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Archive for the ‘monetary policy’ Category

It has been abundantly obvious from day one that Ben Bernanke has no understanding of “liquidity” — whatsoever.

Only 2 months (?) after Bernanke helicoptered $122 billion to AIG, AIG has come cap in hand to Uncle Sam with a down face and a confession: “The money’s all gone.” AIG supposedly wants $200 billion in new money.

AIG in talks with Fed over new bail-out

By Francesco Guerrera in New York

Published: November 8 2008 02:00 | Last updated: November 8 2008 02:00

AIG is asking the US government for a new bail-out less than two months after the Federal Reserve came to the rescue of the stricken insurer with an $85bn loan, according to people close to the situation.

AIG’s executives were last night locked in negotiations with the authorities over a plan that could involve a debt-for-equity swap and the government’s purchase of troubled mortgage-backed securities from the insurer.

People close to the talks said the discussions were on-going and might still collapse, but added that AIG was pressing for a decision before it reports third-quarter results on Monday.

AIG’s board is due to meet on Sunday to approve the results and discuss any new government plan, they added.

The moves come amid growing fears AIG might soon use up the $85bn cash infusion it received from the Fed in September, as well as an additional $37.5bn loan aimed at stemming a cash drain from the insurer’s securities lending unit.

AIG has drawn down more than $81bn of the combined $122.5bn facility. The company’s efforts to begin repaying it before the 2010 deadline have been hampered by its difficulties in selling assets amid the global financial turmoil.

AIG executives have complained to government officials that the interest rate on the initial loan – 8.5 per cent over the London Interbank Borrowing Rate – is crippling the company.

They compared the loan’s terms with the 5 per cent interest rate paid by the banks that recently sold preferred shares to the government.

One of AIG’s proposals to the Fed is to swap the loan, which gave the authorities an 80 per cent stake in the company, for preferred shares or a mixture of debt and equity.

Such a structure would reduce the interest rate to be paid by AIG and possibly the overall amount it has to repay. An extension in the term of the loan from the current two years to five years is also possible, according to people close to the situation.

The renegotiation of the loan could be accompanied by the government’s purchase of billions of dollars in mortgage-backed securities whose steep fall in value has been draining AIG cash reserves.

AIG is also proposing the government buy the bonds underlying its troubled portfolio of credit default swaps in exchange for the roughly $30bn in collateral the company holds against the assets.

Losses on the mortgage-backed assets, which were acquired by AIG with the proceeds of its securities lending programme, and the CDSs caused the company’s collapse.

Since the government rescue, they have continued to haunt AIG, which is required to put up extra capital every time the value of these assets falls. AIG and the Fed declined to comment.

Red staters get a lot of sh*t from their coastal cousins for being stupid. I will say one thing in red staters’ defense, though: it truly takes a blue coast, blue-blood stupidity to concoct such dangerous national policy as Bernanke’s.

It’s the kind of stupidity that only an Ivy League education can buy.

What is Bernanke going to do when he issues $2 trillion in Treasuries next year, and nobody buys?

All the people who thought they got a great deal when Pepsi priced its last bond at 7.5% are going to feel pretty damn stupid 12 months from now. Either that, or AAA corporates will have lower yields than Treasuries.

At the primary dealer desks, there is no net Asian sovereign demand for US sovereigns anymore.

Right now, Uncle Sam is printing the money and planning to float Treasuries “soon.” I am not exaggerating. It is the dirty secret that every FX macro desk at every major institution knows: the Treasury is printing now and issuing later.

In the ivory towers at Treasury and the Fed, “printed” money will be converted to Treasuries soon, because the Fed and Treasury (okay, just the Fed) think that there is an “irrational” “liquidity crisis”, which will abate any day now.

It won’t abate. It will get worse: all bond yields are based on Treasury yields. Treasury yields are definitely going up in the next year. All other yields (corporates … munis … ) will go up too.

That will be the real “credit crisis.” We are just mostly through the second act.

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======================================================================
country; nominal interest rate; date; official CPI; last update; real interest rate
======================================================================
China 7.47% 06/13/08 7.70% 05/31/08 -0.23%
Hong Kong 3.50% 06/13/08 5.40% 04/30/08 -1.90%
India 8.00% 06/11/08 8.75% 05/31/08 -0.75%
Indonesia 8.50% 06/13/08 10.38% 05/31/08 -1.88%
Japan 0.50% 06/13/08 0.80% 04/30/08 -0.30%
Malaysia 3.50% 06/12/08 3.00% 04/30/08 0.50%
Pakistan 12.00% 05/23/08 19.27% 05/31/08 -7.27%
Philippines 5.25% 06/05/08 9.60% 05/31/08 -4.35%
South Korea 5.00% 06/30/08 4.88% 05/31/08 0.12%

Sri Lanka 10.50% 06/06/08 26.20% 05/31/08 -15.70%
Taiwan 3.50% 03/28/08 3.71% 05/31/08 -0.21%
Thailand 3.25% 05/21/08 7.60% 05/31/08 -4.35%
Vietnam 14.00% 06/11/08 25.20% 05/31/08 -11.20%
==============================

========================================

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on today’s seismic Treasury selloff:

“The point is that the world was long Treasury, and we can see how they’ve been suckered.”

In other news, more insanity from the federales, who think they can permanently reduce commodities prices by shoving out leveraged players.

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Didn’t get this memo. No sir.

Fetch your tin helmets once again. The European Central Bank is opting for a monetary purge. So too is the US Federal Reserve, now ruled from Dallas.

Über-hawks and Cromwellians have gained the upper hand at the great fortress banks. Whether or not they admit it, both are embarked on policies that must lead to retrenchment across the Atlantic world.

The City mood turned wicked as the full import of this policy switch sank in last week. On Wall Street, the Dow’s 396-point dive on high volume late Friday had an ugly feel.

“There is now the distinct possibility of a simultaneous sell-off in global bonds, equities and commodities,” said Jonathan Wilmot from Credit Suisse.

I dunno. I saw Lehman almost die again, and we all knew that the Fed was ready to fire a paper fusillade in the hole.

Trichet’s hawkishness is not in doubt. Bernanke’s is. Spain and Ireland do not a dovish majority make.

Bernanke’s hawkishness is in doubt.

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Thomas Palley, Open Society Institute pontificator emeritus cum DC-cocktail laude, mocks himself best when he’s most honest. As do most political people.

Defending the Bernanke Fed

Filed under: U.S. Policy, Uncategorized — Administrator @ 6:37 am

Federal Reserve Chairman Ben Bernanke has recently been on the receiving end of significant criticism for recent monetary policy. One critique can be labeled the American conservative critique, and is associated with the Wall Street Journal. The other can be termed the European critique, and is associated with prominent European Economist and Financial Times contributor, Willem Buiter.

Brought up on the intellectual ideas of Milton Friedman, American conservatives view inflation as the greatest economic threat and believe control of inflation should be the Fed’s primary job. In their eyes the Bernanke Fed has dangerously ignored emerging inflation dangers, and that policy failure risks a return to the disruptive stagflation of the 1970s.

Both argue the Fed has engaged in excessive monetary easing, cutting interest rates too much and ignoring the perils of inflation. Their criticisms raise core questions about the conduct of policy that warrant a response.

At least he didn’t call us “liquidationists.” Generous.

Rather than cutting interest rates as steeply as the Fed has, American conservatives maintain the proper way to address the financial crisis triggered by the deflating house price bubble is to re-capitalize the financial system.

Correct.

This explains the efforts of Treasury Secretary Paulson to reach out to foreign investors in places like Abu Dhabi. The logic is that foreign investors are sitting on mountains of liquidity, and they can therefore re-capitalize the system without recourse to lower interest rates that supposedly risk a return of ‘70’s style inflation.

“Supposedly.

The European critique of the Fed is slightly different, and is that the Fed has gone about responding to the financial crisis in the wrong way. The European view is that the crisis constitutes a massive liquidity crisis, and as such the Fed should have responded by making liquidity available without lowering rates. That is the course European Central Bank has taken, holding the line on its policy interest rate but making massive quantities of liquidity available to Euro zone banks.

In other words, the Buiter critique advocates one set of interest rates for banks, and a very different one for individuals, without regard to respective credit risk. Presumably, there would be no arbitrage between these two bifurcated markets. Presumably, liquidity provisions to other banks–“inflation by other means”–would both 1) save the banks, and 2) not institutionalize higher prices on the tabs of the people who didn’t take the stupid risks.

Never made much sense to me either. [I used to like Buiter because he was the only person who trashed Bernanke way back in the day. Unfortunately his “lender of last resort” bailout loophole was an unforgivable leap of illogic, and while formally very different from the Bank of Japan’s disastrous early-1990’s bailout, was functionally indistinguishable.]

According to the European critique the Fed should have done the same. Thus, the Fed’s new Term Securities Lending Facility that makes liquidity available to investment banks was the right move. However, there was no need for the accompanying sharp interest rate reductions given the inflation outlook. By lowering rates, the European view asserts the Fed has raised the risks of a return of significantly higher persistent inflation. Additionally, lowering rates in the current setting has damaged the Fed’s anti-inflation credibility and aggravated moral hazard in investing practices.

The problem with the American conservative critique is that inflation today is not what it used to be.

It’s different this time.

1970s inflation was rooted in a price – wage spiral in which price increases were matched by nominal wage increases. However, that spiral mechanism no longer exists because workers lack the power to protect themselves. The combination of globalization, the erosion of job security, and the evisceration of unions means that workers are unable to force matching wage increases.

DC establishment liberal: “Inflation is okay now, because workers have to eat all costs themselves.” As if workers will just sit back and take this? As if they can’t read these internet posts, which presume weakness, ignorance and stupidity on the part of American workers?

The problem with the European critique is it over-looks the scale of the demand shock the U.S. economy has received. Moreover, that demand shock is on-going. Falling house prices and the souring of hundreds of billions of dollars of mortgages has caused the financial crisis. However, in addition, falling house prices have wiped out hundreds of billions of household wealth. That in turn is weakening demand as consumer spending slows in response to lower household wealth.

Different. This. Time.

Countering this negative demand shock is the principal rationale for the Fed’s decision to lower interest rates. Whereas Europe has been impacted by the financial crisis, it has not experienced an equivalent demand shock. That explains the difference in policy responses between the Fed and the European Central Bank, and it explains why the European critique is off mark.

The bottom line is that current criticism of the Bernanke Fed is unjustified. Whereas the Fed was slow to respond to the crisis as it began unfolding in the summer of 2007, it has now caught up and the stance of policy seems right. Liquidity has been made available to the financial system. Low interest rates are countering the demand shock. And the Fed has signaled its awareness of inflationary dangers by speaking to the problem of exchange rates and indicating it may hold off from further rate cuts. The only failing is that is that the Fed has not been imaginative or daring enough in its engagement with financial regulatory reform.

Copyright Thomas I. Palley

The bottom line is, DC policy emerati are profoundly ignorant, sycophantic, and irresponsible people.

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There were about five pieces of news on Friday that delivered such a massive upside kick to oil.

1) Chinese oil consumption numbers came in much higher than expected.

Wall Street is still being blindsided by the impact of the Sichuan earthquake, and apparently most of it is ignorant that ~30 percent of Chinese oil/ natgas/ heating oil comes from Sichuan and Gansu (which was also thrown into chaos by the quake).

2) Shaul Mofaz rattled Kadima’s flimsy sabre at Iran, again. Anyone who took that seriously is ill-informed.

3) The dollar continued hemorrhaging. Brokers are cutting back trading with Lehman Brothers, and Bernanke will probably be called out on his fateful March 17 nationalization of banks’ default risk. He will have to throw hundreds of billions of dollars in Treasuries at Lehman’s crippled balance sheet, further debasing Treasuries specifically and US financial credibility generally.

4) Morgan Stanley said oil would go to $150.

5) The USD and EUR are both heavily overvalued. As long as China keeps its currency peg alive, the dollar and euro will both be overvalued. The only other large currency alternative is commodities, so that’s where money is going.

As I have said many times, government witch hunts against “speculators” never signal the top of a bull market.

Israel’s saber-rattling might have been good for 1 percent of oil’s gain. Obama’s triumph in the US presidential primaries multiplied that, for a total of maybe 3 percent.

In the meantime, Asia’s cracking currency regimes are effectively increasing their subsidies of fuel.

HONG KONG: Buckling under the weight of record oil prices, several Asian countries have cut or are thinking of cutting their fuel subsidies, which raises a pressing question for Beijing: Can China afford its own oil subsidies at a time when it is spending billions on post-earthquake reconstruction?

The short answer is yes, because China is blessed with both large trade account and fiscal surpluses. The reconstruction cost is projected to amount to about 1 percent of China’s gross domestic product, while the fuel subsidies account for another 1 percent, JPMorgan estimates.

Remember that China had a fiscal surplus of 0.7 percent of gross domestic product last year, or $174 billion. So even if spending on post-earthquake rebuilding and fuel subsidies were to cause a 1 percent fiscal deficit, that would still be very manageable.

But here is a more important question: Why should China keep domestic fuel prices at about half of the global average?

The usual answers are to keep inflation in check and stave off social instability that could result if prices were to rise too quickly.

But by distorting fuel prices, China is encouraging fuel consumption and discouraging the use of new energy. Since the Chinese still live in an $80-a-barrel oil environment, demand for anything from cars to chemical products will spiral higher and raise the risks of economic overheating.

Increasing subsidies on fuel will crowd out more investment in other areas, such as education or health care, to name two possibilities.

What’s more, a worsening fiscal situation might put downward pressure on the yuan. Fuel subsidies have exaggerated inflation in the developed world, while understating inflation in the developing world. China’s inflation could well hit 15 percent if Beijing were to free up caps on energy prices, Morgan Stanley estimates.

“If China is not able to take away the subsidy and cut down its demand, it will have huge implications for the world,” said Shikha Jha, a senior economist at Asian Development Bank.

Countries like China and India, along with Gulf nations whose retail oil prices are kept below global prices, contributed 61 percent of the increase in global consumption of crude oil from 2000 to 2006, according to JPMorgan.

Other than Japan, Hong Kong, Singapore and South Korea, most Asian nations subsidize domestic fuel prices. The more countries subsidize them, the less likely high oil prices will have any affect in reducing overall demand, forcing governments in weaker financial situations to surrender first and stop their subsidies.

That is what happened over the past two weeks. Indonesia, Taiwan, Sri Lanka, Bangladesh, India and Malaysia have either raised regulated fuel prices or pledged that they will.

Actions taken by those countries will not be able to tame a rally in prices though unless China, the second-largest oil user in the world, changes its policy. While the West is critical of China’s energy policy, there is little outcry for change within the country, except for complaints from two loss-making refineries.

By contrast, Indonesia has convinced its people that fuel subsidies benefit the rich more than the poor, because rich people drive more and consume more electricity. Jakarta rolled out a $1.5 billion cash subsidy program to help low-income Indonesians cope with higher prices. Although no country wants to build a system on subsidies, the cash subsidy at least makes fuel subsidy cuts politically feasible.

“The people need to wonder, who pays for the subsidies?” said Louis Vincent Gave, chief executive of GaveKal, a research and asset management company. “Most Asian countries are printing money to pay for them.”

Fuel subsidies compromise countries’ ability to control their own budget spending. If China and India can cut their subsidies, they would be able to spend more on infrastructure and education.

While Asian governments dole out cheap food and cheap energy, Asian currencies settle the bill. Morgan Stanley expects some emerging market currencies to face downward pressure, probably for the first time in a decade, as those countries unwind their fuel subsidies and domestic inflation shoots up.

China’s domestic fuel prices are among the lowest in the world, equal to about 61 percent of prices in the United States, 41 percent of Japan and 28 percent of England. The longer it waits, the more painful it will be when it tries to remove the subsidy.

China actually doesn’t have much freedom to splash dollars for fuel. Its entire macroeconomic policy can be summarized as “long USD, short RMB.” Not a good trade.

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Setser on the PBOC:

What cann’t go on still hasn’t slowed, let alone stopped (Chinese reserve growth)

… Back in 2004, it was considered rather stunning when China added close to $100 billion to its reserves ($95 billion) in a single quarter, bring its total reserves up to around $600 billion.. The dollar’s fall against the euro (and associated rise in the dollar value of China’s euros) explains around $15 billion of the rise. But at the time, $80 billion was considered a very large sum for China to have added to its reserves.

Now China has $1756 billion in reserves, after a $74.5 billion April increase. The dollar rose against the euro in April, so the underlying pace of increase – after adjusting for valuation changes – was more like $82 billion.

In a month.

And not just any month – in a month when oil topped $100 a barrel.

$82 billion a month, sustained over a year, is close to a trillion dollars. A trillion here, a trillion there and pretty soon you are talking about real money. If a large share of China’s reserves is going into dollars, as seems likely, this year’s increase in China’s dollar holdings could be almost as large as the US current account deficit.

The fact that one country’s government – and in effect two institutions (SAFE and the CIC) – are providing such a large share of the financing the US needs to sustain large deficits (particularly in a world where Americans want to invest abroad as well as import far more than they export) is unprecedented.

The real surprise in some sense is that the increase in China’s April preserves isn’t that much of a surprise. At least not to those who have been watching China closely.

Wang Tao – now of UBS – estimated that China added $600 billion to its foreign assets in 2007, far more than the reported increase in China’s reserves. Logan Wright (as reported by Michael Pettis) and I concluded that Chinese foreign asset growth – counting funds shifted to the CIC – could have topped $200 billion in the first quarter.

China hasn’t disclosed how much it shifted to the CIC, let alone when it shifted funds over to the CIC. But it seems likely that the surprisingly low increase in China’s reserves in March stems from a large purchase of foreign exchange by the CIC. Indeed, the CIC’s March purchase may have used up all of the RMB 1.55 trillion the CIC initially raised.

As a result, all of the increase in the foreign assets of China’s government seems to have showed up at the PBoC in April. Or almost all. China raised its reserves requirement in April, and the banks may have been encouraged to meet that reserve requirement by holding foreign exchange.

China’s current account surplus – adding estimated interest income to its trade surplus – was no more than $25 billion in April. FDI inflows were around $7.5 billion. Sum it up and it is a lot closer to $30 billion than $40 billion. Non-FDI capital inflows – hot money – explain the majority of the increase.

No wonder Chinese policy makers were so focused on hot money this spring. Hot money flows seem to have contributed to their decision to stop the RMB’s appreciation in April. But interest rate differentials still favor China – so it isn’t clear that a slower pace of appreciation will stem the inflows.

It certainly though helps to sustain the underlying imbalance that has given rise to massive bets on China’s currency.

The scale of China’s reserve growth suggests that China’s government is no longer just lending the US what it needs to buy Chinese goods. And it is now lending the US – and indeed the world – far more than the world needs to buy Chinese goods. Vendor financing is a fair description for China’s reserve growth in 2003 or 2004, but not now.

China’s government is increasingly acting as an international as well as a domestic financial intermediary. It has long borrowed — whether through the sale of PBoC bills of Finance Ministry bonds to fund the CIC – rmb to buy dollars, effectively taking the foreign currency domestic Chinese savers do not want to take. Now though it is borrowing from the rest of the world to lend to the rest of the world.

Most intermediaries though make money. Or at least try to. By contrast, China’s government is almost sure to lose money on its external financial intermediation. Selling RMB cheap to buy expensive dollars and euros is not a good business model.

China cannot be entirely comfortable with all the money that is pouring into China. But it isn’t at all clear that Chinese policy makers are willing to take the steps needed to shift decisively toward a new set of policies. It is clear that the costs of China’s current policies are rising.

Remember, China looses [sic] money on its reserves. More isn’t better.

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“With Bold Steps, Fed Chief Quiets Some Criticism”:

[…]

“It has been a really head-spinning range of unprecedented and bold actions,” said Charles W. Calomiris, professor of finance and economics at Columbia Business School, referring to the Fed’s lending activities. “That is exactly as it should be. But I’m not saying that it’s without some cost and without some risk.”

[As yours truly noted back in November, Charles Calomiris wrote a verbose and obtuse article for VoxEU which proclaimed that there was no credit crisis — a restatement of his August claim that there was no credit crisis. I guess that makes him almost as good a forecaster as Bernanke is. ]

Timothy F. Geithner, president of the Federal Reserve Bank of New York, and a close Bernanke ally, defines the Fed chief’s “doctrine” as the overpowering use of monetary policies and lending to avert an economic collapse. “Ben has, in very consequential ways, altered the framework for how central banks operate in crises,” he said. “Some will criticize it and some will praise it, and it will certainly be examined for decades.”

Mr. Bernanke’s actions have transformed his image as a self-effacing former economics professor.

“I am tempted to think of him as somewhat Buddha-like,” said Richard W. Fisher, president of the Dallas Federal Reserve Bank. “He’s developed a serenity based on a growing understanding of the hardball ways the system actually works. You can see that it’s no longer an academic or theoretical exercise for him.”

Did he just say “Buddha-like”?

Within the Bush administration, Mr. Bernanke’s willingness to work with Democrats in Congress on measures to prevent mortgage foreclosures has stirred unease. “The fact that he, an appointee of George Bush, has come very close to advocating — though he hasn’t quite advocated it — a piece of legislation that George Bush threatened to veto is an illustration of his willingness to put his head on the chopping block,” said Alan S. Blinder, a professor of economics at Princeton and friend of the Fed chief.

One reason Mr. Bernanke is sticking his neck out is that he believes the broader economy’s recovery depends on the housing sector, which remains in a serious slump. Plenty of new evidence surfaced on Tuesday that this year’s spring home-buying season will be dismal, with one report showing that prices fell 14.1 percent in March from a year earlier and another that new-home sales are down 42 percent over the last year.

Among Democrats, Mr. Bernanke, a Republican, had previously been criticized by such party luminaries as the two former Clinton administration Treasury secretaries, Robert E. Rubin and Lawrence E. Summers, who worried that he was downplaying the dangers of a recession. But that view has changed.

“I think in the last few months they’ve handled themselves very sure-footedly,” Mr. Rubin said of the Fed. Many Democrats in Congress agree.

“They say that crisis makes the man,” said Senator Charles E. Schumer, Democrat of New York and the chairman of the Joint Economic Committee. “He’s made believers out of people who were just not sure about him before.”

To lessen the chances of a financial collapse, Mr. Bernanke engineered the takeover of one investment bank, Bear Stearns, and tossed credit lifelines to others with exotic new lending facilities — the Fed now has seven such lending windows, some of them for investment banks as well as commercial banks.

He also allowed the Fed to accept assets of debatable value — mortgage-backed securities, car loans and credit card debt — as collateral for some Fed loans. For the first time ever, he installed Fed regulators inside investment banks to inspect their books.

Much to the dismay of conservative economists, Mr. Bernanke has also presided over an extraordinarily aggressive series of interest rate cuts, lowering the fed funds rate seven times, to 2 percent from 5.75 percent, since last September, though it has signaled a pause in further rate-cutting barring a further crisis. …

Bernanke and Paulson are the worst thing that’s happened to capitalism since Arthur Burns and Richard Nixon. Carter would have been awful, but conditions were so bad by 1979 that he had to authorize significant deregulation and capital gains tax cuts (from 35% to 28%, from memory) kicking and screaming.

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MZM (NSA) v USD value v commercial lending

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via

Using figures compile [sic] by independent research house GFMS Ltd., the council says the consumption of 31.5 tons in the first quarter shows a steep increase of 110% year-on-year and accounting for 43% of the world’s net retail investment demand of 72.2 tons in the period.

Vietnam’s arrival into pole position in the retail investment sector ousts India from the top slot with 31 tons, a decline by half from the first quarter in 2007 as Indian purchasers withdrew from the market and waited for lower and more stable prices.

The report says the surge in Vietnam’s demand was partly a response to soaring inflation, which hit 11.6% in 2007 and prompted a rush to buy gold, reflecting its perceived qualities as a hedge against inflation.

Demand was also spurred by the performance of gold relative to other investments such as equities and real estate, which have declined in value over recent months while gold has strengthened.

Furthermore, gold investments have been increasingly marketed by Vietnamese banks. High interest rates enable local banks to offer an interest rate on gold deposits since they can profitably sell the gold for dong, lend the dong out at high interest rates and hedge their gold position by entering into a forward buying agreement with an international bank.

Many Vietnamese prefer to hold gold rather than dong and the fact that this gold can earn interest from commercial banks makes it still more appealing as for investment option, says the report.

Vietnam’s gold demand for jewellery in the first quarter was 5.3 tons, that is stable from the previous quarter but down by 18.9% on a year-on-year comparison and the high price of gold was the primary reason for the decline.

Gold demand is divided into three purposes, jewellery demand, industrial and dental demand, and identifiable investment, comprising net retail investment (primarily bars and coins) and investment in Exchange Traded Funds and similar products (ETFs), the latter not yet available in Vietnam.

The world’s total gold demand in the first quarter fell 16% from a year earlier to 701.3 tons. Of which, jewellery demand was 445.4 tons, down 21%, industrial and dental demand fell 5% to 110.3 tons, while investment in ETFs was double to 72.9 tons and net retail investment dropped 35% to 72.2 tons.

(Source: SGT)

In some parts of the world, gold consumption and CPI are apparently correlated. Who knew?!

Let’s hope the rest of Asia picks up on the trend.

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… underwritten by PIMCO’s Bill Gross.

Just in time for the huge TIPS burp a couple of nights ago, when massive buying pushed the 5-year TIPS yield down to -.77.

I’ve been a huge fan of the SS hypothesis for a long time, so it’s good to see the world’s biggest fixed income guru practically copy-paste from the Shadow Stats website for his latest letter.

Without further ado:

What this country needs is either a good 5¢ cigar or the reincarnation of an Illinois “rail-splitter” willing to tell the American people “what up” – “what really up.” We have for so long now been willing to be entertained rather than informed, that we more or less accept majority opinion, perpetually shaped by ratings obsessed media, at face value. After 12 months of an endless primary campaign barrage, for instance, most of us believe that a candidate’s preacher – Democrat or Republican – should be a significant factor in how we vote. We care more about who’s going to be eliminated from this week’s American Idol than the deteriorating quality of our healthcare system. Alternative energy discussion takes a bleacher’s seat to the latest foibles of Lindsay Lohan or Britney Spears and then we wonder why gas is four bucks a gallon. We care as much as we always have – we just care about the wrong things: entertainment, as opposed to informed choices; trivia vs. hardcore ideological debate.

It’s Sunday afternoon at the Coliseum folks, and all good fun, but the hordes are crossing the Alps and headed for modern day Rome – better educated, harder working, and willing to sacrifice today for a better tomorrow. Can it be any wonder that an estimated 1% of America’s wealth migrates into foreign hands every year? We, as a people, are overweight, poorly educated, overindulged, and imbued with such a sense of self importance on a geopolitical scale, that our allies are dropping like flies. “Yes we can?” Well, if so, then the “we” is the critical element, not the leader that will be chosen in November. Let’s get off the couch and shape up – physically, intellectually, and institutionally – and begin to make some informed choices about our future. Lincoln didn’t say it, but might have agreed, that the worst part about being fooled is fooling yourself, and as a nation, we’ve been doing a pretty good job of that for a long time now.

I’ll tell you another area where we’ve been foolin’ ourselves and that’s the belief that inflation is under control. I laid out the case three years ago in an Investment Outlook titled, “Haute Con Job.” I wasn’t an inflationary Paul Revere or anything, but I joined others in arguing that our CPI numbers were not reflecting reality at the checkout counter. In the ensuing four years, the debate has been joined by the press and astute authors such as Kevin Phillips whose recent Bad Money is as good a summer read detailing the state of the economy and how we got here as an “informed” American could make.

Let me reacquaint you with the debate about the authenticity of U.S. inflation calculations by presenting two ten-year graphs – one showing the ups and downs of year-over-year price changes for 24 representative foreign countries, and the other, the same time period for the U.S. An observer’s immediate take is that there are glaring differences, first in terms of trend and second in the actual mean or average of the 2 calculations. These representative countries, chosen and graphed by Ed Hyman and ISI, have averaged nearly 7% inflation for the past decade, while the U.S. has measured 2.6%. The most recent 12 months produces that same 7% number for the world but a closer 4% in the U.S.

This, dear reader, looks a mite suspicious. Sure, inflation was legitimately much higher in selected hot spots such as Brazil and Vietnam in the late 90s and the U.S. productivity “miracle” may have helped reduce ours a touch compared to some of the rest, but the U.S. dollar over the same period has declined by 30% against a currency basket of its major competitors which should have had an opposite effect, everything else being equal. I ask you: does it make sense that we have a 3% – 4% lower rate of inflation than the rest of the world? Can economists really explain this with their contorted Phillips curve, output gap, multifactor productivity theorizing in an increasingly globalized “one price fits all” commodity driven global economy? I suspect not. Somebody’s been foolin’, perhaps foolin’ themselves – I don’t know. This isn’t a conspiracy blog and there are too many statisticians and analysts at the Bureau of Labor Statistics (BLS) and Treasury with rapid turnover to even think of it. I’m just concerned that some of the people are being fooled all of the time and that as an investor, an accurate measure of inflation makes a huge difference.

The U.S. seems to differ from the rest of the world in how it computes its inflation rate in three primary ways: 1) hedonic quality adjustments, 2) calculations of housing costs via owners’ equivalent rent, and 3) geometric weighting/product substitution. The changes in all three areas have favored lower U.S. inflation and have taken place over the past 25 years, the first occurring in 1983 with the BLS decision to modify the cost of housing. It was claimed that a measure based on what an owner might get for renting his house would more accurately reflect the real world – a dubious assumption belied by the experience of the past 10 years during which the average cost of homes has appreciated at 3x the annual pace of the substituted owners’ equivalent rent (OER), and which would have raised the total CPI by approximately 1% annually if the switch had not been made.

In the 1990s the U.S. CPI was subjected to three additional changes that have not been adopted to the same degree (or at all) by other countries, each of which resulted in downward adjustments to our annual inflation rate. Product substitution and geometric weighting both presumed that more expensive goods and services would be used less and substituted with their less costly alternatives: more hamburger/less filet mignon when beef prices were rising, for example. In turn, hedonic quality adjustments accelerated in the late 1990s paving the way for huge price declines in the cost of computers and other durables. As your new model MAC or PC was going up in price by a hundred bucks or so, it was actually going down according to CPI calculations because it was twice as powerful. Hmmmmm? Bet your wallet didn’t really feel as good as the BLS did.

In 2004, I claimed that these revised methodologies were understating CPI by perhaps 1% annually and therefore overstating real GDP growth by close to the same amount. Others have actually tracked the CPI that “would have been” based on the good old fashioned way of calculation. The results are not pretty, but are undisclosed here because I cannot verify them. Still, the differences in my 10-year history of global CPI charts are startling, aren’t they? This in spite of a decade of financed-based, securitized, reflationary policies in the U.S. led by the public and private sector and a declining dollar. Hmmmmm?

In addition, Fed policy has for years focused on “core” as opposed to “headline” inflation, a concept actually initiated during the Nixon Administration to offset the sudden impact of OPEC and $12 a barrel oil prices! For a few decades the logic of inflation’s mean reversion drew a fairly tight fit between the two measures, but now in a chart shared frequently with PIMCO’s Investment Committee by Mohamed El-Erian, the divergence is beginning to raise questions as to whether “headline” will ever drop below “core” for a sufficiently long period of time to rebalance the two. Global commodity depletion and a tightening of excess labor as argued in El-Erian’s recent Secular Outlook summary suggest otherwise.

The correct measure of inflation matters in a number of areas, not the least of which are social security payments and wage bargaining adjustments. There is no doubt that an artificially low number favors government and corporations as opposed to ordinary citizens. But the number is also critical in any estimation of bond yields, stock prices, and commercial real estate cap rates. If core inflation were really 3% instead of 2%, then nominal bond yields might logically be 1% higher than they are today, because bond investors would require more compensation. And although the Gordon model for the valuation of stocks and real estate would stress “real” as opposed to nominal inflation additive yields, today’s acceptance of an artificially low CPI in the calculation of nominal bond yields in effect means that real yields – including TIPS – are 1% lower than believed. If real yields move higher to compensate, with a constant equity risk premium, then U.S. P/E ratios would move lower. A readjustment of investor mentality in the valuation of all three of these investment categories – bonds, stocks, and real estate – would mean a downward adjustment of price of maybe 5% in bonds and perhaps 10% or more in U.S. stocks and commercial real estate.

A skeptic would wonder whether the U.S. asset-based economy can afford an appropriate repricing or the BLS was ever willing to entertain serious argument on the validity of CPI changes that differed from the rest of the world during the heyday of market-based capitalism beginning in the early 1980s. It perhaps was better to be “entertained” with the notion of artificially low inflation than to be seriously “informed.” But just as many in the global economy are refusing to mimic the American-style fixation with superficialities in favor of hard work and legitimate disclosure, investors might suddenly awake to the notion that U.S. inflation should be and in fact is closer to worldwide levels than previously thought. Foreign holders of trillions of dollars of U.S. assets are increasingly becoming price makers not price takers and in this case the price may not be right. Hmmmmm?

What are the investment ramifications? With global headline inflation now at 7% there is a need for new global investment solutions, a role that PIMCO is more than willing (and able) to provide. In this role we would suggest: 1) Treasury bonds are obviously not to be favored because of their negative (unreal) real yields. 2) U.S. TIPS, while affording headline CPI protection, risk the delusion of an artificially low inflation number as well. 3) On the other hand, commodity-based assets as well as foreign equities whose P/Es are better grounded with local CPI and nominal bond yield comparisons should be excellent candidates. 4) These assets should in turn be denominated in currencies that demonstrate authentic real growth and inflation rates, that while high, at least are credible. 5) Developing, BRIC-like economies are obvious choices for investment dollars.

Investment success depends on an ability to anticipate the herd, ride with it for a substantial period of time, and then begin to reorient portfolios for a changing world. Today’s world, including its inflation rate, is changing. Being fooled some of the time is no sin, but being fooled all of the time is intolerable. Join me in lobbying for change in U.S. leadership, the attitude of its citizenry, and (to the point of this Outlook) the market’s assumption of low relative U.S. inflation in comparison to our global competitors.

William H. Gross
Managing Director

The SS hypothesis extends to unemployment statistics, as well. In most European economies, anyone unemployed between 19 and 55 years of age is apparently counted as unemployed. The massive graduate education and “nonprofit” apparatus in the United States (Peace Corps, Teach for America, etc) means that many Americans who are effectively unemployed — and who often use such institutions to say that they “have something to do” — are not counted as such.

When you add up all the American distortions, the US economy expressed in European metrics comes to approximately 7 percent inflation, 8 percent unemployment, and very low growth.

Which begs the question of what European governments do to cook their own books, which is something I can’t know. Gold-buggery seems to be an overwhelmingly American phenomenon, and virtually all research into effective gold price support has come from Americans, which means that the CPI-skeptic worldview is very familiar with the nuances of American book-cooking, but not at all familiar with European equivalents.

However, European bonds are not nearly the economic anchor that American fixed income and equities prices are.

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The credit crisis has separated true libertarians from phony libertarians, and separated true liberals from phony liberals.

The phony liberals have inadvertently mocked themselves throughout the entire credit crisis, manning the barricades to defend the greatest act of socialism for the rich in US history. Ditto for supposed “libertarians,” eg Robert Rubin, Bruce Kovner, and the vast majority of institutional Wall Street which found itself drowning in its own quagmire, and changed their tune faster than you can say “WTF.”

Anyway, here’s the link.

The editorial in question is by Robert J. Shiller, who is a professor of economics and finance and famous analyst of speculative bubbles. A specialist in behavioral economics, in the application of psychology to understanding financial markets. A co-founder of Case Shiller Weiss, that house price index we talk about a lot. His editorial, “The Scars of Losing a Home,” speaks not of lofty academic economic concepts but of human sympathy, of things that are “really important.” With references from famous academic psychologists. I haven’t taken this kind of a tiger by the tail since I went after Austan Goolsbee last year.

Yes, it was only a year ago that the distinguished Dr. Goolsbee wrote this on the same editorial page:

And do not forget that the vast majority of even subprime borrowers have been making their payments. Indeed, fewer than 15 percent of borrowers in this most risky group have even been delinquent on a payment, much less defaulted.

When contemplating ways to prevent excessive mortgages for the 13 percent of subprime borrowers whose loans go sour, regulators must be careful that they do not wreck the ability of the other 87 percent to obtain mortgages.

For be it ever so humble, there really is no place like home, even if it does come with a balloon payment mortgage.

I actually think Goolsbee’s piece was the high-water-mark of the “subprime helps the poor” talking point. You certainly don’t hear much about that these days. Less than two months after Dr. Goolsbee’s earnest op-ed, we got an interview in the very same NYT with one Bill Dallas, CEO of the famously defunct Ownit Mortgage, effusively testifying to his own burning desire to help out the unfortunate in a way that finally put paid to the respectability of that line (“‘I am passionate about the normal person owning a home,’ said Mr. Dallas, who is also chairman of the Fox Sports Grill restaurant chain and manages the business interests of the Olsen twins. ‘I think owning a home solves all their problems.'”) Plus by now we’ve got some numbers on the 2007 mortgage vintage, the one that Dr. Goolsbee was afraid wasn’t going to ever materialize if we tightened up lending standards too much. A year ago we were looking at a 13% subprime ARM delinquency rate. Per Moody’s (no link) the Q4 07 subprime ARM delinquencies were running 20.02%. And that is not, you know, “just” another 7%. By now, those delinquent borrowers in Goolsbee’s 13% have probably mostly been foreclosed upon and are off the books. The 20% or so who are now delinquent were either part of the 87% that Goolsbee thought were “successful homeowners” last year, or else they’re those lucky duckies who bought homes after the publication date of Goolsbee’s plea that we not tighten standards too much.

Of course Shiller wasn’t exactly spending his time a year ago defending the subprime mortgage industry on the grounds that it put poor and minority people into ever-so-humble homes with balloons attached. I seem to recall him mostly arguing that homebuyers were engaged in a speculative mania. In a June 2007 interview:

Well, human thinking is built around stories, and the story that has sustained the housing boom is that homes are like stocks. Buy one anywhere and it’ll go up. It’s the easiest way to get rich.

At the time, that kind of statement struck some of us, at least, as not possibly the entire story either, but in any event a useful corrective to the saccharine silliness of the “Ownership Society” and Bill Dallas solving everyone’s problems by letting them put Roots in a Community (for only five points in YSP).

So I hope I can be just a tad startled by the New Shiller:

Homeownership is thus an extension of self; if one owns a part of a country, one tends to feel at one with that country. Policy makers around the world have long known that, and hence have supported the growth of homeownership.

MAYBE that’s why President Bush’s “Ownership Society” theme had such resonance in his 2004 re-election campaign. People instinctively understand that homeownership conveys good feelings about belonging in our society, and that such feelings matter enormously, not only to our economic success but also to the pleasure we can take in it.

So it’s no longer irrational exuberance or plain old speculating; it’s now an instinctive affirmation of some eternal verity of the human psyche? The ultimate patriotism: the definition of self so tied up in ownership of a slice of the motherland that to rent becomes not only psychologically dangerous–these people without selves can’t be up to anything good–but politically dangerous as well? Is it possible that Shiller can mean what he is writing here?

If you just scanned the first few paragraphs of Shiller’s op-ed you might come away with the impression of a sincere but somewhat hackneyed plea for us all to have a bit of sympathy for the foreclosed among us, foreclosure not in anyone’s experience being a walk in the park. Fair enough. It being Sunday in America, I suspect millions of us are being treated to exhortations to take a kinder view of the unfortunate than we often do; we need those exhortations; we are often lacking in sympathy. Hands up all who disagree.

But you keep reading and you find Shiller trying to explain the “trauma” of foreclosure. And that’s where this really gets weird:

Now, let’s take the other perspective — and examine some arguments against the stern view. They have to do with the psychological effects of strict enforcement of a mortgage contract, and economists and people in business may need to be reminded of them. After all, too much attention to abstract economic statistics just might make us overlook what is really important.

First, we have to consider that we cannot squarely place the blame for the current mortgage mess on the homeowner. It seems to be shared among mortgage brokers, mortgage originators, appraisers, regulatory agencies, securities ratings agencies, the chairman of the Federal Reserve and the president of the United States (who did not issue any warnings, but instead has consistently extolled the virtues of homeownership).

Because homeowners facing foreclosure must bear the brunt of the pain, they naturally feel indignation when all of these other parties continue to lead comfortable, even affluent lives. Trying to enforce mortgage contracts may thus have a perverse effect: instead of teaching homeowners that they should respect the contracts they sign, it may incline them to take a cynical view of the whole mess.

We need to modify mortgage contracts to keep homeowners from becoming cynical? That’s somehow more respectable an idea than the one saying we should throw them out on the street to “teach them a lesson”? If Shiller is serious that all those other parties are “to blame,” then why isn’t the obvious solution to throw them out on the street? There seems to be an assumption here that nothing can be done to punish those who are “really” to blame, so we’re left managing the psyches of those who can be punished. And that’s not cynical?

This the point at which Shiller dredges up the most stunningly unfortunate quote from William effing James (1890) to define the “fundamental” psychology of homeownership:

Homeownership is fundamental part of a sense of belonging to a country. The psychologist William James wrote in 1890 that “a man’s Self is the sum total of all that he CAN call his, not only his body and his psychic powers, but his clothes and his house, his wife and children, his ancestors and friends, his reputation and works, his lands and horses, and yacht and bank account.”

Now, that’s breath-taking. Horses. Yachts. His wife and his children. Ancestors. The whole late-Victorian wealthy male WASP defining the “Self” (with a capital!) as the wealthy male WASP surveying his extensive possessions, an oddly-assorted list that ranks the family and friends somewhere after the clothes and the house. (Yes, James did that on purpose.) The kind of sentiment that was a caricature of the late-Victorian male even in 1890. And Shiller drags this out in aid of generating sympathy for homeowners? Really? You couldn’t find some psychological insight about the emotional relationship of people to their homes that doesn’t speak the language of the male ego surveying his domain, sizing himself up against all the other males to see where he ranks?

(James on the psychological effect of losing one’s property: ” . . . although it is true that a part of our depression at the loss of possessions is due to our feeling that we must now go without certain goods that we expected the possessions to bring in their train, yet in every case there remains, over and above this, a sense of the shrinkage of our personality, a partial conversion of ourselves to nothingness, which is a psychological phenomenon by itself. We are all at once assimilated to the tramps and poor devils whom we so despise, and at the same time removed farther than ever away from the happy sons of earth who lord it over land and sea and men in the full-blown lustihood that wealth and power can give, and before whom, stiffen ourselves as we will by appealing to anti-snobbish first principles, we cannot escape an emotion, open or sneaking, of respect and dread.”)

I’m actually, you know, in favor of some sympathy for homeowners, but one thing that does get in the way of that for a lot of us is, well, the rather disgusting shallowness that a lot of them displayed on the way up. There is this whole part of our culture that has sprung into being since 1890 that takes a rather severe view of conspicuous consumption, unbridled materialism, and totally self-defeating use of debt to buy McMansions, if not yachts. We were treated to a fair amount of that kind of thing in the last few years. In fact, we had Dr. Shiller explaining to us last year that a lot of folks just wanted to get rich, quick, in real estate.

It is undeniably true, I assert, that not everyone was a speculatin’ spend-thrift maxing out the HELOCs to buy more toys, and that part of our problem today with public opinion is that we extend our (quite proper) disgust for these latter-day Yuppies to the entire class “homeowner.” But it is surely an odd way to engage our sympathies for the non-speculator class to speak of it in Jamesian terms as the man whose self is defined by his Stuff, and whose psychological pain is felt most acutely when he recognizes that he is now just like the riff-raff.

It’s worse than odd–it’s downright reactionary–to then go on to that evocation of homeownership as good citizenship and good citizenship as “feel[ing] at one with [the] country.” This puts a rather sinister light on Shiller’s earlier insistence that we need to make sure people don’t get too “cynical.”

I see that Yves at naked capitalism was just as disgusted by Shiller as I am:

Now admittedly, this is not a validated instrument, but a widely used stress scoring test puts loss of spouse as 100 and divorce at 73. Foreclosure is 30, below sex difficulties (39), pregnancy (40), or personal injury (53). Change in residence is 20.

Note that if we as a society were worried about psychological damage, being fired (47) is far worse than foreclosure (30), and if it leads to a change in financial status (38) and/or change to a different line of work (36) those are separate, additive stress factors. Yet policy-makers have no qualms about advocating more open trade even though it produces industry restructurings that produce unemployment that does more psychological damage than foreclosures. As a society, we’ll pursue efficiency that first cost blue collar jobs, and now that we’ve gotten inured to that, white collar ones as well (although Alan Blinder draws the line there).

But efficiency arguments don’t apply to housing since we are sentimental about it. And it’s that sentimentality that bears examination, since it engendered policies that helped produce this mess.

I would only add that we are about five years too far into a war that has not made a majority of us “feel at one with that country.” I think of another really important policy change we could be pursuing right now to shore up everyone’s psychological estrangement from their patriotic self-satisfaction. But “efficiency arguments” don’t apply to wars, either.

My fellow bleeding heart liberals like Goolsbee found themselves defending the subprime industry in the name of increasing minority homeownership. Now we’re treated to the spectacle of Shiller arguing for homeowner bailout legislation in the same terms that Bush used to defend the “Ownership Society.” Housing policy, I gather, makes strange bedfellows. It certainly makes strange editorials.

Shiller’s unwitting self-parody embodies the principle at the heart of the TAF and every other tentacle of the Wall Street bailout. Far more than “economist statistics which can cause us to lose sight of what’s really important,” what’s REALLY important is protection of those Selves which include “lands and horses, and yacht and bank account.”

You can *not* make this stuff up.

Pardon my French, but our economy is being run by f*cking idiots.

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The entire economy of Iceland has come under massive speculative assault in the past several months, as the most ludicrous example of an overextended, overleveraged, underfunded European economy.

As of December 2006, its rolling annual trade deficit was 26 percent of GDP. That has come down to “only” 15 percent as of January 2008.

However, Iceland’s currency has bled 26 percent in the interim. Because Iceland is a tiny economy, adverse shifts in foreign exchange are telegraphed extremely rapidly to every corner of the economy.

The central banks in Denmark, Norway and Sweden have offered a $2.3 billion loan to Iceland to bolster its faltering currency, the krona, which has lost some 26 percent of its value since January amid concerns that Iceland’s banks carry too much foreign debt, Bloomberg reported May 16. The currency rose 3.7 percent versus the euro on the news. Inflation in Iceland hit 11.8 percent in April, the highest level in nearly two decades, despite a key interest rate set at 15.5 percent.

This is small-scale proof that currency implosion today equals consumption implosion tomorrow. The only variables are the relative size of the country’s economy (smaller economy = faster price realignment in line with forex fluctuations), the size of the country’s trade deficit as a percentage of GDP (larger deficit = sharper adjustment), and the absolute size of the country’s trade deficit relative to all other national trade deficits.

Turning points in the global economic cycle usually hit the smaller, more vulnerable economies first. The big boys get hit last, but hardest.

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Bernanke wingman Frederic Mishkin today, parroting Barney Frank:

I would like to emphasize the importance of regulatory policy. Monetary policy–that is, the setting of overnight interest rates–is already challenged by the task of managing both price stability and maximum sustainable employment. As a result, it falls to regulatory policies and supervisory practices to help strengthen the financial system and reduce its vulnerability to both booms and busts in asset prices.

Of course, some aspects of such policies are simply the usual elements of a well-functioning prudential regulatory and supervisory system. These elements include adequate disclosure and capital requirements, prompt corrective action, careful monitoring of an institution’s risk-management procedures, close supervision of financial institutions to enforce compliance with regulations, and sufficient resources and accountability for supervisors.

More generally, our approach to regulation should favor policies that will help prevent future feedback loops between asset price bubbles and credit supply. A few broad principles are helpful in thinking about what such policies should look like. First, regulations should be designed with an eye toward fixing market failures. Second, regulations should be designed so as not to exacerbate the interaction between asset price bubbles and credit provision. For example, research has shown that the rise in asset values that accompanies a boom results in higher capital buffers at financial institutions, supporting further lending in the context of an unchanging benchmark for capital adequacy; in the bust, the value of this capital can drop precipitously, possibly even necessitating a cut in lending.

=============

Choking tomorrow’s legitimate commerce — or rather, driving it to less profligate nations — to pay for yesterday’s illusory and Fed-stoked boom.

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IFR:

[13:57 US GOVTS: Fallout From Credit Crisis Seen in TIC Data]

Boston, May 15. Though foreigners continued to buy treasuries (a record $55 bln) and agency ($18 bln) paper hand over fist in the latest March TIC data the net flow for the month was actually a negative $48 bln. While far from an expert in these numbers it appears that the shortfall was made in the private flow category and specifically bank liabilities which fell $115 bln.

The thinking is that the latter number ($115 bln) represents a falloff in US bank lending to their European counterparts over the heighten counterpart concern engendered by the subprime/credit crisis. If so, this may be yet another reason why the Fed is contemplating expanded both the size and term maturity of the TAF program.

Either way, the data is causing quite a stir on the Street and is seeing a knee-jerk buying and curve steepening reaction in the treasury market as traders try to sort out what it all means.

Interesting.

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Regular finance-focused readers have probably noticed that I’ve neglected economic commentary recently. That’s because 1) there hasn’t been much net marginal information recently to clarify what I see right now (monstrous reflation in the West, looming monstrous deflation in the East, looming war in the Mid-East, commodities as The Big Thing through late July). 2) the geopolitics of Lebanon is probably the single most influential thing going on (for commodities markets, anyway) with such a corresponding lack of true public analysis.

Anyway, as I have scrolled through my lonnnnnng list of finance blogs and gotten more and more bored, one wasteful meme in particular has infected more and more online financial discourse. (Which is still way ahead of the NYT and WSJ, who are probably wondering how best to appeal to the estrogenated millenials, i.e. the yuppie female/ gay demographic,  with more front-page fashion coverage.) Let’s call it the Complex Systems Meme.

The Complex System Meme is what all the Smart Guys In The Room, the quants, talk about these days. CSM exhibits a predictable life-cycle.

  1. Quant adds long, verbose, high-syllable-per-word, hypertechnical, and thus unfalsifiable comment to a mainstream financial blog.
  2. Blogger, realizing he’s in the presence of a Smartest Guy In The Room, gracefully and tacitly hands over the reins of discussion to Quant.
  3. Many, many jargon-intensive paragraphs ensue. Frequently sighted examples of jargon intensity include “information latency,” “Knightian uncertainty,” “systems architecture,” “the financial transmission mechanism,” “the securitization process is driven by nonlinear systemic processes,” “counterproductive proliferation of systemic dependencies,” “constructive ambiguity” (Greenspan’s fave), and “reflexivity.” The liquidity of discussion within the broader discursive framework of the weblog, if you will, exhibits a six-sigma nonlinear growth trajectory.
  4. At this point, 100.00% of common sense has been scared the hell out of the room. Only certified high priests of quantology, and their most zealous qualitative admirers, remain.
  5. After paragraph count has vaulted into the upper two digit range, absolutely nothing has been said that couldn’t have been stated much more simply.
  6. However, Quant’s intellectual stature has been established beyond all dispute. If anything, the transaction cost of challenging him (requiring at least as many ubersyllabic paragraphs as were just hemorrhaged) has become prohibitive.

Verbose commentary wastes everybody’s time.

I don’t blame quants for crappy writing, just as I don’t blame myself for crappy quantification. The problem is that carpet-bombing a discussion with unnecessary technical verbiage excites a majestic awe in influential qualitatives least able to challenge — but best able to disseminate — quants’ “solutions” to the “problem,” which are at least as benighted as everybody else’s, yet treated with greater credibility.

Everything in life is nonlinear.

Just because liquidity is an economy of scale, doesn’t make it a national imperative of the federal government. In the long run, economic surplus of even the largest economies of scale is captured by the operators of that system. For example, mass transit seems like a great idea on paper, and it is — in the medium run. However, the workers and conductors of any mass transit system quickly realize that society is capturing much more surplus from their activity than they are. So their rational best choice is to unionize, and go on strike, holding the broader economy hostage until they capture (in the form of higher salaries, pensions, etc) the entire social surplus of that activity. Such is the case with the French railway workers’ union.

Liquidity isn’t nearly that nonlinear — I’m just using a more dramatic example to make the point.

Every commodity, whether it’s oil, debt, or whatever, has a parabolic marginal cost/marginal benefit curve. “Scale economies'” MB/MC curves currently seem to offer higher rates of return with greater investment, until some point farther off in the future, than those of corresponding industries. Over time,  scale economies become identical to those of non-economies of scale, except that the production side has fewer participants. Fewer producers relative to consumers means that consumers’ bargaining power asymptotes to zero. Consumers get mad, and government steps in and regulates producers. Leveraging of producers’ superior bargaining power ends. In the long long long run, both producers and consumers enjoy more surplus. In theory.

The market for lending, ostensibly a sacrosanct economy of scale, obviously went into negative territory on that curve. Now it’s snapping back. Government interventions to maintain the current level of debt are only going to cause a snapback much more “nonlinear” than whatever nonlinear correction we would otherwise have undergone.

Getting wrapped up in “the nonlinear nature of liquidity” only obfuscates the discussion for everyone. Every process is nonlinear relative to itself at the distribution of previous moments in time. But processes tend to be much more linear relative to all other processes. Since we’re talking about subsidizing one somewhat nonlinear process (debt-funded liquidity) at the expense of all other nonlinear processes, why bring nonlinearity into the discussion at all.

If smart people spent their time weighing on other Smart People to solve simple problems, instead of taking themselves so seriously and flaunting their technical knowledge, maybe we would actually get somewhere in terms of stopping BS Bernanke & Co. from butchering the financial credibility of the United States, and actually get some return on all this talking/typing time investment.

When that starts happening, and private parties are barred from free-riding off of AAA government bond ratings courtesy of taxpayer sweat, I will crawl out of my dollar-bearish, euro- and “safe” fixed income-uberbearish hibernation. And maybe the future of finance will become an interesting topic to blog about again. It’s just that with Fannie Mae et al. going $400bn-$1.1trn in debt, in addition to the Fed ~$400bn of Treasuries exchanged for worthless MBS, AND $500 billion in FY09 debt, the medium term US bond rating is already staring at either much higher taxes or an epochal downgrade. Capital is already leaving in anticipation of necessarily higher taxes, which will mean still higher taxes on whatever capital is left. Prescriptions of “solutions” to the current “credit crisis,” as if we can outsmart mean reversions of debt if we just think hard enough, are as stale as they are futile.

And in case you were wondering what the point of all that bloviation was … it was just a rant. It’s frustrating, waiting and wishing for a better alternative to capital flight.

[*] unless the abbreviation damages rhythm too much

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Right-wing hedge fund legend Bruce Kovner, responding to the standard “How do you make all of your money?” question, supposedly said, “From stupid governments.” Speaking of which:

Asian Ministers Agree to Pool $80 Billion of Reserves (Update1)

By Keiko Ujikane and Seyoon Kim

May 4 (Bloomberg) — Finance ministers from 13 Asian nations agreed to create a pool at least $80 billion in foreign- exchange reserves to be tapped by nations in case they need to protect currencies.

Contributions from Japan, China and South Korea will total 80 percent of the pool, while the 10-member Association of Southeast Asian Nations will make up the rest, the ministers said in a statement after talks in Madrid, where the Asian Development Bank is holding its annual meeting.

Asian governments are trying to avoid relying on institutions like the International Monetary Fund, which forced them to adopt harsh economic policies in return for bailouts during the financial crisis a decade ago. Pooling of foreign reserves may help prevent a repeat of the region’s turmoil.

All 13 nations will contribute to the fund, and they will still manage their own reserves under the arrangement. Exact contributions have yet to be decided. Today’s talks involved Japanese Finance Minister Fukushiro Nukaga, China’s Xie Xuren, South Korea’s Kang Man Soo and their counterparts from Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand and Vietnam.

Ministers last year agreed to set aside part of their $3.4 trillion of foreign reserves for emergencies, without deciding the size of the pool and when they would start the fund. The nations decided to accelerate discussions on the details of borrowing conditions, the statement said.

`Appropriate Actions’

On the economy, Asian governments “confirmed the importance of taking appropriate actions” to sustain economic activity, the statement said.

“The regional economy has continued its strong growth and is forecast to remain robust although somewhat weaker,” the statement said. “Nonetheless, several risks remain such as further worsening of the growth prospects, vulnerability of financial markets, and continued inflationary pressures from rising oil and non-oil commodity prices.”

Crude oil has soared, and rice prices have more than doubled since Asian finance ministers met a year ago in Kyoto, Japan. The increases have stoked social tensions and led to wider fiscal deficits as governments subsidize food and energy costs for their people.

The reserve pool is an expansion of a current arrangement that only allows for bilateral currency swaps. It is designed to ensure central banks have enough to shield their currencies from speculative attacks like those that depleted the reserves of some countries during the Asian financial crisis in 1997 and 1998.

During that crisis, Indonesia, Thailand and South Korea spent most of their foreign reserves to prop up their currencies. The three nations had to turn to the IMF for more than $100 billion of loans to shore up their finances when investors sold their currencies. The IMF forced governments to cut spending, raise interest rates and sell state-owned companies.

In other words, they will dump their forex reserves to defend their currency pegs, for the privilege of subsidizing American consumption even more than they have for the past six years. Damn it (occasionally) feels good to be American!

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May 2 (Bloomberg) — A month after the Federal Reserve rescued Bear Stearns Cos. from bankruptcy, Chairman Ben S. Bernanke got an S.O.S. from Congress.

There is “a potential crisis in the student-loan market” requiring “similar bold action,” Chairman Christopher Dodd of Connecticut and six other Democrats wrote Bernanke. They want the Fed to swap Treasury notes for bonds backed by student loans. In a separate letter, Pennsylvania Democratic Representative Paul Kanjorski and 31 House members said they want Bernanke to channel money directly to education-finance firms.

The Fed’s loans to Bear Stearns were “a rogue operation,” said Anna Schwartz, who co-wrote “A Monetary History of the United States” with the late Nobel laureate Milton Friedman.

`No Business’

“To me, it is an open and shut case,” she said in an interview from her office in New York. “The Fed had no business intervening there.”

There are already indications that investors perceive the safety net to be widening as a result of the actions by Bernanke, 54, and New York Fed President Timothy Geithner. The Bear Stearns bailout and an emergency facility to loan directly to government bond dealers triggered a decline in measures of credit risk for investment banks and for Fannie Mae, the Washington-based, government-chartered company that is the nation’s largest source of funds for home mortgages.

Yield differences between Fannie Mae’s five-year debt and five-year U.S. Treasuries have fallen to 0.55 percentage point, from 1.15 percentage points on March 14, the day the Fed’s Board of Governors invoked an emergency rule to lend $13 billion to Bear Stearns.

“The market understood that this is the method by which Fannie Mae and Freddie Mac could be bailed out if necessary,” Poole said.

Wall Street Impact

The cost of default protection on Merrill Lynch & Co. debt fell to 1.4 percentage point by April 30 from 3.3 percentage points on March 14, CMA Datavision’s credit-default swaps prices show. The cost of protection on Lehman Brothers Holdings Inc. securities has fallen to 1.5 percentage points from 4.5 percentage points over the same period.

Fed Board spokeswoman Michelle Smith declined to comment, as did New York Fed spokesman Calvin Mitchell.

On March 16, two days after the Fed provided its Bear loan, it agreed to finance $30 billion of the firm’s illiquid assets to secure its takeover by JPMorgan Chase & Co.

The Standard & Poor’s 500 Financials Index had lost 12 percent in the three weeks prior to March 14; Geithner defended the loans before the Senate Banking Committee on April 3, saying that the Fed needed to offset risks posed to the entire financial system.

A systemic collapse on Wall Street would also mean “higher borrowing costs for housing, education, and the expenses of everyday life,” Geithner, 46, said.

While the Fed must by law withdraw its financing backstop for investment banks once the credit crisis passes, investors will probably still bet on its readiness to intervene. …

[…]

The Fed also influenced market incentives last month when it introduced the so-called Term Securities Lending Facility. The program is designed to lend up to $200 billion of Treasury securities from the Fed’s holdings to Wall Street bond dealers in return for commercial and residential mortgage bonds among other collateral. Congress has noticed the program favors mortgage credits, and Dodd has asked the Fed to swap some of its $548 billion in Treasury holdings for bonds backed by student loans.

Back to Congress

Bernanke rejected Dodd’s request in an April 25 letter, saying it’s up to Congress and the Bush administration to address diminishing profits on the loans. He didn’t explain why the Fed is reluctant to swap Treasuries for bonds backed by student loans.

“If there is a public purpose in lending to investment banks, and taking dodgy mortgage securities as collateral, then it is a question of degree about other potential lending,” Vincent Reinhart, former director of the Fed board’s Division of Monetary Affairs, said in an interview. “That’s the consequence of crossing a line that had been well established for three- quarters of a century.”

Having extended welfare to Wall Street Republicans, the Fed cannot now refuse Democratic client industries, such as government-sponsored enterprises, education financiers, etc.

Additionally, the Fed will be on the hook for the “containment” bailouts it arranged in the first stage of the credit crunch. The Bank of America acquisition of Countrywide, for example, was widely seen as a Fed “containment” move. CFC owed at least $51 billion of debt to the FHLBs, and $38 billion is the latest figure Bloomberg is bandying around. Bank of America appears poised to take every BofA asset it can and shovel the debts to the government into a bogus holding company, which will go bankrupt. It will be entertaining to watch the FHLBs make good on a $38 billion hole in their balance sheet. Ambrose Evans-Pritchard said that at one point, Citigroup owed $98 billion to the FHLBs. Assume that has been cut 25 percent by a combination of a slight credit recovery and the Fed taking a lot of what can’t be sold; that still leaves $75bn. The FHLBs are going to have to start calling in loans. There will be another deleveraging frenzy. What’s the Fed going to do then, since it’s already forked over $400 billion of its $950bn in Treasury “bullets” to the banks? Putting bad debt in different buckets doesn’t change the fact that it’s bad debt, especially when the new bucket is owned by the government.

S&P estimated a couple of weeks ago that Fannie and Freddie alone would require a bailout of between $420 billion and $1.1 trillion – enough to jeopardize the United States’ AAA bond rating. Presumably that didn’t include Sallie Mae, the student loan originator.

At any rate, the renewed sense of optimism on equities among “the big boys” ™ has been palpable for at least a week. Wall Street is once again cranking up the leverage. Hence the shift out of commodities and into equities effected by the tacticals (hedge funds) at the expense of the dinosaur pension funds and endowments, which piled into commodities very late.

The data junkies tell me that broad money (MZM) strongly leads narrow money (BASE). The deflation-will-be-the-end-of-us-all crowd (eg, Mish Shedlock, John Mauldin, coming from somewhat different angles) has generally pointed to BASE as at least a quasi-justification of what Bernanke is doing. Bond vigilantes have pointed to MZM as a portent of severe future inflation. Obviously, I think the bond vigilantes are correct.

For now, the “inflationary bull market” classes (leveraged equities and base raw materials) have won the argument against the stagflation asset classes (eg precious metals). As long as the Fed dilutes Treasuries by swapping them for MBS, precious metals will still woefully underperform. Gold has been hammered for the past few weeks and although I am still quite bullish about it in the 6-24 month time horizon, the past four weeks have obviously been very unkind to that thesis.

Short Treasuries; long equities and precious metals.

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Forget about NYC ever recapturing London’s financial crown. What sane hedge fund manager would de-privatize all his information, and submit to “surveillance” by the very Praetorians who have exacerbated every shock of the last 20 years?

Treasury eyes stronger powers for Fed

By Gillian Tett in London and Krishna Guha in Washington

Published: April 29 2008 23:23 | Last updated: April 29 2008 23:23

Meanwhile, data showed accelerating US house price declines and further declines in consumer confidence.

The Federal Reserve could use proposed new regulatory powers to try to stop credit and asset market excesses from reaching the point where they threaten economic stability, the US Treasury said on Tuesday.

David Nason, assistant secretary for financial institutions, said the Fed could even use its proposed “macro-prudential” authority to order banks, hedge funds and other entities to curtail strategies that put financial stability at risk.

By “leaning against the wind” in this way, the US central bank could “attempt to prevent broad economic dislocations caused by potential excesses”, he said.

His comments come amid debate inside the Fed as to whether it should try to do more to contain asset price bubbles, following the housing and dotcom busts. Some see enhanced regulatory powers as a better tool for this than interest rates.

The proposed new powers – outlined in a Treasury blueprint published last month – require legislation and may never be authorised. But policymakers see the plan as offering a template for future regulation.

The blueprint envisages giving the Fed roving authority to collect, analyse and publish market data from a wide range of institutions, from banks to hedge funds.

“The market stability regulator must have access to detailed information about all types of financial institutions,” said Mr Nason.

Hedge funds are uneasy about this proposal. However, many European central bankers are eager to acquire the kind of macro-prudential powers the Treasury would like to give to the Fed.

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via

The Bank of England has imposed a permanent news blackout on its £50bn-plus plan to ease the credit crunch.

Ferocious and unprecedented secrecy means taxpayers will never know the names of the banks that have been supported through the special liquidity scheme, which was unveiled by Bank Governor Mervyn King last week.

Requests under the Freedom of Information Act are to be denied. Details will be kept secret even after 30 years – the period after which all but the most sensitive state documents are released.

Any Bank of England employee leaking the names of institutions involved will face court action for breach of contract.

Even a figure for the overall amount advanced will not be published until October. Meanwhile the Bank is expected to issue at least £50bn of Treasury bills to banks in exchange for their mortgages – entirely in secret.

This hypersensitive official stance is thought to be a response to the events of last year when a huge stigma was attached to any lender suspected of going to the Bank for cash help.

The scheme is intended to steady the markets, but it is feared that reports of banks making widespread use of the facility could trigger further instability.

Barclays and HBoS have both confirmed they will use the Bank of England scheme. ‘We welcome the Bank facility and we will participate in it,’ confirmed Andy Hornby, chief executive of HBoS.

Other banks declined to comment, but it is expected that this week all of the leading banks, with the exception of Lloyds TSB, will tender some of their mortgages to the Bank of England.

HBoS confirmed last week it had packaged up £9bn of mortgages ready either for securitisation – in effect, selling them on in the wholesale financial markets – or to be offered to the Bank in return for Treasury bills.

The scheme, drawn up by King and approved by Chancellor Alistair Darling, aims to improve banks’ liquidity by temporarily swapping bundles of mortgages and credit card debt for Treasury bills, which are short-dated Government debt that matures within nine months.

The scheme will run for three years so these bills will be replaced by new ones when required.

Under the plan, bills will be exchanged only for securities rated triple-A – the highest possible grade of security – by at least two of the three big ratings agencies, Fitch, Moody’s and Standard & Poor’s.

It would not normally be considered acceptable for big companies to arrange billions of pounds of financial support without telling their shareholders.

But one source close to major institutional investors said: ‘I can see why there may be a case for secrecy.

‘It may be the lesser of two evils.’

The £50bn or more of Treasury bills involved will dwarf the £17.6bn currently in issue, but the authorities are adamant this will not destabilise the Government debt market.

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