The Foreclosure Fiasco

Shaun Donovan, Obama’s HUD Secretary, has said that there is no “structural issue” with the mortgage foreclosure process. From Market Watch:

He said there’s no evidence yet of “structural” issues with the Mortgage Electronic Registration System, an electronic registry of home loans that critics have charged with violating property record-keeping laws. Banks that package loans into bonds called mortgage-backed securities often rely on MERS to track owners of mortgages as the securities change hands.

There are plenty of interesting takes on this issue (see below), which we have been following since late 2009.  It seems apparent from Donovan’s comments that the Obama administration doesn’t see the foreclosure issue as something to campaign on.  It’s an interesting political gamble either way.  Standing up to lenders’ foreclosure agents might rally parts of the Dems’ base.  While the “let the market work” counter argument wouldn’t normally sway voters from either side, the fact that We the Taxpayer still own stakes in some of the banks at the center of the crisis might be causing Dems to fear that a foreclosure freeze would hand the GOP another club to beat them over the head with as the campaign season wraps up (though one can also argue that siding with “put back plaintiffs” could recover taxpayer funds too). 

For those who haven’t been following recent developments, here are some key aspects:

The one that has been apparent for the longest is whether or not MERS, which is essentially just a database for securitized mortgages, has standing to foreclose, and whether a clear chain of title can be established to a property where the lender used MERS to track the securitized mortgage on it.  Industry proponents tend to argue that chain of title has conventionally been documented after the fact as necessary to foreclose.  But that’s been put to the test with all of the litigation arising out of the foreclosure mess, and a slew of recent court decisions have put the lending industry on the defensive.

Recent discoveries have documented the existence of “robo-signers”, employees who sign many thousands of affidavits saying they are familiar with the details of each mortgage foreclosure when obviously they couldn’t be.  There have also been clearer (though far fewer) occurrences of outright fraud by foreclosure agents (some of which industry proponents still defend as business as usual practices), as well as instances of baseless foreclosures (people who are not delinquent on their mortgage losing their home).  When you consider the fact that most foreclosed properties are sold to someone, the utter FUBARness of the situation becomes apparent.

A more recent aspect is the potential “put backs” of certain mortgage securities to the investment banks and/or originators, which we wrote about last week.  The recent suit filed by several large money managers, which is mentioned in the HUD article, is based on this aspect of the mortgage fiasco.  It’s interesting to note that investment banks are now reserving for “put back” losses, while most of them felt it was an immaterial risk just six months or so ago.

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More mortgage related reading…hat tips are due, but unfortunately, I forgot to note them. Most are via Warren Mosler’s blog post linked below.

Tax Credit + Tax Credit Expiration + Record Foreclosures + Documentation Issues + Probes + Renewed Foreclosure Spike (?) = Home Price Uncertainty and Volatility

http://www.ibtimes.com/articles/71820/20101014/u-s-foreclosure-repossessions-record-september-housing-bubble-foreclosure-filings.htm

Plaintiffs, including fifty state attorney generals, have been pushing back on foreclosures, while judges are seeking to tighten up the legal proceedings:

http://www.bizjournals.com/jacksonville/stories/2010/10/11/daily38.html?ana=yfcpc

http://www.nypost.com/p/news/business/hear_ye_hear_ye_EVyzIEMklFWu9GSwn3oaSN

An interesting debate between contributors to Calculated Risk and Naked Capitalism: 

http://www.calculatedriskblog.com/2010/10/why-did-mortgage-servicers-use-robo.html

http://www.nakedcapitalism.com/2010/10/guest-post-so-why-did-the-mortgage-servicers-use-robo-signers.html

Warren Mosler’s take — this wave of the crisis lends support to his belief that “The financial sector is a lot more trouble than it’s worth”:

http://www.nakedcapitalism.com/2010/10/guest-post-so-why-did-the-mortgage-servicers-use-robo-signers.html

The world of private equity is involved, via investments in some of the ‘foreclosure mill’ firms. I can understand why this might have looked like an attractive investment idea. But as one of the subjects of the article notes, private equity investors will tend to push hard for lower cost, higher margin (and/or turnover) production, which has obvious social costs and consequences as a foreclosure tsunami unfolds. And what happens if the investments were levered up, and the mill operations are shut down as a result of current probes and litigation? It’s not just the executives and clients of that private equity shop that suffer then — all of us get to share the pain. And that’s the main problem with innovation in the financial sector. Leverage means that the costs are absorbed by society, i.e., people who had nothing to do with the risk taking. Definitely a call for private equity clients to stay on top of what their managers are doing:  http://www.nytimes.com/2010/10/21/business/21equity.html?_r=1

The MMT folks weigh in — Randy Wray, Bill Black, Marshall Auerback:

http://www.benzinga.com/comment/reply/524394

http://www.benzinga.com/life/politics/10/10/517948/if-not-now-when

http://www.newdeal20.org/2010/10/15/foreclosure-fraud-we-need-to-fix-the-banks-again-23421/

“Positively Evil”

Felix Salmon has written a good piece on the behavior of the investment banks that bought, securitized, and sold mortgages in the years leading up to the crisis (emphasis added, bold only):

…[Investment banks] tested only a small portion of the loans in [a] pool [of mortgages]. So [they] knew that if there were a bunch of bad loans [discovered by testing], there were bound to be even more bad loans among the loans that…had not [been] tested. And those loans it couldn’t put back to the originator, because [they] didn’t know exactly which loans they were.

If there had been any common sense in the investment banks, that would have been the end of the deal. But there wasn’t. Rather than simply telling the originator that its loan pool wasn’t good enough, the investment banks would instead renegotiate the amount of money they were paying for the pool.

This is where things get positively evil. The investment banks didn’t mind buying up loans they knew were bad, because they considered themselves to be in the moving business rather than the storage business. They weren’t going to hold on to the loans: they were just going to package them up and sell them on to some buy-side sucker.

In fact, the banks had an incentive to buy loans they knew were bad. Because when the loans proved to be bad, the banks could go back to the originator and get a discount on the amount of money they were paying for the pool. And the less money they paid for the pool, the more profit they could make when they turned it into mortgage bonds and sold it off to investors.

Now here’s the scandal: the investors were never informed of the results of [the] test[s]. The investment banks were perfectly happy to ask for a discount on the loans when they found out how badly-underwritten the loan pool was. But they didn’t pass that discount on to investors, who were kept in the dark about that fact.

Disconcerting stuff, though judging by a recent Bloomberg poll, it wouldn’t surprise most Americans:

Wall Street financial firms and the mortgage industry get the most blame for the country’s economic weakness. More than three-quarters of the 1,000 Americans polled say the former has hurt the economy, while more than 80 percent fault the latter.

On a related note, Warren Mosler made the following observations in a recent presentation (pdf):

There is no public purpose served by allowing:

• Banks to sell their loans
• Sales of credit default risk when loans are based on credit analysis
• Banks to engage in any secondary market activity
• Proprietary trading

Mosler also observed that ”Banking should be a lot more limited than even restoring Glass-Steagall implies,” and that “The number of regulators needed increases geometrically with expanded bank activities.” He also ably dissected TARP and the shortcomings in federal stimulus measures. As he cleverly puts it on his website, “The financial sector is more trouble than it’s worth.”

And indeed, some empirical studies support the argument that the financial sector has been a mammoth rent sucking machine for decades. But good luck doing anything about it. Its immense profitability and resulting political clout have made it a powerful lobby, which is reflected in many parts of the recent Dodd-Frank legislation, as well as the deregulatory push of recent decades. And the fact is, the activities that Mosler listed have made some people incredibly wealthy, and there are simply too many more who want their shot at the million or billion dollar carrot, social consequences be damned. In fact, few if any of them even have a clue that their activities are socially harmful or neutral at best. Nothing quiets one’s conscience like visions of philanthropy, I suppose.

But despite the opaque complexities of the industry, people are on to it, as the Bloomberg poll shows. And the threat of pitch forks, however distant, might be at work in some recent industry actions, like the shutting down of proprietary trading desks and (tangentially) FINRA’s proposal to allow investors to select an all-public panel of arbitrators. Time will tell.

Stranger than Fiction: IRA to target British bankers?

This is fascinating — the Real IRA, a splinter of the Irish Republican Army, has claimed that they may start targeting bankers for a helping of “rough justice”:

Banks and bankers are now potential targets for the Real IRA, leaders of the dissident republican terror group have warned in an exclusive interview with the Guardian. Despite having only 100 activists they also said that targets in England remained a high priority…

“Let’s not forget that the bankers are the next-door neighbours of the politicians. Most people can see the picture: the bankers grease the politicians’ palms, the politicians bail out the bankers with public funds, the bankers pay themselves fat bonuses and loan the money back to the public with interest. It’s essentially a crime spree that benefits a social elite at the expense of many millions of victims.”

Wow. Hat tip to Dealbreaker.com.

FISCAL REFORM WILL FAIL

From an April 2010 presentation by economist Richard C. Koo:

“If you try to reduce government spending [in a balance sheet recession] environment, unless you are absolutely certain that…the money the government refused to borrow will be borrowed and spent by the private sector quickly…fiscal reform will fail.”

You can watch the presentation here, and view the accompanying slides here. Koo’s message, based on his study of Japan and the Great Depression, cannot be overstated in the current economic environment, with Europe embarking on widespread austerity, rising deficit hysteria in the U.S., the IMF counseling mature economies to cut spending and raise taxes, and hyperinflation hysteria going viral.

IN A BALANCE SHEET RECESSION, PREMATURE FISCAL REFORM WILL FAIL.  It’s a simple but critically important observation.  If the private sector desires to repair its balance sheet (and society wishes to avoid severe deflation and serial default), then the public sector must run deficits until the private sector is willing and able to pick up the slack again.

In addition to Koo’s data on Japan, exhibits 22 and 23 are interesting – the double dip in U.S. employment in 1937-38 followed federal budget tightening that started in 1936 — and in Germany, unemployment fell like a stone from 15% to under 5% thanks to government deficits of 5-15% of GDP (discomforting evidence that there were material economic reasons for the Nazis’ electoral success — we pray that no country’s political landscape will have to shift that radically again to break away from punitive policy measures).

[UPDATE 5/25/2010 - Marshall Auerback has pointed out to us that comparing U.S. and German economic statistics from the 1930s is fraught with peril. For example, German figures counted labor camp prisoners as 'employed', while U.S. statistics did not count workfare recipients given their novelty; see Marshall's "Time for a New 'New Deal'". If anyone who knows Richard Koo reads this, you might want to pass it along to him.]

We’d also point out that if our suspicion that demographic cycles are a significant factor in balance sheet cycles is valid, then any near term movement towards fiscal tightening in the U.S. would be about ten years too early — smaller deficits might be appropriate, but a balanced budget or surplus would be rather destructive.

If Koo and deflation phobes are right, then gold is the latest bubble; if inflation phobes are right, then Treasuries and the USD are.  Both camps can look at the data to make their case.  But in our view, only one camp makes a sound argument about the underlying financial and behavioral conditions, and in a ‘real’ (i.e., non-monetary) sense it has strong support from research on demographic cycles. 

We continue to believe that we are in a Keynesian historical moment.  But as long as Democrats continue to agitate for PAYGO and higher taxes, they are likely to cede a good deal of control to Republicans and their spending cuts.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. Some clients of the firm hold positions that are expected to move inversely to gold prices.

URLs:

http://ineteconomics.org/people/participants/richard-koo

http://ineteconomics.org/sites/inet.civicactions.net/files/INETOS-KooPresentation.pdf

http://www.financialpost.com/most-popular/story.html?id=3029003

SEC’s Goldman bombshell

The SEC has filed a civil complaint against Goldman Sachs alleging fraud (yes, the f-word) for synthesizing an asset backed security related to residential mortgage loans in 2007. It was done for one of Goldman’s prize clients — John Paulson’s hedge fund, which returned billions of dollars to partners as the wave of mortgages security downgrades and defaults broke (and according to some authors, alerted Goldman to looming problems in mortgage markets) – so that he could take a large short position in (i.e., sell) U.S. mortgage securities.

The rub is that every short seller requires a buyer. And the SEC complaint alleges that Goldman’s and others’ disclosures to buyers were not above board.

There are many, many angles to this story — reputational risk, the firm’s culture and political capital, effects on pending financial regulation, implications for other investment banks and certain hedge funds — the list goes on. We think there are two quick takeaways worth thinking about:

First, the episode illuminates the dark side of financial innovation. There are actually grounds in financial theory for defending creation of this type of product. But it’s apparent that such innovations create serious agency risks for the parties involved. And the SEC is alleging that Goldman did not manage those risks effectively.

Second, we can use the event to cast a different light on the idea of “too big to fail.” At least in this case, the problem appears to have been that Goldman was too big to conduct itself ethically. We’ll leave it to readers to debate whether  “greedy” should be substituted for “big”. In the meantime, the market has been vomiting Goldman shares since the news broke.

URLs:

http://sec.gov/news/press/2010/2010-59.htm

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. At the time of this writing, neither the firm nor its clients own shares of stock or any securities issued by Goldman Sachs. One of the firm’s principals owns shares of Goldman Sachs common stock. 

Hamilton: Credit crisis causes vs symptoms

Short but interesting post from James Hamilton at Econbrowser on a recent conference re credit market dislocation. His main point is that many (if not most) economists are focusing on the Lehman collapse and its aftermath as problem, rather than symptom of a historic run up in credit. It’s accompanied by some straightforward eye candy.

There’s also a link in the comments section to this New Yorker profile of Ben Bernanke – like Hank Paulson’s recent tell (not quite) all, it’s an interesting story.

URLs:

http://www.econbrowser.com/archives/2010/03/modeling_proble.html

http://www.newyorker.com/reporting/2008/12/01/081201fa_fact_cassidy?currentPage=all

Smart Money: Credit Card Companies

Smart Money magazine has a great long running feature, “Ten Things.” Their latest is “Ten Things Your Credit Card Company Won’t Tell You,” a rather timely dissection given passage of the CARD Act.

URLs:

http://www.smartmoney.com/spending/rip-offs/10-things-your-credit-card-company-wont-tell-you-18808/?cid=1230

Continuing credit disasters

An update from CFO.com on the federal government’s attempts to spur small business lending indicates that there’s a lot of fumbling and bumbling going on:

One proposal by the Obama administration is to take $30 billion of unused TARP money and create a Small Business Lending Fund for banks with less than $10 billion in assets. The amount of capital a bank could receive would be a percentage of its risk-weighted assets. The government would get at least a 5% dividend from the capital investment, but that rate would fall if the bank demonstrated an increase in small-business lending compared with a 2009 baseline. For every 2.5% increase in incremental business lending over a two-year period, the dividend rate would fall one percentage point. After five years, the dividend rate would increase to encourage timely repayment.

Assuming they’re looking for a five to ten year repayment, the government’s corresponding financing rate is between 2-4% (less than 1% if they borrow short), meaning a spread of 1-3%. Granted, there’s risk being taken “with taxpayers’ money”, but at a time when most economic theories say that the public sector should be dissaving (much less earning a fat spread on its existing funds), this kind of thinking is potentially disastrous (unless, of course, the dividends are going to be distributed to each citizen — read on once you’ve finished laughing).

Combined with the TARP stigma for recipient banks, we agree with critics of the idea who see it as a non-starter. This follows on the heels of what has begun to look like abject failure of the mortgage assistance programs enacted in 2009:

Earlier this year, the Making Home Affordable program was unveiled to help 3.2 million struggling homeowners stay in their homes either through a loan modification or a refinance…

…it’s not working.  This week, government officials reported to the House Financial Services Committee that 70 percent of borrowers who have signed up are not getting help…

Unfortunately, time is ticking and [better] ideas cannot be implemented quickly enough to keep up with the looming deadlines for these trial modifications, the increasing unemployment rate and rise in foreclosures.

As Rep. Barney Frank admitted in December, “no one can think we have done a satisfactory job.”

What can the feds do? Briefly, the best thing they could do is to minimize uncertainty for lenders and the entire private sector, and to ensure that fiscal policy is supportive – be it spending, tax cuts, or both (and ensuring that the TARP dividends distributed to its citizen-owners are tax free, ha ha ha…).

URLs:

http://www.cfo.com/article.cfm/14480869

http://www.credit.com/news/housing-market/2010-03-07/hamp-has-not-prevented-foreclosures-realtors-say.html

http://www.zillow.com/blog/mortgage/2009/12/09/hamp-harp-tarp-dud/

http://www.washingtonpost.com/wp-dyn/content/article/2009/12/08/AR2009120804194.html

I’ll see your PAYGO and raise you a double dip

A key objective raised by President Obama in his state of the union address was to address the ‘fiscal hole’ of the federal government. His rationale was that “like any cash strapped family, we will work within a budget to invest in what we need and sacrifice what we don’t.” he asked Congress to reinstate PAYGO, which reportedly helped the federal government “record surpluses in the 1990s,” and advocated investing in people “without leaving them a mountain of debt.” He closed on this point by saying that it’s just common sense.

Culturally, these ideas resonate with Americans. And for a business or household, budget constraints are a matter of common sense (even though we don’t always adhere to them). But there is no budget constraint on a government that can create money, i.e., non-interest bearing debt, out of thin air. The only meaningful constraint to the level of non-interest bearing debt is inflation, which occurs when a government creates more money than the economy requires, causing its non-interest bearing debt to lose value against most goods and services. Thus, while it may score some political points (thanks to our primary educational system’s lack of a financial and economic curriculum?), it’s absurd for the president to embrace the common sense that households and businesses use in setting budgets. The federal government faces an entirely different kind of budget constraint.

Instead, given the government’s power to create money, common sense would hold that the amount of money supplied to the economy should be equal to the amount of money required by the economy (please note, this simplification is not an attempt to resurrect the policy prescriptions of old school monetarism). Thus, the proper approach to budgets at the federal level is to ask whether there is currently a surfeit or deficit of USDs in our economy. Given the number of private financial commitments that were entered into in the past decade, and dramatic declines in economic activity, it’s difficult to argue that there’s currently a surfeit of dollars. And if recent political rhetoric is any indication, dollars are likely to become scarcer in the years ahead (it would be ironic if, instead of inflation, deflation became the motivating force behind a move away from the USD as global reserve currency).

The president did set forth some positive ideas, such as a zero capital gains tax on small business investment, capital investment incentives for companies of all sizes, and infrastructure investment. Assuming these are financed at least in part by new money creation, they would help to prevent a renewed liquidity crunch. But to the extent that they are “offset” by cuts or freezes elsewhere in the name of closing fiscal gaps and filling in budget holes, or by higher taxes on other activities, the net short term effect on the economy will be nil or worse. And like Japan, we’ll be in for our second lost decade out of two. As we’ve pointed out, leaving future generations without a “mountain of debt” sometimes means leaving them with equivalent (or greater) opportunity costs. We should strive to avoid both of those outcomes. To do so, we have to rethink the cultural common sense that debt is always and everywhere to be avoided.

From an investing standpoint, if vigorous policy actions follow the path being laid out by the rhetoric and “common sense” emanating from so many quarters, then the USD will continue to strengthen, the real economy will stagnate or weaken further, and nominal asset values will fall for all but the highest grade government paper. In that scenario, we would be lucky to tread water and leave only 16% of the country underemployed.

Mr. President, I’ll see your PAYGO and raise you a double dip recession.

RELATED READING (file under confirmation bias): 

We’re well aware that our current view of things puts us shoulder to shoulder with some members of the “loony left”, but the macroeconomics of this stuff are fairly straightforward. Our lonely wing nut sojourn continues, placing us in lockstep with one Mr. Paul Krugman: http://krugman.blogs.nytimes.com/2010/01/26/obama-liquidates-himself/.

The Fed is seeking an exit strategy from its liquidity programs and low interest rate policy. The impact of that exit can be either muted or amplified by Congressional actions. If Congress becomes hawkish, there is no reason for the Fed to do so. If they both begin tightening, it’s hello 1937: http://www.bloomberg.com/apps/news?pid=20601015&sid=aXeUAV7_bz_o

An excellent idea from Warren Mosler — a full payroll tax holiday — that has yet to fall on the radar of federal policymakers: http://moslereconomics.com/2010/01/28/tea-party-plan-for-dems-cut-to-the-front-with-tax-cuts/. Here’s how Mosler describes the cause of poor economic policymaking: “…so-called economic experts have confused themselves and their political masters with contrived explanations for the way the economy works, and their limited vision has limited the range of policy choice. The result has been a monumental economic and social disaster caused by an obvious shortage of aggregate demand. The spending power needed to make mortgage payments, car payments, and do a bit of shopping- all of which would fix the economy and end the financial crisis- just isn’t there.”

Marshall Auerback writes that “Any kind of spending cuts in the middle of the worst recession since the Great Depression is insane.  What we are beginning to see is the return of Herbert Hoover and the ‘liquidationists.’” http://www.newdeal20.org/?p=7731

Ed Harrison posts an email exchange with Auerback, in which the latter wrote: “What the US government is now in danger of repeating is taking its economy down the fast track to a double-dip recession.  With investment still flat, consumers trying to increase their saving ratio and net exports making a negative contribution to growth – the President and his advisors evidently believe the persistently high unemployment is something the private sector has to deal with.”  http://www.creditwritedowns.com/2010/01/what-president-obama-can-do-to-improve-the-economy.html. As we’ve noted elsewhere, the demographic research of folks like John Geanakoplos, Diane Macunovich, and Ajay Kapur implies that for the next decade, the U.S. private sector is not going to behave as the baby boomer decades have conditioned us to expect. Hence the case for a more activist — and just as importantly, ’self-financing’ – public sector. ‘Self financing’ today means the Federal Reserve creating the dollars that enable primary dealer banks to absorb Treasury offerings at auction via direct bids.  For that process to continue, the federal government must continue to issue debt, rather than shoveling dirt on the people and institutions that are still near the bottom of our deep ’fiscal hole’.

Jonathan Zasloff writes (TOH Krugman) that “At some point someone must make an argument for government.” http://www.samefacts.com/2010/01/politics-and-leadership/obamas-self-inflicted-lobotomy-proceeds-apace/  Why are Democrats today so afraid to make that argument? Like the health care debacle, could the lessons learned in the Clinton years be ill suited to today? As for the GOP, our take is that by harping on government in all its forms (besides those forms that help favored firms and industries collect their share of rents from the rest of us, of course), Republicans leave the door open to the development of increasingly socialist policies. In fact, if our take on the state of the private sector in the coming decade is accurate, they will practically mandate it.

State unemployment insurance tracker at Pro Publica (TOH Credit Writedowns) shows how critical federal government support currently is for many states: http://projects.propublica.org/unemployment/

George Soros thinks that premature budget tightening could be bearish for gold prices: http://www.telegraph.co.uk/finance/financetopics/davos/7085504/Davos-2010-George-Soros-warns-gold-is-now-the-ultimate-bubble.html. Reminiscent of Jon Nadler’s argument last fall against gold: http://symmetrycapital.net/index.php/blog/2009/11/a-gold-bears-comments/

Finally, in what might be a mirror image of our loney wing nut position, Bill Gross seems to be exhibiting a profound case of anti-Keynesianism: http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2010/February+2010+Gross+Ring+of+Fire.htm

Bookstaber: ‘Controlled Burn’

Rick Bookstaber put forth an interesting argument about easing debt burdens on the public and private sectors through “controlled burn” inflation. If creditors aren’t willing to take large enough haircuts, that’s pretty much what you have to do to get aggregate credit burdens to a more manageable or desirable level.

There are a lot of misperceptions around this issue. FDR allegedly devalued the dollar c. 1934 by repegging it to gold at $35, instead of the $20 that prevailed before WWI. But if you look at the historical data, the USD was powerfully deflationary in the years leading up that action. And at best, the repegging only stemmed the rate of deflation. It did not create any inflation at all. In fact, the more closely we look at the data, the more closely aligned we become with folks who argue that the New Deal didn’t go far enough.  Paul Krugman’s warning in 2008 is looking fairly prescient:

…Barack Obama should learn from F.D.R.’s failures as well as from his achievements: the truth is that the New Deal wasn’t as successful in the short run as it was in the long run. And the reason for F.D.R.’s limited short-run success, which almost undid his whole program, was the fact that his economic policies were too cautious.

[I would add that other FDR actions were too bullheaded and hasty, errors that Obama also risks repeating.]

During the recent crisis and recession, plenty of pundits argued that USD devaluation would be the order of the day. We saw some risk of that, but not as much as those who pointed repeatedly to the Federal Reserve’s unprecedented balance sheet expansion of 2008-2009, or the federal government’s enlarged deficits. That’s because those factors are meaningless if the private sector is not taken into account (i.e., the effects of monetary policy and public and private sector borrowing are not independent). If there’s intensive deleveraging and a rising desire for saving in the private sector, then expansive actions by the central bank and federal government are merely going to absorb some slack. Ony if they absorb more slack than exists will there be any risk of inflation.

Unfortunately, of late, the messages coming out of almost all political quarters is that the slack in the real economy is going to increase — and that means higher deflationary risk, and conversely to Bookstaber’s argument, rising real credit burdens. That, in turn, will lead to credit after shocks and rising unemployment. Granted, to the extent that people’s nominal income stays the same, real incomes rise in a deflationary environment, so this would be good news for pensioners, savers, and highly valued employees. But we shouldn’t overlook the real opportunity costs that deflation implies.

We see a threat of increasing slack because there’s a rising chorus of fiscal hawkishness all around us. Today, Rep. Chris Van Hollen, chairman of the Democratic caucus, told a CNBC interviewer that the government ”need[s] to get every penny back” from TARP. Yesterday, Republican Rep. Jeb Hensarling said that the election of Scott Brown was a sign that voters cared about debt and deficits (to be fair, he did mention lowering capital gains and payroll taxes, but debt and deficits seemed to be on the top of his mind). Today, a CNBC commentator referred to “your [taxpayers'] money” leading into a report on pending transportation spending. Policymakers are treading the line between semi-sensibility and madness.

First, Congress and the Administration should look forward. That requires changing the regulatory framework in a way that will prevent excessive systemic fragility in the future, and that’s the direction that Obama laid out in his remarks yesterday, with Paul Volcker, who imposed a massive deflationary contraction as Fed chairman in the early 1980s,  smiling in the background. But all else equal, this will lower overall credit capacity, and demanding full repayment of TARP will will make it worse. In order to avoid a double dip, the federal government has to act as the borrower of last resort, i.e., run larger deficits. To us, that’s the real problem with the path being laid out by Obama and Democratic leaders — taking with one hand, and not giving with the other, means economic contraction, all else equal.

Second, debt and deficit hawkishness could not be more untimely. We should pay serious attention to where and how public expenditures are directed, but we need to be honest about the need for significant deficit financed expenditures. Looking at underlying demographic structure, we probably shouldn’t concern ourselves with lowering the federal debt until the end of this coming decade.

Finally, the dollar is ”our money” in the sense that we use it to pay our tax liabilities to a government that has monopoly power to create it. Better yet, it creates it out of thin air (yes, if that power is abused or misused, it can lead to inflation, even hyperinflation, but the risk of such an outcome right now is very, very low). If fiscal policy does indeed swing in a more hawkish direction, then there’s going to be a surfeit of monetary units. And the more we taxpayers or our elected representatives grab for ”our money”, the worse it’s going to get. This ‘chartalist’ view is also somewhat complicated by the fact that our money creation process is controlled by the quasi-public Federal Reserve system. That means that the federal government can only issue interest bearing debt to finance its deficits. It sells those securities to primary dealer banks at auction. And the primary dealers rely on the Federal Reserve system to create the monetary units (the non-interest bearing debt of the U.S. government) that are used to purchase its interest bearing debt.

Keeping those last three sentences in mind, consider that:

• The President intends to tighten the tax and regulatory collars on the banks
• Fed Chairman Bernanke’s confirmation by the Senate is now in serious doubt
• Government spending and investment are especially critical in this recession (see here and here)
• Policymakers are clearly signalling that they’re going to get serious about “fiscal responsibility” 

The clear implication is that USDs are more likely to increase in value. So while Rick Bookstaber is right about the ability of inflation to lower existing debt burdens, it looks to us like we’re headed in the opposite direction, at least for now. The consequences will be discouraging to just about everybody.

URLs:

http://rick.bookstaber.com/2010/01/controlled-burn-inflation.html

http://www.aei.org/article/26390

http://www.nytimes.com/2008/11/10/opinion/10krugman.html

http://research.stlouisfed.com/recession/gdpdata.html

http://research.stlouisfed.com/recession/indicators.html