The Banking Scam

Here is an essay by William Blase which is an overview of the conspiracy, addressing the whole question of the Federal Reserve in some depth. Good reading.

Read Gold and the Founding Fathers by Robert S. Getman, as of 1976 an attorney practicing with the firm of Kelley Drye & Warren in NYC. The article is an adaptation of the first part of "The Right to Use Gold Clauses in Contracts," Brooklyn Law Review (Winter, 1976).

In 1899, M. W. Walbert published a book he titled "The Coming Battle." WorldNetDaily summarizes the book as follows:

First published in 1899, republished for the first time in 100 years! The Coming Battle documents from Congressional records, newspaper reports and writings by the founding fathers and others a chronology of events long forgotten that shaped our fledgling nation from 1776 to 1899. Read about the manipulation of our money and its supply, the intentional creation of recessions, depressions and panics. The manipulation of the stock markets. The demonitization of silver. A breathtaking history told in the words of a contemporary witness to these events. You must have this book! Great gift for anyone interested in history, government, economics or the fate of our nation.

You can have it here for free.

"The few who understand the system, will either be so interested in its profits, or so dependent on its favors, that there will be no opposition from that class."
-Rothschild Brothers of London, 1863-Jun-25, in a letter to fellow members of the establishment

Now to prove the Rothschilds wrong! Note that the latin rubric at the top of the page is the motto of the House of Rothschild - or rather, their principal advertising slogan. This from the people who finance wars, fomented by their agents, and fought by other people while they sit around and drink tea. The motto translates as "Harmony, Honesty, Hard Work." ROTFL!

“The best time to buy is when blood is running in the streets.”
-Baron Nathan Mayer de Rothschild

Read The Kerry Report on BCCI, a 1992 watershed exposé.

Read this profile of the Rothschild family.

from the Wall Street Journal, 2010-Jan-27, by Allan H. Meltzer:

The Fed's Anti-Inflation Exit Strategy Will Fail
Sooner or later the pressure to lend out excess bank reserves will be unstoppable.

Federal Reserve Chairman Ben Bernanke has explained his exit strategy to prevent future inflation. The Fed recently began to pay interest to banks on the reserves they hold in their vaults. Using this new tool, it claims the ability to get banks to keep the money instead of lending it out, thus containing the money supply and inflation.

I don't believe this will work, and no one else should.

The exit strategy is incomplete. Proponents are guilty of practicing economics without prices. They never say what the interest rate on reserves must be to get banks to hold the approximately $1 trillion of reserves above the minimum they're legally required to hold. That's the critical question.

The efforts to reduce inflation during the 1970s failed because they ended prematurely. And they ended prematurely when business, unions, Congress and the administration objected loudly to the rising unemployment accompanying higher interest rates. Today's high current and prospective unemployment rates pose a similar dilemma.

No economist doubts that the Fed can induce banks to hold some more reserves by paying interest. But how much?

Normally, banks' principal business is lending, and the interest rate they can get on their loans is more important than the interest they might get on their reserves. Once borrowing resumes, banks will increase loans and expand deposits. The current massive volume of excess reserves will melt into a greater money supply, and later higher inflation.

When will inflation start? The date is uncertain. But the triggering event will be either a sustained increase in bank lending or a large increase in Fed purchases of government debt. Perhaps both. Either one would trigger a sustained increase in money growth.

With the exception of the early years after Paul Volcker became Fed chairman in 1979, the Fed has paid no attention to money growth. There have always been some Fed bank presidents concerned about too much or too little money growth, but they have not affected decisions. That problem remains.

The Federal Reserve has a well-known dual mandate to prevent both inflation and unemployment. It chooses to act on only one part of its mandate at a time. That cannot be the best way to achieve both targets, and it has failed repeatedly to bring low inflation and low unemployment. For example, the policy implied by the famous Phillips Curve—which says you can trade off higher inflation for lower unemployment—failed in the 1970s. We got rising inflation and higher unemployment.

Mr. Volcker publicly and privately discarded the Phillips Curve in favor of bringing inflation down by high interest rates and better control of the money supply. The result: about 15 years of low inflation and low unemployment. But the Fed abandoned its success by keeping interest rates too low after 2003. And now the Phillips Curve is back in fashion, with strong support from the Fed Board of Governors.

Christina Romer, chairman of the Council of Economic Advisers, reminds us regularly about the Fed and the Treasury's tig ht-money mistakes in 1937 which aborted the recovery, and she warns against repeating these mistakes. The principle drivers behind the recovery in 1934-36 were the veterans' bonus in 1936 and a gold inflow following the 1934 devaluation of the dollar—accomplished by unilaterally raising the gold price. The bonus ended, and the Treasury began to sterilize gold inflows in 1937 by selling securities, while the Fed doubled reserve requirements. Monetary policy shifted from excessive ease to excessive restraint.

Nothing of the kind is called for today. Instead, the Fed should announce a policy for preventing inflation that reduces the enormous stock of excess reserves, such as by selling securities. And the Treasury or the Office of Management and Budget should announce a credible policy for reducing deficits. That would help to reduce the uncertainty about future taxes, spending and inflation.

Policies without prices hide the serious problem posed by excessive debt and reserves, and are not credible. Policy makers should develop and announce credible plans now.

Mr. Meltzer is a professor at the Tepper School of Business, Carnegie Mellon University, and the author of "A History of the Federal Reserve" (Chicago, 2003 and 2010).

from the New York Times, 2010-Feb-1, printed 2010-Feb-2, p.A1, by David E. Sanger:

Deficits May Alter U.S. Politics and Global Power

WASHINGTON — In a federal budget filled with mind-boggling statistics, two numbers stand out as particularly stunning, for the way they may change American politics and American power.

The first is the projected deficit in the coming year, nearly 11 percent of the country's entire economic output. That is not unprecedented: During the Civil War, World War I and World War II, the United States ran soaring deficits, but usually with the expectation that they would come back down once peace was restored and war spending abated.

But the second number, buried deeper in the budget's projections, is the one that really commands attention: By President Obama's own optimistic projections, American deficits will not return to what are widely considered sustainable levels over the next 10 years. In fact, in 2019 and 2020 — years after Mr. Obama has left the political scene, even if he serves two terms — they start rising again sharply, to more than 5 percent of gross domestic product. His budget draws a picture of a nation that like many American homeowners simply cannot get above water.

For Mr. Obama and his successors, the effect of those projections is clear: Unless miraculous growth, or miraculous political compromises, creates some unforeseen change over the next decade, there is virtually no room for new domestic initiatives for Mr. Obama or his successors. Beyond that lies the possibility that the United States could begin to suffer the same disease that has afflicted Japan over the past decade. As debt grew more rapidly than income, that country's influence around the world eroded.

Or, as Mr. Obama's chief economic adviser, Lawrence H. Summers, used to ask before he entered government a year ago, “How long can the world's biggest borrower remain the world's biggest power?”

The Chinese leadership, which is lending much of the money to finance the American government's spending, and which asked pointed questions about Mr. Obama's budget when members visited Washington last summer, says it thinks the long-term answer to Mr. Summers's question is self-evident. The Europeans will also tell you that this is a big worry about the next decade.

Mr. Obama himself hinted at his own concern when he announced in early December that he planned to send 30,000 American troops to Afghanistan, but insisted that the United States could not afford to stay for long.

“Our prosperity provides a foundation for our power,” he told cadets at West Point. “It pays for our military. It underwrites our diplomacy. It taps the potential of our people, and allows investment in new industry.”

And then he explained why even a “war of necessity,” as he called Afghanistan last summer, could not last for long.

“That's why our troop commitment in Afghanistan cannot be open-ended,” he said then, “because the nation that I'm most interested in building is our own.”

Mr. Obama's budget deserves credit for its candor. It does not sugarcoat, at least excessively, the potential magnitude of the problem. President George W. Bush kept claiming, until near the end of his presidency, that he would leave office with a balanced budget. He never got close; in fact, the deficits soared in his last years.

Mr. Obama has published the 10-year numbers in part, it seems, to make the point that the political gridlock of the past few years, in which most Republicans refuse to talk about tax increases and Democrats refuse to talk about cutting entitlement programs, is unsustainable. His prescription is that the problem has to be made worse, with intense deficit spending to lower the unemployment rate, before the deficits can come down.

Mr. Summers, in an interview on Monday afternoon, said, “The budget recognizes the imperatives of job creation and growth in the short run, and takes significant measures to increase confidence in the medium term.”

He was referring to the freeze on domestic, non-national-security-related spending, the troubled effort to cut health care costs, and the decision to let expire Bush-era tax cuts for corporations and families earning more than $250,000.

But Mr. Summers said that “through the budget and fiscal commission, the president has sought to provide maximum room for making further adjustments as necessary before any kind of crisis arrives.”

Turning that thought into political action, however, has proved harder and harder for the Washington establishment. Republicans stayed largely silent about the debt during the Bush years. Democrats have described it as a necessary evil during the economic crisis that defined Mr. Obama's first year. Interest in a long-term solution seems limited. Or, as Isabel V. Sawhill of the Brookings Institution put it Monday on MSNBC, “The problem here is not honesty, but political will.”

One source of that absence of will is that the political warnings are contradicted by the market signals. The Treasury has borrowed money to finance the government's deficits at remarkably low rates, the strongest indicator that the markets believe they will be paid back on time and in full.

The absence of political will is also facilitated by the fact that, as Prof. James K. Galbraith of the University of Texas puts it, “Forecasts 10 years out have no credibility.”

He is right. In the early years of the Clinton administration, government projections indicated huge deficits — over the “sustainable” level of 3 percent — by 2000. But by then, Mr. Clinton was running a modest surplus of about $200 billion, a point Mr. Obama made Monday as he tried anew to remind the country that the moment was squandered when “the previous administration and previous Congresses created an expensive new drug program, passed massive tax cuts for the wealthy, and funded two wars without paying for any of it.”

But with this budget, Mr. Obama now owns this deficit. And as Mr. Galbraith pointed out, it is possible that the gloomy projections for 2020 are equally flawed.

Simply projecting that health care costs will rise unabated is dangerous business.

“Much may depend on whether we put in place the financial reforms that can rebuild a functional financial system,” Mr. Galbraith said, to finance growth in the private sector — the kind of growth that ultimately saved Mr. Clinton from his own deficit projections.

His greatest hope, Mr. Galbraith said, was Stein's law, named for Herbert Stein, chairman of the Council of Economic Advisers under Presidents Richard M. Nixon and Gerald R. Ford.

Stein's law has been recited in many different versions. But all have a common theme: If a trend cannot continue, it will stop.

from the Hill, 2010-Jan-28, by Walter Alarkon:

Senate OKs debt ceiling hike to $14.3T

Senate Democrats passed a $1.9 trillion increase in the federal debt limit Thursday, seeking to push off another politically painful debt vote until after the midterm elections.

All 60 Democrats and no Republicans voted for the debt limit increase. The measure, which the House has yet to vote on, would put the debt ceiling at roughly $14.3 trillion.

Sen. Paul Kirk (D-Mass.) voted for the debt increase. Sen.-elect Scott Brown (R-Mass.), his replacement, has not been seated.

Democrats said the move is necessary because the debt is approaching its current ceiling of $12.4 trillion. If the debt breaches the limit, the government would lose its borrowing authority and risk default.

"We have gone to the restaurant, we have eaten the meal; now the only question is whether we pay the check," said Sen. Max Baucus (D-Mont.) in urging his colleagues to increase the limit.

Republicans criticized Democrats for passing a massive increase, arguing that a smaller increase would have been more responsible.

"It's like the drunken sailor asking to have the bar open all night," said Sen. Judd Gregg (R-N.H.).

If the House agrees to the $1.9 trillion debt ceiling hike, lawmakers won't have to make another debt vote until 2011.

Democrats won enough votes for passage only after the White House, Senate centrists and House Democratic leaders reached a deal on measures to tackle the rise in red ink.

A group of centrist Senate Democrats, led by Sens. Evan Bayh (Ind.) and Kent Conrad (N.D.), said that their votes depended on lawmakers committing to a special legislative process to come up with a package of fiscal reforms. President Barack Obama fulfilled that requirement in his State of the Union when he announced that he would create by executive order a fiscal reform commission.

Bayh, who opposed a short-term debt limit increase last month, praised the president for backing measures such as the fiscal commission and a three-year freeze on non-security discretionary spending to address the deficit, which hit a record $1.4 trillion last year and is expected to surpass $1 trillion in 2010.

"We can't allow the country to default on its debt. That would cause an economic calamity," Bayh said. "But we also need fiscal discipline, so I think [Obama has] struck a balance here that will enable us to do both."

House Speaker Nancy Pelosi (D-Calif.) had opposed the commission approach, fearing it would put the power over entitlements, taxes and spending in the hands of an appointed body. But she relented after Senate Democrats agreed to pass a pay-as-you-go measure that requires any new mandatory spending be offset by new taxes or spending cuts elsewhere.

The Senate passed the pay-go measure as an amendment to the debt limit increase Thursday. The pay-go amendment also passed on a party-line vote, 60-40.

The Senate pay-go legislation would not apply to costly items that are expiring that Democrats plan to extend — a host of middle-class tax cuts, Medicare doctor payments, current estate and gift tax rates and a patch to keep the Alternative Minimum Tax from hitting middle-income Americans. The exemptions, except the one for the middle-class tax cuts, would end in five years or less, meaning that lawmakers would have to pay for them eventually.

Conrad had opposed a version of the pay-go measure passed by the House because all of the exemptions would have been permanent.

But Gregg argued that the limits on exemptions did not go far enough, making a floor motion to call the Senate legislation "Swiss-cheese-go."

The debt limit debate revealed bipartisan support for discretionary spending limits, suggesting that Obama's call for a freeze on non-security discretionary spending has a chance of passing the upper chamber. An amendment offered by Sens. Jeff Sessions (R-Ala.) and Claire McCaskill (D-Mo.) sought to cap yearly discretionary spending increases to about 2 percent for the next five years. The amendment didn't get the 60 votes it needed to be adopted, but most of the Senate — 16 Democrats, 39 Republicans and an independent — voted for it.

from the Wall Street Journal's Political Diary, 2010-Jan-29, by James Freeman:

In Coke We Trust

Along with giving Ben Bernanke another term, the Senate voted yesterday to boost the federal debt ceiling by another $2 trillion to a titanic $14.3 trillion. Yet as Democrats debate whether to use the headroom to launch a new trillion-dollar health care entitlement, the choice may not reside with the House (which must still vote on the debt ceiling) but with the bond market.

Trading in the credit-default swap market this week shows that investors now view a default by the U.S. Treasury as more likely than a default by the Coca-Cola Company. Until very recently, this scenario seemed about as likely as Coke winning a taste infringement suit against Coke Zero. Now the United States has taken its place next to Italy and Spain in a special club that no major country wants to join -- countries whose debt is considered less safe than that of Blue Chip businesses.

Mr. Obama may not be deterred by the verdicts rendered by voters in Massachusetts, New Jersey and Virginia lately. But he won't be able to ignore investors if they send Washington's currently cheap borrowing costs soaring. That would surely be the result if markets become convinced that spending and inflation are destined to run out of control under the combo of Nancy Pelosi and Ben Bernanke. To be sure, we're not there yet. But the recent financial crisis should have taught us that, when markets make up their mind that the story has changed, they can turn against you with blinding speed.

from Reuters, 2010-Jan-31, by Glenn Somerville with editing by Leslie Adler:

U.S. bank bailout encourages risky behavior: watchdog

WASHINGTON (Reuters) - The U.S. taxpayer-funded rescue program set up to save banks from collapse during the financial crisis makes future reckless behavior more likely, the government's bailout watchdog said in a quarterly report.

A quarterly report to Congress on the $700 billion Troubled Asset Relief Program, or TARP, made available in draft form late on Saturday, said financial firms seen as too big to fail before 2008 have only grown larger as they feasted on subsidies from the bailout program.

"To the extent that institutions were previously incentivized to take reckless risks through a 'heads I win, tails the government will bail me out' mentality, the market is more convinced than ever that the government will step in as necessary to save systemically significant institutions," the report from the Office of the Special Inspector General for the Troubled Asset Relief Program, said.

The office, headed by Neil Barofsky, acts as a watchdog for taxpayers over how TARP money the Treasury Department administers is used.

The report said little has been achieved in terms of correcting underlying problems that helped create the financial crisis.

"Even if TARP saved our financial system from driving off a cliff in 2008, absent meaningful reform, we are still driving on the same winding mountain road, but this time in a faster car," it warned.

The report noted that TARP, which was originally pitched to Congress as a way to help banks by buying toxic or unwanted assets and then, when Congress approved it, turned into a plan for injecting capital into banks, is changing again.

"Treasury has stated that, going forward, TARP will focus on foreclosure mitigation efforts, small-business lending, and a continuation of support for the asset-backed securities markets," the report said.

With some banks already repaying TARP capital, it appears that taxpayers' ultimate costs may be less than initially feared but many of the program's goals are not being met.

The report noted, for example, that while TARP was supposed to encourage banks to increase financing for U.S. businesses and consumers, lending is actually decreasing on a month-by-month basis.

While preserving homeownership and promoting jobs were "explicit purposes" of the Emergency Economic Stabilization Act of 2008 that enabled TARP, the unemployment rate remains at 10 percent and only a small fraction of troubled mortgages have been permanently modified to lower borrowers' monthly payments.

The report suggested that Treasury's ability to wring concessions from banks that benefited from bailout money was rapidly disappearing just when consumers and businesses need increased access to credit and relief on mortgage loans.

"To the extent that the government had leverage through its status as a significant preferred shareholder to influence the largest TARP recipients to carry out such policy goals, it was lost with their exit from TARP," the report said.

from the Wall Street Journal, 2010-Jan-27, by Edward P. Lazear:

The Spending 'Freeze' That Isn't
Since 2008, the ratio of outlays-to-GDP has risen by about 14%.

In last night's State of the Union address President Obama proposed a three-year "spending freeze" on what amounts to one-sixth of the federal budget. Our biggest entitlement programs, Social Security and Medicare, would be excluded. These changes are optical rather than substantive. Given the spending agenda that is already in place, we can expect to see large increases in the proportion of GDP that is spent by our government for years to come.

Since 2008, the ratio of federal spending-to-GDP has risen by about 14%. From 2008 to 2009 we saw the greatest annual increase in spending in the last 30 years. In the name of stimulating job growth, the share of federal spending is now 24% of the economy, up from 21% in the last year of the Bush administration.

My analysis of data from 1950 to the present shows that periods with high tax-to-GDP ratios exhibit much slower economic growth than lower tax ratio periods. The GDP growth in high tax years (defined as years during which the ratio of tax-to-GDP was above 18%, the 60-year average) was about 1.5 percentage points lower than the growth rate in low-tax years.

High taxes are clearly bad for the U.S. economy. For example, were we to tax above the 18% tax-to-GDP ratio over the next 25 years, GDP per capita in 2035 would be about 50% less than if we were to tax below the 18% ratio. A 50% per capita GDP differential is about as large as the difference between the U.S. and Greece today.

The recent growth in spending has been camouflaged by a focus on deficits. Budgets and proposed legislation, like that on health care, are being judged not by their impact on spending and taxation, but by their projected effect on the deficit. Equal increases in spending and taxes reduce economic growth, even if they do not alter the deficit.

So the rhetoric surrounding the health-care bills misses this point. Were they to pass, it would mean more spending, more taxes and less growth. Both the White House and Congress have discussed fiscal responsibility in terms of the bills' effect on the deficit, not the amount of spending.

The health legislation that looked likely until Massachusetts voted last week included about $1 trillion in new spending, $500 billion in promised Medicare cuts, and slightly more than $500 billion in increased taxes. If the Medicare cuts were to materialize, then the bill would reduce the deficit because tax increases exceed net new spending.

But even if the Medicare cuts were realized, the policy would contribute to the growing size of federal spending and the budget, which, when financed, is the major impediment to economic growth. Arguments over whether the legislation would increase or decrease the deficit or whether it would bend the "cost curve" down or raise it are secondary as far as economic growth is concerned. The largest impact comes from levying over $500 billion of new taxes to pay for the increased spending.

Despite all the talk about deficits, the irony is that we are in little danger of eliminating or reducing the federal deficit. Mr. Obama's target is to lower the deficit to 4% of GDP by 2013. That is twice the level of the Bush deficit in the average year and larger than any Bush-year deficit. During President George W. Bush's term, the ratio of federal spending to GDP averaged 20%. Mr. Obama's budget aspires to reduce the spending ratio to 23% by 2013 from 24% today.

It is true that Mr. Obama inherited much from his predecessor, as the president and his surrogates are wont to remind us. There is no doubt that when the new team came in, the economy was in a deep recession and job losses were large. He inherited an unemployment rate that was over 7%. It now stands at 10%. The job growth that was the promised outcome of the $787 billion stimulus bill has not materialized. And when job growth returns and unemployment falls, it will owe little to the stimulus.

Consider the legacies Mr. Obama will leave his successor. He grew the deficit that he inherited. He grew the government spending ratio that he inherited. And he has already promised to repeal the low tax rates that he inherited. At this point, the question is how much and what form the tax increases will take. Part of the Bush legacy includes low personal tax rates, an average ratio of taxes-to-GDP of about 18%, low rates on capital gains, and a period of low estate taxes.

It will be virtually impossible for Mr. Obama to keep his promise not to raise taxes on the middle class while paying for an enormous increase in spending. Given the planned spending levels, taxes will have to rise substantially to get to the target 4% deficit figure that the White House wants.

Medicare tax increases on wages and dividends, and new levies on businesses, are already being discussed. In the longer run, we may see a push to introduce a federal value-added-tax.

Let us pay close attention to the president's message. But let us not be confused by promises of jobs, coupled with fiscally responsible sounding language that masks the underlying irresponsibility of budget decisions. Proposals that increase taxes and spending, even if they do not increase the deficit, will place a substantial burden on our recovering economy and on future economic growth.

Mr. Lazear, chairman of the President's Council of Economic Advisers from 2006-2009, is a professor at Stanford University's Graduate School of Business and a Hoover Institution fellow.

from e21, 2010-Jan-1, by Stephen Goldsmith:

Red-Ink Tsunami: Why Old Ideas Can't Fix the New Government Perma-Crisis

State and local governments have faced big budget gaps before. Typically, things get tight for a while, then the economy perks up, tax revenues recover, and deficits are eliminated. Life goes back to normal.

For a variety of reasons, however, today's budget deficits are different. Government at all levels now faces an inescapable reality – the promises of public services exceed our ability to pay for them – and will do so regardless of when the recession ends. The steady increase in the quantity and cost of public services, coupled with the needs of an aging population and public pension costs have produced a long term, structural deficit.

Even before the crisis took hold, unfunded liabilities for state and local retirees topped $1.6 trillion.In Illinois alone future taxpayers are on the hook for over $80 billion for public employee pensions.

Even worse, mandates from Washington are expected to further aggravate state costs. For example, a final health care reform bill will almost surely include an expansion of Medicaid coverage and the recent increases in unemployment insurance are expected to be made permanent.

Reductions in tax revenues will also ratchet up the pain. "The decline in government revenue is unprecedented for any period on record going back to 1952,” according to Robert Ward, deputy director of the Rockefeller Institute for Government at the State University of New York (Albany). In the first quarter of 2009, Ward said revenue dropped 11.7% from a year earlier, the most on record.

In cities this deficit is compounded as asset values declined and many middle class jobs disappeared. The recent news about the last decade's economic stagnation stands in sharp contrast to the growth of government serving as a harbinger for permanent deficits. According to Paul Krugman “It was a decade with basically zero job creation … And private-sector employment has actually declined — the first decade on record in which that happened … It was a decade of zero gains for homeowners, even if they bought early: right now housing prices, adjusted for inflation, are roughly back to where they were at the beginning of the decade.” Yet despite this state expenditures grew by an inflation-adjusted 34% over the same period of time.

Rainy day funds are depleted. There is no low hanging fruit to be found to patch over these deficits. There are also no more big accounting tricks to stave off the day of reckoning, no way to play kick-the-can down the road for the next administration.

California, like the canary in the coal mine, is a harbinger of the nation's fiscal future. In the past year, it has raised taxes by $12 billion and received $50 billion in stimulus dollars from the Federal government. Yet, this summer the state still had to issue IOU's to its creditors. The latest projections have California staring up out of a $21 billion hole.

Even worse, the costs from our past threaten our future. The debt service required for retired public employee pensions and health care entitlements must be paid – so where do we get the money for roads, schools, and prisons?

Like it or not, fiscal crisis is the new normal.

Projections are bleak. A December 2009 report from the National Association of State Budget Officers found that “Fiscal conditions significantly deteriorated for states during fiscal 2009, with the trend expected to continue through fiscal 2010 and even into 2011 and 2012.”

At the federal level, the long term projections are even worse. A new report from the Peterson and Pew Foundations found that: “Over the past year alone, the public debt of the United States rose sharply from 41 to 53 percent of gross domestic product (GDP). Under reasonable assumptions, the debt is projected to grow steadily, reaching 85 percent of GDP by 2018, 100 percent by 2022, and 200 percent in 2038. However, before the debt reached such high levels, the United States would almost certainly experience a debt-driven crisis…”

Governments at all levels face a tidal wave of red ink.

The consequences for public budgets and policymakers are immense. The scale of these deficits and the expected duration of the downturn will require a fundamental, transformational re-alignment of the way that governments choose their tasks, define success and generate the revenue to fund their work.

Fortunately, there are new approaches to rethinking the public sector that show promise. But before looking at those, it is important to examine some strategies that have been employed in the past, but which not only won't work today, they will actually be destructive. We need to break out of our old patterns of thinking and break some old habits.  

5 Strategies of Yesteryear That Won't Work Today

1. More Federal Aid: Federal dollars from the American Recovery and Reinvestment Act (2009 Stimulus) pumped more than $150 billion to the states. While it avoided short term pain, this aid has been largely counter-productive. By delaying tough choices, federal injections embedded the dysfunctional policies that led to these budgetary and economic crises in the first place.

According to a National Conference of State Legislatures budget report:

“Ironically, a contributing factor to future state budget gaps is the end of federal stimulus funds provided by the American Recovery and Reinvestment Act (ARRA). Those additional funds supported state budgets in FY 2009 and, to an even greater extent, in FY 2010. That money recedes in FY 2011 and, when it is gone, will leave big holes in state budgets – what many state officials are calling the “cliff effect.”

Congress actually aggravated the problem by preventing state and local governments from having to trim their budgets when they needed to. In many cases, federal money was contingent on states taking on more expenses (or spending more) at the very time they should have been on a rigid diet. For example, the ARRA stimulus provisions called for unsustainable extensions of services such as Medicaid.

The entire approach forced on states by Washington defies economic logic. It forces officials into ever deepening budget holes on the assumption that government creates wealth when it creates a public job. In effect, a bankrupt federal government is merely borrowing to help bankrupt state and local governments cover their operating expenses. Which brings us to our second failed strategy.

2. More Government Debt: The soundness of our debt-driven approach to financing states has come to an end – whether our leaders are ready to admit it or not. The shocking scale of our national debt (see here) and the threat it poses are becoming increasingly clear, in part due to the alarming data and outreach work by former Comptroller General David Walker. Under reasonable budget and economic assumptions, the federal debt, now at about 40% of GDP could reach 200% of our total annual economy by 2038. Systemic economic meltdown – a currency crisis, for example – would likely occur before lenders allowed debt to reach those astronomical levels.

Additional borrowing that allows states to operate above their means only hastens and exacerbates the day of reckoning.

3. More Taxes: At the state level, California has shown the futility of trying to tax your way out of a spending problem. In February 2009, California passed a historic $12 billion tax hike. Less than a year later, the state is looking at a brand new $20 billion budget gap. Business is fleeing the Golden State, where unemployment stands at 12.3%. Governor Schwarzenegger's approval rating is only 27 percent – just about where former Governor Gray Davis stood before he was recalled.

Tax hikes simply won't get governments through this one. Neither the economy nor the electorate will allow for much in the way of tax increases, not after states collectively enacted $23 billion in tax hikes in 2009. (A slew of recent reports document the gory details here, and here –oh, and here.) In Indianapolis, where I served as mayor, voters two years ago refused to reelect my otherwise well regarded successor in a taxpayer revolt. Voters instead chose an unknown and poorly funded but clearly anti-tax increase challenger. Taxpayers in recent gubernatorial elections in Virginia and New Jersey loudly proclaimed the same message.

4. More Delaying Tactics: The time-honored tradition of kicking the can down the road has reached its logical conclusion – we are at the end of the road. The weight of government debt service, unfunded pension obligations, and retiree health care is landing today. More delays will only make things worse.

5. Incremental, stop-gap measures: Hiring freezes. Moratoriums on travel. Across the board cuts. Deferred maintenance for infrastructure. A whole menu of inefficient, counter-productive short term measures won't close the gap either. Even more creative approaches, such as the employee furloughs tried by Atlanta, Utah, and Chicago, which in some cases may actually increase productivity, simply aren't going to be enough. When Atlanta went from a 40-hour work week to a 36 hour, 4-day workweek, city officials noted a boost in productivity and drops in absenteeism—but the city abandoned the program following a property tax increase. Utah started their four day work week during the energy cost spike, but the experience of having most state offices closed on Fridays has been so successful, they haven't switched back. The state's compressed workweek cut energy use 13%. States such as Iowa are considering following suit. There simply aren't enough small ideas to cobble together to fill the big gap between `what is' and `what needs to be.'

The Road Out of Crisis

So what's a government to do? How can we move beyond the strategies that have made the mess even worse? What are new ideas that can help shape a truly transformative change?

These will be explored in depth in future columns.

Stephen Goldsmith is the Daniel Paul Professor of Government and Director of the Innovations in American Government Program at the Ash Center for Democratic Governance and Innovation of Harvard's Kennedy School of Government.

from the Wall Street Journal, 2010-Jan-3:

The Biggest Losers
Behind the Christmas Eve taxpayer massacre at Fannie and Freddie.

Happy New Year, readers, but before we get on with the debates of 2010, there's still some ugly 2009 business to report: To wit, the Treasury's Christmas Eve taxpayer massacre lifting the $400 billion cap on potential losses for Fannie Mae and Freddie Mac as well as the limits on what the failed companies can borrow.

The Treasury is hoping no one notices, and no wonder. Taxpayers are continuing to buy senior preferred stock in the two firms to cover their growing losses—a combined $111 billion so far. When Treasury first bailed them out in September 2008, Congress put a $200 billion limit ($100 billion each) on federal assistance. Last year, the Treasury raised the potential commitment to $400 billion. Now the limit on taxpayer exposure is, well, who knows?

The firms have made clear that they may only be able to pay the preferred dividends they owe taxpayers by borrowing still more money . . . from taxpayers. Said Fannie Mae in its most recent quarterly report: "We expect that, for the foreseeable future, the earnings of the company, if any, will not be sufficient to pay the dividends on the senior preferred stock. As a result, future dividend payments will be effectively funded from equity drawn from the Treasury."

The loss cap is being lifted because the government has directed both companies to pursue money-losing strategies by modifying mortgages to prevent foreclosures. Most of their losses are still coming from subprime and Alt-A mortgage bets made during the boom, but Fannie reported last quarter that loan modifications resulted in $7.7 billion in losses, up from $2.2 billion the previous quarter.

The government wants taxpayers to think that these are profit-seeking companies being nursed back to health, like AIG. But at least AIG is trying to make money. Fan and Fred are now designed to lose money, transferring wealth from renters and homeowners to overextended borrowers.

Even better for the political class, much of this is being done off the government books. The White House budget office still doesn't fully account for Fannie and Freddie's spending as federal outlays, though Washington controls the companies. Nor does it include as part of the national debt the $5 trillion in mortgages—half the market—that the companies either own or guarantee. The companies have become Washington's ultimate off-balance-sheet vehicles, the political equivalent of Citigroup's SIVs, that are being used to subsidize and nationalize mortgage finance.

This subterfuge also explains the Christmas Eve timing. After December 31, Team Obama would have needed the consent of Congress to raise the taxpayer exposure beyond $400 billion. By law, negative net worth at the companies forces them into "receivership," which means they have to be wound down.

Unlimited bailouts will now allow the Treasury to keep them in conservatorship, which means they can help to conserve the Democratic majority in Congress by increasing their role in housing finance. With the Federal Reserve planning to step back as early as March from buying $1.25 trillion in mortgage-backed securities, Team Obama is counting on Fan and Fred to help reflate the housing bubble.

That's why on Christmas Eve Treasury also rolled back a key requirement of the 2008 bailout—that Fan and Fred begin shrinking the portfolios of mortgages they own on their own account, which total a combined $1.5 trillion. Risk-taking will now increase, so that the government can once again follow Barney Frank's infamous advice that the companies "roll the dice" on subsidies for affordable housing.

All of which would seem to make the CEOs of Fannie and Freddie the world's most overpaid bureaucrats. A release from the Federal Housing Finance Agency that also fell in the Christmas Eve forest reports that, after presiding over a combined $24 billion in losses last quarter, Fannie CEO Michael Williams and Freddie boss Ed Haldeman are getting substantial raises. Each is now eligible for up to $6 million annually.

Freddie also has one of the world's highest-paid human resources executives. Paul George's total compensation can run up to $2.7 million. It must require a rare set of skills to spot executives capable of losing billions of dollars.

Where is Treasury's pay czar when we actually need him? You guessed it, Fannie and Freddie are exempt from the rules applied to the TARP banks. The government gave away the game that these firms are no longer in the business of making profits when it announced that the CEOs will be paid entirely in cash, though it is discouraging that practice at other big banks. Who would want stock in the Department of Housing and Urban Development?

Meanwhile, these biggest of Beltway losers continue to be missing from the debate over financial reform. The Treasury still hasn't offered its long-promised proposals even as it presses reform on banks that played a far smaller role in the financial mania and panic. Senate Banking Chairman Chris Dodd (D., Conn.) and ranking Republican Richard Shelby recently issued a joint statement on their "progress" toward financial regulatory reform, but their list of goals also doesn't mention Fannie or Freddie.

Since Mr. Shelby has long argued for reform of these government-sponsored enterprises, their absence suggests that Mr. Dodd's longtime effort to protect Fan and Fred is once again succeeding. It would be worse than a shame if, having warned about the iceberg for years, Mr. Shelby now joins Mr. Dodd in pretending that these ships aren't sinking.

In today's Washington, we suppose, it only makes sense that the companies that did the most to cause the meltdown are being kept alive to lose even more money. The politicians have used the panic as an excuse to reform everything but themselves.

from the Wall Street Journal, 2010-Jan-27, p.A14:

A Fannie and Freddie Earmark
Chuck Schumer doesn't think they're losing enough money.

Taxpayers may look at the unlimited federal credit line now enjoyed by Fannie Mae and Freddie Mac and see disaster. But New York Senator Chuck Schumer sees opportunity.

Yesterday he demanded that the two failed mortgage giants guarantee low rent for tenants in a Manhattan property they now own after the owner defaulted. As they say in Democratic Washington, a crisis is a terrible thing to waste.

Recently we told you about the Treasury's Christmas Eve announcement that after chewing through $111 billion from taxpayers, Fan and Fred can now consume an unlimited amount of cash from the U.S. Treasury. The companies have been losing billions each quarter to serve President Obama's political goal of modifying troubled mortgages. They can lose still more by serving Mr. Schumer.

In truth, they already are. The New York lawmaker has pioneered the use of the Fannie and Freddie earmark, having successfully pressured Fannie to sell another property in the Bronx to an affordable housing group. But his appetite is growing for taxpayer cash to dole out to his constituents. Whereas the Bronx housing complex was worth a mere $29 million, Fan and Fred's interest in the mammoth Stuyvesant Town complex in Manhattan could run into the billions.

The New York Observer quotes Mr. Schumer saying that after Stuyvesant Town's owners defaulted, "Now Fannie and Freddie must guide this process to a conclusion with the least amount of impact on current tenants and families. I am going to watch them like a hawk to make sure they do just that."

While Mr. Schumer seems to have developed a nice racket, we can't help but wonder if Fan and Fred own any properties in the state of Nebraska. Can Senator Ben Nelson perhaps get a piece of this action?

from the Wall Street Journal, 2010-Jan-24, by Peter J. Wallison:

The President's Bank Reforms Don't Add Up
Restricting loans to real estate virtually guarantees another bank crisis in the future.

After the Democrats' disaster in Massachusetts last Tuesday, President Obama appears to be flailing. Gone is the cool and measured demeanor that made him look presidential when the financial crisis struck during the 2008 campaign. Instead, the financial reform proposals he advanced later in the week seem to reflect political panic—a desperate attempt to appeal to the populist sentiment against Wall Street. Unfortunately, they also reflect a limited understanding of good financial or banking policy.

First, Mr. Obama has proposed to limit the size of banks or their holding companies, or both. The trouble with limiting the size of these institutions is that no one has the faintest idea what the right size is. What's more, if the purpose of the size limit is to prevent a bank or bank holding company from being or becoming too big to fail, we have to know what size would cause a failed institution to cause a financial train wreck. No one knows that, either. Under these circumstances, it's hard to take such a proposal seriously.

Second, Mr. Obama says that some firms should be prohibited from engaging in "proprietary trading." The White House announcement seems to apply to both banks and bank holding companies, but there is a huge difference between them. A bank is chartered by the government, its deposits are insured, it can participate in the U.S. payment system, and it has access to the Fed's discount window. None of these things is true of a bank holding company—which is an ordinary corporation that controls a bank.

Because banks are government-backed, and privileged in many ways, their activities are limited by law and regulation. They are restricted in how they can use their insured deposits. The Glass-Steagall Act, despite what we constantly hear in the media and from people who should know better, still applies to banks; it forbids them from engaging in underwriting or dealing in securities. This should prohibit them from engaging in proprietary trading to the extent that this is dealing in securities. Bank holding companies, however, because they are not banks and not government-backed, can engage in any financial activity, including securities dealing. Why would we prohibit them from doing so when they are using their own funds?

Apparently, Mr. Obama is arguing that bank holding companies should be prohibited from proprietary trading because it's too risky. The trouble is that proprietary trading is a profitable business for many bank holding companies, and there is no evidence that it caused serious losses for either banks or bank holding companies in the recent financial crisis.

There are strong firewalls between the holding companies and the banks they control that prevent the activities of the holding companies from affecting their bank subsidiaries. If Mr. Obama's plan is adopted, many bank holding companies will have to give up profitable businesses or sell off their banks. But even that wouldn't really solve the problem, since some would contend that large financial institutions like Goldman Sachs and Morgan Stanley, even if they ceased being bank holding companies, would still be too big to fail.

But if we are going to stop Goldman Sachs and Morgan Stanley from taking risks in securities trading generally because they are too big to fail, why not stop securities trading by all large financial firms, such as investment banks or insurance companies? Even for a newly minted populist, this is a bit much.

There is one more factor to consider. Banks have been committing themselves increasingly to financing real estate. The reason for this is simple. Because they cannot underwrite or deal in securities, they have been losing out to securities firms in financing public companies—that is, most of American business other than small business. It is less expensive for a company to issue notes, bonds or commercial paper in the securities markets than to borrow from a bank.

Where, then, can banks find borrowers? The answer, unfortunately, is commercial and residential real estate.

Real-estate loans rose to 55% of all bank loans in 2008 from less than 25% in 1965. These loans will continue to rise in the future, because only real-estate, small business and consumer lending are now accessible activities for banks.

This is not a good trend, because the real-estate sector is highly cyclical and volatile. It was, indeed, the vast number of subprime and other risky mortgages in our financial system that caused the weakness of the banks and the financial crisis. Requiring banks to continue to lend to real estate, because they have few other alternatives, virtually guarantees another banking crisis in the future.

Since banks can never be let out of these restrictions as long as they are government-backed, one solution for banking organizations is to center their activities in the bank holding company which—because it is not government-backed—does not have to limit its range of activities. The fact that Mr. Obama now proposes to close off this one avenue through which banking organizations can be profitable is strong evidence that neither he nor his advisers, in attempting to lash out at banks, have thought through the long-term prospects and needs of the banking industry.

That might make good populist politics, but it is not responsible policy. Instead of trying to punish the banking industry, Mr. Obama should try to understand why banks have become so heavily invested in real estate.

Banks must remain restricted in their range of activities, but bank holding companies are not banks. The solution to the long-term problems of the banking business is not to narrow the activities of bank holding companies, but to broaden them.

Mr. Wallison is a senior fellow at the American Enterprise Institute.

from the Associated Press via the Washington Post, 2010-Jan-14, by Jim Kuhnhenn, with Tom Raum, Stephen Ohlemacher and Chris Rugaber contributing:

Analysis: Obama playing banks against taxpayers

WASHINGTON -- It's not just about bad banking.

President Barack Obama's biting criticism of big banks frames the problem as a struggle between jobless, suffering Americans and banks making big profits and paying "obscene" bonuses.

It's populism straight out of Frank Capra's "It's a Wonderful Life," and it aims to score political points in the midst of a weak economic recovery that is fueling public doubts about the president's own economic policies.

Obama proposed a 10-year, $90 billion tax on the largest financial institutions on Thursday, saying he wanted the money to back any shortfall in the $700 billion Troubled Asset Relief Program launched to bail out foundering firms at the height of the financial crisis.

Obama's haves-versus-have-nots message was as explicit as any political message he has delivered as president.

"If these companies are in good enough shape to afford massive bonuses, they are surely in good enough shape to afford paying back every penny to taxpayers," he declared. "We want our money back."

To drive the point home, he also said:

"My determination to achieve this goal is only heightened when I see reports of massive profits and obscene bonuses at some of the very firms who owe their continued existence to the American people, folks who have not been made whole and who continue to face real hardship in this recession."

Whether his plan stands a chance in Congress remains to be seen. House leaders and rank-and-file liberals cheered the bank tax. In the Senate, Banking Committee Chairman Chris Dodd, D-Conn., also welcomed the plan. But Democratic Sen. Max Baucus of Montana, the chairman of the Senate tax-writing Finance Committee, was more cautious.

"I remain committed to working with the president, and my colleagues across the aisle, to make sure this proposal is right for America and for American taxpayers," he said in a statement.

Critics of the plan assailed it as bad economic policy that would force banks to simply pass on the costs of the tax to consumers, drying up lending even further and hurting cash-strapped small businesses.

What's more, the tax would also apply to institutions that either chose not to take bailout money or have already paid it back, with interest. And General Motors Co. and Chrysler Group LLC, two automakers that received $66 billion in TARP loans, would not be subject to the tax even though they are not expected to make the government whole.

GOP Rep. Scott Garrett of New Jersey, a member of the House Financial Services Committee, called the plan a "job-killing initiative that will further cripple the economy by increasing fees passed on to consumers and small businesses, while reducing consumer credit."

But the White House made it clear the administration would make things quite uncomfortable for politicians who object.

"They can explain that to their constituents and to the American people," White House spokesman Robert Gibbs said. "If you want to be on the side of big banks, then you're certainly - this is a great country - you're free to do so."

To banks' claims that the tax is unfair, Lawrence Summers, Obama's top economic adviser, pointed out that 15 million people are unemployed. "It's surprising to me to see institutions who have benefited so substantially at a time when there is so much economic distress among others in the country to be complaining about the justice of what has happened to them from their executive suites," he said.

So, prospects of actual passage aside, the real impact of Obama's vocal stance is that it draws unfavorable attention to Wall Street just as the public learns that the bailed-out financial institutions are now on such sound footing that they are declaring profits and paying bonuses.

For bankers, bonus season could not have come at a more difficult time. Unemployment remains stubbornly at 10 percent, the Senate is writing new banking regulations and a special commission is examining the causes of the financial meltdown.

For Democratic lawmakers who find themselves uncomfortably defending their past votes in favor of the huge rescue fund, Obama's finger wagging also provides them with a needed narrative line.

"It was tough to make the TARP vote and the bankers are making it even tougher," Rep. Steve Cohen, D-Tenn., said referring to executive bonuses. "They are pigs at the trough."

Obama's proposal drew some praise from international quarters. Dominique Strauss-Kahn, managing director of the International Monetary Fund, said the United States has sent "a very good signal" to the world.

"I really celebrate this proposal by the U.S. government because it shows the political momentum to move in this direction is still there," he said.

But for now, Obama's message was strictly domestic.

from the Wall Street Journal, 2010-Jan-16, p.A12:

The 'Responsibility' Tax
Fannie and Freddie are exempt from the White House banker 'fee.'

The White House has spent months imploring banks to lend more money, so will President Obama's new proposal to extract $117 billion from bank capital encourage new bank lending?

Just asking. Welcome to one more installment in Washington's year-long crusade to revive private business by assailing and soaking it.

Mr. Obama's new "Financial Crisis Responsibility Fee"—please don't call it a tax—is being sold as a way to cover expected losses in the Troubled Asset Relief Program. That sounds reasonable, except that the banks designated to pay the fee aren't those responsible for the losses. With the exception of Citigroup, those banks have repaid their TARP money with interest.

The real TARP losers—General Motors, Chrysler and delinquent mortgage borrowers—are exempt from the new tax. Why the auto companies? An Administration official told the Journal that the banks caused the crisis that doomed the auto companies, which apparently were innocent bystanders to their own bankruptcy. The fact that the auto companies remain wards of Washington no doubt has nothing to do with their free tax pass.

Also exempt are Fannie Mae and Freddie Mac, which operate outside of TARP but also surely did more than any other company to cause the housing boom and bust. The key to understanding their free tax pass is that on Christmas Eve Treasury lifted the $400 billion cap on their potential taxpayer losses expressly so they can rewrite more underwater mortgages at a loss.

In other words, the White House wants to tax more capital away from profit-making banks to offset the intentional losses that the politicians have ordered up at Fan and Fred. The bank tax revenue will flow directly into the Treasury to be spent on whatever immediate cause Congress favors. Come the next "systemic risk" bailout, taxpayers will still be on the hook. "Responsibility" is not the word that comes to mind here.

The tax will apply to liabilities that are not already insured by government, so the White House is saying it will deter excessive risk-taking. And it does at least tilt at the role of excessive debt in creating systemic risk. But the heart of the moral hazard for the biggest banks is the implicit government guarantee that they will never be allowed to fail, and the tax does nothing about this.

The tax will be levied on financial companies with more than $50 billion in assets. However, as a too-big-to-fail litmus test, $50 billion can't possibly be the right answer. America has just run the experiment by putting a company bigger than $50 billion—CIT Group—through bankruptcy. By any objective reckoning, there were no systemic consequences. The new $50 billion tax threshold thus increases the scope of future bailouts by drawing a wider circle around firms that can gamble with implicit federal backing.

A better idea is to do the hard policy work of creating a plan that allows failure or else separates traditional banking from hedge-fund trading, as Bank of England Governor Mervyn King and former Federal Reserve Chairman Paul Volcker have suggested.

There's encouraging news that bank failure may still be an option. A bipartisan Senate effort led by Bob Corker (R., Tenn.) and Mark Warner (D., Va.) is considering the creation of a special bankruptcy court to decide whether an institution should go through bankruptcy or be subjected to an FDIC resolution process.

The first route sounds better than the second. Although FDIC Chairman Sheila Bair has been an outspoken advocate for a resolution process with certain punishment for failure, the provisions recently passed by the House would yield the opposite. The FDIC could choose among a number of ways to assist a company, and could decide how hard a bargain to drive with the firm's various creditors as well as discriminate within the same class of creditors. Not even the New York Federal Reserve of AIG fame has been willing to do the latter.

Another idea to reduce the moral hazard of too-big-to-fail would be to restore long-ago limits on leverage. For example, abolish the corporate income tax for financial companies and replace it with a tax on assets that rises with the bank's leverage ratio. There could be a tax-free zone at leverage levels below current regulatory standards. Washington could also reform margin requirements.

These ideas should all be thoughtfully considered, but of course that is hard political work and the biggest banks would oppose them because they secretly like too-big-to-fail. As for the politicians, it's so much easier to blame bankers, deplore their bonuses, tax them, regulate them, accept their campaign contributions and then bail them out while you talk about "change" and "responsibility."

from the Wall Street Journal, 2010-Jan-5, by Donald L. Luskin and Chris Hynes:

Why Taxing Stock Trades Is a Really Bad Idea
Everyday investors shouldn't be punished for a subprime fiasco fueled by Fannie Mae and Freddie Mac.

The Democrat-dominated Congress has come up with a new way for President Obama to violate his campaign pledge to not raise taxes on families earning less than $250,000 per year. It's a tax on securities transactions—trading in stocks, options, futures and so on.

And why not single out trading for special taxation? We levy special taxes on tobacco, alcohol and other vices. Except that trading isn't a vice. The exchange and hedging of business interests is a virtuous—and utterly essential—activity in a free economy.

But you'd never know it from the angry anticapitalist rhetoric of the tax's proponents. Rep. Peter DeFazio (D., Ore.), who introduced the House bill establishing the tax—positions it as retribution for "the Bush administration's cowboy capitalism, markets know best, deregulation at all cost policies." Sen. Tom Harkin (D., Iowa), who introduced a similar Senate bill, says, "We need a shift in priorities in this country to ask not what America can do for Wall Street, but ask what Wall Street can do for America."

Are you just an ordinary American who trades stocks? You probably don't think of yourself as having much to do with "Wall Street," or of your trading as a vice that ought to be singled out for a special tax. And you surely don't think of yourself as someone who caused the recent financial crisis, which was, as Rep. DeFazio says, "brought on by reckless speculation in the financial markets."

If anything, you probably think of yourself as a casualty of the crisis, not its cause. Why should a stock market investor like you—or for that matter, even an investor literally on Wall Street—pay a tax as punishment for a crime of which you were the victim, not the perpetrator? The crisis was caused by excesses in the mortgage industry, led by government-sponsored entities such as Fannie Mae and Freddie Mac. How did stock transactions—or transactions in options or futures—have anything to do with this crisis?

The proposed tax would apply to commodity transactions as well. So here we find another class of victims being punished. When excesses in the mortgage market blew up the world economy in 2008, commodity investors were hammered as prices plunged in everything from crude oil to gold to corn. Many of them were ordinary businesses—far from Wall Street—trying to hedge themselves against the rising cost of energy.

To be fair, the tax would apply to credit default swaps, which were closely associated with the excesses in mortgage speculation. But if it's going to apply to stocks—which had nothing to do with the crisis except to be its victim—then why does the tax, as proposed by Rep. DeFazio, not apply to bonds? It was the bond market, not the stock market, that was the conduit for hundreds of billions of dollars of dodgy subprime mortgages. Could this possibly be related to the need for the federal government to issue Treasury bonds from here to eternity to finance the looming deficits from the cornucopia of programs being cooked up in Congress?

Setting aside the critical issue of why certain types of securities are singled out for tax, and others are not, the tax as currently proposed does not even succeed in fairly targeting speculators as opposed to investors. In fact, like most tax schemes, it is riddled with arbitrariness and capriciousness.

Suppose you buy a stock, and you hold the position for 20 years. You're an investor. Suppose the person who sold it to you was a day trader—who might end up buying the stock again 10 minutes later from someone else and then selling it after an hour. You both pay the same tax.

As proposed, you wouldn't have to pay a tax to buy or sell mutual funds. Yet mutual funds themselves would have to pay the tax on any trades they make in stocks. So as the owner of the mutual fund, you still end up paying the tax. According to the Investment Company Institute, the average turnover for stock-market mutual funds in 2008 was 60%, which would add up to a lot of taxes.

Transactions in retirement accounts would be exempted. So a corporation that invests to provide pensions to retired workers won't face higher costs. But a retired individual who has just sold his business and is living off the invested proceeds will pay the tax.

And don't believe the proponents of the tax when the say it's so small you'll never notice it. At one quarter of 1%, that would be a cost of $0.33 on a share of IBM. If you were to buy or sell $100,000 worth of IBM (or any stock), the tax would be $250. Single taxpayers would get an annual exemption of that amount. But trade again, and you're taxed $250. Again, another $250. Over and over. Each time, that's about 20 times the commission that a typical online broker would charge you to make that trade—yes, the greedy broker, the one on Wall Street.

More fundamentally, the proponents of the tax seem not to have thought through what effects it might have on America's global competitive position as the world's pre-eminent stock market. They simply wave away any concern with a flourish of moral indignation. Last summer, when Britain's Financial Services Authority Chairman Adair Turner proposed a trading tax for the United Kingdom, and set in motion a global movement toward such a tax, he called trading "socially useless."

We shouldn't have to "socially" justify any lawful activity. But surely it is "socially useful" to let free people transact freely, without regulators and legislators micromanaging them. If anything, given the spectacular failure of every regulatory authority and legislator to detect and deter the abuses in mortgage markets that led to a near-meltdown of the global economy, it is their activities that would appear to be "socially useless" and deserving of a special tax.

It's Economics 101 that the free actions of market participants cause supply and demand to reach equilibrium. And isn't that what investors—indeed, even speculators—do? Don't they try to buy things they think are cheap and sell things they think are expensive? Can they do it as well when facing the dead-weight costs of a transaction tax?

If not, then trading volume in our stock markets will fall. Beyond the tax, everyone—investor and speculator, great and small—who buys or sells stocks will pay more to transact in markets that are less liquid. And they will transact at prices that are not set as efficiently. In such a world, markets would necessarily be more risky, and the cost of capital for business would necessarily rise. The consequence of that is that innovation, growth and jobs would necessarily fall. That would be the full and true cost of the trading tax being proposed.

Mr. Luskin is chief investment officer at Trend Macrolytics LLC. Mr. Hynes is chief executive officer of Hynes Capital.

from the Wall Street Journal, 2010-Jan-15, p.A18:

D.C. Witness Protection Program
A financial inquiry hits the bankers, ignores the Fed and Fannie Mae.

Law enforcers normally use the witness protection program to shield people willing to provide testimony. So far, the Financial Crisis Inquiry Commission seems determined to protect a political class willing to do almost anything to avoid testifying.

That's the message of the commission's first week of hearings, which focused on repeating the Beltway's pet theory of what caused the credit mania and subsequent panic. To wit, the greedy bankers did it, abetted by Bush Administration deregulators and perhaps, a little, by the Clinton Treasury when it agreed to repeal the Glass-Steagall Act. If the commission is merely going to reinforce this laughably narrow and politicized view, this is going to be a waste of money and time.

Created by Congress and due to report by December 15, the commission is chaired by Phil Angelides, a former chairman of California's Democratic Party. His first group of witnesses on Wednesday were the CEOs of Bank of America, Goldman Sachs and JPMorgan Chase, plus the Chairman of Morgan Stanley.

Mr. Angelides delivered what you would expect of a political hearing, accusing Goldman of "selling a used car with faulty brakes" when it sold mortgage-backed securities. He demanded that the executives accept blame for the crisis and then said he "was troubled by the inability to take responsibility." On day one, Mr. Angelides appeared to have reached his conclusion.

Yesterday, on day two, the commission loaded up on details about "current investigations into the financial crisis" by state, local and federal law enforcers. Attorney General Eric Holder was there, along with Lanny Breuer, head of the Criminal Division, and a lawyer for the Miami-Dade County police department. The theme seemed to be how many banker miscreants will end up in jail.

***

Our point isn't that bankers didn't make stupendous blunders. It is that the roots of the mania and panic are so much larger than any single financial security, compensation practice or regulation. And those roots are found as much in Washington as on Wall Street.

Start with the Federal Reserve, which for years kept interest rates below the rate of inflation and thus created a global subsidy for credit. Bankers and investors had an incentive to sell and take on more debt. A Journal survey of economists this week found that a majority now think Fed policy was a major culprit. Providing a rare source of wisdom at yesterday's hearing was FDIC Chairman Sheila Bair, who explained how the Fed's monetary policy helped inflate the housing bubble.

If the commissioners are looking for historical guidance, they might consult the late Charles Kindleberger's classic, "Manias, Panics, and Crashes: A History of Financial Crises." On page 10 of the Fifth Edition paperback, the good professor declares that "The thesis of this book is that the cycle of manias and panics results from the pro-cyclical changes in the supply of credit." (Our emphasis.) An inquiry that ignores the sources of credit that fed the mania is like a history of the Civil War that ignores slavery.

Also missing this week was anyone from Fannie Mae and Freddie Mac, the mortgage giants that turbocharged the housing boom. With their implicit taxpayer backing, Fan and Fred held or guaranteed more subprime and Alt-A loans than anyone—much more than the combined holdings of the four bankers represented this week.

So long as Fan and Fred kept increasing mortgages to low-income borrowers, the dynamic duo's political protectors kept fighting off efforts to cap the size of Fan and Fred's mortgage portfolios. The pair would ultimately hold or guarantee mortgages amounting to more than $5 trillion. That sum is greater than the annual GDP of Japan, the world's third largest economy, and yes, a whole lot bigger than the balance sheet of Goldman Sachs. A serious inquiry will examine the business practices of Fan and Fred, the long battle to rein them in, and the Members of Congress who blocked reform.

We'll admit we don't have much hope for any inquiry led by Mr. Angelides, who is about as partisan a chairman as one can imagine. As California treasurer and board member at Calpers, the giant pension fund for state employees, Mr. Angelides led the movement to invest to advance political goals. He pushed Calpers to invest in "environmentally screened" funds and helped pressure companies like Safeway and countries like the Philippines to embrace union labor. While at Calpers, he was dogged by questions about investment funds managing Calpers cash whose executives coincidentally were backers of his political campaigns.

Also on the panel is Brooksley Born, who has already been widely portrayed in the media as the lonely regulator who blew the whistle on derivatives but was crushed by other Clinton-era officials. By all means, Ms. Born should be a witness and her story considered. But as heavily invested as she already is in a narrative that blames derivatives and lax regulation, she is another odd choice for a disinterested inquiry.

***

The greatest oddity of the commission may be that its report is set to arrive after Congress and the Administration hope to pass the most far-reaching reform of financial laws since the 1930s. So prescription first, diagnosis later. Perhaps the commission will surprise us, but the evidence of the first week is that this exercise is less about getting to the truth than about reinforcing Democratic theories about whom to blame.

from Forbes, 2010-Jan-21, by Liz Moyer:

Obama Sizes Handcuffs For Banks
President proposes barring bank holding companies from activities that generate big risks and big profits.

On a day when Goldman Sachs announced $13 billion in 2009 profits largely as the result of big trading gains, President Barack Obama called for new curbs on trading activities in large financial institutions and caps on their ability to leverage their balance sheets.

The proposals, which are light on details, will be folded into the broader legislative effort to reform the financial markets. That effort, now winding through Congress, is getting new attention now that the administration's other big projects, health care reform and climate change legislation, have hit roadblocks.

Though the roots of the financial crisis were in lax loan underwriting, followed by lax underwriting of derivative products containing those loans and a poor grasp on the exposures banks were amassing on their books, the administration is relying on populist outrage to regain momentum.

Banks are preparing to pay out tens of billions in bonuses to employees even though the economy and ordinary folks continue to struggle. Trading revenues in 2009 helped replenish bonus pools on Wall Street to near record levels and trading gains returned the big banks to profitability far more quickly than they might have achieved it.

President Obama wants to bar bank holding companies from owning or investing in hedge funds and private-equity funds and stop them from conducting proprietary trading, which is trading for their own accounts. The proposal gives bank regulators the authority to force banks out of those businesses.

In addition, he wants to expand on an existing federal cap on deposit concentration. Right now, no one bank can exceed 10% of the nation's deposits by acquisition, though they can grow past it on their own. Obama wants to cap other sources of funding banks use, which would restrict their ability to use leverage. Read All Comments

The goal is to put an end to the concept of "too big to fail" by restricting the activities of banks that benefit from federal deposit insurance and access to the Federal Reserve's discount window. Companies can engage in riskier activities like trading, but not at the expense of taxpayers, the administration said.

It dredges up an old debate on the definition of a bank. Since the Great Depression, when Congress first enacted laws that split commercial banking from the riskier world of underwriting and securities trading, regulators have gone back and forth on how much risk they will allow banks to assume.

After opening the floodgates a decade ago by allowing the combination of investment banking and commercial banking, Washington now wants to erect a dam. "We should no longer allow banks to stray too far from their central mission of serving their customers," Obama said Thursday. "In recent years, too many financial firms have put taxpayer money at risk by operating hedge funds and private-equity funds and making riskier investments to reap a quick reward. And these firms have taken these risks while benefiting from special financial privileges that are reserved only for banks."

Legislators responsible for pushing the proposals through Congress lined up in support on Thursday. Connecticut Sen. Christopher Dodd, who is not running for re-election but who heads the Senate Banking Committee, said in a statement, "I agree with President Obama that taxpayers should not be underwriting these risky activities. Companies that choose to take such risks should do so on their own dime and not in a way that threatens the stability of our economy."

Wall Street's lobby, the Securities Industry and Financial Markets Association, cautioned against regulatory overreach. "We believe providing for strengthened regulatory oversight, and flexibility like that originally proposed by the Administration, as opposed to arbitrary restrictions on growth and activities, is a more effective way of mitigating systemic risk ending 'too big to fail,' " said SIFMA's Tim Ryan.

In certain respects, the proposals take dead aim at one company in particular, Goldman Sachs ( GS - news - people ), which has emerged stronger financially through the crisis but has taken a beating in the court of public opinion. Goldman, which converted to a bank holding company during the depths of the 2008 financial crisis, trades more aggressively than most, and it also runs hedge funds and private-equity funds.

For all of 2009, Goldman traders raked in $34 billion in revenues, much of that from trading bonds, commodities and currencies. Like most other large banks, Goldman positions itself as a market maker, taking the other side of trades with clients and then offsetting those exposures. It also has dedicated proprietary traders who trade on behalf of the firm, but says that is only a small part of its business. Some estimates have put proprietary trading at Goldman at roughly 10% of revenues.

Bankers are unable to escape the suspicion their traders are acting nefariously, benefiting themselves at the expense of clients. Goldman's chief executive, Lloyd Blankfein, was unable to convince a congressional panel investigating the causes of the financial crisis on this point earlier this month.

At a background briefing for reporters before the president's announcement Thursday morning, senior administration officials denied the timing was coordinated with earnings announcements by any of the big banks. But Obama's speech happened to fall right in the middle of Goldman's earnings conference call.

At Goldman, the sensitivity to the public outrage over banks and pay was evident on Thursday. Despite record results, the firm cut the potential bonus pool to the lowest payout since it became a public company a decade ago and highlighted its charitable giving activities.

from the Wall Street Journal, 2009-Dec-28, by Benn Steil:

Prepare for a Keynesian Hangover
Our government's spending orgy will haunt us in 2010.

In 2008, as the U.S. economy teetered under the weight of years of reckless credit expansion, the Bush administration decided against proposals to sweep out the bad debts from the banking system and then fix the regulatory structure—an approach based on tried and tested models from the S&L crisis and other financial crises.

We will pay the price for this decision in 2010. That's because the Obama administration and the Federal Reserve are plowing forward with Plan B: Nationalize credit creation and "stimulate" the private sector by spending in its stead.

Richard Nixon's famous line, "We're all Keynesians now" never seemed more apropos. With the budget deficit at an eye-popping $1.4 trillion, and on track to stay above $1 trillion indefinitely, Berkeley economist Brad DeLong writes breezily in his Nov. 30 blog that "anything that boosts the government's deficit over the next two years passes the benefit-cost test—anything at all."

On the monetary side, the fireworks have been even more spectacular. Since the financial crisis of late 2008, the Fed has flooded the globe with newly conjured dollars in an unprecedented no-holds-barred effort to prod private credit expansion. Watching the booms in the markets for distressed debt, junk-rated corporate bonds and poor-country sovereign bonds since the summer, one might be forgiven for concluding that the Fed had succeeded well beyond its expectations, and that the market's flight to safety had given way to a flight to Vegas. Yet "the truth is that policy should be piling on," Princeton economist and New York Times columnist Paul Krugman writes in his Nov. 25 blog, "not looking for the exit."

Fed Chairman Ben Bernanke wants it both ways. On the one hand, he regularly reminds the market that he's already found the exit: continuously lending out its securities short term in order to soak up cash. The so-called reverse repo market through which this would be done is probably too small for the task of controlling inflation. But such a softly-softly approach is much more attractive politically than actually collapsing the Fed's bloated balance sheet, which would require dumping hundreds of billions of dollars of stockpiled mortgages.

On the other hand, Mr. Bernanke continues to berate the banks for failing to lend while the government continues to do so with heroic abandon.

Former Salvadoran finance minister Manuel Hinds points out in the latest issue of International Finance that banks have indeed been shirking on their day job of transforming increased deposits into increased private-sector credit. But they haven't quit entirely. In fact, they've funneled significant new funds into nonbank financial institutions—which have not lent them on. What's happening is that U.S. banks have been behaving exactly like developing country banks during earlier crises, such as Indonesian banks in the late 1990s—raising lending to their worst borrowers to keep them alive, lest the banks themselves collapse from their borrowers' defaults.

For U.S. banks, these zombie borrowers are their affiliated financial entities set up to manage so-called off-balance-sheet activities—such as the famous SIVs (structured investment vehicles) created by Citigroup and others during the boom. Thus, the massive fiscal and monetary bailouts of the banks have served to worsen the credit misallocation that led to the general economic collapse in 2008.

What is the right solution? The same one that most observers, including the U.S. government, backed until late 2008: Get the bad assets off of the banks' balance sheets. Banks will continue to use accounting gimmicks for window dressing, but as long as they know the truth—that their assets remain seriously impaired—they will continue to starve far too many sound commercial ventures.

Those who insist that the government buying up soured private assets amounts to an unacceptable bailout should be reminded that the market-driven alternative is called bankruptcy. Unfortunately, this option is now considered too politically toxic.

So what we're left with is the type of government-sponsored orgy of spending and money creation that Washington used to condemn with all-knowing righteousness when undertaken south of the border. But the effect of our doing it is far more consequential, since America possesses the exorbitant privilege of minting not only its own but the world's money.

As we move into 2010, no doubt the horns will be blowing for the long-awaited U-shaped recovery. I suspect it won't be long before we realize we've drunk too much, and that the second dip of a W-shaped recession awaits us.

Mr. Steil is director of international economics at the Council on Foreign Relations and co-author of "Money, Markets, and Sovereignty" (Yale University Press, 2009).

from the Wall Street Journal, 2009-Dec-28, p.A1, by Bob Davis, Deborah Solomon and Jon Hilsenrath, with Dan Fitzpatrick contributing:

After the Bailouts, Washington's the Boss

In 2008 and 2009, Washington strove to save the economy. In 2010, Americans will get a clearer picture of how Washington has changed the economy.

Only as the recession recedes will it become fully evident how permanently the state's role has expanded and whether, as a consequence, a new, hybrid strain of American capitalism is emerging.

One thing is clear: The government is a much bigger force in today's U.S. economy than it was before the financial crisis. "The frontier between the state and market has shifted," says Daniel Yergin, whose 1998 book "Commanding Heights" chronicled the ascent of free-market forces starting in the 1980s. "The realm of the state has been enlarged."

To prevent crumbling housing and credit markets from sinking the broad economy, the Bush and Obama administrations and the Federal Reserve spent, lent and invested more than $2 trillion on one initiative after another. If you owned a credit card or a money-market fund, had a savings account, bought a Dodge pickup or even a hunting rifle, or borrowed to buy a home or finance a small business, odds are good that the U.S. stood behind you or the firm that served you.

Washington pumped $245 billion into nearly 700 banks and insurance companies and guaranteed almost $350 billion of bank debt. It made short-term loans of more than $300 billion to blue-chip companies. It propped up life insurers and money-market funds.

It bailed out two of the three U.S. auto makers. It lent billions trying to jump-start commercial-real-estate, small-business and credit-card lending. In two February stimulus bills enacted a year apart, the government committed $955 billion to rouse the economy.

Today the U.S. government, directly or indirectly, underwrites nine of every 10 new residential mortgages, nearly twice the percentage before the crisis. Just last week, the Treasury said it would cover an unlimited amount of losses at mortgage giants Fannie Mae and Freddie Mac through 2012.

Those who defend this robust interventionism and those who decry its effects are vying to shape the nation's take on the events of the past 16 months.

Lawrence Summers, President Barack Obama's chief economic adviser, says the intervention was essential, short-term therapy, not a reinvention of capitalism. "Our overarching goal was to save an economy that was near the abyss, where depression looked like a real possibility," he says. By that measure, he sees success: "The kind of financial and economic collapse that looked very possible last fall appears remote right now."

The bailouts "were designed to be, and have proved to be, temporary," Mr. Summers says. "There is no aspiration of any kind to change the private-sector basis of our economy."

Even so, he says government won't return to its pre-crisis form. "The way our financial system was operating was much more fragile than many had supposed. Those events point up a need for substantial changes in the way in which we regulate the economy and regulate finance," he says.

John Taylor, a former Bush Treasury official who is now a Stanford University economist, says the government's role will be far greater than Mr. Summers suggests. "While we may be past the emergency, we're still in a mode that will create similar interventions for quite a while, even for minor emergencies," he says. "We have a bailout mentality in this country."

One concern: Even if the government withdraws, business will expect bailouts in the next crisis, and that will inspire another round of cavalier risk-taking. "If we don't re-regulate the banking system properly, we'll either get very slow growth from overregulation, or another financial crisis in just 10 to 15 years," says Kenneth Rogoff, a Harvard University economist and co-author of a new book on financial crises since the Middle Ages.

The story isn't over yet.

Although the economy is growing, unemployment remains a very high 10%. It is far from clear how strongly the economy will grow when the adrenaline of stimulus is withdrawn.

In finance, the recovery has been striking. Since bottoming on March 9, the Dow Jones Industrial Average is up 60%, and financial stocks have more than doubled. Yields on junk bonds, issued by companies with the highest risk of default, have fallen from almost 17 percentage points above yields on Treasury bonds in March to about 6.5 points higher now. That signals both an improving economy and a renewed investor appetite for risk.

Most big banks appear back on their feet. Of the $245 billion invested in bank shares by the Troubled Asset Relief Program, more than $175 billion has been repaid. Since the Treasury tested the financial strength of 19 large financial firms in May, they have raised $136 billion in equity capital and borrowed $64 billion without U.S. guarantees.

But the strengthening of the big banks may be distorting the market. Although smaller banks have long had a higher cost of funds than big ones, the gap has widened. The gap averaged 0.03 percentage point for the first seven years of the decade, but it jumped to a 0.66-point disadvantage for smaller banks in the four quarters ended Sept. 30, estimates Dean Baker of the Center for Economic and Policy Research, a liberal think tank. That suggests investors think the government would bail out big banks, but not small ones, if crisis erupted anew, he says.

Not all of the rescues look successful. The U.S. had to redo its initial bailouts of giant insurer American International Group Inc. and of GMAC Financial Services, which was once a car-finance and mortgage firm and is now a bank holding company. Both remain unable to raise private capital.

The intervention comes with long-lasting costs, among them huge budget deficits that could eventually push up inflation and interest rates.

The International Monetary Fund estimates U.S. government debt will swell to the equivalent of 108% of annual economic output in 2014, from 62% in 2007, absent politically difficult steps such as raising taxes or cutting benefit programs. As federal debt climbs, an ever-greater fraction of the budget goes just to pay interest, much of it to overseas creditors. The bill will worsen if interest rates rise from their current low levels.

Interest on the debt cost $182 billion in the fiscal year ended Sept. 30. Robert Pozen, chairman of MBS Investment Management, worries that within a decade, the interest bill could rival the defense budget, which was $637 billion last year.

The interventions also carry political costs. Their chief architects -- Fed Chairman Ben Bernanke, Treasury Secretary Timothy Geithner and former Treasury chief Henry Paulson -- say saving Wall Street was essential to saving Main Street. Many Americans, and a vocal group of lawmakers, disagree.

Only 21% of Americans polled by The Wall Street Journal and NBC News in December said they trusted the government to "do what is right," versus 64% shortly after the attacks of Sept. 11, 2001. In Congress, there is growing support for having the Government Accountability Office review the Fed's monetary policy, a move the Fed says would crimp its independence.

For some businesses, Washington now looms larger, affecting everything from the choice of executives to the fate of car dealerships. U.S. Bancorp has repaid its TARP money, but CEO Richard Davis nonetheless checked with Fed regulators in December to make sure it would be all right for the Minneapolis-based bank to raise its dividend. "We are still awaiting this guidance," Mr. Davis said in a statement announcing that the bank would retain its dividend level for now.

Bank of America Corp. also has repaid its aid, freeing itself from the condition lenders hate most about the bailouts: Treasury oversight of executive pay. Even so, it sought the Treasury's advice on a pay package before hiring a new chief executive.

The bank was considering paying $35 million to $40 million to hire Robert Kelly, CEO of Bank of New York Mellon Corp., much of it to buy out his unvested shares and options. The Bank of America board wanted to know how that would go over in Washington. Treasury paymaster Kenneth Feinberg told the bank that if it were still under his purview, he would reject the package. Around the same time, President Obama publicly bashed "fat cat" bankers.

With those two signals, the talks with Mr. Kelly fizzled, according to officials involved with the decision. The bank instead promoted an insider, Brian Moynihan, who had been working to repair the bank's reputation in Washington.

It thus chose a more politic man to lead it, post-crisis, than departing CEO Kenneth Lewis, who in a March meeting with the president had said he wouldn't "suck up" to federal economic aides, according to people familiar with the exchange. Mr. Moynihan, by contrast, told Obama aides in October that Bank of America wanted to work with the White House to achieve U.S. policy goals in areas like small-business lending and foreclosure prevention. As for his pay, Mr. Moynihan asked that it be determined later.

In the insurance business, some of the strong are complaining that the U.S. is warping the market by keeping the weak on life support.

Edmund "Ted" Kelly, chief executive of Boston-based insurer Liberty Mutual Group, points to the case of competitor Hartford Financial Services Group Inc. After acquiring a thrift and qualifying as a bank holding company, Hartford got $3.4 billion of TARP funds in June.

Liberty Mutual says it didn't ask for cash, and doesn't see why Hartford got any. "Nothing would have happened to the economy if Hartford failed," Mr. Kelly said. Hartford declined to comment.

The nature of post-crisis capitalism will depend in part on how the administration and Congress wield their new power. Inside Washington, there is profound ambivalence about this. Should the government, for instance, be an activist shareholder demanding change, like a Carl Icahn, or a passive one like an index mutual fund?

Herbert Allison, who left the private sector to run TARP, says, "We can't wait to get out of these investments. We don't view ourselves as a long-term investor." But in the here and now, the government is torn between its roles as shareholder and guardian of the public interest.

At Fannie Mae and Freddie Mac, where the Treasury holds warrants allowing it to acquire stakes of nearly 80%, the administration has put public interest first. It has instructed their regulator to have them administer efforts to cut monthly mortgage payments for millions of Americans to avert foreclosure.

The disagreements over how to wield power over business are playing out both within the Obama administration and between the administration and Congress -- as is happening now in the auto industry.

The White House forced out a CEO of General Motors in March, and crafted car-maker bankruptcy restructurings that drew howls from some creditors. But it later lightened its hand. It appointed a board of private-sector directors and let that board oversee GM. The board, six months later, was able to fire a subsequent CEO without getting prior White House approval, according to Treasury officials.

Congress isn't so willing to surrender its leverage. That was clear when GM and Chrysler decided to terminate about 3,400 dealers. Many turned to their lawmakers, and Congress got involved, prompting the companies to reinstate about 110. But the dealers felt that was insufficient.

GM's frustration with the process boiled over at a mid-November meeting in the office of Sen. Richard Durbin (D., Ill.). GM's usually cool-headed chief lobbyist, Ken Cole, was too agitated to sit, say several participants. When Tammy Darvish, an executive of a dealership in Silver Spring, Md., pressed Mr. Cole about whether it would cost the company any money to reinstate a terminated dealer, the GM team started to pack their briefcases and threatened to walk out, according to Ms. Darvish and a government participant in the meeting. They say the GM team stayed only at the insistence of congressional staffers.

Congress later enacted a provision giving axed dealerships broadened grounds to appeal in arbitration procedures -- broader than the White House or car companies sought.

A spokesman for GM declined to comment on the dealers meeting or Mr. Cole. But the auto maker, now 60% federally owned, said the arbitration law will hurt its efforts to turn a profit and repay the government, which has invested roughly $50 billion in the company.

from the Wall Street Journal, 2009-Dec-16, p.A26:

The Audacity of Debt
Comparing today's deficits to those in the 1980s.

At least someone in America isn't feeling a credit squeeze: Uncle Sam. This week Congress will vote to raise the national debt ceiling by nearly $2 trillion, to a total of $14 trillion. In this economy, everyone de-leverages except government.

It's a sign of how deep the fiscal pathologies run in this Congress that $2 trillion will buy the federal government only one year before it has to seek another debt hike—conveniently timed to come after the midterm elections. Since Democrats began running Congress again in 2007, the federal debt limit has climbed by 39%. The new hike will lift the borrowing cap by another 15%.

There is surely bipartisan blame for this government debt boom. George W. Bush approved gigantic spending increases for Medicare and bailouts. He also sponsored the first ineffective "stimulus" in February 2008—consisting of $168 billion in tax rebates and spending that depleted federal revenues in return for no economic lift.

Democrats ridiculed Mr. Bush as "the most fiscally irresponsible President in history," but then they saw him and raised. They took an $800 billion deficit and made it $1.4 trillion in 2009 and perhaps that high again in 2010. In 10 months they have approved more than $1 trillion in spending that has saved union public jobs but has done little to assist private job creation. Still to come is the multitrillion-dollar health bill and another $100 billion to $200 billion "jobs" bill.

We've never obsessed over the budget deficit, because the true cost of government is the amount it spends, not the amount it borrows. Milton Friedman used to say that the nation would be far better off with a budget half the current size but with larger deficits. Mr. Obama and his allies in Congress have done the opposite: They have increased the budget by 50% and financed the spending with IOUs.

Our concern is that the Administration and Congress view this debt as a way to force a permanently higher tax base for decades to come. The liberal grand strategy is to use their accidentally large majorities this year to pass new entitlements that start small but will explode in future years. U.S. creditors will then demand higher taxes—taking income taxes back to their pre-Reagan rates and adding a value-added tax too. This would expand federal spending as a share of GDP to as much as 30% from the pre-crisis 20%.

Remember the 1980s and 1990s when liberals said they worried about the debt? We now know they were faking it. When the Gipper chopped income and business tax rates by roughly 25% and then authorized a military build-up, Democrats and their favorite economists predicted doom for a decade. The late Paul Samuelson, the revered dean of the neo-Keynesians, expressed the prevailing view in those days when he called the Reagan deficits "an all-consuming evil."

But wait: Those "evil" Reagan deficits averaged less than $200 billion a year, or about one-quarter as large in real terms as today's deficit. The national debt held by the public reached its peak in the Reagan years at 40.9%, and hit 49.2% in 1995. This year debt will hit 61% of GDP, heading to 68% soon even by the White House's optimistic estimates.

Our view is that there is good and bad public borrowing. In the 1980s federal deficits financed a military buildup that ended the Cold War (leading to an annual peace dividend in the 1990s of 3% of GDP), as well as tax cuts that ended the stagflation of the 1970s and began 25 years of prosperity. Those were high return investments.

Today's debt has financed . . . what exactly? The TARP money did undergird the financial system for a time and is now being repaid. But most of the rest has been spent on a political wish list of public programs ranging from unemployment insurance to wind turbines to tax credits for golf carts. Borrowing for such low return purposes makes America poorer in the long run.

By the way, today's spending and debt totals don't account for the higher debt-servicing costs that are sure to come. The President's own budget office forecasts that annual interest payments by 2019 will be $774 billion, which will be more than the federal government will spend that year on national defense, education, transportation—in fact, all nondefense discretionary programs.

Democrats want to pass the debt limit increase as a stowaway on the defense funding bill, hoping that few will notice while pledging to reduce spending at some future date. Republicans ought to force a long and careful debate that educates the public. Ultimately, the U.S. government has to pay its bills and the debt limit bill will have to pass. But debt limit votes are one of the few times historically when taxpayer advocates have leverage on Capitol Hill. Republicans and Democrats who care should use it to discuss genuine ways to put Washington on a renewed and tighter spending regime.

"Washington is shifting the burden of bad choices today onto the backs of our children and grandchildren," Senator Barack Obama said during the 2006 debt-ceiling debate. "America has a debt problem and a failure of leadership. Americans deserve better." That was $2 trillion ago, when someone else was President.

from the Wall Street Journal, 2009-Dec-5, by James Grant:

Requiem for the Dollar

Ben S. Bernanke doesn't know how lucky he is. Tongue-lashings from Bernie Sanders, the populist senator from Vermont, are one thing. The hangman's noose is another. Section 19 of this country's founding monetary legislation, the Coinage Act of 1792, prescribed the death penalty for any official who fraudulently debased the people's money. Was the massive printing of dollar bills to lift Wall Street (and the rest of us, too) off the rocks last year a kind of fraud? If the U.S. Senate so determines, it may send Mr. Bernanke back home to Princeton. But not even Ron Paul, the Texas Republican sponsor of a bill to subject the Fed to periodic congressional audits, is calling for the Federal Reserve chairman's head.

I wonder, though, just how far we have really come in the past 200-odd years. To give modernity its due, the dollar has cut a swath in the world. There's no greater success story in the long history of money than the common greenback. Of no intrinsic value, collateralized by nothing, it passes from hand to trusting hand the world over. More than half of the $923 billion's worth of currency in circulation is in the possession of foreigners.

In ancient times, the solidus circulated far and wide. But it was a tangible thing, a gold coin struck by the Byzantine Empire. Between Waterloo and the Great Depression, the pound sterling ruled the roost. But it was convertible into gold—slip your bank notes through a teller's window and the Bank of England would return the appropriate number of gold sovereigns. The dollar is faith-based. There's nothing behind it but Congress.

But now the world is losing faith, as well it might. It's not that the dollar is overvalued—economists at Deutsche Bank estimate it's 20% too cheap against the euro. The problem lies with its management. The greenback is a glorious old brand that's looking more and more like General Motors.

You get the strong impression that Mr. Bernanke fails to appreciate the tenuousness of the situation—fails to understand that the pure paper dollar is a contrivance only 38 years old, brand new, really, and that the experiment may yet come to naught. Indeed, history and mathematics agree that it will certainly come to naught. Paper currencies are wasting assets. In time, they lose all their value. Persistent inflation at even seemingly trifling amounts adds up over the course of half a century. Before you know it, that bill in your wallet won't buy a pack of gum.

For most of this country's history, the dollar was exchangeable into gold or silver. "Sound" money was the kind that rang when you dropped it on a counter. For a long time, the rate of exchange was an ounce of gold for $20.67. Following the Roosevelt devaluation of 1933, the rate of exchange became an ounce of gold for $35. After 1933, only foreign governments and central banks were privileged to swap unwanted paper for gold, and most of these official institutions refrained from asking (after 1946, it seemed inadvisable to antagonize the very superpower that was standing between them and the Soviet Union). By the late 1960s, however, some of these overseas dollar holders, notably France, began to clamor for gold. They were well-advised to do so, dollars being in demonstrable surplus. President Richard Nixon solved that problem in August 1971 by suspending convertibility altogether. From that day to this, in the words of John Exter, Citibanker and monetary critic, a Federal Reserve "note" has been an "IOU nothing."

To understand the scrape we are in, it may help, a little, to understand the system we left behind. A proper gold standard was a well-oiled machine. The metal actually moved and, so moving, checked what are politely known today as "imbalances." Say a certain baseball-loving North American country were running a persistent trade deficit. Under the monetary system we don't have and which only a few are yet even talking about instituting, the deficit country would remit to its creditors not pieces of easily duplicable paper but scarce gold bars. Gold was money—is, in fact, still money—and the loss would set in train a series of painful but necessary adjustments in the country that had been watching baseball instead of making things to sell. Interest rates would rise in that deficit country. Its prices would fall, its credit would be curtailed, its exports would increase and its imports decrease. At length, the deficit country would be restored to something like competitive trim. The gold would come sailing back to where it started. As it is today, dollars are piled higher and higher in the vaults of America's Asian creditors. There's no adjustment mechanism, only recriminations and the first suggestion that, from the creditors' point of view, enough is enough.

So in 1971, the last remnants of the gold standard were erased. And a good thing, too, some economists maintain. The high starched collar of a gold standard prolonged the Great Depression, they charge; it would likely have deepened our Great Recession, too. Virtue's the thing for prosperity, they say; in times of trouble, give us the Ben S. Bernanke school of money conjuring. There are many troubles with this notion. For one thing, there is no single gold standard. The version in place in the 1920s, known as the gold-exchange standard, was almost as deeply flawed as the post-1971 paper-dollar system. As for the Great Recession, the Bernanke method itself was a leading cause of our troubles. Constrained by the discipline of a convertible currency, the U.S. would have had to undergo the salutary, unpleasant process described above to cure its trade deficit. But that process of correction would—I am going to speculate—have saved us from the near-death financial experience of 2008. Under a properly functioning gold standard, the U.S. would not have been able to borrow itself to the threshold of the poorhouse.

Anyway, starting in the early 1970s, American monetary policy came to resemble a game of tennis without the net. Relieved of the irksome inhibition of gold convertibility, the Fed could stop worrying about the French. To be sure, it still had Congress to answer to, and the financial markets, as well. But no more could foreigners come calling for the collateral behind the dollar, because there was none. The nets came down on Wall Street, too. As the idea took hold that the Fed could meet any serious crisis by carpeting the nation with dollar bills, bankers and brokers took more risks. New forms of business organization encouraged more borrowing. New inflationary vistas opened.

Not that the architects of the post-1971 game set out to lower the nets. They believed they'd put up new ones. In place of such gold discipline as remained under Bretton Woods—in truth, there wasn't much—markets would be the monetary judges and juries. The late Walter Wriston, onetime chairman of Citicorp, said that the world had traded up. In place of a gold standard, it now had an "information standard." Buyers and sellers of the Treasury's notes and bonds, on the one hand, or of dollars, yen, Deutschemarks, Swiss francs, on the other, would ride herd on the Fed. You'd know when the central bank went too far because bond yields would climb or the dollar exchange rate would fall. Gold would trade like any other commodity, but nobody would pay attention to it.

I check myself a little in arraigning the monetary arrangements that have failed us so miserably these past two years. The lifespan of no monetary system since 1880 has been more than 30 or 40 years, including that of my beloved classical gold standard, which perished in 1914. The pure paper dollar regime has been a long time dying. It was no good portent when the tellers' bars started coming down from neighborhood bank branches. The uncaged teller was a sign that Americans had began to conceive an elevated opinion of the human capacity to manage financial risk. There were other evil omens. In 1970, Wall Street partnerships began to convert to limited liability corporations—Donaldson, Lufkin & Jenrette was the first to make the leap, Goldman Sachs, among the last, in 1999. In a partnership, the owners are on the line for everything they have in case of the firm's bankruptcy. No such sword of Damocles hangs over the top executives of a corporation. The bankers and brokers incorporated because they felt they needed more capital, more scale, more technology—and, of course, more leverage.

In no phase of American monetary history was every banker so courageous and farsighted as Isaias W. Hellman, a progenitor of an institution called Farmers & Merchants Bank and of another called Wells Fargo. Operating in southern California in the late 1880s, Hellman arrived at the conclusion that the Los Angeles real-estate market was a bubble. So deciding—the prices of L.A. business lots had climbed to $5,000 from $500 in one short year—he stopped lending. The bubble burst, and his bank prospered. Safety and soundness was Hellman's motto. He and his depositors risked their money side-by-side. The taxpayers didn't subsidize that transaction, not being a party to it.

In this crisis, of course, with latter-day Hellmans all too scarce in the banking population, the taxpayers have born an unconscionable part of the risk. Wells Fargo itself passed the hat for $25 billion. Hellmans are scarce because the federal government has taken away their franchise. There's no business value in financial safety when the government bails out the unsafe. And by bailing out a scandalously large number of unsafe institutions, the government necessarily puts the dollar at risk. In money, too, the knee bone is connected to the thigh bone. Debased banks mean a debased currency (perhaps causation works in the other direction, too).

Many contended for the hubris prize in the years leading up to the sorrows of 2008, but the Fed beat all comers. Under Mr. Bernanke, as under his predecessor, Alan Greenspan, our central bank preached the doctrine of stability. The Fed would iron out the business cycle, promote full employment, pour oil on the waters of any and every major financial crisis and assure stable prices. In particular, under the intellectual leadership of Mr. Bernanke, the Fed would tolerate no sagging of the price level. It would insist on a decent minimum of inflation. It staked out this position in the face of the economic opening of China and India and the spread of digital technology. To the common-sense observation that these hundreds of millions of willing new hands, and gadgets, might bring down prices at Wal-Mart, the Fed turned a deaf ear. It would save us from "deflation" by generating a sweet taste of inflation (not too much, just enough). And it would perform these feats of macroeconomic management by pushing a single interest rate up or down.

It was implausible enough in the telling and has turned out no better in the doing. Nor is there any mystery why. The Fed's M.O. is price control. It fixes the basic money market interest rate, known as the federal funds rate. To arrive at the proper rate, the monetary mandarins conduct their research, prepare their forecast—and take a wild guess, just like the rest of us. Since December 2008, the Fed has imposed a funds rate of 0% to 0.25%. Since March of 2009, it has bought just over $1 trillion of mortgage-backed securities and $300 billion of Treasurys. It has acquired these assets in the customary central-bank manner, i.e., by conjuring into existence the money to pay for them. Yet—a measure of the nation's lingering problems—the broadly defined money supply isn't growing but dwindling.

The Fed's miniature interest rates find favor with debtors, disfavor with savers (that doughty band). All may agree, however, that the bond market has lost such credibility it once had as a monetary-policy voting machine. Whether or not the Fed is cranking too hard on the dollar printing press is, for professional dealers and investors, a moot point. With the cost of borrowing close to zero, they are happy as clams (that is, they can finance their inventories of Treasurys and mortgage-backed securities at virtually no cost). The U.S. government securities market has been conscripted into the economic-stimulus program.

Neither are the currency markets the founts of objective monetary information they perhaps used to be. The euro trades freely, but the Chinese yuan is under the thumb of the People's Republic. It tells you nothing about the respective monetary policies of the People's Bank and the Fed to observe that it takes 6.831 yuan to make a dollar. It's the exchange rate that Beijing wants.

On the matter of comparative monetary policies, the most expressive market is the one that the Fed isn't overtly manipulating. Though Treasury yields might as well be frozen, the gold price is soaring (it lost altitude on Friday). Why has it taken flight? Not on account of an inflation problem. Gold is appreciating in terms of all paper currencies—or, alternatively, paper currencies are depreciating in terms of gold—because the world is losing faith in the tenets of modern central banking. Correctly, the dollar's vast non-American constituency understands that it counts for nothing in the councils of the Fed and the Treasury. If 0% interest rates suit the U.S. economy, 0% will be the rate imposed. Then, too, gold is hard to find and costly to produce. You can materialize dollars with the tap of a computer key.

Let me interrupt myself to say that I am not now making a bullish investment case for gold (I happen to be bullish, but it's only an opinion). The trouble with 0% interest rates is that they instigate speculation in almost every asset that moves (and when such an immense market as that in Treasury securities isn't allowed to move, the suppressed volatility finds different outlets). By practicing price, or interest-rate, control, the Bank of Bernanke fosters a kind of alternative financial reality. Let the buyer beware—of just about everything.

A proper gold standard promotes balance in the financial and commercial affairs of participating nations. The pure paper system promotes and perpetuates imbalances. Not since 1976 has this country consumed less than it produced (as measured by the international trade balance): a deficit of 32 years and counting. Why has the shortfall persisted for so long? Because the U.S., uniquely, is allowed to pay its bills in the currency that only it may lawfully print. We send it west, to the central banks of our Asian creditors. And they, obligingly, turn right around and invest the dollars in America's own securities. It's as if the money never left home. Stop to ask yourself, American reader: Is any other nation on earth so blessed as we?

There is, however, a rub. The Asian central banks do not acquire their dollars with nothing. Rather, they buy them with the currency that they themselves print. Some of this money they manage to sweep under the rug, or "sterilize," but a good bit of it enters the local payment stream, where it finances today's rowdy Asian bull markets.

A monetary economist from Mars could only scratch his pointy head at our 21st century monetary arrangements. What is a dollar? he might ask. No response. The Martian can't find out because the earthlings don't know. The value of a dollar is undefined. Its relationship to other currencies is similarly contingent. Some exchange rates float, others sink, still others are lashed to the dollar (whatever it is). Discouraged, the visitor zooms home.

Neither would the ghosts of earthly finance know what to make of things if they returned for a briefing from wherever they were spending eternity. Someone would have to tell Alexander Hamilton that his system of coins is defunct, as is, incidentally, the federal sinking fund he devised to retire the public debt (it went out of business in 1960). He might have to hear it more than once to understand, but Congress no longer "coins" money and regulates the value thereof. Rather, it delegates the work to Mr. Bernanke, who, a noted student of the Great Depression, believes that the cure for borrowing too much money is printing more money.

Walter Bagehot, the Victorian English financial journalist, would be in for a jolt, too. It would hardly please him to hear that the Fed had invoked the authority of his name to characterize its helter-skelter interventions of the past year. In a crisis, Bagehot wrote in his 1873 study "Lombard Street," a central bank should lend without stint to solvent institutions at a punitive rate of interest against sound collateral. At least, Bagehot's shade might console itself, the Fed was faithful to the text on one point. It did lend without stint.

If Bagehot's ghost would be chagrined, that of Bagehot's sparring partner, Thomson Hankey, would be exultant. Hankey, a onetime governor of the Bank of England, denounced Bagehot in life. No central bank should stand ready to bail out the imprudent, he maintained. "I cannot conceive of anything more likely to encourage rash and imprudent speculation..., " wrote Hankey in response to Bagehot. "I am no advocate for any legislative enactments to try and make the trading community more prudent."

Hankey believed in the price system. It might pain him to discover that his professional descendants have embraced command and control. "We should have required [banks to hold] more capital, more liquidity," Mr. Bernanke rued in a Senate hearing on Thursday. "We should have required more risk management controls." Roll over, Isaias Hellman.

So our Martian would be mystified and our honored dead distressed. And we, the living? We are none too pleased ourselves. At least, however, being alive, we can begin to set things right. The thing to do, I say, is to restore the nets to the tennis courts of money and finance. Collateralize the dollar—make it exchangeable into something of genuine value. Get the Fed out of the price-fixing business. Replace Ben Bernanke with a latter-day Thomson Hankey. Find—cultivate—battalions of latter-day Hellmans and set them to running free-market banks. There's one more thing: Return to the statute books Section 19 of the 1792 Coinage Act, but substitute life behind bars for the death penalty. It's the 21st century, you know.

James Grant, editor of Grant's Interest Rate Observer, is the author, most recently, of "Mr. Market Miscalculates" (Axios Press).

from the Wall Street Journal, 2009-Nov-6, by Mark Spitznagel:

The Man Who Predicted the Depression
Ludwig von Mises explained how government-induced credit expansions led to imbalances in the economy.

Ludwig von Mises was snubbed by economists world-wide as he warned of a credit crisis in the 1920s. We ignore the great Austrian at our peril today.

Mises's ideas on business cycles were spelled out in his 1912 tome "Theorie des Geldes und der Umlaufsmittel" ("The Theory of Money and Credit"). Not surprisingly few people noticed, as it was published only in German and wasn't exactly a beach read at that.

Taking his cue from David Hume and David Ricardo, Mises explained how the banking system was endowed with the singular ability to expand credit and with it the money supply, and how this was magnified by government intervention. Left alone, interest rates would adjust such that only the amount of credit would be used as is voluntarily supplied and demanded. But when credit is force-fed beyond that (call it a credit gavage), grotesque things start to happen.

Government-imposed expansion of bank credit distorts our "time preferences," or our desire for saving versus consumption. Government-imposed interest rates artificially below rates demanded by savers leads to increased borrowing and capital investment beyond what savers will provide. This causes temporarily higher employment, wages and consumption.

Ordinarily, any random spikes in credit would be quickly absorbed by the system—the pricing errors corrected, the half-baked investments liquidated, like a supple tree yielding to the wind and then returning. But when the government holds rates artificially low in order to feed ever higher capital investment in otherwise unsound, unsustainable businesses, it creates the conditions for a crash. Everyone looks smart for a while, but eventually the whole monstrosity collapses under its own weight through a credit contraction or, worse, a banking collapse.

The system is dramatically susceptible to errors, both on the policy side and on the entrepreneurial side. Government expansion of credit takes a system otherwise capable of adjustment and resilience and transforms it into one with tremendous cyclical volatility.

"Theorie des Geldes" did not become the playbook for policy makers. The 1920s were marked by the brave new era of the Federal Reserve system promoting inflationary credit expansion and with it permanent prosperity. The nerve of this Doubting-Thomas, perma-bear, crazy Kraut! Sadly, poor Ludwig was very nearly alone in warning of the collapse to come from this credit expansion. In mid-1929, he stubbornly turned down a lucrative job offer from the Viennese bank Kreditanstalt, much to the annoyance of his fiancée, proclaiming "A great crash is coming, and I don't want my name in any way connected with it."

We all know what happened next. Pretty much right out of Mises's script, overleveraged banks (including Kreditanstalt) collapsed, businesses collapsed, employment collapsed. The brittle tree snapped. Following Mises's logic, was this a failure of capitalism, or a failure of hubris?

Mises's solution follows logically from his warnings. You can't fix what's broken by breaking it yet again. Stop the credit gavage. Stop inflating. Don't encourage consumption, but rather encourage saving and the repayment of debt. Let all the lame businesses fail—no bailouts. (You see where I'm going with this.) The distortions must be removed or else the precipice from which the system will inevitably fall will simply grow higher and higher.

Mises started getting some much-deserved respect once "Theorie des Geldes" was finally published in English in 1934. It is unfortunate that it required such a disaster for people to take heed of what was the one predictive, scholarly explanation of what was happening.

But then, just Mises's bad luck, along came John Maynard Keynes's tome "The General Theory of Employment, Interest and Money" in 1936. Keynes was dapper, fresh and sophisticated. He even wrote in English! And the guy had chutzpah, fearlessly fighting the battle against unemployment by running the currency printing press and draining the government's coffers.

He was the anti-Mises. So what if Keynes had lost his shirt in the stock-market crash. His book was peppered with fancy math (even Greek letters) and that meant rigor, modernity. To add insult to injury, Mises wasn't even refuted by Keynes and his ilk. He was ignored.

Fast forward 70-some years, during which we saw Keynesianism's repeated disappointments, the end of the gold standard, persistent inflation with intermittent inflationary recessions and banking crises, culminating in Alan Greenspan's "Great Moderation" and a subsequent catastrophic collapse in housing and banking. Where do we find ourselves? At a point of profound insight gained through economic logic, trial and error, and objective empiricism? Or right back where we started?

With interest rates at zero, monetary engines humming as never before, and a self-proclaimed Keynesian government, we are back again embracing the brave new era of government-sponsored prosperity and debt. And, more than ever, the system is piling uncertainties on top of uncertainties, turning an otherwise resilient economy into a brittle one.

How curious it is that the guy who wrote the script depicting our never ending story of government-induced credit expansion, inflation and collapse has remained so persistently forgotten. Must we sit through yet another performance of this tragic tale?

Mr. Spitznagel is the founder and chief investment officer of the hedge fund Universa Investments LP, based in Santa Monica, Calif.

from the Wall Street Journal, 2009-Nov-11, by Judy Shelton:

The Fed's Woody Allen Policy
Efforts to stoke a recovery may be creating new asset bubbles in equities and elsewhere.

In the Woody Allen film "Annie Hall," the main character tries to explain irrational relationships by recounting an old joke. "This guy goes to a psychiatrist and says, 'My brother's crazy, he thinks he's a chicken.' The doctor says, 'Well, why don't you turn him in?' And the guy says, 'I would, but I need the eggs.'"

It takes similar reasoning to reconcile the elation felt across America every time the stock market rises—partially replenishing personal investment portfolios and 401(k) retirement plans—with the uneasy feeling that we are being set up for yet another big financial disappointment. We dare to hope that the economy is growing solidly once more, that the Federal Reserve has superior knowledge about providing liquidity, and that the U.S. Treasury knows what it's doing by guaranteeing money market-fund assets.

But what if the Fed's efforts to stoke a recovery are merely creating asset bubbles in equities and elsewhere? What if government guarantees—explicit and implicit—are encouraging high-risk investment behavior rather than restoring conditions for normal market returns? What if excess dollars produced here are being channeled by speculators into foreign stock and bond markets as part of a currency play?

The Fed's decision last week to keep pumping out money at near-zero interest rates is worrisome. In its statement, the Federal Open Market Committee (FOMC) notes that "low rates of resource utilization" are the main justification for continuing to make funds available to banks at "exceptionally low levels of the federal funds rate for an extended period"—by which it means that banks can continue to borrow at 0%-0.25% and then lend the money out to borrowers seeking to earn much higher returns. The FOMC cites "subdued inflation trends" and "stable inflation expectations" as reassuring evidence that money is not being created in excess.

Meanwhile, the Labor Department's announcement last Friday that unemployment surpassed 10% certainly testifies to "low rates of resource utilization," i.e., the considerable slack in the economy. From the Fed's point of view, the nearly 16 million people who can't find jobs represent the "output gap" between actual and potential gross domestic product. If everyone were gainfully employed, so the reasoning goes, there would be pressure on employers to raise wages and the increased cost would be reflected as inflation. Since core inflation is running low— 1.5% as measured by the consumer price index, 1.3% as measured by personal consumption expenditures (the price index preferred by the Fed)—it follows that money can be manufactured with impunity for the foreseeable future.

But wait a minute. If unemployment is high, doesn't that indicate a surplus of labor relative to the demand for labor? Wouldn't that cause the price of labor to come down? If you throw in the fact that industrial capacity utilization, at 70%, is lower now than during any prior recession since the Fed began tracking it in 1967, and that the housing vacancy rate is nearly 11%, you begin to wonder why the price level should nevertheless continue to rise, even by a little bit, every month.

"With substantial resource slack likely to continue to dampen cost pressures," as the FOMC statement so convincingly affirms, it hardly makes sense that "subdued" inflation should provide comfort. Why should there be any inflation at all?

Maintaining stable prices, after all, is one of the Fed's primary missions. The notion of price stability over time suggests that when the economy is going through a deep recession, the level of prices might reasonably be expected to come down.

Deflation is seen as the bugaboo of Keynesian economics. But it can actually serve to spur economic activity as lower prices enable struggling consumers to get back in the game, and enterprising individuals can build businesses using tangible assets that yield valid profits.

But the Fed seems to think that prices should only go in one direction—up—no matter the circumstances. It's this bias toward inflation that is revealed by the FOMC's reference to "stable inflation expectations"—which is less a paean to price stability than an inadvertent oxymoron.

The Fed's asymmetrical thinking extends as well to its treatment of financial assets—such as equity and debt instruments—en route to a bubble. As prices surge and markets soar, the Fed is reluctant to raise interest rates lest it be accused of hindering growth. But when the bubble bursts and asset prices begin to tumble, the Fed quickly steps in with dramatic interest rate reductions to "restore investor confidence" in hopes of avoiding a meltdown.

In the last eight months, the Dow Jones Industrial Average has risen from its March 6 low of 6470 to over 10290 today, a gain of roughly 59%. The Nasdaq Composite Index and the S&P 500 Index have likewise increased about 71% and 65%, respectively, since early March. Are we looking at the restoration of legitimate values or the emergence of disastrous new asset price bubbles?

The answer would seem to lie in whether the Fed's money machine is fueling an illusory recovery that is only manifested in financial markets as opposed to the general economy. The FOMC's own report acknowledges that economic activity remains weak, household spending is constrained, and businesses are still cutting back on fixed investment and staffing.

Indeed, the Fed insists that "tight credit" conditions still persist; doubtless, there are many small business owners who could attest to that reality. But looking at the huge increase in financial asset prices across broad indices—not just in America, but globally—you would never guess that monetary policy could be anything but loose.

Now here's the scary part: Even though more than half of all American households now own equities directly or through mutual funds, an increase in equity prices does not figure into the Fed's calculation of inflation. So while measures of core inflation (which exclude food and energy) carefully register minute gains in the price of a fixed basket of goods and services meant to reflect what a typical family buys to achieve a minimum standard of living, they ignore massive price surges in what has effectively become a widely held consumer good: stocks.

Moreover, the Fed's inflation-targeting approach overlooks price increases for real estate and rising commodity prices. Don't even mention gold, which has gone from $707 to $1,114 since a year ago.

Even if the Fed seems blithely unaware of the havoc it may be wreaking through its irrationally loose monetary policy, in tandem with the distortions of moral hazard inflicted by intrusive government, Americans seem willing to accept the insanity of boom-and-bust cycles. Sure, we could be facing the latest Fed-induced bubble—but so what?

We need the eggs.

Ms. Shelton, an economist, is the author of "Money Meltdown" (Free Press, 1994).

from the Wall Street Journal, 2009-Dec-3, by David Malpass:

Near-Zero Rates Are Hurting the Economy
Low rate expectations are pushing dollars abroad. That capital needs to stay here to grow businesses and create jobs.

The Federal Reserve implemented an emergency monetary policy after the 2008 Lehman bankruptcy to salvage the world financial system. In his testimony yesterday before the Senate Banking Committee, Fed Chairman Ben Bernanke said, "We must be prepared to withdraw the extraordinary policy support in a smooth and timely way as markets and the economy recover."

This leaves all-out emergency monetary stimulus in place, but with a different, much weaker justification. With the system stabilized, the Fed hopes that artificially low interest rates and its purchases of mortgage-backed securities will spur growth. Instead they are pushing dollars abroad and wasting precious growth capital in asset and commodity bubbles.

Since the show of global cooperation at the Nov. 6 G-20 meeting, the rest of the world has challenged the Fed's emergency policy. Asia warned President Barack Obama on his recent trip that the zero-percent fed-funds rate was flooding Asia with excess dollars, causing asset bubbles there and undercutting global growth.

Europe quickly joined Asia's criticism. On Nov. 20, German Finance Minister Wolfgang Schäuble said that the U.S. policy threatened "enormous turbulence." European Central Bank President Jean-Claude Trichet has repeatedly tried to bolster the U.S. commitment to a strong dollar, most recently with yesterday's comment that "I trust the sincerity of the U.S. authorities."

Nevertheless, more than a year after the heart of the panic, the Fed is still promising near-zero interest rates for an extended period and buying over $3 billion per day of expensive mortgage securities as part of a $1.25 trillion purchase plan. Capital is being rationed not on price but on availability and connections. The government gets the most, foreigners second, Wall Street and big companies third, with not much left over.

The irony of the zero-rate policy, coupled with Washington's preference for a weak dollar, is a glut of American capital in Asia (as corporations and investors shun the weakening U.S. currency) and a shortage at home. For gold and oil, the low-rate policy works, weakening the dollar so commodity prices go up and providing traders with ample funds to buy into the expanding bubble. Those markets are almost daring the Fed to try to break out of its zero-rate box.

But for small businesses and new workers, capital rationing is devastating, spelling business failures and painful layoffs. Thousands of start-ups won't launch due to credit shortages, in part because the government and corporations took more credit than they needed (because it was so cheap).

Already countries with higher interest rates, Australia for one, are viewed as less risky because they have room to cut rates if there's another emergency. This wins them capital and jobs that might otherwise be ours.

According to International Monetary Fund data, U.S. GDP has fallen to 24% of world GDP from 32% in 2001. And as U.S. capital escapes the weak dollar and high tax rates, the U.S. share of world equity market capitalization has fallen to 30% from 45%. This leaves the U.S. alone with Japan at the bottom of the monetary heap, with rate expectations so low they repel investment.

Yet the Fed's not nearly as trapped as it seems. Much of its current stimulus is being diverted to commodities and foreign economies—hence Asia's complaint about bubbles. Under emergency stimulus, corporations are borrowing dollars hand-over-fist, pleasing Wall Street while using the proceeds to expand their foreign businesses. If that stimulus could be retained here, the Fed could stand down gradually from the emergency yet still assure appropriate policy accommodation.

The simple goal is to convince the capital now funding gold mines and foreign asset bubbles to instead fund small businesses and the guaranteed mortgages the Fed's been buying. This means stopping the dollar's collapse, since it is fueling the outflow.

Since U.S. inflation is relatively low, even a Fed nod toward normalcy on monetary policy (not evident in Mr. Bernanke's testimony yesterday) should cause a dramatic improvement in the dollar and the magnitude of capital flows.

The fed-funds rate can stay near zero for a while longer, but the Fed can't keep promising "exceptionally low rates for an extended period," as it did last month. The sooner the Fed moves off its policy extreme, the sooner markets can resume their job of allocating capital and assessing relative value. In a more market-oriented allocation of global capital, the U.S. will be a big winner, especially for jobs and small businesses.

If the Fed wants to speed the capital reflow, it could mention the importance of the dollar in its Dec. 16 committee statement on interest-rate policy and inflation risks. In his Nov. 16 address to the Economic Club of New York, Mr. Bernanke said policies should "help ensure that the dollar is strong and a source of global financial stability." Putting that in the Fed's policy statement—with none of the normal winks to those who favor devaluation—would cause capital to flood back into the U.S., loosening small-business credit and adding jobs even when the Fed eventually contemplates rate hikes.

If the Fed announces that an end is in sight to its all-out emergency policies, two other benefits may accrue. China should be more willing to allow yuan appreciation if it thinks there's a net under the dollar. With no net, China fears that yuan appreciation would accelerate dollar flight, driving commodities even higher. And the Fed should be able to maintain its independence, which is at risk from congressional audits as long as the deeply unsettling emergency policies persist.

Wall Street will threaten a tantrum if the Fed even thinks about damping the air-raid sirens. The Street utterly loves the Fed's largess, earning massive profits from trading unstable currencies, the carry trade (borrow short-term dollars near zero, buy longer-term assets abroad), and the high-margin process of transferring America's capital abroad.

The hitch is that there isn't much trickle-down to normal jobs and small businesses from the sophisticated, zero-rate arbitrage that is propelling asset prices ever higher. It would be better to stand down from emergency stimulus and instead help markets direct the capital that is now going into bubbles into the economy and jobs.

Mr. Malpass is president of Encima Global LLC.

from the New York Times, 2009-Nov-23, by Edmund L. Andrews:

Payback Time
Wave of Debt Payments Facing U.S. Government

WASHINGTON — The United States government is financing its more than trillion-dollar-a-year borrowing with i.o.u.'s on terms that seem too good to be true.

But that happy situation, aided by ultralow interest rates, may not last much longer.

Treasury officials now face a trifecta of headaches: a mountain of new debt, a balloon of short-term borrowings that come due in the months ahead, and interest rates that are sure to climb back to normal as soon as the Federal Reserve decides that the emergency has passed.

Even as Treasury officials are racing to lock in today's low rates by exchanging short-term borrowings for long-term bonds, the government faces a payment shock similar to those that sent legions of overstretched homeowners into default on their mortgages.

With the national debt now topping $12 trillion, the White House estimates that the government's tab for servicing the debt will exceed $700 billion a year in 2019, up from $202 billion this year, even if annual budget deficits shrink drastically. Other forecasters say the figure could be much higher.

In concrete terms, an additional $500 billion a year in interest expense would total more than the combined federal budgets this year for education, energy, homeland security and the wars in Iraq and Afghanistan.

The potential for rapidly escalating interest payouts is just one of the wrenching challenges facing the United States after decades of living beyond its means.

The surge in borrowing over the last year or two is widely judged to have been a necessary response to the financial crisis and the deep recession, and there is still a raging debate over how aggressively to bring down deficits over the next few years. But there is little doubt that the United States' long-term budget crisis is becoming too big to postpone.

Americans now have to climb out of two deep holes: as debt-loaded consumers, whose personal wealth sank along with housing and stock prices; and as taxpayers, whose government debt has almost doubled in the last two years alone, just as costs tied to benefits for retiring baby boomers are set to explode.

The competing demands could deepen political battles over the size and role of the government, the trade-offs between taxes and spending, the choices between helping older generations versus younger ones, and the bottom-line questions about who should ultimately shoulder the burden.

“The government is on teaser rates,” said Robert Bixby, executive director of the Concord Coalition, a nonpartisan group that advocates lower deficits. “We're taking out a huge mortgage right now, but we won't feel the pain until later.”

So far, the demand for Treasury securities from investors and other governments around the world has remained strong enough to hold down the interest rates that the United States must offer to sell them. Indeed, the government paid less interest on its debt this year than in 2008, even though it added almost $2 trillion in debt.

The government's average interest rate on new borrowing last year fell below 1 percent. For short-term i.o.u.'s like one-month Treasury bills, its average rate was only sixteen-hundredths of a percent.

“All of the auction results have been solid,” said Matthew Rutherford, the Treasury's deputy assistant secretary in charge of finance operations. “Investor demand has been very broad, and it's been increasing in the last couple of years.”

The problem, many analysts say, is that record government deficits have arrived just as the long-feared explosion begins in spending on benefits under Medicare and Social Security. The nation's oldest baby boomers are approaching 65, setting off what experts have warned for years will be a fiscal nightmare for the government.

“What a good country or a good squirrel should be doing is stashing away nuts for the winter,” said William H. Gross, managing director of the Pimco Group, the giant bond-management firm. “The United States is not only not saving nuts, it's eating the ones left over from the last winter.”

The current low rates on the country's debt were caused by temporary factors that are already beginning to fade. One factor was the economic crisis itself, which caused panicked investors around the world to plow their money into the comparative safety of Treasury bills and notes. Even though the United States was the epicenter of the global crisis, investors viewed Treasury securities as the least dangerous place to park their money.

On top of that, the Fed used almost every tool in its arsenal to push interest rates down even further. It cut the overnight federal funds rate, the rate at which banks lend reserves to one another, to almost zero. And to reduce longer-term rates, it bought more than $1.5 trillion worth of Treasury bonds and government-guaranteed securities linked to mortgages.

Those conditions are already beginning to change. Global investors are shifting money into riskier investments like stocks and corporate bonds, and they have been pouring money into fast-growing countries like Brazil and China.

The Fed, meanwhile, is already halting its efforts at tamping down long-term interest rates. Fed officials ended their $300 billion program to buy up Treasury bonds last month, and they have announced plans to stop buying mortgage-backed securities by the end of next March.

Eventually, though probably not until at least mid-2010, the Fed will also start raising its benchmark interest rate back to more historically normal levels.

The United States will not be the only government competing to refinance huge debt. Japan, Germany, Britain and other industrialized countries have even higher government debt loads, measured as a share of their gross domestic product, and they too borrowed heavily to combat the financial crisis and economic downturn. As the global economy recovers and businesses raise capital to finance their growth, all that new government debt is likely to put more upward pressure on interest rates.

Even a small increase in interest rates has a big impact. An increase of one percentage point in the Treasury's average cost of borrowing would cost American taxpayers an extra $80 billion this year — about equal to the combined budgets of the Department of Energy and the Department of Education.

But that could seem like a relatively modest pinch. Alan Levenson, chief economist at T. Rowe Price, estimated that the Treasury's tab for debt service this year would have been $221 billion higher if it had faced the same interest rates as it did last year.

The White House estimates that the government will have to borrow about $3.5 trillion more over the next three years. On top of that, the Treasury has to refinance, or roll over, a huge amount of short-term debt that was issued during the financial crisis. Treasury officials estimate that about 36 percent of the government's marketable debt — about $1.6 trillion — is coming due in the months ahead.

To lock in low interest rates in the years ahead, Treasury officials are trying to replace one-month and three-month bills with 10-year and 30-year Treasury securities. That strategy will save taxpayers money in the long run. But it pushes up costs drastically in the short run, because interest rates are higher for long-term debt.

Adding to the pressure, the Fed is set to begin reversing some of the policies it has been using to prop up the economy. Wall Street firms advising the Treasury recently estimated that the Fed's purchases of Treasury bonds and mortgage-backed securities pushed down long-term interest rates by about one-half of a percentage point. Removing that support could in itself add $40 billion to the government's annual tab for debt service.

This month, the Treasury Department's private-sector advisory committee on debt management warned of the risks ahead.

“Inflation, higher interest rate and rollover risk should be the primary concerns,” declared the Treasury Borrowing Advisory Committee, a group of market experts that provide guidance to the government, on Nov. 4.

“Clever debt management strategy,” the group said, “can't completely substitute for prudent fiscal policy.”

This article has been revised to reflect the following correction:

Correction: November 24, 2009
An article on Monday about ballooning debt payments for the federal government misspelled, in some copies, the surname of an economist who noted that the bill for debt service would be even higher were it not for current low interest rates. He is Alan Levenson, not Levinson. And a chart with the continuation of the article misstated, in some editions, the size of debt payments due within a year that are currently paying no more than 1 percent in interest. It is $1.9 trillion, not $2.5 trillion.

from the Wall Street Journal, 2009-Dec-26, p.A3, by James R. Hagerty and Jessica Holzer:

U.S. Move to Cover Fannie, Freddie Losses Stirs Controversy

The Obama administration's decision to cover an unlimited amount of losses at the mortgage-finance giants Fannie Mae and Freddie Mac over the next three years stirred controversy over the holiday.

The Treasury announced Thursday it was removing the caps that limited the amount of available capital to the companies to $200 billion each.

Unlimited access to bailout funds through 2012 was "necessary for preserving the continued strength and stability of the mortgage market," the Treasury said. Fannie and Freddie purchase or guarantee most U.S. home mortgages and have run up huge losses stemming from the worst wave of defaults since the 1930s.

"The timing of this executive order giving Fannie and Freddie a blank check is no coincidence," said Rep. Spencer Bachus of Alabama, the ranking Republican on the House Financial Services Committee. He said the Christmas Eve announcement was designed "to prevent the general public from taking note."

Treasury officials couldn't be reached for comment Friday.

So far, Treasury has provided $60 billion of capital to Fannie and $51 billion to Freddie. Mahesh Swaminathan, a senior mortgage analyst at Credit Suisse in New York, said he didn't believe Fannie and Freddie would need more than $200 billion apiece from the Treasury. But he and other analysts have said the market would find a larger commitment from the Treasury reassuring.

In exchange for the funding, the Treasury has received preferred stock in the companies paying 10% dividends. The Treasury also has warrants to acquire nearly 80% of the common shares in each firm.

The Treasury removed the cap on the size of available bailout funds by amending agreements it reached with the companies in September 2008, when the government seized control of the agencies under a legal process called conservatorship. The agreement allowed the Treasury to make amendments through the end of the year, without the consent of Congress. Changes made after Dec. 31 would likely involve a struggle with lawmakers over the terms.

Some Republicans are angry the administration is expanding the potential size of the bailout without having a plan for eventually ending the federal government's role in the companies.

The Treasury reiterated administration plans for a "preliminary report" on the government's future role in the mortgage market around the time the federal budget proposal is released in February.

The companies on Thursday disclosed new packages that will pay Fannie Chief Executive Officer Michael Williams and Freddie CEO Charles Haldeman Jr. as much as $6 million a year, including bonuses. The packages were approved by the Treasury and the Federal Housing Finance Agency, or FHFA, which regulates the companies.

The FHFA said compensation for executive officers of the companies in 2009, on average, is down 40% from the pay levels before the conservatorship.

Under the conservatorship, top officers of Fannie and Freddie take their cues from the Treasury and regulators on all major decisions, current and former executives say. The government has made foreclosure-prevention efforts its top priority.

The pay packages for top officers are entirely in cash; company shares have been trading on the New York Stock Exchange at less than $2 apiece, and it isn't clear when the companies will to profitability or whether common shares will have any value in the long term.

For the CEOs, annual compensation consists of a base salary of $900,000, deferred base salary of $3.1 million and incentive pay of as much as $2 million.

When Mr. Haldeman was hired by Freddie in July, the company set his base pay at $900,000 and said his additional "incentive" pay would depend on a decision by the regulator.

At Fannie, Mr. Williams was chief operating officer until he was promoted in April to CEO. As COO, his base salary was $676,000. He also had annual deferred pay of $2.3 million and a long-term incentive award of as much as $1.5 million.

Under the new packages, Fannie will pay as much as about $3.6 million annually to David M. Johnson, chief financial officer; $2.4 million to Kenneth Bacon, who heads a unit that finances apartment buildings; $2.8 million to David Benson, capital markets chief; $2.2 million to David Hisey, deputy chief financial officer; $3 million to Timothy Mayopoulos, general counsel; and $2.8 million to Kenneth Phelan, chief risk officer.

At Freddie, annual compensation will total as much as $4.5 million for Bruce Witherell, chief operating officer; $3.5 million for Ross Kari, chief financial officer; $2.8 million for Robert Bostrom, general counsel; and $2.7 million for Paul George, head of human resources.

The pay deals also drew fire. With unemployment near 10%, "to be handing out $6 million bonuses to essentially federal employees is unconscionable," said Rep. Jeb Hensarling, a Texas Republican who is a frequent critic of Fannie and Freddie.

He also criticized the administration for approving the compensation without settling on a plan to remove taxpayer supports: "To be doing that with no plan in place is just unconscionable."

The FHFA said that Fannie and Freddie "must attract and retain the talent needed" for their vital role in the mortgage market.

from the Wall Street Journal, 2009-Nov-5, by Charles Gasparino:

Three Decades of Subsidized Risk
There's a reason Dick Fuld didn't believe Lehman would be allowed to fail.

I recently sat down with legendary investor Ted Forstmann to discuss why, on the one-year anniversary of the financial meltdown, the press has largely ignored the role of government in creating the meltdown—and possibly setting the stage for another one—by allowing Wall Street to borrow cheaply and easily during the past three decades.

"I guess reporters think writing about greedy investment bankers is more interesting," Mr. Forstmann laughed.

Mr. Forstmann knows a thing or two about greedy investment bankers: He's been calling them on the carpet for years, most famously during the 1980s when he fulminated against the excesses of the junk-bond era. He also knows that blaming banking greed alone can't by itself explain the financial tsunami that tore the markets apart last year and left the banking system and the economy in tatters.

The greed merchants needed a co-conspirator, Mr. Forstmann argues, and that co-conspirator is and was the United States government.

"They're always there waiting to hand out free money," he said. "They just throw money at the problem every time Wall Street gets in trouble. It starts out when they have a cold and it builds until the risk-taking leads to cancer."

Mr. Forstmann's point shouldn't be taken lightly. Not by the press, nor by policy makers in Washington. But so far it has been, and the easy money is flowing like never before. Interest rates are close to zero; in effect the Federal Reserve is subsidizing the risk-taking and bond trading that has allowed Goldman Sachs to produce billions in profits and that infamous $16 billion bonus pool (analysts say it could grow to as high as $20 billion). The Treasury has lent banks money, guaranteed Wall Street's debt and declared every firm to be a commercial bank, from Citigroup with close to $1 trillion in U.S. deposits, to Morgan Stanley with close to zero. They are all "too big to fail" and so free to trade as they please—on the taxpayer dime.

The conventional wisdom as perpetuated in the media is that these bailout mechanisms are unique, designed to ameliorate a once-in-a-lifetime financial "perfect storm." They are unique, but only in size. A quick look back at the past three decades will demonstrate what Mr. Forstmann meant when he said the government has been ready to hand out free money nearly every time risk-taking led to losses.

The first mortgage market meltdown of the mid-1980s, spurred by the Fed's supply of easy money, was among the most painful market upheavals in the history of the bond market. The pioneers of the mortgage bond market, Lew Ranieri of Salomon Brothers and Larry Fink of First Boston (the same Larry Fink now considered a sage CEO at money management powerhouse BlackRock), lost what were then unheard-of sums of money. (Mr. Fink concedes to losses of over $100 million.)

"What happened then was a dry run of what was to come," Mr. Fink recently told me, as he looked back on the market he created, which would eventually lie at the heart of the most recent financial crisis. Wall Street took excessive risk in mortgage bonds amid the easy money supplied by the Fed—and lost. When the crisis began, the Fed under then Chairman Alan Greenspan slashed interest rates—as it would do after Orange County, Calif., declared bankruptcy in 1994 because of bad bets on complex bonds; and again in 1998 when the hedge fund Long-Term Capital Management (LTCM) blew up; and of course in the bond-market crisis of 2007 and 2008. The lower rates each time lessened the pain of the risk-taking gone awry, and opened the door for increased risk down the line.

Easy money wasn't the only way government induced the bubble. The mortgage-bond market was the mechanism by which policy makers transformed home ownership into something that must be earned into something close to a civil right. The Community Reinvestment Act and projects by the Department of Housing and Urban Development, beginning in the Clinton years, couldn't have been accomplished without the mortgage bond—which allowed banks to offload the increasingly risky mortgages to Wall Street, which in turn securitized them into triple-A rated bonds thanks to compliant ratings agencies.

The perversity of these efforts wasn't merely that bonds packed with subprime loans received such high ratings. It was also that by inducing homeownership, the government was itself making homeownership less affordable. Because families without the real economic means to repay traditional 30-year mortgages were getting them, housing prices grew to artificially high levels.

This is where the real sin of Fannie Mae and Freddie Mac comes into play. Both were created by Congress to make housing affordable to the middle class. But when they began guaranteeing subprime loans, they actually began pricing out the working class from the market until the banking business responded with ways to make repayment of mortgages allegedly easier through adjustable rates loans that start off with low payments. But these loans, fully sanctioned by the government, were a ticking time bomb, as we're all now so painfully aware.

A similar bomb exploded in 1998, when LTCM blew up. The policy response to the LTCM debacle is instructive; more than anything else it solidified Wall Street's belief that there were little if any real risks to risk-taking. With $5 billion under management, LTCM was deemed too big to fail because, with nearly every major firm copying its money losing trades, much of Wall Street might have failed with it.

That's what the policy makers told us anyway. On Wall Street there's general agreement that the implosion of LTCM would have tanked one of the biggest risk takers in the market, Lehman Brothers, a full decade before its historic bankruptcy filing. Officials at Merrill, including its then-CFO (and future CEO) Stan O'Neal, believed Merrill's risk-taking in esoteric bonds could have led to a similar implosion 10 years before its calamitous merger with Bank of America.

We'll never know if LTCM's demise would have tanked the financial system or simply tanked a couple of firms that bet wrong. But one thing is certain: A valuable lesson in risk-taking was lost. By 2007, the years of excessive risk-taking, aided and abetted by the belief that the government was ready to paper over mistakes, had taken their toll.

With so much easy money, with the government always ready to ease their pain, Wall Street developed new and even more innovative ways to make money through risk-taking. The old mortgage bonds created by Messrs. Fink and Ranieri as simple securitized pools had morphed into the so-called collateralized debt obligations (CDOs), complex structures that allowed Wall Street banks as well as quasi-governmental agencies Fannie Mae and Freddie Mac to securitize ever riskier mortgages.

Mr. O'Neal, the man considered most responsible for Merrill's disastrous foray into risk-taking, told me in an interview last year that in the fall of 2007, when he saw that the firm's problems were insurmountable, he had a deal to sell Merrill to Bank of America for around $90 a share. But Merrill's board rejected it, believing he would be selling out cheaply. The CDOs would eventually recover, they argued, as the Fed pumped life into the markets.

Likewise, nearly to the minute he was forced to file for bankruptcy, former Lehman CEO Dick Fuld believed the government wouldn't let Lehman die. After all, government largess had always been there in the past.

All of which brings me back to Mr. Fortsmann's comment about policy makers helping turn a cold into cancer. What if the Fed hadn't eased Wall Street's pain in the late 1980s, and again after the 1994 bond-market collapse? What if policy makers in 1998 had allowed the markets to feel the consequences of risk—allowing LTCM to fail, and letting Lehman Brothers and possibly Merrill Lynch die as well?

There would have been pain—lots of it—for Wall Street and even for Main Street, but a lot less than what we're experiencing today. Wall Street would have learned a valuable lesson: There are consequences to risk.

Mr. Gasparino is a CNBC on-air editor and the author, most recently, of "The Sellout: How Three Decades of Wall Street Greed and Government Mismanagement Destroyed the Global Financial System," just published by HarperBusiness.

from the Wall Street Journal Asia, 2009-Oct-29, p.16, by Holman W. Jenkins, Jr.:

Washington's Suicide Mission

Members of the Obama administration have taken turns deploring the billions of dollars in year-end bonuses the finance industry is getting ready to hand out. Never mentioned is what they think firms should do with the money. Give it back to their customers? Spend it on office decorations?

Firms can't just wish away revenue sitting on their books. That's an accounting crime. More to the point, aren't surging banker bonuses amid a general downturn the proximate and necessary outcome of Washington's recovery Heimlich, which involves doling out free money to banks and artificially goosing asset prices?

Er, wasn't this the plan?

After all, whatever sloppy incentives are introduced into the mix, Ken Feinberg is on hand to fix them by fine-tuning banker pay. Voilà, Washington has figured out how to stoke a credit bubble with one hand while making sure with the other that it feeds only good and sound "long-term" purposes.

Of course, Mr. Feinberg's clever calibration of carrots only works with the seven bailed-out firms under his direct control. As he grandly told PBS, "The private marketplace should be able to have the flexibility to adopt these programs on their own."

Unpack the ironies and contradictions in that sentence.

Mr. Feinberg is no dummy. Everyone knows the folderol about bonuses is a substitute for tackling the political challenge of "too big to fail." His every explanation has consisted of pleading political necessity over good judgment.

Yet the urgent problem now isn't TBTF, or even banker bonuses. These are distractions. The urgent problem is the giant riverboat gamble that Washington can save the economy by doing what comes naturally—spending money carelessly, creating massive new entitlements without funding them, dishing out cheap credit to politically favored sectors, telling business people where and how to invest.

Mr. Feinberg is an apt symbol indeed, for this gamble is built on the conceit that Washington can hector the recipients, whether auto companies, banks or homeowners, into behaving in ways that are "responsible." So far, however, human nature is proving a disappointment: Take the outbreak of tax fraud related to the government's emergency home-buyer's credit.

Nor is the larger gamble looking so good either. Banks continue to fail at an alarming rate, the dollar is under assault, and Washington is looking at a future of trillion-dollar deficits. One might have guessed it would take a decade of Obamanomics to produce European welfare state levels of youth unemployment, but at 18.5% we're there.

About the only positive sign is the price surge in normally uncorrelated assets—stocks, bonds, commodities, gold—as fund managers use cheap credit to play the carry-trade opportunity.

All this might be defensible if time were being bought to clean up an accumulation of past excesses. Instead, the president is creating a new one. It's no exaggeration to say the Senate health-care bill taking shape is the equivalent of climbing aboard a train about to plunge into a canyon and deciding what it really needs is a bomb on board.

By one metric alone, it might succeed—somewhat reducing the numbers of those who tell pollsters they are "uninsured." But it does so in a fashion reminiscent of the means the Clinton and Bush administrations used to raise the homeownership rate from 64% to 70%—which produced the subprime wreckage around us.

The Senate bill includes a mandate requiring all citizens to buy health insurance, but the penalties have been progressively weakened. Insurers, though, would still be required to take all comers, including the already-sick, and charge them a standard rate.

Kaboom—a monumental incentive for Americans not to buy health insurance until they get seriously ill.

Which leads us to a question: When are Ben Bernanke and Larry Summers going to have a quiet conversation about how to steer Team Obama off its suicide mission?

We know they were recently rivals for the Fed chairmanship. We know the Fed itself has become compromised. But who else is there?

The Fed's three-decade habit of rescuing the financial system from episodes of failed risk-taking has crossed into absurdity in the current crisis. Half the Fed's brain wants banks to lend out the massive reserves the Fed has been creating on bank balance sheets. The other half fears if these reserves ever leak into the real economy, it will fuel an inflationary blowout. Yet it still might be possible to muddle to a lasting recovery. It depends on real confidence emerging at some point to replace the short-term grab for gains created by zero-rate borrowing.

Real confidence is what the Japanese, our predecessors down bubble road, have lacked and still lack. Real confidence means real "reform"—the hopper is hardly barren of ideas, like raising the retirement age, enacting the Breaux Commission's Medicare proposals, instituting a flat tax and eliminating the tax distortions that every serious economist knows contributed to the housing bubble and the health-care bubble.

"Change," to borrow a mantra, has to start somewhere. Over to you, Ben and Larry.

from the Wall Street Journal, 2009-Nov-5, p.A18:

Money on Autopilot
The Fed keeps its eye on employment, not on the dollar.

Federal Reserve officials have been at pains to say they are ready, able and—especially, absolutely, don't doubt it for a second—willing to tighten money. Just don't ask them to do it anytime soon. Yesterday's Federal Open Market Committee statement after its two-day meeting declared that the economy has improved but that this is still no reason to stop driving its monetary engine like an Indy race car.

The Fed has been running full throttle for an entire year, while the financial panic has subsided, credit markets are healing, and third quarter GDP growth was 3.5%. The Fed is nonetheless focused principally on the "output gap," by which it means "low rates of resource utilization" and the high jobless rate. As long as the economy isn't going at full capacity, the governors believe, there's no danger of price increases and thus we need "exceptionally low levels of the federal funds rate for an extended period."

English translation: The Fed is going to maintain zero interest rates for as long as the political eye can see.

In our oft-repeated view, this policy ignores the Fed's role as the central bank not merely for the U.S. domestic economy but also for the large chunk of the world known as the dollar bloc. The Fed's irrationally exuberant ease is clearly showing up around the world in a very weak dollar, asset bubbles in the likes of Asian property, and rising commodity prices that include $80 oil despite weak global energy demand. This risks creating new monetary excesses that will eventually have to be corrected in ways that could jeopardize the global and U.S. recovery.

We'd prefer more cautious policy now to avoid more trouble later, but this Fed is clearly on autopilot. It's a good time for the world to strap itself tightly into the passenger crash seat because it looks like the dollar is in for a daredevil ride.

from the Wall Street Journal, 2009-Nov-6, p.A24:

The Return of the Inflation Tax
The Pelosi tax surcharge applies to capital gains and dividends.

All of those twentysomethings who voted for Barack Obama last year are about to experience the change they haven't been waiting for: the return of income tax bracket creep. Buried in Nancy Pelosi's health-care bill is a provision that will partially repeal tax indexing for inflation, meaning that as their earnings rise over a lifetime these youngsters can look forward to paying higher rates even if their income gains aren't real.

In order to raise enough money to make their plan look like it won't add to the deficit, House Democrats have deliberately not indexed two main tax features of their plan: the $500,000 threshold for the 5.4-percentage-point income tax surcharge; and the payroll level at which small businesses must pay a new 8% tax penalty for not offering health insurance.

This is a sneaky way for politicians to pry more money out of workers every year without having to legislate tax increases. The negative effects of failing to index compound over time, yielding a revenue windfall for government as the years go on. The House tax surcharge is estimated to raise $460.5 billion over 10 years, but only $30.9 billion in 2011, rising to $68.4 billion in 2019, according to the Joint Tax Committee.

Americans of a certain age have seen this movie before. In 1960, only 3% of tax filers paid a 30% or higher marginal tax rate. By 1980, after the inflation of the 1970s, the share was closer to 33%, according to a Heritage Foundation analysis of tax returns.

These stealth tax increases—forcing ever more Americans to pay higher tax rates on phantom gains in income—were widely seen to be unjust. And in 1981 as part of the Reagan tax cuts, a bipartisan coalition voted to index the tax brackets for inflation.

We also know what has happened with the Alternative Minimum Tax. Passed to hit only 1% of all Americans in 1969, the AMT wasn't indexed for inflation at the time and neither was Bill Clinton's AMT rate increase in 1993. The number of families hit by this shadow tax more than tripled over the next decade. Today, families with incomes as low as $75,000 a year can be hit by the AMT unless Congress passes an annual "patch."

The Pelosi-Obama health tax surcharge will have a similar effect. The tax would begin in 2011 on income above $500,000 for singles and $1 million for joint filers. Assuming a 4% annual inflation rate over the next decade, that $500,000 for an individual tax filer would hit families with the inflation-adjusted equivalent of an income of about $335,000 by 2020. After 20 years without indexing, the surcharge threshold would be roughly $250,000.

And by the way, this surcharge has also been sneakily written to apply to modified adjusted gross income, which means it applies to both capital gains and dividends that are taxed at lower rates. So the capital gains tax rate that is now 15% would increase in 2011 to 25.4% with the surcharge and repeal of the Bush tax rates. The tax rate on dividends would rise to 45% from 15% (5.4% plus the pre-Bush rate of 39.6%).

As for the business payroll penalty, it is imposed on a sliding scale beginning at a 2% rate for firms with payrolls of $500,000 and rising to 8% on firms with payrolls above $750,000. But those amounts are also not indexed for inflation, so again assuming a 4% average inflation rate in 10 years this range would hit payrolls between $335,000 and $510,000 in today's dollars. Note that in pitching this "pay or play" tax today, Democrats claim that most small businesses would be exempt. But because it isn't indexed, this tax will whack more and more businesses every year. The sales pitch is pure deception.

As for the Senate, instead of the 5.4% surcharge, the Finance Committee bill raises taxes on "high-cost" health care plans. But this too uses the inflation ruse. The Senate bill indexes its tax proposal for the inflation rate plus one percentage point. But that is only about half as high as the rate of overall health-care inflation, i.e., the rate of increase in health-care premiums. So the Joint Tax Committee has found that a Senate tax that starts in 2013 by hitting 13.8 million Americans will hit 39.1 million by 2019.

The return of the inflation tax demonstrates once again the stealth radicalism that animates ObamaCare. In the case of inflation indexing, Democrats would repeal a 30-year bipartisan consensus that it is unfair to tax unreal gains in income, thus hitting millions of middle-class Americans over time with tax rates advertised as only hitting "the rich." Oh, and the House vote on this exercise in dishonest government will come as early as Saturday.

from the Wall Street Journal, 2009-Oct-15, by Ann Lee:

The Banking System Is Still Broken
Borrow from the Federal Reserve at zero and lend to Treasury for a profit. That's some racket.

Treasury Secretary Tim Geithner and Federal Reserve Chairman Ben Bernanke have announced that the recession is over. Now that the Dow Jones Industrial Average has broken the 10,000 mark, we'll surely be hearing assurances that economic growth is here to stay. But the credit markets are in much worse shape than some indicators suggest.

First of all, not all U.S. banks are created equal. A few multinational banks such as Citigroup are officially too big to fail. Credit spreads in the markets reflect the relatively risk-free nature of these large companies, which now have implicit government guarantees.

But this protection doesn't apply to smaller banks, some of which are being shut down by the FDIC without much media attention. These smaller banks have done most of the lending to the many small and medium-sized enterprises that do the bulk of the hiring in our economy. They've now had to cut off the flow of credit to their clients.

According to Automatic Data Processing Inc.'s August employment report, large businesses shed 60,000 jobs, and employment at medium-sized and small businesses declined by 116,000 and 122,000, respectively, in August alone. Small businesses, defined as employing anywhere from one to 49 people, account for 48 million jobs in the U.S., and medium-sized businesses, between 50 and 499 employees, account for 42 million jobs. Large businesses account for just 17 million. Without access to capital, these small and medium-sized businesses will continue to lay off their employees, creating a vicious cycle of shrinking consumer credit and demand.

The volume of overall bank lending has not returned to pre-crisis levels. While credit spreads have contracted, not much debt has been underwritten. In fact, banks that received government bailout money reduced their average loan balance by $54 billion in July, compared to the previous month, according to the Treasury's Capital Purchase Program Monthly Lending report.

The first reason for this slowdown in lending is that underwriting standards have risen across the board, making it much more difficult for businesses to obtain loans. Institutional investors no longer tolerate the easy loans so characteristic of this latest credit bubble. Banks are now also being asked to retain a portion of any loans they underwrite in order to align their interests with their investors. As a result, credit has scaled back dramatically. According to reports issued by the major rating agencies, in 2007 $700 billion of asset-backed securities were underwritten. Only $10 billion has been issued in 2009. This has a significant knock-on effect across every sector of the economy.

The banks have no incentive to lend. Most of them still have a significant amount of bad loans sitting on their books that they don't want to recognize as nonperforming. If the banks recognize these bad loans, all the write-offs may force them into bankruptcy. Instead, they hope that over time renegotiated loan terms will eventually allow the borrowers to make their payments. This ordeal could last at least a decade if this cycle is similar to other crises, like Japan's lost decade of the 1990s. As the fed funds rate goes to zero and existing loans in technical default continue to sit in bank portfolios, why should banks make new loans when they can make money for free with the government? There is no longer a stigma associated with borrowing from the Fed, so banks can earn a huge spread by borrowing virtually unlimited amounts for nothing and lending that same money back to the Treasury.

Wall Street will most definitely get richer again. But a return to easy credit for the average consumer and business is not likely in the near future. The only reason that credit spreads have tightened is because of the extraordinary interventions by the Fed and the Treasury.

Such unprecedented actions by the government have led to speculation over when inflation might get out of control. But why not question whether our current banking system actually makes any sense? Rather than giving capital to businesses with real products and services, Wall Street plays a government-backed shell game, enriching bankers' pockets at everyone else's expense.

If banks are being supported by taxpayer dollars as a public good, wouldn't it be logical to make Citigroup and Goldman part of the government so that they can serve the public like the Department of Motor Vehicles? The powerful banking lobby will likely prevent the nationalization of the entire banking system. But expect new challenges to our assumptions about the status quo if this recovery and the proposed regulatory reforms fail.

Ms. Lee, an adjunct professor at New York University, is a former investment banker and hedge-fund partner.

from the Wall Street Journal, 2009-Nov-4, by Alex Frangos and Bob Davis with Jon Hilsenrath and John Lyons contributing:

Fears of a New Bubble as Cash Pours In
Real-Estate, Stock and Currency Markets, Especially in Asia and Pacific, Are Seen at Risk

Concerns are mounting that efforts by governments and central banks to stoke a recovery will create a nasty side effect: asset bubbles in real-estate, stock and currency markets, especially in Asia.

The World Bank warned Tuesday that the sudden reappearance of billions of dollars in investment capital in East Asia is "raising concerns about asset price bubbles" in equity markets across Asia and in real estate in China, Hong Kong, Singapore and Vietnam. Also Tuesday, the International Monetary Fund cited "a risk" that surging Hong Kong asset prices are being driven by a flood of capital "divorced from fundamental forces of supply and demand."

Behind the trend are measures such as cutting interest rates and pumping money into the financial system, which have left parts of the world awash in cash and at risk of bubbles, or run-ups in asset prices beyond what economic fundamentals suggest are reasonable.

The International Commerce Centre along with luxury residential apartments in Hong Kong. Hong Kong's government says it wants to avoid a big property bubble.

Prices are surging across a host of markets. Gold, up about 44% this year, soared to a record high Tuesday. Copper is up about 50% in the past year. In the U.S., risky assets are rising rapidly in price: The risk spreads, or interest-rate premiums, on low-rated junk bonds have narrowed to about where they were in February 2008, before Bear Stearns and Lehman Brothers fell, according to Barclays Capital.

Policy makers from Beijing to London, seared by the fallout from burst housing and credit bubbles, are searching for ways to head off new ones. How to handle a bubble "is one of the big two or three unanswered questions at the end of this crisis," says Adair Turner, chairman of the U.K.'s Financial Services Authority. Bank of Korea Governor Lee Seong-tae hinted last month he would raise interest rates, if necessary, to prevent Seoul's housing market from lurching out of control.

"This is the beginning of another big and excessive run-up in asset prices," said Simon Johnson, a former IMF chief economist.

The symptoms of a frenzy are most evident in Asia and the Pacific, where economies are recovering most quickly. In Hong Kong, high-end real-estate prices are soaring. A luxury flat in the tony Midlevels district is expected to sell for US$55.6 million, or $9,200 a square foot, said developer Henderson Land Development Co. Elsewhere, a bidder at a city-run auction to operate food stands at February's Lunar New Year celebration recently paid a record US$63,225 for the right to occupy a 400-square-foot stall to sell fish balls and other snacks. Prices in the auction of 180 stalls were up 33% from 2008.

Over the summer, a Singapore condominium developer raised prices 5% the day before units went on sale. After dozens of would-be buyers lined up on a steamy night, the developer -- a joint venture of Hong Leong Group and Japan's Mitsui Fudosan -- held a lottery for a chance to bid on the units. Singapore home prices rose 15.8% in the third quarter, the fastest rate in 28 years.

Australian real-estate markets also have heated up. After a Melbourne property-research firm recently predicted that average home prices will double over the next 12 years, a news report in Australia's Herald Sun said: "The staggering prediction shows the importance of buying a home as soon as you can afford it because the longer buyers delay, the more chance there is that their dream will slip out of their reach."

The Australian dollar has jumped about 35% over the past 12 months as investors borrow in U.S. dollars to purchase Australian currency. The practice is propelling stock and bond markets faster than in the U.S. and Europe. Currency traders are betting that the Australian central bank, which raised interest rates by 0.25% on Tuesday, the second rise in two months, will continue tightening.

Rebounding economies are attracting huge inflows of capital, thanks to low interest rates around the world. That's sending property, stock and commodity prices higher. Some policymakers worry that new price bubbles are forming, especially in Asia.

Asian stock prices are shooting up, in part due to low interest rates in the U.S. Investors looking for higher yields are borrowing in U.S. dollars and then pouring that money "into countries that are growing more rapidly," said Stephen Cecchetti, chief economist at the Bank for International Settlements, the central banks' central bank, which warned early of the last asset bubble and is beginning to do so again. "That runs the risk of creating property and equity booms in those countries."

About $53 billion has gone into emerging-market stock funds this year, according to data collector EPFR Global. Through Monday's trading, the broad MSCI Barra Emerging Markets Index this year was up 60.7%. Brazil was up 100%, and Indonesia had gains of 102.7%. Over the same period, the Dow Jones Industrial Average was up 11.5%.

Discerning a bubble is as difficult as preventing one. Rapidly rising prices aren't definitive proof. Stocks in Asian emerging markets currently trade at about two times book value, about average for the past 20 years, according to UBS. From 2004 to 2008, the price-to-book-value average was about three times. "This doesn't feel like a bubble," said Hugh Simon, chief executive of Hamon Investment Group, which manages Asia-investment funds. "There's too much skepticism" among investors.

To battle bubbles, policy makers are turning first to regulation. Singapore's authorities tightened mortgage requirements, ended real-estate stimulus policies and pledged to make more land available for development. South Korea regulators tightened real-estate lending requirements in seven districts around Seoul where prices have jumped.

"Even those who say we should respond directly [and deflate bubbles] have no idea how to do it," said Laurence Meyer, a former Fed governor. "It is easy to take a philosophical position, but hard to become operational and practical about it."

from the Wall Street Journal, 2009-Oct-15, by Peter J. Wallison:

Barney Frank, Predatory Lender
Almost two-thirds of all bad mortgages in our financial system were bought by government agencies or required by government regulations.

Recent reports that the Federal Housing Administration (FHA) will suffer default rates of more than 20% on the 2007 and 2008 loans it guaranteed has raised questions once again about the government's role in the financial crisis and its efforts to achieve social purposes by distorting the financial system.

The FHA's function is to guarantee mortgages of low-income borrowers (the mortgages are then sold through securitizations by Ginnie Mae) and thus to take reasonable credit risks in the interests of making mortgage credit available to the nation's low-income citizens. Accordingly, the larger than normal losses that will result from the 2007 and 2008 cohort could be justified by Barney Frank, the chairman of the House Financial Services Committee, as "policy"—an effort to ease the housing downturn through the application of government credit. The FHA, he argued, is buying more weak mortgages in order to help put a floor under the housing market. Eventually, the taxpayers will have to judge whether this policy was justified.

Far more interesting than the FHA's prospective losses on its 2007 and 2008 book are the agency's losses on its 2005 and 2006 guarantees, when the housing bubble was inflating at its fastest rate and there was no need for government support. FHA-backed loans during those years also have delinquency rates between 20% and 30%. These adverse results—not the result of a "policy" effort to shore up markets—pose a significant challenge to those who are trying to absolve the U.S. government of responsibility for the financial crisis.

When the crisis first arose, the left's explanation was that it was caused by corporate greed, primarily on Wall Street, and by deregulation of the financial system during the Bush administration. The implicit charge was that the financial system was flawed and required broader regulation to keep it out of trouble. As it became clear that there was no financial deregulation during the Bush administration and that the financial crisis was caused by the meltdown of almost 25 million subprime and other nonprime mortgages—almost half of all U.S. mortgages—the narrative changed. The new villains were the unregulated mortgage brokers who allegedly earned enormous fees through a new form of "predatory" lending—by putting unsuspecting home buyers into subprime mortgages when they could have afforded prime mortgages. This idea underlies the Obama administration's proposal for a Consumer Financial Protection Agency. The link to the financial crisis—recently emphasized by President Obama—is that these mortgages would not have been made if regulators had been watching those fly-by-night mortgage brokers.

There was always a problem with this theory. Mortgage brokers had to be able to sell their mortgages to someone. They could only produce what those above them in the distribution chain wanted to buy. In other words, they could only respond to demand, not create it themselves. Who wanted these dicey loans? The data shows that the principal buyers were insured banks, government sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac, and the FHA—all government agencies or private companies forced to comply with government mandates about mortgage lending. When Fannie and Freddie were finally taken over by the government in 2008, more than 10 million subprime and other weak loans were either on their books or were in mortgage-backed securities they had guaranteed. An additional 4.5 million were guaranteed by the FHA and sold through Ginnie Mae before 2008, and a further 2.5 million loans were made under the rubric of the Community Reinvestment Act (CRA), which required insured banks to provide mortgage credit to home buyers who were at or below 80% of median income. Thus, almost two-thirds of all the bad mortgages in our financial system, many of which are now defaulting at unprecedented rates, were bought by government agencies or required by government regulations.

The role of the FHA is particularly difficult to fit into the narrative that the left has been selling. While it might be argued that Fannie and Freddie and insured banks were profit-seekers because they were shareholder-owned, what can explain the fact that the FHA—a government agency—was guaranteeing the same bad mortgages that the unregulated mortgage brokers were supposedly creating through predatory lending?

The answer, of course, is that it was government policy for these poor quality loans to be made. Since the early 1990s, the government has been attempting to expand home ownership in full disregard of the prudent lending principles that had previously governed the U.S. mortgage market. Now the motives of the GSEs fall into place. Fannie and Freddie were subject to "affordable housing" regulations, issued by the Department of Housing and Urban Development (HUD), which required them to buy mortgages made to home buyers who were at or below the median income. This quota began at 30% of all purchases in the early 1990s, and was gradually ratcheted up until it called for 55% of all mortgage purchases to be "affordable" in 2007, including 25% that had to be made to low-income home buyers.

It was not easy to find candidates for traditional mortgages—loans to people with good credit records or the resources for a substantial downpayment—among home buyers who qualified under HUD's guidelines. To meet their affordable housing requirements, therefore, Fannie and Freddie reduced their lending standards and reached into the FHA's turf. The FHA, although it lost market share, continued to guarantee what it could, adding to the demand that the unregulated mortgage brokers filled. If they were engaged in predatory lending, it was ultimately driven by the government's own requirements. The mortgages that resulted are now problem loans for the GSEs, the FHA and the big banks that were required to make them in order to burnish their CRA credentials.

The significance of the FHA's troubles is that this agency had no profit motive. Yet it dipped into the same pool of subprime and other nontraditional mortgages that the GSEs and Wall Street were fishing in. The left cannot have it both ways, blaming the private sector for subprime lending while absolving the government policies that created the demand for subprime loans. If the financial crisis was caused by subprime mortgages and predatory lending, the government's own policies made it happen.

Mr. Walllison is a senior fellow at the American Enterprise Institute.

from City Journal online, 2009-Oct-20, by Nicole Gelinas:

Our Subprime Federal Government
President Obama’s mortgage plan imitates the lenders who inflated the housing bubble.

Earlier this month, a congressional oversight panel released its first analysis of the Obama administration’s $75 billion Home Affordable Modification Program (HAMP), an effort to keep 4 million families from losing their homes. The analysis shows that the Treasury, in trying to keep people in homes they can’t afford, is relying on the same perverse principle that inflated the housing bubble in the first place: namely, that it’s fine to borrow recklessly to buy a house, because house prices can only go up and up. Trying to maintain a bubble mentality, rather than help people adjust to life after the bubble has burst, will hobble economic recovery.

President Obama first announced HAMP eight months ago. The program helps struggling borrowers slash their monthly mortgage payments to 31 percent of their gross income (from participants’ original median of 45 percent). To encourage the financial industry to modify the loans, the government offers inducements to mortgage “servicers” (the companies that handle paperwork for borrowers and lenders), including a $1,000 payment each year for the first three years of a successful “workout.” The government also offers lenders partial compensation for the losses that they will take on the workouts. And the government gives borrowers $1,000 a year for up to five years for staying current on their modified loans; the extra money will help pay down their loans. The plan, the president promised, “will give millions of families resigned to financial ruin a chance to rebuild.”

Reworking bad loans isn’t a bad idea; it can prevent even bigger losses for both borrower and lender. Say you purchased a house worth $220,000 in 2006, borrowing 100 percent of the value, and the house’s value has since fallen to $150,000. If you can afford a mortgage on $175,000 worth of debt, it likely makes more sense for your lender to cut your mortgage debt down to $175,000 than to sell your house for $150,000. Indeed, such write-downs should be a healthy part of the economy’s readjustment to a post-bubble world. They would help address the housing bubble’s legacy: one-quarter or so of homeowners now owe more than what their houses are worth.

Healthy write-downs of bad debt are not what the White House is encouraging, though. HAMP has been reducing people’s mortgage payments not by cutting the amount they owe in line with realistic home values, but by slashing the interest rates on their mortgages. Of the nearly 2,000 completed workouts so far, mostly of initially fixed-rate mortgages, under 1 percent have included forgiveness of any debt, the congressional oversight panel said; instead, mortgage administrators have cut payments “almost exclusively” through interest-rate reductions. The HAMP borrowers’ median annual interest rate has thus fallen from 6.85 percent to an absurdly low 2 percent annually. The cuts have made a big difference in monthly payments, which have dropped from a median $1,419 to just $849.

But there’s a catch: the cuts are temporary. Five years from modification, the interest rate on each modified mortgage will begin to increase, either to the original mortgage rate or to the market mortgage rate at the time the loan was modified. As the congressional report notes, “the affordability of the loans will move back toward [original] levels eight years from now.” Treasury has taken fixed-rate mortgages that borrowers can’t afford and transformed them into the very “teaser-rate” mortgages that grew so popular during the housing bubble—to mask and exacerbate the same problem: the house costs too much for the buyer.

The workouts may result in people’s owing even more on their houses than they did before. That’s because mortgage administrators and lenders can tack on some of the costs of missed payments and other charges to the original mortgage balance. The median homeowner in HAMP owed an untenable 122 percent of the value of his house before entering the program; today, the same owner owes an even more untenable 124 percent. Worse, before modification, 474 of the 2,000 HAMP borrowers weren’t yet “underwater”—that is, owing more than the value of their homes. Now, only 424 remain in that relatively good position. Will the $5,000 (maximum) in government payments to borrowers who stick to their new mortgages cut the amount they owe by more than the lenders will eventually increase it? So far, it looks to be close to a wash.

Notwithstanding the government’s best efforts to sustain a bubble, home prices are falling to about where they should be so that people can afford to buy houses again without incurring impossible debt burdens. Consider the Treasury’s small universe of HAMP participants. Treasury balks at releasing the raw data behind its program, but the interest rates and monthly payments detailed in the congressional report make it easy to determine that the average HAMP borrower likely owed about $220,000 on his mortgage before and finds himself with a house worth about $180,000 today. Suppose, in an ordinary process of healthy write-downs, lenders reduced that average loan to today’s value and lenders of any second mortgages or home-equity loans—which are supposed to offer less protection—lost all of their money (as they should, but don’t, under HAMP). In that case, the borrowers’ median monthly payment would be less than $1,200, even at the original 6.85 percent interest rate. And at the record-low 5 percent rates that qualified borrowers can secure today—something that the government could more reasonably support than the 2 percent rates—payments would fall below $1,000.

The White House, instead of letting the market bring prices down to where they should be, is kicking the problem five years down the road. It hopes that five years from now, home prices will have risen so much that borrowers will no longer be underwater. Borrowers would then be able to sell their homes at prices higher than their mortgage balances, getting out of their still-unaffordable original mortgages without huge losses for lenders. Washington is trying to prearrange this outcome through other programs, such as its $8,000 tax credit for first-time homebuyers—another attempt to keep home prices artificially high with taxpayer money. But this policy isn’t good for the economy. Overvalued houses force people to continue borrowing too much and keep their financial resources from going into savings or investments—that is, into more productive, job-creating industries. Using borrowed federal money to further this goal also takes funding away from infrastructure and other public investments that a healthy economy needs.

Nor is this policy good for the homeowners whom Treasury is purporting to help—those who can’t afford their mortgages. If housing prices aren’t substantially higher in five years even after the government’s best efforts at distortion, the Treasury program will only have discouraged people from cutting their losses and moving on with their lives.

HAMP’s beneficiaries could better adjust to reality without this government intervention. Borrowers are generally free to walk away from their houses without declaring bankruptcy. Under the contracts that mortgage lenders and servicers drew up as well as precedent, mortgage debt is understood to be backed by the value of the house, not by a borrower’s full pledge to pay the debt with his personal resources. (In fact, that’s why mortgage interest rates have historically been lower than credit-card rates: lenders know that a valuable physical asset secures the home, not a person’s ability and willingness to pay his debt.) A borrower who can’t afford his house under normal conditions may have to leave the property and start renting instead, but that’s hardly sufficient reason for the government to sink tens of billions of dollars into maintaining an irrational environment of high prices—one in which it makes perverse sense to keep mindlessly buying houses.

Instead, the White House should help the economy adjust to lower home prices and force lenders and borrowers to recognize their losses—both key elements to a recovery. Treasury should say that it won’t subsidize mortgage administrators that offer temporary interest-rate cuts; it should use any subsidy to encourage lenders to forgive principal. Someone who couldn’t afford a mortgage based on his home’s current value—or less, if the mortgage administrator thinks fit—would have to move. All of these steps would make far more sense than Washington’s current policy: becoming the biggest predatory lender of them all, and eating the economy alive.

Nicole Gelinas, contributing editor to the Manhattan Institute’s City Journal, is author of the forthcoming After The Fall: Saving Capitalism From Wall Street—and Washington.

from the Wall Street Journal, 2009-Oct-26:

The Spending Rolls On
The fiscal 2010 bills grow domestic programs by 12.1%.

The White House disclosed the other day that the fiscal 2009 budget deficit clocked in at $1.4 trillion, amid the usual promises to do something about it. Yet even as budget director Peter Orszag was speaking, House Democrats were moving on a dozen spending bills for fiscal 2010 that total 12.1% in more domestic discretionary increases.

Yes, 12.1%.

Remember, inflation is running close to zero, or 0.8%. The good news, if we can call it that, is that Senate Democrats only want to increase nondefense appropriations by 8% for 2010. Because these funding increases become part of the permanent baseline for future appropriations, the 2010 House budget bills would permanently raise annual outlays for discretionary programs by about $75 billion a year from now until, well, forever.

These spending hikes do not include the so-called mandatory spending programs like Medicare and Medicaid, which exploded by 9.8% and 24.7%, respectively, in the just-ended 2009 fiscal year. All of this largesse is also on top of the stimulus funding that agencies received in 2009. The budget for the Environmental Protection Agency rose 126%, the Department of Education budget 209% and energy programs 146%.

Spend As You Go Percentage increase in budget authority in House appropriations bills for fiscal 2010 and over 2009 and 2010 combined 2010 2009-10 Defense 3.6% 11% Non-Defense discretionary 12.1 23.5 All appropriations bills (not including entitlements or stimulus) 7.7 16.8

House Republicans on the Budget Committee added up the 2009 appropriations, the stimulus funding and 2010 budgets and found that federal agencies will, on average, receive a 57% increase in appropriated funds from 2008-2010. By contrast, real family incomes fell by 3.6% last year. There's no recession in Washington.

More broadly, the White House and the 111th Congress have already enacted or proposed $3.4 trillion of new spending through 2019 for things like the health-care plan, cap and tax, and the children's health bill passed earlier this year. Very little of this has been financed with offsetting spending cuts elsewhere in the budget.

Throughout the era of Republican rule in Washington, we scored GOP lawmakers for their overspending and earmarks—and so did Nancy Pelosi and other Congressional Democrats. So how do their records compare? From 2001-2008 the average annual increase in appropriations bills came in at 6.4%—or about double the rate of inflation. In this Congress spending is now growing six times faster than inflation.

And here is the kicker. Mr. Obama's 10-year budget forecast predicts that the budget deficit will fall in future years in part because federal spending on discretionary programs will grow at less than the rate of inflation. But spending is already up nearly 8% (including defense) in the first year alone.

For a laugh-out-loud moment on all of this, we recommend yesterday's performance by New York Senator Chuck Schumer on NBC's "Meet the Press." Mr. Schumer declared that "Barack Obama and we Democrats—this is counterintuitive but true—are really trying to get a handle on balancing the budget and we're making real efforts to do it." Counterintiutive? He said this four days after Senate Democrats lost a vote to add $250 billion to the deficit for doctor payments without any compensating spending cuts.

Democrats must figure that they can get away with this sort of rap because no one will call them on the reality of what they're spending. And they're probably right about a press corps that has ignored the spending boom since Democrats took over Congress in 2006. Meanwhile, the spending machine rolls on, all but guaranteeing monumental future tax increases.

from the Wall Street Journal, 2009-Oct-27, p.A20:

Rolling up the TARP
The $700 billion for banks has become an all-purpose bailout fund.

The Troubled Asset Relief Program will expire on December 31, unless Treasury Secretary Timothy Geithner exercises his authority to extend it to next October. We hope he doesn't. Historians will debate TARP's role in ending the financial panic of 2008, but today there is little evidence that the government needs or can prudently manage what has evolved into a $700 billion all-purpose political bailout fund.

We supported TARP to deal with toxic bank assets and resolve failing banks as a resolution agency of the kind that worked with savings and loans in the 1980s. Some taxpayer money was needed beyond what the FDIC's shrinking insurance fund had available. But TARP quickly became a Treasury tool to save failing institutions without imposing discipline (Citigroup) and even to force public capital onto banks that didn't need it. This stigmatized all banks as taxpayer supplicants and is now evolving into an excuse for the Federal Reserve to micromanage compensation.

TARP was then redirected well beyond the financial system into $80 billion in "investments" for auto companies. These may never be repaid but served as a lever to abuse creditors and favor auto unions. TARP also bought preferred stock in struggling insurers Lincoln and Hartford, though insurance companies are not subject to bank runs and pose no "systemic risk." They erode slowly as customers stop renewing policies.

TARP also became another fund for Congress to pay off the already heavily subsidized housing industry by financing home mortgage modifications. Not one cent of the $50 billion in TARP funds earmarked to modify home mortgages will be returned to the Treasury, says the Congressional Budget Office.

As of the end of September, Mr. Geithner was sitting on $317 billion of uncommitted TARP funds, thanks in part to bank repayments. But this sum isn't the limit of his check-writing ability. Treasury considers TARP a "revolving fund." If taxpayers are ever paid back by AIG, GM, Chrysler, Citigroup and the rest, Treasury believes it has the authority to spend that returned money on new adventures in housing or other parts of the economy.

A TARP renewal by Mr. Geithner could thus put at risk the entire $700 billion. Rep. Jeb Hensarling (R., Texas) and former SEC Commissioner Paul Atkins sit on TARP's Congressional Oversight Panel. They warn that the entire taxpayer pot could be converted into subsidies. They are especially concerned about expanding the foreclosure prevention programs that have been failing by every measure.

TARP inspector general Neil Barofsky agrees that the mortgage modifications "will yield no direct return" and notes charitably that "full recovery is far from certain" on the money sent to AIG and Detroit. Mr. Barofsky also notes that since Washington runs huge deficits, and interest rates are almost sure to rise in coming years, TARP will be increasingly expensive as the government pays more to borrow.

Even with the banks, TARP has been a double-edged sword. While its capital injections saved some banks, its lack of transparency created uncertainty that arguably prolonged the panic. Federal Reserve Chairman Ben Bernanke and former Treasury Secretary Hank Paulson recently admitted to Mr. Barofsky what everyone figured at the time of the first capital injections. Although they claimed in October 2008 they were providing capital only to healthy banks, Mr. Bernanke now says some of the firms were under stress. Mr. Paulson now admits that he thought one in particular was in danger of failing. By forcing all nine to take the money, they prevented the weaklings from being stigmatized.

Says Mr. Barofsky, "In addition to the basic transparency concern that this inconsistency raises, by stating expressly that the 'healthy' institutions would be able to increase overall lending, Treasury created unrealistic expectations about the institutions' conditions and their ability to increase lending."

The government also endangered one of the banks that they considered healthy at the time. In December, Mr. Paulson pressured Bank of America to complete its purchase of Merrill Lynch. His position is that a failed deal would have hurt both firms, but this is highly speculative. Mr. Barofsky reports that, according to Fed documents, the government viewed BofA as well-capitalized, but officials believed that its tangible common equity would fall to dangerously low levels if it had to absorb the sinking Merrill.

In other words, by insisting that BofA buy Merrill, Messrs. Paulson and Bernanke were spreading systemic risk by stuffing a failing institution into a relatively sound one. And they were stuffing an investment bank into one of the nation's largest institutions whose deposits were guaranteed by taxpayers. BofA would later need billions of dollars more in TARP cash to survive that forced merger, and when that news became public it helped to extend the overall financial panic.

Treasury and the Fed would prefer to keep TARP as insurance in case the recovery falters and the banking system hits the skids again. But the more transparent way to address this risk is by buttressing the FDIC fund that insures bank deposits and resolves failing banks. The political class has twisted TARP into a fund to finance its pet programs and constituents, and the faster it fades away, the better for taxpayers and the financial system.

from the Wall Street Journal, 2009-Oct-13, by Judy Shelton:

The Message of Dollar Disdain
With U.S. debt set to exceed 100% of GDP in 2011, it's no wonder people are looking for alternative ways to preserve wealth.

Unprecedented spending, unending fiscal deficits, unconscionable accumulations of government debt: These are the trends that are shaping America's financial future. And since loose monetary policy and a weak U.S. dollar are part of the mix, apparently, it's no wonder people around the world are searching for an alternative form of money in which to calculate and preserve their own wealth.

It may be too soon to dismiss the dollar as an utterly debauched currency. It still is the most used for international transactions and constitutes over 60% of other countries' official foreign-exchange reserves. But the reputation of our nation's money is being severely compromised.

Funny how words normally used to address issues of morality come to the fore when judging the qualities of the dollar. Perhaps it's because the U.S. has long represented the virtues of democratic capitalism. To be "sound as a dollar" is to be deemed trustworthy, dependable, and in good working condition.

It used to mean all that, anyway. But as the dollar is increasingly perceived as the default mechanism for out-of-control government spending, its role as a reliable standard of value is destined to fade. Who wants to accumulate assets denominated in a shrinking unit of account? Excess government spending leads to inflation, and inflation plays dollar savers for patsies—both at home and abroad.

A return to sound financial principles in Washington, D.C., would signal that America still believes it can restore the integrity of the dollar and provide leadership for the global economy. But for all the talk from the Obama administration about the need to exert fiscal discipline—the president's 10-year federal budget is subtitled "A New Era of Responsibility: Renewing America's Promise"—the projected budget numbers anticipate a permanent pattern of deficit spending and vastly higher levels of outstanding federal debt.

Even with the optimistic economic assumptions implicit in the Obama administration's budget, it's a mathematical impossibility to reduce debt if you continue to spend more than you take in. Mr. Obama promises to lower the deficit from its current 9.9% of gross domestic product to an average 4.8% of GDP for the years 2010-2014, and an average 4% of GDP for the years 2015-2019. All of this presupposes no unforeseen expenditures such as a second "stimulus" package or additional costs related to health-care reform. But even if the deficit shrinks as a percentage of GDP, it's still a deficit. It adds to the amount of our nation's outstanding indebtedness, which reflects the cumulative total of annual budget deficits.

By the end of 2019, according to the administration's budget numbers, our federal debt will reach $23.3 trillion—as compared to $11.9 trillion today. To put it in perspective: U.S. federal debt was equal to 61.4% of GDP in 1999; it grew to 70.2% of GDP in 2008 (under the Bush administration); it will climb to an estimated 90.4% this year and touch the 100% mark in 2011, after which the projected federal debt will continue to equal or exceed our nation's entire annual economic output through 2019.

The U.S. is thus slated to enter the ranks of those countries—Zimbabwe, Japan, Lebanon, Singapore, Jamaica, Italy—with the highest government debt-to-GDP ratio (which measures the debt burden against a nation's capacity to generate sufficient wealth to repay its creditors). In 2008, the U.S. ranked 23rd on the list—crossing the 100% threshold vaults our nation into seventh place.

If you were a foreign government, would you want to increase your holdings of Treasury securities knowing the U.S. government has no plans to balance its budget during the next decade, let alone achieve a surplus?

In the European Union, countries wishing to adopt the euro must first limit government debt to 60% of GDP. It's the reference criterion for demonstrating "soundness and sustainability of public finances." Politicians find it all too tempting to print money—something the Europeans have understood since the days of the Weimar Republic—and excessive government borrowing poses a threat to monetary stability.

Valuable lessons can also be drawn from Japan's unsuccessful experiment with quantitative easing in the aftermath of its ruptured 1980s bubble economy. The Bank of Japan's desperate efforts to fight deflation through a zero-interest rate policy aimed at bailing out zombie companies, along with massive budget deficit spending, only contributed to a lost decade of stagnant growth. Japan's government debt-to-GDP ratio escalated to more than 170% now from 65% in 1990. Over the same period, the yen's use as an international reserve currency—it clings to fourth place behind the dollar, euro and pound sterling—declined from comprising 10.2% of official foreign-exchange reserves to 3.3% today.

The U.S. has long served as the world's "indispensable nation" and the dollar's primary role in the global economy has likewise seemed to testify to American exceptionalism. But the passivity in Washington toward our dismal fiscal future, and its inevitable toll on U.S. economic influence, suggests that American global leadership is no longer a priority and that America's money cannot be trusted.

If money is a moral contract between government and its citizens, we are being violated. The rest of the world, meanwhile, simply wants to avoid being duped. That is why China and Russia—large holders of dollars—are angling to invent some new kind of global currency for denominating reserve assets. It's why oil-producing Gulf States are fretting over whether to continue pricing energy exports in depreciated dollars. It's why central banks around the world are dumping dollars in favor of alternative currencies, even as reduced global demand exacerbates the dollar's decline. Until the U.S. sends convincing signals that it believes in a strong dollar—mere rhetorical assertions ring hollow—the world has little reason to hold dollar-denominated securities.

Sadly, due to our fiscal quagmire, the Federal Reserve may be forced to raise interest rates as a sop to attract foreign capital even if it hurts our domestic economy. Unfortunately, that's the price of having already succumbed to symbiotic fiscal and monetary policy. If we could forge a genuine commitment to private-sector economic growth by reducing taxes, and at the same time significantly cut future spending, it might be possible to turn things around. Under President Reagan in the 1980s, Fed Chairman Paul Volcker slashed inflation and strengthened the dollar by dramatically tightening credit. Though it was a painful process, the economy ultimately boomed.

Whether the U.S. can once more summon the resolve to address its problems is an open question. But the world's growing dollar disdain conveys a message: Issuing more promissory notes is not the way to renew America's promise.

Ms. Shelton, an economist, is author of "Money Meltdown: Restoring Order to the Global Currency System" (Free Press, 1994).

from the Wall Street Journal, 2009-Oct-29, p.A20:

The Big Mac's Currency Lesson
McDonald's departure from Iceland is a suggestive economic indicator.

As cultural calamities go, there are worse fates than that of Iceland, which is losing all three of its McDonald's franchises, effective next weekend. But the Big Mac's departure from Iceland, a victim of the financial crisis that sent the currency into a tailspin, is nonetheless a suggestive economic indicator.

McDonald's Icelandic franchisee noted, in explaining his decision to throw in the patty, that unlike his local competitors, McDonald's imports most of its raw ingredients, from beef to special sauce, lettuce, cheese, pickles, onions and, we assume, sesame seed buns. This reliance on imports has undercut McDonald's margins in the island nation, which saw the krona plummet by more than 80% after the financial panic took down the country's major banks.

But the lesson here is not about the dangers of globalization or the virtues of buying local. Since Iceland's banks collapsed last fall, and its currency with them, the cost in local currency of all imports, and not just fast food, has soared. This has done nothing to "cushion" the blow to Iceland's economy from what amounted to an international run on its banks. What it has done is added a currency panic to a financial panic, and made Iceland's prospects bleaker than they otherwise might have been.

In countries such as Ireland, some critics of the euro have claimed that membership in the currency bloc has made its economic woes that much more painful, and that Ireland would have been better off if it could have depreciated its way out of trouble. In the U.S., too, there's a chorus arguing that we can devalue our way toward prosperity. But debasing one's currency makes a country poorer, not richer. Just ask the residents of Reykjavik, who now must travel 900 miles to get their Big Mac—in Dublin.

from the Wall Street Journal, 2009-Oct-11, by Lawrence Kadish:

Taking the National Debt Seriously
In 2009 about 40% of income taxes will go towards debt interest payments.

If you think those town hall meetings over health care were fierce, wait until Americans come to understand the threat to our national financial survival posed by the interest on the government's credit card.

When the government spends more than its revenue, there is a budget deficit. These deficits are paid for by Washington selling interest bearing Treasury securities. If the government were ever to default on its promise to pay periodic interest payments or to repay the debt at maturity, the United States economy would plunge into a level of chaos that would make the Lehman bankruptcy look like a nonevent.

It is the interest on the national debt that makes our future unstable. The exploding size of that burden suggests that, short of devaluing the dollar and taking a large bite out of the middle class through inflation and taxation, there is no way to ever pay down that bill.

As of Sept. 30, 2009, the national debt was almost $12 trillion and interest on that debt was $383 billion for the year, according to the Treasury Department's Bureau of the Public Debt. The Congressional Budget Office on Oct. 7 estimated the 2009 budget deficit to be almost $1.4 trillion (about 10% of GDP). In August, the White House Office of Management and Budget (OMB) estimated total government revenues at about $2 trillion. The revenue estimate included $904 billion from individual income taxes. This means the cost of interest on the debt represented more than 40 cents of every dollar that came in from individual income taxes.

Except for a few years in the late 1990s, for decades Washington has spent more than it has taken in each year and borrowed the rest. Taxpayer dollars that could have paid off debt each year have instead been spent on interest to finance debt. Unfortunately, that's a vicious cycle that will likely only get worse.

The OMB projects deficits of about $9 trillion over the next 10 years. If that occurs, the national debt will be almost $21 trillion by 2019. However, the actual amount could be much higher. The OMB also optimistically projects $13.5 trillion of revenue increases over the next decade, while minimizing the inevitable rise in interest rates that will come with an expanding national debt.

During Jimmy Carter's years in the White House, Treasury yields reached 15%. The 2009 average interest rate on the debt was only 3.2%. With our mounting national debt and budget deficits, it is reasonable to assume that in the near future interest rates on new and refinanced debt could double or triple.

In stark but simple terms, unless Americans are made aware of this financial crisis and demand accountability, the very fabric of our society will be destroyed. Interest rates and interest costs will soar and government revenues will be devoured by interest on the national debt. Eventually, most of what we spend on Social Security, Medicare, education, national defense and much more may have to come from new borrowing, if such funding can be obtained. Left unchecked, this destructive deficit-debt cycle will leave the White House and Congress with either having to default on the national debt or instruct the Treasury to run the printing presses into a policy of hyperinflation.

It is against this background that Washington is now debating whether to create social programs it can't afford.

Steve Forbes recently commented that when it comes to the national deficit, voters will put things in order. I certainly hope so. However, it's imprudent to rely just on "hope." Americans need to take notice, stand up, and remind our elected officials that in a democracy the people can change bad leaders.

Mr. Kadish, a real estate investor, is a trustee of the Claremont and Hudson institutes.

from the Wall Street Journal, 2009-Oct-12, by Zachary Karabell:

Deficits and the Chinese Challenge
Debt can become a real liability for a superpower. Recall what happened to postwar Britain.

The dollar's sharp drop over the past few weeks has led to considerable anxiety about the status of the United States as the dominant force in the global economy. Closely related to this fear is constant worry about the rise of China and the evermore complicated relationship between Beijing and Washington.

Most people are now aware that China is the largest creditor to a heavily indebted U.S. government. It holds close to a trillion dollars of U.S. Treasurys and has invested hundreds of billions more in private enterprises in America. Even though these facts are plainly acknowledged, policy makers and experts continue to underestimate the full ramifications of this relationship.

Consider what happened in 1946, when a cash-strapped Great Britain turned to the U.S. for a loan. For 30 years or more, the British had been consumed by the threat of a rising Germany. Two wars had been fought, millions of lives had been lost, and the British treasury was dramatically depleted in the process. Britain survived, but the costs were substantial.

In spite of its global empire, a powerful military, and an enviable position at the center of world-wide commerce, in early 1946 the British government faced a serious risk of defaulting on its financial obligations. So it did what it had done at various points over the previous decade and turned to its closest ally for assistance. It asked the U.S. for a loan of $5 billion at zero-interest repayable over 50 years. As generous as those terms seem today, such financing had been almost routine in years prior. To the surprise and shock of the British, Washington refused.

Unable to take no for answer, Britain explained that unless it received funds the government would be insolvent. The Americans came back with a series of conditions. They would lend Britain $3.7 billion at 2% interest, and the British government would have to abide by the 1944 Bretton Woods plan, which made the dollar rather than the pound sterling the reference point for global exchange rates and required Britain to make the pound freely convertible. Even more significantly, Britain had to end its system of imperial preferences, which meant no more tariffs and duties on goods to and from colonies such as India. These were not mere financial penalties: Taken together, they meant the end of the British Empire.

Within two years, Britain had left India and was on its way to decolonizing throughout Asia and Africa. Unable to compete with the United States economically and no longer able to reap the benefits of colonial trade, Britain's military shrank and its commerce contracted. It quickly receded from its dominant global position and entered several decades of economic malaise. In the 1980s, Britain finally emerged as a prosperous country, but it was a shadow of what it had been in its heyday.

The U.S. replaced Britain as the guardian of the West. As one British official, Evelyn Shuckburgh, remarked in the late 1940s, "it was impossible not to be conscious that we were playing second fiddle." And that was precisely what the U.S. desired. Having supported the British for decades and become its banker and manufacturer during two wars, at the end of World War II the U.S. fully intended to supplant the British Empire. The loan request provided the pretext, but by then the balance had already shifted and Britain could have done little to reverse the tide.

By 2030—if not sooner—China is likely to surpass the U.S. in the size of its economy, though it will remain on a per capita basis a much poorer society for many years after that. Trajectories can change, but the recent implosion of the American financial system has only accelerated China's rise.

Given the lesson of the British Empire's demise, it would be foolish to base current policy on the assumption that China will hit a fatal speed-bump before it is able to supplant the U.S. And while the level of current indebtedness is manageable for the U.S.—and in fact tethers the Chinese closely to the U.S. economy in ways that are arguably beneficial for both countries—the fact that these economies are currently bound together does not mean that their interests will always be in sync.

Here, too, the British analogy is sobering. For decades, the relationship between Britain and the U.S. was mutually beneficial, though the Americans resented being treated as junior partners. As tension festered, the British were consumed with the more immediate threat of Germany. But in the end it was the U.S. that delivered the knockout blow.

The Americans have not had to deal with a true economic rival since the British more than half a century ago. America today is as unaccustomed to global economic competition as the British were at their apex. The U.S. often seems lumbering and ill-suited to the demands of economic rivalry.

The only way to avoid Britain's fate and meet the challenge of China is to reinvigorate economic life. This is a multiyear endeavor that must be done primarily through innovation, not legislation. America needs to retool its domestic economy to build on the global success of many U.S. companies. It must focus on inventing new products and generating new ideas, rather than defending the rusty industries of yesterday. Fights over health care and climate change are the cultural equivalent of fiddling while Rome burns.

China thrives because it is hungry, dynamic, scared of failure and convinced that it should be a leading force in the world. That is why America thrived a century ago. Today, such hunger and dynamism seem less evident in American life than petulance that the world is not cooperating.

The U.S. is in danger of assuming that because it has been a dominant nation on the world stage, it must continue to be so. That is a recipe for becoming Britain.

Mr. Karabell is the author of "Superfusion: How China and America Became One Economy and Why the World's Prosperity Depends on It," just published by Simon & Schuster.

from City Journal, 2009-Summer, by Anthony Daniels (aka Theodore Dalrymple):

Inflation’s Moral Hazard
An age of loose money not only destroys savings; it corrodes character.

Information from the most diverse sources sometimes coalesces and provokes reflection on a subject to which one has not previously given sufficient thought. This happened to me recently with regard to the effect of monetary inflation on human character. With many observers predicting a substantial rise in inflation as a result of various government spending programs undertaken to reverse the current global downturn, the topic is anything but academic.

I was reading The Innocence of Edith Thompson, by Lewis Broad, a book about a notorious murder in 1920s London. Freddy Bywaters was a handsome young sailor, Edith Thompson an unsatisfactorily married woman. They had a torrid love affair, and Bywaters eventually stabbed Thompson’s husband to death as he walked home one evening from the theater with his wife. Thompson’s love letters to Bywaters, prosecutors claimed, were an incitement to murder—such an incitement that they rendered her a murderess herself. She was found guilty of the deed and hanged. Broad’s book—written in 1952, 31 years after the event—happens to mention Thompson’s comparative prosperity. She managed a millinery shop and earned enough to put her in the middle class: “six pounds per week,” as the author puts it, “or twelve pounds in our debased currency.” A doubling of prices in three decades called a debasement of the currency? What would Broad have written if he knew what was to come in the years ahead?

Then I began reading Ursa Major, a study of Doctor Johnson by C. E. Vulliamy. It was hostile to the great man; but from the point of view of inflation, what was interesting was Johnson’s pension from the crown. Worth 300 pounds per year when granted in 1762, Vulliamy informs us, it would have been worth 800 pounds at the time of Ursa Major’s publication in 1946.

But that 800 pounds, according to Broad’s book, would have been worth only 400 pounds as recently as 1921. If we put these two stories together, it means that 300 pounds in 1762 was the equivalent of 400 pounds in 1921; or, in other words, that in a century and a half, prices rose in Britain by about 33 percent, an overall rate so slow as to have been almost imperceptible year to year, even decade to decade. Such stability must have seemed more a fact of nature than a consequence of human behavior or policy, and therefore something that would last forever.

Of course, calculations of prices between different historical epochs can be inexact, if only because some things available to later ages were not available to earlier ones. What was the price of a chocolate bar in 1762? We can never know: bars of chocolate did not exist then.

Nevertheless, I can attest to a prolonged era of price stability from evidence in my own lifetime. When I was born, it cost one and a half times as much to send a letter as it did 100 years earlier. In my childhood, during the fifties, we still used the same coins, with the same denominations, that people had used during the Victorian era. The silver coins were still made of silver, not a worthless silvery metal. Occasionally, we would even come across pre-Victorian coins. Their continued use was not absurd: though prices had risen, they still bore some resemblance to what they had been in the earlier time. When my grandmother gave me a florin—one-tenth of a pound—I felt rich. It was enough, in any case, to buy a paperback book; between 50 and 60 times as much would be required now.

I also remember the vast white five-pound notes, as grandiose and almost as large as professional diplomas or nineteenth-century share certificates, that my father kept in a roll in his pocket, only 100 or 200 of which would have been needed in those days to buy a decent house. And it was still possible for a boy like me to buy something—albeit only a stick of gum—with the smallest coin of the realm, a farthing, worth one-960th of a pound. That something could be sold for such a tiny fraction of money might seem a sign of general poverty. But though the Britain of my youth lagged economically, it was far from poor.

The regime of relative price stability soon collapsed. During the sixties and seventies, the sums of money of which everyone spoke increased, first by a little and then by a lot (and how nonchalantly we now speak of trillions of dollars or euros!). All that had seemed solid, to paraphrase Marx, melted into air.

At the time, I gave no thought to the effects of this inflation, which tended to be discussed in purely economic terms—experts would ask, say, whether inflation was compatible with satisfactory economic growth. In a naive way, I assumed that since most people’s income tended to rise with inflation, there was nothing to worry about. I did not suffer personally because of it, nor did most of the people I knew. If a product once cost y and now cost 10y, what did it matter, so long as your income had gone up by ten times, too? Since people seemed better off, at least measured by what they could consume, one could even assume that incomes had risen faster than inflation.

Yet this was a crude way of looking at things, as my father’s fate should have instructed me. He sold his business in the sixties, at the end of the period of price stability that had reigned throughout his life, for what then seemed a large amount of money. He was a man who, for both temperamental and ideological reasons, held a deep contempt for financial speculation and wheeling and dealing, with the result that he did nothing as inflation inexorably eroded his savings. He grew poorer and poorer through the remaining 30 years of his life, and might have sunk into poverty had he not moved into a house that I owned. And this after reaching a level of wealth that, relatively speaking, was greater than I shall probably ever know.

For a while, I was angry about what seemed my father’s improvidence and lack of foresight. As the current financial crisis has conclusively demonstrated, however, not everyone is blessed with foresight, not even those whose livelihood depends primarily on the claim of possessing it. My father was born of a generation that saw money as a store of value, a far from dishonorable notion—and one that, when it reflected reality, helped give a lot of people peace of mind. And as I reach the age when inflation might cause me some embarrassment, even hardship, my sympathy with my father’s plight has grown. I am no longer young enough to fight another day, economically speaking: the destruction of my wealth by inflation would be final. In an aging population, more and more people are in my position, which helps explain why an age of prosperity can be an age of anxiety, even without a financial crisis.

Like my father, I am not particularly avaricious; on the other hand, I have no vocation for poverty and share the prejudice of most of mankind that a loss of capital and a sharp decline of income are much to be feared. In an era of price stability, a man of my disposition could judge with a degree of certainty how much money he would need for each year of his retirement. The calculation of how much principal he would require now, in order to yield that amount of money in interest each year in the future, was relatively simple and would yield financial tranquillity.

That kind of tranquillity about one’s financial future is more difficult for most of us to achieve now. President Reagan and Prime Minister Thatcher brought raging inflation under control in the U.S. and Britain during the eighties—at the cost of great short-term economic pain and considerable political and social strain—but they could not reverse the public’s loss of confidence in money as a store of value. People must today try to foresee not only how long they will live but also what is even less predictable: the reigning economic conditions of the next 40 years, assuming this to be the upper limit of their retirement period. And this, to quote Doctor Johnson in another context, “requires faculties which it has not pleased our Creator to give us.”

There seems to be no choice, then, but for everyone to have constant regard to his own pile, and to try to outwit the economic moth and rust that threaten to erode all but the largest fortunes: in short, he must speculate, or risk losing nearly everything. The question of whether it is best to hold shares, or bonds, or property, or gold, or some combination of them, is constantly before him. Further, as many who have taken tips from their brokers or bank will attest, funds’ managers and investors do not always have the same interests. A man trying to preserve a competence learns to trust neither himself nor others.

Inflation has overturned centuries of economic wisdom, or at least prejudice. When Polonius conferred his parting platitudes on Laertes, one was to “neither a lender nor a borrower be,” and this because a “loan oft loses both itself and friend.” A quarter of a millennium later, Mr. Micawber famously asserted that the secret of happiness was to live within one’s means; and while credit is obviously essential for economic growth, an intuitive difference exists between borrowing to consume beyond one’s means and borrowing to increase one’s means.

Inflation has blurred that intuitive difference. Many times I have received advice, from friends and banks, to borrow as much as I could so that I might buy the best and most expensive house possible. And for many years it seemed good advice, for what could be more advantageous than to buy an appreciating asset with depreciating currency, especially when my income was likely to appreciate faster than the currency depreciated? It was a painless way to become rich.

I did not take the advice—not entirely, anyway. I remained sufficiently a child of the regime of constant prices that I found it difficult to imagine how a sum that seemed vast now would seem trifling in just a few years: caution seemed wiser. Even so, I borrowed within what I thought to be my means, and thereby accumulated assets of a value that I could not have obtained by the steady buildup of savings. The curious result has been that at no point in my career could I have afforded to buy the real estate that I now own, whose value—even now, after a precipitate post-financial-crisis decline—greatly exceeds my cumulative income over the years. If my borrowing had been bolder, the value would exceed my earnings even more.

My situation is no different from that of millions of others, of course. And since we are all richer than we should otherwise be, is there anything, really, to complain about? The problem is that this “richer” represents a curious kind of wealth. I must live somewhere, after all, and everywhere else has appreciated in value, too. I don’t live any better in my house than I did before simply because it is worth three times what I paid for it. Its increase in value is thus of no use to me, unless I want to sell it to live in a less valuable house and invest the difference. An increase in the value of one’s house is therefore a bit like fool’s gold.

But for many years, people—in Britain, especially—have treated rising property values as if they were the real thing, and the government has supported this belief by allowing extremely easy credit. My bank gave me some good examples not long before the crunch.

I still remember the letter that the bank sent me when I was a student, pointing out with considerable asperity that I was almost three pounds overdrawn and asking when I would correct this serious irregularity. Nearly 40 years later, I briefly overdrew my account again—this time by much more—and wrote to the bank, explaining that I would clear the balance in a few days. Unusually, the bank called me: a banker wanted to see me, and would like to come to my house. I made an appointment and expected him with some trepidation.

When he arrived, I repeated that I would pay off the overdraft, and more, in less than a week’s time. “Oh, we don’t want you to do that,” he said. “I’ve come here to ask whether you want to borrow more money.”

“What for?”

“Well, a nice new car, or perhaps the holiday you’ve always dreamed of.”

I was astonished. The bank was encouraging me to indebt myself for an asset whose value would swiftly melt away—or for one of no resale value whatsoever. After rejecting this offer, I soon found myself receiving others—of large loans that would be advanced to me, as if by right, by a simple telephone call. Apart from home improvements, whose enduring monetary value would depend on the state of the property market, all the suggested uses to which I might want to put the lent money were for consumption in the here and now. It all suggested a giant pyramid scheme.

Some time later, I was thinking about buying another house, for which I would need a short-term loan. Passing my bank, and having a few minutes to spare, I entered and inquired about how I would arrange such a loan. Within five minutes, the bank had offered me a sum that was 20 percent larger than the single asset that it had evidence that I owned (another house)—whose value, in any case, was subject to fluctuation, including downward. I came away feeling that the bank was careless to the point of frivolity; it was treating money as if it were playing Monopoly, not exercising due diligence on behalf of its shareholders and depositors. Sure enough, the bank was nationalized two years later, in 2009, and its 3 million shareholders, who had enjoyed several fat years before the collapse, wound up virtually expropriated.

During those fat years, a man could sit at home watching television and imagine that he was growing richer thereby. I remember an eminent professor’s telling me, with a barely concealed exultation, that he was making nearly $1,000 per day, week after week, merely by owning a very large house in a fashionable area: an amount that, needless to say, dwarfed any savings he might salt away from his salary. The government could not have been better pleased, for the majority of the population, who owned their own homes, felt prosperous as never before and attributed their affluence to the government’s wise economic guidance.

But asset inflation—ultimately, the debasement of the currency—as the principal source of wealth corrodes the character of people. It not only undermines the traditional bourgeois virtues but makes them ridiculous and even reverses them. Prudence becomes imprudence, thrift becomes improvidence, sobriety becomes mean-spiritedness, modesty becomes lack of ambition, self-control becomes betrayal of the inner self, patience becomes lack of foresight, steadiness becomes inflexibility: all that was wisdom becomes foolishness. And circumstances force almost everyone to join in the dance.

Except in one circumstance, that is: the possession of a salary and a pension that the government promises, implicitly or explicitly, to index against inflation. This is the situation of public-sector workers and is a pyramid scheme, too, perhaps the biggest of the lot, since events may require the government to renege on its obligations. But meantime, such employment will seem a safe haven, and the temptation will be for government to expand it, with the happy consequence—for itself—of increasing dependence. And dependence, too, undermines character.

It is no coincidence that the Western leader most worried about a new bout of inflation is German chancellor Angela Merkel. If there is one thing that Germans agree about, it is the necessity—social and political as much as economic—of a sound currency. The hyperinflation of the 1920s brought about a German change in mentality as great as, or greater than, the one caused by World War I, with what disastrous consequences 50 million dead might attest if they had voice. The solidity of the deutsche mark was the great German achievement of the second half of the twentieth century.

Inflation is not a bogey for everyone—not for those who wish to restructure society, for example, or for those who want government control of ever more aspects of people’s lives. But for the rest of us, the consequences of its full-blown return are not likely to be good: for inflation is not an economic problem only, or even mainly, but one that afflicts the human soul.

Theodore Dalrymple, a physician, is a contributing editor of City Journal and the Dietrich Weismann Fellow at the Manhattan Institute. His most recent book is Not with a Bang but a Whimper.

from the Wall Street Journal, 2009-Oct-7, by David Malpass:

The Weak-Dollar Threat to Prosperity
Measured in euros, U.S. per capita GDP is down 25% since 2000.

If you want to know why the dollar has been falling this week and gold hit a new high, look no further than the weak jobs numbers last Friday and the weak communique issued over the weekend at the G-7 meeting in Istanbul. Deploring "excess volatility and disorderly movements in exchange rates" isn't exactly a ringing defense of the greenback. And 9.8% unemployment convinced markets that monetary policy will remain loose regardless of dollar weakness.

Bond buyer Bill Gross of the Pimco fund summed up the situation nicely in a recent CNBC interview. Asked whether low interest rates will weaken the dollar, the influential allocator of global capital said: "I think that's part of the administration's plan. It's obviously not announced—the 'strong dollar' is always the policy, so to speak. One of the ways a country gets out from under its debt burden is to devalue."

On the surface, the weak dollar may not look so bad, especially for Wall Street. Gold, oil, the euro and equities are all rising as much as the dollar declines. They stay even in value terms and create lots of trading volume. And high unemployment keeps the Fed on hold, so anyone with extra dollars or the connections to borrow dollars wins by buying nondollar assets.

Investors have been playing this weak-dollar trade for years, diverting more and more dollars into commodities, foreign currencies and foreign stock markets. This is the Third-World way of asset allocation.

Corporations play this game for bigger stakes, borrowing billions in dollars to expand their foreign businesses. As the pound slid in the 1950s and '60s and the British Empire crumbled, the corporations that prospered were the ones that borrowed pounds aggressively in order to expand abroad. Though British equities rose in pound terms, they generally underperformed gold and foreign equities. At the end of empire, the giant sucking sound was from British capital and jobs moving offshore as the pound sank.

Some weak-dollar advocates believe that American workers will eventually get cheap enough in foreign-currency terms to win manufacturing jobs back. In practice, however, capital outflows overwhelm the trade flows, causing more job losses than cheap real wages create. This was the lesson of the British malaise, the Carter malaise, the Mexican malaise of the 1990s, Yeltsin's Russian malaise through 1999 and the rest. No countries have devalued their way into prosperity, while many—Hong Kong, China, Australia today—have used stable money to invite capital and jobs.

The more the dollar devalued against the yen in the 1970s and '80s, the more Japan gained share in valued-added manufacturing, using the capital from weak-currency countries to increase productivity. China is doing the same now. It watches in chagrin as the U.S. pleads with it to strengthen the yuan, adding productivity fast with the dollars rushing its way in search of currency stability.

If stocks double but the dollar loses half its value, who beyond Wall Street are the winners and losers? There's been a clear demonstration this decade. The S&P nearly doubled from 2003 through 2007. Those who borrowed to buy won big-time. Rich people got richer, seeing their equity bottom line double. At the same time, the dollar's value was cut nearly in half versus the euro and other stable measures. Capital fled, undercutting job growth. Rent, gasoline and food prices rose more than wages.

Equity gains provide cold comfort when currencies crash. From the euro perspective, the S&P peaked at 1700 in 2000, finally reattained 1100 in the 2007 bubble, fell below 600 in March and now stands at 700 (see nearby chart). With most of the market capitalization of U.S. stocks held by Americans, the dollar devaluation has caused a massive decline in the U.S. share of global wealth.

Measured in euros (a more stable ruler than the ever-weakening dollar), U.S. real per capita GDP is down 25% since 2000, while Germany's is up 4% and tops ours.

The solution is a strong U.S. jobs and wealth program. It has to include stable money, a flatter, more competitive tax structure, spending restraint, and common-sense bank regulation so small business lending can restart. Treasury has to rapidly lengthen the maturity of the national debt and take steps to protect the Fed from market losses on its long-term debt holdings.

Instead, Washington's current economic program pushes capital away by weakening the dollar, threatening higher tax rates, borrowing short (the Fed's near trillion-dollar overnight debt, Treasury's mounds of bill and note issuance) to lend long (mortgages, student loans, entitlements), doubling down on government subsidies, and rechanneling bank loans to governments and big businesses instead of the small business job-growth engine.

It's possible global bond vigilantes will call Washington's bluff, reducing their bond purchases until we stop devaluing and restart job growth, which is the ultimate source of tax revenues to repay our bond debt. This would create a Volcker moment when the U.S. might tighten even as the economy slowed (as then Fed Chairman Paul Volcker did back in 1979).

But the accepted outlook is the almost-as-gloomy new norm. If all goes according to current plans, the dollar devalues slowly and bond buyers come back for more even as national debt heads toward $15 trillion. World living standards grow faster than ours, as does global wealth. The Fed chases inflation as the dollar sinks, but not so fast as to stop the recovery. More capital moves abroad, leaving U.S. unemployment too high too long.

A better approach would start with President Barack Obama rejecting the Bush administration's weak-dollar policy. This would invite capital and jobs to come back before interest rates have to rise.

Mr. Malpass is president of Encima Global LLC.

from the Wall Street Journal, 2009-Oct-9, p.A18:

The Dollar Adrift
A global vote of non-confidence.

The biggest story in the world economy is the continuing fall of the U.S. dollar, or at least it is everywhere outside of Washington, D.C., the place most responsible for its declining value. For good reason, the world is wondering if America has cast the dollar adrift.

A passel of Asian central banks—South Korea, Taiwan, the Philippines and Thailand—intervened yesterday to stop the greenback's fall against their currencies. European Central Bank President Jean-Claude Trichet also tried to buoy the buck, telling reporters that "A strong dollar is extremely important in the given circumstances." Neither effort made much difference.

Meanwhile, the London Independent created a splash this week with a thinly sourced and not very credible story that several nations were working secretly to trade oil in currencies other than the dollar. The alleged conspirators all quickly denied it, but the tizzy the story created suggests the global mood of concern about holding American currency.

The attempts at intervention are probably futile, save for the short-term scare they give to currency traders. Currency interventions are typically "sterilized," which means that while a central bank extinguishes a currency (say, Thai baht) in the foreign-exchange markets it creates more baht through domestic monetary operations. Thus there's no underlying change in the relative supply of baht versus dollars. The point of intervention is to frighten traders about the risks of speculating and getting burned. Everything else is commentary.

The value of any currency is ultimately determined by the supply and demand for that currency. And the problem for the dollar at the moment is that there is a much larger supply of dollars than there is global demand for them. The solution rests not in Manila, Bangkok or Paris, but in Washington.

Start with dollar supply, which is entirely a function of America's central bank, the Federal Reserve. The Fed has been flooding the world with dollars in the name of preventing a U.S. deflation after last year's panic, and it shows no sign of tightening any time soon. Last week's awful September jobs report convinced markets that the Fed will keep the money spigot wide open well into 2010. And yesterday, Richard Fisher, president of the Dallas Fed and thought to be a rare hawk on the Fed's Open Market Committee, chimed in that no one at the Fed thinks this is the time to raise interest rates.

All of this is a signal to world markets that holding dollars is a risky proposition, which in turn contributes to falling global demand for dollars. The Fed is telling the world that it is concerned primarily—perhaps only—with the domestic U.S. economy. If the dollar falls against other currencies, that's their problem. The Fed will let the dollar fall.

For a time in the wake of the panic, the dollar benefitted from a flight to the relative safety of U.S. Treasurys and other dollar assets. (See the nearby chart.) In a storm, the dollar was thought to be less risky than other investments. But as this overall global risk aversion has ebbed, the risk calculus has turned and the dollar itself has become more dangerous to hold than nondollar investments.

The world's investors can also see the arc of overall U.S. economic policy, which is becoming less inviting to global capital. Higher taxes on capital gains and income; new entitlements that will require trillions of dollars in new U.S. borrowing; a wave of new antitrust enforcement, more telecom regulation ("net neutrality") and trade protection, new restrictions on energy production, easier rules for union organizing, and so much more. All of these are signals that U.S. growth is likely to be slower than it otherwise would be, and that the returns on investing in America will be lower than they should be. This too is a reason to sell greenbacks.

For many in the Washington establishment, alas, the falling dollar is considered a virtue. They believe it will help U.S. exports and therefore reduce the trade deficit and bring back manufacturing jobs. But as David Malpass argued on these pages yesterday, capital flows dwarf trade flows as a source of wealth creation. The only way to build wealth and create more high-paying jobs over time is through the productivity gains that come from greater investment and innovation. As the dollar falls and capital flees the U.S. for other countries, those global competitors reap its benefits and become more productive and relatively more prosperous.

The more immediate danger—in the coming months—would be if the fall of the dollar becomes a rout. This could cause a spike in commodity prices, such as oil, that are traded in dollars and jeopardize the nascent economic recovery. But even if there is no dollar panic, the volatility of currency markets is distorting investment decisions and creating more economic uncertainty. It could also lead to a round of competitive devaluations, as other nations try to placate their own domestic export constituencies.

Washington may not care to notice, but the sell-off in the dollar is a daily global vote on U.S. economic policy. It is not a vote of confidence.

from the Independent of London, 2009-Oct-6, by Robert Fisk:

The demise of the dollar
In a graphic illustration of the new world order, Arab states have launched secret moves with China, Russia and France to stop using the US currency for oil trading

In the most profound financial change in recent Middle East history, Gulf Arabs are planning – along with China, Russia, Japan and France – to end dollar dealings for oil, moving instead to a basket of currencies including the Japanese yen and Chinese yuan, the euro, gold and a new, unified currency planned for nations in the Gulf Co-operation Council, including Saudi Arabia, Abu Dhabi, Kuwait and Qatar.

Secret meetings have already been held by finance ministers and central bank governors in Russia, China, Japan and Brazil to work on the scheme, which will mean that oil will no longer be priced in dollars.

The plans, confirmed to The Independent by both Gulf Arab and Chinese banking sources in Hong Kong, may help to explain the sudden rise in gold prices, but it also augurs an extraordinary transition from dollar markets within nine years.

The Americans, who are aware the meetings have taken place – although they have not discovered the details – are sure to fight this international cabal which will include hitherto loyal allies Japan and the Gulf Arabs. Against the background to these currency meetings, Sun Bigan, China's former special envoy to the Middle East, has warned there is a risk of deepening divisions between China and the US over influence and oil in the Middle East. "Bilateral quarrels and clashes are unavoidable," he told the Asia and Africa Review. "We cannot lower vigilance against hostility in the Middle East over energy interests and security."

This sounds like a dangerous prediction of a future economic war between the US and China over Middle East oil – yet again turning the region's conflicts into a battle for great power supremacy. China uses more oil incrementally than the US because its growth is less energy efficient. The transitional currency in the move away from dollars, according to Chinese banking sources, may well be gold. An indication of the huge amounts involved can be gained from the wealth of Abu Dhabi, Saudi Arabia, Kuwait and Qatar who together hold an estimated $2.1 trillion in dollar reserves.

The decline of American economic power linked to the current global recession was implicitly acknowledged by the World Bank president Robert Zoellick. "One of the legacies of this crisis may be a recognition of changed economic power relations," he said in Istanbul ahead of meetings this week of the IMF and World Bank. But it is China's extraordinary new financial power – along with past anger among oil-producing and oil-consuming nations at America's power to interfere in the international financial system – which has prompted the latest discussions involving the Gulf states.

Brazil has shown interest in collaborating in non-dollar oil payments, along with India. Indeed, China appears to be the most enthusiastic of all the financial powers involved, not least because of its enormous trade with the Middle East.

China imports 60 per cent of its oil, much of it from the Middle East and Russia. The Chinese have oil production concessions in Iraq – blocked by the US until this year – and since 2008 have held an $8bn agreement with Iran to develop refining capacity and gas resources. China has oil deals in Sudan (where it has substituted for US interests) and has been negotiating for oil concessions with Libya, where all such contracts are joint ventures.

Furthermore, Chinese exports to the region now account for no fewer than 10 per cent of the imports of every country in the Middle East, including a huge range of products from cars to weapon systems, food, clothes, even dolls. In a clear sign of China's growing financial muscle, the president of the European Central Bank, Jean-Claude Trichet, yesterday pleaded with Beijing to let the yuan appreciate against a sliding dollar and, by extension, loosen China's reliance on US monetary policy, to help rebalance the world economy and ease upward pressure on the euro.

Ever since the Bretton Woods agreements – the accords after the Second World War which bequeathed the architecture for the modern international financial system – America's trading partners have been left to cope with the impact of Washington's control and, in more recent years, the hegemony of the dollar as the dominant global reserve currency.

The Chinese believe, for example, that the Americans persuaded Britain to stay out of the euro in order to prevent an earlier move away from the dollar. But Chinese banking sources say their discussions have gone too far to be blocked now. "The Russians will eventually bring in the rouble to the basket of currencies," a prominent Hong Kong broker told The Independent. "The Brits are stuck in the middle and will come into the euro. They have no choice because they won't be able to use the US dollar."

Chinese financial sources believe President Barack Obama is too busy fixing the US economy to concentrate on the extraordinary implications of the transition from the dollar in nine years' time. The current deadline for the currency transition is 2018.

The US discussed the trend briefly at the G20 summit in Pittsburgh; the Chinese Central Bank governor and other officials have been worrying aloud about the dollar for years. Their problem is that much of their national wealth is tied up in dollar assets.

"These plans will change the face of international financial transactions," one Chinese banker said. "America and Britain must be very worried. You will know how worried by the thunder of denials this news will generate."

Iran announced late last month that its foreign currency reserves would henceforth be held in euros rather than dollars. Bankers remember, of course, what happened to the last Middle East oil producer to sell its oil in euros rather than dollars. A few months after Saddam Hussein trumpeted his decision, the Americans and British invaded Iraq.

from the Wall Street Journal, 2009-Sep-22, p.A25, by Arthur B. Laffer:

Taxes, Depression, and Our Current Troubles
Tariffs, rising state and federal taxes, and currency devaluation ruined the 1930s, and they could do the same today.

The 1930s has become the sole object lesson for today's monetary policy. Over the past 12 months, the Federal Reserve has increased the monetary base (bank reserves plus currency in circulation) by well over 100%. While currency in circulation has grown slightly, there's been an impressive 17-fold increase in bank reserves. The federal-funds target rate now stands at an all-time low range of zero to 25 basis points, with the 91-day Treasury bill yield equally low. All this has been done to avoid a liquidity crisis and a repeat of the mistakes that led to the Great Depression.

Even with this huge increase in the monetary base, Fed Chairman Ben Bernanke has reiterated his goal not to repeat the mistakes made back in the 1930s by tightening credit too soon, which he says would send the economy back into recession. The strong correlation between soaring unemployment and falling consumer prices in the early 1930s leads Mr. Bernanke to conclude that tight money caused both. To prevent a double dip, super easy monetary policy is the key.

While Fed policy was undoubtedly important, it was not the primary cause of the Great Depression or the economy's relapse in 1937. The Smoot-Hawley tariff of June 1930 was the catalyst that got the whole process going. It was the largest single increase in taxes on trade during peacetime and precipitated massive retaliation by foreign governments on U.S. products. Huge federal and state tax increases in 1932 followed the initial decline in the economy thus doubling down on the impact of Smoot-Hawley. There were additional large tax increases in 1936 and 1937 that were the proximate cause of the economy's relapse in 1937.

In 1930-31, during the Hoover administration and in the midst of an economic collapse, there was a very slight increase in tax rates on personal income at both the lowest and highest brackets. The corporate tax rate was also slightly increased to 12% from 11%. But beginning in 1932 the lowest personal income tax rate was raised to 4% from less than one-half of 1% while the highest rate was raised to 63% from 25%. (That's not a misprint!) The corporate rate was raised to 13.75% from 12%. All sorts of Federal excise taxes too numerous to list were raised as well. The highest inheritance tax rate was also raised in 1932 to 45% from 20% and the gift tax was reinstituted with the highest rate set at 33.5%.

But the tax hikes didn't stop there. In 1934, during the Roosevelt administration, the highest estate tax rate was raised to 60% from 45% and raised again to 70% in 1935. The highest gift tax rate was raised to 45% in 1934 from 33.5% in 1933 and raised again to 52.5% in 1935. The highest corporate tax rate was raised to 15% in 1936 with a surtax on undistributed profits up to 27%. In 1936 the highest personal income tax rate was raised yet again to 79% from 63%—a stifling 216% increase in four years. Finally, in 1937 a 1% employer and a 1% employee tax was placed on all wages up to $3,000.

Because of the number of states and their diversity I'm going to aggregate all state and local taxes and express them as a percentage of GDP. This measure of state tax policy truly understates the state and local tax contribution to the tragedy we call the Great Depression, but I'm sure the reader will get the picture. In 1929, state and local taxes were 7.2% of GDP and then rose to 8.5%, 9.7% and 12.3% for the years 1930, '31 and '32 respectively.

The damage caused by high taxation during the Great Depression is the real lesson we should learn. A government simply cannot tax a country into prosperity. If there were one warning I'd give to all who will listen, it is that U.S. federal and state tax policies are on an economic crash trajectory today just as they were in the 1930s. Net legislated state-tax increases as a percentage of previous year tax receipts are at 3.1%, their highest level since 1991; the Bush tax cuts are set to expire in 2011; and additional taxes to pay for health-care and the proposed cap-and-trade scheme are on the horizon.

In addition to all of these tax issues, the U.S. in the early 1930s was on a gold standard where paper currency was legally convertible into gold. Both circulated in the economy as money. At the outset of the Great Depression people distrusted banks but trusted paper currency and gold. They withdrew deposits from banks, which because of a fractional reserve system caused a drop in the money supply in spite of a rising monetary base. The Fed really had little power to control either bank reserves or interest rates.

The increase in the demand for paper currency and gold not only had a quantity effect on the money supply but it also put upward pressure on the price of gold, which meant that dollar prices of all goods and services had to fall for the relative price of gold to rise. The deflation of the early 1930s was not caused by tight money. It was the result of panic purchases of fixed-dollar priced gold. From the end of 1929 until early 1933 the Consumer Price Index fell by 27%.

By mid-1932 there were public fears of a change in the gold-dollar relationship. In their classic text, "A Monetary History of the United States," economists Milton Friedman and Anna Schwartz wrote, "Fears of devaluation were widespread and the public's preference for gold was unmistakable." Panic ensued and there was a rush to buy gold.

In early 1933, the federal government (not the Federal Reserve) declared a bank holiday prohibiting banks from paying out gold or dealing in foreign exchange. An executive order made it illegal for anyone to "hoard" gold and forced everyone to turn in their gold and gold certificates to the government at an exchange value of $20.67 per ounce of gold in return for paper currency and bank deposits. All gold clauses in contracts private and public were declared null and void and by the end of January 1934 the price of gold, most of which had been confiscated by the government, was raised to $35 per ounce. In other words, in less than one year the government confiscated as much gold as it could at $20.67 an ounce and then devalued the dollar in terms of gold by almost 60%. That's one helluva tax.

The 1933-34 devaluation of the dollar caused the money supply to grow by over 60% from April 1933 to March 1937, and over that same period the monetary base grew by over 35% and adjusted reserves grew by about 100%. Monetary policy was about as easy as it could get. The consumer price index from early 1933 through mid-1937 rose by about 15% in spite of double-digit unemployment. And that's the story.

The lessons here are pretty straightforward. Inflation can and did occur during a depression, and that inflation was strictly a monetary phenomenon.

My hope is that the people who are running our economy do look to the Great Depression as an object lesson. My fear is that they will misinterpret the evidence and attribute high unemployment and the initial decline in prices to tight money, while increasing taxes to combat budget deficits.

Mr. Laffer is the chairman of Laffer Associates and co-author of "The End of Prosperity: How Higher Taxes Will Doom the Economy—If We Let It Happen" (Threshold, 2008).

from the Wall Street Journal, 2009-Oct-8, p.A16:

Mrs. Pelosi's VAT
The Speaker floats a middle-class tax hike.

Candor about taxes is rare in Washington, so when House Speaker Nancy Pelosi admits that Democrats may have to impose a huge new tax on the middle class to fund their spending ambitions, believe her.

Speaking with PBS's Charlie Rose on Monday, Mrs. Pelosi mused publicly about the rising possibility of enacting a value-added tax, or VAT, as part of broader tax reform. "Somewhere along the way, a value-added tax plays into this," she said. "Of course, we want to take down the health-care cost, that's one part of it. But in the scheme of things, I think it's fair to look at a value-added tax as well."

The allure of a VAT for politicians is that it applies to every level of production or service, rakes in piles of money, and is largely hidden from those who ultimately pay it—namely, consumers. With a $9 trillion 10-year budget deficit, $4 trillion in spending in fiscal 2010 alone, and a $1 trillion (at a minimum) health-care entitlement in the wings, Mrs. Pelosi knows that not even the revenue from the expiration of the lower Bush tax rates in 2011 will cover the bills. Nearly every European country that has passed national health care has also eventually imposed a VAT, and it's foolish to think the U.S. will be different.

Mrs. Pelosi is the second prominent Democrat to call for a VAT in recent weeks. John Podesta, an adviser to President Obama and president of the very liberal Center for American Progress, called in September for a "small and more progressive" VAT. Mrs. Pelosi and Mr. Podesta argue a new tax is necessary to address the nation's exploding financial liabilities, as if those liabilities exploded on their own. Of course, VATs always start "small" and get bigger. The bills for the Democratic spending blowout are coming due even sooner than advertised, and the middle class will pay, whatever Mr. Obama's campaign promises.

from the Wall Street Journal, 2009-Oct-14, by Ernest S. Christian and Gary A. Robbins:

The Dangers of a Value-Added Tax
This European version of the sales tax could stealthily and dramatically grow the federal government.

On its way out of the recession, the economy may encounter a VAT blocking its way.

Last week on PBS's "Charlie Rose Show," House Speaker Nancy Pelosi said she thinks "it's fair to look at a value-added tax." And the Congressional Research Service just published a lengthy new paper on the value-added tax that tends to obscure the fact that the middle class will bear the majority of its burden.

Even Alan Greenspan is on board, albeit reluctantly, he says. Paul Volcker, chairman of Mr. Obama's tax reform panel, may not be far behind.

With the deficits at a historic high, these former heads of the Federal Reserve may prefer to pay for President Obama's spending spree with taxes instead of borrowed money. But tax and spend is no better than borrow and spend. Why not just stop spending so much?

For Mr. Obama, a VAT, which appears on the surface to simply tax goods and services at the cash register, is the ideal tax. At a 17% tax rate, for example, he can quickly increase taxes by $1.5 trillion a year in a partially hidden way. A VAT is by its nature hidden, because no one files a tax return.

The VAT is so slippery that academics here and abroad do not agree on who pays this seemingly magical tax. Some economists still deceive themselves with the old notion that a VAT is simply a tax on consumers. This misperception comes from the European VAT, which uses a system of credits to create the illusion of pushing the tax forward from one business to another and finally to consumers.

Modern economists in the U.S. take the view that consumers bear only about 50% of the VAT, basically through higher prices and fewer product choices. Because of market forces, the rest of the tax ends up back on the owners and the employees of the companies that produce and sell the goods and services subject to the VAT.

Our own simple general equilibrium model suggests that about 33% of the VAT tax is borne by people in proportion to their relative wage levels, about 17% in proportion to their capital, and about 50% in proportion to their consumption. Federal, state and municipal employees escape the implicit wage tax, but otherwise, the VAT is predominantly a tax on middle-class and upper-income earners and consumers.

The VAT also taxes imports, but excludes exports from taxation. But here again there is confusion. For instance, who really pays the import tax?

The old idea was that U.S. consumers would in all cases pony up the import tax in addition to the price of the imported product. In the case of most manufactured goods, however, the modern view is that market competition pushes all or part of the import tax back onto foreign sellers. There is no definitive answer as yet.

Amidst all this uncertainty, just imagine what a master political spin doctor like Mr. Obama could do with vast amounts of additional tax revenues drawn heavily from the wages and savings of the middle class, though widely misperceived to be paid disproportionately by lower-income consumers.

Proceeding from that misperception, he could create a vast new subsidy program that would offset by many multiples the VAT tax actually borne by these newly created welfare recipients. He could also increase the income tax on "the rich," saying that they and the middle class get a nearly free ride under the VAT compared to less affluent people who must spend everything on purchasing "taxable" essentials. Not so, but the VAT lends itself to spin.

Mr. Obama and Mrs. Pelosi might also use the VAT to fund "free" government-run medical care and hospitals for everyone, as well as "free" college education and "free" home mortgages.

How about a temporary VAT, solely to pay down the federal debt? When was the last time a tax ever went away? Or how about a smaller VAT of only 5%? Obviously, it could quickly grow. Any tax increase big enough to repay much of the huge federal debt would devastate the economy for years to come.

The one certainty about a VAT is its enormous revenue-producing potential. At a rate of 17% to 18%—about average for Europe—it could increase total federal taxes to 30% of GDP or more from 15% now, according to the Congressional Budget Office. In combination with higher federal spending, this could forever alter the balance between the public and private sectors.

America and its economy would be radically changed—and not for the better. The first priority in Washington should be to cut spending, not to add a powerful new weapon to the tax arsenal.

Mr. Christian, a lawyer, is co-author of "The Value Added Tax: Orthodoxy and New Thinking" (Kluwer, 1989). Mr. Robbins is the chief economist at the Center for Strategic Tax Reform in Washington, D.C.

from City Journal online, 2009-Sep-17, by Nicole Gelinas:

Global Warning
Iceland’s failed banks offer the West a lesson.

Why Iceland?: How One of the World’s Smallest Countries Became the Meltdown’s Biggest Casualty, by Asgeir Jonsson (McGraw-Hill, 224 pp., $22.95)

Nearly a year ago, tiny Iceland’s financial institutions collapsed, just as banks and investment firms did all over the West last autumn. But Iceland differed from the rest of the developed world in forcing its insolvent financial institutions’ bondholders to take their losses. Alone among the world’s nations, Iceland has efficiently taken the principle of “too big to fail,” which governs taxpayer rescues of large or complex financial institutions, to its inevitable end: failure. Other nations, including the United States, risk eventually following Iceland, unless they understand its lesson.

As Asgeir Jonsson, chief economist at one of the banks at the center of the crisis, observes in Why Iceland?, Iceland had a tense relationship with finance long before 2008. A century ago, the island nation benefited from creative financial growth, with a foreign-owned bank supporting the modernization of its fishing industry. But when the Depression came, that bank failed, and Icelanders opposed spending money to benefit the overseas speculators who owned it. Rather than create regulations to support a healthier private-sector financial industry, as much of the West did, Iceland nationalized its banks, causing a “50-year pause in Iceland’s financial development,” writes Jonsson.

Iceland gave little thought to banking again until the 1980s, when a severe recession soured its citizens on postwar statism and pushed them to embrace the Thatcherite reforms taking hold in Britain. The Nordic country slashed taxes, broke inflation, gradually sold off its banks (completing that process in 2003), and signed an agreement to gain access to European markets.

The previous decades of government dominance continued to haunt finance, though. A “lack of institutional memory” in the industry “allowed all participants, bankers and government officials alike, fundamentally to underestimate systemic risk,” Jonsson writes, while private firms, until 2003, had to compete against the remaining state firms, which retained the advantage of government backing. (Similarly, in America, few financiers or regulators after the 1980s remembered the lessons of the Depression five decades earlier, and America, too, had its fair share of government distortion of finance, especially in the Washington-dominated mortgage markets.) In Iceland, this government shadow helped define one upstart private-sector bank, Kaupthing. Kaupthing made up for its disadvantages against state-owned competitors with what seemed at the time like smart aggression. Eventually, the rest of Iceland’s banking system followed suit, with Iceland’s two big banks matching the growing Kaupthing risk for risk.

In the decade leading up to the 2008 crisis, Iceland’s banks, along with the rest of the world’s financial economy, became short-lived beneficiaries of the global debt and derivatives bubble. They could attract tens of billions of dollars from global investors partly because Iceland had no public-sector debt, but largely because international banks desired the Icelandic banks’ bonds, folding them into AAA-rated securities and selling them to other international banks. Absent this global hunger for debt, Iceland’s banks couldn’t have grown so quickly, as Icelanders’ savings were tiny compared with the size of their banks’ ambition. Much of the debt was in dollars—a tremendous risk, since if the local currency fell against the dollar, the banks would owe much more. But the bankers didn’t let this concern slow them down. The derivatives they used would hedge that risk, they thought, just as financial institutions around the world convinced themselves that they had solved similarly irresolvable problems.

But the fundamental reason for Icelandic banks’ growth—and financial growth around the world—was the universal faith that because finance had grown so complex and interconnected, no Western nation would allow any of its big, complex financial institutions to fail. As Jonsson writes, “Banks in the western world have operated for decades under the assumption that both bondholders and depositors have a government guarantee against their loss. . . . This assumption of state support unquestionably helped to fuel the Western banking bubble, and it also helped the Icelandic banks to shine.” By 2007, Iceland’s banks had amassed assets ten times the nation’s annual GDP—tenfold growth in a decade. But even as foreign investors grew nervous in 2006, bond analysts at Moody’s assuaged their worry, determining that each of Iceland’s banks was “too important to fail” and declaring that if the need for government support arose, “access to finance will always be available.”

This happy thought proved ephemeral. When, starting in 2007, the world’s lenders lost confidence in the main technique behind all that global debt—securitization—they also lost confidence that financial firms’ assets could hold their values without the easy debt that securitization had provided. As exuberance turned to pessimism, the financial world used unregulated credit derivatives to bet against the Bear Stearns and Lehman Brothers investment banks—and against Iceland’s banks, too. With cheap debt gone and with unregulated financial instruments monetizing and magnifying fear, the banks faced the prospect of selling into a plummeting market, forcing more distressed sales as prices fell.

After the U.S. government bailed out Bear Stearns’s bondholders and trading partners in March 2008, investors stopped pretending to trust financial institutions and looked instead to the strength of national governments. In June, Iceland had an opportunity to shore up its banks with public money, but that would have required extensive borrowing, and it saw the interest rate, while affordable, as unfairly high. Iceland’s central bank also sought help from the world’s central banks, including the Federal Reserve, attempting to secure access to dollars and euros in an emergency. But Iceland failed to get the help it needed, partly because Icelanders “seemed not at all ready to abandon their aggressive international banking model, an impossible dream made real,” Jonsson writes. In this stubbornness, Iceland was like Lehman Brothers, which, during the spring and summer of 2008, balked at selling out to a stronger outside investor at what seemed like an unfair price.

After Lehman’s September 15 bankruptcy, each nation protected its own, but by now, Iceland couldn’t borrow to save its banks at any price. Officials tried, assuming that the impossibly high interest rates that the market was demanding to hold its banks’ debt would come down and meet the lower rates that bondholders had required to buy government debt, since the banks would now have government support. That was what happened in America and much of Western Europe. But in Iceland, the opposite occurred, and borrowing costs for the government skyrocketed out of reach. The world started to understand that Iceland’s financial sector was, not too big to fail, but too big to save. So Iceland—out of necessity, not ideology—did what no other Western nation has done: it let two of its three financial giants go under, nationalizing them and forcing losses on bondholders.

As the banks failed, Iceland, too, did what it could to protect its own. It pledged to expand coverage to all domestic deposits under its version of FDIC insurance. But the strategy had a weak spot. One Icelandic bank, Landesbanki, had marketed its “Icesave” accounts over the Internet to British customers, and it had used its own branches to do so, not a separate British company. That meant that Iceland’s deposit insurance applied to the Britons, too, and European regulations forbade Iceland from saving domestic depositors at the expense of equally insured foreign ones. This put Iceland in a fiscally untenable position, since Icesave had amassed foreign deposits worth 70 percent of the country’s GDP.

As Iceland dithered over whether it could make good on a liability that would take its debt from zero to levels that would have been considered high at the time even in the rest of the indebted West, British depositors panicked, and so did the British government, which feared that the public wouldn’t differentiate between Britain’s banks and Icesave. To maintain confidence in its banks, Britain offered Icesave account holders its own government protection. Then, using powers granted under antiterrorism law, the government seized the British assets of Landesbanki, by now Iceland’s last remaining big bank. The bank then collapsed back home, bringing 95 percent of Iceland’s financial system into bankruptcy and under state control. “Most ordinary Icelandic citizens felt as if they had been expelled from Europe,” Jonsson writes, with Icelanders abroad cut off from international credit-card and ATM systems.

So that its citizens and businesses could import necessities as its currency cratered, Iceland went to the International Monetary Fund, borrowing money on terms that included budget cuts and a promise to repay the British and the Dutch (whose government had also stepped in to protect its Icesave customers). In addition to the $2 billion IMF loan (with more likely to follow), Iceland now owes $5 billion because of Landesbanki’s Icesave obligations—roughly one foreign Icesave account for every Icelandic citizen.

It’s comforting to think, as Tufts professor Daniel W. Drezner wrote in the Wall Street Journal, that “what happened in Iceland will probably stay in Iceland.” Yet we ignore Iceland at our peril. “The biggest difference between the Icelandic banks and the banks abroad was first and foremost the level of assistance their government would be able to grant in times of crisis,” Jonsson correctly notes. But Iceland’s financial sector outgrew the nation’s ability to rescue it because global investors thought that the nation could rescue it—and unless the rest of the West credibly rejects its too-big-to-fail approach, the same thing, someday, could happen here. Thirty-five years ago, financial-sector debt in America was 17 percent of GDP; today, it’s 18 percent greater than GDP. We don’t know how big is too big for the government to rescue, but without adequate regulations, we risk finding out.

Yes, the U.S. and significant parts of Europe have obvious protections against an Iceland-style capital runoff. America borrows in dollars, the world’s reserve currency; Europe, too, has strength in the euro. America and Europe have more diverse economies than Iceland’s. But the first advantage can slowly erode the second. America’s access to debt could allow it to keep underwriting an unsustainable financial system. The government has already used its credit to bail out banks instead of financing modern infrastructure. Private capital could continue to find a home in a profitable, government-protected financial industry—at the expense of healthier growth in other industries and a robust economy maintained and refined through fair competition. Perversely, Iceland’s demise may accelerate concentration of financial services in seemingly stronger nations, crowding out other businesses, because nobody will recklessly lend money to a bank headquartered in a country that can’t back up its banks.

What’s next for Iceland—its economy sunk, its self-esteem ruined, its government slashing spending, and its citizens angry at becoming “Iceslaves” to reimburse foreign depositors? University of Missouri econ professor Michael Hudson wonders if Iceland will “be plunged into austerity in an attempt to squeeze out an economic surplus to avoid default.” Some observers believe that Icelanders will end up like the Germans after World War I, resentful at the world and tempted to spite global lenders. For now, Iceland’s economy depends partly on Western creditors’ giving it some slack; Britain and the Netherlands have agreed to delay the country’s repayment of the Icesave obligation and then limit it to 6 percent of future GDP per year. But Iceland can’t avoid cutting public spending as it weans itself from unsustainable financial services’ illusory wealth.

Icelanders may in time understand that they have bought something quite valuable with all of this debt, which now exceeds 100 percent of GDP: freedom from a too-big-to-fail financial system. Iceland’s taxpayers may owe a lot, but they’ve cut the tab off. “Iceland now enjoys the dubious distinction of being the only Western nation to have ‘solved’ its banking problem,” writes Jonsson. The rest of the West is still racking up charges.

As Iceland recovers, it should even think about returning to global finance. In a few years’ time, if Iceland reprivatizes its financial industry and improves regulation to limit borrowing, it could credibly argue that its rebuilt industry offers the West’s only real measure of financial risks, absent government guarantees. It might get few takers. That would say a lot about investors’ confidence in an industry upon which the West has become dangerously dependent for economic growth.

Nicole Gelinas, a City Journal contributing editor, is author of the forthcoming After the Fall: Saving Capitalism from Wall Street—and Washington.

from City Journal, 2009-Summer, by Nicole Gelinas:

“Too Big to Fail” Must Die
If we continue to subsidize irresponsible risk-taking, we’ll just get more of it.

In an April speech to the Economic Club of New York, the chairman of the Federal Deposit Insurance Corporation, Sheila Bair, took a stand on one of today’s most pressing economic questions. The idea that certain financial firms were “too big to fail,” she said, should be “tossed in the dustbin.” Congress should pay attention. Since the early 1980s, Washington has increasingly refused to let the largest or most complex financial institutions—the expression “too big to fail” includes both—go under in a predictable manner. Instead, it has taken extraordinary actions to rescue and protect them, lest their failure inflict broader harm on the economy. By sheltering the lenders to these firms from market discipline, it has encouraged the financial industry and its consumers’ debt load to grow to unsustainable size. Yet even after the Wall Street collapse, the Obama administration, far from following Bair’s advice, is pushing the “too big to fail” policy even further. This course will exact a terrible cost. For our economy to thrive, “too big to fail” must die.

Until the early 1980s, it was generally assumed that failure was a possibility for financial institutions, along with losses for investors who lent to them or held shares in them. Sensible regulation underpinned the assumption. Back in the mid-1930s, the trough of the Great Depression, the federal government created a way for commercial banks to go under without catastrophically damaging the broader economy—as had happened earlier in the decade, when customers, panicked about banks’ health, rushed to withdraw their money, making lending dry up completely. The feds’ instrument was the very institution that Bair now heads: the FDIC, a government-chartered body that insured small depositors’ funds so that they wouldn’t panic. With mom-and-pop depositors protected, the FDIC could then take over failed banks and wind them down in a predictable way, ensuring that shareholders and uninsured lenders—that is, depositors whose accounts exceeded FDIC limits, as well as bondholders—took their lumps. (The FDIC covered only commercial banks—the storehouses of the economy’s vital money and credit supplies—not investment banks, which failed through the normal bankruptcy process.)

Fifty years of policy died in 1984. That May, the nation’s eighth-largest commercial bank, Chicago’s Continental Illinois, found itself in deep trouble. Like any enterprising company in a capitalist society, it had exercised its right to establish a competitive edge and pursue greater profits—with a corresponding risk of failure, which had now struck. Continental’s biggest error was how it paid for its investments. All banks use depositors’ money and other sources of funding to make loans and other investments. But beyond using funds from FDIC-insured small depositors and other stable, long-term lenders (such as bondholders), Continental relied more than most banks on short-term, uninsured lenders from around the globe, particularly large depositors. Global corporations and other investors often park their money overnight or for a few weeks at a time in bank accounts that offer slightly higher rates because, once they’ve exceeded the FDIC limits, they carry risk. For a lender who doesn’t mind that risk, these short-term, uninsured accounts are attractive, since he can pull his money at any time if he needs cash, finds a better rate elsewhere, or perceives a new danger. For the borrower, like Continental, however, that ease of withdrawal made the funding source perilous. A sudden panic could leave the accounts depleted and the bank without money just when it needed it most.

Continental’s reliance on uninsured short-term lenders was especially negligent because it had invested heavily and unwisely in speculative loans, meaning that a drop in its lenders’ confidence was almost inevitable. Only long-term lenders or guaranteed depositors, who wouldn’t yank their money out immediately in a crisis, could insulate the bank in such a situation. As soon as rumors swirled that Continental’s investments were going bad, the short-term global lenders predictably pulled their funds. Fear of Continental’s books then metastasized into worldwide fear of all American banks’ books. The reason: many of those banks had also started to rely on uninsured short-term lenders for funds, and the lenders often didn’t make distinctions among individual banks.

After taking some modest and ultimately unsuccessful steps to calm the panic, the U.S. government did something radical. The Federal Reserve and the FDIC, in a “race to save Continental and thereby sustain confidence in the nation’s banking system,” the New York Times reported, pledged that no uninsured depositor or other lender, including bondholders, would lose money should the bank collapse. In July, to avoid “a major financial crisis,” as the Times put it, the Reagan administration outright nationalized the hobbled bank, with the FDIC taking 80 percent ownership and responsibility for its bad loans. The era of “too big to fail” had begun.

The break from normal practice divided the administration. Treasury Secretary Donald Regan found the intervention outrageous: “We believe it is bad public policy, would be seen to be unfair . . . and represents an unauthorized and unlegislated expansion of federal guarantees in contravention of executive branch policy,” he wrote to his colleagues. But the White House, by offering its quiet support to the Fed and the FDIC, plainly agreed with their compelling argument that the alternative was to risk a systemic crisis in the financial industry.

Federal Reserve chairman Paul Volcker told Congress that the decision to protect uninsured lenders of a private institution from the consequences of a freely assumed risk wasn’t meant to set a precedent. But the federal comptroller of the currency, which regulates banks, made clear that a shift in policy had taken place, telling Congress that none of the nation’s top 11 banks would be allowed to fail. Small banks were apoplectic. Jokes flourished about investors’ not wanting to put money into the nation’s 12th-largest bank. “How often and to what extent can the government, and in turn the taxpayers, prop up any institutions that are neither the nation’s best or brightest?” wondered the Independent Bankers Association of America.

The “too big to fail” principle persisted during the savings-and-loan crisis of the late eighties and early nineties, when Washington saved uninsured lenders to big banks wherever it saw a risk to the broader system, letting uninsured lenders to smaller banks languish. In the summer of 1991, Fed chairman Alan Greenspan—just a few years after saying (as a libertarian private-sector economist at the time) that he wasn’t even “a great fan of deposit insurance”—reminded lawmakers of the post-Continental stance that “there may be some banks, at some particular times, whose collapse and liquidation would be excessively disruptive.”

Gradually, lenders to big banks understood that their money was no longer at risk. And the banks realized that the bigger and more complicated they got, the safer they would be from market discipline—and so they became. Of course, the financial industry changed in response to many other forces, too, including shifting market demand, global competition, and increasing investment in the stock market. But we’ll never know exactly how great a role government protection played in driving finance’s transformation, since government subsidies—and that’s what “too big to fail” amounts to—always distort the valuable information that markets provide.

Nearly a decade and a half after the government rescued Continental Illinois, “too big to fail” expanded beyond commercial banks to other parts of the financial world. The catalyst: the 1998 collapse of a small Connecticut hedge fund, Long-Term Capital Management. Long-Term, a money manager for wealthy investors, used exotic, often unregulated, financial instruments called derivatives to bet on the up-and-down movement of certain securities and financial markets. In the summer of 1998, after four years of good profits, the firm miscalculated badly. Like Continental, it had exercised its American right to take risks—and it screwed up.

It couldn’t afford to. Long-Term had made $125 billion in investments, even though its own shareholders had given it only $2.3 billion. It had borrowed the rest—$53 for every dollar it had in hand. But that wasn’t all: through its derivatives, Long-Term magnified its potential obligations to a scarcely conceivable $1.25 trillion. There would be no way for the hedge fund to pay its debts should anything go wrong, and now it had.

“Too big to fail” played a key role in bringing the crisis about. The source of Long-Term’s breathtaking borrowing was none other than the big banks, both commercial and investment. Lenders to the commercial banks had known that the government implicitly protected them, and thus didn’t worry much about what the banks were doing with their money, including extending so much credit to the hedge fund. The investment banks had to keep up with the commercial banks as competition intensified and their profit margins shrank, so they had poured their money into Long-Term, too.

Long-Term’s pending collapse represented a huge risk to the rest of the financial world—an even greater risk than Continental’s had—and an incalculable one. Nobody knew which of the world’s banks, brokerage firms, and hedge funds might be left owing or might be owed billions of dollars if Long-Term declared bankruptcy. And this opacity of exposure wasn’t Long-Term’s only threat to the financial system. The firm’s enablers had lent it money on a short-term, often overnight, basis. The collateral for the loans was Long-Term’s various investments, meaning that in a default, the lenders could swoop in, seize the collateral, and dump it into the global markets. This forced selling would instantly drive down the price of everything from junk bonds to mortgage securities, causing problems for other firms that had borrowed against similar collateral—and for the broader economy.

Long-Term couldn’t fail, then, regulators determined. Under the New York Fed’s supervision, the banks and investment firms that had lent the fund enough money to push the financial world to the precipice now pulled the company back. They infused $3.6 billion into Long-Term and took 90 percent ownership. Lenders to Long-Term lost nothing. Now, lenders to all complex financial firms enjoyed the same implicit protection from normal failure mechanisms that the biggest commercial banks had.

The new precedent was stunning. Scarcely a half-decade earlier, Greenspan had said he couldn’t imagine that the U.S. government would ever bail out a securities firm. In 1990, a prominent American investment firm, Drexel Burnham Lambert, had declared bankruptcy and the financial world survived; in 1995, just three years before the Long-Term rescue, a large British-based investment bank, Barings, had gone bankrupt, also with no horrific repercussions. But since then, the financial world, through the expansion of unregulated derivatives, had become more complex and thus vulnerable to contagion from one firm’s failure, putting the economy at risk, too.

As the dust settled from the Long-Term debacle, Washington tried to backtrack, pointing out that no taxpayer money had been used in the bailout. But Greenspan’s public statements and his rattled demeanor during and after the crisis made clear that the Fed would have used government funds if the banks had refused to help. Uninsured lenders everywhere recognized that if the government protected lenders to a hedge fund, then it certainly wouldn’t let an investment bank collapse. Lenders’ critical role in disciplining the financial system—by refusing to lend to overly risky institutions—was gone.

From that absence sprang the current financial crisis. Lenders had every reason to lend freely and carelessly to financial firms’, letting them pile up cheap debt—which they did, leaving themselves little room for error if even a few of the investments that they supported with the debt went sour. In turn, the firms lent too much to American consumers. Between 1980 and 2008, total debt in the economy more than doubled as a percentage of gross domestic product. Massive amounts of cheap debt helped create the asset bubble that burst, starting in 2006, and took the global economy with it.

By the time the crisis intensified in 2008 with the foundering of Bear Stearns, Citigroup, and AIG, the government’s rescue of these too-big-to-fail firms wasn’t surprising. True, the feds declined to bail out Lehman Brothers, letting its lenders take losses. But the panic after Lehman’s bankruptcy seems to have convinced officials that permitting losses was a mistake. By the end of last year, the government, through a “temporary” new FDIC program, was offering to guarantee virtually all new lending to banks.

In every one of these cases—Continental, the savings and loans, Long-Term, the current crisis—the government’s immediate response was understandable. If it had permitted disorderly failure in either 1984 or 1998, the short-term consequences would have been dire, bringing the risk of a deep recession as financial firms and instruments failed and survivors tightened lending. Similarly, it was economically impossible for President George W. Bush to force lenders to Bear Stearns, Citigroup, and AIG to take losses when there was no consistent, orderly process through which they could do so without risk to the economy. Uninsured depositors and other lenders had come to expect bailouts over the decades and had acted accordingly, running risks that left themselves, and the economy, vulnerable to systemic catastrophe. A sudden shutdown of an inadequately regulated financial industry could have resulted in a depression.

What’s unforgivable is the government’s response after each crisis. After their ad hoc rescue of Continental Illinois, regulators and elected officials should have presented it to the public as harsh evidence that the old regulations to wind down bad financial institutions had stopped working, necessitating credible new ones that would let uninsured lenders to banks know that they risked warranted losses. Such enforcement of market discipline might have prevented Long-Term Capital Management from happening 14 years later. After it did happen, the government, once again, should have instituted regulations to protect the economy from both disorderly failures and exploding financial instruments. Instead, we have had two and a half decades of punting on the key regulatory questions.

Today, after the most recent and destructive round of explosions, the government’s response threatens to be more of the same. The Obama administration claims that it wants to create a way for bad financial firms to fail. Yet in its June financial-regulatory proposal, it formalizes “too big to fail,” giving the Treasury new power to “stabilize a failing institution . . . by providing loans to the firm, purchasing assets from the firm, guaranteeing the liabilities of the firm, or making equity investments in the firm.” The proposal says nothing about making sure that bondholders and other uninsured lenders take losses.

Reintroducing a predictable, credible way for lenders to financial firms to take losses when failure strikes would go a long way toward protecting the economy from speculative excesses. Market forces, coupled with overdue new rules for inadequately regulated financial instruments, would have a better chance of reducing reckless risk-taking before it got out of control.

As a first step, the government should create an FDIC-style conservatorship for failed big or complex financial institutions. A new kind of bankruptcy could come into play in such a process, says University of Texas business-law professor Jay Westbrook. It might keep some lenders (and trading partners on derivatives) from seizing their collateral immediately and selling it. This would reduce the possibility that instant sales of billions of dollars’ worth of securities would destabilize the financial system.

In another elaboration of the conservatorship idea, economists R. Glenn Hubbard, Hal Scott, and Luigi Zingales have proposed an elegant FDIC-managed system that would begin by splitting failed financial firms in two. One new entity would take over the toxic assets that caused the firm’s problems. This “bad bank” would also bring the failed firm’s lenders with it, and the lenders would take losses based on the collapsed value of the assets. The other new entity, no longer weighed down by the bad assets, could meet the original firm’s remaining obligations and raise new funds. It could then free itself from government administration, as in any corporate exit from bankruptcy. Lenders to the original failed firm, now lenders to the bad bank, would receive stock in the restructured firm, sharing in its future profits, just as lenders to an ordinary bankrupt firm can.

However the arcane details take shape, the key factor in imposing market discipline on the financial world is credibility. Lenders to big banks and other financial firms must be made to worry that their money really is potentially at risk—that the feds won’t keep stepping in to save them. If credibility isn’t soon established, Washington’s actions will have created a monster, stoking more reckless debt creation at a time when debt has already reached a staggering and record 350 percent of GDP. Witness how quickly banks were able to borrow money earlier this year from private lenders—sometimes without the FDIC’s new emergency guarantee. The government heralded the loans as evidence that lenders were regaining confidence in the financial sector. They weren’t. Lenders merely had confidence that Washington would stick to its policy of bailouts for tottering financial companies.

Too big to fail” imperils the economy’s long-term health in other ways. If big or complex financial firms keep their state subsidy, they’ll continue to divert lenders’ money away from other, perhaps more deserving, industries. Why lend money to Cisco when you can lend it to Citigroup risk-free? Further, failure is necessary in a free market, since it improves economic efficiency. When a company fails, a more successful firm can buy its good assets, releasing them from incompetent management. Failed firms’ workers can likewise find more useful outlets for their labor. Even people who made the mistakes that led to a firm’s failure can start anew. Vitally for the economy, failure helps ensure that bad ideas die, so that government and private resources aren’t wasted on a business model that doesn’t work.

If real reform doesn’t happen, get ready for a fearsome certainty: that markets will eventually correct our unsustainable financial system. They have tried to do so several times over the decades by punishing firms like Continental, Long-Term, and, most recently, Citigroup, as well as the lenders who financed them. The government thwarted these necessary corrections at every turn, bailing out the reckless and their enablers. But the price of maintaining our untenable system keeps growing, and eventually the government won’t be able to pay the bill. The multitrillion-dollar price tag attached to the government’s current endeavors already endangers the nation’s fiscal health. A decade from now, failing financial firms could take the credit of the U.S. government right down with them.

Nicole Gelinas, a City Journal contributing editor and the Searle Freedom Trust Fellow at the Manhattan Institute, is a Chartered Financial Analyst and the author of the forthcoming After the Fall: Saving Capitalism from Wall Street—and Washington.

from the Wall Street Journal's Political Diary, 2009-Oct-13, by Stephen Moore:

Ill Fed

At least one rising congressman, Rep. Mark Kirk of Illinois, is raising an alarm about the Federal Reserve's ability to protect the dollar and maintain the Fed's own inflation-fighting capacity. At the root of his concern, he says, is the Fed's new role as "one of the largest bondholders in the world."

Fed Chairman Ben Bernanke has been piling up purchases of "mortgage-backed" securities to keep money flowing into the housing market. Though the Fed recently said it would slow its buying, the central bank now sits on a giant portfolio worth $650 billion. Here's the problem: If the Fed decides to raise interest rates to combat inflation, even a small hike would likely knock billions of dollars off the value of the Fed's holdings.

Mr. Kirk estimates that if rates go up two percentage points -- a plausible scenario given short-term rates are near zero now -- the Fed could lose $100 billion from its own balance sheet. The danger is that the mere existence of such a concern could become a self-fulfilling prophecy if the markets doubt the Fed would endanger its own financial welfare to fight inflation.

"No other Fed Chairman in history held such a heavy bond position, exposing the Reserve Board to this risk if it chooses to combat inflation," he says. "Now that the Fed is a huge bondholder, higher interest rates will trigger a large loss in the value of its Mortgage Backed and other securities." Mr. Kirk is currently running away with the GOP primary for Barack Obama's old Senate seat (now held by Roland Burris), even though Chicago Bears legend Mike Ditka recently endorsed his more conservative opponent, real estate developer Patrick Hughes. Reportedly, a private poll commissioned by his campaign also shows Mr. Kirk leading Democrat Alexi Giannoulias 42-35 in the general election.

Perhaps the best option for the Federal Reserve would be not only to stop buying MBSs, but to sell the mortgage assets it already holds -- and quickly. Mr. Kirk notes that another helpful policy change would be to drive down federal spending to reduce the hefty borrowing requirements of the federal government. Good luck with that.

from City Journal, 2009-Autumn, by Edward Pinto:

Yes, the CRA Is Toxic
So why is Congress thinking about expanding it?

Did the Community Reinvestment Act—the 1977 federal law pressing banks to lend to low- and moderate-income borrowers—fuel toxic lending and thus play a significant role in causing the financial meltdown? “CRA was not the cause of the crisis,” Comptroller of the Currency John Dugan maintained this past August. Though he had little quantitative detail about the performance of CRA-related loans, Dugan claimed that they had performed better than loans made by lenders not subject to the CRA. Further, he contended, borrowers of CRA loans had defaulted at much lower rates than borrowers of subprime mortgages. Other defenders of the act assert that almost all CRA loans originated at “prime” interest rates, rather than the higher rates that lenders offered risky “subprime” borrowers. And they add that the mortgages made under CRA were almost entirely fixed-rate, not the notorious adjustable-rate mortgages with quick rate resets and high payment shock that led so many borrowers to default.

The question of how well CRA loans have performed is of vital importance because of the trillions of dollars in such lending. During the first 15 years of the act's existence, total announced commitments under the CRA totaled $9 billion. But starting in 1992, volume exploded. Over the next 16 years, from 1992 to 2008, announced CRA commitments totaled $6 trillion. And incredible though it may seem, the same federal regulators who forced the CRA on banks have neglected to track the performance of trillions of dollars of loans made to satisfy it. But there is a strong prima facie case that they constitute toxic lending—that is, lending that leads to unsustainable loans, resulting in an unacceptable level of foreclosures.

To begin with, the CRA defenders' claim that CRA lending mostly wasn't subprime is highly misleading. It would be more accurate to say that 90 percent of CRA lending wasn't classified as subprime. CRA lenders, along with Fannie Mae and Freddie Mac—the two government-sponsored entities that bought loans from lenders, enabling them to make more loans—commonly classified CRA loans as “subprime” only if they contained such features as high fees, high rates, or low initial payments with adjustable interest rates. But approximately 50 percent of CRA loans for single-family residences were nevertheless made to borrowers who made down payments of 5 percent or less or had low credit scores—characteristics that indicated high credit risk. Whether or not anyone called these loans “subprime,” in other words, the chances are good that many of them have defaulted or remain at high risk of doing so.

Though the feds, again, haven't collected figures for CRA loans' performance as a whole, we do have statistics from a few lenders that are troubling indeed. In Cleveland, Third Federal Savings and Loan has a 35 percent delinquency rate on its CRA-mandated “Home Today” loans, versus a 2 percent delinquency rate on its non–Home Today portfolio. Chicago's Shorebank—the nation's first community development bank, with largely CRA-related loans on its books—has a 19 percent delinquency and nonaccrual rate for its portfolio of first-mortgage loans for single-family residences. And Bank of America said in 2008 that while its CRA loans constituted 7 percent of its owned residential-mortgage portfolio, they represented 29 percent of that portfolio's net losses.

Whatever the precise magnitude of the CRA's role, there is no question that as the government pursued affordable-housing goals—with the CRA providing approximately half of Fannie's and Freddie's affordable-housing purchases—trillions of dollars in high-risk lending flooded the real-estate market, with disastrous consequences. Over the last 20 years, the percentage of conventional home-purchase mortgages made with the borrower putting 5 percent or less down more than tripled, from 8 percent in 1990 to 29 percent in 2007. Adding to the default risk: of these loans with 5 percent or less down, the average down payment declined from 5 percent to 3 percent of the loan's value.

As for Fannie and Freddie, most of the loans with 5 percent or less down that they had acquired by 2005 had down payments of 3 percent or even no down payment at all. From 1992 to 2007, the two entities acquired over $3.1 trillion in low-down-payment or credit-impaired loans and private securities backed by credit-impaired loans—and these are performing horribly: the delinquency rate on Fannie's and Freddie's remaining $1.1 trillion in such high-risk loans is 15.5 percent as of this past June 30, about 6.5 times the rate on the entities' traditionally underwritten loans. All this risky lending, of course, drove the nation's homeownership rate up and inflated a housing-price bubble.

Taxpayers deserve to know why not one regulator had the common sense to track the performance of CRA loans. They also deserve to know why the Federal Reserve, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and other regulators appear to have no idea how trillions of dollars in CRA loans are performing now. But above all, they deserve to know that the damage done by the CRA won't happen again. Incredibly, the House Financial Services Committee is considering legislation that would broaden the scope of the CRA. Before it takes any action on HR 1479—which would expand the CRA's mandates from banks to bank subsidiaries, mortgage bankers, credit unions, insurance companies, and other nonbank financial institutions—the committee should demand that regulators request detailed CRA performance data from Fannie Mae and Freddie Mac, as well as from the four banks that have announced 94 percent of the nation's $6 trillion in CRA commitments: Wells Fargo, JPMorgan Chase, Citibank, and Bank of America. These six institutions should be able to provide performance information for an estimated 70 percent of outstanding CRA loans.

The pain and hardship that CRA has likely spawned are immeasurable. What is measurable, though, is exactly how the trillions in past CRA loans are performing and what we can learn from this debacle.

Edward Pinto, a consultant to the mortgage-finance industry, was the chief credit officer at Fannie Mae in the 1980s.

from the Wall Street Journal, 2009-Sep-30, p.A2, by Damian Paletta and Michael R. Crittenden with David Enrich contributing:

FDIC Fund to Be in Red for Years as Bank Failures Jolt System

WASHINGTON -- The government said the fund that protects consumer bank deposits has fallen into the red and will remain there into 2012, a pointed symbol of how the aftershocks of the financial crisis will reverberate for years as banks continue to fail at a high rate.

The negative balance is a headache for the Federal Deposit Insurance Corp., which runs the fund. On Tuesday, it proposed the unprecedented step of having the banking industry prepay $45 billion in fees by the end of the year to give the government more breathing room to handle future failures.

The only other time the fund fell into the red was in 1991, during the savings-and-loan crisis, and it shows how U.S. officials underestimated the impact of this crisis on the government's cash needs.

"Though some of our largest bank failures have already taken place, there are still hundreds and hundreds of banks that are going to fail in this cycle," said Gerard Cassidy, a bank analyst at RBC Capital Markets.

FDIC officials stressed that the fund's depleted state wouldn't affect depositors because federally insured deposits are backed by the full faith and credit of the U.S. government.

The prepayment proposal was met with unexpected support from banks. Some saw it as preferable to another option the FDIC seriously considered -- an emergency charge of $5.6 billion on top of the regular fees. This would have likely come directly out of the capital reserves at thousands of banks.

FDIC officials said banks would be able to spread the impact of the fee prepayment over several years by the way they account for it on their balance sheet.

J.P. Morgan Chase & Co. Chief Executive James Dimon, in an interview, praised the FDIC's plan as "an elegant way for them to do it."

In essence, the FDIC is proposing that most banks hand over by the end of the year their deposit-insurance fees -- the fund's standard source of income -- for the end of 2009 and all of 2010, 2011 and 2012.

The FDIC said that without the new policy, its cash on hand would be outpaced by its cash needs sometime early next year. Bank failures are expected to hit their peak either this year or in 2010.

The FDIC continues to have cash even though its deposit insurance fund has fallen into the red. It has already taken more than $30 billion out of the fund to cover bank failures over the next year. This is the money that is expected to run dry early next year without the prepayment assessments. FDIC officials estimated the deposit insurance fund wouldn't be back to comfortable levels until 2017.

Government officials on Tuesday estimated that bank failures from 2009 through 2013 will cost the FDIC $100 billion, up from a projection several months ago of $70 billion. Ninety-five banks have failed so far this year.

The FDIC's proposal reflects a growing recognition from government officials that more money will be needed to mop up the mess than they projected just months ago. It is also a stark reminder of how the banking sector continues to be strangled by bad loans.

There have been bank failures in most states since January 2008, hitting Georgia, Illinois and California particularly hard. The FDIC had 416 banks on its "problem" list at the end of June, and the number is expected to grow.

FDIC officials project the deposit insurance fund will remain in the red into 2012, despite the prepaid assessments from banks. This is largely an accounting issue -- the FDIC has to count the prepaid assessments as both an asset and a liability because it is technically deferred revenue.

Another option the FDIC considered was to borrow billions of dollars from the Treasury Department. Officials felt such a move would send the wrong message to the public.

"I do think that the American people would prefer to see an end to policies that looked to the federal balance sheet as the remedy to every problem," FDIC Chairman Sheila Bair said.

But for the first time, Ms. Bair said Tuesday that she had directed the agency to prepare the "mechanics" for borrowing from the Treasury in case it ever became necessary, although "today is not that day."

The evaporating deposit-insurance fund had $10.4 billion in June, the latest figure available, down from $45.2 billion in June 2008. That posed a public-relations problem for Ms. Bair. She has had to both move rapidly to close failing banks, which is costly for her agency, while retaining public confidence in the FDIC.

The rising number of bank failures has infuriated some politicians who have recently begun pressuring Ms. Bair's regulators to ease up on their increasingly close supervision of the industry.

The FDIC said banks could ask for an exemption if they didn't have the cash on hand to prepay the fees.

from the Wall Street Journal, 2009-Sep-29:

Subprime Uncle Sam
The FHA makes Countrywide Financial look prudent.

The Treasury has announced new "capital cushion" requirements for financial institutions to reduce excessive risk and prevent taxpayer bailouts. Seems sensible enough. Perhaps the Administration will even impose those safety and soundness standards on federal agencies.

One place to start is the Federal Housing Administration, the nation's insurer of nearly $750 billion in outstanding mortgages. The agency acknowledged this month that a new but still undisclosed HUD audit has found that FHA's cash reserve fund is rapidly depleting and may drop below its Congressionally mandated 2% of insurance liabilities by the end of the year.

At a 50 to 1 leverage ratio, the FHA will soon have a smaller capital cushion than did investment bank Bear Stearns on the eve of its crash. (See nearby table.) Its loan delinquency rate (more than 30 days late in payments) is now above 14%, or from two to three times higher than on conventional mortgages. Its cash reserve ratio has fallen by more than two-thirds in three years.

The reason for this financial deterioration is that FHA is underwriting record numbers of high-risk mortgages. Between 2006 and the end of next year, FHA's insurance portfolio will have expanded to $1 trillion from $410 billion. Today nearly one in four new mortgages carries an FHA guarantee, up from one in 50 in 2006. Through FHA, the Veterans Administration, Fannie Mae and Freddie Mac, taxpayers now guarantee repayment on more than 80% of all U.S. mortgages. Sources familiar with a new draft HUD report on FHA's worsening balance sheet tell us that the default rates have risen most rapidly on the most recent loans, i.e., those initiated or refinanced in 2008 and 2009.

All of this means the FHA is making a trillion-dollar housing gamble with taxpayer money as the table stakes. If housing values recover (fingers crossed), default rates will fall and the agency could even make money on its aggressive underwriting. But if housing prices continue their slide in states like Arizona, California, Florida and Nevada—where many FHA borrowers already have negative equity in their homes—taxpayers could face losses of $100 billion or more.

So far Congress has pretended that these liabilities don't exist because they are technically "off budget." They stay invisible until they move on-budget when a Fannie Mae-type cash bailout is needed. The Obama Administration is at least finally catching on to these perils and last week proposed some modest reforms. These include appointing a "chief risk officer" at FHA, tightening home appraisals, requiring that FHA lenders have audited financial statements, and increasing the capital requirement of FHA lenders to $1 million up from $250,000. The scandal is that these basic standards weren't in place years ago.

Unfortunately, Washington won't touch more significant reforms for fear of angering the powerful nexus of Realtors, mortgage bankers and home builders. As we've written for years, the FHA's main lending problem is that it requires neither lenders nor borrowers to have a sufficient financial stake in mortgage repayment. The FHA's absurdly low 3.5% down payment policy, in combination with other policies to reduce up-front costs for new homebuyers, means that homebuyers can move into their government-insured home with an equity stake as low as 2.5%. The government's own housing data prove that low down payments are the single largest predictor of defaults.

Private banks know this. Burned on subprime mortgages, they are back to requiring 10% or even 20% down payments. Congress should at least require a 5% down payment on loans that carry a taxpayer guarantee. If borrowers can't put at least 5% down, they can't afford the house.

As for rooting out fraud that contributes to high loss rates, the obvious solution is to drop the 100% guarantee on FHA mortgages. Why not hold banks liable for the first 10% of losses on the housing loans they originate, a reform that has been recommended since as far back as the early Reagan years? No other mortgage insurer insures 100% loan repayment. Alas, while offering its minireforms, the Obama Administration reassured its real-estate pals that FHA insurance will continue to carry "no risk to homeowners or bondholders."

Which means all the risk is on taxpayers. David Stevens, the FHA commissioner, nonetheless declared this month: "There will be no taxpayer bailout." That's also what Barney Frank said about Fannie and Freddie.

from RealClearMarkets.com, 2009-Sep-16, by Steven Malanga:

ACORN Is Much a Creature of the CRA

The Acorn scandal, in which freelance journalists posing as a prostitute and a pimp went seeking a mortgage for a house of prostitution and received advice on how to evade the law, is a fitting new chapter in the controversial history of the advocacy group.

Acorn found its way into the mortgage business through the Community Reinvestment Act, the 1977 legislation that community groups have used as a cudgel to force lenders to lower their mortgage underwriting standards in order to make more loans in low-income communities. Often the groups, after making protests under CRA, were then rewarded by banks with contracts to act as mortgage counselors in low-income areas in return for dropping their protests against the banks. In one particularly lucrative deal, 14 major banks eager to put CRA protests behind them in 1993 signed an agreement to have Acorn administer a $55 million, 11-city lending program. It was precisely such agreements that helped turn Acorn from a network of small local groups into a national player. And Acorn hasn't been alone. A U.S. senate subcommittee once estimated that CRA-related deals between banks and community groups have pumped nearly $10 billion into the nonprofit sector.

Given the economic fallout from the long efforts by advocacy groups to water down mortgage lending standards, as well as the controversy surrounding Acorn's mortgage counseling methods, you would imagine that politicians in Washington would be eager to narrow the scope of the CRA and reduce the leverage that community groups wield under it. But to the contrary, Washington is actually looking to expand the CRA once again.

On Capitol Hill today the House Committee on Financial Services under Chairman Barney Frank is holding hearings on legislation supported by the Obama administration that would bring insurance companies and credit unions under the umbrella of CRA, placing new lending demands on these groups and opening them up to protests and pressure tactics by organizations like Acorn. As proof that Washington is a looking-glass world where basic values and logic get perverted, proponents of the new legislation claim we need more CRA to rein in the bad practices of the housing bubble, which is sort of like arguing that the cure for alcoholism is another martini. Any review of the history of the affordable mortgage movement in America demonstrates the power that CRA had in helping to shred mortgage underwriting standards throughout the industry and exposing us to the kind of market meltdown we've experienced.

Congress passed CRA in 1977 as legislation designed to prompt banks to lend more in lower income areas which advocates claimed were being ignored. Gradually over time community groups learned they could use the law as leverage to negotiate new inner-city lending programs with banks based on lower underwriting standards, which the groups demanded when banks complained that one reason they weren't doing more lending in some neighborhoods was because few applicants in those areas qualified for loans under traditional criteria.

Acorn led the way in this movement. In 1986, for instance, it protested a potential acquisition by Louisiana Bancshares, a Southern institution, until the bank agreed to new, "flexible credit and underwriting standards" for minority borrowers which included counting public assistance and food stamps as income in mortgage applications.

Acorn also put pressure on the two quasi-government purchasers of mortgages, Fannie Mae and Freddie Mac, to lower their standards, complaining that they were "strictly by-the-book interpreters" who stood in the way of new lending programs. Under pressure both organizations committed to backing billions of dollars in affordable housing loans under so-called "alternative qualifying" programs which approved loans to individuals who didn't qualify under traditional standards, including those who agreed to go to mortgage counseling classes run by community groups like Acorn.

The threat of CRA proved an effective tool in gathering non-bank lenders into this affordable lending maelstrom, too. In late 1993 President Clinton's Secretary of Housing and Urban Development, Henry Cisneros, announced a plan to boost homeownership in the U.S. through a series of government initiatives, including having government subsidize mortgages that required no down payments. To produce more of these new, riskier loans Cisneros proposed expanding CRA to cover mortgage lenders and other financial institutions that were not chartered banks. In Congress Rep. Maxine Waters dubbed mortgage companies "egregious redliners" who needed to be corralled by CRA.

Under pressure from these threats, the trade group that represented mortgage bankers announced an agreement with HUD to sharply boost lending in low-income areas. These mortgage bankers, the so-called non-bank lenders, agreed to "voluntarily" help develop new mortgage products with laxer underwriting standards. The first member of the trade group to sign onto the new program was Countrywide Financial, which partnered with Fannie Mae to commit to $2.5 billion in lending in minority communities under new, lower standards.

Other programs soon followed. Sears Mortgage Corp began a massive effort with Freddie Mac's backing, known as the alternative qualifying initiative, in which low-income borrowers could qualify for a mortgage if their monthly mortgage payment amounted to 45 percent of income, when the industry standard had traditionally been that a mortgage payment should amount to no more than one-third of monthly income. Arbor National Mortgage Inc., a nonbank lender, went further, making loans with monthly payments up to 50 percent of income.

These lending institutions were not only pushed by politicians and advocates into these new programs but were assured by federal institutions that the loans could be safe. In 1992 the Federal Reserve Bank of Boston produced lending guidelines for banks operating in low-income markets which advised them to take into consideration the "economic culture of urban, lower income and nontraditional customers."

The Fed told lenders, for instance, that applicants with poor credit histories, a problem which plagued many would-be urban borrowers, could still be good loan risks if they agreed to mortgage counseling, even though there was no evidence that counseling programs prevented defaults. The Fed also told banks to consider junking their traditional income requirements in favor of lending with much higher ratios of income to mortgage payments, and to consider nontraditional sources of income as qualifying earnings, including unemployment benefits, even though by definition they are temporary and don't last nearly as long as the term of a mortgage.

Some of the recommendations by the Boston Fed and other groups led directly to new mortgage products that engendered the greatest abuses during the housing bubble. The Boston Fed, for instance, urged lenders to allow borrowers who didn't have enough money for down payments and closing costs to accept gifts and grants from charities and nonprofits. That spurred nonprofit groups to solicit donations from builders with houses to sell, which the nonprofits turned around and gave to low-income buyers to use as down payments on homes purchased from the participating builders. Heavily criticized by the IRS as a tax scam and by the Government Accountability Office for their high rates of default, such programs were eventually banned by the Federal Housing Administration, but not until 2007, when the housing bubble was already upon us.

Over time, the mortgage industry not only developed new products based on these lower underwriting standards but eventually allowed many borrowers to qualify for such loans under the reasonable assumption that if they were "safe" for low-income borrowers they were certainly safe for middle and upper income borrowers, too.

Of course, these loans weren't actually safe, and as far back as the early 1990s it was clear that mortgages made under affordable housing standards had a significantly higher default rate. But the facts weren't allowed to get in the way of the housing juggernaut, and so the quantity of risky loans increased. By 2005 HUD required that 45 percent of all loans purchased by Fannie Mae and Freddie Mac had to be from low and middle income borrowers, with no sense whatsoever of whether such a quota was advisable or doable.

It wasn't. Despite all of the talk of how the mortgage crisis has affected all sorts of borrowers across the income spectrum, once the troubles started with the market in 2006 a disproportionate percentage of foreclosures and defaults occurred in low and lower-middle income areas. And some of the pioneers of the affordable mortgage market, like Countrywide, collapsed spectacularly under the weight of their riskier loans, as did Fannie Mae and Freddie Mac.

The subsequent drying up of the mortgage market and failure of many banks has proved an especially great burden to the umbrella of nonprofit groups who were operating programs financed by CRA, which has become big business for nonprofits. So now we have, rather than a diminished CRA, legislation in Washington which would find new sources of funding for community groups in the form of credit unions and insurance companies. And the new legislation takes CRA well beyond the mortgage market and into small business lending, requiring financial institutions to begin keeping records on the race and gender of owners of firms who apply for loans. If form follows, soon banks and other financial institutions operating under CRA will be cudgeled into lending to small businesses based on race and gender, which will be the opening of a new round of lower lending standards in the very risky small business sector.

The effort to save and extend CRA in the face of its role in the mortgage market's massive meltdown is testament to the unique power of this legislation to nourish an entire industry of nonprofits which, like Acorn, have been reliable supporters of politicians like Barney Frank, Maxine Waters and a former community organizer and associate of Acorn by the name of Barack Obama.

Steven Malanga is an editor for RealClearMarkets and a senior fellow at the Manhattan Institute

from the Wall Street Journal, 2009-Sep-4, by John Fund:

Warning: The Deficits Are Coming!
The former head of the Government Accountability Office is on a crusade to alert taxpayers to their true obligations.

Washington, D.C.

David Walker sounds like a modern-day Paul Revere as he warns about the country's perilous future. "We suffer from a fiscal cancer," he tells a meeting of the National Taxpayers Union, the nation's oldest anti-tax lobby. "Our off balance sheet obligations associated with Social Security and Medicare put us in a $56 trillion financial hole—and that's before the recession was officially declared last year. America now owes more than Americans are worth—and the gap is growing!"

His audience sits in rapt attention. A few years ago these antitax activists would have been polite but a tad restless listening to the former head of the Government Accountability Office, the nation's auditor-in-chief. Higher taxes is what hikes their blood pressure the most, but the profligate spending of the Bush and Obama administrations has put them in a mood to listen to this green-eyeshade Cassandra. "He's so unlike most politicians," says Sharron Angle, a former state legislator from Nevada, "his message is clear, detailed and with no varnish."

Mr. Walker, a 57-year-old accountant, didn't set out to be a fiscal truth-teller. He rose to be a partner and global managing director of Arthur Anderson, before being named assistant secretary of labor for pensions and benefits during the Reagan administration. Under the first President Bush, he served as a trustee for Social Security and Medicare, an experience that convinced him both programs are looming train wrecks that could bankrupt the country. In 1998 he was appointed by President Bill Clinton to head the GAO, where he spent the next decade issuing reports trying to stem waste, fraud and abuse in government.

Despite many successes, he was able to make only limited progress in reforming Washington's tangled bookkeeping. When he arrived he was told the Pentagon was nearly a decade away from having a clean audit, or clear evidence that its financial statements were accurate. When he left in 2008, he was told the Pentagon was still a decade away from that goal. "If the federal government was a private corporation, its stock would plummet and shareholders would bring in new management and directors," he said as he retired from the GAO.

Although he found the work fulfilling, Mr. Walker said he decided to leave last year with a third of his 15-year term left because "there are practical limits on what one can—and cannot—do in that job." He became president and CEO of the Peter G. Peterson Foundation, a group seeking to educate the public and policy makers on the need for fiscal prudence. Although it accepts private donations, its own future is secure given that Mr. Peterson, a former head of the Blackstone private equity firm and secretary of commerce under Richard Nixon, has endowed it with a $1 billion gift.

We met to hash over current events in his tastefully appointed office just off of New York's Fifth Avenue. Mr. Walker, a lean man with an unflappable demeanor, welcomed me with the observation that he's never been in more demand as a speaker "but it's only because everyone is so worried for our future."

His group calls itself strictly nonpartisan and nonideological, and that seems to limit how tough and specific it can be. Last year, it released a documentary "I.O.U.S.A.," that followed Mr. Walker as he toured the country on his fiscal "wake up" tour. The solutions the film proposes for the debt crisis are either glib or gray: The country should save more, reduce oil consumption, hold politicians accountable and get more value from health-care spending.

But in its diagnosis of the problem the film scores a bull's-eye. Among the fiscal hawks featured in the film is Rep. Ron Paul, who memorably tells Alan Greenspan that if doctors had the same success rate in meeting his goals as the Fed has had, patients would be dead all over America.

Mr. Walker's own speeches are vivid and clear. "We have four deficits: a budget deficit, a savings deficit, a value-of-the-dollar deficit and a leadership deficit," he tells one group. "We are treating the symptoms of those deficits, but not the disease."

Mr. Walker identifies the disease as having a basic cause: "Washington is totally out of touch and out of control," he sighs. "There is political courage there, but there is far more political careerism and people dodging real solutions." He identifies entrenched incumbency as a real obstacle to change. "Members of Congress ensure they have gerrymandered seats where they pick the voters rather than the voters picking them and then they pass out money to special interests who then make sure they have so much money that no one can easily challenge them," he laments. He believes gerrymandering should be curbed and term limits imposed if for no other reason than to inject some new blood into the system. On campaign finance, he supports a narrow constitutional amendment that would bar congressional candidates from accepting contributions from people who can't vote for them: "If people can't vote in a district not their own, should we allow them to spend unlimited money on behalf of someone across the country?"

Recognizing those reforms aren't "imminent," Mr. Walker wants Congress to create a "fiscal future commission" that would hold hearings all over America to move towards a consensus on reform. It would then present Congress with a "grand bargain" on entitlement and budget-control reforms. Its recommendations would be guaranteed a vote in Congress and be subject to only limited amendments. I note that critics have called such a commission an end-run around the normal legislative process. He demurred, saying that Congress would still have to approve any recommendations in an up-or-down vote—much like the successful base-closing commission created by GOP Rep. Dick Armey in the 1980s.

What kind of reforms would Mr. Walker hope the commission would endorse? He suggests giving presidents the power to make line-item cuts in budgets that would then require a majority vote in Congress to override. He would also want private-sector accounting standards extended to pensions, health programs and environmental costs. "Social Security reform is a layup, much easier than Medicare," he told me. He believes gradual increases in the retirement age, a modest change in cost-of-living payments and raising the cap on income subject to payroll taxes would solve its long-term problems.

Medicare is a much bigger challenge, exacerbated by the addition of a drug entitlement component in 2003, pushed through a Republican Congress by the Bush administration. "The true costs of that were hidden from both Congress and the people," Mr. Walker says sternly. "The real liability is some $8 trillion."

That brings us to the issue of taxes. Wouldn't any "grand bargain" involve significant tax increases that would only hurt the ability of the economy to grow? "Taxes are going up, for reasons of math, demographics and the fact that elements of the population that want more government are more politically active," he insists. "The key will be to have tax reform that simplifies the system and keeps marginal rates as low as possible. The longer people resist addressing both sides of the fiscal equation the deeper the hole will get."

I steer towards the fiscal direction of the Obama administration. He says his stimulus bill was sold as something it wasn't: "A number of people had agendas other than stimulus, and they shaped the package."

As for health care, Mr. Walker says he had hopes for comprehensive health-care reform earlier this year and met with most of the major players to fashion a compromise. "President Obama got the sequence wrong by advocating expanding coverage before we've proven our ability to control costs," he says. "If we don't get our fiscal house in order, but create new obligations we'll have a Thelma and Louise moment where we go over the cliff." Mr. Walker's preferred solution is a plan that combines universal coverage for all Americans with an overall limit on the federal government's annual health expenditures. His description reminds me of the unicorn—a marvelous creature we all wish existed but is not likely to ever be seen on this earth.

As I prepare to go, Mr. Walker returns to the theme of economic education. Poor schools often produce young people with few tools to help them realize the extent of the fiscal trap their generation is going to fall into.

One way the Peterson Foundation wants to change that is to bring big numbers down to earth so people can comprehend them. "Our $56 trillion in unfunded obligations amount to $483,000 per household. That's 10 times the median household income—so it's as if everyone had a second or third mortgage on a house equal to 10 times their income but no house they can lay claim to." As for this year's likely deficit of $1.8 trillion, Mr. Walker suggests its size be conveyed thusly: "A deficit that large is $3.4 million a minute, $200 million an hour, $5 billion a day," he says. That does indeed put things into perspective.

Despite an occasional detour into support for government intervention, Mr. Walker remains the Jeffersonian he grew up as in his native Virginia. "I view the Constitution with deep respect," he told me. "My ancestors and those of my wife fought and died in the Revolution, and I care a lot about returning us to the principles of the Founding Fathers."

He notes that today the role of the federal government has grown such that last year less than 40% of it related to the key roles the Founders envisioned for it: defense, foreign policy, the courts and other basic functions. "What happened to the Founders' intent that all roles not expressly reserved to the federal government belong to the states, and ultimately the people?" he asks. "I'm pleased the recent town halls show people are waking up and realizing it's time to pay attention to first principles."

With that we parted, as he had to get back to work. Today's Paul Revere is hard at work on a book due out in January from Random House that will be called, "Come Back America."

from the Wall Street Journal, 2009-Sep-7, by Martin Feldstein:

ObamaCare's Crippling Deficits
The higher taxes, debt payments and interest rates needed to pay for health reform mean lower living standards.

While the deficits caused by the fiscal stimulus package will end in 2011 and will help to sustain a fragile recovery in 2010, the deficits projected for the longer term are a threat to our economic future. The starting point for controlling those future deficits is for Congress to abandon the administration's health-care plan—a plan that will cost more than $1 trillion.

The deficits projected for the next decade and beyond are unprecedented. According to an assessment released in March by the Congressional Budget Office (CBO), the president's budget implies that deficits will average 5.2% of GDP over the next decade and will be 5.5% of GDP in 2019. Without the president's proposals, the budget office forecasts a 2019 deficit of only 2% of GDP.

The CBO's deficit projections are based on the optimistic assumptions that the economy will grow at a healthy 3% pace with no recessions during the next decade; that there will be no new spending programs after this year's budget; and that the rising national debt will increase the rate of interest on government bonds by less than 1%. More realistic assumptions would imply a 2019 deficit of more than 8% of GDP and a government debt of more than 100% of GDP.

Such enormous deficits would crowd out productivity-enhancing investments in new equipment and software as the government borrows funds otherwise available to private investors. The result would be slower economic growth and a lower standard of living.

In the nearer term, the projected deficits could cause interest rates on bonds and mortgages to rise sharply if bond investors fear that the government will not prevent inflation. This is a greater risk now that more than half of the U.S. government debt is held by the Chinese and other foreign investors. Such an interest rate rise could kill a recovery in 2010 or 2011 and depress growth in the years that follow.

Dropping the Obama health plan would significantly reduce fiscal deficits over the next decade and help restore public confidence in the ability of Congress to control spending. The CBO estimates that the House committee versions of the Obama health plan would add more than $1 trillion to federal deficits over the next decade. But the actual costs would be much higher.

For starters, $1 trillion of extra debt-financed spending would cause the government to pay about $300 billion of extra interest in the next decade. Moreover, the CBO's method of estimating the cost of such a program doesn't recognize the incentives it creates for households and firms to change their behavior.

The House health-care bill gives a large subsidy to millions of families with incomes up to three times the poverty level (i.e., up to $66,000 now for a family of four) if they buy their insurance through one of the newly created "insurance exchanges," but not if they get their insurance from their employer. The CBO's cost estimate understates the number who would receive the subsidy because it ignores the incentive for many firms to drop employer-provided coverage. It also ignores the strong incentive that individuals would have to reduce reportable cash incomes to qualify for higher subsidy rates. The total cost of ObamaCare over the next decade likely would be closer to $2 trillion than to $1 trillion.

The administration's claim that the health-care plan would be "self-financing" is both false and irrelevant. It is false because it would only be self-financing if one counts a variety of President Obama's proposed tax increases—and even those would produce much less revenue than is assumed in the budget calculations. The claim is irrelevant because those tax increases have nothing to do with health care and could be used instead to reduce other projected deficits.

For example, the administration and the congressional designers of ObamaCare say they would finance a substantial part of health reform with the revenue from new taxes on corporate foreign profits and on high-income individuals. The likely revenue from these tax changes would be much less than the official estimates because of the induced changes in taxpayer behavior that the estimators ignore.

Previous experience with changes in the marginal tax rates of high-income individuals implies that the current proposal to raise the marginal tax rate to about 50% from today's 40% would produce only about half of the official revenue estimates. No one knows how much of the estimated extra tax revenue on foreign profits would be lost as the resulting fall in international competitiveness reduces profits, and as businesses sell their overseas subsidiaries or shift their profits in other ways.

While abandoning health reform would be an important step, it would not be enough to limit the exploding level of future deficits and debt. That requires substantial reductions in existing spending programs, if large tax increases are to be avoided. Since Medicare is the largest contributor to the explosive growth in government spending, a good way to start shrinking government outlays would be by restructuring Medicare to shift more of its costs to supplementary private insurance, perhaps on an income-related basis.

Given the perceived need for significant additional tax revenue to shrink future fiscal deficits, there is now talk in Washington of introducing a value-added tax (VAT), the kind of national sales tax that European governments use to finance their welfare states. That would be a triply bad idea. Although it is a tax on spending, a VAT effectively raises marginal tax rates. Like the income tax, it reduces the reward for work and entrepreneurship by adding a tax to the prices of all goods and services. A VAT would also be grossly unfair to those whose lifetime savings would now be subject to a new tax when they start to spend those savings.

A VAT would open the door to an explosion of new spending programs. That's because, no matter how low the initial rate, the tax rate would be drawn inevitably to European rates of more than 15%—on top of existing income and payroll taxes.

The key to raising revenue without raising marginal tax rates or creating a new tax is to reduce or eliminate some of the "tax expenditures" that now lower tax revenue by special deductions and exclusions. Ending the current exclusion from taxable income of employer payments for health insurance would increase income tax revenue by more than $1 trillion over the next five years and nearly $3 trillion over the next decade. Eliminating this subsidy would also lead to a restructuring of private health insurance that would give patients the incentive to seek more cost-effective care and thereby bring down the overall cost of health care.

Restructuring Medicare and reforming tax rules would be politically difficult. But a failure by Congress to address the exploding path of fiscal deficits would be morally irresponsible.

Mr. Feldstein, chairman of the Council of Economic Advisers under President Ronald Reagan, is a professor at Harvard and a member of The Wall Street Journal's board of contributors.

from the Wall Street Journal, 2009-Sep-27:

Max's Mad Mandate
The Baucus health bill will break 50 state budgets via Medicaid.

The more we inspect Max Baucus's health-care bill, the worse it looks. Today's howler: One reason it allegedly "pays for itself" over 10 years is because it would break all 50 state budgets by permanently expanding Medicaid, the joint state-federal program for the poor.

Democrats want to use Medicaid to cover everyone up to at least 133% of the federal poverty level, or about $30,000 for a family of four. Starting in 2014, Mr. Baucus plans to spend $287 billion through 2019—or about one-third of ObamaCare's total spending—to add some 11 million new people to the Medicaid rolls.

About 59 million people are on Medicaid today—which means that a decade from now about a quarter of the total population would be on a program originally sold as help for low-income women, children and the disabled. State budgets would explode—by $37 billion, according to the Congressional Budget Office—because they would no longer be allowed to set eligibility in line with their own decisions about taxes and spending. This is the mother—and father and crazy uncle—of unfunded mandates.

This burden would arrive on the heels of an unprecedented state fiscal crisis. As of this month, some 48 states had shortfalls in their 2010 budgets totaling $168 billion—or 24% of total state budgets. The left-wing Center for Budget and Policy Priorities expects total state deficits in 2011 to rise to $180 billion. And this is counting the $87 billion Medicaid bailout in this year's stimulus bill.

While falling revenues are in part to blame, Medicaid is a main culprit, even before caseloads began to surge as joblessness rose. The National Association of State Budget Officers notes that Medicaid spending is on average the second largest component in state budgets at 20.7%—exceeded only slightly by K-12 education (20.9%) and blowing out state universities (10.3%), transportation (8.1%) and prisons (3.4%).

In some states it is far higher—39% in Ohio, 27% in Massachusetts, 25% in Michigan, Rhode Island and Pennsylvania. Forcing states to spend more will crowd out other priorities or result in a wave of tax increases, or both, even as Congress also makes major tax hikes inevitable at the national level.

The National Governors Association is furious about Mr. Baucus's Medicaid expansion, and rightly so, given that governors and their legislatures will get stuck with the bill while losing the leeway to manage or reform their budget-busters. NGA President Jim Douglas of Vermont recently said at the National Press Club that the Baucus plan poses a "tremendous financial liability" and doesn't "respect that no one size fits all at the state level." He added: "Unlike the federal government, states can't print money."

Mr. Baucus hopes to use his printing press to bribe the governors, at least for a time. Currently, the federal government pays about 57 cents out of every dollar the states spend on Medicaid, though the "matching rate" ranges as high as 76% in some states. That would rise to 95%—but only for five years. After that, who knows? It all depends on which budget Congress ends up ruining. Either the states will be slammed, or Washington will extend these extra payments into perpetuity—despite the fact that CBO expects purely federal spending on Medicaid to consume 5% of GDP by 2035 under current law.

As for the poor uninsured, they'll be shunted off into what Democratic backbencher Ron Wyden calls a "caste system." While some people will be eligible for subsidized private health insurance, everyone in the lowest income bracket will be forced into Medicaid, the country's worst insurance program by a long shot. States try to control spending by restricting access to prescription drugs and specialists. About 40% of U.S. physicians won't accept Medicaid at all.

Why? One reason is that Medicaid's price controls are even tighter than Medicare's, which in turn are substantially below private payers. In 2009 or 2010, 29 states will have either reduced or frozen their reimbursement rates to providers. Democrats love Medicaid because is it much cheaper than subsidizing private insurance, but that is true only because of this antimarket brute force. Of course, such coercion will be extended to the rest of the health market under ObamaCare.

***

The states aren't entirely victims here. Both Republican and Democratic state houses regularly game the Medicaid funding formula—which itself is designed to reward higher spending—to steal more money from national taxpayers. Then when tax collections fall during downturns, budget gaskets blow all over the place. This dynamic helps explain the spectacular budget catastrophes in New York and California. We'd prefer a policy of block grants, which would extricate Washington from state accounting and encourage Governors to spend more responsibly.

That's not going to happen any time soon, but the least Mr. Baucus can do is not make things worse. Instead, his Medicaid expansion is a disaster on every level—like the rest of ObamaCare.

from the Wall Street Journal, 2009-Sep-3, by Mitch Daniels:

The Coming Reset in State Government
My fellow governors and I are likely facing a permanent reduction in tax revenues.

State government finances are a wreck. The drop in tax receipts is the worst in a half century. Fewer than 10 states ended the last fiscal year with significant reserves, and three-fourths have deficits exceeding 10% of their budgets. Only an emergency infusion of printed federal funny money is keeping most state boats afloat right now.

Most governors I've talked to are so busy bailing that they haven't checked the long-range forecast. What the radar tells me is that we ain't seen nothin' yet. What we are being hit by isn't a tropical storm that will come and go, with sunshine soon to follow. It's much more likely that we're facing a near permanent reduction in state tax revenues that will require us to reduce the size and scope of our state governments. And the time to prepare for this new reality is already at hand.

The coming state government reset will be particularly wrenching after the happy binge that preceded this recession. During the last decade, states increased their spending by an average of 6% per year, gusting to 8% during 2007-08. Much of the government institutions built up in those years will now have to be dismantled.

For now, my state's situation is far better than most, but it won't stay that way if we fail to act in Indiana. At present, we are meeting our obligations, without raising taxes, and still have over $1 billion in reserve. But the dominant reality is that even assuming the official revenue projections are accurate (and they have been consistently too rosy for the past two years), the state of Indiana will have fewer dollars to work with in 2011 than it did in 2007. Most other states face similar or worse prospects.

And, unlike the aftermath of past recessions, odds are that revenues will take a long time to catch back up to their previous trend lines—if they ever do. Tax payments have fallen so far that it would require a rousing economic rally to restore them. This at a time when the Obama administration's policies on taxes, spending and more seem designed to produce the opposite result. From 1930 to 2008, our national average annual real GDP growth rate was 3.49%. After crunching the numbers, my team has estimated that it would take GDP growth of at least twice the historical average to return state tax revenues to their previous long-term trend line by 2012.

I doubt even that would suffice to rescue most states. Instead, historical forecasting models need to be revised. One-third of state revenues (over half in seven states) come from sales taxes, but it's hard to imagine them snapping all the way back up to where they were just a few years ago. Americans are now saving much more then they used to relative to how much they are spending. This sudden shift will mean that even in good economic times to come consumers will likely spend less and therefore pay less in sales taxes than they did during bubble years.

Even if Americans wanted to go back to their high-spending, high-borrowing ways, will anyone lend them the funds to spend like it's 2007 all over again? Consumer credit will remain tighter as a matter of both sound business practice and new government regulation. Home equity appreciation is gone as a huge source of collateral, even if lenders were either willing or permitted to loan freely against it.

The "progressive" states that built their enormous public burdens by soaking the wealthy will hit the wall first and hardest. California, which extracts more than half its income taxes from a fraction of 1% of its citizens, is extreme but hardly alone in its overreliance on a few, highly mobile taxpayers. Both individuals and businesses are fleeing soak-the-rich states already. Those who remain in high-tax states will be making few if any capital gains tax payments in the years to come. Even if the stock market comes roaring back to life, the best it could do is speed the deduction of recent losses.

Sadly, the political impulse to protect government largess leads many states to aggravate their dilemma. Already more than half have raised taxes, often on businesses, serving only to chase them and their tax payments away and into the open arms of states like Indiana. Our traffic flow of interested investors is as heavy as it was in 2007. Since January we have welcomed the consolidation of more than 30 firms that closed up shop elsewhere and chose us as the low-cost, enterprise-friendly environment among their current locations.

Indiana was near bankruptcy five years ago but is relatively solvent today because we have spent the intervening years making hard choices. We have reformed state procurement, contracted out some jobs, cut costs, and relentlessly scrutinized expenditures in pushing for annual improvement in departments large and small. We've also reduced the number of state employees by some 5,000 from the 2004 level.

In contrast to the national pattern, our per capita state spending has cut, on average, 1.4% each of the past five years. Indiana is now the sixth thriftiest state by this measure. And if we Hoosiers are realizing that we need to re-examine what we can afford to have our government do, what must they be thinking in Albany, Lansing or Trenton?

Truth be told, officials in those cities are probably not thinking about this at all. But they will because state governments will soon have to choose between a major downsizing or consigning themselves to permanent decline. Wishing for an improbably huge boom while chasing your own tail through self-destructive taxes won't prove much of a strategy.

Unlike the federal government, states cannot deny reality by borrowing without limit. The Obama administration's "stimulus" package in effect shared the use of Uncle Sam's printing press for two years. But after that money runs out, the states will be back where they were. Even if Congress goes for a second round of stimulus funding, driven by the political panic of bankrupt Democratic governors, it would only postpone the reckoning.

The time to plan and debate is now. This is a test of our adulthood as a democracy. Washington, as long as our Chinese lenders enable it, can practice denial for a while longer. But for states the real world is about to arrive.

Mr. Daniels, a Republican, is the governor of Indiana.

from the Wall Street Journal, 2009-Sep-30, by Conor Dougherty, with Leslie Eaton contributing:

Falling Tax Revenues Slam States

State tax revenues in the second quarter plunged 17% from a year earlier as rising unemployment and reduced spending hurt sales- and income-tax collections, according to Census Bureau figures released Tuesday.

The decline was the sharpest since at least the 1960s. The biggest drop among major revenue sources was in state income taxes, which were down 28% from a year ago. Sales-tax revenues fell 9%. About two-thirds of state revenues are derived from sales and income taxes. The numbers aren't adjusted for inflation or changes in tax rates.

The steep declines show how the recession continues to cripple state finances, despite support from the federal stimulus package and signs of a nascent recovery in economic activity.

"This brings really bad news for almost every single state and leaves them with unprecedented budget crises," said Lucy Dadayan, a senior policy analyst with the Nelson A. Rockefeller Institute of Government at the State University of New York.

Falling revenues, combined with growing demand for social programs like Medicaid, have forced states to slash spending and scramble to raise revenue through changes including new taxes, legalized slot machines and pricier fishing licenses.

But with tax collections continuing to decline, many have been forced to reopen budgets after they have been passed to push through even bigger cuts to staffing and services. States, unlike the federal government, are generally required to balance their budgets.

In Michigan, stalled budget negotiations between the governor and the legislature could force state government to shut down if a deal isn't reached by Wednesday night. The governor would likely have to take emergency steps to keep essential services, such as hospitals and prisons, operating. "We remain optimistic that we will have a budget in place," says Liz Boyd, a spokeswoman for Gov. Jennifer Granholm.

Some cash-strapped states are rethinking the level of services the government provides. In Louisiana, a commission next month will ponder ideas including cutting 15,000 state jobs, about 13% of the total, in the next three years and eliminating money-losing toll collections on a New Orleans bridge.

"Anything is fair game," said Amber King, a public information officer for state Treasurer John N. Kennedy, who serves on the "streamlining commission." The group is supposed to make final recommendations by mid-December, she said.

Some of the sharpest tax declines were in states that have been among those hit hardest by the recession, particularly those with high concentrations of jobs in the battered housing sector. In Arizona, overall tax revenues fell 27% in the second quarter. Tax revenues fell 12% in Florida and 14% in California.

States across the country saw big declines in personal income taxes, the largest single source of state funding, representing about a third of states' overall revenues. Eleven states -- including California, New York and Wisconsin -- saw personal income taxes fall more than 30%.

Corporate income taxes, which tend be volatile and generally account for only a small portion of state revenues, rose 3%.

Despite signs that the recession is abating, many analysts don't foresee state revenues rebounding anytime soon. Economists widely expect the national unemployment rate, 9.7% in August, to remain around 9% through 2010, keeping pressure on wages and incomes. At the same time, after losing trillions in wealth, many consumers are paying down debt and paring back spending -- reducing sales taxes.

"The decline in tax revenue collections indicates that states will likely continue facing weak tax revenues for the quarters ahead," the Rockefeller Institute's Ms. Dadayan said. For many states, even grim revenue projections are turning out to be too high. Lower-than expected revenues caused Massachusetts's governor to cut the budget four times during the fiscal year that ended in June, including drawing down reserves from a rainy day fund and eliminating unfilled jobs.

History may repeat itself: With revenues still weaker than expected, the state could be forced reopen the budget as early as next month, said a spokesman for the state's Executive Office for Administration and Finance.

from the Arizona Republic, 2010-Jan-16, by Casey Newton:

Board votes to close 21 of 30 state parks by June

The Arizona State Parks Board voted unanimously Friday to begin shuttering state parks, a move that will leave the parks system with fewer than one third of its properties open by June 3.

In an emotional public meeting that lasted nearly six hours, parks-board members heard from dozens of residents from across the state, pleading to keep the parks open despite steep budget cuts.

Local elected officials warned of dire economic consequences to their towns. Sheriff's deputies said they will no longer be able to patrol some lakes. Park volunteers offered to run the parks for free.

But board members said they had no choice but to close 21 of 30 parks and recreation areas following last month's special session of the Legislature, in which $8.6 million was cut from their budget. That was on top of $34 million in cuts in the previous year.

"Unfortunately, we don't have options," said Walter Armer, a member of the board.

Among the most popular parks slated for closure are Roper Lake, which drew 86,000 visitors in 2008, and Picacho Peak, which drew more than 98,000. The parks that will remain open generate revenue for the system, such as Slide Rock and Kartchner Caverns.

The parks system records more than 2.2 million total visits a year, according to the Arizona State Parks Department.

Armer added that the board would work to reopen the parks as soon as it had the funds to do so. Several proposals are making the rounds in the Legislature, including one that would add a roughly $9 fee to the cost of registering a vehicle. The money would pay for park operations, and Arizonans would then be able to get into any state park without paying an additional fee.

The proposal with the most support at the moment would refer the question of whether to impose that fee to voters, said Jay Ziemann, the department's legislative liaison.

Wittmann resident Chrissy Kondrat-Smith took her daughter, Sydney, to every state park one recent summer. The 4,000-mile journey inspired Sydney to become a junior park ranger at Red Rock State Park, which is slated to close.

Sydney, 8, recorded a video letter to Santa Claus over the holidays, asking him to keep the parks open.

Sydney began crying when she learned the parks would close. She couldn't understand why the parks can't stay open with volunteer labor, her mother said.

Others expressed concern about what will happen to the parks once staff members aren't around to protect them. Although the parks board does intend the closed parks to be patrolled, it remains unclear how many staffers will be available.

Charles Adams, a professor of archaeology at the University of Arizona, warned that closed parks would become magnets for vandals and thieves. Adams expressed particular concern for the Homolovi Ruins, an archaeological treasure that was brought into the parks system in part to protect it from theft.

"There is great concern in the archaeological community as some of these close," Adams told the board. "They are extremely vulnerable."

As the meeting concluded, members of the parks staff received word that Gov. Jan Brewer's budget proposal released Friday would make further reductions to the parks budget, which could make Arizona the first state in the nation to close its entire parks system.

"We have a huge collective fight on our hands," said Arlan Colton, a member of the board. "And that's our fight for survival."

from the Wall Street Journal, 2009-Aug-13, by Kimberley A. Strassel:

Bernanke in the Cross-Hairs
Benjamin Bernanke's problems are now Team Obama's.

What to do when your plans to save the financial system from future disaster are being derailed by the guy who supposedly saved the financial system from current disaster? Someone hide Ben Bernanke.

The Obama administration might be wishing it had a secure location for the Federal Reserve chief. The Treasury Department's proposal to overhaul the financial regulatory system is in trouble. Congress left town after bitter hearings, rancorous accusations and dire warnings about the proposal's future. And that was just from Democrats.

At the center of the fight is Mr. Bernanke, or more precisely the administration's central idea: to invest his Federal Reserve with new "ultimate authority" to oversee the nation's banks, hedge funds and insurers. In relatively normal times, such a serious proposal might merit a serious debate. But these are not normal times.

Mr. Bernanke's extraordinary moves the past year—bailing out financial institutions, forcing bank takeovers, elbowing into fiscal policy—has turned him into a lightning rod. Politicians frustrated by the handling of the financial crisis have turned sour on giving the central bank even more powers. The White House helped create this Frankenstein, having encouraged Mr. Bernanke to operate as an arm of the Treasury. It's now left to handle the monster, as Congress seizes on the administration's proposal as a proxy to bash the Bernanke Federal Reserve.

Mr. Bernanke is unrepentant—whether on the monetary, fiscal or bailout front—and argues his sweeping actions staved off "Depression 2.0." He only needs to convince most of Congress.

On the right, he's under fire for the bailouts of Bear Stearns and AIG as ill-defined interventions in the private sector. His decision to make direct purchases of mortgage securities, troubled assets, and even Treasury securities—directly monetizing federal debt to effectively finance congressional spending—has fueled claims of dangerous fiscal meddling.

The left is no happier, casting the bailouts as Mr. Bernanke's smooch to a corrupt corporate America. Add in the Fed's deliberate secrecy, and many liberals are nursing visions of the Fed chief overseeing a fleet of black helicopters.

Meanwhile, both sides have joined to seize on his handling of Bank of America's Merrill Lynch acquisition. Put aside the question of whether that deal spread more risk than it contained. The accusations that Mr. Bernanke had threatened CEO Ken Lewis and sat on pertinent financial disclosure was a red flag to House investigators to go digging.

Far from deference, Mr. Bernanke's recent testimonies have been treated with all the delicacy usually reserved for a mob boss. Indiana Republican Rep. Dan Burton at a summer hearing went so far as to accuse Mr. Bernanke of phrasing his answers to avoid perjury. Some members of Congress also object to Mr. Bernanke's handling of his actual job—monetary policy—not that anyone's had much time to get to that.

Mr. Bernanke can't even catch a break from fellow regulators. In recent congressional hearings, Federal Deposit Insurance Corp. Chairman Sheila Bair and Comptroller of the Currency John Dugan opposed giving the Fed more power. Even a dressing down by Treasury Secretary Tim Geithner couldn't make them shut up. This is the usual turf warfare, but it is also payback; Ms. Bair has split with Treasury and the Fed over bank bailouts and other policy decisions.

Instead of discussing ways to give the Fed new powers, the bank's actions have given Congress the opening it has long wanted to exert more control over the institution. Nearly two-thirds of the House has co-sponsored a bill requiring deep financial audits of the central bank. Other members are pushing to revamp the Fed's structure in a way that gives Congress more say over the regional Federal Reserve banks.

Mr. Obama's problem is that there's no easy exit. Mr. Bernanke's term is up in January, which theoretically gives the president the ability to name a replacement. Then again, while the Bernanke power grab began with Hank Paulson, it was aided by then-New York Fed president Mr. Geithner—who as Mr. Obama's Treasury Secretary has used the Fed as an extension of his department. The Fed's claim of independence is today so tenuous that an Obama knock on Mr. Bernanke is in effect a knock on his own policies.

Mr. Bernanke, for his part, is waging a campaign for another term. Yet renomination sets up an uncertain confirmation fight with an increasingly hostile Congress. The president's top economic adviser, Larry Summers, has been as subtle as Genghis Khan in his desire to be tapped for the job, but he brings his own headaches. If the hot topic is too much Fed independence, Mr. Obama's naming of a close political ally won't calm any fears on Capitol Hill.

Congress intends to take up the financial regulatory proposal in earnest in September, at which point the Bernanke show continues. The once hard line between the "independent" Fed and the rest of official Washington has been blurred. Mr. Bernanke's problems are now the Obama team's.

from the Wall Street Journal, 2009-Jun-11, by Arthur B. Laffer:

Get Ready for Inflation and Higher Interest Rates
The unprecedented expansion of the money supply could make the '70s look benign.

Rahm Emanuel was only giving voice to widespread political wisdom when he said that a crisis should never be "wasted." Crises enable vastly accelerated political agendas and initiatives scarcely conceivable under calmer circumstances. So it goes now.

Here we stand more than a year into a grave economic crisis with a projected budget deficit of 13% of GDP. That's more than twice the size of the next largest deficit since World War II. And this projected deficit is the culmination of a year when the federal government, at taxpayers' expense, acquired enormous stakes in the banking, auto, mortgage, health-care and insurance industries.

With the crisis, the ill-conceived government reactions, and the ensuing economic downturn, the unfunded liabilities of federal programs -- such as Social Security, civil-service and military pensions, the Pension Benefit Guarantee Corporation, Medicare and Medicaid -- are over the $100 trillion mark. With U.S. GDP and federal tax receipts at about $14 trillion and $2.4 trillion respectively, such a debt all but guarantees higher interest rates, massive tax increases, and partial default on government promises.

But as bad as the fiscal picture is, panic-driven monetary policies portend to have even more dire consequences. We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s.

About eight months ago, starting in early September 2008, the Bernanke Fed did an abrupt about-face and radically increased the monetary base -- which is comprised of currency in circulation, member bank reserves held at the Fed, and vault cash -- by a little less than $1 trillion. The Fed controls the monetary base 100% and does so by purchasing and selling assets in the open market. By such a radical move, the Fed signaled a 180-degree shift in its focus from an anti-inflation position to an anti-deflation position.

The percentage increase in the monetary base is the largest increase in the past 50 years by a factor of 10 (see chart nearby). It is so far outside the realm of our prior experiential base that historical comparisons are rendered difficult if not meaningless. The currency-in-circulation component of the monetary base -- which prior to the expansion had comprised 95% of the monetary base -- has risen by a little less than 10%, while bank reserves have increased almost 20-fold. Now the currency-in-circulation component of the monetary base is a smidgen less than 50% of the monetary base. Yikes!

Bank reserves are crucially important because they are the foundation upon which banks are able to expand their liabilities and thereby increase the quantity of money.

Banks are required to hold a certain fraction of their liabilities -- demand deposits and other checkable deposits -- in reserves held at the Fed or in vault cash. Prior to the huge increase in bank reserves, banks had been constrained from expanding loans by their reserve positions. They weren't able to inject liquidity into the economy, which had been so desperately needed in response to the liquidity crisis that began in 2007 and continued into 2008. But since last September, all of that has changed. Banks now have huge amounts of excess reserves, enabling them to make lots of net new loans.

The way a bank or the banking system makes new loans is conceptually pretty simple. Banks find an entity that they believe to be credit-worthy that also wants a loan, and in exchange for the new company's IOU (i.e., loan) the bank opens up a checking account for the customer. For the bank's sake, the hope is that the interest paid by the borrower more than makes up for the cost and risk of the loan. The recently ballyhooed "stress tests" on banks are nothing more than checking how well a bank can weather differing levels of default risk.

What's important for the overall economy, however, is how fast these loans are made and how rapidly the quantity of money increases. For our purposes, money is the sum total of all currency in circulation, bank demand deposits, other checkable deposits, and travelers checks (economists call this M1). When reserve constraints on banks are removed, it does take the banks time to make new loans. But given sufficient time, they will make enough new loans until they are once again reserve constrained. The expansion of money, given an increase in the monetary base, is inevitable, and will ultimately result in higher inflation and interest rates. In shorter time frames, the expansion of money can also result in higher stock prices, a weaker currency, and increases in commodity prices such as oil and gold.

At present, banks are doing just what we would expect them to do. They are making new loans and increasing overall bank liabilities (i.e., money). The 12-month growth rate of M1 is now in the 15% range, and close to its highest level in the past half century.

With an increased trust in the overall banking system, the panic demand for money has begun to and should continue to recede. The dramatic drop in output and employment in the U.S. economy will also reduce the demand for money. Reduced demand for money combined with rapid growth in money is a surefire recipe for inflation and higher interest rates. The higher interest rates themselves will also further reduce the demand for money, thereby exacerbating inflationary pressures. It's a catch-22.

It's difficult to estimate the magnitude of the inflationary and interest-rate consequences of the Fed's actions because, frankly, we haven't ever seen anything like this in the U.S. To date what's happened is potentially far more inflationary than were the monetary policies of the 1970s, when the prime interest rate peaked at 21.5% and inflation peaked in the low double digits. Gold prices went from $35 per ounce to $850 per ounce, and the dollar collapsed on the foreign exchanges. It wasn't a pretty picture.

Now the Fed can, and I believe should, do what it must to mitigate the inevitable consequences of its unwarranted increase in the monetary base. It should contract the monetary base back to where it otherwise would have been, plus a slight increase geared toward economic expansion. Absent this major contraction in the monetary base, the Fed should increase reserve requirements on member banks to absorb the excess reserves. Given that banks are now paid interest on their reserves and short-term rates are very low, raising reserve requirements should not exact too much of a penalty on the banking system, and the long-term gains of the lessened inflation would many times over warrant whatever short-term costs there might be.

Alas, I doubt very much that the Fed will do what is necessary to guard against future inflation and higher interest rates. If the Fed were to reduce the monetary base by $1 trillion, it would need to sell a net $1 trillion in bonds. This would put the Fed in direct competition with Treasury's planned issuance of about $2 trillion worth of bonds over the coming 12 months. Failed auctions would become the norm and bond prices would tumble, reflecting a massive oversupply of government bonds.

In addition, a rapid contraction of the monetary base as I propose would cause a contraction in bank lending, or at best limited expansion. This is exactly what happened in 2000 and 2001 when the Fed contracted the monetary base the last time. The economy quickly dipped into recession. While the short-term pain of a deepened recession is quite sharp, the long-term consequences of double-digit inflation are devastating. For Fed Chairman Ben Bernanke it's a Hobson's choice. For me the issue is how to protect assets for my grandchildren.

Mr. Laffer is the chairman of Laffer Associates and co-author of "The End of Prosperity: How Higher Taxes Will Doom the Economy -- If We Let It Happen" (Threshold, 2008).

from the Wall Street Journal, 2009-Jul-16:

A Tale of Two Bailouts
Goldman's profits, CIT's trouble, and 'too big to fail.'

Yesterday saw one TARP recipient, Goldman Sachs, report $3.44 billion in profits even as another, CIT, teeters on the edge of either bankruptcy or another taxpayer bailout. Which way CIT will tip remained unclear as we went to press, but its very plight shows how the government's approach to systemic risk has created groups of financial "haves" and "have nots."

What the Goldmans of the world have in addition to profits is the widespread belief that they are too big to fail. Both Goldman and CIT converted into bank holding companies at the height of the financial panic last fall, which made them eligible for TARP injections. Goldman also benefited at a crucial moment from the Federal Reserve takeover of AIG, and it received the additional filip of FDIC-guaranteed debt issuance through the Temporary Liquidity Guarantee Program. CIT was excluded from the latter program on grounds that it didn't pose a systemic risk, even as larger competitors like General Electric were allowed in.

CIT's asset quality has since fallen further, and it now faces $2.7 billion in maturing debt this year that investors fear it will not be able to roll over. So it is seeking another taxpayer rescue, and officials at Treasury and Fed are sympathetic.

But if CIT -- a company one-tenth the size of Lehman Brothers -- can be bailed out long after the panic has passed, the word "systemic" has lost all meaning. CIT has long been a lender to subprime corporate borrowers, and this decade it took on even greater risks at precisely the wrong time. It has lost money for eight straight quarters. Its lending supports less than 1% of the total U.S. retail and manufacturing, and plenty of competitors could pick up its market share.

There's also a question of why the FDIC -- which is supposed to protect bank depositors -- should be the rescue agent. CIT's bank is only a small part of the company and is so far walled off from trouble. CIT executives want permission to stuff some of the company's assets into the bank so they can finance them with brokered deposits. But that would put the FDIC's deposit fund at greater risk just when it is stretched from other bank failures. The FDIC should also be winding down its debt guarantee program, not extending it to new and riskier companies. Taxpayers shouldn't be put at risk for further losses via the FDIC merely because Treasury and the Fed don't want to admit losses on their TARP investment.

Of course, if the feds do let CIT fail, this will only confirm that the only certain survivors in the current market are banks big enough that the government figures it must bail them out. Just ask the many small banks that have been rolled up by the FDIC at a rate of two a week since the beginning of the year, with eight so far in July alone. That can only strengthen the likes of Goldman, which apparently needs no help printing money anyway.

Goldman's traders profited in the second quarter from taking advantage of spreads left wide by the disappearance of some competitors (Lehman, Bear Stearns) and the risk aversion of others (Morgan Stanley). Meantime, Goldman's own credit spreads over Treasurys have narrowed as the market has priced in the likelihood that the government stands behind the risks it is taking in its proprietary trading books.

Goldman will surely deny that its risk-taking is subsidized by the taxpayer -- but then so did Fannie Mae and Freddie Mac, right up to the bitter end. An implicit government guarantee is only free until it's not, and when the bill comes due it tends to be huge. So for the moment, Goldman Sachs -- or should we say Goldie Mac? -- enjoys the best of both worlds: outsize profits for its traders and shareholders and a taxpayer backstop should anything go wrong.

We like profits as much as the next capitalist. But when those profits are supported by government guarantees or insured deposits, taxpayers have a special interest in how the companies conduct their business. Ideally we would shed those implicit guarantees altogether, along with the very notion of too big to fail. But that is all but impossible now and for the foreseeable future. Even if the Obama Administration and Fed were to declare with one voice that banks such as Goldman were on their own, no one would believe it.

If there is a lesson in this week's tale of two banks, it's that it won't be enough to give the Federal Reserve a mandate to "monitor" systemic risk. Last fall's bailouts are reverberating through the financial system in a way that is already distorting the competition for capital and financial market share. Banks that want to be successful will also want to be more like Goldman Sachs, creating an incentive for both larger size and more risk-taking on the taxpayer's dime.

One policy response to the incentives created by last fall's bailout is simply to restrict the proprietary trading done by the subsidiaries of bank holding companies that enjoy both FDIC deposit insurance and an implicit government subsidy on their cost of capital. This is what Paul Volcker proposed, only to be overruled by Tim Geithner and Larry Summers. Another answer would be an FDIC-style bailout tax, perhaps tied to leverage ratios, for those in the too-big-to-fail camp. Developing a template to facilitate the seizure and orderly winding down of failing financial giants is also an essential element of whatever reform Congress cooks up.

* * *

No one welcomes the pain and dislocation if CIT files for bankruptcy. But U.S. policy toward financial companies cannot avoid all hardship, or the result will be a de facto cartelization of finance, with a resulting loss of competition and dynamism that have long been an American strength. The divergent fortunes of CIT and Goldman Sachs show how much we changed when we stepped in to save certain banks in the name of saving the system.

from the Washington Post, 2009-Jun-26, by Lori Montgomery:

CBO Paints Dire Portrait of Long-Term Revenue, Spending

The nation's long-term budget outlook has darkened considerably over the past six months, and President Obama's plan to extend an array of tax cuts and other policies adopted during the Bush administration has the potential to "create an explosive fiscal situation," congressional budget analysts reported yesterday.

In a new report, the Congressional Budget Office found that extending the Bush administration tax cuts, reining in the alternative minimum tax and canceling a scheduled reduction in payments to Medicare doctors would dramatically slash tax collections at a time when federal spending would be "sharply rising." The resulting budget gap would drive the nation's debt over 100 percent of gross domestic product by 2023, the report says, and past 200 percent of GDP by the late 2030s.

Obama has not proposed to extend all of the Bush tax cuts, which are scheduled to expire in December 2010. But he would keep all cuts benefiting the middle class -- a substantial portion of the total -- and has advocated additional borrowing to cover the costs of that and other policy changes analyzed by the CBO.

The CBO released its report on the same day that White House Office of Management and Budget Director Peter Orszag appeared on Capitol Hill to defend Obama's request to extend the Bush tax cuts and make other policy changes without making up the lost revenue. Orszag argued that no one has offered "credible proposals" for raising the necessary cash, and that simply allowing the tax cuts to expire or permitting a 21 percent cut in payments to doctors who care for Medicare patients to proceed next year would "unrealistically reduce costs or increase revenues."

Democratic lawmakers generally agree, and the budget resolution they adopted earlier this year assumes that many of the Bush tax cuts will be extended and future deficits will rise. Yesterday's CBO report highlights the cost of that trade-off. ad_icon

The news is not particularly good even if the government were to collect the extra money, primarily because of the rapidly rising cost of Social Security and federal health programs for the elderly and the poor. According to the CBO, the annual gap between spending and revenue would briefly drop below 2 percent of GDP in the next decade before rising to 5.6 percent in 2035, 8.3 percent in 2050, and nearly 18 percent in 2080. But the outlook is much worse if the tax cuts and other policies are extended, the CBO found: Annual deficits would never drop below 4 percent of GDP; they would approach 15 percent by 2035 and surpass 42 percent by 2080.

Already heavily in debt, the nation would be forced to borrow ever more massive sums to keep the government afloat, the CBO warns, with the national debt nearly 200 percent of the overall economy by 2035.

"We're drowning in unprecedented levels of red ink, and there is no plan to fix the situation. Having spent over a decade worrying about budget deficits, I can quite honestly say that things have never looked as bad as they do now," said Maya MacGuineas, president of the bipartisan Committee for a Responsible Federal Budget. "We need to be focused on slowing spending and finding better ways to raise revenue, not on cutting taxes and introducing new entitlement programs. We can either make these hard choices now, on our own terms, or we can make them in a panic on the heels of a full-blown fiscal crisis."

from the Wall Street Journal, 2009-May-7, p.A17, by Richard A. Posner:

Capitalism in Crisis
It's hard to run a safe banking system when the central bank is recklessly easy.

The current economic crisis so far eclipses anything the American economy has undergone since the Great Depression that "recession" is too tepid a term to describe it. Its gravity is measured not by the unemployment rate but by the dizzying array of programs that the government is deploying and the staggering amounts of money that it is spending or pledging -- almost $13 trillion in loans, other investments and guarantees -- in an effort to avoid a repetition of the 1930s.

Much of this sum will not be spent (the guarantees), and probably most will eventually be recovered. But a commitment of such magnitude -- stacked on top of enormous budget deficits enlarged by sharply falling federal-tax revenues -- could lead to high inflation, greatly increased interest costs on a greatly increased national debt, much heavier taxes, the restructuring of major industries, and the redrawing of the line that separates business from government.

How did this happen? And what is to be done?

The key to understanding is that a capitalist economy, while immensely dynamic and productive, is not inherently stable. At its heart is a banking system that enables large-scale borrowing and lending, without which most businesses cannot bridge the gap between incurring costs and receiving revenues and most consumers cannot achieve their desired level of consumption. When the banking system breaks down and credit consequently seizes up, economic activity plummets.

Lending borrowed capital -- the essence of banking -- is risky. That risk is amplified when interest rates are very low, as they were in the early 2000s because of a mistaken decision made by the Federal Reserve under Alan Greenspan to force interest rates down and keep them down. Because houses are bought with debt (for example, an 80% first mortgage on a house), low interest rates spur demand for houses. And because the housing stock is so durable a surge in demand increases not only housing starts but also the prices of existing houses. When people saw house prices rising -- and were assured by officials and other experts that they were rising because of favorable "fundamentals" -- Americans decided that houses were a great investment, and so demand and prices kept on rising.

In fact, prices were rising because interest rates were low. So when the Federal Reserve (fearing inflation) began pushing interest rates up in 2005, the bubble began leaking air and eventually burst. It carried the banking industry down with it because banks were so heavily invested in financing houses.

The banking crash might not have occurred had banking not been progressively deregulated beginning in the 1970s. Before deregulation banks were forbidden to pay interest on demand deposits. This gave them a cheap source of capital, which enabled them to make money even on low-risk short-term loans. Competition between banks was discouraged by limits on the issuance of bank charters and by (in some states) not permitting banks to establish branch offices. And nonbank finance companies (such as broker-dealers, money-market funds and hedge funds) did not offer close substitutes for regulated banking services.

Those days are gone. Had Americans' savings not become concentrated in houses and common stocks, the banking meltdown would have had less effect on the general economy. When these assets -- their prices artificially inflated by low interest rates -- fell in value, credit tightened and people felt (and were!) poorer. So people reduced their spending and allocated more of their income to precautionary savings, including cash, government securities and money-market accounts.

The Fed tried to encourage lending by once again pushing interest rates way down. But the banks -- their capital depleted by the fall in value of their mortgage-related assets -- have hoarded most of the cash they've received as a result of being able to borrow cheaply, rather than risk lending into a depression. Their hoarding, like that of consumers, is entirely rational, but it inhibits investment as well as consumption.

With easy money failing to do the trick, the government began lending large sums of money directly to banks. It also tried to bypass the banks in its efforts to stimulate consumption and employment by implementing tax cuts, benefits increases and public-works projects hard hit by unemployment. Though the banks are continuing to hoard bailout money and the stimulus program is just beginning to be implemented, these and other recovery programs have probably slowed the downward spiral.

It's not too soon, therefore, to derive some important lessons from the economic crisis:

First, businessmen seek to maximize profits within a framework established by government. We want businessmen to discover what people want to buy and to supply that demand as cheaply as possible. This generates profits that signal competitors to enter the market until excess profit is eliminated and resources are allocated most efficiently. Financial products are an important class of products that we want provided competitively. But because risk and return are positively correlated in finance, competition in an unregulated financial market drives up risk, which, given the centrality of banking to a capitalist economy, can produce an economic calamity. Rational businessmen will accept a risk of bankruptcy if profits are high because then the expected cost of reducing that risk also is high. Given limited liability, bankruptcy is not the end of the world for shareholders or managers. But a wave of bank bankruptcies can bring down the economy. The risk of that happening is external to banks' decision-making and to control it we need government. Specifically we need our central bank, the Federal Reserve, to be on the lookout for bubbles, especially housing bubbles because of the deep entanglement of the banking industry with the housing industry. Our central bank failed us.

The second lesson is that we may need more regulation of banking to reduce its inherent riskiness. But now is not the time for that: There is no danger of a renewed housing or credit bubble in the immediate future. The essential task now is to recover from the depression. That requires, as John Maynard Keynes taught, a restoration of business confidence. Investment is inherently uncertain, and it is even more uncertain in a depression. Anything that amplifies this uncertainty slows recovery by making businessmen more likely to freeze and hoard rather than venture and spend. Reregulating banking, hauling bankers before congressional committees, passing laws tightening credit-card lending, and capping bonuses all impede recovery. All that is for later, once the economy is back on track. For now such measures are just distractions.

Moreover, it is unclear how banking should be regulated. Banking in the broad sense of financial intermediation (borrowing capital in order to lend or otherwise invest it) is immensely diverse. It is also international. If one nation reduces the riskiness of its banking industry, business will flow to other nations, just as a bank that decides to be cautious will lose investors to its competitors because of the positive correlation of risk and return. So international regulation of banking is needed in principle, but international regulation tends to be lowest-common-denominator regulation and so may be ineffectual.

Finally, let's place the blame where it belongs. Not on the bankers, who are not responsible for assuring economic stability, but on the government officials who had that responsibility and failed to discharge it. They failed even to develop contingency plans to deal with what everyone knew could happen in a context of escalating housing prices (it had happened in Japan in the late 1980s and the 1990s). Lacking such plans, the government responded to the crisis with spasmodic improvisations, amplifying uncertainty and mistrust and thus retarding recovery.

And let's not forget to apportion some of the blame to the influential economists who assured us that there could never be another depression. They argued that in the face of a recession the Federal Reserve had only to reduce interest rates and flood the banks with money and all would be well. If only.

Mr. Posner is a federal circuit judge and a senior lecturer at the University of Chicago Law School. He is the author of the just-published "A Failure of Capitalism: The Crisis of '08 and the Descent into Depression" (Harvard University Press).

from McClatchy Newspapers via the Miami Herald, 2009-May-11, by David Lightman:

WASHINGTON -- The White House on Monday projected 2009 and 2010 federal budget deficits far higher than it forecast just two and a half months ago, even as it continued to defy most experts and predict that the economy is headed for a strong comeback starting late this year.

Economists scoffed at the latest administration predictions.

"If they keep playing this game, they're going to have real credibility problems," predicted Brian Bethune, the chief U.S. financial economist at IHS Global Insight, an economic research firm.

The new administration budget said that the fiscal 2009 deficit would reach $1.84 trillion, or $89 billion more than forecast in February, while the 2010 figure now is estimated at $1.26 trillion, or $87 billion above the previous number. The fiscal 2008 deficit was $459 billion.

The new figures dwarf the $17 billion in budget reductions and program terminations that President Barack Obama proposed with a flourish last week, reductions that Congress is unlikely to approve in full.

Budget Director Peter Orszag, writing on his blog, explained that the latest changes, which are the final pieces of Obama's rollout of his $3.6 trillion fiscal 2010 budget, reflect "upward technical revisions" caused largely by revenues that were lower than expected and costs for rescuing financial institutions that were higher than anticipated.

As it has done since taking office in January, however, the administration tried to stay upbeat. On Monday, it offered new plans for cutting health care costs and in the new budget still maintained its February economic assumptions, which are rosier than nearly any other economists foresee.

The White House still is projecting that the nation's economy will shrink by 1.2 percent this year and increase by 3.2 percent next year. In addition, it projects that "by the end of this year," the economy will be growing at a 3.5 percent annual rate.

The nonpartisan Congressional Budget Office predicts a gross domestic product decline of 3 percent this year, but 2.9 percent growth next year, while the April consensus of 50 blue-chip private economists sees a 2.6 percent decline in 2009 and only 1.8 percent growth next year.

The administration's assumptions, Orszag said, will be revisited this summer, "the traditional point" when an administration makes such revisions.

The biggest discrepancy involves unemployment, which reached 8.9 percent last month. The White House sees the number declining to an average of 7.9 percent next year, well below the CBO's 9 percent estimate and the blue chip 9.5 percent.

"The (Obama) unemployment number is crazy," said Roberton Williams, senior fellow at the Urban Institute-Brookings Institution Tax Policy Center.

The Office of Management and Budget explains the discrepancy by saying that its assumptions are based on data available as of late January. The jobless rate that month was 7.6 percent. It reached 8.9 percent in April, the government reported Friday.

The CBO issued its forecast in March and the blue-chip predictions came out last month; in a revision Monday, the blue-chip forecast turned slightly more pessimistic.

The differences can be significant in assessing the federal deficit's future path, because recovering economies mean more jobs and more revenue and less government spending.

Even with its more optimistic economic scenario, the administration projects record deficits for years to come. The annual deficit would drop to $512 billion by 2013, but then would begin to go up again, reaching $779 billion by 2019, as the costs of Social Security and government health care programs soar, the administration projects.

It's a grim picture, analysts said.

"Even using their ... economic assumptions - which now appear to be out of date and overly optimistic - the administration never puts us on a stable path," said Marc Goldwein, the policy director of the nonpartisan Committee for a Responsible Federal Budget.

Global Insight's Bethune said that Obama could face a growing political problem. His public relations initiatives stress his devotion to slashing spending. In recent months, the president has vowed to cut at least $100 million in wasteful spending, trim $17 billion in unnecessary programs and overhaul Congress' system of using earmarks, or special funding for local projects. On Monday, the Council of Economic Advisers reported that the economy was on track to create or save the 3.5 million jobs promised in this winter's $787 billion economic stimulus.

However, Republicans are pouncing eagerly on what they view as budget hypocrisy.

"The president's recent proposal for some modest reductions in government spending was a start, but the administration acknowledged today that since the president took office, their projections for the deficit grew five times faster than the proposed cuts would save," said Senate Minority Leader Mitch McConnell, R-Ky.

Obama, analysts suggested, should be more circumspect, because taming this budget is proving unusually difficult.

"So many things are in motion," Bethune said, including weak banks, weaker American auto companies, fragile consumer confidence and so on. "Their economic assumptions could become an issue; it's not a good way to go."

To Goldwein, the latest budget news was more confirmation that Obama needs to make hard choices to cut popular programs.

"The president made clear that he understands the critical importance of fiscal discipline," he said. "Now we need to see some action."

ON THE WEB

Council of Economic Advisers jobs reports: http://tinyurl.com/q9ll9a

White House February economic and budget data: http://tinyurl.com/bp5m5o

from the Wall Street Journal, 2009-May-23, p.A9, by Scott E. Harrington:

Moral Hazard and the Meltdown
Everybody felt too big to fail.

An appropriate government response to the bursting of the housing bubble requires a full understanding of what went wrong and why. Many commercial banks, investment banks, savings and loans, mortgage originators, subprime borrowers, and insurance giant AIG obviously placed heavy bets on continued housing-price appreciation. They gambled; the losses have been huge and widespread.

Why did so many players place these large, risky bets? A simple yet significant part of the answer is that the potential gains and losses were asymmetric. If housing prices continued to climb, or at least not fall, the participants could achieve large profits. If housing prices failed to appreciate, or even fell, the losses would be largely borne by others, including taxpayers. "Heads" and the bettors would win -- "tails" and others would lose.

On the supply side, de facto -- and now de jure -- government guarantees of Fannie Mae and Freddie Mac debt lowered their financing costs and thus amplified mortgage-credit expansion and housing-price appreciation. Bank deposit insurance and implicit guarantees of bank obligations encouraged risky mortgage lending and investment, especially given strong pressure from Congress for more subprime lending. The shift to corporate ownership of investment banks, with limited liability, encouraged them to take greater risk in relation to capital, especially given expanded competition with investment-bank affiliates of bank holding companies that followed the Gramm-Leach-Bliley Act in 1999.

Moreover, the Security and Exchange Commission's adoption in 2004 of "consolidated supervision" of the largest investment banks allowed them to increase leverage substantially, in significant part by taking on more subprime-mortgage exposure.

Meanwhile, AIG facilitated investment in mortgage securitization by domestic and foreign banks and investment banks by selling cheap protection against default risk. Subprime mortgage originators were often new entrants that had little reputational capital at risk, and didn't have to hold the mortgages.

On the demand side, many subprime borrowers acquired properties with little or no money down. They faced relatively little loss if housing prices fell and they defaulted. Many people took cheap mortgages on investment property to speculate on housing-price increases. Others took cheap second mortgages to fund current consumption.

The Federal Reserve played a key role in making these bets attractive to borrowers, lenders and investors. It kept interest rates at historically low levels until it was too late to prevent the eventual implosion. This deliberate policy and public statements by then Fed Chairman Alan Greenspan fueled demand for credit and housing and encouraged lenders to relax mortgage-lending criteria.

Given what we know about the bubble's causes, the main objectives of legislative and regulatory responses should be to encourage market discipline as a means to promote prudence, safety and soundness in banking and securities. We should avoid extending explicit or implicit "too big to fail" policies beyond banking.

Unfortunately, the most conspicuous proposals on Capitol Hill -- the creation of a "systemic risk" regulator and expanded federal authority over financially distressed insurers and other nonbank institutions -- could easily undermine both objectives by protecting even more institutions, investors and consumers from the downside of their actions.

Mr. Harrington is a professor of health-care management and insurance and risk management at the University of Pennsylvania's Wharton School.

from the Wall Street Journal, 2009-May-4, p.A15 by L. Gordon Crovitz:

Easy Credit and the Depression

What caused this recession? We still don't have a simple explanation. Such is the uncertainty sapping the country's confidence that in a recent Rasmussen Reports poll only 53% of Americans said they prefer capitalism to socialism; 27% were unsure and 20% preferred socialism.

Before seeking political asylum in free-market Hong Kong, consider reading a new book that critiques what went wrong with capitalism, written in order to save it. Judge Richard Posner's "A Failure of Capitalism: The Crisis of '08 and the Descent into Depression" is noteworthy. As a longtime University of Chicago professor and father of the free-market-based law-and-economics movement, Judge Posner makes an unlikely critic of capitalism. But as author of some 40 books and as the most frequently cited federal appeals court jurist, he is also one of our most original and clearheaded thinkers.

Who's to blame and who's responsible for the recession? Judge Posner, who calls it a depression, distinguishes between the roles played by government and the private sector. "Although financiers bear the primary responsibility for the depression," he writes, "I do not think they can be blamed for it -- implying moral censure -- any more than one can blame a lion for eating a zebra. Capitalism is Darwinian." A pragmatic explanation for behavior that looks irrational in retrospect shows that it was logical, based on incentives at the time. Blame lies elsewhere: "The responsibility for building the fences that prevent an economic collapse as a result of risky lending devolves on the government."

As Judge Posner told me in an interview, "The role of bankers is to operate banks, which is inherently a risky business. It's not to save the economy." But he disagrees that government is chiefly responsible. Banks are responsible in the sense that as each financial firm made rational choices for itself, such as embracing new credit instruments, these choices in aggregate created huge risk to the system.

Unlike responsibility, blame goes to those in government for creating the credit bubble, and then failing to have a contingency plan when the economy was headed off the rails. "Even if the risk of this depression was 1%, the effect of it occurring was so serious that the blame must go to regulators who were too slow."

The conventional wisdom is that very smart bankers misunderstood their own interests. In a capitalist system, if you can't trust self-interest, what can you trust? Judge Posner instead reminds us that shareholders would have punished individual banks that failed to take advantage of low interest rates and seemingly safe, mortgage-backed securities. Likewise, consumers acted rationally over the years to accept offers of mortgages they couldn't afford, given the low risk of a burst bubble.

"At no stage need irrationality be posited to explain what happened," Judge Posner writes. Instead, this was a case of "intelligent businessmen rationally responding to their environment yet by doing so creating the preconditions for a terrible crash." He chiefly blames the Federal Reserve, for "cheap credit."

Judge Posner, who shares an influential blog with Chicago Nobel prize-winning economist Gary Becker, proposes a partly psychological definition of a depression: "A steep reduction in output that causes or threatens to cause deflation and creates widespread public anxiety and, among the political and economic elites, a sense of crisis that evokes extremely costly efforts at remediation."

The causes include failures of information at many levels. "Even though the financial industry has more information bearing on the likelihood of a depression than the government does, it has little incentive to analyze that information," Judge Posner writes. The models for assessing the riskiness of mortgage-backed securities failed, but at any one time the chances of a bubble resulting in a depression were remote. Likewise, "investors had limited information about the riskiness of individual mortgages, and there was insufficient experience with large-scale subprime lending to enable the risk of default of subprime mortgages to be assessed with confidence."

If we can agree that the private sector is responsible but the government gets the blame, we can move on to prevention. A streamlined set of regulators with access to public and private information should be charged with tracking systemic risk. We also need clear, predictable rules for how the Federal Reserve and other regulators would respond to various risk situations, which would give financial markets clearer rules of the road. Under this view, Washington's on-the-fly approaches to banks, autos and other industries risks further undermining confidence.

Even capitalism's staunchest supporters recognize that it cannot function unless government plays its proper part. If all the players, including regulators and bankers, can accept their rightful share of blame and responsibility, we can begin to prevent future failures.

from the Wall Street Journal, 2009-May-12, p.A16:

Geithner's Revelation
He concedes that monetary policy was 'too loose too long.'

The Earth stood still, the seas parted and a member of the U.S. political class admitted last week that the Federal Reserve helped to cause the financial meltdown. OK, only the last of those happened, but it's a welcome miracle nonetheless.

The revelation came from Timothy Geithner last Wednesday with PBS's Charlie Rose, who asked the Treasury Secretary: "Looking back, what are the mistakes and what should you have done more of? Where were your instincts right, but you didn't go far enough?"

Mr. Geithner: "We need a little more time to get full perspective."

Mr. Rose: "Right."

Mr. Geithner: "But I would say there were three types of broad errors of policy and policy both here and around the world. One was that monetary policy around the world was too loose too long. And that created this just huge boom in asset prices, money chasing risk. People trying to get a higher return. That was just overwhelmingly powerful."

Mr. Rose: "It was too easy."

Mr. Geithner: "It was too easy, yes. In some ways less so here in the United States, but it was true globally. Real interest rates were very low for a long period of time."

Mr. Rose: "Now, that's an observation. The mistake was that monetary policy was not by the Fed, was not . . ."

Mr. Geithner: "Globally is what matters."

Mr. Rose: "By central bankers around the world."

Mr. Geithner: "Remember as the Fed started -- the Fed started tightening earlier, but our long rates in the United States started to come down -- even were coming down even as the Fed was tightening over that period of time, and partly because monetary policy around the world was too loose, and that kind of overwhelmed the efforts of the Fed to initially tighten. Now, but you know, we all bear a responsibility for that. I'm not trying to put it on the world."

Mr. Geithner went on to cite a lack of supervision over bank risk-taking and the slow pace of government response to the problem -- both of which are now conventional wisdom. But the real news here is Mr. Geithner's concession that monetary policy was "too loose too long." The Washington crowd has tried to place all of the blame for the panic on bankers, the better to absolve themselves. But as Mr. Geithner notes, Fed policy flooded the world with dollars that created a boom in asset prices and inspired the credit mania. Bankers made mistakes, but in part they were responding rationally to the subsidy for credit created by central bankers.

We disagree with Mr. Geithner on one point. He's right that monetary policy needs to be considered in global terms, but he's still too quick to pass the buck from the Fed to other central banks. The European Central Bank was much tighter than the Fed throughout this period. The Fed was by far the major monetary player because much of the world was on a dollar standard, with its monetary policy linked to the Fed's. That was true of China, most of Asia and the Middle East.

The Fed's loose policy from 2003 to 2005 created the commodity and credit bubbles that made these countries flush with dollars. Given their low domestic propensity to consume, these countries then recycled those dollars back into dollar-denominated assets, such as Treasurys and real-estate-related assets such as Fannie Mae securities. The Fed itself had created the surplus dollars that kept long rates low and undermined for a substantial period its belated attempts to tighten.

Mr. Geithner's concession is important nonetheless because before he moved to Treasury he was vice chairman of the Fed's Open Market Committee that sets monetary policy. His comments mark a break with the steadfast refusal of Fed Chairmen Alan Greenspan and Ben Bernanke to admit any responsibility. They prefer to blame bankers and what they call the "global savings glut," as if the Fed had nothing to do with creating that glut.

Mr. Geithner's remarks are a sign of intellectual progress, and they suggest that at least some in government are thinking about their own part in creating the mess. The role of Fed policy should also be at the heart of the hearings that Speaker Nancy Pelosi is planning on the causes of the financial meltdown. We won't begin to understand the credit mania and panic until we acknowledge their monetary roots.

from MarketWatch.com, 2009-May-15, by Greg Robb:

When will Fed get off zero? No time soon
The perils of taking the economy off life support

WASHINGTON - The Federal Reserve is not expected to tighten monetary policy until the end of the year at the earliest, Fed watchers said this week.

Policymakers are seen in no rush to remove the economy from the elaborate life-support system central bankers have erected over the past year.

The Fed has bought massive amounts of private-sector assets to keep credit flowing through the economy. So whenever the Fed does stop and reverse this policy, there will be a major "jolt" to financial markets, experts said.

Gary Stern, the retiring president of the Minneapolis Federal Reserve Bank, said on Friday that the Fed did not have to hike rates "soon."

"We have some time to observe the performance of the economy and hope that the recovery will not only materialize but that it has a firm foundation," Stern said in an interview on Bloomberg television.

With signs that the economy has at least stopped its free-fall, Wall Street has started to debate the Fed's "exit strategy." It hasn't taken long for a bitter row between two camps to break out.

One side believes the money that the Fed has been pumping into the economy is bound to create inflation down the road and it is better to start worrying about it, and doing something about it, now.

Others take the opposite view and think there is so much slack in the economy that the threat of falling prices is being dismissed too easily. They are deeply concerned that it may be a long time before the recession ends.

The dispute almost has "theological" overtones, said James Glassman, economist at JP Morgan Chase.

Concerns about inflation won't go away even though consumer inflation as measured by the consumer price index has fallen 0.7% in the past 12 months ended in May.

Others, like Ian Shepherdson of High Frequency Economics, believe deflation "has much, much further to run." Wages are rolling over as unemployment soars, he said.

David Jones, a veteran Fed watcher, believes that Bernanke has a foot in both camps.

Bernanke is moving away from "a total preoccupation with the declining economy" toward a "leveling out" of activity, Jones said in an interview.

But, at the same time, Bernanke has "no great urgency at the moment to take any specific action to pull back," Jones said.

"I expect the Fed to keep the balance sheet quite high and the Fed funds rate level at record low for a significant part of this year," Jones said.

In the wait-and-see camp

Some economists believe that the Fed will stay on hold far longer.

Dean Maki, co-head of U.S. economic research at Barclays Capital PLC, said the Fed is on hold until the end of 2010. "The Fed will take the cautious road," he said.

Maki said it was the combination of high unemployment -- 9.5% average in 2010 -- and falling core inflation -- 0.8% on core PCE price index by end of 2010 -- that will keep the Fed on hold.

"Just as it was in 2003 to early 2004, we think the Fed will be concerned enough about deflation risks in an environment of falling core inflation and high unemployment to want to keep rates on hold," he said.

Jay Bryson, economist at Wachovia, said the Fed will be on hold until "well into 2010."

"You have to see signs that the recovery is becoming sustainable," Bryson said.

This means that the massive declines in nonfarm payroll employment and business spending have to come to an end, he said.

The sooner-rather-than-later folks

But several economists think the Fed may have to act sooner.

John Taylor, a monetary policy expert at Stanford University, raised eyebrows this week when he said the Fed may soon have to start raising rates. He said that the appropriate level of the funds rate was now 0.5%.

Taylor has been one of the few vocal critics of the Fed's purchase of private-sector assets. He said they will be very difficult to sell once financial markets improve.

Robert Brusca, chief economist at FAO Economics, said the model of past recessions has been that a strong downturn generates a strong recovery.

The Fed may see fast growth over a four- to six-quarter span that will make it difficult for the Fed to "take its time."

Handle with care

Whenever the Fed decides to tighten, it will likely "jolt" the economy, Jones said.

The central bank also has to be careful because soaring interest rates could complicate the Treasury's projected massive borrowing next year to finance the widening federal budget deficit.

Economists do not expect the Fed to start the tightening process with a surprise interest rate hike. Instead, they see the Fed telegraphing its punch well in advance by taking some other steps.

Bernanke listed a series of tools that the Fed could use. The tools are fairly technical but involve trying to "drain the swamp" of excess money in the system.

But the bottom line is the Fed can do what it wants when the time comes to tighten, economists said. There is no rule book for ending the most massive effort in modern monetary history.

"This is all trial-and-error," Jones said.

from the Wall Street Journal, 2009-May-23, p.A9, by Mary Anastasia O'Grady:

Don't Monetize the Debt
The president of the Dallas Fed on inflation risk and central bank independence.

Dallas

From his perch high atop the palatial Dallas Federal Reserve Bank, overlooking what he calls "the most modern, efficient city in America," Richard Fisher says he is always on the lookout for rising prices. But that's not what's worrying the bank's president right now.

His bigger concern these days would seem to be what he calls "the perception of risk" that has been created by the Fed's purchases of Treasury bonds, mortgage-backed securities and Fannie Mae paper.

Mr. Fisher acknowledges that events in the financial markets last year required some unusual Fed action in the commercial lending market. But he says the longer-term debt, particularly the Treasurys, is making investors nervous. The looming challenge, he says, is to reassure markets that the Fed is not going to be "the handmaiden" to fiscal profligacy. "I think the trick here is to assist the functioning of the private markets without signaling in any way, shape or form that the Federal Reserve will be party to monetizing fiscal largess, deficits or the stimulus program."

The very fact that a Fed regional bank president has to raise this issue is not very comforting. It conjures up images of Argentina. And as Mr. Fisher explains, he's not the only one worrying about it. He has just returned from a trip to China, where "senior officials of the Chinese government grill[ed] me about whether or not we are going to monetize the actions of our legislature." He adds, "I must have been asked about that a hundred times in China."

A native of Los Angeles who grew up in Mexico, Mr. Fisher was educated at Harvard, Oxford and Stanford. He spent his earliest days in government at Jimmy Carter's Treasury. He says that taught him a life-long lesson about inflation. It was "inflation that destroyed that presidency," he says. He adds that he learned a lot from then Fed Chairman Paul Volcker, who had to "break [inflation's] back."

Mr. Fisher has led the Dallas Fed since 2005 and has developed a reputation as the Federal Open Market Committee's (FOMC) lead inflation worrywart. In September he told a New York audience that "rates held too low, for too long during the previous Fed regime were an accomplice to [the] reckless behavior" that brought about the economic troubles we are now living through. He also warned that the Treasury's $700 billion plan to buy toxic assets from financial institutions would be "one more straw on the back of the frightfully encumbered camel that is the federal government ledger."

In a speech at the Kennedy School of Government in February, he wrung his hands about "the very deep hole [our political leaders] have dug in incurring unfunded liabilities of retirement and health-care obligations" that "we at the Dallas Fed believe total over $99 trillion." In March, he is believed to have vociferously objected in closed-door FOMC meetings to the proposal to buy U.S. Treasury bonds. So with long-term Treasury yields moving up sharply despite Fed intentions to bring down mortgage rates, I've flown to Dallas to see what he's thinking now.

Regarding what caused the credit bubble, he repeats his assertion about the Fed's role: "It is human instinct when rates are low and the yield curve is flat to reach for greater risk and enhanced yield and returns." (Later, he adds that this is not to cast aspersions on former Fed Chairman Alan Greenspan and reminds me that these decisions are made by the FOMC.)

"The second thing is that the regulators didn't do their job, including the Federal Reserve." To this he adds what he calls unusual circumstances, including "the fruits and tailwinds of globalization, billions of people added to the labor supply, new factories and productivity coming from places it had never come from before." And finally, he says, there was the 'mathematization' of risk." Institutions were "building risk models" and relying heavily on "quant jocks" when "in the end there can be no substitute for good judgment."

What about another group of alleged culprits: the government-anointed rating agencies? Mr. Fisher doesn't mince words. "I served on corporate boards. The way rating agencies worked is that they were paid by the people they rated. I saw that from the inside." He says he also saw this "inherent conflict of interest" as a fund manager. "I never paid attention to the rating agencies. If you relied on them you got . . . you know," he says, sparing me the gory details. "You did your own analysis. What is clear is that rating agencies always change something after it is obvious to everyone else. That's why we never relied on them." That's a bit disconcerting since the Fed still uses these same agencies in managing its own portfolio.

I wonder whether the same bubble-producing Fed errors aren't being repeated now as Washington scrambles to avoid a sustained economic downturn.

He surprises me by siding with the deflation hawks. "I don't think that's the risk right now." Why? One factor influencing his view is the Dallas Fed's "trim mean calculation," which looks at price changes of more than 180 items and excludes the extremes. Dallas researchers have found that "the price increases are less and less. Ex-energy, ex-food, ex-tobacco you've got some mild deflation here and no inflation in the [broader] headline index."

Mr. Fisher says he also has a group of about 50 CEOs around the U.S. and the world that he calls on, all off the record, before almost every FOMC meeting. "I don't impart any information, I just listen carefully to what they are seeing through their own eyes. And that gives me a sense of what's happening on the ground, you might say on Main Street as opposed to Wall Street."

It's good to know that a guy so obsessed with price stability doesn't see inflation on the horizon. But inflation and bubble trouble almost always get going before they are recognized. Moreover, the Fed has to pay attention to the 1978 Full Employment and Balanced Growth Act -- a.k.a. Humphrey-Hawkins -- and employment is a lagging indicator of economic activity. This could create a Fed bias in favor of inflating. So I push him again.

"I want to make sure that your readers understand that I don't know a single person on the FOMC who is rooting for inflation or who is tolerant of inflation." The committee knows very well, he assures me, that "you cannot have sustainable employment growth without price stability. And by price stability I mean that we cannot tolerate deflation or the ravages of inflation."

Mr. Fisher defends the Fed's actions that were designed to "stabilize the financial system as it literally fell apart and prevent the economy from imploding." Yet he admits that there is unfinished work. Policy makers have to be "always mindful that whatever you put in, you are going to have to take out at some point. And also be mindful that there are these perceptions [about the possibility of monetizing the debt], which is why I have been sensitive about the issue of purchasing Treasurys."

He returns to events on his recent trip to Asia, which besides China included stops in Japan, Hong Kong, Singapore and Korea. "I wasn't asked once about mortgage-backed securities. But I was asked at every single meeting about our purchase of Treasurys. That seemed to be the principal preoccupation of those that were invested with their surpluses mostly in the United States. That seems to be the issue people are most worried about."

As I listen I am reminded that it's not just the Asians who have expressed concern. In his Kennedy School speech, Mr. Fisher himself fretted about the U.S. fiscal picture. He acknowledges that he has raised the issue "ad nauseam" and doesn't apologize. "Throughout history," he says, "what the political class has done is they have turned to the central bank to print their way out of an unfunded liability. We can't let that happen. That's when you open the floodgates. So I hope and I pray that our political leaders will just have to take this bull by the horns at some point. You can't run away from it."

Voices like Mr. Fisher's can be a problem for the politicians, which may be why recently there have been rumblings in Washington about revoking the automatic FOMC membership that comes with being a regional bank president. Does Mr. Fisher have any thoughts about that?

This is nothing new, he points out, briefly reviewing the history of the political struggle over monetary policy in the U.S. "The reason why the banks were put in the mix by [President Woodrow] Wilson in 1913, the reason it was structured the way it was structured, was so that you could offset the political power of Washington and the money center in New York with the regional banks. They represented Main Street.

"Now we have this great populist fervor and the banks are arguing for Main Street, largely. I have heard these arguments before and studied the history. I am not losing a lot of sleep over it," he says with a defiant Texas twang that I had not previously detected. "I don't think that it'd be the best signal to send to the market right now that you want to totally politicize the process."

Speaking of which, Texas bankers don't have much good to say about the Troubled Asset Relief Program (TARP), according to Mr. Fisher. "Its been complicated by the politics because you have a special investigator, special prosecutor, and all I can tell you is that in my district here most of the people who wanted in on the TARP no longer want in on the TARP."

At heart, Mr. Fisher says he is an advocate for letting markets clear on their own. "You know that I am a big believer in Schumpeter's creative destruction," he says referring to the term coined by the late Austrian economist. "The destructive part is always painful, politically messy, it hurts like hell but you hopefully will allow the adjustments to be made so that the creative part can take place." Texas went through that process in the 1980s, he says, and came back stronger.

This is doubtless why, with Washington taking on a larger role in the American economy every day, the worries linger. On the wall behind his desk is a 1907 gouache painting by Antonio De Simone of the American steam sailing vessel Varuna plowing through stormy seas. Just like most everything else on the walls, bookshelves and table tops around his office -- and even the dollar-sign cuff links he wears to work -- it represents something.

He says that he has had this painting behind his desk for the past 30 years as a reminder of the importance of purpose and duty in rough seas. "The ship," he explains, "has to maintain its integrity." What is more, "no mathematical model can steer you through the kind of seas in that picture there. In the end someone has the wheel." He adds: "On monetary policy it's the Federal Reserve."

Ms. O'Grady writes the Journal's Americas column.

from the Wall Street Journal, 2009-May-15, by Viral V. Acharya and Robert Engle:

Derivatives Trades Should All Be Transparent
Disclosure would go a long way toward preventing future AIGs.

On Wednesday, Treasury Secretary Timothy Geithner proposed new regulations on derivatives trading. The administration's goal is to introduce greater transparency to these financial contracts in order to reduce the systemic risk they pose to financial markets and to the economy as a whole. The proposals are good as far as they go, but they don't go far enough.

Under the proposed reforms,standard derivative products such as credit default swaps (CDS) -- in which one party sells insurance to another party against the possibility of default by a firm or country -- will be traded on open, centralized exchanges. Trades will thus be recorded on a timely basis and regulators will gain unfettered access to information on prices, volumes and the risk exposures of all parties to these contracts. It has not yet been recommended that all such information be made available fully to the public. It should be.

Certain other financial derivatives -- such as collateralized debt and loan obligations (CDOs and CLOs), in which pools of bonds and loans are put together and their cash flows sliced up -- are not amenable to trading on a public exchange because of their nonstandard nature. But they too pose a systemic risk and need to meet minimum levels of transparency.

Most financial contracts are arrangements between two parties to deliver goods or cash in amounts and at times that depend upon uncertain future events. By their nature, they entail risk, but one kind of risk -- "counterparty risk" -- can be difficult to evaluate, because the information needed to evaluate it is generally not public. Put simply, a party to a financial contract might sign a second, similar financial contract with someone else -- increasing the risk that it may be unable to meet its obligations on the first contract. So the actual risk on one deal depends on what other deals are being done. But in over-the-counter (OTC) markets -- in which parties trade privately with each other rather than through a centralized exchange -- it is not at all transparent what other deals are being done.

This makes it likely that some institutions will build up excessively large positions in OTC derivatives without the full knowledge of other market participants. If these institutions were to default, their counterparties would also incur significant losses, creating a systemic risk.

For example, in September 2008 it became known that the liquidity of American International Group (AIG) was inadequate, given that it had written credit default swaps for many investors guaranteeing protection against default on mortgage-backed products. Each investor now realized that the value of AIG's protection was dramatically reduced. Investors demanded increased collateral -- essentially extra cash -- which AIG was unable to come up with. The Treasury had to take over the company. The counterparty risks were so widespread that a default by AIG would probably have spurred many other defaults, generating a downward spiral around the world. The AIG example illustrates well the cost that large OTC exposures can impose on the system.

When trading in such derivatives is moved to exchanges under the Treasury's proposals, the positions of counterparties will naturally be subject to capital requirements. But inadequately capitalized positions might still build up in derivatives such as collateralized debt obligations and collateralized loan obligations that continue to trade in opaque OTC markets. And this means continued systemic risk to the economy.

To prevent this from happening again in the future, we suggest that regulators make all derivatives transparent. In particular, derivative transactions in OTC markets should be public information.

Suppose every trade was posted on an Internet site within a reasonable time after execution -- as is now required by the National Association of Securities Dealers for all OTC trades in corporate bonds. Counterparties could then determine the volume of contracts of any form and by any other counterparty. Vendors would presumably make a profitable business compiling, analyzing and selling the complex data from this source.

Counterparty risk could be more accurately priced and collateral arrangements more safely based on this information. The sellers of risk in derivatives markets would have incentives to limit their exposures and to advertise this to other market participants. Investors, regulators and even the financial institutions themselves would have a much better way to analyze and hedge the true risk of their exposures. Systemic risks arising from derivatives traded OTC would be substantially reduced.

Large broker-dealers and banks will naturally resist such transparency legislation. But such resistance needs to be balanced against the risk of systemic losses when large players fail.

Centralized exchange trading of standard derivative products, which Mr. Geithner has proposed, is an important step forward. But regulators must look to fighting the next war, not just the last one. Transparency in OTC markets would discourage players from cloning standard derivative products to reduce capital requirements on centralized exchanges.

The huge losses announced by the Royal Bank of Scotland and State Street Corp. earlier this year suggest that we still don't know exactly what toxic assets are held by which banks. With our proposed transparency reforms, we eventually would.

Mr. Acharya teached at New York University's Stern School of Business and is affiliated with the London Business School. Mr. Engle also teaches at the Stern School and is the 2003 recipient of the Nobel Prize in Economics.

from Kitco.com, 2009-May-4, by James Turk:

A Short History of the Gold Cartel

This week Bill Murphy and Chris Powell, co-founders of the Gold Anti-Trust Action Committee (www.gata.org), will be in London, England. Their trip is part of GATA's ongoing effort to raise awareness of the gold cartel and its surreptitious intervention in the gold market.

Bill and Chris will meet with the British media to explain GATA's findings. They will also attend an important fund raising event being held in support of GATA's work. Their trip is another important step by GATA aimed at creating a free market in gold, one which is unfettered by government intervention.

Governments want a low gold price to make national currencies look good. Gold is recognizable the world over as the `canary in the coalmine' when it comes to money. A rising gold price blurts the unpleasant truth that a national currency is being poorly managed and that its purchasing power is being inflated.

This reality is made clear by former Federal Reserve chairman Paul Volcker. Commenting in his memoirs about the soaring gold price in the years immediately following the end of the gold standard in 1971, he notes: “Joint intervention in gold sales to prevent a steep rise in the price of gold, however, was not undertaken. That was a mistake.” It was a mistake because a rising gold price undermines the thin reed upon which all fiat currency rests – confidence. But it was a mistake only from the perspective of a central banker, which is of course at odds with anyone who believes in free markets.

The US government has learned from experience and taken Volcker's advice. Given the US dollar's role as the world's reserve currency, the US government has the most to lose if the market chooses gold over fiat currency and erodes the government's stranglehold on the monopolistic privilege that it has awarded to itself of creating `money'.

So the US government intervenes in the gold market to make the dollar look worthy of being the world's reserve currency when of course it is not equal to the demands of that esteemed role. The US government does this by trying to keep the gold price low, but this aim is an impossible task. In the end, gold always wins, i.e., its price inevitably climbs higher as fiat currency is debased, which is a reality understood and recognized by government policymakers. So recognizing the futility of capping the gold price, they instead compromise by letting the gold price rise somewhat, say, 15% per annum. In fact, against the dollar, gold is actually up 16.3% p.a. on average for the last eight years. In battlefield terms, the US government is conducting a managed retreat for fiat currency in an attempt to control gold's advance.

Though it has let the gold price rise, gold has risen by less than it would in a free market because the purchasing power of the dollar continues to be inflated and also because gold remains so undervalued notwithstanding its annual appreciation this decade. These gains started from gold's historic low valuation in 1999. Gold may not be as good a value as it was in 1999, but it nevertheless remains extremely undervalued.

For example, until the end of the 19th century, approximately 40% of the world's money supply consisted of gold, and the remaining 60% was national currency. As governments began to usurp the money issuing privilege and intentionally diminish gold's role, fiat currency's role expanded by the mid-20th century to approximately 90%. The inflationary policies of the 1960s, particularly in the US, further eroded gold's role to 2% by the time the last remnants of the gold standard were abandoned in 1971. Gold's importance rebounded in the 1970s, which caused Volcker to lament the so-called mistakes of policymakers. Its percentage rose to nearly 10% by 1980. But gold's percent of the world money supply thereafter declined, reaching about 1% in 1999. Today it still remains below 2%.

From this analysis it is reasonable to conclude that gold should comprise at least 10% of the world's money supply. Because it is nowhere near that level, gold is undervalued.

So given the ongoing dollar debasement being pursued by US policymakers, keeping gold from exploding upward to a true free-market price is the first thing they gain from their interventions in the gold market. The other thing they gain is time. The time they gain enables them to keep their fiat scheme afloat so they can benefit from it, delaying until some future administration the scheme's inevitable collapse.

So how does the US government manage the gold price? They recruit Goldman Sachs, JP Morgan Chase and Deutsche Bank to do it, by executing trades to pursue the US government's aims. These banks are the gold cartel. I don't believe that there are any other members of the cartel, with the possible exception of Citibank as a junior member. The cartel acts with the implicit backing of the US government to absorb all losses that may be taken by the cartel members as they manage the gold price and further, to provide whatever physical metal is required to execute the cartel's trading strategy. How did the gold cartel come about?

There was an abrupt change in government policy circa 1990. It was introduced by then Federal Reserve chairman Alan Greenspan in order to bail out the banks back then, which like now were insolvent. Taxpayers were already on the hook for hundreds of billions to bail out the collapsed `savings & loan' industry, so adding to this tax burden was untenable. He therefore came up with an alternative.

Greenspan saw the free market as a golden goose with essentially unlimited deep pockets, and more to the point, that these pockets could be picked by the US government using its tremendous weight, namely, its financial resources for timed interventions in the free market combined with its propaganda power by using the media. In short, it was easier to bail out the insolvent banks back then by gouging ill-gained profits from the free markets instead of raising taxes.

Banks generated these profits by the Federal Reserve's steepening of the yield curve, which kept long-term interest rates relatively high while lowering short-term rates. To earn this wide spread, banks leveraged themselves to borrow short-term and use the proceeds to buy long-term paper. This mismatch of assets and liabilities became known as the carry-trade.

The Japanese yen was a particular favorite to borrow. The Japanese stock market had crashed in 1990, and the Bank of Japan was pursuing a zero interest rate policy to try reviving the Japanese economy. A US bank could borrow Japanese yen for 0.2% and buy US T-notes yielding more than 8%, pocketing the spread, which did wonders for bank profits and rebuilding their capital base.

Gold also became a favorite vehicle to borrow because of its low interest rate. This gold came from central bank coffers, but they refused to disclose how much gold they were lending, making the gold market opaque and ripe for intervention by central bankers making decisions behind closed doors. The amount lent by central banks has been reliably estimated in various analyses published by GATA to be 12,000 to 15,000 tonnes, nearly one-half of central banks total holdings and 4-to-6 times annual new mine production of 2500 tonnes. The banks clearly jumped feet first into the gold carry-trade.

The carry-trade was a gift to the banks from the Federal Reserve, and all was well provided the yen and gold did not rise against the dollar because this mismatch of dollar assets and yen or gold liabilities was not hedged. Alas, both gold and the yen began to strengthen, which if allowed to rise high enough would force marked-to-market losses on those carry-trade positions in the banks. It was a major problem because the losses of the banks could be considerable, given the magnitude of the carry-trade.

So the gold cartel was created to manage the gold price, and all went well at first, given the help it received from the Bank of England in 1999 to sell one-half of its gold holdings. Gold was driven to historic lows, as noted above, but this low gold price created its own problem. Gold became so unbelievably cheap that value hunters around the world recognized the exceptional opportunity it offered, and demand for physical gold began to climb. As demand rose, another more intractable and unforeseen problem arose for the gold cartel.

The gold borrowed from the central banks had been melted down and turned into coins, small bars and monetary jewelry that were acquired by countless individuals around the world. This gold was now in `strong hands', and these gold owners would only part with it at a much higher price. Therefore, where would the gold come from to repay the central banks?

While yen is a fiat currency and can be created out of thin air by the Bank of Japan, gold in contrast is a tangible asset. How could the banks repay all the gold they borrowed without causing the gold price to soar, further worsening the marked-to-market losses on their remaining positions?

In short, the banks were in a predicament. The Federal Reserve's policies were debasing the dollar, and the `canary in the coalmine' was warning of the loss of purchasing power. So Greenspan's policy of using interventions in the market to bail-out banks morphed yet again.

The gold borrowed from central banks would not be repaid because obtaining the physical gold to repay these loans would cause the gold price to soar. So beginning this decade, the gold cartel would conduct the government's managed retreat, allowing the gold price to move generally higher in the hope that, basically, people wouldn't notice. Given its `canary in a coalmine' function, a rising gold price creates demand for gold, and a rapidly rising gold price would worsen the marked-to-market losses of the gold cartel.

So the objective is to allow the gold price to rise around 15% p.a., while at the same time enable the cartel members to intervene in the gold market with implicit government backing in order to earn profits to offset the growing losses on its gold liabilities. Its trading strategy to accomplish this task is clear. The gold cartel reverse engineers the black-box trend-following trading models.

Just look at the losses taken by some of the major commodity trading managers on their gold trading over the last decade. It is hundreds of millions of dollars of client money lost, and gained for the gold cartel to help offset their losses from the gold carry-trade. All to make the dollar look good by keeping the gold price lower than it should be and would be if it were allowed to trade in a market unfettered by government intervention.

There are only two outcomes as I see it. Either the gold cartel will fail in the end, or the US government will have destroyed what remains of the free market in America. I hope it is the former, but the continuing flow of events from Washington, D.C. and the actions of policymakers suggest it could be the latter.

*****

James Turk is the Founder & Chairman of GoldMoney.com. He is the co-author of The Coming Collapse of the Dollar, which has been updated for a newly released paperback version, now entitled The Collapse of the Dollar.

from Reuters, 2009-May-14, by John Parry, Haitham Haddadin and Ellis Mnyandu:

Stocks still face deflationary collapse: Prechter

NEW YORK - Longtime technical analyst Robert Prechter, who forecast the 1987 stock market crash, predicted this week that U.S. equities may plunge to half their lows hit in March as a deflationary depression bites.

Oil and U.S. Treasury bonds are also locked in long term bear markets, while corporate bond prices will plunge precipitously by next year as broad economy, banking system and company earnings sustain more damage from a financial crisis that's akin to the Great Depression, he said.

The U.S. S&P 500 stock index's rebound by nearly 40 percent since it sagged to a 12-year closing low of 676 points on March 9 is not sustainable, Prechter said in an interview with Reuters.

"It's not the start of a new bull market," said Prechter, chief executive at research company Elliott Wave International in Gainesville, Georgia. "Our models are (showing) right now that it is a much bigger bear market than most people realize, something along the lines of 1929-1932," he told Reuters in a wide ranging interview. "It's a very rare event," he added.

"I think the next leg down will be at least as severe if not more severe than what we just experienced. So you want to stay on the side of safety," he said.

As in his 2002 book "Conquer the Crash," which warned of the dangers of a U.S. debt bubble and deflationary depression, Prechter continues to advocate safer cash proxies such as Treasury bills.

SEVEN MORE YEARS?

Riskier assets such as commodities, corporate bonds, and stocks which are currently anticipating that the severe global economic downturn may be bottoming, are likely to have short lived intense rallies, but within an inexorable long-term decline that may last another seven years, he said.

As banks continue to accumulate losses and corporate earnings fall, "the difficulties will probably last through about 2016," he said. "There will be plenty of rallies along the way."

Oil may rally further from current levels just below $60 per barrel but the upside will be capped at about $80 per barrel as the commodity is locked in a long-term bear market, he said.

In July, U.S. crude oil hit a record peak above $147 per barrel and was just above $57 per barrel around noon on Thursday.

"Deflation is coming, it's going to lead to a depression. We're not at the bottom yet," Prechter said. "I think we are going to have bouts of deflation separated by recoveries."

Prechter also painted a bleak picture for commodities like silver and is largely unenthusiastic about gold, believing the precious metal made a major peak when it rose above $1,000 last year.

While gold may have already topped at above $1,000 an ounce in March 2008, Treasury bond prices are likely to fall in a long term bear market, with huge government debt issuance being the main catalyst.

The benchmark U.S. 10-year Treasury note yield, which moves inversely to its price, hit a five-decade low of 2.04 percent in mid-December.

"People got very enamored with bonds and very enamored with gold and I don't like to be invested in markets that are over subscribed," Prechter said.

"The Treasury (Department) has taken on so much bad debt" at a time tax receipts are falling, that "there will be a slow, but very steady change in the way people will view the U.S. government," said Prechter. As a result, investors in Treasury notes and bonds will ultimately demand higher yields, he said.

The U.S. central bank will not be able to control the government bond market and prevent yields from rising, regardless of how much money the Fed uses to buy Treasuries, he added.

Next year, U.S. corporate bond prices will probably fall below their extreme price lows of December during the market panic of 2008 when investors fled riskier assets, he said.

"Corporates in terms of price have the big wave down coming. This has been a prequel," Prechter said.

"Many corporations who (now) say we can borrow more money and take more risks: those are the ones who will get in trouble," he said. "Many municipalities will default," he added.

from the Wall Street Journal, 2009-Apr-6, by Steven Gjerstad and Vernon L. Smith:

From Bubble to Depression?

Bubbles have been frequent in economic history, and they occur in the laboratories of experimental economics under conditions which -- when first studied in the 1980s -- were considered so transparent that bubbles would not be observed.

We economists were wrong: Even when traders in an asset market know the value of the asset, bubbles form dependably. Bubbles can arise when some agents buy not on fundamental value, but on price trend or momentum. If momentum traders have more liquidity, they can sustain a bubble longer.

But what sparks bubbles? Why does one large asset bubble -- like our dot-com bubble -- do no damage to the financial system while another one leads to its collapse? Key characteristics of housing markets -- momentum trading, liquidity, price-tier movements, and high-margin purchases -- combine to provide a fairly complete, simple description of the housing bubble collapse, and how it engulfed the financial system and then the wider economy.

In just the past 40 years there were two other housing bubbles, with peaks in 1979 and 1989, but the largest one in U.S. history started in 1997, probably sparked by rising household income that began in 1992 combined with the elimination in 1997 of taxes on residential capital gains up to $500,000. Rising values in an asset market draw investor attention; the early stages of the housing bubble had this usual, self-reinforcing feature.

The 2001 recession might have ended the bubble, but the Federal Reserve decided to pursue an unusually expansionary monetary policy in order to counteract the downturn. When the Fed increased liquidity, money naturally flowed to the fastest expanding sector. Both the Clinton and Bush administrations aggressively pursued the goal of expanding homeownership, so credit standards eroded. Lenders and the investment banks that securitized mortgages used rising home prices to justify loans to buyers with limited assets and income. Rating agencies accepted the hypothesis of ever rising home values, gave large portions of each security issue an investment-grade rating, and investors gobbled them up.

But housing expenditures in the U.S. and most of the developed world have historically taken about 30% of household income. If housing prices more than double in a seven-year period without a commensurate increase in income, eventually something has to give. When subprime lending, the interest-only adjustable-rate mortgage (ARM), and the negative-equity option ARM were no longer able to sustain the flow of new buyers, the inevitable crash could no longer be delayed.

The price decline started in 2006. Then policies designed to promote the American dream instead produced a nightmare. Trillions of dollars of mortgages, written to buyers with slender equity, started a wave of delinquencies and defaults. Borrowers' losses were limited to their small down payments; hence, the lion's share of the losses was transmitted into the financial system and it collapsed.

During the 1976-79 and 1986-89 housing price bubbles, the effective federal-funds interest rate was rising while housing prices rose: The Federal Reserve, "leaning against the wind," helped mitigate the bubbles. In January 2001, however, after four years with average inflation-adjusted house price increases of 7.2% per year (about 6% above trend for the past 80 years), the Fed started to decrease the fed-funds rate. By December 2001, the rate had been reduced to its lowest level since 1962. In 2002 the average fed-funds rate was lower than in any year since the 1958 recession. In 2003 and 2004 the average fed-funds rates were lower than in any year since 1955 when the rate series began.

Monetary policy, mortgage finance, relaxed lending standards, and tax-free capital gains provided astonishing economic stimulus: Mortgage loan originations increased an average of 56% per year for three years -- from $1.05 trillion in 2000 to $3.95 trillion in 2003!

By the time the Federal Reserve began to slowly raise the fed-funds rate in May 2004, the Case-Shiller 20-city composite index had increased 15.4% during the previous 12 months. Yet the housing portion of the CPI for those same 12 months rose only 2.4%.

How could this happen? In 1983, the Bureau of Labor Statistics began to use rental equivalence for homeowner-occupied units instead of direct home-ownership costs. Between 1983 and 1996, the price-to-rental ratio increased from 19.0 to 20.2, so the change had little effect on measured inflation: The CPI underestimated inflation by about 0.1 percentage point per year during this period. Between 1999 and 2006, the price-to-rent ratio shot up from 20.8 to 32.3.

With home price increases out of the CPI and the price-to-rent ratio rapidly increasing, an important component of inflation remained outside the index. In 2004 alone, the price-rent ratio increased 12.3%. Inflation for that year was underestimated by 2.9 percentage points (since "owners' equivalent rent" is about 23% of the CPI). If home-ownership costs were included in the CPI, inflation would have been 6.2% instead of 3.3%.

With nominal interest rates around 6% and inflation around 6%, the real interest rate was near zero, so household borrowing took off. As measured by the Case-Shiller 10 city index, the accumulated inflation in home-ownership costs between January 1999 and June 2006 was 151%, but the CPI measured a mere 23% increase. As the Federal Reserve monitored inflation in the early part of this decade, home-price increases were no longer visible in the CPI, so the lax monetary policy continued. Even after the Fed began to slowly raise the fed-funds rate in May 2004, the average rate remained low and the bubble continued to inflate for two more years.

The unraveling of the bubble is in many ways the most fascinating part of the story, and the most painful reality we are now experiencing. The median price of existing homes had fallen from $230,000 in July to $217,300 in November 2006. By the beginning of 2007, in 17 of the 20 cities in the Case-Shiller index, prices were falling. Serious price declines had not yet begun, but the warning signs were there for alert observers.

Kate Kelly, writing in this newspaper (Dec. 14, 2007), tells the story of how Goldman Sachs avoided the fate of many of the other investment banks that packaged mortgages into securities. Goldman loaded up on the Markit ABX index of credit default swaps between early December 2006 and late February 2007, as their price dropped from 97.70 on Dec. 4 to under 64 by Feb. 27. But the market was not yet in free-fall: The insurance on AAA-rated parts of the mortgage-backed securities (MBS) remained inexpensive. By mid-summer 2007, concern spread to the AAA-rated tranches of MBS.

At the end of February 2007, the cost of $10 million of insurance on the AAA-rated portion of a mortgage-backed security was still only $68,000 plus a $9,000 annual premium. Housing-market conditions deteriorated further in the first half of 2007. Case-Shiller tiered price sequences in Los Angeles, San Francisco, San Diego and Miami all show serious declines by the summer of 2007. Prices in the low-price tier in San Francisco were down almost 13% from their peak by July 2007; in San Diego they were off 10% by July 2007. Startling developments began to unfold that month. Between July 9 and Aug. 3, 2007, the cost of insuring AAA MBS tranches went from $50,000 upfront plus a $9,000 annual premium for $10 million of insurance to over $900,000 upfront (plus the annual premium).

Once the cost of insuring new mortgage-backed securities skyrocketed, mortgage financing from MBS rapidly declined. Subprime originations plummeted from $160 billion in the third quarter of 2006 to $28 billion in the third quarter of 2007. Mortgage-backed security issuance fell comparably, from $483 billion in all of 2006 to only $30.7 billion in the third quarter of 2007. Other measures of new loan originations were falling at the same time. The liquidity that generated the housing market bubble was evaporating.

Trouble quickly spread from the cost of insuring mortgage-backed securities to problems with credit markets generally, as the spread between short-term U.S. Treasury debt and the LIBOR rate increased to 2.40% from 0.44% between Aug. 8 and Aug. 20, 2007. Since U.S. Treasury debt is generally considered secure, but a bank's loans to another bank carry some risk of default, the spread between these rates serves as an indicator of perceived risk in financial markets.

In one city after another, prices of homes in the low-price tier appreciated the most and then fell the most; prices in the high-priced tier appreciated least and fell the least. The price index graphs for Los Angeles, San Francisco, San Diego and Miami show that in all of these cities, prices in the low-price tier have fallen between 50% and 57%. Moreover, housing prices have continually declined in every market in the Case-Shiller index. According to First American CoreLogic, 10.5 million households had negative or near negative equity in December 2008. When housing prices turned down, many borrowers with low income and few assets other than their slender home equity faced foreclosure. The remaining losses had to be absorbed by the financial system. Consequently, the financial system has suffered a blow unlike anything since the Great Depression, and the source is the weak financial position of the people holding declining assets.

Earlier, during the downturn in the equities market between December 1999 and September 2002, approximately $10 trillion of equity was erased. But a measure of financial system performance, the Keefe, Bruyette, & Woods BKX index of financial firms, fell less than 6% during that period. In the current downturn, the value of residential real estate has fallen by approximately $3 trillion, but the BKX index has now fallen 75% from its peak of January 2007. The financial sector has been devastated in this crisis, whereas it was almost completely unaffected by the downturn in the equities market early in this decade.

How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?

In the equities-market downturn early in this decade, declining assets were held by institutional and individual investors that either owned the assets outright, or held only a small fraction on margin, so losses were absorbed by their owners. In the current crisis, declining housing assets were often, in effect, purchased between 90% and 100% on margin. In some of the cities hit hardest, borrowers who purchased in the low-price tier at the peak of the bubble have seen their home value decline 50% or more. Over the past 18 months as housing prices have fallen, millions of homes became worth less than the loans on them, huge losses have been transmitted to lending institutions, investment banks, investors in mortgage-backed securities, sellers of credit default swaps, and the insurer of last resort, the U.S. Treasury.

In an important paper in 1983, Ben Bernanke argued that during the Depression, severe damage to the financial system impeded its ability to perform its economic role of lending to households for durable goods consumption and to firms for production and trade. We are seeing this process playing out now as loan funds for automobile purchases have withered. Auto sales fell 41% between February 2008 and February 2009. Retail and labor markets too are now part of the collateral damage from the housing debacle. Housing peaked in early 2006. Losses from the mortgage market began to infect the financial system in 2006; asset prices in that sector began to decline at the end of 2006. Meanwhile, equities and the broader economy were performing well, but as the financial sector deteriorated, its problems blindsided the rest of the economy.

The events of the past 10 years have an eerie similarity to the period leading up to the Great Depression. Total mortgage debt outstanding increased from $9.35 billion in 1920 to $29.44 billion in 1929. In 1920, residential mortgage debt was 10.2% of household wealth; by 1929, it was 27.2% of household wealth.

The Great Depression has been attributed to excessive speculation on Wall Street, especially between the spring of 1927 and the fall of 1929. Had the difficulties of the banking system been caused by losses on brokers' loans for margin purchases in 1929, the results should have been felt in the banks immediately after the stock market crash. But the banking system did not show serious strains until the fall of 1930.

Bank earnings reached a record $729 million in 1929. Yet bank exposures to real estate were substantial; as the decline in real estate prices accelerated, foreclosures wiped out banks by the thousands. Had the mounting difficulties of the banks and the final collapse of the banking system in the "Bank Holiday" in March 1933 been caused by contraction of the money supply, as Milton Friedman and Anna Schwartz argued, then the massive injections of liquidity over the past 18 months should have averted the collapse of the financial market during this current crisis.

The causes of the Great Depression need more study, but the claims that losses on stock-market speculation and a monetary contraction caused the decline of the banking system both seem inadequate. It appears that both the Great Depression and the current crisis had their origins in excessive consumer debt -- especially mortgage debt -- that was transmitted into the financial sector during a sharp downturn.

What we've offered in our discussion of this crisis is the back story to Mr. Bernanke's analysis of the Depression. Why does one crash cause minimal damage to the financial system, so that the economy can pick itself up quickly, while another crash leaves a devastated financial sector in the wreckage? The hypothesis we propose is that a financial crisis that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we're witnessing the second great consumer debt crash, the end of a massive consumption binge.

Mr. Gjerstad is a visiting research associate at Chapman University. Mr. Smith is a professor of economics at Chapman University and the 2002 Nobel Laureate in Economics.

from der Spiegel, 2009-May-29, by Markus Dettmer, Rüdiger Falksohn, Alexander Jung, Alexander Neubacher, Gregor Peter Schmitz, Holger Stark, and Gabor Steingart, translated from the German by Christopher Sultan:

Is 2009 the New 1929?
Current Crisis Shows Uncanny Parallels to Great Depression

Is history repeating itself? The current global downturn has many parallels to the Great Depression. And if the current massive bailout packages fail, the effect on the world's economies could be similarly drastic.

The Germans have always had a penchant for looking to America to gain a glimpse into the future.

They marveled at the Apollo 11 mission to the moon. They admired the gray but affordable Commodore personal computer. And they succumbed to the spell of an Internet company with the odd name of Google.

Now the Germans are looking across the Atlantic once again, but this time they see images that remind them of their own past, images of sad-looking people standing in long lines, hoping for work.

One of them is Michael Sheehan, who worked as an engineer with a large company until February. Not too long ago, Sheehan was the one doing the hiring. Today he is only one of 900 other job-seekers attending a job fair in a depressing hotel ballroom in Philadelphia.

One of the flyers arranged on the tables exhorts the attendees to "Stay Positive." But Sheehan feels more outraged than positive. Someone at the fair asks him for his resume. "I don't have a resume," he says. "I worked at one company for more than 30 years."

Natalie Ingelido, 21, is standing nearby, trying to calm down her bawling two-year-old son, who clearly doesn't like it here. "I'm looking for a job, any job, in a restaurant, a bar, cleaning, whatever," she says.

In the past, says Ingelido, "Help Wanted" signs were plastered on the doors of shops and bars. The past she refers to is last summer, when Natalie and her husband still lived in their own apartment. Now they live with his parents.

Across America, people like Sheehan and Ingelido are standing in lines, waiting and hoping. At one job fair in New York, the line stretched for several city blocks. Many would turn away, embarrassed to be seen there, whenever TV reporters attempted to document their fates.

More than 5 million people in the United States have lost their jobs since the crisis began. As if the country were undergoing fever convulsions, more than 650,000 were catapulted into the streets in the last month alone.

Most experts are now convinced that Germany will follow the United States along this downward trajectory. And those who, like many a politician, had refused to believe it until now were disabused of that notion last week.

Wednesday was a dark day for the leaders of Berlin's grand coalition government, which comprises the center-left Social Democratic Party (SPD) and the conservative Christian Democratic Union (CDU). All their hopes that the skies over Germany could quickly brighten -- just in time for September's national election -- were suddenly dashed when leading economic institutes released their annual forecasts, which turned out to be even gloomier than expected: a 6 percent shrinkage in the German economy this year, followed by another year with no economic growth.

Unemployment will rise sharply. It is expected to exceed 4 million by this fall and hit 5 million by next year. By then, at the latest, the crisis will have become reality for millions of people, as it reaches private households, forces more companies into bankruptcy and pushes countless loans into default, only making things worse for the country's already ailing banks.

Politicians around the world are forced to look on as the economic crisis jumps from one industrial sector to the next and spreads to more and more social groups. They are the witnesses of a reality that repeatedly debunks their worst prognoses as being all too optimistic.

They are approving billions in government spending for economic stimulus programs and bank bailout packages, and pumping more and more money into the economy to rejuvenate the economic cycle. But no one knows whether this medicine actually works -- and if it does, when it will take effect.

Politicians, in their desperation, are clinging to even the tiniest glimmer of hope. At the opening ceremony of the Hanover Trade Fair early last week, where the number of exhibitors had just about remained stable, Chancellor Angela Merkel announced that the worst appeared to be over.

At an economic summit at the Chancellery a few days later, none of the 31 invited representatives of industry was willing to share this optimism. Instead, the meeting was marked by pessimism and a deep sense of helplessness. The mood reminded one of the attendees of a "funeral wake."

It appears that the German federal government, labor unions and employers have exhausted their options. As a result, the course of the meeting was predictable. The assembled representatives of industry groups used the opportunity to present the government with their familiar demands. The invited economists argued over terminology and forecasts, and the members of the government snubbed those officials who had expressed their opinions somewhat too loudly of late.

The mood at the Chancellery only worsened in response to the grim forecast for growth presented by Hans-Werner Sinn, the president of the Munich-based Ifo Institute for Economic Research, who predicted that the worst is yet to come. According to Sinn, German banks will have to make write-downs equivalent to up to 90 percent of their capital, while most businesses hold a pessimistic view of the future. Sinn even believes that deflation is possible, a situation in which demand would continue to decline despite falling prices.

But not all of the economics professors in attendance agreed with the Munich economist's theories. Wolfgang Franz, an economist from the southwestern German city of Mannheim, said that he believed that the economy could fall back into step more quickly than others predicted. Axel Weber, the head of Germany's central bank, the Bundesbank, made it clear that he sees possible inflation as a much greater threat. By the end of the economists' presentations, the attendees were no longer sure which danger they were supposed to combat.

Deflation, inflation, mass unemployment -- these are words reminiscent of the darkest chapter in economic history. Thus, it comes as no surprise that experts are mentioning with growing frequency a term that was believed to have been relegated to the history books: Great Depression.

'The Consequences Are Real'

In the United States, the term "depression" has already crept into daily usage. Christina Romer, the chair of the Council of Economic Advisers appointed by US President Barack Obama, doesn't like to hear the comparison with the past. The Great Depression was Romer's field of expertise as an economic historian at the University of California, Berkeley, before she came to the White House under the new administration.

Now Romer has the feeling that history moved to Washington with her, that the past is alive once again and, on some days, is already beginning to look like the present. "In the last few months, I have found myself uttering the words 'worst since the Great Depression" far too often,'" she said in a recent speech at the Brookings Institution in Washington.

She went on to repeat all of the depressing references to the past: "The worst 12 month job loss since the Great Depression; the worst financial crisis since the Great Depression; the worst rise in home foreclosures since the Great Depression."

Even Ben Bernanke, the chairman of the US Federal Reserve, whose job requires him to be a professional optimist, finds it difficult to dispel the current melancholy. As a professor at Princeton, Bernanke wrote a substantial book on the world economic crisis. "I've always been more skeptical than others when it comes to predicting the potential effects of this crisis," he says. "Some people thought that we would get over this easily."

He chuckles, but it sounds more like a groan. "I hope that no one subscribes to that view any more. The consequences of this crisis are very real, and they are extremely serious."

But how serious? That's what everyone wants to know, and yet no one is able to predict how the crisis will continue -- not Romer, not Bernanke and not German Finance Minister Peer Steinbrück. Last week, Steinbrück admitted, openly and helplessly: "I don't know."

That's what makes this crisis so uncanny.

It's clear where it comes from, but no one knows where it is going. Will it continue to rage on at the same pace? Or will it subside, even just for a few months?

Or is the worst already behind us, as some market players seem to believe? They pushed Germany's DAX stock index up by 24 percent and the US's Dow Jones Industrial Average up by 22 percent in the last seven weeks. Is the market smarter than all of the experts, who were denying the possibility of a deep recession as recently as last year? Or is the market blind to the major fault lines in the world economy? The mood on Wall Street remained positive for a long time after real estate prices began tumbling in the fall of 2007.

Every small sign of hope is eagerly interpreted as a turn for the better. When the Ifo Business Climate Index, an early indicator for economic development in Germany, rose last Friday, the DAX promptly added 3 percent -- even though a majority of the firms polled by Ifo Institute expect the situation to worsen even further.

The crisis is currently putting an excessive burden on everyone. It behaves like an aggressive, previously unknown virus, changing its appearance and speed from week to week. At first, it looked like an American real estate crisis, then a banking crisis, a market crisis and a financial crisis. But the virus was consistently worse than the words that were being used to describe it.

At the beginning of the crisis, everyone felt that it was someone else's problem. Carmakers thought that it was a crisis for banks. The Europeans thought that it was an American problem. The rich believed that it would only affect the poor. The opposition felt that it was the government's crisis.

Today, everyone knows that these notions were too short-sighted. The virus is raging in all parts of the world, and striking at all levels of society. The pathogen has spread more quickly than all other pathogens in the past. It is invisible, but the trail it leaves behind is not pretty.

'No Land in Sight'

At the container terminal in the northern German port city of Hamburg, only 12 of 100 parking spots for trucks that transport containers to and from the docks are occupied. "Only a year ago, they had to wait in line for a spot," says dockworker Gerhard Hamann.

Things are even worse in Bremerhaven, another northern German port city, where German cars are shipped to destinations around the world. The automobile shipping industry has lost almost half of its business, and the company that provides harbor services has plans to lay off more than 1,000 of its 2,700 employees.

In the boom days of globalization, German cars were hot items, status symbols for the nouveau riche in China, Russia and India. German machinery was in high demand when large sums of money were being invested in emerging economies. As a result, Germany, the world's leading exporter, benefited the most from globalization. Conversely, the effects of a shrinking global economy are felt all the more acutely in Germany.

As the virus rages, it is already claiming its first victims. German industrialist Adolf Merckle threw himself in front of a moving train because his life's work, which includes the companies Ratiopharm, a pharmaceutical company, and HeidelbergCement, was threatened.

David B. Kellermann, the chief financial official of the US's second-largest mortgage lender, Freddie Mac, hung himself at his home in a Washington suburb last week. "It is plain that at Freddie Mac, as at many of the companies in the center of this economic storm, there are forces so strong they can overwhelm almost anyone," wrote the New York Times.

No part of the world is currently unaffected by the crisis. From the United States to China to Germany, the pictures of devastation are the same. Poor countries, especially in Africa, are even worse off. According to a report by the World Bank and the IMF, the global recession will plunge up to 90 million into extreme poverty and drive up the number of chronically hungry people to more than 1 billion.

Emerging economies are also getting nowhere fast. In fact, they have been brought to their knees. As Western consumers cut back on spending, much of their export industry is at a standstill. In March alone, Taiwanese exports dropped by 30 percent over the previous month. Hundreds of empty freighters are at anchor off Singapore's port, while Japanese Prime Minister Taro Aso sees "no land in sight" for his country.

In Latin America, Western companies are pulling out their investments en masse. In Brazil, half of the 35 modern ethanol plants planned for 2009 and 2010 will not be put into service. Western capital is flowing back into the country that triggered the crisis in the first place. US treasury bonds are now considered a safer investment than the biofuel business.

At the same time, prices for many crops have dropped sharply -- the price of soybeans, for example, has declined by 40 percent -- meaning the Brazilian economy is caught in a dangerous pincer movement. The country's traditional sectors are no longer viable while new businesses are not yet fully developed.

Even export giant China is losing steam. Chinese exports fell by 25 percent in February, a number Bank of America calls "ugly."

Donating Sperm to Beat the Crisis

All eyes are on the US, the country where the disaster began. American consumers have lost their erstwhile reputation as the engine of worldwide growth. Instead, they are now seen as reserved and uncertain, potential consumers who need strong persuasion before they buy anything. Chains like Pizza Hut are offering customers who buy a pizza a second one for a penny, while car dealers are trying to entice customers by offering a second vehicle for $1 -- if only the consumers would buy the first one.

New business ideas are cropping up, providing ways for budget-conscious Americans to earn a quick buck.

Phil Maher, who runs the Web sites bloodbanker.com and spermbanker.com, which feature information on how people can earn extra income by donating blood and sperm, says that traffic to his sites has grown by 50 percent and 80 percent respectively in recent months. Men, he says, are mainly donating sperm. "You can donate every two to three days, twice to three times a week if you're lucky," Maher told the news agency AFP. "Three times a week, $100 per donation -- with a year's commitment it can get really interesting."

Germany hasn't reached this stage yet. Many Germans are nervously awaiting whatever comes next. They still have their jobs and are still collecting their salaries, and yet the uneasy feeling that things could take a turn for the worse is difficult to dispel.

In fact, many are now wary of the reality they see around them, a reality imbued with ominous words like "still" and "until now," words that rob one's feeling of security.

Many can take comfort in the fact that their favorite stores are still open, and that their own employers have not resorted to layoffs -- yet. Most Germans are doing well, but how much longer can it last? A classic German company like Porsche is still a strong carmaker -- or is it?

Humanity has yet to find cures for diseases like AIDS, Alzheimer's and Parkinson's, even though all the relevant data for these illnesses can be found inside a single body.

But the economic crisis is taking place in 6.5 billion minds at the same time, making it the biggest psychodrama in world history. Experiences and television images become condensed into expectations, expectations turn into fears, and fears shape what is happening in every market today. These fears exert a stronger impact on markets than politicians and central bankers, with their speeches and their programs. The virus has eluded the powerful.

The entire world is now on edge, causing large numbers of people and businesses -- from housewives to CEOs to bankers -- to hesitate and take a wait-and-see approach to things. This partly explains why the World Bank and the IMF predict a decline in global economic activity in 2009 -- for the first time since World War II.

In its most recent report, the Organization for Economic Cooperation and Development (OECD) writes: "The world economy is in the midst of its deepest and most synchronized recession in our lifetimes, caused by a global financial crisis and deepened by a collapse in world trade." According to the OECD, by 2010, the gap between our current economic potential and the current output of goods and services will be twice as large as in the early 1980s, when many countries faced their most severe recession since World War II.

One has to go back even further in time to find anything comparable -- to a time when photographs were still in black and white and life was grim.

The Great Depression was the primal event of the last century, the root of all evil in the 20th century, including poverty, mass unemployment, Hitler and total war. It is a painful comparison to make, because it presupposes an inevitability that, of course, doesn't exist.

Drawing this historical analogy is dangerous, Frank Schirrmacher, a co-publisher of the heavyweight German newspaper Frankfurter Allgemeine Zeitung, warned last fall. According to Schirrmacher, it creates precisely the reality that it warns against, conjuring up "a social type -- that of our grandparents or great-grandparents -- with which an insecure and outclassed society can, at the very least, identify."

Comparing is not the same as equating, but it improves our understanding. The past illuminates the present, the German philosopher Karl Jaspers once said. But perhaps the comparison will also show that the differences are greater than the similarities.

Is 2009 a new 1929? "I believe and hope it is not, but I wouldn't be surprised if I were wrong," says Robert Samuelson, a leading US commentator on economic issues.

When Nobel laureate Paul Krugman was asked the same question recently, he reflected for a moment before responding. Finally, he said, with his trademark thoughtfulness: "It's impossible to rule out anything at this point."

Today's data are still a long way from the dramatic -- and, for many, traumatic -- economic statistics of the Great Depression. In the United States, the epicenter of the current crisis, a quarter of all citizens available to work were unemployed at the height of the Great Depression. Today, only 8.5 percent of Americans who are available to work are unemployed.

Between September 1929 and June 1932, stock markets lost up to 85 percent of their value, representing a massive destruction of wealth. By comparison, today's Dow Jones index has lost only about 40 percent of its value. But the total value wiped out by the crisis exceeds the destruction of wealth in the Great Depression several times over, even when adjusted for inflation. This is because there is simply more money invested in stocks today than there was 80 years ago.

At the time, the entire US economy shrank by almost a third, as tens of thousands of factories, stores and banks went out of business. Between 1929 and 1932, 5,000 banks filed for bankruptcy, and another 4,000 financial institutions went under in 1933, at the height of the financial crisis. These bankruptcies meant that roughly one-fifth of American banks disappeared.

In the current crisis, only a few dozen financial institutions have declared bankruptcy. Nevertheless, today's banks are not in a significantly better position than banks were during the Great Depression. Their balance sheets remain burdened by toxic assets.

The government continues to inject new, clean money into the economic system. Although this doesn't make banks healthy, it at least prevents their demise. Nevertheless, many institutions are now known in the industry as "zombie banks" -- banks that continue to exist like the undead.

During the Great Depression, governments, especially in the United States, stood by and watched as the crisis deepened [This description is counterfactual, as investigated elsewhere in AMPP, e.g. “Five Myths About the Great Depression: Herbert Hoover was no proponent of laissez-faire.”, from the Wall Street Journal, 2008-Nov-4, by Andrew B. Wilson. -AMPP Ed.]. The economy stumbled -- and the government allowed it to fall [Indeed, to an accelerating degree, made it fall, through foolish action. -AMPP Ed.], leaving citizens, banks and companies to their own devices [Still counterfactual. -AMPP Ed.]. Governments today, however, are coming to the rescue with billions in bailout funds. This is an important difference, as Obama's adviser Christina Romer is quick to point out.

Unfettered Capitalism

In 1930, the first year of the crisis, the German economy was caught in a downward spiral, as the population became more and more impoverished each day. Unlike today, very few citizens could claim significant benefits under unemployment insurance, and many were dependent on meager local assistance programs.

The victims of the crisis included people who, as the then-mayor of Cologne, Konrad Adenauer -- who would later become the first chancellor of West Germany -- once said, "would never have had to rely on public assistance in normal economic times: pensioners, independent craftsmen and tradesmen."

Germans did their best to limit their consumption. One Berlin newspaper, the Berliner Lokalanzeiger, reported that people would drive to restaurants on the outskirts of the city catering to day-trippers, and would often "order only a bottle of mineral water and eat cake they brought along from home."

Foreclosure auctions were announced in the newspapers on a daily basis. Bakers decorated cakes with sayings like: "This cake is small, because I too am out of work!"

Cafés saved costs by eliminating live bands, playing music from the radio instead, and by serving glasses of milk for 10 pfennigs instead of sparkling wine.

In our day, there is more fear than suffering. Germany now boasts a relatively sizeable and stable social welfare state, and even the United States of today cannot be compared with the America of the 1930s.

Capitalism was primitive and unfettered at the time. In the United States, government spending as a percentage of gross domestic product was barely 10 percent at the end of the 1920s.

Today, the same ratio amounts to around 40 percent in the United States and 44 percent in Germany. As a result, governments have economic forces at their disposable that they can now put into action.

During the Great Depression, workers who lost their jobs usually ended up directly on the street. Unemployment meant poverty, while prolonged unemployment led to a slide into economic misery.

Both the German and the American welfare states are much stronger today. The United States has unemployment insurance benefits (albeit relatively small), a mandatory social security system and health insurance for retirees and children. In addition, 32 million Americans, or more than 10 percent of the population, receive government food stamps.

The greatest similarities between 2009 and 1929 have to do with the causes of the crisis. The history leading up to the Great Depression reads like a review of the last decade.

In both eras, people were enamored of the present. They celebrated themselves, and they consumed and invested -- doing both with money they didn't have. They failed to notice growing economic imbalances, and they ignored the trouble brewing in the global economy.

People in the 1920s were fascinated by progress and the fashionable new products it spawned, including cars, airplanes, radios and telephones.

They were finally able to take part in the latest technical achievements. For only two months' worth of wages, a worker at Ford could buy himself the first affordable automobile, the Model T, popularly known as the "Tin Lizzy."

The stock markets also came under the spell of modernity, as more and more citizens became fascinated by stocks and invested their savings in the market. People at all levels of society were suddenly overtaken by a new stock market fever.

Unbelievable stories made the rounds, like the tale of a New York valet who made a quarter of a million dollars in the stock market, or the nurse who became $30,000 richer on the basis of a stock tip she had received, or the shoeshine boy who bought stocks worth $50,000 for $500 in cash.

Many investors speculated with borrowed money, convinced that they would be able to pay off their debts when their shares appreciated. The American fondness for buying things on credit was already very pronounced at the time. More than half of all cars and three-quarters of all furniture bought in the 1920s were financed on credit.

John Kenneth Galbraith, the great student of the world economic crisis, wrote that a "mass escape from reality" had brought movement into the markets -- not in slow, sedate steps, but by leaps and bounds. According to Galbraith, a mass exodus into an economic world of make-believe had begun.

Everyone was convinced that the stock market boom in God's own country could only continue, perhaps not indefinitely, but certainly for several more years. Homebuyers in the United States felt the same way until recently. They too were living in an illusory world, except that this time it consisted of their own homes.

Politicians played a less than admirable role in both eras, encouraging people to do the wrong things.

President George W. Bush told Americans to "go shopping" after the terrorist attacks of Sept. 11, 2001 had shaken the country to its core. The Federal Reserve, America's central bank, provided low interest rates. As a result, economic growth in the United States was driven, not by rising exports or groundbreaking inventions, but by consumption paid for with credit. The US had "the best recovery that money can buy," says Kenneth Rogoff, a former chief economist at the IMF.

A similarly unshakable belief in the future prevailed in the 1920s. In the 1928 election campaign, President Herbert Hoover crowed: "We in America today are nearer to the final triumph over poverty than ever before in the history of any land."

As late as November 1929, the Harvard Economic Society was still declaring that "a serious depression seems improbable."

In both eras, the drama began with a crash. "Despite many differences in terms of detail, the market crash of 1929 and the banking crisis of 1931 closely resemble the problems of today," says economic historian Werner Abelshauser.

The bankruptcy of US investment firm Lehman Brothers, for example, bears a fatal resemblance to the events that led to the demise of Germany's Danat Bank. The Danat Bank drama ran its course on the evening of May 11, 1931, when the bank's chairman, Jakob Goldschmidt, was informed during a dinner that his most important client, the Bremen-based textile giant Nordwolle, had falsified its accounts and was hopelessly insolvent. "Nordwolle is finished, Danat Bank is finished, Dresdner Bank is finished, and I am finished," he said frantically.

Goldschmidt was not wrong in his assessment. Danat Bank was indeed finished, and every major Berlin bank was in trouble. The debacle was followed by a crisis meeting of politicians and bankers on the weekend of July 11 and 12.

Underestimating the Crash

The large conference room at the Reich Chancellery at Wilhelmstrasse 77 in Berlin was filled with dignitaries from the world of politics and money. Contemporary observers reported that the mood in the room was extremely tense. As Hjalmar Schacht, the then president of the central bank, the Reichsbank, recalled, the bank directors were hurling "accusations at each other concerning their financial condition and business practices."

But the bankers downplayed the gravity of the situation in their discussions with politicians. Then-Deutsche Bank Chairman Oskar Wassermann even insisted that the situation among Germany's major banks was "no worse than anywhere else in the world." The bankers sought to portray the Danat failure as an isolated case and treated Goldschmidt "like someone with the plague," as then-Chancellor Heinrich Brüning wrote in his memoirs.

When Brüning asked the bankers about the condition of Dresdner Bank, "the question alone was perceived as an insult," as he wrote. Three days later, Dresdner was ready to be bailed out.

The events in Germany were mirrored in the United States. First the banks came down, followed by their customers -- manufacturers, department store barons and small businesses. After that, all economic activity went into a tailspin, something the modern world had never quite experienced before.

Global trade volume fell by 30 percent in three years, while industrial production shrank by 37 percent. It was a shocking experience for everyone involved, from beggars to businessmen.

The official unemployment figure in Germany rose to 6.1 million by February 1932, but real unemployment was in fact much higher.

Today's contractions in the overall economy and the labor market are relatively modest by comparison. The US economy is expected to shrink by 3 percent in 2009, while Germany will experience a significantly greater decline.

The comparisons between the current crisis and the Great Depression are indeed problematic. What exactly is being compared? One set of statistics represents the ultimate outcome of the Great Depression, but what do today's statistics signify? Perhaps merely the beginning of the current crisis?

In the late 1920s, the crisis began when it was underestimated. No one recognized the events of the day as the turning point they would eventually become. So much was whitewashed and so many people were placated. If speculation was the mother of the crisis, its father was naïveté. The players, says the economic historian Werner Abelshauser, lacked an "awareness of disaster."

At one point, on October 24, 1929, the Dow Jones index fell from 305 to 272 points. The next day, the headline in the New York Daily Investment News declared: "Stock Market Crisis Over." The chairman of the New York Stock Exchange continued his honeymoon in Honolulu.

The stock market would not hit bottom until three years later when, in July 1932, the index fell to 41 points. It would take the market another 22 years to reach its pre-crisis level.

Politicians at the time, not unlike politicians today, were notoriously optimistic at first. President Hoover heralded a recovery, but the real downturn was yet to come. When his successor, Franklin D. Roosevelt, came into office in 1933, he too believed that the worst was over -- and he too would be proven wrong.

President Obama, also unable to resist temptation, used the first halfway positive economic data to instill confidence in the public. In mid-April, he said the economy was showing "glimmers of hope," while his chief economic advisor, Lawrence Summers, said that the sense of "unremitting freefall" in the US economy had disappeared.

But that was before the IMF revised its forecasts drastically downward. By that point, there could be no question of an end to the crisis or even a reversal of the current trend.

When Obama gave a speech to workers in Iowa last Wednesday, the talk of glimmers of hope had already evaporated. This time, the president told his audience to be patient and bold, not to give up hope, and to believe in America's future. He looked tired. His staff said that he was still exhausted from his European trip.

In the decade following 1929, there were repeated signs of a recovery, and politicians were not the only ones to eagerly grasp at every hopeful opportunity. People believed that they had put the worst behind them, and yet their hopes were deceptive. An even bleaker future lay ahead.

Even John D. Rockefeller, the richest man of his day, was mistaken in his assessment of the markets. At the end of the week of the 1929 crash, he returned to the market and bought stocks, "believing that fundamental conditions of the country are sound." Last September, Warren Buffett, one of the world's richest men today, made a similarly hasty decision when he invested $5 billion (€3.8 billion) in the firm Goldman Sachs a little more than a week after the Lehman bankruptcy. He would have turned a decent profit if he had waited a while longer.

More than anyone else, President Herbert Hoover would go down in history for downplaying the Great Depression. In December 1929, he said that it was "the strong position of the banks" that had "carried the whole credit system through the crisis without impairment." But the real banking crisis was yet to come.

In May 1930, the president boldly announced that he was "convinced we have now passed the worst and with continued unity of effort we shall rapidly recover."

German Chancellor Angela Merkel seems to be doing her best to imitate Hoover. In the spring of 2008, she believed that the crisis would "perhaps not affect Germany." She was quickly proven wrong. A short time later, Merkel said that German banks were in good shape, and yet the first of those banks had to be rescued soon afterwards.

Perhaps the most astute contemporaries are those who withhold judgment. When asked the question: "Can you explain what has happened?" Robert Solow, a winner of the Nobel Prize in Economics, simply shakes his head and says: "No, I don't think that normal economic thinking can help explain this crisis."

In light of the difficulties in comparing a past depression with a depression in its embryonic stages, it is worth taking a look at the speed of the respective processes of disintegration. It is an exercise that exposes the raw forces that prevail.

The current downward spiral exceeds all previous downturns when it comes to its intensity and speed. The United States has experienced seven recessions since 1947, which lasted 10 months on average. It was only in 1982 and 1983 that the unemployment rate climbed to around the 10 percent mark.

But this time jobs are being destroyed at a rate that suggests the outbreak of an epidemic in factories and office buildings. Last August saw 640,000 people being added to the unemployment rolls, followed by 629,000 in October, 255,000 in November and 632,000 in December, and the rate of new unemployment has continued unabated ever since. The US economy is currently losing about 700,000 jobs a month. At this rate, the 10 percent threshold will likely be exceeded at a gallop.

The Rise of Hitler

A similar decline in economic activity is also unprecedented in Germany. Most German economic research institutes now predict a 6 percent decline in growth for this year, and although the decline is not expected to be as severe in 2010, forecasts do not foresee growth.

These assumptions are not based on the opinions of business owners and consumers. Instead, they reflect the decline in orders for goods and services. Both the machine-building and steel industries report a 50 percent drop in orders. Indeed, it is hard to find an industry that is not shrinking dramatically.

Germany's postwar society has never experienced turmoil of similar proportions. The major economic tremors have always been felt in neighboring countries, brought on by France's nationalization policies in the 1980s, the withdrawal of the British pound sterling from the European Monetary System, and the conditions in Italy that led to the rise of current Prime Minister Silvio Berlusconi. "This is the first postwar crisis that we are not experiencing as someone else's crisis," says Wolfgang Nowak, the director of Deutsche Bank's Alfred Herrhausen Society.

One can only guess at the long-term political impact of today's crisis. The reason the comparison with the Great Depression is so horrifying is that the world economic crisis led not only to the impoverishment of large segments of the population in Germany and elsewhere, but also to a political catastrophe.

In the wake of the economic crisis, Germany fell into the hands of the Nazis. The slogan, "Hitler - Our Last Hope," was plastered on campaign posters in the 1930s. Many agreed with the sentiment at the time.

A bizarre political group that had formed around Adolf Hitler, a former vagrant and veteran of World War I, was suddenly catapulted to the center of the public eye. On May 2, 1930, Hitler, a man who had been ridiculed until then, was suddenly speaking to a packed house at Berlin's Sportpalast hall. Now the people, or at least a significant portion of the people, were eager to hear Hitler speak.

After the Reichstag election in the late summer of 1930, a splinter group had suddenly become a force to be reckoned with. The Nazi Party won 18.3 percent of the vote and 107 seats in the Reichstag, making it the country's second-most powerful party. The economic crisis had catapulted the party to power within just a short space of time.

Berlin is not Weimar. And the current economic crisis has not produced any noticeable political changes -- at least not yet. Demonstrations and protests by those affected by the crisis have attracted moderate crowds at best, as was the case at last week's demonstration outside the annual meeting of the Continental automotive parts company's annual meeting in Hanover.

This could change if the crisis worsens and unemployment rises significantly. But will that lead to "social unrest," as Michael Sommer, the head of the DGB federation of German trade unions warns? Could the situation in Germany become explosive, posing a threat to democracy, as Gesine Schwan, the SPD's presidential candidate, cautions?

Nothing so far suggests that this is the case. Both Sommer and Schwan have already been reproached for engaging in scare tactics, even by fellow party members like Frank-Walter Steinmeier, the SPD's chancellor candidate.

But what is realistic? How will the crisis change the country and the rest of the world?

When experts don't know what will happen next, they develop scenarios. And because future economic developments are so politically explosive, Germany's foreign intelligence agency, the Bundesnachrichtendienst (BND), has decided to address the issue.

In mid-April, BND President Ernst Uhrlau presented German President Horst Köhler with his analysis of the repercussions of the current situation. During the meeting at Berlin's Bellevue Palace, the president's official residence, the two men discussed a "metamorphosis in geopolitics" and the future political make-up of a world that will never be the same again.

The core message for the German government is that Europe and the United States will come under growing political pressure, and will face growing competition from China. Beijing will be one of the likely beneficiaries of future shifts on the political map.

Uhrlau believes that there are three possible scenarios. The first scenario, the most optimistic of the three, assumes that the current economic stimulus programs will work, leading to a rapid shift in trends in the stock and credit markets, and that confidence will return and the economy will pick up speed soon.

Under this scenario, the United States will remain the dominant superpower, but it will emerge from the crisis economically weakened and with less available capital to fund its military activities. The People's Republic of China would benefit from this development as the strongest exporting nation.

The Chinese will benefit even more if scenario two, which the BND calls the "China scenario," becomes reality. It describes what will happen if the billions from the West's economic stimulus programs end up primarily in Asian countries.

The foreign capital would reinvigorate Asian domestic markets, allowing Beijing to invest even more heavily in advanced technology and take over the prime assets of Western industry, thereby accelerating its modernization process.

This, in turn, would speed up China's process of catching up with the West. For Beijing, the crisis would serve as the catalyst for a development that has already been underway for several years. "China would develop even more strongly into a superpower in Asia and a reference point for countries like the Arab Gulf states and other raw materials producers," says Uhrlau. "The United States, on the other hand, could forfeit some of its dominant status."

India would also grow in the slipstream of the Chinese, though not as dynamically. The BND believes that under this scenario, competitors to central institutions like the IMF would take shape, such as an Asian Monetary Fund.

The third scenario is the most dismal. It describes the consequences if the economic stimulus programs are ineffective, which will become all the more likely the longer it takes for the recovery to emerge. It is a catastrophic scenario for large parts of Africa, as well as for countries like Argentina, Venezuela, Iran, Kazakhstan and parts of the European Union, which would come under massive pressure.

Countries like Yemen could turn into "failing" states, with central governments losing much of their authority, while the loss of aid payments from other countries would push countries like Jordan to the brink of insolvency. The flow of refugees to Europe would surge, benefiting Islamists worldwide.

In this scenario, the BND predicts mass unemployment for China, internal unrest and a loss of its monopoly on power for the Communist Party. This would constitute virtually a revolutionary development with grave risks to global stability, because it would prompt the government in Beijing to become more aggressive abroad to compensate for internal tensions.

The BND expects to see a blend of the first two scenarios emerge -- not exactly a soft landing, but not an all-out catastrophe, either. What all three scenarios have in common is the theory that, after this crisis, the world will likely not be as dependent on the United States and Asia will play a greater role than in the past. "There will be a development in the direction of regionalization," says Uhrlau, "and we will have to get used to a more self-confident China in the future."

But is the third scenario truly out of the question? Isn't it possible that the billions now being pumped into the economy could seep away without producing the desired effect, because the foundation of the economy has become so porous after years of being fueled by debt?

The End of American Hegemony

There are, at the very least, signs that this scenario is not quite as unlikely as some would like to claim. The severe crisis is affecting the United States, which is already in a weakened position, and it could accelerate the country's relative demise as a superpower which already began a long time ago.

American industry, or what is left of it, is already in a deplorable condition today. Detroit's Big Three carmakers, General Motors, Ford and Chrysler, have been ailing for a long time and are now on their last legs. In the last three years alone, the three companies have lost a combined $110 billion (€83 billion).

The history of the US auto industry -- and this is what makes the current situation so dramatic -- is the history of America as an economic superpower, from its brilliant ascent to its agonizingly slow demise. The GM model, characterized by massive marketing, little substance and an excessive policy of debt financing, has also become the country's model.

Never before has a country lived at the expense of the future with such reckless abandon. The United States today is an economy that sucks in the savings of other nations. America currently needs more than half of worldwide savings merely to avoid falling below the levels of previous years. The government and private households borrow roughly $1 billion (€760 million) on each business day. Three years ago, the country was only borrowing two-thirds of this amount.

Even when adjusted for the size of today's economy, the US's current debts significantly exceed debt levels during the Great Depression. The superpower has become an empire of debt.

The most dangerous element of President Obama's crisis management program is that this debt is not being reduced, but expanded. The US's national deficit will reach an estimated $1.8 trillion (€1.36 trillion) in 2009 and will only continue to grow after that, perhaps even doubling. About 40 percent of the national budget is already not being covered by revenues.

If only the problem were limited to the United States. But the situation that has been brewing on the periphery of the crisis is far more dramatic than it was in 1929.

This is mainly attributable to the fact that modern globalization had only begun at the time. Many of today's industrialized nations were agricultural economies, and were not linked to the global economic system.

Countries like Romania, Hungary, Russia, Latvia and Ukraine did not play a significant role at the time of the Great Depression. Today, they are either on the brink of bankruptcy or, like Russia, they are in serious trouble because the price of oil has declined dramatically and Western investors are pulling out their money.

The Institute of International Finance expects the flow of capital into the emerging economies of Eastern Europe, Latin America and Asia to fall to only $165 billion (€125 billion) this year, or one-sixth of the level of foreign investment in these countries only two years ago.

Eastern Europe, in particular, is suffering from a massive exodus of capital. The Hungarian forint has lost more than 20 percent of its value since last July, while the Ukrainian hryvna has declined by a third. The tailspin affects banks in Austria, Germany and Italy that had heavily invested in the region. In some countries, more than half of all loans were denominated in foreign currencies.

Experts like economics Nobel Prize winner Krugman believe that, barring a noticeable improvement in Eastern Europe, Austria could face national bankruptcy. Austria's wellbeing depends on the wellbeing of the Eastern Europeans. This, in turn, is closely tied to the influx of foreign investment capital.

There would be serious political consequences if any Eastern European countries became failed states. One would be a threat to the goal of European unification. A divided Europe would not be a peaceful Europe, as radical influences would quickly begin flowing from the edges of the continent towards its center, which is precisely where Germany is located.

The IMF is currently doing its utmost to prevent the collapse of these countries. Special task forces are being established, Hungary and Latvia are being supported and rescue programs for other countries have already been approved.

At its recent summit in London, the G-20 group of major industrialized nations voted to provide the IMF with an additional $500 billion (€380 billion) in lending capital.

Germany is also preparing itself for tougher times, at least in theory. As unemployment rises, tax and social security revenues will naturally decline. As a result, Germany will sink further into the red.

The Nuremberg-based Federal Labor Agency has already sounded the alarm, noting that its reserves will be depleted by this fall. Some €2.1 billion ($2.8 billion) have already been set aside for 2009 to pay for the large numbers of workers that are on short-time schemes, where the shortfall in their wages is partly made up by the government.

The government's reserves for social security benefits are likely to be tapped even further, partly to prevent the development of a politically explosive atmosphere. The "Agenda 2010" labor market and social system reforms adopted under former Chancellor Gerhard Schröder have helped to reduce the costs to the government of welfare programs. But in a crisis of the current dimensions, these laws could also lead to the rapid impoverishment of people who are still part of the middle class today.

Anyone who is unable to find a new job within a few months automatically becomes a welfare case in Germany. In the past, if a 57-year-old worker became unemployed, he would continue to receive 60 percent of his last net salary for 32 months. Only then would he qualify for unemployment assistance. Under the old system, he was able to keep his home and his life insurance policies. This helped to slow the descent into poverty.

Today, the same worker would lose his unemployment benefits after 18 months. If he fails to find a job after that, he stands to descend quickly into poverty. A person who is classified as long-term unemployed receives €351 ($463) a month in government assistance, as well as the cost of rent for "suitable" housing, which, for a single person, is generally restricted to an apartment no larger than 45 square meters (484 square feet). And he only qualifies for this assistance if his savings are minimal.

Germany could soon face a debate over the future of the social welfare state. "We must take an offensive approach to discussing the threat of impoverishment," says one SPD cabinet member.

The cabinet member insists that an amendment to the Hartz IV reforms is at the top of the political agenda, and that the Social Democrats cannot allow their political base to fall into the poverty trap.

Nevertheless, no one in Berlin is currently interested in actively discussing the issue. No one wants to be suspected of fueling public anxiety even further. Politicians are still holding onto the hope that things will not turn out to be as bad as expected after all. Everyone, in fact, still hopes that the differences between today's crisis and the Great Depression will be greater than the parallels.

Unlike 1929, the governments of the major industrialized nations today are generally in agreement and are combating the crisis together, a commitment they agreed upon at the London G-20 summit in early April.

Unlike 1929, the social welfare network, especially in Germany, provides citizens with a cushion against the most acute hardships. Under the Obama administration, America's social safety net is also being improved.

Unlike 1929, the world's major countries are flooding the economy with money to prevent deflation and, with it, a downward spiral of declining prices and income.

But no one knows whether this will suffice, or whether all the money being thrown at the aggressive virus fueling this crisis will only make it worse. Debts are being fought with debts, meaning that not only banks but entire countries could end up bankrupt. Perhaps the efforts to combat the current crisis are merely laying the foundations for the next crisis, which will be bigger still.

Economic historian Werner Abelshauser is among those who refuse to rule out anything. "History doesn't repeat itself," he says. But then he quickly adds: "Or does it?"

from MarketWatch.com, 2009-May-7, by Emily Barrett:

N.Y. Fed board chair Stephen Friedman resigns

NEW YORK -- Stephen Friedman has resigned as chairman of the Board of Directors of the Federal Reserve Bank of New York, saying his role had been at the central bank has been maligned.

Friedman notified New York Fed President William Dudley and Fed Chairman Ben Bernanke of his decision, effective immediately, in a letter Thursday.

At the end of April, Friedman, a former Goldman Sachs Group chief executive and White House economic adviser, said he would leave his post at the N.Y. Fed by the end of 2009, a year before his term ends.

The sudden move Thursday follows controversy over Friedman's continued presence on the board of Goldman Sachs last autumn, and his large holdings of stock in the firm when its status switched to that of a bank holding company. In November, when then-president of the New York Fed Timothy Geithner was nominated as Treasury Secretary in the Obama Administration, Friedman led the search committee for his replacement.

The NY Fed had secured a waiver from the Fed's Board of Governors to allow Friedman to stay to the end of 2009 while remaining a Goldman director and shareholder. To remain beyond that, he would have to sell his Goldman shares and leave the Goldman board; he has chosen to leave the Fed board instead.

"Although I have been in compliance with the rules, my public service motivated continuation on the Reserve Bank Board is being mischaracterized as improper," Friedman wrote in his resignation letter. "The Federal Reserve System has important work to do and does not need this distraction."

Executive vice president and general counsel at the New York Fed Thomas Baxter said in a press release published on the central bank's Web site that, "there is no doubt that 2008 was one of the most challenging years in the New York Fed's history," and "we were fortunate to have Steve as our chairman during that time."

Referring to Friedman's purchase of additional Goldman shares in December and January, Baxter wrote "it is my view that these purchases did not violate any Federal Reserve statute, rule or policy."

Representing the Fed's Board, vice chairman Donald Kohn thanked Friedman for his service, adding in the press release, "I particularly appreciate the very rigorous process Steve established to select the new president of the New York Fed."

In keeping with the Federal Reserve Act, Deputy Chair of the board Denis Hughes will take over the immediate vacancy.

from Commentary, 2009-Jul/Aug, by John H. Makin:

A Government Failure, Not a Market Failure

As a people we need, at all times, the encouragement of home ownership.

HERBERT HOOVER, 1932

The idea that home ownership confers special benefits on American society is deeply embedded in our culture—so much so that our national tax policy confers a special benefit of its own on it. Home ownership is granted an advantage over all other forms of ownership in the form of an enormous deduction on the interest payments most individuals incur in financing their homes. Nothing else in the tax code comes anywhere near that deduction in scope or size. We have decided, as a nation, that home ownership is not only a good thing for an individual or a family, but that it is beneficial for the public at large and the country as a whole. Otherwise, why would it be necessary for the government to give it this kind of preferential treatment? Without it, clearly, we believe that the national rate of home ownership would be lower, and that a lower rate of home ownership would be deleterious to our common weal.

After 2000, the national push toward home ownership intensified in three dimensions, leading to a doubling of housing prices in just five years' time. First, the Federal Reserve Board's interest-rate policy drove down the cost of borrowing money to unprecedented lows. Second, a common conviction arose that home ownership should be available even to those who, under prevailing conditions, could not afford it. Finally, private agencies charged with determining the risk and value of securities were exceptionally generous in their assessment of the financial products known as “derivatives” whose collateral resided in the value of thousands of mortgages bundled together. The rating agencies understated the risks from these bundled mortgages by assuming that home prices were simply going to rise forever.

When the housing bubble burst in 2006, the damage to the financial system pushed the global economy into the worst contraction since the Great Depression. In the midst of the pain and suffering that have accompanied financial collapse and economic contraction—over $15 trillion in wealth has been lost by American households alone while, to date, more than 6 million job losses have boosted the unemployment rate to 9.4 percent—much of the blame has been placed on unregulated financial markets whose behavior is said to have revealed a terrible flaw in the foundation of capitalism itself.

This was a market failure, we are told, and the promise of capitalism has always been that the self-correcting mechanisms built into the system would preclude the possibility of a systemic market failure.

But the housing bubble only burst after government subsidies pushed house prices up so fast that marginal buyers could no longer afford to chase prices even higher. A bubble created by rigged financial markets and a government-sponsored obsession with home ownership is not a result of market failure, but rather, a result of bad public policy. The belief that home ownership, per se, is such a benefit that no amount of government support could be too great and no pace at which home prices rise could be too fast is the root of the crisis.

There was no market failure.

According to The New Palgrave Dictionary of Economics, an invaluable collection of precise summaries of virtually every topic in the dismal science: “The best way to understand market failure is first to understand market success, the ability of a collection of idealized competitive markets to achieve an equilibrium allocation of resources which is Pareto optimal.” Allow me to translate. “Pareto optimality,” a term named after the Italian economist Vilfredo Pareto (1848– 1923), is defined as an allocation of economic resources that produces the greatest good. Thus, if one changes the allocation of resources away from “Pareto optimality” for the purpose of making someone better off, that change will make someone else worse off. Economists have expended a great deal of effort to demonstrate that free and competitive markets produce an outcome that is “Pareto optimal.”

This is not to say that there is no such thing as market failure. There are many instances of market failure. Someone may possess information that others do not, as in insider trading, and thereby gain an illegitimate leg up. There may be too few players in a given market, which allows them to manipulate, hoard, and toy with prices. Capricious government intervention in cases where it is neither required nor appropriate constitutes another condition that may create a market failure.

There are also cases of market failure in which some people get a free ride while others bear a disproportionate burden. This is the case in national defense, for example, in which soldiers bear a burden non-soldiers do not. Consequently, a government subsidy for national defense is necessary for the maintenance of security and power, and the overwhelming majority of citizens acknowledges it and does not complain about it. National defense is a public good, perhaps the original public good.

Owner-occupied housing is something else that has been deemed a public good. Herbert Hoover's affirmation of the need for encouragement of home ownership “at all times” came in 1932 at the fiercest stage of the Great Depression. Others have made powerful arguments that homeowners make better citizens and contribute to stable communities. Why renters do not and cannot offer the same contribution to the public good is never specified, but existing homeowners, homebuilders, mortgage lenders, and mortgage servicers have all seized on the idea that subsidizing home ownership is “Pareto optimal.”

It isn't.

Subsidies for home ownership—in the form of full deductibility of mortgage interest, lower mortgage borrowing rates derived from government guarantees for mortgage lenders like Fannie Mae and Freddie Mac, and deductibility of local real-estate taxes—have long benefited those who own homes at the expense of those who do not. The size and severity of the burst bubble makes a mockery of the argument that the disproportionate gains to homeowners also improved the welfare of renters. By erasing, in just a few years, nearly one-third of the wealth on the national balance sheet, the collapse has created a substantial loss in national welfare, including for renters.

Home ownership shoue form of home prices that are higher than they would otherwise be without government support. The subsidies make homeowners better off while they make renters worse off. They are, therefore, not Pareto optimal.

In addition, home-ownership subsidies are inherently unjust. They favor the relatively well-off at the expense of those who are poorer. Why? Because the value of an owned home and the size of the government subsidy both grow as income increases. A tax deduction tied to home ownership for a well-to-do American with a $1 million mortgage and a $60,000 annual interest payment is worth $22,000 (assuming the American is in the 35 percent ssary to qualify for mortgages so that Americans with lower incomes could participate in the leveraged purchases of homes.

The goal of expanding home ownership led to the creation of new mortgage subsidies across the board. The loosening of standards became the policy of Fannie Mae and Freddie Mac, the pseudo-private “government-sponsored enterprises” that bought mortgages from originating lenders. A particular change in the tax law in 1997 encouraged many households to make buying and improving a home the primary vehicle by which they enhanced net worth. By eliminating any capital-gains tax on the first $500,000 of profits from the sale of an owner-occupied residence once every two years, Washington encouraged enterprising American families to purchase homes, fix them up, re-sell them, and then repeat the process. Flipping became a financial pastime for millions because this special advantage created a new incentive—which didn't exactly fit the model of encouraging people to remain in a stable home for many years and thereby help to stabilize the neighborhood around them.

There was, however, a rival to home ownership as a way of building wealth in the late 1990s—the run-up in the stock market, which was caused by another bubble, this one in the technology sector. Given the size of the gains in the stock market, which were running 20 percent or more a year, the relative desirability of home ownership eroded. But when, in 2000, the tech bubble burst, households were left in search of an alternative way to store and enhance wealth. Home ownership emerged as the most promising alternative. After 2000, and especially after 2002, U.S. real house prices began to surge.

Everything I have described thus far constituted a necessary but not sufficient precondition for a full-fledged housing bubble. It took the addition of a new market in derivatives to drive bankers, lenders, and credit agencies to create the conditions for an implosion by expanding mortgage financing to borrowers who could not possibly afford the homes they were purchasing.

In February 2003, Angelo Mozilo, then head of the major mortgage supplier called Countrywide, declared that the need to provide a down payment should no longer be an impediment to home ownership for any American.1 Was it any wonder that a home-buying frenzy occurred when Countrywide's chieftan was suggesting that there was no need for a purchaser to supply even a minimal equity stake in his purchase? During 2004 and 2005, the rise in home prices accelerated. That, in turn, caused Americans to refinance their homes to remove their equity—their accumulated wealth, in other words—and convert it into disposable income. They did so because they were confident the equity would simply be recreated by continued growth in the value of their homes.

The hunger for more mortgages that could serve as backing for more new securities led to the acceleration of undocumented, no-down-payment, negative-amortization mortgage loans to individuals with virtually no prospect of servicing them. The designers of derivative securities effectively collaborated with the rating agencies, such as Standard & Poor's and Moody's, that were relied upon (often through government mandate) by pension funds and other gigantic repositories of wealth with identifying the securities safe enough to invest in.

A situation in which creators of derivatives provide the monetary compensation for the very agencies that are tasked with determining the riskiness of their securities hardly constitutes a competitive market. Indeed, it constitutes dangerous collusive behavior. But that collusion, again, was made possible by the distorting actions of government agencies, which effectively provided a subsidy for risk-taking that was, by definition, unsustainable.

It is fair to ask, in the light of past bubbles that have burst—like the entire economy of Japan in the 1990s and the tech-stock tragicomedy—why investors were prepared to take on the substantial risks tied to unfamiliar derivative securities whose value was tied to the continued rise in house prices. A substantial part of the answer lies with the Federal Reserve Board. It deliberately adopted a policy that it would not seek to identify bubbles and then to act in ways that would let the air out slowly. Instead, Fed Chairman Alan Greenspan allowed bubbles to inflate and then stepped in to repair any damage afterward. This constituted a substantial subsidy to excessive risk-taking.

The policy became clear in 1998, the year in which the unwinding of the Asian currency crisis together with Russia's defaulting on its debt created huge volatility in the credit markets. At the time, Long Term Capital Management, a hedge fund, was on the verge of collapse, and an aggressive intervention was staged to save it. The New York Fed provided its offices and encouragement to bring financial firms together to contain it.

The salvation of Long Term Capital Management suggested a new reality for the marketplace: Aggressive risk-taking in pursuit of huge profits was manageable even if bubbles were created, just so long as the Fed was around to raise the “systemic risk flag” in the event of serious trouble. There would always be a rescue; the trick was to get out before everything began to collapse. It was this fact that led Charles Prince, then the head of Citicorp, to give the game away in July 2007 about the reckless and imprudent nature of his bank's conduct. “When the music is playing,” Prince said, “you've got to get up and dance.”

The housing bubble was thus a fully rational response to a set of distortions in the free market—distortions created primarily by the public sector. The heads of large financial institutions, as Prince's remark suggested, recognized the risk-taking subsidy inherent in public policy, but t they had no choice but to play along or fall behind the other institutions that were also responding rationally to the incentives created by government intervention.

The housing collapse and its painful aftermath, including that $15 trillion wealth loss for U.S. households (so far), do not, therefore, represent a market failure. Rather, they represent the dangerous confluence of three policy errors: government policy aimed at providing access to home ownership for American households irrespective of their ability to afford it; the Fed's claim that it could not identify bubbles as they were inflating but could fix the problem afterward; and a policy of granting monopoly power to rating agencies like Standard & Poor's, Moody's, and Fitch's to determine the eligibility of derivative securities for what are supposed to be low-risk portfolios, such as pension funds.

The Fed's bubble policy has evolved in a constructive direction since the bursting of the U.S. housing bubble. The trauma of dealing with the aftermath, including the fire sale of the investment bank Bear Stearns and the outright failure of Lehman Brothers, has convinced the Fed that more effort should be directed toward identifying bubbles before they grow too large.

Now the collusive relationship between rating agencies and creators of derivative securities needs to be ended by bringing more market discipline to the process. Free entry into the rating business should be permitted. The monopoly of a small number of rating agencies to determine the eligibility of new securities for investment by massive pension funds is unjustifiable. The practice whereby the creators of such derivative securities compensate the rating agencies for the ratings also needs to be ended.

Alas, the federal government's response to the collapse of the housing bubble has been deeply problematic. It has chosen to provide additional subsidies to homeowners while nationalizing the government-sponsored enterprises, Fannie Mae and Freddie Mac, that helped to subsidize lower mortgage-interest rates. While the extreme distress visited on American households by the collapse of the housing bubble certainly needs some alleviation, over the longer run we must have a serious national debate on the question of the degree to which we still want to consider home ownership a public good.

The long-term solution is for government to stop playing favorites, as it has for decades with housing. Home ownership should neither be penalized nor favored under government policy. We have seen how that distortion led inexorably to a degree of wealth destruction we have not seen in our lifetimes. The distortion of the market introduced by government intervention can and must be brought to an end. The market that would take its place after this dramatic and admittedly difficult change would allow Americans to allocate their resources more effectively. It would no longer create an unjust advantage for the wealthy homebuyer. And it would, finally, make it possible for Americans to see their homes as they should be seen—not as investment vehicles, but rather, as the places they live, the hearthstones of their families.

from the Wall Street Journal, 2009-May-5, p.A13:

The Next Housing Bust

Everyone knows how loose mortgage underwriting led to the go-go days of multitrillion-dollar subprime lending. What isn't well known is that a parallel subprime market has emerged over the past year -- all made possible by the Federal Housing Administration. This also won't end happily for taxpayers or the housing market.

Last year banks issued $180 billion of new mortgages insured by the FHA, which means they carry a 100% taxpayer guarantee. Many of these have the same characteristics as subprime loans: low downpayment requirements, high-risk borrowers, and in many cases shady mortgage originators. FHA now insures nearly one of every three new mortgages, up from 2% in 2006.

The financial results so far are not as dire as those created by the subprime frenzy of 2004-2007, but taxpayer losses are mounting on its $562 billion portfolio. According to Mortgage Bankers Association data, more than one in eight FHA loans is now delinquent -- nearly triple the rate on conventional, nonsubprime loan portfolios. Another 7.5% of recent FHA loans are in "serious delinquency," which means at least three months overdue.

The FHA is almost certainly going to need a taxpayer bailout in the months ahead. The only debate is how much it will cost. By law FHA must carry a 2% reserve (or a 50 to 1 leverage rate), and it is now 3% and falling. Some experts see bailout costs from $50 billion to $100 billion or more, depending on how long the recession lasts.

How did this happen? The FHA was created during the Depression to help moderate-income and first time homebuyers obtain a mortgage. However, as subprime lending took off, banks fled from the FHA and its business fell by almost 80%. Under the Bush Administration, the FHA then began a bizarre initiative to "regain its market share." And beginning in 2007, the Bush FHA, Congress, the homebuilders and Realtors teamed up to expand the agency's role.

The bill that passed last summer more than doubled the maximum loan amount that FHA can insure -- to $719,000 from $362,500 in high-priced markets. Congress evidently believes that a moderate-income buyer can afford a $700,000 house. This increase in the loan amount was supposed to boost the housing market as subprime crashed and demand for homes plummeted. But FHA's expansion has hardly arrested the housing market decline. The higher FHA loan ceiling was also supposed to be temporary, but this year Congress made it permanent.

Even more foolish has been the campaign to lower FHA downpayment requirements. When FHA opened in the 1930s, the downpayment minimum was 20%; it fell to 10% in the 1960s, and then 3% in 1978. Last year the Senate wisely insisted on raising the downpayment to 3.5%, but that is still far too low to reduce delinquencies in a falling market.

Because FHA also allows borrowers to finance closing costs and other fees as part of the mortgage, the purchaser's equity can be very close to zero. With even a small drop in prices, many homeowners soon have mortgages larger than their home's value -- which is one reason FHA's defaults are rising. Every study shows that by far the best way to reduce defaults and foreclosures is to increase downpayments. Banks know this and have returned to a 10% minimum downpayment on their non-FHA loans.

In a rational world, Congress and the White House would tighten FHA underwriting standards, in particular by eliminating the 100% guarantee. That guarantee means banks and mortgage lenders have no skin in the game; lenders collect the 2% to 3% origination fees on as many FHA loans as they can push out the door regardless of whether the borrower has a likelihood of repaying the mortgage. The Washington Post reported in March a near-tripling in the past year in the number of loans in which a borrower failed to make more than a single payment. One Florida bank, Great Country Mortgage of Coral Gables, had a 64% default rate on its FHA properties.

The Veterans Affairs housing program has a default rate about half that of FHA loans, mainly because the VA provides only a 50% maximum guarantee. If banks won't take half the risk of nonpayment, this is a market test that the loan shouldn't be made.

These reforms have long been blocked by the powerful housing lobby -- Realtors, homebuilders and mortgage bankers, backed by their friends in Congress. They claim FHA makes money for taxpayers through the premiums it collects from homebuyers. But keep in mind these are the same folks who said taxpayers weren't at risk with Fannie Mae and Freddie Mac.

A major lesson of Fan and Fred and the subprime fiasco is that no one benefits when we push families into homes they can't afford. Yet that's what Congress is doing once again as it relentlessly expands FHA lending with minimal oversight or taxpayer safeguards.

from NewsMax.com, 2009-May-4, by Dan Weil:

Buffett Sees Massive Inflation to Handle Staggering Debt

The explosive rise of the U.S. budget deficit and debt burden will lead to serious inflation down the road, says billionaire and Obama supporter Warren Buffett.

The Congressional Budget Office predicts that government debt will peak around 54 percent of GDP in 2011.

But Buffett told CNBC Monday morning that the ratio could surpass 80 percent — unless there are significant spending cuts or tax increases.

After a testy exchange with Sen. Judd Gregg, who suggested that President Obama's plans to hike federal spending would only increase the nation's staggering national debt, Buffett relented by stating that, in the end, the U.S. government simply will do what every other government has done in such circumstances.

“A country that continuously expands its debt as a percentage of GDP and raises much of the money abroad to finance that, at some point, it's going to inflate its way out of the burden of that debt,” Buffett said.

Experience proves that, he points out.

“Every country that has denominated its debt in its own currency and has found itself with uncomfortable amounts of debt relative to the rest of the world, in the end they inflate,” Buffett explains.

“That becomes a tax on everybody that has fixed dollar investments.”

Of course, it's likely that these trends also will mean a serious swoon for the U.S. dollar.

Buffett also suggested that dollar denominated investments like T-bills won't be a wise investment, in the long run.

Elsewhere in the economy, Buffett sees unemployment rising further. “Who knows where it tops out,” he says. But, “it will top out eventually.”

Buffett remains bullish long-term for the economy. “We have a wonderful economy over time,” he says.

We do come out of recessions, Buffett says.

“The biggest thing that brings us out of them is the fact that we have a system that works very well over time, even though it gets gummed up periodically.”

Buffett's Berkshire Hathaway has $20 billion in cash and is "perfectly willing to make a deal that's compelling," he told reporters at the end of the company's annual meeting Sunday.

The Oracle of Omaha doesn't have anything specific in mind, and neither he nor Berkshire's Vice Chairman Charlie Munger would reveal which sectors of the economy or regions of the country interest them most.

Berkshire is holding its annual meeting over the next few days, an event to which thousands travel just to hear Buffett and Munger hold forth on the economy and Berkshire's prospects.

Buffett did say that, of the three banks whose stock he already holds — Wells Fargo, US Bancorp and M&T Bank — that Berkshire "would buy stock in any of the three banks at present prices."

Last year, Buffett invested in troubled blue chips Goldman Sachs and General Electric.

Buffett and Munger say the company isn't currently planning to issue new shares or bonds to pay for a big acquisition.

They defended the company's performance, despite a 31 percent slump in share price from a year ago.

Munger says it's foolish to judge the firm's fate by short-term movements in its share price.

"If you think we're in trouble because the stock price went down, you don't understand what's going on," Munger says.

Munger says Berkshire is following "Andrew Carnegie's playbook."

The steel mogul made himself famous by snapping up market share from struggling competitors during recessions.

Many experts view Berkshire's purchases of shares in Goldman Sachs and GE in the same terms.

from the Wall Street Journal, 2008-May-8:

Stressed for Success?
At the Hotel Geithner, you can check in, but . . .

The Treasury released its bank "stress test" results late yesterday, and the good news is that the financial system has survived this very public undressing better than most analysts figured three months ago. We'd attribute the results much more to Adam Smith's continuing workout than to this public strip-tease, but we'll take relief wherever we can get it.

Stress-testing is what banks and their regulators are supposed to do as a matter of course, albeit more quietly. The current very loud and public effort was advertised to provide an extraordinary measure of transparency at a time when no one trusted bank books. Do markets trust them any better now? Judging by the run-up in bank stock prices from their oversold levels in January, they do. This is progress.

On the other hand, all we really have to go on is the word of the federal employees who looked at the banks and estimated their losses against certain economic assumptions. Did they go easier than they might have, and how much did they bend when the banks fought back? The Fed's overview yesterday claimed they ran a "deliberately stringent test" and pegged potential "adverse"-case losses at the 19 largest banks at $600 billion this year and next.

Yet markets are also full of reports that regulators showed more than a little forbearance, especially after it became clear that President Obama had no desire to go back to Congress to ask for more public money. With only $110 billion or so in Troubled Asset Relief Program (TARP) funds left uncommitted, it's probably no coincidence that Treasury now sees new net bank capital needs as a manageable $75 billion.

And maybe that optimism will prove correct. Most banks are earning healthy profits again, thanks to a low cost of funds and steep yield curve. They're also taking steps to burn bad debt and clean up their balance sheets. Some banks that got too big during the boom are looking to sell some of their operations in order to raise cash. This is how a financial system shapes itself up under the market pressure of recession, with or without stress tests.

Not that there still aren't plenty of financial risks out there. On the credit side, commercial real estate is ugly and both home mortgage and credit card losses are a long way from receding. While the economy seems to be bottoming out at last, unemployment will keep rising for several months, which will mean more bank losses.

But our biggest question concerns interest-rate risk. Thanks to the Federal Reserve's emergency easing, short-term rates are close to zero. That can't last forever, and the longer the Fed keeps rates this low the more likely it is that rates will have to climb higher down the road to prevent inflation. Remember how the Fed's 1% rate of 2003-2004 rose to 5.25% by 2006 and what that did to housing prices and the cost of bank funds? Yet the Fed didn't disclose the interest-rate projections for 2010 and beyond that it built into its stress test models.

On the interest-rate point, by the way, one omen was yesterday's terrible 30-year Treasury bond auction. Treasury sold $14 billion of the securities, but investors demanded yields in mid-auction that were higher than forecast and bond prices fell the most since February. The 30-year yield hit 4.3%. With trillions of dollars in budget deficits still in the pipeline -- even before health care -- Treasury may find the world keeps demanding higher yields to offset the fear of potential inflation. Fed Chairman Ben Bernanke didn't help on that score this week when he told Congress that it was too early to take liquidity out of the financial system because the economy was still too weak. By the time the economy is growing, it will be too late. Think 2004, again.

In the wake of the stress tests, the weaker banks will now have six months to raise private capital to fill the hole identified by Treasury. They'll be desperate to do so, because the alternative is that Treasury will force them to accept more public capital. This will include the conversion of Treasury's preferred stock, bought last year via the TARP, into common shares.

Under accounting rules, this gives the banks more "tangible common equity," the measure of capital favored by Treasury. Yet it provides not a penny more in actual capital to absorb losses. Meantime, the feds would suddenly own big chunks of those banks via common stock, the way they now are the largest shareholder in once-proud Citigroup. We've called this a back-door nationalization, and it means Congress looking over banker shoulders. The silver lining is that bank executives are now so appalled by this idea that they'll sell anything that moves to avoid such a fate.

As for the "stronger" banks, a major goal will be to flee as fast as possible from the TARP, also known as the Hotel Geithner. Banks can check in but it's a lot harder to check out. Treasury has set up major hurdles before a bank can escape, even if it wants to. Clearly banks at risk of failing can't be allowed to endanger the larger financial system, but banks that have adequate capital shouldn't be held hostage to the political worries of regulators.

The best that can be said about the stress tests is that they're over. Now the most urgent task is to get back to a financial system free of government guarantees, public capital and political control.

from the Wall Street Journal, 2009-Apr-28, p.A13:

Busting Bank of America
A case study in how to spread systemic financial risk.

The cavalier use of brute government force has become routine, but the emerging story of how Hank Paulson and Ben Bernanke forced CEO Ken Lewis to blow up Bank of America is still shocking. It's a case study in the ways that panicky regulators have so often botched the bailout and made the financial crisis worse.

In the name of containing "systemic risk," our regulators spread it. In order to keep Mr. Lewis quiet, they all but ordered him to deceive his own shareholders. And in the name of restoring financial confidence, they have so mistreated Bank of America that bank executives everywhere have concluded that neither Treasury nor the Federal Reserve can be trusted.

Mr. Lewis has told investigators for New York Attorney General Andrew Cuomo that in December Mr. Paulson threatened him not to cancel a deal to buy Merrill Lynch. BofA had discovered billions of dollars in undisclosed Merrill losses, and Mr. Lewis was considering invoking his rights under a material adverse condition clause to kill the merger. But Washington decided that America's financial system couldn't withstand a Merrill failure, and that BofA had to risk its own solvency to save it. So then-Treasury Secretary Paulson, who says he was acting at the direction of Federal Reserve Chairman Bernanke, told Mr. Lewis that the feds would fire him and his board if they didn't complete the deal.

Mr. Paulson told Mr. Lewis that the government would provide cash from the Troubled Asset Relief Program (TARP) to help BofA swallow Merrill. But since the government didn't want to reveal this new federal investment until after the merger closed, Messrs. Paulson and Bernanke rejected Mr. Lewis's request to get their commitment in writing.

"We do not want a disclosable event," Mr. Lewis says Mr. Paulson told him. "We do not want a public disclosure." Imagine what would happen to a CEO who said that.

After getting the approval of his board, Mr. Lewis executed the Paulson-Bernanke order without informing his shareholders of the material events taking place at Merrill. The merger closed on January 1. But investors and taxpayers had to wait weeks to learn that the government had invested another $20 billion plus loan portfolio insurance in BofA, and that Merrill had lost a staggering $15 billion in the last three months of 2008.

This was the second time in three months that Washington had forced Bank of America to take federal money. In his testimony to the New York AG's office, Mr. Lewis noted that an earlier TARP investment in his bank had a "dilutive effect" on existing shareholders and was not requested by BofA. "We had not sought any funds. We were taking 15 [billion dollars] at the request of Hank [Paulson] and others," Mr. Lewis testified.

But it is the Merrill deal that raises the most troubling questions. Evaluating the policy of Messrs. Bernanke and Paulson on their own terms, this transaction fundamentally increased systemic risk. In order to save a Wall Street brokerage, the feds spread the risk to one of the country's largest deposit-taking banks. If they were convinced that Merrill had to be saved, then they should have made the public case for it. And the first obligation of due diligence is to make sure that their Merrill "rescuer" of choice -- BofA -- had the capacity to bear the losses. Instead they transplanted the Merrill risk to BofA shareholders, the bank's depositors and the taxpayers who ensure those deposits. And then they had to bail out BofA too.

Messrs. Bernanke and Paulson also undermined the transparency that is a vital source of investor confidence. Disclosure is not a luxury to be enjoyed only when markets are rising. It is the foundation of the American regulatory system and a reason investors have long sought to keep their money within U.S. borders. Could either man have believed that their actions wouldn't eventually come to light, with all of the repercussions for their bank rescue plans?

Mr. Paulson told Mr. Cuomo's investigators that he also kept former SEC Chairman Christopher Cox out of the loop while forcing BofA to rescue Merrill. Mr. Cox wasn't the only one. Mr. Paulson and Mr. Bernanke both sit on the Financial Stability Oversight Board, comprised of federal regulators who oversee TARP. Two days after Mr. Lewis told the dynamic duo that Merrill's losses were exploding and that he was looking for a way out, Mr. Bernanke chaired and Mr. Paulson attended a meeting of this board. Minutes of the meeting show no mention of BofA or Merrill.

At the next meeting on January 8, a week after the merger had closed, the minutes again make no mention of either regulator telling their colleagues that they had committed tens of billions of dollars. Yet the minutes helpfully note that among the topics discussed were "coordination, transparency and oversight."

Meeting minutes suggest Messrs. Bernanke and Paulson finally informed fellow board members at 4:30 p.m. on January 15, after news outlets had already reported a pending new taxpayer investment in BofA. What exactly did Mr. Bernanke and Mr. Paulson tell their colleagues about their plans for TARP prior to January 15?

Let's hope they treated their government colleagues better than they've treated Ken Lewis, whom they hung out to dry. After making him an offer he could hardly refuse, they've let him endure a public flogging from shareholders and the press, lengthy discussions with prosecutors, plus new hiring and compensation rules that limit his bank's ability to compete.

No wonder no banker in his right mind trusts the Fed or Treasury, and no wonder nobody but Pimco and other Treasury favorites is eager to invest in the TALF, the PPIP, or any of the other programs that require trusting the government as a business partner.

The political class has spent the last few months blaming bankers for everything that has gone wrong in the financial system, and no doubt many banks have earned public scorn. But Washington has been complicit every step of the way, from the Fed's easy money to the nurturing of Fannie Mae and Freddie Mac, and since last autumn with regulatory and Congressional panic that is making financial repair that much harder. The men who nearly ruined Bank of America have some explaining to do.

from the Wall Street Journal, 2009-Apr-29, p.A12:

Kent for Rent
There's no reconciling Conrad's contradiction.

Some changes in politics aren't all that surprising -- see above -- but others leave you slack-jawed with amazement. For an example of the latter, consider North Dakota Senator Kent Conrad's triple back-flip with a double-twisting dismount off the budget deficit high bar.

Mr. Conrad is Chairman of the Senate Budget Committee, and for decades he has advertised himself to the folks in Fargo as a skin-flint deficit hawk. He's a particular scourge of entitlements like Medicare. But this week he provided the decisive vote in House-Senate conference to allow Congress to pass a new $1 trillion health-care entitlement with a mere 51 votes.

Under this "reconciliation" process, the Senate avoids the 60 votes typically needed to close debate. It's an unprecedented abuse of a procedure that was designed to protect minority rights -- and make it harder to spend money without being paid for -- and that has historically been used sparingly.

Not so long ago, Mr. Conrad was indignant at the very thought of this maneuver. In an earlier budget debate this year, he said that doing this would blow apart Senate precedent, rob Members of their "leverage" and result in legislation that looked like "Swiss cheese." "I've been as clear as I can be publicly and privately that I don't think reconciliation is the right way to write fundamental reform legislation," Mr. Conrad said. "It wasn't designed for that purpose."

Well, on Monday night, Mr. Conrad was one of three Senators who voted in conference on a final 2010 budget outline. Washington Democrat Patty Murray was always going to vote yes. New Hampshire Republican Judd Gregg was always going to vote no. Since a majority of each chamber was needed for passage, Senator Conrad could have killed reconciliation for health care as the price of his support.

Instead, Mr. Conrad signed on, making it that much easier for Congress to pass a health-care bill that is neither bipartisan nor honest about how it will be financed. He makes Arlen Specter look principled.

from the Wall Street Journal, 2009-Apr-15:

A Triple-A Idea
Ending the rating oligopoly.

'The disease has spread," says University of San Diego law professor Frank Partnoy, in remarks to be delivered today at the Securities and Exchange Commission. He's talking about the sickness in financial markets caused by the federal government's decision to select certain companies to judge credit risk. Instead of a free market judging the likelihood that a particular bond will be repaid, regulation by the SEC and Federal Reserve forces market participants to use the government's hand-picked experts at Standard and Poor's, Moody's and Fitch.

Mr. Partnoy argues that the financial meltdown could have been avoided if these anointed ratings agencies had never slapped their triple-A seals of approval on collateralized debt obligations (CDOs). Without the comfort of AAA, investors would have wondered how they could possibly have evaluated the mortgages buried deep inside these opaque securities.

Virtually everyone who has reviewed the causes of the meltdown has concluded that credit ratings were a major factor. Yet most in Washington now claim the core problem is that issuers of securities pay the major rating agencies for their analysis. Regulators now focus on managing this conflict of interest, but they appear unwilling to address the much larger conflict of interest: To wit, that the major ratings firms assess the creditworthiness of the U.S. government, even as they depend for their profits on the special status bequeathed by the government.

Since 1975, the SEC has anointed a small group of firms as Nationally Recognized Statistical Rating Organizations (NRSROs), and money market funds and brokerages have no choice but to hold securities rated by them. To this day, the Fed will only accept assets as collateral if they carry high ratings from S&P, Moody's and Fitch.

We aren't urging the Big Three to yank the U.S. Government's AAA rating as a show of independence. But we are suggesting that the SEC and Fed get out of the business of dictating which firms may judge credit risk. By all accounts SEC Chairman Mary Schapiro has an open mind on this issue. She could do worse than consult her colleague down the hall, Commissioner Kathleen Casey.

In a February speech, Ms. Casey explained the essential problem, which has nothing to do with how raters get paid: "The rating agencies' conduct and performance was entirely rational, and quite similar to the market dominance and behavior of other companies that have enjoyed a similar 'most favored' status from the government, such as Fannie Mae and Freddie Mac. Although many of their ratings turned out to be catastrophically misleading, the large rating agencies enjoyed their most profitable years ever during the past decade."

Ms. Casey proposed last year to eliminate all references to NRSROs from SEC rules, but it was never enacted. Recent events have only confirmed her wisdom. Peter Fisher at Blackrock argues that it's time to abolish the NRSRO designation for entire firms and instead allow individuals to become licensed to do credit analysis, like brokers and equity analysts. Mr. Partnoy argues that instead of relying on the failed ratings agencies, regulators should harness the power of the bond and credit default swap markets, which yielded more accurate readings on the default risk of firms like Bear Stearns.

Those ideas deserve debate, but the starting point for reform must be ending the government-created oligopoly in credit analysis.

from the Wall Street Journal, 2009-Sep-1, p.A16:

AAA Cartel Protection
An SEC 'watchdog' tries to discourage ratings competition.

When everyone else is blaming you for creating the credit crisis, it helps to have a friend at the Securities and Exchange Commission. Especially when the SEC has the power to prevent new competitors from entering your market. The Big Three credit-ratings agencies—Standard and Poor's, Moody's and Fitch—abetted the meltdown with their hyper-optimistic calls on mortgage-backed securities. Triple-A-rated toxic waste has been fouling the world's financial system ever since.

Yet David Kotz, the SEC's inspector general, has apparently concluded that the real problem is not this government-anointed oligopoly, but the upstarts that have lately been approved to compete with them. In a new report that could not be more helpful to the Big Three, Mr. Kotz argues that the SEC should not have approved one unnamed new competitor because there were "suspicions" about the accuracy of the firm's financial statements and "questions" about whether the firm was charging investors a reasonable fee for its ratings. Mr. Kotz has also issued recommendations certain to make competing with the Big Three more difficult, time-consuming and expensive.

Mr. Kotz wants the SEC's bureaucrats to assess whether firms are charging the right amount for their services, hiring the right compliance officers, and rotating employees often enough into different assignments, among other changes. No doubt the Big Three can afford this bureaucratic swamp with their hefty profit margins, but it can only discourage upstarts that might finally give the world a better way to judge the likelihood of bond defaults.

Given recent scandals, you might expect the staff at the SEC to accept this beating from the agancy's "watchdog" and promise to do better next time. But to its credit, the acting co-director of the SEC's Division of Trading and Markets, Daniel Gallagher, has done no such thing. He points out in a response published along with Mr. Kotz's report that there was "no legally viable basis" for rejecting the application of the new competitor.

Mr. Gallagher explains to Mr. Kotz that the upstart firm fulfilled all of its obligations under the Credit Rating Agency Reform Act of 2006 to become a "Nationally Recognized Statistical Ratings Organization" (NRSRO). Mr. Gallagher and his SEC colleagues also helpfully note that the point of this 2006 reform—which tragically took effect too late to mitigate the credit crisis—was to allow more competition in the ratings business, not to prevent it.

Of course, the greatest reform of all would be to get the government out of the business of approving credit raters. The SEC should enact its 2008 proposal to remove all references to NRSROs from the agency's rules and let markets decide how to judge default risk. But if the SEC doesn't have the good sense to allow markets to fix this government-created problem, it should at least ensure that companies outside the Big Three are allowed to compete.

Among the most costly of Mr. Kotz's ill-advised recommendations is the suggestion that all ratings agencies should be audited by a firm regulated by the Public Company Accounting Oversight Board, the bureaucratic monster created by Sarbanes-Oxley. For a small private firm that simply wants to focus on serving its customers with an informed opinion on credit risks, the costs and hassle of public-company accounting could be significant—and they will do nothing to improve the product. As if investors care, in any case, how research firms do their internal accounting.

Let's hope SEC Chairman Mary Schapiro understands—even if Mr. Kotz does not—that what investors need is better analysis of debt securities, not more regulation of people who might want to offer such analysis.

from the New York Times, 2009-Apr-18, printed 2009-Apr-19, p.BU7, by N. Gregory Mankiw:

It May Be Time for the Fed to Go Negative

WITH unemployment rising and the financial system in shambles, it's hard not to feel negative about the economy right now. The answer to our problems, however, could well be more negativity. But I'm not talking about attitude. I`m talking about numbers.

Let's start with the basics: What is the best way for an economy to escape a recession?

Until recently, most economists relied on monetary policy. Recessions result from an insufficient demand for goods and services — and so, the thinking goes, our central bank can remedy this deficiency by cutting interest rates. Lower interest rates encourage households and businesses to borrow and spend. More spending means more demand for goods and services, which leads to greater employment for workers to meet that demand.

The problem today, it seems, is that the Federal Reserve has done just about as much interest rate cutting as it can. Its target for the federal funds rate is about zero, so it has turned to other tools, such as buying longer-term debt securities, to get the economy going again. But the efficacy of those tools is uncertain, and there are risks associated with them.

In many ways today, the Fed is in uncharted waters.

So why shouldn't the Fed just keep cutting interest rates? Why not lower the target interest rate to, say, negative 3 percent?

At that interest rate, you could borrow and spend $100 and repay $97 next year. This opportunity would surely generate more borrowing and aggregate demand.

The problem with negative interest rates, however, is quickly apparent: nobody would lend on those terms. Rather than giving your money to a borrower who promises a negative return, it would be better to stick the cash in your mattress. Because holding money promises a return of exactly zero, lenders cannot offer less.

Unless, that is, we figure out a way to make holding money less attractive.

At one of my recent Harvard seminars, a graduate student proposed a clever scheme to do exactly that. (I will let the student remain anonymous. In case he ever wants to pursue a career as a central banker, having his name associated with this idea probably won't help.)

Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

Of course, some people might decide that at those rates, they would rather spend the money — for example, by buying a new car. But because expanding aggregate demand is precisely the goal of the interest rate cut, such an incentive isn't a flaw — it's a benefit.

The idea of making money earn a negative return is not entirely new. In the late 19th century, the German economist Silvio Gesell argued for a tax on holding money. He was concerned that during times of financial stress, people hoard money rather than lend it. John Maynard Keynes approvingly cited the idea of a carrying tax on money. With banks now holding substantial excess reserves, Gesell's concern about cash hoarding suddenly seems very modern.

If all of this seems too outlandish, there is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates — interest rates measured in purchasing power — could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend.

Having the central bank embrace inflation would shock economists and Fed watchers who view price stability as the foremost goal of monetary policy. But there are worse things than inflation. And guess what? We have them today. A little more inflation might be preferable to rising unemployment or a series of fiscal measures that pile on debt bequeathed to future generations.

Ben S. Bernanke, the Fed chairman, is the perfect person to make this commitment to higher inflation. Mr. Bernanke has long been an advocate of inflation targeting. In the past, advocates of inflation targeting have stressed the need to keep inflation from getting out of hand. But in the current environment, the goal could be to produce enough inflation to ensure that the real interest rate is sufficiently negative.

The idea of negative interest rates may strike some people as absurd, the concoction of some impractical theorist. Perhaps it is. But remember this: Early mathematicians thought that the idea of negative numbers was absurd. Today, these numbers are commonplace. Even children can be taught that some problems (such as 2x + 6 = 0) have no solution unless you are ready to invoke negative numbers.

Maybe some economic problems require the same trick.

N. Gregory Mankiw is a professor of economics at Harvard. He was an adviser to President George W. Bush.

from Portfolio Magazine, 2009-Feb, by Matthew Malone:

The Usual Suspects
Blankfein. Steel. Thain. Paulson. Kashkari. See a pattern? The Goldman Sachs “conspiracy” to take over the U.S. financial system.

Wall Street bankers who've spent any time in the business often find they suffer from “Goldman Sachs envy”—a bitter mix of resentment and begrudging admiration for the firm's seemingly endless list of triumphs. It thrived while others struggled, and even if competitors were succeeding, Goldman always one-upped them. It sealed bigger deals, showered its executives with more money, and placed its powerful alumni in higher levels of government.

Now, with Goldman emerging from the financial crisis battered but still on top, the Street is seeing something more insidiously silly: a bona fide Goldman conspiracy. “A lot of people think that they must have gotten where they are because of some unfair advantage,” hedge fund manager Bill Fleckenstein says. “Nobody likes to think that someone flat out beat 'em.” (See a list of Goldman Sachs alumni and how they figure into the market turmoil of recent months.)

Believers point to the one degree of separation between Goldman bankers and recent financial events. Bush's Treasury secretary, Hank Paulson, is a former Goldman C.E.O., and his replacement at Treasury, Tim Geithner, was mentored by Goldman alumni. Mario Draghi, who is leading the crisis response for the E.U., is a former Goldman vice chairman.

Merrill Lynch C.E.O. John Thain was once Goldman's co-president, and Wachovia chief Robert Steel was a vice chairman. Ed Liddy, the new C.E.O. of A.I.G., was Goldman's vice chairman. World Bank president Robert Zoellick was a managing director. Even Neel Kashkari, the 35-year-old tapped to oversee the $700 billion Troubled Assets Relief Program, served at Goldman as a vice president. Are they plotting to take over the world? Who knows. They sure are a tight-knit group, and potential conflicts abound.

When we asked the participants about their roles in the alleged conspiracy, some didn't appreciate the joke. Goldman said that such claims are ludicrous. In fact, a spokesman said that the firm is at a disadvantage, since its alums must go out of their way to avoid the appearance of favoritism. Geithner, Paulson, the S.E.C., and others also dismissed the theories.

But for those who believe in smoky back rooms and secret handshakes, here's what your fellow theorists are whispering. Read with the lights on.

from Portfolio.com, 2009-Jan-7, by Matthew Malone:

Conspiracy Theory, Exposed

With Goldman emerging from the financial crisis battered but still on top, the Street is seeing something more insidiously silly: a bona fide Goldman conspiracy. “A lot of people think that they must have gotten where they are because of some unfair advantage,” hedge fund manager Bill Fleckenstein says.

1. Bear Stearns

The news: In March, Bear Stearns’ stock plummeted, and clients questioned the firm’s viability. J.P. Morgan, with government assistance, agreed to buy Bear for $10 a share.
The facts: Rumors appeared in print that traders in Goldman’s London unit tried to drive Bear’s stock down.
The conspiracy theory: Goldman Sachs and other Wall Street firms have held a grudge against Bear since 1998 when the company refused to join in the $3.6 billion bailout of hedge fund Long-Term Capital Manage­ment. By spreading fear about Bear, Goldman stood to pick up some lucrative new clients. (Goldman’s response: “We went out of our way to be supportive of Bear Stearns.”)

2. Merrill Lynch Sale

The news: On the weekend that the government allowed Lehman to fail, Merrill Lynch, led by C.E.O. John Thain, sold itself to Bank of America for a tidy premium. Days later, the Britain-based bank Barclays agreed to buy Lehman’s core assets for pennies, wiping out Lehman’s shareholders.
The facts: Thain was a frequent adviser to Tim Geithner, who was then president of the New York Fed. Thain also worked as Goldman’s co-president under Paulson.
The conspiracy theory: To protect Thain’s sterling reputation (and Goldman’s too), Geithner and Paulson urged him to find a buyer immediately. If he hadn’t, Merrill would have followed Lehman Brothers into oblivion.

3. A.I.G. Bailout

The news: Officials agreed to extend A.I.G. an $85 billion loan—later upped to $123 billion—to prevent its collapse. Goldman C.E.O. Lloyd Blankfein was (albeit briefly) the only investment-banking chief at a key meeting to discuss the deal.
The facts: Paulson installed Goldman vice chairman Ed Liddy as A.I.G.’s new C.E.O.
The conspiracy theory: Had the insurance giant failed, Goldman would have lost big. It’s said to have $20 billion in A.I.G. exposure. (Goldman says any exposure is offset by collateral and hedges.) Liddy was put in to protect Goldman’s interests. When asked why A.I.G. was bailed out but not Lehman, Dick Fuld, Leh­man’s C.E.O., told Congress, “Until the day they put me in the ground, I will wonder.”

4. Billions for the Banks

The news: The government injected $250 billion into U.S. banks as part of its bailout plan.
The facts: Before its collapse, Lehman Brothers was looking for a capital infusion of roughly $6 billion. Unable to raise the money, the company filed for bankruptcy. The government’s bailout plan, which included $10 billion for Goldman, came in October, just three weeks after Lehman was allowed to fail.
The conspiracy theory: The government let Lehman go under to eliminate one of Goldman’s biggest competitors. Though ­Goldman’s write-downs were tiny relative to those of its competitors, it was nonetheless granted the $10 billion in the bailout to preserve its advantage.

5. Bank Holding Companies

The news: In September, with markets swooning, Goldman Sachs applied to become a bank holding company. The Federal Reserve quickly approved the move, allowing Goldman (and Morgan Stanley, which had also applied for the change) to take deposits backed by the F.D.I.C.
The facts: Over the summer, Lehman C.E.O. Dick Fuld considered converting Lehman to a bank holding company. After discussions with the Fed, Lehman didn’t apply for the change.
The conspiracy theory: Goldman was thrown a lifeline by its many friends in government. Said a former Lehman swaps trader: “They were a lot more connected in government than Fuld was. At the end of the day, that cost Lehman.”

6. Short-Selling Ban

The news: On September 19, S.E.C. Commissioner Christopher Cox announced a month-long ban on the short-selling of stocks in 799 financial companies.
The facts: Executives at Bear and Lehman had long complained to regulators about traders’ irresponsibly shorting their stocks and stoking investor panic. The S.E.C. short-selling ban was implemented after both firms failed and Goldman’s stock dropped 20 percent over three days.
The conspiracy theory: When Goldman’s competitors felt pressure from the shorts, regulators acted timidly. Once the short-sellers turned their attention to Goldman, the company used its influence to push through a ban.

7. Rescuing Citigroup

The news: In November, after Citigroup’s stock dropped more than 60 percent in one week, the government injected $20 billion into the company—adding to the $25 billion it had already committed. The government also agreed to backstop the company’s losses once they surpass $29 billion.
The facts: Citigroup adviser and Goldman alum Robert Rubin mentored Geithner at Treasury and was one of Paulson’s contemporaries at Goldman.
The conspiracy theory: Geithner and Paulson came to the rescue of their friend. The bailout preserved Rubin’s big gig—he made more than $62 million from 2004 to 2007—despite claims he championed some of Citi’s riskiest strategies.

8. The Obama Presidency

The news: Barack Obama was elected the 44th president of the United States.
The facts: As a group, Goldman Sachs employees were among the largest donors to the Obama presidential campaign, giving more than $884,000. Former Goldman hotshots, including Rubin and New Jersey Governor Jon Cor­zine, were reportedly candidates to become Obama’s Treasury secretary. Geithner was eventually picked.
The conspiracy theory:  Obama’s victory and Geith­ner’s appointment are the completion of Goldman’s meticulously crafted plan to become a superpower. The firm now has the clout to impose its will on the financial markets—and the world.

from MarketWatch.com, 2009-Apr-22, by Sam Mamudi and Ronald D. Orol:

Freddie Mac acting CFO found dead in apparent suicide
U.S. officials express condolences to Kellermann's family and colleagues

NEW YORK -- The acting chief financial officer of Freddie Mac was found dead at his home Wednesday morning in an apparent suicide.

David Kellermann, acting chief financial officer at the government-controlled mortgage company, was found dead at his home in Fairfax County, Va.

Kellermann was named acting CFO in late September, three weeks after the government took charge of Freddie Mac. He had previously been senior vice president and corporate controller there.

His death came as staff from the Securities and Exchange Commission and Justice Department were probing the home-finance company about issues including possible accounting violations.

Freddie disclosed the investigation in a March 11 filing, and the firm said it was "cooperating fully in these matters."

According to the SEC filing, Freddie said it received a federal grand jury subpoena Sept. 26 from the U.S. attorney's office for the southern district of New York. The subpoena sought documents related to accounting, disclosure and corporate-governance matters, according to the filing.

But that subpoena was later withdrawn and the investigation was taken over by the U.S. attorney for the eastern district of Virginia.

According to the filing, on Oct. 21, Freddie said the SEC had begun its own investigation, asking Freddie for documents. Specifically, on Jan. 23, Jan. 30 and Feb. 25, the SEC issued subpoenas for documents. The agency also began its own interviews of company employees, Freddie said in the filing.

In addition to the investigation, Freddie Mac received a request from the House Committee on Oversight and Investigations on Oct. 20 seeking documents for a hearing it held on Dec. 9.

Freddie Mac has received more than $30 billion in government support as the mortgage and credit crisis intensified.

Kellermann's apparent suicide surprised some key regulators in Washington, who expressed their condolences.

"On behalf of the Treasury family, we are deeply saddened by the news this morning of David Kellermann's death," said Treasury Secretary Timothy Geithner in a statement. "Our deepest sympathies are with his family and his colleagues at Freddie Mac during this difficult time."

The Federal Housing Finance Agency issued this statement: "For many years, we have known David as a person of the utmost ethical standards who was hardworking and knowledgeable in his field. As the Acting Chief Financial Officer of Freddie Mac during particularly challenging times, David was an inspiration to his staff and many others who were privileged to work with him. We extend our condolences to his family, friends and colleagues."

Kellermann's apparent suicide would be the latest of several putatively motivated by the financial crisis. French financier Rene-Thierry Magon de la Villehuchet killed himself in December after losing roughly $1 billion of his own and clients' money to the Ponzi scheme orchestrated by Bernard Madoff.

Seventy-four-year-old German billionaire Adolf Merckle in January committed suicide after the conglomerate he controlled, with investments in pharmaceuticals, cement and other sectors, experienced problems related to the global financial crisis.

In 2002, J. Clifford Baxter, a former Enron Corp. vice chairman, was found dead in his car in Houston, in an apparent suicide, after the company collapsed in a massive corruption scandal and bankruptcy filing.

from the Wall Street Journal, 2009-Apr-20:

The Public Pension Shakedown
Why would a smart guy invest in a movie named 'Chooch'?

President Obama's auto fix-it man, Steven Rattner, is in the news as one of the Wall Street financiers hit up for big money as part of New York state's unfolding pension-kickback scandal. The White House says he's done nothing wrong, and there's no public evidence that he broke any laws.

But Mr. Rattner's high profile is nonetheless useful in drawing attention to the real story here, which is the growing evidence of corruption by officials who use their power over public pension funds to shake down private companies. This is the same political class that has been blaming banks for "greed" in the financial crisis. The pension fund scandal exposes the myth of the superior virtue of the public and nonprofit worlds. Greed is universal. And the opportunity for corruption is enormous when political discretion is tied to vast sums of public money.

New York Attorney General Andrew Cuomo and the Securities and Exchange Commission allege that investment firms paid politically connected "placement agents" in return for a piece of New York's $122 billion pension fund. The AG has indicted three politicos for kickbacks, but the media have focused on the private firms that hired some of these political agents. Thus the attention on Mr. Rattner, who as co-founder of the Quadrangle investment firm met with a consultant about paying a finder's fee for pension cash.

The motive and knowledge of these private investors need to be explored, but the main culprits are the public officials and their agents. Former New York Comptroller Alan Hevesi resigned in 2006 after pleading guilty to unrelated charges of defrauding the government. But his office served as exclusive manager for the pension fund that is one of the world's biggest institutional investors. What the New York scam is laying bare is the extent to which officials allegedly leveraged those taxpayer dollars to enrich themselves and increase their political power.

For the record, it isn't illegal for investment firms to hire "placement agents." Hedge funds and private equity firms have long outsourced their marketing to companies whose job it is to reach out to potential investors and arrange roadshows. These placement agents are typically paid a percentage of the money raised.

In New York, however, the agents were also major political players. Hank Morris is a noted Democratic strategist and was a top adviser and chief fundraiser for Mr. Hevesi; Mr. Cuomo has indicted him for money laundering and bribery. Former Liberal Party boss Raymond Harding had aided in Mr. Hevesi's election. When men like these come knocking on investment-house doors, the message is pay to play.

Mr. Morris and associates are alleged to have made $30 million selling access to the fund. Mr. Harding helped to clear a state Assembly seat for Mr. Hevesi's son, and was allegedly rewarded by being allowed to pocket $800,000 as a pension placement agent. The indictment says Mr. Morris was aided by former deputy comptroller David Loglisci, who made clear to investment firms that they should hire Mr. Morris and who signed off on the subsequent pension fund investments. (All three men deny the charges. Mr. Hevesi, who hasn't been charged in this case, also denies any wrongdoing.)

In Mr. Rattner's case, SEC documents say he met with the brother of Mr. Loglisci to discuss acquiring the DVD rights to "Chooch," a low-budget movie that Mr. Loglisci and his brothers were producing. Quadrangle, through an affiliate called GT Brands, agreed to acquire the rights for about $89,000. Several weeks later, Mr. Loglisci told Mr. Rattner that Quadrangle would be getting a $100 million investment from the pension fund. Quadrangle then paid $1.1 million in finders fees, most of which went to Mr. Morris. Now that Mr. Rattner holds sway over the U.S. auto industry, we hope his judgment about cars is better than his taste in cinema.

This scandal is only one example of how political actors leverage pension-fund cash for personal gain. The most routine and pervasive practice is the way officials like Mr. Hevesi tap hedge funds and private equity firms for campaign contributions. The Wall Street crowd knows that to refuse to pony up would limit their access to pension money.

It has also become routine for politicians to inject their pension funds into partisan debates that have nothing to do with the sound management of retiree money. Mr. Hevesi once used a pension-fund investment to threaten Sinclair Broadcasting into taking off the air a documentary critical of Senator John Kerry. Calpers, the California public pension fund, tried to bludgeon Safeway into capitulating to a striking union. The then-chairman of Calpers was executive director of the same food worker union that was striking. Safeway held firm.

Such misuse of pension dollars is increasing, and it was inevitable that it would lead to pay-to-play schemes. New York Governor David Paterson says he wants to end his state's practice of giving the comptroller sole control over the pension fund, and to move toward the system in which a board oversees the money. But as Calpers makes clear, any political board can also abuse its power. The real problem is the huge political temptation and leverage these public pensions create. The solution is to take these assets and the pension investment decisions away from political actors.

from the Associated Press, 2009-May-4, by Aoife White:

EU revises forecast; predicts deep, wide recession

BRUSSELS — Deepening the economic gloom in Europe, the European Union admitted Monday that its previous forecasts were way off the mark. It now predicts "a deep and widespread recession" across the continent and says unemployment among the 16 nations that use the euro will rise to a postwar record of 11.5 percent in 2010.

Driving the pessimism was the region's biggest economy, Germany, which has been hit hard by the "near collapse" in global trade — a potentially difficult backdrop for Chancellor Angela Merkel as she strives to win elections later this year.

The EU now reckons that Germany will contract by a massive 5.4 percent this year as global demand dries up for high-value goods such as Germany's cars and machinery. In January, the EU thought Germany would only shrink 2.3 percent this year.

Partly because of the bigger than anticipated downturn in Germany, the EU's executive said both the 27-nation EU and euro-zone will shrink by 4 percent this year, more than double its January estimates, when it forecast a 1.8 percent contraction for the EU and a 1.9 percent decline for the euro-zone area.

The EU's top economy official, Joaquin Almunia, blamed the EU downgrades on an "exceptionally bad" first three months of this year as industrial output slumped at a record pace, exports stalled and business and consumer confidence hit new lows. EU growth figures for the first quarter are due on May 15.

Almunia told reporters that recent surveys for euro-zone and German confidence "appear to confirm that the economy is no longer in free fall." He said the EU now expected the economy to start bottoming out in the middle of this year as "the fiscal stimulus measures, the bank rescue plans and the monetary easing are expected to start bearing fruit in the next quarters."

He said a new stimulus package could not be ruled out and could be discussed by EU leaders at a June summit.

Quarterly growth is unlikely to emerge until 2010, Almunia said, but even then both the EU and the euro-zone will likely shrink 0.1 percent over the whole year provided stability emerges in the banking sector and world trade turns around.

Plunging exports and industrial output are causing the economy to shrink — and will see some 8.5 million jobs shed from the EU in 2009 and 2010, more than wiping out the number of new jobs created in the last two years. In the 16 nations that use the euro, unemployment will hit a postwar record of 11.5 percent next year.

Euro-zone exports are "forecast to suffer one of the worst setbacks on record" with a 13-percent slump this year, partly because the strong euro makes euro goods more expensive for U.S. and British customers.

Germany will see exports shrink by a worse 16 percent, forcing companies to reduce investment in new equipment by a fifth and cut 1.5 million jobs this year and next year. An export pick-up next year is Germany's main hope for growth, the EU said, as household demand and business spending will remain weak next year.

The EU forecast that Britain and Italy will shrink by between 4 percent to 4.5 percent this year, while France, cushioned by heavy government spending that supports growth, will post a smaller 3-percent drop. Spain will also likely shrink by 3 percent.

Only one of the EU's 27 states — Cyprus — may see economic growth this year, while countries cooling from a housing bubble experience the biggest tumble in growth rates — Latvia, Lithuania and Estonia are all expected to post double-digit declines.

Both Britain and France will see unemployment climb over 3 million next year — with France reporting an 11 percent jobless rate, the EU said. Spain is forecast to fare worse with one in five workers unable to find a job — an unemployment rate of 20 percent.

The EU warned that even worse may be ahead and banks' efforts to deleverage — shore up their financial position by putting more money aside to cover bad debt — "may unravel with greater intensity than currently expected."

It also said a bad debt spiral from falling house prices could trigger a wave of business bankruptcies that lift unemployment and lead to more debt defaults.

To avoid this, it called on European governments to shore up confidence in banks by moving swiftly to clean up banks' balance sheets by taking on hard-to-value assets that have racked up huge losses and launching new bank recapitalizations as needed.

EU banks have already written down euro290 billion in losses, it said, calling for close-monitoring of debt defaults, particularly in eastern Europe where many western banks may face bad loan books as housing prices collapse and unemployment rises.

It also warned of fluctuating exchange rates and protectionist measures that could further cut global trade and remove a major crutch to an economic recovery next year.

The EU said Europe faces a limited risk of deflation — a corrosive spiral of falling prices — but that several countries will see "disinflation" for several months this year as energy prices plunge from record highs last summer.

The EU now expects euro-zone inflation of 0.4 percent this year and said lower inflation and interest rates may help support the economy by giving people more money to spend and less to repay on housing loans.

from the Wall Street Journal's Political Diary, 2009-Mar-30, by Stephen Moore:

Real (!) Money

Remember when a trillion-dollar budget deficit seemed unfathomable? Well, that was only a few weeks ago. With the $800 billion economic de-stimulus, the second tranche of the TARP bailout, and the Obama mortgage rescue plan, this year's deficit is estimated by most private forecasters to approach $2 trillion.

But it could get worse, much worse. The deficit could soon spiral to between $2.5 and $2.9 trillion in 2009. A compelling and frightening report by investment advisors at Casey Research notes that "if the tax revenues fall, the deficit may even exceed the total U.S. budget of 2008: $2.9 trillion." Yikes, this is banana republic-type borrowing.

As the Casey Research report notes, these are much bigger levels of debt than during the New Deal, which topped out at 50% of GDP in the 1930s. Today's debt of 70% of GDP could quickly reach 100%, and perhaps as high as 120%. A new Heritage Foundation report points out that FDR's New Deal raised spending by 1.02% of GDP, whereas the Obama New New Deal raises spending by 2.45% of GDP.

And the real deficit will only grow with Mr. Obama's massive new budget plans, unless you subscribe to his fantastically optimistic scenario for the return of growth. Kevin Hassett, an economist at the American Enterprise Institute, says that projected borrowing by Uncle Sam over the next ten years has already increased by a gargantuan $5 trillion just since the January 2008 Congressional Budget Office baseline was established.

Why are the numbers spiraling out of control? Aside from all the new spending, tax revenues have dropped off a cliff, as the recession vaporizes corporate profits, corporate hiring and capital gains. We are likely to see a huge decline in revenues, perhaps by 20 to 25% this year.

These numbers are so gargantuan that even Keynes would probably be cringing right now. What's needed is a dose of Friedmanism, says Chris Edwards, budget analyst at the Cato Institute. He reminds me that Milton Friedman concluded that New Deal programs only "hampered recovery from the contraction, prolonged and expanded unemployment, and set the stage for a more intrusive and costly government." Now what we have is the New Deal on steroids.

from the Wall Street Journal, 2009-Mar-21, by Mary Anastasia O'Grady:

Now Is No Time to Give Up on Markets

"What can we do that would be beneficial? [One thing] is lower corporate taxes and businesses taxes and maybe taxes in general. Particularly, you want to lower the tax on capital so you raise the after-tax return to investing and get more investing going on."

Gary Becker, the winner of the 1992 Nobel Prize in Economic Sciences, is in New York to speak to a special meeting of the Mont Pelerin Society on the global meltdown. He has agreed to sit down to chat with me on the subject of his lecture.

Slumped in a soft chair in a noisy hotel coffee lounge, the 78-year-old University of Chicago professor is relaxed and remarkably humble for a guy who has achieved so much. As I pepper him with the economic and financial riddles of our time, I am impressed by how many times his answers, delivered in a pronounced Brooklyn accent, include an "I think" and sometimes even an "I don't know the answer to that." It is a reminder of why he is so highly valued. In contrast to a number of other big-name practitioners of the dismal science, he is a solid empiricist genuinely in search of answers -- not the job as the next chairman of the Federal Reserve. What he sees is what you get.

What Mr. Becker has seen over a career spanning more than five decades is that free markets are good for human progress. And at a time when increasing government intervention in the economy is all the rage, he insists that economic liberals must not withdraw from the debate simply because their cause, for now, appears quixotic.

As a young academic in 1956, Mr. Becker wrote an important paper against conscription. He was discouraged from publishing it because, at the time, the popular view was that the military draft could never be abolished. Of course it was, and looking back, he says, "that taught me a lesson." Today as Washington appears unstoppable in its quest for more power and lovers of liberty are accused of tilting at windmills, he says it is no time to concede.

Mr. Becker sees the finger prints of big government all over today's economic woes. When I ask him about the sources of the mania in housing prices, the first culprit he names is the Fed. Low interest rates, he says, were "partly, maybe mainly, due to the Fed's policy of keeping [its] interest rates very low during 2002-2004." A second reason rates were low was the "high savings rates primarily from Asia and also from the rest of the world."

"People debate the relative importance of the two and I don't think we know exactly," Mr. Becker admits. But what is clear is that "when you have low interest rates, any long-lived assets tend to go up in price because they are based upon returns accruing over many years. When interest rates are low you don't discount these returns very much and you get high asset prices."

On top of that, Mr. Becker says, there were government policies aimed at "extending the scope of homeownership in the United States to low-credit, low-income families." This was done through "the Community Reinvestment Act in the '70s and then Fannie Mae and Freddie Mac later on" and it put many unqualified borrowers into the mix.

The third effect, Mr. Becker says, was the "bubble mentality." By this "I mean that much of the additional lending and borrowing was based on expectations that prices would continue to rise at rates we now recognize, and should have recognized then, were unsustainable."

Could this behavior be considered rational? "There is a lot of debate in economics about whether we can understand bubbles within a rational framework. There are models where you can do it, but it's not easy," he says. What he does seem sure about is that "the lending would not have continued unless there was this expectation that prices would continue to rise and therefore one could refinance these assets through the higher prices." That mentality was at least partly related to Fed action, he says, because the low interest rates "generated an increase in prices and I think that helped generate some of this excess of optimism."

Mr. Becker says that the market-clearing process, so important to recovery, is well underway. "Construction in new residential housing is way down and prices are way down. Maybe 25% down. Lower prices stimulate demand, reduced construction reduces supply."

That's the good news. But he complains about "counterproductive" government policies "designed to lower mortgage rates to stimulate demand." He says he was against the Bush Treasury's idea of capping mortgage rates (which was only floated) and he has "opposed the mortgage plan of President Obama." "It goes against both these adjustments . . . it would hold up prices and increase construction. I think that's a bad idea at this time."

Yet the professor is no laissez-faire ideologue. He says we have to think about what the government can do to "moderate the hit to the real economy," and he says it should start with "the first law of medicine: Do no harm." Instead it has done harmful things, and chief among them has been the "inconsistent policies with the large institutions . . . We let some big banks fail, like Lehman Brothers. We let less-good banks, big [ones] like Bear Stearns, sort of get bailed out and now we bailed out AIG, an insurance company."

Mr. Becker says that he opposed the "implicit protection" that the government gave to Bear Stearns bondholders to the tune of "$30 billion or so." So I wonder if letting Lehman Brothers go belly up was a good idea. "I'm not sure it was a bad idea, aside from the inconsistency." He points out that "the good assets were bought by Nomura and a number of other banks," and he refers to a paper by Stanford economics professor John Taylor showing that the market initially digested the Lehman failure with calm. It was only days later, Mr. Taylor maintains, that the market panicked when it saw more uncertainty from the Treasury. Mr. Becker says Mr. Taylor's work is "not 100% persuasive but it sort of suggest[s] that maybe the Lehman collapse wasn't the cause of the eventual collapse" of the credit markets.

He returns to the perniciousness of Treasury's inconsistency. "I do believe that in a risky environment which is what we are in now, with the market pricing risk very high, to add additional risk is a big problem, and I think this is what we are doing when we don't have consistent policies. We add to the risk."

On the subject of recovery, Mr. Becker repeats his call for lower taxes, applauds the Fed's action to "raise reserves," (meaning money creation, though he said this before the Fed's action a few days ago), and he says "I do believe one has to try to do something more directly to help with the toxic assets of the banks."

How about getting rid of the mark-to-market pricing of bank assets [that is, pricing assets at the current market price] that some say has destroyed bank capital? Mr. Becker says he prefers mark-to-market over "pricing by cost because costs are often completely out of whack with what the real prices are." Then he adds this qualifier: "But when you have a very thin market, you have to be very careful about what it means to mark-to-market. . . . It's a big problem if you literally take mark-to-market in terms of prices continuously based on transactions when there are very few transactions in that market. I am a mark-to-market person but I think you have to do it in a sensible way."

However that issue is resolved in the short run, there will remain the problem of institutions growing so big that a collapse risks taking down the whole system. To deal with the "too big to fail" problem in the long run, Mr. Becker suggests increasing capital requirements for financial institutions, as the size of the institution increases, "so they can't have [so] much leverage." This, he says, "will discourage banks from getting so big" and "that's fine. That's what we want to do."

Mr. Becker is underwhelmed by the stimulus package: "Much of it doesn't have any short-term stimulus. If you raise research and development, I don't see how it's going to short-run stimulate the economy. You don't have excess unemployed labor in the scientific community, in the research community, or in the wind power creation community, or in the health sector. So I don't see that this will stimulate the economy, but it will raise the debt and lead to inefficient spending and a lot of problems."

There is also the more fundamental question of whether one dollar of government spending can produce one and a half dollars of economic output, as the administration claims. Mr. Becker is more than skeptical. "Keynesianism was out of fashion for so long that we stopped investigating variables the Keynesians would look at such as the multiplier, and there is almost no evidence on what the multiplier would be." He thinks that the paper by Christina Romer, chairman of the Council of Economic Advisors, "saying that the multiplier is about one and a half [is] based on very weak, even nonexistent evidence." His guess? "I think it is a lot less than one. It gets higher in recessions and depressions so it's above zero now but significantly below one. I don't have a number, I haven't estimated it, but I think it would be well below one, let me put it that way."

As the interview winds down, I'm thinking more about how people can make pretty crazy decisions with the right incentives from government. Does this explain what seems to be a decreasing amount of personal responsibility in our culture? "When you get a larger government, when you have the government taking over Social Security, government taking over health care and with further proposals now for the government to take over more activities, more entitlements, the rational response is to have less responsibility. You don't have to worry about things and plan on your own as much."

That suggests that there is a risk to the U.S. system with more people relying on entitlements. "Well, they become an interest group," Mr. Becker says. "The more you have dependence on the government, the stronger the interest group of people who want to maintain it. That's one reason why it is so hard to get any major reform in reducing government spending in Scandinavia and it is increasingly so in the United States. The government is spending -- at the federal, state and local level -- a third of GDP, and that share will go up now. The higher it is the more people who are directly or indirectly dependent on the government. I am worried about that. The basic theory of interest-group politics says that they will have more influence and their influence will be to try to maintain this, and it will be hard to go back."

Still, there remain many good reasons to continue the struggle against the current trend, Mr. Becker says. "When the market economy is compared to alternatives, nothing is better at raising productivity, reducing poverty, improving health and integrating the people of the world."

from the New York Times, 2009-Apr-1, by Joseph E. Stiglitz:

Obama's Ersatz Capitalism

THE Obama administration's $500 billion or more proposal to deal with America's ailing banks has been described by some in the financial markets as a win-win-win proposal. Actually, it is a win-win-lose proposal: the banks win, investors win — and taxpayers lose.

Treasury hopes to get us out of the mess by replicating the flawed system that the private sector used to bring the world crashing down, with a proposal marked by overleveraging in the public sector, excessive complexity, poor incentives and a lack of transparency.

Let's take a moment to remember what caused this mess in the first place. Banks got themselves, and our economy, into trouble by overleveraging — that is, using relatively little capital of their own, they borrowed heavily to buy extremely risky real estate assets. In the process, they used overly complex instruments like collateralized debt obligations.

The prospect of high compensation gave managers incentives to be shortsighted and undertake excessive risk, rather than lend money prudently. Banks made all these mistakes without anyone knowing, partly because so much of what they were doing was “off balance sheet” financing.

In theory, the administration's plan is based on letting the market determine the prices of the banks' “toxic assets” — including outstanding house loans and securities based on those loans. The reality, though, is that the market will not be pricing the toxic assets themselves, but options on those assets.

The two have little to do with each other. The government plan in effect involves insuring almost all losses. Since the private investors are spared most losses, then they primarily “value” their potential gains. This is exactly the same as being given an option.

Consider an asset that has a 50-50 chance of being worth either zero or $200 in a year's time. The average “value” of the asset is $100. Ignoring interest, this is what the asset would sell for in a competitive market. It is what the asset is “worth.” Under the plan by Treasury Secretary Timothy Geithner, the government would provide about 92 percent of the money to buy the asset but would stand to receive only 50 percent of any gains, and would absorb almost all of the losses. Some partnership!

Assume that one of the public-private partnerships the Treasury has promised to create is willing to pay $150 for the asset. That's 50 percent more than its true value, and the bank is more than happy to sell. So the private partner puts up $12, and the government supplies the rest — $12 in “equity” plus $126 in the form of a guaranteed loan.

If, in a year's time, it turns out that the true value of the asset is zero, the private partner loses the $12, and the government loses $138. If the true value is $200, the government and the private partner split the $74 that's left over after paying back the $126 loan. In that rosy scenario, the private partner more than triples his $12 investment. But the taxpayer, having risked $138, gains a mere $37.

Even in an imperfect market, one shouldn't confuse the value of an asset with the value of the upside option on that asset.

But Americans are likely to lose even more than these calculations suggest, because of an effect called adverse selection. The banks get to choose the loans and securities that they want to sell. They will want to sell the worst assets, and especially the assets that they think the market overestimates (and thus is willing to pay too much for).

But the market is likely to recognize this, which will drive down the price that it is willing to pay. Only the government's picking up enough of the losses overcomes this “adverse selection” effect. With the government absorbing the losses, the market doesn't care if the banks are “cheating” them by selling their lousiest assets, because the government bears the cost.

The main problem is not a lack of liquidity. If it were, then a far simpler program would work: just provide the funds without loan guarantees. The real issue is that the banks made bad loans in a bubble and were highly leveraged. They have lost their capital, and this capital has to be replaced.

Paying fair market values for the assets will not work. Only by overpaying for the assets will the banks be adequately recapitalized. But overpaying for the assets simply shifts the losses to the government. In other words, the Geithner plan works only if and when the taxpayer loses big time.

Some Americans are afraid that the government might temporarily “nationalize” the banks, but that option would be preferable to the Geithner plan. After all, the F.D.I.C. has taken control of failing banks before, and done it well. It has even nationalized large institutions like Continental Illinois (taken over in 1984, back in private hands a few years later), and Washington Mutual (seized last September, and immediately resold).

What the Obama administration is doing is far worse than nationalization: it is ersatz capitalism, the privatizing of gains and the socializing of losses. It is a “partnership” in which one partner robs the other. And such partnerships — with the private sector in control — have perverse incentives, worse even than the ones that got us into the mess.

So what is the appeal of a proposal like this? Perhaps it's the kind of Rube Goldberg device that Wall Street loves — clever, complex and nontransparent, allowing huge transfers of wealth to the financial markets. It has allowed the administration to avoid going back to Congress to ask for the money needed to fix our banks, and it provided a way to avoid nationalization.

But we are already suffering from a crisis of confidence. When the high costs of the administration's plan become apparent, confidence will be eroded further. At that point the task of recreating a vibrant financial sector, and resuscitating the economy, will be even harder.

Joseph E. Stiglitz, a professor of economics at Columbia who was chairman of the Council of Economic Advisers from 1995 to 1997, was awarded the Nobel prize in economics in 2001.

from the New York Times, 2009-Apr-16, printed 2009-Apr-17, p.A29, by Paul Krugman:

Green Shoots and Glimmers

Ben Bernanke, the Federal Reserve chairman, sees “green shoots.” President Obama sees “glimmers of hope.” And the stock market has been on a tear.

So is it time to sound the all clear? Here are four reasons to be cautious about the economic outlook.

1. Things are still getting worse. Industrial production just hit a 10-year low. Housing starts remain incredibly weak. Foreclosures, which dipped as mortgage companies waited for details of the Obama administration’s housing plans, are surging again.

The most you can say is that there are scattered signs that things are getting worse more slowly — that the economy isn’t plunging quite as fast as it was. And I do mean scattered: the latest edition of the Beige Book, the Fed’s periodic survey of business conditions, reports that “five of the twelve Districts noted a moderation in the pace of decline.” Whoopee.

2. Some of the good news isn’t convincing. The biggest positive news in recent days has come from banks, which have been announcing surprisingly good earnings. But some of those earnings reports look a little ... funny.

Wells Fargo, for example, announced its best quarterly earnings ever. But a bank’s reported earnings aren’t a hard number, like sales; for example, they depend a lot on the amount the bank sets aside to cover expected future losses on its loans. And some analysts expressed considerable doubt about Wells Fargo’s assumptions, as well as other accounting issues.

Meanwhile, Goldman Sachs announced a huge jump in profits from fourth-quarter 2008 to first-quarter 2009. But as analysts quickly noticed, Goldman changed its definition of “quarter” (in response to a change in its legal status), so that — I kid you not — the month of December, which happened to be a bad one for the bank, disappeared from this comparison.

I don’t want to go overboard here. Maybe the banks really have swung from deep losses to hefty profits in record time. But skepticism comes naturally in this age of Madoff.

Oh, and for those expecting the Treasury Department’s “stress tests” to make everything clear: the White House spokesman, Robert Gibbs, says that “you will see in a systematic and coordinated way the transparency of determining and showing to all involved some of the results of these stress tests.” No, I don’t know what that means, either.

3. There may be other shoes yet to drop. Even in the Great Depression, things didn’t head straight down. There was, in particular, a pause in the plunge about a year and a half in — roughly where we are now. But then came a series of bank failures on both sides of the Atlantic, combined with some disastrous policy moves as countries tried to defend the dying gold standard, and the world economy fell off another cliff.

Can this happen again? Well, commercial real estate is coming apart at the seams, credit card losses are surging and nobody knows yet just how bad things will get in Japan or Eastern Europe. We probably won’t repeat the disaster of 1931, but it’s far from certain that the worst is over.

4. Even when it’s over, it won’t be over. The 2001 recession officially lasted only eight months, ending in November of that year. But unemployment kept rising for another year and a half. The same thing happened after the 1990-91 recession. And there’s every reason to believe that it will happen this time too. Don’t be surprised if unemployment keeps rising right through 2010.

Why? “V-shaped” recoveries, in which employment comes roaring back, take place only when there’s a lot of pent-up demand. In 1982, for example, housing was crushed by high interest rates, so when the Fed eased up, home sales surged. That’s not what’s going on this time: today, the economy is depressed, loosely speaking, because we ran up too much debt and built too many shopping malls, and nobody is in the mood for a new burst of spending.

Employment will eventually recover — it always does. But it probably won’t happen fast.

So now that I’ve got everyone depressed, what’s the answer? Persistence.

History shows that one of the great policy dangers, in the face of a severe economic slump, is premature optimism. F.D.R. responded to signs of recovery by cutting the Works Progress Administration in half and raising taxes; the Great Depression promptly returned in full force. Japan slackened its efforts halfway through its lost decade, ensuring another five years of stagnation.

The Obama administration’s economists understand this. They say all the right things about staying the course. But there’s a real risk that all the talk of green shoots and glimmers will breed a dangerous complacency.

So here’s my advice, to the public and policy makers alike: Don’t count your recoveries before they’re hatched.

from the New York Times, 2009-Apr-3, p.A29, web-posted 2009-Apr-2, by David Brooks:

Greed and Stupidity

What happened to the global economy? We seemed to be chugging along, enjoying moderate business cycles and unprecedented global growth. All of a sudden, all hell broke loose.

There are many theories about what happened, but two general narratives seem to be gaining prominence, which we will call the greed narrative and the stupidity narrative. The two overlap, but they lead to different ways of thinking about where we go from here.

The best single encapsulation of the greed narrative is an essay called “The Quiet Coup,” by Simon Johnson in The Atlantic (available online now).

Johnson begins with a trend. Between 1973 and 1985, the U.S. financial sector accounted for about 16 percent of domestic corporate profits. In the 1990s, it ranged from 21 percent to 30 percent. This decade, it soared to 41 percent.

In other words, Wall Street got huge. As it got huge, its prestige grew. Its compensation packages grew. Its political power grew as well. Wall Street and Washington merged as a flow of investment bankers went down to the White House and the Treasury Department.

The result was a string of legislation designed to further enhance the freedom and power of finance. Regulations separating commercial and investment banking were repealed. There were major increases in the amount of leverage allowed to investment banks.

The U.S. economy got finance-heavy and finance-mad, and finally collapsed. When it did, the elites did what all elites do. They took care of their own: “Money was used to recapitalize banks, buying shares in them on terms that were grossly favorable to the banks themselves,” Johnson writes.

In short, he argues, the U.S. financial crisis is a bigger version of the crises that have afflicted emerging-market nations for decades. An oligarchy takes control of the nation. The oligarchs get carried away and build an empire on mountains of debt. The whole thing comes crashing down. Johnson’s remedy is clear. Smash the oligarchy. Nationalize the banks. Sell them off in medium-size pieces. Revise antitrust laws so they can’t get back together. Find ways to limit executive compensation. Permanently reduce the size and power of Wall Street.

The second and, to me, more persuasive theory revolves around ignorance and uncertainty. The primary problem is not the greed of a giant oligarchy. It’s that overconfident bankers didn’t know what they were doing. They thought they had these sophisticated tools to reduce risk. But when big events — like the rise of China — fundamentally altered the world economy, their tools were worse than useless.

Many writers have described elements of this intellectual hubris. Amar Bhidé has described the fallacy of diversification. Bankers thought that if they bundled slices of many assets into giant packages then they didn’t have to perform due diligence on each one. In Wired, Felix Salmon described the false lure of the Gaussian copula function, the formula that gave finance whizzes the illusion that they could accurately calculate risks. Benoit Mandelbrot and Nassim Taleb have explained why extreme events are much more likely to disrupt financial markets than most bankers understood.

To me, the most interesting factor is the way instant communications lead to unconscious conformity. You’d think that with thousands of ideas flowing at light speed around the world, you’d get a diversity of viewpoints and expectations that would balance one another out. Instead, global communications seem to have led people in the financial subculture to adopt homogenous viewpoints. They made the same one-way bets at the same time.

Jerry Z. Muller wrote an indispensable version of the stupidity narrative in an essay called “Our Epistemological Depression” in The American magazine. What’s new about this crisis, he writes, is the central role of “opacity and pseudo-objectivity.” Banks got too big to manage. Instruments got too complex to understand. Too many people were good at math but ignorant of history.

The greed narrative leads to the conclusion that government should aggressively restructure the financial sector. The stupidity narrative is suspicious of that sort of radicalism. We’d just be trading the hubris of Wall Street for the hubris of Washington. The stupidity narrative suggests we should preserve the essential market structures, but make them more transparent, straightforward and comprehensible. Instead of rushing off to nationalize the banks, we should nurture and recapitalize what’s left of functioning markets.

Both schools agree on one thing, however. Both believe that banks are too big. Both narratives suggest we should return to the day when banks were focused institutions — when savings banks, insurance companies, brokerages and investment banks lived separate lives.

We can agree on that reform. Still, one has to choose a guiding theory. To my mind, we didn’t get into this crisis because inbred oligarchs grabbed power. We got into it because arrogant traders around the world were playing a high-stakes game they didn’t understand.

from the Wall Street Journal, 2009-Mar-30, by L. Gordon Crovitz:

Transparency Is More Powerful Than Regulation
FDR sided with advisers who argued for disclosure.

In 1933, newly elected president Franklin D. Roosevelt had to make a tough choice in dealing with the aftermath of the stock-market crash that wiped out much of the equity in American companies. Leading members of FDR's brain trust wanted federal regulators to get the power to make key decisions over markets, such as which companies deserved to be publicly traded. Today, many of President Barack Obama's advisers want unprecedented authority to oversee details of the credit markets, and how banks lend.

FDR decided instead to side with advisers who argued for disclosure as the key operating principle of our markets. Helping markets function better, they reasoned, was a sounder safeguard than trusting regulators to decide.

Supreme Court Justice Louis Brandeis had made the point that "sunlight is the best disinfectant," and the Securities Act of 1933 mandated the information that public companies would have to share. One indicator that disclosure was more important than regulatory power is that it wasn't until the following year that the Securities and Exchange Commission (SEC) was created.

What worked to restore confidence in the equity markets then can help to restore confidence in the debt markets now: more disclosure, aimed at making the terms of debt such as mortgages more transparent. Unlike the case of stocks, under current law no one in the chain of making, insuring and rating debt is required to disclose full terms to regulators or to the market. Instead, debt markets function based on best estimates, with mathematical models determining probabilities of cash flows and defaults.

Ever since the models failed due to an unpredicted bubble, the market has been paralyzed with uncertainty. There is still a wide gap between what banks think their bad debt might be worth and what the Treasury or private investors are willing to pay.

It didn't get much attention, but earlier this month Congress got a lesson on the potential of better disclosure. "Today's financial crisis was driven in part by a lack of accurate, easily usable information to give investors what they need to make informed, responsible decisions," testified Mark Bolgiano, chief executive of a nonprofit technology and accounting consortium called XBRL US. "The value of toxic asset-backed securities remains a mystery because information on the underlying loans and ongoing viability of those loans and the securities themselves was not collected consistently and even if it had been, it would not have been in a usable, portable form."

XBRL sounds complicated, but eXtensible Business Reporting Language is simply a new technology language that allows data to be easily extracted, searched and analyzed. XBRL is already being used for some equity disclosures, tagging financial information into a globally consistent, computer-readable format.

Philip Moyer, who runs the Edgar Online service that distributes SEC data, studied more than 500 mortgage-backed securities priced between 2006 and mid-2008. He found there were only 600 relevant data points needed to assess the risk of a mortgage, which is many fewer than the tens of thousands of factors used to report on stocks. "This crisis has proven that lack of transparency ultimately destroys a market," Mr. Moyers said.

The good news is that with the innovation of XBRL, tracking debt instruments is no longer a technological challenge. Instead, it's a political challenge.

Regulators would need to define new disclosures robust enough that data can be collected and compared, even as credit instruments continue to be rolled into complex securities and their derivatives. Other factors would include tracking the institutions holding various positions and how much leverage is involved. Put another way: If bar codes can track down bad peanuts on store shelves, shouldn't we be able to use technology to track details of mortgages and other debt instruments?

Paul Wilkinson, a lawyer who worked with former SEC Chairman Chris Cox to support the development of XBRL, has set the goal of making debt markets as regularized as titling property or registering shares. "Thanks to XBRL, there is a means to achieve the goal of moving from pseudocapitalism based on speculation to real capitalism based on facts, and a world where willing buyers and sellers can make markets based on those facts," he said.

This is an encouraging vision during these anxious times. But even with the country's long tradition of relying on disclosure, the discussion in Washington has focused almost exclusively on new powers for regulatory agencies.

FDR was no Milton Friedman, and neither was Brandeis, but they grasped what we seem to be forgetting, which is that markets are too complex for even the most powerful regulators to dictate. Better transparency is the surest way to make markets more efficient and less volatile. Market wisdom results when more people access better information.

The global credit crisis was made possible by real-time markets powered by new technologies that enabled massive global trading and the creation of opaque securities. It would be fitting now to use another new technology, in the form of XBRL, to make the credit markets simpler, more transparent and better insulated against bubbles.

from MarketWatch.com, 2009-Mar-10, by Laura Mandaro:

U.S. sovereign-credit spreads rise sevenfold in year
Risk gauge outpaces measure of corporate-credit risk as U.S. bails out banks

SAN FRANCISCO -- The cost of buying protection against the risk that the United States will default on its mounting debt has surged in the past months, outpacing the rise in corporate-credit costs, now that the government has absorbed more private-sector debt.

The spreads on credit-default swaps for U.S. government debt jumped to 97 basis points Tuesday, nearly seven times higher than a year ago and 60% higher than the end of last year, to a level roughly in line with those of France, according to data supplied by Markit. The spreads also hit a record last week.

In contrast, an index that tracks the cost of buying credit protection against defaults on North American companies with investment-grade ratings -- the Markit CDX.NA.IG index -- has not even doubled in the past year. The index, which includes CDS on blue-chip companies like Altria Group and Bristol-Meyers Squibb Co., has risen 30% this year.

Higher spreads on credit-defaults swaps indicate sellers have raised the price of guaranteeing protection because they perceive the likelihood of a default as higher. A spread of 97 means it would cost about $97,000 to buy protection on $10 million in U.S. government debt.

The rise in U.S. sovereign CDS spreads reflects the increasingly active role the United States has played in debt markets, according to Bank of America Securities analysts. In the past year, it's absorbed the toxic assets that led to Bear Stearns' collapse; taken mortgage-backed and asset-backed securities as collateral for loans; and bought commercial paper and agency debt, among other moves.

"Having effectively guaranteed the short-term markets, that risks shifts to the government," wrote Bank of America Securities-Merrill Lynch analysts led by Jeffrey Rosenberg, in a note issued early Tuesday.

Record highs not a good sign

The rising costs to buy credit protection undermine hopes that credit markets are improving -- a turnaround that could set up the U.S. economy and stock market for revival.

Such costs also reflect an increase in money spent buying the type of complicated derivatives that sent American International Group Inc., a seller of credit-default swaps, to ask for several rounds of bailout money last year -- one of the series of shockwaves that have hit the financial system.

The chance that a seller of CDS won't be able to make good on its commitment to cover an underlying entity's debt default, or what's known as counterparty risk, prompted "Black Swan" author and investor Nassim Taleb to describe CDS purchases as tantamount to buying insurance on the Titanic from someone on the Titanic.

Other gauges that track costs of credit protection also have been rising lately.

An index that tracks the costs of credit protection of 14 leading banks and brokerages -- including Bank of America Corp., Citigroup Inc., Goldman Sachs Group and J.P. Morgan Chase & Co. -- hit a record high Monday, according to index publisher Credit Derivatives Research.

Spreads on U.S. sovereign CDS hit a record 100 basis points last week, Markit said.

Records aren't tough to come by in this relatively new market, though. Markit's vice president in credit research, Gavan Nolan, estimates that U.S. sovereign credit-default swaps have been trading with significant volume only in the past year and a half.

Over the past year, U.S. and European central banks have taken unprecedented steps to prop up the financial system.

The U.K. government has nationalized or bought large stakes in struggling lenders Northern Rock, Royal Bank of Scotland and Lloyds Banking Group, and is buying government bonds to drive down rates.

Last month, the U.K. Office for National Statistics said the government injections into Lloyds and RBS would drive up the public sector's debt to as much as 1.5 trillion pounds -- or 100% of gross domestic product.

The United Kingdom's CDS spreads have vaulted to about 160 basis points, up 50% from the start of the year. That ranks the cost of buying credit protection on U.K. government debt as the second highest among G7 countries, behind Italy.

Federal Reserve Chairman Ben Bernanke on Tuesday reiterated the central bank's commitment to taking a heavy role in the banking system, saying major financial institutions would not be allowed to fail given the fragile state of financial markets.

"By effectively transferring the risks underlying the credit crisis to governments, sovereign risk becomes the focal point for credit uncertainty," the Bank of America analysts concluded. "On the road to recovery, now paved with sovereign risk."

from the Washington Post, 2009-Mar-18, by Neil Irwin:

Federal Reserve to Buy $1.2T in Bonds, Mortgage-Backed Securities

The Federal Reserve said today that it will deploy an additional $1.2 trillion to try to lower interest rates and stimulate the economy, an aggressive move aimed at containing the recession.

The central bank will increase its purchases of mortgage-backed securities by $750 billion, on top of a previously announced $500 billion. It also will double its purchases of debt in Fannie Mae and Freddie Mac to $200 billion. Those steps are intended to lower mortgage rates. The announcement of the previous purchases pushed mortgage rates down a full percentage point.

The Fed also said it will buy $300 billion in long-term Treasury bonds, a step it had previously considered but had been reluctant to act on. That move will lower long-term interest rates for the U.S. government directly and, Fed officials hope, will indirectly lower borrowing costs for businesses and individuals.

Following today's announcement, Treasury bond prices spiked and yields on those bonds declined, as traders anticipated the Fed bond purchases. At 2:30 p.m., 15 minutes after the announcement, the yield on 10-year Treasury bonds had fallen half a percentage point, to 2.53 percent.

The stock market also rose steeply, with the Standard & Poor's 500-stock index up 2.2 percent at 2:30 p.m.

Since the last meeting of the Fed's policymaking arm, "job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending," the Federal Open Market Committee said in a statement. "Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment."

"In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability," the statement said.

Since cutting the interest rate it controls to essentially zero in December, the Fed has had to find other tools to try to combat a rapidly deepening recession. At its policymaking meeting that concluded today, the central bank left that rate at a range of zero to 0.25 percent.

The vote was unanimous, in contrast to the FOMC's previous meeting, at which one official dissented.

from MarketWatch.com, 2009-Mar-18, by Moming Zhou in New York and Laura Mandaro in San Francisco:

Gold rallies as dollar tumbles after Fed's decision

NEW YORK -- Gold futures rallied more than 6% in electronic trading Wednesday, as the dollar tumbled after the Federal Reserve surprised investors and said it will buy long-term Treasurys, raising gold's appeal as an investment alternative.

By buying Treasurys, the Fed is essentially creating more money to buy national debt, which weighs on the dollar. The rally in gold came after the metal lost 3% to end at a two-month low in floor trading, which ended before the Fed's announcement.

Gold for April delivery rose $57, or 6.4%, to $946.10 an ounce in late afternoon North American trading. It ended floor trading at $889.10 an ounce, the lowest closing level for the contract since Jan. 22

By Wednesday's close, gold had lost 4.4% this week, and was more than $110 lower than its recent high above $1,000, hit on Feb. 20.

Gold rallied after the Fed decision "as dollar slid," said George Gero, a precious metals trader for RBC Capital Markets' global futures division. "Once again looked like sell-off [earlier in the session] is a buying opportunity."

At the end of a two-day meeting in mid-afternoon, the Fed said it was committed to buying $300 billion in longer-term Treasurys to help the struggling American economy recover. The central bank also tweaked its other credit-easing programs by committing to buy more mortgage-backed securities and agency debt and include more asset-backed securities under a new credit facility starting this week.

The dollar plunged after the decision, with the dollar index, which gauges the value of the greenback against its major rivals, down nearly 3% to 84.616. A weakening greenback tends to push up dollar-denominated gold prices.

In equity trading, financial stocks jumped, and all three major U.S. indexes were higher after the Fed's announcement.

The Financial Select SPDR Fund, an exchange-traded fund that tracks the financial stocks in the S&P 500, rose 3%. Citigroup shares rallied 22% to more than $3 a share; its shares had fallen below $1 earlier this month.

The gains in financials had lured investors away from gold earlier.

"We've got short covering in financials, and there may be some liquidation in gold from that," said Michael Berry, a former Heartland Advisors portfolio manager and finance professor at the University of Virginia who publishes commentary on resources and other stocks.

Investors who short a stock bet that its price will fall by borrowing it and then selling it. If the price has fallen when it comes time to replace those borrowed shares, they make a profit. If the price rises, as it has recently with financial stocks this month, they "cover" their positions by buying shares.

In economic news, U.S. consumer prices moved up for a second straight month, but stayed moderate compared to year-ago levels.

With energy prices rising at their fastest rate in seven months, the consumer price index increased a seasonally adjusted 0.4% in February from the prior month, the Labor Department reported Wednesday. In the past year, CPI has edged up just 0.2%.

In other gold news, holdings in the SPDR Gold Shares, the biggest gold ETF, stood at a record high of 1,069.05 tons Tuesday, unchanged from a day ago, according to the latest data from the fund.

Other metals also rose after the Fed's decision. Silver for May delivery gained 5.5% to $12.595 an ounce, while April platinum rose 1.2% $1,054.90 an ounce. The June contract for palladium added 1.2% to $197.05 an ounce. Meanwhile, May copper reversed to tick 1.7% higher to $1.7455 a pound.

from Reuters via the Financial Post of Canada, 2009-Apr-24, by Alfred Cang and Tom Miles:

China admits to building up stockpile of gold

SHANGHAI/BEIJING - China revealed on Friday that it had secretly raised its gold reserves by three-quarters since 2003, increasing its holdings to 1,054 tonnes - or a pot worth about US$30.9-billion - and confirming years of speculation it had been buying.

Hu Xiaolian, head of the State Administration of Foreign Exchange, told Xinhua news agency in an interview that the country's reserves had risen by 454 tonnes from 600 tonnes since 2003, when China last adjusted its state gold reserves figure.

The confirmation of its surreptitious stockpiling is likely to fuel market talk about Beijing's ability to buy secretly and its ambitions for spending its nearly US$2-trillion pile of savings. And not just in gold: copper and other metals markets are booming thanks to China's barely-visible hand.

Speculation has gathered speed over the last year, since the tumbling dollar has threatened to weaken China's buying power - and give it yet more reason to diversify into gold, oil and metals.

Gold prices jumped on the news of Chinese buying and were up more than 1% on the day at US$912.05 an ounce at 0715 GMT. By a Reuters calculation, China's holding of gold would be worth around US$30.9-billion at current prices.

That accounts for only about 1.6% of China's total foreign exchange holdings and is little more than one-tenth of the value of the U.S. gold reserve, the world's biggest. It also means gold has slipped as a share of China's total reserves from about 2%, based on end-2003 prices.

Only six countries hold more than 1,000 tonnes, and China is ranked fifth, having leap-frogged Switzerland, Japan and the Netherlands with its announcement.

However, the International Monetary Fund and the SPDR Gold Trust exchange traded fund are even bigger, leaving China with the world's seventh-biggest pot of gold.

Several gold market participants said they thought China had bought on the international market, helping to absorb hundreds of tonnes sold off by central banks and the International Monetary Fund in recent years.

"China has been buying via government channels from South Africa, Russia and South America," said Ellison Chu, director of precious metals at Standard Bank in Hong Kong.

But Hu said the increase in China's stocks was achieved by buying on the domestic market and from domestic producers.

China is the world's largest gold producer and does not permit exports of gold ingots, only jewellery, leaving plentiful supplies for the domestic market.

China produced 282 tonnes of gold last year, meaning the state bought around one quarter of domestic production, assuming 454 tonnes increase in state purchases were spread out over the six years since China last reported a change in its holdings.

Despite the rumours, buying by the state was partially obscured by soaring demand for gold as an investment, especially after the bursting of the Shanghai stock market bubble last year.

Investment demand in China rose to 68.9 tonnes from 25.6 tonnes in 2007. But that was still less than one third of retail demand in India, where total bullion consumption topped 660 tonnes last year.

Hu said China recently reported the change in its gold holdings to the International Monetary Fund and would include the latest change in central bank reports and balance of payment statistics.

She did not say when China notified the IMF.

Although gold rose after Hu's comments were published, the price move was not a huge one for the highly liquid market. Prices had jumped by US$13 in the space of an hour on Thursday.

Gold market participants said the news signalled likely further buying by China.

"The comments indicate that China will buy more gold as reserve to improve its foreign reserve portfolio. This is a trend," said Yao Haiqiao, president of Longgold Asset Management.

Hou Huimin, vice general secretary of the China Gold Association, said China should build its reserves to 5,000 tonnes.

"It's not a matter of a few hundred, or 1,000 tonnes. China should hold more because of its new international status, and because of the financial crisis," he said.

"The financial crisis means the U.S. dollar value is changing fast, and it may retreat from being the international reserve currency. If that happens, whoever holds gold will be at an advantage."

The European Central Bank recommends its member banks hold 15% of their reserves in gold, but among Asian nations the percentage is far smaller, said Albert Cheng, World Gold Council managing director for the far east.

from the Washington Post, 2009-Mar-20, by Lori Montgomery:

U.S. Federal Deficit Soars Past Previous Estimates

Deteriorating economic conditions will cause the federal deficit to soar past $1.8 trillion this year and leave the nation wallowing in a sea of red ink far deeper than the White House had previously estimated, congressional budget analysts said today.

In a new report that provides the first independent analysis of President Obama's budget request, the nonpartisan Congressional Budget Office predicted that the administration's agenda would generate deficits averaging nearly $1 trillion a year over the next decade -- $2.3 trillion more than the president predicted when he unveiled his spending plan just one month ago.

And although Obama would come close to meeting his goal of cutting the deficit in half by the end of his first term, the CBO predicts that the nation's annual operating deficit would never drop below 4 percent of the overall economy over the next decade, a level administration officials have said is unsustainable because the national debt would grow too rapidly.

By the CBO's estimate, for example, the nation's debt would grow to 82 percent of the overall economy by 2019 under Obama's policies, compared with a pre-recession average of 40 percent.

The new report could complicate efforts to win congressional approval for Obama's $3.6 trillion budget request for the fiscal year that begins Oct. 1. Democrats in the House and Senate are currently putting the finishing touches on their versions of Obama's spending plan, which calls for an expensive expansion of health coverage for the uninsured and new spending on education programs, as well as a first-time tax on greenhouse gas emissions.

Democrats hope to approve the measure before the Easter recess.

Senate Budget Committee Chairman Kent Conrad (D-N.D.) has said the gloomier CBO forecast would require "adjustments" to Obama's budget, though he declined to specify what changes would be necessary. To reduce the deficits, Democrats could dial back Obama's spending plans or find new sources of revenue.

After meeting with Obama at the White House this week, Conrad said the president "understands the legislative process" and that "it's going to require everyone to make adjustments."

But other Democrats are not necessarily ready to follow Conrad's lead. At her weekly news conference on Thursday, House Speaker Nancy Pelosi dismissed the expectation of bad news from CBO, the official budget scorekeeper for Capitol Hill, saying differences between that agency and the White House budget office are "not unusual."

"Our priorities are the same," Pelosi said. "This budget is a statement of our values and our investments in education, health care and the health of America. That includes prevention as well as care, and the energy initiatives as well as tax relief for 95 percent of the American people, as well as an approach that takes the deficit down. Those are the priorities of the budget."

White House budget director Peter Orszag made the same point after speaking with reporters on Tuesday.

"There are always some adjustments," Orszag said of the legislative budget process. "But those four pillars" -- health care, education, clean energy and deficit reduction -- "will be represented."

from Reuters, 2009-Apr-6, by Lisa Richwine, with editing by Jackie Frank:

Estimated U.S. taxpayer cost for bailout jumps

WASHINGTON - U.S. congressional budget analysts have raised their estimate of the net cost to taxpayers for the government's financial rescue program to $356 billion, an increase of $167 billion from earlier estimates.

The Congressional Budget Office had originally projected the $700 billion Troubled Asset Relief Program would cost taxpayers $189 billion.

The additional cost, which applies to TARP spending for fiscal years 2009 and 2010, was included in the CBO's March projection of a $1.8 trillion deficit for fiscal 2009, which ends September 30.

The TARP cost projection was raised due to changes in financial market conditions, new transactions and a shift in expected timing of payments, the CBO said.

The Treasury Department announced plans to use some of the money to help avoid home foreclosures and made new deals with Bank of America and American International Group. Those programs involved higher subsidy rates than previously estimated, the report said.

Congress passed the Wall Street bailout program in October with the goal of stabilizing banks and reassuring jittery markets.

from the Wall Street Journal, 2009-Mar-20:

Secretary of the Fed

In case there was any residual doubt, the Bernanke Fed threw itself all in this week to unlock financial markets and spur the economy. With its announced plan to make a mammoth purchase of Treasury securities, the Fed essentially said that the considerable risks of future inflation and permanent damage to the Fed's political independence are details that can be put off, or cleaned up, at a later date. Whatever else people will say about his chairmanship, Ben Bernanke does not want deflation or Depression on his resume.

It's important to understand the historic nature of what the Fed is doing. In buying $300 billion worth of long-end Treasurys, it is directly monetizing U.S. government debt. This is what the Federal Reserve did during World War II to finance U.S. government borrowing, before the Fed broke the pattern in a very public spat with the Truman Administration during the Korean War. Now the Bernanke Fed is once again making itself a debt agent of the Treasury, using its balance sheet to finance Congressional spending.

It is also monetizing U.S. debt indirectly with the huge expansion of its direct purchase program of mortgage-backed securities (MBS). It was $500 billion, and now it will add $750 billion more "this year." Foreign governments have been getting out of Fannie and Freddie MBSs in recent months and going into Treasurys. Thus the Fed is essentially substituting as these foreign governments finance U.S. debt by buying presumably safer Treasurys.

The purpose of these actions is to keep rates low on both Treasurys and MBSs, and to keep the cost of funds low for banks and especially for home buyers. It worked on Tuesday; long bond and mortgage rates fell.

The case for doing all this is that the Fed needs to supply dollars at a time when money velocity is low and the world demand for dollars is high amid the global recession. As long as the world keeps demanding dollars, the Fed can get away with this extraordinary credit creation. That said, bear in mind that the Fed's balance sheet has more than doubled since September -- to $1.9 trillion from $900 billion. These latest commitments mean it may more than double again, close to $4 trillion. That would be about 30% of GDP, up from about 7%.

The market reaction clearly showed the implied risks, with gold leaping and the dollar taking a dive the past two days. As the economy improves, and thus as the velocity of money increases, the risk of inflation will soar. Mr. Bernanke says the Fed can remove the money fast, but central bankers always say that and rarely do. The Fed statement isn't reassuring on that point. It says, "the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term." The Fed seems to be saying it wants a little inflation, which we know from history can easily become a big inflation or another asset bubble. The last time the Fed cut rates to very low levels to fight "deflation," we ended up with the housing bubble and mortgage mania.

The other great, and less appreciated, danger is political. The Bernanke Fed has now dropped even the pretense of independence and has made itself an agent of the Treasury, which means of politicians. With its many new credit facilities -- the TALF and the others -- it is making credit allocation decisions across the economy. If a business borrower qualifies for one of these facilities, it gets cheaper money. If it doesn't, it's out of luck. Thus the scramble by so many nonbanks to become bank holding companies, so they can tap the Fed's well of cheap credit.

The question is how the Fed will withdraw from all of this unchartered territory now that it has moved into it. How will it wean companies off easy credit, especially since some companies may need it to survive? What happens when Members of Congress lobby the Fed to keep credit loose for auto loans to help Detroit, or credit cards to help Amex? House Speaker Pelosi yesterday gave a taste, saying the AIG bailout was the Fed's idea "without any prior notification to us." Mr. Bernanke, meet your new partners.

Above all, the Treasury and Congress won't be happy if the Fed decides to stop buying Treasurys and the result is a big increase in government borrowing costs. This was the source of the dispute between the Federal Reserve and the Truman Treasury. The Fed wanted to raise rates amid rising inflation, while the Truman Treasury wanted cheap financing for Korea and its domestic priorities. The Fed prevailed in the famous "Accord" of 1951, thanks to a young assistant secretary of the Treasury named William McChesney Martin. He would go on to become Fed Chairman and create the modern era of Fed independence. The U.S. and the Fed are going to need another Martin, sooner rather than later.

from the Wall Street Journal, 2009-Mar-18:

Mr. Wen's Debt Bomb

Chinese Premier Wen Jiabao created a useful stir late last week when he said he's a "little bit worried" about the safety of U.S. assets -- meaning the Treasury bonds his government owns. Whatever Mr. Wen's political motives, his concerns about the integrity of U.S. sovereign debt are timely and apt.

U.S. debt held by the public has now hit $6.6 trillion -- up from $5.3 trillion only a year ago. That doesn't count another $5.3 trillion in Fannie Mae and Freddie Mac liabilities that we now know also have a taxpayer guarantee. And it doesn't count the many ways that both the Federal Reserve and Treasury have guaranteed financial assets more broadly -- such as $29 billion in Bear Stearns paper, $301 billion in dodgy Citigroup assets, and hundreds of billions in Federal Housing Administration loans.

President Obama's stimulus plan and new budget will require an additional $3 trillion to $4 trillion in new borrowing over the next two or three years, and that's if the economy recovers smartly. Adding it all up, Federal Reserve Chairman Ben Bernanke last week estimated that U.S. public debt-to-GDP would reach 60% over the next few years, up from 40% before the financial panic hit -- and the highest level since the aftermath of World War II. He must be an optimist. As the nearby chart shows, Mr. Obama's budget anticipates a decade of outlays far above postwar spending and revenue averages. And even that assumes, implausibly, that most "stimulus" spending will be temporary.

That's a lot of T-bills to flog, and the world is taking note. Our colleagues at MarketWatch reported last week that the cost to buy insurance against U.S. sovereign debt default has surged in the past year. The spreads on credit default swaps for U.S. government debt hit 97 basis points last week -- or $97,000 to buy insurance on $10 million in debt -- nearly seven times higher than a year ago and 60% higher than the end of 2008.

Mr. Wen called on the U.S. to "maintain its credibility, honor its commitments and guarantee the safety of Chinese assets." Little wonder: China, like other trading nations, has a big stake in this fiscal free-for-all. Although it doesn't release detailed data, roughly two-thirds of Beijing's $1.9 trillion foreign-exchange reserves are likely parked in U.S. Treasury debt.

The Obama Administration revealed its sensitivity on the issue by responding quickly, with Presidential spokesman Robert Gibbs saying Friday "there's no safer investment in the world than in the United States." Mr. Obama added Saturday that "not just the Chinese government, but every investor can have absolute confidence in the soundness of investments in the United States."

The White House is almost certainly right that the U.S. won't default; the consequences would be too dire. But there are risks well short of formal debt repudiation. As the supply of U.S. debt increases, investors may demand a higher yield and interest rates would rise, reducing the tradable value of current Treasury bonds. The other temptation will be to inflate away the debt, which would also devalue dollar-denominated assets.

What Mr. Wen is really saying is that even the U.S. national balance sheet has limits. The dollar is the world's reserve currency, so the U.S. has the rare privilege among nations of being able to borrow (and then repay its debts) in its own currency. America also remains the world's main safe haven in a crisis, as the flight to the dollar and T-bills in recent months underscores.

But reserve currency status isn't a birthright and it can vanish when nations are irresponsible. Deficits are sometimes necessary to finance tax cuts and investments that promote economic growth. The tragedy of Mr. Obama's $787 billion stimulus and $410 billion 2009 budget is that they spend principally on transfer payments that have little growth payback. The U.S. received another foreign rebuke on this score this weekend, when German Chancellor Angela Merkel and other Europeans rejected Mr. Obama's calls for a comparable spending binge on the Continent.

Mr. Wen may have been trying to placate his domestic Chinese audience, which is suffering through its own economic slowdown. Or perhaps he was trying to repay Treasury Secretary Timothy Geithner for his nomination-hearing comments on Chinese currency "manipulation." Mr. Wen doesn't have much room to lecture the U.S., having done too little in his nearly six years in office to liberalize the Chinese economy.

But the Chinese Premier is right to warn the U.S. political class that the global demand for American debt will continue only if the U.S. runs economic policies that make U.S.-dollar assets worth the risk.

from the Wall Street Journal, 2009-Mar-17, by Peter J. Wallison:

Congress Is the Real Systemic Risk

After their experience with Fannie Mae and Freddie Mac, you'd think that Congress would no longer be interested in creating companies seen by the market as backed by the government. Yet that is exactly what the relevant congressional committees -- the Senate Banking Committee and the House Financial Services Committee -- are now considering.

In the wake of the financial crisis, the idea rapidly gaining strength in Washington is to create a systemic risk regulator. The principal sponsor of the plan is Barney Frank, the chair of the House Financial Services Committee. A recent report by the Group of Thirty (a private sector organization of financial regulation specialists), written by a subcommittee headed by Paul Volcker, also endorsed the idea, as has the U.S. Chamber of Commerce and the Securities Industry Financial Markets Association.

If implemented, this would give the government the authority to designate and supervise "systemically significant" companies. Presumably, systemically significant companies would be those that are so large, or involved in financial activities of such importance, that their failure would create systemic risk.

There are several serious problems with this plan, beginning with the fact that no one can define a systemic risk or its causes. The Congressional Oversight Panel, which was established to advise Congress on the use of the TARP funds, concluded -- with two Republicans dissenting -- that the current crisis is an example of a systemic risk evolving into a true systemic event. After all, virtually all the world's major financial institutions are seriously weakened, and many have either failed or been rescued. If this is not an example of a systemic risk, what is?

The current financial crisis is certainly systemic. But what caused it? The failure of Lehman Brothers occurred long after the market for mortgage-backed securities (MBS) had shut down, and six months after Bear Stearns had to be rescued because of its losses. In other words, the crisis did not arise from the failure of a particular systemically significant institution. The world's major financial institutions had already been weakened by the realization that losses on trillions of dollars in MBS were going to be much greater than anyone had imagined, and before the major asset write-downs had begun. So if this was a systemic event, it was not caused by the failure of one or more major institutions. In fact, it was the other way around: The weakness or failure of financial institutions was the result of an external event (losses on trillions of dollars of subprime mortgages embedded in MBS).

If this is true, what is the value of regulating systemically significant financial institutions? Financial failures, it seems, can be the result, rather than the cause, of systemic events like the one we are now experiencing. Even if we assume that regulating systemically significant companies will somehow prevent them from failing -- a doubtful proposition, given that the heavily regulated banks have been the most severely affected by the current crisis -- we will not have prevented the collapse of a major oil-supplying country, an earthquake or a pandemic from causing a similar problem in the future. All we will have done is given some government agency more power and imposed more costs on financial institutions and consumers.

But increased government power and higher costs are not the worst elements of the proposal to designate and supervise systemically significant companies. The worst result is that we will create an unlimited number of financial institutions that, like Fannie Mae and Freddie Mac, will be seen in the financial markets as backed by the government. This will be especially true if, as Mr. Frank has recommended, the Federal Reserve is given supervisory authority over these institutions. The Fed already has the power -- without a vote of Congress -- to provide financing under "exigent circumstances" to any company, and will no doubt be able to do so for the institutions it supervises.

A company that is designated as systemically significant will inevitably come to be viewed as having government backing. After all, the designation occurs because some government agency believes that the failure of a particular institution will have a highly adverse effect on the rest of the financial system. Accordingly, designation as a systemically significant company will in effect be a government declaration that that company is too big to fail. The market will understand -- as it did with Fannie and Freddie -- that loans to such a company will involve less risk than loans to its competitors. Counterparties and customers will believe that transactions with the company will generally be more secure than transactions with other firms that aren't similarly protected from failure.

As a consequence, the effect on competition will be profound. Financial institutions that are not large enough to be designated as systemically significant will gradually lose out in the marketplace to the larger companies that are perceived to have government backing, just as Fannie and Freddie were able to drive banks and others from the secondary market for prime middle-class mortgages. A small group of government-backed financial institutions will thus come to dominate all sectors of finance in the U.S. And when that happens they shall be called by a special name: winners.

Mr. Wallison is a fellow at the American Enterprise Institute.

from the Wall Street Journal, 2009-Mar-24, by Vincent Reinhart:

Why Congress Will Kill the Bank Rescue
What happens when the hedge funds make profits?

Americans can be forgiven for experiencing a sense of deja vu as they digest the details of Treasury Secretary Timothy Geithner's Public-Private Investment Program (PPIP) for troubled bank assets. What was rolled out on the pages of newspapers this week read like press releases on the various plans over the past year from Mr. Geithner's predecessor, Hank Paulson.

The two Treasury secretaries share a touching faith in public-private cooperation to lift the value of troubled assets. This assumes, of course, that those assets are troubled because their true values are obscured by irrational self-doubt and market illiquidity, and not by fundamental problems in the prospects of repayment. It also assumes that the solution to problems created by excessive leverage is for government to encourage more leverage.

Notably absent in the Geithner plan is any progress on the barrier at which Mr. Paulson stumbled last year: What are the right prices for troubled assets? To believe that the solution lies in harnessing the public and private sectors in tandem shows a misunderstanding of these sectors' incentives.

Public officials want this problem to go away without being stuck with the smoldering wreckage of large and complicated financial institutions. That requires buying assets quickly from problematic firms at the highest prices possible.

Private investors want to make a profit. That can best be achieved by delaying purchases, thereby lowering prices and sticking the government with as much of the loss as possible.

The possibility of outsized profit, made possible by government guarantees and matching capital contributions, is the carrot government can offer to those with private capital willing to commit to the enterprise. The problem is that Congress has been demonizing the financial sector and considering ex post expropriation of bonuses.

For the PPIP to work, the government will have to use the expertise of much-vilified financial professionals, create massive expected profit opportunities to entice capital, and tap places where there are deep pools of money -- including sovereign wealth funds. If the PPIP is successful, is there any chance that Congress would not be holding hearings complaining about the massive rewards to those who took on the risk? Unless members of Congress cool the heat of their rhetoric, the potential profits Mr. Geithner is putting on the table will simply be left there.

When the government's carrot does not work, next will come the stick. Remember, 19 of the largest financial firms have been asked to submit to stress tests detailing the adequacy of their capital.

Talk about irony. Financial markets are in disarray today because leading firms chose to bury complicated instruments in their books. The results were opaque balance sheets that hid the considerable use of leverage, and proved misleading both to investors and examiners. These same firms are now being required by regulators to use these misshapen accounts to make far-ahead predictions.

But the objective of the stress test is not to get useful forecasts. Rather, it will provide the excuse for regulators, outside the usual process of examination and resolution, to open a discussion with major firms about the adequacy of their capital.

A dialogue, once started, can then proceed to capital infusions, forced mergers and other forms of balance-sheet relief. This will all be with an eye to creating strong incentives for bank managers to attract private capital. If necessary, the stress tests can be used to force fire sales that will attract private capital through the PPIP.

So the government, once again, has opted for a circuitous route to the goal of sorting out financial firms. This will take longer than necessary and sacrifice clarity. But obfuscation was probably a design principle. As yet, the American public does not appear ready to admit that its government will have to absorb large losses to restart financial markets. Until that day comes, government action will continue to be indirect and probably insufficient.

This circuitous route can work, provided that the branches of the government pull in the same direction. Politicians are going to have to understand that the longer-term good of the nation involves cooperating with, not castigating, financial professionals. And the Obama administration will have to understand that its approval rating is to be used to convince the public of hard choices.

Mr. Reinhart is a resident scholar at the American Enterprise Institute and former director of the division of monetary affairs at the Federal Reserve.

from Bloomberg News, 2009-Mar-23, by Scott Lanman:

Nobel Winners Spence, Krugman Clash on Geithner Plan Prospects

Washington -- Treasury Secretary Timothy Geithner has a good chance of succeeding with his plan to cleanse banks of toxic assets, says A. Michael Spence, co-winner of the 2001 Nobel Prize in economics. Paul Krugman, the newest laureate, is so sure Geithner will fail that he's full of “despair.”

Even winners of the highest awards in economics can't always be right. Which prediction proves correct depends in part on whether private investors can be enticed to bid on as much as $1 trillion of illiquid loans and securities that banks are now stuck with.

“This program is crucially dependent on the private sector as participants and price setters,” said Spence, 65, who shared the Nobel Prize with George Akerlof and Joseph Stiglitz for a theory that found some government intervention can make markets more efficient. “It could work,” Spence said.

That's not an opinion shared by 2008 Nobel laureate Krugman. “The real problem with this plan is that it won't work,” Krugman, 56, said in his New York Times opinion column today.

Geithner appears to be going back to the “cash for trash” approach of his predecessor as Treasury Secretary, Henry Paulson, Krugman said. “This is more than disappointing. In fact, it fills me with a sense of despair.”

Krugman's Advice

Instead of financing the purchase of illiquid assets, the government should guarantee many bank debts, take control of “insolvent” firms and clean up their books, similar to what Sweden did in the 1990s, Krugman said.

While Spence, a Stanford University professor and former business-school dean, has more confidence in Geithner, even he isn't positive the Treasury secretary can pull it off.

The Treasury plan “is a little complex to implement,” Spence said. “I assume the Treasury has done its homework, and has people lined up” to commit private capital to Geithner's public-private partnerships, he said.

A crucial question is whether private investors can stomach potential threats and scrutiny from Congress, whose move last week toward taxing employee bonuses may drive bidders away, said Carnegie Mellon University professor Allan Meltzer, 81, author of a history of the Federal Reserve.

Geithner's plan “will certainly help,” Meltzer, 1997 winner of New York University's Money Marketeers Distinguished Achievement Award, said in a telephone interview today. At the same time, “the Congress has really clobbered the rule of law, and that has terrible implications for the future,” he said.

$1 Trillion of Assets

The plan is aimed at financing $500 billion to $1 trillion in purchases of illiquid real-estate assets, using $75 billion to $100 billion of the Treasury's remaining bank-rescue funds. It also will rely on Fed financing and guarantees from the Federal Deposit Insurance Corp.

Treasury left some details to be announced later, including the precise amounts investors would be required to put up for each type of asset and the terms of loans that the Fed would provide.

Lawrence Summers, 54, a former Treasury secretary and head of Obama's National Economic Council, said in a Bloomberg Television interview today that he was “surprised” by the negative comments from Krugman.

Summers, no Nobel laureate but the 1993 winner of the John Bates Clark medal as outstanding U.S. economist under 40, said he doesn't know of “any economist who doesn't believe that better-functioning capital markets, on which assets can be traded, are a good idea.”

from the New York Daily News, 2009-Mar-17, by Helen Kennedy:

AIG Bonus Checks May Be Taxed At Up to 100%, Says Sen. Chuck Schumer

Eleven AIG execs who got $1 million-plus "retention" bonuses to keep them at the firm have already left - including one who walked away with $4.6 million.

The bombshell revelation came as Congress warned AIG execs to return their millions in bonuses - or face a possible new law taxing those payouts at up to 100%.

"They should voluntarily return them. If they don't, we plan to tax virtually all of it," New York Sen. Chuck Schumer declared on the Senate floor.

"To those of you getting these bonuses: be forewarned, you will not be getting to keep them."

New York Attorney General Andrew Cuomo, in a letter to Congress, said he had learned that 11 AIG executives who got retention bonuses of over $1 million no longer even work there.

In total, Cuomo said, the top 10 bonus recipients at AIG shared a combined $22 million, 73 got more than $1 million and the most handsomely paid got a whopping $6.4 million.

Schumer called it "Alice in Wonderland business practices" to give bonuses to executives at a firm that lost nearly $100 billion last year and had to be rescued with $170 billion in taxpayer money.

"It boggles the mind," he said.

Rep. Carolyn Maloney (D-N.Y.), head of the Joint Economic Committee, was drawing up one tax bill, and there were others being proposed.

"What is the highest excise tax we can impose that will stand up in court?" mused Senate Finance Committee Chairman Max Baucus. "Let's find out."

As the rhetoric grew ever more heated, Iowa Sen. Chuck Grassley had to apologize for saying AIG execs should "follow the Japanese example and...do one of two things: resign or go commit suicide."

AIG, which has been hunkering down under the fusillade, issued a statement saying: "The remark is very disappointing, but AIG's employees continue to work with poise and professionalism to take care of policyholders and repay taxpayers."

After President Obama declared himself outraged about the bonuses on Monday, Republicans - and some Democrats - pointed fingers at the White House, saying Obama and his team should have stopped the bonuses long ago.

"It looks like a lot of incompetence," said Sen. Richard Shelby (R-Ala.). "I think (Treasury) Secretary Geithner does not have his hands around the details of this."

Democratic Sen. Chris Dodd, chairman of the Senate banking committee, demanded a full briefing from the Federal Reserve and the Treasury on why clauses weren't attached to the four various AIG bailouts to halt bonuses.

"Why wasn't the Fed putting conditionality four different times they provided resources to AIG?" Dodd asked.

"We need to find out exactly who they are and exactly how many more may be coming along."

Dodd included a clause in the $787 billion stimulus package - different from the TARP bank bailout and the AIG handouts - that allowed payment of corporate bonuses agreed to before Feb. 11.

Meanwhile, New York Attorney General Andrew Cuomo said he has issued subpoenas for the names of AIG employees given bonuses despite the company's near-collapse. Cuomo said his office will investigate whether the bonus payments are fraudulent law because they were promised when the company knew it wouldn't have the money to cover them.

from New York Newsday's Real Estate blog, 2009-Mar-17, by Ellen Yan:

A move to tax bonuses promised before subprime collapse

AIG is not the first bailout recipient accused of excesses, but its $165 million payout to execs in the unit that helped cause the global crisis is burning up lawmakers in Congress, so much that several swore today to tax the bonuses into almost nothing.

“It is the grossest perversion of the idea of a 'performance bonus' imaginable,” 12 Senate Democrats, including New York's Charles Schumer, wrote to Edward Liddy, chairman and chief of the American International Group.

The lawmakers have threatened to pass legislation that would impose taxes as high as 91 percent on the bonuses unless the executives give them back.

AIG has said it had to fulfill its contracts with management, agreements written last year before the company realized it was in dire straits. The subprime mortgage market collapsed in August 2007, helping to set off a series of economic implosions.

“We insist that you immediately renegotiate these contracts in order to recoup these payments and make the American taxpayer whole,” the letter continued.

But last month as lawmakers drafted the $789 billion economic stimulus bill, it was the Senate that pulled out a provision to tax “excessive bonuses” -- defined as more than $100,000 -- if the bailed-out firm did not repay the cash portion to the government. The provision would have set up an excise tax of 35 percent on what was not immediately repaid.

from the New York Times's Caucus blog, 2009-Mar-17, by Kate Phillips:

Bonuses, Bailouts and Blame

Updated From the House to the Senate and from Republicans to Democrats, lawmakers have slammed the bonus packages awarded to executives by American International Group, the insurance conglomerate, all day long today in an effort to assign blame for the debacle involving a company that received $170 billion in bailout money so far.

It's been a virtual pile-on on Capitol Hill (and from the public) since it was disclosed that A.I.G. gave out $165 million in bonuses to executives in a troubled business unit at a time when the corporation has repeatedly required propping up with new federal funds. (The Times's Louise Story details the payouts in an article on our home page.)

Senator Chuck Schumer, Democrat of New York, today called the bonuses an “Alice in Wonderland” business practices, and he has joined others threatening to impose an excise tax if executives don't return them. Representative Barney Frank, Democrat of Massachusetts and chairman of the House Financial Services Committee, wants the government to claim ownership rights of A.I.G. and sue for repayment of the money.

Update, 4:45 p.m. Representative Nancy Pelosi, speaker of the House, issued a statement late this afternoon indicating that several committees will be reviewing whether to use special tax legislation, prohibit future compensation from bailout companies or whether to authorize the Attorney General to pursue repayment.

But lawmakers' efforts to recoup the money may be far more difficult. While caps on executive compensation were put into the stimulus law, under a proposal by by Senator Chris Dodd, the Banking committee chairman, that language excludes any package negotiated before Feb. 11 of this year. (The date reflects the period of time when the final stimulus was being negotiated.) A tougher provision, sponsored by Senators Olympia Snowe, Republican of Maine and Ron Wyden, Democrat of Oregon, was dropped during conference negotiations.

Asked whether Democrats blew it by not keeping the tougher cap in, Mr. McConnell repeated his criticism that they failed when billions more dollars was handed over a few weeks ago. He would not discuss whether he favored using the tax code to recoup the money, as the Democrats are considering.

And Senator Chuck Grassley, the ranking Republican on the Senate Finance Committee, said today that any measure would have to be respectful of the constitutional right to engage in contracts, as A.I.G. has asserted in saying it cannot undo the bonus deals and that a court might have to decide whether they're binding. But he added, “From my standpoint, it's irresponsible for corporations to give bonuses at this time, when they're so sucking the tit of the taxpayer. We need to make sure that we move along to give an ethic to corporate America.”

Other Republican leaders were quick today to slam the Obama administration — namely the Treasury Department — in recent weeks. “Where were they?” Senator Mitch McConnell, the minority leader, demanded, when $30 billion in additional funds was handed out to A.I.G. just a few weeks before bonus payments issued last Friday. “It's shocking that they would — the administration would come to us now and act surprised about these contracts. Why didn't they ask the question two weeks ago, before they gave them $30 billion?” Mr. McConnell asked. (Some Democrats have been quick to point out that A.I.G. received its earlier bailouts from the Federal Reserve last year, before Congress acted on a bailout package and before the changeover at the White House.)

Other lawmakers were examining ways to stop future bonus payouts.

The joint letter by Senate Democratic leaders issued an ultimatum to A.I.G. executives: return the money or face a possible 91 percent tax on their rewards. Signed by 10 senators and addressed to Edward Liddy, the chief executive officer of AIG, the letter slammed the bonus packages the “grossest perversion of the idea of a “performance bonus” imaginable.”

The letter continued:

If these contracts are not renegotiated immediately, we will take action to make American taxpayers whole by recouping all of the bonuses that A.I.G. has paid out to its financial products unit, which, by all accounts, is primarily responsible for the near-failure of the company and the devastating impact on the global financial markets.

For a company that would not exist anymore but for a $170 billion taxpayer funded rescue, it is simply morally unacceptable to spend $165 million on bonus payments, and especially offensive to spend $450 million over the next two years rewarding the employees that helped fuel the nation's financial crisis.

Update: House Republican leaders also proposed today that the Treasury Department be compelled to disclose all communications with AIG.

Other lawmakers want to redefine the relationship with corporations like AIG. Mr. Frank, whose committee tomorrow will be questioning (grilling might be a more appropriate term) Mr. Liddy, outlined how he believed the government should pursue repayment. Without mentioning the word “nationalization,” Mr. Frank argued at a briefing today:

My own view is and what I will be talking to the administration about is, people have been looking at that from the standpoint of the federal government as the entity that lends the money to these parties, but I think we should look at it from the standpoint of us as the owner. We're the owner of that company, in fact.

Now there are some covenants that have kept us from doing that. I think the time has come to exercise our ownership rights — we own most of the company — and then say, as owner, “No, I'm not paying you the bonus. You didn't perform. You didn't live up to this contract.” Presumably the bonus had some merit substance. In other words, I think we are in a stronger case to try and get those bonuses back if we bring them as the owner of the company, rather than as the regulator interfering with a contract between two other parties.

We're fairly certain we'll be hearing more from Mr. Frank at his hearing tomorrow morning.

from MarketWatch.com, 2009-Mar-9, by Paul B. Farrell:

Warning: Quants love the 'predictably irrational'
By predicting your behavior, quants control your mind, money, the markets

ARROYO GRANDE, Calif. -- Warning: Quants, the grand magicians of the illusionary arts of neuroeconomics, behavioral finance, investment psychology and the "new science of irrationality," are working with Wall Street in a massive conspiracy to scam America's 95 million investors.

They are your worst enemies. You cannot trust them. Their new books are deceptive and misleading, part of Wall Street's secret efforts to dominate, manipulate and control your mind, money and the markets.

This is not a review of Hollywood TV thriller like "24" involving corrupt politicians and corporations. Rather, we are targeting an emerging culture that's far more dangerous than we just read in "Recipe for Disaster: The Formula That Killed Wall Street," Wired magazine's fascinating analysis of how "Wall Street turned to quants -- brainy financial engineers -- to invent new ways to boost profits. Their method for minting money worked brilliantly ... until one of them devastated the global economy."

Just one? No, the real story is far worse than in Wired: Maybe the "one quant and his one formula" did create a lethal virus that triggered the subprime-credit meltdown and devastate the global economy. But that's old news. Moreover, Wired suggests it will never happen again "if" we just increase data transparency, "empowering all investors," thus creating "an army of citizen regulators."

Laudable, but unlikely. Not with 40,000 Washington lobbyists and Wall Street the biggest political donor: They hate transparency.

But that's not the real reason quants will rule the Street. The real story: Quants are everywhere, hiding in the shadows. Wired's "one quant, one formula" plot is merely the tip of an iceberg dead ahead as the global economy recovers and a new bull market roars back. Quants are hiding in academia, research institutes, think tanks, and on Wall Street's payroll, locked up in proprietary-secret no-talk contracts.

Quant thinking rules everything Wall Street does to America

Quant technologies influence everything Wall Street does "to" Main Street: Not just trading, portfolio management and market manipulation, but every aspect of the Street including financial planning and broker training, day-trading systems, data design and transparency, 401(k) retirement programs, marketing, advertising and branding, lobbying and government regulations, and so many other niches.

The real story is far broader and much more interesting, offering clues to the next meltdown. But first, some context and history about how we got here, why this "Wall Street/Quant Conspiracy" is expanding.

Don't be misled by their latest pop-psychology books and their cute titles: "Blunder: Why Smart People Make Bad Decisions;" "Blind Spots: Why Smart People Do Dumb Things;" "Sway: The Irresistible Pull of Irrational Behavior;" "Drunkard's Walk: How Randomness Rules Our Live;" "The Logic of Life: Rational Economics in an Irrational World;" "Nudge: Improving Decisions About Health, Wealth and Happiness;" "Predictably Irrational: Hidden Forces That Shape Our Decisions" and other misleading stuff on neuroeconomics. These books reflect the relentless dumbing down of Americans in the economics arena.

They read like press releases from a modern-day P.T. Barnum, the great 19th century circus impresario, Remember: "There's a sucker born every minute." Today, the "suckers" are America's 95 million investors because the quants message is grossly misleading.

It goes like this: If investors simply learn and adopt the tips in these books they will understand why their decisions are "predictably irrational" and as a result, they will stop making the "big mistakes" irrationality creates, plus in the future they will have a defense against the manipulations of Wall Street and its quants.

Wrong. Wall Street's army of quants are always light-years ahead of the suckers. Quants are constantly inventing new technologies, algorithms and marketing tools that'll run circles around America's 95 million "predictably irrational" investors.

The pros and academics who wrote these books should be embarrassed. There's little new we haven't already read many years ago in classics like Hersh Shefrin's "Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing;" John Nofsinger's "Investment Madness: How Psychology Affects your Investing ... and What to Do About It;" Gary Belsky & Thomas Gilovich's "Why Smart People Make Big Money Mistakes and How to Correct Them: Lessons from the New Science of Behavioral Economics;" and many since. The new books are just rehashing ideas now part of our conventional wisdom as well as scientific literature.

Quants love predicting 'predictably irrational' investors

The real story reads like covert military special-ops, a dangerous war game played in the shadows: Yale's Robert Shiller exposed this game in his 2000 classic "Irrational Exuberance." Irrational exuberance put the spotlight on individual investors driven by a "herd instinct." But that scapegoated the little guy. Their "exuberance" was not the cause of irrational markets. That's an illusion invented by Wall Street and its army of quants.

"Irrational exuberance" no longer fits in a world that now includes the exploding new $683 trillion global "shadow banking system." Today MIT Prof. Dan Ariely's "Predictably Irrational: The Hidden Forces That Shape Our Decisions" more accurately profiles a market driven by millions of investors whose irrational behavior is being secretly "predicted" and manipulated by Wall Street's quants, armed with an arsenal of neuroeconomic WMDs.

P.T. Barnum would love today's scenario! If he were here today he'd one-up Madoff, Sanford, the CEOs of AIG and all our clueless Wall Street bosses. Barnum would arm his team with powerful new neuroeconomic technologies that'd make his chutzpah irresistible.

And that's exactly what we better expect from the next generation of Wall Street leaders and quants, coming in the next bull market; investors won't even know they are being manipulated by the next army of quants.

How did we get here? To understand how these new books mislead America's 95 million investors, you need a brief summary of the four stages and principles in their evolution:

1. Investors are "irrational," their irrationality leads to "big mistakes." For two centuries, Wall Street's "rational investor" theory was gospel. But after 30 years of research by many leaders in the neurosciences, Princeton psychologist Daniel Kahneman was awarded the 2002 Nobel Economics prize for proving that investors are irrational decision-makers who often act against their best economic interests.

2. Main Street's "irrational exuberance" does not "cause" bulls. In his 2000 book Shiller defined irrational exuberance as "wishful thinking on the part of investors that blinds us to the truth of our situation," creating a collective madness that turns investors into irrational mobs. Shiller's still "old school," still believes that Main Street investors are a blind mob driven by an "invisible hand," not quants' mind games.

3. Investment decision-making is now "predictably irrational." Chicago's behavioral finance genius Richard Thaler periodically edits Advances in Behavioral Finance, collections of cryptic quant research. He says Wall Street "needs investors who are irrational, woefully uninformed, endowed with strange preferences, or for some other reason willing to hold overpriced assets. We shall refer to these conditions collectively as 'irrational' ... it seems reasonable to equate nonpecuniary with irrational." And earlier, speaking as a true quant: "In the financial markets, if you are prepared to do something [predictably] stupid there are many professionals happy to take your money."

4. Knowing the new rules make you more vulnerable their scams. Bottom line, the new neuroeconomics pop-psychology books don't work, they are based on a false premise: That "predictable irrational" investors can teach themselves to become "less irrational." Wrong. Paradoxically, the more we learn about our irrational brains, the more we convince ourselves we're in control, acting rationally.

We forget that 88% of our behavior is driven by our subconscious mind: Preconceived rationales, family and tribal beliefs, primal convictions, honor codes and commandments, ideologies, dogma and other "irrational" ideas locked deep in our brains, stuff we can't see but quants can access, reprogram, take advantage of and manipulate. So we continue making irrational decisions and big mistakes.

Amazing isn't it: Your brain really is your worst enemy. Even if you learn all the new rules from the new pop-psychology books your brain will unconsciously ignore the new neuroeconomic stuff you read and convince you that you're acting "rational."

No wonder Wall Street's quants can easily predict behavior in advance and take advantage of America's 95 million investors, siphoning off hundreds of billions in extra fees and commissions annually.

from the Wall Street Journal, 2009-Feb-18, by Marc Faber:

Synchronized Boom, Synchronized Bust
Bad U.S. monetary policy had global consequences.

The world has gone from the greatest synchronized global economic boom in history to the first synchronized global bust since the Great Depression. How we got here is not a cautionary tale of free markets gone wild. Rather, it's the story of what can happen when governments ignore market signals and central bankers believe in endless booms.

Following the March 2000 Nasdaq bust, the Federal Reserve began to slash the fed-funds rate from 6.5% in January 2001 to 1.75% by year-end and then to 1% in 2003. (This despite the fact that officially the U.S. economy had begun to recover in November 2001). Almost three years into the economic expansion, the Fed began to increase the fed-funds rate in baby steps beginning June 2004 from 1% to 5.25% in August 2006.

But because interest rates during this time continuously lagged behind nominal GDP growth as well as cost of living increases, the Fed never truly implemented tight monetary policies. Indeed, total credit increased in the U.S. from an annual growth rate of 7% in the June 2004 quarter to over 16% in early 2007. It grew five-times faster than nominal GDP between 2001 and 2007.

The complete mispricing of money, combined with a cornucopia of financial innovations, led to the housing boom and allowed buyers to purchase homes with no down payments and homeowners to refinance their existing mortgages. A consumption boom followed, which was not accompanied by equal industrial production and capital spending increases. Consequently the U.S. trade and current-account deficit expanded -- the latter from 2% of GDP in 1998 to 7% in 2006, thus feeding the world with approximately $800 billion in excess liquidity that year.

When American consumption began to boom on the back of the housing bubble, the explosion of imports into the U.S. were largely provided by China and other Asian countries. Rising exports from China led to that country's strong domestic industrial production, income and consumption gains, as well as very high capital spending as capacities needed to be expanded in order to meet the export demand. An economic boom in China drove the demand for oil and other commodities up. Rapidly accumulating wealth allowed the resource producers in the Middle East, Latin America and elsewhere to go on a shopping binge for luxury goods and capital goods from Europe and Japan.

As a consequence of this expansionary cycle, the world experienced between 2001 and 2007 the greatest synchronized economic boom in the history of capitalism. Past booms -- of the 19th century under colonial economies, or after World War II when 40% of the world's population remained under communism, socialism, or was otherwise isolated -- were not nearly as global as this one.

Another unique feature of this synchronized boom was that nearly all asset prices skyrocketed around the world -- real estate, equities, commodities, art, even bonds. Meanwhile, the Fed continued to claim that it was impossible to identify any asset bubbles.

The cracks first appeared in the U.S. in 2006, when home prices became unaffordable and began to decline. The overleveraged housing sector brought about the first failures in the subprime market.

Sadly, the entire U.S. financial system, for which the Fed is largely responsible, turned out to be terribly overleveraged and badly in need of capital infusions. Investors grew apprehensive and risk averse, while financial institutions tightened lending standards. In other words, while the Fed cut the fed-funds rate to zero after September 2007, it had no impact -- except temporarily on oil, which soared between September 2007 and July 2008 from $75 per barrel to $150 (another Fed induced bubble) -- because the private sector tightened monetary conditions.

In 2008, a collapse in all asset prices led to lower U.S. consumption, which caused plunging exports, lower industrial production, and less capital spending in China. This led to a collapse in commodity prices and in the demand for luxury goods and capital goods from Europe and Japan. The virtuous up-cycle turned into a vicious down-cycle with an intensity not witnessed since before World War II.

Sadly, government policy responses -- not only in the U.S. -- are plainly wrong. It is not that the free market failed. The mistake was constant interventions in the free market by the Fed and the U.S. Treasury that addressed symptoms and postponed problems instead of solving them.

The bad policy started with the bailout of Mexico following the Tequila crisis in 1994. This prolonged the Asian bubble of the 1990s, because investors became convinced there was no risk in growing current-account deficits and continued to finance Asia's emerging economies until the bubble burst with the start of the Asian crisis in 1997-98.

Then came the ill-advised bailout of Long-Term Capital Management in 1998, which encouraged the financial sector to leverage up even more. This was followed by the ultra-expansionary monetary polices following the Nasdaq bubble in 2000, which led to rapid and unsustainable credit growth.

So what now? Unfortunately, Fed Chairman Ben Bernanke and Treasury Secretary Tim Geithner were, as Fed officials, among the chief architects of easy money and are therefore largely responsible for the credit bubble that got us here. Worse, their commitment to meddling in markets has only intensified with the adoption of near-zero interest rates and massive bank bailouts.

The best policy response would be to do nothing and let the free market correct the excesses brought about by unforgivable policy errors. Further interventions through ill-conceived bailouts and bulging fiscal deficits are bound to prolong the agony and lead to another slump -- possibly an inflationary depression with dire social consequences.

Mr. Faber is managing director of Marc Faber Ltd. and editor of "The Gloom, Boom & Doom Report."

from the New York Times, 2009-Mar-13, p.B1, web-posted 2009-Mar-12, by Vikas Bajaj:

Household Wealth Falls by Trillions

In the last few months, most Americans have felt poorer. Now they have the numbers to prove it.

The Federal Reserve reported Thursday that households lost $5.1 trillion, or 9 percent, of their wealth in the last three months of 2008, the most ever in a single quarter in the 57-year history of recordkeeping by the central bank.

For the full year, household wealth dropped $11.1 trillion, or about 18 percent. Though the numbers do not yet reflect it, the decline in the stock market so far this year has probably erased trillions more in the country's collective net worth.

The next biggest annual decline in wealth came in 2002, when household net worth fell 3 percent after the collapse of the technology bubble. The most recent loss of wealth is staggering and will probably put further pressure on the economy because many people will have to spend less and save more.

Most of the wealth was lost in financial assets like stocks, which tumbled at the end of last year. The Standard & Poor's 500-stock index, for instance, fell 23 percent in the fourth quarter. The value of residential real estate, the biggest asset for most families, fell much less — $870 billion, or about 4 percent.

Even the richest among us have become a lot poorer. This week, Forbes magazine published its list of the richest people in the world. At No. 1, Bill Gates, the founder of Microsoft, still had $40 billion to his name, but that was down $18 billion. The wealth of Warren E. Buffett, the investor whose company Berkshire Hathaway had a rare bad year, tumbled $25 billion, to $37 billion.

The loss of wealth is concentrated among the most affluent Americans, in large part because they own more stocks and bonds than the rest of the country. Only about 50 percent of households own stock, and many of them own relatively small sums in retirement accounts.

As a result of their greater wealth and higher incomes, the affluent tend to spend a lot more than their share of the population would imply. The top 20 percent of income earners spend more than the bottom 60 percent of income earners, according to calculations by Tobias Levkovich, the chief United States equity strategist at Citigroup.

“When their wealth is mauled, they are not particularly interested in spending,” Mr. Levkovich said.

The Fed report released on Thursday also showed that total borrowing and lending increased at an annual rate of 6.3 percent in the fourth quarter, mostly as a result of increased borrowing by the federal government to finance its operations and various bailouts of the financial system. The government's borrowing increased at an annual rate of 37 percent.

But borrowing by households dropped 2 percent. Lending to businesses was up 1.7 percent. Recent surveys of loan officers by the Fed have shown that companies have been drawing down lines of credit that were established in the past, and that only a small fraction of the lending to the private sector is through new loans, which are much harder to obtain than in recent years.

from the Wall Street Journal, 2009-Mar-11, by Phil Izzo:

Obama, Geithner Get Low Grades From Economists

U.S. President Barack Obama and Treasury Secretary Timothy Geithner received failing grades for their efforts to revive the economy from participants in the latest Wall Street Journal forecasting survey.

The economists' assessment stands in stark contrast with Mr. Obama's popularity with the public, with a recent Wall Street Journal/NBC poll giving him a 60% approval rating. A majority of the 49 economists polled said they were dissatisfied with the administration's economic policies.

On average, they gave the president a grade of 59 out of 100, and although there was a broad range of marks, 42% of respondents rated Mr. Obama below 60. Mr. Geithner received an average grade of 51. Federal Reserve Chairman Ben Bernanke scored better, with an average 71.

The economists, many of whom have been continually surprised by the depth of the downturn, also pushed back yet again their forecasts for when a recovery would begin. On average, they expect the downturn to end in October. Last month, they said the bottom would arrive in August. They estimate that U.S. gross domestic product will continue to contract in the first half of this year, with slow growth returning in the third quarter.

Economists were divided over whether the $787 billion economic-stimulus package passed last month is enough. Some 43% said the U.S. will need another stimulus package on the order of nearly $500 billion. Others were skeptical of the need for stimulus at all.

However, economists' main criticism of the Obama team centered on delays in enacting key parts of plans to rescue banks. "They overpromised and underdelivered," said Stephen Stanley of RBS Greenwich Capital. "Secretary Geithner scheduled a big speech and came out with just a vague blueprint. The uncertainty is hanging over everyone's head."

Mr. Geithner unveiled the Obama administration's plans Feb. 10, but he offered few details, and stocks sank on the news. The Dow Jones Industrial Average is down almost 20% since the announcement, as multiple issues have weighed on investors' confidence. The Treasury secretary has since appeared before Congress and offered more specifics but has said action on key parts of the plan still is weeks away.

About the Survey The Wall Street Journal surveys a group of 54 economists throughout the year. Broad surveys on more than 10 major economic indicators are conducted every month. Once a year, economists are ranked on how well their forecasts have fared. For prior installments of the surveys, see: WSJ.com/Economist.

"We have taken an unprecedented level of action toward economic recovery, accomplishing in weeks what took other countries years to do," Treasury spokesman Isaac Baker said. "While Wall Street and investors were disappointed when they didn't get a sweeping bank bailout, we've laid out a plan to stabilize the financial system while protecting the taxpayer and ensuring government funds are spent wisely. This crisis was years in the making, and it will take time to solve."

Treasury has started implementing a housing-recovery plan, moved forward on a joint program with the Fed to boost consumer lending, and has begun stress-testing banks in an effort to determine which institutions will need additional capital from the government. The results of the stress tests won't be known for a few weeks. Meanwhile, a key part of the plan -- a public-private partnership to take toxic assets off bank balance sheets -- remains in the planning stages.

The economists' negative ratings mark a turnaround in opinion. In December, before Mr. Obama took office, three-quarters of respondents said the incoming administration's economic team was better than the departing Bush team. However, Mr. Geithner's latest marks are lower than the average grade of 57 that former Treasury Secretary Henry Paulson received in January.

Mr. Geithner, who is relying on a skeleton crew of advisers in the Treasury Department as the administration struggles to make key appointments to his staff, is encountering the same problems as his predecessor in dealing with the complexities of a bailout plan. Richard DeKaser of Woodley Park Research, who gave high marks to Messrs. Obama and Geithner, admitted disappointment in the delay in action but said he appreciated the magnitude of the task. "I don't know what's holding it up," he said. "But I'm assuming it's not just because they're hitting the golf course."

There was widespread initial support for the appointment of Mr. Geithner, who as president of the New York Federal Reserve had been on the front lines of the crisis since it erupted. However, in the ensuing weeks Mr. Geithner has had to deal with tax troubles and criticism from those opposed to any bailouts as well as those who think the government needs to be doing more.

Meanwhile, the economists surveyed this month predict that the economy will shed another 2.8 million jobs over the next 12 months as the unemployment rate climbs to 9.3% by December, up from the 8.1% rate recorded in February. Economists also see nearly a one-in-six chance that the U.S. will fall into a depression, defined as a decline in per-person GDP or consumption by 10% or more.

"We just keep moving the date [when the recession will end] out, hoping at some point in time we will be able to move the date back in," said Diane Swonk of Mesirow Financial.

The economists didn't just single out the U.S. for criticism; 70% of participants said the response of governments around the world to the global recession has been inadequate. "The Europeans or Japanese don't seem to be doing near enough to kickstart their economies," said Nariman Behravesh of IHS Global Insight. "It could be we've done all the right things, but the rest of the world goes down the tubes."

Despite the growing criticism elsewhere, the respondents were broadly supportive of the Fed. More than 85% of the economists agreed that the central bank's proliferating lending programs are well-designed, well-executed and helping the economy. And while grades for Mr. Bernanke remain off of their 2007 highs, the average has stabilized after falling as low as 69 in the November survey.

Amid all the gloom, there is a bright spot: Four-fifths of the economists said now is a good time to buy equities, especially if the investor has a long-term view.

from MarketWatch.com, 2009-Mar-8:

World Bank predicts global contraction, credit shortfall

SAN FRANCISCO -- The global economy is likely to shrink this year for the first time since World War II and developing countries will face a financing shortfall as private sector creditors shun emerging markets, the World Bank said Sunday.

In a paper for next Saturday's meeting of the Group of 20 finance ministers and central bank governors, the World Bank said its forecasts show the world's economic growth will be at least 5 percentage points below potential. Global industrial production by the middle of 2009 could be as much as 15% lower than 2008 levels.

World trade is on track in 2009 to record its largest decline in 80 years, with the sharpest losses in East Asia, the bank.

Developing countries will face a financing shortfall of $270 billion to $700 billion this year, including public and private debt and trade deficits, and only one quarter of the most vulnerable countries have the resources to prevent a rise in poverty, the bank said.

International financial institutions cannot by themselves currently cover the shortfall for these 129 countries, even at the lower end of the estimated range. Only one-quarter of vulnerable developing countries have the ability to finance measures to blunt the economic downturn, such as job-creation or safety net programs, the bank said.

Debt issuance by high-income countries is set to increase dramatically, which will crowd out many developing country borrowers, both private and public. Many institutions that have provided financial intermediation for developing country clients have virtually disappeared, the bank said.

Developing countries that can still access financial markets face higher borrowing costs, and lower capital flows, leading to weaker investment and slower growth in the future.

A solution will require governments, multilateral institutions, and the private sector, the bank said.

from MarketWatch.com, 2009-Mar-5, by William L. Watts:

Bank of England embarks on quantitative easing
Halves key lending rate to 0.5%; sets $106 billion asset-purchase program

LONDON -- The Bank of England took unprecedented steps Thursday to prevent a deflationary spiral, launching a program to effectively print money through the purchase of billions of pounds worth of corporate and government bonds.

The nine-member Monetary Policy Committee also voted to cut the bank rate from 1% to 0.5%, the lowest level in the central bank's 315-year history.

The rate cut, which had been widely anticipated, could be the final reduction in a series of cuts that have seen the key lending rate slashed from 5% since October.

In a statement, the policy-setting MPC said the bank would buy a total of 75 billion pounds in high-quality corporate debt and U.K. government bonds, or gilts, over the next three months. The majority of purchases will be medium- to long-maturity gilts, the Bank of England said. Read the statement.

The move makes the Bank of England the first European central bank to join the U.S. Federal Reserve and the Bank of Japan in a rare practice known as quantitative easing. The long-expected decision came after the MPC determined that a rate cut alone wouldn't be enough to prevent inflation from significantly undershooting the central bank's 2% annual target.

"Accordingly, the committee also resolved to undertake further monetary actions, with the aim of boosting the supply of money and credit and thus raising the rate of growth of nominal spending to a level consistent with meeting the inflation target in the medium term," the statement said.

The purchases will be paid for by the creation of new central bank reserves.

In other words, the Bank of England will purchase the assets from financial institutions and credit their reserve balances at the central bank, electronically creating new money.

The central bank is aiming to boost the money supply in hopes the moves will ease tight credit conditions and translate into increased spending, thereby preventing a sustained, widespread and potentially destructive fall in prices.

Also, purchases of high-quality corporate debt and gilts will bring down interest rates.

The U.K. Treasury has authorized the central bank to expand the plan to150 billion pounds, if needed, pushing the total size of the initiative toward the top end of expectations. Also, the three-month window for the operation is also aggressive, said John Wraith, a gilt strategist at RBC Capital Markets.

The news sent gilt prices soaring, particularly at the long end. Yields, which move inversely to price, fell sharply.

The 10-year bond's yield dropped 34 basis points, or 0.34 of a percentage point, to around 3.29%, according to FactSet Research.

"It's a dramatic announcement, and all else being equal, you have to think that until there are signs of some traction getting back into the economy ... it's extremely bullish for gilts," Wraith said.

In foreign-exchange dealings, the pound initially spiked on the news, then tumbled. Sterling recently changed hands at $1.4117, a loss of 0.5%.

Not done yet

With the Bank of England now focused on boosting the money supply, it's likely that the pound will be exposed to further selling pressure, said Kenneth Broux, economist at Lloyds TSB.

Meanwhile, the effect of quantitative easing on nominal spending isn't likely to materialize in the near future, he said, noting that British consumers remain highly leveraged and that corporate default rates are on the rise.

Indeed, a rise in bank lending and broad money growth might not bring about a big rise in economic activity if firms don't spend the extra money, said Jonathan Loynes, chief European economist at Capital Economics.

In technical terms, the rise in the money supply could be offset by a slowdown in the "velocity of circulation" of money, he said.

"The upshot is that we suspect that the MPC will have to use the full 150 billion pounds, or even more, if it is to have a material impact on the economy and inflation," Loynes said.

British gross domestic product shrank at a quarterly rate of 1.5% in the final three months of 2008, the sharpest contraction since the early 1980s.

The International Monetary Fund has forecast the British economy would post the worst performance in the developed world for 2009, projecting a 2.8% drop in GDP.

Surveys measuring confidence in the manufacturing and services sectors point to ongoing retrenchment in activity, although the pace of contraction appears to have slowed in recent months.

Meanwhile, house prices continue to plunge following the bursting of a housing bubble in 2007.

Mortgage lender Halifax, a unit of Lloyds Banking Group, reported Thursday that house prices fell 2.3% in February, wiping out a 2% January bounce. The three-month average house price was 17.7% below the level seen in February 2008.

from Kitco.com, 2009-Feb-23, by Mark Skousen:

Barbarians at the Golden Gate: Get Ready for the War on Gold

“Auri sacra fames! Gold has its special glamour, its age-long appeal to the grasping palm, to those who would be safe and greedy at the same time. This may be an evil way in which to run our economic life.”

--John Maynard Keynes, 1933

Yesterday I walked into the largest Barnes & Noble bookstore in New York and saw a big display table up front with all kinds of books on John Maynard Keynes and Keynesian economics. One book, “The Return of Depression Economics,” was written by Paul Krugman, the New York Times columnist who just won the Nobel Prize.

Another book was called “The Case for Big Government,” by Jeff Madrick, the editor of Challenge magazine. I can understand writing a book in support of good, efficient, strong, and productive government, but “big” alone? Most Americans prefer the motto “cheaper and better.”

The biggest surprise at Barnes & Noble was to see my own book, “The Big Three in Economics,” prominently displayed along side all the Keynesian and Marxist books. It has suddenly become my most successful book.

Mine was the only book there that took a dim view of Keynes and Marx, and their solutions to the financial crisis (always more government, more taxes, and more regulations). For my money, Adam Smith and his followers (Ludwig von Mises, Friedrich Hayek, Milton Friedman, Murray Rothbard) deserves to be on top of the Totem Pole of Economics.

Unfortunately, Keynes is all the rage now. The British economist became famous in the 1930s for advocating going off the gold standard, running deficits and bailing out troubled banks with easy money as a way to end the Great Depression.

Keynes hated the “barbarous relic” and urged Britain to go off the gold standard in the 1930s (they followed his advice). He was one of the chief architects of the post-war Bretton Woods agreement that further removed gold as the lynchpin of global monetary stability.

Today's politicians, from George Bush to Barack Obama, have suddenly become Keynesians during this financial crisis, spending money they don't have in a vain effort to right the ship. Even Newsweek has gone so far to say, “We are all socialists now.” Alan Greenspan, the ex-student of Ayn Rand, now favors nationalization of the big American banks Citibank and Bank of America.

Every investor and gold bug should know the enemy--Keynes, the advocate of big government and the welfare state, and Karl Marx, the radical who advocated outright state socialism and total central control of the means of production.

After World War I, Randolph Bourne observed, “War is the health of the state.” Today he might say, “A financial crisis is the health of the state.”

Keynes himself warned about the danger of going off gold: “There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

As gold inevitably moves higher in price, and stock prices and the dollar fall further, the politicians of envy will speak out against the hoarders of gold and silver. They may not confiscate your gold, but they might dump Treasury gold on the market, or tax it heavily. Smart gold bugs buy their silver dollars and American eagles privately, and store it away secretly.

Mark Skousen is editor of "Forecasts & Strategies," and producer of FreedomFest, the world's largest gathering of free minds (www.freedomfest.com). His book, "The Big Three in Economics" is available from Amazon for only $17.31, plus shipping: http://www.amazon.com/Big-Three-Economics-Maynard-Keynes/dp/0765616947

from MarketWatch.com, 2009-Mar-6, by Thomas Kostigen:

The $700 trillion elephant
Commentary: Gargantuan derivatives market weighs on all other issues

SANTA MONICA, Calif. -- There's a $700 trillion elephant in the room and it's time we found out how much it really weighs on the economy.

Derivative contracts total about three-quarters of a quadrillion dollars in "notional" amounts, according to the Bank for International Settlements. These contracts are tallied in notional values because no one really can say how much they are worth.

But valuing them correctly is exactly what we should be doing because these comprise the viral disease that has infected the financial markets and the economies of the world.

Try as we might to salvage the residential real estate market, it's at best worth $23 trillion in the U.S. We're struggling to save the stock market, but that's valued at less than $15 trillion. And we hope to keep the entire U.S. economy from collapsing, yet gross domestic product stands at $14.2 trillion.

Compare any of these to the derivatives market and you can easily see that we are just closing the windows as a tsunami crashes to shore. The total value of all the stock markets in the world amounts to less than $50 trillion, according to the World Federation of Exchanges.

To be sure, the derivatives market is international. But much of the trouble we're in began with contracts "derived" from the values associated with U.S. residential real estate market. These contracts were engineered based on the various assumptions tied to those values.

Few know what derivatives are worth. I spoke with one derivatives trader who manages billions of dollars and she said she couldn't even value her portfolio because "no one knows anymore who is on the other side of the trade."

Derivatives pricing, simply put, is determined by what someone else is willing to pay for the contract. The value is based on an artificial scenario that "X" will be worth "Y" if "Z" happens. Strip away the fantasy, however, and the reality of the situation is akin to a game of musical chairs -- without any chairs.

So now the music has finally stopped.

That's why stabilizing the housing market will do little to take the sting out of the snapback we are going through on Wall Street. Once people's mortgages were sold off to secondary buyers, and then all sorts of crazy types of derivative securities were devised based on those, and those securities were in turn traded on down the line, there is now little if any relevance to the real estate values on which they were pegged.

We need to identify and determine the real value of derivatives before we give banks and institutions a pass-go with more tax dollars. Otherwise, homeowners will suffer as banks patch up the holes left in their balance sheets by the derivatives gone poof; new credit won't be extended until the raff of the old credit is put behind.

It isn't the housing market devaluation, or the sub-prime mortgage market defaults that have us in real trouble. Those are nice fakes to sway attention away from the place where greed truly flourished -- trading phony instruments to the tune of $700 trillion.

Let's figure how to get out from under that. Then maybe the capital will begin to flow again through the markets. Right now, this elephant isn't just in the room, it's sitting on us.

Thomas M. Kostigen is the author of You Are Here: Exposing the Vital Link Between What We Do and What That Does to Our Planet (HarperOne). www.readyouarehere.com

from the Wall Street Journal, 2009-Mar-3, by Holman W. Jenkins, Jr.:

Rethinking the Fan and Fred Takeover
'Nationalization' has done nothing good.

Those of us who criticized Fannie Mae and Freddie Mac on policy grounds, and who last year called for their nationalization to cure what we considered a pernicious subsidy program, must still reckon with the cavalier way their shareholders were treated when they were taken over last September.

Markets rightly judged that conservative objections to Fannie and Freddie in no way meant that shareholders in other financial institutions would therefore be treated any better if and when government decided to intervene.

An additional irony is that Fannie and Freddie now pose a bigger risk to taxpayers than ever, as arms of Congressional housing policy.

Take it as sour grapes if you want, but two respected fund managers, Edward Lampert and Bill Miller, both of whom were big shareholders in the mortgage giants, argue that Fannie and Freddie's forcible takeover helped kick off the landslide that has nearly wiped out equity values in the financial sector.

Let's recap. In early July, the Fed opened up its discount window to Fannie and Freddie. Legislation was enacted to shore them up. Six weeks before they were seized, their federal regulator, James Lockhart, declared them more than adequately capitalized.

Treasury Secretary Henry Paulson at every turn insisted that government policy was to keep them in their "current form." Yet he allowed a snake into the garden that immediately undermined his efforts to restore their investors' confidence -- a legislative provision that would shield their boards from shareholder lawsuits if they ever agreed to a government takeover.

When their share prices continued to drop, though both were still in compliance with statutory capital requirements, their boards did exactly that -- surrendering an 80% stake to Treasury without a shareholder vote, without their boards ever explaining their actions to shareholders, for a price of 0.001 cents a share.

Mr. Lampert addressed the takeover in his annual letter last week to Sears shareholders (his fund is the retail chain's biggest holder, and he serves as its chairman): "Investors in regulated industries rely on the fact that regulators will not behave in an arbitrary fashion and, if they do, that there are due process remedies that their managements and boards can pursue."

Mr. Lampert tells me his fund bought its Fannie stake after the July rescue operation and after public assurances that Fannie and Freddie were considered well capitalized, and that it was government policy to keep them in their existing form.

Mr. Miller, whose Legg Mason fund owned 53 million Freddie Mac shares last June, outlined his own criticism in a letter to investors near year-end: "The contradiction was that the government repeatedly said financial institutions needed more capital, and that it wanted private capital to solve the problem. But the government also indicated that if it needed to provide additional assistance in the future, then shareholders who had provided capital should be completely or mostly wiped out."

Let us acknowledge that there was no good solution, just as there isn't for Citigroup (another sad story, in which both managers also own sizable stakes). Washington has stepped up mightily with guarantees to protect depositors and creditors, allowing financial firms to stay in business regardless of any technical concerns about their solvency. But its message to bank shareholders was fatally mixed, with the result that regulators repeatedly have been impelled to take costly actions in response to a swoon in bank share prices that itself was driven by uncertainty about government actions.

Upshot: Investors don't have to put their money in any particular company's stock, or in stocks at all -- and the wholesale flight of investors from bank stocks has put almost the entire weight of recapitalizing the financial sector on the taxpayer.

As Mr. Lampert puts it, "These companies need to be investable. Citigroup survives as a company but it's not investable. Running a company to create value -- the government doesn't have any notion of that."

He adds that he means investors won't put up money if they don't have clear rules and assurance that regulators won't unreasonably damage their investment, and that boards won't abandon their basic duty to stockholders. And you only need to see the deepening hole that AIG has become to appreciate his point that government control, however well intentioned, is unlikely to do a better job of extracting value from an asset than properly incentivized private management.

With Fannie and Freddie in particular, any policy end Washington might have sought, including breaking them up, would have been entirely doable with shareholders still in charge.

A lesson here is that confidence in a crisis is indivisible. No moral calculus yields the result that bank equity investors are bad and must be punished for the credit bubble while creditors are innocent and must be protected -- though that haphazard political conceit seems recurrently to have guided policy. The consequences have been simply terrible. Nothing was inevitable about the collapse of equity values that has made the banking problem so much more difficult.

from the Wall Street Journal, 2009-Mar-2:

Call Them Irresponsible
Rewarding those who put the 'liar' in liar loans.

President Obama continues to insist that only "responsible families" will benefit from his foreclosure prevention program. Addressing Congress last week, Mr. Obama said his plan "won't help speculators or that neighbor down the street who bought a house he could never hope to afford." Sorry, Mr. President. It's becoming increasingly obvious that your plan is going to help tens of thousands of borrowers who put the "liar" into liar loans.

Just listen to Federal Reserve Chairman Ben Bernanke and FDIC Chairman Sheila Bair. In Congressional testimony last week, Mr. Bernanke compared many troubled borrowers to people who accidentally start fires by smoking in bed. For her part, Ms. Bair told public radio that it would be "simply impractical" to review old mortgage applications and try to distinguish between honest and dishonest borrowers. All of this moved the Associated Press to report that the President's "assurance Tuesday night that only the deserving will get help rang hollow."

Mortgage fraud exploded during the housing boom and appears to have continued even as home prices fall. In December the Mortgage Asset Research Institute reported that mortgage fraud increased 45% in the second quarter of 2008, compared to a year earlier. The Treasury's Financial Crimes Enforcement Network reports a similar rise for the full year ended in June of last year. A federal bailout of troubled loans will do nothing to discourage this trend.

But let's assume for the moment that most of the program's beneficiaries did tell the truth. Does that make them "responsible," as Mr. Obama says? Many borrowers are underwater, owing more on the mortgage than their home is worth. Declining home prices are of course a big reason. The other big reason is that many of them traded home equity for cash, in some cases several times, while taking on larger mortgages. To say that all troubled borrowers did cash-out refinancings and spent the money on kitchen remodeling, jet skis and trips to Cancun would be unfair. It would be equally unfair to taxpayers not to recognize how common such deals were during the bubble.

At the height of the housing boom, Americans were pulling $300 billion each year out of their home equity, according to research by James Kennedy of the Federal Reserve. Since 2005, cash-out refinancings have represented a third of all mortgage originations in the United States. Rod Dubitsky of Credit Suisse estimates that close to half of subprime mortgages were cash-out refis. Spending the winnings from the rise in home prices meant that borrowers were converting to more risky mortgages, typically with higher monthly payments. According to Freddie Mac, most of its refinancings have resulted in larger loan amounts in every quarter since the middle of 2004.

Is taking on more debt a sign of responsibility? The Obama plan focuses on subsidizing borrowers to reduce their debt-to-income ratio, but taxpayers might be more interested in another statistic. Call it the flat-screen-to-kidney-transplant ratio. Can the Administration report how many of the people due to receive tax dollars spent home equity on plasma TVs? When this figure is divided by the number who spent the money on medical care, then Mr. Obama can make his case on the facts.

He might also explain why he is creating still another borrower bailout, when the $300 billion Hope for Homeowners plan enacted last year has hardly gotten off the ground. Although that program, launched in October, appears to be an attractive option for borrowers and lenders, housing analysts are puzzled at the slow roll-out. There are likely several factors at work, not least management of the program by the efficiency experts at the Department of Housing and Urban Development. We also wonder how many borrowers don't care for the requirement that they certify that their original mortgage applications were honest. Could it be that some "responsible families" will prefer the new Obama proposal because it lacks this requirement?

There is a moral hazard in rewarding bad decisions. But it's worse than that: The White House plan contains penalties for everyone else. The mortgage "cramdown," allowing bankruptcy judges to reduce the amount owed, can only make investors less willing to lend to future homebuyers.

Meanwhile, the politicians may claim that more generous refinancing by Fannie Mae and Freddie Mac will keep borrowers current and benefit everyone. But Fannie recently warned investors that its focus on foreclosure prevention "is likely to contribute to a further deterioration" in results. Since the Obama plan shovels another $100 billion each to Fan and Fred -- for a total commitment so far of $400 billion -- Fannie is talking to you.

from the Washington Post, 2009-Feb-20, p.A23, by Michael Kinsley:

Upside-Down Economics

In January, Suze Orman, the blonde financial adviser who's all over TV telling you to cut up your credit cards, went on "Oprah" to discuss how to cope with the recession. Orman recommended not eating in restaurants for a month. The appalled National Restaurant Association pointed out that if every "Oprah" watcher took this advice, it would cost 53,000 jobs.

But what are we supposed to do? Hoard our pennies, or spend them? For decades we've been told -- correctly -- that we're a profligate people with a profligate government, all living beyond our means. Some day, they said (okay, okay, I, among many others, said) that we would pay for all this profligacy. Now the black day has arrived, and we're told that the best way out of this mess is for the government to shovel money out the door even faster than before, with preference given to projects that can spend it as quickly as possible.

There has been less emphasis on what we, as individuals, should do. President Obama ducked the question at his news conference last week. But logic suggests that we should be gluing those credit cards back together. The government is actually going to pay us to buy a new house or car. Borrow and spend, borrow and spend is what got us into this mess. Apparently, borrow and spend will get us out of it.

It sounds too good to be true, but it is true. By now we all know about the "paradox of thrift": If everyone stops spending because times are bad, times get even worse. An economist writing in the New York Times the other day addressed the wonderfully inverted problem of people who feel guilty about not spending enough. His advice: Don't feel guilty about saving money, because it's the government's job, not yours, to make sure that we spend enough. But what if you don't feel guilty about reckless borrowing and spending? What if you actually enjoy it? This has been a more common attitude in recent years. Is it still okay? Or does the medicine have to taste bad to be any good?

And can we rely on the government to spend enough? This also seems like a wonderfully upside-down problem. The answer is, apparently not. We're going to need a second stimulus package, probably a third chapter of the bank bailout, more for the auto industry and others. It's all going to cost at least two or three trillion. If it works, it will be money well spent. If it doesn't work, that means we should have spent more.

Trouble is, money well spent is still money spent. The reasons that made it a bad idea to run up all that debt haven't disappeared just because something even worse came along. Almost no one in Washington is talking about this. Since 1981, Republicans have run up massive deficits and Democrats have discovered fiscal responsibility. Now they're all having too much fun reverting to type. Republicans reject the Keynesian premise that the money is being well spent because it is being spent. Too zen for them, or something. For some Democrats, meanwhile, the very fact that a program is costly has magically become an argument in its favor.

But even if the stimulus is a magnificent success, the money still has to be paid back. The plan of record apparently is that we keep borrowing, spending and stimulating, faster and faster, until suddenly, on some signal from heaven or Timothy Geithner, we all stop spending and start saving in recordbreaking amounts. Oh sure, that will work.

There is another way. If it's not the actual, secret plan, it will be an overwhelming temptation: Don't pay the money back. So far, even as one piggy bank after another astounds us with its emptiness, there have been only the faintest whispers about the possibility of an actual default by the U.S. government. Somewhat louder whispers can be heard, though, about the gradual default known as inflation. Just three or four years of currency erosion at, say, 10 percent a year would slice the real value of our debt -- public and private, U.S. bonds and jumbo mortgages -- in half.

Anyone who regards the prospect of double-digit inflation with insouciance is either too young to have lived through it the last time (the late 1970s) or too old to remember. Among other problems, inflation works only as a surprise or betrayal. It can never be part of any public, official plan. Plan for 10 percent inflation, and you'll get 20. Plan for 20 and you'll need a wheelbarrow to pay for your morning Starbucks. But if that's not the plan, what is?

Michael Kinsley is resuming a weekly column in The Post. His e-mail address is kinsleym@washpost.com.

from the Wall Street Journal, 2009-Feb-26:

The 2% Illusion
Take everything they earn, and it still won't be enough.

President Obama has laid out the most ambitious and expensive domestic agenda since LBJ, and now all he has to do is figure out how to pay for it. On Tuesday, he left the impression that we need merely end "tax breaks for the wealthiest 2% of Americans," and he promised that households earning less than $250,000 won't see their taxes increased by "one single dime."

This is going to be some trick. Even the most basic inspection of the IRS income tax statistics shows that raising taxes on the salaries, dividends and capital gains of those making more than $250,000 can't possibly raise enough revenue to fund Mr. Obama's new spending ambitions.

Consider the IRS data for 2006, the most recent year that such tax data are available and a good year for the economy and "the wealthiest 2%." Roughly 3.8 million filers had adjusted gross incomes above $200,000 in 2006. (That's about 7% of all returns; the data aren't broken down at the $250,000 point.) These people paid about $522 billion in income taxes, or roughly 62% of all federal individual income receipts. The richest 1% -- about 1.65 million filers making above $388,806 -- paid some $408 billion, or 39.9% of all income tax revenues, while earning about 22% of all reported U.S. income.

Note that federal income taxes are already "progressive" with a 35% top marginal rate, and that Mr. Obama is (so far) proposing to raise it only to 39.6%, plus another two percentage points in hidden deduction phase-outs. He'd also raise capital gains and dividend rates, but those both yield far less revenue than the income tax. These combined increases won't come close to raising the hundreds of billions of dollars in revenue that Mr. Obama is going to need.

But let's not stop at a 42% top rate; as a thought experiment, let's go all the way. A tax policy that confiscated 100% of the taxable income of everyone in America earning over $500,000 in 2006 would only have given Congress an extra $1.3 trillion in revenue. That's less than half the 2006 federal budget of $2.7 trillion and looks tiny compared to the more than $4 trillion Congress will spend in fiscal 2010. Even taking every taxable "dime" of everyone earning more than $75,000 in 2006 would have barely yielded enough to cover that $4 trillion.

Fast forward to this year (and 2010) when the Wall Street meltdown and recession are going to mean far few taxpayers earning more than $500,000. Profits are plunging, businesses are cutting or eliminating dividends, hedge funds are rolling up, and, most of all, capital nationwide is on strike. Raising taxes now will thus yield far less revenue than it would have in 2006.

Mr. Obama is of course counting on an economic recovery. And he's also assuming along with the new liberal economic consensus that taxes don't matter to growth or job creation. The truth, though, is that they do. Small- and medium-sized businesses are the nation's primary employers, and lower individual tax rates have induced thousands of them to shift from filing under the corporate tax system to the individual system, often as limited liability companies or Subchapter S corporations. The Tax Foundation calculates that merely restoring the higher, Clinton-era tax rates on the top two brackets would hit 45% to 55% of small-business income, depending on how inclusively "small business" is defined. These owners will find a way to declare less taxable income.

The bottom line is that Mr. Obama is selling the country on a 2% illusion. Unwinding the U.S. commitment in Iraq and allowing the Bush tax cuts to expire can't possibly pay for his agenda. Taxes on the not-so-rich will need to rise as well.

On that point, by the way, it's unclear why Mr. Obama thinks his climate-change scheme won't hit all Americans with higher taxes. Selling the right to emit greenhouse gases amounts to a steep new tax on most types of energy and, therefore, on all Americans who use energy. There's a reason that Charlie Rangel's Ways and Means panel, which writes tax law, is holding hearings this week on cap-and-trade regulation.

Mr. Obama is very good at portraying his agenda as nothing more than center-left pragmatism. But pragmatists don't ignore the data. And the reality is that the only way to pay for Mr. Obama's ambitions is to reach ever deeper into the pockets of the American middle class.

from the Wall Street Journal, 2009-Feb-28:

Your Citibank
Too big to fail, too big to succeed.

The taxpayer never sleeps when it comes to Citigroup, which yesterday got its third rescue in recent months from Uncle Sam. The amount and terms of the taxpayer commitment keep changing, while the management stays in place. The only institution that has a comparable track record on those two scores is Congress.

We don't mean to laugh, but we have to in order not to cry. No company on Earth has failed more often than Citigroup without being put out of its misery. Taxpayers have already put more than $50 billion in capital into the bank, while guaranteeing $301 billion of its bad assets, and the bank still can't stop its slide.

In a better world, Citi would have long ago been put into bankruptcy. The FDIC could have taken over and disposed of the bank's assets, while protecting insured deposits as it always does. The profitable parts of Citigroup could then have been sold off to people who could better manage them.

But in this vale of taxpayer tears, Citi is "too big to fail" and thus must be propped up lest it (allegedly) spread contagion through the financial system. While that may have been true last fall amid the worst of the financial panic, we don't think the contagion would be the same now that the federal government has guaranteed anything in the financial system that moves.

That isn't the view at Treasury, which yesterday agreed to a stock swap that will buy Citi more time to, well, who knows? The feds will trade the preferred taxpayer shares for Citigroup common, which means giving up their 5% dividend and taking on more future risk in return for a 36% ownership stake. Some of Citi's largest private preferred holders will also convert to common, which should give the bank a more stable capital base.

Meanwhile, Treasury is forcing the bank to get some new, and presumably more competent, directors. Many of the current directors were going to leave later this spring anyway, but at least this imposes some discipline in return for the federal largesse. Citi's management will stay in place, at least for now.

Again in a better world, the new board and Treasury would find better managers. But yesterday's announcement included no roadmap for how the bank plans to restructure, if it even plans to do so. The hope is that it can earn itself back to profitability. More realistically, a bank that has failed as often as Citigroup needs to shrink until it is no longer too big succeed.

from the Wall Street Journal, 2009-Feb-18, by Holman W. Jenkins, Jr.:

How Democracy Ruined the Bailout
Getting politics involved was Bernanke and Paulson's biggest mistake.

Woulda, coulda, shoulda, despite being a reputational black hole, can be educational.

Never was it a good idea to have a financial crisis in the middle of a presidential election. Involving Congress was a mistake. Letting the technical matter of keeping the banks afloat become a political football was a terrible idea. Letting our willingness to deploy giant sums of taxpayer money become the measure of credibility was a disaster. Letting all this be sold on Capitol Hill amid shrieks about the country collapsing into a Second Great Depression was a confidence killer across the economy, which until that point had held up well.

It's possible in hindsight to imagine a better course. Had matters simply been left in the hands of the Federal Reserve and fellow bank regulators, the "crisis" might have become fodder for little more than future late-night reminiscences by retired bureaucrats, pleasuring themselves with how closely the world came to burning down without the public ever knowing it.

Their efforts wouldn't have spared us a recession, perhaps a deep recession. But one mistake has been the degree to which recession-fighting has gotten mixed up with the system-bracing that should have been the preoccupation of the technocrats, with the less said to the broader public the better.

A rational, not political, approach would also have latched on early to the striking fact that much of the subprime crisis stemmed from just a handful of fast-growing counties in four states where housing prices zoomed then plummeted.

Looking back, the biggest mistake was the original Troubled Asset Relief Program -- not the idea itself, but because it required Congress's participation. Giant appropriated sums were never necessary, except perhaps by the screwy reasoning that banks had to be made to lend again for antirecession purposes.

The Fed and FDIC, formally or informally, had already guaranteed the deposits and other liabilities of the banks. Bank runs were off the table, so even if banks were technically insolvent, they could stay in business and have an opportunity to earn their way out of trouble. Withdrawal of investor support for the securitization of credit-card loans, auto loans and jumbo mortgages does present a big and somewhat related challenge (one the Fed is addressing), but otherwise the economy is not being starved for bank credit.

On the contrary, month after month, the National Federation of Independent Business, the authoritative small business trade group, has reported deepening pessimism among its members -- and yet no credit crunch. "Fewer loans are being made, but a substantial share of the decline is due to lower demand, not problems on the supply side," the group reported along with its just-released January survey.

The dynamics of our rapidly decelerating economy are not a mystery. Fear begets fearful actions. Employers cut costs and refrain from hiring. House shoppers pull back. What were good credit-card loans on bank balance sheets become bad ones. Good mortgages turn into bad ones. Nobody wants to buy a car, so auto jobs are lost.

To blame politicians is at once churlish and unavoidable. Nobody really is in control of the dynamic. Economists and philosophers talk about "path dependency" -- how a small act can shunt events onto one path or another, producing a cascade of consequences that were far from inevitable.

Ben Bernanke and Henry Paulson, in a phone call last Sept. 17, decided to involve political actors in the bailout following the Lehman debacle. They had good, legal, democratic and constitutional reasons for doing so, but it was a terrible mistake.

With perfect foresight, Mr. Paulson might have put his foot down and said, "No. We will solve this ourselves, even if it means stretching our powers beyond every precedent." After all, the Fed, Treasury, FDIC, and Fannie and Freddie (which by then were under Treasury control) jointly represented a set of tools, and balance sheets, that could credibly have stood behind just about any guarantee the two men chose to issue against further Lehman-like bankruptcies of important financial firms.

Let Congress complain about their actions after the fact. Avoided would have been the Pandora's Box of trying to politicize the delicate job of maintaining confidence in the financial system.

Harry Truman "scared hell" out of the country to get it ready to support a multigenerational facing-down of the Soviets. Scaring hell out of the economy, begun by President Bush and continued by President Obama, has produced only the runaway crisis it was advertised to prevent.

from the Wall Street Journal, 2009-Feb-14, by Henry Kaufman:

The Great Interest Rate Wave
What's caused such a wide swing in interest rates?

Amid the daily news about economic woes, it is useful to ponder the long view. And the long view shows that we now stand at the tail end of the greatest secular swing in interest rates in U.S. history. Interest rates are a barometer of economic conditions. So where have they been, and what can they tell us?

Secular swings are long-term movements that span years or decades and are punctuated by shorter cyclical movements. The pattern observed in the nearby chart -- which shows yields on the U.S. Treasury's 30-year long bond over the last six decades -- is unmistakable. The upward move began in 1946, when long bonds were yielding about 2.5%, and ended October 1981, when they peaked at 15%. Thereafter, yields on 30-year bonds fell irregularly to a low of 2.69% early this year, which probably marks the end of this extended wave.

The magnitude of this long up-and-down yield movement dwarfs by a very wide margin all four previous secular swings in American financial history. The cumulative change in the postwar trough-to-peak-to-trough swing was 25.3 percentage points. In the prior four secular swings, the largest change was just 5.6 percentage points, and that occurred in the much shorter period from 1810 to 1824. Indeed, the current secular swing is much longer than any previous wave.

This does not mean, however, that economic conditions at the beginning and end of the great swing are similar. They are, rather, similarly extreme. As Mark Twain once put it, history doesn't repeat itself, but often it rhymes.

In 1946, World War II had just ended and Americans -- after 16 years of depression and wartime constraints -- were eager to spend, their accounts flush with wartime full-employment savings. In the financial markets, banks were highly liquid, holding a large volume of U.S. government obligations and very little of private debt. The financial system already had been restructured by Congress during FDR's New Deal. At the same time, fresh memories of the depression caused banks and borrowers alike to spurn aggressive financial risk-taking.

Today, in contrast, even though the long government bond yield is nearly as low as it was in 1946, the financial scene is strikingly different. The private sector is overloaded with debt. The federal government continues to issue an unprecedented volume of new obligations. Our financial institutions are overleveraged and dependent on government largess for their survival. Whereas the nation stood on the brink of an unprecedented economic boom in 1946, today wealth is contracting massively and the economy is grinding through a severe recession.

So interest-rate movements, in their extreme highs and lows, reflect extremes in financial and economic conditions -- the restoration of global peace, the struggle to break the back of 1970s stagflation, and today's toxic combination of a deep recession with massive private-sector debt overload -- that are hobbling financial institutions.

The current interest-rate trough reflects several weaknesses in today's financial markets that also are undermining the broader economy, from the failure of monetary policy makers to recognize the impact of financial and structural changes on market behavior, to serious lapses by credit rating agencies, to the inability of the senior management of financial institutions to stay within reasonable risk parameters.

Which raises the question: Why are we so poor at managing our key economic institutions while at the same time so accomplished in medicine, engineering and telecommunications? Why can we land men on the moon with pinpoint accuracy, yet fail to steer our economy away from the rocks? Why do our computers work so well -- except when we use them to manage derivatives and hedge funds? The answer lies in methodology. In science and technology, we rely on the scientific method: experimental design with dependent and independent variables and with reproducible results.

Economists and financial experts like to fancy themselves as exact scientists as well. Back in the 1960s, when we landed on the moon, economists emulated the terminology of Space Age navigation. They spoke of "midcourse corrections" and of bringing in the economy for a "soft landing." Since then, quantification and modeling have only grown thicker in the economics profession, where econometricians and other "quants" employ complicated analytical techniques and mathematical formulas.

By the 1980s, many economists had embraced the theory of "rational expectations," which essentially held that markets were all knowing and infallible. All of this infused the profession with an aura of authority, authenticity and accuracy.

The computations were correct, but far too often the conclusions drawn from them were not. This is because the models rely on historical data but fail to take into account the profound impact of structural changes in our economy and in financial markets that have unfolded in the postwar decades.

These structural changes -- including securitization, globalization and the explosion of debt -- have altered financial behavior in ways that the econometric models miss. In the decades since World War II, they have liberated financial risk-taking, as markets learned to game the system beyond the parameters of quantitative models. That is a critical difference between now and the last time interest rates were comparably low six decades ago.

Let's hope that is about to change. A central goal of new financial legislation should be to rein in extreme financial behavior. To inject some restraint into the rampant securitization that contributed so much to the current crisis, loan originators should be made responsible for a portion of repackaged loans. Off balance sheet activities should be brought back onto the balance sheet. Credit derivatives should be limited to a small proportion above the outstanding credit obligations. Financial conglomerates, which by their sprawling scale and scope are vulnerable to conflicts of interests, should be given special scrutiny by regulators.

These and similar measures will help induce financial institutions to balance their entrepreneurial drive with their fiduciary responsibilities. And if that happens, the next secular swing in interest rates should be more moderate than the great interest wave we have just ridden.

Mr. Kaufman, president of Henry Kaufman & Company Inc., a financial consulting firm, is the author of "On Money and Markets: A Wall Street Memoir" (McGraw-Hill, 2001).

from the Wall Street Journal, 2009-Feb-18:

Dukes of Moral Hazard
Re-default rates are 55% after six months.

President Obama yesterday announced his plan to prevent home foreclosures, saying he wanted to be "very clear about what this plan will not do: It will not rescue the unscrupulous or irresponsible by throwing good taxpayer money after bad loans . . . And it will not reward folks who bought homes they knew from the beginning they would never be able to afford."

We really do wish he were right. In fact, the details released yesterday suggest the President's plan will do all of the above. The plan will help some struggling homeowners. But by investing in failure, the Administration will also prolong the housing downturn and make financing a home purchase more difficult for future borrowers. Meanwhile, the plan isn't likely to slow the continuing decline in housing prices.

Let's focus on the plan's effect on the individual borrower. Anyone with mortgages owned or guaranteed by Fannie Mae and Freddie Mac will be able to refinance to lower rates if his mortgage is between 80% and 105% of the value of the home. This is a sweet deal that is not available, for example, to many renters looking to buy homes now. Sadly for those who deferred the gratification of homeownership, the 20% down payment has now become industry standard. But at least their taxes will allow other people to stay in homes they can't afford.

Existing borrowers who may not qualify for Fan/Fred refinancing can still receive loan modifications that move their mortgage payments down to 31% of monthly income. In either case, no effort will be made to verify that recipients of aid were truthful on their original mortgage applications. Given that mortgage fraud skyrocketed during the housing boom, and that the Obama Administration intends to assist up to nine million troubled borrowers, we can say with certainty that the unscrupulous will be among those rescued.

Going forward, it will be up to lenders to verify income. Getting this number correct is critical to the government's hopes for the plan. That's because, if pending Treasury guidelines follow the Federal Deposit Insurance Corp. model on which they are based, new modifications will forgo extensive underwriting. The FDIC believes that a lot of the normal research that goes into making a loan or a refinancing decision can be skipped as long as the mortgage-debt-to-income ratio can be moved, even if only for a few years, down to that magic number of 31%. So the government will pay loan servicers $1,000 for each mortgage modified, share the cost of lowering the monthly payments and pay other subsidies to lenders and borrowers -- adding up to $75 billion in taxpayer assistance for modifications. The government will then spend another $10 billion compensating lenders if the housing market continues to decline and some of these loans go bad again.

Will $10 billion be enough? The recent history of mortgage modifications isn't encouraging. According to the December report by the Comptroller of the Currency and the Office of Thrift Supervision, "The number of loans modified in the first quarter that were 30 or more days delinquent was 37 percent after three months and 55 percent after six months. The number of loans modified in the first quarter that were 60 or more days delinquent was 19 percent at three months and nearly 37 percent after six months."

Said Comptroller John Dugan, "One very troubling point is that, whether measured using 30-day or 60-day delinquencies, re-default rates increased each month and showed no signs of leveling off after six months and even eight months."

Those who favor Mr. Obama's plan say that many of these modifications haven't lowered monthly payments the way the new plan does. True, and the more taxpayer dollars are spent subsidizing a particular borrower, the more affordable a loan becomes. But in part to avoid putting an astronomical price tag on this plan, the Administration doesn't necessarily fix loans for the long term.

In fact, the program encourages mortgage servicers to keep the payments low only for five years, after which rates will rise. During the housing bubble, these were called "teaser" rates. Modifications also may extend the term of, say, a 30-year mortgage to 40 years, but still leave the borrower underwater. Research at Credit Suisse suggests that borrowers without equity are not a good bet to stay current. What research cannot answer is how many people will seek assistance when they are told that a new federal program is available to cut their mortgage bill.

Mr. Obama's mortgage plan is his third big economic rescue proposal in a month, and perhaps someone in the White House has noticed that financial markets haven't exactly cheered. Yesterday's end-of-day wrap from UBS put it this way: "Obama Speaks, Market Listens, Sells Off."

What investors, businesses and working Americans want to hear is a President with ideas to spur economic recovery. What they've been getting are plans for a long national Chapter 11 workout.

from syndication via the Manchester Union-Leader, 2009-Jan-31, by Walter E. Williams:

The stimulus plan fails the swimming pool test

Here is what my George Mason University colleague, Professor Richard Wagner, wrote, which was published by the Office of the House Republican Leader: "Any so-called stimulus program is a ruse. The government can increase its spending only by reducing private spending equivalently. Whether government finances its added spending by increasing taxes, by borrowing or by inflating the currency, the added spending will be offset by reduced private spending. Furthermore, private spending is generally more efficient than the government spending that would replace it because people act more carefully when they spend their own money than when they spend other people's money."

A short translation of Wagner's comment is: There is no Santa Claus or Tooth Fairy.

Let's examine the ruse. Suppose the value of all that we will produce in 2009, our gross domestic product (GDP), totals $14 trillion. There cannot be any disagreement that if Congress spends $4 trillion, of necessity there is only $10 trillion left over for us to spend privately. In other words, if Congress is going to spend $4 trillion, it must find a way to get us to spend $4 trillion less. The most open and aboveboard method to force us to spend less privately is to tax us to the tune of $4 trillion.

You might say, "Congress doesn't have to tax us $4 trillion. They could tax us $3 trillion and run a $1 trillion budget deficit." You have that wrong. There is no way for Congress to spend $4 trillion out of our 2009 $14 trillion GDP by getting us to spend only $3 trillion less privately. It has to be $4 trillion less.

Another method to force us to spend less privately is to print money and inflate the currency. Rising prices reduce our ability to spend privately since each dollar we hold will not buy as much. Another way is for Congress to borrow, thereby reducing our ability to spend privately. By the way, all of this means that in any real economic sense the federal budget is always balanced. That is, if Congress spends $4 trillion we must privately spend $4 trillion less whether it is accomplished through taxation, inflation or borrowing.

The stimulus package being discussed is politically smart but economically stupid. It's that bedeviling, omnipresent Santa Claus and Tooth Fairy problem again.

Let's say that Congress taxes you $500 to put toward creating construction jobs, building our infrastructure. The beneficiaries will be quite visible, namely those employed building a road. The victims of Congress are invisible and are only revealed by asking what you would have done with the $500 if it were not taxed away from you. Whatever you would have spent it on would have contributed to someone's employment. That person is invisible.

Politicians love it when the victims of their policies are invisible and the beneficiaries visible. Why? Because the beneficiaries know for whom to vote, and the victims do not know who is to blame for their plight.

In stimulus package language, if Congress taxes to hand out money, one person is stimulated at the expense of another, who pays the tax and is unstimulated. A visual representation of the stimulus package is: Imagine you see a person at work taking buckets of water from the deep end of a swimming pool and dumping them into the shallow end in an attempt to make it deeper. You would deem him stupid. That scenario is equivalent to what Congress and the new President proposes for the economy.

A far more important measure that Congress can take toward a healthy economy is to ensure that the 2003 tax cuts don't expire in 2010 as scheduled. If not, there are 15 separate taxes scheduled to rise in 2010, costing Americans $200 billion a year in increased taxes. In the face of a recession, we don't need that.

Walter E. Williams is a professor of economics at George Mason University.

from the New York Post, 2009-Feb-13, by Nicole Gelinas:

STIMULUS = DEATH?

NEW York politicians are already exulting over the state's share of the $789 billion "economic stimulus." That puts us on track to disaster.

State and local pols need to remember: This money isn't free, and it's not infinite. We have one chance to do this right. If we don't, we'll pay for this "stimulus" again and again.

The bill nationalizes the practice that helped put New York on the skids in the '70s: borrowing money so that states and cities can pay operating expenses. Bad idea:

* First, once you've spent the money on day-to-day costs, the benefit is gone - but you're stuck with debt.

* Second, if you're borrowing for everyday spending, you're wasting a finite amount of debt that should be going toward improving things like flood-control systems, subways and bridges. So when you finally run out of money, this stuff will start to break down because of neglect and cost more to fix than it would have if you'd dealt with it earlier - a triple whammy that makes it harder to recover.

Yet the stimulus involves borrowing by the feds to give states and cities nearly $170 billion for everyday expenses like education and health-care costs.

Federal borrowing is still borrowing. This vast new debt will likely prompt lenders to demand higher interest rates. And it will inevitably push up municipal-bond interest rates, making it more expensive for New York to borrow.

In effect, then, the federal government is consuming some of our power to borrow - and giving us some of the money back to pay operating expenses. We're right back to the '70s, through the back door.

What about the $37 billion that the stimulus will give the states for roads, bridges and transit? The risk here is that we'll use the cash for the wrong things.

Because the vast new federal borrowing could constrict our credit for years to come, it's crucial that Gov. Paterson, Mayor Bloomberg, Assembly Speaker Sheldon Silver and the rest act responsibly in spending this small amount of infrastructure money.

And that cash has already shrunk: Because the bill's latest version has less for transit spending, New York will be lucky to get $1.8 billion for its subways and buses. (If you call it "luck" to send money to DC only to get some of it back.)

Our last "windfall" federal funding - the post-9/11 grant to build an $850 million subway station near Ground Zero - suggests the dangers.

We'd never have spent our own money on this Fulton Street project - there's a thousand better ways to spend nearly $1 billion on transit in the city. But the pols figured: The money's free - why not?

Because the MTA wound up starting a luxury project it can't afford to finish - that's why not.

Last year, it became clear that the Fulton Street project, as conceived, would cost us about half a billion more than the feds had granted - showing the real cost of "free money" spent recklessly. And the MTA's start of the project has torn down a previously healthy swath of Downtown.

Now, the feds have saved us again - seemingly. The MTA, upon Silver's self-described "complaint," will spend $500 million in stimulus funds to try to finish the project.

Sorry, this is not the best use of $500 million in transit funds - a quarter or more of our federal money. Throwing more cash into Fulton Street at the expense of other projects isn't a rational decision but a political one - the immensely powerful Silver wants a hole in his district filled in.

Sure, it would be nice to get the thing done - but the trains are still running underneath. And the cold reality is that the MTA needs far more billions than the feds are giving New York - to pay for projects that aren't fancy extras but will avert disasters.

What's worse - another vacant lot or subway lines that don't run reliably because we've stopped replacing obsolete equipment? The MTA says it needs $15 billion over the next 15 years just to maintain and replace signals.

Another potential waste of our finite stimulus money: Developer Bruce Ratner is reportedly lobbying for some of the cash to go to his Atlantic Yards basketball stadium and apartment project.

Sorry, surplus "luxury" apartments and a stadium aren't core infrastructure. This boondoggle shouldn't be taking a dime away from the region's real capital-starved assets - which the private sector needs to be running reasonably well so that it can recover.

President Obama once said that the stimulus bill would be a chance to invest in bold new infrastructure - but it isn't. So, until New York can find the political will to invest in its own future, it needs triage. The last thing we need to do is waste borrowed, finite money on any more white elephants.

Nicole Gelinas is a contributing editor at City Journal.

from the Wall Street Journal, 2009-Feb-14:

Committee on Doubt and Uncertainty
A day in the life of House Financial Services.

Anyone trying to understand why the credit mess keeps getting messier needs only to have sat through Wednesday's hearing of the House Financial Services Committee. The eight bank CEOs were mere props. The stars were the politicians, who managed to demand more loans for consumers while simultaneously giving lenders new cause to wonder if they'll ever be repaid. This gathering of the esteemed Committee on Doubt and Uncertainty occurred as markets desperately need less of both.

Chairman Barney Frank's hearing was intended to flay the CEOs for not lending enough. It fell flat as political theater because banks have actually increased their lending in recent months. The people who aren't lending more are investors in nonbank financing such as asset-backed securities.

In fact, the nonbank credit market is normally much bigger than bank lending. But new issues backed by auto loans, credit cards and the like have been rare this year, as markets wonder how the government's next move will change the value of such investments. Buyers and sellers of existing securities are "sitting on the sidelines," according to Asset-Backed Alert, waiting for still another Washington recalibration of risk and reward.

Most investors who lend in these markets are not recipients of financial bailout money, so Congress can't simply browbeat them into making another big bet on the American consumer. They've been burned badly. They need reassurance that our capital markets operate with a consistent set of rules. The Committee on Doubt and Uncertainty offered only the assurance that the rules will keep changing.

Early in the hearing, Mr. Frank urged all lenders not to foreclose on any mortgage borrowers until Treasury Secretary Timothy Geithner unveils a new foreclosure mitigation plan. In fact, foreclosures had already started to decline due to Treasury-created uncertainty. Mr. Frank's admonition will cause a more rapid fall, since Citigroup, Bank of America and J.P. Morgan "volunteered" to a temporary freeze after the hearing.

Don't confuse this with a sign that the housing market is improving. The pols are simply delaying the pain until they decide how much to inflict on taxpayers versus investors. It's true that investors in consumer debt can expect subsidized financing from Mr. Geithner, but it's a flip of the coin whether the new subsidies will outweigh the costs of new foreclosure limits.

The safest bet is a huge new rescue of those who borrowed too much, and Mr. Geithner has already promised another $50 billion of your tax dollars. Meanwhile, Mr. Frank made clear that Congress's obsession with promoting homeownership is alive and well. He explained that his foreclosure moratorium pending the Geithner plan is to avoid a circumstance akin to a soldier who is killed after a ceasefire agreement but before the news has reached the front. Readers who don't equate moving into a rental with death in combat should direct their comments to Mr. Frank's office.

Maxine Waters (D., Calif.), for her part, demanded to know why some banks don't modify loan terms until borrowers are 60-days delinquent. Heck, why stop at mortgages? Shouldn't lenders convert all of their money-making contracts into losers?

If potential investors weren't frightened enough, Nydia Velazquez (D., N.Y.) then seized the microphone. She demanded to know if the assembled CEOs would back "cramdown" legislation, which rewrites the bankruptcy code to allow judges to reduce the amount people owe on their mortgages. So investors who might have jumped back into housing now must calculate the odds that this provision will pass the Senate, and if it does, how much bankruptcy judges will reduce their overall returns.

Goldman Sachs CEO Lloyd Blankfein pointed out that a potential consequence of bankruptcy cramdowns is that "less capital flows into this market." The only CEO who sided with Rep. Velazquez was Citigroup's Vikram Pandit, who also agreed with nearly everything the politicians had to say. This is what a CEO does when his bank becomes a de facto ward of the state, as Citi now is. Unfortunately, Mr. Pandit's support for cramdowns will only discourage nongovernment investors in housing markets.

All in all, just another day's work for the Committee on Doubt and Uncertainty, which continues to believe that proposing more ways to punish lenders will somehow produce more lending.

from the Wall Street Journal, 2009-Feb-17, by John Steele Gordon:

A Short History of the National Debt
Deficits are nothing new. It's the trend that should worry us.

When President Barack Obama signed the American Recovery and Reinvestment Act of 2009 into law yesterday, he was adding to what is already almost guaranteed to be the largest deficit in American history. In January, the Congressional Budget Office projected that the deficit this year would be $1.2 trillion before the stimulus package. That's more than twice the deficit in fiscal 2008, more than the entire GDP of all but a handful of countries, and more, in nominal dollars, than the entire United States national debt in 1982.

But while the sum is huge, it is not in and of itself threatening to the solvency of the Republic. At 8.3% of GDP, this year's deficit is by far the largest since World War II. But the total debt is, as of now, still under 75% of GDP. It was almost 130% following World War II. (Japan's national debt right now is not far from 180% of that nation's GDP.)

Still, it's the trend that is worrisome, to put it mildly. There have always been two reasons for adding to the national debt. One is to fight wars. The second is to counteract recessions. But while the national debt in 1982 was 35% of GDP, after a quarter century of nearly uninterrupted economic growth and the end of the Cold War the debt-to-GDP ratio has more than doubled.

It is hard to escape the idea that this happened only because Democrats and Republicans alike never said no to any significant interest group. Despite a genuine economic emergency, the stimulus bill is more about dispensing goodies to Democratic interest groups than stimulating the economy. Even Sen. Charles Schumer (D., N.Y.) -- no deficit hawk when his party is in the majority -- called it "porky."

It was not ever thus. Before the Great Depression, balancing the budget and paying down the debt were considered second only to the defense of the country as an obligation of the federal government. Before 1930, the government ran surpluses in two years out of three. In 1865, the vast debt run up in the Civil War amounted to about 30% of GDP; by 1916 it was less than a tenth of that.

There even was a time when the U.S. made it a deliberate policy to pay off the national debt entirely -- and succeeded in doing so. It remains to this day the only time in history a major country has been debt free. Ironically, the president who achieved this was the founder of the modern Democratic Party, Andrew Jackson.

Jackson was a Jeffersonian through and through. The smaller the federal government, the more he liked it. And, like Jefferson, he hated banks, speculation and the "money interest." Unlike Jefferson, however, he was born poor and made his own fortune. An early personal encounter with debt had taught him to fear it. When the notes of someone who had bought land from him proved worthless, he became liable for the debts he had secured with those notes, and it took him years to pay them off.

When he ran for president the first time, in 1824, Jackson called the debt a "national curse." He vowed to "pay the national debt, to prevent a monied aristocracy from growing up around our administration that must bend to its views, and ultimately destroy the liberty of our country."

"How gratifying," he wrote in 1829 as he began his presidency, "the effect of presenting to the world the sublime spectacle of a Republic of more than 12 million happy people, in the 54th year of her existence . . . free from debt and with all . . . [her] immense resources unfettered!"

When Jackson entered the White House, the national debt, which had reached $125 million at the end of the War of 1812, had already been reduced to $48 million. To get it to zero he was perfectly willing to forego what were then called "internal improvements" and are now known as infrastructure projects. One Kentucky congressman, after a trip to the White House to beg Jackson to sign one such bill, reported to his allies that "nothing less than a voice from Heaven would prevent the old man from vetoing the Bill, and [I doubt] whether that would!"

At the end of 1834, Jackson reported in the State of the Union message that the country would be debt free as of Jan. 1, 1835, with a Treasury balance of $440,000. Government revenues that year would be twice expenses.

It didn't last long, to be sure. The great prosperity of the early 1830s broke in the summer of 1836 when a bubble in land speculation, fueled by easy credit, abruptly ended. The bubble burst, ironically enough, thanks to Andrew Jackson's issuance of the "specie circular," which required that all land bought from the government, except that actually settled on, be paid for in gold or silver.

By the next spring, just as Jackson left the White House, the longest contraction in American history -- six years -- had begun. As one Wall Streeter put it, "The fortunes we have heard so much about in the days of speculation, have melted like the snows before an April sun." Federal revenues fell by half that year and the national debt was back, this time for good.

While today there is no hope of balancing the budget -- or wisdom in trying to -- until the economy substantially improves, we could make a sort of down payment on reforming Washington's porky ways by simply starting to tell the truth.

It has been widely noted that 2009 will have the first "trillion-dollar deficit" in American history. Actually it's the second. In fiscal 2008, the national debt increased from $9 trillion to slightly over $10 trillion. Yet the budget deficit in the last fiscal year was officially reported as being $455 billion. How could the national debt have increased by considerably more than twice the "deficit"? Simple. Just call the money borrowed from the Social Security trust fund an "intragovernmental transfer" and exclude it from the calculation of the deficit.

Corporate managers have gone to jail for less book cooking than that.

Mr. Gordon is the author of "Hamilton's Blessing: The Extraordinary Life and Times of Our National Debt" (Walker, 1997).

from the Wall Street Journal, 2009-Feb-3:

Nationalize This
The Fed's embrace is suffocating AIG.

Thirty years ago, Nobel prize-winning economist Milton Friedman and wife Rose wrote that "the combination of economic and political power in the same hands is a sure recipe for tyranny." As we're learning, it's also really, really expensive.

Washington regulators tempted to nationalize banks don't need to study decades of history to understand the point. Merely consider the last five months, and the nationalization experiment the New York Federal Reserve Bank has conducted at AIG.

In September, the government took control of almost 80% of the giant insurer and to date has provided AIG with more than $150 billion in taxpayer financing. The initial terms of the government assistance were so poorly crafted that some AIG shareholders said the firm would be better off in bankruptcy. After several rewrites to the deal and a lot more taxpayer money at risk, an AIG spokesman now says that executives "hope" that they won't need more federal help.

Still, the firm is reviewing its options. One of them seems to be to seek government guarantees on new categories of assets. So far, taxpayer cash has largely relieved AIG of the burden of bad bets on residential mortgages. The firm is now at a "preliminary" stage in considering whether taxpayers can also help insure AIG's $22 billion in commercial mortgage-backed securities. Meanwhile, the company's stock price hovers near $1 per share, and AIG watchers are beginning to think the feds may never get the taxpayer's investment back. In short, the federal "rescue" appears to be squeezing the life out of AIG.

At the time of the September intervention, AIG had very healthy insurance businesses trapped under a holding company that had bet wrong on housing. Outsiders familiar with the firm say that now even those once-healthy AIG businesses are losing talent and having to cut prices to keep customers. Any price discounting will lead to further losses down the road. The company denies that it is writing unprofitable insurance policies and says that executive defections are within the range of normal turnover.

A clearer picture of AIG will emerge in a few weeks when the company files its annual 10-K report with the SEC. What's clear already is that the company has had difficulty fulfilling its stated plan to sell assets to repay government loans. With institutional buyers and even foreign capital scarce, AIG management is considering selling business units to the public. Buyers aren't very plentiful in that market either, however, as the U.S. suffers through the worst environment for initial public offerings since the 1970s.

We wish AIG well and we should note that the current management -- unlike many of the current directors -- did not create this mess. Still, we're waiting for someone to make the argument that this nationalization of a major financial firm has been a success. AIG has become the intervention that nobody in Washington wants to discuss, least of all the New York Fed or its former President and now Treasury Secretary Timothy Geithner. However, since some of the same people who gave us the AIG debacle are now contemplating plans to nationalize a good chunk of the banking system, it's vital that someone encourages them to learn from their mistakes.

from Reuters, 2009-Feb-23, by Paritosh Bansal, with additional reporting by Chris Kaufman and Euan Rocha and editing by Richard Chang, Jeffrey Benkoe, Tim Dobbyn, andf Gary Hill:

AIG in talks with U.S. government, sees $60 billion loss: source

NEW YORK - American International Group Inc, rescued twice last year by the U.S. government, is asking for more aid and bracing for a fourth-quarter loss of roughly $60 billion, a source familiar with the matter said. It would be the biggest loss in a quarter in corporate history.

The $60 billion would exceed Time Warner's $54 billion single-quarter loss in 2002 and dwarf the $24.5 billion loss AIG posted in the third quarter, when the government increased its rescue package for the insurer to about $150 billion.

By contrast, two analysts polled by Reuters Estimates have forecast on average a net loss of $5.46 billion.

The latest round of talks with the government include the possibility of additional funds for the insurer and trading debt for equity, another source said on Monday.

The situation is fluid and other options are being discussed, this second source said, adding that it was unclear where the talks would lead.

AIG may look to convert preferred shares held by the government into common stock, Bloomberg reported, citing an unnamed source.

The discussions are going on as U.S. financial authorities try to put out other fires, as well. Citigroup Inc, whose stock has been pounded by fears that the government may seize the bank and wipe out shareholders, is also in talks to give the government a larger stake, a person familiar with the matter told Reuters.

CNBC, which first reported AIG's discussions, said the losses to be announced next Monday were due to writedowns on commercial real estate and other assets. It said the insurer's board will meet next Sunday to work out an agreement with the government.

In case they do not reach a deal, AIG's lawyers at Weil, Gotshal & Manges LLP were preparing for the possibility of bankruptcy, CNBC said.

But the first source told Reuters that while AIG has retained Weil Gotshal, the insurer has no plans to file for bankruptcy.

"Is it likely that $60 billion more of capital has been destroyed? Or is it likely that they are just accounting for that which already happened?" said Thomas Russo, a partner at Gardner, Russo & Gardner, which manages more than $2 billion. "I suspect it's more of the latter than the former."

AIG said in a statement it had not yet reported results and would provide an update when it does so in the near future.

"We continue to work with the U.S. government to evaluate potential new alternatives for addressing AIG's financial challenges," AIG said.

U.S. Treasury officials declined to comment. Weil could not be reached immediately for comment.

AIG shares closed down 1 cent at 53 cents on the New York Stock Exchange on Monday.

AIG was first rescued in September after bad mortgage bets left it on the verge of collapse. The government stepped in with $85 billion in bailout financing, as the credit crisis peaked with Lehman Brothers Holdings Inc filing for bankruptcy and Merrill Lynch agreeing to be bought by Bank of America Corp.

The rescue swelled in November as AIG posted its then-largest ever loss, hurt by writedowns on assets linked to subprime mortgages and capital losses. The Federal Reserve and U.S. Treasury stepped in with even more money to buy mortgage assets that had left AIG deeply in the red, and eased the terms of its loan repayment.

AIG has said it plans to sell all assets except its U.S. property and casualty business, foreign general insurance, and an ownership interest in some foreign life operations, as it looks to raise money to pay back the government.

Although AIG has announced some sales, it is trying to sell assets at a time when buyers are often dealing with their own problems and credit for acquisitions is scarce. The insurer's ongoing troubles are likely making things harder.

"The seller is in a rather perilous position," Russo said. "And buyers typically appreciate the amount of leverage they have."

from MarketWatch.com, 2009-Jan-14, by Greg Robb:

Fault lines emerge at Fed
Bernanke, Philadelphia Fed's Plosser differ publicly on new policy

WASHINGTON - Key fault lines are emerging at the Federal Reserve over the central bank's journey into uncharted monetary policy.

In a speech on Tuesday, Philadelphia Fed Bank president Charles Plosser publicly took issue with positions advocated by Fed chief Ben Bernanke.

In a breathtaking innovation in monetary policy, the Bernanke Fed since the fall has not only expanded its balance sheet from $900 billion to well over $2 trillion in its efforts to restore the credit markets to health but has stopped offsetting the expanding bank reserves.

The Fed has begun purchasing commercial paper, mortgage-backed securities, and other assets to keep the markets from collapsing.

Bernanke signaled on Monday that it was full speed ahead with these new purchases.

He even talked about an expansion of the plan - saying the Fed's plan to purchase consumer and small business loans with the help of the Treasury was a model "that can be expanded to accommodate higher volumes or additional classes of securities as circumstances warrant.

He said he sees no near-term problem with inflation.

On the other hand, Plosser urged the Fed to "proceed with caution" with the new policy. Others outside the Fed are much more strident and want plans in place immediately to reverse it. They believe an inflation storm is already in train.

"It is a huge disagreement," said Robert Brusca, chief economist at FAO Economics.

While the Fed chairman has made it a practice to run a more democratic central bank, the disagreements come at a crucial time when the Fed is striving to appear on top of the current financial market crisis and steep recession.

Bernanke argued that focusing on the size of the balance sheet misses the point, arguing the Fed's various asset purchase programs are not easily summarized in a single number.

But Plosser said that the growth of the Fed's balance sheet was a key metric.

"It is not appropriate to ignore quantitative metrics in this new policy environment," Plosser said.

On the surface, the debate is about how the describe the programs.

Bernanke and Fed officials have gone to great lengths to say that the new policy is not "quantitative easing" similar to the Bank of Japan's actions in the 1990s.

Instead, Bernanke called the new program "credit easing" and tried to put the focus on "the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses."

But Plosser is bringing the spotlight right back to the Fed's balance sheet.

"The size of the balance sheet does offer a possible nominal anchor for monitoring the volume of our liquidity provisions," Plosser said.

Underneath the surface is a real concern about how and when the Fed tries to exit from its new monetary policy.

Fed officials who pay attention to the money supply believe that the Fed's current policy of printing money never ends well and the danger of inflation is very high. They believe the Fed must withdraw the stimulus before there is any sign of inflation or it is too late.

Bernanke's remarks indicate he wants the flexibility and doesn't want to tie his hands.

William Poole, who recently left his post as president of the St. Louis Fed, says it is crucial that the Fed set a target for cutting its balance sheet.

Poole said the expansion of the Fed's balance sheet is unprecedented and research suggests that a surge of inflation is sure to follow.

"I would say if the policy is not reversed, there is a high probability that the unpleasant risk (of inflation) materializes," Poole said in an interview.

"I believe that the Fed should set a hard number - a target that they take seriously for the overall size of the balance sheet," he said.

Plosser also argued that the Fed has put its independence at risk by buying long-term assets. He worried that some "interest groups" will try to use political persuasion to stop the Fed from selling these longer-term assets even if the central bank has decided it makes sense.

"We will need to have the political fortitude to make some difficult decisions about when our policies must be reversed or unwound," Plosser said.

Bernanke said that he would watch this situation closely but didn't expect it to be a "significant problem."

Poole said he was very concerned that the Fed could simply lend money to anyone, without constraint.

In the Soviet Union and Eastern Europe during the Cold War era, economies were inefficient because they had a soft-budget constraint. If a firm got into trouble, the banking system would give them more money, Poole said.

The current situation at the Fed seems eerily similar, he said.

"What is discipline - where are the hard choices - when does Fed say our resources are exhausted?" Poole asked.

from Bloomberg, 2009-Jan-25, by Rich Miller:

Bernanke Risks `Very Unstable' Market as He Weighs Buying Bonds

Federal Reserve Chairman Ben S. Bernanke and his colleagues may try once again to cure the aftermath of a bubble in one kind of asset by overheating the market for another.

Fed policy makers meeting tomorrow and the day after are exploring the purchase of longer-dated Treasury securities in an effort to push up their price and bring down their yield. Behind the potential move: a desire to reduce long-term borrowing costs at a time when the Fed can't lower short-term interest rates any further because they are effectively at zero.

The risk is that central bankers will end up distorting the Treasury market, triggering wild swings in prices -- and long-term interest rates -- as investors react to what they say and do. “It sets forth a speculative dynamic that is very unstable,” says William Poole, former president of the Federal Reserve Bank of St. Louis and now a senior fellow at the Cato Institute in Washington.

The Treasury market has “some bubble characteristics,” Bill Gross, the manager of Newport Beach, California-based Pacific Investment Management Co.'s $132 billion Total Return Fund, said in December on Bloomberg Television. He echoed that sentiment last week.

“I will say, and I have said for the past three months, the governments are very overvalued,” Gross said in a Jan. 20 interview. Treasuries last year returned 14 percent, according to Merrill Lynch & Co.'s Treasury Master Index, their best performance since 1995.

Inflated Prices

Recent history shows the economic danger of inflating asset prices. After a stock-market bubble burst in 2000, the Fed slashed interest rates to as low as 1 percent and in the process helped inflate the housing market. The collapse of that bubble is what eventually helped drive the U.S. into the current recession, the worst in a generation.

Faced with the danger of a deflationary decline in output, prices and wages, the Fed is considering steps to revive the moribund economy. On the table besides bond purchases: firming up a pledge to keep short-term interest rates low for an extended period and adopting some type of inflation target to underscore the Fed's determination to avoid deflation.

The central bank has been buying long-term Treasury debt off and on for years as part of its day-to-day management of reserves in the banking system. Yet it has always gone out of its way to avoid influencing prices. What it's discussing now, says former Fed Governor Laurence Meyer, is deliberately trying to push long rates below where they otherwise might be.

Fed Purchases

Bernanke raised this possibility in a speech on Dec. 1. While he didn't specify what maturities the Fed might buy, in the past he has suggested that purchases might include securities with three- to six-year terms.

Investors immediately took notice, with the yield on the 10-year note falling to 2.73 percent from 2.92 percent the day before. Yields fell further on Dec. 16, dropping to 2.26 percent from 2.51 percent the previous day, after the central bank's policy-making Federal Open Market Committee said it was studying the issue.

“Every time they mention it, the market reacts,” says Stephen Stanley, chief economist at RBS Greenwich Capital Markets in Greenwich, Connecticut.

Yields have since risen, with the 10-year note ending last week at 2.62 percent. Behind the reversal: expectations of massive fresh supplies of Treasuries as the government is forced to finance an $825 billion economic-stimulus package and a possible new bank-bailout plan. This week alone, the Treasury is scheduled to auction $135 billion worth of securities.

Jump in Yields

David Rosenberg, chief North American economist for Merrill Lynch in New York, says the jump in yields may prompt the Fed to go ahead with Treasury purchases.

This isn't the first time Bernanke and the Fed have discussed buying longer-dated securities and ended up roiling the market. Bernanke touted the idea as a tool to fight deflation in speeches in November 2002 and May 2003.

Egged on by his comments -- and later remarks by then-Fed Chairman Alan Greenspan that the central bank needed to build a “firewall” against deflation -- many investors became convinced the central bank was poised to buy bonds. The yield on the 10-year Treasury note fell to 3.11 percent in June 2003 from 3.81 percent at the start of the year.

Traders quickly reversed course as it became clear the Fed had no such intentions, sending the 10-year Treasury yield soaring to 4.6 percent just three months later, on Sept. 2.

`Miscommunication'

Poole, who was then at the St. Louis Fed, was critical at the time of what he called the central bank's “miscommunication.” He now sees the Fed making the same mistake with its latest suggestions that it might buy longer- dated securities.

“If they do it, it's going to be disruptive to the market,” says Poole, who is a contributor to Bloomberg News. “If they don't do it, it will impair the Fed's credibility and erode the confidence the market has in the statements that the Fed makes.”

Meyer, now vice chairman of St. Louis-based Macroeconomic Advisers, says the Fed should, and probably will, go ahead with purchases as a way to lower borrowing costs. “The story is stop talking and start buying,” he says.

Still, he notes that not everyone at the Fed is enthusiastic about the idea. One concern: Foreign central banks and sovereign-wealth funds, which are big holders of Treasuries, might cool to buying many more if they believe prices are artificially high.

Undermine the Dollar

That may undermine the dollar. “There's no guarantee that international investors would switch to other dollar- denominated debt if flushed from the Treasury market,” says Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey.

Tony Crescenzi, chief bond-market strategist at Miller Tabak & Co. in New York, says foreign investors might also get spooked if they conclude that the Fed is monetizing the government's debt -- in effect, printing money -- by buying Treasuries.

Bernanke himself, in his 2003 speech, said monetization of the debt risked faster inflation -- something bond investors, foreign or domestic, wouldn't like.

Some economists argue the Fed would help the economy more if it bought other types of debt. Even after their recent rise, 10-year Treasury yields are still well below the 4.02 percent level at the start of last year.

Corporate Bonds

Yields on investment-grade corporate bonds, in contrast, stood at 8.24 percent on Jan. 22, the latest date for which information is available, compared with 6.45 percent at the start of 2008, according to data compiled by the Fed.

Hawks at the Fed wouldn't welcome such purchases. They are already uneasy that some of the central bank's programs are effectively allocating credit to one part of the economy rather than others. Case in point: the Fed's ongoing program to buy $500 billion of mortgage-backed securities, which Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, has called “credit policy” rather than monetary policy.

J. Alfred Broaddus Jr., who was Richmond Fed president from 1993 to 2004, says the lesson from the early part of the decade isn't that the Fed went too far in easing policy to avoid deflation -- it's that policy makers should have tightened more quickly afterwards and not allowed themselves to be boxed in by their pledge to keep interest rates low for a considerable period.

In the current context, that means buying bonds “is something worth looking at,” he says. Still, the Fed “needs to be careful and be ready to reverse course, especially given all the money that it's pumped into the system.”

from the Wall Street Journal, 2009-Jan-29, by Jon Hilsenrath and Liz Rappaport:

Fed Weighs Idea of Buying Treasurys as Focus Shifts

The Federal Reserve inched toward a new program to purchase long-term U.S. Treasury securities, possibly the next step in the central bank's battle against a recession that it said has only deepened in recent weeks.

"Industrial production, housing starts and employment have continued to decline steeply, as consumers and businesses have cut back spending," Fed officials said Wednesday in a policy statement following a two-day meeting of the Federal Open Market Committee, which sets the central bank's direction. "Furthermore, global demand appears to be slowing significantly."

The Fed has already pulled its main lever for managing the economy as far as it can. Its benchmark short-term interest rate -- the federal-funds rate -- hovers near zero, and policy makers reiterated the rate would remain low "for some time."

With the funds rate about as low as it can go, officials are focused on developing new lending and asset-purchase programs to bring down an array of other interest rates and boost the economy.

On the list of next steps could be an effort to buy long-term government debt, which could in effect lower rates on mortgages and other debt. But the Fed is taking a slow path toward embracing the idea, something that has unsettled some investors. Disappointed that the central bank didn't take a more decisive step toward buying government bonds, investors sold Treasury bonds Wednesday.

An effort to buy long-term government bonds could help the economy broadly because many kinds of debt -- from mortgages to corporate bonds -- are benchmarked to Treasury yields. Fed purchases could raise Treasury prices, which would reduce their yields and thus yields on other kinds of debt.

Still, it would be a controversial move at a time when government budget deficits are soaring. Some might see it as an inflationary move to finance deficits by printing money.

With economic slack building so abruptly around the world, Fed officials don't see inflation as a worry now. In their statement, they pointed to a different worry: that inflation would fall below their comfort levels, believed to be roughly between 1% and 2%. An abrupt fall in inflation raises the inflation-adjusted cost of borrowing, which could be a new hindrance to growth and recovery.

Two other programs geared toward the credit market are still in the process of being ramped up. Officials have high hopes they will more directly ease strains afflicting consumers and businesses.

In one, the Fed is buying $600 billion of securities issued or guaranteed by government-linked mortgage-finance companies like Fannie Mae and Freddie Mac. In the other, which won't be operational until February, it will provide up to $200 billion of financing to investors buying securities tied to consumer debt like car loans or credit cards.

"There are lots of channels through which the Fed is working hard and using its balance sheet to ease financial conditions," said Richard Berner, chief U.S. economist with Morgan Stanley. "Buying Treasurys is only one of those."

Operationally, buying Treasurys would be easy for the Fed after a year of complicated efforts to revive markets. It has clear legal authority to buy government debt and the markets desk of the Federal Reserve Bank of New York has a long history of trading bonds with securities dealers.

The approach is favored by some members of the Fed's policy-making arm, the Federal Open Market Committee. Dissenting from the Fed's latest policy statement Wednesday, Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, said purchasing Treasury bonds was preferable to the Fed's many other new lending programs.

Moreover, Fed Chairman Ben Bernanke has highlighted the possibility of Treasury purchases twice in speeches since December. In its statement Wednesday, the central bank said it "is prepared" to take such a step, stronger language than it has used before. But the Fed said it depended on "evolving circumstances," and whether such a move would translate into help for private-sector debt markets. It offered no plan for moving forward on such purchases.

The market sold off sharply on the hesitant approach. The 10 and 30-year Treasury bonds fell on the day by 1 9/32 points and 4 11/32 points, respectively. Treasury yields are still very low. The yield on a 10-year note hit 2.66% Wednesday. Still, they have pushed higher in recent weeks, from just above 2% in December.

Uncertainty about the Fed is one factor pushing yields up recently. A range of other factors are at play, from the mountain of supply hitting the market as deficits rise, to concerns that foreign buyers may back away as the global economy contracts. Many estimates put the Treasury's borrowings this year at $1.5 trillion to $2 trillion. In recent years, $300 billion was considered a large amount.

Peter Hooper, chief economist for Deutsche Bank, said the Fed hasn't felt much pressure to begin the program because Treasury yields have been so low. But "if Treasury yields rise appreciably," he said, then the program "becomes a more important part of the picture."

The economic backdrop is souring fast. Economists believe the nation's gross domestic product contracted at an annual rate of 5% or more in the fourth quarter.

from the Wall Street Journal, 2009-Jan-15:

Leadership and Panics
TARP II and other reasons people are scared.

Stocks took another header yesterday, nearly 3% on the Dow this time, continuing their decline in the New Year since Congress has returned and as the federal government once again revs up its bailout machinery. Maybe this isn't a coincidence.

With Barack Obama about to take the oath of office, this ought to be a moment for fresh, more consistent economic leadership. Instead, we're getting a new version of the same ad hoc policy and scare-tactics that marked 2008. No clear spokesman or leader has emerged with a strategy to rebuild the financial system, and now Mr. Obama's term may begin without a Treasury Secretary (see here). This is no way to start a recovery -- or a Presidency.

Consider Fed Chairman Ben Bernanke, who used a London speech on Tuesday to pat the Fed on the back as the Horatio at the Bridge of this panic. This would have been appropriate for a Princeton seminar a couple of years from now. Amid the current uncertainty, however, he succeeded mainly in suggesting that the financial system is in even worse shape than we thought, the President-elect's "stimulus" isn't sufficient, and thus more of Mr. Bernanke's policy magic will be needed to save the day.

"With the worsening of the economy's growth prospects, continued credit losses and asset markdowns may maintain for a time the pressure on the capital and balance sheet capacities of financial institutions," he declared. "Consequently, more capital injections and guarantees may be necessary to ensure stability and the normalization of credit markets." Message: There's more mayhem to come, but don't worry, the Fed can keep printing money and buying private assets. No wonder the world is scared half to death.

The Fed has been creating new vehicles right and left for nearly 18 months, so the problem isn't a lack of liquidity. The problem is that too few people want to use the liquidity the Fed is creating. They don't want to lend money, or take risks, in part because they never know what Mr. Bernanke and the government might do next.

Then there's the Treasury's request for the second $350 billion in Troubled Asset Relief Program (TARP) cash. This commitment to backstop the financial system ought to be reassuring, especially for financial stocks. Yet in requesting the funds, Obama transition aide Larry Summers indulged in familiar scare rhetoric about "a potential catastrophe."

Congress also seems eager to use TARP II to bail out any and all industries that have powerful enough patrons. The car makers are already in line for a bigger chunk, and Barney Frank's draft bill orders Treasury to line up community banks for a taste -- whether they pose a larger risk to the banking system, or not.

Democrats are also insisting that as much as $100 billion go to prevent more home foreclosures, though this will have little impact on housing prices. The evidence from the last two years is that foreclosure mitigation often merely delays a reckoning because many of these homeowners never could afford the home in the first place. Meanwhile, Mr. Frank, the Dr. Kevorkian of capital injections, wants to impose new management and compensation restrictions on any institution that gets TARP money, whether it is well-managed or not. The bankruptcy "cramdown" now streaking through Congress will also impose more losses that will destroy more bank capital.

Mr. Obama has threatened to veto any Congressional vote of disapproval for TARP II, so Treasury will get its cash. But if the money is squandered on foreclosures and nonfinancial industries, the Obama Administration is setting itself up to need TARP III or TARP IV down the road. Asset values are going to continue to fall until they find a market bottom, and no declaration of Congress can make them stop in mid-descent. There are going to be more bank failures.

We supported TARP as a way to prevent a financial meltdown, providing public capital to help regulators manage problem banks, arrange mergers, and work off bad assets. TARP has since become a cash pool for all and sundry, casting a pall over the entire financial system. Mr. Obama would make more progress against recession if he steered the TARP back to the purpose that Paul Volcker and Eugene Ludwig first proposed on these pages -- as a resolution agency on the model of the Resolution Trust Corp. of the 1990s. Working in tandem with the Federal Deposit Insurance Corp., such an outfit could close problem banks before they collapse, serve as a holding and work-out agency for bad assets, and then sell them back over time into private hands.

A new TARP should also have a leader of recognized stature and independence -- not a 30-something assistant secretary -- who isn't afraid to take the heat and can also reassure the public. Mr. Volcker would be ideal for the job, and for that matter for overseeing the design of a new, sturdier financial system. Down the current road lies more uncertainty, and more market selloffs.

from the Wall Street Journal, 2009-Jan-17:

Mugging Bank of America
No good financial deed goes unpunished.

So much for being a good corporate citizen. Bank of America CEO Ken Lewis earned kudos last year for stepping into the breach when the mortgage market and Wall Street cratered. BofA's purchase of Countrywide Financial and its September agreement to buy Merrill Lynch offered a welcome dose of optimism and private capital amid the panic.

In December, Mr. Lewis realized that he had been too optimistic. And when he considered breaking off the Merrill engagement, Washington arranged a shotgun wedding. After BofA shareholders approved the Merrill purchase on December 5, Mr. Lewis saw Merrill's assets plunge in value and began to explore a way out. At least he wanted a better price given the erosion in Merrill's real estate and corporate portfolio.

Mr. Lewis's effort to protect his common shareholders was vetoed by his most important shareholder, the feds. In October the U.S. Treasury had insisted on investing $15 billion in his bank. Come December, Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke told him that Merrill had to be saved, and that BofA had to be the savior. Mr. Lewis said yesterday that the government was "firmly of the view" that canceling or delaying the Merrill deal might result in "serious systemic harm."

In other words, the feds believe that the way to calm financial markets is to force the nation's largest, and a heretofore healthy, bank to swallow toxic assets it didn't want. In return, yesterday the Treasury agreed to invest $20 billion in BofA, for which the government will receive preferred shares paying 8%. Treasury, the FDIC and the Fed will also partially insure $118 billion in troubled assets -- mostly Merrill's. In return for this downside protection, BofA will have to render unto Caesar another $4 billion of preferred stock plus warrants.

These preferreds will also pay 8%, but private shareholders are not so fortunate. The agreement limits quarterly common stock dividends to a penny a share. The Charlotte bank will also have to accept new executive compensation limits. And the bank will need to submit for government approval a plan to modify troubled mortgages.

Mr. Lewis doesn't seem thrilled that the government has a larger piece of his business. When asked yesterday when the bank might escape federal ownership, he replied, "I wish I knew," and then added, "clearly as soon as possible." Bank of America investors, who've taken a beating since the Journal reported on Merrill's latest troubles and the government "rescue," would surely agree. BofA shares fell 14% yesterday. If the feds really want to attract private capital to the banking system, this isn't the way to do it.

from Dow Jones Newswires via CNNMoney.com, 2009-Jan-30, by Corey Boles:

Senator Unveils Bill To Cap Pay At Firms Getting TARP Funds

WASHINGTON - U.S. Sen. Claire McCaskill, D-Mo., introduced legislation Friday that would impose salary caps on executives at financial firms receiving bailout funds from the federal government.

The legislation would cap any employee compensation at the level of the president's salary. The U.S. president earns $400,000 a year, not including benefits.

The private-sector limit would include salary, bonuses and stock options and would last as long as the firm relies on federal government assistance.

President Barack Obama has pledged to place limits on executive compensation as a condition of firms receiving federal government assistance under the second $350 billion tranche of the Troubled Asset Relief Program, or TARP.

That commitment was outlined in a letter sent to Congress by White House economic adviser Lawrence Summers shortly before the Senate voted to release the TARP money to the Treasury earlier this month.

Summers said that any compensation above a "specified threshold" would have to be paid in stock that could not be liquidated by the individual until any public money was repaid to the Treasury.

Summers is the head of the National Economic Council.

The administration hasn't said what the threshold would be.

A spokeswoman for the Treasury wasn't immediately available to comment.

Maria Speiser, McCaskill's press secretary, said the senator doesn't believe the pledge from the Obama administration goes far enough to place limits on executive compensation and thinks legislation is required.

News that banks receiving the lion's share of the first $350 billion in TARP money paid out billions in bonuses to executives at the end of last year sparked outrage by lawmakers of both parties.

"Right now they're on the hook to us," McCaskill said on the Senate floor while introducing the bill. "And they owe us something other than a fancy waste basket and $50 million jet."

McCaskill was referring to a since-abandoned plan by Citigroup Inc. (C) to purchase a new $50 million corporate jet and the $1.2 million spent by former Merrill Lynch Chief Executive John Thain to redecorate his office in late 2007. The redecoration included a $1,400 waste basket.

Shortly after news of the office renovation was made public, Thain was fired by Bank of American Corp. (BAC), which acquired Merrill Lynch last year.

Citigroup has been among the largest recipients of taxpayer money, having been given $45 billion and a federal government guarantee on around $300 billion in toxic assets.

Bank of America also received $45 billion, and guarantees for $118 billion in bad assets.

from the Associated Press via NewsMax.com, 2009-Jan-29, by Matt Apuzzo, with Stevenson Jacobs contributing from New York:

Community Banks Rejecting Fed Bailout Money

WASHINGTON -- A small but growing number of community banks are backing out of the government's bailout, which they see as fraught with hidden strings and government interference.

About 20 banks so far that applied for or had been approved to receive about $1 billion combined in taxpayer money have reversed course in the past month and refused to take the money. That's just a fraction of the hundreds of billions of dollars the government already has spent, but it shows that taxpayers aren't the only ones anxious about the financial bailout.

"The government's going to own a good portion of these banks," said David Heintzman, president of Stock Yards Bank & Trust in Louisville, Ky. The bank recently turned down $43 million in approved bailout money.

After Congress approved the $700 billion bailout in October, the government gave banks only a few weeks to decide whether they wanted to take part in the government investment program. Many applied to get a foot in the door, in case predictions of an economic collapse came true.

"We drank the Kool-Aid," said Michael Ross, president of Fidelity Bank in Dearborn, Mich., which applied for about $29 million in November.

But as details emerged, the deal didn't look so good. For Fidelity, taking the money would mean the government would have owned about 25 percent of the company's outstanding stock. Then Congress and the White House could start calling the shots, Ross said. He remembers the government's failure overseeing Freddie Mac and its sister company, Fannie Mae, the two housing companies so badly mismanaged they were taken over by the Bush administration.

"These are the guys who brought you Hurricane Katrina. These are the guys who were supposed to be watching Fannie and Freddie," Ross said. "I've not seen anything like this, where they really are talking about nationalizing banks."

Much of the criticism about the bailout has focused on the lack of oversight, which allowed banks to take money and refuse to say where it's going. Wall Street executives, who make millions of dollars and enjoy lavish perks like private jets, earned the ire of consumer watchdogs who said taxpayers were getting a raw deal.

But some community banks, which had little or nothing to do with the subprime mortgage crisis, say the deal didn't look great for them, either.

Congress wants banks to make loans, so businesses can expand and people can start buying houses again. But lawmakers also want them to make only trustworthy loans. But there are only so many good loans to make in a weak economy with high unemployment.

Explaining that to investors is easy. To politicians, it might looks like you're hoarding taxpayer money.

"Then what? Then they have a guy at our board meeting?" said William Campbell, president of Pamrapo Savings Bank, a Bayonne, N.J., bank that walked away from its $11 million bailout application.

The government also can force banks to cut dividends to shareholders, making a bank's stock less attractive to investors. President Barack Obama has said he wants to prohibit banks from buying other banks. And at any time, Congress can change the law and add new terms.

"Are you going to enter into a contract that will cost you millions of dollars if you can't live with the rules and you don't even know what the rules are?" said Steve Buster, CEO of Richmond, Calif.-based Mechanics Bank, which refused $60 million in bailout money. "I don't know of any other forum that parties can change the contract at will. This is not fair."

The banks that turned down the money said they were comfortable their own finances will allow them to weather the storm. For some, taking the money seemed riskier than turning it down.

"We finally said, 'Hey do we really want to go down this path?'" said Michael Blodnick, chief executive of Glacier Bancorp of Kalispell, Mont. "I understand a lot of banks do, and a lot of banks need to."

The following banks have announced they no longer planned to participate in the government-sponsored bank bailout program:

• American River Bankshares, of Rancho Cordova, Calif., said it would not accept $6 million

• Chemical Financial Corp., of Midland, Mich., said it will not accept $84 million

• California United Bank, of Encino, Calif., said it will not accept $8.4 million

• Dime Community Bancshares Inc., of Brooklyn, N.Y., said it will not accept $77.3 million

• Dearborn Bancorp Inc., of Dearborn, Mich., withdrew its application for $29 million

• Eagle Financial Services, Inc., of Berryville, Va., said it will not accept $10 million

• First Capital Inc., of Corydon, Ind., said it would not accept bailout money

• Friendly Hills Bank, of Whittier, Calif., said it would not accept $1.6 million

• Glacier Bancorp Inc., of Kalispell, Mont., said it would not accept bailout money

• Legacy Bancorp Inc., of Pittsfield, Mass., said it would not accept $20 million

• Liberty Bancorp Inc., of Liberty, Mo., said it would not accept $8.5 million

• Mechanics Bank, of Richmond, Calif., said it withdrew its application for $60 million

• NBT Bancorp Inc., of Norwich, N.Y., said it would not accept bailout money

• New York Community Bancorp Inc., of Westbury, N.Y., said it would not accept $596 million.

• OptimumBank Holdings Inc., of Fort Lauderdale, Fla., said it would not accept $4.6 million

• Pamrapo Bancorp Inc., of Bayonne, N.J., withdrew its application for $11 million

• Pacific Continental Corp., of Eugene, Ore., said it would not accept $30 million

• Smithtown Bancorp, of Hauppauge, N.Y., said it would not accept $37.8 million

• S.Y. Bancorp Inc., of Louisville, Ky., said it would not accept $43 million

• Tompkins Financial Corp., of Ithaca, N.Y., said it would not accept $15 million

from the New York Times, 2009-Jan-28, p.A31, web-posted 2009-Jan-27, by Maureen Dowd:

Wall Street's Socialist Jet-Setters

WASHINGTON -- As President Obama spreads his New Testament balm over the capital, I'm longing for a bit of Old Testament wrath.

Couldn't he throw down his BlackBerry tablet and smash it in anger over the feckless financiers, the gods of gold and their idols — in this case not a gilt calf but an $87,000 area rug, a cache of diamond Tiffany and Cartier watches and a French-made luxury corporate jet?

Now that we're nationalizing, couldn't we fire any obtuse bankers and auto executives who cling to perks and bonuses even as the economy is following John Thain down his antique commode?

How could Citigroup be so dumb as to go ahead with plans to get a new $50 million corporate jet, the exclusive Dassault Falcon 7X seating 12, after losing $28.5 billion in the past 15 months and receiving $345 billion in government investments and guarantees?

(Now I get why a $400 payment I recently sent to pay off my Citibank Visa was mistakenly applied to my sister-in-law's Citibank Mastercard account.)

The “Citiboobs” — as The New York Post, which broke the news, calls them — watched as the car chieftains got in trouble for flying their private jets to Washington to ask for bailouts, and the A.I.G. moguls got dragged before Congress for spending their bailout on California spa treatments. But the boobs still didn't get the message.

The former masters of the universe don't seem to fully comprehend that their universe has crumbled and, thanks to them, so has ours. Real people are losing real jobs at Caterpillar, Home Depot and Sprint Nextel; these and other companies announced on Monday that they would cut more than 75,000 jobs in the U.S. and around the world, as consumer confidence and home prices swan-dived.

Prodded by an appalled Senator Carl Levin, Tim Geithner — even as he was being confirmed as Treasury secretary — directed Treasury officials to call the Citiboobs and tell them the new jet would not fly.

“They woke up pretty quickly,” says a Treasury official, adding that they protested for a bit. “Six months ago, they would have kept the plane and flown it to Washington.”

Senator Levin said that the financiers will not be able to change their warped mentality, but will have to be reined in by Geithner's new leashes. “I have no confidence that they intend or desire to change,” Levin told me. “These bankers got away with murder, and it's obscene that close to nothing is being asked of financial institutions. I get incensed at the thought that a bank that's getting billions of dollars in taxpayer money is out there buying fancy new airplanes.”

New York's attorney general, Andrew Cuomo, always gratifying on the issue of clawing back money from the greedy creeps on Wall Street, on Tuesday subpoenaed Thain, the former Merrill Lynch chief executive, over $4 billion in bonuses he handed out as the failing firm was bought by Bank of America.

In an interview with Maria Bartiromo on CNBC, Thain used the specious, contemptible reasoning that other executives use to rationalize why they're keeping their bonuses as profits are plunging.

“If you don't pay your best people, you will destroy your franchise” and they'll go elsewhere, he said.

Hello? They destroyed the franchise. Let's call their bluff. Let's see what a great job market it is for the geniuses of capitalism who lost $15 billion in three months and helped usher in socialism.

Bartiromo also asked Thain to explain, when jobs and salaries were being cut at his firm, how he could justify spending $1 million to renovate his office. As The Daily Beast and CNBC reported, big-ticket items included curtains for $28,000, a pair of chairs for $87,000, fabric for a “Roman Shade” for $11,000, Regency chairs for $24,000, six wall sconces for $2,700, a $13,000 chandelier in the private dining room and six dining chairs for $37,000, a “custom coffee table” for $16,000, an antique commode “on legs” for $35,000, and a $1,400 “parchment waste can.”

Does that mean you can only throw used parchment in it or is it made of parchment? It's psychopathic to spend a million redoing your office when the folks outside it are losing jobs, homes, pensions and savings.

Thain should never rise above the level of stocking the money in A.T.M.'s again. Just think: This guy could well have been Treasury secretary if John McCain had won.

Bartiromo pressed: What was wrong with the office of his predecessor, Stanley O'Neal?

“Well — his office was very different — than — the — the general décor of — Merrill's offices,” Thain replied. “It really would have been — very difficult — for — me to use it in the form that it was in.”

Did it have a desk and a phone?

How are these ruthless, careless ghouls who murdered the economy still walking around (not to mention that sociopathic sadist Bernie Madoff?) — and not as perps?

Bring on the shackles. Let the show trials begin.

from MarketWatch.com, 2009-Jan-21, by Greg Robb:

Obama to unveil new rescue plan: Geithner
Treasury nominee offers no estimate of cost, signals more money needed

WASHINGTON -- President Obama is working on a comprehensive bank-rescue package that will be unveiled in the next few weeks, according to Timothy Geithner, Obama's nominee to be the nation's next Treasury secretary.

In testimony Wednesday before the Senate Finance Committee, Geithner didn't say how much the new package would cost. He refused to give specifics, saying that Wall Street wouldn't benefit from advance signals.

Paul Volcker, the former Federal Reserve Board chairman, told the panel that the cost of fixing the banks would cost several trillion dollars. No one took issue with that estimate.

More government assistance would be needed, Geithner added, because the crisis is far from over. More money also will have to be used to get credit markets back to normal.

The Senate has just approved giving Treasury the second half of the $700 billion rescue fund.

Geithner said the new plan would address concerns arising from the first bailout overseen by former Treasury chief Henry Paulson, with assistance from Federal Reserve Chairman Ben Bernanke and Geithner in his role of president of the New York Federal Reserve.

The Treasury would begin to work more closely with the Federal Deposit Insurance Corp. and the Fed, according to Geithner.

He also promised top-to-bottom reform of the government's rescue plan for financial markets in remarks during his confirmation hearing. "We have to fundamentally reform this program to ensure that there is enough credit available to support recovery," Geithner told legislators.

Moreover, he vowed aggressive action to get the economy back on track and pledged to strengthen what he called a "fragile" U.S. financial system.

'We need to make it work'

Geithner had an unenviable task in his question-and-answer session with the panel: explaining to the senators why the $700 billion TARP, or Troubled Assets Relief Program, hasn't cleaned up the mess.

As the current president of the Federal Reserve Bank of New York, Geithner was a key participant in discussions with Paulson and Bernanke that led to the first bailout plan.

"Obviously, you played an instrumental role in developing this rescue plan," said Sen. Olympia Snowe, R-Maine.

Geithner said he was at the "center" of the efforts to stem the crisis. He said he urged aggressive action beginning in early 2007, when the first sparks of the financial fire were seen.

But Geithner suggested he had much more influence on central-bank efforts, although he urged Paulson to seek new power.

The government did move to counter the crisis, but not aggressively enough, he commented.

Geithner said the first rescue package was absolutely necessary, and was a success in that the crisis would have been far worse without it. But he admitted that the financial system "remains under stress."

The nominee told the panel that he understands the frustrations with the plan, but that the only course was to fix it. "This is an important program and we need to make it work," according to Geithner.

He said the first plan suffered because it appeared "ad hoc," with confusion about its ultimate goals.

Talk of a different approach, like establishing a "bad bank" to quarantine "toxic" mortgage assets, surfaced last week, just as Bank of America Corp. revealed new problems.

Geithner acknowledged that the concept of a "bad bank" was under consideration.

Sen. Charles Schumer, D-N.Y., said experts have told him that such a concept would cost more than $3 trillion.

Volcker defends pick

Earlier, Volcker spoke at the hearing in favor of Geithner's nomination.

Geithner had come under fire earlier this month, when a probe revealed that he didn't pay all of his self-employment and Medicare taxes during the years that he worked at the International Monetary Fund.

His nomination doesn't appear to hinge on the mistakes on his taxes, but they served to put blood in the water at the hearing. As president-elect, Obama on several occasions stepped in personally to keep the issue from gaining traction.

At the start of the hearing, Sen. Max Baucus, D-Mont., the Senate Finance Committee chairman, signaled that he did not believe the tax issue was a matter of concern, calling them "innocent errors."

Geithner was contrite about his tax errors, saying the unpaid taxes were "careless" and "avoidable" mistakes. But he said that they were "unintentional" errors, and that he had used TurboTax software to prepare his returns.

Deficit fears

In addition to the bailout and the tax problems, Geithner sought to dampen concerns from deficit hawks about forecasts that the federal government's budget deficit is expected to balloon to more than $1 trillion in the current fiscal year.

He said the budget would have to tamed on a five-year horizon.

Along these lines, Obama is looking for a "mechanism" to move forward on entitlement reform on a bipartisan basis, Geithner added.

Democrats' stimulus package did not receive much attention at the hearing. The $825 billion plan was unveiled in the House of Representatives last week and includes $550 billion for spending and $275 billion for tax cuts.

Geithner also disclosed that Obama's building a team of experts to oversee the domestic auto industry.

Two factors did work in Geithner's favor at the hearing ahead of the Senate Finance Committee's vote on his nomination, scheduled for Thursday.

The first is that the Obama economic team is fairly centrist, and secondly, many members saw no need to challenge a member of Obama's inner circle so soon.

Only Sen. Jim Bunning, R-Ky., said he would oppose Geithner's nomination. Bunning said that he questioned Geithner's judgment, but that the tax errors tipped the scales.

The nominee also defended his actions related to the collapse of Lehman Brothers. He said the Treasury and the Fed did not have the authority from Congress to lend Lehman or a buyer of the investment firm the amount of money necessary to stabilize the firm.

He commented that the government should "never had been in this position."

While the failure of Lehman did not cause the crisis, it clearly made things worse, Geithner said.

Asked by Sen. Debbie Stabenow, D-Mich., if he was worried that Japan was planning to intervene in currency markets to strengthen the yen, Geithner would only say that he would insist that major U.S. trading partners adopt flexible exchange rates.

The strength of China's currency remains a "significant issue," according to Geithner. He said he would report to the finance panel when he had decided on an approach to this sensitive issue.

China has allowed its currency to strengthen gradually over the past three years, but maintains close control over it.

Baucus scheduled a vote on Geithner's nomination for 10:00 am on Thursday.

from the Wall Street Journal, 2009-Jan-12, by George Melloan:

We're All Keynesians Again
Nobody can accuse the government and the Fed of inaction.

In 1935, six years after the 1929 Crash, the U.S. remained mired in the Great Depression -- as it would be for five years more. At a congressional hearing, then Federal Reserve Chairman Marriner Eccles told Rep. Thomas Alan Goldsborough (D., Md.) that there was very little the Fed could do beyond what it was already doing to pull the country out of the doldrums.

"You mean you cannot push on a string," said the congressman.

"That is a very good way to put it," replied Mr. Eccles. "One cannot push on a string. We are in the depths of a Depression and beyond creating an easy money situation through reduction of discount rates, there is very little, if anything, that the reserve organization can do to bring about recovery."

The Fed is in that position once again. With a federal-funds interest-rate target near zero, the Fed has pumped tons of newly created dollars into the economy over the last four months. This has doubled the monetary base (bank reserves and currency), a phenomenal increase that has shocked market watchers and raised fears of inflation. But all economic indicators are flashing recession.

Last week brought the dispiriting news that the U.S. suffered a net loss of 2.6 million jobs in 2008, the most since 1945. Now 7.2% of the work force is idle. New factory orders, housing construction and retail sales have shriveled. Mortgage foreclosures are rising.

Last year's crash was caused primarily by the deflation of a real-estate bubble that those two government-sponsored behemoths, Fannie Mae and Freddie Mac, had a large role in inflating. As the Japanese demonstrated in 1990, real-estate crashes cause far more collateral damage than mere stock-market slumps. It's amazing that the U.S. policy makers chose to ignore the danger, despite repeated warnings from these pages.

Between 2002 and the fall of 2007, funds raised in U.S. credit markets nearly doubled. Talk about a credit explosion! Easy money, much beloved by politicians and Wall Street, is a sure recipe for an asset bubble.

So the Fed is again in the position of "pushing on a string" and finding that nothing happens. Some economists describe this as a "liquidity trap." Money creation loses its stimulative power -- vastly overrated even in ordinary times -- because public demand for loans is weak. Americans are too strapped financially, too short on investment opportunities, or too concerned about the future to borrow. They prefer to save instead.

Some economists argue that "trap" is an inappropriate description. The new money the Fed has pumped into the economy to replace the financial-sector liquidity wiped out by the collapse of the bubble has to go somewhere, they point out. It has to end up in someone's bank account and banks have to quickly convert deposits (liabilities) into investments or go broke even faster than some have by loading up on polluted, mortgage-backed securities. Maybe "liquidity malfunction" is a better term than "trap."

With 30-year mortgage rates now hovering near 5%, banks are spending a lot more of their time and resources responding to householder demands for refinancing at the lower rates. That doesn't do much for bank profits, but it does improve household balance sheets, cushioning to some degree the impact of the recession.

But what the Fed has mainly been doing since Black September has been transferring economic resources to government from the private sector on a massive scale. There is one thing the banks can do with their deposits if they can't find willing and qualified borrowers -- the word "qualified" was rather neglected when Fannie and Freddie stood ready to buy any cats and dogs offered. They can put those deposits into U.S. Treasury securities.

Banks and investors around the world fleeing for safety have been doing just that, holding down federal borrowing costs, at least temporarily. The global flight for the presumed safety of Treasurys has also shored up the U.S. dollar in foreign-exchange markets, sending crude oil prices plunging. Because of the Treasury mania, 30-year Treasury bonds were yielding only 3.06% and the popular 10-year bond 2.39%.

So the Treasury has a good deal. The Fed pumps money into the economy by buying Treasurys with checks written on thin air. The Treasury quickly spends those dollars on the huge ongoing expenses of a government running a trillion-dollar deficit. Recipients of its spending put the money into bank accounts and, presto, the money comes right back to the Treasury to finance yet more government spending.

The government is thus the main beneficiary of the phenomenal rise in the monetary base. The base remained relatively stable through the ups and downs of Fed interest-rate policies in this decade, until it went on its fourth-quarter skyrocket trip. For what it's worth, Fed Chairman Ben Bernanke, a student of the 1929 crash, has at least made sure that no one in the future will be able to accuse him of starving the economy into a Depression, as conventional wisdom has held that the Fed did 80 years ago.

Keynesians were banished in the 1980s by Reaganomics but made a comeback years ago and again control U.S. levers of power. They argue that massive deficit spending by the federal government is the right policy for these times. Paul Krugman of the New York Times has asserted that the Great Depression lasted 10 years because the New Deal didn't spend enough. Japan tried to spend its way out of its postbubble malaise in the 1990s but ended up with a mountain of debt and a "lost decade" of little or no economic growth. Nevertheless, the incoming Obama administration is promising close to a trillion dollars in fiscal stimulus, and the Bernanke Fed seems to believe the way to deal with a collapsed bubble is to reinflate it. That of course takes no account of how we got the bubble in the first place.

Well, there's a lot of high-powered money out there in the huge monetary base the Fed has created. It's at the Treasury's disposal. All that can be said to the Keynesians is, "better luck than last time."

Mr. Melloan is a former deputy editor of the Journal's editorial page.

from the Hill, 2009-Jan-15, by Mike Soraghan and Molly K. Hooper:

Rep. Obey not sure $825B stimulus is enough

The $825 billion economic stimulus package rolled out by Democrats on Thursday might not be enough to prevent an economic catastrophe, according to the chief architect of the package.

House Appropriations Committee Chairman David Obey (D-Wis.) also told reporters it may not be the last effort to use big government spending to spur the economy.

“This represents the largest effort by any legislative body in the world to take government action to prevent economic catastrophe,” Obey said, “and even that may be insufficient alone.”

Later in his briefing, he added, “This product may undershoot the mark.”

The bill could be voted on in committee next Wednesday. That's the day after the inauguration of President-elect Obama — or, as Obey put it, “the day after the crown prince is sworn in.”

He's hoping to get the bill to the floor by Jan. 28 in order to pass it by Feb. 13.

Among Democrats, liberals said they believe the massive package has enough for all different constituencies to win passage. Conservative Democrats, while alarmed at the spending, don't want to pick a fight with Obama immediately after he takes office and are looking for ways to support the bill.

But key Republicans are protesting sharply.

“Oh my God,” House Minority Leader John Boehner (R-Ohio) said of the Democratic proposal.

Boehner read portions of the Democratic draft and said he was “shocked” by what he saw.

“I just can't tell you how shocked I am at what we're seeing, that they're moving on this path of the flawed notion that we can borrow and spend our way back to prosperity,” Boehner told reporters shortly after he reviewed drafts of the proposal.

The package, staggering in size, fails to meet the hopes of some members that it would rise over $1 trillion. Still, it has many times the spending that most Democrats were contemplating after Obama's election.

It has $550 billion in spending on items like assistance for local government, public-works projects and green energy.

It also has $275 billion in tax cuts, $25 billion less than Obama had sought and a smaller part of the package than the 40 percent Obama had proposed.

It also leaves out the “patch” to prevent the Alternative Minimum Tax (AMT), designed to ensure the very rich pay taxes, from hitting the middle class. Some hoped to cover the $70 billion tab in the stimulus, where it won't be offset with spending cuts or tax hikes.

But House Ways and Means Committee Chairman Charles Rangel (D-N.Y.) said he expects the Senate to put the AMT patch back in. “I know they will,” Rangel said.

House Democrats also included spending proposals that Obama hadn't asked for, such as $30 billion to subsidize the so-called “COBRA” payments that people pay to keep health insurance after losing their jobs.

“That idea came from me based on personal experiences,” Obey said. “I felt there was a hole in our hearts if we weren't taking care of that problem.”

The package would funnel tens of billions of dollars to state governments, including $87 billion for a temporary increase in the federal match for Medicaid. It also includes $90 billion for roads, bridges and other infrastructure works and $43 billion for increased unemployment benefits.

“It's about modernizing our roads, bridges, et cetera, education for the 21st century, tax cuts that make work pay and create jobs and lower — as initiatives to lower healthcare costs and help workers who are hurt in this economy, and protect our vital services,” said House Speaker Nancy Pelosi (D-Calif.).

from CNSNews.com, 2008-Dec-18, by Fred Lucas:

Value of 2008 Bailouts Exceeds Combined Costs of All Major U.S. Wars

The total value of the bailouts undertaken by the federal government in 2008 now exceeds the combined cost of every major war the United States has ever engaged in, according to a comparison of war costs calculated by the Congressional Research Service (CRS) and the value of the bailouts as calculated by Bloomberg News or Bianco Research.

According to CRS, all major U.S. wars (including such events as the American Revolution, the War of 1812, the Civil War, the Spanish American War, World War I, World War II, Korea, Vietnam, Iraq and Afghanistan, but not the invasion of Panama or the Kosovo War), cost a total of $7.2 trillion in inflation-adjusted 2008 dollars.

According to Bloomberg, the federal government has made commitments worth a total of $8.5 trillion in the bailouts of 2008. That includes actual expenditures as well as loan and asset guarantees.

Bianco Research puts the total value of the bailouts at $8.7 trillion.

The $296 billion spent on World War II, America's most expensive war, would be $4.1 trillion adjusted to today's dollars, according to the CRS report from June.

The adjusted cost of the Civil War would be $60.4 billion for both the Union and the Confederacy combined. The inflation-adjusted cost of the Vietnam War would be $686 billion. The cost of the current Iraq war up to last June was $648 billion, while the adjusted cost for Afghanistan to that point was $171 billion.

The total cost of the American Revolution was a relatively inexpensive $1.8 billion.

“World War II was financed by savings, the American people's savings, when Americans bought war bonds,” said Olivier Garret, CEO of Casey Research, who analyzed the value of the bailout compared to the major U.S. wars and other major historical government expenses. “Today, families are in debt and government is in debt.”

A Bianco Research report cited in Politico puts the number for the total value of bailouts at $8.7 trillion and also affirms the value to be higher than the cost of all American wars and historic initiatives. A spokesman with Bianco Research could not be reached for comment as this story went to press.

The bailouts, led by Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke, were taken as emergency actions to keep U.S. companies from going under and to prevent a total financial markets meltdown in the United States. Similar bailouts were issued in other countries to address the global financial crisis.

The Bush administration is mulling whether to use some of the $700 billion in TARP funds approved by Congress to bailout the financial industry to bailout U.S. automakers.

The bailouts could put U.S. taxpayers in a tough spot in the future, said Pete Sepp, spokesman for the National Taxpayers Union.

“I'm assuming the figures do not include the Cold War defense expenditures, which would probably amount to several trillion on their own,” Sepp told CNSNews.com. “In any case, it's a stark illustration of just how quickly the federal government has gotten into a huge financial hole and dragged taxpayers into it in the process.”

“We can only hope and pray that many of these liabilities and guarantees and commitments the government has made will not have to be made good on,” Sepp said. “If we were to be responsible for paying out all of these obligations, even in the period of one or two years, it would be financially disastrous to the government's credit rating and our own as taxpayers.”

Garret pointed to the cost that will be paid by Americans in the future. “Future generations of Americans are going to continue to finance the enormous amount of debt,” he said.

from MarketWatch, 2009-Jan-7, by Robert Schroeder:

U.S. budget deficit of $1.2 trillion seen for fiscal 2009
Budget office sees recession lasting well into 2009, with slow recovery in 2010

WASHINGTON (MarketWatch) -- The U.S. government will run a $1.2 trillion budget deficit in fiscal 2009, the Congressional Budget Office estimated Wednesday, offering a stark assessment of the red ink facing the country and the incoming administration of President-elect Barack Obama.

The nonpartisan office said in a report that the ongoing U.S. recession will probably last "well into" 2009, and that the economy will only undergo "slow recovery" next year. The CBO pegged real gross domestic product growth at 1.5% in 2010.

The overall deficit number is a challenge to President-elect Obama, who is seeking to enact a major stimulus plan of close to $800 billion.

"Enactment of an economic stimulus plan would add to that deficit," the CBO warned Wednesday. Read the budget report.

The figures come a day after Obama predicted years of deficits of more than $1 trillion.

On Tuesday, he told reporters that he and his economic team are studying ways to bring the deficit down in the long term.

"We're going to have to stop talking about budget reform," Obama said. "We're going to have to totally embrace it. It's an absolute necessity."

The CBO also estimated that unemployment would exceed 9% early in 2010 and that GDP would fall by 2.2% in calendar year 2009.

from the Telegraph of London, 2009-Jan-8, by Ambrose Evans-Pritchard:

Merrill Lynch says rich turning to gold bars for safety

Merrill Lynch has revealed that some of its richest clients are so alarmed by the state of the financial system and signs of political instability around the world that they are now insisting on the purchase of gold bars, shunning derivatives or "paper" proxies.

Gary Dugan, the chief investment officer for the US bank, said there has been a remarkable change in sentiment. "People are genuinely worried about what the world is going to look like in 2009. It is amazing how many clients want physical gold, not ETFs," he said, referring to exchange trade funds listed in London, New York, and other bourses.

"They are so worried they want a portable asset in their house. I never thought I would be getting calls from clients saying they want a box of krugerrands," he said.

Merrill predicted that gold would soon blast through its all time-high of $1,030 an ounce, and would hit $1,150 by June.

The metal should do well whatever happens. If deflation sets in and rocks the economic system it will serve as a safe-haven, but if massive monetary stimulus gains traction and sets off inflation once again it will also come into its own as a store of value. "It's win-win either way," said Mr Dugan.

He added that deflation may prove the greater risk in coming months. "It's very difficult to get the deflation psychology out of the human brain once prices start falling. People stop buying things because they think it will be cheaper if they wait."

Merrill expects global inflation to hover near zero, with rates of minus 1pc in the industrial economies. This means that yields on AAA sovereign bonds now at 3pc will offer a real return of 4pc a year, which is stellar in this grim climate. "Don't start selling your government bonds," Mr Dugan said, dismissing talk of a bond bubble as misguided.

He warned that the eurozone was likely to come under strain this year as slump deepens. "There is going to be friction as governments in the south start talking politically about coming out of the euro. I don't see the tensions in Greece as a one-off. It is a sign of social strain in countries that have lost competitiveness."

from Reuters, 2009-Jan-16, by Jonathan Stempel and Dan Wilchins, with additional reporting by Elinor Comlay, Joseph A. Giannone, Juan Lagorio, and editing by Jeffrey Benkoe and John Wallace:

Citigroup splits in two, BofA gets government aid

NEW YORK - Citigroup Inc plans to split into two units and Bank of America Corp took $20 billion in government aid after the two banks suffered huge quarterly losses from the worsening credit crisis.

After losing more than $28.5 billion in the last 15 months, including $8.29 billion in the fourth quarter, Citigroup said on Friday it will divide itself into one business focused on commercial and retail banking, and another with brokerage, retail asset management, consumer finance and troubled assets.

Bank of America obtained a second capital infusion from the U.S. government, which agreed to limit potential losses on $118 billion in troubled assets. The bank added much of these assets when it bought Merrill Lynch & Co on January 1. Bank of America also reported a $1.79 billion fourth-quarter loss and slashed its quarterly dividend to a penny per share from 32 cents.

"It doesn't give you a warm and comfortable feeling that we have bottomed from the banking standpoint," said Walter Todd, a portfolio manager at Greenwood Capital Associates in Greenwood, South Carolina.

Shares of several major U.S. lenders tumbled, with Bank of America falling to its lowest level since 1991.

Fueling the slide were worries about whether British lender Barclays Plc and Royal Bank of Scotland Group Plc had enough capital to cope with writedowns, and over Ireland's decision to nationalize Anglo Irish Bank.

$90 BILLION INJECTIONS

Bank of America and Citigroup face mounting pressure over how well they will absorb a surge in soured loans, amid a deep recession that shows few signs of easing.

The largest and third-largest U.S. banks by assets have now each taken $45 billion from the government's taxpayer-funded $700 billion Troubled Asset Relief Program.

"Everyone out there believes that the government will not let these banks fail," said Matt McCall, president of Penn Financial Group in Ridgewood, New Jersey. "I still don't know how we're going to pay for all of this."

Half of the TARP funds have been committed, and the U.S. Senate voted on Thursday to let President-elect Barack Obama tap the rest.

The second-largest U.S. bank, JPMorgan Chase & Co, is viewed as much healthier than Bank of America and Citigroup, despite posting a 76 percent drop in quarterly profit on Thursday. JPMorgan got $25 billion of TARP money.

In afternoon trading, Bank of America shares were down $1.20, or 14.4 percent, at $7.12, while Citigroup was down 6 cents, or 1.6 percent, to $3.77.

Other banks also fell, with JPMorgan down 8.7 percent and Wells Fargo & Co, which became the fourth-largest U.S. bank when it bought troubled Wachovia Corp, off 10.2 percent. Wells Fargo is scheduled to report results on January 28.

WEILL MODEL ABANDONED

Citigroup's quarterly loss equaled $1.72 per share, and was $2.43 per share before a gain from selling a German retail bank unit. Analysts, on average, expected a loss of $1.32 per share, according to Reuters Estimates.

Under the split-up, the New York-based bank will separate into Citicorp, housing its key businesses, and Citi Holdings.

Citicorp will be home to the company's retail banking and credit card businesses, its corporate and investment bank, Citi Private Bank and a transaction services unit.

Citi Holdings would house brokerage and asset management units, including the Primerica life unit, Nikko Cordial Securities and a 49 percent stake in a new brokerage venture with Morgan Stanley. It would also hold local consumer finance operations, including CitiFinancial and CitiMortgage.

Citi Holdings would also house $301 billion in assets that received government backing in a November rescue package. The unit would have about $850 billion in assets, or 44 percent of Citigroup's total $1.95 trillion.

The split-up abandons the New York-based bank's decade-old "financial supermarket" strategy once advanced by its former chief executive, Sanford "Sandy" Weill.

Vikram Pandit, the current CEO, is trying to preserve capital, while keeping what he called Citicorp's "global scope and regional strength."

Chief Financial Officer Gary Crittenden said the bank is "not in a rush to sell anything." Tight credit markets have dramatically thinned the pool of asset buyers.

MERRILL LOSS SHOCK

Bank of America's fourth-quarter loss was 48 cents per share, or 44 cents excluding merger costs. Analysts, on average, expected a profit of 2 cents per share.

"It is difficult to focus on what is going right at this time," a downbeat Kenneth Lewis, Bank of America's CEO, said on a conference call.

Results did not include Merrill, which Bank of America said lost $15.31 billion, or $9.62 per share, in the quarter.

This dwarfed the losses the Charlotte, North Carolina-based bank expected when it agreed to buy Merrill last September 15, the same day Lehman Brothers Holdings Inc went bankrupt, and prompted the push for government help.

Lewis said that in December he explored invoking a contractual provision to allow Bank of America to back out of the Merrill deal, but said government officials told him that doing so could create "serious systemic harm."

He said the Federal Reserve and Treasury Department gave assurances they would provide help if the $19.4 billion purchase closed. The government package caps Bank of America's potential losses on $118 billion of troubled assets, most of which come from Merrill.

Bank of America's own lending also suffered in the fourth quarter as it set aside $8.54 billion for bad loans, up from $3.31 billion a year earlier. Net charge-offs nearly tripled to $5.54 billion. Lewis said he expects "no relief" in the amounts set aside for credit losses for "several quarters."

from the Examiner of Seattle, 2009-Jan-2, by Joseph Hight:

Top 15 economic events of 2008

Usually these lists are limited to a ‘top 10.’  But with all the action in the economy in 2008, I’ve stretched out my list to 15, also an excuse for the length of the column. Readers with the patience to read through to the end may think I missed some important event that should be put ahead of those on my list. Let me hear from you via the comment section below.

1. January 8, 2008: Calling the recession

If only we had listened, we might have pulled some money out of stocks, thus saving a good part of our 401(k) money.

David Rosenberg calling the start of the 2008 economic recession  eleven months before the National Bureau of Economic Research dated the beginning of the recession as December 2007. Rosenberg is Merrill Lynch's chief North American economist. He based his call on two relevant pieces of data - the rise in the unemployment rate rising to five percent in December 2007 and the decline in aggregate hours worked in the economy for two consecutive calendar quarters.  He noted that "Back-to-back declines in total hours worked have always been associated with recession," and added that “At no time in the past 60 years has the unemployment rate risen 60 basis points … from the cycle low without the economy slipping into recession."

2. January 25, 2008: The first bank failure in 2008

Douglass National Bank Kansas City, Mo., Assets: $58.5 million, closed by the Office of the Comptroller of the Currency. Consistent with the policy of the Comptroller of the Currency, no advance notice was given to the public. It is on the list because the event presaged a difficult year for banks. Twenty-four more were to fail during 2008.

3. March 16, 2008: Bear Stearns collapses

The collapse of Bear Stearns and its subsequent takeover organized by JP Morgan Chase and the Federal Reserve Board, marked a major turning point in U.S. central bank involvment in the U.S. economy.  Long gone would be the days when the Fed simply tried to control interest rates and the money supply.  They never taught us this in macroeconomics or monetary theory.

4. July 17, 2008: Gas prices go through the roof

Gas hits a record price of $4.114 per gallon, a jump of 28 % over a year earlier. Everyone was predicting the end of the SUV and the gasoline powered automobile. Is this too early for an obituary?

5. August 1, 2008: The cutting off of Adam Smith’s ‘invisible hand’ predicted

Little did he know how right he was to be, since unprecedented moves by government into the private sector were still a month away, but prize winning Washington Post business columnist Steven Pearlstein made the call early about the withering of Adam Smith's 'invisible hand,' though as everyone knows we never had an invisible hand economy.  All modern industrial economies are mixed market-government regulated, taxed, and subsidized economies. Some are a little more regulated, taxed, and subsidized than others.
 
6.  September 7, 2008: The government takes over Fannie Mae and Freddie Mac

Treas. Sec. Henry Paulson speaks during a news conference in Washington. The government seizes control of mortgage giants Fannie Mae and Freddie Mac, two companies that were funding more than 67 % of home loans.  The government was ready to inject up to $100 billion into each company to keep them solvent.

7. September 15, 2008: Lehman Brothers goes bankrupt

The world financial system faced a giant upheaval as Lehman Brothers, the fourth largest investment firm in the U.S. files for bankruptcy protection . The government lets it go, unlike the treatment afforded Bear Stearns.

8. September 16, 2008: The U.S. government goes into the insurance business

The government loans $85 billion to Wall Street insurance giant AIG in exchange for a 79.9 per cent stake in the company. The government will have the right to fire senior management .

9. Sept 16, 2008: Dow falls 504 points

The Dow fell 504.48 points, its biggest one-day point drop since the fall after 9-11 terrorist attacks. I was on Wall Street in front of the New York stock exchange on September 16, 2008, and could see fear and dread on the faces of traders on the sidewalks. Of course, even more dramatic stock market declines were to follow, but on that day this was bad enough.

10. September 25, 2008: Washington Mutual close its doors, the biggest bank in U.S. history to fail

Washington Mutual, with assets of $307 billion, the largest “thrift” bank in the US, failed, after a run on savings by its customers. Regulators from the Office of Thrift Supervision (OTS) stepped in to take over the company, before selling it to JP Morgan Chase for $1.9 billion.

11.  October 3, 2008: Bailout bill, the Congress passesTroubled Asset Relief Program

A day after the Senate passed the bailout bill, the house follows suit and sends it to president to sign into law.  The bill authorizes the Treasury Secretary to spend as much as $700 billion with very little oversight. The plan is to buy up the illiquid assets on the balance sheets of many U.S. financial institutions – details to be worked later.

12. October 14, 2008: The government goes into the commercial banking business

U.S. government announces it will buy a stake in nine leading banks, using $125 billion of the TARP money, a change in the original plan to use TARP money to buy up troubled bank assets.  This is the first time since the Great Depression of the 1930s that the government will take ownership in private commercial banks.

13. October 16, 2008: Barack Obama called a socialist

After unprecedented moves by the government into the private sector, under a Republican president, the Cleveland Plain Dealer reports Sen. George Voinovich (R) calling Barack Obama a socialist, quoting the senator as saying about Obama, "He is left of Teddy Kennedy. With all due respect, the man is a socialist. The Plain Dealer goes on to report “The "socialist" theme is going strong today, with Sarah Palin invoking the name of everyone's favorite plumber, Joe, during an appearance in West Chester, near Cincinnati. The Republican running mate referred to Joe the Plumber's recent conversation with Obama about taxes and spreading the wealth, and ‘Joe suggested that sounded a little bit like socialism.’" Is Barack Obama a socialist?

14. November 18, 2008: Auto makers flop before Congress after flying corporate jets to Washington

"This is a slap in the face of taxpayers," said Tom Schatz, President of Citizens Against Government Waste. "To come to Washington on a corporate jet, and asking for a hand out is outrageous," reported by ABC News.

15. December 30, 2008: Gas prices fall to $1.61 per gallon

Does this mean we ended 2008 on an upbeat note? Gas prices averaged $1.61 per gallon, making it a lot easier to fill up our tanks.  But sadly this is a reflection of more economic distress ahead, before we really get news of a turn around for the better.

from the Wall Street Journal, 2008-Dec-20, by James Grant:

Is the Medicine Worse Than the Illness?
The world ran out of trust in 2008 -- but there is no shortage of money because the Fed is printing like mad. It's the wrong approach, with potentially dire consequences, says James Grant.

It is a sorry place at which we Americans find ourselves this none-too-festive holiday season. The biggest names on Wall Street have gone to their rewards or into partnership with the U.S. Treasury. Foreigners stare wide-eyed from across the waters. A $50 billion Ponzi scheme (baited with, of all things in this age of excess, the promise of low, spuriously predictable returns)? Interest rates over which tiny Japanese rates fairly tower? Regulatory policy seemingly set by a weather vane? A Federal Reserve that can't make up its mind: Is it in the business of central banking or of central planning? And to think -- our disappointed foreign friends mutter -- all of these enormities taking place under a Republican administration.

Trust itself entered a bear market in 2008, complementing and perhaps surpassing the selloffs in stocks, mortgages and commodities. Never to be confused with angels, we humans seem to outdo ourselves when money is on the line. So it is that Bernard Madoff, supposed pillar of the community, stands accused of perpetrating one of the greatest hoaxes since John Law discovered the inflationary possibilities of paper money in the early 18th century.

Barely nudging Mr. Madoff out of the top of the news was the Federal Reserve's announcement last Tuesday that it intends to debase its own paper money. The year just ending has been a time of confusion as much as it has been of loss. But here, at least, was the bright beam of clarity. Specifically, the Fed pledged to print dollars in unlimited volume and to trim its funds rate, if necessary, all the way to zero. Nor would it rest on its laurels even at an interest rate low enough to drive the creditor class back to work. It would, on the contrary, "continue to consider ways of using its balance sheet to further support credit markets and economic activity."

Wall Street that day did handsprings. Even government securities prices raced higher, as if, somehow, Treasury bonds were not denominated in the currency with which the Fed had announced its intention to paper the face of the earth. Economic commentators praised the central bank's determination to fight deflation -- that is, to reinstate inflation. All hands, including President-elect Obama, seemed to agree that wholesale money-printing was the answer to the nation's prayers.

One market, only, registered a protest. The Fed's declaration of inflationary intent knocked the dollar for a loop against gold and foreign currencies. In many different languages and from many time zones came the question, "Tell me, again, now that the dollar yields so little, why do we own it?"

It was on Oct. 6, 1979, that then-Fed Chairman Paul A. Volcker vowed to print less money to bring down inflation. So doing, he closed one monetary era and opened another. With Tuesday's promise to print much more money, the Federal Reserve of Ben S. Bernanke has opened its own new era. Whether Mr. Bernanke's policy of debasement will lead to as happy an outcome as that which crowned the Volcker anti-inflation initiative is, however, doubtful. Whatever the road to riches might be paved with, it isn't little green pieces of paper stamped "legal tender."

Our troubles, over which we will certainly prevail, stem from a basic contradiction. The dollar is the world's currency, yet the Fed is America's central bank. Mr. Bernanke's remit is to promote low inflation, high employment and solvent finance -- in the 50 states. He wishes the Chinese well, of course, and the French and the Singaporeans and all the rest besides, but they don't pay his salary.

They do, however, buy the U.S. Treasury's bonds, which frames the emerging American dilemma. If the Fed is going to create boatloads of depreciating, non-yielding dollar bills, who will absorb them? Who will finance the Obama administration's looming titanic fiscal deficits? Who will finance America's annual surplus of consumption over production (after 25 more or less continuous years, almost a national trait)? Inflation is a kind of governmentally sanctioned white-collar crime. Every crime needs a dupe. Now that the Fed has announced its plan to deceive, where will it find its victims?

Mr. Bernanke has good reason to worry about the economy. We all do. In the boom, a superabundance of mispriced debt led countless people down innumerable blind investment alleys. E-Z credit financed bubbles in real estate, commodities, mortgage-backed securities and a myriad of other assets. It punished saving and encouraged speculation. Imagin reaching for technology stocks.

The underlying cause of these mishaps is the dollar and the central bank that manipulates it. In ages past, it was so simple. A central banker had one job only, and that was to assure that the currency under his care was exchangeable into gold at the lawfully stipulated rate. It was his office to make the public indifferent between currency or gold. In a crisis, the banker's job description expanded to permit emergency lending against good collateral at a high rate of interest. But no self-respecting central banker did much more. Certainly, none arrogated to himself the job of steering the economy by fixing an interest rate. None, I believe, had an economist on the payroll. None facilitated deficit spending by buying up his government's bonds. None cared about the average level of prices, which rose in wartime and sank in peacetime. It sank in peacetime because technological progress and the opening of new regions to agricultural production made merchandise and commodities cheaper and more abundant.

Not everyone agreed that these arrangements were heaven-sent. In comparison to the rigor of the gold standard, paper money seemed, to many, an intelligent and forgiving alternative. In 1878, a committee of the House of Representatives was formed to investigate the causes of the suffering of working people in the depression that was five years old and counting. Not a few witnesses pleaded for the creation of more greenbacks. They asked that the government not go through with its plan to return to the gold standard in 1879. But the nation did return to gold -- it had financed the Civil War with paper money -- and the depression ended in the very same year.

Gold is a hard master, and a capricious one, too, insofar as growth in the world's monetary base depends on the enterprise of mining engineers. But, as we have seen lately, there is no caprice like the caprice of sleep-deprived Mandarins improvising a monetary solution to a credit crisis (or, for that matter, of fully rested Mandarins setting interest rates by the lights of their econometric models).

The times were hard in the 1870s and, for that matter, again in the 1890s, but Americans repeatedly spurned the Populist cries for a dollar you didn't have to dig out of the ground but could rather print up by the job lot. "If the Government can create money," as a hard-money propagandist put it in an 1892 broadside entitled "Cheap Money," "why should not it create all that everybody wants? Why should anybody work for a living?" And -- in a most prescient rhetorical question -- he went on to ask, "Why should we have any limit put to the volume of our currency?"

A couple of panics later, the Federal Reserve came along -- the year was 1913. Promoters of the legislation to establish America's new central bank protested that they wanted no soft currency. The dollar would continue to be exchangeable into gold at the customary rate of $20.67 an ounce. But, they added, under the Fed's enlightened stewardship, the currency would become "expansive." Accordion-fashion, the number of dollars in circulation would expand or contract according to the needs of commerce and agriculture.

Elihu Root, Republican senator from New York, thought he smelled a rat. Anticipating the credit inflations of the future and recalling the disturbances of the past, Mr. Root attacked the bill in this fashion: "Little by little, business is enlarged with easy money. With the exhaustless reservoir of the Government of the United States furnishing easy money, the sales increase, the businesses enlarge, more new enterprises are started, the spirit of optimism pervades the community.

"Bankers are not free from it," Mr. Root went on. "They are human. The members of the Federal Reserve board will not be free of it. They are human....Everyone is makin money. Everyone is growing rich. It goes up and up, the margin between costs and sales continually growing smaller as a result of the operation of inevitable laws, until finally someone whose judgment was bad, someone whose capacity for business was small, breaks; and as he falls he hits the next brick in the row, and then another, and then another, and down comes the whole structure.

"That, sir," Mr. Root concluded, "is no dream. That is the history of every movement of inflation since the world's business began, and it is the history of many a period in our own country. That is what happened to greater or less degree before the panic of 1837, of 1857, of 1873, of 1893 and of 1907. The precise formula which the students of economic movements have evolved to describe the reason for the crash following the universal process is that when credit exceeds the legitimate demands of the country the currency becomes suspected and gold leaves the country."

Little did Mr. Root suspect that the dollar would lose its gold backing altogether -- that, starting in 1971, there would be nothing behind it more than the good intentions of the U.S. government and (somewhat more substantively) the demonstrated strength of the U.S. economy. Still less could he have guessed that the world would nonetheless fall in love with that uncollateralized piece of paper or -- even more astoundingly -- that the United States would enjoy so great a reservoir of good will that it would be allowed to borrow its way to a net international investment position of minus $2.44 trillion ($17.64 trillion of foreign assets held by Americans vs. $20.08 trillion of American assets held by foreigners). "It goes up and up," Mr. Root said of the inflationary cycle, but just how high he could not have dreamt.

Knowledge of the precepts of classical central banking prepared no one to understand, much less to anticipate, the Fed's conduct in this credit crackup. The central bank is lending freely, all right, but not at the stipulated "high" interest rate. As a matter of fact, it is starting to lend at a rate below which there is no positive rate. The gold standard was objective. Modern monetary management is subjective (under Alan Greenspan, it was intuitive). The gold standard was rules-based. The 21st century Fed goes with what works -- or seems to work. What it hopes is going to work for the fellow who fell off the stepladder is more debt and more dollars. Just how much of each can be found every Thursday evening on the Fed's own Web site. Open up form H4.1 and prepare to be amazed. Since Labor Day, the Fed's assets have zoomed to $2.31 trillion from $905.7 billion. And what is the significance of this stunning rate of asset growth? Simply this: The Fed pays for its assets with freshly made dollars. It conjures them into existence on a computer; "printing" is a figure of speech.

In this crisis, the Fed's assets have grown much faster than its capital. The truth is that the Federal Reserve is itself a highly leveraged financial institution. The flagship branch of the 12-bank system, the Federal Reserve Bank of New York, shows assets of $1.3 trillion and capital of just $12.2 billion. Its leverage ratio, a mere 0.9%, is less than one-third of that prescribed for banks in the private sector. Such a thin film of protection would present no special risk if the bank managed by Timothy F. Geithner, the Treasury secretary-designate, owned only short-dated Treasurys. However, the mystery meat acquired from Bear Stearns and AIG foots to $66.6 billion. A writedown of just 18.3% in the value of those risky portfolios would erase the New York Fed's capital account. In congressional testimony eight years ago, Laurence Meyer, then a Fed governor, tried to allay any such concerns (which then must have seemed remote, indeed). "Creditors of central banks...are at no risk of a loss because the central bank can always create additional currency to meet any obligation denominated in that currency," he soothingly reminded his listeners.

Yes, today's policy makers allow, there are risks to "creating" a trillion or so of new currency every few months, but that is tomorrow's worry. On today's agenda is a deflationary abyss. Frostbite victims tend not to dwell on the summertime perils of heatstroke.

But the seasons of finance are unpredictable. Prescience is rare enough in the private sector. It is almost unheard of in Washington. The credit troubles took the Fed unawares. So, likely, will the outbreak of the next inflation. Already the stars are aligned for a doozy. Not only the Fed, but also the other leading central banks are frantically ramping up money production. Simultaneously, miners and oil producers are ramping down commodity production -- as is, for instance, is Rio Tinto, the heavily encumbered mining giant, which the other day disclosed 14,000 layoffs and a $5 billion cutback in capital expenditure. Come the economic recovery, resource producers will certainly increase output. But it is far less certain that, once the cycle turns, the central banks will punctually tighten.

The public has been slow to anger in this costliest and scariest of post World War II financial crises. Wall Street and the debt ratings agencies have come in for well-deserved castigation. But pointing fingers rarely find the Federal Reserve, whose low, low interest rates helped to set house prices levitating in the first place.

After Mr. Bernanke gets a good night's sleep, he should be called to account for once again cutting interest rates at the expense of the long-suffering (and possibly hungry) savers. He should be asked to explain how the central-banking methods of the paper-dollar era represent any improvement, either in practice or theory, over the rigor, elegance, simplicity and predictability of the gold standard. He should be directed to read aloud the text of critique by Elihu Root and explain where, if at all, the old gentleman went wrong. Finally, he should be directed to put himself into the shoes of a foreign holder of U.S. dollars. "Tell us, Mr. Bernanke," a congressman might consider asking him, "if you had the choice, would you hold dollars? And may I remind you, Mr. Chairman, that you are under oath?"

James Grant, the editor of Grant's Interest Rate Observer, is the author most recently of "Mr. Market Miscalculates."

from the Wall Street Journal, 2008-Nov-11:

Participants in Government Investment Plan

In unveiling its bank-share purchase program, the Treasury Department required nine of the nation's largest financial-services companies to sell a total of $125 billion in preferred stock to the government, and said an additional $125 billion in stock could be bought from other firms on a voluntary basis. Below, see a list of participating companies. Click the headers of the columns to sort by company, state and amount. Last updated: 11/11/2008

13-Oct-08	Wells Fargo & Co.	California	$25,000
13-Oct-08	State Street Corp.	Massachusetts	$2,000
13-Oct-08	Bank of America Corp.	North Carolina	$15,000
13-Oct-08	Bank of New York Mellon Corp.	New York	$3,000
13-Oct-08	Goldman Sachs Group Inc.	New York	$10,000
13-Oct-08	Morgan Stanley	New York	$10,000
13-Oct-08	Merrill Lynch & Co Inc.	New York	$10,000
13-Oct-08	Citigroup Inc.	New York	$25,000
13-Oct-08	JPMorgan Chase & Co.	New York	$25,000
24-Oct-08	Regions Financial Corp	Alabama	$3,500
24-Oct-08	PNC Financial Services Group Inc.	Pennsylvania	$7,700
24-Oct-08	Valley National	New Jersey	$330
24-Oct-08	First Horizon	Tennessee	$866
26-Oct-08	Washington Federal	Washington	$200
27-Oct-08	United Commercial	California	$298
27-Oct-08	Northern Trust	Illinois	$1,500
27-Oct-08	City National Corp.	California	$395
27-Oct-08	First Niagara	New York	$186
27-Oct-08	Provident Bankshares Corp	New York	$16
27-Oct-08	Huntington Bancshares Inc.	Ohio	$1,400
27-Oct-08	KeyCorp	Ohio	$2,500
27-Oct-08	Fifth Third Bancorp	Ohio	$3,450
27-Oct-08	Comerica	Texas	$2,250
27-Oct-08	SunTrust	Virginia	$3,500
27-Oct-08	Capital One	Virginia	$3,550
27-Oct-08	BB&T	North Carolina	$3,100
28-Oct-08	Zions Bancorporation	Utah	$1,400
28-Oct-08	Marshall & Ilsley	Wisconsin	$1,700
28-Oct-08	Umpqua Holdings Corp.	Oregon	$214
28-Oct-08	HF Financial	South Dakota	$25
28-Oct-08	Saigon National	California	$1
28-Oct-08	Old National Bancorp	Indiana	$150
28-Oct-08	Bank of Commerce Holdings	California	$17
28-Oct-08	Bank of Florida Corp	Florida	$0
28-Oct-08	Whitney Holding Corp	Louisiana	$282
03-Nov-08	U.S. Bancorp	Minnesota	$6,600
03-Nov-08	TCF Financial	Minnesota	$361
03-Nov-08	Midwest Banc Holdings Inc.	Illinois	$86
31-Oct-08	First Financial Bancorp	California	$80
30-Oct-08	First Community Bancshares, Inc.	Virginia	$43
30-Oct-08	Simmons First National Corp.	Arkansas	$40
03-Nov-08	Cascade Financial Corporation	Washington	$39
29-Oct-08	FFW Corp.	Indiana	$7
06-Nov-08	Associated Banc-Corp	Wisconsin	$530
06-Nov-08	Pacific Capital Bancorp	California	$188
06-Nov-08	Capital Pacific Bancorp	Oregon	$4
04-Nov-08	Columbia Banking System Inc.	Washington	$79
04-Nov-08	Berkshire Bancorp Inc.	Massachusetts	$20
05-Nov-08	Heritage Commerce Corp.	California	$40
06-Nov-08	WesBanco, Inc.	West Virginia	$75
04-Nov-08	Banner Corporation	Washington	$124
04-Nov-08	Heritage Financial Corporation	Washington	$24
07-Nov-08	Intermountain Community Bancorp	Idaho	$27
07-Nov-08	Webster Financial Corp.	Connecticut	$400
10-Nov-08	American International Group Inc.	New York	$40,000
10-Nov-08	First Midwest Bancorp Inc.	Illinois	$193
07-Nov-08	ETrade Financial Corp.	New York	$800
06-Nov-08	Fulton Financial Corp.	Pennsylvania	$375
06-Nov-08	Trustmark Corp.	Mississippi	$215
04-Nov-08	Taylor Capital Group Inc.	Illinois	$105

Total: $213,985

Firms Participating: 60

Sources: Wall Street Journal research, Dealogic

from MarketWatch.com, 2009-Jan-15, by Alistair Barr in San Francisco and Sam Mamudi in New York:

Bank of America to get billions more in U.S. funds
Cash to help bank digest Merrill acquisition, report says, while shares hit 17-year low

Bank of America shares gyrated wildly Thursday as investors reacted to reports that the firm will need more government funds to stay afloat.

The shares lost almost 30% of their value at one point during the trading session, before recovering more than half those losses in afternoon trade.

Late Wednesday, The Wall Street Journal reported that the Treasury Department decided to use money from its Troubled Asset Relief Program, or TARP, to help Charlotte, N.C.-based Bank of America because it feared the deal's failure could affect the stability of U.S. financial markets, the report said.

Details are expected to be announced when the company -- the largest U.S. bank by assets -- reports fourth-quarter results, scheduled for Tuesday.

Bank of America spokesman Scott Silvestri declined to comment, as did a Treasury spokeswoman.

"Even with help from the government, we think Bank of America's tangible-equity levels are low relative to peers and that it will need to cut its dividend and or raise equity capital in the coming months," said Stuart Plesser, analyst at Standard & Poor's Equity Research.

Bank of America received a $25 billion investment from the Treasury Department last year under TARP. But the bank told the Treasury in mid-December that it was unlikely to complete its purchase of Merrill because the brokerage firm had suffered larger-than-expected losses in the fourth quarter, the report said, citing a person familiar with the talks.

Any possible arrangement might protect Bank of America from losses on Merrill's bad assets. There would be a cap on the amount of losses the bank would have to absorb, with the federal government being on the hook for the remainder, according to the report.

Bank of America closed its acquisition of Merrill on Jan. 1, albeit with the understanding that the Treasury and the bank would hammer out a plan to provide more government support.

More trouble for banks

The news suggests that the worst of the banking crisis may not have yet passed. The KBW Bank Index has dropped 19% so far this year.

Barclays Capital fixed-income analysts Jonathan Glionna and Miguel Crivelli said that deteriorating loan quality, continued losses on risky securities and goodwill impairments will result in losses for the 27 major banks they cover. The analysts published a fourth-quarter industry preview on Wednesday.

The recession will cause the problems in loan portfolios to spread from residential-related products to credit cards and commercial real estate, leading to materially higher nonperforming assets and exposing the inadequacy of banks' loan-loss reserves, they said.

"With unemployment reaching 7.2% and [gross domestic product] declining, we expect nonperforming loans to increase substantially, from $94 billion to $125 billion for our 27-bank aggregate," the analysts said. "This will force banks to set aside large loan-loss provisions, impairing earnings."

The only bright spot is that the government will continue to support large, important banks such as Bank of America, J.P. Morgan Chase & Co. and Wells Fargo & Co., they said.

Separately, J.P. Morgan Chase reported a fall in profits of more than 75% earlier Thursday.

Citi's woes

Meanwhile, Citigroup Inc. is due to report financial results Friday morning that promise to command great scrutiny. The Wall Street Journal reported Wednesday that Citi executives are bracing for an operating loss of at least $10 billion.

Shares of Citigroup lost more than one-third of their market value this week as news emerged that the bank will try to shrink itself under pressure from big losses.

Citi's shares closed well under $5 -- the first time its stock was below that level since Nov. 21 -- as investors worried that the bank may struggle to sell units and unwind positions at attractive prices in the midst of turbulent markets.

"We are embarked on a long-term transformation of Citi," chief executive officer Vikram Pandit told employees in a memo made public Wednesday.

"Our goal is to streamline our operations, strengthen our balance sheet [and] position ourselves to take advantage of historic global growth opportunities."

Pandit sought to strike an optimistic note.

"Economics and psychology are both important in the markets," he said. "The economic model of our business is sound and positions the company for success over the long term. The clarity we provide as we report earnings should address the psychology of the market."

What Would Milton Friedman Say?

The day after Milton Friedman died in November 2006, The Wall Street Journal published an article about monetary policy that Friedman had written. Unable to recall when the article had first appeared, I asked the editor. "Today," he said. "Milton adapted it just a couple of weeks ago from a research paper he was working on."

This took a moment to sink in. Friedman, by universal consent one of the two or three most consequential economists of the 20th century, had still been performing original economic research then describing his findings for ordinary readers--at the age of 94.

What would Milton have said if he were still with us today? Friedman spent his final three decades at the Hoover Institution--my office was just two doors down the hall from his--and earlier this week I sat down with two of my Hoover colleagues, economists Thomas MaCurdy and Jay Bhattacharya, both close students of Milton, to decide what questions we would have asked him--and how he might have replied.

Would Milton have seen this crisis coming?

Of course. The moment the housing bubble burst Milton would have recognized that we were in for trouble. Why? Because as banks limited their lending, the money supply contracted. And whereas Milton believed that changes in the money supply affect only the price level over the long term, he recognized that over the short-term changes in the money supply can produce dramatic effects in the real economy.

"What would Milton have told you caused the recession in the early 1980s?" Tom asks. "[Federal ReserveChairman] Paul Volcker's reduction in the rate of growth of the money supply. And what has happened now? Another relativecontraction in the money supply. Milton would have told us we're headed right into a recession."

Whom would Milton have blamed?

For the bubble itself? Probably nobody. From the tulip mania in Holland more than three-and-a-half centuries ago to the dot-com bubble here in the U.S. less than a decade ago, wildly irrational behavior sometimes develops in markets. "Friedman never argued that markets are perfect," says Jay, "only that over the long run they're a lot more efficient than any other method of allocating resources." Sometimes, Milton recognized, bubbles just happen.

Whatever the origin of the bubble, however, Milton would have blamed Congress for making it much, much worse. Congress, after all, created Fannie Mae and Freddie Mac, institutions that spent tens of billions of dollars on subprime instruments. "Congress told Fannie and Freddie to subsidize bad loans for the purposes of social engineering," says Jay. "It was terrible, just terrible."

What would Milton have made of government efforts to address the crisis?

He would have approved of such efforts in Britain--but expressed grave reservations about those here in the U.S.

"Milton would have wanted the authorities to find very, very aggressive ways of expanding the money supply," says Tom. The Bank of England did just that, placing large deposits in banks throughout the British financial system. "What they did in England was quick, clean and direct."

Here in the U.S., by contrast, Treasury Secretary Henry Paulson's original bailout plan, under which the Treasury would have spent hundreds of billions of dollars purchasing subprime and other instruments from major banks, went at the problem backwards. "The government should take responsibility for the money supply, but not for setting prices," says Jay. "The problem with subprime assets is that nobody knows what they're worth. Friedman would have told you that bringing the government in wouldn't have helped that."

With his new plan, under which the Treasury has now taken equity stakes worth $125 billion in nine big banks, Paulson has finally begun to make sense. "Direct injections of capital into banks--Milton would have approved of that," Tom says. "But why did it take so long? Why did we have to wait for the Bank of England to set the example?"

What would Milton have seen as the principal danger to the economy that the crisis now poses?

The very same equity stakes mentioned above. It is one matter for the government to make deposits in banks, as the Fed regularly does, Milton would have held, but another for the government to purchase equity, as Paulson has just done.

"Look, if the government wraps up its equity positions and gets out of the banks quickly, then okay," says Tom. "The danger is that the government will stick around and start managing the banks, setting loan policies, establishing salary limits for the top executives and stuff like that. Friedman would have been really clear on this. Banks should be run by bankers, not politicians."

Would Milton have seen the crisis as a setback for capitalism?

Only in the short term.

"If this election goes the way it looks as though it's going to go," says Tom, "then the political system is about to get a major overcorrection to the left. And that means the American people are about to get an extreme illustration of just how badly government intervention screws stuff up."

"If Milton were here," Tom says, "he'd tell us to remember what happened during the Clinton administration. After just two years, the Republicans ended up in control of both houses of Congress."

Peter Robinson, a research fellow at the Hoover Institution and contributor to RobinsonandLong.com, writes a weekly column for Forbes.com.

from the Wall Street Journal, 2008-Nov-20, by Daniel Henninger:

Mad Max and the Meltdown
How we went from Christmas to crisis.

Notwithstanding the cardboard Santas who seem to have arrived in stores this year near Halloween, the holiday season starts in seven days with Thanksgiving. And so it will come to pass once again that many people will spend four weeks biting on tongues lest they say "Merry Christmas" and perchance, give offense. Christmas, the holiday that dare not speak its name.

Mortgage-backed security survivor.

This year we celebrate the desacralized "holidays" amid what is for many unprecedented economic ruin -- fortunes halved, jobs lost, homes foreclosed. People wonder, What happened? One man's theory: A nation whose people can't say "Merry Christmas" is a nation capable of ruining its own economy.

One had better explain that.

How the financial markets fell so far so fast will occupy economic seers for years. The path to 50% wealth reductions and the death of Wall Street was paved with good intentions, notably the notion that all should own a house, even if that required giving away the house to untutored borrowers with low-to-no-interest loans.

This good intention set off history's largest chain of moral hazard. The great unraveling began sometime between 2005 and 2007, when borrowers, lenders and securitizer shamans all found themselves operating in a zero-gravity environment, aloft on moral hazard.

The technical details have been described with harrowing precision by Robert Stowe England in "Anatomy of a Meltdown" for Mortgage Banker magazine. Briefly: "The underwater earthquake that first rattled the foundations of the mortgage industry came in the form of sharply higher delinquencies and defaults from a book of poorly underwritten subprime loans from the fourth quarter of 2005 through the first quarter of 2007."

His narrative runs through borrowers making misrepresentations on loan applications (fraud), the collapse of Bear Stearns's hedge funds, revised ratings-agency methodologies that led to "unprecedented" mass downgrades, causing a contagion that spread from subprime to prime home-equity loans, and a warning from the president of the IndyMac S&L that "the private secondary market is not functioning." This in turn precipitates a "torrent of deleveraging." Here's the best part: Mr. England's chapter-and-verse article appeared in October -- of 2007, one year before the current mass panic.

A more recent, widely emailed article for Portfolio.com by Michael Lewis of "Liar's Poker" fame describes a skeptical hedge-fund manager and his associates walking through the wild world of mortgage-backed securities like stunned characters in "Mad Max," in effect asking bankers, borrowers and ratings-agency executives one question: Why? Why do you think all of you can get rich, all at the same time, forever?

On Sept. 25, a week after Lehman Brothers declared bankruptcy, Nicolas Sarkozy announced, "Laissez-faire is finished." Then the Washington Post asked on its front page: "Is American Capitalism Finished?"

Little or nothing that has occurred through this crisis discredits the system of free-market capitalism. Across several centuries of rising world incomes and social gains, the system has proved its worth. In this instance, the system has been badly used -- by mere people. Nonetheless, the dimensions of the fall and devastation that originated in subprime mortgages are breathtaking.

Amid all these downward-pushing pressures, occurring in plain sight, hardly anyone or anything stepped up to brake the fall. What happened?

The answer echoing through the marble hallways of Congress and Europe's ministries is: regulation failed. In short, throw plaster at cracked walls. Trusting the public sector to protect us from financial catastrophe is a bad idea. When the Social Security and Medicare meltdowns arrive, as precisely foretold by their trustees, will we ask again: What were they thinking?

What really went missing through the subprime mortgage years were the three Rs: responsibility, restraint and remorse. They are the ballast that stabilizes two better-known Rs from the world of free markets: risk and reward.

Responsibility and restraint are moral sentiments. Remorse is a product of conscience. None of these grow on trees. Each must be learned, taught, passed down. And so we come back to the disappearance of "Merry Christmas."

It has been my view that the steady secularizing and insistent effort at dereligioning America has been dangerous. That danger flashed red in the fall into subprime personal behavior by borrowers and bankers, who after all are just people. Northerners and atheists who vilify Southern evangelicals are throwing out nurturers of useful virtue with the bathwater of obnoxious political opinions.

The point for a healthy society of commerce and politics is not that religion saves, but that it keeps most of the players inside the chalk lines. We are erasing the chalk lines.

Feel free: Banish Merry Christmas. Get ready for Mad Max.

from the Wall Street Journal, 2009-Jan-2, by Jeff D. Opdyke:

The Doomsayers Who Got It Right
More Bad News in Store for 2009? Last Year's Cassandras Are Still Gloomy

For years, they were the party poopers: financial prognosticators who, amid the ebullient stock prices and effervescent home values that defined the early 21st century, warned of trouble. In hindsight, they're the ones who got it right -- or, at least, some of it.

Even those spotting the trouble early don't agree how it will unfold -- or the right way to cash in.

Often mocked for predictions that seemed outlandish at the time -- big banks will fail, Fannie Mae will go bankrupt -- a few of these outliers, including money manager Jeremy Grantham, mutual-fund manager Bob Rodriguez and brokerage-house owner Peter Schiff, were among the first to describe key parts of the U.S. financial meltdown.

Still, they say the worst may be ahead.

They weren't always entirely on the money. Mr. Schiff's main thesis, that the U.S. dollar will crash, hasn't panned out.

Their views often are at odds with what economists generally expect. The consensus continues to predict a recovery in late 2009, with rising stocks leading up to that. Economists speak of a stronger dollar as the rest of the world struggles with recession. Bottom line: They expect the U.S. economy to lead the world out of the doldrums.

Those who saw the crisis coming, on the other hand, fret that U.S. government spending on bailouts and stimulus plans that preserve failed business models could increase the likelihood of a worse calamity later.

They foresee a long season in which consumers cut their spending, and instead sharply increase the savings rate. That would be healthy for savings-anemic U.S. households, which have spent beyond their means for years, but deeply problematic for a country where consumers drive 70% of all economic activity.

They also envision higher taxes and the likelihood of further declines in U.S. stock prices as the Standard & Poor's 500-stock index bottoms out as much as 30% lower than today. And while noting that "deflation" is today's catchword, several experts say that inflation and perhaps even hyperinflation (in which prices rise at double- or triple-digit percentages) is the real issue a few years down the road as the Federal Reserve increases the money supply and relies on untested measures, such as buying home mortgages or other assets, to spur the economy.

"It's all a grand experiment at this point, with no historical precedent," says Mr. Rodriguez, CEO at Los Angeles's First Pacific Advisors.

Of course, Mr. Rodriguez and the others have been pessimists for many years, and even a broken clock is right twice a day. Here are their views for the future.

Jeremy Grantham: 'Competitive currency devaluation' could break out among nations.

As early as 2000, Mr. Grantham, co-founder of Boston money-management shop GMO LLC, was warning his shareholders that "a sensational bust" was coming. That made him more than a half-decade premature.

However, he notes that because the Federal Reserve cut interest rates to ward off the 9/11-inspired recession, the day of atonement was delayed. The government's fiscal actions after the 2001 terrorist attacks sparked "the greatest sucker rally in history," which, he predicted, would ultimately lead to a collapse of the financial system.

By July 2007 he wrote that the real risk to the system would likely emerge in October 2008. He wrote that by the time the crisis passed, "at least one major bank will have failed."

Surveying the wreckage today, he says that the unintended consequences of the government's response so far to the crisis are "unknowable. There is no playbook."

For instance, he says "competitive currency devaluation" could break out among nations as each tries to boost its own economy by weakening its currency, possibly spurring similar moves by other nations fearful of losing any economic advantage. A weaker currency can boost exports (by making those goods cheaper abroad) but also heightens inflation risk.

"With so many moving parts," he says, "you could easily have a surge of inflation."

Treasury bonds, he says, are currently overpriced, "the 30-year ridiculously so." Bond prices move in the opposite direction as yields, and at current price levels, the 30-year bond is effectively forecasting little more than 1% annual inflation for the next three decades.

"In your dreams," Mr. Grantham says.

And while stocks have gotten hammered, he says, they're still not as cheap as they were in the 1974 and 1982 recessions. He gives it a "better than 50-50" chance that the S&P 500 falls further in 2009. He has set aside cash to invest in case stocks retreat to "a shockingly low number," he says, "like 600 on the S&P," which would be about 34% lower than 2008's closing value.

His firm has waded back into a few emerging markets -- in particular, Turkey, Korea and Thailand -- because of cheap valuations. Mr. Grantham is worried the dollar could weaken, and foreign securities provide the potential for gains as foreign currencies potentially strengthen.

Moreover, stocks overseas fell harder during the crisis and are now cheaper than in the U.S., he says. He expects that over the next seven years, real returns in emerging markets will be about 9.5% a year.

Returns in the U.S. will be about 7.5% annually, he says. That's not a nightmare, but it is below what investors will reap outside the U.S.

One domestic bright spot: franchise names like Coca-Cola Cos., Wal-Mart Stores Inc. and Microsoft Corp. should do better, he says. "The super-blue-chips are the most attractive part of the market anywhere in the world."

Mr. Rodriguez manages the FPA New Income fund, which was up more than 4% in 2008 due to some notable shifts in the investment strategy in recent years.

He saw storm clouds gathering in 2005 when newly minted pools of supposedly high-quality "Alt-A" mortgages began acting oddly: Delinquencies and foreclosures were surging on mortgages just nine months old. (Alt-A mortgages, sometimes called "liar loans," were widely used by borrowers with high credit scores but undocumented income.)

"We'd never seen that before," he says.

He quickly dumped the holdings, reckoning that by the time he figured out what was actually going on, whatever disaster the odd behavior foreshadowed would have already occurred.

Over the next few years he penned increasingly dour shareholder letters attacking every area of financial services. He stopped buying Fannie Mae and Freddie Mac debt and took giant insurer American International Group Inc. off the list of approved commercial-paper investments. He refused to invest in financial-services companies because of what he saw as "a pandemic collapse" in the rules by which lenders approved mortgages.

As of 2004, he began moving his fund to more than 45% cash, even as one big shareholder yanked out $300 million because of his bearish stance.

Looking forward, he, too, sees "a massive bubble in Treasurys" forming. "Quite frankly, we do not trust government," he says, as the U.S. government adds more debt to pay for economic-revival measures. He's not buying Treasurys because "We will not lend long-term money to a borrower that capriciously erodes its balance sheet."

His real concern, he recently told shareholders, isn't the next two years, "but period three through 10." In an interview, he says it will be punctuated by inflation, and he expects real GDP growth of no more than 2% a year, possibly less.

He also expects consumers to save rather than spend, spawning "severe difficulty for a large segment of the economy directly or indirectly related to consumers."

By the time the March quarter ends, he expects the U.S. savings rate will approach 4%. By the first quarter 2010 it could be in the 7% to 10% range. In recent years, that rate has hovered near 1% or lower, indicative of a country binging rather than saving.

In other words, Mr. Rodriguez doesn't think Americans will shop their way out of a recession.

He believes the U.S. consumer has transformed into a saver, though policymakers don't fully understand that. President-elect Barack Obama "will try to stimulate spending with one foot on the gas, while consumers are pushing on the brake" by saving. "We're in for a very discontinuous environment." Thus, he says, the economy will sputter in fits and starts. The recession will deepen over the next six to 18 months.

Still, for the first time in more than a year, he bought stocks as the crisis unfolded in October and November. Nearly 70% of those purchases, though, were in the energy sector, he says, because prices for real assets, such as a barrel of oil, tend to rise as inflation rises.

Since at least 2004, as president and chief global strategist at EuroPacific Capital, a broker/dealer in Darien, Conn., Mr. Schiff has routinely peddled warnings that the housing market was a house of cards and that stock values were artificially inflated by Federal Reserve and White House policies that, he says, "were working against market forces."

In a speech at the Western Regional Mortgage Brokers Conference in 2006, he essentially told the audience of mortgage bankers many would soon be unemployed due to a housing collapse. He noted as well that a recession could begin in December 2007 -- correct, according to the National Bureau of Economic Research. In his 2007 book "Crash Proof," he forecast the demise of Fannie Mae and Freddie Mac.

Still, he has been wrong on significant parts of his argument. Many detractors point out that two of his core beliefs -- a longstanding prediction that the dollar would collapse and that foreign stocks would outperform U.S. shares -- have been well off the mark in this crisis. A rush into the safety of the greenback sent the dollar soaring against other currencies and, as a side effect, helped undermine shares of stocks around the world.

Mr. Schiff acknowledges that he wasn't expecting that to happen. But he says his worries aren't misplaced: A dollar dive and foreign-stock outperformance are still in the cards.

Looking ahead, Mr. Schiff foresees "massive inflation," and sharply higher interest rates, since the U.S. will have to entice foreign investors to buy the trillions of dollars in government-issued bonds that the U.S. needs to sell to pay for bailouts and stimulus plans.

The quandary, though, is that at some point global investors will stop buying U.S. debt. "They will stop enabling us," he says, amid concerns about America's ability to repay the debts. "They will stop buying our bonds, our currency, and the value of the dollar will drop precipitously."

Taxes, too, will have to rise, particularly on upper-income families, he says, because an economy based largely on consumption, not production, has few ways to generate the money needed to repay its debt when consumption is waning.

He thinks there's time for government officials to limit the damage he says they are inflicting. But "if they're not careful," he says, "their actions are going to wipe out the value of savings in this country."

from the Wall Street Journal, 2008-Nov-24, by Christopher Wood:

The Fed Is Out of Ammunition
A discredited dollar is a likely outcome of the current crisis.

With an estimated $4 trillion in housing wealth and $9 trillion in stock-market wealth destroyed so far in the United States, there is little doubt that we are witnessing a classic debt-deflation bust at work, characterized by falling prices, frozen credit markets and plummeting asset values.

Those who want to understand the mechanism might ponder Irving Fisher's comment in 1933: When it comes to booms gone bust, "over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money."

The growing risk of falling prices raises a challenge for one of the conventional wisdoms of the modern economics profession, and indeed modern central banking: the belief that it is impossible to have deflation in a fiat paper-money system. Yet U.S. core CPI fell by 0.1% month-on-month in October, the first such decline since December 1982.

The origins of the modern conventional wisdom lies in the simplistic monetarist interpretation of the Great Depression popularized by Milton Friedman and taught to generations of economics students ever since. This argued that the Great Depression could have been avoided if the Federal Reserve had been more proactive about printing money. Yet the Japanese experience of the 1990s -- persistent deflationary malaise unresponsive to near zero-percent interest rates -- shows that it is not so easy to inflate one's way out of a debt bust.

In the U.S., the Fed can only control the supply of money; it cannot control the velocity of money or the rate at which it turns over. The dramatic collapse in securitization over the past 18 months reflects the continuing collapse in velocity as financial engineering goes into reverse.

True, this will change one day. But for now, the issuance of nonagency mortgage-backed securities (MBS) in America has plunged by 98% year-on-year to a monthly average of $0.82 billion in the past four months, down from a peak of $136 billion in June 2006. There has been no new issuance in commercial MBS since July. This collapse in securitization is intensely deflationary.

It is also true that under Chairman Ben Bernanke, the Federal Reserve balance sheet continues to expand at a frantic rate, as do commercial-bank total reserves in an effort to counter credit contraction. Thus, the Federal Reserve banks' total assets have increased by $1.28 trillion since early September to $2.19 trillion on Nov. 19. Likewise, the aggregate reserves of U.S. depository institutions have surged nearly 14-fold in the past two months to $653 billion in the week ended Nov. 19 from $47 billion at the beginning of September.

But the growth of excess reserves also reflects bank disinterest in lending the money. This suggests the banks only want to finance existing positions, such as where they have already made credit-line commitments.

Monetarist Bernanke and others blame Japan's postbubble deflationary downturn on policy errors by the Bank of Japan. But he and others are about to find out that monetary gymnastics are not as effective as they would like to think. So too will the Keynesians who view an aggressive fiscal policy as the best way to counter a deflationary slump. While public-works spending can blunt the downside and provide jobs, it remains the case that FDR's New Deal did not end the Great Depression.

There are no easy policy answers to the current credit convulsion and intensifying financial panic -- not as long as politicians and central bankers are determined not to let financial institutions fail, and so prevent the market from correcting the excesses. This is why this writer has a certain sympathy for Treasury Secretary Henry Paulson, even if nobody else seems to. The securitized nature of this credit cycle, combined with the nightmare levels of leverage embedded in the products dreamt up by the quantitative geeks, means this is a horribly difficult issue to solve.

Virtually everybody blames Mr. Paulson for the decision to let Lehman Brothers go. But this decision should be applauded for precipitating the deflationary unwind that was going to come sooner or later anyway.

The Japanese precedent also remains important because the efforts in the West to prevent the market from disciplining excesses will have, as in Japan, unintended, adverse, long-term consequences. In Japan, one legacy is the continuing existence of a large number of uncompetitive companies which have caused profit margins to fall for their more productive competitors. Another consequence has been a long-term deflationary malaise, which has kept yen interest rates ridiculously low to the detriment of savers.

Meanwhile, the most recent Fed survey of loan officers provides hard evidence of the intensifying credit crunch in America. A net 83.6% of domestic banks reported having tightened lending standards on commercial and industrial loans to large and midsize firms over the past three months, the highest since the data series began in 1990. A net 47% of banks also indicated that they had become less willing to make consumer installment loans over the past three months.

Consumers are also more reluctant to borrow. A net 48% of respondents indicated that they had experienced weaker demand for consumer loans of all types over the past quarter, up from 30% in the July survey. This hints at the Japanese outcome of "pushing on a string" -- i.e., the banks can make credit available but cannot force people to borrow.

What happens next? With a fed-funds rate at 0.5% or lower in coming months, it is fast becoming time for investors to read again Mr. Bernanke's speeches in 2002 and 2003 on the subject of combating falling inflation. In these speeches, the Fed chairman outlined how policy could evolve once short-term interest rates get to near zero. A key focus in such an environment will be to bring down long-term interest rates, which help determine the rates of mortgages and other debt instruments. This would likely involve in practice the Fed buying longer-term Treasury bonds.

It would seem fair to conclude that a Bernanke-led Fed will follow through on such policies in coming months if, as is likely, the U.S. economy continues to suffer and if inflationary pressures continue to collapse. Such actions will not solve the problem but will merely compound it, by adding debt to debt.

In this respect the present crisis in the West will ultimately end up discrediting mechanical monetarism -- and with it the fiat paper-money system in general -- as the U.S. paper-dollar standard, in place since Richard Nixon broke the link with gold in 1971, finally disintegrates.

The catalyst will be foreign creditors fleeing the dollar for gold. That will in turn lead to global recognition of the need for a vastly more disciplined global financial system and one where gold, the "barbarous relic" scorned by most modern central bankers, may well play a part.

Mr. Wood, equity strategist for CLSA Ltd. in Hong Kong, is the author of "The Bubble Economy: Japan's Extraordinary Speculative Boom of the '80s and the Dramatic Bust of the '90s" (Solstice Publishing, 2005).

from the New York Times, 2008-Dec-14, by Edmund L. Andrews:

As Rates Near Zero, the Fed Turns to Unproven Methods

WASHINGTON — Having printed more than $1 trillion in new money since September, yet still failing to stop the economy from sinking, the Federal Reserve is expected to enter a new era of cheap money this week.

On Tuesday, policy makers are expected to lower their target for the overnight federal funds rate to 0.5 percent, a record low.

In itself, analysts said, the move will be anticlimactic. Because demand for interbank loans has been so low, the actual Fed rate has been close to zero for a month. The real change will be in how the Fed tries to fight the recession from here on.

After Tuesday, the Fed will have to resort to mostly untested tools for promoting growth, because it cannot reduce its benchmark interest rate below zero.

Its goal will be to drive down borrowing costs wherever credit markets remain paralyzed. But the approach is much more complicated than raising or lowering a single rate, and it could have unintended consequences.

Analysts say the current recession, which officially began a year ago, is all but certain to break the postwar record for duration, 16 months. But it could also set a record for depth.

The economy has already lost two million jobs this year. Analysts predict that unemployment, now 6.5 percent, could hit 9 percent by the end of next year.

The Fed must now turn to an approach called “quantitative easing,” because it involves injecting money into the economy rather than aiming at an interest rate. The Fed has almost no experience with this approach.

“This is a whole new world,” said Richard Berner, chief economist at Morgan Stanley. “You don't have a whole lot of historical precedent for knowing how this is going to work and what the unintended consequences could be.”

The risks include provoking inflation or yet another speculative bubble. Economists generally agree that the Fed's long stretch of easy money from 2001 through 2004 contributed to the bubble in housing prices and the surge in reckless lending.

For now, neither Fed officials nor most private economists see evidence of inflation or a bubble. If anything, forecasters are worried about the kind of deflation Japan experienced in the 1990s.

Indeed, the Japanese central bank used quantitative easing for years when Japan was mired in chronic price deflation and had reduced its benchmark interest rate to zero. The results were not good, and it took Japan nearly a decade to break out of the mire.

Although Fed officials have denied it, they actually began a form of quantitative easing months ago. Since the financial crisis erupted in August 2007, the Fed has created a raft of new lending programs that have lent hundreds of billions of dollars to banks, Wall Street firms and money market funds.

Until three months ago, the Fed financed that lending with its existing reserves, mostly Treasury securities. Because it was simply exchanging its cash or Treasury securities for hard-to-sell securities, the programs did not increase the total amount of money in the financial system.

But since September, when the Fed started to run low on Treasuries, it has been creating new money at a blistering pace. As a result, the Fed's “balance sheet” has ballooned to just over $2 trillion last week from about $900 billion in September.

from the Financial Times of London, 2008-Oct-31, by Christopher Caldwell:

The hedonists' reckoning

We are in for a time of austerity. Are we ready for it? The US Department of Commerce has just released its advance third-quarter gross domestic product figures. They do not look good. The economy contracted over the past three months, due to the deepest fall in consumer spending since the Carter administration. Disposable income fell 8.7 per cent. This is an international downturn. Shop sales in the UK fell for the sixth month in a row in September, according to the British Retail Consortium. The European Commission announced that consumer confidence in the eurozone was the lowest in 15 years.

We should worry less about the bigness of our problems than about the smallness of our character. We are out of practice at handling a world of repossessed cars, hand-me-down clothes and cancelled vacations and graduation parties. For many decades, people were steeled against recession by a knowledge that things could be a lot worse. Britain had memories of postwar rationing. In the US, 8m people were unemployed throughout the 1930s. Even people in their mid-40s may remember Edward Heath's three-day week and Jimmy Carter's “malaise” speech.

Most people, though, are too young to remember that stuff. Perhaps that is why we are in the mess we are in. The US has not had a deep nationwide recession since at least 1981-82. The present consumer pessimism has not been equalled since December 1974, just after the Nixon resignation, when the US was still reeling from the oil embargo and President Ford was exhorting citizens to wear buttons that said “whip inflation now”. The youngest Americans who can remember the difficulty of paying for their children's college education under such circumstances are approaching 70.

The US is not the same country it was the last time people had to tighten their belts. It has changed socially, economically and demographically. The range of problems has widened and the range of solutions has narrowed. Back in the 1970s, there were relatively few people with credit cards and hardly any who were “maxed out” on half a dozen. But the US now has $2,600bn (€2,000bn, £1,600bn) in outstanding non-mortgage debt, and The New York Times recently reported that 5.5 per cent of outstanding credit card debt had been written off by card issuers as losses. Indications are that the credit card problem in Britain is considerably worse.

Many of the arrangements and institutions that got Americans through the 1970s are gone. It is not often remembered how socialistic the US was in those days. It was a disguised socialism, administered by huge corporations, but it was socialism. The flabbiness and misrule of American companies was a kind of insulation. No one mentions it now, not even in the heat of an election campaign. Republicans fear telling voters that things of value have indeed been stripped from them in recent decades, just as Democrats warned. Democrats fear telling voters that heavy-handed socialism is indeed their ideal, just as Republicans warned.

Many avenues out of adversity have been closed. This crisis started because people were unable to keep borrowing on their houses – especially in places such as Phoenix and Las Vegas, where home valuations are down by a third. Financial institutions have cleverly lobbied to protect themselves from a predictable headlong rush of unvetted, unsecured borrowers into credit card debt.

The US Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 steered troubled borrowers away from Chapter 11 into Chapter 7 bankruptcies, which are more expensive to file for and carry a longer-lasting stigma. In the UK, the 2007 Tribunals, Courts and Enforcement Act may allow increasing use of “charging orders” – that is, court-imposed post facto attaching of security to loans that were contracted as unsecured.

In many countries it is becoming easier for banks to share information on clients, permitting such practices as “universal default”, whereby a borrower who misses payments on one debt can have his interest rates raised on others. So where is the nest egg of last resort that will get us through this emergency? In the US, it is in the 401(k)s and other private retirement funds set up to replace old corporate pensions.

If people engage in the financial equivalent of burning their furniture for firewood, the politics of western countries will turn invidious and populist. As the first outlines of the Treasury department's plan to bail out troubled mortgage-holders emerged this week, there was an understandable public anger at payoffs to people who made bad decisions and spent on vacations the money they ought to have spent on their mortgages.

For quite a while, we lived unapologetically as rich people. We even patted ourselves on the back for it. If poverty causes so many social ills, then luxury ought to cure them, right? If you want to cut misery and social unrest you should let people go shopping. If you want to be “tough on the causes of crime”, let me have that flat-screen television.

As E.F. Schumacher wrote in his classic diatribe, Small Is Beautiful, in 1973: “This dominant modern belief has an almost irresistible attraction, as it suggests that the faster you get one desirable thing the more securely do you attain another. It is doubly attractive because it completely bypasses the whole question of ethics.” It turns out you cannot do that. So here we are, stuck in some dismal, minatory, moralistic, pre-information age fable. For a long while, banks lent and people borrowed as if we were living in an era of post-ethical hedonism. Now we face a reckoning as if we never left the era of neither-a-borrower-nor-a-lender-be.

The writer is a senior editor at The Weekly Standard

from the Financial Times of London, 2008-Sep-19, by Christopher Caldwell:

There's no free lunch and no free economy

“Sovereign is he who decides whether there is a state of emergency,” wrote the German legal philosopher Carl Schmitt in 1922, on the eve of the Weimar Republic's great economic crisis. Authorities that can be bypassed in times of stress are not real authorities. Laws that are suspended when push comes to shove are not real laws. Whether this is true in all places and times, it is true for those Americans who believed, up until this week, that they were living in a capitalist country. Having been lectured that there is no such thing as a free lunch, they are coming to suspect that there is now no such thing as a free economy, either.

An extraordinary credit crisis that arose from a real-estate bubble, excess leverage and financial instruments too complicated to value has goaded the US government into action. It has begun a programme of economic interventionism more typical of socialist governments in moments of utopian zeal. In March, a Federal Reserve loan helped sweeten the sale of the dying investment giant Bear Stearns. Treasury took over the secondary mortgage giant Fanny Mae in midsummer. This week the Fed assumed a 79.9 per cent stake in AIG, the world's largest insurer, in return for an $85bn (£47bn, €59bn) loan. On Thursday, the Fed, the Treasury and Congress began discussing a plan, potentially costing hundreds of billions of dollars, to bail out homeowners with illiquid mortgages and the banks that hold them.

No use to say it is “only” housing, trading and insurance that is being taken under the government wing. The significance for socialism of the first big British nationalisations after the second world war is that they involved the engine of the domestic economy (coal) and the repository of the country's wealth (the Bank of England). What is the engine of the US economy? Financial services. What is the main repository of Americans' wealth? Housing.

In a sense, the public has willed its way into government intervention by entertaining socialist expectations of a capitalist economy. Housing values were not supposed to fall and neither were any of the investments for which they served as collateral. Once enough citizens collateralise their investments with the roof over their heads, and once it becomes impossible to disentangle mortgages from other investment instruments, then the ordinary, healthy working of creative destruction will drive thousands of small-time investors from their homes. Small-time investors won't tolerate it. Almost every institution in the financial sector, big or not so big, looks too important to fail.

The crisis is partly an epistemological one. Few people outside of the financial industry have ever understood how the new complex derivatives work. Were they hedges or means of multiplying leverage? It turns out that few people inside the industry understood either. The most astonishing stories of the past week have to do with AIG's final weekend, when teams of government analysts and accountants from the world's leading investment banks could not figure out how much cash the company would require in order to collateralise its credit-default swaps. Estimates rose from $20bn to $85bn. A lot of commentators have complained about the opacity of the Fed's moves. It was unclear as of Thursday whether and how much Lehman Brothers, which filed for bankruptcy on Monday, was drawing from the Fed, for instance. Nor is it clear even today what assets the government holds from Bear Stearns. But the opacity is in the nature of modern markets and the instruments that arose from them.

In the US it is probably Democrats who stand to benefit from this crisis. Not that they have original ideas for getting out of it. At the centre of Democratic economic policy are plans to provide $25bn in loans to Detroit automakers and $50bn in transfer payments to the poor. Barney Frank, House banking committee chairman, demands that the Fed be democratically accountable: “No one in a democracy, unelected, should have $800bn to dispense as he sees fit.” Now that the Fed is allocating and targeting resources as well as controlling money supply, Mr Frank has a point. Since he is arguing for changing horses mid-stream, though, it will not get much of a hearing.

Republicans may suffer damage not because their remedies are worse but because a lot of their ideology about how markets work has been belied by events. Republicans are the party of rewarding people for risk-taking. If the government covers part of the losses, then the risks were illusory in the first place. (So, of course, were some of the rewards. A good percentage of the proceeds from the controversial Bush tax cuts was surely poured into this black hole of speculation and unknowability.)

President George W. Bush, Fed chairman Ben Bernanke and treasury secretary Hank Paulson all declare their preference for free-market solutions and a desire to minimise moral hazard. But they sound like François Mitterrand in mid-1983 when he abandoned his socialist programme commun in the face of capital flight and a collapsing franc, all the while proclaiming his devotion to socialism.

Panicked actions speak louder than words – and have more lasting consequences. The financial era that started a quarter-century ago is drawing to a close. Since the instruments that permitted an extraordinary leveraging of assets have been discredited without really being understood, leverage itself will be regulated against. Once that happens, there simply will not be the profitability in investment banking to enable hundreds of well-connected Ivy League kids of middling talents to become multi-millionaires every year.

By the time the situation calms and memories fade, there is unlikely to be enough capital in the economy to fund a restoration. Right now, the oldest baby boomers are 63. The ratio of earners to dependents has been at an all-time high. A vast earner generation is about to begin its transformation into a dependent generation. Probably a more dependent one than anticipated.

The writer is a senior editor at The Weekly Standard

from the New York Times, 2008-Dec-21, by Jo Becker, Sheryl Gay Stolberg and Stephen Labaton, with Kitty Bennett contributing reporting:

White House Philosophy Stoked Mortgage Bonfire

“We can put light where there's darkness, and hope where there's despondency in this country. And part of it is working together as a nation to encourage folks to own their own home.” — President Bush, Oct. 15, 2002

WASHINGTON — The global financial system was teetering on the edge of collapse when President Bush and his economics team huddled in the Roosevelt Room of the White House for a briefing that, in the words of one participant, “scared the hell out of everybody.”

It was Sept. 18. Lehman Brothers had just gone belly-up, overwhelmed by toxic mortgages. Bank of America had swallowed Merrill Lynch in a hastily arranged sale. Two days earlier, Mr. Bush had agreed to pump $85 billion into the failing insurance giant American International Group.

The president listened as Ben S. Bernanke, chairman of the Federal Reserve, laid out the latest terrifying news: The credit markets, gripped by panic, had frozen overnight, and banks were refusing to lend money.

Then his Treasury secretary, Henry M. Paulson Jr., told him that to stave off disaster, he would have to sign off on the biggest government bailout in history.

Mr. Bush, according to several people in the room, paused for a single, stunned moment to take it all in.

“How,” he wondered aloud, “did we get here?”

Eight years after arriving in Washington vowing to spread the dream of homeownership, Mr. Bush is leaving office, as he himself said recently, “faced with the prospect of a global meltdown” with roots in the housing sector he so ardently championed.

There are plenty of culprits, like lenders who peddled easy credit, consumers who took on mortgages they could not afford and Wall Street chieftains who loaded up on mortgage-backed securities without regard to the risk.

But the story of how we got here is partly one of Mr. Bush's own making, according to a review of his tenure that included interviews with dozens of current and former administration officials.

From his earliest days in office, Mr. Bush paired his belief that Americans do best when they own their own home with his conviction that markets do best when let alone.

He pushed hard to expand homeownership, especially among minorities, an initiative that dovetailed with his ambition to expand the Republican tent — and with the business interests of some of his biggest donors. But his housing policies and hands-off approach to regulation encouraged lax lending standards.

Mr. Bush did foresee the danger posed by Fannie Mae and Freddie Mac, the government-sponsored mortgage finance giants. The president spent years pushing a recalcitrant Congress to toughen regulation of the companies, but was unwilling to compromise when his former Treasury secretary wanted to cut a deal. And the regulator Mr. Bush chose to oversee them — an old prep school buddy — pronounced the companies sound even as they headed toward insolvency.

As early as 2006, top advisers to Mr. Bush dismissed warnings from people inside and outside the White House that housing prices were inflated and that a foreclosure crisis was looming. And when the economy deteriorated, Mr. Bush and his team misdiagnosed the reasons and scope of the downturn; as recently as February, for example, Mr. Bush was still calling it a “rough patch.”

The result was a series of piecemeal policy prescriptions that lagged behind the escalating crisis.

“There is no question we did not recognize the severity of the problems,” said Al Hubbard, Mr. Bush's former chief economics adviser, who left the White House in December 2007. “Had we, we would have attacked them.”

Looking back, Keith B. Hennessey, Mr. Bush's current chief economics adviser, says he and his colleagues did the best they could “with the information we had at the time.” But Mr. Hennessey did say he regretted that the administration did not pay more heed to the dangers of easy lending practices. And both Mr. Paulson and his predecessor, John W. Snow, say the housing push went too far.

“The Bush administration took a lot of pride that homeownership had reached historic highs,” Mr. Snow said in an interview. “But what we forgot in the process was that it has to be done in the context of people being able to afford their house. We now realize there was a high cost.”

For much of the Bush presidency, the White House was preoccupied by terrorism and war; on the economic front, its pressing concerns were cutting taxes and privatizing Social Security. The housing market was a bright spot: ever-rising home values kept the economy humming, as owners drew down on their equity to buy consumer goods and pack their children off to college.

Lawrence B. Lindsey, Mr. Bush's first chief economics adviser, said there was little impetus to raise alarms about the proliferation of easy credit that was helping Mr. Bush meet housing goals.

“No one wanted to stop that bubble,” Mr. Lindsey said. “It would have conflicted with the president's own policies.”

Today, millions of Americans are facing foreclosure, homeownership rates are virtually no higher than when Mr. Bush took office, Fannie and Freddie are in a government conservatorship, and the bailout cost to taxpayers could run in the trillions.

As the economy has shed jobs — 533,000 last month alone — and his party has been punished by irate voters, the weakened president has granted his Treasury secretary extraordinary leeway in managing the crisis.

Never once, Mr. Paulson said in a recent interview, has Mr. Bush overruled him. “I've got a boss,” he explained, who “understands that when you're dealing with something as unprecedented and fast-moving as this we need to have a different operating style.”

Mr. Paulson and other senior advisers to Mr. Bush say the administration has responded well to the turmoil, demonstrating flexibility under difficult circumstances. “There is not any playbook,” Mr. Paulson said.

The president declined to be interviewed for this article. But in recent weeks Mr. Bush has shared his views of how the nation came to the brink of economic disaster. He cites corporate greed and market excesses fueled by a flood of foreign cash — “Wall Street got drunk,” he has said — and the policies of past administrations. He blames Congress for failing to reform Fannie and Freddie. Last week, Fox News asked Mr. Bush if he was worried about being the Herbert Hoover of the 21st century.

“No,” Mr. Bush replied. “I will be known as somebody who saw a problem and put the chips on the table to prevent the economy from collapsing.”

But in private moments, aides say, the president is looking inward. During a recent ride aboard Marine One, the presidential helicopter, Mr. Bush sounded a reflective note.

“We absolutely wanted to increase homeownership,” Tony Fratto, his deputy press secretary, recalled him saying. “But we never wanted lenders to make bad decisions.”

A Policy Gone Awry

Darrin West could not believe it. The president of the United States was standing in his living room.

It was June 17, 2002, a day Mr. West recalls as “the highlight of my life.” Mr. Bush, in Atlanta to unveil a plan to increase the number of minority homeowners by 5.5 million, was touring Park Place South, a development of starter homes in a neighborhood once marked by blight and crime.

Mr. West had patrolled there as a police officer, and now he was the proud owner of a $130,000 town house, bought with an adjustable-rate mortgage and a $20,000 government loan as his down payment — just the sort of creative public-private financing Mr. Bush was promoting.

“Part of economic security,” Mr. Bush declared that day, “is owning your own home.”

A lot has changed since then. Mr. West, beset by personal problems, left Atlanta. Unable to sell his home for what he owed, he said, he gave it back to the bank last year. Like other communities across America, Park Place South has been hit with a foreclosure crisis affecting at least 10 percent of its 232 homes, according to Masharn Wilson, a developer who led Mr. Bush's tour.

“I just don't think what he envisioned was actually carried out,” she said.

Park Place South is, in microcosm, the story of a well-intentioned policy gone awry. Advocating homeownership is hardly novel; the Clinton administration did it, too. For Mr. Bush, it was part of his vision of an “ownership society,” in which Americans would rely less on the government for health care, retirement and shelter. It was also good politics, a way to court black and Hispanic voters.

But for much of Mr. Bush's tenure, government statistics show, incomes for most families remained relatively stagnant while housing prices skyrocketed. That put homeownership increasingly out of reach for first-time buyers like Mr. West.

So Mr. Bush had to, in his words, “use the mighty muscle of the federal government” to meet his goal. He proposed affordable housing tax incentives. He insisted that Fannie Mae and Freddie Mac meet ambitious new goals for low-income lending.

Concerned that down payments were a barrier, Mr. Bush persuaded Congress to spend up to $200 million a year to help first-time buyers with down payments and closing costs.

And he pushed to allow first-time buyers to qualify for federally insured mortgages with no money down. Republican Congressional leaders and some housing advocates balked, arguing that homeowners with no stake in their investments would be more prone to walk away, as Mr. West did. Many economic experts, including some in the White House, now share that view.

The president also leaned on mortgage brokers and lenders to devise their own innovations. “Corporate America,” he said, “has a responsibility to work to make America a compassionate place.”

And corporate America, eyeing a lucrative market, delivered in ways Mr. Bush might not have expected, with a proliferation of too-good-to-be-true teaser rates and interest-only loans that were sold to investors in a loosely regulated environment.

“This administration made decisions that allowed the free market to operate as a barroom brawl instead of a prize fight,” said L. William Seidman, who advised Republican presidents and led the savings and loan bailout in the 1990s. “To make the market work well, you have to have a lot of rules.”

But Mr. Bush populated the financial system's alphabet soup of oversight agencies with people who, like him, wanted fewer rules, not more.

Like Minds on Laissez-Faire

The president's first chairman of the Securities and Exchange Commission promised a “kinder, gentler” agency. The second was pushed out amid industry complaints that he was too aggressive. Under its current leader, the agency failed to police the catastrophic decisions that toppled the investment bank Bear Stearns and contributed to the current crisis, according to a recent inspector general's report.

As for Mr. Bush's banking regulators, they once brandished a chain saw over a 9,000-page pile of regulations as they promised to ease burdens on the industry. When states tried to use consumer protection laws to crack down on predatory lending, the comptroller of the currency blocked the effort, asserting that states had no authority over national banks.

The administration won that fight at the Supreme Court. But Roy Cooper, North Carolina's attorney general, said, “They took 50 sheriffs off the beat at a time when lending was becoming the Wild West.”

The president did push rules aimed at forcing lenders to more clearly explain loan terms. But the White House shelved them in 2004, after industry-friendly members of Congress threatened to block confirmation of his new housing secretary.

In the 2004 election cycle, mortgage bankers and brokers poured nearly $847,000 into Mr. Bush's re-election campaign, more than triple their contributions in 2000, according to the nonpartisan Center for Responsive Politics. The administration did not finalize the new rules until last month.

Among the Republican Party's top 10 donors in 2004 was Roland Arnall. He founded Ameriquest, then the nation's largest lender in the subprime market, which focuses on less creditworthy borrowers. In July 2005, the company agreed to set aside $325 million to settle allegations in 30 states that it had preyed on borrowers with hidden fees and ballooning payments. It was an early signal that deceptive lending practices, which would later set off a wave of foreclosures, were widespread.

Andrew H. Card Jr., Mr. Bush's former chief of staff, said White House aides discussed Ameriquest's troubles, though not what they might portend for the economy. Mr. Bush had just nominated Mr. Arnall as his ambassador to the Netherlands, and the White House was primarily concerned with making sure he would be confirmed.

“Maybe I was asleep at the switch,” Mr. Card said in an interview.

Brian Montgomery, the Federal Housing Administration commissioner, understood the significance. His agency insures home loans, traditionally for the same low-income minority borrowers Mr. Bush wanted to help. When he arrived in June 2005, he was shocked to find those customers had been lured away by the “fool's gold” of subprime loans. The Ameriquest settlement, he said, reinforced his concern that the industry was exploiting borrowers.

In De