Friday, January 30, 2009

Global Thermonuclear war?

No ... just Wal-Mart expanding.  I frankly love Wal-Mart and will hear no shit about how evil they are.  If Wal-Mart shares were to be given to the general public, so that the shoppers were also the owners, we would have essentially a perfect communist economy.  How's that for bunching-up the leftists panties?

Macro-Man is funny

The Alternate Universe Newswire

Our world newsfeed(OWN): Russia, China blame woes on capitalism

Alternative world newswire (AWN): Wen, Putin admit Martingale forex strategies "misguided".

Wednesday, January 28, 2009

If the lunch is truly free ...

there will be high demand for lunches, as Jim Hamilton points out.

Smoking and Investing

Not that it would do any more good in the case of investing than it did in the case of smoking, but I still love this slide from a Japanese economists discussion of how to avoid doing what they did after their debt bubble burst.

Kinda makes you wonder if you should just do to investing what they did to curtail smoking -- make it more expensive.

Thursday, January 22, 2009

Dollar Downfall

Right in the middle of this crisis, when Lehman and other US institutions were imploding on a daily basis, I think it was actually pretty rational to worry that after everybody piled into Treasuries in the flight-to-safety trade, they would all shortly come piling back out in a paper-money-is-bunk trade.  If "trade" is what you would call that.  Ergo gold.  This was right but wrong.  Gold surged quite a bit during the crisis, but fell back immediately as it became clearer and clearer that people weren't going to stop believing in paper money, and particularly not in the dollar, just yet.  Part of this was related to the fact that it was quickly apparent that the problems were not confined to the US, and that basically most of the G7 banking system (save Japan) was going to end up as a ward of the state.  In that case, the dollar is unlikely to be any worse than the euro or the pound.  So your only choices as an alternate store of value were the yen and gold, and, well, the yen won.


I don't know whether gold will eventually close this gap (after all, what the hell is the difference between the yen the dollar and gold?  None of them pay an interest anymore, two of them can be produced indefinitely at the drop of a government bureaucrat's hat, both of these governments are deeply in debt, one of them to a bunch of chinamen, (that is, to guys who don't vote in their own country) and both have deeply and fundamentally broken political systems).  But I am less worried now about the immediate collapse of the dollar, given that holders of our debt are not in panic mode, perhaps simply because they have no better place to go to store their value, given the size of the value they need to store.  Why panic if you know in advance there's no chance of getting to the exit?

Ths does not however mean that the dollar is on solid ground in the more distant future.  The US still has too many major imbalances to make it a satisfying reserve currency, and we should expect the current legacy effect to gradually wear off.  This is all prelude to a much more detailed analysis that Brad Sester published today, tackling the question of exactly how the US has financed its current account deficit since the criss started (short answer - short term borrowings).  I found the final elipsis interesting and ominous, if not wildly helpful in telling me wht to do with my money:

At the same time, it is risky to finance a large external deficit with short-term debt. Even for the US. If the US deficit starts to head back up again — as, for example, the effect of the recent fall in oil prices wears off and a large fiscal stimulus in the US stimulates the world economy — without a shift in the composition of inflows, there would be cause for concern.

That just highlights a bigger issue, one that I don't think has been settled: How will the world's remaining current account deficits be financed in the post-crisis world? Right now, they are in some sense being financed by the unwinding of all the pre-crisis bets. And by running down existing stocks of foreign assets. But that process cannot last forever …

Tuesday, January 20, 2009

Deja vu all over again

As if you haven't already seen this laid out six ways from Sunday, Krugman goes over the stealth bailout again in simple language.  The money quote:

What I suspect is that policy makers — possibly without realizing it — are gearing up to attempt a bait-and-switch: a policy that looks like the cleanup of the savings and loans, but in practice amounts to making huge gifts to bank shareholders at taxpayer expense, disguised as "fair value" purchases of toxic assets.

I suspect that they guys at the Treasury realize it and the guys at the Fed don't, and this is perhaps part of why it can happen.  The interaction of a highly politicized Treasury and a supposedly a-political Fed are a recipe for disaster in the same way that letting the fox into the EPA or FDA hen-house only becomes apparent when you later realize that there's just one guy in a basement doing all the inspecting for lead in Chinese toys.

Thursday, January 15, 2009

One more for the road

Somebody just doesn't understand the ratchet effect of letting the government print money:

[O]ne price we are paying in these bailouts is the creation of a new tier of mega-banks that, because they are Too Big To Fail, have the competitive advantage of being essentially government-guaranteed. What we really need as a condition on TARP money is a new regulatory structure to make sure that these mega-banks do not abuse the oligopolistic position we have just handed them, and perhaps a commitment to break them up when economic circumstances allow. That would be considerably more valuable than a cap on executive salaries and corporate jets. But it will also be a lot more difficult to define and to agree on.

These bailouts are just going to go on and on and on.  Each big bank is going to keep dribbling out losses like an incontinent elephant and our politicians are going to keep lecturing out of one side of their mouth and whispering about future campaign contributions from bank executives out of the other.  Meanwhile helicopter Ben will jump around in the background shouting, "Me too! Me too! I want to regulate everybody!".  It kinda reminds me of that great scene with the mechanical contraption in Rules of The Game.

Wednesday, January 14, 2009

Wolf releases the hounds

Martin Wolf has another good column.  He keeps saying the same thing again and again of course, but as he refines it it's easier for us macro-economic novices to understand.  The punchline:

In last week's column ("Choices made in 2009 will shape the globe's destiny", January 6) I argued that the debt-encumbered US private sector would now be forced to save (see chart). The excess of income over expenditure in the private sector might be, say, 6 per cent of GDP for a lengthy period. If the structural current account deficit remained 4 per cent of GDP, the overall fiscal deficit would need to be 10 per cent of GDP. Moreover, this would be the structural – or full employment – deficit.

After that you can look at Naked Capitalism's typically anodyne comments on this logic.  She emphasizes a point which is slightly obscured by the way Wolf presented things, namely that his calculations of the deficits required to bring things back into balance are cumulative and structural.   That is, they are the best case scenario where the whole system stays at full employment the whole time.  The best way to do this is to take your lumps immediately, rather than letting things drag along and letting the gradually unfolding of the insolvency of the financial system, and the uncertainty this creates, lead to lost production.  This is why Wolf suggests proceeding directly to not just bank recapitalizations, but the forced mark downs of mortgages, asset-backed securities, and commercial real estate loans.  Or as Yves puts it:

Wolf is recommending cleaning out a badly infected wound full of shrapnel before it turns to gangrene. We'd rather take a penicillin shot and hope it clears up. Fat chance.

The end of her post also has an interesting quote from M. Pettis:

To get back to China and current issues, the problem with the US trade deficit now is sort of a "Keynesian" problem. US demand has the impact of generating both US production (and employment) as well as foreign production (and employment), and in a world of contracting demand, it is natural that countries that export demand – i.e. trade deficit countries – are going to be a lot less eager to do so. Anything that brings imports closer into balance with exports is likely to have a demand-enhancing impact similar to fiscal expansion, with the benefit that this isn't achieved by running up fiscal debt. On the other hand it will have a demand-reducing impact for trade surplus countries. That is why trade disputes are likely to be very attractive to trade deficit countries who have – I will continue to insist but it seems recently that this has become a much less "surprising" claim – the upper hand in any dispute with the "virtuous" countries with high savings rates and trade surpluses.

This actually adds another element to the debate, because it takes the 4% structural current account deficit that Wolf talks about as a given (the US as a whole currently "exports demand" to China because we have) and makes it a variable.  If the US needs to produce more than it consumes for a time, one way to do this would be to produce ourselves the part that we have China producing for us now.  This sudden repatriation, needless, to say, would not make the Chinese happy.


Jim Hamilton says it better:

One of Bernanke's goals was to reassure the public that the many new loans that the Fed is extending and assets it is purchasing do not pose a significant risk to taxpayers. From Bernanke's remarks:

Importantly, the provision of credit to financial institutions exposes the Federal Reserve to only minimal credit risk; the loans that we make to banks and primary dealers through our various facilities are generally overcollateralized and made with recourse to the borrowing firm. The Federal Reserve has never suffered any losses in the course of its normal lending to banks and, now, to primary dealers.

Left unsaid here is the fact any private lender could equally well have also extended said overcollateralized loans to these same borrowing institutions, but decided that the compensation for absorbing such a risk was inadequate. Bernanke's core assumption is thus that private lenders are currently mispricing risk, but the Fed can do it correctly. I'm prepared to believe that's true-- there is some degree of overcollateralization that might be inadequate for markets but should be sufficient for the Fed, but what is it? Are the underlying assets really worth 99 cents, 90 cents, or 50 cents on the dollar? Should the overcollateralization therefore be 1%? 10%? 100%? The devil is in the details, and whatever details we know about this aren't coming from the Fed.

... and he throws in some comments on the "exit strategy" for good measure:

Bernanke also addressed the question of what's the exit plan for bringing the Fed's balance sheet back to normal size and safety:

However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs. To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities....

As lending programs are scaled back, the size of the Federal Reserve's balance sheet will decline, implying a reduction in excess reserves and the monetary base. A significant shrinking of the balance sheet can be accomplished relatively quickly, as a substantial portion of the assets that the Federal Reserve holds-- including loans to financial institutions, currency swaps, and purchases of commercial paper-- are short-term in nature and can simply be allowed to run off as the various programs and facilities are scaled back or shut down. As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy-- namely, by setting a target for the federal funds rate.

That sounds to me like an exit strategy for how to get out of this if everything works out just right and the problems all go away.

And what's the exit strategy if it doesn't work? I suppose more lending facilities.

It's really hard to see how we're not turning into Japan with all this. So much of what the US is doing now reeks of the same political denial of the scale of the problem that left Japan marooned for a decade. The Fed is over-confident, the stimulus is over-small, and the Congress is over-stupid -- putting on a show about $20k in back taxes that the new Treasury secretary has already over-paid.

Hot Money and Cold Water

The question of China's role in the global economy and financial system is so complex that I should just turn it over to an expert. But first, a summary of the basic points that might be useful later:
  1. China's reserve growth is slowing dramatically and is essentially at zero now, but ...
  2. This is not because they are now running a trade deficit. In fact, though their exports are falling, their imports are falling faster and their trade surplus is growing. Bad news for the rest of Asia.
  3. A growing trade surplus but no reserve growth means that the money is flowing out somewhere else. China has already stated that they are worried about "unusual swings in capital flows", which in this case means hot money flowing out of the country on the suspicion that they will devalue the Renminbi to support their exports.
  4. None of this has any clear implications for the yields on Treasuries though. The money flowing out of China is going somewhere, after all, Sester thinks to Hong Kong and Taiwan, and thence, perhaps, to T-bills. In addition, China is moving their existing reserves away from risky assets and even agency debt, and into plain vanilla treasuries. And finally, the economy sucks and people are willing to buy treasuries now just to avoid losing money, so private demand is strong.

Tuesday, January 13, 2009

The reverse midas touch

Bernanke Speech

Helicopter Ben's speech today was actually pretty good.  In it he distinguishes between what he calls "credit easing" from the quantitative easing that Japan did post 2001.

The Federal Reserve's approach to supporting credit markets is conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006.  Our approach--which could be described as "credit easing"--resembles quantitative easing in one respect:  It involves an expansion of the central bank's balance sheet.  However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank's balance sheet is incidental.  Indeed, although the Bank of Japan's policy approach during the QE period was quite multifaceted, the overall stance of its policy was gauged primarily in terms of its target for bank reserves.  In contrast, the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses.  This difference does not reflect any doctrinal disagreement with the Japanese approach, but rather the differences in financial and economic conditions between the two episodes.  In particular, credit spreads are much wider and credit markets more dysfunctional in the United States today than was the case during the Japanese experiment with quantitative easing.  To stimulate aggregate demand in the current environment, the Federal Reserve must focus its policies on reducing those spreads and improving the functioning of private credit markets more generally.

Of course, he makes believe that this spread targeting can do just what the market (theoretically) does, namely correctly price credit risk.  If he's right, and his pricing of spreads is smarter than the market's, then we will have no problem.  If he's wrong, and he's not as smart as the market, or even just dumb in a different way, then the Fed will end up owning a lot of securities that are not worth face value -- ie. the Fed will be taking credit risk.  In this case, they will either be able to unwind this risk before suffering losses on it by pushing it back into the private market at a moment when things look (deceptively) more normal, or they will stomach the losses themselves. 

Later on in the speech, he answers to critics who say that the Fed's dramatic balance sheet expansion may not be inflationary now, but must be down the road, and he discusses how they intend to shrink their balance sheet at the appropriate time in order to prevent this from happening.  The idea is simply to later un-print the money they are printing right now to make these loans and buy these assets, by calling in the loans or selling the assets back into the market. That works fine as long as the loans are short-term and the assets are liquid and money good.  If not, once again the Fed will be taking credit risk.  I suppose though that this is an inherent part of "credit easing".  If you were just quantitatively easing, then you could have your Central Bank Hand print money to buy up the government debt that your Federal Government Hand has just issued (what people call monetizing the debt).  This doesn't require any credit risk, but thereby prevents you from targeting spreads directly and thus doing an end-run around the broken financial intermediation system.

So the approach here is smarter than what Japan did, but also much riskier.  If they screw this up we will get the mother of all inflationary booms.


Macro Man is clever and funny, and typically pretty insightful with his economic observations.  Today he is on about the collapse in world trade, and how to profit by it.  You'll have to read the post for the graphs and data, but it will come as no surprise that global trade has stopped, full stop. 

But the two trading ideas MM is using to play this theme illustrate the impossibility (at least most of the time) of profiting off your macro views, even if you get the economics correct -- in this case, he's short the Singaporean and Australian dollars.  Talk about a bank-shot.

To me, the only macro trades that make sense are the ones that would fall under the heading of mis-priced insurance.  The ABX trade last year qualified.  You might find some commodity producing companies or some commercial real estate or retail debt this year that qualify.  The basic insight is that the difficulty of isolating a particular macro variable requires you to find not only a situation where the downside and upside are asymmetrical (which they arguably are with the two MM trades at issue) but in addition, one where the downside is limited.  This is not the case with Gold, shorting equity, or the Australian dollar.  Interestingly, it seems like it might be the case with shorting treasuries, or any other AAA rated credits.  After all, have you ever heard of a AAA credit being upgraded?

Monday, January 12, 2009

Utter Batshit Insanity

There's really no other words I can use to describe the complete drivel that these two Stanford economists are flogging over at VoxEU.  And this after I've promised myself to try to be less breathlessly antagonistic when writing.  I moused over there because I read the abstract, and it sounded like a view quite different from my own, which is always useful -- the title of the article is The Recession Will Be Over Sooner Than You Think.  The abstract:

A key source of the today's economic weakness is uncertainty that led firms to postpone investment and hiring decisions. This column, by the authors whose model forecast the recession as far back as June 2008, report that the key measures of uncertainty have dropped so rapidly that they believe growth will resume by mid-2009. This means any additional economic stimulus has to be enacted quickly. Delaying to the summer may mean the economic medicine is administered just as the patient is leave the hospital.

Sounds okay, ¿no?  Then you read the article, and you realize that the entire thing is based on the neo-classically idiotic notion that you can use the VIX (an index of option implied volatility often cited as a measure of fear and uncertainty) not only to predict the depth of a recession, but in fact to time the whole thing as well. 

This is the sort of thing that gives economists a bad name, and it's hard to no where to begin when one sets out to enunciate just how dumb this idea is.  Let's start with the fact that the whole thing implies that both the economy and markets were cruising along in equilibrium before the recent volatility spike.  What husing bubble?  Then let's move on to what the VIX actually measures, namely, a number inferred from an equation that we know is wrong, and is any any case completely backward looking and based on a tiny, specialized subsegment of the market where a few traders go to bet on horses when they're not in Vegas.

Finally, let's go to how useful this actually is a macro-economic predictor, even if it didn't suffer from other problems.  What happens if the pricing of options begins to change again tomorrow?  For example, they trumpet how their model predicted a recession as far back as ... June ... as if this were a tremendous feat of sooth-saying daring.  Wow, I definitely needed a sophisticated model like this to tell me there might be problems as I watched Freddie and Fannie and their $6 trillion in quasi-governmental obligations go under.  Thanks.  And now of course, it's comforting to know that everything is fine again because the VIX is falling.  Oh god wait ... what if it goes back up again?  The recession will get deeper again!  We cannot afford to have this sort of output gap!  We need to put all the options traders on federally mandated prozac and fill the canyons of Wall St. with subsidized low-rider-jeans-sporting fomer strippers in order to save the economy!

These guys need to be taken out back along with VaR, the Laffer Curve, and Tier 1 capital ratios ... and shot.  We are surrounded by chimps.

But what about the timing?

Ambrose Evans-Pritchard tells a completely coherent story about how bond yields are going to rise (the headline is dumb -- people have started abusing the term bubble, and pretty soon it isnt going to mean anything anymore).

Yields on 10-year US Treasuries have fallen to 2.4pc – a level that was unseen even in the Great Depression. This is "return-free risk", said bond guru Jim Grant.

The problem is that timing this trade is pretty hard.  I doubt that it will take a better part of the decade for Helicopter Ben to reflate the economy, but the better part of a year or two ... that doesn't sound so crazy.  This is why it's so hard to go short treasuries and long inflation at the moment.

Sunday, January 11, 2009

Depression Economics

Interfliudity has a long thoughtful post today about the forms and manner of protectionism.  He points out that there are two distinct economic phenomena that sometimes get tagged with the same label -- competitive beggar-thy-neighbor trade barriers (import or export tariffs) are a negative sum game that raise the price for everyone, and hence lower aggregate demand; production subsidies, however, do not have the same pernicious economic effect, and, in fact, can be very useful if the problem at hand is a lack of aggregate demand.  He starts off by looking at subsidies as a form of investment:

A fair review of the history of "protectionism" would be much more mixed than the economic mainstream would like us to believe, with their stories of comparative advantage and expanding production possibility frontiers. (Thankfully, economists like Dani Rodrik and Paul Krugman weave more nuanced tales, but still "protectionism" rates somewhere just below coprophagia on the economic profession's list of distasteful things.) In some times and places, trade barriers have served to isolate and impoverish people. In other times and places, tariffs have protected infant industries that grew into powerhouses in countries (like the United States) that otherwise might have remained agricultural backwaters. That said, I think we should avoid tariffs, not in deference to economic pseudoscience, but because they are stultifying. Intercourse across borders is a per se good. A mixed-up, intermingling world is better than one made up of insulated national tribes. We should avoid tariffs not because of their adverse economic consequences, but despite their potential economic benefits.

But subsidy is a different story. Export subsidies do not diminish international commerce, they, um, subsidize it. From a libertarian perspective, there is a strong case against tariffs. Trade restrictions prevent free people across borders from interacting as they wish. But subsidies restrict no one. Sure, libertarians might complain of the wealth expropriated to fund the subsidy, but that critique applies to nearly all functions of modern government. Until we abolish public schools and the NIH, there's no reason we shouldn't have export subsidies.

China of course, has been a massive subsidizer of its export industries via the crawiling peg of its undervalued currency.  This subsidy takes the form of giving money to the United States by buying low-yielding treasuries.  Interestingly, his complaint is not of the typical "China is distorting the free market" flavor, but is of the "China is providing this subsidy in a round-about and non-transparent way" flavor.

As Brad Setser has described for years, in order to maintain a "crawling" currency peg, China's central bank has been forced to purchase US dollar assets on which it must expect an eventual loss in real terms. China's subsidy to foreign consumers has been hidden in this overpayment. China's policy of giving worked very well for it, but executing that policy by pretending to lend rather than to give has put the nation in a bind. The technocrats responsible for China's huge currency reserves must continually expand their losses by purchasing more dollars to keep the value of the dollar high and hide the costs of subsidies already granted. If they do not, the exposure of large financial losses might create a firestorm of domestic outrage. China's central bank might be able to hide reserve losses by engineering a large domestic inflation, so that its US dollar portfolio does not lose value in nominal terms. In either case, even though the development gains were almost certainly worth the financial cost of China's export support, China's leaders face a problem since they pretended there was no subsidy when in fact the subsidy was very large.

It would have been better for China as well as for its trade partners (who face traumatic currency devaluations) if its policies had involved explicit, sustainable, and broad-based subsidies to foreign consumers. Explicit subsidies paid over time are more politically palatable than sharp losses suddenly revealed.

This gets to the heart of the problem with currency pegging, in my opinion -- the inevitable sudden end of the regime is often disruptive enough to wipe out all of the gains that the peg produced to begin with.  But that's a sidelight to the main argument in this case.  Fine, China should have been more transparent about what it was doing, and not relied on the bank shot that accidentally careened off the table and produced the housing bubble.  But was it such a bad idea for them to subsidize US and European consumption as a way of turbocharging their industrialization?  I think this is a real question.

Of course, I came away from the Interfluidity's argument with a couple of questions. 

The first was whether the idea he lays out to have a market for consumption subsidies makes sense when we're not trapped in a depression economics scenario.  If the world is more or less in equilibrium, governments subsidizing consumption via vouchers or whatever would seem to be inherently inflationary.  There's no point in subsidizing consumption is everyone is working as hard as they can to produce what everyone is consuming already.  

The second question was related to the already built up imbalances that have resulted from China subsidizing consumption while the US has not.  This turns out to be outside the scope of the post, as was revealed in the comments.  Bascially, if you were the only one subsidizing consumption and everyone else was profligately living off your thrift, you would end up owning everything, which is an unstable equilibirum, to say the least.

Saturday, January 10, 2009

Follow the Money

That's the apt title of Brad Sester's column on central banking and macro-monetary policy. Today he is saying what I said yesterday, albeit a lot more eloquently. He steps through each piece in the housing bubble, demonstrating once again how we arrived at the time honored correlation between banking crises and real estate crashes. One key piece that I hadn't clearly fixed on before (though I did understand that pegging your currency is the original "Black Swan" idea -- which and in a beef completely beside the point, I find this Taleb guy to be a bit of a huckster and this black swan term pretty useless and/or abused. Currency pegs end in disaster, even though for a while they inevitably look like they are working wonders. Is that a black swan event just because it doesn't follow a log-normal probablitity distribution. Do we really need to pay a guy a guy a gazillion dollars per lecture to tell us that not everything works like physics? I mean, at least if we're not recovering physicists? And if you take the semantic high road and argue that black swan is not meant to refer to actually pretty predictable (though not log-normal) events like the sub-prime implosion or the sudden cracks that eventually rip open every pegged currency like it were a tectonic house of cards -- that is if you argue that instead it is meant to refer to events we can't predict at all, visionary events so to speak, then exactly how useful is that? I bet if you pay Donald Rumsfeld a gazillion dollars to have lunch he'll be happy to tell you about the unknowns unknowns too.)

... anyway, I hadn't clearly seen another difficulty that the RMB peg created in this situation.

The impact of US policies to restrain domestic demand on global adjustment is complicated by the the fact that the large savings surplus countries peg to the dollar. Suppose the US takes steps that restrain domestic demand growth (tighter regulation of risky lending, tighter fiscal policy, higher policy interest rates). The result would tend to be slower US growth — and less US import demand. Less import demand translates into a smaller current account surplus in the exporting countries. Their income falls a bit, and unless spending or investment falls, their savings would fall too. That is the first effect. But a US slowdown — at least one not induced by a strong rise in US rates — tends to put downward pressure on the dollar. The US imports a lot, but a US slump still has a bigger impact on activity in the US than activity in the world. And a slowdown in the US — especially one that leads to lower rates — tends to put downward pressure on the dollar. If say China (or any other major emerging economy) pegs to the dollar, their currencies go down too — and that tends to push up exports to places like Europe that let their currencies float. That keeps Chinese income and savings up.

And if a weaker dollar leads to higher commodity prices even as the US– still a big commodity importer — slows, that helps support savings in the commodity exporters.

Now we're putting together a lot of pieces in the recent puzzle ... housing, the dollar, commodities ... I wish I could say that this made it easier to see what happens next, but I'm not sure I can claim that. There is a fork just ahead in the road which is primarily political. After the political decision is (at least for a few years) taken or not taken to stick with the dollar system and its imbalances, then we will get some clarity on where we are headed. But the basic decision seems clearer and clearer -- we either try to patch together the system we had and restore the previous imbalances, or we try to move towards something more balanced and sustainable.

  1. Would imply that the current recession will be less horrific than anticipated, that the Fed's reflation will, with China's help, take hold, but that with 2 years we will be back in commodity bubble-landia, with results similar to those we have today.
  2. Would presumably imply a longer slowdown both here and in China as both side attempt to readjust their structural imbalances. The US can't learn to save overnight, and the Chinese can't learn to spend overnight, but I imagine that if we cooperate, we can both readjust over the period of a few years. I assume this would mean a period of subpar growth, but no major macro-economic changes.
  3. Would be 2 without the cooperation. These imbalances can end overnight, either now, or in two years, if everyone runs in the directions of protectionism.
Do you have to be crazy to think we can manage 2?

Friday, January 9, 2009


Joseph Stiglitz has an interesting column this morning. I think his point is a good one -- everyone is single-mindedly focused on the crisis and the stimulus that is meant to solve it as a kind of silver bullet. We hear almost no serious discussion of any real macro-economic reform that would change the forces that led us up to this brink to begin with. Do we really want to restore the same meta-stable disequilibium we had before this started?

I am not sure that there is sufficient appreciation of some of the underlying problems facing the global economy... For a long time,... without American profligacy, there would have been insufficient global aggregate demand. In the past, developing countries filled this role, running trade and fiscal deficits. But they paid a high price, and fiscal responsibility and conservative monetary policies are now the fashion.

Indeed, many developing countries, fearful of losing their economic sovereignty to the IMF – as occurred during the 1997 Asian financial crisis – accumulated hundreds of billions of dollars in reserves. Money put into reserves is income not spent.

Moreover, growing inequality in most countries of the world has meant that money has gone from those who would spend it to those who are so well off that, try as they might, they can't spend it all. ...

Many bits have been spilled recently over the validity of Tyler Cowen's claim that this whole cycle began with the decision to bail out LTCM back in 1998. I hardly agree that this was the birth of moral hazard, but I do think that this moment in financial history was crucial, not from the perspective of the borrowers (Goldman Sachs, Morgan Stanley, LTCM, The United States of America) but from the perspective of the savers (Russia, Brazil, China, the Gulf States). Nowadays you cannot pick up the WSJ without hearing about how "banks aren't lending", and about how we have to prevent people from "putting their money into the mattress". But this is exactly what the rest of the world has effectively been doing for the last 10 years. China buying trillions of dollars worth of US treasuries is effectively putting its money in the mattress -- a lot of money and a big mattress, but the analogy is exact.

Macroeconomically, the mattress is just defined as that place where savings go to die -- i.e. are not turned into productive investment. As far as I can make out, this was the basic insight of Keynes. Normally, investment is equal to savings. In depressions, people save just fine thank you, but they put this money away rather than risk investing it in any risky economic proposition like, in those days, a bank. This touches off the vicious cycle of cutbacks, even lower investment, unemployment, lower consumption and savings, and finally deflation, which then serves to vindicate the original fear, as people notice that their neighborhood who did have the temerity to invest saw that money lose its value. In the end, everybody stops doing everything, in capitalism's version of mass catatonia, and the only option you are left with to get things moving is the mass hysteria of a war.

So ... the US government is where savings go to die ... is basically what I'm saying. That doesn't have to be true, but it certainly has been since 1998. And now the US is this giant, bloated soggy macro mattress.

Prior to the crisis, there were still private mechanisms by which the savings of the rest of the world could be turned into investment. This was known as the sub-prime housing bubble. Instead of China using its savings to invest in its own factories, it gave this money to the US governement, who then passed it on to the private sector via the gigantic US housing subsidy. We "invested" in houses, their prices sky-rocketed, and we then took the money out as a loan against the house and spent it on cheap plastic shit from China, which closed the loop by providing them with more savings.

That mechanism is broken (though not in the way many, including myself, originally envisioned -- the housing bubble burst before the Chinese got sick of buying Treasuries, rather than as a result of this) and the new one people are proposing is to have the US government (and every other developed government) do the investing itself, rather than rely on the low rates created by this Chinese willingness to save. This was Keynes solution too -- to have the government step in, reposses that mattress, and do the investing itself.

And in fact, incredibly, that just might work. We can debate whether the second part of this mechanism is on the verge of a breakdown -- but so far, the part where China and others lend to the US government has held up pretty well. I do worry that if times get tough, the rest of the world may want to open up the mattress with a knife. But one big thing we have going for us is that they all know that if they all try to do this a the same time, nobody will get anything. The financial version of mutually assured destruction.

Having the US government invest Chinese savings can work. Or at least it can get us back to where we were before the private mechanisms for this broke down. But is that really the solution we want to have for the long-term? And once we start down that road, how do we come back to an economy where investment decisions are made privately? This solution only works so long as you can think "Chimerica" can hold together as a unit. The Chinese save, we invest, and the co-dependence of this relationship is reinforced by the centralization of savings decisions on their side, investment decisions on our side, and the catastrophic consequences that both sides can see if this breaks down. If there were millions of Chinese savers trying to coordinate with millions of American investors, there would be no chance for this to work. If there's just CHINA on one side and AMERICA on the other, it might.

Or it might not. This is the fundamental problem with following Mohammed El-Erian's investment advice in yesterday's FT -- don't fight the super-Fed sounds like great advice, but the converse, following along with them, seems tricky because:
  1. ... badges, we don't need no stinking badges ... These guys are in charge by default, and they have no plan, so following along with them could be like sailing dead into the wind with the boom whipping back and forth. Here Mr. Dr. PIMCO is a bit disingenuos because you know that as a former IMF guy, manager of the Harvard endowment, current manager of the world's largest bond fund, author, and all-around financial superhero, he is front-running the Fed following trade.
  2. Even the guys in charge of the finances are at the mercy of the politicians. Any day now we are going to get the charming and probably trade-able spectacle of the Republicans temporarily holding up Obama's new stimulus bill. They'll pass the thing eventually, just like they did the TARP. But one of these days some measure will fail and the government will end up investing in solid gold office towers in Duluth. The Chinese will get pissed, we'll get pisseder, and the whole thing will come careening down. The history of the last time we let the government do the investing provides ample evidence of this problem, though hopefully this time we won't have to destroy so much of Europe in order to solve it.
Now, we can come back to Stiglitz's point. Even if this Keynesian scheme might work, it's certainly not the optimal solution. He suggest three things to move towards a more stable system:

We need not just temporary stimuli, but longer-term solutions. ...

First, we need to reverse the worrying trends of growing inequality. More progressive income taxation will also help stabilise the economy, through what economists call "automatic stabilisers". It would also help if the advanced developed countries fulfilled their commitments to helping the world's poorest by increasing their foreign-aid budgets to 0.7% of GDP.

Second, the world needs enormous investments if it is to respond to the challenges of global warming. Transportation systems and living patterns must be changed dramatically.

Third, a global reserve system is needed. It makes little sense for the world's poorest countries to lend money to the richest at low interest rates. The system is unstable. The dollar reserve system is fraying, but is likely to be replaced with a dollar/euro or dollar/euro/yen system that is even more unstable. Annual emissions of a global reserve currency (what Keynes called Bancor, the IMF calls SDRs) could help fuel global aggregate demand and be used to promote development and address the problems of global warming.

This year will be bleak. The question we need to be asking now is, how can we enhance the likelihood that we will eventually emerge into a robust recovery?

This may seem a bit vague and general, but I think it actually helps. Second, it addresses the question of what the government should invest in, if it's going to be the one doing the investing. We have some obvious places to look here. The US needs a new infrastructure so that driving around the Bronx doesn't feel like driving around Beruit, and China needs a new atmosphere so that the folks in Bejing don't choke to death on their first breath of modernity. Third, it address the need for a new monetary system that isn't unilaterally controlled. If the current system is a defacto detente between China and the US, let's make that official, and have one global reserve currency that everybody has a say in controlling. I don't really see how this is different than the gold standard with a fancy name, but, hey I'm not an IMF economist either. And finally, First, on a fundamental level, capitalism cannot work if one group does the working, and another group does the high living. After all, who's going to buy the products of High Living Inc. if not the workers? A complete class bifurcation is theoretically possible (though it relies on the rich consuming an ever increasing amount of stuff or being content with an ever more dubiously increasing claim on the consumption of future stuff) but it is hardly stable.

Thursday, January 8, 2009

German bond failure

This just cannot bode well for treasuries.

A German sovereign bond auction failed on Wednesday as investors shunned one of the most liquid and safe assets in the world in a warning for governments seeking to raise record amounts of debt to stimulate slowing economies.

The fate of the first eurozone bond auction of 2009 signals trouble ahead as governments around the world hope to issue an estimated $3,000bn in debt this year, three times more than in 2008.

The 10-year bonds failed to attract enough bids to reach the €6bn the German government wanted. Bids of €5.24bn, a cover of only 87 per cent, amounted to the second worst auction on record in terms of demand.

Hopefully this is not a sign of more failed auctions to come. 

Reasons it is hard to get bullish

Stimulus or no, it is going to be difficult to see a sustained improvement in the economy or the market without a functioning banking system.  The Fed's liquidity programs, the zero interest rate target, and the quantitative and qualitative easing all go in the right direction, but if the financial system remains too big for its economic britches, the credit transmission mechanism will remain in slipped clutch mode because every bank will be quite rationally worried that downsizing means them.

This makes the problems with commercial real estate, and banks heavy exposure to these problems, yet another shoe to drop in this crisis.  CR has the quote and the context.

The delinquency rate will likely hit 3% by the end of 2009, its highest point in more than a decade, says Richard Parkus Deutsche Bank's head of research on such bonds, known as commercial-mortgage-backed securities, or CMBS.
This is not only a problem for CMBS, but many banks and thrifts have excessive exposure to CRE loans:
 According to research firm Foresight Analytics, soured commercial mortgages on banks' books jumped to 2.2% as of the third quarter of last year, from 1.5% at the end of 2007. The research firm estimates that the rate could rise to 2.6% in the fourth quarter of 2008.
Banks and thrifts would suffer in a commercial-real-estate downturn because they own nearly 50% of all commercial mortgages outstanding. ... According to Foresight Analytics, as of Sept. 30, 2008, some 1,400 commercial banks and savings institutions had more than 300% of their Tier 1 capital in commercial mortgages.

Distressed investors of the world unite!  You have nothing to lose but your shirts!

Wednesday, January 7, 2009

Macro Simplicity

Martin Wolf is able to encapsulate the basic macro dilemma in the space of just one FT column.

Given the persistent structural current account deficit, how large does the fiscal deficit need to be to balance the economy at something close to full employment? Assuming, for the moment, that the private sector runs a financial surplus of 6 per cent of GDP and the structural current account deficit is 4 per cent of GDP, the fiscal deficit must be 10 per cent of GDP, indefinitely.

And to get to this point the fiscal boost must be huge. A discretionary boost of $760bn (€570bn, £520bn) or 5.3 per cent of GDP is not enough. The authors argue that "even with the application of almost unbelievably large fiscal stimuli, output will not increase enough to prevent unemployment from continuing to rise through the next two years".

Now think what will happen if, after two or more years of monstrous fiscal deficits, the US is still mired in unemployment and slow growth. People will ask why the country is exporting so much of its demand to sustain jobs abroad. They will want their demand back. The last time this sort of thing happened – in the 1930s – the outcome was a devastating round of beggar-my-neighbour devaluations, plus protectionism. Can we be confident we can avoid such dangers? On the contrary, the danger is extreme. Once the integration of the world economy starts to reverse and unemployment soars, the demons of our past – above all, nationalism – will return. Achievements of decades may collapse almost overnight.

I suppose this is because, for all the complexity, the basic macro forces that are moving the world these days are remarkably simple.  In fact, they are the same ones you could have heard Warren Buffett explaining all the way back in 2003.  Little has changed in the interim, unless way more of the same is considered a change.  We are still consuming more than we produce, and the Chinese are still producing more than they consume.  The fundamental question remains how long this can go on.  Or rather, the question is how, and how quickly, we can back down from the disequilibirum. 

By the way, the paper cited in Wolf's column is worth reading, but you should sit down beforehand.

Monday, January 5, 2009

Nothing to see here ...

Buiter has a long post today.  It rambles and staggers (in an interesting way though) to the basic conclusion that the US cannot afford a Keynesian stimulus.  Complementary reading includes Paul Krugman's almost-response, where he admits that he worries about the same things, but puts some numbers to how big a difference various stimulus packages might make.  The answer: not much -- basically, if you think the US is going to default on its debt, it's going to do so regardless of whether we pass a stimulus bill or not.  But first, the question:

Given the bad fiscal position of the US Federal government and given the vulnerability of the external position of the US and its growing reliance on foreign funding, the scope for expansionary fiscal policy in the US is much more limited than president-elect Obama's advisers appear to realise.  Underneath the effective demand problem is a deep structural rot, especially in household sector and financial sector balance sheets.  Keynesian cyclical policy options that would be open to more structurally sound economies should therefore not be tried on anything like the same scale by the US authorities.