QE is Working!

The Bernanke speech on Friday was a nothingburger, as expected. The real fireworks at Jackson Hole came from the new head of the IMF, Christine Lagarde:

Two years ago, it became clear that resolving the crisis would require two key rebalancing acts—a domestic demand switch from the public to the private sector, and a global demand switch from external deficit to external surplus counties… the actual progress on rebalancing has been timid at best, while the downside risks to the global economy are increasing…

I would like to delve deeper into the different problems of Europe and the United States.

I’ll start with Europe…

Banks need urgent recapitalization. They must be strong enough to withstand the risks of sovereigns and weak growth. This is key to cutting the chains of contagion. If it is not addressed, we could easily see the further spread of economic weakness to core countries, or even a debilitating liquidity crisis. The most efficient solution would be mandatory substantial recapitalization—seeking private resources first, but using public funds if necessary. One option would be to mobilize EFSF or other European-wide funding to recapitalize banks directly, which would avoid placing even greater burdens on vulnerable sovereigns…

The United States needs to move on two specific fronts.

First—the nexus of fiscal consolidation and growth. At first blush, these challenges seem contradictory. But they are actually mutually reinforcing. Credible decisions on future consolidation—involving both revenue and expenditure—create space for policies that support growth and jobs today. At the same time, growth is necessary for fiscal credibility—after all, who will believe that commitments to cut spending can survive a lengthy stagnation with prolonged high unemployment and social dissatisfaction?

Second—halting the downward spiral of foreclosures, falling house prices and deteriorating household spending. This could involve more aggressive principal reduction programs for homeowners, stronger intervention by the government housing finance agencies, or steps to help homeowners take advantage of the low interest rate environment.

Sobering stuff, and shockingly frank talk from a central banker.

And yet today, the markets are up, way up (on very little volume, which is rather suspect). The common wisdom is because consumer spending reported an increase, hooray! You can't keep the American consumer down. Or can you? Digging into the numbers reveals some subtleties. From a post on Zero Hedge: Personal Saving Rate Plunges From 5.5% To 5.0% As July Energy Expenditures Soar

July personal income and expenditures were quite surprising in that while many were expecting the drop in the market to force consumer saving to upshift (lower spending than income), not only was this not true, but expenditures spiked by 1 whole percent from -0.2% to 0.8%, on expectations of 0.5%, even as Personal Income came in line with expectations of 0.3%, up from a revised 0.2% (concurrent with extensive prior data revisions). This was the biggest difference between a monthly change in income and spending since October 209. The net result was a plunge in the savings rate from 5.5% to 5.0%. And while on the surface this would be good news, as in Americans are spending again, a quick look at the PCE components indicates that virtually the entire surge is due to a spike in Energy goods and services. In other words, the entire spike in spending was to... pay for gas and associated energy expenses. Which makes sense: in June this was a drop of -4.5%, it is only logical that the subsequent jump in Brent and WTI forced American savings to drop. All in all: in July Americans continued to max out their credit cards to pay for gas. As for the income side, transfer payments as a % of spending refuse to budge: thank you Uncle Sam.

If you've read Bernanke's speech from 2002, you'll know this is exactly what he had in mind when he said the Fed has the power to increase nominal spending by injection of liquidity (QE). But is this a real increase in aggregate demand that is required to support a real recovery? I don't see how these dots connect. Without the latter, it is just another transfer of wealth from have-nots trying to make ends meet to haves with speculative free credit to play with and drive up commodity prices.

The central banks and governments are all-in on the idea that the existing financial system can be kept from falling in a deflationary spiral "just long enough" for households to start spending again. Consumer confidence is key and the political and economic situation does not appear rosy for the average citizen. If more people decide to save instead of spend, it will be a "disaster" for the existing system.

The Fed's Dual Mandate

From The Federal Reserve FAQ Page:

The Congress established two key objectives for monetary policy - maximum employment and stable prices - in the Federal Reserve Act. These objectives are sometimes referred to as the Federal Reserve's dual mandate. The dual mandate is the long-run goal for monetary policy, and the Congress also established the Federal Reserve as an independent agency to help ensure that this monetary policy goal can be achieved. The independence of the Federal Reserve in conducting monetary policy is critical to guaranteeing that monetary policy decisions are free from political influence and focused exclusively on achieving the Federal Reserve's dual mandate. For example, a problem experienced in many countries without an independent central bank is that elected officials have put pressure on monetary policymakers to follow policies that boost the economy in the short run even if doing so would result in high levels of inflation later on. The Federal Reserve's dual mandate and the provisions for the independence of the Federal Reserve are two key factors that help guard against such outcomes in the United States.

So, let's see how the Fed has done with their dual mandate, to provide maximum employment and price stability over the last 20 years.

US economic policy hasn't been bad for everyone, though.

So much for households. Maybe they meant market price stability?

Nope. Perhaps their policies have not been as "free from political influence" as they would like you to believe. The Wealth Effect certainly doesn't hurt one's election chances.

Inside Bernanke's Mind; All-In Against Deflation

I'm back from a few days off the grid, and have some thoughts on where we are here in the latter half of 2011, with analysts (and data) seemingly split 50/50 on the likelihood of another global recession. I've been trying to go back to basics and figure out where the primum movens in this crisis really lies. To understand where we are, you have to understand the belief system of those that have their hands on the world's levers.

What keeps Ben Bernanke, Chairman of the US Federal Reserve Bank since 2006, awake at night? Deflation. This is must-read material from his 2002 speech, just after leaving his academic position at Princeton University as chair of the Department of Economics. Since the 2008 crisis he has certainly become one of the most powerful people in the world; in many ways the fate of the globe is tied to his theories on economic policy. NEVER BEFORE has a fiat money system successfully dealt with deflation - Japan has been fighting a losing battle against deflation for 21 years now, with no end in sight and debt to GDP of 225% and rising. Will Bernanke's remedies to defeat deflation work? He certainly thinks so:

Deflation: Making Sure "It" Doesn't Happen Here
Remarks by Governor Ben S. Bernanke
Before the National Economists Club, Washington, D.C.
November 21, 2002

(Some choice quotes in there, like "So, is deflation a threat to the economic health of the United States? [No.] A particularly important protective factor in the current environment is the strength of our financial system: Despite the adverse shocks of the past year [2001], our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape." Not for long.)

But is his theory true that "... under a paper-money system, a determined government can always generate higher spending and hence positive inflation."?

While it is true that QE did cause inflation, I think there are limits to what "increased nominal spending" can achieve. If zombie banks are propped up but refuse to lend, if corporations hoard cash to bolster their balance sheets by slashing workers and postponing investment, that extra credit is going to end up chasing speculative bubbles like we've seen in the commodities. This has the effect of putting even more pressure on an under-employed population and is a transfer of wealth from those that require the commodities either as basics (food, gas) or input materials to those with an excess of speculative credit. If this sounds familiar, one should not expect a different result with the same conditions.

Eventually, without a broad increase in demand, those prices will no longer be sustainable. It's all a confidence game. Bernanke has all his hoped pinned on staving off deflation until confidence increases and spending, lending and investment pick up.

Keep in mind deflation has already started:

Graph is from this illuminating post discussing the case for unstoppable deflation:

The Automatic Earth Blog: August 27 2011: Et tu, Commodities?

There are only 3 possibilities going forward:

1. Bernanke's dollar debasement theory (described in plain speak in his 2002 speech above) works and staves off deflation long enough for a genuine recovery to take place. The day is saved and we enter another period of growth. Business as usual. Bernanke is supremely confident that the Fed can do whatever it takes to hold off a deflationary spiral (ala Japan).
   
2. Deflation reappears, due to a lack of aggregate demand no matter how much inflation is pumped into the system. Cash is king and debt rollover becomes unsustainable as dollars increase in value, causing increasing bankruptcies and large scale systemic resets.
   
3. Ever larger liquidity injections (QE3 through 99) are required to prop up a failed system. Rather than admit defeat and allow liquidation, the central banks keep running their printing presses, lose control and cause hyper-inflation. Savers are wiped out and commodities are the new bubble as excess liquidity sloshes around.
   

What seems clear is that central bankers know how to handle inflation; they have lots of data to work with, lots of recent examples, and many lived through the last period of rampant US inflation in 79-81. While it was not pleasant, it is something they have seen first hand and studied. Some extreme measures were required (Volcker raised interest rates to 20% in June 1981), but inflation was tamed. There are no economists or bankers alive today that have seen a modern, successful response to a deflationary period to use as a template to recovery.

Bernanke agrees we are in uncharted waters: "One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies."

The bond market is saying "we bet on deflation!" and the gold market is saying "we bet on inflation!" and the stock market rallies say "we bet on muddling through!"

What is clear is that nobody REALLY knows how this is going to play out - but time is running out for the "back to normal" scenario.

Welcome to Couterparties

Instead of constantly spamming my friends and family with my thoughts on economics, finance, and investing, I've decided to start a blog to collect my musings. I am not a professional investor or advisor, have no formal economics or financial training, and have terrible market timing. None of what I say should be considered as investment advice.

Here follows the journal of one child of the 80s trying to make sense of a screwed up global economic system, protect himself from catastrophic outliers, and maybe even have something left to retire on in 30 years.