Here Comes the Spaghetti! The Fed's $850 Billion Bet.

The headline reads that the Federal Reserve is going to engage in a new round of quantitative easing. The Fed is going to purchase an additional $600 billion in U. S. Treasury securities over the next eight months, or $75 billion per month, in order to get the economy growing again.

The information that did not make the headlines is that over the same time period, roughly $250 billion will run off of the Fed’s Mortgage-backed securities portfolio. This $250 billion in Mortgage-backed securities will be replaced by the Fed with $250 billion in U. S. Treasury securities.

The world investment community sees a Washington, D. C. is disarray. The Fed is going crazy. (But, this is not the first time that Bernanke has shown panic. See “The Bailout Plan: Did Bernanke Panic”, http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.) And, the additional federal deficit is projected to be at least $15 trillion over the next ten years.

What we are seeing, in my mind, is the culmination of a half century or more of governmental economic policy that has had the wrong focus. This began with the Employment Act of 1946. Full employment became a goal of the United States government and the Federal Reserve was charged with the task of contributing to the achievement of this goal.

Right now, the Fed believes that there will be little or no stimulus programs coming from the federal government, especially with the changes in the makeup of Congress resulting from this week’s election. Thus, the Fed seems to believe that it must carry the full burden of reducing unemployment.

We have reached this state of desperation over a long period of time. The background of this environment is presented in the book by Raghuram Rajan called “Fault Lines” which just won the Financial Times award for the best business book of the year. (See my review of this book: http://seekingalpha.com/article/224630-book-review-fault-lines-how-hidden-fractures-still-threaten-the-world-economy-by-raghuram-g-rajan.) The next five paragraphs contain material from this review.

Rajan states that “Almost every financial crisis has political roots.” Beginning from this premise, he discusses the foundation of the economic policies of the United States. The root of the government’s economic policies, he contends, is the concern over “the growing inequality of income” in the United States, a disparity that can lead to political unrest.

Politicians, however, have not responded to this problem by focusing on the longer run solutions to inequality connected with education and opportunity, but has instead focused on short run solutions because of the nature of the American political process.

Rajan argues that these politicians have responded to the discontent this divergence in incomes creates in the electorate with two short run panaceas: first, the effort to achieve high levels of employment through the monetary and fiscal policies of the government. This resulted in the Employment Act of 1946 and the Humphrey-Hawkins Full Employment Act of 1978. The second is the effort to help as many individuals as possible own their own homes.

Thus the government has created policies that underwrite efforts to attain high levels of economic growth and employment and will provide downside protection against economic contractions and unemployment. Likewise, it will underwrite the supportive credit inflation of the private sector and will “save” financial institutions experiencing trouble on the downside.

Home ownership has become the default policy of government in the inequality debate because efforts to directly combat income inequality in the United States, Rajan contends, have been exiled from political debate. Supporting home ownership for as many people as possible and in as many ways as possible has been substituted. As a consequence, the number of programs, institutions, and incentives advocated for home ownership has grown to the point where they dominate most economic and social policies of the United States government. Credit creation is the vehicle of choice for the achievement of homeownership and prancing from “bubble to bubble” has become the essence of the fiscal and monetary policy that supports this effort.

The problem is that these policies don’t work over the longer run. In fact, the efforts to achieve success in these areas over time may do more to help the wealthy and educated at the expense of the less-wealthy and the less-educated.

In the fifty years that the efforts Rajan describes have been incorporated into the economic policy of the federal government, the United States has actually seen the inequality of incomes become even more skewed toward the higher end of the income spectrum.

And, it appears that most of the efforts of the Obama administration to protect and better the position of the less-wealthy and the less-educated have done exactly the opposite of what the administration intended!

For example, look at this article by Shahien Nasiripour in Huffington Post this morning, “Federal Reserve Rains Money on Corporate America—but Main Street Left High and Dry”. (http://www.huffingtonpost.com/2010/11/03/federal-reserve-qe2_n_778392.html)

So, who has benefitted from the policy of the Federal Reserve? The big banks. Big corporations. Emerging nations. (More and more of these countries are thinking of imposing controls on money flows to stem the flood of dollars coming across their borders), China. India. Brazil.

You don’t see on this list smaller banks, smaller businesses, middle class Americans, and so on.

And, who is capable of positioning themselves to take advantage of these federal monetary and fiscal policies? The wealthy and the educated…not the less wealthy or the less-educated.

Just a case in point: as the credit inflation of the 1960s and 1970s built up, the wealthy began to build portfolios of assets that served as inflation hedges. Houses, of course, were one of these assets.

In fact, housing became the piggy bank of many, many Americans during this time. But, since the prices of housing never went down during this period of credit inflation it appeared that one way to help the less-well-to-do in the society was to help them get a “piece of the bank.” The subprime loan was one of the last vehicles to get people into the piggy bank. I mean, how could they miss with housing prices rising 10% to 12% year-after-year. And, the Fed would never let these people down for long.

And, what about unemployment? Unemployment may actually be made worse by too much credit inflation. Trying to put people back into the jobs they have recently lost through credit inflation may only make the employment situation worse as under-employment grows, as it has over the past fifty years, and as capacity utilization declines, as it has over the past fifty years.

I really can see little or no good coming from this “quantitative easing”. However, I can imagine a lot of bad things happening. The plunge that is now taking place in the value of the dollar leads me to believe that a lot of other people believe the same thing.

The Chinese Dilemma

China seems to be determined to continue to peg the value of its currency against the dollar. Then it points its finger at the United States anytime someone representing the United States raises a question about its practice.

As long as China continues to follow this policy, the United States is locked into a corner with no really good options.

The problem of the United States is the problem of a country that has lost its discipline: a person, an organization, a nation, that loses its discipline is only left with painful decisions. And, given an adversary like China that knows when it has a favorable advantage over another, the bad situation only becomes worse.

The assumption of United States supremacy which most presidential administrations worked with since the 1960s created an aura of invincibility, a feeling that the government could conduct its monetary and fiscal policies without regard for the rest of the world. The Bush administration “strutted” into power in its cowboy boots and its Colt 45s ready to enforce this attitude on other nations.

Unfortunately, for the United States this assumption no longer holds. Although the United States is still the most powerful nation on this planet, both in terms of its economic machine and its military presence, it is not in the same place it once was relative to other nations. As a consequence, the country pays a price if it tries to disregard the rest of the world in the conduct of its monetary and fiscal policies.

The prodigal nature of Bush 43 resulted in the value of the dollar, using almost any measure, declining by about 40% between early 2002 and the summer of 2008. Obviously, the monetary and fiscal policies of Bush 43 were not well received by the international financial community.

After the flight to quality into the dollar during the financial crisis of 2008, the value of the dollar has dropped about 14% from its near-term peak in March 2009 to the present time. World financial markets are not approving the economic policies of the United States government!

Meanwhile the Chinese sell goods to the rest of the world and live off of an export driven economy.

And, what happens if the United States does nothing about this?

The value of the dollar will continue to decline and the prestige of the United States in the world will continue to fall. And, the carry trade will continue to prosper and big financial institutions and financial players will continue to rake in billions of dollars in profits by borrowing dollars at ridiculously low United States interest rates, selling the dollar, and investing in higher interest rates throughout the world.

The big banks will continue to get stronger…and bigger. The rest: well that is their problem!

The two major alternatives being suggested are either to raise interest rates and try to moderate the rise in government debt or to raise protective barriers against international trade.

The first of these alternatives does not seem realistic to expect at this time. With unemployment at current levels and with foreclosures and bankruptcies remaining high, the political interests in the United States are not going to condone higher interest rates and a less expansionary fiscal policy. Using monetary and fiscal policy to stem the decline in the dollar is, it seems to me, just not going to happen.

The other major alternative now being floated: greater protection for United States manufacturing and industry. Paul Krugman, the Nobel prize-winning economist, writes about “Chinese New Year” in last Thursday’s New York Times (see http://www.nytimes.com/2010/01/01/opinion/01krugman.html). He concludes as follows:

“there’s the claim that protectionism is always a bad thing, in any circumstances. If that’s what you believe, however, you learned Econ 101 from the wrong people — because when unemployment is high and the government can’t restore full employment, the usual rules don’t apply.

Let me quote from a classic paper by the late Paul Samuelson, who more or less created modern economics: “With employment less than full ... all the debunked mercantilistic arguments” — that is, claims that nations who subsidize their exports effectively steal jobs from other countries — “turn out to be valid.” He then went on to argue that persistently misaligned exchange rates create “genuine problems for free-trade apologetics.” The best answer to these problems is getting exchange rates back to where they ought to be. But that’s exactly what China is refusing to let happen.

The bottom line is that Chinese mercantilism is a growing problem, and the victims of that mercantilism have little to lose from a trade confrontation. So I’d urge China’s government to reconsider its stubbornness. Otherwise, the very mild protectionism it’s currently complaining about will be the start of something much bigger.”

If unemployment remains high and economic growth continues to stagnate, and the value of the United States dollar continues to decline, the argument that Krugman presents will become more and more convincing, especially as we move to an election. Krugman is now saying that a double-dip economy is more probable than it was a month or two ago and the current stimulus will disappear after the middle of the year. Thus, tighter monetary and fiscal policies, toeing this line, are not appropriate.

This alternative can, therefore, become a real threat and we could experience a rising tide of interest in greater amounts of protectionism as 2010 proceeds. Once the ball gets rolling in this direction it becomes hard to stop and other nations must respond in kind to protect themselves. This would just be a replay of the 1930s, when an earlier death spiral of globalization took place. Even a person who was generally in favor of free trade like John Maynard Keynes became, for a while, a supporter of protectionism because the British government was doing nothing else.

The United States is in a corner and there are no real good choices available to it. As said earlier, when one loses their discipline nothing becomes easier. Bush 43 was totally undisciplined and we are currently paying the price for it. No one seems to have a good idea how to get out of the current malaise and so alternatives like protectionism are bound to gain ascendency.

A Strong Dollar?

“It is very important to the United States that we have a strong dollar.”
So said the United States Secretary of the Treasury.

Yes, Paul O’Neill said that.

Oh, yes, John Snow said that.

And, Hank Paulson.

Oh, you say, that the quote is attributed to Tim Geithner, who made the statement yesterday at a news conference of Asia-Pacific finance ministers.

As my good friends would say, “you have to walk the walk, not just talk the talk!” Or, in the case of those looking on, “watch the hips, not the lips!”

The only public person alive today that, in my mind, has any credibility on this issue is Paul Volcker. And, it is Paul Volcker that has written, “A nation’s exchange rate is the single most important price in its economy; it will influence the entire range of individual prices, imports and exports, and even the level of economic activity. So it is hard for any government to ignore large swings in its exchange rate…” (This quote is found on page 232 in the book “Changing Fortunes: The World’s Money and the Threat to American Leadership” by Paul Volcker and Toyoo Gyohten, Times Books, 1992.)

The United States government has no credibility left when it comes to the value of the United States dollar.

During the administration of Bush 43, the value of the United States dollar fell by 37% against an index of major currencies from February 2002 to March 2008 while the dollar fell in value by 45% against the Euro from February 2002 to July 2008.

The United States dollar did rebound at the time of the financial crisis: up 19% against the index of major currencies and up 23% against the Euro.

However, since February of this year the United States dollar fell back by about 13% against the index of major currencies and by about 15% against the Euro.

In watching the hips, not the lips, we see, for the United States government, potential cumulative fiscal deficits of $15 to $20 trillion over the next 10 years. We have a banking system with almost $1.1 trillion in excess reserves during the two week period ending November 4, 2009. We are faced with an unknown “exit strategy” to remove these excess reserves on the part of the Federal Reserve System.

And all this with several other “shocks” on the horizon. Obama “owns” Afghanistan now and it is totally unknown what his “new strategy” for that country will mean in terms of more government spending. Then there is the health care initiative. Obama has said that the program should not add “one dime” to the deficit, yet all indications are that whatever is passed will add to the deficit, although we don’t know what that amount will be. Then there is the climate change bill along with some other proposals that are setting in the wings.

Oh, yes, people within the administration have suggested that the rest of the TARP money, whatever that amounts to, can be applied to reducing the deficit. Whoopee!

I hear the Obama administration talking the talk. I don’t see them walking the walk.

And what about Bernanke. He is staying particularly silent these days. Oh, yes, we learned from the New York Times earlier this week that he is letting Barney Frank do all his talking for him.

The strong dollar is, at present, a myth!

It will continue to remain weak and its value will continue to trend downward for the foreseeable future.

How far am I looking forward?

I will continue to believe that the dollar will remain weak until someone emerges that has some credibility. Right now, I don’t know where that person is going to come from.