It's Still The Economy, Stupid


Thursday, June 26, 2003  

New jobless claims fall....but...

Jobless claims fall to 3-month lows

(Reuters) — Applications for initial U.S. jobless aid plunged to three-month lows last week, the government said Thursday in a report showing a better-than-expected improvement in the still-weak job market.

The Labor Department said 404,000 idled workers filed for unemployment insurance payments in the June 21 week, down 22,000 from a revised 426,000 a week earlier and the lowest since March 22.

Well, it's about time! Pop out the champagne, thumb your nose at all those "jobless recovery" naysayers.

What do you mean that's not the whole story? You mean there's bad news too?

The advance seasonally adjusted insured unemployment rate was 3.0 percent for the week ending June 14, an increase of 0.1 percentage point from the prior week's unrevised rate of 2.9 percent.

The advance number for seasonally adjusted insured unemployment during the week ending June 14 was 3,741,000, an increase of 43,000 from the preceding week's revised level of 3,698,000. The 4-week moving average was 3,724,500, an increase of 5,250 from the preceding week's revised average of 3,719,250.

So while there were 22K fewer new claims, nearly twice as many people failed to find jobs, and so had to continue to draw unemployment benefits.

And since no day of mine is complete without at least one reference to Bush I, should we take a quick peek and see if there are, once again, any similarities between Poppy and son on this issue?

week_clms.gif

[The x-axis represents the corresponding week during the 3rd year of the term.]

Not surprisingly, new claims peaked just after war with Iraq, and trended downward thereafter. But what the media seems to have missed, is that although an increase in new claims almost always results in a higher unemployment rate, a subsequent decrease in new claims need not have the same corresponding effect. Take the above chart, for example. In April, 1991, at the peak of new claims, the unemployment rate was 6.7%, up 1.5% from its low the previous spring [I put up a nifty graph back here, data courtesy of the BLS. But even as the number of new claims fell during the summer of '91, the unemployment rate continued to climb, albeit more slowly. This was due in part to the fact that although fewer people were losing their jobs, companies were still not hiring, and so new entrants into the job market, recent graduates, immigrants, moms returning to work, soldiers retiring from active duty, etc., while not laid off, were still counted, rightly so, as unemployed.

That the continued claims are still increasing should be a red flag to the current Bush Administration. Millions of students just graduated from high school, college and grad school, and will be pounding the pavement looking for work. If laid off experienced workers are still not finding jobs, and today's help wanted index is still at near record low levels, chances are the recent drop in claims will spell as much for job growth as it did in 1991.

posted by MB | 12:28 PM |
 

A Picture Tells a Thousand Words

Remember, these graphs only go through 2000, so this is before the Bush tax cuts. Still, these wealthy people stand to lose a lot more from a crappy economy than they stand to gain from Bush's tax cuts--but when will they figure this out? Go read the whole NYT story. And hell, I pay an effective tax rate a bit over 20%, the same as 400 wealthiest taxpayers paid in 2000.

AB

posted by Angry Bear | 9:40 AM |


Wednesday, June 25, 2003  

Income Inequality

CalPundit has a great post on income inequality (hint: it's increasing, and it's not being offset by increased mobility). Read it. Then note how the income of the top 20% started increasing even faster right around the time of the Clinton tax hike (no, I'm not saying that the tax hike caused the acceleration, but rather that it clearly did not have a deleterious effect on incentives to create wealth at the top, as Republicans vociferously claimed at the time).

AB

posted by Angry Bear | 12:39 PM |
 

Rate cut 1/4 point

To 1%, the lowest level since 1958:

NEW YORK (CNN/Money) - The Federal Reserve cut its key short- term interest rate Wednesday by a quarter percentage point to the lowest level in 45 years, expressing worry that the economy still isn't strong enough to fight off deflation.

Because the rate cut came in at the minimum level that people expect, it was already largely priced into the stock market, so don't expect to see much action there. It will help to keep finance rates around their current levels, continuing to prop up consumer durable goods and housing expenditures. Some of the effects will be attenuated by the fact that so many people expected a 1/2 point cut that those expectations will shift to expecting another 1/4 point rate cut at the next Fed meeting (in August)--so firms that might have borrowed now in response to a 1/2 point cut may choose to wait two months (for a second cut) before borrowing. On balance, it's a "hold the course" cut that, given the current course, seems a little timid. On the other hand, the Fed doesn't want to run out of bullets (it's got four left now).

AB

posted by Angry Bear | 11:47 AM |
 

Expectation versus Reality

[I meant to post this yesterday when the Conference Board's report came out and I wrote it for Wampum, but Blogger pulled a typical fast one.]

Ever vigilant to spin economic news in the best possible fashion, the media put the best face on this morning's consumer confidence report:

Consumer Confidence Steady in June

By ADAM GELLER

AP Business Writer

NEW YORK (AP)--Consumer confidence held steady in June as growing optimism about the future offset worsening sentiments about current conditions, a private research group said Tuesday.

The New York-based Conference Board said its Consumer Confidence Index edged back to 83.5 in June from a revised 83.6 in May, following two consecutive months of increases. Still, the reading was better than analysts projected reading of 82.

Economists called the report modestly positive and said it shows that consumers, continuing to exhibit the optimism that followed the end of the war in Iraq and buoyed by reports of coming tax cuts, see better times ahead.

So, even though the index fell slightly, because it wasn't as bad as some market analysts expected, it's now good news. And what about those predictions anyway? With the passage of the purportedly stimulus-heavy Bush tax cuts, shouldn't economists expect that consumers would be brimming with confidence, anticipating that hefty check they'll be getting in the mail next month?

Well, it turns out that even that bad-but-not-so-bad number was only as good (bad?) as it was due to consumer expectations that things will soon get better. When asked about their current situations, it turns out things are actually getting worse:

[T]he report's present situation index declined to 64.9 in June from 67.3 in May. The number of consumers who say business conditions are good and jobs are plentiful both fell.

If the jobless recovery continues for any length of time, as those same analysts seem to indicate it might, how long before consumer expectations reflect reality, versus merely hoping for reality to match expectations?

posted by MB | 9:24 AM |
 

Durable Orders Dip Unexpectedly in May


The story continues:

U.S. durable goods orders sank 0.3 percent last month -- in contrast to the expectations of private economists that they would rise 0.8 percent. The data from the Commerce Department showed April orders plunged 2.4 percent, revised down from an earlier reported 2.3 percent drop.


I don't know whether the economy is going to immolate itself, but it doesn't seem like we're in a roaring recovery yet. And given our extraordinarily high debt levels, it doesn't seem like we can have anything but a stutter-step recovery at best.

posted by Matthew | 7:27 AM |


Tuesday, June 24, 2003  

Directed Discussion (semi-open thread)

My last post (and I apologize for the length of it) touched on a number of debatable issues. If interest rates hit zero, and Federal Reserve policy seems to no longer be effective, should Alan Greenspan continue to try? What would be the role of the Federal Government, if any? Should the powers that be try to prevent a recession, or should they educate their citizens to accept the downturn and instead work to minimize the suffering?

What about international organizations (e.g. World Bank and IMF)? Would it be wise (or possible) to have a second "Bretton Woods" reorganization of the financial system if the U.S. gets stuck in a Japan-like scenario? Is the U.S. unavoidably heading to a Japan-like scenario? I'm sure there's more than my tiny brain can think up. I'm going to shut up now. You've got the floor. Discuss.

posted by Teddy | 10:56 AM |
 

In god's hands now

Marshall Auerback has penned another insightful commentary on the state of Federal Reserve policy. The thrust of the piece is that now that the Fed has been so successful at spreading the "deflation" mantra, market expectations are now for continued rate cuts even if the economy begins to recover or inflation becomes more of a threat. Changing policy now (not cutting rates) would impart a shock to the market.

Most economists need to divorce themselves of the notion that the Federal Reserve can influence the economy in the traditional ways: cutting interest rates to stimulate investment in production and increasing reserves to stimulate bank lending. In the past three years, non-residential investment spending has fallen by 10% in real terms and in nine of the past ten quarters, all the while the Fed was cutting interest rates from 6.5% to the current 1.25%. In the past year the Fed increased the monetary base $70 billion, or 10%. At the same time, commercial and industrial loans have decreased by 6%, or $60 billion, to a $932.7 billion annual rate. The economy has clearly not responded in the traditional way to Federal Reserve monetary policy.

But last year, the Fed estimates that homeowners extracted at least $200 billion in equity from their homes. The effective interest rate on all U.S. mortgages has fallen 1.8% since the Fed started cutting rates on January 3, 2001. Not only are homeowners refinancing at record levels, but corporations are also issuing debt in record amounts ($70 billion in May alone), and the financial sector has increased its borrowing by $2.1 trillion (25%) since year-end 2000.

Rather than stimulate the economy in the traditional way, the Fed now relies on manipulating lending spreads - keeping the yield curve steep to widen the gap between borrowing short and lending long - in order to stimulate lending activity, which is now predominantly done by the non-bank financial sector via asset-backed securities and other forms of structured finance. To have somewhere for that money to go, borrowers must be induced to overconsume and refinance. Demand is stimulated by keeping mortgage, personal and corporate borrowing rates falling, which the Fed can influence by simply issuing a "bias" toward cutting or raising rates, inducing lenders to reduce their rates knowing they can maintain their interest rate spread.

The Fed's effectiveness in this regard has increased so much that 10-year treasury rates have declined nearly 20%, from 4% to 3.3% in the past six weeks, in anticipation of "deflation" and at least a 25 basis point "insurance" rate-cut by Alan and Co. tomorrow. The anticipation has been heightened by the 50 basis point rate cut by the European Central Bank, so now many economists feel the Fed will cut the Fed Funds rate by 50 basis points tomorrow as an "exclamation point" on two years of historic intervention. This would put the Federal Funds rate at 0.75%, a level seen only twice, briefly in 1958, in recorded history.

Auerback notes that this isn't the first time that Alan Greenspan's verbal machinations have backfired. Alan was part of Gerald Ford's "Whip Inflation Now" economic team and through his 1996 speech on "irrational exuberance" and his continuing espousal of a productivity-driven new economy before and through the popping of a stock market bubble.

But while the Fed flounders for an answer to the recession, it's important to also note that economic recovery is really beyond Fed control. The monthly payment on a $400,000 mortgage (very common for the majority of the population in large urban centers) is $2147 at 5%, not including taxes and insurance. For every 1/2% increase in mortgage rates, that monthly payment rises by $127. By the time mortgage rates get to 7% (where they were just two years ago!), the monthly payment is $2661. And remember, this is not including taxes (which localities are raising nationwide to deal with budget deficits) and not including insurance (also rising in price at double-digit rates to deal with issues like mold and the rising replacement values of houses). The mortgage finance industry, expected to do $4 trillion in volume this year alone, 40% of our entire GDP, simply cannot grow unless rates continue to fall. Any significant back up in rates would make houses unaffordable to the marginal homebuyer (and are there even any left?) and refinancing would come to a screeching halt.

Slowing down business and consumer lending is not possible for lenders faced with increasing unemployment, near-record bankruptcy rates (personal and corporate). They need to keep lending to outpace defaults. It is also not healthy for demand, as a good chunk of that $200 billion in home equity extraction fed back into purchasing goods and services, not to mention the money freed by corporations refinancing to allow even a limited amount of new investment.

A backup in interest rates would severely increase government borrowing rates. Despite our anticipated $450 billion Federal Government deficit for 2003, the deficit would be worse if interest rates were much higher on the $6.4 trillion and counting of accumulated Federal Government debt. So far, many state and local governments have still been able to borrow at historically low rates to fix funding shortfalls without raising taxes or cutting spending. Without employment growth to raise income tax receipts, or without a second stock market boom to provide a windfall of capital gains tax receipts, once the interest rate escape hatch is closed state and local governments will not have reserves to tap into.

And on the international scene, funding our trade deficit currently requires $500 billion of annual borrowing. A growing economy relative to the rest of the world will only increase this deficit. For a time, foreign investors have been placated by capital gains from lower interest rates on the bonds they hold, which has offset the exchange rate loss due to the falling dollar. But international investors have to be concerned now that interest rates are at very low levels. The dollar's value increases exponentially in importance once the capital gains spigot is no longer functional. China and Japan, our two largest creditors, have so far played along by recycling our trade deficit back to us by accumulating our dollar-denominated debt in exchange for the income that our deficits (their surplus) provide them. As their stock of our debt increases, they cost of the dollar falling may outweigh the benefit of the trade surplus. Japan and China also have very large bank lending problems, which will undoubtedly require the repatriation of large amount of capital. The hundreds of billions of dollars siphoned off annually to fund the U.S. overspending will be their first place to start.

So regardless of whether inflation is a threat or the economy is recovering, the Fed's played all their cards long ago. Higher interest rates are simply not an option. Rates must continue to fall or stay low, and the Fed must cut to allow the financial sector to keep lending by increasing lending profits. An inverted yield curve, or even a less steep yield curve could be fatal, setting in process a contraction of lending and borrowing and a devastating drop in asset prices.

At the same time, our accumulated debt becomes more of an issue. While in 1991 their policy could still work with interest rates at 9% and U.S. total debts at 240% of GDP, the tactic is much less successful in 2000, with interest rates at 6.5% and debts at 300% of GDP. It is simply much harder to get the U.S. economy to overconsume when they struggle to service ever increasing debt burdens. An asset bubble and lower interest rates give the economy a new lease on life, by allowing borrowers to leverage themselves further and to extract income they cannot earn or have to divert to rising property taxes, HMO premiums, college tuitions, and the Hummer they bought to replace their Civic. But this process is not profitable at all in reverse, so it cannot be allowed to reverse. What economist could imagine it possible in 1987 or 1996, that with unemployment at 6% and the economy growing at 2% that the Fed is now cutting rates to levels not seen in nearly fifty years? That's evidence enough that the situation for Fed has changed for the worse. The Fed has no choice in the matter anymore, it is allow credit to exponentially increase or die.

The Fed's failure was not that they raised rates in 2000 or cut rates too late or too slowly. It's not even that they allowed the stock market or housing bubbles to develop, which at least would have minimized the damage to millions of Americans' retirement security. Their failure is that they exchanged their responsibility to manage the issuance of credit for political favor. Instead of talking about credit, the Fed Chairman has said whatever the President and Congress wants to hear. Balancing the budget is great under Clinton. Tax cuts, even nonsensical ones like dividend taxes, are okay under Dubya Bush.

The Fed was created to manage the lending of the banking system, not to minimize unemployment or inflation. They can (or used to be able to) indirectly control the latter, while bank lending was the majority of credit generation. But as the Depression-era Glass-Steagal banking laws were systematically repealed, non-bank lenders were allowed to perform the functions of banks. The GSE's (Fannie Mae, Freddie Mac, and the FHL Banks) now generate over half of the new lending in the economy.

In addition, the financial system evolved and the stock market boomed during the 1980s. Deposits poured into equity mutual funds rather than CDs or savings accounts. The architects of corporate finance found they now had trillions at their disposal to do their own fractional reserve lending and institutions like Citigroup, JP Morgan and Goldman Sachs floated ABS and MBS, as well as made big profits in IPOs and SPEs, and thus became the real arbiters of monetary policy. It's not surprising that one of their own (Rubin) ran the Treasury successfully for over half a decade, with the Fed's role gradually was reduced to a third-party arbitrator, most notably when the implosion of the LTCM hedge fund nearly brought down the bond markets and the economy in 1998. New York Fed Chair William McDonough served drinks while the CEOs of the major financial firms negotiated the untangling of LTCM's obligations.

Despite the reduction of the Fed to minor player, the Fed meeting still attracts the usual panoply of economic talking heads, debating whether the fourteenth interest rate cut will be the one that does the trick, whether stocks are "fairly valued", or whether the economic data is improving and the economy will recover in the second half of 2003. We're still hopeful the "Maestro" can do something, because if he can't, what hope do we have?

I'm still hopeful that the actors in the U.S. economy can fix their balance sheets and do so with minimum pain to the economy. But this is going to require far more coordination than just the Fed acquiescing to tiny, unegalitarian tax cuts while they continue to incite speculation and unproductive lending on a massive scale. If only it was just whether we cut dividend taxes for the rich or payroll taxes for all.

Some tougher choices are coming up. As we get closer to zero interest rates (and I feel that zero rates for Fed Funds are inevitable at this point), the palliative of refinancing will have to give way to the old choice whether to fish or cut bait. Can we afford that new Expedition if Ford decides to charge us interest again on the loan, or even if our raises get smaller and our HMO premiums get larger? Can we afford carrying 1000 extra employees in the hope of a recovery that continually fails to appear? Can we continue to run deficits without raising taxes or cutting spending? Do we keep giving Americans money for virtually free so that they can come back to us asking for even more next year, and we have our own problems? Do we keep lending though the economy keeps struggling, and our number of bad loans keep rising?

Most importantly, as individuals we need to ask ourselves just what we are prepared for. A quick economic recovery would be wonderful, but given the obstacles to growth and the apparent impotence of the Fed, is it really wise to neglect a worse outcome? We can prepare for disaster even though we do not expect to see it. Otherwise, our insurance industry would surely fall on hard times. It might even be profitable. Most money managers will admit that you can double your returns by simply not owning stocks during a bear market. It isn't necessary to sell short. (I would never recommend any investment in any case. I'm an economist, not a stockbroker, dammit!)

Trust me, being a harbinger of economic doom is not a popular pursuit. A James Grant will only occasionally be on CNBC, while a Kudlow or Cramer get their own shows. But to dispel any notions, I'd like to add that a boom always follows a bust, and a recovery always follows a recession. In economic matters, though, it's always more beneficial to follow reason rather than hope and prepare accordingly.

posted by Teddy | 10:00 AM |


Monday, June 23, 2003  

This just in from the Stating the Obvious Department

The fourteenth time might not be a charm. But never fear, Bob McTeer is on the case!

In trying to analyze the Fed's analysis, it seems to me that they've lost all concept of stock versus flow variables. There's plenty of talk about boosting consumption, a flow variable, without any mention of the stock variable, debt, which accumulates after years of overconsumption. All three post-zero-interest-rate solutions look at flow variables, those that take a value every time period, without addressing the issues related to the stock variables, those who keep their values from the previous period.

For example, the foreign exchange escape route, depreciating the dollar by buying foreign currencies, does not address whether existing foreign debt holders (total positions $9 trillion, net +$2.5 trillion) will sit well with the depreciation of their existing U.S. dollar assets. Instead, the Dallas Fed examines this policy as exporting a contractionary monetary policy (a flow), that would be counteracted by foreign governments running the same policy (which Japan, China and a number of other East Asian countries are already running).

The real goods and services solution (in practice, the "helicopter money drop") is discounted because of the large amounts of GDP relative to reserves that would have to be monetized. While this policy would help demand somewhere in the economy (yet another flow variable), it doesn't address the stock of bubble assets that have risen in value far in excess of the stock of productive assets required to sustain that demand over time. The analysis also doesn't address whether this demand will go where the Fed would want it to go. Increasing inflation in medical care and pharmaceuticals, making housing even less affordable, while further crushing the profits of technology companies is probably not a very desirable outcome after doubling the monetary base.

The simplest strategy, the "bail out everyone by buying their debt securities" method, is rife with flow variable affecting strategies. By buying "government debt with positive yields" the Fed would lower interest rates on those securities (a flow). The price of these assets (another flow) would rise and people would increase consumption (another flow) in order to reduce their holdings of these securities (another flow). The value of the stock of these assets, now held as the reserves of the banking system, valued in dollars, which we assume someone other than the Fed would still want to hold, is not addressed, except should the policy be successful. In that case, the Fed is guaranteed to take a capital loss on its investment, but only in flow terms: when interest rates rise again.

Perhaps the conceit is that since we've been able to run any monetary policy we please to this point, by virtue of us being the U.S. and not say, Argentina or Japan, we don't dwell on the future consequences of our actions, only in how we can affect the present. Regardless, any economic policy where rising interest rates are the indication of "success" doesn't seem consistent with the assumption that someone holding a portion of our stock of $32 trillion in dollar-denominated debt will be quite as sanguine as the Fed with the prospect of those guaranteed capital losses.

posted by Teddy | 1:50 PM |
 

John Edwards Gets it Right

This is the best speech on taxes and values I've read this election cycle. I highly recommend it.

posted by Matthew | 12:46 PM |
 

How To Win Friends and Influence People.

The IMF way. An emergency law designed to suspend foreclosures in Argentina must be repealed "as a precondition to any comprehensive agreement" to renegotiate Argentina's debts. About 22,000 Argentines would be at risk to be thrown out of their homes. Apparently the IMF doesn't care too much about the Argentinian Dream.

It's worth noting that in this case, creditors as well as debtors are against this provision.

"This country is still in a state of emergency, and we have to recognize and adjust to that," said Carlos Heller, president of the Argentine Association of Private and Public Banks, which represents domestically owned banks here. "This crisis has severely damaged the image of banks in Argentine society, and the only way to regain that confidence is with policies that are flexible and tailored to individual cases."

The IMF routinely requires countries to undertake economic policies that are antithetical to economic growth in exchange for "aid".

One question Bush might want to ask the IMF is WWJD?

posted by Teddy | 9:32 AM |


Sunday, June 22, 2003  

Stephen Roach dutifully supplies us with negativity

Ah, Stephen, must you always be so pessimistic?

With policy makers and financial markets now fixated on the great deflation debate, it’s easy to lose sight of what precipitated this state of affairs. In my view, it’s all traceable to asset bubbles -- the excesses they fostered on the way up and the wrenching adjustments they require on the way down. The big problem with bubbles is that they tend to be contagious across asset classes -- spreading from stocks to property to bonds. That’s been the case in Japan, and a similar pattern is now evident in the United States. The result is a seemingly endless array of bubbles that only heightens the perils of the post-bubble endgame.

Unfortunately, the policy response to asset bubbles virtually guarantees cross-asset contagion. That stems mainly from the behavior of central banks. The US experience provides a classic example of this multi-bubble syndrome. The Federal Reserve, in my view, played a key role in nurturing the equity bubble of the late 1990s. By setting monetary policy with an eye to the so-called New Economy -- a high-growth, low-inflation macro scenario -- the US central bank maintained a low interest rate regime that provided extraordinary valuation support for equities. A pre-Y2K liquidity injection was the icing on the cake. The persistence of low interest rates in the immediate aftermath of the popping of the equity bubble in early 2000 quickly became the great enabler for the US property bubble. And then when the Fed began cutting interest rates aggressively in order to combat multiple pitfalls -- recession, the subsequent anemic recovery, and newly emerging deflation risks -- a bubble emerged in the bond market. The Fed, in effect, has become a serial bubble blower.

The wealth effects derived from these asset bubbles became key sources of support to economic growth in the United States. Consumers first learned how to play this game in the late 1990s. On the heels of five consecutive years of 25% gains in the S&P 500, American households concluded that the stock market had become a new and permanent source of saving. As a result, consumer spending growth surged well in excess of disposable personal income and the personal saving rate plunged from 6.6% in late 1994 to 0.3% in late 2001. By the time the equity bubble popped in early 2000, consumers had moved on to a new strain of the asset or wealth effect -- taking advantage of home mortgage refinancing to extract newfound purchasing power from the ever-appreciating housing stock. This kept the magic alive for the ever-resilient American consumer in the early stages of the post-bubble shakeout. Then as property prices started to flatten out in 2002, the bond bubble kicked in -- providing cost-of-capital relief for corporate borrowers and a new source of asset appreciation for bond holders. And now, of course, as the bond bubble reaches what may believe is an advanced stage, there is hope that the game can start all over again with a resurgence in the equity market.

The legacy of these bubbles is a sad testament to the excesses of an increasingly wealth-dependent US economy: Consumers have now become addicted to the “extra” purchasing power they can extract from over-valued assets. But this is hardly a costless supplement -- it has given rise to a record overhang of personal indebtedness. Household sector debt is now in excess of 80% of US GDP, fully 15 percentage points higher than debt ratios prevailing in the early 1990s. We’re told repeatedly not to worry -- that the debt overhang is of little consequence in a low nominal interest rate climate. After all, it’s debt service that matters -- the ratio of interest expenses to disposable personal income. Yet even on that basis, there’s little ground for comfort. Federal Reserve estimates place the overall household sector debt service burden at 14.0% in early 2003; that’s down only slightly from the all-time high of 14.4% hit in late 2001 and well above the 12.9% norm of the 1990s. To me that says it all: Even in the face of 45-year lows in interest rates, the debt overhang is large enough to push debt service burdens to the upper end of historical experience. That’s hardly a comforting place for any economy. But with interest rates vulnerable to upside pressures in a US current-account adjustment and with personal income vulnerable to downside pressures if the pendulum of cost-cutting swings to labor, there is good reason to be worried about a potential debt problem. For a US economy on the brink of deflation, such concerns cannot be taken lightly.

All this underscores the continuum of moral hazards that prevails in this post-bubble era. At first, the equity bubble seemed too big to fail -- making the Fed very concerned over the repercussions of a sharp downdraft in the stock market. The Fed’s New Economy mantra added to investor convictions that there was little reason to worry about an interest-rate spike in a rapidly growing, fully-employed US economy. Once the equity bubble popped, interest-rate support to the home mortgage refinancing cycle then became essential in order to contain the damage. By stressing the importance of the “refi-cycle” as a source of economic growth in an otherwise perilous post-bubble climate, the Fed was, in effect, providing a guarantee that it would continue to provide the fuel for this wealth extraction process. And now as the Fed’s battle has shifted to the anti-deflation fight, a bond bubble has emerged -- a by-product of investor expectations that now envision the central bank keeping its policy rate unusually low for as far as the eye can see. At the same time, yield-starved investors have moved out the risk curve, taking credit spreads to amazingly low levels. Suddenly, the bond bubble now seems too big to fail -- symptomatic of yet another moral hazard. First it was the “Greenspan put” that supported equities and now it’s the “Bernanke put” -- the belief that the Fed is about to target bond yields in an effort to fight deflation -- that fuels the bond market. America’s Federal Reserve seems to be stopping at nothing in order to keep a post-bubble US economy afloat.

It’s hard to know where and how this all ends. The Fed’s strategy seems to be aimed mainly at buying time -- hoping for a gradual and benign endgame to the post-bubble workout. That’s certainly possible. But there’s also the distinct possibility that the Fed is hoping against hope. I would personally assign equal odds to the chance that there will be a more treacherous moment of reckoning. My concerns in this latter regard stem from the increasingly ominous current-account implications of a saving-short US economy. Courtesy of outsize Federal budget deficits and massive multi-year tax cuts just enacted by Washington, it is not that farfetched to envision a net national saving rate that falls from a record low of 1.3% in the second half of 2002 to “zero” over the next 12-18 months. If that were to occur, the current-account deficit could widen sharply further from its record 5.1% of GDP just reported for 1Q03 into the 6.5% to 7.0% range by the end of 2004. Such a massive and ever-widening US current-account deficit could well set the stage for the ultimate post-bubble endgame -- a full-blown dollar crisis that would deal a lethal blow to the global economy and world financial markets.

The biggest difference between my bearish view of the world and the more sanguine views of others can be traced to the bubble. More than three years after America’s equity bubble popped, there is an understandable temptation to believe that it’s time to move on. A massive dose of fiscal and monetary stimulus, in conjunction with a sharp rebound in the stock market, adds to that conviction. As I see it, however, the legacy of this monstrous bubble endures -- not just in financial markets but also in the form of the excesses that it has fostered in the real economy and in its balance-sheet underpinnings. Until those excesses are purged, I maintain my view that America still needs to be seen through the lens of a post-bubble workout. As one bubble morphs into the next one, the moral hazard dilemma only deepens. And the endgame -- including the risks of deflation and a dollar crisis -- appears all the more treacherous.

posted by Matthew | 10:18 PM |
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