Excellent- an instant classic!

Modern Monetary Theory—A Primer on the Operational Realities of the Monetary System

By Scott Fulwiller

Karim writes:

Yes, contrary to my opinion. This about managing expectations. With falling inflation and unemployment this high it makes no sense that they would be holding back something that could make a material difference.

Agreed.

Again, if they did have anything that would substantially increase agg demand they’d have done it.

Yes, and, again, it’s doubtful lower credit spreads will do much for the macro economy but would shift a lot of credit risks to the Fed for very little gain.

FRB: Bernanke, The Economic Outlook and Monetary Policy

At best, though, fiscal impetus and the inventory cycle can drive recovery only temporarily.

That is not correct. Fiscal adjustment can sustain demand at any politically desired level.

For a sustained expansion to take hold, growth in private final demand–notably, consumer spending and business fixed investment–must ultimately take the lead. On the whole, in the United States, that critical handoff appears to be under way.

Agreed that hand off is slowly materializing and private sector debt expansion will then drive additional growth. But sustained expansion could come immediately from a fiscal adjustment as well.

However,although private final demand, output, and employment have indeed been growing for more than a year, the pace of that growth recently appears somewhat less vigorous than we expected.

Agreed.

Among the most notable results to emerge from the recent revision of the U.S. national income data is that, in recent quarters, household saving has been higher than we thought–averaging near 6 percent of disposable income rather than 4 percent, as the earlier data showed.

Non govt net savings of financial assets = govt deficit spending by identity, and with foreign sector savings relatively constant, the majority of the increase is in the domestic economy, either businesses or households.

That means in general household savings goes up with the deficit regardless of the level of consumer spending.

However, when household savings does start to fall, it’s due to household credit expansion, at which time, if the deficit is unchanged, the savings of financial assets is shifted to either the business or the foreign sector.

And, as growth accelerates, the automatic fiscal stabilizers- increased federal revenues and falling transfer payments- reduce the deficit and therefore reduce the growth in the total net savings of the other sectors.

So the hand off process is usually characterized by the federal deficit falling as private sector debt expands to ‘replace it.’

This continues until the private sector again necessarily gets over leveraged, ending the expansion.

3 On the one hand, this finding suggests that households, collectively, are even more cautious about the economic outlook and their own prospects than we previously believed.

At best his means that he thinks with this much savings households would start leveraging more.

But on the other hand, the upward revision to the saving rate also implies greater progress in the repair of household balance sheets. Stronger balance sheets should in turn allow households to increase their spending more rapidly as credit conditions ease and the overall economy improves.

Yes, as I explained. He seems to understand the sequence of the data but doesn’t seem to be quite there on the causation.

Going forward, improved affordability–the result of lower house prices and record-low mortgage rates–should boost the demand for housing. However, the overhang of foreclosed-upon and vacant housing and the difficulties of many households in obtaining mortgage financing are likely to continue to weigh on the pace of residential investment for some time yet

Yes, which is a traditional source of private sector credit expansion, along with cars, that drives the process.

Generally speaking, large firms in good financial condition can obtain credit easily and on favorable terms; moreover, many large firms are holding exceptionally large amounts of cash on their balance sheets. For these firms, willingness to expand–and, in particular, to add permanent employees–depends primarily on expected increases in demand for their products, not on financing costs.

I couldn’t agree more!
Employment is primarily a function of sales as discussed in prior posts.

Bank-dependent smaller firms, by contrast, have faced significantly greater problems obtaining credit, according to surveys and anecdotes. The Federal Reserve, together with other regulators, has been engaged in significant efforts to improve the credit environment for small businesses. For example, through the provision of specific guidance and extensive examiner training, we are working to help banks strike a good balance between appropriate prudence and reasonable willingness to make loans to creditworthy borrowers. We have also engaged in extensive outreach efforts to banks and small businesses. There is some hopeful news on this front: For the most part, bank lending terms and conditions appear to be stabilizing and are even beginning to ease in some cases, and banks reportedly have become more proactive in seeking out creditworthy borrowers.

Another problem is that the regulators are forcing small banks to reduce what’s called ‘non core funding’ in a confused strategy to enhance small bank ‘deposit stability.’ Unfortunately, at the local level the regulators have interpreted the rules to mean, for example, it’s better for a small bank’s financial stability to fund, for example, a 3 year business loan with 1 year local deposits, vs funding it with a 5 year advance from the Federal Home loan bank. It’s also a fallacy of composition, as at the macro level there aren’t enough core deposits to fund local small businesses, as many larger corporations and individuals use money center banks and leave their deposits with them. The regulatory insistence on small banks using ‘core deposits’ rather than ‘wholesale funding’ recycled from the larger banks causes a shortage of local deposits and forces the small banks to pay substantially higher rates as they compete with each other for funding artificially limited by regulation.

In lieu of adding permanent workers, some firms have increased labor input by increasing workweeks, offering full-time work to part-time workers, and making extensive use of temporary workers.

Yes, and when you include this growth in employment the economy is doing better than most analysts seem to think.

Like others, we were surprised by the sharp deterioration in the U.S. trade balance in the second quarter. However, that deterioration seems to have reflected a number of temporary and special factors. Generally, the arithmetic contribution of net exports to growth in the gross domestic product tends to be much closer to zero, and that is likely to be the case in coming quarters.

Also, part of the hand off will be US consumers going into debt (reducing savings) to buy foreign goods and services, which increases foreign sector savings of financial assets.

Overall, the incoming data suggest that the recovery of output and employment in the United States has slowed in recent months, to a pace somewhat weaker than most FOMC participants projected earlier this year. Much of the unexpected slowing is attributable to the household sector, where consumer spending and the demand for housing have both grown less quickly than was anticipated. Consumer spending may continue to grow relatively slowly in the near term as households focus on repairing their balance sheets. I expect the economy to continue to expand in the second half of this year, albeit at a relatively modest pace.

Agreed.

Despite the weaker data seen recently, the preconditions for a pickup in growth in 2011 appear to remain in place.

Agreed.

Monetary policy remains very accommodative,

Yes, for many borrowers, but the lower rates have also net reduced incomes. QE alone resulted in some $50 billion of ‘profits’ transfered to the Treasury from the Fed that would have been private sector income, for example.

and financial conditions have become more supportive of growth, in part because a concerted effort by policymakers in Europe has reduced fears related to sovereign debts and the banking system there.

Agreed.

Banks are improving their balance sheets and appear more willing to lend.

Agreed, though via a reduction in interest earned by savers that’s gone to increased net interest margins for banks.

Consumers are reducing their debt and building savings, returning household wealth-to-income ratios near to longer-term historical norms.

Yes, ‘funded’ by the federal deficit spending.

Stronger household finances, rising incomes, and some easing of credit conditions will provide the basis for more-rapid growth in household spending next year.

Yes, and that basis is credit expansion.

On the fiscal front, state and local governments continue to be under pressure; but with tax receipts showing signs of recovery, their spending should decline less rapidly than it has in the past few years. Federal fiscal stimulus seems set to continue to fade but likely not so quickly as to derail growth in coming quarters.

Yes, and traditionally matched or exceeded by private sector credit expansion as above.

Recently, inflation has declined to a level that is slightly below that which FOMC participants view as most conducive to a healthy economy in the long run. With inflation expectations reasonably stable and the economy growing, inflation should remain near current readings for some time before rising slowly toward levels more consistent with the Committee’s objectives. At this juncture, the risk of either an undesirable rise in inflation or of significant further disinflation seems low. Of course, the Federal Reserve will monitor price developments closely.

The channels through which the Fed’s purchases affect longer-term interest rates and financial conditions more generally have been subject to debate.

With the debate subsiding as more FOMC participants, but far from all of them, seem to be coming to understand the quantity of the reserves per se has no consequences.

I see the evidence as most favorable to the view that such purchases work primarily through the so-called portfolio balance channel, which holds that once short-term interest rates have reached zero, the Federal Reserve’s purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public. Specifically, the Fed’s strategy relies on the presumption that different financial assets are not perfect substitutes in investors’ portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets. Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration. For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well.

This is evidence Bernanke himself has come around to the understanding that the quantity of reserves at the Fed per se is of no further economic consequence.

We decided to reinvest in Treasury securities rather than agency securities because the Federal Reserve already owns a very large share of available agency securities, suggesting that reinvestment in Treasury securities might be more effective in reducing longer-term interest rates and improving financial conditions with less chance of adverse effects on market functioning.

Again, it shows the understanding that QE channel is price (interest rates) and not quantities.
This is a very constructive move from understanding indicated in prior statements.

Also, as I already noted, reinvestment in Treasury securities is more consistent with the Committee’s longer-term objective of a portfolio made up principally of Treasury securities. We do not rule out changing the reinvestment strategy if circumstances warrant, however.

In particular, the Committee is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly. The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do. As I will discuss next, the issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool.

Notwithstanding the fact that the policy rate is near its zero lower bound, the Federal Reserve retains a number of tools and strategies for providing additional stimulus. I will focus here on three that have been part of recent staff analyses and discussion at FOMC meetings: (1) conducting additional purchases of longer-term securities, (2) modifying the Committee’s communication, and (3) reducing the interest paid on excess reserves. I will also comment on a fourth strategy, proposed by several economists–namely, that the FOMC increase its inflation goals.

In my humble opinion those tools carry no risk and provide no reward to the macro economy.

>   
>   (email exchange)
>   
>   On Tue, Aug 24, 2010 at 8:32 AM, Seth wrote:
>   
>   stocks look bad
>   looks like another panic
>   

It doesn’t look good technically.

Must be coming out of europe with gold up/euro down dynamic, etc.

Insiders there must be bailing.

Maybe they know something we don’t, or maybe they are wrong.

History is no help as in the past it’s been both.

Austerity is trimming growth there a bit around the edges, but deficits remain reasonably high, so GDP’s are probably at least muddling through, with overall growth probably positive.

The ECB keeps the short term funding channels open for the member nations, but that may not be fully appreciated yet.

On a mark to market basis bank capital is probably below requirements, and they may not realize that doesn’t have to matter to the real economy for as long as the ECB continues to fund them.

Lower crude oil prices support consumption of other things. With US crude oil product consumption up and Saudi output rising, demand must be ok. Maybe Saudis are worried and want lower prices to help world growth as well. Hard to ever say what they are actually up to. They may see the Iraqi production coming on stream and are trying to engineer an increase in demand. Again, no way to tell what they are up to.

The lower 10 year rates reflects expectations of ‘low for longer’ from the Fed due to high unemployment and falling rates of inflation as measured by the Fed. And the possibility of more QE that could flatten the curve further.

There is also the notion that there’s nothing left that the Fed can do of any consequence regarding aggregate demand, and Congress thinks it’s run out of money, which means flying without a net. That increases the weight of the downside in the balance of risks.

If markets and Congress knew that fiscal policy had no nominal limit and deficit spending was not dependent on being able to borrow from the likes of China to be paid by our grandchildren, the balance of risks would be viewed very differently. But they don’t know that.

With the elections coming and California reverting to vouchers again, the time is right for my per capita revenue sharing. But it’s not even a consideration.

Q3 and Q4 GDP estimates are looking more like 1.5%, and Q2 looks to be revised down toward 1% Friday. Not a double dip but no drop in unemployment either as productivity might be at least that high. That’s worse politically than it is for equities, and adds support for a ’second stimulus’ type of reaction. But that’s way down the road. More likely it causes most of the expiring tax cuts to be extended.

Thursday’s claims can make a big difference as well. The jump to 500,000 last week added an element of fear internationally.

Also, in thin summer markets technicals often cause exaggerated moves. Volume is very low, and a given size buying or selling causes larger moves to find someone willing to take the other side, and momentum type traders can easily overwhelm investors.

The staff still expected that the pace of economic activity through 2011 would be sufficient to reduce the existing margins of economic slack, although the anticipated decline in the unemployment rate was somewhat slower than in the previous projection.

Karim writes:

Table below is average of FOMC members, not staff, but appears to have similar profile. Average expectations for 2011 growth at 3.85% from 3.95% prior..

A few participants cited some risk of deflation. Other participants, however, thought that inflation was unlikely to fall appreciably further given the stability of inflation expectations in recent years and very accommodative monetary policy. Over the medium term, participants saw both upside and downside risks to inflation.

Deflation talk still seems contained to a ‘few’ members.

Members noted that in addition to continuing to develop and test instruments to exit from the period of unusually accommodative monetary policy, the Committee would need to consider whether further policy stimulus might become appropriate if the outlook were to worsen appreciably.

This was only mention of QE2 – not very extensive.

This latest announcement of the purchase of Irish bonds shows the ECB is continuing its policy of buying national govt bonds to facilitate solvency:

EU Headlines:
Europe’s bankers in talks over bail-out fund

Support for European spending cuts strong

European Bank’s Economist Is Optimistic on Sovereign Debt, but Critics Are Wary

EU Ministers Pressured to Give More Stress Test Data

ECB’s Bini Smaghi Favors Lower Deficit Limit for Stability Pact

ECB Buys 8 Billion Euros of Irish Bonds, Sunday Tribune Says

ECB Buys 8 Billion Euros of Irish Bonds, Sunday Tribune Says

July 11 (Bloomberg) — The European Central Bank bought about 8 billion euros ($10.1 billion) of Irish government bonds in the last seven weeks, the Sunday Tribune said, without saying where it got the information. The purchases account for as much as 10 percent of outstanding Irish bonds, the Dublin-based newspaper said.

Euro Central Banks Step Up Bond Buying, Traders Say

By Paul Dobson

June 29 (Bloomberg) — Euro-region central banks stepped up purchases of Greek, Portuguese and Irish government securities today, traders said, deepening efforts to support the region’s bond market in the wake of the sovereign-debt crisis.

The purchases focused on maturities of five years and below, with some buying interest also shown for longer-maturity Greek bonds, said the traders, who declined to be identified because the transactions are confidential. The extra yield, or spread, investors demand to hold the nations’ securities instead of benchmark German debt narrowed.

The European Central Bank took the unprecedented decision to start buying government bonds last month to help the European Union contain the Greek debt crisis. The ECB said yesterday it bought 4 billion euros ($5 billion) of bonds last week, taking the total purchases as of June 25 to 55 billion euros. Greek debt spreads had been widening, approaching their levels before the EU rescue was announced in early May, amid speculation funds that track bond indexes were selling the debt.

Central banks “are more active than they have been of late,” said Huw Worthington, a fixed-income strategist at Barclays Capital in London. “There has been a lot of volatility in a lot of the spreads, and some concerns of selling ahead of the month end.”

Greek two-year notes rose, sending the yield down 41 basis points to 10.19 percent as of 3:43 p.m. in London. The yield spread with German two-year notes fell 39 basis points to 1001 basis points. The yield on 10-year Greek bonds fell 41 basis points to 10.57 percent.

Greek securities will leave indexes managed by Citigroup Inc., Barclays Plc and the Markit iBoxx index at the end of this month after they were downgraded to junk by Moody’s Investors Service, potentially triggering sales by managers in so-called passive funds.

The Irish two-year bond yield fell 11 basis points to 2.88 percent and equivalent-maturity Portuguese yields dropped nine basis points to 3.61 percent.

>   
>   (email exchange)
>   
>   On Mon, Jun 21, 2010 at 6:31 AM, wrote:
>   
>   Soros’s recipe, FYI
>   much about bubbles,
>   also about how bad can be deficit reductions at this time
>   

I usually don’t read or comment on Soros, but comments below this one time only for you.

:)

George Soros Speech

Institute of International Finance, Vienna, Austria
June 10, 2010

In the week following the bankruptcy of Lehman Brothers on September 15, 2008 – global financial markets actually broke down and by the end of the week they had to be put on artificial life support. The life support consisted of substituting sovereign credit for the credit of financial institutions which ceased to be acceptable to counter parties.

As Mervyn King of the Bank of England brilliantly explained, the authorities had to do in the short-term the exact opposite of what was needed in the long-term: they had to pump in a lot of credit to make up for the credit that disappeared and thereby reinforce the excess credit and leverage that had caused the crisis in the first place. Only in the longer term, when the crisis had subsided, could they drain the credit and reestablish macro-economic balance.

Not bad, but he doesn’t seem to understand there is no ‘macro balance’ per se in that regard. He should recognize that what he means by ‘macro balance’ should be the desired level of aggregate demand, which is altered by the public sector’s fiscal balance. So in the longer term, the public sector should tighten fiscal policy (what he calls ‘drain the credit’) only if aggregate demand is deemed to be ‘too high’ and not to pay for anything per se.

This required a delicate two phase maneuver just as when a car is skidding, first you have to turn the car into the direction of the skid and only when you have regained control can you correct course.

It’s more like when you come to an up hill stretch you need to press harder on the gas to maintain a steady speed and if you get going too fast on a down hill section you need to apply the brakes to maintain a steady speed. And for me, the ‘right’ speed is ‘full employment’ with desired price stability.

The first phase of the maneuver has been successfully accomplished – a collapse has been averted.

But full employment has not been restored. I agree this is not the time to hit the fiscal brakes. In fact, I’d cut VAT until output and employment is restored, and offer a govt funded minimum wage transition job to anyone willing and able to work.

In retrospect, the temporary breakdown of the financial system seems like a bad dream. There are people in the financial institutions that survived who would like nothing better than to forget it and carry on with business as usual. This was evident in their massive lobbying effort to protect their interests in the Financial Reform Act that just came out of Congress. But the collapse of the financial system as we know it is real and the crisis is far from over.

Indeed, we have just entered Act II of the drama, when financial markets started losing confidence in the credibility of sovereign debt. Greece and the euro have taken center stage but the effects are liable to be felt worldwide. Doubts about sovereign credit are forcing reductions in budget deficits at a time when the banks and the economy may not be strong enough to permit the pursuit of fiscal rectitude. We find ourselves in a situation eerily reminiscent of the 1930’s. Keynes has taught us that budget deficits are essential for counter cyclical policies yet many governments have to reduce them under pressure from financial markets. This is liable to push the global economy into a double dip.

Yes, and this is an issue specific to govts that are not the issuers of their currency- the US States, the euro zone members, and govts with fixed exchange rates.

It is important to realize that the crisis in which we find ourselves is not just a market failure but also a regulatory failure and even more importantly a failure of the prevailing dogma about financial markets. I have in mind the Efficient Market Hypothesis and Rational Expectation Theory. These economic theories guided, or more exactly misguided, both the regulators and the financial engineers who designed the derivatives and other synthetic financial instruments and quantitative risk management systems which have played such an important part in the collapse. To gain a proper understanding of the current situation and how we got to where we are, we need to go back to basics and reexamine the foundation of economic theory.

I agree, see my proposals here.

I have developed an alternative theory about financial markets which asserts that financial markets do not necessarily tend towards equilibrium; they can just as easily produce asset bubbles. Nor are markets capable of correcting their own excesses. Keeping asset bubbles within bounds have to be an objective of public policy. I propounded this theory in my first book, The Alchemy of Finance, in 1987. It was generally dismissed at the time but the current financial crisis has proven, not necessarily its validity, but certainly its superiority to the prevailing dogma.

First we can always act to sustain aggregate demand and employment at desired levels across any asset price cycle with fiscal policy. No one would have cared much about the financial crisis if we’d kept employment and output high in the real sectors. Note that because output and employment remained high (for whatever reason) through the crash of 1987, the crash of 1998, and the Enron event, they were of less concern than the most recent crisis where unemployment jumped to over 10%.

Let me briefly recapitulate my theory for those who are not familiar with it. It can be summed up in two propositions. First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. This is the principle of fallibility. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced. When there is a significant divergence between market prices and the underlying reality I speak of far from equilibrium conditions. That is where we are now.

I’d say ‘equilibrium’ conditions are necessarily transitory at best under current institutional arrangements, including how policy is determined in Washington and around the world, and continually changing fundamentals of supply and demand.

Second, financial markets do not play a purely passive role; they can also affect the so called fundamentals they are supposed to reflect. These two functions that financial markets perform work in opposite directions. In the passive or cognitive function the fundamentals are supposed to determine market prices. In the active or manipulative function market prices find ways of influencing the fundamentals. When both functions operate at the same time they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other so that neither function has a truly independent variable. As a result neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified.

Goes without saying.

I call the interaction between the two functions reflexivity. Frank Knight recognized and explicated this element of unquantifiable uncertainty in a book published in 1921 but the Efficient Market Hypothesis and Rational Expectation Theory have deliberately ignored it. That is what made them so misleading.

Reflexivity sets up a feedback loop between market valuations and the so-called fundamentals which are being valued. The feedback can be either positive or negative. Negative feedback brings market prices and the underlying reality closer together. In other words, negative feedback is self-correcting. It can go on forever and if the underlying reality remains unchanged it may eventually lead to an equilibrium in which market prices accurately reflect the fundamentals. By contrast, a positive feedback is self-reinforcing. It cannot go on forever because eventually market prices would become so far removed from reality that market participants would have to recognize them as unrealistic. When that tipping point is reached, the process becomes self-reinforcing in the opposite direction. That is how financial markets produce boom-bust phenomena or bubbles. Bubbles are not the only manifestations of reflexivity but they are the most spectacular.

Ok, also seems obvious? Now he need to add that the currency itself is a public monopoly, as the introduction of taxation, a coercive force, introduces ‘imperfect competition’ with ’supply’ of that needed to pay taxes under govt. control. This puts govt in the position of ‘price setter’ when it spends (and/or demands collateral when it lends). And a prime ‘pass through’ channel he needs to add is indexation of public sector wages and benefits.

In my interpretation equilibrium, which is the central case in economic theory, turns out to be a limiting case where negative feedback is carried to its ultimate limit. Positive feedback has been largely assumed away by the prevailing dogma and it deserves a lot more attention.

Even his positive feedback will ‘run its course’ (not to say there aren’t consequences) for the most part if it wasn’t for the fact that the currency itself is a case of monopoly and the govt. paying more for the same thing, for example, is redefining the currency downward.

I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced.

Makes sense.

Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved.

I’d say it’s more like the price gets high enough for the funding to run dry at that price for any reason? Unless funding is coming from/supported by govt (and/or it’s designated agents, etc), the issuer of the currency, that funding will always be limited.

A twilight period ensues during which doubts grow and more and more people lose faith but the prevailing trend is sustained by inertia.

‘Inertia’? It’s available spending power that’s needed to sustain prices of anything. The price of housing sales won’t go up without someone paying the higher price.

As Chuck Prince former head of Citigroup said, “As long as the music is playing you’ve got to get up and dance. We are still dancing.”

This describes the pro cyclical nature of the non govt sectors, which are necessarily pro cyclical. Only the currency issuer can be counter cyclical. Seems to me Minsky has the fuller explanation of all this.

Eventually a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.

The spending power- or the desire to use it- fades.

Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions. Disillusionment turns into panic, reaching its climax in a financial crisis.

The simplest case of a purely financial bubble can be found in real estate. The trend that precipitates it is the availability of credit; the misconception that continues to recur in various forms is that the value of the collateral is independent of the availability of credit. As a matter of fact, the relationship is reflexive. When credit becomes cheaper activity picks up and real estate values rise. There are fewer defaults, credit performance improves, and lending standards are relaxed. So at the height of the boom, the amount of credit outstanding is at its peak and a reversal precipitates false liquidation, depressing real estate values.

It all needs to be sustained by incomes. the Fed’s financial burdens ratios indicate when incomes are being stretched to their limits. The last cycle went beyond actual incomes as mortgage originators were sending borrowers to accountants who falsified income statements, and some lenders were willing to lend beyond income capabilities. But that didn’t last long and the bust followed by months.

The bubble that led to the current financial crisis is much more complicated. The collapse of the sub-prime bubble in 2007 set off a chain reaction, much as an ordinary bomb sets off a nuclear explosion. I call it a super-bubble. It has developed over a longer period of time and it is composed of a number of simpler bubbles. What makes the super-bubble so interesting is the role that the smaller bubbles have played in its development.

Fraud was a major, exaggerating element in the latest go round, conspicuously absent from this analysis.

The prevailing trend in the super-bubble was the ever increasing use of credit and leverage. The prevailing misconception was the believe that financial markets are self-correcting and should be left to their own devices. President Reagan called it the “magic of the marketplace” and I call it market fundamentalism. It became the dominant creed in the 1980s. Since market fundamentalism was based on false premises its adoption led to a series of financial crises.

Again, a financial crisis doesn’t need to ’spread’ to the real economy. Fiscal policy can sustain full employment regardless of the state of the financial sector. Losses in the financial sector need not affect the real economy any more than losses in Las Vegas casinos.

Each time, the authorities intervened, merged away, or otherwise took care of the failing financial institutions, and applied monetary and fiscal stimuli to protect the economy. These measures reinforced the prevailing trend of ever increasing credit and leverage and as long as they worked they also reinforced the prevailing misconception that markets can be safely left to their own devices. The intervention of the authorities is generally recognized as creating amoral hazard; more accurately it served as a successful test of a false belief, thereby inflating the super-bubble even further.

‘Monetary policy’ did nothing and probably works in reverse, as I’ve discussed elsewhere. Fiscal policy does not have to introduce moral hazard issues. It can be used to sustain incomes from the bottom up at desired levels, and not for top down bailouts of failed businesses. Sustaining incomes will not keep an overbought market from crashing, but it will sustain sales and employment in the real economy, with business competing successfully for consumer dollars surviving, and those that don’t failing. That’s all that’s fundamentally needed for prosperity, along with a govt that understands its role in supporting the public infrastructure.

It should be emphasized that my theories of bubbles cannot predict whether a test will be successful or not. This holds for ordinary bubbles as well as the super-bubble. For instance I thought the emerging market crisis of 1997-1998 would constitute the tipping point for the super-bubble, but I was wrong. The authorities managed to save the system and the super-bubble continued growing. That made the bust that eventually came in 2007-2008 all the more devastating.

No mention that the govt surpluses of the late 90’s drained net dollar financial assets from the non govt sectors, with growth coming from unsustainable growth in private sector credit fueling impossible dot com business plans, that far exceeded income growth. When it all came apart after y2k the immediate fiscal adjustment that could have sustained the real economy wasn’t even a consideration.

What are the implications of my theory for the regulation of the financial system?

First and foremost, since markets are bubble-prone, the financial authorities have to accept responsibility for preventing bubbles from growing too big. Alan Greenspan and other regulators have expressly refused to accept that responsibility. If markets can’t recognize bubbles, Greenspan argued, neither can regulators–and he was right. Nevertheless, the financial authorities have to accept the assignment, knowing full well that they will not be able to meet it without making mistakes. They will, however, have the benefit of receiving feedback from the markets, which will tell them whether they have done too much or too little. They can then correct their mistakes.

Second, in order to control asset bubbles it is not enough to control the money supply; you must also control the availability of credit.

Since the causation is ‘loans create deposits’ ‘controlling credit’ is the only way to alter total bank deposits.

This cannot be done by using only monetary tools;

Agreed, interest rates are not all that useful, and probably work in the opposite direction most believe.

you must also use credit controls. The best-known tools are margin requirements

Changing margin requirements can have immediate effects. But if the boom is coming for the likes of pension fund allocations to ‘passive commodity strategies’ driving up commodities prices, which has been a major, driving force for many years now, margin increases won’t stop the trend.

and minimum capital requirements.

I assume that means bank capital. If so, that alters the price of credit but not the quantity, as it alters spreads needed to provide market demanded risk adjusted returns for bank capital.

Currently they are fixed irrespective of the market’s mood, because markets are not supposed to have moods. Yet they do, and the financial authorities need to vary margin and minimum capital requirements in order to control asset bubbles.

Yes, man is naturally a gambler. you can’t stop him. and attempts at control have always been problematic at best.

One thing overlooked is the use of long term contracts vs relying on spot markets. Historically govts have used long term contracts, but for business to do so requires long term contracts on the sales side, which competitive markets don’t allow.

You can’t safely enter into a 20 year contract for plastic for cell phone manufacturing if you don’t know that the price and quantity of cell phones is locked in for 20 years as well, for example. And locking in building materials for housing for 20 years to stabilize prices means less flexibility to alter building methods, etc. But all this goes beyond this critique apart from indicating there’s a lot more to be considered.

Regulators may also have to invent new tools or revive others that have fallen into disuse. For instance, in my early days in finance, many years ago, central banks used to instruct commercial banks to limit their lending to a particular sector of the economy, such as real estate or consumer loans, because they felt that the sector was overheating. Market fundamentalists consider that kind of intervention unacceptable but they are wrong. When our central banks used to do it we had no financial crises to speak of.

True. What the govt creates it can regulate and/or take away. Public infrastructure is to serve further public purpose.

But both dynamic change and static patterns have value and trade offs.

The Chinese authorities do it today, and they have much better control over their banking system. The deposits that Chinese commercial banks have to maintain at the People’s Bank of China were increased seventeen times during the boom, and when the authorities reversed course the banks obeyed them with alacrity.

Yes, and always with something gained and something lost when lending is politicized.

Third, since markets are potentially unstable, there are systemic risks in addition to the risks affecting individual market participants. Participants may ignore these systemic risks in the belief that they can always dispose of their positions, but regulators cannot ignore them because if too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or a collapse. They have to monitor the positions of participants in order to detect potential imbalances. That means that the positions of all major market participants, including hedge funds and sovereign wealth funds, need to be monitored. The drafters of the Basel Accords made a mistake when they gave securities held by banks substantially lower risk ratings than regular loans: they ignored the systemic risks attached to concentrated positions in securities. This was an important factor aggravating the crisis. It has to be corrected by raising the risk ratings of securities held by banks. That will probably discourage loans, which is not such a bad thing.

My proposals, here, limit much of that activity at the source, rather than trying to regulate it, leaving a lot less to be regulated making regulation that much more likely to succeed.

Fourth, derivatives and synthetic financial instruments perform many useful functions but they also carry hidden dangers. For instance, the securitization of mortgages was supposed to reduce risk thru geographical diversification. In fact it introduced a new risk by separating the interest of the agents from the interest of the owners. Regulators need to fully understand how these instruments work before they allow them to be used and they ought to impose restrictions guard against those hidden dangers. For instance, agents packaging mortgages into securities ought to be obliged to retain sufficient ownership to guard against the agency problem.

One of my proposals is that banks not be allowed to participate in any secondary markets, for example

Credit default swaps (CDS) are particularly dangerous they allow people to buy insurance on the survival of a company or a country while handing them a license to kill. CDS ought to be available to buyers only to the extent that they have a legitimate insurable interest. Generally speaking, derivatives ought to be registered with a regulatory agency just as regular securities have to be registered with the SEC or its equivalent. Derivatives traded on exchanges would be registered as a class; those traded over-the-counter would have to be registered individually. This would provide a powerful inducement to use exchange traded derivatives whenever possible.

There is no public purpose served by allowing banks to participate in CDS markets and therefore no reason to allow banks to own any CDS.

Finally, we must recognize that financial markets evolve in a one-directional, nonreversible manner. The financial authorities, in carrying out their duty of preventing the system from collapsing, have extended an implicit guarantee to all institutions that are “too big to fail.” Now they cannot credibly withdraw that guarantee. Therefore, they must impose regulations that will ensure that the guarantee will not be invoked. Too-big-to-fail banks must use less leverage and accept various restrictions on how they invest the depositors’ money. Deposits should not be used to finance proprietary trading. But regulators have to go even further. They must regulate the compensation packages of proprietary traders to ensure that risks and rewards are properly aligned. This may push proprietary traders out of banks into hedge funds where they properly belong. Just as oil tankers are compartmentalized in order to keep them stable, there ought to be firewalls between different markets. It is probably impractical to separate investment banking from commercial banking as the Glass-Steagall Act of 1933 did. But there have to be internal compartments keeping proprietary trading in various markets separate from each other. Some banks that have come to occupy quasi-monopolistic positions may have to be broken up.

Banks should be limited to public purpose as per my proposals, here.

While I have a high degree of conviction on these five points, there are many questions to which my theory does not provide an unequivocal answer. For instance, is a high degree of liquidity always desirable? To what extent should securities be marked to market? Many answers that followed automatically from the Efficient Market Hypothesis need to be reexamined.

Also in my proposals, here.

It is clear that the reforms currently under consideration do not fully satisfy the five points I have made but I want to emphasize that these five points apply only in the long run. As Mervyn King explained the authorities had to do in the short run the exact opposite of what was required in the long run. And as I said earlier the financial crisis is far from over. We have just ended Act Two. The euro has taken center stage and Germany has become the lead actor. The European authorities face a daunting task: they must help the countries that have fallen far behind the Maastricht criteria to regain their equilibrium while they must also correct the deficinies of the Maastricht Treaty which have allowed the imbalances to develop. The euro is in what I call a far-from-equilibrium situation. But I prefer to discuss this subject in Germany, which is the lead actor, and I plan to do so at the Humboldt University in Berlin on June 23rd. I hope you will forgive me if I avoid the subject until then.

We still contend that the world’s economic analysts do not understand the problem with the EMU mechanism, namely that there is no central fiscal authority that is allowed to credit accounts in an unlimited fashion. If you have doubts, please read the article below.

I mentioned when Estonia announced entry three weeks ago that if any sovereign really understood that they were giving up true ability to simply supply all the credits necessary in local currency, versus now having to tax or borrow before you spend (like municipalities), Estonia would not enter.

And please read the underlined portion of the article below. They still position the Euro mechanism weakness as “no policy fits all” or “there is no authority to distribute EU wide tax revenues collected”, or “there is no political union”. It all misses the point.

The U.S., Canada, Japan, Australia and UK do not borrow money. They drain excess reserves by issuing government securities so we can earn interest. Remember, when Japan allowed 30trn of excess reserves by not issuing government securities, the bill auctions were 200 times oversubscribed, even though the bills yielded only 2 or 3bps.

The mechanism is not fixed, the governments have limited resources for obligations, unless they allow the ECB or some other fiscal authority to have unlimited ability to credit accounts.

Thanks, Cliff

Agreed.

They also seem to equate a strong euro with economic prosperity.

What Crisis? The Euro Zone Adds Estonia

June 18 (NYT) —Guess what? The funniest thing happened in Europe on Thursday. A new country joined (yes, joined) the euro zone. And the mood here was upbeat.

With a debt crisis that appears to be spreading from Greece to Spain, membership for the country, Estonia, might seem more curse than blessing. There had been speculation that countries might abandon the single currency. And some doubt Estonia is even ready for the move.

“Maintaining low inflation rates in Estonia will be very challenging,” the European Central Bank warned last month.

Still, the euro remains among the strongest currencies in the world, and membership opens the door to a club with global influence. For small and unsure countries on the fringes of the European Union, it doesn’t get much better — no matter the mounting downsides for countries already on the inside.

“Joining the euro is a status issue for countries seeking to cement their position at Europe’s top table,” said Simon Tilford, the chief economist for the Center for European Reform, a research organization based in London. “But you also could call it sheer bloody-mindedness of Estonia to join now with the outlook for the currency so uncertain.”

Meeting in Brussels, Europe’s 27 governments hailed the “sound economic and financial policies” that had been achieved by Estonia in recent years. They said Estonia would shift from the kroon to the euro on Jan. 1, 2011.

For the leaders of the bloc, expanding the euro zone to 17 nations is tantamount to a show of confidence at an inauspicious time for the battered euro, which has lost about 13 percent of its value against the dollar since the beginning of the year.

“The door to euro membership is not closed because we are going through a sovereign debt crisis,” said Amadeu Altafaj, a spokesman for Olli Rehn, Europe’s commissioner for economic and monetary affairs. “Estonia’s admission is a sign to other countries that our aim is to continue enlarging economic and monetary union through the euro.”

With economic output of about $17 billion, the Estonian economy is tiny. Yet the country’s central bank governor, Andres Lipstok, will now be able to take a seat on the European Central Bank’s powerful council that sets interest rates.

Membership is also an important signpost that a country is on the way to achieving Western European standards of living, an important goal for a former Soviet republic like Estonia that has long been among the Baltic states eager to develop.

Perhaps most important, membership is recognition of the hard work and sacrifice it took to keep Estonia’s bid on track.

Estonia, along with Sweden, were the two countries with the smallest shortfalls between revenue and spending among all members of the 27-member European Union. Moreover, public debt in Estonia at 7.2 percent of gross domestic product is tiny compared with that of most other countries in the bloc.

“It’s a great day for Estonia,” Andrus Ansip, the Estonian prime minister, told Latvian state radio in an interview here.

“We prefer to be inside, to join the club, to be among decision makers.”

Estonia becomes the third ex-Communist state to make the switch to the euro, after Slovenia and Slovakia, but it is the first former Soviet republic to do so, sending a signal to other countries in Central and Eastern Europe that they, too, can aspire to membership.

That said, the euro zone is not expected to expand further for some time to come as other candidates like the Czech Republic, Hungary, Latvia, Lithuania, Bulgaria, Romania and Poland still fall short of the entry criteria partly because of their large budget deficits.

And the accession of Estonia will do little to erase the chief criticism of the euro project: that Europe’s nations are too economically disparate to maintain supranational institutions like a single currency in the long term.

Price stability is one of the main criteria for admission to the euro club. But in the past, political leaders have brushed off concerns from the European Central Bank about candidate nations in their eagerness to expand the euro zone.

Greece won admission even after the central bank reported in 2000 that the country’s debt equaled 104 percent of gross domestic product, far above the limit of 60 percent set out in the Maastricht Treaty. The bank said that Greek inflation met targets only because of declines in oil prices and other exceptional factors.

According to economists, the preparation to join the euro zone created some disadvantages for Estonia compared with neighboring countries, which have enjoyed a relative degree of flexibility by hanging on longer to their legacy currencies for now.

Now that Estonia is joining the euro zone, the most immediate advantages are likely to include greater interest from foreign investors and lower borrowing costs for both the public and private sectors.

But those could be short-term advantages. Estonia and its export-driven economy could be quickly overshadowed by financial difficulties, particularly if the euro zone remains unstable and if neighboring countries like Poland and its Baltic neighbors insist on hanging on to their currencies.

“Investors will only be willing to lend to Estonia on favorable terms if Estonia can continue to compete,” said Mr.

Tilford, the London economist. “That is where the biggest risks for Estonia now lie.”

And there is another downside, Mr. Ansip, the Estonian prime minister, said in the radio interview.

“Our banknotes are more beautiful than euro banknotes,” he said.

The Swiss have been buying euro all along to support their exporters (at the expense of the macro economy but that’s another story).

No doubt other nations are/will do same, also to protect exporters, and do the best they can managing risk of their euro denominated financial asset portfolios.

Over the last two years or so the ‘automatic stabilizers’ in the euro zone added to deficits and weakened the currency, helping to support domestic demand and exports, but threatening solvency as the national govts are credit constrained.

The credit constraint aspect blocked further fiscal easing, and caused a proactive move toward fiscal tightening.

If the easing phase was sufficient to cause them to ‘turn the corner’ with regards to GDP, which appears to be the case, it is possible GDP growth can remain near 0 with the austerity measures, while the firming currency works to slowly cut into exports.

In other words, the euro zone may, in its own way, also be going the way of Japan, but with the extreme downside risk that the austerity measure cut too deep and the deflationary forces get out of hand, as they are flying without a fiscal safety net.

Switzerland’s Gerber Sees ‘Hope’ of SNB Countering Franc Gains

By Simone Meier

June 4 (Bloomberg) — Jean-Daniel Gerber, the Swiss
government’s head of economic affairs, said he’s counting on the
central bank to counter any “excessive” gains of the franc to
protect the country’s export-led recovery.

“I’m of course concerned” about franc gains, Gerber, who
heads the State Secretariat for Economic Affairs, told Cash in
an interview published on the newspaper’s website today. “But
there’s hope that the SNB will be able to keep its promise of
countering an excessive appreciation of the franc.”

The Swiss currency has been pushed higher on concerns that
a Greek debt crisis will spread across the 16-member euro region
and hurt an economic recovery. The Swiss National Bank has
countered franc gains by purchasing billions of euros at an
unprecedented pace to protect exports and fight deflation risks.

The franc today breached 1.40 per euro for the first time
since the single currency was introduced in 1999. It
strengthened to as much as 1.3867 against the euro, trading at
1.3942 at 3:29 p.m. in Zurich.

Gerber said that while it’s “up to the central bank” to
decide on the extent of currency purchases, the SNB’s ability to
counter franc gains is “theoretically unlimited.”

“You can always counter an appreciation if you want to,
you just have to inject money into the market, purchase euros,
and that’s how you’re able to stabilize the value of the franc
versus the euro more or less,” he said. “But of course it
could have considerable negative side effects, namely of larger
liquidity sparking inflation if it isn’t re-absorbed.”

G20 Says Expansionary Fiscal Policy Not Sustainable

The G20 has dropped its support for fiscal expansion. The deficit hawks are prevailing. But why is that? We all either know or should know that operationally Federal spending is not constrained by revenues, as Chairman Bernanke stated last year, when asked on ’60 Minutes’ by Scott Pelley where the funds given to the banks came from :

“…we simply use the computer to mark up the size of the account that they have with the Fed.”

We know that when the Fed spends on behalf of the Treasury it simply credits a member bank or foreign government’s reserve account at the Fed.

We know that a US Treasury security is a credit balance in a securities account, also at the Fed.

We know that buying a Treasury security means US dollars (numbers on the Fed’s spreadsheet) shift from a Fed reserve account to a Fed securities account, which adds to the ‘national debt.’

We know that government deficits = ‘non government’ saving (net dollar financial assets) to the penny, as a matter of national income accounting.

And we know paying off the Treasury securities happens continuously when Treasury securities mature and the Fed simply shifts those US dollars from the securities account back to a Fed reserve account (including the interest).

So why should we care if US dollars are in a Fed reserve account or a Fed securities account?

We should not, yet most still do.

There are two featured sides to the argument, pro and con, deficit hawks and deficit doves. The deficit hawks aren’t the problem. They have no argument that makes any sense as a point of simple monetary operations. There is no such thing as the Federal Government running out of money, being dependent on foreigners or anyone else for funding to be able to spend, and the US is not the next Greece.

The problem is the deficit doves featured by the media don’t understand actual monetary operations and reserve accounting, and so they take the same ‘fundamentally wrong’ positions as the deficit hawks. The difference is nothing more than timing and degree. In effect, the media is showing only one side of the argument.

To be a credible media deficit dove, you agree deficits are ‘bad’ but in the long term, arguing that in the short term we need tax cuts or spending increases now, and deficit reduction later. You agree that deficits can be too high, but argue they have been higher, particularly in World War II, so current levels should be easily manageable, further agreeing there is a level that could not be manageable. You agree markets could be ‘unfriendly’ and a lack of confidence could translate into far higher interest rates, but argue that the current low rates for Treasury securities are the markets telling us that currently they do have confidence in the US and they are eager to fund current deficits. You agree that ‘bang for the buck’ matters and support tax cuts and spending increases based on higher ‘multipliers.’

The two ‘sides of the story’ are in fact on the same side, just with differing degrees. The media does not feature the true deficit dove story. Nor do any of the true doves have even a small piece of the administration’s ear, or the ear of anyone in Congress willing to speak out. There are maybe a hundred of them, including many senior economics professors. The nagging question is why this professional, highly educated, highly experienced collection of true doves, who happen to be correct and could get us back to full employment and prosperity in reasonably short order, does not get a fair hearing.

The answer may be credentials. My BA in Economics from the University of Connecticut in 1971 doesn’t cut it, nor the fact that the very large fund I managed was the highest rated firm for the time I ran it. And my net worth never getting anywhere near a billion hasn’t helped either. Seems billionaires get celebrity status and airtime for just about anything they want to say.

The same is true of the Economics professors who’ve got it right. Without being from and at the usual ‘top tier’ schools none can even get published in main stream economics journals, where submissions featuring obvious accounting realities are routinely rejected. In fact, any economist who states accounting identities and operational realities such as ‘deficits = savings’ or ‘loans create deposits’ or ‘Federal spending is not constrained by revenues’ is immediately labeled ‘heterodox’ and unworthy of serious mainstream consideration. Even the late Wynne Godley, who did have reasonable credentials as head of Cambridge Economics, and was the number one UK economics forecaster, was labeled ‘unorthodox’ because his mathematical models featured the deficits = savings accounting identity.

The breakthrough could happen at any time, in addition to economists at the ‘right schools’ or right financial sector firms, there are government officials with sufficient credentials to lead the breakthrough, including the head of the CBO and OMB, the Treasury Secretary and Fed Chairman, as well as former Fed officials, particularly from monetary operations.

Unfortunately Treasury Secretary Geithner, a potential hero due to the celebrity of his office, and the rest of the G20 are acting out the deficit hawk position, acting as if they do indeed believe the US has run out of money, is dependent on its creditors, and could be the next Greece. They speak as if they have no idea that the euro nations operate within a unique institutional structure that puts them in a ‘revenue constrained’ financial position similar to the US States, but with nothing equivalent to the US Treasury to run the countercyclical deficits for them. They speak as if they have no idea that the US, UK, Japan, and others with ‘normal’ central governments taxes function to regulate aggregate demand, and not to raise revenue per se. They act as if they don’t realize they can immediately make the fiscal adjustments- cut taxes and/or increase government spending- that will restore aggregate demand, employment, and output. In short, they act as if they were all still on the gold standard, an institutional arrangement where indeed government spending was constrained by revenues, and, as a consequence, the world witnessed repetitive, devastating deflationary depressions, far worse than what we’ve seen so far in this cycle.

The results of unnecessarily allowing a universal lack of aggregate demand to persist are already tragic, and if policy continues along the line of this weekend’s G20 results no relief is in sight, and it could all get a whole lot worse.

The euro remains under the cross currents of deflation driven further by the austerity measures that make it stronger.

And portfolio shifting out of euro mainly into dollars and gold out of fears of disintegration and restructuring that are making it weaker.

The latter is currently the stronger force as evidenced by the falling euro and rising price of gold, especially when priced in euro.

It may even be a case of allowing ‘insiders’ to get out and leave the public institutions like banks holding the bag at the point of restructuring at the expense of the remaining shareholders.

The deflation forces are evident in the falling commodity prices, declining equity values, and declining term structures of rates outside of the euro zone, where the politics of fiscal austerity also seem to be getting the upper hand as the world goes the way of Japan.

And each passing day provides more evidence that ultra low overnight rates from central banks are in fact deflationary, probably through the income and cost channels, which allows governments to have a much lower level of taxation for a given level of government spending (higher deficits) to sustain optimal levels of output and employment.

Unfortunately they firmly believe the opposite and continue with their deflationary, overly tight fiscal policies.

And talk coming out of China about ‘monetary easing’ tells me they see reason to be very concerned about their growth as well.

So it looks like the two external threats to the US economy, the euro zone and China, are indeed happening as feared.

Last, on a reread and after discussion, the new Fed swap lines look to be both unsecured and containing rollover language that reads as the foreign central banks being able to roll over their loans in perpetuity meaning they are not loans but one way fiscal transfers from the US to foreign central banks, as repayment is strictly voluntary.

EU Daily

Zapatero Said Sarkozy Threatened to Leave Euro, El Pais Says
ECB’s Trichet Dismisses Inflation Fears
ECB’s Tumpel Says Inflation to Be Fought ‘Without Compromise’
Volcker Sees Euro ‘Disintegration’ Risk From Greece
Trichet Says ECB Plans Time Deposits to Sterilize Buys
ECB Will Give ‘Sterilization’ Details Next Week
Quaden Says Market Reaction to Greece Was Excessive
German Cities’ Deficits to Hit Record in 2010, Rundschau Says
ECB Pares Spanish, Italian Bond Purchases, AFME Says
Constancio Says ECB Will Give Details on Sterilization Soon
Spain’s Core Inflation Turns Negative for First Time

“While each component makes sense in its own narrow terms, the EU policy as a whole is madness for a currency union. Stephen Lewis from Monument Securities says Europe’s leaders have forgotten the lesson of the “Gold Bloc” in the second phase of the Great Depression, when a reactionary and over-proud Continent ground itself into slump by clinging to deflationary totemism long after the circumstances had rendered this policy suicidal. We all know how it ended.”

Ambrose Evans-Pritchard

The meeting took 14 hours and produced numbers large enough and rhetoric credible enough to trigger today’s short covering that might continue at least through half of tomorrow.

But all the actual announced funding comes from the same nations that are having the funding issues. There is no external funding of consequence of national govt borrowing needs coming any source other than the euro governments, nor can there be, as the the funding needs are in euro. And the ECB, the only entity that can provide the euro zone with the needed net financial assets, remains limited to ‘liquidity’ provision which does not address the core funding issue.

Yes, the funding needs have been move evenly distributed among the national governments. But even the financially strongest member, Germany, is structurally in need of continually borrowing increasing quantities of euro to roll over existing debt and fund continuing deficits, with no foreseeable prospects of even stabilizing its debt to GDP ratio or debt to revenue ratio. Adding this new financing burden only makes matters worse, and do the austerity measures now under way in all the member nations.

The one bright spot is the ‘whatever it takes’ language that presumably includes the only move that can make it work financially- actual funding of national govt. debt by the ECB either directly or indirectly through guarantees. But there can be no assurance, of course, that it’s just another bluff to buy time, hoping for a large enough increase in net exports which would be evidence of the rest of the world deciding to reduce its euro net financial assets via the purchase of goods and services from the euro zone.

And with a meaningful increase in exports likely to happen in a meaningful way only with a much lower euro, the terms and conditions of today’s announcements introduce conflicting forces. The austerity measures work to strengthen the euro to the extent they succeed, and to weaken it to the extent they result in increased national govt debt and changes in portfolio preferences.

My best guess is that market forces will soon be testing this new package and its core weaknesses.

Fed throwing unsecured $ loans at the world to keep libor down.

They are all in this way over their heads.

On Sun, May 9, 2010 at 9:09 PM, wrote:

RTRS-BOJ SAYS AGREED WITH CANADA, UK, ECB, FED, SWISS CENTRAL CANKS ON TEMPORARY DOLLAR SWAP AGREEMENT

I now understand it this way:

The IMF creates and allocates new SDR’s to its members.

There is no other source of SDR’s.

SDR’s exist only in accounts on the IMF’s books.

SDR’s have value only because there is an informal agreement between members that they will use their own currency to lend against or buy SDR’s from members the IMF deems in need of funding who also accept IMF terms and conditions.

Originally, in the fixed exchange rate system of that time, this was to help members with balance of payments deficits obtain foreign exchange to buy their own currencies to keep them from devaluation.

The system failed and now the exchange rates are floating.

Currently SDR’s and the IMF are used by members needing help with foreign currency funding needs.

Looks to me like Greece will be borrowing euro from other euro nations using its SDR’s as collateral or selling them to other euro nations.

Either way it’s functionally getting funding from the other euro members.

Greece is also accepting IMF terms and conditions.

The only way the US is involved is if a member attempts to use its SDR’s to obtain $US.

The US is bound only by this informal agreement to accept SDR’s as collateral for $US loans, or to buy SDR for $US.

SDR’s have no intrinsic value and are not accepted for tax payments.

It’s a lot like the regional ‘currencies’ like ‘lets’ and ‘Ithaca dollars’ that are also purely voluntary and facilitate unsecured lending of goods and services with no enforcement in the case of default.

It’s a purely voluntary arrangement which renders all funding as functionally unsecured.

There is no IMF balance sheet involved.

While conceptually/descriptively different than what I erroneously described in my previous post, it is all functionally the same- unsecured lending to Greece by the other euro nations with IMF terms and conditions.

The actual flow of funds and inherent risk is as I previously described.

No dollars leave the Fed, euro are transferred from euro members to Greece.

I apologize for the prior incorrect descriptive information and appreciate any further information anyone might have regarding the actual current arrangements.

Prior post:

I understand it this way:

The US buys SDR’s in dollars.
those dollars exist as deposits in the IMF’s account at the Fed.

The euro members buy SDR’s in euro.
Those euro sit in the IMF’s account at the ECB

The IMF then lends those euro to Greece
They get transferred by the ECB to the Bank of Greece’s account at the ECB.

The IMF’s dollars stay in the IMF’s account at the Fed.

They can only be transferred to another account at the Fed by the Fed.

U.S. taxpayers are helping finance Greek bailout

By Senator Jim DeMint

May 6 — The International Monetary Fund board has approved a $40 billion bailout for Greece, almost one year after the Senate rejected my amendment to prohibit the IMF from using U.S. taxpayer money to bailout foreign countries.

Congress didn‚t learn their lesson after the $700 billion failed bank bailout and let world leaders shake down U.S taxpayers for international bailout money at the G-20 conference in April 2009. G-20 Finance Ministers and Central Bank Governors asked the United States, the IMF‚s largest contributor, for a whopping $108 billion to rescue bankers around the world and the Obama Administration quickly obliged.
Rather than pass it as stand-alone legislation, President Obama asked Congress to fold the $108 billion into a war-spending bill to send money to our troops.

It was clear such an approach would simply repeat the expensive mistake of the failed Wall Street bailouts with banks in other nations. Think of it as an international TARP plan, another massive rescue package rushed through with little planning or debate. That‚s why I objected and offered an amendment to take it out of the war bill. But the Democrat Senate voted to keep the IMF bailout in the war spending bill. 64 senators voted for the bailout, 30 senators voted against it.

Only one year later, the IMF is sending nearly $40 billion to bailout Greece, the biggest bailout the IMF has ever enacted.

Right now, 17 percent of the IMF funding pool that the $40 billion bailout is being drawn from comes from U.S. taxpayers. If that ratio holds true, that means American taxpayers are paying for $6.8 billion of the Greek bailout. Although the $108 billion extra that Congress approved for the IMF in 2009 hasn‚t yet gone into effect, you can bet that once it does Greek bankers will come to the IMF again with their hat in hand. And, if other European Union countries see free money up for grabs they could ask the IMF for bailouts when they get into trouble, too. If we‚ve learned anything from the Wall Street bailouts it‚s that just one bailout is never enough.
To hide the bailout from Americans already angry with the $700 billion bank bailout, Congress classified it as an „expanded credit line.‰ The Congressional Budget Office only scored it as $5 billion because IMF agreed to give the United States a promissory note for the rest of the bill.
As the Wall Street Journal wrote at the time, „If it costs so little, why not make it $200 billion. Or a trillion? It‚s free!‰

Of course, money isn‚t free and there are member nations of the IMF that won‚t be in a hurry to pay it back. Three state sponsors of terrorism, Iran, Syria and Sudan, are a part of the IMF. Iran participates in the IMF‚s day-to-day activities as a member of its executive board.

If the failed bank bailout and stimulus bill wasn‚t enough to prove to Americans the kind of misguided, destructive spending that goes on in Washington this will: The Democrat Congress, aided by a few Republicans, used a war spending bill to send bailout money to an international fund that‚s partially-controlled by our enemies.

America can‚t afford to bail out foreign countries with borrowed dollars from China and certainly shouldn‚t allow state sponsors of terror a hand in that process.

This has to stop if we are going to survive as a nation. Congress won‚t act stop such foolishness on its own. The only way Americans can stop this is by sending new people to Washington in November who will.

Sen. Jim DeMint is a Republican U.S. Senator from South Carolina.

I wrote this in 2001, the euro has been an accident waiting to happen.

It’s an unstable equilibrium, as Mike just reminded me I used to say.

Like balancing a marble on top of an upside down bowl, if it starts to go it accelerates downward

Vs the dollar, a stable equilibrium system, which is like placing a marble in a bowl right side up, and any movement meets forces which brings it back to the starting point.

And like many ponzi schemes, it works just fine on the way up, and can go on a long time before it crumbles.

Rites of Passage

The Child of Consensus

Conceived in post WWII politics, and baptized in the political waters of the 90’s, a new common currency- the euro- assumed its position on January 1, 1999. Representatives of the prospective member nations masterfully achieved political consensus by both the absence of objectionable clauses and the inclusion of national constraints, as manifested in the Treaty of Maastricht. During that tumultuous process, with deep pride, the elders grasped and shielded the credit sensitive heel of the infant euro. The ‘no bailout’ directive for the new ECB (European Central Bank) emerged as a pillar of the political imperative to address the ‘moral hazard’ issue that so deeply concerned the political leadership, and, two years later, that same rhetoric of fiscal responsibility continues to ring at least as loudly when the merits of the EMU (European Monetary Union) are proclaimed. Unfortunately, however well intended as protection from a genetic proclivity toward fiscal irresponsibility, the naked heel is but a magnet for the financial market’s arrows of our hero’s mortal demise.

As Apollo’s chariot adeptly carries its conflagration from east to west, the European Monetary Union carries its members on the path of economic growth. Unlike the path of the sun, however, the path of an economy continuously vacillates, including occasional dips into negative territory. And, like the sign most rental car agencies post by the entrance for returning cars about to drive over a one way bump strip, the new EMU, with its lurking unidirectional bias, could do a service to it members with a similar posting – WARNING- DO NOT BACK UP!

The Dynamics of the Instability

The euro-12 nations once had independent monetary systems, very much like the US, Canada, and Japan today. Under EMU, however, the national governments are now best thought of financially as states, provinces, or cities of the new currency union, much like California, Ontario, and New York City. The old national central banks are no longer the issuers of their local currency. In their place, the EMU has added a new central bank, the ECB, to manage the payments system, set the overnight lending rate, and intervene in the currency markets when appropriate. The EP (European Parliament) has a relatively small budget and limited fiscal responsibilities. Most of the governmental functions and responsibilities remain at the national level, having not been transferred to the new federal level. Two of those responsibilities that will prove most problematic at the national level are unemployment compensation and bank deposit insurance. Furthermore, all previous national financial liabilities remain at the national level and have been converted to the new euro, with debt to GDP ratios of member nations as high as 105%, not including substantial and growing unfunded liabilities. These burdens are all very much higher than what the credit markets ordinarily allow states, provinces, or cities to finance.

Since inception a little over two years ago the euro-12 national governments have experienced moderate GDP growth, declining unemployment, and moderate tax revenue growth. Fiscal deficits narrowed and all but vanished as tax revenues grew faster than expenditures, and GDP increased at a faster rate than the national debts, so that debt to GDP ratios declined somewhat. Under these circumstances investors have continued to support national funding requirements and there have been no substantive bank failures. Furthermore, it is reasonable to assume that as long as this pattern of growth continues finance will be readily available. However, should the current world economic slowdown move the euro-12 to negative growth, falling tax revenues, and concerns over the banking system’s financial health, the euro-12 could be faced with a system wide liquidity crisis. At the same time, market forces can also be expected to exacerbate the downward spiral by forcing the national governments to act procyclically, either by cutting national spending or attempting to increase revenue.

For clues to the nature and magnitude of the potential difficulties, one can review the US Savings and Loan crisis of the 80’s, with the difference being that deposit insurance would have been a state obligation, rather than a federal responsibility. For example, one could ask how Texas might have fared when faced with a bill for some $100 billion to cover bank losses and redeem depositors? And, once it was revealed that states could lack the borrowing power for funds to preserve depositors insured accounts, how could any bank have funded itself? More recently, if Bank of America’s deposit insurer and lender of last resort were the State of California rather than the Federal Reserve, could it have funded itself under the financial cloud of the state’s ongoing power crisis and credit downgrade? And, if not, would that have triggered a general liquidity crisis within the US banking system? Without deposit insurance and lender of last resort responsibilities the legal obligation of a non-credit constrained entity, such as the Federal Reserve, is systemic financial risk not ever present?

The inherent instability can be expressed as a series of questions:
*Will the euro-12 economy slow sufficiently to automatically increase national deficits via the reduction of tax revenues and increased transfer payments?
*Will such a slowdown cause the markets to dictate terms of credit to the credit sensitive national governments, and force procyclical responses?
*Will the slowdown lead to local bank failures?
*Will the markets allow national governments with heavy debt burdens, falling revenues and rising expenses the finance required to support troubled banks?
*Will depositors lose confidence in the banking system and test the new euro-12 support mechanism?
*Can the entire payments system avoid a shutdown when faced with this need to reorganize?

Conclusion

Water freezes at 0 degrees C. But very still water can be cooled well below that and stay liquid until a catalyst, such as a sudden breeze, causes it to instantly solidify. Likewise, the conditions for a national liquidity crisis that will shut down the euro-12’s monetary system are firmly in place. All that is required is an economic slowdown that threatens either tax revenues or the capital of the banking system.
A prosperous financial future belongs to those who respect the dynamics and are prepared for the day of reckoning. History and logic dictate that the credit sensitive euro-12 national governments and banking system will be tested. The market’s arrows will inflict an initially narrow liquidity crisis, which will immediately infect and rapidly arrest the entire euro payments system. Only the inevitable, currently prohibited, direct intervention of the ECB will be capable of performing the resurrection, and from the ashes of that fallen flaming star an immortal sovereign currency will no doubt emerge.

Warren Mosler
May 1, 2001

Yet Another ‘Innocent Fraud’ Attack On Social Security And Medicare

The Future of Public Debt

By John Mauldin

For the rest of this letter, and probably next week as well, we are going to look at a paper from the Bank of International Settlements, often thought of as the central bankers’ central bank. This paper was written by Stephen G. Cecchetti, M. S. Mohanty, and Fabrizio Zampolli. ( http://www.bis.org/publ/work300.pdf?noframes=1)

The paper looks at fiscal policy in a number of countries and, when combined with the implications of age-related spending (public pensions and health care), determines where levels of debt in terms of GDP are going. The authors don’t mince words. They write at the beginning:

“Our projections of public debt ratios lead us to conclude that the path pursued by fiscal authorities in a number of industrial countries is unsustainable.

Solvency is never the issue with non convertible currencies/ floating exchange rates. The risk is entirely inflation, yet I’ve never seen a manuscript critical of deficit spending that seriously looks at the inflation issue apart from solvency concerns.

Drastic measures are necessary to check the rapid growth of current and future liabilities of governments and reduce their adverse consequences for long-term growth and monetary stability.”

The negative consequences are always due to the moves presumed necessary to reduce deficits, not deficit spending per se.

Drastic measures is not language you typically see in an economic paper from the BIS. But the picture they paint for the 12 countries they cover is one for which drastic measures is well-warranted.

That would mean a hyper inflation scare, not solvency fear mongering.

I am going to quote extensively from the paper, as I want their words to speak for themselves, and I’ll add some color and explanation as needed. Also, all emphasis is mine.

“The politics of public debt vary by country. In some, seared by unpleasant experience, there is a culture of frugality. In others, however, profligate official spending is commonplace. In recent years, consolidation has been successful on a number of occasions. But fiscal restraint tends to deliver stable debt;

Stable public debt means stable non govt nominal savings with economies that require expanding net financial assets to support expanding credit structures and offset institutional demand leakages.

rarely does it produce substantial reductions. And, most critically, swings from deficits to surpluses have tended to come along with either falling nominal interest rates, rising real growth, or both. Today, interest rates are exceptionally low and the growth outlook for advanced economies is modest at best. This leads us to conclude that the question is when markets will start putting pressure on governments, not if.

Govts with non convertible currency/floating fx are not subject to pressure from markets with regards to funding or interest rates.

“When, in the absence of fiscal actions, will investors start demanding a much higher compensation for the risk of holding the increasingly large amounts of public debt that authorities are going to issue to finance their extravagant ways?

Investors have to take what’s offered, or exit the currency by selling it so someone else. And floating exchange rates continuously express the indifference levels

In some countries, unstable debt dynamics, in which higher debt levels lead to higher interest rates, which then lead to even higher debt levels, are already clearly on the horizon.

Only countries such as the euro zone members who are not the issuer of the euro, but users of the euro. They are analogous to us states in that regard, and are credit sensitive entities.

“It follows that the fiscal problems currently faced by industrial countries need to be tackled relatively soon and resolutely.

Agreed, except fiscal drag needs to be removed to restore private sector output and employment. They have this backwards.

Failure to do so will raise the chance of an unexpected and abrupt rise in government bond yields at medium and long maturities, which would put the nascent economic recovery at risk.

Like Japan? Triple the ‘debt’ of the US with a 1.3% 10 year note? And never a hint of missing a payment. And Japan, the US, UK, etc. all have the same institutional structure.

It will also complicate the task of central banks in controlling inflation in the immediate future and might ultimately threaten the credibility of present monetary policy arrangements.

Yes, inflation is the potential risk, which is mainly a political risk. People don’t like inflation and will topple a govt over it. But there is no economic evidence that inflation is a negative for growth and employment.

“While fiscal problems need to be tackled soon, how to do that without seriously jeopardising the incipient economic recovery is the current key challenge for fiscal authorities.”

Yes, exactly. Because they have it wrong. The fiscal problem that has to be tackled soon is that it’s too tight, as evidenced by the high rates of unemployment.

They start by dealing with the growth in fiscal (government) deficits and the growth in debt. The US has exploded from a fiscal deficit of 2.8% to 10.4% today, with only a small 1.3% reduction for 2011 projected. Debt will explode (the correct word!) from 62% of GDP to an estimated 100% of GDP by the end of 2011.

Yes, and not nearly enough, as unemployment is projected to still be over 9%, and core inflation is what is considered to be dangerously low.

Remember that Rogoff and Reinhart show that when the ratio of debt to GDP rises above 90%, there seems to be a reduction of about 1% in GDP. The authors of this paper, and others, suggest that this might come from the cost of the public debt crowding out productive private investment.

Can be true for fixed exchange rate regimes/convertible currency, but not true for today’s non convertible currency and floating fx regimes. And today, deficits generally rise due to slowdowns that drive up transfer payments and cut revenues ‘automatically’ (automatic stabilizers) so it’s no mystery that rising deficits are associated with slowing economies, but the causation is the reverse RR imply.

Think about that for a moment. We are on an almost certain path to a debt level of 100% of GDP in less than two years. If trend growth has been a yearly rise of 3.5% in GDP, then we are reducing that growth to 2.5% at best. And 2.5% trend GDP growth will NOT get us back to full employment. We are locking in high unemployment for a very long time, and just when some one million people will soon be falling off the extended unemployment compensation rolls.

Nothing that a sufficient tax cut won’t cure. There is a screaming shortage of aggregate demand that’s easily restored by a simple fiscal adjustment- tax cut and/or spending increase.

Government transfer payments of some type now make up more than 20% of all household income. That is set up to fall rather significantly over the year ahead unless unemployment payments are extended beyond the current 99 weeks. There seems to be little desire in Congress for such a measure. That will be a significant headwind to consumer spending.

Yes, backwards policy. They need to work to restore demand, not reduce it.

My first proposal is for a full payroll tax (fica) holiday, for example.

Government debt-to-GDP for Britain will double from 47% in 2007 to 94% in 2011 and rise 10% a year unless serious fiscal measures are taken.

Or unless the economy rebounds. In that case the deficit comes down and the danger is they let it fall too far as happens with every cycle.

Greece’s level will swell from 104% to 130%,

Yes, and they are credit sensitive like the US states.
This is ponzi.
Ponzi is when you must borrow to pay maturing debt

The US, UK, Japan, etc. Have no borrowing imperative to pay debt, the way Greece does.
They make all payments the same way- they just mark up numbers on their computers at their own central banks:

(SCOTT PELLEY) Is that tax money that the Fed is spending?
(CHAIRMAN BERNANKE) It’s not tax money. The banks have accounts with the Fed, much the same way that you have an account in a commercial bank. So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed.

Bernanke didn’t call china to beg for a loan or check with the IRS to see if they could bring in some quick cash. He just changed numbers up with his computer.

so the US and Britain are working hard to catch up to Greece, a dubious race indeed.

Confused!

Spain is set to rise from 42% to 74% and “only” 5% a year thereafter; but their economy is in recession, so GDP is shrinking and unemployment is 20%. Portugal? 71% to 97% in the next two years, and there is almost no way Portugal can grow its way out of its problems.

Yes, they are in Ponzi

Japan will end 2011 with a debt ratio of 204% and growing by 9% a year. They are taking almost all the savings of the country into government bonds, crowding out productive private capital.

Nothing is crowded out with non convertible currency and floating fx. Banks have no shortage of yen lending power. The yen the govt net spends can be thought of as the yen that buy the jgb’s (japan govt bonds)

Reinhart and Rogoff, with whom you should by now be familiar, note that three years after a typical banking crisis the absolute level of public debt is 86% higher, but in many cases of severe crisis the debt could grow by as much as 300%. Ireland has more than tripled its debt in just five years.

Ireland is in Ponzi as they are users of the euro.

The BIS continues:

“We doubt that the current crisis will be typical in its impact on deficits and debt. The reason is that, in many countries, employment and growth are unlikely to return to their pre-crisis levels in the foreseeable future. As a result, unemployment and other benefits will need to be paid for several years, and high levels of public investment might also have to be maintained.

“The permanent loss of potential output caused by the crisis also means that government revenues may have to be permanently lower in many countries. Between 2007 and 2009, the ratio of government revenue to GDP fell by 2-4 percentage points in Ireland, Spain, the United States and the United Kingdom.

Again, failure to recognize the critical differences between issuers and users of the currency.

It is difficult to know how much of this will be reversed as the recovery progresses. Experience tells us that the longer households and firms are unemployed and underemployed, as well as the longer they are cut off from credit markets, the bigger the shadow economy becomes.”

Yes, responsible fiscal policy would not have let demand fall this far. The US should have had a full payroll tax holiday no later than sept 08, and most of the damage to the real economy would have been avoided.

We are going to skip a few sections and jump to the heart of their debt projections. Again, I am going to quote extensively, and my comments will be in brackets [].Note that these graphs are in color and are easier to read in color (but not too difficult if you are printing it out). Also, I usually summarize, but this is important. I want you to get the full impact. Then I will make some closing observations.

The Future Public Debt Trajectory

“We now turn to a set of 30-year projections for the path of the debt/GDP ratio in a dozen major industrial economies (Austria, France, Germany, Greece, Ireland, Italy, Japan, the Netherlands, Portugal, Spain, the United Kingdom and the United States). We choose a 30-year horizon with a view to capturing the large unfunded liabilities stemming from future age-related expenditure without making overly strong assumptions about the future path of fiscal policy (which is unlikely to be constant). In our baseline case, we assume that government total revenue and non-age-related primary spending remain a constant percentage of GDP at the 2011 level as projected by the OECD. Using the CBO and European Commission projections for age-related spending, we then proceed to generate a path for total primary government spending and the primary balance over the next 30 years. Throughout the projection period, the real interest rate that determines the cost of funding is assumed to remain constant at its 1998-2007 average, and potential real GDP growth is set to the OECD-estimated post-crisis rate.

[That makes these estimates quite conservative, as growth-rate estimates by the OECD are well on the optimistic side.]

Yes, future liabilities are always quoted in isolation from future demand leakages including growth of reserves in pension funds, insurance companies, corps, foreign govts, etc.

And they are always used to imply solvency issues. No actual calculations are ever done regarding inflation.

Debt Projections

“From this exercise, we are able to come to a number of conclusions. First, in our baseline scenario, conventionally computed deficits will rise precipitously. Unless the stance of fiscal policy changes, or age-related spending is cut, by 2020 the primary deficit/GDP ratio will rise to 13% in Ireland; 8-10% in Japan, Spain, the United Kingdom and the United States; [Wow!] and 3-7% in Austria, Germany, Greece, the Netherlands and Portugal. Only in Italy do these policy settings keep the primary deficits relatively well contained – a consequence of the fact that the country entered the crisis with a nearly balanced budget and did not implement any real stimulus over the past several years.

Yes, this is big trouble for the solvency of the euro zone members, but not the rest.

“But the main point of this exercise is the impact that this will have on debt. The results plotted as the red line in Graph 4 [below] show that, in the baseline scenario, debt/GDP ratios rise rapidly in the next decade, exceeding 300% of GDP in Japan; 200% in the United Kingdom; and 150% in Belgium, France, Ireland, Greece, Italy and the United States. And, as is clear from the slope of the line, without a change in policy, the path is unstable. This is confirmed by the projected interest rate paths, again in our baseline scenario. Graph 5 [below] shows the fraction absorbed by interest payments in each of these countries.From around 5% today, these numbers rise to over 10% in all cases, and as high as 27% in the United Kingdom.

“Seeing that the status quo is untenable, countries are embarking on fiscal consolidation plans. In the United States, the aim is to bring the total federal budget deficit down from 11% to 4% of GDP by 2015. In the United Kingdom, the consolidation plan envisages reducing budget deficits by 1.3 percentage points of GDP each year from 2010 to 2013 (see eg OECD (2009a)).

Why would anyone who understood actual monetary operations want to increase fiscal drag with elevated unemployment and excess capacity .

“To examine the long-run implications of a gradual fiscal adjustment similar to the ones being proposed, we project the debt ratio assuming that the primary balance improves by 1 percentage point of GDP in each year for five years starting in 2012. The results are presented as the green line in Graph 4. Although such an adjustment path would slow the rate of debt accumulation compared with our baseline scenario, it would leave several major industrial economies with substantial debt ratios in the next decade.

“This suggests that consolidations along the lines currently being discussed will not be sufficient to ensure that debt levels remain within reasonable bounds over the next several decades.

“An alternative to traditional spending cuts and revenue increases is to change the promises that are as yet unmet. Here, that means embarking on the politically treacherous task of cutting future age-related liabilities.

Here we go- this is too often the ‘hidden agenda’

It’s all about cutting social security and medicare.

Who would have thought!!!

Yes, the euro zone’s institutional arrangements that make member govt spending revenue constrained have it on the road to collapse, maybe very soon, and for reasons other than long term liabilities.

The rest of the world doesn’t have that issue, as govt spending is not revenue constrained, and the risk to prosperity is acting as if we all have the same revenue constraints as the euro zone.

With this possibility in mind, we construct a third scenario that combines gradual fiscal improvement with a freezing of age-related spending-to-GDP at the projected level for 2011. The blue line in Graph 4 shows the consequences of this draconian policy. Given its severity, the result is no surprise: what was a rising debt/GDP ratio reverses course and starts heading down in Austria, Germany and the Netherlands. In several others, the policy yields a significant slowdown in debt accumulation. Interestingly, in France, Ireland, the United Kingdom and the United States, even this policy is not sufficient to bring rising debt under control.

Greece CAN Go it Alone
Yesterday at 5:00pm
By Marshall Auerback and Warren Mosler

Greece can successfully issue and place new debt at low interest rates. The trick is to insert a provision stating that in the event of default, the bearer on demand can use those defaulted securities to pay Greek government taxes. This makes it immediately obvious to investors that those new securities are ‘money good’ and will ultimately redeem for face value for as long as the Greek government levies and enforces taxes. This would not only allow Greece to fund itself at low interest rates, but it would also serve as an example for the rest of the euro zone, and thereby ease the funding pressures on the entire region.

We recognize, of course, that this proposal would also introduce a ‘moral hazard’ issue. This newly found funding freedom, if abused, could be highly inflationary and further weaken the euro. In fact, the reason the ECB is prohibited from buying national government debt is to allow ‘market discipline’ to limit member nation fiscal expansion by the threat of default. When that threat is removed, bad behavior is rewarded, as the country that deficit spends the most wins, in an accelerating and inflationary race to the bottom.
It is comparable to a situation where a nation like the US, for example, did not have national insurance regulation. In this kind of circumstance, the individual states got into a race to the bottom, where the state with the laxest standards stood to attract the most insurance companies, forcing each State to either lower standards or see its tax base flee. And it tends to end badly with AIG style collapses.

Additionally, the ECB or the Economic Council of Finance Ministers (ECOFIN) effectively loses the means to enforce their austerity demands and keep them from being reversed once it’s known they’ve taken the position that it’s too risky to let any one nation fail.

What Europe’s policy makers would like to do is find a way to isolate Greece and mitigate the contagion effect, while maintaining the market discipline that comes from the member nations being the credit sensitive entities they are today; hence, the mooted “shock and awe” proposals now being leaked, which did engender an 8% jump in the Greek stock market on Thursday.

But these proposals don’t really get to the nub of the problem. Any major package weakens the others who have to fund it in the market place, because the other member nations are also revenue dependent, credit sensitive entities. Much like the US States, they do not control central bank operations, and must have good funds in their accounts or their checks will bounce.

The euro zone nations are all still in a bind, and their mandated austerity measures mean they don’t keep up with a world recovery. And Greek financial restructuring that reduces outstanding debt reduces outstanding euro financial assets, strengthening the euro, and further weakening output and employment, while at the same time the legitimization of restructuring risk weakens the credit worthiness of all the member nations.

It does not appear that the markets have fully discounted the ramifications of a Greek default. If you use a Chapter 11 bankruptcy analogy, large parts of the country would be shut down and the “company” (i.e. Greece Inc) could spend only its tax revenues. But the implied spending cuts represent a further substantial cut in aggregate demand and decreased revenues, in a most un-virtuous spiral that ends only with an increase in exports or privation driven revolt.

The ability of Greece to use the funds from the rescue package as a means to extinguish Greek state liabilities would improve their financial ratios and stave off financial collapse, at least on a short term basis, with the side effect of a downward spiral in output and employment, while the sovereign risk concerns are concurrently transmitted to Spain, Portugal, Ireland, Italy, and beyond. Those sovereign difficulties also morph into a full-scale private banking crisis which can quickly extend to bank runs at the branch level.

Our suggestion will rescue Greece and the entire euro zone from the dangers of national government insolvencies, and turn the euro zone policy maker’s attention 180 degrees, back to their traditional role of containing the potential moral hazard issue of excessive deficit spending by the national governments through the Stability and Growth Pact. If the member states ultimately decide that the Stability and Growth Pact ratios need to be changed, that’s their decision. But the SGP represents the euro zone’s “national budget”, precisely designed to prevent the hyperinflationary outcome that the “race to the bottom” could potentially create. At the very least, our proposal will mitigate the deflationary impact of markets disciplining credit sensitive national governments and halting the potential spread of global financial contagion, without being inflationary.

This one’s for the bloggers-

Dollar swap lines are functionally unsecured loans to foreign govts. that the Fed can do unilaterally. Congress only finds out well after the fact. Last time around they did $600 billion, including lending (unsecured) to nations Congress never would have approved.

The problem is the Fed Chairman insists they are secured because we get local currency deposits at the foreign central bank as collateral.

That’s like putting up your watch as collateral for a loan but you still wear it.

Chatter About the Fed/ECB CCY Swap Line
If reinstituted, it is a basic spot/forward FX trading line.

What this does is to give the ECB the power to lend USD in Europe. It
has 2 potential benefits:

1.Not all banks in Europe who require USD funding has access to the Fed
or the FF market

2.They don’t have to wait until NY opens if panic breaks out in Europe
over USD funding.

There is a third benefit. Politics. It let’s the market know that the
central banks are on the case, and the Fed doesn’t want to see the
FRA-OIS spread spin out of control.

Fed also re opening swap lines to ECB – looks ready to do more unsecured dollar lending to them and maybe others.

They look to be doing what they did last time around to keep libor down – lend unsecured to bad credits. High risk but it does get rates down.

On Fri, Apr 30, 2010 at 12:23 PM, Jason wrote:

Confluence of events..


Month end bid for treasuries
Goldman stock down 14 and financial CDS wider creating some fears for financial sector
Greece flight to quality concerns going into the weekend

Fed to begin expanding the Term deposit facility which will remove excess cash and remove downward pressure on term LIBOR

LIBOR quoted for Monday as 35.375 / 35.5 +1

1y OIS-LIBOR 5 day chart:

Result

2y spreads leading the way wider +5 to 23.5

Still cheap though

Press Release
Release Date: April 30, 2010


For immediate release
The Federal Reserve Board has approved amendments to Regulation D (Reserve Requirements of Depository Institutions) authorizing the Reserve Banks to offer term deposits to institutions that are eligible to receive earnings on their balances at Reserve Banks. These amendments incorporate public comments on the proposed amendments to Regulation D that were announced on December 28, 2009.

Term deposits, which are deposits with specified maturity dates that are held by eligible institutions at Reserve Banks, will be offered through a Term Deposit Facility (TDF). Term deposits will be one of several tools that the Federal Reserve could employ to drain reserves when policymakers judge that it is appropriate to begin moving to a less accommodative stance of monetary policy. The development of the TDF is a matter of prudent planning and has no implication for the near-term conduct of monetary policy.

The amendments approved by the Board are a necessary step in the implementation of the TDF. As noted in the attached Federal Register notice, the Federal Reserve anticipates that it will conduct small-value offerings of term deposits under the TDF in coming months to ensure the effective operation of the TDF and to help eligible institutions to become familiar with the term-deposit program. More detailed information about the structure and operation of the TDF, including information on the steps necessary for eligible institutions to participate in the program, will be provided later.

The amendments will be effective 30 days after publication in the Federal Register, which is expected shortly.

Yes, his causation is off on the less important point of the central bank eliminating opportunity costs when in fact market forces eliminate opportunity cost as they express indifference levels to central bank rate policies.

But apart from that it’s very well stated and what we’ve been saying all along, thanks!!! The highlighted part is especially on message and hopefully becomes common knowledge.

Jaime Caruana, General Manager of the BIS says ‘unconventional
measures’ do not increase lending, nor are inflationary:

In fact, bank lending is determined by banks’ willingness to grant
loans, based on perceived risk-return trade-offs, and by the demand
for those loans. An expansion of reserves over and above the level
demanded for precautionary purposes, and/or to satisfy any reserve
requirement, need not give banks more resources to expand lending.
Financing the change in the asset side of the central bank balance
sheet through reserves rather than some other short-term instrument
like central bank or Treasury bills only alters the composition of the
liquid assets of the banking system. As noted, the two are very close
substitutes. As a result, the impact of variations in this composition
on bank behaviour may not be substantial.

This can be seen another way. Recall that in order to finance balance
sheet policy through an expansion of reserves the central bank has to
eliminate the opportunity cost of holding them. In other words, it
must either pay interest on reserves at the positive overnight rate
that it wishes to target, or the overnight rate must fall to the
deposit facility floor (or zero). In effect, the central bank has to
make bank reserves sufficiently attractive compared with other liquid
assets. This makes them almost perfect substitutes, in particular for
other short-term government paper. Reserves become just another type
of liquid asset among many. And because they earn the market return,
reserves represent resources that are no more idle than holdings of
Treasury bills.

(…) What about the concern that large expansions in bank reserves
will lead to inflation – the second issue? No doubt more accommodative
financial conditions resulting from central bank lending and asset
purchases, insofar as they stimulate aggregate demand, can generate
inflationary pressures. But the point I would like to make here is
that there is no additional inflationary effect coming from an
increase in reserves per se. When bank reserves are expanded as part
of balance sheet policies, they should be viewed as simply another
form of liquid asset that is comparable to short-term government
paper. Thus funding balance sheet policies with reserves should be no
more inflationary than, for instance, the issuance of short-term
central bank bills.

(…) Ultimately, any inflationary concerns associated with
monetisation should be mainly attributed to the monetary authorities’
accommodating fiscal deficits by refraining from raising rates. In
other words, it is not so much the financing of government spending
per se – be it in the form of bank reserves or short-term sovereign
paper – that is inflationary, but its accommodation at inappropriately
low interest rates for too long a time. Critically, these two aspects
are generally lumped together in policy debates because the prevailing
paradigm has failed to distinguish changes in interest rate from
changes in the amount of bank reserves in the system. One is seen as
the dual of the other: more reserves imply lower interest rates. As I
explained earlier, this is not the case. While both the central bank’s
balance sheet size and the level of reserves will reflect an
accommodating policy, neither serves as a summary measure of the
stance of policy.