IMF: Excess Liquidity and Inflation Originate in the U.S.

The IMF has published an interesting paper on global liquidity effects and their impact on eurozone monetary policy. The authors found that excess U.S. liquidity is a primary determinant of excess liquidity and inflation in the eurozone:

Global excess liquidity is sometimes believed to limit sovereign monetary policy even in large economies, including the euro area. There is much discussion about what constitutes global excess liquidity and our approach adjusts liquidity for longer-term interest rate and output effects. We find that especially excess liquidity in the U.S. leads developments in euro area liquidity. U.S. excess liquidity also enters consistently positive as a determinant of euro area inflation. There is some evidence that this result may be related to a weakening of the effectiveness of monetary policy in the euro area during times of excessive U.S. liquidity.

This observation should inform the common sense of monetary policy; that the actions of the supplier of the world’s reserve currency impact global monetary conditions is hardly a new or radical idea. But it does provide additional support to the idea that the U.S. has been a pretty lousy global monetary steward since it assumed that role around WWI. And it argues, in our view, against the overwhelming consensus that monetary policy is the most appropriate policy lever for supporting the U.S. economy. If this were the 1930s or 1940s, such an approach might work. But in an integrated global economy, the issuer of the primary reserve currency needs to manage policy based on global, not domestic, economic conditions. As Robert Mundell has argued, the Federal Reserve, which was formed in 1913, was the ‘new kid on the block’ in the interwar period, and it struggled to provide the caliber of monetary leadership that the Bank of England had provided in the 19th century. Unfortunately, that hasn’t changed much. The Fed has yet to accept its global leadership role, remaining mired in an inwardly focused framework that is a legacy of the Great Depression, prevailing theory, and misguided Congressional mandates.

Kotok’s Scathing Indictment

We recently expressed our misgivings about Treasury Secretary Geithner; David Kotok of Cumberland Advisors let him — and the new Administration — have it with both barrels. This is an important read, whether one agrees with him or not (we do):

…Geithner (on page 81 and again on page 95) answered: “President Obama – backed by the conclusions of a broad range of economists – believes that China is manipulating its currency. President Obama has pledged as President to use aggressively all the diplomatic avenues open to him to seek change in China’s currency practices.”

“Manipulation?”  “Aggressively?“  This is strong language.  Geithner did not do this on his own authority.  These are prepared answers.  He is citing the new President, not once but twice.

…the dollar [is] likely to get stronger.  Right now it is the default choice of the world.  We have currency strength not because we are so desirable but because we are currently better than the others…

So what do we do within 72 hours of launching the Obama administration that says it is seeking “change?”  We fire the first public salvo in what could easily become a trade war or a threat to global financial integration.

What makes us so credible?  Is it our proven record of regulatory oversight of our financial markets, as demonstrated by the Madoff scandal and the SEC?  Is it the way our rating agencies work so diligently to place a coveted “AAA” on paper that was peddled to the rest of the world and was found out to be highly toxic?  Is it the way we honor the promises of federal agencies by having tier-one-eligible Fannie and Freddie preferred held in the US and abroad by institutions, and then essentially cause a structural default on that preferred (actually, dividend suspension)?  Or is it the way the actions of Treasury and the Federal Reserve allowed a primary dealer (Lehman) to fail, thus triggering a global contagion?

C’mon?  Where is the plan to restore confidence and credibility and transparency and consistent policy for the United States?  And how does the Obama administration believe that launching a fight with China is beneficial?

In the 1930s the severe recession of 1929-1931 was turned into the depression of 1931-1933 because of protectionism.  Every historian knows that.  Every economist learns it in school.  This is well-known by Geithner and even better-known by Larry Summers and Paul Volcker.  They are the three members of the Obama economic troika.

The statement Geithner repeated twice was certainly known to them in advance.  Why did they not temper it?  What is the plan?  Do they want to threaten and see if China backs down?  This, too, is dangerous.  Do they intend to pursue the Schumer tariff scheme?  There are more questions than answers.

Lastly, Larry Summers was going to attend the World Economic Forum in Davos, Switzerland.  He has cancelled.  Why?  Was it because he did not want to have to face the private conversations that would follow such statements as have been made by Geithner in the name of the President?

Watch Davos closely.  And remember that the absence of statements is as revealing, if not more so, than the presence of them.  Not one mention of trade openness appears in our reading of the 100 pages of answers to the Senate.  Maybe someone else can find an affirmation of free and open trade.  I cannot.

We fear protectionism.  It starts with rhetoric. We now have that threat.  If it is pursued, it ends badly for everyone.  No one wins.

Cumberland also posted Geithner’s written Q and A responses on its website.

http://www.654advisors.com/newsandviews/newsandviews/2009012240.html

http://www.cumber.com/special/geithnerquestions2009.pdf

Some Misgivings on Geithner

We caught a bit of Treasury Secretary designate Tim Geithner’s testimony to the Senate yesterday. While we were completely neutral on the appointment initially, we now have some misgivings:

• Given his background as a monetary economist, versus the obvious need to revise the federal tax code and address pressing long term fiscal issues, is he the best person for the job of chief tax and fiscal authority?
• Some mild character concerns were raised in yesterday’s hearing related to his past tax problems, and while we don’t find those overly troubling at this point, we are somewhat shocked that Geithner doesn’t mention his experiences with the U.S. tax code as a clear and compelling argument for tax simplification.
• On currency and foreign exchange issues, and specifically on the Chinese Yuan – USD exchange rate, it’s not clear at all where the Obama Administration is headed, and this is a potentially explosive issue for the global economy.

On the first point, when asked whether he thought rising tax burdens in the late 1930s had exacerbated or extended the Great Depression, Geithner professed ignorance of tax policies in that era, and said he had far more knowledge of the role that monetary policy had played. This admission highlighted a question that no one (to our knowledge) has asked yet: Given that Geithner was steeped in monetary policy during his tenure as a central banker, and given that the key focus for a Treasury Secretary is tax and fiscal policy, is he the right person for the job?

On the second point, one or more Republican senators raised a legitimate character issue, based upon the fact that (1) when Geithner originally settled his IRS tax claim, he did not pay any back taxes for which the statute of limitations had expired (as most people would do) and (2) after his appointment, he chose to pay those back taxes several years after he the fact (in other words, he paid the full tax bill only when it became apparent that it could thwart a high profile career opportunity). Of the questions raised, this issue troubled us the least, because the taxes involved are notoriously complex, it’s a legal truism that one pays only those damages that they owe, and there doesn’t appear to have been a longstanding pattern of misconduct. What surprises us is that neither Geithner, nor any of the Senate Finance members, even Republicans (at least while we were watching) pointed out the obvious implications of his tax problems — that tax simplification is critically important and long overdue, and that the problem’s been getting worse in recent years.

On currency and foreign exchange issues, it’s not entirely clear yet where Geithner and the Obama Administration are headed. In his hearing, Geithner subscribed to the prevailing idea that "market forces" should determine exchange rates. But as we like to point out, (1) governments in most mature economies prefer floating exchange rates because they help to obscure the fact that burdensome policies and regulations drive capital, investment, production and jobs abroad; and (2) many export oriented businesses prefer floating rates because when taxes and regulations are costly and inflexible, exchange rates become the only public policy tool that confers a competitive advantage over foreign competitors.

So the Treasury’s direction on exchange rates is worrisome enough, especially when you consider that Senator Obama supported a bill in the last Congress that sought to categorize a fixed exchange rate ("currency manipulation") as a trade violation. But the issue was muddied significantly by Geithner’s written follow ups which were provided to the Senate today, as he called for a "strong dollar", a policy last pursued by Treasury during the Clinton Administration.* The thrust of such a claim is that President Obama and Treasury Secretary Geithner (if approved, which looks very likely) will pursue a stronger dollar and an even stronger yuan. If they are truly committed to this path, then things could get even stranger — perhaps uglier — in the months and years ahead.

To sum up, we now have some concerns about a Geithner Treasury. However, he deserves an opportunity to prove himself, and his experience at the Fed since the financial crisis began should be a strength if and when he assumes the post.

* The sudden reference to a "strong dollar policy" would seem to have the fingerprints of Larry Summers, Clinton’s last Treasury Secretary, all over it. And while a "strong dollar" has a nice ring to it, there is no good economic argument to be made for it, just as there’s no good argument for a "weak" dollar. To clarify, we realize that those arguments, along with plenty of fancy theories used to support them, exist in spades. We just don’t think they’re good arguments. The value of money ought to be stable, and from that perspective, exchange rates should be relatively stable as well.

Basel II Changes: Better Late Than Never

The Bank for International Settlements — the central banks’ bank — has announced some important changes to its Basel II Accord (Basel II sets out global standards for commercial bank capital requirements). They’re clearly aimed at preventing a repeat of the current financial disaster:

The Basel Committee on Banking Supervision today issued a package of consultative documents to strengthen the Basel II capital framework. These enhancements are part of a broader effort the Committee has undertaken to strengthen the regulation and supervision of internationally active banks in light of weaknesses revealed by the financial markets crisis. Nout Wellink, Chairman of the Basel Committee and President of the Netherlands Bank, said that "the proposed enhancements will help ensure that the risks inherent in banks’ portfolios related to trading activities, securitisations and exposures to off-balance sheet vehicles are better reflected in minimum capital requirements, risk management practices and accompanying disclosures to the public."

The proposed changes to capital requirements cover:

• trading book exposures, including complex and illiquid credit products;
• certain complex securitisations in the banking book (eg so-called CDOs of ABS); and
• exposures to off-balance sheet vehicles (ie asset-backed commercial paper conduits).

The Committee is also proposing standards to promote more rigorous supervision and risk management of risk concentrations, off-balance sheet exposures, securitisations and related reputation risks. Through the supervisory review process, the Committee is promoting improvements to valuations of financial instruments, the management of funding liquidity risks and firm-wide stress testing practices.

In addition, the Committee is proposing enhanced disclosure requirements for securitisations and sponsorship of off-balance sheet vehicles, which should provide market participants with a better understanding of an institution’s overall risk profile.

As we noted in the title to this piece, better late than never. However, not all of the institutions and entities that contributed to the global credit bubble are governed by Basel II (i.e., by their country’s central banks), so there’s still plenty of heavy lifting to be done by regulators worldwide; and for those revisions to be a net positive, they must be well designed and reasonably well coordinated, conditions that call to mind another pithy adage — easier said than done.

There are also several proverbial elephants in the room that are not addressed by the Basel II changes. BIS provides regulatory frameworks for central banks to apply to their client banks in the private sector — it does not regulate the policy actions of central banks themselves. Insofar as central bank policies helped set the table for the credit bubble and crisis, this is an important gap. And because the most important central banks have no explicit regulators, they face the daunting task of carrying out critical self-appraisals of their institutional status quos. This is a continuation of the ‘governance cycle’, a concept we’ve developed and followed over the past several years. It holds that higher standards of conduct, whether directed towards accountants, auditors, executives in Silicon Valley or on Wall Street, or elsewhere, are not only a double edged sword to those who call for them (e.g., the Spitzer Effect), but are also applied to most or all institutions eventually. The last time the Fed faced such a crisis was toward the end of the 1970s.

URLs:

http://www.bis.org/press/p090116.htm 

CFO: Trillions in Dry Powder?

According to an article at CFO.com (reporting on a private industry report on alternative asset investment), "there’s still more than $1 trillion in ‘dry powder’ for future deals." While this is good news, it also raises some troublesome questions about policy developments in D.C. Is the uncertainty emanating from Congress, the Fed, the Treasury, and the outgoing and incoming Administrations keeping that "dry powder" on the sidelines?

It’s an important question because, from the figures provided, there may be enough private capital available to return the financial system to health (eventually). For example, in an interview on CNBC this morning, economist Nouriel Roubini estimated that an infusion of at least $2T is required by the financial system (an equivalent amount to his estimate of "toxic" financial assets). The U.S. Treasury’s TARP program is expected to infuse $750B, and while Congress has proposed an $800B stimulus plan, at this point it involves very little assistance to the financial sector (the Fed’s programs can be thought of as more analogous to bridge loans than equity infusions). But while there may be sufficient private capital, it’s possible that the uncertainty over federal policy — created by the multiple twists and turns by various policymakers and regulators since the crisis began, and the pending installation of a new Congress and Administration — is keeping that capital on the sidelines. In other words, due to the uncertainties that are an unintended consequence of policymaking, private capital is sitting tight and allowing (future) U.S. taxpayers to assume the risk instead. 

A few caveats: first, depending on the kinds of deals Treasury strikes with TARP and its successors (if any), taxpayers may very well want to stand in the front of the line, as the eventual returns could be very attractive; second, it’s not clear (from the CFO.com report anyways) whether there’s any leverage behind the funds raised (if the current crisis has taught anything, it’s that only truly unencumbered capital should be called "dry powder"); and finally, we’re obviously speculating about how the managers of that private capital would behave in the absence of policy uncertainty.

URLs:

http://www.cfo.com/article.cfm/12958163?f=alerts

A Slow, Steady Credit Thaw

It appears from several leading indicators that credit markets are returning to something resembling normalcy. The two year swap spread has fallen below 60 basis points from a peak above 150 in Sep-Oct. The TED spread has also returned to normal levels from a similar spike. Both of these measures indicate that a good deal of uncertainty has been wrung out of credit markets.

The commercial paper market also appears to be stabilizing, according to recent Fed data. However, it’s important to note that the the current dynamics do not augur a robust economic recovery. As noted by CFO.com:

Sales by financial issuers were virtually unchanged, however. They fell by $5 billion the previous week. The total commercial paper market still is down from $1.82 trillion about four months ago and the peak of $2.2 trillion during the summer of 2007.

There’s a stock market adage that performance of the financial sector is indicative of how robust an economic recovery will be. It’s also widely accepted that credit market trends usually lead equity markets. Applying those principles to the evidence in hand, it seems likely that economic performance in the U.S. will be subdued for some time.

URLs:

http://www.bloomberg.com/apps/quote?ticker=USSP2%3AIND 

http://www.bloomberg.com/apps/quote?ticker=.TEDSP:IND 

http://www.cfo.com/article.cfm/12918406?f=alerts 

Depression Watch: Trade Policy

We’ve been publicly skeptical about the likelihood of the current recession turning into full blown depression since September.

For a depression to occur, Congress would have to dramatically raise taxes, regulations, and trade barriers, and the Federal Reserve would have to significantly hike interest rates.

While the Fed is clearly not preparing to make USD reserves more scarce, policymakers — in the US and abroad — are increasingly hawkish on trade, a development we have been monitoring closely and occasionally posting on. Today, the WSJ editorial page criticized the U.S. steel industry for pushing a Buy American campaign as part of the pending stimulus package:

The U.S. steel industry has now joined autos and ethanol in the conga line to Capitol Hill. Sort of. Steelmakers aren’t seeking government bailout money — a la Detroit and Wall Street — but they are pressuring President-elect Obama and the new Congress to stack any stimulus proposal in favor of domestic producers, even though that would inevitably come at the expense of the nation’s overall economic health.

You might think that the prospect of a $1 trillion spending plan that includes significant outlays for steel-intensive construction projects would be enough to placate an industry that has experienced record profits in recent years. Not so. Daniel DiMicco of Nucor, the nation’s largest minimill steelmaker, said last week that "what we are asking is that our government deal with the worst economic slowdown in our lifetime through a recovery program that has in every provision a ‘buy America’ clause."

Such rhetoric may sound patriotic, but in practice it amounts to protectionism that would only hurt American consumers and taxpayers — and might kick off a trade war the world economy can’t afford. To begin with, domestic steelmakers don’t produce enough steel to meet U.S. demand. According to the American Institute for International Steel, steel imports account for between 20% and 25% of the U.S. market. The industry has also gone thorough dramatic changes in the past decade, including bankruptcies and dumping pension liabilities on taxpayers. Most importantly, there has been tremendous consolidation, which eliminated many producers that once made steel no matter what the cost.

The Journal editorial board’s concerns are not misplaced. Anti-trade pressures still seem to be mounting, with much of the focus on China. For example, in October, Congress asked the U.S. International Trade Commission to monitor textiles and apparel imports from China. According to a Bloomberg story, political pressures look set to widen to other industries and import categories:

In the U.S., business and labor groups, along with lawmakers, are pushing the new Obama administration to take a harder line with China than President George W. Bush did.

Senate Finance Committee Chairman Max Baucus, a Democrat from Montana, plans legislation that would raise tariffs on dumped imports from China and other nations. And newly elected Democratic congressmen such as Larry Kissell of North Carolina and Dan Maffei of New York have pledged actions to stop jobs from being shipped to China.

Lawyers representing companies such as Nucor Corp., the second-largest U.S. steelmaker, NewPage Corp., a maker of coated paper, and smaller textile and steel pipe makers say they are considering new trade complaints against China. During the presidential campaign, Obama promised groups including the National Council of Textile Organizations and the Alliance for American Manufacturing that he would take a tougher stance on China’s currency policies.

A recent story from The Hill also indicates that pressure towards China is likely to expand and intensify: 

…the China Currency Coalition, which has argued that Treasury Secretary Henry Paulson should have taken aggressive actions to force China to increase the value of its currency…is planning an offensive on currency in 2009, and hopes a changed political environment in Washington, which will include larger Democratic majorities in Congress and a Democrat in the White House, will be fruitful. In addition, the image of Wall Street lobbies opposed to action against China has been weakened by the financial crisis…

We’re not hard hearted liquidationists / reallocationists, and we recognize that concerns over domestic and foreign trade policies are often legitimate. Unfortunately, most of the current pressures are calling for monetary and/or trade measures that are the primary levers of beggar-thy-neighbor economic policy. What’s likely to slow these demands, if anything? While Obama appears to buy into the currency manipulation thesis in regards to China, his economic team is not likely to push for a trade war, and they surely understand the importance of addressing these challenges constructively. Hopefully the new President will prove willing to stand up to Congress over these issues. From the Hill article:

Obama’s economic team is led by Larry Summers, who has said repeatedly that the U.S. should not use a stick with China. In an interview with the U.S. News and World Report in June of last year, he said attempting to “bludgeon China is a very risky course.” The U.S. would be better off engaging in a dialogue than in making demands, he said.

URLs:

http://www.654advisors.com/newsandviews/newsandviews/2008123036.html 

http://online.wsj.com/article/SB123137418481962821.html 

http://www.bloomberg.com/apps/news?pid=20601068&sid=ai3pbN.JY7tY&refer=home 

http://thehill.com/business–lobby/debate-renewed–on-u.s.-china-ties-2009-01-07.html 

Obanomics Looking Better

More information has come to light regarding the soon-to-be-pending stimulus bills in Congress. The plans being discussed sound better than the recent comments from Obama advisor David Axelrod led us to hope. From the WSJ:

President-elect Barack Obama and congressional Democrats are crafting a plan to offer about $300 billion of tax cuts to individuals and businesses, a move aimed at attracting Republican support for an economic-stimulus package and prodding companies to create jobs…

Republicans and business leaders hadn’t seen specifics of the proposals Sunday night, but welcomed the idea of basing a bigger proportion of the stimulus plan on tax cuts. Their response suggests the legislation could attract relatively broad support, and it highlighted the Obama team’s determination to win backing from varied interests…

William Gale, a tax-policy analyst at the Brookings Institution think tank in Washington, said the scale of the whole package is larger than expected. He called the business offerings a true surprise, since most attention has been focused on the spending side of the equation, especially the hundreds of billions of dollars being discussed for infrastructure and aid to state and local governments.

"On the other hand, it was hard to figure out how they were going to spend all that money in intelligent ways, so it makes sense to do more on the tax side," Mr. Gale said.

As Mr. Gale notes, working from the tax side, even though it’s a surprise development, makes good sense — which is why we’ve been advocating it for some time. The quality of these measures is yet to be known, but at least resources are being pushed in that direction now.

More generally, the current approach indicates that policymakers have learned from experiences with the recent tax stimulus: 

Economists of all political stripes widely agree the checks sent out last spring were ineffective in stemming the economic slide, partly because many strapped consumers paid bills or saved the cash rather than spend it. But Obama aides wanted a provision that could get money into consumers’ hands fast, and hope they will be persuaded to spend money this time if the credit is made a permanent feature of the tax code.

Of course, as we’ve been pointing out, household consumption simply isn’t in the cards. We’re in for a long cycle of balance sheet repair, i.e., higher savings and lower consumption, and there’s a pressing need for global trade and capital flows to rebalance. Stimulating consumption in the U.S. would only be counter productive to this process.

As for the business tax package, a key provision would allow companies to write off huge losses incurred last year, as well as any losses from 2009, to retroactively reduce tax bills dating back five years. Obama aides note that businesses would have been able to claim most of the tax write-offs on future tax returns, and the proposal simply accelerates those write-offs to make them available in the current tax season, when a lack of available credit is leaving many companies short of cash.

This is a good measure, although the claim from Obama aides is suspect — businesses are not allowed to carry operating losses forward indefinitely, and when those losses expire, they represent a loss of wealth (carried losses are a financial asset to a firm, since they can be used to lower future tax expense).

A second provision would entice firms to plow that money back into new investment. The write-offs would be retroactive to expenditures made as of Jan. 1, 2009, to ensure that companies don’t sit on their money until after Congress passes the measure.

Another good measure and well designed, at least insofar as the retroactivity goes.  

Another element would offer a one-year tax credit for companies that make new hires or forgo layoffs, which could be worth $40 billion to $50 billion. And the Obama plan also would allow small businesses to write off a broad range expenditures worth up to $250,000 in 2009 and 2010. Currently, the limit is $175,000.

This is OK — it certainly pushes in the right direction given the employment outlook — but it has some problems. First, as Mr. Gale notes in the article, this may simply reward actions that would have been taken anyways (it’s reasonable to assume that few or no firms are going to hire simply because of the tax credit). Second, it’s well short of the mark as far as corporate tax overhaul goes. The US code is still not as competitive as it once was, and it continues to distort many business decisions.

The following section is interesting as well, as it shows that the problem of free riding is not confined to the personal tax code:

Business lobbyists are pushing hard for Congress to allow companies that haven’t paid corporate income taxes to get a break, too. Start-up companies, alternative-energy firms and large corporations that have been swallowing losses for years — such as automotive and steel companies and some airlines — have already begun lobbying for such "refundability."

They argue that a provision to claim losses on back taxes will have little effect on the economy if firms that need it most — struggling companies that weren’t obligated to pay any taxes — can’t benefit from a tax break.

Mr. Obama, however, doesn’t back payments to companies that haven’t paid taxes, aides said. Instead, businesses that haven’t been paying taxes would be able to get payments from tax credits they would have taken in 2008 and 2009 for incentives offered by Congress, such as the production tax credit offered to renewable-energy firms. These amounts would likely be relatively small.

To be fair, some of this lobbying may be driven by past (or expected, in the case of startups) expirations of carried tax losses; it’s also true that for industries or firms that have not incurred any significant tax hits in the past five years, this measure would have little or no value. Perhaps it would be worthwhile for Congress to consider getting rid of tax loss expirations permanently. We would also point out that a broad improvement in the corporate (and business) tax code would also enhance — at least marginally — the prospects of all businesses, including many troubled ones. That’s preferable to having government prop up failing firms or dying industries.

Finally, the article fleshes out some of the principles at work in the coming stimulus bills: 

"We’re working with Congress to develop a tax-cut package based on a simple principle: What will have the biggest and most immediate impact on creating private-sector jobs and strengthening the middle class?" said transition-team spokeswoman Stephanie Cutter. "We’re guided by what works, not by any ideology or special interests."

Despite (or perhaps because of) their lack of detail, we find Cutter’s words more reassuring than Axelrod’s. We’ll be keeping an ear to the ground as the stimulus plans develop.