Category Archives: Financial Times

Comment on EU Daily

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On Thu, Jun 24, 2010 at 7:37 AM, wrote:

you seem to be arguing that the fix is in for the eurozone. is that a correct read?

Yes, looks like it to me.

if so, then your expected rise in the euro could occur sooner rather than later.

Yes.

seems to me that it will be difficult for the euro to rally anytime soon as central banks / portfolio managers trim their euro exposure on any strength.

Right, the portfolio shifting may not have run its course yet. That’s the risk. I’m thinking a sell off in gold, which went up this last bit due to euro fears, will signal the turn in psychology/reduction in euro fear.

With restructuring risk already on the table, seems it has to be mainly discounted in that anyone who can readily shift out of euro already have, and for those still holding euro financial assets they probably have euro liabilities and don’t want to add currency risk by shifting out of euro?

I suppose the real test will be the next mini funding crisis to see how the euro handles that stress.

Makes sense.

i’m getting fixated on the whole monetarists vs keynesian showdown that seems to be unfolding. in my mind the Greenspan era conditioned traders to believe that monetary policy was all powerful and the solution to every bump in the road. with rates near zero almost everywhere that impression will certainly fade.

And rightly so. The reality is sinking in that the Fed has no more meaningful tools, and the ones they thought they had can only help liquidity, and not support aggregate demand beyond keeping it from getting worse due to liquidity issues.

at the same time, the magnitude of the financial crisis and now the Greek crisis has seriously damaged the credibility of deficit spending.

Yes, for the wrong reasons, but I agree that’s the perception that’s driving policy.

so here we are with little faith in either concept and no clear sign anywhere of the handoff from public sector to private sector demand growth.

Right, that hand off traditionally comes from a return of private sector credit expansion, mainly housing and cars, which still hasn’t taken hold in this cycle. With all the demand leakages of unspent income due to pension funds, corp reserves, etc, some entity has to spend more than its income to make up for that.

I see a big test of theory coming in the next few years with little ammunition to proactively fight.

interesting times for sure.

Depressing, too.

I’d like to live during at least one period of true prosperity that’s ours for the taking in this time of abundant resources and geometrically expanding technology.

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George Soros Speech

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

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

:)

George Soros Speech

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

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

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

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

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

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

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

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

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

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

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

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

I agree, see my proposals here.

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

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

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

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

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

Goes without saying.

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

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

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

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

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

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

Makes sense.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

This cannot be done by using only monetary tools;

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

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

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

and minimum capital requirements.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Also in my proposals, here.

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

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Estonia adopts the euro

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

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

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

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

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

Thanks, Cliff

Agreed.

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

What Crisis? The Euro Zone Adds Estonia

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Our govt molding our children’s minds

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See below what our govt. is directing at our children.

Truly depressing.

All donations to my campaign are added to what I’m spending anyway to try to get the word out.

Many thanks to all of you who have already donated, no matter how small!!!
It all goes into the pot to sustain the effort.

Also many thanks to all of you who continue to try to organize meetings and speaking events for me- much appreciated!

CBO’s Director’s Blog: Letter to a Seventh Grader

A short time ago, I received an interesting letter from a young man in Michigan asking about federal budget deficits. I thought that perhaps other students would be interested in the kinds of questions he asked and how I answered him, so I’ve decided to share my letter to him with all of you. Here’s what I wrote:

1. What are the primary causes of the current federal budget deficits?

The current large deficits are the result of a combination of factors. These include an imbalance between tax revenues and the government’s spending that began before the recent economic recession and turmoil in the financial markets, sharply lower revenues and higher spending related to current economic conditions, and the budgetary costs of policies put in place by the government to respond to those conditions.

2. How will budget deficits affect people under the age of 18?

The government runs a budget deficit when it spends more on its programs and activities than it collects in taxes and other revenues. The government needs to borrow to make up the difference. When the federal government borrows large amounts of money, it pushes interest rates higher, and people and businesses generally need to pay more to borrow money for themselves. As a result, they invest less in factories, office buildings, and equipment, and people in the future—including your generation—will have less income than they otherwise would.

Also, the government needs to pay interest on the money it borrows, which means there will be less money available for other things that the government will spend money on in the future. Squeezing other spending affects different people in different ways, depending on their individual situations. For example, many young people benefit from government programs that provide money to families in need of food or medical care or to people who have lost their job, or from the financial support the federal government provides to local schools, or from the grants or loans the government offers to help pay for college education.

3. How is the U.S. government working to reduce budget deficits?

The President created a National Commission on Fiscal Responsibility and Reform to draw up plans to address the deficit problem. Most of the people on the commission are Members of Congress.

The commission will consider ways to reduce the budget deficit by 2015 as well as ways to improve the long-term budget outlook. Under current government policies, the gap between the government’s spending and revenues in coming years will be large. Therefore, balancing the budget would require significant changes in spending, taxes, or both. On CBO’s Web site, you can find information about the budget outlook during the next 10 years and over the long term.

More information about the commission can be found on its Web site: http://www.fiscalcommission.gov.

Congress also has enacted a new law (called “Pay-As-You-Go”) that typically requires legislation that increases spending or lowers tax revenues to include other measures to offset the costs of those changes.

4. What can people, and especially school-aged children, do to help curb budget deficits? The most important thing that school-aged children can do to help reduce future deficits is to study hard and acquire the best possible education. This will help you and your classmates get better jobs when you grow up, which will help the economy grow. In turn, a stronger economy will produce higher tax receipts for the government, which will lower the deficit.

When young people get jobs, they should be sure to save some of the money they earn. Through a fun and important bit of math called compounding, savings of small amounts can grow over time into significant amounts. For the economy as a whole, the more people save, the more money is available for businesses to invest in factories, office buildings, and equipment. For individuals and families, more savings provide a financial cushion in times of economic difficulty. In particular, more savings can help people pay large medical expenses or save their home in case they lose their job or become ill, thus helping them avoid needing government assistance.

People of all ages can also help to reduce the deficit by learning how the government spends money and from whom the government collects money. Understanding the current budget is essential for choosing intelligently among different ways to change programs and policies in order to reduce deficits.

5. If I am to convey one key message to my school regarding the federal budget deficit, what would it be?

The prospect of budget deficits for many years in the future is a serious problem for our country. Ultimately, people in the United States will have to bring into balance the amount of services they expect the government to provide, particularly in the form of benefits for older Americans, and the amount of taxes they are willing to send to the government to finance those services. Because it takes a long time to implement major policy changes, deciding what those changes will be is an urgent task for our citizens and for our policymakers.

Thank you for taking the time to write to us about these difficult issues.

Best wishes,

Doug Elmendorf

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Krugman has it right

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Lost Decade Looming?

By Paul Krugman

May 20 (NYT) —Despite a chorus of voices claiming otherwise, we aren’t Greece. We are, however, looking more and more like Japan.

For the past few months, much commentary on the economy — some of it posing as reporting — has had one central theme: policy makers are doing too much. Governments need to stop spending, we’re told. Greece is held up as a cautionary tale, and every uptick in the interest rate on U.S. government bonds is treated as an indication that markets are turning on America over its deficits. Meanwhile, there are continual warnings that inflation is just around the corner, and that the Fed needs to pull back from its efforts to support the economy and get started on its “exit strategy,” tightening credit by selling off assets and raising interest rates.

And what about near-record unemployment, with long-term unemployment worse than at any time since the 1930s? What about the fact that the employment gains of the past few months, although welcome, have, so far, brought back fewer than 500,000 of the more than 8 million jobs lost in the wake of the financial crisis? Hey, worrying about the unemployed is just so 2009.

But the truth is that policy makers aren’t doing too much; they’re doing too little. Recent data don’t suggest that America is heading for a Greece-style collapse of investor confidence. Instead, they suggest that we may be heading for a Japan-style lost decade, trapped in a prolonged era of high unemployment and slow growth.

As we discussed, could not agree more!

Let’s talk first about those interest rates. On several occasions over the past year, we’ve been told, after some modest rise in rates, that the bond vigilantes had arrived, that America had better slash its deficit right away or else. Each time, rates soon slid back down. Most recently, in March, there was much ado about the interest rate on U.S. 10-year bonds, which had risen from 3.6 percent to almost 4 percent. “Debt fears send rates up” was the headline at The Wall Street Journal, although there wasn’t actually any evidence that debt fears were responsible.

Correct, it was fears that growth would cause the fed to hike rates to something more ‘normal’

Since then, however, rates have retraced that rise and then some. As of Thursday, the 10-year rate was below 3.3 percent. I wish I could say that falling interest rates reflect a surge of optimism about U.S. federal finances. What they actually reflect, however, is a surge of pessimism about the prospects for economic recovery, pessimism that has sent investors fleeing out of anything that looks risky — hence, the plunge in the stock market — into the perceived safety of U.S. government debt.

Yes, though I would say pessimism that slow growth and negative CPI cause markets to discount ‘low for a lot longer’ rates from the Fed. It’s all about the Fed’s reaction function. Long rates are the sum of short rates, plus or minus a few ‘supply technicals.’

What’s behind this new pessimism? It partly reflects the troubles in Europe, which have less to do with government debt than you’ve heard; the real problem is that by creating the euro, Europe’s leaders imposed a single currency on economies that weren’t ready for such a move.

The euro govt debt is highly problematic as they are all set up like US States and will bounce checks if they don’t have sufficient funds in their accounts. Unlike the US, Japan, UK, etc. the credit risk in the euro zone is real, just like the US States. And that forces them to act pro cyclically, cutting back and tightening up in slowdowns, again like the US States.

But there are also warning signs at home, most recently Wednesday’s report on consumer prices, which showed a key measure of inflation falling below 1 percent, bringing it to a 44-year low.

This isn’t really surprising: you expect inflation to fall in the face of mass unemployment and excess capacity. But it is nonetheless really bad news. Low inflation, or worse yet deflation, tends to perpetuate an economic slump, because it encourages people to hoard cash rather than spend, which keeps the economy depressed, which leads to more deflation. That vicious circle isn’t hypothetical: just ask the Japanese, who entered a deflationary trap in the 1990s and, despite occasional episodes of growth, still can’t get out. And it could happen here.

Banks, too, are necessarily pro cyclical, making matters worse in down turns. Only the Federal government can be counter cyclical, however, unfortunately, our Federal government thinks it’s ‘run out of money’ and ‘dependent on foreign borrowing that our children will have to pay back.’ Complete nonsense, but they believe it, as does the mainstream media and academic community.

So what we should really be asking right now isn’t whether we’re about to turn into Greece. We should, instead, be asking what we’re doing to avoid turning Japanese. And the answer is, nothing.

Agreed!

It’s not that nobody understands the risk. I strongly suspect that some officials at the Fed see the Japan parallels all too clearly and wish they could do more to support the economy. But in practice it’s all they can do to contain the tightening impulses of their colleagues, who (like central bankers in the 1930s) remain desperately afraid of inflation despite the absence of any evidence of rising prices. I also suspect that Obama administration economists would very much like to see another stimulus plan. But they know that such a plan would have no chance of getting through a Congress that has been spooked by the deficit hawks.

Agreed, and because they don’t have a sufficient grasp of monetary operations to support the case for a fiscal adjustment large enough to close the output gap and get us back to full employment.

In short, fear of imaginary threats has prevented any effective response to the real danger facing our economy.

Completely agree! See my ‘7 Deadly Frauds of Economic Policy’

Will the worst happen? Not necessarily. Maybe the economic measures already taken will end up doing the trick, jump-starting a self-sustaining recovery. Certainly, that’s what we’re all hoping. But hope is not a plan.

They seem complacent with the forecast 5 year glide path to 5% unemployment.

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Krugman: We’re Not Greece

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We’re Not Greece

By Paul Krugman

It’s an ill wind that blows nobody good, and the crisis in Greece is making some people — people who opposed health care reform and are itching for an excuse to dismantle Social Security — very, very happy. Everywhere you look there are editorials and commentaries, some posing as objective reporting, asserting that Greece today will be America tomorrow unless we abandon all that nonsense about taking care of those in need.

True. I just finished a week in dc fighting back against the bipartisan move to cut social security.

The truth, however, is that America isn’t Greece — and, in any case, the message from Greece isn’t what these people would have you believe.

So, how do America and Greece compare?

Both nations have lately been running large budget deficits, roughly comparable as a percentage of G.D.P. Markets, however, treat them very differently: The interest rate on Greek government bonds is more than twice the rate on U.S. bonds, because investors see a high risk that Greece will eventually default on its debt, while seeing virtually no risk that America will do the same. Why?

One answer is that we have a much lower level of debt — the amount we already owe, as opposed to new borrowing — relative to G.D.P.

That has nothing to do with it. Japan’s debt is near triple ours, and their 10 year rates are about 1.3% for example.

True, our debt should have been even lower. We’d be better positioned to deal with the current emergency if so much money hadn’t been squandered on tax cuts for the rich and an unfunded war.

Not true. With us govt spending not operational revenue constrained the way greece is, we are always able to spend (or cut taxes) however much we want to. It’s a political decision without external constraints.

But we still entered the crisis in much better shape than the Greeks.

Yes, because we are the issuer of the dollar and greece is not the issuer of the euro. Greece is like a us state in that regard.

Even more important, however, is the fact that we have a clear path to economic recovery, while Greece doesn’t.

For the same reason. We can manage our aggregate demand because our fiscal policy is not operationally constrained by revenue the way Greece is.

The U.S. economy has been growing since last summer, thanks to fiscal stimulus

Yes, mostly the automatic stabilizers with some help from the proactive measures congress has taken, however misguided.

and expansionary policies by the Federal Reserve.

I don’t agree with this but that’s another story.

I wish that growth were faster; still, it’s finally producing job gains — and it’s also showing up in revenues.

True, however the output gap is finally stable at best as it remains tragically wide.

Right now we’re on track to match Congressional Budget Office projections of a substantial rise in tax receipts. Put those projections together with the Obama administration’s policies, and they imply a sharp fall in the budget deficit over the next few years.

Yes, with our only hope for lower unemployment being an increase in private sector debt that exceeds that. Not my first choice in mending what ails us.

Greece, on the other hand, is caught in a trap. During the good years, when capital was flooding in, Greek costs and prices got far out of line with the rest of Europe. If Greece still had its own currency, it could restore competitiveness through devaluation.

Should have been said this way-

‘If Greece had its own currency and was running its deficits in local currency market forces would have caused the currency to depreciate.’

But since it doesn’t, and since leaving the euro is still considered unthinkable, Greece faces years of grinding deflation and low or zero economic growth. So the only way to reduce deficits is through savage budget cuts, and investors are skeptical about whether those cuts will actually happen.

True. And worse. The proactive cuts and tax hikes can slow the economy to the point the deficit doesn’t come down, and might even increase, making matters even worse.

It’s worth noting, by the way, that Britain — which is in worse fiscal shape than we are, but which, unlike Greece, hasn’t adopted the euro — remains able to borrow at fairly low interest rates. Having your own currency, it seems, makes a big difference.

It is all the difference.

Hard to see why that isn’t obvious. US, UK, Japan, etc. Etc. With one’s own non convertible currency and floating exchange rates, interest rates are necessarily set by the central bank, not by markets.

And govt securities function to support interest rates and not to fund expenditures

And note the uk economy is on the mend. Even housing has found a bid, with the main risk being a govt that doesn’t get it and tries to balance the budget.

In short, we’re not Greece. We may currently be running deficits of comparable size, but our economic position — and, as a result, our fiscal outlook — is vastly better.

Wrong reason- we are the issuer of our own currency, the dollar, while Greece is the user of the euro and not the issuer.

That said, we do have a long-run budget problem. But what’s the root of that problem? “We demand more than we’re willing to pay for,” is the usual line. Yet that line is deeply misleading

First of all, who is this “we” of whom people speak? Bear in mind that the drive to cut taxes largely benefited a small minority of Americans: 39 percent of the benefits of making the Bush tax cuts permanent would go to the richest 1 percent of the population.

Wasn’t my first choice of which tax to cut to support the private sector. I’d have cut fica taxes and i continue to propose that.

And bear in mind, also, that taxes have lagged behind spending partly thanks to a deliberate political strategy, that of “starve the beast”: conservatives have deliberately deprived the government of revenue in an attempt to force the spending cuts they now insist are necessary.

And liberals have artificially constrained themselves with the misguided notion that spending is operationally constrained by revenues, and fail to understand the ‘right sized’ deficit is the one that coincides with full employment and desired price stability.

Meanwhile, when you look under the hood of those troubling long-run budget projections, you discover that they’re not driven by some generalized problem of overspending. Instead, they largely reflect just one thing:

An understanding of national income account and monetary operations shows deficits are driven by ‘savings desires’ and any proactive attempt to increase deficits beyond savings desires results in inflation.

the assumption that health care costs will rise in the future as they have in the past. This tells us that the key to our fiscal future is improving the efficiency of our health care system — which is, you may recall, something the Obama administration has been trying to do, even as many of the same people now warning about the evils of deficits cried “Death panels!”

Wrong causation. What he calls our ‘fiscal future’ is the size of future deficits and they will always reflect future ‘savings desires.’ if we proactively get them smaller than that the evidence will always be unemployment.

So while cutting health care costs may be a ‘good thing,’ when the time comes, future deficits need to reflect future savings desires to keep us fully employed.

So here’s the reality:

The mistaken, political reality.

America’s fiscal outlook over the next few years isn’t bad. We do have a serious long-run budget problem,

Unfortunately, this kind of talk makes him part of the problem, not part of the answer.

which will have to be resolved with a combination of health care reform and other measures, probably including a moderate rise in taxes.

Wonderful, with screaming shortfall in aggregate demand as evidenced by tragic levels of unemployment, the celebrity voice from the left is calling for spending cuts and tax hikes not to cool an over heating economy, but to reduce non govt savings of financial assets.

(govt deficit = non govt savings of financial assets to the penny as a matter of national income accounting, etc)

But we should ignore those who pretend to be concerned with fiscal responsibility, but whose real goal is to dismantle the welfare state — and are trying to use crises elsewhere to frighten us into giving them what they want.

This is one of the current iteration of the ‘deficit dove’ position.

It does not cut it.

It is part of the problem, not part of the answer.

Doing the best i can to get the word out.

Please distribute to the max!

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IMF fact sheet on SDRs

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FACTSHEET

Special Drawing Rights (SDRs)

January 31, 2010

The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves. Its value is based on a basket of four key international currencies, and SDRs can be exchanged for freely usable currencies. With a general SDR allocation that took effect on August 28 and a special allocation on September 9, 2009, the amount of SDRs increased from SDR 21.4 billion to SDR 204.1 billion (equivalent to about $ 321 billion).

The role of the SDR

The SDR was created by the IMF in 1969 to support the Bretton Woods fixed exchange rate system. A country participating in this system needed official reserves—government or central bank holdings of gold and widely accepted foreign currencies—that could be used to purchase the domestic currency in foreign exchange markets, as required to maintain its exchange rate. But the international supply of two key reserve assets—gold and the U.S. dollar—proved inadequate for supporting the expansion of world trade and financial development that was taking place. Therefore, the international community decided to create a new international reserve asset under the auspices of the IMF.

However, only a few years later, the Bretton Woods system collapsed and the major currencies shifted to a floating exchange rate regime. In addition, the growth in international capital markets facilitated borrowing by creditworthy governments. Both of these developments lessened the need for SDRs.

The SDR is neither a currency, nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members. Holders of SDRs can obtain these currencies in exchange for their SDRs in two ways: first, through the arrangement of voluntary exchanges between members; and second, by the IMF designating members with strong external positions to purchase SDRs from members with weak external positions. In addition to its role as a supplementary reserve asset, the SDR, serves as the unit of account of the IMF and some other international organizations.

Basket of currencies determines the value of the SDR

The value of the SDR was initially defined as equivalent to 0.888671 grams of fine gold—which, at the time, was also equivalent to one U.S. dollar. After the collapse of the Bretton Woods system in 1973, however, the SDR was redefined as a basket of currencies, today consisting of the euro, Japanese yen, pound sterling, and U.S. dollar. The U.S. dollar-value of the SDR is posted daily on the IMF’s website. It is calculated as the sum of specific amounts of the four currencies valued in U.S. dollars, on the basis of exchange rates quoted at noon each day in the London market.
The basket composition is reviewed every five years by the Executive Board to ensure that it reflects the relative importance of currencies in the world’s trading and financial systems. In the most recent review (in November 2005), the weights of the currencies in the SDR basket were revised based on the value of the exports of goods and services and the amount of reserves denominated in the respective currencies which were held by other members of the IMF. These changes became effective on January 1, 2006. The next review will take place in late 2010.

The SDR interest rate

The SDR interest rate provides the basis for calculating the interest charged to members on regular (non-concessional) IMF loans, the interest paid and charged to members on their SDR holdings and charged on their SDR allocations, and the interest paid to members on a portion of their quota subscriptions. The SDR interest rate is determined weekly and is based on a weighted average of representative interest rates on short-term debt in the money markets of the SDR basket currencies.

SDR allocations to IMF members

Under its Articles of Agreement, the IMF may allocate SDRs to members in proportion to their IMF quotas. Such an allocation provides each member with a costless asset. However, if a member’s SDR holdings rise above its allocation, it earns interest on the excess; conversely, if it holds fewer SDRs than allocated, it pays interest on the shortfall.
There are two kinds of allocations:

General allocations of SDRs. General allocations have to be based on a long-term global need to supplement existing reserve assets. Decisions to allocate SDRs have been made three times. The first allocation was for a total amount of SDR 9.3 billion, distributed in 1970-72 in yearly installments. The second allocation, for SDR 12.1 billion, was distributed in 1979–81 in yearly installments.

The third general allocation was approved on August 7, 2009 for an amount of SDR 161.2 billion and took place on August 28, 2009. The allocation increased simultaneously members’ SDR holdings and their cumulative SDR allocations by about 74.13 percent of their quota.

Special allocations of SDRs. A proposal for a special one-time allocation of SDRs was approved by the IMF’s Board of Governors in September 1997 through the proposed Fourth Amendment of the Articles of Agreement. Its intent is to enable all members of the IMF to participate in the SDR system on an equitable basis and correct for the fact that countries that joined the Fund after 1981—more than one-fifth of the current IMF membership—had never received an SDR allocation.

The Fourth Amendment became effective for all members on August 10, 2009 when the Fund certified that at least three-fifths of the IMF membership (112 members) with 85 percent of the total voting power accepted it. On August 5, 2009, the United States joined 133 other members in supporting the Amendment. The special allocation was implemented on September 9, 2009. It increased members’ cumulative SDR allocations by SDR 21.5 billion using a common benchmark ratio as described in the amendment.

Buying and selling SDRs

IMF members often need to buy SDRs to discharge obligations to the IMF, or they may wish to sell SDRs in order to adjust the composition of their reserves. The IMF acts as an intermediary between members and prescribed holders to ensure that SDRs can be exchanged for freely usable currencies. For more than two decades, the SDR market has functioned through voluntary trading arrangements. Under these arrangements a number of members and one prescribed holder have volunteered to buy or sell SDRs within limits defined by their respective arrangements. Following the 2009 SDR allocations, the number and size of the voluntary arrangements has been expanded to ensure continued liquidity of the voluntary SDR market.

In the event that there is insufficient capacity under the voluntary trading arrangements, the Fund can activate the designation mechanism. Under this mechanism, members with sufficiently strong external positions are designated by the Fund to buy SDRs with freely usable currencies up to certain amounts from members with weak external positions. This arrangement serves as a backstop to guarantee the liquidity and the reserve asset character of the SDR.

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Re: Run on European Banks?

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>   
>   (email exchange)
>   
>   On Wed, Apr 28, 2010 at 8:23 AM, wrote:
>   
>   Given this view warren, do you think Natl Bk of Greece goes to zero here?
>   Or do you think Europe will do a “shock an awe” 100b package that makes
>   greek banks a buying opportunity?
>   

Wish I knew!

They might like to, but they still don’t have an answer to the moral hazard issue or popular support for a ‘bailout’

What’ they’d like to do is figure out a way to isolate Greece, hence the presumed proposals from yesterday, but those aren’t satisfying either.

And any major package weakens the others who have to fund it in the market place.

Nor do they have a way to enforce their austerity demands and keep them from being reversed once it’s known they’ve taken the position that it’s too risky to let any one nation fail.

They are still in a bind, and their austerity measures mean they don’t keep up with a world recovery

Also, a Greek restructure that reduces outstanding debt is a force that strengthens the euro as it reduces outstanding euro financial assets.

The negative is that it further reduces euro ‘savings desires’ and drives more portfolios to shift away from euro.

And domestic taxes are still payable in euro, so there is that fundamental support .

Again, could go either way from here.

Sometimes that’s how it is!

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Altman is back

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America’s disastrous debt is Obama’s biggest test

By Roger Altman

April 21 (FT) — The global financial system is again transfixed by sovereign debt risks. This evokes bad memories of defaults and near-defaults among emerging nations such as Argentina, Russia and Mexico.

Yes, all fixed FX blowups.

But the real issue is not whether Greece or another small country might fail. Instead, it is whether the credit standing and currency stability of the world’s biggest borrower, the US, will be jeopardised by its disastrous outlook on deficits and debt.

This comp completely misses the fundamental difference between the two. The Fed is an arm of the US govt, while the ECB is not an arm of greece.

America’s fiscal picture is even worse than it looks. The non-partisan Congressional Budget Office just projected that over 10 years, cumulative deficits will reach $9,700bn and federal debt 90 per cent of gross domestic product – nearly equal to Italy’s.

Another apples/oranges comp. This is less than poor analysis.

Global capital markets are unlikely to accept that credit erosion. If they revolt, as in 1979,

There was no ‘revolt’ in regards to the US in 1979.

ugly changes in fiscal and monetary policy will be imposed on Washington. More than Afghanistan or unemployment, this is President Barack Obama’s greatest vulnerability.

His greatest vulnerability is listening to this nonsense, and not recognizing that taxes function to regulate aggregate demand, and not to raise revenue.

The unemployment rate is all the evidence needed, screaming there is a severe shortage of aggregate demand, and a payroll tax holiday would restore private sector sales by which employment immediately returns.

Instead, the admin is listening to this nonsense and working to take measures to tighten fiscal policy which will work to reduce aggregate demand.

How bad is the outlook? The size of the federal debt will increase by nearly 250 per cent over 10 years, from $7,500bn to $20,000bn. Other than during the second world war, such a rise in indebtedness has not occurred since recordkeeping began in 1792.

Point? Govt deficit spending adds back the demand lost because of ‘non govt’ savings desires for dollar financial assets.

The cumulative govt ‘debt’ equals and is the net financial equity- monetary savings- of the rest of us.

You could change the name on the deficit clock in nyc to the savings clock and use the same numbers.

It is so rapid that, by 2020, the Treasury may borrow about $5,000bn per year to refinance maturing debt and raise new money; annual interest payments on those borrowings will exceed all domestic discretionary spending and rival the defence budget. Unfortunately, the healthcare bill has little positive budget impact in this period.

That just means our net savings is rising and the interest payments are helping our savings rise.

In fact, treasury securities are nothing more than dollar savings accounts at the fed. Savers include us residents and non residents like the foreign countries that save in dollars.

Why is this outlook dangerous?

Because it leads to backwards policies by people who don’t get it.

Because dollar interest rates would be so high as to choke private investment and global growth.

There is no such thing.

First, rates are set by the fed.

Second, there is no imperative for the tsy to issue longer term securities or any securities at all.

Third, there is no econometric evidence high interest rates do that. In fact, because the nation is a net saver of the trillions called the national debt, higher rates increase interest income faster than the higher loan rates reduce it (bernanke, sacks, reinhart, 2004 fed paper).

It is Mr Obama’s misfortune to preside over this.

It’s his misfortune to be surrounded by people who don’t understand monetary operations. Otherwise we’d have been at full employment long ago.

The severe 2009-10 fiscal decline reflects a continuation of the Bush deficits and the lower revenue and countercyclical spending triggered by the recession. His own initiatives are responsible for only 15 per cent of the deterioration. Nonetheless, it is the Obama crisis now.

It’s the obama crisis because taxes remain far too high for the current level of govt spending and saving desires.

Now, the economy is too weak to withstand the contractionary impact of deficit reduction. Even the deficit hawks agree on that.

It’s too weak because the deficit is too small. And yes, making it smaller makes things worse.

In addition, Mr Obama has appointed a budget commission with a December deadline. Expectations for it are low and no moves can be made before 2011.

Yes, and then to cut social security and medicare!!!!

Yet, everyone already knows the big elements of a solution. The deficit/GDP ratio must be reduced by at least 2 per cent, or about $300bn in annual spending. It must include spending cuts, such as to entitlements,

Here you go!!!!!!!!!!!!!!

and new revenue. The revenues must come from higher taxes on income, capital gains and dividends or a new tax, such as a progressive value added tax.

Yes, all working to cut aggregate demand and weaken the economy.

It will be political and financial factors that determine which of three budget paths America now follows.

Yes, the backwards understanding by our leaders.

The first is the ideal. Next year, leaders adopt the necessary spending and tax changes, together with budget rules to enforce them, to reach, for example, a truly balanced budget by 2020. President Bill Clinton achieved a comparable legislative outcome in his first term. But America is more polarised today, especially over taxes.

Clinton was ‘saved’ by the unprecedented increase in private sector debt chasing impossible balance sheets of the dot com boom, which was expanding at 7% of GDP, driving the expansion even as fiscal was allowed to go into a 2% surplus, which drained that much financial equity, and ending in a crash when incomes weren’t able to keep up.

The second possible course is the opposite: government paralysis and 10 years of fiscal erosion. Debt reaches 90 per cent of GDP. Interest rates go much higher, but the world’s capital markets finance these needs without serious instability.

Japan is well over 200% (counting inter govt holdings) with the 10 year JGB at 1.35%. Interest rates are primarily a function of expectations of future fed rate settings, along with a few technicals.

History suggests a third outcome is the likely one: one imposed by global markets.

There is no history that suggests that, just misreadings of history.

Yes, there may be calm in currency and credit markets over the next year or two. But the chances that they would accept such a long-term fiscal slide are low. Here, the 1979 dollar crash is instructive.

A dollar crash, whatever that means, is a different matter from the funding issues he previously implied.

The Iranian oil embargo, stagflation and a weakening dollar were roiling markets. Amid this nervousness, President Jimmy Carter submitted his budget, incorporating a larger than expected deficit. This triggered a further, panicky fall in the dollar that destabilised markets. This forced Mr Carter to resubmit a tighter budget and the Fed to raise interest rates. Both actions harmed the economy and severely injured his presidency.

The problem was the policy response to the ‘dollar crash.’ rates went up because the fed raised them with a vote. Market forces aren’t a factor in the level of rates per se. They are part of the Fed’s reaction function, which is an entirely different matter.

America’s addiction to debt poses a similar threat now. To avoid an imposed and ugly solution, Mr Obama will have to invest all his political capital in a budget agreement next year. He will be advised that cutting spending and raising taxes is too risky for his 2012 re-election. But the alternative could be much worse.

So it’s all about avoiding a dollar crash?

So why are we pressing china to revalue their currency upward which means reducing the value of the dollar? Can’t have it both ways?

Altman was in the Clinton admin confirms they were in the ‘better lucky than good’ category.

Feel free to distribute, thanks.

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Email exchange with Dan

Posted on by

On Thu, Apr 15, 2010 at 12:08 PM, wrote:
Hi Warren,

I must admit that your writing and thoughts have had a significant impact upon me. Interestingly—at least from where I sit—your Soft Currency Economics paper, which I have now read 5 or 6 times, has provided me with an odd peace of mind…not sure if that is a GOOD thing or not. :)

thanks!

KNOWING that—so long as trust and confidence in our fiat system remains—we are always able to mitigate, at least in some manner, the impact of global financial crises through the changing of numbers ‘upward’ in the accounts of men and of institutions, is somewhat akin, I’d imagine, to an alcoholic knowing that, no matter what, an endless supply of Johnny Walker Black always exists in his basement stash.

Actually, as long as we can enforce tax collections the currency will have value.

Problem is the currency can’t be eaten or drunk, so if the crops fail it won’t help much.
All we can insure is enough currency to pay people to work, not enough things to buy

OK, so maybe the analogy is a tad morose…but hence my funny feeling about my peace of mind.

So, my question of the week revolves around the U.S.’s apparent choice to monetize (again, if you will) the IMF coffers. I point to the following from Zerohedge:

“…As we reported a few days ago, the IMF massively expanded its last resort bailout facility (NAB) by half a trillion dollars, in which the US was given the lead role in bailing out every country that has recourse to IMF funding.

We buy SDR’s with dollars which the IMF then loans, so yes.

Yesterday, Ron Paul grilled Bernanke precisely on the nature of the expansion of the US role to the NAB: “The IMF has announced that they are going to open up the NAB which coincides with the crisis in Greece and Europe and how they are going to bailed out. The irony of this promise is that in the new arrangement Greece is going to put in $2.5 billion in. I think only a fiat monetary system worldwide can come up and have Greece help bail out Greece and be prepared to bail out even other countries.

Greece needs euros, so the IMF will sell SDR’s to the euro nations to fund Greece, not the US.

SDR’s are only bought with local currency.

But we are going from $10 to $105 billion… We are committing $105 billion to bailing out the various countries of the world, this does two thing I want to get your comments on one why does it coincide with Greece,

Coincidental.

what are they anticipating, why do they need $560 billion, do we have a lot more trouble, and when it comes to that time when we have to make this commitment, who pays for this, where does it come from?

Seems they anticipate more nations will be borrowing dollars from the IMF?

We buy them by crediting the IMF’s account at the Fed. If and when the IMF lends dollars we move those dollars from the IMF’s account to the account at the Fed for the borrowing nation.

Will this all come out of the printing press once again, as we are expected to bail out the world?

Short answer, yes. long answer above.

Are you in favor of this increase in the IMF funding and our additional commitment to $105 billion?”

No.

Bernanke, of course, washes his hands of any imminent dollar devaluation – it is all someone else’s responsibility to bail out life, the universe and everything else. Bernanke pushes on “I think in general having the IMF available to try to avoid crises is a good idea.”

2 problems. First the borrowers would probably be better off using local currency solutions rather than dollars, and second the IMF terms and conditions can and often do make things worse for the borrower.

Yet Paul pushes on “Where will this money come from? We are bankrupt too.” Indeed we are, but nobody cares – that is simply some other poor shumck’s problem…”

He’s flat out wrong about the US being bankrupt but that’s another story.

best,
warren

Warren, this strikes me as problematic. YES, we can add zeros to the end of accounts and thus ‘create’ more liquidity in the global economy. HOWEVER, at what point does the world choose not to believe that those numbers in those accounts have true value?

As long as we enforce dollar taxes the dollar will have value.

warren

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