naked capitalism

Rob Parenteau, CFA, is sole proprietor of MacroStrategy Edge, editor of the Richebacher Letter, and a research associate with the Levy Economics Institute.

At a Brookings Institution session last March, while Bear Stearns was flaming out, Robert Rubin asserted “few, if any people anticipated the sort of meltdown that we are seeing in credit markets at present.” Der Spiegel recently carried an insightful piece on one of the few, former central banker William White (http://www.spiegel.de/international/business/0,1518,635051,00.html). White and his protégés at the BIS – the central bank for central banks – like Claudio Borio repeatedly stuck their necks out to warn of the financial imbalances building in the global economic system. In contrast, most of their colleagues in central banks, backed by the prevailing mainstream macroeconomics, mistakenly asserted that inflation stability would insure both stability in economic growth and financial stability. Indeed, this was part of the narrative that central bankers like Chairman Bernanke took up with their Great Moderation story.

Similarly, Nassim Taleb has gained notoriety for his view that the recent episode of financial instability is an example of a Black Swan event – a type of “tail event” that will randomly disrupt human affairs because we tend to systematically clip off the extremes of the possible when examining the range of likely outcomes. Yet a recent paper by Dirk Bezemer at Groningen University, “No One Saw This Coming”, however, documents that dissenting voices were there to be heard, if one was only willing to listen (http://mpra.ub.uni-muenchen.de/15892/1/MPRA_paper_15892.pdf).

This in itself is not entirely surprising – after all, financial markets require bulls and bear if any trading is to actually occur, and there is always a contingent of knee jerk contrarians, misanthropes, and malcontents known as permabears willing to spin the doom and gloom narrative. However, what Bezemer uncovered is that an identifiable common thread ran across the dissenting views.

The dissenters, Bezemer found, shared an emphasis on a stock/flow coherent macroeconomics. That is, starting from what should be an uncontroversial, accounting based view that at the level of the economy as a whole, total income must equal total expenditures, and total assets must equal total liabilities, those who saw this coming were able to identify unsustainable sectoral cash flow and balance sheet developments. In advance, a stock/flow coherent macroeconomics revealed the reasons why the Great Moderation was bound, by construction, to eventually give way to the Great Disruption.

As Bezemer put it,

“Surveying these assessments and forecasts, there appears to be a set of interrelated elements central and common to the contrarians’ thinking. This comprises a concern with financial assets as distinct from real sector assets, with the credit flows that finance both forms of wealth, with the debt growth accompanying growth in financial wealth, and with the accounting relation between the financial and real economy.”

Having performed one such analysis for the Levy Economics Institute in 2006 (http://www.levy.org/vdoc.aspx?docid=866) and studied financial instability reports issued by the Levy Institute, the BIS, the IMF, and others prior to the recent financial crisis, we believe Bezemer has it largely correct. If policy makers are indeed serious about the “never again” pledge regarding a financial crises the size of the recent one, they will need to set aside the prevailing macroeconomic paradigm – one which has largely made itself irrelevant by approaching macro as little more than aggregated microeconomics. Instead, they will need to become familiar with a stock/flow coherent macroeconomics that highlights the way financial conditions can shape economic outcomes. This is an economics examined and utilized by J.M. Keynes, Irving Fisher, Hy Minsky, Wynne Godley, Kurt Richebacher, and others – it is an economics especially relevant to the world we actually inhabit.

When a plane crashes, investigators swarm over the site and retrieve the “black box” in order to determine the cause of the crash, with the aim of reducing the odds of future crashes. In that fashion, knowledge it built over time about what works and what does not work, and appropriate adjustment in technology or best practices can be made along the way.

Little in the way of such procedures appears to be set in motion following a financial crash. Given the ability of financial crises to disrupt the lives of more people than can fit on a plane, this should strike most people as somewhat cavalier, if not absurd.

Some, like Bill Black, have suggested nothing less than a modern version of the Pecora Commission should be launched (http://neweconomicperspectives.blogspot.com/2009/07/some-want-whole-truth-about-what-went_13.html). We are no fans of witch hunts, but we do believe ignoring useful frameworks for understanding financial instability, and leaving applied analysis based on these frameworks essentially ignored or marginalized, is unlikely to benefit anyone except those who gain the most from manufacturing and milking serial asset bubbles. Any attempt at an autopsy of the Great Disruption must go beyond cataloguing the inherent fragilities of the financial instruments and specific market structures themselves, as well as the flawed incentive structures and ample room for fraudulent practices, to a serious examination of the unsustainable macrofinancial dynamics that were either ignored or simply explained away.

If macroprudential supervision or any such related effort at reducing the odds of systemic economic crises unfolding from financial instability is to be successful, the core analytics will need to be built around a stock/flow coherent approach macroeconomics. The ground work in this area has been already been done by the likes of Claudio Borio, Wynne Godley, Levy Institute research associates, and others working in financial stability projects within various national and international institutions. Without paying attention to unsustainable sectoral cash flows and the resulting balance sheet leverage building up over time, financial vulnerabilities that can trip up the entire economy – indeed, as we have seen, the entire global economy – will remain largely invisible to investors, entrepreneurs, and policy makers. Perhaps that serves the interests of asset bubble perpetrators, but after recent events, it is high time to question whether those interests should remain paramount.

Bob Rubin is right – a few people did see an episode of financial instability brewing. Dirk Bezemer is also correct – these people tended to share a common approach to viewing economic and financial dynamics. That this framework is not being used to explicitly inform solutions to the current crisis is dumbfounding. That attempts to reduce the odds of future episodes of financial instability may not incorporate this framework, which after all is grounded in relatively straight forward and uncontroversial accounting, is senseless.

Rob Parenteau, CFA, serves as an economic and investment strategy consultant at MacroStrategy Edge, and edits the monthly Richebacher Letter. He also serves as a research associate at the Levy Economics Institute.

The Austrian School works with a world where money and finance can have repercussions on the real economy, primarily through the effects of financial signals and credit flows on the allocation of productive resources. So too did J.M. Keynes and Hy Minsky, and so too did Dr. Kurt Richebacher. It is a world most of us would recognize as part of our actual experience in the economy.

Contemporary macroeconomics has little room for money and finance to matter. General equilibrium theory, the intellectual pinnacle of the profession, has no room for money. Real business cycle theory has no room for finance – negative shocks to productivity, virtually from out of the blue, are the stated source of recessions. The Taylor rule, which ostensibly guides central bank policy rate setting, has an interest rate but no room for either money or finance, unless it is packed away in the error terms of the canonical equations. Recently, the Henry Kaufman Professor of Financial Institutions at Columbia University and his co-authors concluded the US housing bubble had little effect on consumer spending patterns. Huh?

Investors clobbered repeatedly by financial crises have good reason to search beyond conventional economic analysis. Much of the mainstream approach to economics has made itself irrelevant or at least foreign to our actual experience. Indeed, there is an argument to be made that the representation of human behavior in mainstream economics has approached qualities that would more likely be associated with people struggling with various degrees of autism (you will find this notion, which actually deserves to be taken more seriously, developed in greater detail at www.paecon.net: a quick glance at the quotes from contemporary economists in the left column will convince you that some members of the profession know there is a problem).

Apparently, repeated episodes of financial instability may also be getting through to not just investors, but policy makers as well. Much to our surprise, the latest World Economic Outlook published by the IMF reveals a macro framework that we believe those pursuing the unconventional insights of the Austrian School, Keynes, Fisher, Minsky, Dr. Richebacher and many others would largely recognize. In discussing the distinct characteristics of business cycles that involve a major financial crisis, the IMF staff discovered the following:

“…expansions associated with financial crises may be driven by overly optimistic expectations for growth in income and wealth. The result is overvalued goods,
services, and, in particular, asset prices. For a period, this overheating appears to confirm the optimistic expectations, but when expectations are eventually disappointed, restoring household balance sheets and adjusting prices downward toward something approaching fair value require sharp adjustments in private behavior. Not surprisingly, a key reason recessions associated with financial crises are so much worse is the decline in private consumption.”

While not as precise as the models developed by heterodox economists over the decades here the IMF recognizes the end of an expansion has something to do with falsified income expectations and mispriced financial assets. When financial signals promote misallocation of productive resources, profit income expectations are likely to be falsified as malinvestment or overinvestment is revealed. With earnings expectations falsified, equity and corporate bond prices are likely to fall toward “fair” or intrinsic value. As product and financial markets react to profit disappointments, households face layoffs leading to further income disappointments, as well as falling wealth, and consumer spending growth contracts. All of this should sound very familiar.

What about the recovery profile from recessions accompanied by major financial crises? Here, summarizing the results of the “Big Five” financial crisis episodes identified by economists Reinhart and Rogoff – which include Finland (1990–93), Japan (1993), Norway (1988), Spain (1978–79), and Sweden (1990–93) – the IMF has found some notable differences from the typical recovery trajectory.

“What do these observations tell us about the dynamics of recovery after a financial crisis? First, households and firms either perceive a stronger need to restore their balance sheets after a period of overleveraging or are constrained to do so by sharp reductions in credit supply. Private consumption growth is likely to be weak until households are comfortable that they are more financially secure. It would be a mistake to think of recovery from such episodes as a process in which an economy simply reverts to its previous state.

Third, given the below-average trajectory of private demand, an important issue is how much public and external demand can contribute to growth. In many of the recoveries following financial crises examined in this section, an important condition was robust world growth. This raises the question of what happens when world growth is weak or nonexistent.”

Again, these are themes which should sound familiar to you. Professional equity investors were, up until the past month, very eager to count the green shoots sprouting from the monthly flow of economic statistics. Policy makers are eager to get banks to revive loan activity. Both of these constituencies appear to be ignoring that the way out of a recession that was triggered in no small part by an overleveraged US consumer may not be the same as the way in. The IMF staff, in contrast, may be starting to get the joke.

More importantly, the IMF staff seems to understand the unique nature of the challenge this time around. In the five prior recessions they studied with significant financial crises, the way out was not through releveraging of the private sector, but rather through improved trade balances, as global growth successfully floated all boats. If private sector spending is dampened by balance sheet repair and lender caution, then economic recovery prospects become more dependent on fiscal stimulus or foreign demand. This time around, the latter exit, the one the IMF identifies as most frequently employed in such situations, is somewhat blocked as the countries running the largest current account deficits wrestle with the most severe recession in many decades.

Calls for a second round of fiscal stimulus have begun to crop up around the US in recent weeks as fears the green shoots will fade to brown have been fed by a weaker than expected employment result, more signs of debt distress, and the continued ravages of home price deflation. That such calls are arising just weeks after investors were debating the prospects for hyperinflation dynamics taking hold, and bidding up commodity prices while selling Treasury bonds, tells you something about the deep uncertainty that still prevails. We are indeed in uncharted waters. What remains missing is any serious investigation of a new global growth model. The old one, based on consumer debt binges fueled by serial asset bubbles on the one hand, and headlong expansion of productive capacity in low labor cost countries that prefer to accumulate foreign currency reserves in part to manage currency pegs, is impaired enough that even the IMF realizes the scope of the challenges ahead.

On the US side, we know issues of private sector deleveraging, energy independence, water infrastructure, education and health care need to be addressed. Entrepreneurs, investors, policy makers, and economists best train their efforts in these directions to craft a plausible way forward from what is clearly not a garden variety recession with a conventional monetary or fiscal policy fix. If public/private collaboration is required to execute solutions in these areas because investors and creditors remain too short term oriented or too risk averse, then so be it. Reality has intruded on a global growth model that has proven itself unsustainable. Time to drop the delusions and move forward.

Rob Parenteau, CFA, is sole propreitor of MacroStrategy Edge, editor of the Richebacher Letter, and a research assistant with the Levy Institute of Economics

Retail sales remained fairly stable from January through May in dollar level terms. That is generally not what a debt deflation looks like, nor is it what a recovery looks like. A recovery requires rising retail sales, not stagnant retail sales. We suspect the fiscal stimulus is just offsetting the deflationary pressures that were unleashed in the second half of last year. Two offsetting waves are crashing into each other and perhaps canceling each other out, leaving nominal retail sales stagnant at 2005 levels. Stagnant sales can indeed stick around for months on end, as this was the case in the last recession from Q1 2000 into Q3 2001. However, this time around, the fiscal impulse is larger, but so too is the damage to household balance sheets. Not an easy situation to evaluate, but we believe equity investors need to see something better than stable retail sales if they are to take equity indexes appreciably higher.

Q1 2009 Flow of Funds results show the housing sector ran a financial surplus or net saving position of $341b in the past quarter, while paying down $155b in household debt. Monthly consumer installment credit points to the same household sector deleveraging with credit cards and non-revolving loans. We believe professional investors may be underestimating the importance of household sector deleveraging this time around. We have never seen households retire debt like this, now in three of the past four quarters, over more than a half century of results reported in the Flow of Funds accounts.

Household debt can only be reduced by three actions. Households can default on debt, and the debt is written off. Households can sell assets to another sector, and use the proceeds to pay off debt. Or households can save money by spending less than their income flows, and use the saving to retire debt. The rise in household net saving suggests the third method is playing a key role in household debt deleveraging, and this has import implications for the profile of any prospective consumer spending recovery, even one backed by massive fiscal stimulus. We suspect working from the usual business cycle playbook will not be especially rewarding in such an environment.

Furthermore, if banks are sitting on excess reserves, are perceived to now have sufficient capital, and are reporting an increased willingness to lend (which makes sense given the slope of the yield curve and the associated net interest margins), while consumers are intent on net paying down debt, then banks may need to consider a new business model. Loan volumes to households are going nowhere. Alternatively, they can ride the yield curve like they did in 1991-3, but here they will need to buy and hold longer dated Treasuries if they wish to avoid capital losses as Treasury bond yields back up.

Nevertheless, ETF’s on consumer discretionary stocks are up over 50% since the March 6th lows, and the ETF on banks are up over 100%. What do equity investors know that we may be missing?

Our beef with the equity market boils down to this: the widespread perception is that the old global growth model, dependent in no small part on the willingness of US consumers (and other consumers in the developed world) to deepen their deficit spending, can and will be revived. We would merely suggest with the level of household net worth to disposable income back to a level last seen in 1995 (before household deficit spending began), and with households extinguishing debt for the first time in over half a century, this assumption deserves to be questioned. Humpty Dumpty may not be able to be put together again.

Treasury results this week reported a trailing 12 month federal government fiscal deficit of over $1.1tr, well on track to break the CBO $1.8tr forecast by September end. The reality is that without some other sector increasing its deficit spending or reducing its net saving, attempts by some domestic firms and households to save out of their money income flows will simply show up as income shortfalls, and hence unexpected dissaving, by other domestic private firms and households. Call it the tyranny of double entry book keeping.

If the trade deficit is done shrinking (which means foreign net saving is done shrinking) as appears to be the case over the past three months, then the domestic private sector can only increase its net saving if the fiscal deficit increases. Without net saving, the domestic private sector will find it difficult to deleverage without dumping assets or defaulting on even more debt, which begs the Fisher debt deflation dynamics that have been discussed on this blog previously. Few but the Austrian School want to go there, and for good reason: debt deflations introduce instabilities and dislocations that most democracies cannot handle. These conclusions about financial balance flows from simple accounting, not high theory, yet they remain essential points that escapes many professional investors and economists. In a monetary production economy, one sector cannot net save unless another is prepared to deficit spend.

Just the same, even if fiscal deficit spending is the necessary counterpart to private net saving, and so a necessary condition for private sector deleveraging, we have noticed the percent of marketable privately held Treasury debt that comes due in a year or less has surged of late from just above 30% to nearly 45%. Short term debt was last this large a share of outstanding debt in the first Reagan administration.

We believe the dramatic shortening of the maturity privately held marketable federal government debt is very significant for two reasons. First, since the short end of the Treasury curve has been suppressed by the near ZIRP policy of the Fed, the net interest expense outlays on public debt have been suppressed. Since this is a line item on the expenditure side of the federal fiscal balance, Fed policy is also reducing the fiscal deficit from what it would otherwise be if the short end of the Treasury yield curve was closer to historically normal levels.

That means Chairman Bernanke may face more friction from the Administration than usual once he believes the time to lift the fed funds rate has arrived. That may be many quarters away, but questions about the Fed’s independence are already being raised, and would be inflamed by such a confrontation. It also means that if the short end of the Treasury yield curve starts to return to historical norms, interest expense will rise, and this will add to the fiscal deficit at the time. For deficit hawks, this introduces fears of compounding and a runaway public debt/income ratio.

However, it must not be forgotten that that the federal government’s interest expense must become somebody else’s income. The nuance under current conditions is with so much of the marketable federal debt held abroad, the creditors that benefit from bond coupon payments are less likely to be domestic households. With the Treasury issuing at the short end of the curve, and thereby minimizing current interest expense on the public debt, this is no big deal now, but what happens if interest rates return to historical norms?

Such a development not only suggests a larger current account deficit, as interest payments to foreign lenders reduce the trade balance, but it also takes a stream of income out of the range of federal government taxation, so a feedback loop that would otherwise reduce the budget deficit is thereby thwarted. To be clear, we are not fans of the “twin deficits” view since we find it neither holds true empirically nor theoretically, but this interest expense channel is one that could lead to spillover effects on the trade balance.

Looking at the unique aspects of this recession, we find the sharp reversal of household financial balances from a deep deficit position to a net saving position quite important. Households are reducing debt loads, in part with higher saving out of income flows, and this has implications for prospective bank loan volumes and sales revenue growth at consumer discretionary firms. Larger fiscal deficits are supporting the ability of households to net save, yet the shortening of maturity of Treasury debt issued, as well as the reaction of investors to a heavy calendar of issuance this year and beyond, is complicating matters. In addition, the shift of investors toward inflation hedges like oil is draining income from US households to foreign producers that tend to net save. We try not to be stubborn in our portfolio positioning – having learned the hard way that is a very expensive luxury – but we can think of two sectors that have led the US equity market charge, banks and consumer discretionary stocks, that can be questioned if we are correct that household deleveraging is unique to this business cycle recession and still matters.

The old saw on Wall Street is that it is never wise to conclude “this time, it is different”. Yet we believe it is in the early identification of the key differences, and in tracing out their implications, that macro analysis can add value to intelligent investors. Arbitraging the gap between reality and perception eventually tends to pay off – just make sure you can remain solvent as long as the thundering herd remains deluded!

Which Way Forward? Some Suggested First Principles

Submitted by Rob Parenteau, CFA, and sole proprietor of MacroStrategy Edge and editor of The Richebacher Letter. He also serves as a research assistant to the Levy Institute of Economics.

Two of the responses to yesterday’s guest post reminded me of something I wrote back in the November 2008 Richebacher Letter (http://www.richebacher.com) . With a sharp move up in emerging market equities, banking stocks, consumer discretionary stocks, and material stocks, professional investors appear to believe we can go back to some semblance of the prior global growth model. Running an economy based on serial asset bubbles, consumer deficit spending, and perpetual trade deficits has proven risky, to put it mildly. The risks were identified well in advance by Dr. Kurt Richebacher and those who have been willing to apply Hy Minsky’s insights. Maybe it is time to find a more sustainable global growth model, rather than simply trying to prop up the old, clearly unsustainable model. To do so, it is worth considering some first principles that could inform a transition to a less financially fragile growth model.

After at least two major asset bubbles – first tech and telecom equities a decade ago, and then housing in this decade – many people have come to confuse an increase in the money value of financial assets with an equal or similar increase in the productive capacity of the economy. While there is no doubt that an increase in the money value of financial assets can encourage the expansion and shift the mix of the productive capacity of the economy – particularly its tangible capital equipment and structures – the two are not equivalent.

In the admittedly limited view of economics, wealth must be measured by the capacity to produce goods and services both in the present, and in the future. The money value of financial assets must be tied to the ability of the wealth holder to claim control over present and future products. In a 2006 keynote speech by William R. White, formerly head of the Bank of Canada, highlighted this distinction offered decades ago, but long since forgotten.

“As a corollary, I also agree with M J Bailey, who stated much earlier that this lifetime flow of produced goods and services depends on the production possibilities of the society and that ‘when no change at all has occurred in physical capital, land or labour or in their present or prospect productivities,… no new productivity or wealth has appeared to make possible any increase in future consumption’.”

The significance of this insight cannot be underestimated. If the tangible productive capital stock, along with other productive resources, is not enhanced during the course of an asset bubble, then the attendant surge of financial wealth is essentially illusory.

If productive capacity is not enhanced during an asset bubble, two outcomes are possible. Either inflation will tend to emerge as the spending power accompanying financial wealth is exercised against a productive capacity that has not kept pace, or a sustained trade balance erosion will prevail, as spending power is fulfilled by the productive capacity put in place by other nations.

White, in his poignant August 31, 2006 speech to the Irving Fisher Committee at the BIS near the close of his career, took this one step further, by noting what happens when households use portfolio appreciation as a substitute for saving out of income flows.

“Viewed from this perspective, the suggestion that countries benefiting from large increases in measured wealth, largely because of asset price increases, need no longer save out of income in the traditional way looks not only questionable but dangerous. Saving associated with illusory wealth increases is illusory savings. The end result must be a lower level of domestically owned capital and an associated lower standard of living over time. Moreover, such spending can contribute to current account deficits, with all the associated potential for mischief noted above. And to this must be added the diminished political authority associated with countries that become increasingly indebted. History has many lessons to teach us in this regard.”

Confusing appreciating financial asset prices with enhanced productive capacity is bad enough. Confusing appreciating financial asset prices with saving simply compounds the illusion. For many years now, Americans have implicitly sought to avoid the consequences described above – a lower level of domestically owned capital as foreign claims accumulate on the US capital stock through perpetual trade deficits, and an associated lower standard of living over time as domestically generated income flows are siphoned off to foreign owners – by pursuing serial asset bubbles that enhanced their financial wealth while distorting the mix of productive capacity.

White clearly foresaw the consequences of a household deficit spending spree built on the back of a housing bubble. As White puts is so clearly, revealing his careful study of financial stability during the course of his career, the asset values have disappeared, but the liabilities remain to be serviced.

“If higher house prices do induce an increase in spending, then the households that have done so finish with fewer assets or more liabilities than they would otherwise have had. In practice, debt levels have trended sharply higher in recent years as consumers have remortgaged their existing house at higher levels or have traded up. In spite of record low interest rates in recent years, debt service levels (as a proportion of disposable income) have also risen sharply and now stand at record levels in a number of industrial countries.

Should house prices fall, which is one way to re-establish a more normal ratio of house prices to rents, then the payback referred to earlier will be primarily at the expense of homeowners. It will then be evident that the wealth they spent was illusory; the assets have disappeared but the liabilities linger on. This would have negative implications for spending. However, even were prices only to stop rising, the growth rate of consumption would be affected due to the absence of the earlier stimulus of rising prices.”

Sustained or serial asset bubbles can introduce distortions. We should be prepared to recognize that by now. Financial wealth can become confused with an increase in productive capacity. Asset appreciation can become confused with saving out of income flows. Leverage can be built up on the back of asset appreciation that is not associated with an increase in income generating capacity, leaving borrowers susceptible to financial distress and economies susceptible to financial fragility down the road.

Any earnest attempt at putting the US and the global economies back on a robust, sustainable growth path needs to break through these confusions that have built up over the past two decades or more. Reviving asset bubbles is not enough.

Submitted by Rob Parenteau, CFA, and sole proprietor of MacroStrategy Edge and editor of The Richebacher Letter. He also serves as a research assistant to the Levy Institute of Economics.

A combination of falling asset prices and falling nominal incomes against the back drop of high private debt loads tends to pose a serious challenge to the ability of market economies to self adjust. In response to a financial crisis, the private sector tries to net save and favors liquid assets in the face of large losses of wealth and income uncertainty. Unless some other sector is willing to net deficit spend, nominal incomes will fall, reducing the ability of the private sector to service existing debt commitments. Spending will drop even as final product prices drop, profits will dry up, and delinquencies and defaults will spread.

In addition, unless some other sector is willing to accumulate risky assets or increase the stock of money, asset prices will fall, reducing collateral values and net worth. Bankruptcy and attempts to deleverage, with all their ensuing contagion effects, will spread. Along the way, as markets adjust along these paths, history suggests that societies can experience substantial dislocations. Hy Minsky traced out many of these dynamics decades ago based in part on the contributions of J.M. Keynes and Irving Fisher, but his work was mainly ignored or forgotten by professional investors and mainstream economists favoring the self-equilibrating properties of markets.

The response to recent dislocations in many countries has been to a) increase fiscal deficit spending to both meet the surge in desired private net saving and reduce solvency uncertainty for key financial institutions, while b) reducing policy rates to near zero and expanding central bank balance sheets through purchases of privately held assets (quantitative easing). Market self-adjustment mechanisms that can otherwise lead to market self-destruction are thereby believed to have been short circuited. A “corridor of stability” is being re-established as the guard rails of fiscal and monetary policy have been buttressed.

This time around, however, it may be more complicated than that. Two questions arise with regard to the policy fix underway: who is going to accumulate the issuance of government debt associated with large (and possibly prolonged) fiscal deficit spending, and are there inconsistencies introduced by pursuing a large quantitative easing approach at the same time?

The nub of the policy challenge is as follows. Central banks have dropped policy rates to zero and they have begun purchasing government debt, MBS, and even corporate debt while expanding their balance sheets. Their aim is clear: reduce the cost of private borrowing, and raise the price of less liquid assets by lowering the return on the most liquid assets, thereby forcing many investors to reach for yield in riskier asset classes. Raising prices of risky assets in this indirect fashion reduces insolvency fears, reverses wealth losses and hence adverse wealth effects on spending, and sends favorable financial signals to producers – all of which are expected to contribute to reversing downward economic momentum.

Zero (or near zero) policy rates plus outright purchases have drawn government bond yields down to historically low levels. Low yields on bonds introduce a high risk of capital loss to investors if yields return to historical norms (for bond geeks, think McCauley duration), and if investors cannot be sure they will hold the bond to maturity. The private sector will wish to raise their holdings in government bonds only if they perceive risk adjusted returns elsewhere are less attractive – yet this is antithetical to the very purpose of quantitative easing, which is to break the high liquidity preference of private investors by “trashing cash” and lowering the yield on default free government bonds.

If government yields back up – either because private sector portfolio preferences are taking their cue from QE and shifting toward riskier assets or because fiscal stimulus is helping economic activity which has the same effect – then mortgage rates are likely to back up as well, confounding any stabilization in housing sales.

Alternatively, if central banks step in to buy Treasuries and thereby contain the back up in Treasury yields, more professional investors are likely to conclude “monetization” is underway and they will try to increase their exposure to inflation hedges. The net result would be a likely rise in the relative prices of energy, precious and industrial metals, “commodity” currencies, and ag products and ag land – all of which, as inputs to final products, would tend to represent an adverse supply shock to the economy. In addition, raising the price of essentials like food and energy is more likely to crowd out consumer spending in discretionary items. Neither of these supply and demand effects are particularly supportive of an economic recovery.

The expectations management effort, this time around, looks somewhat challenging. We previously took the stance that central banks can peg government bond yields at a level of their choosing, much as they did during WWII. We now think the policy path that involves QE and rising fiscal deficits may prove more problematic given likely shifts in private portfolio preferences. Put simply, central banks may have created something of a “liquidity trap” by pulling government bond yields below historical norms with near ZIRP (zero interest rate policy) moves. In addition, to the extent QE operations are successful in encouraging private investors to migrate toward riskier assets, government bond yields are likely to rise if that asset class is to compete with expected returns on other assets.

This obviously endangers any incipient housing recovery, and we are hard pressed to imagine much of an economic recovery will transpire if home prices are still falling. Commercial banks could step into the breach with their $1tr in reserves, but they probably will need more clarity on future loan losses before they try to ride the yield curve like they did in 1991-3 in order to rebuild net interest income and capital. Alternatively, if central banks end up being the main bidders of government bonds as a last resort, this is liable to send private investors in search of even more inflation hedges. The subsequent relative price increases for industrial metals, energy, food, etc. could equally inhibit economic recovery by increasing costs of production and draining discretionary household income.

Many professional investors have concluded the policy response to date has once again reset the game. Bank stocks have doubled since their lows, and US equity indexes are up 30-40% since early March. A rise in interest rates and commodity prices is certainly typical of economic recoveries, but this has not been a typical recession. The housing market damage is unprecedented; so too is the dramatic shift of households to a higher saving rate and a net reduction of household debt. The fact is that housing and consumer durable spending historically have tended to lead the US economy out of recession. The higher mortgage rates and higher gas prices resulting from investor reactions to the policy push may get in the way. They are salt in existing wounds. Perhaps the fiscal thrust is so large this time around that a recovery can be led by different sectors like infrastructure and technology and a Japanese style stagnation can be sidestepped. On the above analysis, however, the way forward may be a bit trickier than many investors now expect.