10 Notes on the Current Markets

1) Great minds think alike. Fools seldom differ. Remember my post on AIG’s subsidiaries? Well, now in the New York Times, much of the same.

2) Fed Independence! (spit, spit). Come on, Bernanke, you argue against the Fed being audited because it might compromise Fed independence, and yet you regularly have lunch with leaders of the Executive branch. You compromise the independence of the Fed more than any audit could by acting cooperatively with the Treasury. If you were really independent, you would do what is best for your explicit mandate — fighting inflation and unemployment, rather than tinkering with non-bank credit markets, and rescuing companies.

3) Manus manum lavat. One hand washes the other. Banks that have been bailed out are buying more Treasuries. Some of that is lower spreads — lack of lending opportunities. The rest is implicitly paying back the government.

4) The government may be increasing its sales of TIPS. I’ve been less bullish on TIPS of late, and this does not encourage me to change. Further, farmland values may be falling. Given growth in demand for food in the world, that should not be so, but maybe that is wrong. Maybe depressionary conditions are that strong. I also offer up the piece from UBS, via FT Alphaville, that suggests that deflation is more likely to minimize the total cost of debt to the US government.

All of this depends on the current length of US government debt. If all of it were nominal (not inflation-indexed) 30-year debt, the US Government would gladly inflate. Their financing is locked in. But if it were all short-dated, the US government would have to manage the powder keg. After all, that was Mexico in 1994 — the government was financed in the short-term interest rate markets.

Thus, governments that have not been prudent, and have financed short-term, can face a run on the currency. The US government finances to an average of 4-5 years, so it is not apparent whether they could face a run or not.

The more TIPS that are issued as a fraction of the total debt, the less valuable the inflation guarantee becomes. If China, or any other creditor, thinks that TIPS are the solution to loss of value on US debt claims, let them realize this:

• Yes, if the US inflates its currency, there will be protection.
• No, if the US defaults on its obligations, you won’t be materially better off.
• If the US decided to selectively default on foreigners, paying them back in a different US dollar than the domestic one, TIPS won’t help you much.

5) Bye, bye, Fannie and Freddie? Sending them into runoff was my proposed solution when the crisis hit. Now that the reality of the humongous losses from mortgage lending and guarantees has become apparent, the government faces reality, and may wind them down. As it is now, we know that F&F are unlikely to pay back their aid from the government in full. In my opinion, better that the government would have let the companies go into Chapter 11 without interference. Instead, the taxpayers bail out much of the capital structure that did not deserve a bailout.

6) Should Ben Bernanke be reappointed as Fed Chairman? It doesn’t matter. There is no significant variation in ideas among likely candidates that would make a significant difference in how the Fed behaves. I don’t think Ben should be reappointed, but I don’t see any worthy replacements. Ron Paul is out of the question, sadly.

These articles argue that Ben Bernanke should not be reappointed, and they make some good arguments:

• Ben Bernanke Was Incredibly, Uncannily Wrong
• Reappoint Ben Bernanke? No Way
• SHOULD BERNANKE BE REAPPOINTED?

All that said, what is the option? Is there someone stunningly good standing in the wings, with a materially different view of monetary policy from Bernanke, who would be acceptable to the activist Obama administration? I don’t see one available, so perhaps the devil you know is better than the devil you don’t.

7) The corporate bond market has been on fire of late, with higher prices, tightening spreads and greater issuance. We had several episodes like that in 2002, before facing reversals. The first time is not the charm, and I would expect more of a backup in prices because corporate loss rates have not peaked yet.

8) Let me just point out that “cash for clunkers” is another version of the “broken window fallacy.”

9) As for AIG (AIG), I don’t expect the government to be paid back in full. Sales of AIG subsidiaries have gone at cheap prices, and only the simple subsidiaries have been able to be sold. Investment banks will make money on the deal, though.

10) Even if GDP shrinkage is slowing due to government spending, that still means that the private sector is weak. GDP ex-government growth will be a statistic to watch in the future.

Comments

[Larry House:]

Excellent points and insights as always. I totally agree on Bernanke. It doesn't matter who is in that position going forward; there is no real difference in any of the possible candidates. I too have cooled on TIPS and have sold my position in them. But I am cool on most asset classes right now. Stocks don't look compelling, neither do bonds; I don't see commmodities going on a tear. I probably lean more toward silver right now anything.

Aug 06 10:40 AM

[Joseph L. S...:]

Applying a slight variation of the broken window fallacy to AIG, it seems the elected and appointed elitists in government believe that, yes there may be some harm, but since taxpayers own 80% of AIG, by allowing AIG to default on its obligations to taxpayers the harm would be so diffused that it could only cost each taxpayer a couple hundred dollars.

Whereas allowing AIG to default on obligations to Goldman Sachs or JP Morgan could -- horreurs! -- mean a loss, maybe even a whole quarter of losses, then a possible snowball effect bringing down the financial sector, then the stock markets, then the end of Western civilization as we know it.

And thus ends another of Wall Street's Fairy Tales...

Aug 06 11:55 AM

[Wisdom vs. ...:]

i have listened to several bernanke press conferences. he is smart enough, but this administration is going to micromanage anyone who is not "smart like them." so he is going to do what he must, like when he wanted to raise interest rates a few years ago when cap ex and hiring were down; what would you have done? hind sight is easy. as far as j yellen goes, yeah, let's hire someone from the most unsuccessful area, not smart. everyone in fricso should get fired, not promoted

Aug 06 11:56 AM

[WhoisJohnGalt:]

Thank for your note on the "broken window fallacy", it makes a lot of sense. Car deals were finally made incentivized enough to draw consumers from essential components to their day i.e. food, clothes, etc. I'm all for fuel emission efficiency, but should that goal really be at the top of the list? But then again, is that really the point of this stimulus? The government is getting smart about handing bailouts without actually declaring one. If anyone feels like the auto industry will be the driving force of the U.S. economy in the next 3-5 years, please speak up.

To add to point 8 further, "cash for clunkers" is drawing us back down the dark road of debt. Consumers were just on the right track of deleveraging along with increased savings rates, but the govt. apparently needs to show faster results. Ironically, their progam of glutony may prolong the recession.

Aug 06 12:05 PM

[speeddaimon:]

One note from me about your article. I used to think that TIPS were going to be a great investment vehicle to hedge against the coming inflation. Then, after watching the complete and utter skewing of nearly all data coming from the government, I realized that once inflation hits, the government will just change the way that they calculate CPI-U in order to manage the payout from TIPS. Honestly, I at this point if I were to invest in inflation protection bonds, I would go the route of WIP. At least there you have a chance of actually protecting yourself against inflation.

Aug 06 12:15 PM

[Moon Kil Woong:]

LOL we will have to pay to get rid of AIG because all the consultants are the main players.

Likewise, Fannie Mae and Freddie Mac have alrready been supporting the market with unusually low rates that are obvious losses if sold without any government guarantee because they can't even cover the default and forclosure rates. That's why banks refuse to write a mortgage at their rates unless they are guaranteed they can sell it to the loser government Fannie Mae or Freddie Mac instantly. We will also pay for this disposal.

What we need is a Treasury Secretary who says no. What we need in the Fed is someone that says tough luck. What we need is a President that sks if it's real growth or fake. What we need in Congress is someone that demands efficiency and accountability over spending and cronyism. Yes, we are a very needy society. Needy not because we are in a recession as much as needy because our officials are not honest or responsible. The recession is a effect not a cause.

Aug 06 01:05 PM

[Thomas J. G...:]

I don't understand why David is talking seriously about the u.s. defaulting on its debt (last 2 subpoints on item #4). The Fed can print money. If the u.s. defaulted on its debt that really would cause Great Depression II. Why is David talking about that. I don't think we're anywhere near that.

Aug 06 01:55 PM

[whidbey:]

What does it all mean Alfy ??

1.The current administration is in a hole why over its head and refuses to stop digging and hoping.

2.The Fed is hog tied and Wall Street knows that, and so do the Chinese. Nothing is going to happen to the currency except it will be worth less soon. But there is no salvation the part the $ play is too big so the no new actors and the play goes on and is a flop.

3.The Japanese economy sinks further and threatens all of Asia, but the race with China for that honor is hot and the outcome dicy.

4.The emerging markets turn out to be the drivers of final demand, but they have not money to buy anything.

5. The Oil scene is going down hill in output, but up in prices, and it will put the finishing touches on the world economy - next year or sooner.

6. No one gives a damned about medical care since it is too pricey and dangerous to your health to purchase. Eat less and run more is the new mantra.

7 A new and dumber Congress is elected in 2010, but no one can figure out who they represent.

Aug 06 02:12 PM

[OceanTiger:]

Ben Bernanke is not a good person for Fed chairman. He only can followed and solved problems, why he has no advanced sight to see problem. Did he predict house bubble?Maybe Buffett can be Fed chairman . He is crative and value stocks (Trade4Rich.com)investors. His experience is practical.

Aug 06 04:37 PM

[Alan von Al...:]

'GDP ex-government growth will be a statistic to watch in the future.' - thank you, I was beginning to feel like a Lone Ranger.

Aug 07 03:27 AM

[Dave Raithel:]

Silly me. I'd thought for an "economic act" to commit the "broken window fallacy", there must be no net wealth created. The parable I'd been taught has the GLAZIER breaking the windows secretly at night to generate demand for his services; hence the direct transfer of wealth. On your analysis (which is, I guess, the one you cite to in Wikipedia), replacing worn capital equipment isn't free of the fallacy: The capitalist cannot spend that money on a new additional machine, or more likely, hide the money in an off-shore account ...

Today's (Friday Aug 7) WAPO reads: "The average miles per gallon of the new vehicles is 25.3, compared with the trade-ins that averaged 15.8 miles per gallon. " (www.washingtonpost.com...) Granted, the program could have been improved had auto recyclers been allowed to cannibalize for parts - the net reduction of clunkers on the road would have been the same, though the parts would have kept similar vehicles on the road longer. So a more exact analysis is required to evaluate whether any net wealth results from this. There may not be, but you're simply begging the question.

Still, the piling on has been amusing: The same political/ideological factions that bloat about big guvmint needing to leave taxpayers more of their dollars now object that some taxpayers get a tax-credit; the same faction that cared nothing about saving The Big Three now bellyache that foreign car companies (some of which make eligible vehicles in the US) are getting the majority of sales; the same faction that waxes indignant on the importance of locally owned dealerships no longer finds them all that important ...

Some people just need to grouse...

Aug 07 09:23 AM

[Jimbo:]

I detoured from your article to read the Von Mises article about Bernanke's past prognostications. Wow! I once read that Hell is a big theater where you go when you die. You sit in the audience and have to watch all your life's missed opportunities on the stage. Bernanke may have an epic waiting for him in the theater.

Aug 07 09:57 AM

[bobbobwhite:]

Every time I see Bernanke interviewed on TV he appears to be very nervous and totally stilted/nervous. The controlled I can understand, but nervous is not something comforting to see in a person with so much influence on our counrty's financial direction and future.

I would temporarily like to be a shrink with Bernanke on my couch for some sessions. Getting to the bottom of the reasons for his gross nervousness while he discusses national fiscal policy would be my goal. Perhaps he is scared to death about being unqualified and incompetant for the job and, as a result, is barely keeping his head above water? Not a great sign for this country to have him so challenged by his job that he faces a mental/physical breakdown while attempting to perform it.

And, "attempting" is the best word for his job perfomance to date.

Aug 07 10:18 AM

[Old Rick:]

re: #6 Paul Volker?? Not a chance as he is a) too old and b) more importantly to BHO & Co. he is not a lapdog like Ben and Larry and Timmy and ........

Aug 07 10:40 AM

[Old Rick:]

Further point on #8 and on whoisjohngalt discussion on clunkers: What is happening is the cannibalization of the auto market for the next year or so coupled with the utter waste of the destruction of mostly good and functional cars thereby raising prices in the used market. There was an article on SA about 4-5 days ago concerning the marginal sales increase over what could be the "normal" sales level and attributing the $1B of subsidy to only the marginal increase thus the cost of the program was something like $45K per marginal sale.

Aug 07 10:58 AM

[Old Rick:]

Sorry to keep posting, but as part of watching the mises link to youtube, I watched the "Peter Schiff was right" video. (www.youtube.com/watch?...). In the course of watching, I saw that Arthur Laffer and Ben Stein (not that they mattered) were also incredibly wrong. Peter Schiff sounded in 06-07 as if he were reading the front page of the WSJ for the last year.

Aug 07 11:22 AM

[Alphameister:]

Excellent collection of points on which to reflect!

Could the decline in the price of farmland reflect elimination of the premium for "development potential" in the wake of the collapse of the housing market?

Note to Dave R: The fact that the broken window was replaced with a superior grade of glass does not invalidate the parable, though I agree that the basic principle is more readily understood through the window example than through the c4c example.

Aug 07 12:24 PM

[Go Lakers:]

Thomas, you got a very poor reaction from the crowd for your comment which almost by definition means you must be right. And you are. Write this anywhere you like and hold me to it for as long as you like.

THE US WILL NEVER DEFAULT ON ITS DEBT OBLIGATIONS.

Worst case, it prints the money to pay the debt holder. The Treasury, the Fed and whoever is in the White House at the time are too smart to default. They understand the domino effect of that action all too well after the domino effects that came to light in 2008.


On Aug 06 01:55 PM Thomas J. Gordon wrote:

> I don't understand why David is talking seriously about the u.s.
> defaulting on its debt (last 2 subpoints on item #4). The Fed can
> print money. If the u.s. defaulted on its debt that really would
> cause Great Depression II. Why is David talking about that. I don't
> think we're anywhere near that.

Aug 07 01:08 PM

[Kimball Corson:]

You are correct that we should keep Bernanke. We ought not to be changing horses in mid-stream. He was responsible for the liquidity build-up and he should be around to manage the liquidity mop up to avoid a second recessionary dip and inflation.

Aug 07 01:47 PM

[Thomas J. G...:]

Go Lakers, Thanks. I like David a lot. He's measured, careful, and non-sensational. I understand that the chinese should think about their treasury holdings. But it seemed like David was holding default over their head like a club. It seemed out of character, and as you and I agree, default is not in the cards for the u.s.

Aug 07 02:33 PM