naked capitalism

Lordie, if this Reuters article is to be taken at face value, the Fed is even more detached from reality than I feared. The Fed does not understand why the Treasury bond market had a mini-panic last week. Is it that investors believe the “green shoots” story and are seeking riskier assets? Or is it that they are worried about burgeoning Treasury auctions and a possible fall in the dollar?

Note there is another theory, that it was Fannie and Freddie moves to manage their duration risk that caused the mess. However, it did appear that the selloff in the dollar and longer Treasuries was triggered by Standard & Poors’ announcement that it was putting the UK on negative watch, meaning it is at risk of losing its AAA rating.

While both factors, a shift to riskier assets and worries about a tsunami-like incoming tide of Treasuries, bizarrely, are in play, from what I can tell, the second, the fear of the growing Treasury calendar, is the big driver. Look, the Chinese have done everything but put up a billboard in Time Square to let the US know that it is not happy about US fiscal deficits (really, it ought to be, they need the economy to be something other than prostrate) and has moved aggressively to the short end of the yield curve.

So we have two possibilities. Either the Fed is as completely clueless as this story suggests it is, or it is coming to realize that it cannot, like the Wizard of Oz, manage all the variables it is trying to control and tune things as it would like. Doug Noland offers a similar line of thought (hat tip Andrew U):

The notion that there is a system price level easily manipulated by our monetary authorities to produce a desired response is an urban myth. During the 2000-2004 reflation, I would often note that “liquidity loves inflation.” The salient point was that the Fed could indeed create/inflate system liquidity. It was, however, quite another story when it came to directing stimulus to a particular liquidity-challenged sector. Almost inherently it would flow instead to where liquidity – and resulting inflationary biases – were already prevalent.

The Fed’s reaction strikes me, behaviorally, as a re-run of 2007. The Fed saw the credit contraction as only the subprime mess, therefore something familiar, sat on its hands, then overreacted. As things appear to be working out not to its liking, it its reflex again is to hold pat. I’d expect the Fed to overreact as before if it comes to believe it has a real problem on its hands.

The fact set this time of course is wildly different. The Fed is trying to achieve aims that are not internally consistent, namely, prop up asset prices by directing credit to preferred sectors, and create positive inflation expectations.

Keeping yields (or more accurately spreads, the Fed claims it is only trying to control spreads) while also trying to raise inflation expectations, albeit modestly, is a conflict. Higher inflation expectations mean higher yields, particularly on long dated assets like mortgages. And enough observers think privately that the Fed secretly wants to create much more significant inflation, say 5-6%, to alleviate the real debt burden on households. Those sorts of worries among bond investors are cause enough for some to abandon the long end of the curve.

And the “will the Fed amp up its quantitative easing” is yet another concern. Even though the Fed could in theory control rates at the long end of the curve via its unlimited firepower, Mr. Market could well play a game of chicken. If the Fed decided to hold a particular long rate, it could well wind up owning that market. The Fed is no doubt well aware of this risk, which may be the big reason it is holding off, and hoping this problem somehow resolves itself.

From Reuters:

The Federal Reserve is studying significant moves in the U.S. government bond market last week that could have big implications for the central bank’s strategy to combat the country’s recession.

But the Fed is not really sure what is driving the sharp rise in long-dated bond yields, and especially a widening gap between short and long term yields.

Do rising U.S. Treasury yields and a steepening yield curve suggest an economic recovery is more certain…..

Or does the steepening yield curve mean investors are worried about the deterioration in the U.S. fiscal outlook, or the potential for a collapse in the U.S. dollar….

Another possibility is that China, the largest foreign holder of U.S. Treasury debt, has decided to refocus its portfolio by leaning more heavily on shorter-term maturities.

With officials still grappling to divine the factors steepening the yield curve, a speedy decision on whether to ramp up the Treasury debt purchase program or the related plan to snap up mortgage-related debt seems unlikely.

“I’m in wait-and-see mode,” said one Fed official …”We laid out the asset purchase plan and we’re following it. That is going to have some affect on various interest rates, but together with a hundred other things. So I don’t think we should be chasing a long-term interest rate,”…

Economists at Barclays Capital in New York have argued that the Fed should announce plans to increase its planned purchases of longer-dated Treasuries to $1 trillion from $300 billion to drive yields back down….

But the Fed is not so sure, and officials note that corporate bond spreads have narrowed over U.S. Treasuries, and that although mortgage rates have risen, they are still low..

Yves here. The funniest bit of the piece is a part I omitted, where the Fed types figured that the jump in yields couldn’t be due to the big supply, after all, that had been known for some time. Gods, they actually believe that rational expectations stuff. People are inertial, and Bill Gross and his buddies have believed that the Fed would protect him, since it has done such a good job until now.

The last person one might expect to criticize the Obama Administration bailout of GM is a unapologetic liberal like Robert Reich, labor secretary under Clinton. Yet he does precisely that in today’s Financial Times.

And his logic is similar to the arguments made here and elsewhere against the bank rescue operations. Unlike some other commentators, who would be happy to Big Auto fail and devil take the hindmost, Reich believes the social cost would be so great (if nothing else, the whackage to GDP), that means to address the fallout are warranted, But he strongly disagrees with the bailout program, seeing it as wasteful and intellectually dishonest.

Bizarrely, the rescue, by throwing dollars at the problem, somehow looks more surgical and hands-off. Indeed, in the various announcements of the imminent GM bankruptcy filing, the powers that be have gone to some lengths to say they will be a hands off 60% owner. Yet the sort of active measures that Reich calls for, such as retraining programs, extended unemployment (and I would add relocation aid) weirdly raises the specter of “big government” in the public mind more than just writing very large checks. So we’ll go for costly and indirect rather than focused, cheaper, but more moving parts.

From the Financial Times:

As president of General Motors when Eisenhower tapped him to become secretary of defence in 1953, “Engine Charlie” Wilson….asked whether he could make a decision in the interest of the US that was adverse to the interest of GM, he said he could.

Then he reassured them that such a conflict would never arise. “I cannot conceive of one because for years I thought what was good for our country was good for General Motors, and vice versa. Our company is too big. It goes with the welfare of the country.”….

In 1953, GM was the world’s biggest manufacturer…It generated 3 per cent of US gross national product….It was also America’s largest employer, paying its workers solidly middle-class wages with generous benefits.

Today, Wal-Mart is America’s largest employer, Toyota is the world’s largest carmaker and General Motors is expected to file for bankruptcy. And Wilson’s reassuring words in 1953 now have an ironic twist. There will be little difference between what is good for America and for GM because it is soon to be owned by US taxpayers who have forked out more than $60bn (€42bn, £37bn) to buy it.

But why would US taxpayers want to own today’s GM? Surely not because the shares promise a high return when the economy turns up. GM has been on a downward slide for years. In the 1960s, consumer advocate Ralph Nader revealed its cars were unsafe. In the 1970s, Middle East oil producers showed its cars were uneconomic. In the 1980s, Japanese carmakers exposed them as unreliable and costly. Many younger Americans have never bought a GM car and would not think of doing so. Given this record, it seems doubtful that taxpayers will even be repaid our $60bn. But getting repaid cannot be the main goal of the bail-out. Presumably, the reason is to serve some larger public purpose. But the goal is not obvious.

It cannot be to preserve GM jobs, because the US Treasury has signalled GM must slim to get the cash. It plans to shut half-a-dozen factories and sack at least 20,000 more workers. It has already culled its dealership network.

The purpose cannot be to create a new, lean, debt-free company that might one day turn a profit. That is what the private sector is supposed to achieve on its own and what a reorganisation under bankruptcy would do.

Nor is the purpose of the bail-out to create a new generation of fuel-efficient cars. Congress has already given carmakers money to do this. Besides, the Treasury has said it has no interest in being an active investor or telling the industry what cars to make.

The only practical purpose I can imagine for the bail-out is to slow the decline of GM to create enough time for its workers, suppliers, dealers and communities to adjust to its eventual demise. Yet if this is the goal, surely there are better ways to allocate $60bn than to buy GM? The funds would be better spent helping the Midwest diversify away from cars. Cash could be used to retrain car workers, giving them extended unemployment insurance as they retrain.

But US politicians dare not talk openly about industrial adjustment because the public does not want to hear about it. A strong constituency wants to preserve jobs and communities as they are, regardless of the public cost. Another equally powerful group wants to let markets work their will, regardless of the short-term social costs. Polls show most Americans are against bailing out GM, but if their own jobs were at stake I am sure they would have a different view.

So the Obama administration is, in effect, paying $60bn to buy off both constituencies….But it is not telling anyone the complete truth: GM will disappear, eventually. The bail-out is designed to give the economy time to reduce the social costs of the blow.

Behind all of this is a growing public fear, of which GM’s demise is a small but telling part. Half a century ago, the prosperity of America’s middle class was one of democratic capitalism’s greatest triumphs. By the time Wilson left GM, almost half of all US families fell within the middle range of income. Most were headed not by professionals or executives but by skilled and semi-skilled factory workers. Jobs were steady and health benefits secure. Americans were becoming more equal economically.

But starting three decades ago, these trends have been turned upside down. Middle-class jobs that do not need a college degree are disappearing. Job security is all but gone. And the nation is more unequal. GM in its heyday was the model of economic security and widening prosperity. Its decline has mirrored the disappearance of both.

Middle-class taxpayers worry they cannot afford to bail out companies like GM. Yet they worry they cannot afford to lose their jobs. Wilson’s edict, too, has been turned upside down: in many ways, what has been bad for GM has been bad for much of America.

Larry Summers appears to have a less than operational moral compass.

The former Treasury Secretary, now head of the National Economic Council (and presumed Fed chairman if Obama decides against recommending Bernanke for another term) was in the employ of hedge fund DE Shaw to the tune of $5 million for sixteen months while working with actively on Democratic economic policy, with the clear expectation that he would have a major role. In other words, Summers is already way too cozy with the financial services industry.

And now we have the latest, from Mark Amos (hat tip reader Marshall). I’ve put up some excerpts, and strongly recommend you read the entire piece.

Ames points out that a number of very big Wall Street firms made an unusual investment in a start-up, one Revolution Money, a “PayPal meets Mastercard” in the Steve Case “Revolution” sphere. Weirdly, the company says Summers was on the board, and Summers certainly was talking up to the media, but filings suggest otherwise. But while the exact nature of Summers’ relationship is unclear, he was certainly promoting the venture.

While Summers did terminate his relationship with the Revolution Money before the big players invested, fundraising and getting to closing documents is generally a lengthy process, so it is reasonable to surmise that Summers’ salesmanship and relationship with the company played a meaningful role in these banks’ decision to invest in a company with lousy performance, dubious prospects, and no obvious synergies. Amos notes the investees got off better in the stress tests than their brethren did. That may be happenstance, but it was reported that the stress tests were tougher on loans than on trading portfolios, and the investors in Revolution Money all had big capital markets operations.

The Ames piece is provocative, but it’s certain no explicit payoff was made. But the flip side is it is highly likely the banks invested to curry favor with Summers. Even if the only payoff was privileged access to him, that alone would be troubling,

From Ames:

Is Larry Summers taking kickbacks from the banks he’s bailing out?

Last month, a little-known company where Summers served on the board of directors received a $42 million investment from a group of investors, including three banks that Summers, Obama’s effective “economy czar,” has been doling out billions in bailout money to: Goldman Sachs, Citigroup, and Morgan Stanley. The banks invested into the small startup company, Revolution Money, right at the time when Summers was administering the “stress test” to these same banks.

A month after they invested in Summers’ former company, all three banks came out of the stress test much better than anyone expected — thanks to the fact that the banks themselves were allowed to help decide how bad their problems were (Citigroup “negotiated” down its financial hole from $35 billion to $5.5 billion.)

The fact that the banks invested in the company just a few months after Summers resigned suggests the appearance of corruption, because it suggests to other firms that if you hire Larry Summers onto your board, large banks will want to invest as a favor to a politically-connected director…

According to filings obtained for this story, Summers first joined the board of directors of Revolution Money back in 2006 (when it was called “GratisCard…Revolution Money/GratisCard was a startup headed by former AOL chief Steve Case. Revolution Money billed itself as the Next Big Thing in online payment,…

In September 2007, Revolution Money announced that it had raised $50 million from a group of investors including Citigroup, Morgan Stanley and Deutsche Bank. Some found the investment strange even then, because normally big banks don’t get involved in seeding small startups — that’s the domain of venture capitalists, not mega-banks. Especially not in September, 2007, when these same megabanks were Chernobyling their way into full-fledged balance-sheet meltdown.

What seems clear is that at least part of Revolution Money’s success in raising funds is due to their star-studded board of directors — which included not only Larry Summers, but also the notorious Frank Raines, the former Fannie Mae chief whom Time Magazine named to its “25 People To Blame For The Financial Crisis” list. Raines is still a board member.

Over the next year and a half, Revolution Money didn’t quite live up to its promise of competing with PayPal or Visa/Mastercard. At least some of this could be attributed to the difficulty of starting up an online credit card company in the middle of a triple-cluster credit crunch, banking crisis and recession. But there is also evidence that the company wasn’t run well. Another one of Steve Case’s “Revolution” brand startups, “Revolution Health,” (which also features a star-studded board of directors including Carly Fiorina, Colin Powell, and several future-Obama Administration officials) essentially folded last autumn when it was sold to Everyday Health last September and merged into that company’s operations.

In spite of all of this, on April 6, 2009, Revolution Money announced the happy news: it had just successfully raised $42 million dollars in the most difficult market since the 1930s. The investors? Goldman Sachs, Citigroup and Morgan Stanley — bankrupt institutions that Larry Summers was transferring billions in bailout funds to.

At the very same time that these three megabanks were pouring millions into Summers’ former company, Obama’s economic team, starring Larry Summers, was subjecting these same banks to a “stress test” to decide how deep in shit these same banks really were. The banks wanted the government to fudge the results for obvious reasons — who wants the world to know how deep of a hole you’ve dug for yourself?

When the stress test results were finally released, the banks all came out with glowing reports that beat expectations and caused plenty of skepticism.

In an interview for this article, William Black, a former bank regulator who exposed the $160 billion Savings & Loan scandal and its ties to powerful U.S. Senators, remarked,“Summers wasn’t hired [by Revolution Money] for his expertise because he doesn’t have relevant expertise in this kind of credit card operation.”

“He’s not a techie. He doesn’t have business expertise,” Black said. “So this is solely someone hired for the name and contacts because he’s politically active and politically connected. And that’s made all the more clear by the fact that Frank Raines was put on the board at a time when he was pushed out in disgrace from Fannie Mae. Why? Because of his political connections.”

And it worked, as the recent investment shows.

“That’s the pattern of this entity,” said Black, “Which hasn’t been doing well financially and desperately needs to get money from others, and has been able to get money from banks at a time when [these same banks] largely stopped lending to productive enterprises. But with this politically-connected entity [Revolution Money], they’re happy to dump money.”

According to a company spokesperson, Summers resigned from the board of directors at Revolution Money this January, just three months before the banks invested. On one of Revolution Money’s main websites, Revolution Money Exchange, you could still see Summers’ name still listed as a director when this story was filed…

Whatever the case, Summers was pushing Revolution Money as recently as last September, in an interview with Portfolio magazine:

“I’ve enjoyed being involved with a number of smaller companies such as the Revolution Money venture….”..

His involvement wasn’t just incidental—if you look at the press releases, Larry Summers’ name is always touted as part of its selling point — one press release in 2007 refers to Summers as “Legendary.”

Moreover, Summers’ longtime chief of staff, Marne Levine, who also served as Summers’ chief of staff when he was in Treasury under Clinton and again at Harvard, joined Summers at Revolution Money, serving as “Director of Product Management.”

Black pointed out another sleazy aspect of Revolution Money’s pitch: it proudly boasted in late 2007 that it would make it easier than ever for people with low credit ratings to find access to lines of credit. In other words, Revolution Money billed itself as the ultimate ghetto loan shark.

According to a 2007 press release, the same one boasting of “Legendary” Larry Summers, “Unlike most bank credit card issuers who are limited to a narrow scope of credit approval guidelines specific to their bank, RevolutionCard seamlessly utilizes multiple partners to achieve unparalleled consumer approval rates.”

Nineteen months later, Larry Summers, now in control of the economy, told Meet The Press, “We need to do things to stop the marketing of credit in ways that addicts people to it and so that our households are again savings, and families are again preparing to send their kids to college, for their retirement and so forth.”

So once again, Larry Summers creates a problem that the rich profit from, then is put in charge of “fixing” it after vulnerable Americans have been picked clean.

Whether or not the three bailed-out banks’ investment in Revolution Money last month represents some kind of bribe or kickback or even the appearance of corruption is almost secondary, because the shameless cronyism is the problem, and this is the reason why America is in the horrible mess today.

“Polite society was supposed to impose social pressures to make sure this wasn’t tolerated,” Black said. “Like the old phrase about hogs being slaughtered. But now the hogs get even wealthier, even fatter.”

Please read my latest comment:

Why is Small Beautiful?

And please post comments here on NC.

Kind regards,

Leo Kolivakis

We still have some technical glitches, and the fellow who did the transfer was oddly MIA Saturday, which is far from a good devleopment.

Some images are not showing up in the daily e-mail. Most troubling, the RSS feed does not seem to be working with all clients. There are also some problems with comments (how they format while being written).

Please ping yves@nakedcapitalism.com with any anomalies. Thanks for your patience.

Elephant rescued from ditch BBC

Altruism repays the best-connected individuals physics arXiv

On the Street and On Facebook: The Homeless Stay Wired Wall Street Journal

Susan Boyle loses Britain’s Got Talent crown to Diversity dancers Times Online. Remember, Jennifer Hudson was a talent show loser too.

Drive-by Economics: The Meta Edition Paul Kedrosky

Guest Blog: Japan’s first trade deficit in 28 years Eiji Fujii, Econbrowser

Harvard datapoint of the day Felix Salmon. Wow, is Harvard going to have a fiscal crisis, in an upmarket version of what hit New York City in the 1970s?

Geithner Wields Little Leverage In China Talks Huffington Post

The CBMS market about to implode Economic Populist

Green Shoots in Escapism Michael Panzner

What Was THAT? (Friday Market Close) Karl Denninger

Troubled Bank Loans Hit a Record High Floyd Norris, New York Times

Harvard Business Students Take Dumb “Ethics” Pledge Clusterstock. The really stupid thing is when some HBS names were prominent in scandals in the 1980s, the school did a study and concluded ethics couldn’t be taught, you had them or not by the time you got to business school. So is a silly ritual pledge going to make an iota of difference?

The browning of America Willem Buiter

Antidote du jour:

The New York Times discusses whether Americans will return to buying cars at the pre-bust level when conditions return to some level of normalcy. Of course, the subtext is that the US economy will get back on track later this year, when many those who anticipate growth starting 3Q/4Q, when pressed, say the recovery will be so lackluster as to be a borderline recession.

The article does point to demographics, that the baby boomers are moving into retirement, and retirees are not big on buying cars. But it still misses or glosses over a couple of key points.

One is that every country experiencing a major financial crisis suffered a permanent decline in its standard of living. It isn’t unreasonable to think that car purchases will take dent longer term. In fact, a very good slide show by David Rosenberg, until recently, chief economist for North America for Merrill Lynch, had a chart that showed the ratio of adults to cars over a long period of time (sadly, I cannot locate said chart, but I would presume it excluded the prison population). It showed a near continuous decline to its recent level of 1.2 adults for every car.

The implication is that not even that long ago, Americans lived with fewer cars, and conceivably could again. I have also been told, but do not have any stats to prove it, that car ownership has fallen sharply among the young in Japan, in part because many are “freeters” with little job security.

The flip side is that if these conservative forecasts do not come to pass, the industry would have gotten so lean that it would be coining money if Americans start buying cars in force again.

From the New York Times:

Can American drivers live without that new-car smell?

In recent years Americans appeared to be hooked on it…Now the market has collapsed by 46 percent to below 10 million, as people are making do with the cars they have, leaving the industry to debate — and worry — about what the new normal will be once the recession ends.

Some say the downturn is temporary and that sales will spring back in a few years. Others believe Americans will rethink whether they need so many cars, particularly new ones…

The Treasury Department’s advisers, who initially expected auto sales to pick up late next year, now foresee no jump in demand this year or in 2010. And even five years out, they expect annual sales to be about 15 million, still well below the peaks of this decade…

If sales do not recover, the Treasury will have to provide more financial support for G.M. and for Chrysler, which has received about $10 billion in federal aid, before they can stand on their own and the government can divest its shares…

If sales do pick up, carmakers eventually could be more profitable than they have ever been because of all the costs they have shed, said David Cole, chairman of the Center for Automotive Research in Ann Arbor, Mich.

“After you rebound from this artificial low in demand, wow,” Mr. Cole said of the potential for auto sales and profits.

He estimates that pent-up demand for new cars is actually about 4 million vehicles higher than the current selling rate, which in April would translate to 9.3 million a year, according to Autodata Incorporated.

Others, however, point to shifts suggesting that Americans’ desire — and need — for new cars may be cooling….

“We sold to people who purchased cars by refinancing their houses,” said Wilbur Ross, the billionaire financier who has invested in steel mills and auto parts companies….

Lifestyles have changed, too. As many people move back to cities from suburbs, they are swapping three-car garages for a single parking space. Public transit use is up….

Donald Grimes, an economist at the University of Michigan, is forecasting the lowest sales for the driving-age population this year since 1970.

From 1970 to 2001, there were 0.76 vehicles sold per driver in the United States. Now that figure has dropped to 0.4 vehicles per driver, and he does not see much of a rebound in coming years.

The swift decline has spooked the industry. “I don’t think there has ever been a period in our history like this,” Josephine Cooper, Toyota’s group vice president for government and industry affairs, said of her company, which lost $7.1 billion in the first three months of the year. “It is very, very sobering.”

Until I figure out a way to quickly copy and paste hyperlinks from Blogger to WordPress, I invite you to go to my blog and read my latest comment:

Street Fighters and their Pension Clients

You can leave your comments here on NC.

Kind regards,

Leo Kolivakis

Submitted by Tyler Durden of Zero Hedge

In the week ended May 22, NYSE program trading dropped to a statistically significant low of 2.9 billion shares, down from 3.3 billion the week before, and from a 3.8 billion prior 52 week average. As for specific actors, no surprise, Goldman leading the government’s SLP team with a 7:1 ratio of principal to facilitation/agency.

As for today’s market close, with a literally parabolic jump in the last minute of trading, if anyone still thinks this market trades based on anything resembling normal behavior (unless someone had a very Jerome Kerviel-esque fat delta hedging finger or one/two moderate/large quants who had a huge index hedge imploded), I have some BBB+ rated CMBS to sell to you at par. One culprit could be hiding in the huge drop of agency trading, which this week dropped to a several month low of 1.875 billion shares.

So as essentially no institutional or retail clients are trading any more, it is just a few desperate computers trying to front run each other. And, of course, for the biggest beneficiary of this PT principal bonanza, look no further than the chart below.

Going back to today’s ridiculous close, the chart below shows it all: the complete tape painting volume spike at the very end of the day speaks for itself. And as computers now simply issue forced stock recall orders to each other, painting the tape wet with manipulative intent and volume spikes into the last 20 minutes of trading every day, their human creators are left on the sidelines, trying to outshout each other as to the reason for why the market keeps rising while the economy keeps tumbling.

Is there ever going to be any transparency in this market again?

The blog will be switched from Blogger to WordPress starting at 8:00 PM this evening. It should be on WordPress by 10:00 PM.

There will be NO change in address or RSS feeds. There may, however, be an interruption in your ability to leave comments, as the new address related to the www.nakedcapitalism.com domain name propagates through the net (ie. domain servers will be pointing to the old address). Or your comments in that window may be at Blogger and not get transferred over. Apologies in advance if that happens.

We’ve tested it for speed, and it seems to be more or less the same as Blogger (now, having made some tweaks) but weirdly different items on the blog load at different speeds on the two services, so hopefully the user experience will be the same.

I have stuck with the same letter from the gulag look for now, and know a redesign is badly in order, but the priority was getting the site over.

Thanks for your patience, and hopefully this will go like clockwork and no patience will be needed! Wish Ed and Alex the best in making this happen.

Submitted by Rolfe Winkler, publisher of OptionARMageddon

Back in February, amidst the neo-Keynesian rage to spend our way out of recession, I argued that stimulus wouldn’t stimulate. Pointing to the graph of the 10-year Treasury vs. 30-year mortgage rates I said that the government wouldn’t be able to flood the market with Treasurys without driving up interest rates. Higher rates on government debt imply higher rates for mortgages, which would hammer house prices and other assets, blowing an ever-larger hole in bank balance sheets.

The Fed knows long-term rates can’t be allowed to rise because that would run their economic “recovery” off the rails. Enter “quantitative easing,” the policy by which the Fed prints money to buy fixed-income securities like Treasurys and MBS. By printing money to inflate demand, they hope to hold interest rates down.

Sounds great, right? Why can’t the Fed just keep printing money to buy bonds in order to hold interest rates artificially low?

Because bond investors call bullsh*t. As the Fed prints money, inflation expectations rise. When investors anticipate higher future inflation they demand higher interest rates to buy debt. After all, they don’t want to hold fixed-income securities when fixed-incomes lose their purchasing power to inflation.

And so we have a great game of chicken between the Fed and the bond market. The Fed prints money to keep interest rates down while bond investors zip tight their wallets because Fed printing makes bonds less appealing. What is the Fed going to do, become the lender of last resort to the federal government? Print whatever cash is necessary to literally displace vanishing private demand for government debt? This is no solution of course; in the long-run it implies hyperinflation.

And so we return to the question Keynesians like Krugman simply won’t address when they advocate government “stimulus:” How do we pay for it? If we run up additional debts without making some provision to pay them, then in the long-run interest rates have to rise.

You could raise taxes to pay down debt, but that would destroy the positive impact of additional government spending.

The point is there’s no way to financially engineer our way out of this crisis.

Economists love the idea that the Fed is all powerful, that it has some magic wand to wave which can rescue Americans from debt deflation. I suspect this is because, deep down, they harbor ambitions to be Fed Chairman themselves. For most economists, the Fed’s printing press is the ultimate toy….one they’ve always wanted to play with.

And it is a powerful one. Most recessions are easily “solved” because the Fed can always use that printing press to inflate a credit bubble, to inflate demand artificially. This works great until it doesn’t. Eventually the credit bubble becomes so big it’s simply impossible to sustain with more printing.

I suspect this is why Keynesians never bothered asking how we’d pay for stimulus. The answer—”we can’t”—shatters their economic theory.

Krugman offers a partial rebuttal to this argument in his column today. He argues that inflation isn’t a big issue right now. And he’s right: deflation is the real threat. He argues that Fed printing is necessary to counteract it, but he misses the larger point that, in the long-run, higher government debts imply higher interest rates regardless of what the Fed does. Debt is not a static thing. It has to be rolled over, paid down or repudiated (via default). In ascending order of economic violence, each of these implies a debt deflationary depression.

Outright default isn’t an option. Imagine the worldwide economic calamity if Tim Geithner stops making interest payments on Treasurys…

Paying down debt means running surpluses. To do so would require draconian cutbacks in spending by indebted governments, corporations and individuals. Aggregate demand would collapse, leading to depression.

Both of the above are unappealing so the Fed conspires with government to inflate aggregate demand with more borrowing. But more borrowing means more debt that has to be paid down later. More debt means bigger future cutbacks. The longer we kick the can down the road, the deeper the depression we’ll be faced with in the “long-run.”

The bottom line is that we have to pay down debt. We’ve no other choice. Yeah, it’s going to be very painful, but we should have thought of that before we inflated the credit bubble.

———

Post Script:

I can’t leave this piece without rebutting the conclusion to Krugman’s op-ed:

But it’s hard to escape the sense that the current inflation fear-mongering is partly political, coming largely from economists who had no problem with deficits caused by tax cuts but suddenly became fiscal scolds when the government started spending money to rescue the economy. And their goal seems to be to bully the Obama administration into abandoning those rescue efforts.

Because Republicans lost their fiscal bearings during the Bush years doesn’t mean that budget arithmetic somehow no longer applies. Deep down, Krugman desperately wants to support Democratic ambitions to dramatically increase the size of government. But “Republicans did it so we can too” is not an argument. PK knows this but, hyper-partisan that he is, he can’t resist getting in the dig. He should know that plenty of independents abhorred runaway government spending under Bush. We were hoping Obama would bring “change” by putting our fiscal house in order.

Needless to say, the president should not let himself be bullied. The economy is still in deep trouble and needs continuing help.

Yes, we have a long-run budget problem, and we need to start laying the groundwork for a long-run solution. But when it comes to inflation, the only thing we have to fear is inflation fear itself.

Here, for the first time that I’m aware of, Krugman acknowledges the paradox of his prescription. Spending creates a long-run budget problem! But by adding the “long-run” modifier, he gets to kick the can down the road. Deficits aren’t an issue we have to address now so Democrats shouldn’t let themselves be “bullied” into a policy of spending restraint.

But my goodness: what is the the “groundwork” we should be “laying” to provide a “long-run solution” to this “problem?” Krugman owes his readers an answer to this question.

Last week I commented on CPPIB’s 19% loss in FY2009. On Thursday, CPPIB released its 2009 Annual Report and it’s worth going over some details below.

[Note: For some strange reason (probably to annoy me), CPPIB locked their PDF file, so I had to embed images below. Click to enlarge the images to properly view text and tables.]

We begin on page 4 where there is a discussion on management compensation:

We then skip over to page 54 to see the following:

This brings us to the summary compensation table:

As you can see, even though the senior officers did not get their STIP, they still got phenomenal total compensation packages, way above what ordinary Canadian citizens receive.

And that four year rolling return benefits the senior officers because if you go back 100 years and look at a portfolio of 60% stocks/40% bonds, you’ll see there were very few negative rolling four-year returns.

Moreover, as I wrote last week:

Can you please stop with this four year rolling return nonsense? You lost 19% or $23.6 billion in FY2009 and you have the audacity to even think you deserve any bonus whatsoever? For what? To retain your talented investment managers?

I would add that FY2009 losses wiped out four years of contributions but senior managers collected millions over those years.

CPPIB’s 2009 Annual Report did provide a discussion on benchmarks on pages 18-21:

And on private market benchmarks, they state the following on page 21:

In the case of private equity, we select a benchmark that matches as closely as possible the geography and industry of the underlying investments. Accordingly, energy company operating in the United Kigndom would be benchmarked against the U.K. energy sector with an adjustment for the increased leverage inherent in many private equity structures.

They go on to state that the same principles are applied to benchmarking other types of active investment strategies such as real estate and infrastructure.

They also show a table at the bottom of page 21 showing how they translate actual and benchmark return into an incentive compensation system for private equity:

If this all sounds too sophisticated and complicated to you, that’s because it is. I believe CPPIB is complicating these benchmarks deliberately to blow smoke and hide what they really are.

Importantly, given the size of the CPP Fund, there is every reason to believe they are primarily investing in large private equity buyout funds in the U.S. and Europe and if this is the case, there is simply no need to set benchmarks according to specific geography and sectors.

Ever heard of the KISS principle (Keep it Simple Stupid)? Give me a benchmark like MSCI World Equity and add a spread to reflect illiquidity and leverage of private markets and for pete’s sake, publish your benchmarks in private markets!

What we got in this 2009 Annual Report was a justification for paying outrageous compensation following a disastrous year and a complicated explanation of private market benchmarks.

What a joke. Is this the transparency and accountability Canadians can be proud of? I can just imagine what hedge fund managers struggling with hurdle rates and high water marks are saying to themselves: “Damn, how do I get a gig at CPPIB so I can get a big fat comp based on four year rolling returns?”

The Consolation of Animals Richard Coniff, New York Times Happy Days, The piece is nice, but the very existence of this blog (“The Pursuit of What Matters”) is a real sign of the times.

The Obama Time Capsule (hat tip reader lambert). I am not sure what to make of this…and it does seem to be serious.

Stupid Burglar Nabbed by Backup Program Bruce Perens

G.M. Plan Gets Support From Key Bondholders New York Times and Hopes rise for fast GM bankruptcy exit Financial Times. Both stories report progress on the GM bondholder front, with the FT more positive, in keeping with the headline. The Times article is much more detailed on the state of play and seems more credible.

Proposal for US bank regulation draws flak Financial Times

Making Sausages, Data in China Wall Street Journal (hat tip reader Michael)

Insight: Recovery not as easy as U, V, W Gillian Tett, Financial Times. A balanced and useful reading.

The Inefficient Capital Markets Hypothesis Steve Lubben, Credit Slips

The Big Inflation Scare Paul Krugman

A Return to a Nasty External Dynamic? Tim Duy, Today’s must read. Directly addresses the Treasury yield issue which Krugman pointedly avoided.

Antidote du jour, from reader North:

I’ve attached a picture of a goat from my trip to a goat dairy outside Philadelphia (the only place I’ve ever seen chubby dairy animals – the owner really loves his goats). The goats were, if possible, even cuter than they look in the photos, and because they’re bottle-fed, they’re friendly as puppies.

Given that we are (hopefully) going into a time of year when the news will continue to be less than gut-wrenching, and therefore provide less ready grist for blogging, I wondered if any readers might enjoy taking a hand at a book review. It can take either the “what is this book about and do I think it is any good” form, or the essay approach, using the book as a point of departure for a broader discussion of the general subject area.

I am open to ideas, but these would seem to be ripe candidates:

Animal Spirits by George Akerlof and Robert Shiller

Bailout Nation Barry Ritholtz

Lecturing Birds on Flying: Can Mathematical Theories Destroy the Financial Markets? Pablo Triana

Mr. Market Miscalculates: The Bubble Years and Beyond James Grant

When Giants Fall: An Economic Roadmap for the End of the American Era Miichael Panzner

If you are interested, please ping me at yves@nakedcapitalism.com. Thanks!

The Japanese have a wonderful expression that I will take some liberty in translating. They use it to signify when someone is trying to claim great distinctions among low levels of activity or achievement. The phrase is roughly “A height competition among peanuts.”

Reader DoctoRx flagged this Bloomberg report as a Pangloss item. What is odd is Bloomberg, in theory, is the last place one ought to see this sort of thing, since its serious money still comes from its professional terminals, and those types are not keen about being spun.

Now there is no denying that this change is a big bounce. But it comes after a tremendous plunge, so the overall level of activity is far from robust. And the article attributes the improvement to domestic and foreign fiscal stimulus.

The headline is Japan’s Industrial Production Surges Most in 56 Years . Technically, that is accurate. But the article verges on schizophrenia. You have this first paragrpah:

Japan’s industrial output surged the most in 56 years in April as a rebound in exports helps the economy emerge from its worst recession since World War II.

Yves here. Um, the last GDP report had Japan shrinking at an amazing rate, 15.2% annualized, in a report issued May 19. Now we have a Bloomberg reporter unilaterally declaring the recession over? OK, BOJ governor Shirakawa says the economy will emerge from recession this quarter. But that’s a forecast, not a fact, as the first paragraph suggests. Back to the story:

Production rose 5.2 percent from March, the second monthly gain, the Trade Ministry said today in Tokyo. The increase was faster than the 3.3 percent economists estimated, and companies said they planned to boost output in May and June as well.

The yen rose on speculation funds will flow into Japan as the economy resumes growing after last quarter’s record contraction. Still, output is running at two-thirds last year’s levels, saddling manufacturers such as Nikon Corp. with workers they no longer need and driving the jobless rate to a five-year high of 5 percent.

Yves again. The yen’s strength is not favorable for exports, which has been Japan’s driver. And notice the grim reality in the last sentence: even with this increase, output is 66% of last year’s rate. That’s an amazing fall. Yet the most bullish analyst quote comes first, with the next, more tempered, a full seven paragraphs later:

“This is not so much a green shoot as it is a green tree,” said Glenn Maguire, chief Asia-Pacific economist at Societe Generale SA in Hong Kong. “Optimism on Japan is certainly not misplaced as we look at a reasonably strong quarter of growth in April to June.”…

“Japan’s economy may return to growth in the second quarter, but looking beyond, there will be strong downside risks,” said Junko Nishioka, an economist at RBS Securities Japan Ltd. in Tokyo. “The deterioration in employment and income conditions will likely become clearer in the months ahead, taking a toll on consumers and the economy.”

And these two comments, spaced apart towards the end of the story:

“Confidence has turned,” said Masamichi Adachi, a senior economist at JPMorgan Chase & Co. in Tokyo. “Even if corporate management thinks demand will be sluggish in the medium-to-long term, all of this fiscal support means there’s definitely demand in the short term.”…

“It’s dangerous to be too pleased with the economy bottoming out,” said Yasunari Ueno, chief market economist at Mizuho Securities Co. in Tokyo. “Japan’s economy will fly low and experience more turbulence until the second half of next year.”

Submitted by Edward Harrison of the site Credit Writedowns.

I was on the BBC yesterday talking autos and my commentary was almost entirely political. So, as we await the likely General Motors bankruptcy, I think it bears discussing how political this process has been and will continue to be.

General Motors is a monster company employing a quarter million people worldwide. It sells $150 billion in cars – or at least it used to. It is not just a producer of vehicles. It is also a supplier. It has been through several joint ventures and has owned a number of foreign manufacturers, Isuzu and Opel being but two. In short, the company is a very big player, financially, economically and politically. Yet, somehow you get the impression that many in the financial media think we could just turn the lights out and go home. Witness the video below of CNBC anchors Mark Haines, Erin Burnett and Phil Lebeau and a trio of auto analysts trying to impress upon Haines how important GM is.

The GM bankruptcy is a very big deal and will have wide-ranging implications. Let me review a few of the issues here starting with the politics.

2010 elections

In the U.S., we have just witnessed an historic election that some are comparing to the election of Ronald Reagan in 1980 and Franklin Roosevelt in 1932. Indeed, there has been a sea change in the political climate here in Washington since January, with the Democrats and their agenda taking precedence over the Republicans. But, none of that is going to last if we don’t see a recovery that lasts through the mid-term elections in 2010. And that is already very much on the minds of politicians in Washington. Here is the calculus.

In 2008, the Democrats benefitted greatly from Barack Obama’s election as President, taking large majorities in both houses of Congress. Their mandate was to work with the President to fix America’s economic problem. So, Obama’s and Congressional Democrats’ first priority is to end the recession as quickly as possible. I guarantee you there would be hell to pay if this is not done well before November 2010 when the next general election is held.

From Obama’s perspective, it is crucial that he fix the banks and fix the auto industry as these were the two economic issues front and centre in the election which he said he could tackle. With the banking industry stabilised, the Obama legacy rides crucially on how the Auto Bailout proceeds. Under no circumstances is the Obama Administration going to allow General Motors to do to the economy in 2009 what Lehman Brothers did to it in 2008. They are going to fix GM no matter what it takes. And if this includes heavy-handed tactics, so be it.

So, be very clear that the GM and Chrysler issue is an existential question for this administration. Handle it well and you get the Roosevelt treatment and ensure a good outcome for your party in 2010. Screw things up and the depression bears down on America and you’re out of office in due course. The key policy decision is how to ensure a favourable outcome. And when I say favourable, I mean one that ensures as many jobs as possible while minimizing any wider economic fallout. Other issues like treating bondholders well, not committing taxpayer monies to the effort, or keeping government out of the auto industry are going to be much less important.

German General Election

And if Obama is concerned about his political fortunes because of an election next year, you can bet that Germany’s Chancellor Angela Merkel is concerned given her election is later this year. In Germany, cars have a mythical status. The Autobahn was begun in the Depression as a way to jumpstart the German economy. The first such road was completed in 1931 between Bonn and Cologne, a road I drove I have driven at least 2 or 300 times (it is a great road for fast driving, by the way, and was opened by Germany’s first Chancellor Adenauer when he was Mayor of Cologne. I believe the Bonn Porsche dealership is literally a few hundred meters from the entrance). Shortly thereafter, also during the Depression, the Germans began the car company Volkswagen (literally “the people’s car”) as yet another car-oriented way to jumpstart the economy.

Today there are hundreds of thousands of jobs in Germany tied to the auto sector, which has huge importance in the Rhineland, Germany’s industrial heartland and part of the most populous German state North Rhine-Westphalia, as well as in Lower Saxony, Bavaria, and Baden-Württemberg. In short, destroying auto jobs is a sure-fire way to lose an election. The ruling coalition is keenly aware of this and that is why they too will be very involved in the GM bankruptcy as it affects Germany through GM subsidiary Opel.

Below is the video of me discussing this yesterday on the BBC (I know I should put these videos up more often, so I promise to get a hold of the footage or audio whenever I do a media appearance).

And I haven’t even mentioned the politics in Sweden, the U.K., Austria, Canada or Italy where this expected bankruptcy is equally important.

As for the finance side of things I only want to highlight a single issue, credit default swaps. Back on April 30th, I wrote an article called “CDS contracts and the implosion of several Eastern European economies.” In it, I argued that the ‘insurance’ of credit default swaps changed creditor behaviour in a way that made bankruptcy more likely. I also warned that credit default swaps were going to be an issue in the Chrysler and GM bankruptcies (for a German-language take on the same, see Blicklog’s “Warum Gläubiger von GM ein Interesse an der Insolvenz haben“).

Think about this for a second: what if CDS contracts were exchange-traded? Then, we would know exactly who held what CDS exposure. So the motives of creditors would be made much more transparent and I believe this would help to prevent bankruptcies. The likes of Whitney Tilson, managing partner of the hedge fund T2 Partners, have been making similar noises of late. If any financial reforms do indeed result from this financial crisis, my hope is that this be one of them.