy" was.

When the last industry fails, will we be able to invent an industry to take its place? Maybe we have been expending resources on the wrong things.

Yes, we are still rich compared to most people in the world. Yes, improvements in technology may continue to improve everyone's life, even if our relative position in the world declines. Meeting expectations is another matter. Maintaining a vibrant economy is another matter.


There are already warnings in the press that vulnerable retailers will start to fail. Mall vacancies are increasing, and it will be difficult to make consumers spend what money they have.

As tax revenues drop, states and municipalities are in severe budget trouble and will be forced to economize. They will be challenged to deal with public pension funds stresed by stock market losses. Layoffs of public employees threaten to add to economic woes, and essential services will be stressed.
The rolls of the unemployed are growing and people are running out of benefits. Many support networks are already stretched to the breaking point.

Baby boomers approaching retirement have seen their investments evaporate but have few prospects of being able to work longer to fill the gap.
Demand for goods and services is dropping, and even the official statistics may eventually reflect the deflationary reality.

The Obama administration will use fiscal policy to try to counter the drop in consumer spending and business investment. Already there are warnings that the initial stimulus package (as large as it is) will not be enough, and that Congress will have to pass another package later next year. We will see how far this policy gets, and how long its effects last.


I hate to say "it's different this time", but the world does change.

After the the Federal government's unprecedented intrusions into the financial markets this past year, financial markets are operating under more uncertainty than ever. When will failing enterprises be allowed to fail? How creditworthy is an apparently investment grade security? Who really owns an enterprise? Will the government honor its own guarantees to investors? These factors will drive valuations of securities for all the enterprises touched by Federal bailouts, but the government has changed its mind often enough to leave investors uncertain of the rules. As mentioned in a Dec 30 New York Times article, In 2009, Economy Will Depend on Unlocking Credit, investors will be hesitant to risk their money until they know the rules.

If investing has been politicized, one approach is to buy what the government supports. As Bill Gross implied in an interview (Big Brother Investing) in Forbes, some of the government's support rules have been established. If the government will continue to throw money at ailing financial institutions, it is presumably safe to invest in sufficiently senior debt of those institutions.

Finding wealth in the stock market is looking less likely. Consumer frugality, declining demand overseas, and the prospect of increased regulation suggest that corporate profitability is unlikely to return to levels seen in recent years. Government promises to consume a bigger share of economic resources. Less leverage and a lower investor risk appetite threaten to reduce the demand for equities.

Many observers suggest that investment-grade investment debt as the place to invest in the new year. Others worry that a surge in US debt issuance (to pay for bailouts and stimuli) will crowd out private debt. Whichever way it goes, a lot of money rides on the the government's issuance and the reaction of the bond market.

Some day in the future, Jim Rogers will be proven right, and we will see a definite and sustained renewal of the uptrend in overall commodity prices. It is hard to imagine this for 2009, but at some point prices will reach a level where those with a long-term planning horizon will start to accumulate commodities. Maybe some selected commodities are already at that point.


We have already seen the Federal government react wildly to the financial crisis with an ill-considered and ineffective bailout package for the financial industry. With this track record, there is more than enough reason to mistrust future government actions. A failure to restart the economy could lead to yet more wild measures.

Need a concrete example? A recent posting on The Big Picture (Low Mortgate Rates to Spur New Wave of Defaults) already suggested that a failure to restart housing could be met with a wild measure such as permitting "no appraisal" re-fi's. What a prescription for worsening the crisis -- extending loans to unqualified recipients who are already under water.


Beggar Thy Neighbor. In a depression, every country wants to protect domestic industry from foreign competition, and one way of doing that without formal trade barriers is to debase your currency. The hope is to avoid protectionist reactions by debasing currency enough to make products cheap to trading partners and their products expensive to import. In view of the skyrocketing Federal deficit, the US might be well on its way to debasing its currency. If other countries follow suit, will any currency be worth anything?

However, other countries are in economic trouble too. Far from sinking the dollar, our trading partners may fight hard to debase their own currencies and support the dollar. On the other hand, they may lose patience with our sinking currency and let us sink.

Protectionism. The President-elect has already mentioned the possibility of raising trade barriers to protect American jobs. This is a sure way to worsen the crisis, which we can hope will be avoided.

Foreign Support of US Indebtedness. Trade partners have found it in their interest to park funds in US Treasury securities and to pursue currency policies supportive of exporting to the US -- and to supporting US over-consumption. Now that US Federal debt threatens to skyrocket, there is the oft-mentioned risk that China and others may cut their losses and withdraw support from Treasury prices and the dollar. However, these trade partners have much to lose from such a disruptive move. Continued deleveraging of the financial system should also tend to support the dollar.


Social Change in Developing Nations. Reduced demand in the First World for manufactured goods and natural resources is being felt in much of the developing world in terms of sharply increased unemployment in the export sector of their economies. Depending on their circumstances, different nations will face different challenges in managing the consequences of the downturn. There have already been protests by the unemployed in Russia. Will China be able to find a role for the newly unemployed, for example, reintegrating returning workers back into rural economies? Oil-rich nations may also be stressed as they cut back on consumer subsidies and public projects. The outcome of all these social and political stresses is far from clear, but we should remain alert for disruptive changes that could exacerbate the economic downturn.

Social Change in the US. This crisis has brought about big changes in lifestyle and attitudes for many Americans. Considering the degree to which elite groups continue to profit from the crisis at the expense of the majority of America, it is surprising that social reactions have been very muted so far. What kinds of reactions could arise? Extremist movements among the dispossessed hopeless? Violent reactions to economic reversals have happened before in this country. Or perhaps positive changes will occur, such as an increase in community participation and other cooperative ventures. Something unexpected in the human dimension may very well come out of this crisis.

Smarter Economic Policy. The American people may soon realize that budget deficits, easy credit, and unregulated financial markets have resulted only in wasting their precious, limited resources. Resources squandered on leveraged speculation and on unnecessary consumption and housing were unavailable for savings and investment. Without savings, there was no investment. Without past investment, America today lacks the human capital, national infrastructure, and efficient industrial processes necessary to compete in today's world and provide for the Americans of tomorrow. Good times are some time off in the future, beyond 2009, because it takes time to save, invest, and build an economy.

Surprises of Nature. Everything we do depends on the natural world, and that is changing too. Global warming always poses the risk of disrupting human enterprises through unexpected extremes in the climate.


Evolutionary success depends on the ability to adapt to changing circumstances. We cannot predict the future, but we can watch events unfold and try to adapt. To do that, we need to know what kinds of events to watch for, and a framework in which to interpret events. The purpose of this list is to stimulate that process a little bit for 2009.

We are sure that readers have their own ideas, and we hope that they can improve on this framework and profit in 2009. Let me hear your thoughts.

Cassandra, Evelyn de Morgan (1855-1919),
De Morgan Centre, London

Thursday, December 25, 2008

Christmas Linkfest

Links to Christmas posts from around the blogosphere:

Live webcam from the skating rink at Rockefeller Center:

Puritan attitudes toward Christmas in England during the time of Oliver Cromwell:

From The Vindication of Christmas, 1652:

From Nicholas Breton's 1626 Fantasticks:

Nativity art:

The authors of the linked-to blogs selected very clever and cheery messages for the holiday season.

Monday, December 22, 2008

Mohammed El Erian on Investing in 2009

PIMCO's Mohammed El Erian appeared on CNBC this morning and gave his views on investing in 2009.

CNBC labeled the interview Back to Basics for Investors in 2009, which is not a bad summary of the interview. The investing basics mentioned in the interview included asset allocation, risk management, and solid investment vehicles.

Underlying the investing advice was a view that the economic downturn will worsen next year. El Erian contrasted 2008 as a year of financial crisis, with 2009 as a year of economic crisis. He listed "unemployment, defaults, companies defaulting, etc." as examples of the economic crisis.

Investors can expect 2009 to be different from 2008. One of the differences will be that in 2008 investors could not count on the investment basics: asset allocation, risk management, and investment vehicles that are perceived to be good ones.

In addition to going back to the basics, El Erian advised investors to consider government initiatives. "We're going to see fiscal stimulus packages going into the trillions of dollars. We're going to see support for various sectors, and despite that the economy will be bumpy."

One would expect a PIMCO bond manager to talk his book, but El Erian mentioned asset classes that many other investment managers have also mentioned in recent weeks. Among his favored classes for 2009 are investment quality fixed income, mortgages, and the top emerging markets.

He recommended moving out of Treasuries, but was also cautious about that move. He said specifically that some attractive assets could turn out to be "traps". To capture the upside and avoid the downside risk, he advised looking for "assets that are not only dislocated but where there's a catalyst for normalization."

Although he advised a "back to basics" approach, El Erian also warned: ". . . for the average investor conditions have changed and therefore the game plan has got to change, which means don't go and chase what are very attractive valuations from a historical standpoint".

Here is a link to the CNBC video: Video: El-Erian Talks About the Economy for 2009

Monday, December 15, 2008

Sing to Me, O Muse

The Murder of Agamemnon, Pierre Narcisse Guerin (1774-1883), The Louvre

At the start of The Odyssey, the gods are gathered in the house of Zeus, who says:

See now, how men lay blame upon us gods for what is after all nothing but their own folly.

This refers to the folly of Aegisthus, who brought about his own death at the hands of Orestes, avenging adultery with Orestes' mother Klytemnestra and the murder of his father Agamemnon.

The Father of Gods and Men might well have the same reaction to the Federal Open Market Committee's recent meeting statement, which included these goodies:

  • ... a target range for the federal funds rate of 0 to 1/4 percent
  • ... the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets
  • Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.
  • The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

This is the same policy of easy money and too-low interest rates that contributed to the crisis in the first place. In no way does this policy solve the present crisis. It doesn't provide more transparency to asset values, reduce universal risk aversion, or lower the burden of debt on consumers, businesses, and state and local governments. The only contribution to liquifying markets is to punish the individual saver with low rates. Current policies are perpetuating bubbles in real estate valuations, high levels of public and private indebtedness, and misallocation of our economic resources.

Unless this country stops pointing the finger and faces up to the blame, our economic system will be ruined, just as America's reputation has already been ruined around the world. Liar loans, lax SEC supervision, nonexistent risk management in the banks, and other follies have exposed just how far America has fallen from being the paragon on which the rest of the world was supposed to model its own economic and financial systems.

All of these financial follies were well known before the bubbles burst. Everyone knew that mortages for unaffordable homes were being given to unqualified buyers with falsified incomes. The long line at the feeding trough looked the other way and included buyers, developers, realtors, assessors, loan officers, mortgage bundlers, security underwriters, and rating agencies. Regulators looked the other way, and politicians at local, state, and national levels pandered to pet ideologies and special interests.

Consumers, financial executives, and legislators alike all seek bailouts and a quick fix, but ignore the basic fact that the roots of the crisis lie in their own folly. Where there is wanton disregard of risk, there should be blame.

Don't perpetuate failed policies, and don't bail out poor risk managers. Listen to the Son of Kronos.

Sunday, December 14, 2008

Competitive Devaluation: More Support for the Dollar

Here is more evidence that concerns about immediate dollar devaluation are misplaced.

Mish's Global Economic Trend Analysis has a nice collection of news clips about the economic slowdown in China and the Chinese response to expand their money supply. His post China To Print Money To Combat Deep Slowdown also puts China's monetary policy in the context of the ongoing global game of "beggar thy neighbor", where all parties are pursuing policies of competitive devaluation and trade protection:

. . . the US seems hell bent on destroying the dollar to boost exports and/or to get consumers spending again, and Japan has threatened to get in on the act by selling Yen and buying dollars. Brown is certainly hellbent on destroying the British Pound.

In such a dynamic, our trading partners hardly want to see the dollar crater:

With everyone in on the act, or threatening to get there, the dollar is far more likely to enter a trading range than to crash.

Mish also mentions that this kind of deflationary environment is supportive of an asset that I like at this time, which is gold.

Thursday, December 11, 2008

US Default and Dollar Devaluation

The government poured billions of taxpayer dollars into the banks and the GSEs to keep the credit markets working. Not only are credit markets still dysfunctional, but we are on the deflationary expressway to depression.

WPA: unemployed shown at Volunteers of America Soup Kitchen: Washington, D.C. (Circa 1936). Courtesy of the Franklin D. Roosevelt Library Digital Archives, National Archives and Records Administration. http://www.fdrlibrary.marist.edu/images/photodb/27-0637a.gif

The latest idea for greasing the rusty credit system came out of Washington yesterday, as Jon Hilsenrath and Damian Paletta of the Wall Street Journal reported in Fed Weighs Debt Sales of Its Own. The Fed is considering asking Congress for permission to directly issue its own debt, not tied to Treasuries.

The prospect of another source of US debt issuance has naturally raised a lot of eyebrows. For example, Jesse's Cafe Americain was asking Is the Fed Taking the First Steps Toward Selective Default and Devaluation?

What an image. The NY Fed as a GSE, the new and improved Fannie and Freddie. Zimbabwe Ben can simply print a new class of Federal Reserve Notes with no backing from Treasuries. BenBucks. Federal Reserve Thingies.

Perhaps we're missing something, but this looks like a step in anticipation of an eventual partial default or devaluation of US debt and the dollar.

It is prudent to consider this risk. In an earlier posting, Will Quantitative Easing Crater the Dollar?, we have seen Nouriel Roubini's warning that the Fed's quantitative easing

... will eventually leads to much higher real interest rates on the public debt and weaken the US dollar once this tsunami of implicit and explicit public liabilities and monetary debt driven by rising twin fiscal and current account deficits will hit a world where the global supply of savings is shrinking – as most countries moves to fiscal deficits thus reducing global savings – and foreign investors start to ponder the long term sustainability of the US domestic and external liabilities.

But when will this "eventually" occur? There are good reasons to believe that the big risks lie rather far in the future.

So far, money injected by the Fed seems to be falling into a deflationary pit ... that is, it is not effectively offsetting money lost as the private financial system deleverages. And borrowers and lenders are all extremely risk averse right now.

So, the risks of default or dollar devaluation appear to be mainly in the future -- after the financial crisis ameliorates, credit starts flowing, and the economy shows some signs of life again.

Saturday, December 6, 2008

Kill the Canary

Once the Arsenal of Democracy, Michigan has suffered from a weak economy for years now. Now that the depression is approaching, things are worse than ever with the cyclical economy of Detroit.

Congress only wants to dribble out the money, maybe to keep Big 3 from immediate bankruptcy.

Wake up, Congress. Detroit is the canary in the coal mine. After it fails, the rest of the dominoes are falling too.

If the auto industry goes under, so many other businesses will fail that we won't have to guess about the start of the depression. It will be here with a vengeance.

Friday, December 5, 2008

Paulson Should Wake Up and Fight the Depression

Robert Reich has joined the ranks of those saying that the economy is falling off a cliff. His latest blog entry, "Shall We Call It a Depression Now", takes note of Friday's alarming unemployment report -- the US has lost nearly 1.2 million jobs in the past three months -- and makes the appropriate conclusions about where the economy is headed. With consumers cutting back spending in the face of historically high indebtedness, tightening credit, and failing job prospects, there are very real risks that we are heading toward a depression. Someone needs to be bailed out, but who is it?

If the heart of the economy is the consumer, government's response should act directly to help the consumer. It's that simple, and Robert Reich's prescription is exactly in that direction, with this two-pronged approach:

First, the massive Treasury bailout of the financial industry must be redirected toward Main Street -- loans to small businesses, distressed homeowners, and individuals who are still good credit risks.

Second, a stimulus package must be enacted right away. It needs to be more than $600 billion -- which is 4 percent of the national product.

Stimulus Should Include Essential Services

Robert Reich's prescription for avoiding depression (see preceding post) includes an important point about the composition of the necessary stimulus package:

Construction jobs are critical but so are elder care, hospital, child care, welfare, and countless other services that are getting clobbered.

As I have said before in "Policy for Financial Crisis Should Target Those Most in Need", those who suffer most in this downturn will be those who are already most in need. Reich's prescription will help to meet those needs. It will also be the most effective solution for the whole economy . . .

This is supposed to be a service economy. It isn't going to be stimulated if service jobs aren't included in the stimulus package.

Lots of infrastructure is decaying in this country, and that includes the people and systems that comprise our social, educational, health and other kinds of human infrastructure. It isn't just a matter of bricks and bridges. We need to nourish and grow our human capital if this company is going to face the future as a thriving enterprise.

Wednesday, December 3, 2008

Depression Level Unemployment

Mish Shedlock has a thoughtful posting about trends in unemployment and their likely effects on the deflationary trajectory of the economy. In Prepare For Depression Level Unemployment Mish estimates:
Given that job losses are accelerating and that unemployment is a lagging indicator (unemployment is expected to rise for some number of months after the economy bottoms), it is not unreasonable to be talking about 10% unemployment sometime in 2010, with 8.5% to 9% or higher extremely likely.

8.5% or higher unemployment is enormously deflationary with the current backdrop of consumer debt and huge numbers of people underwater on their homes.

Unemployment was much higher during the Great Depression, but these are sobering estimates nonetheless.

"Prepare For Depression Leel Unemployment"
Mish's Global EconomicTrend Analysis

Tuesday, December 2, 2008

The Great Crash

Finally a noted economist says outright that the markets have experienced a crash. In The Great Crash of 2008 Robert Reich points out that, as of the close on December 1, markets have dropped 47 percent since the peak of last year, which is in the range of the Great Crash of 1929.

Reich also is right that more credit won't solve the problem, because debt loads are unaffordable relative to stagnant incomes ... and now we are hit with a severe economic downturn. That's what you get when the nation's resources have misallocated for years on end -- a bubble economy, bubble markets, and a Great Crash.

Look for the bad news to continue.

"The Great Crash of 2008"
Robert Reich's Blog, Monday, December 01, 2008

Sunday, November 30, 2008

Money As a Quantum Fluctuation in the Markets?

It turns out that matter isn't so substantial after all. An article in the New Scientist confirms that matter consists of little more than quantum fluctuations in the vacuum, with most of its mass attrituted to the virtual gluons that pop in and out of existence and conduct the strong force that binds particles like protons and neutrons together.

With that news, is it so incredible that the Fed and the Treasury can bind the markets together with virtual money? The risk is that this money will disappear into the deflationary pit of deleveraging.

Virtual money consisting of Paulson, Bair, and Bernanke quarks

"It's confirmed: Matter is merely vacuum fluctuations"
Stephen Battersby
The New Scientist, 20 November 2008

Rescuing the Markets

Change is necessary, but for markets to work you need to have something of value to trade. (Author's photo of the ancient agora of Athens)

Will Quantitative Easing Crater the Dollar?

When the Federal Reserve announced on November 25 that is was spending around $600B on bailing out agency debt and MBS and around $200B on bailing out ABS, many worried that a new program of quantitative easing will sink the dollar and raise interest rates. At RGE Monitor, Nouriel Roubini referred to "desperate actions" and said the the Fed was implementing:

an effective policy of aggressive quantitative easing as the balance sheet of the Fed – already grown from $800 billion to over $2 trillion – will be expanded further as most of the new bailout actions and new programs will be financed via injections of liquidity rather than issuance of public debt. ...

Effectively the Fed Funds rate has been abandoned as a tool of monetary policy
... the Fed is now relying on massive quantitative easing and direct purchases
of private sector short term and long term debts to try to aggressively push
down short term and long term market rates.

Although these moves have reduced ABS and MBS spreads, Roubini believes as others do that there are negative longer-term implications:

... These policies – however partially necessary – will eventually leads to much higher real interest rates on the public debt and weaken the US dollar once this tsunami of implicit and explicit public liabilities and monetary debt driven by rising twin fiscal and current account deficits will hit a world where the global supply of savings is shrinking – as most countries moves to fiscal deficits thus reducing global savings – and foreign investors start to ponder the long term sustainability of the US domestic and external liabilities.

When will this "eventually" occur? In an article titled Ricardian Equivalence, Macro Man commented on the markets' immediate reaction to put the dollar under pressure. To summarize his arguments:

The past few decades, but particularly the past few years, have seem enormous rise in private sector leverage....both through traditional lending and derivatives contracts.
At the end of 2007, Citigroup had more than $2 trillion of assets on their
balance sheet. That number will be a lot lower by the time all is said and done. ...

So in Macro Man's view, any dollars "created" by the Fed to expand its balance sheet (and let's not forget, they have yet to really crack out the printing presses by not sterilizing their asset purchases) will merely partially offset dollars lost through de-leveraging and the implosion of the shadow banking system ...

The impact of these programs will, in Macro Man's view, only submarine the dollar once the crisis is resolved and domestic demand begins growing organically again. That seems likely to be several years away, for there is another kind of Ricardian equivalence at work- the ballooning of the US budget deficit should be offset by a sustained rise in the US private sector savings rate.

This is an important point for investment strategies. If the resolution of the crisis is several years away, perhaps we can expect a relatively stable dollar for some time.

And if the dollar remains stable, and the Fed's actions are offset by private sector deleveraging, perhaps we can expect a deflationary environment to continue for some time.


"Ricardian Equivalence"
Macro Man, Nov 26, 2008

"Desperate Measures by Desperate Policy Makers in Desperate Times: the Fed Moves to Radically Unorthodox Policies as Economy Is in Free Fall and Stag-Deflation Deepens"
Nouriel Roubini's Global EconoMonitor, Nov 26, 2008

Press Release on MBS
Board of Governors of the Federal Reserve System, Nov 25, 2008

Press Release on ABS
Board of Governors of the Federal Reserve System, Nov 25, 2008

Saturday, November 29, 2008

Interest Rates and the Dollar

There is a good article at Naked Capitalism on interest rates and the dollar. Two of the anomalies noted there:

1. Long dated Treasuries rising (a deflation signal) as stocks stage a dramatic rally

2. Dollar weakening while long dated Treasuries rise (the dollar and bonds usually go together)

The first item is actually consistent with many periods of market history when rates fall and stock prices rise. We have, after all, just been through a long period of falling rates and rising stock prices beginning in the early 1980s and continuing until either the dot-com crash of 2000, or perhaps until the present crisis. When long-term rates fall, the present value of corporate earnings streams rises.

The second item occurs in the context of a great variety of contending and fluctuating forces, making currency and Treasury directions very, very hard to call. But this is not inconsistent with some periods of history. If there is some expectation of a collapse under all this debt, there should well be ambivalence about Treasury debt and the dollar.

Others have already commented that long rates will continue to stay low until added money is not consumed in the deleveraging, perhaps not until there is a real economic expansion, which could be a long time off. Or perhaps continued stimulation will make it occur sooner.

Reference: http://www.nakedcapitalism.com/2008/11/some-anomalies.html

Thursday, November 27, 2008

Real Interest Rates and the Dollar?

Nouriel Roubini has been calling for stag-deflation for some time, but worsening economic news, mounting budget deficits, and a swelling Fed balance sheet give his latest warnings even more urgency. The bad news in his latest posting at RGE Monitor includes these snippets:
At this rate of contraction as revealed by the latest data it would not be surprising if fourth quarter GDP were to fall at an annualized rate of
... the balance sheet of the Fed – already grown from $800 billion to over $2 trillion – will be expanded further as most of the new bailout actions and new programs will be financed via injections of liquidity rather than issuance of public debt.

Desperate times and desperate economic news require desperate policy actions ... The Treasury will be issuing in the next two years about $2 trillion of additional debt ...

The amounts of money involved are staggering, so is it no surprise that Roubini concludes (emphasis mine):

These policies – however partially necessary – will eventually lead to much higher real interest rates on the public debt and weaken the US dollar once this tsunami of implicit and explicit public liabilities and monetary debt driven by rising twin fiscal and current account deficits will hit a world where the global supply of savings is shrinking – as most countries moves to fiscal deficits thus reducing global savings – and foreign investors start to ponder the long term sustainability of the US domestic and external liabilities.

When and how severely will these injections of liquidity and swelling debt result in higher real interest rates and weaken the US dollar? Roubini is not alone in thinking that we are about at that point, a good example being these snippets from a recent article in the Financial Times:

The banks have been recapitalised. The government has started buying and guaranteeing distressed debt. Finally, the Federal Reserve has begun in earnest to use its balance sheet (in a sterilised manner) to step into the absent shoes of the private sector in the financial system.

A failure of the initial set of policies to reflate the economy is likely to lead to the next, more risky, set of policy choices – those involving unsterilised intervention.

As the US embarks on the next set of policy choices for curing deflation, as outlined by Ben Bernanke, Fed chairman, in his 2002 speech “Deflation – Making Sure it Doesn’t Happen here” – inflationary risks will begin to rise. With that comes the risk of sustained medium term dollar weakness and the risk ultimately of the demise of the dollar as the world’s sole reserve currency.


"Desperate Measures by Desperate Policy Makers in Desperate Times: the Fed Moves to Radically Unorthodox Policies as Economy Is in Free Fall and Stag-Deflation Deepens"
by Nouriel Roubini
RGE Monitor, Nov 26, 2008

"Insight: US debt puts strain on dollar"
by Chris Watling
Financial Times, November 26, 2008

Tuesday, November 25, 2008

Policy for the Financial Crisis Should Target Those Most in Need

Speakers at a meeting of The Gerontological Society of America said that the brunt of the current economic and financial crisis will fall hardest on the elderly and the soon-to-retire of the boomer generation. This is no surprise, but bears more scrutiny. If younger workers and families are struggling financially, just imagine the problems for the elderly who have seen the value of their homes and their retirement accounts dwindle, with little prospect of having the time or the means of making up the deficit.

What to do now? The plight of the elderly and others most at risk well deserved special consideration by the President-elect and his team as they prepare policies and initiatives to cope with the financial and economic crisis.

New Economic Woes Hit Boomers, Seniors Hardest
The Gerontological Society of America

TALF Blows a Bigger Bubble, Keeps Markets from Clearing

The Fed created a new lending facility to promote consumer loans by supporting the ABS market. The announcement says:

The Federal Reserve Board on Tuesday announced the creation of the Term Asset-Backed Securities Loan Facility (TALF), a facility that will help market participants meet the credit needs of households and small businesses by supporting the issuance of asset-backed securities (ABS) collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration (SBA).
Under the TALF, the Federal Reserve Bank of New York (FRBNY) will lend up to $200 billion on a non-recourse basis to holders of certain AAA-rated ABS backed by newly and recently originated consumer and small business loans. The FRBNY will lend an amount equal to the market value of the ABS less a haircut and will be secured at all times by the ABS. The U.S. Treasury Department--under the Troubled Assets Relief Program (TARP) of the Emergency Economic Stabilization Act of 2008--will provide $20 billion of credit protection to the FRBNY in connection with the TALF.

More details accompany the announcement, but the impact is clear: The TALF will sustain the consumer credit bubble and blow a bigger bubble, which will pop later and cause even greater pain. The consumer debt load is already too high for many, and there is already too much bad paper in the ABS market. How does the TALF help solve the problem?

If markets were allowed to clear, we would get out of this mess more quickly and resume a path of positive economic growth.


Press Release, November 25, 2008
Board of Governors of the Federal Reserve System

Monday, November 24, 2008

Citi Rescue Includes Equity Stake and Asset Guarantee

The new deal with Citi is that US taxpayers have invested $20 billion , plus we have guaranteed up to $306 billion in residential and commercial real estate and related securities. So, the Government has an equity stake in another ruined bank and is on the hook for $306B more.

Why are we investing more money in an instituion that has shown such absolutely foolish and short-sighted behavior? Just this Sunday, the New York Times published another increment in the unfolding saga of imprudent (nonexistent) risk management at Citi.

At least Citi is forced to lower the dividend (but not eliminate it). We can hope that some pressure is put on management to use the capital infusion to make loans, to keep the financial system working. Of course, that hope is predicated on the assumption that the best way out of the crisis is to get banks to make more loans. Wasn't that the problem to begin with?

The Government's aim is supposedly to bring stability to the overall financial system. In an era of networked information, why are we trying to fix a complex financial system with such blunt measures as multi-billion dollar bailouts of lending institutions? This is like trying to repair your iPod with a sledgehammer.


Joint Statement by Treasury, Federal Reserve, and the FDIC on Citigroup

Citigroup Saw No Red Flags Even as It Made Bolder Bets
By Eric Dash and Julie Creswell

Sunday, November 23, 2008

Rescue of Citigroup -- More Turbulence in the System

Bad news impacts markets, and so does uncertainty. If you do not know the rules of the market, or who the major players are going to be, you cannot form prudent estimates of the future of the market.

According to the latest report from the NY Times, it is too early to tell exactly how the bailout of Citigroup will be structured, but some level of assumption of troubled Citi assets will apparently be involved. Didn't Secretary Paulson decide that such purchases were not the best way to expend funds from the TARP? The source of the funds has reportedly not yet been decided, but the principle is the same.

If the Citi deal results in a general approach that can be applied to other institutions, that might help to remove some of the uncertainty, but in the face of such policy turbulence it will be hard to build confidence.

Source: http://www.nytimes.com/2008/11/24/business/24citibank.html?_r=1&ref=business

Redefining the Markets

The financial crisis and the responses to it are restructuring the markets:

Rather then look for a market bottom, look for how the crisis will morph next.

We are witnessing a redefinition of long term market landscape.

Mohammed El Erian, CNBC interview, 11/21/2008