Series of audio interviews with Warren.

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The Fed has a dual mandate of full employment and price stability. Both are still moving the wrong way for a hike.

When they move it will likely be based on their forecasts, which remain well on the dovish side.

Karim writes:

STAFF

..the projected pace of real output growth in 2010 and 2011 was expected to exceed that of potential output by only enough to produce a very gradual reduction in economic slack.

…the staff continued to project that core inflation would slow somewhat from its current pace over the next two years. Moreover, the staff expected that headline consumer price inflation would decline to about the same rate as core inflation in 2010 and 2011.

FOMC

..some participants remained concerned about the economy’s ability to generate a self-sustaining recovery without government support. In particular, they noted the risk that improvements in the housing sector might be undercut next year as the Federal Reserve’s purchases of MBS wind down, the homebuyer tax credits expire, and foreclosures and distress sales continue. Though the near-term outlook remains uncertain, participants generally thought the most likely outcome was that economic growth would gradually strengthen over the next two years as financial conditions improved further, leading to more-substantial increases in resource utilization.

The weakness in labor markets continued to be an important concern to meeting participants, who generally expected unemployment to remain elevated for quite some time. The unemployment rate was not the only indicator pointing to substantial slack in labor markets: The employment-to-population ratio had fallen to a 25-year low, and aggregate hours of production workers had dropped more than during the 1981-82 recession. Although the November employment report was considerably better than anticipated, several participants observed that more than one good report would be needed to provide convincing evidence of recovery in the labor market. Participants also noted that the slowing pace of employment declines mainly reflected a diminished pace of layoffs; few firms were hiring. Moreover, the unusually large fraction of those individuals with jobs who were working part time for economic reasons, as well as the uncommonly low level of the average workweek, pointed to only a gradual decline in unemployment as the economic recovery proceeded. Indeed, many business contacts again reported that they would be cautious in their hiring, saying they expected to meet any near-term increase in demand by raising their existing employees’ hours and boosting productivity, thus delaying the need to add employees.

Most participants anticipated that substantial slack in labor and product markets, along with well-anchored inflation expectations, would keep inflation subdued in the near term, although they had differing views as to the relative importance of those two factors. The decelerations in wages and unit labor costs this year, and the accompanying deceleration in marginal costs, were cited as factors putting downward pressure on inflation. Moreover, anecdotal evidence suggested that most firms had little ability to raise their prices in the current economic environment. Some participants noted, however, that rising prices of oil and other commodities, along with increases in import prices, could boost inflation pressures going forward. Overall, many participants viewed the risks to their inflation outlooks as being roughly balanced. Some saw inflation risks as tilted to the downside, reflecting the quite elevated level of economic slack and the possibility that inflation expectations could begin to decline in response to the low level of actual inflation. But others felt that inflation risks were tilted to the upside, particularly in the medium term, because of the possibility that inflation expectations could rise as a result of the public’s concerns about extraordinary monetary policy stimulus and large federal budget deficits. Moreover, a few participants noted that banks might seek, as the economy improves, to reduce their excess reserves quickly and substantially by purchasing securities or by easing credit standards and expanding their lending. A rapid shift, if not offset by Federal Reserve actions, could give excessive impetus to spending and potentially result in expected and actual inflation higher than would be consistent with price stability. To keep inflation expectations anchored, all participants agreed that monetary policy would need to be responsive to any significant improvement or worsening in the economic outlook and that the Federal Reserve would need to continue to clearly communicate its ability and intent to begin withdrawing monetary policy accommodation at the appropriate time and pace.

Although members generally saw little risk that maintaining very low short-term interest rates could raise inflation expectations or create instability in asset markets, they noted that it was important to remain alert to these risks. All agreed that the path of short-term rates going forward would depend on the evolution of the economic outlook.

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Some of governments’ mystery money showed up in sovereign budgets funded by debt sold to investors, but more of it showed up on central bank balance sheets as a result of check writing that required no money at all.

The US govt never has nor doesn’t have dollars. It necessarily spends by changing numbers up in bank accounts, and taxes and borrows by changing numbers down in bank accounts.

The latter was 2009’s global innovation known as “quantitative easing,” where central banks and fiscal agents bought Treasuries, Gilts, and Euroland corporate “covered” bonds approaching two trillion dollars. It was the least understood, most surreptitious government bailout of all, far exceeding the U.S. TARP in magnitude.

Agreed! To the extent the purchases were govt and agency securities it was not a bailout for the issuers. To the extent it allowed investors to make profits from the govt over paying for outstanding securities it could be considered a bailout. But I think that was minimal at best.

In the process, as shown in Chart 1, the Fed and the Bank of England (BOE) alone expanded their balance sheets (bought and guaranteed bonds) up to depressionary 1930s levels of nearly 20% of GDP. Theoretically, this could go on for some time,

Indefinitely. Better still, the tsy could simply stop issuing the securities in the first place, as Charles Goodhart has recommended for the UK. That would save the transactions expenses, which are not trivial.

but the check writing is ultimately inflationary

Not per se. Only to the extent the resultant lower rates are inflationary, and the jury is out on that. Note the Fed just turned $60 billion or so in profits over to the tsy. This is interest income the private sector did not earn because the Fed bought the securities.

Point is, QE removes interest income from the non govt sectors and is thereby a contractionary bias.

and central bankers don’t like to get saddled with collateral such as 30-year mortgages that reduce their maneuverability and represent potential maturity mismatches if interest rates go up.

None of that should matter to central bankers, but agreed it does (for the wrong reasons).

So if something can’t keep going, it stops – to paraphrase Herbert Stein – and 2010 will likely witness an attempted exit by the Fed at the end of March, and perhaps even the BOE later in the year.

It can keep going, but agreed it is likely to stop.

Here’s the problem that the U.S. Fed’s “exit” poses in simple English: Our fiscal 2009 deficit totaled nearly 12% of GDP and required over $1.5 trillion of new debt to finance it. The Chinese bought a little ($100 billion) of that, other sovereign wealth funds bought some more, but as shown in Chart 2, foreign investors as a group bought only 20% of the total – perhaps $300 billion or so. The balance over the past 12 months was substantially purchased by the Federal Reserve. Of course they purchased more 30-year Agency mortgages than Treasuries, but PIMCO and others sold them those mortgages and bought – you guessed it – Treasuries with the proceeds. The conclusion of this fairytale is that the government got to run up a 1.5 trillion dollar deficit, didn’t have to sell much of it to private investors, and lived happily ever – ever – well, not ever after, but certainly in 2009.

I submit it could have easily issued at least that many 3 mo bills if it wanted to but chose not to, again for the wrong reasons.

It also could have issue no securities and simply let the deficit spending sit as additional excess reserves in member bank accounts at the fed, which would be my first choice. Reserve balances are functionally nothing more than one day securities. I see no reason to issue further out the curve and thereby support the term structure of rates at higher levels.

Now, however, the Fed tells us that they’re “fed up,” or that they think the economy is strong enough for them to gracefully “exit,” or that they’re confident that private investors are capable of absorbing the balance.

Yes, in fact, it’s a non event, much like when Japan ‘exited’ from its 30t yen of excess reserves several years ago.

Not likely. Various studies by the IMF, the Fed itself, and one in particular by Thomas Laubach, a former Fed economist, suggest that increases in budget deficits ultimately have interest rate consequences and that those countries with the highest current and projected deficits as a percentage of GDP will suffer the highest increases – perhaps as much as 25 basis points per 1% increase in projected deficits five years forward.

Wonder how they explain Japan with far higher deficits than the us, less QE, and a 10 year JGB of only 1.30% vs 3.80% for the us. The term structure of rates is a function of the combination of anticipated central bank rate settings and technicals. (the three month eurodollar futures add up to the 10 year swap rate, convexity adjusted)

If that calculation is anywhere close to reality,

No reason to think they will be. They aren’t based on reality.

investors can guesstimate the potential consequences by using impartial IMF projections for major G7 country deficits as shown in Chart 3.

Using 2007 as a starting point and 2014 as a near-term destination, the IMF numbers show that the U.S., Japan, and U.K. will experience “structural” deficit increases of 4-5% of GDP over that period of time, whereas Germany will move in the other direction. Germany, in fact, has just passed a constitutional amendment mandating budget balance by 2016.

Hopefully they don’t actually do that as the recession could be severe enough to bring down the entire system of govt.

If these trends persist, the simple conclusion is that interest rates will rise on a relative basis in the U.S., U.K., and Japan compared to Germany over the next several years and that the increase could approximate 100 basis points or more. Some of those increases may already have started to show up – the last few months alone have witnessed 50 basis points of differential between German Bunds and U.S. Treasuries/U.K. Gilts, but there is likely more to come.

The fact is that investors, much like national citizens, need to be vigilant and there has been a decided lack of vigilance in recent years from both camps in the U.S. While we may not have much of a vote between political parties, in the investment world we do have a choice of airlines and some of those national planes may have elevated their bond and other asset markets on the wings of central bank check writing over the past 12 months.

Yes, govt policy, or lack of it, sets the term structure of rates. When it comes to the risk free rate, govt is necessarily price setter, as it is the monopoly supplier of reserves at the margin.

Downdrafts and discipline lie ahead for governments and investor portfolios alike. While my own Pollyannish advocacy of “check-free” elections may be quixotic, the shifting of private investment dollars to more fiscally responsible government bond markets may make for a very real outcome in 2010 and beyond.Additionally, if exit strategies proceed as planned, all U.S. and U.K. asset markets may suffer from the absence of the near $2 trillion of government checks written in 2009.

True!

It seems no coincidence that stocks, high yield bonds, and other risk assets have thrived since early March, just as this “juice” was being squeezed into financial markets. If so, then most “carry” trades in credit, duration, and currency space may be at risk in the first half of 2010 as the markets readjust to the absence of their “sugar daddy.”

True, the curve could steepen some. But at the same time, if the output gap remains high, and it becomes more likely the fed will be low for long, the term structure of rates could decline accordingly, as it did in Japan.

There’s no tellin’ where the money went?

Where it always goes. One account at the Fed is debited and another credited.

Not exactly, but it’s left a suspicious trail. Market returns may not be “so fine” in 2010.

William Gross
Managing Director

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There is no operational support for this scenario. Comments below:

Global bear rally will deflate as Japan leads world in sovereign bond crisis

By Ambrose Evans-Pritchard

Jan. 5 (Telegraph) —

Weak sovereigns will buckle. The shocker will be Japan, our Weimar-in-waiting. This is the year when Tokyo finds it can no longer borrow at 1pc from a captive bond market, and when it must foot the bill for all those fiscal packages that seemed such a good idea at the time. Every auction of JGBs will be a news event as the public debt punches above 225pc of GDP. Finance Minister Hirohisa Fujii will become as familiar as a rock star.

With non convertible currency this makes no sense. If deficit spending does generate excess demand and inflation short rates will rise if markets anticipate BOJ rate hikes as a BOJ reaction function to inflation.

Once the dam breaks, debt service costs will tear the budget to pieces.

That statement has no operational meaning. All payments in yen, dollars, sterling, etc. Are met in one way only- changing numbers upward in member bank reserve accounts. Operationally there is no ‘financial stress’ associated with this process.

Yes, excess deficit spending can cause the currency to fall and inflation, but to get out of a hole first you have to stop digging, and right now the currency is strong and deflation continues as the main concern.

The Bank of Japan will pull the emergency lever on QE.

A non event, apart from somewhat lower term rates.

The country will flip from deflation to incipient hyperinflation.

Not from QE. There is no channel from QE to the real economy, lending, or anything of consequence apart from (modestly) lower term rates.

The yen will fall out of bed, outdoing China’s yuan in the beggar-thy-neighbour race to the bottom.

Yes, excess deficit spending can cause the yen to fall and inflation to increase via the import/export channels.

By then China too will be in a quandary. Wild credit growth can mask the weakness of its mercantilist export model for a while, but only at the price of an asset bubble. Beijing must hit the brakes this year, or store up serious trouble. It will make as big a hash of this as Western central banks did in 2007-2008.

China will also reach political limits only when inflation becomes a political problem.

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More on the Bernanke testimony:

Shortly after the failure of Lehman Brothers, I was in Brazil at an international meeting, and I had a meeting there with bankers, and I asked them how the Brazilian economy was doing. And they said well, it had been doing fine, but within a week after Lehman Brothers collapsed, it was like a frigid wind descended on the economy in Brazil. And there was an enormous impact almost immediately on their economy, on their ability to raise funds and make loans.

In dollars, I’m sure.

And it’s astonishing how quickly that one failure spread throughout the world, and created a very severe recession, not just in the U.S., but around the world.

The Federal Reserve, by making a large loan under very tough terms to AIG,

But allowing those funds to be used to meet margin calls on CDS and probably other related market losses. That’s perhaps the most controversial part. Those payments to creditors perhaps could have been labeled ‘loans from the Fed’ subject to AIG ultimate solvency rather than payments from the Fed.

prevented the failure of that institution, and, therefore, tried to contain the impact of the Lehman Brothers failure on the rest of the global financial system. I’ll come back and talk more about AIG, and those things later, but that was just the first step of many that we took to try to stop the crisis.

Subsequently, again, very concerned with the possibility of a global financial meltdown, we worked with Treasury and the Congress to develop a bill that would provide funding that the Fed, the Treasury and other agencies could use to stabilize the financial system, to prevent collapse of the financial system.

This immediately became relevant, because in mid-October, the crisis heated up again to the point that we thought that we were again within days or hours of a collapse of many of the largest financial firms in the world. It was a dramatic weekend. It was Oct. 10 or 11, Columbus Day weekend, when the Finance Ministers and the central bankers of seven of the largest industrial economies had a meeting here in Washington, which, of course, I attended. Usually, those meetings are very scripted and very dry. In this case, there was palpable concern among the participants that the collapse of their financial system might be just days away, and there was a great deal of discussion about how we, collectively, as the policy makers leading those countries could stop the collapse.

In the days that followed, countries all over the world, particularly the advanced industrial countries, took strong measures to prevent the collapse of the financial systems. That included putting capital into banks;

Obviously they didn’t know it was nothing more than regulatory forbearance.

it included preventing the failure of large financial firms; it included guaranteeing the debts of financial firms so they could borrow and keep themselves afloat; it included making short-term loans to firms so that they would have the short-term credit they needed to pay off lenders who were withdrawing their funding. And, again, this was the U.S. doing this, but also many of the most important industrial countries around the world simultaneously, including the U.K., Germany, France, Switzerland and others.

Again, many of those creditors ‘bailed out’ by the Fed’s liquidity provisions could have had those funds labeled ‘loans from the Fed’ rather than simply receiving payments from the Fed.

The result of this collective global effort over that week was essentially to succeed in stabilizing the global banking system, in that subsequent to that week the fears of utter collapse were largely overcome.

Now, in the following months after that, there were still many, many great difficulties in the financial markets. And the Fed, and other central banks and Treasuries around the world, worked very hard to restore the normal functioning of those markets. For example, following the Lehman failure, there was a run where ordinary investors went as quick as they could to pull their money out of money market mutual funds, which are a common investment vehicle for many Americans. It was very analogous to 100 years ago when a bank was about to fail, and the depositors would go to the bank, they would run and pull their money out as quickly as possible, and then the bank would fail. The money market mutual funds were experiencing exactly the same phenomenon.

The Fed and the Treasury working together provided short-term loans to these funds. The Treasury provided some insurance to depositors, or to investors so they would know they wouldn’t lose their money. We stopped the run on the money market mutual funds, and that was an example of how we helped stabilize the situation.

Not sure why that was critical?

There were many other steps we had to take helping individual institutions, and providing programs for backstop lending to make sure that the key markets in the financial system were functioning again, because for months after Lehman Brothers, the amount of fear and uncertainty in the financial markets was so elevated that these markets were, essentially, not functioning properly, and it took really many months until we had reached the point that these markets had begun to approach a normal state.

Doesn’t mention the dollar swap lines to foreign CB’s???

But bank lending is still weak. The banks had a near-death experience, they are now lending in a difficult economic environment. We are strongly encouraging them to lend. We have taken a lot of steps to help them raise new capital, so they’ll have a basis on which to make new loans. And we are taking a number of steps to try to open up markets through which investors invest directly in various forms of credit, like auto loans and credit card loans. All of these steps are improving the financial situation, but particularly the banking sector, we’re still in the convalescent stage.

They only bought AAA traunches which didn’t address the credit issues. They were more worried about taking losses than restoring auto credit, but wanted to give the appearance they were doing something.

As I said, I was a professor. I never worked for Wall Street. I have no connections on Wall Street. In fact, when I first became chairman, I was criticized in some quarters for not being close enough, or knowing enough about Wall Street. So, why did I take these actions?

I didn’t take these actions, or the Federal Reserve didn’t take these actions because we were trying to help bankers, or trying to help Wall Street. What I understood, and what knowledgeable people all around the world understood, is that the financial system is essential to the functioning of any economy. And that if the financial system had collapsed to the extent to which we believed was very likely in September and October 2008, then no force on earth, no policy, could have prevented the collapse of the entire U.S. economy with long-lasting and extreme consequences for every American.

How about a proportionate fiscal response, like a payroll tax holiday and per capita revenue distributions to the States? Instead, he continues to preach ‘fiscal responsibility.’

It was because we were concerned about jobs and incomes and the economic well-being of every American that we intervened to prevent the collapse of the financial system.

Now, going forward, we have a lot to do to get the economy back to stability, get jobs created. You can talk as much as you like about the things we’re doing there, but we’re also going to have to take some very strong steps to make sure that the crisis doesn’t ever happen again.

There were, certainly, weaknesses in our financial regulatory system. There were weaknesses in the way that financial regulators supervised the banks and other financial institutions. And the financial institutions themselves made lots of mistakes in terms of their ability to measure the risks that they were taking, and to control them properly. And to make sure we don’t ever have a crisis like this again, we need to have extensive reform in the private sector, in the public sector, to eliminate these risks in the future.

You had said that the banks were convalescent still, Mr. Chairman. Can you talk to us a little bit more about what that means?

Well, the banks have been stabilized. They’ve raised a good deal of capital, so they’re in much better shape than they were. They are lending, but they are not lending enough to support a healthy recovery. One important reason for that, is that given their losses, given what they’ve been through, they’re being very conservative in the face of what is still a very weak economy; and, therefore, a sense that many borrowers are quite risky.

As bank supervisors, we have a difficult challenge. We have told the banks very clearly that we want them to make loans to credit-worthy borrowers, where there are borrowers who can repay the loans. It’s in the interest of the banks, it’s in the interest of the economy, and, of course, it’s in the interest of the borrowers for those loans to get made.

But the problem is, of course, that we got into trouble in the first place by banks making loans that couldn’t be repaid, so we don’t want banks to make bad loans. Therefore, we are trying to work with banks to make sure that they are, in fact, able to make as many good loans as possible, that they have enough capital, that they have enough short-term funding, and that the examiners and the regulators who work with the banks are not unduly restricting the loans that they make. We want to work with the banks to make sure that they balance the appropriate prudence and caution against the need to make good loans for the economy, and for their own profits.

Banks and the entire private sector is necessarily procyclical.

Only govt via fiscal policy can be countercyclical.

So, what this means is that economic policy, and financial oversight have to take into account all the international dimensions of that. So, for example, on the monetary policy side, we have worked carefully and closely with other central banks to talk about monetary policy in different parts of the world. In fact, during the heat of the crisis in October 2008, the Federal Reserve and five other major central banks cut interest rates together on the same day, as a sign of how committed we were to cooperating on monetary policy.

Doesn’t seem concerned that interest rate cuts may in fact be deflationary as he knows they remove interest income for the private sectors (Bernanke, Sacks, Reinhart, 2004 Fed paper- see ‘the fiscal channel’)

The system worked.

It did work. It was an important first step. I mean, even after we took those steps, the financial markets were in a great deal of stress, and credit at all levels was very much constrained. But it stabilized the situation, and from there, we were able to take a number of steps to - both we, and our partners in other countries - to get the key markets working again, to get the banks stabilized, and to begin the very difficult process of getting the financial system back on its feet.

Never realizing that all the alphabet soup measures to get liquidity going missed the point that all the Fed had to do was lend fed funds to member banks without limit, as the ECB effectively did by immediately accepting any and all bank collateral, to immediately restore bank liquidity.

So, while it’s difficult to know exactly what the outcome would have been, certainly, just judging on what happened after the failure of a single firm, the collapse of the global financial system would surely have led to a far deeper recession, higher unemployment, much greater fiscal cost to the taxpayer, and to rebuild the financial system, and to get the economy moving again. And almost certainly, [we would have had] many, many years of subnormal - substandard - performance by the U.S. economy, and by other industrial economies, as well. Again, we can’t know precisely, but I think if anything, the financial crisis last fall was as severe, and as dangerous as anything we’ve ever seen, including the 1930s.

The whole point of going off the gold standard in 1934 was to be able to provide liquidity without limit to the banking system, so the fact that he did that, however belatedly, is nothing to brag about. It also allowed for unlimited fiscal responses, which he still seems to not fathom.

There is an irony here that’s literary, that here’s this man who spends his life distinguishing himself studying economic history. And then one day you wake up and realize that you’re at the center of economic history in this really unusual chapter. How do you process that personally? I mean, how does that change how you go from being the academic expert to you are in the arena?

Well, I certainly didn’t anticipate when I came to Washington in 2002, I certainly didn’t anticipate these events, or how things would evolve. No question about it. And when I became chairman in 2006, I thought that - I hoped that my main objectives would be improving the management, communication and monitoring policy.

We were certainly attentive to the risks of financial crisis. Secretary Paulson and I talk frequently to people on Wall Street, and we secured the Federal Reserve. We set up a team of staff drawn from different disciplines to try to identify problems and weaknesses in the financial sector. So, we were certainly aware of the risks of financial crisis, but one as large and as dangerous as this one, I certainly did not anticipate. I wish I had, but I didn’t.

Then when the crisis came, you know, rather unexpectedly, a different part of my training and research became relevant, which was to work on financial crises generally, and also on the Great Depression. And I believe very much that that experience, and that knowledge, was very helpful to me in many dimensions of this effort, ranging from - I think the most important lesson, there are many lessons, but I think the most important lesson was that we were not going to have a healthy stable economy with a completely dysfunctional financial system. We had to take strong measures to prevent that from happening.

And in the 1930s, the Federal Reserve was quite passive, and allowed the banks to fail, and we know the result of that. So, we were determined that that wasn’t going to happen on my watch, on our watch, so we were prepared to take very strong actions to avoid that.

That was under the gold standard. Nothing could be done without losing the nation’s gold supply. It was only after the banks reopened in 1934 with a non convertible currency could there be credible deposit insurance unlimited Fed provision of liquidity. Clearly he doesn’t understand that or a) he’d be stating it b) I don’t want to say…

You’ve been quite forthcoming, I think, in your testimony about saying, there’s a lot of things you didn’t see, there’s some things that we didn’t do. If I gave you a kind of do-over to go back as long as you want to say you know what, if we’d seen this, if we’d looked at the sub-prime mortgage crisis. I mean, how could you have handled it, and the Fed handled it better to have a different outcome?

Well, we have, based on the experience of the crisis, we - the Treasury and others - have made proposals for how the financial regulatory system ought to be reformed and restructured. I’ll say a word about that. If we had been in that forum, I think we would have avoided the crisis. So, there were some important lessons.

One was that our regulatory system was too myopic. It was too focused on individual firms, or individual markets, and there was nobody paying attention to the broad overall financial system. So, the Federal Reserve was not entrusted with looking at the whole financial system. We were - we had very specific assignments. We were supposed to look at specific institutions. Those institutions did not include many of the firms that had severe problems, like Lehman Brothers or Bear Stearns or AIG. Those were outside of our purview, and since they were outside of our purview, we didn’t look at them.

They missed one critical factor- allowing bank loan officers to work on a commission basis. Nor, did the regulators look into actual loan files to check for fraudulent appraisals and income statements promoted by loan officers working on a commission basis. Regulation is necessarily a work in progress. Mistakes will be made, including mistakes of this scale. Critical to our well being is the knowledge of how to keep these errors in the financial sector from damaging the real economy. And that requires appropriate fiscal responses to sustain aggregate demand, preferably in an equitable manner.

But there were many situations where there was really nobody who was looking carefully at what was going on, and nobody who was looking at how the parts of the system fit together. So, a very important recommendation that we have made is that there be a more systemic approach - that is, have some arrangement whereby a regulator, or a group of regulators, has responsibility to look at the system as a whole, and try to identify emerging problems, or gaps in the regulatory apparatus, or weaknesses in individual institutions, as they relate to other institutions, that threaten the integrity of the system as a whole.

Better still, most of the issues came from allowing banking activities that in fact served no further public purpose. That includes any bank participation in secondary markets, loaning against financial assets, using LIBOR as an index, and many others.

We didn’t have that. Therefore, nobody paid enough attention to AIG, nobody paid enough to attention to credit and call swaps, nobody paid enough attention to some of the activities of investment banks. You go on, and on, and on. Again, if we had had a more comprehensive overview approach that would have been helpful.

A second key element is the problem too big to fail, and how to address that. So, I just want to be very, very clear that even though the Federal Reserve was involved in rescuing Bear Stearns and AIG, we did that extremely reluctantly, and with - it was a very distasteful thing for us to do. We did not do it - we were not set up to do it. We were - it was very difficult for us to do, but we did it because there was no appropriate mechanism, there was no set of laws that would allow the government to intervene in a situation like that in a way that would allow the firm to fail, but would not have all the negative consequences for the financial system and the economy.

So, we had a situation where there were firms who were literally too big to fail, or too complex to fail, or too interconnected to fail. When they came to the edge of collapsing, we had only two very, very bad choices: we either bailed them out, put taxpayer money at risk, put the Federal Reserve at risk in terms of our lending, or we could let them collapse and have all the hugely negative consequences for the financial system and for the economy.

So, what we did not have, and what we very much need going forward, is a third option, and that option should be a legal framework which allows the government - and I think that means, in practice, the Treasury and Federal Deposit Insurance Corporation - to intervene when a large complex systemically critical firm is about to fail, and to allow the firm to fail, impose losses on the lenders, the creditors of the firm, the shareholders, fire the management, protect the taxpayer, but be able to do that in a way that protects the system, so that the financial system is protected from the immediate impact of that collapse.

I submit we already have that for the large banks, and the others as well. He just didn’t grasp how to use it. The receivership they did set up did not have to pay off all the creditors, and if there were issues, it would have been a relatively simple matter to petition congress for an ‘emergency’ alteration of current law. They didn’t even try.

We did not have a system like that in place. I think if we had, we could have dealt with Lehman Brothers and AIG in a much more satisfactory way. We would have avoided many of the problems. And, most importantly, we would have not, in some sense, rewarded failure, which is what happened. In the future, it’s important that firms be allowed to fail if they, in fact, take excessive risks, and make bad gambles.

But that mechanism is not in place now.

The mechanism is not in place, and we have asked Congress to address it, and I believe that they will. But until they do, we are really still in a situation where we don’t have good options in dealing with potential collapse of a global financial firm.

It isn’t that hard to do.

Right now people are sort of looking to you, and to Congress, to kind of break the back of unemployment. And you’ve talked about how that is really our biggest challenge right now. Do you feel there is anything else that can be done, or has the Fed shot all its bullets, and has Congress shot all its bullets?

Well, the Federal Reserve has been very aggressive on the unemployment side. So, let me just first say that even though the recession may be technically over., in a sense that the economy is growing, it’s going to feel like a recession for some time, because unemployment remains very high, about 10%. And even people who have jobs, there are many people who are on short hours, that are in voluntary part-time, or maybe people who are not technically unemployed, only because they stopped looking. So, the labor market is in very weak condition, and we’re not going to see a healthy, vibrant economy again until the labor market - the job market - has recovered. So, that is really an extraordinarily important objective for policy going forward. And, certainly, our job won’t be done until the economy is growing again, and jobs are being created.

The Federal Reserve’s attempts to address employment issues, we’ve done several things. Certainly, one of the things is we’re using our monetary policy. In December 2008, while the crisis was still in an intense phase, we cut the short-term interest rate that is the measure of our monetary policy almost to zero. The first time that had ever been the case, the Fed had ever done that, in order to provide the maximum amount of support to the economy, and it remains close to zero today. So, that is a very powerful measure.

Again, he gives no weight to the possibility that the interest income he removed from ’savers’ is weighing on the economy, even though it’s in his own paper from 2004.

Having used that tool to its maximum extent, we have then turned to new and innovative tools, things that have never been done before in the Federal Reserve. I’ll give you two examples. One, we’ve purchased about $1 trillion worth of mortgages that are guaranteed by Fannie Mae and Freddie Mac, and the U.S. Treasury. And in doing those purchases, we have succeeded in reducing the national 30-year fixed-rate mortgage rate from about 6-1/2% to about 4.8%. By lowering mortgage rates that way, we have helped to stabilize the housing sector, to help stabilize the housing crisis, and allow people to refinance, to buy homes. And that, obviously, should get construction started again and house prices stabilizing, and people being able to meet their mortgages. That’s obviously going to be helpful.

The far more effective way would be to directly fund the agencies at the fixed rate the Fed wanted for mortgages and allow that funding to be prepaid without penalty if the mortgages prepaid. But that was never even a consideration.

We’ve also created a program that helps bring credit from Wall Street to support a wide variety of consumer and small-business loans. So, for example, our program allows Wall Street money to come in and support auto loans, credit card loans, student loans, small business loans, commercial real estate loans. By providing that conduit, we are supporting what the banks are doing to get credit flowing into those important sectors.

But only the AAA pieces, as previously discussed.

And I guess a third thing, an additional thing I would mention is that we serve not only as monetary policy makers, but also as bank supervisors. And there we’ve been sparing no effort, as I talked about earlier, to get the banks able and willing to lend again, to create - particularly the small businesses - to create the credit that’s needed to create new jobs and get employment back on track.

I would mention, in particular, our leadership of the stress tests. In the spring, the Federal Reserve led an effort to evaluate the balance sheets of 19 of the largest banking companies in the U.S., and our report on those balance sheets, along with the FDIC, the OCC, to other banking agencies, our reports on those balance sheets is public, greatly increased the confidence in the banking system, which meant that they were able to go out and raise new capital in the stock market, and many of them have paid back the capital to the government.

Still no clue it was only regulatory forbearance.

But by raising new capital, they increased their own capacity to lend. And, as conditions improve, they’ll be able to make new loans as well.

So, by keeping interest rates low, including both short-term rates and long-term rates, like mortgage rates, by supporting a flow of credit to small businesses, consumers and the like, that is our primary effort. Those are the tools that we have. We can always do more, if necessary, but those are the tools that we are applying trying to get job growth going again.

They have more tools but aren’t using them? Unless this is a bluff, what are they waiting for? This is an extraordinary statement.

And we have seen, obviously, the labor market is still very weak, but the last report we saw shows that we’re now coming closer to the point where we’ll stop seeing job losses and start seeing job gains.

We’ve talked about a lot of those extraordinary things you’ve done. But is that it? Like now do we have to - because there’s still really bad numbers, even your forecasts are like what, 10% [unemployment] this year, 9% going forward, I think like 8% in 2012. Do we just have to kind of now sit back and take it?

Well, the Federal Reserve will continue to see what other policy actions we can take. And we’ve really been very aggressive, thus far. And the additional steps aren’t as obvious or clear as the ones that we’ve already taken.

Right, they don’t have any actual ideas.

A lot of the scope now is on the fiscal side of the house. As you know, the government passed a major fiscal program earlier this year, and I think it was just today the President announced a number of individual - a package of programs to try to address unemployment. So, [there are] a lot of new initiatives probably coming from the fiscal side.

While he preaches fiscal responsibility. See below.

Did they ask you for your opinion of those before…

Well, our staffs confer frequently with the Treasury and other parts of the Economic Advisory Groups that advise the President. And we often give our views. Our views are solicited. But, of course, they are responsible for their policy choices.

Have you said before, or are you prepared to say now, that a second stimulus, a round of incentives, is a good idea, on the fiscal side?

So, my domain is monetary policy and financial stability. And we have done, of course, a lot of aggressive things to try to support the economy, try to support job creation. I generally leave the details of fiscal programs to the Administration and Congress. That’s really their area of authority and responsibility, and I don’t think it’s appropriate for me to second guess.

You have said that there’s a long-term deficit program that needs to be dealt with. You said health care costs ought to be cut back, so it’s not like you won’t talk at all about the fiscal situation. Regardless of the details, which I understand that you don’t want to tell them how to do it, do you think that the fiscal side ought to do something?

Well, let me say this, I think that it’s very important that whatever actions that Congress and Administration take on the fiscal side, that they begin soon, or even sooner, to develop a credible medium-term interest strategy for fiscal policy, one that will persuade the markets and the public that over the medium term, the next few years, we will - we, as government, we, as a country - will be able to bring our deficits down to a level that could be sustained over a period of time.

Yes, he’s clearly part of the problem, not part of the answer. He’s failed to realize the ramifications of lifting convertibility in 1934 (and 1971 internationally) and is one of the leading deficit terrorists.

If we can do that, which will increase the confidence of the markets in American fiscal policy, that would give us more scope to take action today, because, again, there would be confidence that we have a way out, a way back towards sustainability.

There is no sustainability issue and he should know that. But he doesn’t even fully understand monetary operations of the Fed itself.

In your testimony the other day, one Senator talked about here’s the money that the federal government takes in, here’s what we spend on entitlements. It’s basically the same. Everything else we have to borrow for. I mean, there are a lot of people saying that it’s not sustainable, as you have said. And they said one of the only solutions is some kind of tax, a sales tax, value-added tax, something other than an income tax. But would you be in favor of any of those alternatives?

So, the way I put this before Congress before is that the one law that I strongly advocate is the law of arithmetic. (Laughter.) That law of arithmetic says that if you are a low-tax person, then you have to - you are responsible for finding ways on saving on expenditure, so that you don’t have enormous imbalances between revenues and spending. And by the same law of arithmetic, if you were somebody who believes that government spending is important, and you are for bigger and more spending, and bigger programs, then it’s incumbent upon you to figure out where the revenues are going to come from to meet that spending. So, again, I think that’s, again, Congress’ main responsibility.

I have spoken about deficit, and I think deficits are important, because they address broad economic and financial stability. We need to talk about that. But in terms of the specifics about how to get to fiscal balance, that’s the elected officials’ responsibility.

He sees spending as revenue constrained where that concept is entirely inapplicable to non convertible currency and floating fx policy.

Do you think Congress is fiscally illiterate? Economically illiterate?

No, of course not. But what they have to deal with is not just a question of understanding. It’s a question of making very, very tough choices, and in a political environment, where people understandably are resistant to cuts in programs or benefits, or increases of taxes. So, there needs to be tough choices made, there needs to be leadership. And I don’t envy Congress those choices, because they’re very difficult ones to make.

Are you saying that time for fiscal and monetary stimulus is over? And, if so, what’s the downside of pushing even harder?

There are not easy solutions. It’s an enormous problem. I think the Federal Reserve - one direction that we can go is to continue to encourage the extension of credit, small businesses, in particular, create a lot of jobs, particularly during economic recoveries. And we have lots and lots of evidence and anecdotes suggesting that small businesses are particularly harmed by the tightness of the bank lending standards and unavailability of credit. So, everything we can do, and that the Administration and Congress can do, to support credit extension to all business, but primarily small business, would be a very powerful.

You don’t think it’s a liquidity problem?

Well, I mean, interest rates are very low, so I think it’s going to be a question, first of all, of getting credit flowing again. And the Federal Reserve has got a role to play there. And then, Congress and the Administration will consider possible programs and fiscal policies.

You’re definitely not okay with long-term profligacy, but are you okay with them doing something in the short-term?

I think if they do that, it’s critically important they clarify the longer-term plan for establishing sustainable fiscal [policy].

Again ducking the question. But it’s clear he is not a supporter of using fiscal adjustments to sustain aggregate demand.

Adair Turner, the chief British [financial services] regulator, said that we’ve learned that much of what the financial services sector did in the past 10 years has no economic or social value. Do you agree? Did the financial services sector just get too big, and should it be smaller?

Okay. Well, a strong financial system is very important. It allocates capital to new businesses and new industries. It allows for people to invest in a wide range of activities, so it’s critically important to have a good financial system. And the evidence for that is that when the financial system breaks down, the system just doesn’t function.

That is not evidence for that. Seems a breakdown of logic???

You see what the impact has had on the economy. With that being said, the financial system is unique to the extent, first, that it is so critical to the economy, and, secondly, to the very, very old tendency to succumb to booms and busts.

Again, this is too confused to not be an insight into his basic sense of logic.

And, therefore, we do need to have an effective comprehensive financial regulatory system that will essentially allow us to tame the beast so that it provides the benefits, the growth and development without creating these kinds of crisis.

And then this says it all regarding his understanding of monetary operations:

Okay. When the Federal Reserve buys mortgages, it pays for them by creating reserves the banks hold in Federal Reserve. So, as we purchase $1 trillion of mortgages, we’ve created roughly $1 trillion of reserves that banks hold at the Federal Reserve. The banks, at this point, are just willing to hold those reserves with the Fed, and not do anything with them.

Banks don’t ‘do anything’ with reserves.

Ultimately, if the economy normalized, and the Fed took no action, the banks would take those reserves, try to lend them out, and they would begin to circulate, and the money supply would start to grow.

Banks don’t ‘lend out’ reserves.

And then, ultimately, that would create an inflationary risk.

This is not how it works.

So, therefore, as the economy begins to recover, and as we move away from this very weak economic environment, the Federal Reserve is going to have to pull those reserves out of the system.

We have a number of means for doing that, which we have explained to the markets, and the public, and everyone is confident we can do that. And we will do that over time, in order to make sure that as we come out of this crisis, we don’t generate inflation at the end.

Reserve management has nothing to do with inflation with a non convertible currency and floating fx. This is ancient gold standard rhetoric.

So, the reserves can be pulled out through various mechanisms or can mobilize. And we don’t have to do that yet, but when the time comes, we have tools to do that.

And are there lurking dangers in those mortgages that you purchased that we don’t even know about now?

Well, the mortgages are guaranteed. The credit, even if they go bad, Fannie and Freddie with the backing of the U.S. Treasury will pay them off, so the Fed is not taking any credit risk by holding these mortgages.

It’s comforting for you, but not for the taxpayers. Right?

Well, on the other hand, what’s happening is that we earn the interest from those mortgages, and then we remit that interest back to the Treasury, so the money finds its way back to the taxpayer.

That’s exactly how the Fed’s portfolio removes interest income from the private sectors.

And, indeed, the Federal Reserve will be paying the Treasury a good bit more money the next few years than it has in the past, because of the interest we’re earning on these mortgages we acquired.

On that note, this week we did learn the TARP is going to pay back nearly all of what it was required to from the taxpayer. Looking back a year later, are surprised by that?

Well, we said at the beginning that the TARP money was an investment. It was going to acquire assets, and that most or all might come back to the taxpayer. Right now, if you look at all these repayments from banks, and the fact that the government is sitting on capital gains, as well as other investments, I think it’s a reasonable probability that the TARP money invested in financial institutions, that the great majority of it will come back to the taxpayer. So, in the end, we will have stabilized the financial system and avoided this global crisis at not a small amount of money, but relative to the alternative, a quite small amount of money.

Were there days where you woke up and you thought, what am I not thinking of that we could be doing?

We had a philosophy right here, which was what we called blue-sky thinking. And what blue-sky thinking was, was we have a problem, I want everybody to give me just three associations. What can you think of? How can we approach this, what can we do? And we’ll worry about getting rid of the silly answers later. So, there’s been a lot of creativity here, and I give credit to terrific staff . I think one of the lessons of the depression, and this is something that Franklin Roosevelt demonstrated, was that when orthodoxy fails, then you need to try new things. And he was very willing to try unorthodox approaches when the orthodox approach had shown that it was not adequate.

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I was asked by a reporter to state how I’d fix the economy in 500 words and replied:

Fixing the Economy

1. A full ‘payroll tax holiday’ where the US Treasury makes all FICA payments for us (15.3%). This will restore ’spending power’ allowing households to make their mortgage payments, which ‘fixes the banks’ from the ‘bottom up.’ It also helps keep prices down as competitive pressures will cause many businesses to lower prices due to the tax savings even as sales increase.

2. A $500 per capita Federal distribution to all the States to sustain employment in essential services, service debt, and reduce the need for State tax hikes. This can be repeated at perhaps 6 month intervals until GDP surpasses previous high levels at which point state revenues that depend on GDP are restored.

3. A Federally funded $8/hr job for anyone willing and able to work that includes healthcare. The economy will improve rapidly with my first two proposals and the private sector far more readily hires people already working vs people idle and unemployed.
In 2001 Argentina, population 34 million, implemented this proposal, putting to work 2 million people who had never held a ‘real’ job. Within 2 years 750,000 were employed by the private sector.

4. Returning banking to public purpose. The following are disruptive and do not serve no public purpose:
a. No secondary market transactions
b. No proprietary trading
c. No lending vs financial assets
d. No business activities beyond approved lending and providing banking accounts and related services.
e. No contracting in LIBOR, only fed funds.
f. No subsidiaries of any kind.
g. No offshore lending.
h. No contracting in credit default insurance.
5. Federal Reserve- The liability side of banking is not the place for market discipline. The Fed should lend in the fed funds
market to all member banks to ensure permanent liquidity. Demanding collateral from banks is disruptive and redundant, as
the FDIC already regulates and supervises all bank assets.
6. The Treasury should issue nothing longer than 3 month bills. Longer term securities serve to keep long term rates higher than
otherwise.
7. FDIC
a. Remove the $250,000 cap on deposit insurance. Liquidity is no longer an issue when fed funds are available from the Fed.
b. Don’t tax the good banks for losses by bad banks. All that does is raise interest rates.
8. The Treasury should directly fund the housing agencies to eliminate hedging needs and directly target mortgage rates at
desired levels.
9. Homeowners being foreclosed should have the option to stay in their homes at fair market rents with ownership going to the
government at the lower of the mortgage balance or fair market value of the home.
10. Remove the ’self imposed constraints’ that are disruptive to operations and serve no public purpose.
a. Treasury debt ceiling- Congress already voted for the spending and taxes
b. Allow Treasury ‘overdrafts’ at the Fed. This is left over from the gold standard days and is currently inapplicable.
11. Federal taxes function to regulate aggregate demand, not to raise revenue per se, and therefore should be increased only
to cool down an overheating economy, and not to ‘pay for’ anything.

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This is a recent statement by Chairman Bernanke regarding the ‘exit strategy:’

Federal Reserve Chairman Ben Bernanke sat down on Dec. 8, 2009 with TIME managing editor Richard Stengel, Time Inc. editor-in-chief John Huey, TIME assistant managing editor Michael Duffy, and TIME senior correspondent Michael Grunwald for a conversation on everything from the state of the economy to the contents of his wallet. Here is an extended, edited transcript of the interview:

Ultimately, if the economy normalized, and the Fed took no action, the banks would take those reserves, try to lend them out, and they would begin to circulate, and the money supply would start to grow. And then, ultimately, that would create an inflationary risk. So, therefore, as the economy begins to recover, and as we move away from this very weak economic environment, the Federal Reserve is going to have to pull those reserves out of the system.

In fact, the causation is that loans create deposits in the banking system. Reserves are not involved. So even if the banks advanced $2T in loans tomorrow, excess reserves of $2T would still be there. Sadly, it seems to be a case of senior Fed officials who no doubt more than understand this obvious point not feeling comfortable enough to discuss it with the Chairman in casual conversation and bring him up to speed on banking and reserve accounting.

He also made the following statements, indicating he had no idea that, functionally, ‘putting capital into banks’ is nothing more than regulatory forbearance, and that the banking system- the some 8,000 regulated and supervised public/private partnerships already in place to do the bidding of the Fed- could have just as easily been used to make the loans and buy the securities in question. Instead, the Fed has burdened itself with the logistics of accounting for the multi thousands of individual mortgage backed securities it currently has in its Maiden Lane and other portfolios that are also currently removing over $50 billion in income from the ‘non govt.’ sectors:

This immediately became relevant, because in mid-October, the crisis heated up again to the point that we thought that we were again within days or hours of a collapse of many of the largest financial firms in the world. It was a dramatic weekend. It was Oct. 10 or 11, Columbus Day weekend, when the Finance Ministers and the central bankers of seven of the largest industrial economies had a meeting here in Washington, which, of course, I attended. Usually, those meetings are very scripted and very dry. In this case, there was palpable concern among the participants that the collapse of their financial system might be just days away, and there was a great deal of discussion about how we, collectively, as the policy makers leading those countries could stop the collapse.

In the days that followed, countries all over the world, particularly the advanced industrial countries, took strong measures to prevent the collapse of the financial systems. That included putting capital into banks; it included preventing the failure of large financial firms; it included guaranteeing the debts of financial firms so they could borrow and keep themselves afloat; it included making short-term loans to firms so that they would have the short-term credit they needed to pay off lenders who were withdrawing their funding. And, again, this was the U.S. doing this, but also many of the most important industrial countries around the world simultaneously, including the U.K., Germany, France, Switzerland and others.

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I’m perhaps a bit harsher and more direct in my criticisms than Time Magazine when they named Chairman Bernanke their
Man of the Year:

His latest speech shows he’s got ‘quantitative easing’ and monetary operations completely wrong as he believes the banks lend out reserves.

His alphabet soup of programs for the interbank lending freeze up completely missed the
point that all the fed has to do is lend in the fed funds market which would have immediately solved the problem that never should have happened, and lingered for over 6 months and contributed to the last leg of the collapse.
He’s on the wrong side of fiscal policy, urging the Congress to balance the budget, at least longer term.

He’s on the wrong side of the trade issue, trying to engineer exports at the expense of domestic consumption,
which is indeed happening, and causing our real terms of trade and standard of living to deteriorate.

He hasn’t even begun to consider the evidence that is showing lower rates to be deflationary rather than inflationary.

He still adheres to inflations expectations theory.

His unlimited dollar swapline program was an extraordinarily high risk policy that fortunately worked out,
but never should have been done without discussion with Congress. In fact, last I read he still thinks it was low risk,
not understanding that fx deposits at the foreign CB are not actual collateral.

If I had to select someone from outside the Fed for the next chairman Vince Reinhart is the only one I can think of that at least thoroughly understands monetary ops and reserve accounting, though we do have our differences on theory and policy .

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Right, this is the nonsense that’s been moving the speculators and portfolio managers, but not the underlying fundamentals.

If an asset inflation does materialize it will be for an entirely different reason.

>   
>   (email exchange)
>   
>   On Wed, Dec 9, 2009 at 2:03 PM, wrote:
>   

Yesterday, U.S. Fed Chief Ben Bernanke declared the U.S. economy is facing “formidable headwinds” and effectively vowed to continue printing paper dollars like there’s no tomorrow.

The reaction from China came quickly, as Andy Xie, recently named by BusinessWeek as one of China’s most influential economists, pulled no punches.

Xie accused the Fed chief of “poisoning” the U.S. economy by keeping interest rates near zero and creating a tidal wave of newly printed paper dollars. He warned that the next global crisis will be driven by asset inflation.

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Greece is small, 2.7% of Eurozone GDP and roughly 3.9% of
Eurozone public debt.

* Greece is not an economic basket case. GDP is declining by 1.1%
in 2009, much less than the 4.0% fall in the Eurozone as a whole (EU
Commission estimates).

* Having had less of a recession, Greece will likely lag in the
recovery. For 2010, the EU Commission projects a 0.3% fall in GDP for
Greece and 0.7% growth for the Eurozone. We are much more optimistic
for the Eurozone (2.2% growth in 2010) and Greece (1%).

* Greece has a huge current account deficit. But the shortfall has
already declined from a peak of 15.2% of GDP in the year to 3Q 2008 to
11.9% in the year to 3Q 2009. It looks set to fall much further.

* One third of Greek export revenues come from transport services,
including shipping. Transport has been hit hard by the post-Lehman
collapse in global trade. The recovery in global trade should benefit
the external position of Greece and its corporate tax revenues.

* Greece does not have an unusually severe banking problem. Many
Greek banks have a solid domestic deposit base. Greek banks have
already scaled back their use of ECB liquidity from 7% of the total in
June to 5% in September. Our banking analysts foresee no major
problems for the Greek banks to unwind ECB liquidity further Greek
Banks, 26 November 2009

It is not about the specific banks. It is about the risk of a ‘run’ on the banks, a liquidity crisis, triggered by a fear that the govt. deposit insurance is not credible. See more below.

* Greece has a serious fiscal problem. The EU expects a fiscal
deficit of 12.7% for 2009, roughly in line with Ireland and the UK.

The critical distinctions is the UK obligations are at the ‘federal’ level, where Greece and the other ‘national govts’ in the Eurozone are more like a US state.

The EU projects that Greece will have the highest debt-to-GDP ratio of
all EU members in 2011 at 135.4%.

Far higher than California, for example, which was well under 25% of its GDP.

* The rise in the debt-to-GDP ratio for Greece from 2007 to 2011
will be 39.8ppts. This is bad. But it is below the projected increases
for the UK (44 points) and Ireland (71.1 points), roughly in line with
Spain (37.9) and not much worse than the US (35.7 points according to
IMF estimates).

* As we are more optimistic on growth, we believe that the rise in
the debt ratio will be smaller in Greece and in most other countries
than the EU projects.

None of the EU national govts could survive a liquidity crisis without the ECB itself.

* Greece has a new socialist government facing an immediate
crisis. That might even make the fiscal adjustment less difficult. The
government can blame the pain on its predecessor. It may face less
opposition from trade unions than a conservative government would. Of
course, the new government will have to make the promised adjustment
in its budget soon (vote due on 23 December). More may have to follow
in early 2010.

* Greece is not primarily an issue for the ECB. Central banks are
the lenders of last resort to banks, not to governments. Greece has a
fiscal problem, not primarily a banking problem.

True, but the point is deposit insurance, and not liquidity for the banks.
A run on the banks due to fear of credible deposit insurance would mean the ECB would have to fund the entire bank system which would mean extending ‘allowable collateral’ to any and all bank assets including the copy machines and the carpets, as well as any intangibles on the books.

In the highly unlikely case that worst came to worst, that is if the Greek
government could no longer fund itself on the capital market, the
decision what assistance the EU or the Eurogroup would offer to Greece
under which conditions would be up to finance ministers and heads of
governments, not to central bankers. It would be a political issue.

Yes, and how long would it take to make that decision?
If it is longer than a day or so, the govt would be shut down and the banks would have no source of deposit insurance.

* Greece is a member of the inner family of Europe, the Eurozone.
In the market turmoil in February and March, top European officials
(Eurogroup head Juncker, EU Commissioner Almunia and even some finance
ministers such as the German one) stated that a Euro member in trouble
would get an help if need be, in exchange for fiscal conditions.

All unspecified, and widely suspected to be empty rhetoric.

These statements have not been retracted. Of course, the Euro partners of
Greece may not be eager to repeat such statements just yet. They may
not yet want to take the pressure off the Greek government to make
fiscal adjustments.

Nor do they want to write the check and introduce moral hazard.

* Many Eurozone governments face fiscal challenges. Many finance
ministers of the more peripheral members would probably want to avoid
the rise in their own financing costs that would come if a
restructuring of Greek public debt were to blow out spreads across
Europe much further. The German government would be very unlikely to
veto conditional assistance, in our view. In the highly unlikely case
that assistance may be needed, such theoretical help could take the
form of an EU guarantee for newly issued Greek public debt in exchange
for some IMF-style fiscal conditions.

Yes, very possible. But, again, how long would it take to reach that decision if a liquidity crisis did happen?

I am not saying any of this is going to happen.
I am saying the systemic risk is inherent in the institutional structure of the Eurozone.

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Karim writes:

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The possibility of announcing an exit from Afghanistan with the funds saved to pay down the deficit would be extremely popular short term and contribute to lower GDP and higher levels of unemployment over the medium term.

Those shorting dollars are selling them to foreign central banks who want their currencies weaker vs the dollar. This means it is unlikely they ever sell their dollars.

Float to lower crude prices and modestly declining us gasoline consumption would threaten the viability of the dollar shorts.

Much of this has been a reaction to the fed building its portfolio, which many presume to be an inflationary act of ‘printing money’ which it is, in fact, not.

Dollar Overwhelms Central Banks From Brazil to Korea

By Oliver Biggadike and Matthew Brown

Nov. 12 (Bloomberg) — Brazil, South Korea and Russia are losing the battle among developing nations to reduce gains in their currencies and keep exports competitive as the demand for their financial assets, driven by the slumping dollar, is proving more than central banks can handle.

South Korea Deputy Finance Minister Shin Je Yoon said yesterday the country will leave the level of its currency to market forces after adding about $63 billion to its foreign exchange reserves this year to slow the appreciation of the won. Chile Finance Minister Andres Velasco said the same day that lawmakers approved an increase in local debt sales to finance spending, a move that will allow the government to keep more of its dollar-based savings overseas and slow the peso’s rally.

Governments are amassing record foreign-exchange reserves as they direct central banks to buy dollars in an attempt to stem the greenback’s slide and keep their currencies from appreciating too fast and making their exports too expensive. Half of the 10-best performers in the currency market this year came from developing markets, gaining at least 14 percent on average, according to data compiled by Bloomberg.

“It looked for a while like the Bank of Korea was trying to defend 1,200, but it looks like they’ve given up and are just trying to slow the advance,” said Collin Crownover, head of currency management in London at State Street Global Advisors, which has $1.7 trillion under management.

The won, after falling 44 percent against the dollar in March 2009 from its 10-year high of 899.69 to the dollar in October 2007, is now headed for its biggest annual rally since a 15 percent gain in 2004. It traded today at 1,160.32, up 8.6 percent since the end of December.

‘Suffered Tremendously’

Brazil’s real is up 1.6 percent this month, even after imposing a tax in October on foreign stock and bond investments and increasing foreign reserves by $9.5 billion in October in an effort to curb the currency’s appreciation. The real has risen 33 percent this year.

“We have to be careful that our exchange rate doesn’t appreciate too much as to deindustrialize the country,” Marcos Verissimo, chief of staff at Brazil’s state development bank known as BNDES, said yesterday at a conference in Sao Paulo. “The capital goods industry has suffered tremendously.”

Russia’s Bank Rossii increased its foreign reserves by 15 percent since March 13 as it sold rubles in an attempt to cap the currency’s gain. Even so, the surge in commodities prices this year means Russia’s steps to fight a stronger ruble may “not be productive,” the International Monetary Fund said yesterday. Energy, including oil and natural gas, accounted for 69.5 percent of exports to countries outside the former Soviet Union and the Baltic states in the first nine months, according the Federal Customs Service.

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He may be right, but for the wrong reason.
Central Banks buying securities and growing their portfolios of financial assets, aka ‘quantitative easing, has nothing to do with inflation or aggregate demand.

However, direct Central Bank purchase of gold do amount to what I call ‘off balance sheet deficit spending’ which does support the price of whatever they buy and can go on indefinitely as a function of political will:

Gold Price Won’t Drop Below $1,000 an Ounce Again, Faber Says

By Zijing Wu

Nov. 11 (Bloomberg) — Gold won’t fall below $1,000 an ounce again after rising 27 percent this year to a record as central banks print money to help fund budget deficits, said Marc Faber, publisher of the Gloom, Boom & Doom report.

The precious metal rose to all-time highs in New York and London today as the dollar weakened. The Dollar Index, a gauge of value against six other currencies, has declined 7.9 percent this year and today fell to a 15-month low. News last week of bullion purchases by the Indian and Sri Lankan governments raised speculation that other countries would follow suit.

“We will not see less than the $1,000 level again,” Faber said at a conference today in London. “Central banks are all the same. They are printers. Gold is maybe cheaper today than in 2001, given the interest rates. You have to own physical gold.”

China will keep buying resources including gold, he said.

“Its demand for commodities will go up and up and up,” he added. “Emerging economies will grow at the fastest pace.”

In contrast, Western countries will be lucky to avoid economic contraction, while the Federal Reserve will maintain interest rates near zero percent, he said.

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Translation:  China threatens to liquidate it’s dollars to keep the dollar weak so China can peg to it and increase global exports??? 

China hopes U.S. keeps deficit to appropriate size

(Reuters) - China hopes that the United States will keep its deficit to an appropriate size to ensure basic stability in the U.S. dollar exchange rate, Chinese Premier Wen Jiabao said on Sunday.

“We have seen some signs of recovery in the U.S. economy … I hope that as the largest economy in the world and an issuing country of a major reserve currency, the United States will effectively discharge its responsibilities,” Wen told a news conference in Egypt.

“Most importantly, we hope the United States will keep an appropriate size to its deficit so that there will be basic stability in the exchange rate, and that is conducive to stability and the recovery of the global economy,” he added.

The premier had expressed concern in March that massive U.S. deficit spending and near-zero interest rates would erode the value of China’s huge U.S. bond holdings.

China is the biggest holder of U.S. government debt and has invested an estimated 70 percent of its more than $2 trillion stockpile of foreign exchange reserves, the world’s largest, in dollar assets.

“I follow very closely Chinese holdings of U.S. assets because that constitutes a very important part of our national wealth. Our consistent principle when it comes to foreign exchange reserves is to ensure the safety, liquidity and good value of the reserves,” Wen said.

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Well stated!

*Not house view.

Since March I have been arguing that the world was a better place than people thought. I am now shifting my core view, which still might take several months to develop in the marketplace.

Skipping to the Conclusions
1. Deflation will be the surprise theme of 2010, when Congress will go into a pre-election deadlock; elections have only underscored this is the public direction
2. Excess Reserves will neither generate new lending nor generate inflation; actually, the quantity of reserves (M0) basically has no real economic effect
3. ZIRP and QE actually CONTRIBUTE to the deflation mostly by depriving the spending public of much-needed coupon income
4. When Federal Tax Rates increase in 2011 this problem will become even more severe
5. The overall level of public indebtedness (vs GDP) will not put upward pressure on yields in this backdrop and there will be a reckoning in the high-rates/‘deficit hawk’ community
6. Strong possibility that QE will actually be upsized next year rather than ended when the Fed observes these effects (and this might actually make things WORSE)

The Explanation (a Journey)

It seemed fairly intuitive and obvious for thousands of years that the Earth was at rest and the Sun moving around it. Likewise, it has ’seemed’ that the Fed controls the money supply, balances the economy by setting interest rates and fixing reserves which power bank lending, that more ‘Fed’ money means less buying power per dollar (inflation), that the federal government needs to borrow this same money from The People in order to be able to spend, and that it needs to grow its way out of its debt burden or risks fiscal insolvency. I have, in just a fortnight, been COMPLETELY disabused of all these well-entrenched notions. Starting from the beginning, here is how I now think it works:

1. The first dollar is created when Treasury gives it to someone in exchange for something - ammo, a bridge, labor. It is a coupon. In exchange for your bridge, here is something you - or anyone you trade it with - can give me back to cover your taxes. In the mean time, it goes from person A to person B, gets deposited in a bank, which then deposits it at the Fed, which then records the whole thing in a giant spreadsheet. Liability: One overnight reserve/demand deposit/tax coupon. Asset: IOU from Treasury general account. Tax day comes, Person A pulls his deposit, ‘cashes in’ the coupon, the Treasury scraps it, and POOF, everything is back to even.

2. For various reasons (either a gold-standard relic or a conscious power restraint, depending who you ask), we ‘make’ the Treasury cover its ‘shortfall’ at the Fed and SWAP one type of tax-coupon (a deposit or reserve) for another by selling a Treasury note. Either the Fed (in the absence of enough reserves – we’ll get to this) or a Bank (to earn risk-free interest) or Person A (who sets a price for his need to save) is ‘forced’ out his demand deposit dollar and into a treasury note at the auction clearing price. What about the fact that treasuries aren’t fungible like currency? On an overnight basis, that doesn’t really constrain anyone’s behavior. A reserve or a deposit means you get your money back the next day. Same thing with a treasury. Functionally it’s cash and won’t influence your decision to buy a car. Likewise for the bank. In the overnight duration example, it does NOT affect their term lending decisions if they have more reserves and few overnight bills, or more bills and fewer reserves. It’s even possible to imagine a world (W.J.Bryan’s dream) where the Fed, with its scorekeeping spreadsheet, combines the line-items we call treasuries and reserves.

3. Total “public sector dissavings is equal to private sector savings (plus overseas holdings)” as a matter of accounting identity. This really means that the only money available to buy treasuries came from government itself (here I am being a bit loose combining Tres+Fed), from its own tax coupons. If there aren’t enough ready coupons at settlement time for those Treasuries, the Fed MUST ‘supply’ them by doing a repo (trading deposits/coupons for a treasury by purchasing one themselves at least temporarily). They don’t really have a choice in the matter, however, because if the reserves in the banking system didn’t cover it, overnight rates would go to the moon. So in setting interest rates they MUST do a recording on their spreadsheet and the Fedwire and shift around some reserve-coupons (usable as cash) for treasury-coupons (usable for savings but functionally identical).

4. Thus ‘monetizing the deficit’ is actually just the Fed’s daily recordkeeping combined with its interest rate targetting, just ‘keeping the score in balance.’ However, duration is real, as only overnight bills are usable as currency, and because people (and pensions!) need savings, they need to be able to pay taxes or trade tax-coupons for goods when they retire, and so there is a price for long-term money known as interest rates. The Fed CAN affect this by settings rates and by shifting between overnight reserves, longer-term treasuries, and cash in circulation. When the Fed does a term repo or a coupon sale, they shift around the banking and private sector’s duration, trading overnight coupons for longer-term ones as needed to keep the balance in order.

5. But all this activity doesn’t influence the real economy or even the amount of money out there. The amount of money out there dictates the recordkeeping that the Fed must do.

6. This is where QE comes in to play. In QE, aside from its usual recordkeeping activities, the Fed converts overnight reserves into treasuries, forcing the private sector out of its savings and into cash. This is just a large-scale version of the coupon-passes it ‘needed’ to do all along. Again, they force people out of treasuries and into cash and reserves.

7. The private sector is net saving, by definition. It has saved everything the Treasury ever spent, in cash and in treasuries and in deposits. In fact, Treasuries outstanding plus cash in circulation plus reserves are just the tangible record of the cumulative deficit spending, also by IDENTITY.

8. So when QE is going on, there is some combination of savers getting fewer coupons – which constrains their aggregate demand just like a lower social security check would, and banks being forced out of duration instruments and into cash reserves. I do not think this makes them ‘lend more’ – their lending decision was not a function of their ‘cashflow’ but rather a function of their capital and the opportunities out there (even when you judge a bank’s asset/equity capital ratio, there is no duration in accounting, so a reserve asset and a treasury asset both ‘cost’ the same). If they had the capital and the opportunities, they would keep lending and ‘force’ the Fed to give them the cash (via coupon passes and repos, which we then wouldn’t call QE but rather ‘preventing overnight rates from going to infinity’). As far as I can tell, excess reserves is a meaningless operational overhang that has no impact on the economy or prices. The Fed is actually powering rates (cost of money) not supply (amount of money) which is coming from everyone else in the economy (Tres spending and private loan demand).

9. I’ll grant there is a psychological component to inflation phenomenon, as well as a preponderance of ignorance about what reserves are, and that might result in some type of inflationary event in another universe, but not in the one we are in where interest rates are low and taxes are going up and the demand for savings is therefore rising rather than falling.

10. One can now retell history through this better lens. Big surpluses in ‘97-’01, then a big tax cut in ‘03. Big surpluses in ‘27-’30, then a huge deficit in ‘40-’41. Was an aging Japanese public ’shocked’ into its savings rate or is that savings just the record of the recessionary deficit spending that came after ‘97? It will be interesting to watch what happens there as the demographic story forces households to live moreso off JGB income - will this force the BOJ to push rates higher or will they never ‘get it’ and force the deflation deeper?

11. There are, as always mitigating factors. Unlike in the Japan example, a huge chunk of US fixed income is held abroad, so lower rates are depriving less exported coupon income which is actually a benefit. There is of course some benefit from lower private sector borrowing rates as well - MEW, lower startup costs for new capital investment, etc. Also, even if one denies that higher debt/gdp ratios are what weakened it (rather than China’s decisions - again something unavailable to Japan), the dollar IS weaker now which is inflationary. But this is all more than offset, I think, by ppl’s expectation that higher taxes are coming, and that’s hugely deflationary and curbs aggregate demand via multiple channels.

12. Additionally, there seems to be a finite amount of political capital that can be spent via the deficit, and that amount seems to be rapidly running out. See https://portal.gs.com/gs/portal/home/fdh/?st=1&d=8055164 . The period of deficit stimulus is mostly behind us. Instead, people are depending upon ZIRP and the Fed to stimulate the economy, and in fact there is marginal, and possible negative, stimulation coming from that channel. The Fed is taking away the social security checks knowns as ‘coupon interest.’

13. Finally, there is a huge caveat that I can’t get around, which is whether we are measuring inflation correctly. It happens that I don’t think we are – strange effects like declining inventory will provide upward pressure and lagged-accounting for rents providing downward pressure in the CPI. This is an unfortunate, untradeable fact about the universe that I think will be offset by other indicators (Core PCE) sending a better signal. But this is part of the reason this whole story will take time to develop in the marketplace. As a massive importer of goods and exporter of debts we are not quite Japan, but the path of misunderstanding is remarkably similar.

* Credit due Warren Mosler and moslereconomics.com for guiding my logic.


J.J. Lando

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If gold is a bubble it certainly hasn’t broken yet.

And if central banks decide to buy it in size they are capable of running it up until they decide to stop.
It’s what I’d call off balance sheet deficit spending. When a CB buys gold functionally it’s govt spending without taxing, adds to demand, etc. just as if the tsy had bought the gold with deficit spending, but it’s not accounted for as part of the deficit.

So we go out and spend enormous effort and energy to build the heavy equipment and related hardware to dig vast holes in the ground we call gold mines, bring up immense quantities of ore to get tiny quantities of gold out of it and by labor and energy intensive refining to make it into gold bars, which we then spend more time and energy to transport to each CB’s hole in the ground also constructed with large quantities of real resources, and spend more time and materials guarding our gold in our hole in the ground against someone going to the the trouble to take our gold out of our hole in the ground and put it in their hole in the ground. (Steve Cianciola, circa 1970)

Printing new highs in Gold this morning in London (1093.10 the high paid so far) 1 month atms up another +1.5pts (after being up 3.5pts yesterday: 17 –>20.5) as we continue to see a lot of interest and short dated upsides from a variety of accounts/investors over the past 24hrs. I have attached GSJBWere note below with their thoughts on IMF gold sales to India which they published overnight - it’s a quick read and just reiterates what we have been saying on the desk that this has been most certainly a key development for the gold market on its own; also worth noting that GSJBWere raised 12-month trading range in Gold to $950 - $1200/oz.


GSJBWere Commodities: Gold Sector: Indian Rope Trick
Commodities | Australia

• The International Monetary Fund (IMF) has completed a sale of 200 tonnes of gold to India, for a consideration of US$6.7 billion.


• The quantity is a little under 50% of the total of 403.3 tonnes of gold to be sold by the IMF, approved for sale as recently as September this year. It also constitutes half of the annual sales capacity agreed by the current Central Bank Gold Agreement.


• The gold price rallied to a fresh record high above US$1,085/oz shortly after the news was released.


• The fact that such a large sale was executed off-market and without any negative impact on the gold price will greatly reduce concerns about the overhang of the remaining 203 tonnes of approved sales quota.


• Furthermore, we find it hard to imagine that India will be the only country looking at gold as an opportunity to diversify its reserves away from the US dollar.


• We therefore view this development as very positive for the gold price outlook, and we have raised our 12-month trading range to US$950 - $1,200/oz (formerly $925 to $1,100/oz).


• We have also raised the base price for our gold price assumptions to $1,000/oz (formerly $950/oz), given that the average price in October exceeded our expectations at $1,043/oz. The changes to our annual average gold price assumptions and earnings estimates are tabulated below.

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Hopefully, when Goldman talks, people listen:
Clarification from author Franesco Cafagna: Views expressed in this piece are his own and are not necessarily reflect the view of Goldman Sachs

1. Do excess reserves really matter and does the FED really need to drain them?

The short answer is: I don’t think so. The total amount of reserves currently in the banking system is the sum of all Required Reserves (including a certain amount that banks hold for precautionary reasons) and Excess Reserves. The FED HAS to provide the banking system with the amount of Required Reserves it needs otherwise rates spike higher (potentially to infinity if the discount window or other forms of “marginal lending facilities” did not exist): the amount required is the result of banks’ individual credit decisions (how many loans they make) and the FED’s job is to estimate that amount and provide it to the system. But the FED does not control this number. When it comes to Excess Reserves, lots of people worry about the potential long-term inflationary impact they may have. The truth is that they don’t matter because they bear no weight in banks’ credit decisions (how many new loans they make). They simply appear on banks’ balance sheets as an Asset that gets “invested” every night in the form of a deposit that they leave at the FED and on which they currently get a 25bps remuneration. If the FED decided to drain excess reserves via Reverse Repo the impact on the system as a whole would be zero because the system as a whole is “self contained”. To understand this let’s think of the most extreme case: the FED drains all excess reserves via one giant Overnight Reverse Repo executed with all the
banks in the banking system. At a macro level all that’s happened is that each bank has changed its Excess Reserve asset (which is effectively an O/N asset) into and O/N Reverse Repo and the two are virtually identical. Another way to think of this is that Excess Reserves are ALREADY being drained every night because banks leave them on their account at the FED every night. The only thing that will change is the liquidity profile of banks IF the FED decided to execute Reverse Repos longer than 1 day: in that case a 1-day assets (excess reserve) would be transformed into a longer asset (Reverse Repo longer than 1 day). Whilst this may affect individual institutions, the system as a whole is unaffected because this amount “extra cash” in the system (excess reserves) is NOT being used for anything. It just sits at the FED every night. So effectively it’s being “drained” already every night. So all this talk about excess reserves and their potential inflationary impact seems misplaced: they are just irrelevant and the FED simply does not need to drain them because they are “self-drained” every night anyway.

2. Does the FED really need to execute Reverse Repos with Non-Primary dealers?

This item has gained press coverage following the Fed’s release of the last Fomc minutes in which it was clear that it debated the possibility of executing large scale reverse repo operations with non-primary dealers: the motivation behind this discussion is the perceived balance-sheet capacity constraint that the 16 Primary dealers might face (a Reverse Repo increases the assets of the broker-dealer entity facing the Fed). This statement by the Fed has created all kind of debate across the street with various dealers coming up with all kinds of estimates of the overall size that the Primary dealers can handle (with some estimates being as low as 100-150bn out of a total of over 800bn that the Fed might want to execute). Leaving aside the actual need to execute Reverse Repo in the first place (point 1 above) and assuming that the Fed will, in fact, choose to execute these operations because it has stated that they are part of the exit strategy policy, I think the alleged Primary Dealers’ balance sheet capacity constraint has been VASTLY exaggerated. It’s true that a Reverse Repo increases the assets of a broker-dealer entity, but this is an issue only for stand-alone broker-dealers (Jeffreys and alike). For Primary Dealers with big commercial banks operations (JPM, Citi, BOA) I don’t believe that this is an issue at all: since they are already sitting on big amounts of Excess Reserves and because 23A (which regulates the activity between a bank entity and its affiliates) does not impose any restriction on the amount of UST, Agencies and Agencies MBS repos that a bank can execute with an affiliate broker-dealer entity, this means that the JPMs of the world could potentially execute reverse repo operations with the Fed up to the amount of excess reserves they are already sitting on without increasing their balance sheet by 1 single cent: it would simply be a transformation of an asset (excess reserves of the bank entity) into another (reverse repo of the broker-dealer entity). So, in my view, the conclusion has to be that the Primary Dealers can in fact absorb a much bigger amount of Reverse Repo than originally thought even by the Fed itself and that realistically the only other counterparties that the Fed might engage directly for these kind of operations are the GSEs: but in this case the reason would not be balance sheet driven but would be driven by the distortion that the GSEs’ participation in the fed funds mkt creates (call me if you would like to discuss this further).

By Franesco Cafagna

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Earlier this year I thought the UK was on track with their understanding of their monetary system.

Recent headlines don’t look so promising:

Conservatives Say Low Rates Are U.K.’s Best Route Out of Slump

By Robert Hutton and Jennifer Joan Lee

Oct. 28 (Bloomberg) — Philip Hammond, a lawmaker who speaks on Treasury policy for the Conservatives, said the opposition party wants the Bank of England to keep interest rates low and will cut the deficit to allow this to happen.

“It is essential that in the recovery we are able to continue to keep monetary policy relatively loose,” Hammond said in an interview at Bloomberg’s office in London. “We will only be able to do that if we have got the deficit under control.”

The focus on monetary policy contrasts with Prime Minister Gordon Brown’s argument that maintaining government spending is the best bring Britain out of the worst recession since World War II.

With an election due within seven months, the question of how and when to cut spending is at the heart of the debate between the ruling Labour Party and the opposition. Brown argues that maintaining spending and cutting taxes are the best ways to return to growth. The Conservatives say those steps risk lifting inflation and interest rates, choking off recovery.

“What has got Britain through the recession so far has been the activist monetary policy at the Bank of England, keeping interest rates low, supporting the economy through quantitative easing,” Hammond said. “We will only be able to do that if we have sent a clear signal to the markets that we intend to execute a plan to get the deficit under control. We need to make a start in 2010.”

‘Active Monetary Policy’

Conservative leader David Cameron yesterday said he was “a great believer in an active monetary policy,” a step away from previous comments that the bank’s quantitative easing program would have to end soon.

Cameron told journalists that a speech he’d made at the start of the month had been misunderstood. “The point I was making was about how easy or difficult to fund our debt, because the market for gilts hasn’t really been tested yet, because of QE,” he said. He repeated his point that the intervention will have to end some time. “You can’t go on indefinitely.”

Policy makers at the central bank will decide next week whether to extend their asset purchase program, which is pumping

175 bln pounds ($286 bln) in newly created money into the economy.

The program has increased demand for U.K. government bonds, known as gilts, as the Treasury sells a record 220 bln pounds of debt this year.

The Conservatives have repeatedly warned this year that Brown’s spending plans are putting the U.K.’s AAA debt rating at risk. Hammond’s boss, George Osborne, told an audience of financiers on Monday that it was only the likelihood of a Conservative victory at the next election that was keeping Britain’s debt costs down. Conservatives have led Labour in polls for two years.

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CIBC Says Canada Should Consider ‘Bounded Float’ of Currency

This would help support exports. (But my first choice would instead be funding an $8/hr job for anyone willing and able to work and a tax cut to sustain domestic demand and optimize real terms of trade.)

Carney Says Intervention Needs Policy to Back It Up to Work

Oct. 27 (Bloomberg) — Bank of Canada Governor Mark Carney said today that central banks that try to affect the level of their currencies through market actions need to back the transactions with monetary policy to be effective.

Speaking to lawmakers, Carney said the bank could use tools, including quantitative easing, to implement policy with

the bank’s key interest rate as low as it can go.

Selling your own currency is the back up to your other, export oriented policy.

There is no limit to the amount of your own currency you can sell into a bid at that level.

The (operational) limit is how much the rest of world wants to buy at your selling price.

Quantitative easing has nothing to do with this.

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The article completely misses the point.

There is no ‘cash pouring into’ anything.

Nor is there a constraint on lending/deposits in any non convertible currency.

It is not a matter of taking funds from one currency and giving them to another.

There is no such thing.

Yes, the interest rate differential may be driving one currency high in the near term (not the long term) due to these portfolio shifts.

But the nation with the currency seeing the appreciation has the advantage, not the other way around.

Imports are the real benefits, exports the real costs, which the author of this piece has backwards.

The nation with the stronger currency is experiencing improving real terms of trade- more imports in exchange for fewer exports.

The most common way to realize this benefit is for the government to use the currency strength to accumulate foreign currency reserves by ‘pegging’ its currency to sustain it’s exports. This results in the same real terms of trade plus foreign exchange accumulation which can be of some undetermined future real benefit.

Better still, however, is cut taxes (or increase govt. spending, depending on your desired outcome) and sustain domestic demand, employment, and output, so now the domestic population has sufficient spending power to buy all that can be produced domestically at full employment, plus anything the rest of the world wants to net export to you.

Unfortunately those pesky deficit myths always seem to get in the way of anyone implementing that policy, as evidenced by this
article below and all of the others along the same lines. Comments in below:

>   
>   Steve Keen pointed me to it. Talks about the carry trade in US$ over to AUD$.
>   There are not Federal unsecured swap lines, would be interested in your take.
>   

Foreign speculation on our currency is a bubble set to burst

By Kenneth Davidson

Oct. 26 (National Times) — The pooh-bahs running US and British hedge funds and the banks supporting them are more than capable of reading the minutes of the Reserve Bank of Australia board meetings and coming to the conclusion that RBA Governor Glenn Stevens is committed to pushing up the cash rate from the present 3.25 per cent to 4 to 5 per cent if necessary.

And they are already betting tens of billions of dollars on what has so far been a sure bet.

But is always high risk, and not permitted for US banks by our regulators, though no doubt some gets by.

These foreign financial institutions are up to their old tricks. After getting trillions of dollars out of their respective governments to avoid GFC-induced bankruptcy - which was largely engineered by their criminal greed - because they are ”too big to fail”, they are already using their influence to maintain ”business as usual”.
Why funnel the money gouged out of American and British taxpayers into lending to their national economies to maintain employment when there are richer pickings elsewhere?

As above, these transactions directly risk shareholder equity. The govt. is not at risk until after private capital has been completely eliminated.

Two of those destinations are Brazil and Australia. Their resource-rich economies are still doing well compared with most other countries because they are riding in the slipstream of the strong demand for commodities from China and India.

Cash is pouring into these economies, not for development, but to speculate on the local currency and the sharemarket. The rising value of the Brazilian real and the Australian dollar against the US dollar has had a disastrous impact on both countries’ non-commodity export and import competing industries.

Yes, except to be able to export less and import more is a positive shift in real terms of trade, and a benefit to the real standard of living.

Brazil’s popular and largely economically successful left-wing Government led by President Lula da Silva is meeting the problem head on. It has decided to impose a 2 per cent tax on all capital inflows to stop the real appreciating further.

Instead, it could cut taxes to sustain full employment if that’s the risk they are worried about.

Arguably, the monetary strategy adopted by Stevens has compounded Australia’s lack of international competitiveness for our manufacturing and service industries, especially tourism. Since the end of 2008 our dollar has appreciated 27 per cent (as of last week). This means that financial institutions that invested money at the beginning of January are enjoying an annual rate of return on their investments of 35 per cent.

Tourism is an export industry. Instead of working caring for tourists a nation is better served taking care of its people’s needs.
And those profits are from foreign capital paying ever higher prices for the currency.

US and British commercial banks can borrow from their central banks at a rate less than 1 per cent. The equivalent RBA rate is 3.25 per cent and many pundits are forecasting the rate could go to 3.75 per cent before the end of 2009. This will increase the differential between Australian and British and US interest rates and make the scope for speculative profits even higher.

They are risking their shareholder’s capital if they do that, not their govt’s money, at least not until all the private equity is lost.
And the regulators are supposed to be on top of that.

Since the beginning of the year, $64 billion has poured into Australia in the form of direct and portfolio (share) investment and foreign lenders have switched $80 billion of foreign debt payable in foreign currencies to Australian currency. Most of the portfolio investment ($41 billion) has gone into bank shares. Banks now represent 40 per cent of the value of shares traded on the stock exchange, and while shares in the big four bank shares have increased by about 80 per cent (as measured by CBA shares), the Australian Stock Exchange Index has risen by only 30 per cent.

When anyone buys shares someone sells them. There are no net funds ‘going into’ anything.

Also, portfolio mangers do diversify globally, and I’d guess a lot of managers went to higher levels of cash last year, and much of this is the reversal. And it’s also likely, for example, that Australian managers have increased their holdings of foreign securities as well.

Foreigners have shifted out of Australian fixed interest debt and into equities because as interest rates go up, the capital value of fixed debt declines. By driving up interest rates to curb inflationary expectations and the prospect of a housing price bubble the RBA is in far greater danger of creating a stock exchange asset price bubble as well as an Australian dollar bubble. Once foreigners believe interest rates have peaked, the bubbles are likely to be pricked as financial speculators attempt to realise their gains. This could lead to a stampede out of Australian denominated securities.

Markets do fluctuate for all kinds of reasons, both short term and long term. The Australian dollar has probably reacted more to resource prices than anything else. But again, the issue is real terms of trade, and domestic output and employment.

With unemployment expected to continue to rise, and the level of unemployment disguised by growing numbers of workers being forced to work part-time, there is little chance of the underlying inflation rate, already below 2 per cent, increasing as a result of a wages break-out. The last wages breakout (leaving aside the explosive growth in executive salaries in the past three decades) occurred in 1979.

This gives the govt. cause to increase domestic demand with fiscal adjustments, including Professor Bill Mitchell’s ‘Job Guarantee’ proposal which is much like my federally funded $8/hr job for anyone willing and able to work proposal.

The world has moved on but the obsessive debate about wage inflation and union powers hasn’t. Since the beginning of the ’80s, the problem has been periodic bouts of asset price inflation. It is the biggest danger now.

Instead of controlling the unions, there should be control of financial institutions. The Australian dollar bubble and the incipient housing bubble should be micro-managed. Capital inflow could be dampened by a compulsory deposit of 1 to 2 per cent to be redeemed after a year to stop speculative inflow. Home ownership has become a tax shelter. The steam could be taken out of the rise in house prices if negative gearing was limited to new housing. This would obviate the need for higher interest rates that affect everyone.

The Job Guarantee offers a far superior price anchor vs our current use of unemployment as a price anchor. Also, I strongly suspect that the mainstream has it wrong, and that it is lower rates that are deflationary.

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