Six months after our last update on the Federal Reserve's balance sheet in visual form, it is time to resume updating readers on what the biggest balance sheet in America looks like, especially since now that Fed is back in the monetization business. So without further ado, here is how Bernanke Capital, LLC looked as of September 1.

• Securities held outright: $2,045 billion 
  • Total Treasury holdings increased from $783 billion to 786 billion, as it bought another $3 billion in USTs as part of QE Lite. Look for this number to grow to well over $1.5 trillion in the next 6 months
  • MBS holdings declined by $8 billion from $1.111 trillion to $1.103 trillion
  • Agency holdings were flat at $157 billion
• Net borrowings: unchanged at $60 billion from the prior fortnight.
• Float, liquidity swaps, Maiden Lane and other assets: $184 billion. FX liquidity swaps are at $44 million. The "value" of Maiden Lane I increased to the highest since November 2008, and was at $16 billion. Maiden Lane II was at $23 billion, while AIA Aurora was $27 billion. 
• The monetary base was $1.995 trillion
• Reserve balances with banks: $1.035 trillion
• Foreign holdings of USTs and MBS hit a fresh weekly high of $3.21 trillion.
• The ratio of Fed assets to the monetary basy was an elevated 1.15x, where it has been for a while.

→ Washington’s Blog

Fed chief Ben Bernanke told the financial crisis inquiry commission today:

If the crisis has a single lesson, it is that the too-big-to-fail problem must be solved

 

***

 

Too-big-to-fail financial institutions were both a source ... of the crisis and among the primary impediments to policymakers' efforts to contain it ....

That's funny, given that Bernanke has been one of the biggest defenders of the too big to fail banks, arguing strenuously against breaking them up, throwing trillions of dollars their way, and begging the banks to play nice with one hand, while patting them on the back with the other hand and giving them a big wink.

And Christina Romer - Obama's outgoing chief economist and Chair of the Council of Economic Advisers - said in her outgoing speech yesterday, as summarized by Dana Milbank at the Washington Post:

She had no idea how bad the economic collapse would be. She still doesn't understand exactly why it was so bad. The response to the collapse was inadequate. And she doesn't have much of an idea about how to fix things.

Many have tried to explain to the neoclassical economists running the show exactly how bad the economic collapse would be, why it was so bad, and how to mount an adequate response to fix things. But Bernanke, Romer and the rest of the gang ignored them.

Who Knew?

As I pointed out in March:

Greenspan's big defense is that the financial crisis was caused by a "once-in-a-century" event.

 

 

Forget about the fact that the "once-in-a-century event" couldn't have happened if Greenspan's Fed hadn't:

• Turned its cheek and allowed massive fraud

• Acted as cheerleader in chief for unregulated use of derivatives at least as far back as 1999 (see this and this)

• And for subprime loans

• Allowed the giant banks to grow into mega-banks. For example, Citigroup's former chief executive says that when Citigroup was formed in 1998 out of the merger of banking and insurance giants, Greenspan told him, “I have nothing against size. It doesn’t bother me at all”

• Argued that economists had conquered the business cycle, and that modern, technologically advanced financial markets are best left to police themselves

• Preached that a new bubble be blown every time the last one bursts

• Kept interest rates too low

• And did alot of other hinky things

More importantly, as Nassim Taleb repeatedly points out, financial experts who don't plan for rare events are like pilots who don't know about storms.

 

There are storms out there, Taleb says, and any pilot who doesn't know how to deal with storms shouldn't be flying. Similarly, no one should be in a position of financial leadership if they don't know about - and plan for - the infrequent event:

High Priests Shake their Magic Wands Even Harder

As Australian economist Steve Keen wrote last week, mainstream economists have been acting like religious fundamentalists, rather than scientists:

Bernanke’s failure to realize this: it’s a failing that he shares in common with the vast majority of economists. His problem is the theory he learnt in high school and university that he thought was simply “economics”—as if it was the only way one could think about how the economy operated. In reality, it was “Neoclassical economics”, which is just one of the many schools of thought within economics. In the same way that Christianity is not the only religion in the world, there are other schools of thought in economics. And just as different religions have different beliefs, so too do schools of thought within economics—only economists tend to call their beliefs “assumptions” because this sounds more scientific than “beliefs”.

 

Let’s call a spade a spade: two of the key beliefs of the Neoclassical school of thought are now coming to haunt Bernanke—because they are false. These are that the economy is (almost) always in equilibrium, and that private debt doesn’t matter.

Indeed, as I wrote in June:

Most economists don't exercise any independent thinking because economists are trained to ignore reality:

As I have repeatedly noted, mainstream economists and financial advisors have been using faulty and unrealistic models for years. See this, this, this, this, this and this.

And I have pointed out numerous times that economists and advisors have a financial incentive to use faulty models. For example, I pointed out last month:

The decision to use faulty models was an economic and political choice, because it benefited the economists and those who hired them.

For example, the elites get wealthy during booms and they get wealthy during busts. Therefore, the boom-and-bust cycle benefits them enormously, as they can trade both ways.

Specifically, as Simon Johnson, William K. Black and others point out, the big boys make bucketloads of money during the booms using fraudulent schemes and knowing that many borrowers will default. Then, during the bust, they know the government will bail them out, and they will be able to buy up competitors for cheap and consolidate power. They may also bet against the same products they are selling during the boom (more here), knowing that they'll make a killing when it busts.

But economists have pretended there is no such thing as a bubble. Indeed, BIS slammed the Fed and other central banks for blowing bubbles and then using "gimmicks and palliatives" afterwards.

It is not like economists weren't warning about booms and busts. Nobel prize winner Hayek and others were, but were ignored because it was "inconvenient" to discuss this "impolite" issue.

Likewise, the entire Federal Reserve model is faulty, benefiting the banks themselves but not the public.

However, as Huffington Post notes:

The Federal Reserve, through its extensive network of consultants, visiting scholars, alumni and staff economists, so thoroughly dominates the field of economics that real criticism of the central bank has become a career liability for members of the profession, an investigation by the Huffington Post has found.

 

This dominance helps explain how, even after the Fed failed to foresee the greatest economic collapse since the Great Depression, the central bank has largely escaped criticism from academic economists. In the Fed's thrall, the economists missed it, too.

 

"The Fed has a lock on the economics world," says Joshua Rosner, a Wall Street analyst who correctly called the meltdown. "There is no room for other views, which I guess is why economists got it so wrong."

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Read more at: http://www.huffingtonpost.com/2009/09/07/priceless-how-the-federal_n_278805.html

The problems of a massive debt overhang were also thoroughly documented by Minsky, but mainstream economists pretended that debt doesn't matter.

And - even now - mainstream economists are STILL willfully ignoring things like massive leverage, hoping that the economy can be pumped back up to super-leveraged house-of-cards levels.

As the Wall Street Journal article notes:

As they did in the two revolutions in economic thought of the past century, economists are rediscovering relevant work.

It is only "rediscovered" because it was out of favor, and it was only out of favor because it was seen as unnecessarily crimping profits by, for example, arguing for more moderation during boom times.

The powers-that-be do not like economists who say "Boys, if you don't slow down, that bubble is going to get too big and pop right in your face". They don't want to hear that they can't make endless money using crazy levels of leverage and 30-to-1 levels of fractional reserve banking, and credit derivatives. And of course, they don't want to hear that the Federal Reserve is a big part of the problem.

Indeed, the Journal and the economists it quotes seem to be in no hurry whatsoever to change things:

The quest is bringing financial economists -- long viewed by some as a curiosity mostly relevant to Wall Street -- together with macroeconomists. Some believe a viable solution will emerge within a couple of years; others say it could take decades.

Saturday, PhD economist Michael Hudson made the same point:

I think that the question that needs to be asked is how the discipline was untracked and trivialized from its classical flowering? How did it become marginalized and trivialized, taking for granted the social structures and dynamics that should be the substance and focal point of its analysis?...

To answer this question, my book describes the "intellectual engineering" that has turned the economics discipline into a public relations exercise for the rentier classes criticized by the classical economists: landlords, bankers and monopolists. It was largely to counter criticisms of their unearned income and wealth, after all, that the post-classical reaction aimed to limit the conceptual "toolbox" of economists to become so unrealistic, narrow-minded and self-serving to the status quo. It has ended up as an intellectual ploy to distract attention away from the financial and property dynamics that are polarizing our world between debtors and creditors, property owners and renters, while steering politics from democracy to oligarchy...

[As one Nobel prize winning economist stated,] "In pointing out the consequences of a set of abstract assumptions, one need not be committed unduly as to the relation between reality and these assumptions."

This attitude did not deter him from drawing policy conclusions affecting the material world in which real people live. These conclusions are diametrically opposed to the empirically successful protectionism by which Britain, the United States and Germany rose to industrial supremacy.

Typical of this now widespread attitude is the textbook Microeconomics by William Vickery, winner of the 1997 Nobel Economics Prize:

"Economic theory proper, indeed, is nothing more than a system of logical relations between certain sets of assumptions and the conclusions derived from them... The validity of a theory proper does not depend on the correspondence or lack of it between the assumptions of the theory or its conclusions and observations in the real world. A theory as an internally consistent system is valid if the conclusions follow logically from its premises, and the fact that neither the premises nor the conclusions correspond to reality may show that the theory is not very useful, but does not invalidate it. In any pure theory, all propositions are essentially tautological, in the sense that the results are implicit in the assumptions made."

Such disdain for empirical verification is not found in the physical sciences. Its popularity in the social sciences is sponsored by vested interests. There is always self-interest behind methodological madness. That is because success requires heavy subsidies from special interests, who benefit from an erroneous, misleading or deceptive economic logic. Why promote unrealistic abstractions, after all, if not to distract attention from reforms aimed at creating rules that oblige people actually to earn their income rather than simply extracting it from the rest of the economy?

***

Michael Rivero may have the hardest-hitting critique of all:

This seems to be a return to the mindset of the middle ages where only the clergy were allowed to read and interpret the bible and the laity were presumed incapable of comprehending the intricacies and subtle nuances of the faith.

 

And indeed there is a great deal of similarity between economics and [fundamentalist version of] religion in that both depend on the unquestioning faith of the masses that those pretty printed pieces of paper represent something real, albeit invisible.

 

But the advent of the printing press led people to take a closer look at the actual content of [fundamentalist version of] religion and it has been revealed not as a complex and sophisticated system but as a mish-mash of half-baked myths and legends often in contradiction with itself and used to enrich the church ....

 

The same is true of economics. the advent of the blog has led people to take a closer look at the actual content of economics and it has been revealed not as a complex and sophisticated system but as a mish-mash of half-baked theories and math often in contradiction with itself and used to enrich the bankers and conceal their fraud against the public. Athreya is reacting to the blogs the way [fundamentalist] priests reacted to Gutenberg's Printing Press.

 

The fraud and danger of the Federal Reserve system of banking stands exposed to the public eye, sans the "benefit" of correct interpretation by the self-appointed priests of Mammon. The public now understands that when a private bank issues the public currency at interest, debt will always exceed the available money supply. The public now understands that the Federal Reserve is no more Federal than Federal Express. The public now understands that the Federal Reserve is a legalized counterfeiting operation, that creates the money they loan out out of thin air! The public now understands that the Federal Reserve system of banking, since its creation in 1913, has reduced the value of a dollar down to about four cents! The public now understands that the Federal Reserve system is a pyramid scam that only works when ever larger populations of borrowers can be found, and that once an entire nation or planet has borrowed to the max, the system must crash (which is what is happening now).

 

Just as the [fundamentalist] priests, stripped of the arcane scriptures and rituals, stand exposed ... so too the economists, stripped of their arcane equations and theories, stand exposed ....

Karthik Athreya doesn't like that fact that the public sees the Federal Reserve for what it really is.

What Could Possibly Go Wrong?

Not only have our government "leaders" in the Fed, Treasury, Congress and White House ignored the real world, they have taunted it - like monkeys who pull the tail of the lion and then are surprised when the lion attacks:

They have:

• Let the largest U.S. banks go bankrupt repeatedly due to wild speculation, then blessed the speculation and helped cover up the bankruptcies

• Privatized profits and socialized losses, trashed the real value of the dollar, and let corruption run rampant

• Covered up all of the fraud which led to the crisis

• Rewarded looting by the big banks

• Given trillions in bailout or other emergency funds to private companies, but then refusing to disclose to either the media, the American people or even Congress where the money went

• Let banks buy the government lock, stock and barrel (and see this and this)

• Blown bubble after bubble

• Plundered the treasury to effect "a massive redistribution of wealth to the bank shareholders and their top executives"

• Allowed high-frequency trading to completely warp the markets

• Waged unnecessary wars all over the world, so that even our top military commanders are begging to slash defense costs, and otherwise buried our nation under mountains of debt (see this, this, this, this, this and this)

• Failed to take any meaningful steps to stabilize - let alone fix - the economy (see this and this)

Under these conditions, it is impossible to have a decent economy. After pulling these kind of shenanigans, of course the lion of debt and depression is going to eat us alive.

Scott Minerd, CIO of Guggenheim Partners, parses through the years of the Great Depression, and focuses on the pivotal 1936, which contained in it the seeds for the destruction of the period of relative economic growth and stability from 1932 to 1936, and resulted in a plunge in the economy in the second great recession of the Depressionary period: that of 1937 and 1938. While the first period saw "GNP grow at an annualized rate of 10 percent, the Dow rose approximately 20 percent per annum, and unemployment declined from as high as 25 percent in 1933 to as low as 11 percent in 1937" the second and much more dire phase of 1937-1938 . saw a unprecedented plunge in economic data: "national output declined by 5.4 percent, unemployment skyrocketed from 11 percent back to 20 percent, the Dow Jones Industrial Average declined 49 percent, and four years of healthy price recovery receded into 3 percent annual deflation." What precipitated the second collapse? "The short answer is that it was a confluence of factors, a perfect storm of monetary and fiscal policy mistakes" yet the immediate catalyst, if one can be defined was "the fiscal policy missteps of the Roosevelt Administration, who, in an effort to balance the budget after six years of deficits, implemented a series of tax increases in 1936 and 1937 that caused output, prices, and income to fall and sent unemployment skyrocketing." We are currently faced with precisely the same juncture, and unfortunately for America, things now have a far lower probability of occurring "just as they should" in order for the country to emerge in one piece on the other side of the tunnel. Here is why.

First a question - what caused Rooselvelt to flip out and commence on a series of disastrous economic policies? Minerd explains:

In response to such Republican criticism of his fiscal policies, Roosevelt fired back by issuing the following points in the Democratic Party platform of 1936 (my paraphrase, followed by direct excerpts originally published June 23, 1936):

1. Deficit spending was a result of the crisis inherited from the previous Administration: “We hold this truth to be self-evident – that 12 years of Republican leadership left our Nation sorely stricken in body, mind, and spirit; and that three years of Democratic leadership have put it back on the road to restored health and prosperity.”

2. The Democratic Party restored confidence in America, thus the cost of deficit borrowing had declined to extremely low levels: “We have raised the public credit to a position of unsurpassed security. The interest rate on government bonds has been reduced to the lowest level in 28 years.”

3. The Democratic Party would still balance the budget through the austerity of limited growth in government and by higher taxes: “We are determined to reduce the expenses of government...Our retrenchment, tax, and recovery programs thus reflect our firm determination to achieve a balanced budget and the reduction of the national debt at the earliest possible moment.”

Does any of this seem familiar? It shoud, as should the fact that in his several years in office the budget deficit had soared, and the attempt to balance it resulted first and foremost in an explosion in unemployment, as the chart below demonstrates:

What specifically went wrong to cause the 1937-1938 episode?

Someone once asked me what Roosevelt did that was so bad leading up to the recession of 1937-38. The answer I give is simple: “He attempted to balance the budget at the wrong time.” More specifically, he attempted to balance thebudget by increasing tax revenues at a time when the economy was still finding its footing and the Federal Reserve was attempting to reverse policy. Even after the four years of recovery following the Great Depression, when Roosevelt began his series of tax increases unemployment remained over 12 percent, which on its own would be considered the worst labor market in modern U.S. economic history.

If the Roosevelt Administration’s driving purpose was to prove to the world that it could balance the budget, it was successful. In 1937, the budget deficit declined by 1.9 percentage points in relation to GNP. In 1938, that trend continued with the deficit declining another 1.4 percentage points in relation to GNP. By December of 1938 the Roosevelt Administration had essentially achieved its goal of a balanced budget.

But what was the cost of such actions? According to data from BCA Research, the unemployment rate went from 11.2 percent in May of 1937 to 20.0 percent just 14 months later. Data from the Federal Reserve Bank of Minneapolis shows the overall economy contracted 5.4 percent in 1938. The Dow Jones Industrial Average fell 49 percent from March 1937 to March 1938. Two years later, in March of 1939, the equity market remained depressed, still 30 percent below its March 1937 levels. The U.S. economy, which had whipped unemployment down from 25 percent in 1933 to 11 percent in 1937, limped into the 1940s with unemployment hovering just over 15 percent. The silver lining of all this economic carnage? For one month in 1938 the budget deficit was reduced to just $89 billion dollars – nearly, but not quite balanced.

So have we learned anything from the past? And even if we have, will the imminent expiration of the tax cuts be the equivalent of the tax hike the rapidly plunged America into the biggest economic deterioration at the tail end of the Great Depression? Alas, the answer is probably yes.But not before the Fed embarks on a proper QE strategy, one that has the potential to not only spike asset prices as the Primary Dealers bid up everything that is not nailed down, but this would happen in a time of surging unemployment. With the true unemployment rate already in the 20% ballpark as calculated by objective, non-governmental estimates, will the outcome of the tax changes of 2011 result in the biggest economic catastrophe in US history? We should look back in time for the answer...

It’s evident from Chairman Ben Bernanke’s speech in Jackson Hole last week that the Fed stands ready to continue to provide quantitative easing if necessary. I believe it will be necessary since the economic data in the next few months is likely to be pretty ugly and the rhetoric out of Washington is likely to devolve into a nightly news highlight reel of partisan feuding.

Yet despite the Fed’s commitments, some of the same issues that occurred in 1937 loom on the horizon today. For instance, in the first quarter of 2011 the United States faces massive tax increases. Similar to the mid-1930s, many have argued that deficits must be tamed now and that the economy is healthy enough to sustain austerity measures. Under such political pressure, it appears unlikely that even a portion of the Bush tax cuts will be extended.

There are a host of economic forecasts about the potential size of the fiscal drag that would result from a full expiration of the Bush tax cuts. Macroeconomic Advisers, for instance, believes it will subtract 0.9 percentage points off GDP. ISI Consulting thinks it could be even larger, around 1.2 percentage points. Arthur Laffer, the famed supply-side economist, prefers a number significantly larger, predicting as much as 6 percentage points of fiscal drag. Any way you slice it, if estimates for economic growth in 2011 range from 2 to 3 percent, these tax increases could result in flat to anemic growth and elevate the risk of recession due to the slightest bit of economic turbulence.

In addition to the expiration of the Bush tax cuts, there is the additional cost of healthcare reform. While some would argue that healthcare reform is just a transfer payment program, the fact remains that there will be no incremental healthcare benefits available in the next three years. Therefore, the transfer payments, which are intended to be revenue neutral over the next 10 years, actually create a fiscal drag between 2011 and 2013 before becoming modestly stimulative when the benefits become available from 2014 to 2020.

So what does this imminent change to tax expectations mean for investors in practical terms? Very bad things, especially for those who anticipate a run up in stocks into the mid-term elections: "One clear consequence of the repeal of the Bush tax cuts will be an urgency to accelerate taxable income into 2010. This will have a number of impacts on the market, the most direct being a desire to liquidate positions in equities and other financial assets to realize capital gains before the New Year. This will continue to put downward pressure on equities and increase volatility."

That's right: equity liquidations, meaning the long expected second major leg down in stocks is at most 4 months away.

There's more:

Last week, Bernanke also referenced the importance of a “baton pass” from the economic boosts of government spending and inventory replenishing to the more sustainable support of consumer spending. If equity prices decline in conjunction with the renewed pressure on the housing market as tax incentives are removed, the net effect is likely to be an adverse impact to already fragile consumer sentiment and spending. In essence, the economy is in danger of a fumbled baton pass from 2010 to 2011.

In the face of this uncertainty, and in light of the Jackson Hole remarks, it appears Chairman Bernanke and the FOMC will find it necessary to increase their holdings in long-term securities and increase the size of their balance sheet. This will ultimately lead to lower interest rates and a need to maintain low long-term rates for several years in a hope to prop up the housing market by maintaining record low mortgage rates (see my recent commentary on “The Story in Housing”). What remains to be seen is how severe the economic headwinds will be as a result of the fiscal tightening going into 2011, and how dramatically the Fed will move once it reaches the decision to continue to grow its balance sheet.

In the short run, given the amount of purchases that the Fed will have to make, quantitative easing will most likely swamp the amount of incremental borrowing required by the government, which means that financing the deficit won’t be a problem. Ultimately, however, the U.S. economy will come to the end of the road and inflation concerns will reemerge.

Once the market collapse has transpired, then, and only then, once we enter the proverbial revulsion stage in equities, will the stage be set for an actual bull market:

I believe further quantitative easing is likely to take place in the near term. I also believe there is a strong probability that there will be some form of additional fiscal stimulus passed by the government as it yields to mounting pressure to address the nation’s historically high unemployment rate. After these two events take place, the stage should be set for the green shoots of recovery to reappear in 2011. Once these harbingers of economic health appear, the Fed will come under pressure to convince the market that it has a sound exit strategy to unwind its massive balance sheet. Simultaneously, pressure will reemerge for fiscal austerity and deficit reduction.

As we approach the presidential election of 2012, monetary and fiscal policymakers will be faced with their greatest challenge: whether to reverse the emergency policies applied up to that point, and if so, at what pace and timing to conduct such measures. The risks surrounding these decisions are even greater than the risks that surround the near-term policy decisions about further fiscal stimulus and quantitative easing – taking away support is always more difficult than giving it. The dangers will be strikingly similar to the risks that faced the economy in 1936. Remember, it was Roosevelt’s dash to fiscal discipline in 1936 – combined with the Fed’s misguided decision to tighten monetary policy by doubling the required reserve ratio for banks – that resulted in the severe fiscal drag on aggregate demand and economic output that pulled the economy back into a deep recession.

While I remain optimistic that the current economic “soft patch” will not unravel into a full-blown recession, my concern increases when I look ahead to the challenges the economy will face once it regains its footing. The parallels to 1936 grow increasingly striking the closer one looks to 2012, especially if the green shoots of economic recovery take hold between now and then, which I believe they will thanks to additional policy actions later this year and in early 2011. Oddly enough, the foundation for the recession of 1937-1938 was laid in the election year of 1936. The question remains, will the presidential election of 2012 lay the foundation for a parallel series of events? Given the unprecedented monetary and fiscal policies enacted in recent months, as well as those that are likely to be enacted in the near term, the opportunities for future errors of policy judgment loom large. In light of this, whether it’s in relation to 2010 or 2012, the lessons of 1936 are stark and disturbing.

And while America in 1938 and onward was a different country, whose manufacturing industry and thus real economic output potential, was only starting to stretch its wings, further having the rather tragic benefit of World War II as an unprecedented attractor for record economic activity, the current outlook is far more bleak. The US consumer is on average far older, the pension system is on the verge of bankruptcy, the US' chief export (at least on a relative basis) is services, and the spectre of a war at this juncture would have far more dire ramifications: a small regional conflict that avoids the participation of the superpowers may have a marginal boost to the economy, but likely nowhere near enough. A full blown collapse into another world war leads to consequences too dire to even imagine. Which is why we agree with Minerd, that while the intermediate steps that occurred in the immediately preceding 1937 period are all in line, and which the government will only have itself to blame if it screws up on the transition to a smooth glide slope, the events on the other end of the tunnel look far bleaker.

Full must read paper from Guggenheim.

Seeing Past The Hologram, by Mike Krieger of KAM LP

There is no distinctly American criminal class - except Congress.

Patriotism is supporting your country all the time, and your government when it deserves it.

All you need is ignorance and confidence and the success is sure.

It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.

There are lies, damned lies and statistics.

Courage is resistance to fear, mastery of fear, not absence of fear.

Laws control the lesser man... Right conduct controls the greater one.

- All quotes by Mark Twain

We Need Real Confidence to Return, Not Confidence in a Ponzi Scheme

Last week I pointed out that what I got from Banana Ben’s speech in Jackson Hole was that he realized any major public statement of interference in markets was too risky at this point following his announcement at the last meeting to keep the balance sheet steady by reinvesting MBS proceeds into treasury securities.  The operative word in this sentence being “public.”  Anyone that believes this means the Fed and government will just take a back seat and do nothing behind the scenes is deluding themselves.  Washington D.C. and the Fed still fail to comprehend how to increase standards of living in the real world, rather they remain completely addicted to the short-term buzz of printed money heroin as it flows through the house of cards they have created.  They also think that the only thing that really matters in an economy is “confidence.”  As Madoff can attest to, that is indeed the case when you are running a ponzi scheme and since the U.S. government is basically that I can understand where they are coming from.

 I agree that confidence is a huge part of any healthy economy; however, I do not define confidence in the way these arrogant bureaucrats do.  They think confidence comes from rising asset prices, including stocks and homes.  They think this is enough to spark growth in the real economy.  This is nonsense.  The confidence that is needed more than anything else today is two-fold.  First, confidence that there is the rule of law and there will be the rule of law in the future.  The second is that the money issued by the government will maintain its purchasing power over time.  As I have made clear on various occasions, I do not have confidence in either of these things based on how the government has responded to the crisis.  I do not like buying physical gold.  I do not like feeling the need to write these emails every week to warn people.  I wish I could employ capital into businesses and the real economy.  I hope that one day I will be able to do so, but at the moment I do not trust my government and I certainly don’t trust the fascist Federal Reserve.  So I will hoard what I have as the government prints and let the storm pass me by.  I am not the only one.  People are collectively starting to understand this.  So what happens when the big, smart money takes itself out of the investment and capital allocation game because they don’t trust anything?  What happens when the government’s response to this is to print money to keep up the spending habits of people with no jobs or people with government jobs that produce no goods for the economy?  You get the worst case scenario and that is exactly what is staring us straight in the face.

Is a Trade War with China Coming?

The quicker the dollar is devalued the better.  This is not to say that I think dollar devaluation is a good thing.  It is to say we are past the point of avoiding it.  We could have taken the pain in 2008, but instead it was extend and pretend all over again.  Now the debt and promises are too big.  The behind the scenes manipulations are too entrenched.  There is no avoiding a devaluation relative to things people need (food and energy) and capital goods that are imported.  The best thing would be to get it over with and then change policies and restore the rule of law.  The problem with this is that the main currencies the dollar needs its major adjustment against are those in emerging Asia and China.  What has prevented the realignment from happening in a quick and healthy way is China’s refusal to allow the yuan to appreciate.  This creates a situation where Central Banks throughout emerging Asia take steps to prevent their “free-floating” currencies from adjusting either.  If China does not change its policy I fear that what we are looking at a trade war with China after the November elections.  I think Congress and the Administration will start to introduce aggressive policies to discourage Chinese goods and encourage goods made at home.  Think it can’t happen?  We are a lot closer than you think.  This all goes back to my “think local” theme.  While I am inherently a fan of free trade we do not have free trade in any sense whatsoever.  We have policies that are geared to advantage the multi-national corporations at the expense of the U.S. citizen.  The U.S. consumer has merely been spending borrowed money.  This gave an illusion that the U.S. was benefiting from the global multinational corporate rigged market whose model mainly thrives on companies moving abroad to exploit the labor arbitrage caused by a combination of what was a labor surplus (no longer it seems) and a rigged currency.  As more people realize this, more pressure will be placed on politicians and ultimately this will overpower the corporate lobbyists and a trade war of sorts will begin.  Then the chaos could really ensue as we engage in a trade war with our biggest creditor!

Seeing Past the Hologram

The past couple of weeks have been extraordinarily interesting and some of the moves appear to be extremely important.  Although a lot of people like to point to the treasury market and then extrapolate out as to what this means to equities and the ability of the government to increase spending, I think this is the most USELESS market in the world to watch.  If anything is a hologram and a PR tool it is the U.S. treasury market.  How can people with a straight face come out and extrapolate anything from a market where the Federal Reserve is buying the debt of its own government!  The Fed is merely the fiat drug dealer to a government addicted to spending and false promises.  The equity market is the second most useless market in my opinion.  There is no doubt in my mind that a huge part of the government’s “strategy” to build confidence is to keep this thing from doing what it should be doing.  Thus, I am not surprised at all that since I last wrote the S&P500 was +1.6%, -1.5%, flat, and then +3.0%.  So what you have seen is high volatility with no real direction.  How can anyone have confidence this that thing is for real?

So what markets do I watch?  I get the most from the FX markets and the commodity markets.  While these markets are no doubt manipulated heavily as well, I think this is where the players that really understand the macro are playing.  The first currency I check in the morning is the dollar/yen.  The reason for this is that the yen is back to the highs of 1995 and if it does not stop appreciating around this level I think the Bank of Japan is going to absolutely panic.  While the yen has not broken higher yet as market participants are afraid of such intervention, unless the BOJ does something extreme soon the market may test their resolve and push this thing further.  I guess the main point I am trying to make is that with the Chinese yuan NOT strengthening and the yen threatening to break out we could be in for some major fireworks.  Meanwhile Japanese 10 year government bond yields have really started to spike lately (chart GJG10 Index on Bloomberg).  Something big is happening in the land of the rising sun.  In the back of my head I think that any panic move from the BOJ could be the spark that breaks government bond bubbles globally and ushers in a period of massive global commodity driven inflation as every country tries to devalue their way to prosperity.  Essentially, a fiat money version of the 1930’s beggar thy neighbor policies.  When this begins the rush into gold and silver that we have seen thus far will look like a trickle.  I don’t think people will be able to find supply anywhere near the quoted price on comex (or as some like to call it “crimex”).

This brings me to silver which potentially experienced a game changer last week.  I can’t remember the last time silver bounced back almost immediately after every attempted raid.  I am starting to wonder how much physical silver is available.  What we do know is that Central Banks do not store silver to manipulate markets.  Even if it doesn’t break out right now, there is no asset in the world that has more upside than silver.  Don’t buy SLV either.  Buy physical silver not something with JPM as a custodian. 

I also continue to watch food prices very closely.  Wheat, which has come off of its high now seems to have found a base at a price that is 50% higher than the end of June.  Corn prices are threatening to break above resistance at levels 30% where they were at the end of June.  Rice looks like it could have a long way to go on the upside as it is only 20% off of its June low.  If I were a foreign government I would be using this opportunity to buy every single grain of rice I could in order to feed my people when things get dicey in the months ahead.  After strong performance in recent months lean hogs and live cattle also look set to make another push to the upside.  How people in the investment world still focus on the government inflation statistics is beyond me.  It was the rampant commodity inflation, trucker strikes and food riots that played a key role in ending the game in 2008.  This is because it forced the emerging markets to raise rates and cool growth as the Western world imploded under a pile of debt.  It seems the whole play is starting again and people remain focused on deflation.  Deflation in some things yes I agree (discretionary things like homes, technology, stock prices, etc), but not in the things you NEED to buy!!!

Onto oil which is also exhibiting some strange moves.  The Asian benchmark Tapis has not experienced the recent volatility and weakness that WTI has and is currently trading at $80/b.  The Asian price is the one I really pay attention to since that is where the demand growth resides.  The spread between the two now is back above $6/b, which is toward the high end of the range for the past two years.  This tells me that one price is wrong and the spread should narrow.  Given what I think about currency debasement and lack of appropriate investment in the space I think WTI should rally.  We shall see…

A Primer on the Federal Reserve

For those that read my commentary on the Federal Reserve as an immoral an fascist institution and think to themselves “what is this guy talking about,” I have attached a video from G Edward Griffith (the author of The Creature from Jekyll Island).  It’s a great description of how the Fed was formed and who it answers to when push comes to shove.  http://video.google.com/videoplay?docid=6507136891691870450#

Also in case you weren’t aware of the power grab that the “Financial Reform” legislation allowed the Fed, read this Bloomberg article. 

http://www.bloomberg.com/news/print/2010-09-02/bernanke-meets-buffett-in-new-role-conceived-to-protect-markets.html

All the best,
Mike

As day two of the FCIC hearing into why the Fed flips a coin, and/ore answers a call from 200 West, to decide which bank is TBTF and which isn't, watch Ben Bernanke's tenuous dance with truth and reality at the following FCIC link.

And for some inexplicable reason Sheila Bair will be there too.

• Session 1: The Federal Reserve

  Ben S. Bernanke
  Chairman
  Board of Governors of the Federal Reserve System

• Session 2: Federal Deposit Insurance Corporation

  Sheila C. Bair
  Chairman
  U.S. Federal Deposit Insurance Corporation

With the dramatic rise in gold's popularity many still need to be educated about some of the core concepts of the gold market, such as who holds it, and who produces it. Courtesy of Money Hacker we have a useful visual representation that answers precisely these two questions. In addition, here are some of the most useful and trivial factoids about gold, that have no bearing on its price whatsoever, but serve as perfect cocktail small talk.

Some Insights into the data on the infographic:

All Gold Ever Mined – The total amount of gold ever mined is estimated to be worth around US$5 trillion.

How Gold is Used – You might have though (like me) that most of the gold in the world stored in bank vaults and lock-boxes? Actually, 78 % of the worlds’ gold is made into jewelery. Other industries, mostly electronics, medical, and dental, require about 12%. The remaining 10% of the yearly gold supply is used in financial transactions.

Producers and Owners – The starkest contrast is South Africa: number 27 on the list of nations that own the most gold list despite producing the most gold in the world per year from its mines.

Gold production in the United States – The State of Nevada has the world’s lowest cost and most profitable gold mines. The mines average output is about 7 million ounces per year.

The Fed’s Vault – The Federal Reserve Bank of New York has the largest accumulation of monetary gold. The vault is 25 meters (80 feet) underground and holds $147 billion worth of gold bullion.

Current gold price trading on Wall Street:

If the value of gold on the New York stock market is anything to go by then you can see how much its been a safe haven for investors:

And now for some facts and factoids about gold:

Gold Discovery – The first discovery of gold in the USA is the found of 8-kilograms stone of gold by the son of the farmer. He and his father were using this stone as the support for a door until the local jeweller noticed it. And the owner sold this stone for $3.5. Finally the farmer understood this piece was very valuable and opened the first gold-mine in the country.

Largest Gold Nugget Ever Found – The largest gold nugget ever found was in Australia in 1869. It was named “Welcome Stranger,” It weighed 78 kilograms. After it was melted down 71 Kg of pure gold was left.

The US Gold Drain – When the American dollar was first pushed as the world de-facto currency it was backed by gold. One ounce of gold was worth $35 dollars. After 25 years of the American’s continual printing of money however, $35 dollars was no longer worth an ounce of gold. In actual fact one ounce of gold was worth $105. As a result foreign countries, beginning with France in the late 1960’s, started to buy gold at $35 dollars until the United States Government stopped selling its gold, thus removing gold backing from its dollar.

Private Gold Ownership Banned in the USA – Private ownership of gold was banned in the United States for 41 years. It lasted from 1933 to 1974.

Gold Refined and Rare – If all the gold that had been refined in the world was put into a cube, its sides would be roughly 20 metres long but would only weigh 1/10 of the Washington Monument.

Gold Nugget – Gold nuggets are actually quite rare. A gold nugget can sell for up to 4 times the worth of the amount of gold in it.

Gold Leaf – Gold leaf is commonly 0.18 microns (seven millionths of an inch) thick. It’s so thin that a stack of 7,055 sheets would be no thicker than a dime.

Largest Gold Nugget Still in Nugget Form – The ‘Hand of Faith’, is the largest gold nugget still in existence. It weighs 27 Kg (60 pounds) and is currently on display at the Golden Nugget hotel and casino in Las Vegas.

Gold and Medicine – Thousands of rheumatoid arthritis victims have chemically liquefied gold injected into their muscles. It is said that the treatment is successful in seven out of ten cases.

The Heaviness of Gold – Gold is so heavy that one cubic foot of it weighs half a ton.

The Malleability of Gold – A single ounce of gold can be drawn into a wire 60 miles long.

Gold in Water – The worlds’ largest stock pile of gold is actually in the oceans. For every cubic mile of sea water there is 25 tons of gold! That’s a total of about 10 billion tons of gold in the oceans; unfortunately, there’s no known way to recover it economically.

Artificial Creation of Gold – Gold can be transmitted from platinum by nuclear reaction. But, because of the rarity of platinum, it is far too costly.

Gold in Space – The visors of astronauts’ space helmets receive a coating of gold so thin (0.00005 millimeters, or 0.000002 inches) that it is partially transparent. The astronauts can see through it, but even this thin layer reduces glare and heat from sunlight.

Gold in the Bible – You may be interested to know that gold is mentioned 417 times in the Bible. And, the last book of the New Testament, the Book of Revelation states that in the New Heavens and New Earth the streets will made from pure gold!

Today's key economic events include weekly claims, productivity revisions, retail chain store reports, pending home sales, factory orders, and the Fed’s weekly report on its own balance sheet, plus testimony from Chairman Bernanke and some other FOMC speakers.
 
8:30: Unemployment insurance claims….back in the old range?  Last week’s report showed initial claims returning to the upper end of the 425k-475k range in which they had fluctuated during most of 2010 before some elevated readings in late July and early August.  The median forecast shows little change in either initial claims or continuing claims (those receiving payments under regular programs).  The overall number of claimants has risen sharply since the renewal of emergency benefits in late July.
For initial claims, median forecast (of 40): 475k, ranging from 460k to 485k; last 473k.
For continuing claims, median forecast (of 11): 4.45 million, ranging from 4.4 million to 4.5 million; last 4.456mm.
 
8:30: Productivity and costs for Q2 (revised)…a bigger setback.  The downward revision to Q2 real GDP growth included a 1-point markdown in the growth rate of nonfarm output; this should show through to the productivity data.  The impact on unit labor costs is slightly smaller, as the Q2 revisions also showed a slightly smaller increase in labor compensation.  First-quarter data for unit labor costs are apt to be revised down.
For productivity, median forecast (of 56) -1.9%, ranging from -2.4% to -0.5%; last (Q2 prelim) -0.9%.
For unit labor costs, median forecast (of 54) +1.2%, ranging from +0.3% to +2.0%; last (Q2 prelim) +0.2%.
 
9:00: Boston Fed President Eric Rosengren and Cleveland Fed President Sandra Pianalto deliver opening remarks…at a summit looking at the effects of foreclosures and vacancies on neighborhoods.  Both are voting members of the FOMC this year, though the specialized nature of this session makes it unlikely they will make market-moving comments.
 
c. 9:15: GS Retail Index for Aug…Our retail analysts are looking for a slowing in this index of same-store sales gains, to 2.7% from 3.7% in June and 3.9% in July.
 
10:00: Federal Reserve Chairman Ben Bernanke testifies….at a hearing of the Financial Crisis Inquiry Commission (FCIC), which is charged with examining the causes of the 2007-2008 financial meltdown.
 
10:00: Pending home sales index for July....further weakness?  That’s the bias of forecasts for July.  This index plunged nearly 30% in May, as activity to take advantage of the homebuyer tax credit was winding down, and it was off another 2.6% in June.  Although we do not forecast this index, there’s a reasonable case for a rebound, as these declines were much deeper than the increases that preceded them.
Median forecast (of 37): -1.0%, ranging from -5% to +4%; last -2.6%.
 
10:00: Factory orders for July….a small increase?  As it usually the case, we expect this report to mimic – in subdued fashion – the patterns drop already reported for durable goods bookings.  For July, this means roughly no change in overall orders (durable goods orders were up 0.3%) but a significant decline in those outside transportation (this component of durable goods orders fell 3.8%).  Revisions to the durable goods data are always possible, and the inventory data bear some attention, as the durable goods component has risen significantly for six months running.
Median forecast (of 59) +0.2%, ranging from -1.2% to +2.5%; last -1.2%.
 
16:30: Federal Reserve balance sheet….We will highlight this report again as the reinvestment of principal repayments of MBS and agency debt begins to alter the asset composition.  This actually started to show up in last week’s data.  The overall size of the balance sheet should stay approximately the same, at $2.3trn.

From Goldman Sachs

Chris Whalen has a particularly tough-minded post at Reuters in which he explains why QE does little for the real economy (similar to the conclusions reached by the Bank of Japan regarding its own QE) and why its benefits for banks fade over time. Key sections:

When interest rates are low, savers move their preference for liquidity to infinity, especially after the past several years of market breakdown. Retirees spend less because the interest earned on bonds and savings has plummeted….

When the Fed buys securities through QE, it is removing duration from the markets, pushing down yields and volatility. For a while this boosts the net interest margin (NIM) of leveraged investors such as banks, who are able to borrow at lower rates to fund current assets. As assets re-price to the low rates maintained by the Fed, however, NIM begins to disappear. Over the medium to longer term, think of duration and NIM as being linked, so obviously a sustained period of QE is bad for NIM. This is why NIM in the U.S. banking sector is starting to fall.

Just as the earnings of leveraged investors like banks are starting to suffer due to zero rate policy, so too the spending by all manner of savers, from retirees to companies and not-for-profits to municipalities, is falling too. Fed Chairman Bernanke and the other members of the FOMC are killing the real economy to save the banks — but none of the benefit flowing to the banks is reaching U.S. households. In fact, the Obama Administration has been providing political cover for the Fed to conduct a massive, reverse Robin Hood scheme, moving trillions of dollars in resources from savers and consumers to the big banks and their share and bond holders.

Yves here. A big error the Fed made during the crisis was overly sharp rate cuts when markets swooned. The cliche was “75 [basis points] is the new 25.” A lot of commentators got nervous when the Fed cut its Fed funds rate below 2% because that put it on the path to ZIRP. But there were so many other distractions that concerns about the level of policy interest rates got lost in other crisis issues.

Whalen further argues that increased concentration in the banking industry has allowed the big banks to strangle credit:

“In every Fed easing event during my career in finance (1986, 1992, 1998, 2002), it was the wave of refinancing of debt after the Fed eased interest rates that put permanent disposable income into the hands of households,” notes a former Fed official who worked in the banking industry for decades. “In this last easing, however, FNM, FRE and the TBTF banks have conspired to break the transmission mechanism for monetary policy and are now strangling the U.S. economy to save themselves from past errors.”….

First, the Obama Administration should use the power provided in the Dodd-Frank legislation to force an accelerated cleanup of bad assets and to mandate refinancing and principal reductions for performing loans with viable borrowers….

Second, President Obama also needs to focus on the growing competitive problem in the U.S. mortgage sector…

The top three banks control 55% of all mortgage originations. The top 10 banks control 95%. The top five run the only surviving channels to sell loans to Fannie Mae (FNM) and Freddie Mac (FRE), and force their pricing upon the entire banking industry. Small banks give up half the economics of a typical loan to sell a loan to FNM or FRE indirectly, through WFC or JPM. Why is there no antitrust investigation of the top banks by the Department of Justice?

The Obama Administration should move to restructure FNM and FRE now, not in 2011. The Treasury should use its existing authority under the conservatorship to force FNM and FRE to make rules changes to allow for the refinancing of all existing residential mortgages, if only to reduce the current cost of the debt and increase disposable income for households…

President Obama should make some political hay over the fact that loan origination margins for the top four banks have gone from ½ point to over 4 points in the last two years. This is the subsidy for Wall Street above and beyond the zero interest rate policy of the Fed.

My quibble about the Fannie/Freddie refi idea is that this more deeply entrenches the role of the GSEs when Whalen argues against their powerful role, and it also creates large amounts of low yield paper which if we escape our near deflation conditions, will mean big time losses to the chump holders (and until we get over causing pain to bondholders, having Bill Gross hold a lot of securitized low yield mortgages means Bill Gross will be lobbying for more ZIRP and QE). Plus this move (by design) is a subsidy to homeowners and not renters. I’d prefer more straightforward ways of getting cash to ordinary consumers. But putting more heat on the banks is very much in order. And if they don’t like official criticism, they have only themselves to blame.

OK, maybe it hasn’t really crashed yet. But the 3 1/2 point sell off in the futures for the 30 year Treasury bond (TBT), at the end of last week was the sharpest drop in 18 months. Winston Churchill’s great 1942 quote, which marked the turning of the tide for Britain in WWII, comes to mind. “This is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”

 In my recent piece on the extreme overvaluation of government debt, I pointed out that the last time rates were this low, Treasury bonds brought in a miserly 1.9% yield for a decade (click here for the piece at http://www.madhedgefundtrader.com/august-26-2010.html ). Professor Jeremy Siegel at the Wharton School at the University of Pennsylvania has one upped me. After yields bottomed in 1956, bonds suffered negative returns for 30 years!

This should have occurred to me, as the first mortgage I took out on a Manhattan coop in 1982 carried an 18% interest rate. That was then Federal Reserve governor Paul Volker was waging a holy war on inflation and eventually won. I took out one of the first ever floating rate mortgages, and by the time I sold it three years later for my first double in real estate, the rate had melted down to only 11%. I tell this story to kids buying their first starter homes now and they look at me like I’m some kind of dinosaur.

 I have always believed that markets will do whatever they have to do to screw the most people. A big part of the parabolic move in bond prices was caused by so many investors going into this the wrong way. Hedge funds were short Treasuries and long steepeners, while mutual and pension funds were underweight.

Remember, this was supposed to be the trade of the year? Of the decade? Only individuals and momentum players have been in there buying with both hands, not because they love low yielding bonds so much, but because they hate equities. All it took to set the cat among the pigeons was for Q2 GDP to come in at 1.6%, not as bad as expected, and for Ben Bernanke to remain silent about any plans to flood the markets with more liquidity.

This may not be the top in the bond market, but it is starting to resemble what tops look like. One more equity puke out in September could easily get us there.

To see the data, charts, and graphs that support this research piece, as well as more iconoclastic and out-of-consensus analysis, please visit me at www.madhedgefundtrader.com . There, you will find the conventional wisdom mercilessly flailed and tortured daily, and my last two years of research reports available for free. You can also listen to me on Hedge Fund Radio by clicking on “This Week on Hedge Fund Radio” in the upper right corner of my home page.

The man who back in May wrote "Why the world is better than you think", only for the world to turn out about as bad as thought, if not much worse, Jim O'Neill, has just released the sequel to his required reading Kool Aid, "The World Is Down, But Far From Out" (is that a tacit apology for the previous title full of sound and fury?) which is currently making the rounds at all pension and mutual funds as well as all other institutions whose existence depends on the perpetuation of the illusion that the market is undervalued and that America is solvent. The latest essay provides absolutely nothing new and original in terms of though, and merely regurgitates the traditional expectation that China will rescue the world, as it continues decoupling from everyone else. We wonder if it has ever dawned on anyone that the only reason why China is so "resilient" in the face of the ongoing depression is because all of its numbers are completely made up? But that is apocryphal so we wont even ask that rhetorically, and accept at face value O'Neill projection that Chinese GDP will increase by over $7 trillion in the next 9 years, or nearly 3 times more than the US, even as both countries issue about $20 trillion in incremental debt (not bad: $2 of debt for $1 in GDP - even economists can probably figure that out). And where will this growth come from if not from the traditional driver of near-zero cost growth: low interest debt? Oh, so Jim is basically saying the world will grow arithmetically, as the credit bubble (now in its global iteration) grows semi-exponentially. Truly wonderful news.

Yet even O'Neill, in his permabullish element, finally agrees that his entire forecast is based on one and only variable coming true- the Fed's ongoing debasement of the dollar: "Over the past couple of months, as evidence has accumulated that the US economy is slowing once again, US financial conditions have not  tightened. Indeed, as a result of the aggressive policies of the Federal Reserve, conditions have remained very easy. In order for our more positive underlying views of the world to bear fruit, it is important that this situation persists." Basically, the entire global growth story, decoupling included, is based on what side of the bed the chairman of the politically and special interest independent Federa Reserve wakes up on.

Back in September of 2007 when I was preparing to launch a hedge fund, I came up with this interesting name for a blog. It was BoomBustBlog. What made it interesting is that I can literally blog ad infinitum on the synthetically crafted booms and busts of the global economy, for the method of shepherding the economy in this day and age is actually predicated on the existence and/or creation of Booms and Busts. Of course, from my common sense perspective, one would think that the job of a central banker would be to ameliorate the effects of, and in time eliminate booms and busts… Apparently, that doesn’t appear to be the flavor du jour. As a matter of fact, it appears as if central bankers are doing the exact opposite. Of course, attempting to cure a bust with a boom, or worse yet attempting to prevent a boom from busting with another boom is a recipe for disaster, and worse yet the probability of success is close to nil, yet central bankers try anyway. This leads to overt and explicit policy errors, which leads to outsized profit opportunities to those who pay attention. Enter “The Great Global Macro Experiment, Revisited“, from which I will excerpt below. Please keep in mind that this article was written in October of 2008, and turned out to be quite prescient, I will annotate in bold parentheticals the portions of particularly prescient relevance. The original macro experiment piece was posted on my blog in September of 2007… For those that are interested, I plan on discussing this topic live on Bloomberg TV today: “Street Smart” with Matt Miller & Carol Massar at 3:30 pm.

As the US real estate market (residential, and soon commercial) is tanking (see BoomBustBlog.com’s answer to GGP’s latest press release and Another GGP update coming), the opaque derivative structures that allowed banks to write loans bigger than their balance sheets follow (see Is this the Breaking of the Bear? among many others). This will ripple throughout the world as speculative real estate and exotic financing vehicles follow the same paths in Europe (see the Pan-European Sovereign Debt Crisis series), Africa (reference Dubai’s solvency issues), Asia (see Chubble (The Unmistakeable, Yet Thoroughly Argued Chinese Bubble), Unemployed/Deleveraging Shopaholics Pushing Retail Stocks & Other News and What Are the Odds That China Will Follow 1920’s US and 1980’s Japan?), and South America. Spain’s residential real estate market is currently on fire and 92% of the mortgages issued are ARMs, most of which are concentrated to the lower income buyers (see “The Spanish Inquisition is About to Begin…“ and Spain Reports 20%+ Unemployment, a Structural Problem That May Persist For Some Time). Sound familiar? Similar scenes in Brazil. UK residential prices have soared (see Osborne Seems to Have Read the BoomBustBlog UK Finances Analysis, His U.K. Deficit Cuts May Rattle Coalition as well as the near collapse of several large UK banks), Australia up nearly 3 times (relative) (see Australia: The Land Down Under(water in mortgage debt), China homebuilders and contractors or roaring, condos in Dubai everywhere… Add in the US exported structured products… Practically all of the popularized risky assets are destined to follow suit, not just real estate – expect pressure in the emerging market debt markets as a follow-through…

Understanding my proprietary investment style

My own, personal and discretionary investment style leverages long and short positions in any traditional or alternative asset class, in any instrument, in any market around the world with the goal of profiting from macroeconomic trends. Put most simply, I attempt to employ the tried and true adage: buy low and sell high – I simply aim to do it during all phases of the market cycle. The often used, but seldomly recognized as meaningless, investment style classifications of value investing, growth company investing, etc. are silly, to say the least. Everybody is a value investor. We all buy something with the understanding that we will be able to sell it for more, thus the implication that it is undervalued at the time of purchase. The reason why we feel we can sell it for more is the impetus behind these nonsensical monikers of value, growth, Amy, Cindy and Karen! At the end of the day, we all want to buy low and sell high. The key is, how do we successfully go about doing it.

Now, in reading the now historical missive above which references debacle after debacle that policy makers retort “were impossible to see coming” (yeah, uh huh!), it could conceivably be argued that a) I had a crystal ball, b) I’m just smart as hell, or c) I simply pay attention and adhere to basic math, i.e., 2 + 2 = 4, all day, everyday – you know, realism. I’ll let you decide which answer is most appropriate. I go through this exercise because while reading through Bloomberg at 2 am in the morning (yeah, I know I should have better things to do,  but how else will this blog get written), I came across a statement from some professionals that reinforced my thesis that some investors literally cannot possibly fathom that we are still in a bubble despite 40% drops in commercial real estate prices. Take a look at the chart above, the cycle goes up and down, and has been doing so for centuries. Despite the fact that nothing has really changed for over a 1,000 years, it is amazing that so very few have learned their lesson. Or to put it another way, just because something is cheap doesn’t mean it can’t get a whole lot cheaper. Wait a minute, I’ve got another one… I fall out of a 10 story window, and drop 60 feet in a matter of seconds…. Does this really mean that my fall is over just because I fell 60 feet so fast, or do I really have another 100 feet to go, then a very hard impact before all is said and done???

Bloomberg writes: Real Estate Premium to U.S. Bonds Signal Time to Buy Property

Sept. 1 (Bloomberg) — U.S. commercial real estate yields are near the highest level relative to Treasury bonds on record, a signal to some investors it’s time to buy property. Capitalization rates, a measure of real estate yields, averaged 7.22 percent in the second quarter, based on an index calculated by the National Council of Real Estate Investment Fiduciaries. That was 429 basis points, or 4.29 percentage points, higher than the yield on 10-year government bonds as of June 30, according to data compiled by Bloomberg. It’s about 475 basis points higher than Treasury yields as of yesterday.

That spread is near the record 539 basis points in the first quarter of 2009, when the U.S. was mired in the worst of the financial crisis and property prices sank. Risk-averse investors are seeking the highest-quality office towers, hotels and apartments as the gap widens, according to Nori Gerardo Lietz, partner and chief strategist for private real estate at Partners Group AG in San Francisco.

“The data indicate that real estate is poised for a rebound,” said Gerardo Lietz, who advises pension funds on property investments.

Well, I have several problems with the statement above. For one, it is very difficult to “time” real estate markets due to their illiquid nature and a lack of a crystal ball, but if one were a market timer the strategy above makes sense right? Actually, no it doesn’t. For one, we are not in any better an economic or fundamental position now than we were in 2009, its just that the government and the fed have spent so many trillions of dollars to create the illusion that we are under the umbrella of attempting to reinflate the bubbles of 2000 to 2007. With that being said, of course spreads are similar, the situations are similar save the government has less ammunition to fight the battle this time around.

Chart sourced from CREconsole.com

The strategy above appears to be borne from the long only asset management mantra of always buying an asset. Sometimes its best just to say “No!”. For instance, the story clearly states that spreads are almost as wide as they were in the first quarter of 2009, the height of the financial malaise. So, if one were to use the logic inherent and bought at those even wider blowout spreads (the argument for the thesis was stronger back then), take a look at what would  have happened to your hard earned (or your client’s hard earned) money…

The Moodys/REAL commercial property index (CPPI) is a periodic same-property round-trip investment price change index of the U.S. commercial investment property market based on data from MIT Center for Real Estate industry partner Real Capital Analytics, Inc (RCA). The index has been developed with the objective of supporting the trading of commercial property price derivatives. The index is designed to track same-property realized round-trip price changes based purely on the documented prices in completed, contemporary property transactions. The index uses no appraisal valuations. The set of indices developed so far includes a national all-property index at the monthly frequency, national quarterly indices for each of the four major property type sectors (office, apartment, industrial, retail), selected annual-frequency indices for specific property sectors in specific metropolitan areas, and primary markets quarterly indices for the top 10 metropolitan areas in the major property types.

The biggest hole (and there are a few) in this “spread” thesis is the gross reliance of the spread to Treasuries without recognition and appreciation that Treasuries themselves are most likely in a bubble. This is why it is best to take a truly fundamental look at your investments. Back to the story…

Some buyers already are acquiring buildings at lower cap rates, which move inversely to price. In June, a group of South Korean pension fund investors bought the 33-story Wells Fargo Building in San Francisco for $333 million from Principal Financial Group Inc. in one of the largest transactions in the second quarter, according to Real Capital Analytics Inc., a property research firm. The office tower sold at a cap rate of about 7 percent, said Goodwin Gaw, the developer who helped broker on the deal.

My question is, why not just wait until there is a discernible trend in the stability of CRE? Why must everyone rush in to be first? Do rental rates look to be going much higher in the near to medium term due to materially firmer business fundamentals or lessened supply? Do interest rates look to be dropping considerably in the near to medium term? Are the fundamentals of the renters firm and strong? How does supply vs demand look after rampant, bubblicious overbuilding (which is still going on, may I add)? How does the financing and credit landscape look? How about the credit metrics of existing buildings? Do we have low LTVs or are these things thoroughly underwater (see the Macerich excerpt below). Let’s take a few pages out of my CRE 2010 Outlook report for subscribers (click here to subscribe). Be aware that this 47 page report was written nearly 10 months ago…

Are US Treasuries In A Bubble?

Well, if they are, not only does that debunk the “spread only” thesis to CRE investing but it will devastate those who employed said thesis when the bubble pops. As treasury yields spike, the cap rates on said buildings will have to spike to maintain said spread or the spread will have to lessen making the CRE that much more expensive relative to the safer treasuries. Either way, the CRE investor would have wished they waited! Let’s take a look at the NYSE US 10 yr index…

Whoa!!! Looks pretty bubblicious to me! Herein lies the problem. I don’t think that many investors truly understand the predicament that the US, much Europe and those big boys in Asia are in. Pray thee tell me, how is the US going to pay back its massive debt? Taking this from the beginning, many of us were told that the Federal Reserve’s mandate was to management inflation and unemployment rates. I lost a lot of profit and messed up a 7 year record of investing in the 2nd quarter of 2009 when the federal reserve performed a stealth mandate change, which in essence was to reinflate and maintain the credit and risky asset bubbles of the new millenium. This bubble blowing has been funded by the tax payer through the US Treasury. I challenge anybody to prove that the Fed’s objective has been anything but. The government and the CB has literally pulled out all stops to prevent the “Bust” portion of the Boom/Bust cycle. They have bought trillions in MBS, toxic assets directly off of private companies balance sheets, insured and indemnified private transaction, nationalized failed private financial institutions, purchased treasuries and MBS directly in a bid to artificially lower market interest rates -this is a move which is in and of itself by definition, unsustainable and guarantees a rate spike.

To make a long story short, nearly all of the biggest private sector problems have effectively been nationalized and made public sector problems without forcing the private sector to right its wrongs. Since nothing has really changed in the private sector and we are not marking bad assets to market but rather letting whatever we couldn’t goose the government into buying and converting into treasuries remain as they were while cash generating from the faux recovery was paid out as bonuses – the banks still have a shit load of trash on their balance sheets amid a worsening macro environment, the most indebted government of our lifetime and crumbling fundamentals. I pray thee tell me, exactly how are rates not going to spike? US Treasures are the new CDOs, wherein back in 2007 private banks scooped the trash they couldn’t convince suckers clients into buying directly, said trash was aggregated and repackaged with a AAA moniker and then sold to suckers clients. So, what is the difference between what Lehman, Goldman, Merrill and Bear Steans did and what out Central Bank is doing – that is picking up the garbage that nobody wants, recycling it into treasuries with a AAA moniker and then reselling them? The biggest difference is that one of the biggest suckers clients buying these repackaged toxic assets cum treasuries is the Federal Reserve, itself. Talk about a Ponzi scheme that is unsustainable. Again, how is it that treasuries are not in a bubble? How will rates stay low enough to justify buying CRE based upon the spread over treasuries at historic lows that are virtually guaranteed to go higher before the fundamentals of CRE improve significantly? I haven’t even touched upon the situation of our friends over there in Europe  – see .Pan-European Sovereign Debt Crisis series, where several nations are skirting default or restructuring (de facto default, you don’t get your money as promised) which will most likely cause some serious interest rate volatility, of which some banks are not prepared to withstand – See The Next Step in the Bank Implosion Cycle???). Since banks lend to CRE investors…. Oh well, back to the article…

Comparing Yields

Investors compare property yields with Treasuries to determine how much potential profit real estate offers relative to an investment that’s considered low-risk. The spread shrank to less than 80 basis points, the narrowest in 16 years, when commercial real estate prices peaked in 2007. Property values have dropped more than 40 percent since the October 2007 top of the market, according to Moody’s Investors Service.

The gap’s widening follows a plunge in bond yields after the global financial crisis spurred a flight to safety and the Federal Reserve slashed interest rates to a record low. Treasury bonds yesterday completed the biggest monthly rally since the end of 2008 amid signs economic growth is faltering, with the benchmark 10-year note yielding 2.47 percent.

“Property is attractively priced versus the fixed-income market,” said Ritson Ferguson, chief investment officer of ING Clarion Real Estate Securities in Radnor, Pennsylvania, which manages about $12 billion.

Yes, he’s right. Then again, 2 day old oysters smell attractive versus 3 day old oysters as well. Does that mean that 2 day old oysters smell good? The primary mantra of investing should be return of capital over return on capital!

The wide spread carries a warning signal to some investors because the economy remains weak, hurting commercial rents and occupancy. To contact the reporter on this story: Hui-yong Yu in Seattle at hyu@bloomberg.net

Those would be the more prudent investors they are referring to, at least in my oh so humble opinion.

The Amount of Underwater Properties is Nothing to Sneeze At

In December of 2009, I posted an article and accompanying research titled, “A Granular Look Into a $6 Billion REIT: Is This the Next GGP?” The following are excerpts from it:

More on commercial real estate:

• Even With Clawbacks, the House Always Wins in Private Equity Funds
• Commercial Real Estate Continues to Dropped into Foreclosure as the Landlords of Said Properties Enjoy Skyrocketing Share Prices? Yep, Makes Plenty of Sense
• The Conundrum of Commercial Real Estate Stocks: In a CRE “Near Depression”, Why Are REIT Shares Still So High and Which Ones to Short?
• The Shortlist of the Shortlisted “Stocks to Short for 2010″: What We See as the Most Profitable Bear Postions for 2010
• Developing Implications on Loan Accounting Law: Mark to Market, Mark to Model, or Mark to Market Crash?

More on residential real estate:

• I Told You Housing Was Going to Take a Downturn for the Worse. I’ll Tell You Something Else, We Are in a Housing Depression! It’ll Get Worse Until Market Forces Rule Over Government Bubble Blowing!
• Anecdotal Evidence That Banks Are Hiding Depressed High End Real Estate
• As I Made Very Clear In March, US Housing Has a Way to Fall
• Australia: The Land Down Under(water in mortgage debt)
• Australia: The Land Down Under(water in mortgage debt), pt. Deux: Which Banks to Short?
• Aussi Bubble Video to Go With You Aussie Bubble Speculation?
• Recent Mortgage Loss and Credit Performance Commentary

A month ago, we took aim at Bank of America economist Neil Dutta, whose consistently bullish exhortations were starting to sound far too hollow in light of the prevalent, and all too obvious, economic deterioration. Today, the second most bullish bank on Wall Street (after Morgan Stanley) has finally relented and cut its 2011 GDP forecast from 2.3% to 1.8%, raised its unemployment expectations, and is now firmly in the "bad news is better news" camp, expecting the launch of QE2 in Q1 of 2011. Elsewhere, Goldman's Jan Hatzius took offense to the FOMC minutes, and stopped just short of calling the Fed a bunch of myopic liars What seems to have angered Hatzius is the Fed's "bald statement"(sic... or Freudian slip?) that “no member saw an appreciable risk of deflation.” Hatzius goes all out: "This seems surprising given (1) the recent data on economic activity, wages, and prices, (2) the decline in breakeven measures of inflation expectations, (3) a recent article suggesting that at least one FOMC member (President Bullard of St. Louis) is indeed quite worried about deflation, and (4) the observation by an unnamed meeting participant that “…survey measures of longer-run inflation expectations had remained positive in Japan throughout that country's bout of deflation." As a result, Goldman has now revised its call for no action from the Fed until the mid-term election, and anticipates a new round of QE to come as soon as the Fed's next meeting in three weeks. Is Jan finally starting to call the Fed on its bullshit?

From Bank of America:

The growth recession is here

After salami-slicing our forecast in recent months, we are ready to make a deeper cut. We now expect a growth recession: we think the economy will manage to post positive headline GDP numbers, but this growth will not be fast enough to keep the unemployment rate from drifting higher. We expect below-trend GDP growth in each of the next four quarters, and with a gradual rise in the unemployment rate above 10%. With the weaker growth, we believe the Fed will launch QE2—a new asset buying program—in Q1 of next year. Our interest rate team expects this to push 10-year yields below 2% in the early part of the year.

Recent data show a steady deceleration in growth. After surging in the first few months of the year, the two most important monthly  indicators—private payrolls and core retail sales—have stalled (Chart 1). At the same time the post-tax-credit housing hangover has been worse than expected, and even the business equipment recovery shows signs of faltering. Our sense is that the growth recession is already here and it is likely to linger through the first half of next year.

• For 2010, our full-year GDP forecast has been sliced 0.3ppts to just 2.6%.
• For 2011, we have shaved growth 0.5ppts to just 1.8%.
• The downward revision comes from weaker anticipated spending from both consumers and businesses. With business confidence weakening and the economy slowing, we took our 2011 capex forecast down to 7.0% from 12.0%.
• And, given the protracted inventory overhang in residential real estate and weaker labor market, we assume a long, even more painful, U-shaped
  housing recovery.

Yet far more curious was Jan Hatzius' note from yesterday in which he openly casts doubt on the Fed's predictive skills, and their constant inability to see deflation even where it is now prevalent. We present the full note with highlights:

How “Appreciable” Is the Risk of Deflation? (Hatzius)
 
•        The minutes of the August 10 FOMC contain the bald statement that “no member saw an appreciable risk of deflation.”  This seems surprising given (1) the recent data on economic activity, wages, and prices, (2) the decline in breakeven measures of inflation expectations, (3) a recent article suggesting that at least one FOMC member (President Bullard of St. Louis) is indeed quite worried about deflation, and (4) the observation by an unnamed meeting participant that “…survey measures of longer-run inflation expectations had remained positive in Japan throughout that country's bout of deflation.”
 
•        Further signs of economic weakness and/or disinflation over the next few months would likely increase the perceived risk of deflation, and persuade the committee to address these risks via renewed quantitative easing.  Our best guess is that this will happen in late 2010 or early 2011, but if the economic activity data are very weak and/or breakeven inflation falls quickly, we would not rule out a move at the September 21 FOMC meeting.
 
The most surprising aspect of the August 10 FOMC minutes was the highlighted part of the following sentence (near the start of the discussion of the committee’s policy action): “While no member saw an appreciable risk of deflation, some judged that the risk of further near-term disinflation had increased somewhat.”  The “members” in this sentence are the five current Fed governors, including Chairman Bernanke, as well as the presidents of the Federal Reserve Banks of Boston, Cleveland, Kansas City, New York, and St. Louis.  This is a stronger version of Chairman Bernanke’s assessment in his speech last Friday that “falling into deflation is not a significant risk for the United States at this time…” (emphasis added).
 
We don’t know exactly what the term “appreciable” means in terms of probabilities, but our interpretation is that the threshold would be no higher than 20%.  Moreover, we don’t know exactly what the term “deflation” means in terms of the measure used or the time period, but our interpretation is a negative year-on-year reading for the core PCE price index over the next 2-3 years—i.e., roughly through the end of the Fed’s formal forecast horizon.
 
We are surprised by this statement, for several reasons.
 
First, it seems to be at odds with the recent economic data.  While we are still some distance from outright core deflation, and while it is not our central expectation, the PCE price index excluding food and energy currently stands at 1.4% year-on-year, and the Dallas Fed’s trimmed-mean PCE index—which may well be a better measure of underlying inflation trends than the ex-food and energy index—stands at 1.0%.  These numbers are clearly below the Fed’s implicit targets, as Chairman Bernanke noted in his speech on Friday.  Moreover, this is at a time when the output/employment gap is at its largest since at least the early 1980s, and may be starting to widen once again given the economy’s transition to below-trend growth.
 
Second, the confidence that deflation will be avoided is at odds with the recent moves in some measures of inflation expectations.  Survey expectations have not changed much, but the decline in forward measures of breakeven inflation is noticeable.  The 5-year 5-year forward breakeven inflation rate calculated from on-the-run Treasury securities stood at 1.87% in the latest week, down from a high of 2.77% in late April 2010, and it is now at its lowest level since April 2009.  Other measures of breakeven inflation have also been declining.  A further substantial decline—say by another 30-40 basis points—would likely make Fed officials quite nervous.
 
Third, the statement seems to be at odds with a recent article by President Bullard of St. Louis suggesting that a continuation of the Fed’s current stance on short-term interest rates could result in deflation (see “Seven Faces of ‘The Peril’”, July 28, 2010).  The first sentence of the abstract reads: “In this paper I discuss the possibility that the U.S. economy may become enmeshed in a Japanese-style, deflationary outcome within the next several years.”  Moreover, the article suggests that this is indeed a significant risk, at least if the FOMC maintains the current low-interest rate policy.  (We do not agree with President Bullard’s view that low interest rates increase the risk of deflation, but that is a separate issue.)
 
Fourth, the statement about the risk of deflation follows the observation a few paragraphs earlier that “[o]ne [participant] noted that survey measures of longer-run inflation expectations had remained positive in Japan throughout that country's bout of deflation.”  This is at least noteworthy because Fed officials have frequently pointed to the stability of inflation expectations as a reason to downplay deflation concerns.
 
Ultimately, the FOMC’s views and policy will evolve with the data.  Further signs of economic weakness and/or disinflation over the next few months would likely increase the perceived risk of deflation, and persuade the committee to address these risks via renewed quantitative easing.  Our best guess is that this will happen in late 2010 or early 2011.  However, if the data on economic activity—especially Friday’s employment report—surprise sharply on the downside and/or breakeven inflation falls quickly, we would not rule out a move at the September 21 FOMC meeting.
 
Jan Hatzius

Full BofA note

The FCIC's daily mouthful-and-a-half matine titled "Too Big to Fail: Expectations and Impact of Extraordinary Government Intervention and the role of Systemic Risk in the Financial CrisisThe Role of Derivatives in the Financial Crisis" (price of admission: free, if entrance before the S&P rises by 3% on weaker than expected Chinese, European and US data) starring Dick Fuld and co-starring a bunch of corrupt politicians is now playing. There is no expectation of Fuld fictional love interest Erin Calan appearring at least until the sequel. For all those who are sick and tired of watching the [AUDJPY|gold] take all stops to the [upside|downside], tune in to today's theatrical pastiche at the following link.

Today's full program of appearances. For all those asking, Ben Inkjet and Mary Corrupto will be appearing tomorrow.

• Session 1: Wachovia Corporation

  Scott G. Alvarez
  General Counsel
  Board of Governors of the Federal Reserve System
  Testimony (PDF)
  John H. Corston
  Acting Deputy Director, Division of Supervision and Consumer Protection
  U.S. Federal Deposit Insurance Corporation
  Testimony (PDF)
  Robert K. Steel
  former President and Chief Executive Officer
  Wachovia Corporation
  Testimony (PDF)

• Session 2: Lehman Brothers

  Thomas C. Baxter, Jr.
  General Counsel and Executive Vice President
  Federal Reserve Bank of New York
  Testimony (PDF)
  Richard S. 'Dick' Fuld, Jr.
  Former Chairman and Chief Executive Officer
  Lehman Brothers
  Testimony (PDF)
  Harvey R. Miller
  Business Finance & Restructuring Partner
  Weil, Gotshal & Manges, LLP
  Testimony (PDF)
  Barry L. Zubrow
  Chief Risk Officer
  JPMorgan Chase & Co.
  Testimony (PDF)

Goldman's Ed McKelvey summarizes today's key economic data:

Lots going on today, beginning with some labor market indicators, then industrial and construction data, then Fed speeches punctuated by reports from vehicle manufacturers….
 
The Mortgage Bankers Association’s index of mortgage applications rose 2.7%, the fifth consecutive weekly increase.  This one was composed of a 1.8% increase in the purchase loan index and a 2.8% increase in the refinancing index.  However, this index remains in a very low range.

7:30: Challenger job cuts for Aug….a moderation in the rate of improvement.  With the labor market appearing to have stalled, the year-to-year decline may be less than 50%, especially since layoffs a year ago were already improving.
 
8:15: ADP employment report for Aug…did private hiring slow?  The median forecast shows only a trivial increase.  Since the last revamping of this report in December 2008, it has tended to understate the net change in private-sector payrolls (by 63k, on average) and has only overstated in two months.
Median forecast (of 35): +15k, ranging from -50k to +55k; last +42k.
 
10:00: ISM manufacturing index for Aug…slowdown?  The industrial data continue to show a weakening trend in the US manufacturing sector, leading most economists to forecast a step down in the ISM’s index.
Median forecast (of 78) 52.7, ranging from 49.9 to 56; last 55.5.
 
10:00: Construction outlays for July…a decline?  Our model suggests a sharp slowing in the wake of a post-tax-credit drop-off in starts and weak fundamentals outside the residential sector.
GS: -1.6%; median forecast (of 50): -0.5%, ranging from -1.6% to +0.5%; last +0.1%.
 
10:45: Federal Reserve Governor Elizabeth Duke speaks…at a Washington summit looking into the effects of foreclosures and vacant properties on neighborhoods.  Although Gov. Duke was cited last week in the Wall Street Journal as one of seven FOMC members expressing reservations about the decision to reinvest MBS proceeds, she ultimately voted for it.  It is unlikely that this appearance will shed any light on her views regarding this decision given the specific focus of this speech and the lack of a Q&A session.
 
13:40: Dallas Fed President Richard Fisher speaks on the US economy…in Houston.  Mr. Fisher was also among the seven cited in the Wall Street Journal article.  His next turn on the voting rotation of the FOMC comes in 2011.
 
Late morning/early afternoon: Lightweight vehicle sales for Aug…still subdued. Anecdotal reports from the manufacturers suggest a moderation in August.
For total sales: Median forecast (of 40): 11.55mm, ranging from 11.3mm to 11.85mm; last: 11.56mm.
For domestic only: Median forecast (of 16): 8.85mm, ranging from 8.5mm to 9.23mm; last 9.11mm.
 
8:45: Chicago Fed President Charles Evans speaks….closing the summit at which Gov. Duke is also expected to appear.  Mr. Evans is not currently a voting member of the FOMC; his next turn is in 2011.

A key paragraph in a post on a new paper by Jim Hamilton:

We can summarize the implications of that forecast in terms of the following scenario. Suppose that the Federal Reserve were to sell off all its Treasury securities of less than one-year maturity, and use the proceeds to buy up all the longer term Treasury debt it could. For example, in December of 2006, this would have required selling off about $400 B in bills and notes or bonds with less than one year remaining, with which the Fed could have effectively retired all Treasury debt beyond 10 years. The figure below summarizes the implied average change in forecast for the 1990-2007 period as a result of this change for interest rates of various maturities. Yields on maturities longer than 2-1/2 years would fall, with those at the long end decreasing by up to 17 basis points. Yields on the shortest maturities would increase by almost as much. While our estimates imply that the Fed could make a modest change in the slope of the yield curve, it would not make any difference for the average level of interest rates.

Note Hamilton clearly states that the Fed could clearly lower rates further. As Scott Fulwiler commented via e-mail:

They just have to announce the rate they want and be willing to buy everything offered at that price. Since the real point of QE2 is to cut longer-term rates, the only conclusion is that they don’t understand the fundamental fact that their operations are about price, not quantity.

Also, Hamilton’s evidence should work in reverse–i.e., don’t fear the Chinese dumping all their lt Treasuries . . . 17bp for every $400B.

I’d love to see a study that parses out the impact of Fed announcements. It might be that talk really is cheaper than action.

Submitted by Gonzalo Lira

A Termite-Riddled House: Treasury Bonds

When termites eat your house, you don’t notice a thing. You don’t hear a thing, you don’t see a thing—you’re house stands there, silent and staid, while you and your family happily go about your days, without a care in the world—
 
—until your house crashes on top of your head.
 
Right now, we are at a stage where Treasury bonds are as weakened as a termite-riddled house. They look fine: Nice glossy coat of paint, pretty shingles, bright clear windows, sturdy-looking plankings on the open-aired porch.
 
But Treasuries are well on their way to a complete collapse. Why? Because of the way they have been mishandled and mistreated by the Federal Reserve Board, and the U.S. Treasury. Whether by incompetence or by design, U.S. Treasury bonds have become the New & Improved Toxic Asset. The question is no longer if they will collapse—it’s when.
 
Let me explain why.

 
First of all, what exactly were Toxic Assets—does anybody remember? I do: They were bonds made out of bundles of dodgy real estate deals. They didn’t seem dodgy at the time. What’s that old expression, “safe as houses”? At the time they were made, those bonds seemed safe as houses. Now we call them “Toxic Assets”—because now, we know better. But back then—before they collapsed—they were called “Mortgage Backed Securites”, or “Commercial Mortgage Backed Securites”, or else “Collateralized Debt Obligations”.
 
Essentially, all these sophisticated-sounding terms were to emphasize that the bonds were secured loans—the houses and commercial real estate were supposed to back up these debts. If the payments failed, the properties could be confiscated and auctioned off. So the bonds would be repaid. So the bonds were safe—safe as houses. Or so it was thought.
 
Of course, we saw how that show ended.
 
For those who missed those exciting episodes, a recap: Sub-prime mortgages began to default first, as the economy slowed down. This in theory should not have affected Mortgage Backed Securities based on those sub-prime loans. But the real estate which had been purchased with sub-primes weren’t worth what they had been purchased for—they were worth much less. So the bonds backed by the sub-prime loans began to explode.
 
Soon after the sub-primes, alt-A loans and prime loans, and finally commercial real estate—their prices all began to collapse, and so the bonds manufactured out of these loans also began to explode.
 
All those banks holding all those “safe as houses” MBS’s and CMBS’s and assorted CDO’s all of a sudden found that those bits of paper were not safe as houses. They were so un-safe in fact, that the banks damned near went broke—they would have, too, if it hadn’t been for the Fed and the Treasury, who bailed them out: The Treasury with TARP (cash), the Fed with “liquidity windows” (more cash).
 
But even that didn’t work—so we got “extend & pretend”, whereby the accounting rules were suspended in order to create the illusion of solvency among the TBTF (Too Big To Fail) banks. (My discussion of that is here.) That’s how bad the Toxic Assets were.
 
The reason these debts became “toxic” was that it became obvious in 2007–’08 that those bonds would never be repaid. They couldn’t be repaid: The properties which backstopped the value of the bonds had fallen irretrievably in price—or more properly, the real estate bubble which had goosed the valuation of those properties to absurd, Tulipmania levels had finally burst.
 
So even if the real estate was foreclosed and sold at auction, the holders of these now-Toxic Assets would only receive a fraction of the nominal price of the bonds. What had once been worth 100 was now worth 80, 60, 40, and in some cases, Cop Snacks.
 
I’ve never liked the term “asset”, when discussing bonds. They’re not “assets”—they’re debt. They’re a loan. And a loan only has value so long as it’s being repaid. If the debtor defaults—or tries to pay back the loan with something of less valuable than what was originally lent out—then this “asset” becomes a loss.
 
So to prevent these catastrophic losses, Backstop Benny—Ben Bernanke, Chairman of the Federal Reserve—essentially did the ol’ switcheroo on the Toxic Assets: In order to save the banks whose balance sheets depended so heavily on these now-dead turds, the Fed purchased the Toxic Assets at their nominal price. Then the banks—the so-called Too Big To Fail banks—took that cash and purchased U.S. Treasury bonds.
 
I have yet to find a better chart than this one here, that describes so succinctly how the Fed expanded its balance sheet to bail out the banks. (Hat tip Ashley Huston at WSJ.com: Alex Lowe designed the chart, based on reporting by Phil Izzo—extra-special kudos to them both.)
 
Meanwhile, the U.S. Treasury, in its attempts to finance bailouts, stimulus, health care, Social Security, and endless pointless wars, went into further debt—to the tune of $1.4 trillion dollars, roughly 10% of U.S. gross domestic product, for both 2009 and 2010.
 
Or to put it another way—a very scary way—in both 2009 and what’s projected for 2010, the Federal government has issued $1 of Treasury debt for every $1 of tax receipts. Between the actual budget deficit, plus Social Security liabilities, the U.S. Federal government is in the hole for about $13.5 trillion—or roughly 100% of GDP: That is what the Federal government owes. And if 2011 continues to be the same (as is almost certainly to be the case), then another $1.5 trillion or so (give or take a couple of hundred billion dollars) will be added to that tab.
 
All told, the United States will have a fiscal-debt-to-GDP ratio of 100% this year, and 110% next year—if not higher, depending on the tax receipts in 2011. A lot of wishful thinking is going on for 2012, but the way the numbers are playing out, another trillion dollars’ worth of debt is very likely in the offing—which would put the total fiscal-debt-to-GDP ration to 120%.
 
(Funny: That number—120%—reminds me of something . . . what was it? Oh! Right! Greece! This past spring, Europe had a medium-sized meltdown when Greece—roughly 2% of the EU as measured by GDP—revealed it was running a 120% fiscal-debt-to-GDP ratio. The Europeans and the IMF finally caved and bailed out Greece. Ah, the Greeks! But I digress, sorry—after all, the United States is not Greece. The United States has absolutely nothing in common with Greece—not at all! First of all, buddy, and for your freakin’ information, the United States is roughly 45 times the size of Greece, and . . . oh . . . wait a sec . . . )
 
Let 2012 take care of 2012—right now, September 2010, we have 100% fiscal-debt-to-GDP, in an environment of falling tax receipts and more strains on the various social safety nets. Right now, we have debt matching tax receipts dollar-for dollar. Right now, the interest on the outstanding debt, for 2010 according to government projections, is $375 billion—in other words, 25¢ of every dollar of tax receipts goes to pay interest. Right now, with recent economic numbers, the likelihood of a turn-around are unlikely—so because of the inevitable political pressure come the winter, more “stimulus” is likely in the offing.
 
Meaning more Treasury bonds, floating out into the market.
 
But who is buying all this new Federal government debt? Why, that’s very simple: The Federal Reserve.
 
The reason that the Federal government could go into the aforementioned massive spending spree was precisely because of the Federal Reserve’s bail-out: The Fed created money out of thin air (as is their power), in order to buy Toxic Assets from the Too Big To Fail banks. The banks, in turn, took this cash and bought Treasuries—which financed the Federal government’s deficit.
 
This is what I call Stealth Monetization: Unlike in some banana republics, which dispense with the niceties and simply turn on the printing presses whenever they need more money to spend, the U.S. Federal government and the U.S. Federal Reserve got creative, and used the TBTF banks to essentially hide the monetization of the fiscal debt in plain sight.
 
Many people complain that the bail-out money the TBTF banks received was never lent out—oh, but they’re wrong: The money was lent out. It was lent out to the Federal government. 
 
After all, what did the TBTF banks do, with all that cash they got from the Federal Reserve for unloading all those Toxic Assets? Why, they went and bought themselves boatloads of Treasury bonds.
 
It’s been the Federal government that has been “mopping up excess liquidity”—mopping it up and spending it on stimulus that doesn’t work, wars that can’t be won, dodgy dinosaur-projects that aren’t going to do squat to improve people’s health. That’s why the TBTF haven’t been lending money to businesses and “getting the economy back on track”—they’ve been too busy lending to the Federal government.
 
Clever people call Treasuries “assets”—but like I’ve said, I’m just stupid: I just call it debt. When I look at all this Federal government debt—unprecedented amounts of fiscal debt—I can’t help but notice that it is all unsecured—because it is unsecured. At least Toxic Assets had something backing them up, even if they were worth much less than advertised. Treasury bonds, on the other hand, are based only—solely—on the “full faith and credit” of the United States Federal government.
 
Y’Know: The one in Washington. The same U.S. Federal government that is running 100% debt-to-GDP ratios this year, 110% next year, and likely 120% the year after that—if not more.
 
Mm-hmm . . .
 
What happens when a debtor becomes so over-extended that he cannot possibly pay back his loans? Naturally: They default—or they try to wriggle their way out of the debt, by giving you something less valuable than what you are owed.
 
It is not controversial to say—and indeed, it is widely discussed—that the U.S. Treasury has only two options: Default on Treasury bonds, or debase the currency by way of inflation, so that the nominal value of Treasuries is stable, but their real value decays by inflationary attrition.
 
Default is politically unacceptable—apart from pissing off foreign Treasury holders, it would cause havoc in America if the Federal government woke up one day, clapped its hands like a schoolmarm, and announced to the world, “Okay Treasury holders! Time for a haircut!” Default ain’t gonna happen.
 
So that leaves “controlled” or “induced” inflation—the only method for the Federal government to get out from underneath this debt.
 
Backstop Benny is doing his damnedest to bring about precisely this scenario: He is trying to print the economy out of this Global Depression. With QE, the recently anounced QE-lite, and the likely-to-be-coming-soon QE2, Bernanke is going to pump more and more money into the system—“Print ’til you puke!!” seems to be his motto.
 
Bernanke is being egged on by everyone, from Paul Krugman to the Republicans to Larry Summers and Tim Geitner—everybody wants him to print more: Either because they want more fiscal spending (Krugman, et al.), or because they want asset prices to be pumped up again to unnatural highs (Wall Street and their Washington lackeys).
 
And Benny is obliging. The way Bernanke is doing this printing is by buying Treasuries. The Federal Reserve buys Treasuries and squirts some more dollars into the system—just as he propped up the prices of Toxic Assets by buying them up, when there was the need.
 
Yields of Treasuries are at absurd lows, there is a veritable T-bond rally every single day that equities drop even just a bit—in other words, Treasuries are in a bubble. Why? Because the market knows that Bernanke and the Fed will backstop Treasuries—
 
—backstop them right off the cliff.
 
The more the Fed prints, the more it encourages the Federal government to “stimulate”—id est, go further into debt in an attempt to grow the economy out of this Depression by way of fiscal spending. But as I said, right now, 25¢ of every dollar of tax receipts goes to pay interest on the fiscal debt. How long before 50¢ of every dollar goes to pay interest? 100¢ of every dollar? Is that when the fiscal debt finally becomes insurmountable?
 
Or will there be a Moment of Clarity in the markets? Will there come a day when the bond markets collectively realize that Treasuries will never ever be repaid—cannot be repaid? And when that day comes, when that Moment of Clarity falls on the markets, will it spark a panic?
 
In two previous posts, I essentially said “yes”: “Yes” to a collective Moment of Clarity, “yes” to a panic in Treasuries. I further argued that such a panic would lead—inexorably—to a flight to safety in actual, physical commodities, which would then result in a massive hyperinflation that would kill the dollar dead. Part I is here, Part II is here.
 
What is most important is, I do not know when such a Moment of Clarity will occur—but I have no doubt that it will occur. Inevitably, unavoidably: Treasury bonds are bound to collapse, triggering the sequence of events that I have described.
 
Plenty of people disagree with me. Actually, most people disagree with me.
 
Weirdly, plenty of people told me in no uncertain terms that, not only would there never be a panic in Treasuries—these people claimed that there couldn’t be such a panic. A couple of these people claimed (I swear to God) that it was systemically impossible for there to be a panic in Treasuries—“Because the government can just print its way out of a panic!”
 
Uh-huh. So no hyperinflation after a Treasury bond collapse, ’cause the government can—y’know—print all the money needed to shore up Treasuries and avoid hyperinflation. Okay.
 
The people who defended this insane argument are under the spell of MMT—Modern Monetary Theory. It’s currently the most fashionable dismissal of the importance of Treasury over-extension. People in this camp effectively say, “Treasury debt doesn’t matter!”, and explain how government debt is basically a numbers game.
 
According to this theory—which is just a modern-day retelling of the chartalist myth—all money is basically government chits, which are moved around within a game-board, said game-board being owned and controlled by the government. According to MMT, governments which issue their own currency may go into as much debt as they wish, certain and confident that nothing bad will happen because the government controls the currency. In other words, macroeconomically speaking, MMT claims that it’s a government’s world—we only live in it.
 
My objection to this, in snooty eccy terminology: I think that these MMT macro-economic theorists are purveyors of an interesting new meta-neo-Keynesianist world-view. It seems they are employing a closed-system, zero-sum proto-monetarist model. This model—though compelling—does present certain structural issues and disappointing limitations, vis-à-vis the uses of a reserve currency, which might make the theory less than apropos, were it to face a real-world scenario. Or not.
 
My objection to this, in just plain ol’ regular words? I think this MMT theory is full of shit, propagated by fucking idiots.
 
MMT is just a clever way to justify insurmountable levels of fiscal debt—it’s a rationalization of this insurmountable debt, using a veneer of economic terminology to cloak the purveyors’ political ideology of spend!-spend!-spend!-your way out of a recession or depression: In other words, Keynesianism-redux. Keynesianism on steroids—Keynesianism gone fucking in-sane.
 
(I’m going to write a detailed take-down of these MMT fools in a couple of weeks. But for now, let me limit myself to just a couple of paragraphs.)
 
These irresponsible peddlers of MMT claptrap—because that’s what they are, irresponsible buffoons for peddling such irresponsible, arrogant bullshit—simply do not understand what money is: It is a medium of exchange. The government—which controls this medium of exchange, especially in a fiat currency—is supposed to be the honest broker between economic participants who use this medium of exchange for their transactions.
 
A government issues the medium (the currency), and the government can debase it at will, for whatever reasons it deems worthy. But if the medium—the currency—is debased to a tipping point, then the economic participants will no longer believe in the currency’s worth. They will therefore run from the currency, and turn elsewhere to fulfill the need that money satisfies, which is: To store wealth, and to act as a medium of exchange.
 
If the dollar and Treasury bonds are pushed hard enough—that is, debased hard enough—there will come a point where people will lose trust in them both, and not want them. It’s one thing if a currency organically inflates by way of ordinary demand on consumables and expansion of credit—that’s just normal fiat currency wear-and-tear. It’s quite another if economic parties realize that a government is deliberately trying to debase the currency, in order to get out from under insurmountable debt.
 
If people no longer trust dollars as a medium of exchange and Treasuries as stores of value, where will they go? They will leave both and go to something else—commodities, as I have argued. And when that day comes, people will do anything to get out of the dollar and Treasuries, and into something that is stable in terms of value storage and medium of exchange.
 
MMT doesn’t see this—it just sees spread-sheets and board-games. This story here, which giddily, girlishly describes Federal Reserve drones “printing money”—and how wonderful and magical that process is—is pretty indicative of the fundamental detachment from reality of this world-view.
 
It’s why MMT fails at describing both reality, and predicting the future. It’s why—among other reasons, which I will discuss more fully in another post—MMT is a big ol’ steaming crock of shit.
 
MMT is one theory as to why nothing bad will happen to Treasuries.
 
The other theory—much more sensible, and backed up with empirical evidence—is what I’d call the Japan Is Us theory of Treasury bond stability. It’s the only truly serious challenge to the argument of Treasury bond collapse which I am arguing. Therefore, it’s a challenge that must be met.
 
On the blogosphere, Michael “Mish” Shedlock is probably the smartest proponent of the Japan Is Us theory.
 
I have a lot of respect for Mish—he was one of the very few serious commentators who argued that the U.S. economy was going to experience deflation. He argued that position literally years before it caught on. People now—in 3Q of 2010—are wising up to deflation. Because of Mish’s insights, I was on to deflation as of 3Q of 2008—and was fortunately able to plan accordingly.
 
Mish also thinks I’m full of it, for claiming that there’ll be a Treasury bond collapse, commodity spike and then hyperinflation.
 
His rationale is, we are experiencing deflation (which I agree). This deflation has been brought about by destruction of credit (check again), brought by the bursting of the housing bubble and the concomitant reduction in mortgages and loans (check once again).
 
Mish further argues that, like Japan, the U.S. Federal government will spend-spend-spend on all sort of needless projects, but that the deflation is much stronger. Therefore, no matter how much the U.S. spends, there is no way to escape from a Japan-style Lost Decade (or two) of stagnant growth and systemic deflation.
 
This is where we part company.
 
Mish is convinced that through these deflationary years/decades, Treasuries will continue to be the only safe store of value. From a recent post, here’s a representative quote:

I do think corporate bonds, especially most junk is playing for the greater fool. regards to treasuries, there is going to be an exit problem for sure, but that could be years away. In Japan, yields stayed low for a decade. Why can't it happen here?

Yields certainly might stay low for an extended period. Whether or not they do remains to be seen.  

(The underlining is mine.)
 
Mish thinks that there’ll never be a Moment of Clarity, regarding Treasuries. He admits that there might be an “exit problem” in Treasuries, but vaguely posits that that might be “years away”. In the meantime, he thinks that Treasury yields will remain low, prices high (or go even higher), as companies and banks basically “keep money under the mattresses”.
 
Mish has a good case in arguing for the Japan Is Us theory—but he is wrong, on two fronts.
 
First, Mish doesn’t realize that Federal Governments’s deficit spending is rapidly approaching its limit. Because unlike Japan in 1990, when its deflationary death-spiral began, the U.S. Federal government started this depression already with a massive deficit. The eight years of Bush 43, to be precise, were all borrow-and-spend years: In those eight years, the fiscal deficit had already goosed the economy.
 
That’s why the massive stimuls Obama implemented hasn’t really helped—the economy is already hung-over from the Bush stimulus years.
 
Besides—and so obvious that it shouldn’t even be up for debate—yearly fiscal deficits of 10% of GDP per year are simply unsustainable. I don’t care what argument you make, deficits of this ever-increasing size will lead to a collapse in the economy. Certainly a blow-up in Treasuries—the instrument of this deficit—long before.
 
Mish further fails to realize that the Federal Reserve has abandoned both of its mandates—to fight inflation and to maintain full employment—in favor of its new mantra: Maintaining aggregate asset price levels. Whatever it takes. This means essentially inflating asset price levels back to pre-Depression levels.
 
Everything the Fed has been doing since September 2008 has been in the service of this goal. The MBS buys, the alphabet-soup of liquidity windows, QE, now QE-lite, QE2 soon to come—the Fed is hell-bent on maintaining the bubble it created between 1987 and 2007.
 
Since September 2008, the way the Fed achieved this goal was by effectively nationalizing private debt, and turning it into public debt—one look at the Fed balance sheet is enough to convince any skeptic. This means that all the bad debt accumulated during the last two-and-a-half decades have been effectively turned into Treasuries.
 
So Treasuries are getting squeezed and pulled two ways: By the U.S. Federal government, and by the U.S. Federal Reserve. Because of the massive fiscal debt of the Federal government, Treasury bonds will not be repaid, at least not in real terms. And because of the Federal Reserve’s constant goosing of their prices in order to both maintain low interest rates and prop up asset prices, Treasury bond prices have left planet earth altogether, and are in the realm of Bubble-land.
 
In a couple of private e-mails, Mish objected to—and dismissed—my Treasury-run/commodity-moonshot/hyperinflation scenario altogether. According to him, I was arguing for a Shazaam! moment: When all of a sudden—for no reason whatsoever—people would collectively panic and—Shazaam!—they would exit Treasuries en masse.
 
Mish is actually right—that’s what I’m saying. I pompously call it a “Moment of Clarity”, Mish more cuttingly calls it a Shazaam! moment.
 
But that is, in essence, what I am arguing: Because in a termite-riddled house, no one can predict when the house will collapse—but we all know deep in our bones that it will collapse. So the second you hear a creak in the plankings, what do you do? You run for the exits.
 
I have no idea when that Shazaam moment will happen: Tomorrow, next month, next year. But it will occur—because everybody knows that Treasury debt cannot be repaid. So it’s not a question of if—the damage has been done, and is irreparable. It’s now just a question of when.
 
I hope I have explained why.

Submitted by Gonzalo Lira

A Termite-Riddled House: Treasury Bonds

When termites eat your house, you don’t notice a thing. You don’t hear a thing, you don’t see a thing—you’re house stands there, silent and staid, while you and your family happily go about your days, without a care in the world—
 
—until your house crashes on top of your head.
 
Right now, we are at a stage where Treasury bonds are as weakened as a termite-riddled house. They look fine: Nice glossy coat of paint, pretty shingles, bright clear windows, sturdy-looking plankings on the open-aired porch.
 
But Treasuries are well on their way to a complete collapse. Why? Because of the way they have been mishandled and mistreated by the Federal Reserve Board, and the U.S. Treasury. Whether by incompetence or by design, U.S. Treasury bonds have become the New & Improved Toxic Asset. The question is no longer if they will collapse—it’s when.
 
Let me explain why.

 
First of all, what exactly were Toxic Assets—does anybody remember? I do: They were bonds made out of bundles of dodgy real estate deals. They didn’t seem dodgy at the time. What’s that old expression, “safe as houses”? At the time they were made, those bonds seemed safe as houses. Now we call them “Toxic Assets”—because now, we know better. But back then—before they collapsed—they were called “Mortgage Backed Securites”, or “Commercial Mortgage Backed Securites”, or else “Collateralized Debt Obligations”.
 
Essentially, all these sophisticated-sounding terms were to emphasize that the bonds were secured loans—the houses and commercial real estate were supposed to back up these debts. If the payments failed, the properties could be confiscated and auctioned off. So the bonds would be repaid. So the bonds were safe—safe as houses. Or so it was thought.
 
Of course, we saw how that show ended.
 
For those who missed those exciting episodes, a recap: Sub-prime mortgages began to default first, as the economy slowed down. This in theory should not have affected Mortgage Backed Securities based on those sub-prime loans. But the real estate which had been purchased with sub-primes weren’t worth what they had been purchased for—they were worth much less. So the bonds backed by the sub-prime loans began to explode.
 
Soon after the sub-primes, alt-A loans and prime loans, and finally commercial real estate—their prices all began to collapse, and so the bonds manufactured out of these loans also began to explode.
 
All those banks holding all those “safe as houses” MBS’s and CMBS’s and assorted CDO’s all of a sudden found that those bits of paper were not safe as houses. They were so un-safe in fact, that the banks damned near went broke—they would have, too, if it hadn’t been for the Fed and the Treasury, who bailed them out: The Treasury with TARP (cash), the Fed with “liquidity windows” (more cash).
 
But even that didn’t work—so we got “extend & pretend”, whereby the accounting rules were suspended in order to create the illusion of solvency among the TBTF (Too Big To Fail) banks. (My discussion of that is here.) That’s how bad the Toxic Assets were.
 
The reason these debts became “toxic” was that it became obvious in 2007–’08 that those bonds would never be repaid. They couldn’t be repaid: The properties which backstopped the value of the bonds had fallen irretrievably in price—or more properly, the real estate bubble which had goosed the valuation of those properties to absurd, Tulipmania levels had finally burst.
 
So even if the real estate was foreclosed and sold at auction, the holders of these now-Toxic Assets would only receive a fraction of the nominal price of the bonds. What had once been worth 100 was now worth 80, 60, 40, and in some cases, Cop Snacks.
 
I’ve never liked the term “asset”, when discussing bonds. They’re not “assets”—they’re debt. They’re a loan. And a loan only has value so long as it’s being repaid. If the debtor defaults—or tries to pay back the loan with something of less valuable than what was originally lent out—then this “asset” becomes a loss.
 
So to prevent these catastrophic losses, Backstop Benny—Ben Bernanke, Chairman of the Federal Reserve—essentially did the ol’ switcheroo on the Toxic Assets: In order to save the banks whose balance sheets depended so heavily on these now-dead turds, the Fed purchased the Toxic Assets at their nominal price. Then the banks—the so-called Too Big To Fail banks—took that cash and purchased U.S. Treasury bonds.
 
I have yet to find a better chart than this one here, that describes so succinctly how the Fed expanded its balance sheet to bail out the banks. (Hat tip Ashley Huston at WSJ.com: Alex Lowe designed the chart, based on reporting by Phil Izzo—extra-special kudos to them both.)
 
Meanwhile, the U.S. Treasury, in its attempts to finance bailouts, stimulus, health care, Social Security, and endless pointless wars, went into further debt—to the tune of $1.4 trillion dollars, roughly 10% of U.S. gross domestic product, for both 2009 and 2010.
 
Or to put it another way—a very scary way—in both 2009 and what’s projected for 2010, the Federal government has issued $1 of Treasury debt for every $1 of tax receipts. Between the actual budget deficit, plus Social Security liabilities, the U.S. Federal government is in the hole for about $13.5 trillion—or roughly 100% of GDP: That is what the Federal government owes. And if 2011 continues to be the same (as is almost certainly to be the case), then another $1.5 trillion or so (give or take a couple of hundred billion dollars) will be added to that tab.
 
All told, the United States will have a fiscal-debt-to-GDP ratio of 100% this year, and 110% next year—if not higher, depending on the tax receipts in 2011. A lot of wishful thinking is going on for 2012, but the way the numbers are playing out, another trillion dollars’ worth of debt is very likely in the offing—which would put the total fiscal-debt-to-GDP ration to 120%.
 
(Funny: That number—120%—reminds me of something . . . what was it? Oh! Right! Greece! This past spring, Europe had a medium-sized meltdown when Greece—roughly 2% of the EU as measured by GDP—revealed it was running a 120% fiscal-debt-to-GDP ratio. The Europeans and the IMF finally caved and bailed out Greece. Ah, the Greeks! But I digress, sorry—after all, the United States is not Greece. The United States has absolutely nothing in common with Greece—not at all! First of all, buddy, and for your freakin’ information, the United States is roughly 45 times the size of Greece, and . . . oh . . . wait a sec . . . )
 
Let 2012 take care of 2012—right now, September 2010, we have 100% fiscal-debt-to-GDP, in an environment of falling tax receipts and more strains on the various social safety nets. Right now, we have debt matching tax receipts dollar-for dollar. Right now, the interest on the outstanding debt, for 2010 according to government projections, is $375 billion—in other words, 25¢ of every dollar of tax receipts goes to pay interest. Right now, with recent economic numbers, the likelihood of a turn-around are unlikely—so because of the inevitable political pressure come the winter, more “stimulus” is likely in the offing.
 
Meaning more Treasury bonds, floating out into the market.
 
But who is buying all this new Federal government debt? Why, that’s very simple: The Federal Reserve.
 
The reason that the Federal government could go into the aforementioned massive spending spree was precisely because of the Federal Reserve’s bail-out: The Fed created money out of thin air (as is their power), in order to buy Toxic Assets from the Too Big To Fail banks. The banks, in turn, took this cash and bought Treasuries—which financed the Federal government’s deficit.
 
This is what I call Stealth Monetization: Unlike in some banana republics, which dispense with the niceties and simply turn on the printing presses whenever they need more money to spend, the U.S. Federal government and the U.S. Federal Reserve got creative, and used the TBTF banks to essentially hide the monetization of the fiscal debt in plain sight.
 
Many people complain that the bail-out money the TBTF banks received was never lent out—oh, but they’re wrong: The money was lent out. It was lent out to the Federal government. 
 
After all, what did the TBTF banks do, with all that cash they got from the Federal Reserve for unloading all those Toxic Assets? Why, they went and bought themselves boatloads of Treasury bonds.
 
It’s been the Federal government that has been “mopping up excess liquidity”—mopping it up and spending it on stimulus that doesn’t work, wars that can’t be won, dodgy dinosaur-projects that aren’t going to do squat to improve people’s health. That’s why the TBTF haven’t been lending money to businesses and “getting the economy back on track”—they’ve been too busy lending to the Federal government.
 
Clever people call Treasuries “assets”—but like I’ve said, I’m just stupid: I just call it debt. When I look at all this Federal government debt—unprecedented amounts of fiscal debt—I can’t help but notice that it is all unsecured—because it is unsecured. At least Toxic Assets had something backing them up, even if they were worth much less than advertised. Treasury bonds, on the other hand, are based only—solely—on the “full faith and credit” of the United States Federal government.
 
Y’Know: The one in Washington. The same U.S. Federal government that is running 100% debt-to-GDP ratios this year, 110% next year, and likely 120% the year after that—if not more.
 
Mm-hmm . . .
 
What happens when a debtor becomes so over-extended that he cannot possibly pay back his loans? Naturally: They default—or they try to wriggle their way out of the debt, by giving you something less valuable than what you are owed.
 
It is not controversial to say—and indeed, it is widely discussed—that the U.S. Treasury has only two options: Default on Treasury bonds, or debase the currency by way of inflation, so that the nominal value of Treasuries is stable, but their real value decays by inflationary attrition.
 
Default is politically unacceptable—apart from pissing off foreign Treasury holders, it would cause havoc in America if the Federal government woke up one day, clapped its hands like a schoolmarm, and announced to the world, “Okay Treasury holders! Time for a haircut!” Default ain’t gonna happen.
 
So that leaves “controlled” or “induced” inflation—the only method for the Federal government to get out from underneath this debt.
 
Backstop Benny is doing his damnedest to bring about precisely this scenario: He is trying to print the economy out of this Global Depression. With QE, the recently anounced QE-lite, and the likely-to-be-coming-soon QE2, Bernanke is going to pump more and more money into the system—“Print ’til you puke!!” seems to be his motto.
 
Bernanke is being egged on by everyone, from Paul Krugman to the Republicans to Larry Summers and Tim Geitner—everybody wants him to print more: Either because they want more fiscal spending (Krugman, et al.), or because they want asset prices to be pumped up again to unnatural highs (Wall Street and their Washington lackeys).
 
And Benny is obliging. The way Bernanke is doing this printing is by buying Treasuries. The Federal Reserve buys Treasuries and squirts some more dollars into the system—just as he propped up the prices of Toxic Assets by buying them up, when there was the need.
 
Yields of Treasuries are at absurd lows, there is a veritable T-bond rally every single day that equities drop even just a bit—in other words, Treasuries are in a bubble. Why? Because the market knows that Bernanke and the Fed will backstop Treasuries—
 
—backstop them right off the cliff.
 
The more the Fed prints, the more it encourages the Federal government to “stimulate”—id est, go further into debt in an attempt to grow the economy out of this Depression by way of fiscal spending. But as I said, right now, 25¢ of every dollar of tax receipts goes to pay interest on the fiscal debt. How long before 50¢ of every dollar goes to pay interest? 100¢ of every dollar? Is that when the fiscal debt finally becomes insurmountable?
 
Or will there be a Moment of Clarity in the markets? Will there come a day when the bond markets collectively realize that Treasuries will never ever be repaid—cannot be repaid? And when that day comes, when that Moment of Clarity falls on the markets, will it spark a panic?
 
In two previous posts, I essentially said “yes”: “Yes” to a collective Moment of Clarity, “yes” to a panic in Treasuries. I further argued that such a panic would lead—inexorably—to a flight to safety in actual, physical commodities, which would then result in a massive hyperinflation that would kill the dollar dead. Part I is here, Part II is here.
 
What is most important is, I do not know when such a Moment of Clarity will occur—but I have no doubt that it will occur. Inevitably, unavoidably: Treasury bonds are bound to collapse, triggering the sequence of events that I have described.
 
Plenty of people disagree with me. Actually, most people disagree with me.
 
Weirdly, plenty of people told me in no uncertain terms that, not only would there never be a panic in Treasuries—these people claimed that there couldn’t be such a panic. A couple of these people claimed (I swear to God) that it was systemically impossible for there to be a panic in Treasuries—“Because the government can just print its way out of a panic!”
 
Uh-huh. So no hyperinflation after a Treasury bond collapse, ’cause the government can—y’know—print all the money needed to shore up Treasuries and avoid hyperinflation. Okay.
 
The people who defended this insane argument are under the spell of MMT—Modern Monetary Theory. It’s currently the most fashionable dismissal of the importance of Treasury over-extension. People in this camp effectively say, “Treasury debt doesn’t matter!”, and explain how government debt is basically a numbers game.
 
According to this theory—which is just a modern-day retelling of the chartalist myth—all money is basically government chits, which are moved around within a game-board, said game-board being owned and controlled by the government. According to MMT, governments which issue their own currency may go into as much debt as they wish, certain and confident that nothing bad will happen because the government controls the currency. In other words, macroeconomically speaking, MMT claims that it’s a government’s world—we only live in it.
 
My objection to this, in snooty eccy terminology: I think that these MMT macro-economic theorists are purveyors of an interesting new meta-neo-Keynesianist world-view. It seems they are employing a closed-system, zero-sum proto-monetarist model. This model—though compelling—does present certain structural issues and disappointing limitations, vis-à-vis the uses of a reserve currency, which might make the theory less than apropos, were it to face a real-world scenario. Or not.
 
My objection to this, in just plain ol’ regular words? I think this MMT theory is full of shit, propagated by fucking idiots.
 
MMT is just a clever way to justify insurmountable levels of fiscal debt—it’s a rationalization of this insurmountable debt, using a veneer of economic terminology to cloak the purveyors’ political ideology of spend!-spend!-spend!-your way out of a recession or depression: In other words, Keynesianism-redux. Keynesianism on steroids—Keynesianism gone fucking in-sane.
 
(I’m going to write a detailed take-down of these MMT fools in a couple of weeks. But for now, let me limit myself to just a couple of paragraphs.)
 
These irresponsible peddlers of MMT claptrap—because that’s what they are, irresponsible buffoons for peddling such irresponsible, arrogant bullshit—simply do not understand what money is: It is a medium of exchange. The government—which controls this medium of exchange, especially in a fiat currency—is supposed to be the honest broker between economic participants who use this medium of exchange for their transactions.
 
A government issues the medium (the currency), and the government can debase it at will, for whatever reasons it deems worthy. But if the medium—the currency—is debased to a tipping point, then the economic participants will no longer believe in the currency’s worth. They will therefore run from the currency, and turn elsewhere to fulfill the need that money satisfies, which is: To store wealth, and to act as a medium of exchange.
 
If the dollar and Treasury bonds are pushed hard enough—that is, debased hard enough—there will come a point where people will lose trust in them both, and not want them. It’s one thing if a currency organically inflates by way of ordinary demand on consumables and expansion of credit—that’s just normal fiat currency wear-and-tear. It’s quite another if economic parties realize that a government is deliberately trying to debase the currency, in order to get out from under insurmountable debt.
 
If people no longer trust dollars as a medium of exchange and Treasuries as stores of value, where will they go? They will leave both and go to something else—commodities, as I have argued. And when that day comes, people will do anything to get out of the dollar and Treasuries, and into something that is stable in terms of value storage and medium of exchange.
 
MMT doesn’t see this—it just sees spread-sheets and board-games. This story here, which giddily, girlishly describes Federal Reserve drones “printing money”—and how wonderful and magical that process is—is pretty indicative of the fundamental detachment from reality of this world-view.
 
It’s why MMT fails at describing both reality, and predicting the future. It’s why—among other reasons, which I will discuss more fully in another post—MMT is a big ol’ steaming crock of shit.
 
MMT is one theory as to why nothing bad will happen to Treasuries.
 
The other theory—much more sensible, and backed up with empirical evidence—is what I’d call the Japan Is Us theory of Treasury bond stability. It’s the only truly serious challenge to the argument of Treasury bond collapse which I am arguing. Therefore, it’s a challenge that must be met.
 
On the blogosphere, Michael “Mish” Shedlock is probably the smartest proponent of the Japan Is Us theory.
 
I have a lot of respect for Mish—he was one of the very few serious commentators who argued that the U.S. economy was going to experience deflation. He argued that position literally years before it caught on. People now—in 3Q of 2010—are wising up to deflation. Because of Mish’s insights, I was on to deflation as of 3Q of 2008—and was fortunately able to plan accordingly.
 
Mish also thinks I’m full of it, for claiming that there’ll be a Treasury bond collapse, commodity spike and then hyperinflation.
 
His rationale is, we are experiencing deflation (which I agree). This deflation has been brought about by destruction of credit (check again), brought by the bursting of the housing bubble and the concomitant reduction in mortgages and loans (check once again).
 
Mish further argues that, like Japan, the U.S. Federal government will spend-spend-spend on all sort of needless projects, but that the deflation is much stronger. Therefore, no matter how much the U.S. spends, there is no way to escape from a Japan-style Lost Decade (or two) of stagnant growth and systemic deflation.
 
This is where we part company.
 
Mish is convinced that through these deflationary years/decades, Treasuries will continue to be the only safe store of value. From a recent post, here’s a representative quote:

I do think corporate bonds, especially most junk is playing for the greater fool. regards to treasuries, there is going to be an exit problem for sure, but that could be years away. In Japan, yields stayed low for a decade. Why can't it happen here?

Yields certainly might stay low for an extended period. Whether or not they do remains to be seen.  

(The underlining is mine.)
 
Mish thinks that there’ll never be a Moment of Clarity, regarding Treasuries. He admits that there might be an “exit problem” in Treasuries, but vaguely posits that that might be “years away”. In the meantime, he thinks that Treasury yields will remain low, prices high (or go even higher), as companies and banks basically “keep money under the mattresses”.
 
Mish has a good case in arguing for the Japan Is Us theory—but he is wrong, on two fronts.
 
First, Mish doesn’t realize that Federal Governments’s deficit spending is rapidly approaching its limit. Because unlike Japan in 1990, when its deflationary death-spiral began, the U.S. Federal government started this depression already with a massive deficit. The eight years of Bush 43, to be precise, were all borrow-and-spend years: In those eight years, the fiscal deficit had already goosed the economy.
 
That’s why the massive stimuls Obama implemented hasn’t really helped—the economy is already hung-over from the Bush stimulus years.
 
Besides—and so obvious that it shouldn’t even be up for debate—yearly fiscal deficits of 10% of GDP per year are simply unsustainable. I don’t care what argument you make, deficits of this ever-increasing size will lead to a collapse in the economy. Certainly a blow-up in Treasuries—the instrument of this deficit—long before.
 
Mish further fails to realize that the Federal Reserve has abandoned both of its mandates—to fight inflation and to maintain full employment—in favor of its new mantra: Maintaining aggregate asset price levels. Whatever it takes. This means essentially inflating asset price levels back to pre-Depression levels.
 
Everything the Fed has been doing since September 2008 has been in the service of this goal. The MBS buys, the alphabet-soup of liquidity windows, QE, now QE-lite, QE2 soon to come—the Fed is hell-bent on maintaining the bubble it created between 1987 and 2007.
 
Since September 2008, the way the Fed achieved this goal was by effectively nationalizing private debt, and turning it into public debt—one look at the Fed balance sheet is enough to convince any skeptic. This means that all the bad debt accumulated during the last two-and-a-half decades have been effectively turned into Treasuries.
 
So Treasuries are getting squeezed and pulled two ways: By the U.S. Federal government, and by the U.S. Federal Reserve. Because of the massive fiscal debt of the Federal government, Treasury bonds will not be repaid, at least not in real terms. And because of the Federal Reserve’s constant goosing of their prices in order to both maintain low interest rates and prop up asset prices, Treasury bond prices have left planet earth altogether, and are in the realm of Bubble-land.
 
In a couple of private e-mails, Mish objected to—and dismissed—my Treasury-run/commodity-moonshot/hyperinflation scenario altogether. According to him, I was arguing for a Shazaam! moment: When all of a sudden—for no reason whatsoever—people would collectively panic and—Shazaam!—they would exit Treasuries en masse.
 
Mish is actually right—that’s what I’m saying. I pompously call it a “Moment of Clarity”, Mish more cuttingly calls it a Shazaam! moment.
 
But that is, in essence, what I am arguing: Because in a termite-riddled house, no one can predict when the house will collapse—but we all know deep in our bones that it will collapse. So the second you hear a creak in the plankings, what do you do? You run for the exits.
 
I have no idea when that Shazaam moment will happen: Tomorrow, next month, next year. But it will occur—because everybody knows that Treasury debt cannot be repaid. So it’s not a question of if—the damage has been done, and is irreparable. It’s now just a question of when.
 
I hope I have explained why.

As part of the Fed's latest QE iteration, it has already been made clear that despite initial disclosures that the Fed would stay in the 2-10 Year bound of Treasurys, Ben Bernanke is now also gobbling up the very long end of the curve. For all those who are, therefore, still confused why bonds continue to surge to record levels, don't be: when there is a guaranteed bidder just below you in the face of the Fed, and who you can turn around and sell to at will, there is no pricing risk. The problem, from a bigger stand point, is what happens when the Fed is actively buying up 30 Year bonds with impunity and the much desired (by the Fed) inflation still does not appear? Well, the Fed then, in Michael Pento's opinion, will begin to purchase stocks and real estate. And as all those who enjoy comparing the US to Japan can attest, outright purchases of securities by the Japanese government is a long-honored tradition in the ongoing fight with deflation in Japan. However, and as the recent BOJ (lack of) intervention demonstrated, Japan never could do anything with the required resolve, and bidding up one stock here and there would never achieve anything. Which is why in this interview with Eric King, Michael Pento makes the case that as opposed to the occasional market intervention via the President's Working Group, Bernanke will soon make stock purchases an outright policy of the Federal Reserve as its last ditch attempt to engender inflation before the hundreds of billions of Commercial Real Estate and other bank debt start maturing in 2011/2012. Bernanke is running out of time and he knows it. And once the Fed becomes the bidder of last resort in stocks, all bets are off, as the Central Bank will become the defacto only market in virtually every risky category. And the only safe vehicle, once the market then begins to price in Fed driven asset-price hyperinflation, will be gold.

Pento also provides some perspectives on the Fed's balance sheet, which he anticipates will expand in a "great fashion", but a much bigger concern to the recent Euro Pacific Capital addition, is the possible surge in M2: "That base money can expand, M2 which is currently running around 8.5 trillion all the way up to nearly 25 to 30 trillion dollars of money supply and that's enough obviously to send prices through the roof." All Bernanke needs to do is light the "alternative asset purchasing" match and all those who wonder what left field hyperinflation could come out of, will get their answer.

Of course, it wouldn't be a Pento interview without a requisite smack-down, in this case of Dennis Gartman, whose call to sell gold denominated in euros at the very bottom of the recent gold correction needs no further commentary: EUR-denom gold has jumped well over 10% since Gartman said to get out. Pento adds the following: "There is so much misinformation out there, Dennis Gartman was out there saying gold has lost its inflation hedging properties: this is just ludicrous and insane. I can tell you that gold will never lose its inflation lure, and that's precisely why I've stepped up my purchases of gold., I see what the monetary base is doing, I can clearly see Bernanke's next step to vastly increase the size of the balance sheet and the monetary base. So for me, it's 100% an inflation hedge."

Pento also goes into explaining why housing is facing a "deflationary depression," and a further collapse in pricing, why inflation benefits only those closest to the money, i.e., the banks and the military complex, why it destroys the middle class (we are sure Buffett ca. 2003 could say something about that too... the current, far more senile and captured Uncle Warren, not so much), the impact on discretionary purchases, on unemployment, real incomes, and all other items which tend to "follow the money."

Lastly, Pento concludes with an analysis of what would have happened had the government allowed the deflationary depression to occur two years ago, without the tens of trillions in bank bailouts. We protracted, and elongated the depression. But instead of having the benefit of falling prices, you have rising prices." And if Pento is right, the price rise has only just begun.

Full King World News interview here.

Much of the monetary actions made by the Federal Reserve and other central banks last year were done under the auspices that they were “trying to save capitalism” or “the free market.”

Setting aside the fact that the US hasn’t been a free market in decades, IF EVER (we’ll address that point in a moment), this statement is so boldly stupid that it’s amazing no one laughed at the powers that be when they claimed it.

“Save capitalism?” what exactly does this statement mean? How does one save a system that by very its nature encompasses failure and collapse for those who mess up? For capitalism, in its purest form, is nothing if not a system through which bad business decisions result in failure and good business decisions result in success.

Indeed, if some financial firm makes a colossal mistake (say, betting trillions of dollars of mortgage backed securities the wrong way for example), and subsequently finds itself insolvent, capitalism dictates that said firm should GO UNDER. End of story. That IS Capitalism. And we have a bankruptcy system in place to hand off the assets to creditors and more capable business people.

However, that’s not the system we have in the US today. Indeed, it’s not clear to me that we ever had that sort of system. As far back as the 1850s the US business game was somewhat rigged as various entities attempted to form monopolies to increase their leverage over their respective industries (John D Rockefeller’s Standard Oil being the most obvious example). To think that these monopolies were formed without some degree of government allowance or even approval is naive.

However, at least Rockefeller’s company actually MADE money.

In today’s Crony capitalist economy, the political system is bought outright by the large multinational corporations via various lobbying efforts/ corporate donations. These multinationals then receive kickbacks in the form of deregulatory policies and other tax loopholes, which permit them to further expand their power and influence.

However, unlike Rockefeller’s Standard Oil, most of these large-scale firms, especially the banks, are in fact insolvent or would be if they did not have unprecedented access to the US Federal Reserve and taxpayer dollars.

These groups aren’t strong pillars of profitability, they’re massively insolvent, unprofitable messes that wouldn’t exist if not for the fact that accounting standards have been suspended or disregarded as a national policy (unless you’re talking about ordinary Americans).

These companies don’t “add value” to the US economy, if anything they are a net drag on US productivity as they simply move capital around, most often from their clients accounts into their own. How many Goldman Sachs clients made fortunes in 2008-2009? Not many. How many Goldman EMPLOYEES made fortunes or took in record bonuses during that time? Quite a few.

Goldman of course is only one example. But the whole US system operates based on the principles of moral hazard, double standards, and crony capitalism.

Which brings me to my final point.

The US is NOT a capitalist country. And is sure as heck ain’t a free market. No, the US is a CRONY capitalist state: a state where one’s position in the socio-economic complex dictates the rules by which one can play. END OF STORY.

Look at the individuals dictating our economic policy: Geithner, Summers, Rubin (to a lesser degree). All of them have either been responsible for massive blow-ups, which should have ended their careers OR have played by a different set of rules their entire lives.

Instead, they’ve been promoted to the most powerful economic positions in the country. Why? Because they understand the part of Crony Capitalism that matters the most: it’s the Cronies… not the Capitalism.

Until we change this, and start leveling the playing field so that individuals with REAL ideas and solutions and STRONG track records can rise to positions of power in public policy, the US as a whole is screwed, or rather, those of us who don’t fall into the “Crony” category (the 300+ million) are.

Good Investing!

Graham Summers

PS. If you’re worried about the future of the stock market and have yet to take steps to prepare for the Second Round of the Financial Crisis… I highly suggest you download my FREE Special Report specifying exactly how to prepare for what’s to come.

I call it The Financial Crisis “Round Two” Survival Kit. And its 17 pages contain a wealth of information about portfolio protection, which investments to own and how to take out Catastrophe Insurance on the stock market (this “insurance” paid out triple digit gains in the Autumn of 2008).

Again, this is all 100% FREE. To pick up your copy today, www.gainspainscapital.com and click on FREE REPORTS.

So JPMorgan fires 20 people in its commodity prop book. What about Sempra Energy, which Dimon purchased recently? Is that getting spun off too? Or are all the 20 whopping newly unemployed advised to seek employment at Sempra? One wonders why JP Morgan named a new global head of commodity strategy today. But yes, let's wave the white flag in the face of the dumb public and pretend we are complying with Volcker. But first, let's have the corpulent Frank in charge of the finreg abortion lisp something on TV about what a great success his capture by Wall Street is proving to be.

From Bloomberg:

JPMorgan Chase & Co., the second- largest U.S. lender by assets, told traders who bet on commodities for the firm’s account that their unit will be closed as the company begins to shut down all its proprietary trading, according to a person briefed on the matter.

The bank eventually will end all proprietary trading to comply with new curbs on investment banks, said the person, who asked not to be identified because JPMorgan’s decision isn’t public. The New York-based bank will shut proprietary trading in fixed-income and equities later, the person said.

Closing the prop trading desk for commodities affects fewer than 20 traders, including one in the U.S. and the rest in the U.K., the person said. The unit is based in London, where traders on Aug. 27 were given notice, as required by U.K. law, that their jobs may be in jeopardy, according to the person.

Congress passed curbs on financial firms this year designed to prevent a recurrence of the 2008 credit crisis, which almost caused the banking system to collapse. Proprietary trading involves transactions made on behalf of the bank rather than its customers. The curbs on proprietary trading are known as the Volcker rule, named after former Federal Reserve Chairman Paul Volcker, who campaigned for limits on risk-taking by lenders.

Traders will be given a chance to apply for jobs elsewhere in the company, according to the person. JPMorgan spokeswoman Kimberly Weinrick declined to comment.

Update: magical unicorn, meet Neil Patrick Harris

Futures drop on the minutes which disclose increased economic weakness, which is sufficient for magical unicorns to push ES right back up.

On the economt:

In the economic forecast prepared for the August FOMC meeting, the staff lowered its projection for the increase in real economic activity during the second half of 2010 but continued to anticipate a moderate strengthening of the expansion in 2011... Real GDP growth was noticeably weaker in the second quarter of 2010 than most had anticipated, and monthly data suggested that the pace of recovery remained sluggish going into the third quarter. Private payrolls and consumer spending had risen less than expected.

On inflation:

The staff’s forecasts for headline and core inflation in 2010 were revised up slightly in response to the higher prices of oil and other commodities and the depreciation of the dollar.

On disinflation:

Participants viewed the risk of deflation as quite small, but a number judged that the risk of further disinflation had increased somewhat despite the stability of longer-run inflation expectations.

While no member saw an appreciable risk of deflation, some judged that the risk of further near-term disinflation had increased somewhat. More broadly, members generally saw both employment and inflation as likely to fall short of levels consistent with the dual mandate for longer than had been anticipated.

On the mortgage roll:

The Manager also noted the staff’s projection that, if mortgage rates were to remain near their levels at the time of the meeting, repayments of principal on the agency MBS held in the SOMA likely would reduce the face value of those holdings by roughly $340 billion from August 2010 through the end of 2011. The level of repayments would be expected to increase further if mortgage rates were to decline from those levels. In
addition, about $55 billion of agency debt held in the SOMA portfolio would mature over the same time frame.

The Committee directs the Desk to maintain the total face value of domestic securities held in the System Open Market Account at approximately $2 trillion by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.

To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longerterm Treasury securities.¹ The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature.

On the now-traditional posturing by Hoenig:

Mr. Hoenig dissented because he thought it was not appropriate to indicate that economic and financial conditions were “likely to warrant exceptionally low levels of the federal funds rate for an extended period” or to reinvest principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. Mr. Hoenig felt that the “extended period” expectation could limit the Committee’s flexibility to  begin raising rates modestly in a timely fashion, and he believed that the recovery, which had entered its second year and was expected to  continue at a moderate pace, did not require support from additional accommodation in monetary policy. Mr. Hoenig was also concerned that these accommodative policy positions could result in the buildup of future financial imbalances and increase the risks to longer-run macroeconomic and financial stability.

On the now imminent QE2:

A few members worried that reinvesting principal from agency debt and MBS in Treasury securities could send an inappropriate signal to investors about the Committee’s readiness to resume large-scale asset purchases. Another member argued that reinvesting repayments of principal from agency debt and MBS, thereby postponing a reduction in the size of the Federal Reserve’s balance sheet, was likely to complicate the eventual exit from the period of exceptionally accommodative monetary policy and could have adverse macroeconomic consequences in future years.

Full minutes.

As for how to trade this market, just replace NPH with BPS and you are golden.

Former TCW Total Return Bond Fund maven Jeff Gundlach, who since December has been running his own money at OakStreet-blessed DoubleLine, has just moved from "overweight" to "small underweight" on Treasurys. The gradual shift out of USTs is in line with the bond manager's forecast made in June when the 10 Year was 3.1% that yields would drop another 60 bps to 2.5%. Yet the main catalyst for the selling is driven by the inability of the 10 Year to make a new record low, unlike both the 2 and 5 Years, both of which are trading at historical tights, no doubt facilitated by the Fed's gradual encroachment of ever to the right of the entire yield curve. As Bloomberg reports: "this “divergence in behavior across the yield curve is very significant,” said Gundlach, who oversees $4.8 billion in assets in Los Angeles as chief executive officer of DoubleLine. “So while the fundamentals for low rates remain compelling, the message of the market action suggests that much of these now widely recognized fundamentals are reflected in Treasury bond prices." We are confident that given enough time, and enough fiat linen printed, the entire curve will eventually be one flat line as the Fed (and Pimco) are now the marginal buyers of any resort in their attempt to make homeownership with zero money down, an interest-free endeavor. After all, you can't have growth unless the animal spirits are rekindled, and this kind of direct intervention is the only thing the Keynesian acolytes at the Marriner Eccles building know how to do well. So where is Gundlach investing next:"We moved the proceeds from the Treasury sales into a mix of corporate bonds, including our first allocation to below investment grade corporate bonds." Of course, with even traditional MBS and UST investors now actively gobbling up HY, we are very concerned that when the inevitable flush in the B2/B space occurs, and it always eventually does, there will be no marginal buyers of anything less than IG. But with a market as broken, technically driven and centrally planned as ours, who even pretends to think about what tomorrow may bring...

More from Bloomberg:

Yields on 10-year notes were 3.12 percent when Gundlach made his prediction on June 23 during a speech at a Morningstar Inc. conference in Chicago. The yield touched a 19-month low of 2.4158 percent on Aug. 25. Ten-year note yields, which fell 5 basis points today to 2.48 percent, reached a record low of 2.04 percent on Dec. 18, 2008.

The notes’ prices tumbled the most since June 2009 on Aug. 27 after Federal Reserve Chairman Ben S. Bernanke said the central bank will provide additional stimulus as needed during opening remarks to central banks at a symposium in Jackson Hole, Wyoming. The two-year note yield touched a record low of 0.4542 percent on Aug. 24.

“This is a long-term bottoming process, which could very well take several weeks or even a few months more to play out,” Gundlach said in an interview. “We moved the proceeds from the Treasury sales into a mix of corporate bonds, including our first allocation to below investment grade corporate bonds since the launch of the Core Fixed Income Fund on June 1,” which invests in different sectors of the global fixed income markets. The fund is up 5 percent since its inception through Aug. 27, he said.

The five-year Treasury note yield touched a 20-month low on Aug. 25 of 1.2775 percent, just 9 basis points shy of its record low of 1.1852 percent, reached on Dec. 17, 2008.

An “underweight” position in Treasuries means that a firm owns a smaller percentage of the securities in its portfolios as is contained in benchmark indexes used to measure performance. “Overweight” means the firm owns a greater percentage.

In the meantime, we are confident that the other major bond powerhouse, Pimco, will be more than happy to bid up everything that Gundlach wishes to part ways with. The former, which is now effectively the Fed lite, has no other choice, than to frontrung and mimic the Fed in every single action, as with over $1.2 trillion in assets, there are just no players of sufficient size left that it can transact with. To say that this will all end in guaranteed tears is an understatement.

David R. Kotok
Chairman and Chief Investment Officer
The Emperor, the Gladiator & the Lion
August 30, 2010

>

The last surviving gladiator stood alone in the Coliseum as the crowd shouted approval of his victories. The emperor called for a lion. In bounded a fierce beast that loped to the gladiator. As it was about to pounce on him, the gladiator whispered in the lion’s ear. The beast promptly sat down. The crowd roared approval.

A frustrated emperor called for a bigger lion. That one, too, sat down after the whisper in his ear.

Once the cheering throngs calmed down the Emperor summoned the most ferocious of the lions. The huge cat shook the stadium with his roars and leapt into the arena. About to eat the gladiator, the cat heard a few words and promptly sat down.

The emperor put thumbs up. The crowd roared again. Emperor to gladiator: “Tell me what you said and I will give you half the empire.” Gladiator: “All I said was that the meal comes after the speeches.”

Federal Reserve Chairman Ben Bernanke delivered his speech in Jackson Hole at breakfast time. He explained the Fed’s recent balance-sheet decisions and clarified policy with this framework: “The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do. As I will discuss next, the issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool.”

Emperor Ben discussed four tools. The last in the list, namely, that the FOMC increase its inflation goals, was mentioned, and the Chairman explained his opposition to it. Of course he left all doors open for future consideration.

Crowds liked the speech, stock markets rallied. Treasury bonds corrected (sold off) their deflationary pricing as market yields rose following the Bernanke commitment to avoid a deflationary recession. Emperor Bernanke showed the assembled that he still had his clothes.

ECB president Trichet gave the lunch speech. Like Bernanke, he rejected the inflation option. He worried about sovereign debt and the expansion of its use. In contrast to the US policy of gradualism, Trichet argued firmly that sovereign debt must be reduced relative to GDP. Trichet wanted markets to see that his Eurozone empire leaders also still wore their clothes.

I recall another, earlier set of speeches at Jackson Hole. Then-professor Ben Bernanke and his research partner Mark Gertler presented arguments for explicit inflation targeting and central bank accountability. In that speech, Bernanke and Gertler discussed monetary policy and asset price volatility. This 1999 view occurred at the early stage of the housing-price inflation in the United States and in the heyday of the tech-stock bubble. At the same 1999 symposium, new ECB president William Duisemberg made the anti-inflation case and described the policy framework for his role as the leading central banker for a new currency in its first year of existence. Both of these speech texts and the discussion reside in the archives of the Kansas City Fed website.

Professor Ben is now Chairman Ben. His true colors were clearer then. Being emperor requires some tempering of one’s expressiveness.

We will excerpt from the discussion held after the Bernanke-Gertler paper was presented in 1999. Of particular note is Bernanke’s response to Rudi Dornbusch, a prestigious and well-liked economist who, sadly, is no longer with us. Bernanke said: “I have studied the Depression quite a bit in my career, and I think there are two distinguishing mistakes that the Federal Reserve made. The first was to allow a serious deflation, which an inflation-targeting regime would not have permitted. And the second was to allow the financial system to collapse.”

No more explanation of today’s Bernanke Fed policy is necessary. Emperor Ben and Professor Ben are the same person.

Readers can find details about the current emperors’ views. The Bernanke and Trichet 2010 speeches are public and available on their respective central bank websites.

So is there a gladiator? The answer is yes. His name is Brian Sack. However, he was not present at Jackson Hole, according to press reports.

Is there also a ferocious lion? Yes again. And, it has already roared in the debt markets

Brian Sack runs the Fed’s System Open Market Account at the NY Fed. He is bright, pleasant, and articulate. He followed Bill Dudley into this position when Dudley graduated and became NY Fed president.

As the leading gladiator in the New York Fed’s coliseum, Brian has presided over the $140 billion of mortgage runoff to date. He is going to manage the annualized runoff of up to $400 billion of additional mortgage-related paper held by the Fed. This new tool received a lot of attention in Bernanke’s speech. Bernanke described how the acceleration of payments from foreclosure and refi could lead to a “perverse outcome” because a “weakening of the economy might act indirectly to increase the pace of passive policy tightening.” Bernanke clearly explained why the FOMC has stabilized the size of the Fed’s balance sheet as it makes this lateral transfer of existing portfolio from mortgages to treasuries.

Nevertheless, emperors only give broad policy outlines. Moreover, their committees (FOMC) ratify them. However, the gladiator must tame the lion.

Brian Sack is involved in the largest purchase of US Treasury securities in the Fed’s history. In addition, he is trying to estimate the prepayment speeds of those mortgage pools. Moreover, his goal is to keep the total balance sheet of the Fed stable while attempting to minimally induce dysfunction in operating markets.

His task is to subdue a most ferocious lion. To do it, he has to buy US Treasury bills, notes, and bonds at the pace at which the mortgage prepayments arrive. This coordination is difficult enough in “normal times.” In this crisis period of high refi volume and of large foreclosure volume, it is nearly impossible to estimate these speeds with any accuracy. Bernanke admitted as much in his speech, as he discussed the Fed’s balance-sheet realignment from GSE mortgage paper to treasury holdings while maintaining the overall size of the Fed’s balance sheet. Moreover, those of us in the portfolio-management business know that doing this also requires constant recalculation of duration in order to gauge market impact. The Fed does not do these trades in isolation. The rest of the world is watching, trading, investing, swapping, hedging, and attempting to front-run the Fed’s tsunami every single minute. In sum, it ain’t easy to be a gladiator.

Jim Bianco, an articulate and thoughtful observer of financial markets, has accurately described the Fed’s portfolio-management dilemma as a huge “convexity trade.” Jim’s eponymous research firm notes how the Fed creates a piling-on effect with it transactions. According to Jim: “At-the-money option-adjusted spreads (ATM-OAS) for 30-year Fannie Mae to-be-announced pools tracked long-term Treasury yields until the housing market collapse … reduced prepayment risk by destroying the market. The reduction in ATM-OAS continued through the Federal Reserve’s purchases of $1.25 trillion of mortgage-backed securities and even crossed into negative territory by mid-July.” Jim further noted, “The decline in ten-year treasury yields accelerated once [the Fed’s mortgage purchases] ended and once the March 2009-April 2010 global equity rally ended. This drop in yields has started to raise ATM-OAS levels … to levels reached only twice before, in June 2003 and December 2008.”

Can Brian Sack tame the beast? Will the Fed maintain a duration-matching tactic? So far, it does not seem to be doing so. That is why the longer end of the US treasury curve has rallied so strongly since April. Can the Fed avoid Bernanke’s “perverse outcome” if it ignores duration matching? We will assuredly find out in time.

At Cumberland, we are watching the Fed’s trading closely. Portfolio alignment is in spread positions and not in treasuries. The results have been good for our clients. We are engaged in hedging parallel shifts in the yield curve as a way to soften the impact of interest-rate volatility while capturing the spread narrowing that is inevitable once the Fed completes its transitions. Like other friends and colleagues in the independent, separate-account, portfolio-management business, we too feel like the gladiators in the arena. And there are many lions on the prowl these days.

I recall a visit to Jackson Hole many, many years ago. It was in the halcyon days, when income velocity was assumed stable, when the worry was an oil price shock, when speeches examined the disintermediation effects of deregulating interest rates, and when debates centered on which “M” had forecast power. In that era, one could walk to the tent in the back of the lodge and easily approach a gracious and friendly Milton Friedman. A prominent consultant from New York named Greenspan held court in the corner. Security was absent then. We could take a drive through Yellowstone, stop at Jackson for some conversation, then see if the trout were rising as we floated the Snake or the Green Rivers.

On Thursday, we are off to Leen’s Lodge for Labor Day weekend. A few of us will talk about markets and the Fed and the annual gathering we held three weeks before Jackson Hole. We will look for the early reds that brighten New England foliage. Maybe some faint aurora will be visible in the night sky. The waning crescent moon will be nearly new. With luck, the weather will be clear, the nights cooling down into the 50s, and the bass actively interested in fattening up as they prepare for winter.

Tight lines.

~~~

David R. Kotok, Chairman & Chief Investment Officer, Cumberland Advisors, www.cumber.com

The San Fran Fed conducts yet another mindnumbingly (and taxpayer funded) obvious study, this time uncovering what everyone with half a brain knows: namely that immigrants are good for the economy. But don't tell that to all those who want the H1-B program destroyed and to seal of the Mexico-Texas border by digging a mile deep trench filled with sharks with laser beams attached to their heads. Setting aside the fact that absent a surge in immigration, and a forced household formation impetus, the demand curve of the home price equilibrium chart will continue shrinking until homes will be worth less than half, to have to explain to other economists that immigrants are a net-net positive just makes one wonder about the inbreeding trends prevalent within the Keynesian shaman elite (how about the FRBSF do a study on that for a change?). But of course, stating the obvious would not get one too far in the citation-demanding economotenure track, so instead author Giovanni Peri, uses polysyllabic words such as: "Statistical analysis of state-level data shows that immigrants expand the economy’s productive capacity by stimulating investment and promoting specialization. This produces efficiency gains and boosts income per worker. At the same time, evidence is scant that immigrants diminish the employment opportunities of U.S.-born workers." And since none of those who are convinced that immigration, and not laziness, or flawed fiscal policy, is the main reason why nobody is not only having a job, but looking for one, will actually read this paper, we once again ask politely and simply: "why the hell was this thing commissioned, and how much did the national deficit increase because of its completion?"

Either way, here is the full thing, for your single-ply amusement:

The Effect of Immigrants on U.S. Employment and Productivity
BY GIOVANNI PERI

Immigration in recent decades has significantly increased the presence of foreign-born workers in the United States. The impact of these immigrants on the U.S. economy is hotly debated. Some stories in the popular press suggest that immigrants diminish the job opportunities of workers born in the United States. Others portray immigrants as filling essential jobs that are shunned by other workers. Economists who have analyzed local labor markets have mostly failed to find large effects of immigrants on employment and wages of U.S.-born workers (see Borjas 2006; Card 2001, 2007, 2009; and Card and Lewis 2007).

This Economic Letter summarizes recent research by Peri (2009) and Peri and Sparber (2009) examining the impact of immigrants on the broader U.S. economy. These studies systematically analyze how immigrants affect total output, income per worker, and employment in the short and long run. Consistent with previous research, the analysis finds no significant effect of immigration on net job growth for U.S.-born workers in these time horizons. This suggests that the economy absorbs immigrants by expanding job opportunities rather than by displacing workers born in the United States. Second, at the state level, the presence of immigrants is associated with increased output per worker. This effect emerges in the medium to long run as businesses adjust their physical capital, that is, equipment and structures, to take advantage of the labor supplied by new immigrants. However, in the short run, when businesses have not fully adjusted their productive capacity, immigrants reduce the capital intensity of the economy. Finally, immigration is associated with an increase in average hours per worker and a reduction in skills per worker as measured by the share of college-educated workers in a state. These two effects have opposite and roughly equal effect on labor productivity.

The method

A major challenge to immigration research is the difficulty of identifying the effects of immigration on economic variables when we do not observe what would have happened if immigration levels had been different, all else being equal. To get around this problem, we take advantage of the fact that the increase in immigrants has been very uneven across states. For example, in California, one worker in three was foreign born in 2008, while in West Virginia the comparable proportion was only one in 100. By exploiting variations in the inflows of immigrants across states at 10-year intervals from 1960 to 2000, and annually from 1994 to 2008, we are able to estimate the short-run (one to two years), medium-run (four years), and long-run (seven to ten years) impact of immigrants on output, income, and employment.

To ensure that we are isolating the effects of immigrants rather than effects of other factors, we control for a range of variables that might contribute to differences in economic outcomes. These include sector specialization, research spending, openness to trade, technology adoption, and others. We then compare economic outcomes in states that experienced increases in immigrant inflows with states that did not experience significant increases.

As a further control for isolating the specific effects of immigration, we focus on variations in the flow of immigrants that are caused by geographical and historical factors and are not the result of state-specific economic conditions. For example, a state may experience rapid growth, which attracts a lot of immigrants and also affects output, income, and employment. In terms of geography, proximity to the Mexican border is associated with high net immigration because border states tend to get more immigrants. Historical migration patterns also are a factor because immigrants are drawn to areas with established immigrant communities. These geography and history-driven flows increase the presence of immigrants, but do not reflect state-specific economic conditions. Hence, economic outcomes associated with these flows are purer measures of the impact of immigrants on economic variables.

The short- and the long-run effects of immigrants

Figure 1
Employment and income

Immigration effects on employment, income, and productivity vary by occupation, job, and industry. Nonetheless, it is possible to total these effects to get an aggregate economic impact. Here we attempt to quantify the aggregate gains and losses for the U.S. economy from immigration. If the average impact on employment and income per worker is positive, this implies an aggregate “surplus” from immigration. In other words, the total gains accruing to some U.S.-born workers are larger than the total losses suffered by others.

Figures 1 and 2 show the response of key economic variables to an inflow of immigrants equal to 1% of employment. Figure 1 shows the impact on employment of U.S.-born workers and on average income per worker after one, two, four, seven, and ten years. Figure 2 shows the impact on the components of income per worker: physical capital intensity, as measured by capital per unit of output; skill intensity, as measured by human capital per worker; average hours worked; and total factor productivity, measuring productive efficiency and technological level. Some interesting patterns emerge.

Figure 2
Capital intensity, hours per worker, and total factor productivity

First, there is no evidence that immigrants crowd out U.S.-born workers in either the short or long run. Data on U.S.-born worker employment imply small effects, with estimates never statistically different from zero. The impact on hours per worker is similar. We observe insignificant effects in the short run and a small but significant positive effect in the long run. At the same time, immigration reduces somewhat the skill intensity of workers in the short and long run because immigrants have a slightly lower average education level than U.S.-born workers.

Second, the positive long-run effect on income per U.S.-born worker accrues over some time. In the short run, small insignificant effects are observed. Over the long run, however, a net inflow of immigrants equal to 1% of employment increases income per worker by 0.6% to 0.9%. This implies that total immigration to the United States from 1990 to 2007 was associated with a 6.6% to 9.9% increase in real income per worker. That equals an increase of about $5,100 in the yearly income of the average U.S. worker in constant 2005 dollars. Such a gain equals 20% to 25% of the total real increase in average yearly income per worker registered in the United States between 1990 and 2007.

The third result is that the long-run increase in income per worker associated with immigrants is mainly due to increases in the efficiency and productivity of state economies. This effect becomes apparent in the medium to long run. Such a gradual response of productivity is accompanied by a gradual response of capital intensity. While in the short run, physical capital per unit of output is decreased by net immigration, in the medium to long run, businesses expand their equipment and physical plant proportionally to their increase in production.

How can these patterns be explained?

The effects identified above can be explained by adjustments businesses make over time that allow them to take full advantage of the new immigrant labor supply. These adjustments, including upgrading and expanding capital stock, provide businesses with opportunities to expand in response to hiring immigrants.

This process can be analyzed at the state level (see Peri and Sparber 2009). The analysis begins with the well-documented phenomenon that U.S.-born workers and immigrants tend to take different occupations. Among less-educated workers, those born in the United States tend to have jobs in manufacturing or mining, while immigrants tend to have jobs in personal services and agriculture. Among more-educated workers, those born in the United States tend to work as managers, teachers, and nurses, while immigrants tend to work as engineers, scientists, and doctors. Second, within industries and specific businesses, immigrants and U.S.-born workers tend to specialize in different job tasks. Because those born in the United States have relatively better English language skills, they tend to specialize in communication tasks. Immigrants tend to specialize in other tasks, such as manual labor. Just as in the standard concept of comparative advantage, this results in specialization and improved production efficiency.

Figure 3
Communication/manual skills among less-educated U.S.-born workers

Note: The data on average communication/manual skills by state are from Peri and Sparber (2009), obtained from the manual and communication intensity of occupations, weighted according to the distributional occupation of U.S.-born workers.

If these patterns are driving the differences across states, then in states where immigration has been heavy, U.S.-born workers with less education should have shifted toward more communication-intensive jobs. Figure 3 shows exactly this. The share of immigrants among the less educated is strongly correlated with the extent of U.S.-born worker specialization in communication tasks. Each point in the graph represents a U.S. state in 2005. In states with a heavy concentration of less-educated immigrants, U.S.-born workers have migrated toward more communication-intensive occupations. Those jobs pay higher wages than manual jobs, so such a mechanism has stimulated the productivity of workers born in the United States and generated new employment opportunities.

To better understand this mechanism, it is useful to consider the following hypothetical illustration. As young immigrants with low schooling levels take manually intensive construction jobs, the construction companies that employ them have opportunities to expand. This increases the demand for construction supervisors, coordinators, designers, and so on. Those are occupations with greater communication intensity and are typically staffed by U.S.-born workers who have moved away from manual construction jobs. This complementary task specialization typically pushes U.S.-born workers toward better-paying jobs, enhances the efficiency of production, and creates jobs. This task specialization, however, may involve adoption of different techniques or managerial procedures and the renovation or replacement of capital equipment. Hence, it takes some years to be fully realized.

Conclusions

The U.S. economy is dynamic, shedding and creating hundreds of thousands of jobs every month. Businesses are in a continuous state of flux. The most accurate way to gauge the net impact of immigration on such an economy is to analyze the effects dynamically over time. Data show that, on net, immigrants expand the U.S. economy’s productive capacity, stimulate investment, and promote specialization that in the long run boosts productivity. Consistent with previous research, there is no evidence that these effects take place at the expense of jobs for workers born in the United States.

Giovanni Peri is an associate professor at the University of California, Davis, and a visiting scholar at the Federal Reserve Bank of San Francisco.

References

Borjas, George J. 2006. “Native Internal Migration and the Labor Market Impact of Immigration.” Journal of Human Resources 41(2), pp. 221–258.

Card, David. 2001. “Immigrant Inflows, Native Outflows, and the Local Labor Market Impacts of Higher Immigration.” Journal of Labor Economics 19(1), pp. 22–64.

Card, David. 2007. “How Immigration Affects U.S. Cities.” University College London, Centre for Research and Analysis of Migration Discussion Paper 11/07.

Card, David. 2009. “Immigration and Inequality.” American Economic Review, Papers and Proceedings 99(2), pp. 1–21.

Card, David, and Ethan Lewis. 2007. “The Diffusion of Mexican Immigrants during the 1990s: Explanations and Impacts.” In Mexican Immigration to the United States, ed. George J. Borjas. Chicago: The University of Chicago Press.

Peri, Giovanni, and Chad Sparber. 2009. “Task Specialization, Immigration, and Wages.” American Economic Journal: Applied Economics 1(3), pp. 135–169.

Peri, Giovanni. 2009. “The Effect of Immigration on Productivity: Evidence from U.S. States.” NBER Working Paper 15507.

As everyone who has taken Introduction to Voodoo Bullshit, better known Econ 101, can attest the following chart is basically as ugly as it gets: in simple terms when you have a collapsing demand curve coupled with a surge in supply, the bottom line is that no matter how much intervention is involved, nothing can help to restore the pricing equilibrium to its old level (at least not for a long, long time).

And as can be expected from economists, despite having come up with the S-D concept, they consistently focus on the part that's (relatively) easy to control - the supply side, and tend to ignore the "demand" aspect, which is far more difficult to jigger in the desired direction (think the constant blaming of banks for not lending when it is in fact the consumers who do not want loans). As such, using data from Bank of America, we focus on the complete picture, with an emphasis on the much ignored Demand side of the home price equilibrium, to conclude that prices are set to drop much lower from current levels.

The simplest way to analyze the outlook for the housing market is to compare the evolution of housing demand and supply. Housing demand comes from the creation of new households and purchases of vacation homes. Households are defined as the number of separate housing units, either families or individuals. A household can be created when children move out of their parents’ homes, couples separate, or roommates decide to live apart. Housing supply is a function of new construction and, in today’s market, foreclosures. The foreclosure will only create net new supply if the former homeowner moves in with friends or family rather than becoming a renter. By this reasoning, we also do not count “turnover” – transactions from existing owners – when analyzing demand and supply. If homeowners decide to sell their home and move to a new house or a rental unit, it will show up as both supply and demand. As a result, we are only focused on new housing demand and vacant housing supply.

Of the above paragraph, the key notable is the highlighted sentence, or the ever critical "household formation" variable. Unfortunately as the chart below shows, household growth has plummeted over the past 3 years, declining by about 700,000, after clocking in materially positive numbers in the 6 years prior.

So focusing on the far more critical Demand side:

Demand: fewer new households

Household creation depends on the state of the economy. The combination of high unemployment, weak wage and salary growth, and tight credit has led to a decline in household growth over the past few years. The two main surveys of household formation from the Census Bureau – the Housing Vacancy Survey and Current Population Survey – show that about 500,000 households were created annually over the past three years compared to an annual average of about 1.2 million during the first half of the decade (Figure 6). How can we explain such a notable drop in household formation?

Moving in with the folks

The obvious answer is to look at homeownership rates, which have tumbled to 66.9% from a peak of 69.2% in 4Q04. This translates to a loss of nearly 2.5 mn homeowners. Most of these homeowners became renters, which means they remain a household, but not all. As can be seen by the surge in the rental vacancy rate to 10.6%, it seems that there was not a perfect shift from homeowners to renters (Figure 7). This begs the question: what happened to these former households? There was doubling up among economically stressed households; in other words people moved in with friends or family. Many of these former homeowners were probably foreclosure victims (Figure 8).

As Figure 8 shows, household formation can also decline if there are fewer young households created to replace the aging homeowners. Given the nearly 10 point surge in the unemployment rate among 16 to 24 year olds from the trough to peak during this cycle, it seems like this was a considerable factor. A recent paper sponsored by the Research Institute for Housing America estimates that the probability of a young adult forming a household declines by 4% during a recession, and up to 10% if unemployed. In addition to the slowdown in “headship rates” domestically, there was a drop in household formation from immigration. According to the Office of Immigration Statistics at the Department of Homeland Security, the number of unauthorized immigrants decline by 1.0 million from 2007 to 2009 compared to a net gain of 1.3 million from 2005 to 2007.

Household growth to improve, but with a lag

Household formation will naturally pick up as the economy improves, but if our forecast for a sluggish recovery is realized, household growth will also be lackluster. The main factor influencing household growth will be the state of the labor market. The above-referenced paper finds that the unemployment rate must fall by 2pp from current levels to return to normal rates of household formation of about 1.2-1.4 million a year. We do not expect the unemployment rate to reach the mid-7% range until 2013, implying another two and a half years of sluggish household formation of about 800,000 a year. This is also when we expect the pace of foreclosures to slow notably, which means that fewer households will have to double-up.

Looking ahead to 2013 and beyond, we use forecasts from the Joint Center for Housing Studies at Harvard University. They present two possible trajectories for household growth: 1) an average of 1.48 million annually through 2020 assuming net immigration returns to the 2000-05 pace and headship rates at 2008 levels; and 2) an average of 1.25 million annually through 2020 assuming the same 2008 headship rates but slower immigration. We believe the latter is more likely and use this as our baseline forecast (Figure 9).

Renters will take market share

Although we expect household formation to start to improve in 2013, the homeownership rate should still fall further, suggesting that most of the gain in households will be due to an increase in renters. This is because there is still a considerable number of homeowners with mortgages in some stage of delinquency that are likely to end in foreclosure. Based on data from the Mortgage Bankers Association, there are about 5.5 mn seriously delinquent mortgages currently outstanding.

A recent paper by economists at the NY Federal Reserve (Haughwout, Andrew, Richard Peach, Joseph Tracy. “The Homeownership Gap”, Federal Reserve Bank of New York Current Issues in Economics and Finance, Volume 16, Number 5, May 2010) attempts to quantify the effective lower bound for the homeownership rate. They make the assumption that underwater borrowers (negative equity), who currently account for about a quarter of mortgage holders, will transition to renters over time. Subtracting these underwater borrowers yields an “effective homeownership rate” of 61.6% (Figure 10). This would be a record low in the data which goes back to 1965. We do not expect such a precipitous drop because not all underwater homeowners will become renters. Indeed, a recent study by Trulia.com and RealtyTrac found that 59% of respondents would not go into foreclosure simply because of negative equity. We believe it is more likely that the homeownership rate will bottom at 65%, returning to mid-1990s levels.

It is plainly obvious why the demand-side is so often ignored in polite conversation: it is the consumer-driven aspect of the house price variable, over which neither the Fed, nor the Treasury, nor the FHA has any authority, and which is a function purely of expectations of the future. Alas, those right now are lously and getting worse. We expect that Demand-side housing economics will take on progressively more importance in the future, as it becomes obvious that no amount of Supply-side tinkering will prevent another 20% drop in prices.

And speaking of Supply, this is also a critical factor, if much more prevalent in the daily media. Alas, that in itself does not make the problem any easier to resolve.

Supply: out of balance

The drop in housing demand triggered homebuilders to slash new construction. In theory, this should have balanced the market. A shift lower in the demand curve will temporarily depress prices until the supply curve shifts to balance the market at a lower quantity. The problem is that this model does not take into account the additional source of supply: foreclosed properties that have returned to the market for sale. As a result, housing supply has not normalized and greatly exceeds housing demand, creating a large imbalance in the housing market.

We can measure this imbalance two ways. The simplest method is to calculate the number of excess vacant homes for sale. Assuming a normal homeowner vacancy rate of 1.7% and rental vacancy rate of 8%, there is an excess of 1.87 mn vacant homes (again, see Figure 7).

Another, more detailed, way to measure the imbalance is to estimate the gap between housing supply and demand over the past few years. We define housing demand as the sum of household formation, demolitions and purchases of vacation homes, and housing supply as the sum of new construction, mobile homes and foreclosures from households that double up (Demolitions: Assume historical average of 0.24% of housing stock; Vacation homes: annual survey from National Association of Realtors which is about 10% of sales – we assume that 80% plan to use the home for vacation rather than rent it out and of which about three quarters plan to keep their first home; New construction: single and multi-family completions; Foreclosures: measure REOs (real estate owned) – we assume that half of the former homeowners will double-up). We estimate an excess of about 2 mn homes created over the past four years, consistent with our estimate from the vacancy data.

It will take years to clear the excess

Our mortgage strategists expect approximately 6 mn additional foreclosures to enter the market for resale over the next three years. It will then take a few years for the pace of foreclosures to gradually normalize to about 200,000 a year. If we plug in our baseline forecast for household formation (as explained above) and assumptions for the remaining variables (as explained in the footnote), we can run a few scenarios for the amount of time it will take to clear the imbalance under different paths of housing starts. At one extreme, if housing starts fall to zero, translating to zero completions next year, the excess supply will be cleared by early 2013. At the other extreme, if housing starts surge back to the historical norm of 1.5 mn next year and hold indefinitely, there would be another 2 mn homes added to the excess, bringing the total to 4mn, which would take until 2027 to offset. We believe the truth falls somewhere between these two extreme scenarios.

If we pencil in our baseline forecast for housing starts of 590,000 this year and 690,000 next year, another 500,000 excess homes will be created. Looking ahead, we must be more judgmental. A reasonable scenario is that starts slowly edge higher to 1 mn by 2013 and reach the “normal pace” of 1.5 mn by 2015. At this point, most of the excess supply will have nearly cleared, allowing starts to pick up to match the pace of demand (Figure 12).

 

 

Why any building given shadow inventory?

We often get asked why builders would start new construction given the considerable number of vacant homes on the market for sale. As the above example showed, if housing starts fell to zero, the market would return to normal much quicker.

There is a good reason for new construction: a foreclosed home is not a perfect substitute for a new home. Foreclosures will sell at a discount to a new home, but will often require a great deal of renovations. This will discourage some buyers. In addition, foreclosures are not equally distributed geographically or across price ranges. The bulk of foreclosures are in the lower end of the housing market. This creates two types of markets: “passive” and “active:” The passive market has the undesirable foreclosures, which are either in very poor condition and/or in a foreclosure-dense, and therefore suffering, neighborhood. It is likely that many of these homes will remain vacant and on the market for sale or rent. In contrast, the active market will contain foreclosures that can compete with regular homes in a market with housing demand.

The regional difference is particularly interesting. According to RealtyTrac, 37% of foreclosures are in either California or Florida and 65% are in the 10 states with the highest foreclosure rates. Even within these states, there are stark differences between zip codes. Homebuilders will avoid building new homes in the areas with a large presence of foreclosures. In the first half of the year, only 27% of housing starts were the top 10 foreclosure states (Figure 13). Comparing two large states is noteworthy: about 22% of foreclosures were in California, but only about 6% of housing starts, compared to Texas, which had only 4% of foreclosures and 15% of housing starts.

So now that both the very dire Demand and Supply sides of the pricing equilibrium have been discusses, what does this imply for the broader economy?

Unlike in prior recoveries, it is clear that housing will lag rather than lead the recovery. The monetary policy transmission typically has a very strong impact in the housing market – low rates encourage home sales and greater residential investment. In turn, job creation picks up in the  construction sector, further supporting consumer spending and home sales, and creating a virtuous cycle. This feedback loop is currently broken. Mortgage rates have plunged to record lows, and yet have done little to stimulate home purchases because credit conditions are still incredibly tight and consumer confidence is depressed. That said, we believe the direct drag from housing, through construction, is nearly over. Our forecasts for housing starts imply that residential investment will subtract from growth in 3Q, but then consistently add to output going forward. Still, the contribution to growth will be feeble relative to prior cycles, where housing was decidedly the force of growth (Figure 14).

While housing construction is the most direct link to the economy, it is not the only one. The path of home prices is also very important as consumers respond to changes in housing wealth. Our baseline view is that national home prices will edge lower over the rest of the year and then bounce around the bottom for some time. The downside risk is that foreclosures flood the market at a rapid pace, depressing home prices greatly, which could tip the overall economy back into recession.

Alas, we are already there, and yes, it is BofA's job to put a favorable spin on the data. Look for another 15-25% drop in home prices from here on out, and another wave of hundred billion+ charge offs at undercapitalized banks.

By Scott Fullwiler, Associate Professor of Economics at Wartburg College

At its core, there are two parts to Modern Monetary Theory (MMT). The first is a description of how the monetary system actually works, mostly focusing upon interactions between the central bank, the treasury, and the financial system, though this part also requires a very thorough understanding of the Minskyan-related literature of many MMT’ers (I note this because so many critics of MMT ignore or not aware of the vast MMT literature on financial instability and reforming the financial system). The second is a set of policy proposals that arise from this description and is largely outside the scope of this particular post but which can be found in any number of MMT publications and blogposts (and, again, including the sizeable MMT literature on reforming the financial system).

Of critical importance to most of MMT’s description of the monetary system is its elaboration of the system’s operational realities, which for MMT’ers generally means three things:

First is the accounting logic of real-world transactions. Any relevant theory simply must be consistent with real-world accounting as a very basic criteria, and furthermore it is just this sort of base level understanding of accounting that is quite often absent from economic theories and how both the public and policymakers discuss and understand economics. In other words, our focus on accounting is anything but trivial in the current environment—it’s like the adage about being able to crawl before you walk, and as such it’s no wonder that the economics profession as a whole continues to trip over itself when it comes to understanding the monetary system.

Every transaction in a real-world economy affects financial statements of those engaged, and if an economic theory or a posited model is not consistent with how real-world financial statements are affected, then the theory is inapplicable. A typical example used by MMT’ers is a framework used in mainstream economics, the so-called loanable funds market. It posits a demand for loanable funds and a supply of loanable funds available for the macroeconomy, and contains classic supply-demand curve assumptions from goods markets, thaT higher prices (in this case interest rates) will elicit more “supply” (as in investors will divert more funds from other uses, such as risky venture investments, and make them available for lending). This model is simply inapplicable to our current monetary system in which empirical studies have demonstrated that banks create loans “out of thin air” without the requirement of prior reserve balances or deposits to “fund” the loan’s creation. Completely contrary to the loanable funds model, in fact, the vast majority of bank liabilities have been created by banks simply growing their balance sheets through loans and asset purchases. Similarly, there are macroeconomic accounting identities, such as the often-cited sector financial balances equation in which the domestic private sector’s net saving of financial assets is by definition equal to the government sector’s deficit and the current account balance (see here, here, and here for further discussion). MMT’ers understand very well that an accurate understanding of accounting is not in itself a theory.

The second part of operational realities is the tactical logic for operations necessary to achieve particular, fundamental ends given a particular monetary regime. Different monetary regimes have different operational realities—the currency issuer has a different operational reality from currency users; a central bank under a gold standard has different operational realities than a central bank under flexible exchange rates. The tactical logic of operations as employed by MMT’ers is (a) general, in the sense that the purpose is to consider a “pure” fiat system under flexible exchange rates, or a state government that is a currency user, and so forth—in a general sense, not specifically referring to any particular nation or state, and (b) particularly concerned with a hierarchy of authority and thus a hierarchy of “money”.

Regarding (a), for example, it is recognized that under a monetary regime other than gold standards or currency boards, the central bank is able to expand its balance sheet to enable smooth functioning of the retail and wholesale payments systems. Even in this case, though, the operational logic of interbank markets means that for the central bank to achieve its target rate in the absence of interest on reserves at the target rate, it must offset any changes occurring to its own balance sheet (i.e., an increase in currency that by accounting identity drains bank reserve accounts) that are inconsistent with banks’ desired reserve holdings at the central bank’s target rate. As for (b), it is recognized that different monetary regimes leave institutions occupying different spaces within the hierarchy of money—a currency-issuer government under flexible exchange rates sits at the top of the hierarchy, whereas under a gold standard or a currency union its place would be lower in the hierarchy.

The third aspect of operational realities is what is not possible given the accounting and the tactical logic. A good example here is the traditional money multiplier model that assumes central banks target reserve levels or the monetary base in order to target a monetary aggregate via a money multiplier. But the money multiplier gets both the accounting logic and the tactical logic of the monetary system wrong. For the former, as noted above, loans create deposits and the creation of more bank liabilities does not require that banks hold more reserve balances; banks do use reserve balances to settle payments and meet reserve requirements, but the quantity of reserve balances held for these purposes is mostly unrelated to growth in monetary aggregates. For the latter, absent interest on reserves at the target rate, a central bank would not be able to achieve its target rate if it employed the money multiplier model and tried to directly target reserves (and, by extension, the monetary base, as again according to tactical logic of the monetary system the currency component of the monetary base is set by the public’s portfolio preferences). Instead of the money multiplier, a proper understanding of the operational realities of the monetary system demonstrates that central banks—as monopoly suppliers of reserve balances to the banking system—must set an interest rate target (or, in the case of the Fed during 1979-1982, an operating range for the target rate) but can only directly target the quantity of reserves if the target rate is set equal to the central bank’s remuneration rate on reserves.

While there is over 20 years of MMT literature published in books, refereed journals, and in working papers available all over cyberspace (though most can be found at CFEPS, CofFEE, the Levy Institute, and MoslerEconomics) it’s only recently that we began blogging, and it is clear that many commenters on MMT-related posts are largely unaware that this extensive literature exists and serves as the basis for our blogposts that are by necessity less detailed. Indeed, over the past 10-15 years, I have personally waded through all of the publications from various official sources on the (relevant-to-MMT aspects of the) monetary system’s functioning that I could get my hands on and have found nothing that is inconsistent with how MMT describes it. We have had numerous conversations with individuals responsible for Fed operations, Treasury operations, and relevant parts of the financial system, and cannot recall any significant disagreements there, as well. It is interesting to note that an increasing number of neoclassical economists are publishing research describing the monetary system in a manner consistent with MMT (without appropriate attribution, usually), though these descriptions have yet to make their way into neoclassical models of the macroeconomy.

Particularly where the operational realities of the Treasury’s actions are concerned, blogposts by MMT’ers can be met with dissenting comments. A good deal of this is because the MMT understanding of the operational realities of the monetary system is completely counter to that of the neoclassical economics that most learn. But another reason is that a number of people appear to confuse the MMT description of the operational realities of the monetary system with procedures self-imposed by existing laws and/or regulations.

A case in point is a paper by Stephanie Kelton titled “Can Taxes and Bonds Finance Government Spending?” This paper is a classic in the MMT literature first published in 1998. The main points of Kelton’s paper are entirely related to operational realities of the existing monetary system: (1) Given the accounting logic of the Fed’s balance sheet, changes to the Treasury’s account affect the quantity of reserve balances circulating—that is, government spending creates reserve balances, taxes and bond sales destroy them; (2) Given the tactical logic of the Fed’s operations to achieve an interest rate target, flows to/from the Treasury’s account must be offset; (3) Consistent with the tactical logic of the Fed’s operations, calls/adds to/from the Treasury’s tax and loan system are universally understood to be monetary operations to minimize the influence of flows to/from the Treasury’s account on the Fed’s operations—essentially reducing the complexity of the Fed’s daily operations, particularly given the Treasury’s assumed superior ability to forecast its own account balance; (4) Bond sales are much like calls from the tax and loan accounts—monetary operations—since if the Treasury doesn’t sell bonds, the Fed must to be able to hit its fed funds rate target; (5) Given the hierarchy of money, it is not the Treasury that needs the reserve balances to spend—indeed, as Kelton put it, the very act of paying taxes (when the taxpayer’s bank settles with the Treasury) or purchasing a Treasury security is also the “destruction” of reserve balances, while (6) the act of government spending is the creation of reserve balances.

Having said that, MMT’ers are keenly aware that governments can and do write laws that their treasuries’ operations be legally bound in certain ways. For instance, the Fed is constrained by law to only purchase Treasury securities in the “open market,” is thereby forbidden from directly lending or providing overdrafts to the Treasury. In other words, “specific” cases can and do differ from the “general” case MMT’ers describe for a sovereign currency issuer under flexible exchange rates in the sense that self-imposed constraints specify particular operations. But, this does not mean that the operational function of the Treasury’s bond sales to aid the Fed has changed—to the contrary, with or without legal prohibition of overdrafts for the Treasury’s account, either the Fed or Treasury must offset flows to/from the Treasury’s account to achieve the Fed’s target rate (with the caveat that interest on reserve balances can potentially eliminate this necessity).

The overarching point here is to recognize who sits at the top of the hierarchy of money for a given monetary regime. Since under flexible exchange rates it is the currency issuing government, self-imposed constraints are simply that—self-imposed and not operational. For MMT’ers, concerns that a nation cannot “afford” to put idle capacity to use through tax cuts or appropriately targeted spending (i.e., NOT bailouts of the financial system or pet political projects—MMT’ers dislike those as much as anyone) are akin to a person with his/her shoes tied together concerned that he/she can’t run. Indeed, it is the very fact that such self-imposed constraints can be and have been disregarded in the past when it has been deemed desirable (e.g., the law requiring that the Fed only purchase Treasury obligations in the open market has been periodically relaxed) that demonstrates who is in charge—as Marshall Auerback recently put it, particularly where fiscal actions, such as military appropriations in a time of war, are deemed important, “we don’t go to China to give them a line-item veto for what we can and can’t spend. We just spend the money.”

The self-imposed constraint for a sovereign currency issuer is thus clearly quite different from the constraints on, say, households or firms or even state governments, which truly do not operationally or otherwise have the ability to issue a non-convertible currency—these entities can most definitely find themselves in the metaphorical position of having their shoes tied together and no ability to run, or walk for that matter, as the constraints are obviously not merely self imposed. This is not the case for the sovereign-currency issuer—if it pretends that its self-imposed constraints are of the same character as operational constraints on households or state governments, the result can be involuntary unemployment, retirees below the poverty line, military defeat, and so forth. In other words, while the ability to “just spend the money” is recognized in times of war or when a financial bailout is deemed necessary (by politicians, at least), MMT’ers want it to be just as obvious when the issue at hand is involuntary unemployment, crumbling infrastructure, children or retirees living below the poverty line, a major city devastated by natural disaster, and so forth. Please note that this is not to say that such a government should always spend simply because it can operationally—that would be ridiculous—but, rather, that there is no such thing as it not being able to ”afford” to put idle capacity to work; the appropriate constraint to consider is whether there is idle capacity in the first place, while also recognizing the obvious point that not all fiscal actions are equally efficient.

This all leads me to the often noted MMT point that “spending comes before tax revenues are received or bond sales.” If one expands this a bit to include loans from the Fed, then this statement is absolutely correct in terms of the operational realities of the monetary system. That is, according to both the tactical and accounting logics, taxes credited to the Treasury’s account and the settlement of Treasury bond auctions can only occur via bank reserve accounts, while the original source of banks’ balances in their reserve accounts can only be previous government deficits (which are net credits reserve accounts) or loans from the Fed (repos, loans, purchases of private securities, or overdrafts—note that an outright purchase of a Treasury security by the Fed to add reserve balances requires a previous government deficit). Therefore, it very much is the operational reality that for taxes to be paid or bonds to be settled, there has to have been previous government spending or loans from the Fed to the non-government sector, and this is true whether or not the Fed is legally prohibited from providing overdrafts.

However, the statement that “deficits or Fed lending logically precede tax payments and bond sales” should not be interpreted as “MMT’ers think there is no legal obligation that the Treasury have balances in its account before it spends or are otherwise ignoring the existing law prohibiting Fed overdrafts for the Treasury.” As I noted above, it is clear that the Fed cannot legally provide overdrafts to the Treasury, and every MMT’er does in fact understand this—the key is to understand what “deficits or Fed lending logically precede tax payments and bond sales” does and does not mean. That is, when MMT’ers say the latter, they are effectively saying “deficits or Fed loans logically precede taxation and bond sales as an operational reality of the monetary system” (the general case), and this and the statement “the Treasury must have positive balances in its account prior to spending under current law” (the specific case) are in fact not mutually exclusive. Both can be and are true—the government can and does require itself through its own self-imposed constraint to obtain credits to its own account at the Fed that were created via previous deficits or Fed lending before it spends again.

Finally, to fully understand the operational realities associated with the Treasury’s account at the Fed, it must be recognized that the lowest rate the Treasury would reasonably expect to pay on the national debt in the case of overdrafts on its account would be the Fed’s target rate. Operationally, the Fed would have to pay interest on reserve balances at its target rate or otherwise offer its own time deposits at competitive rates in line with the current and anticipated target rates to drain the reserve balances and achieve its target rate (in the case that the remuneration rate on reserve balances is below the target rate or even zero), both of which reduce the Fed’s profits returned to the Treasury and act functionally like debt service for the Treasury. The situation is unchanged even if the Treasury deficit spends via a “helicopter drop” of pure cash or coins, since the private sector will deposit the vast majority in banking accounts, and banks will return excess vault cash to the Fed in exchange for reserve balances.

One can then think of three different degrees or “forms” (to borrow the taxonomy used by financial economists in describing the efficient markets hypothesis) related to deficits and interest on the national debt for a currency issuer under flexible exchange rates. The “strong form” deficits would be where the Treasury has an overdraft or similar at the Fed and interest on the national debt is essentially at the Fed’s target rate or on average a bit higher if the Fed issues time deposits to drain reserve balances. While the “strong form” is operationally “pure,” it is again obviously not current law in the US. The “semi-strong form” deficits would be where the Treasury is not provided with overdrafts and must issue its own securities to have positive balances in its account before spending again while the securities issued—given their zero-default-risk that results from operational realities and the fact that any “constraint” on the Treasury is self-imposed—mostly arbitrage with the Fed’s target (for short-term Treasuries) and the expected target rate (for longer-term Treasuries) aside from some technical effects (like convexity) and some demand/supply issues (like maturity and liquidity at different maturities). Examples of the “semi-strong form” would be here and here. The “weak-form” deficits would consider that bond markets might at some point choose to repudiate even a currency-issuer’s debt with zero default risk (the “semi-strong form” does, too, but presumes the effect is temporary as arbitrage relationships would over-rule at least in the medium-term), but recognizes that the Fed always has the ability to set the market rate on Treasuries as long as it is willing to buy all quantities offered at its bid price (and has no operational or even legal constraint for doing so). Examples would be the Fed’s “Operation Twist” or the Fed prior to the Treasury Accord, or in the non-currency issuer case, consider how the recent EMU crisis quickly faded once the ECB began purchasing the debt of troubled member nations.

All three forms, while different in degree, agree that the interest on the national debt for a sovereign currency issuer under flexible exchange rates is a policy variable—not a market-set rate—or at the very least could be if the government so desires. And note that this is the case whether or not the Treasury receives overdrafts at the Fed. In other words, since the outcome is roughly the same in all three cases, it really doesn’t matter if the Treasury receives overdrafts in its Fed account or not—if it can sell its debt at roughly the Fed’s target, then there is no economically meaningful difference from the Treasury’s perspective between the government enabling itself to obtain an overdraft and the government forbidding itself from doing so. That self-imposed “constraint” is really not a constraint at all even if it is never abandoned.

Submitted by Jim Quinn of The Burning Platform

The Age of Mammon

“Financiers – like bank robbers – do not create wealth. They merely distribute it. While the mob may idolize holdup men in good times, in the bad times it lynches them. What they will do to the new money men when their blood is up, we wait eagerly to find out.”  - Mobs, Messiahs and Markets

As our economy hurtles towards its meeting with destiny, the political class seeks to assign blame on their enemies for this Greater Depression. The Republicans would like you to believe that Bill Clinton, Robert Rubin, Chris Dodd, and Barney Frank and their Community Reinvest Act caused the collapse of our financial system. Democrats want you to believe that George Bush and his band of unregulated free market capitalists created a financial disaster of epic proportions. The truth is that America has been captured by a financial class that makes no distinction between parties. These barbarians have sucked the life out of a once productive nation by raping and pillaging with impunity while enriching only them. They live in 20,000 square foot $10 million mansions in Greenwich, CT and in $3 million dollar penthouses on Central Park West.

These are the robber barons that represent the Age of Mammon. The greed, avarice, gluttony and acute materialism of these American traitors has not been seen in this country since the 1920′s. The hedge fund managers and Wall Street bank executives that occupy the mansions and penthouses evidently don’t find much time to read the bible in their downtime from raping and pillaging the wealth of the middle class. There are cocktail parties and $5,000 a plate political “fundraisers” to attend. You can’t be cheap when buying off your protection in Washington DC.

Lay not up for yourselves treasures upon earth, where moth and rust doth corrupt, and where thieves break through and steal: But lay up for yourselves treasures in heaven, where neither moth nor rust doth corrupt, and where thieves do not break through nor steal: For where your treasure is, there will your heart be also. No one can serve two masters, for either he will hate the one and love the other; or else he will be devoted to one and despise the other. You cannot serve both God and Mammon. – Matthew 6:19-21,24

It seems that Lloyd Blankfein, the CEO of Goldman Sachs, may have been overstating the case in saying his firm doing God’s work. With his $67.9 million compensation in 2007 and payment of $20.2 billion to his co-conspirators, Blankfein appears to be a proverbial camel trying to pass through the eye of a needle. This compensation was paid in the year before the financial collapse brought on by the criminal actions of Lloyd and his fellow henchmen. After having his firm bailed out by the American middle class taxpayer at the behest of his fellow Goldman alumni Hank Paulson, Lloyd practiced his version of austerity by cutting compensation for his flock to only $16.2 billion ($500,000 per employee) in 2009. I’m all for people making as much money as they can for doing a good job. But, I ask you – What benefits have Goldman Sachs, the other Wall Street banks, and hedge funds provided for America?

Never have so few, done so little, and made so much, while screwing so many.

In 2005, the top 25 hedge fund managers “earned” $9 billion, or an average of $360 million. One year after a financial collapse caused by the financial innovations peddled by Wall Street, the top 25 hedge fund managers paid themselves $25 billion, or an average of $1 billion a piece. For some perspective, there were 7 million unemployed Americans in 2006. Today there are 14.6 million unemployed Americans. While the country plunges deeper into Depression, the barbarians pick up the pace of their plundering and looting of the remaining wealth of the nation. Bill Bonner and Lila Rajiva pointed out a basic truth in 2007, before the financial collapse.

“On the Forbes list of rich people, you will find hedge fund managers in droves, but no one who made his money as a hedge fund client.” - Mobs, Messiahs and Markets

Ask the clients of Bernie Madoff how they are doing.

1920′s Redux

The parallels between the period leading up to the Great Depression and our current situation leading to a Greater Depression are revealing. When you examine the facts without looking through the prism of party politics it becomes clear that when the wealth and power of the country are overly concentrated in the clutches of the top 1% wealthiest Americans, financial collapse and depression follow. This concentration of income and wealth did not cause the Stock Market Crash of 1929 or the financial system implosion in 2008, but they were a symptom of a sick system of warped incentives. The top 1% of income earners were raking in 24% of all the income in America in 1928. After World War II until 1980, the top 1% of income earners consistently took home between 9% and 11% of all income in the country. During the 1950′s and 1960′s when Americans made tremendous strides in their standard of living, the top 1% were earning 10% of all income. A hard working high school graduate could rise into the middle class, owning a home and a car.

From 1980 onward, the top 1% wealthiest Americans have progressively taken home a greater and greater percentage of all income. It peaked at 22% in 1999 at the height of the internet scam. Wall Street peddled IPOs of worthless companies to delusional investors and siphoned off billions in fees and profits. The rich cut back on their embezzling of our national wealth for a year and then resumed despoiling our economic system by taking advantage of the Federal Reserve created housing boom. By 2007, the top 1% again was taking home 24% of the national income, just as they did in 1928. When the wealth of the country is captured by a small group of ruling elite through fraudulent means, collapse and crisis becomes imminent. We have experienced the collapse, while the crisis deepens.

It’s Good To Be the King

The Wall Street oligarchs  were able to accumulate an ever increasing portion of corporate profits by inventing securitization, interest-rate swaps, and credit-default swaps which swelled the volume of transactions that bankers could make money on. These products were originally introduced as a means for corporations to hedge their risks. Wall Street shysters chose to use their “creative” financial products to build the biggest gambling casino in the history of the world. They functioned as the house, siphoning off billions in profits, but then got caught up in the hysteria and placed billions of bets themselves. This resulted in the financial industry generating 41% of all business profits in 2007. From World War II through 1980, financial industry profits ranged between 10% and 15%. Simon Johnson explains the despicable hijacking that has taken place since then.

From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007. 

The original robber barons amassed huge personal fortunes, typically through the use of anti-competitive business practices. These well known titans of industry included Henry Ford, Andrew Carnage, John D. Rockefeller, and JP Morgan. They may have practiced questionable business ethics, but they did create wealth while benefitting the country as a whole. They introduced the automobile, provided the nation with steel, produced the oil that powered our economy, and brought order to industrial chaos of the day. It seems their fortunes were built by creating rather than destroying.

The disgustingly rich Wall Street wheeler dealers who live in Greenwich CT and NYC and summer in the Hamptons have created nothing. Their immense wealth has been created through draining the economic system of its lifeblood. Their financial innovations have created no lasting benefit for our society. Wall Street knowingly created no documentation (liar loans) mortgage loans, Option ARM loans, and subprime loans. You do not create products that beg for fraud unless you want fraud. The packaging of these fraudulent mortgages into CDOs and CDSs by Wall Street’s crime machine benefitted Wall Street only. Those who got the loans defaulted, lost the homes, and had their credit ruined. Wall Street financiers have lured the American public into debt with easy credit and a marketing machine geared to convince the average Joe that he could live just like the rich. Simon Johnson explained the phenomena in a recent article.  

You Call This Capitalism?

Capitalism is supposed to be an economic system in which the means of production and distribution are privately owned and operated for profit; decisions regarding supply, demand, price, distribution, and investments are not made by the government; Profit is distributed to owners who invest in businesses, and wages are paid to workers employed by businesses. The American economy is in no way a free market capitalistic system. It has become a oligarchic consumer capitalist society that is manipulated, in a deliberate and coordinated way, on a very large scale, through mass-marketing techniques, to the advantage of Wall Street and mega-corporations.

When you hear the Wall Street class on CNBC argue against tax increases for the rich, they hark to the fact that small businesses would be hurt most by the expiration of the Bush tax cuts. There are 6 million small businesses in the US, with 90% of them employing less than 20 employees. These are not the rich. The vast majority of these businesses earn less than $1 million per year. There are only about 134,000 people in America who make on average $2.5 million per year. There are another 600,000 people who make on average $760,000 per year. Out of a workforce of 150 million, less than 1 million rake in over $750,000 per year. These are not small businesses. They are the Wall Street elite, corporate CEOs and the privileged classes that control the power in NYC and Washington DC.

The following charts clearly show that  perverse incentives in the US financial system have allowed corporate executives to reap ungodly pay packages, while the middle class workers who do the day after day heavy lifting in corporations have been treated like dogs. Considering the S&P 500, which measures the stock returns of the 500 largest companies in the U.S., has returned 0% for the last 12 years, the CEOs of these companies would slightly embarrassed paying themselves 300 times as much as their average workers. Not in the age of mammon. Big time CEOs are rock stars. Outrageous pay packages are a medal of honor in a world where humility and honor don’t exist.

The Depression that currently is engulfing the nation was 30 years in the making. The criminal Wall Street financiers are the modern day John Dilingers. They have mastered the art of stealing from the masses while convincing these same people that they should admire them because they are rich. This is the oddity about Americans as pointed out by Bill Bonner and Lila Rajiva.

“The poor genuinely believe the rich are better than they are. They are smarter and better educated. The poor even support low tax rates for the rich, as long as they have a lurking chance of joining them.” -   Mobs, Messiahs and Markets

The truth is that the poor have no chance of joining the the rich. The game is rigged. The poor have admired the rich for decades. But, hard times have arrived. And they are about to get harder. The rich have armed guards to keep the poor at bay. They will need an army of guards before this crisis subsides.

Leonard Cohen sums it up perfectly in his song Everybody Knows:

Everybody knows that the dice are loaded
Everybody rolls with their fingers crossed
Everybody knows that the war is over
Everybody knows the good guys lost
Everybody knows the fight was fixed
The poor stay poor, the rich get rich
That’s how it goes
Everybody knows
Everybody knows that the boat is leaking
Everybody knows that the captain lied
Everybody got this broken feeling
Like their father or their dog just died