Ireland and beyond

Ireland is still in a fix it has not been fixed. In an effort to cut-off the belief in knock on effects a huge package has been given to Ireland that is so massive that Ireland probably will not be able to afford it. Irish banks are in trouble as is Ireland and as are all those banks that lent to them. And while all the Ireland bailout stories are about Ireland, Ireland is not the point. The Ireland and Irish credit default swaps are at issue as well as the not guaranteed loans. In other words the real worry here is not about Ireland but about the various kinds of knock-on effects. These range from the crises spreading to Spain and Portugal to an intensified concern about the banks that lent to these countries.

Europe ran some stress tests but those tests did not really imply much more than mild haircuts on sovereign debt. Everyone knows it was not a real test just as you know the difference between how people act in a fire drill is different compared when there is a real fire. With Ireland we shovel money in, tie Ireland’s hands and feet and pretend everything will be fine. How did this happen?

The e-zone was badly conceived as fiscal rules were too loose. Some of the nations in the Zone have run inflation rates that have further widened price level differences (exacerbating competitiveness issues) within the currency area, instead of narrowing them. This is a difficult and painful situation to remedy. Countries within the Zone cannot depreciate against one another; they are in a locked currency grid. Since December of 1998 German core HICP price level has fallen nearly 8% below the e-Zone average while Greece is 20% above that average, Spain is 12% above that average, Portugal and Ireland are nearly 9% above that average and Italy is 6% above that average. Those are huge shifts of competiveness to give away within a fixed exchange rate system. That list of higher-than-average inflation countries pretty much identifies the countries that are under pressure in the Zone, too. Putting that toothpaste back in the tube will be a huge job. It will take more than just financing or a little soaping down with some Irish Spring.

The current bail out of Ireland has shifted eyes to Portugal and to Spain, Spain being a much larger potential problem than the all the previous countries with difficulties combined. Spain is a large e-Zone nation. The Irish bail out has ratcheted Ireland’s already large deficit-to-GDP ratio from 12% to 32% and some seem to think it can deal with that. Such a burden from the bailout must be viewed with extreme suspicion. Ireland will now operate with a huge weight around its neck. However, any plan that would have given it debt relief would have impacted the international banking system which may still not be off the hook. As Ireland wavers in its task, the banks will remain nervous. On top of that, concerns continue to mount about who is next. Italy’s bonds’ spread to Germany bunds ratcheted to a historic high on Monday. That’s not exactly a vote of confidence in the steps that have been taken to calm frayed nerves.

The economic news shows progress; the burden for the future on some Zone economies is nonetheless huge. The challenge is for the ECB to make one monetary policy that can survive these sorts of strains; it is an extreme challenge, the ultimate reality show. With such a Bundesbank-influenced staff we know how the ECB will tilt its policy and that just brings us back to being skeptical about how this sort of a bailout can work, one that just mounds up the debt on a troubled economy. Have Europe’s banks been saved or are they standing on still-thin ice that continues to make strange cracking sounds? I guess it’s probably not a good time to do another round of stress tests on Europe’s banks, is it?

While the Zone has toted up some nice numbers for November in the EU Commission survey we know that there are termites actively munching on that wooden framework. Solid as it may seem it is under duress. Ireland’s debt load likely cannot be borne by Ireland. It cannot be reduced since that world harm banks or trigger credit default swap payments. We are back in familiar, though not very tasty, soup.

Getting competiveness back in line is a main challenge for the Zone. But how Ireland gets there from here with that load of debt is beyond me. There will have to be some sort of restructuring before long. Is Europe just hoping to forestall the issue until banks are healthier? Can we wait that long? More questions are raised than answered by this alleged bailout which is why we should not call it that. It is a bail-along like a sing-along and it will go on for some time with everybody joining in most of them off-key.

Catch QE-II Meets Operation Leap Frog

Catch QE-II Meets Operation Leap Frog

Joseph Heller did not write the script for the Fed’s latest move, but he might have. Ben Bernanke is pursuing a policy that can only work if people suspend disbelief. In Heller’s famous book, Catch-22, the pivotal idea was that while insanity could get you out of military service requesting discharge for the reason of insanity was proof that you were sane after all. That was ‘catch-22.’ In this case there is also a ‘catch’ but if the Fed can get you to stop thinking about the details and to suspend some logistical disbelief, its policy can be effective. Will it?

As the G-20 meet and about 19 out of the 20 members are hostile to the current US policy this is an ever-pressing question.

The problem, or ‘catch’, with QE-II is that mechanically it just is not working. The Fed already has tried reserve injections and banks still are sitting on billions of excess reserves. As any ‘Money and Banking 100’ student knows, if the reserves are not lent by banks (as loans to the public) then the money multiplier is thwarted. So the jump start ability of QE-II is dead in the water from the start since this process is not underway. To see this version QE-II work now, you must suspend disbelief.

But any reserve injection process has two sides to its scissor. Asking which blade of the scissor cuts the paper misses the point. The ‘other blade’ in this case is the Fed’s asset purchase program which enables the reserve injection. But it is hard to believe that a $600bln asset purchase program could have the effect the Fed wants given the huge stock of treasury securities in the world. Again, to see this policy as effective, you must suspend disbelief, or play leap frog...

The Fed and Operation leap frog

Interestingly, the Fed’s policy is unnerving the foreign exchange market. Interestingly, the nations of the G-20 are worried about the impact. What the Fed appears to be successful in doing is in convincing markets that QE-II can leap frog over the broken mechanisms that give the policy teeth and affect market performance anyway. Its scissors are broken, but the Fed is talking with such conviction that its goal has become ‘credible.’ This is an amazing twist of logic and made more amazing since it seems to be working. Future historians looking back at this - if it works – will take it as evidence of cognitive dissonance on a grand scale (this can’t work…but it is working!).

Read the Fed’s last policy statement. It expunged from that statement nearly all forward-looking negative thoughts about the economy. No more forecast that growth will be ‘modest’ or inflation ‘too low.’ The Fed eliminated this sentence for its September 21 policy statement when it issued a new one in November:

“With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.”

It also eliminated this one:

”The Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be modest in the near term”

It is as though the Fed thinks that through the sheer force of its will and rhetoric it can get the results sought by QE by pretending that QE-II can work. Hence I call it Operation Leap Frog.

Interestingly, the Fed has left in its policy statement the reference to rates being kept low for an extended period of time. But there is no longer a low inflation or growth statement to support that tilt. The Fed is engaged in Open Mouth Operations instead of Open Market Operations to do its will. If it can project the force of its will onto the market and if the market believes that the Fed can have an impact on inflation expectations (raising them) then the Fed can make real interest seem lower than they really are and make current policy more stimulative to the economy.

This is a game. We know the important central role expectations have come to have in modern economics. But, of course, it takes credibility to alter expectations. It takes a ‘policy will’ and ‘mechanical ability’ to do achieve what that will is focused upon. The Fed seems to be succeeding with only one of the prerequisites in place. How is that possible?

Maybe the Fed’s timing is right. Like the Druid priest that warned his people that God will swallow the sun he has no power to make this happen but knows there is an eclipse coming. The Fed has timed its policy move to coincide with the economy actually doing better, and with the US elections that have been cathartic. People have a taste for change. For once they want to believe. They are acting even though it is illogical. Cognitive dissonance rears its helpful head. This is also like the period in the financial crisis when the bank ‘stress tests’ were run as mark-to-market rule were suspended. When banks stocks rebounded the Fed/Treasury argued it was the stress tests that convinced people that banks were safer, when in fact it was the suspension of mark to market rules that had been so destabilizing. Bait and switch can make good policy even if it’s devious. In this case the Fed seems to have channeled some careful timing and a delicate alignment of all the stars. To the G-20’s chagrin QE-II seems to be working. But maybe QE-II is a good thing for its members too.

Bernanke after pushing for $800 billion for TARP for another strangely esoteric ‘reverse auction’ rescue of banks in the depths of the financial crisis may have stumbled or craftily maneuvered (you decide) into anther esoteric rescue scheme. This one may work… but for all the wrong reasons. It will be interesting to see how history will judge him for his various innovations some of which worked some of which did not even get started. But this one will be his crowning achievement – if it works.

This is no ordinary QE.

Beyond aliens and the trilateral commission

This past week markets again were dazzled by myriad events. The elections produced the expected results. QE was put in motion and defended by the Fed president himself in an unusual Op-Ed piece written after the Fed meeting. October jobs were stronger than expected and past job gains were revised to be stronger so that the trend is now firmer looking and backsliding should see a much more remote possibility.

There’s something about QE… The Fed chairman has defended QE as being not that far from the doings of normal monetary policy. He says that there is little deviation by the Fed from its normal policy. H also says that the Fed takes both sides of its mandate equally seriously. This alone is huge break from the past.

The economics profession has gone a long way in agreeing to what the Phillips curve really is. In the long run there is no unemployment –inflation tradeoff. So what is the Fed chairman doing apparently seeking more growth and more inflation? Well, the economy has lots of slack so there is plenty of room for stimulus to work some magic without creating inflation of the bottleneck sort. But what of inflation due to expectations and stronger money growth? Can’t we get that even with an output gap? There is a debate about that.

Benjamin’s choice: What the Fed has done this time that is different, is to take on the burden for growth in the short term, a burden that had been lifted from its shoulders. Under Paul Volcker the Fed had ‘resolved’ the apparent dichotomy between looking for maximum sustainable growth (MSG) and price stability by arguing that MSG is a long run property, not a short run property. It argued that by pursuing price stability it was freeing the economy to be all that it could be in the long run which is all that the Fed and monetary policy could be expected to do. It is not clear why Bernanke has ‘bought into’ the notion of the Fed having responsibility for short run growth especially with interest rates at zero. Isn’t that about all that the Fed can do? Why put yourself on the hook for more?

The trilateral commission, aliens, and smoke filled rooms - Some think it is because the Fed was under duress and pressure from its role in the financial crisis. While the Fed acted when no other agency did it also did some things that are controversial. On top of that, it made mistakes that helped to foster the crisis. The Fed eventually lobbied to get more power instead of to lose power in the re-regulation of the economic system, and it won its case but to do so did it have to strike a bargain ‘with the devil’ and is this it? Is taking responsibility for short run growth the Fed’s pay-back for retaining and acquiring more power? We may never know if this is some conspiracy theory allegation or if there is truth here. Whatever the reason, Bernanke’s choice puts the Fed in an odd spot.

So is this QE a Bad idea or not? The economics are complicated. But basically the idea is that banks have excess reserves, the raw material to make loans. They choose not to do that,however. They are also under pressure to raise capital and have been prohibited from dividend pay outs. They are being hounded by bank examiners. But they are being encouraged to lend! In any event, they are not lending so money supply is not expanding (or it has not been until recently). As long as we have excess reserves without loan growth the reserve growth is ineffective so why do more?

What it is - The answer here is complicated but it’s a lot of like this… Suppose you have a car and it is sound, except the starter is broken. As long as the starter won’t start it the car can’t run and it sits idle. But if you and some friends can push it down the street, and pop the clutch with the car in motion, the car just might start and be able to run and get to the garage where it could be fixed- problem solved. So there is a way, a bit of an unusual way, to get the car going with a broken starter. In some ways this is the Fed’s plan. The problem is that while it’s a work around it’s a work-around with risk. It’s like getting all the big guys to push that car and putting the lightest teenage pre-driver at the wheel. Once the car gets going can he control it? Can Bernanke? For all his protestation he is in uncharted waters and he is running the Fed on a completely different model since the Fed became successful in controlling inflation. In many ways we are back to the Arthur F Burns trust-me (I’m a central banker and expert) days of five monetary-aggregate monetary-monte. Only Bernanke’s shtick is the depression he means is bank reserves.

Is that a good thing? Aren’t we already depressed?

The really good news and new news last week was the jobs report. For chapter and verse on that see our weekly PowerPoint on the subject.

Let’s Boogie with the Boogieman- For our purposes here, let’s just hit some of the highlights: 159K jobs reported in Oct. combined with upward revisions to past months means that the level of jobs rose by 240K in Oct. We now have more momentum. The work week expanded so its jobs and hours-worked in demand. The NFIB (small business) survey showed less resistance to hiring among small firms. The productivity report showed productivity gains waning from having workers whipped and cajoled and threatened and coerced. The thrill of overtime and fear of unpaid hours worked are gone. There is no more gas in that tank. Firms will now have to HIRE to get more output and spending is picking up. All that is good for job growth prospects. Best of all, however, spending on services is picking up, since that is both the low productivity sector and the sector where jobs are created - that is good news indeed. It’s about time. So those are the main reasons to be really optimistic and to spank any pessimist you see. Double dip is a risk that is gone. It never was that big; those rumor mongers will continue to talk about it until they can put it to rest without harming their own credibility. These are the same people that keep their children from sleeping by telling them the boogieman is under their bed. He isn’t but they don’t know that, so they worry all night about something that isn’t there. It’s a case of how something you ‘know’ that’s really wrong that can hurt you. So forget those fears don’t waste time worrying about what ain’t there. Time to boogie with that boogie man.

Back to the future with the Fed?

Back to the future with the Fed

The Federal Reserve is at it again. We now know another round of ‘QE’ (quantitative easing) is in the pipeline even though the FOMC and Board of Governors have not met to approve it. Apparently it is a done-deal and the ‘stimulus’ will be parceled out in batches instead of in one giant slug. What is its objective? How is it supposed to work? What are the risks? Sadly, the Fed has told us little about these things and it will suffer for those omissions.

Too-much is not enough? The Fed has done QE before in this cycle and now we are to have more of the same. Banks already have many billions of dollars in excess reserves and the Fed leaves unexplained how more are supposed to stimulate the economy. I guess this is a case of too-much not being enough. Perhaps the real idea is not what is happening on the reserve injection side but what is happening on the ‘other side’ of this transaction that enables reserve injections, the asset purchase side. To inject reserves the Fed must buy (or accumulate) assets. If that is the case we could argue that this action is more like fiscal policy in disguise than like a monetary policy action. Altering the stocks of assets in the economy is playing with fire. Traditionally the main impact of a central bank’s action has been its operations in the reserve market or in the interest rate market. Traditionally, the main concern with asset stocks has been that they be liquid enough to permit reserve injections or drains without disturbing markets. The Fed policy seems to have turned this upside down- a position many homeowners with mortgages can readily appreciate.

Don’t capital flows trump reserves? If the Fed’s idea is that asset purchases can make a difference, then why not just wait? One of the biggest asset purchase programs of all is already in force. Here I refer to the huge US current account gap. Each month billions of dollars of capital flows surge into the US. That capital needs to go somewhere. These are not funds swimming around in some ‘reserve pool’ locked away by banks, earning a return paid by the Fed and held in ‘excess.’ These are real monies being invested in the active economy. If these can’t stimulate the economy how will the Fed’s behind the curtain flows do it when reserves already are being hoarded to such a degree?

Playing a new game or not? The new reserve injections planned for QEII do not really matter. They do not change the game. If the economy (banking system) reverts to normal times the reserves currently in excess are plenty of kindling to start a fire under the economy –in fact one that would be too hot. The real objective of QEII is to play with this fire and to reduced the stocks of certain assets in the economy to gain some policy traction. The Fed’s idea is to convince market participants that the Fed is playing a new game. But, this game is a chameleon. The Fed calls it ‘end deflation now’ but it is more famously known as ‘start real inflation now’ and it spawned another game years ago called ‘whip inflation now’. The Fed uses only one of these names, but it’s the same game-board. QE is such a crude tool the Fed cannot fine-tune it and assure us that game-one won’t morph into game-two. Yet, the Fed wants to convince us that it is being responsible and that its plan will ‘work,’ ignoring this very important complication. Doesn’t that undermine Fed credibility?

Consuming credibility – Credibility is not a consumption good for a central bank; when it becomes so, it is in especially short-supply. I find these Fed actions surrounding plans for QEII inconsistent with the Fed’s promise of conduct; these actions have become a drain on Fed credibility itself. The Fed’s ’mandates,’ to which it very oddly referred in its last public policy statement, are not the issue. The issue is the Fed’s own conduct measured against its promise to us about how it would act. The Fed no longer is transparent. Its policy is opaque. Policy decisions are being spoon-fed to us by journalists instead of after FOMC meetings or in speeches after a decision is made. We are now informed by leaks or ‘scoops’. The Fed’s policy tilt is being announced to us by consulting economists with inside access before the policy has been formally announced to the public! The Fed is losing credibility as it is no longer truthful. It is not being candid about the risks of QEII and instead is overpromising its results; hubris is not an excuse for overpromising (and ‘overpromising’ a nice word for ‘deception’).

Shooting at a target or itself in the foot? In truth the Fed has no inflation target but it is playing fast and loose with the ‘forecasts’ the FOMC generates in calling inflation ‘too low’. These Fed forecasts (actually FOMC expectations which are presented in a range format) are not policy targets, they are forecasts. Even a long-run desired result can’t be the basis for short run policy although some Fed members have argued this in public. This sort of argumentation leads to more confusion about Fed policy and the role of its public ‘forecasts’. Early in his first term, Ben Bernanke and the Fed considered inflation targeting but could not get agreement, as Congress stood in the way. But the Fed spoke of an inflation cap like other central banks have of 2%. So how does 1% become too low? If 2% is/was the top of a desired range then zero is the bottom and 1% is the middle. How is 1% too low and how has 2% become the new minimum? How did it happen? What was the process? The Fed ‘forecasts’ do not help us here. Without targets the Fed cannot articulate its policy with precision. These sorts of changes appear as chaos. Is this another game of bait and switch using benchmarks that do not even have normal policy standing?

Shell Game? I see the Fed as engaged in another shell game of policy options like the one it pursued under Arthur F Burns with the many-money targets. Only the Fed knows why it is doing what it is doing. We no longer have intermediate targets like money supply growth ranges; we do not have inflation targets or ceilings like other central banks. We do have the occasional Fed ‘forecast’. The Fed’s credibility is its only credibility, if you will pardon that redundancy. But it is true. There is no process from which the Fed can draw credibility. That fact has become another big problem. Even if the Fed extracts us from this mess where does it leave us in terms of being able to trust our central bank? I ‘d say back in the 1970s.