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Daily Archives: December 17, 2008

David Rosenberg interview

David Rosenberg, Chief economist at Merrill Lynch (now part of Bank of America) talks about the Fed’s ZIRP (zero-interest-rate-policy) and the outlook of the housing market. He says Fed’s and government policies just set a cushion to the blow; nothing is guaranteed to work and this recession is nothing like post-War recessions.

David Rosenberg has been a long-time bear; but his predictions so far were all proved correct.

By the way, Rosenberg said days ago, “We are already in a Japan-like lost decade”.

2x (3x) ETFs and Last-hour Voloatility

Courtesy of Bespoke Investments:


WSJ’s analysis on the same story:

Fed’s balance sheet management

In the latest FOMC meeting announcement, the Fed stressed the need of using its balance sheet as one of the tools to stimulate the economy. Let’s look at the Fed’s balance sheet then in September, October and now.

I bet every central bank facing deflation threat in the world will one way or another print the money. I agree deflation is a bigger threat now, but I am just worried how we will get out of this mess, say 2-5 years from now — Global inflation???

Mankiw: time to abandon ‘price stability’

Fear of deflation outweighs fear of inflation.  Greg Mankiw suggests the Fed to abandon 'price stability' in its policy goals.  Radical. 

From his blog:

With the Fed having cut its target interest rate today to a range of zero to 1/4 percent, many people will be asking whether the central bank has run out of ammunition. A good question. Obviously, the next step is not going to be further cuts in the federal funds rate. But there is still more the Fed can do.

Notice this passage in the Fed's press release (emphasis added):

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

The phrase "for some time" is aimed at managing expectations in order to keep long-term interest rates down.

The next step for the Fed is to drop the "price stability" rhetoric. The Fed has never been truly committed to stable prices. After all, inflation during the Volcker-Greenspan era averaged about 2 to 3 percent. The Fed could have lowered inflation to zero if it had wanted. Now that zero, or even below zero, is a possibility, the Fed needs to convince people that we are going back to the normal inflation rate of 2 to 3 percent.

Let me suggest this wording for the Fed's next press release:

The Committee recognizes that moderate inflation would be desirable under the present circumstances. In particular, the overall level of prices a decade hence should be about 30 percent higher than the price level today. The committee anticipates keeping the stance of monetary policy sufficiently accomodative to achieve that degree of inflation over the coming decade.

That is, even if the Fed cannot reduce nominal interest rates, it can reduce real interest rates by committing to a modest amount of inflation.

Some would view this as a radical change in monetary policy. In some ways, it would be. Given how weak the economy is, however, a bit of radicalism may be called for. I am more comfortable having the Fed commit itself to modest inflation than having the federal government commit itself to a trillion dollars of new spending. The more we can rely on monetary rather than fiscal policy to return the economy to full employment and sustainable growth, the better off future generations of taxpayers will be.

The abandonment of "price stability" would be the modern equivalent of Roosevelt's abandonment of the gold standard. Of all the things that Roosevelt did to get the economy out of the Depression, jettisoning the gold standard was the most successful. Today, monetary policy is fettered not by gold but by fear of inflation. Perhaps it is time is get over that fear, at least for a while. As Jim Tobin said in an earlier era, there are worse things than inflation, and we have them.

U.S. and China: two countries, one system.

Tom Friedman has a witty piece on today's NYT.  For years, the rest of the world looked America for leadership. Now America is in big trouble, who is there to look to for exemplary leadership? 

The stranger, a Western businessman, slipped into the chair next to me at an Asia Society lunch here in Hong Kong and asked me a question that I can honestly say I’ve never been asked before: “So, just how corrupt is America?”

His question was occasioned by the arrest of the Wall Street money manager Bernard Madoff on charges of running a Ponzi scheme that bilked investors out of billions of dollars, but it wasn’t only that. It’s the whole bloody mess coming out of Wall Street — the financial center that Hong Kong moneymen had always looked up to. How could it be, they wonder, that such brand names as Bear Stearns, Lehman Brothers and A.I.G. could turn out to have such feet of clay? Where, they wonder, was our Securities and Exchange Commission and the high standards that we had preached to them all these years?

One of Hong Kong’s most-respected bankers, who asked not to be identified, told me that the U.S.-owned investment company where he works made a mint in the last decade cleaning up sick Asian banks. They did so by importing the best U.S. practices, particularly the principles of “know thy customers” and strict risk controls. But now, he asked, who is there to look to for exemplary leadership?

“Previously, there was America,” he said. “American investors were supposed to know better, and now America itself is in trouble. Whom do they sell their banks to? It is hard for America to take its own medicine that it prescribed successfully for others. There is no doctor anymore. The doctor himself is sick.”

I have no sympathy for Madoff. But the fact is, his alleged Ponzi scheme was only slightly more outrageous than the “legal” scheme that Wall Street was running, fueled by cheap credit, low standards and high greed. What do you call giving a worker who makes only $14,000 a year a nothing-down and nothing-to-pay-for-two-years mortgage to buy a $750,000 home, and then bundling that mortgage with 100 others into bonds — which Moody’s or Standard & Poors rate AAA — and then selling them to banks and pension funds the world over? That is what our financial industry was doing. If that isn’t a pyramid scheme, what is?

Far from being built on best practices, this legal Ponzi scheme was built on the mortgage brokers, bond bundlers, rating agencies, bond sellers and homeowners all working on the I.B.G. principle: “I’ll be gone” when the payments come due or the mortgage has to be renegotiated.

It is both eye-opening and depressing to look at our banking crisis from China. It is eye-opening because it is hard to avoid the conclusion that the U.S. and China are becoming two countries, one system.

How so? Easy, in the wake of our massive bank bailout, one can now look at China and America and say: “Well, China has a big-state-owned banking sector, next to a private one, and America now has a big state-owned banking sector next to a private one. China has big state-owned industries, alongside private ones, and once Washington bails out Detroit, America will have a big state-owned industry next to private ones.”

Yes, an exaggeration to be sure, but the truth is the differences are starting to blur. For two decades, a parade of U.S. officials came to China and lectured Beijing on the necessity of privatizing its banks, said Qu Hongbin, the chief economist for China at HSBC. “So, slowly we did that, and now, all of a sudden, we see everybody else nationalizing their banks.”

It’s depressing because China in many ways feels more stable than America today, with a clearer strategy for working through this crisis. And while the two countries are looking more alike, they appear to be on very different historical trajectories. China went crazy in the 1970s, with its Cultural Revolution, and only after the death of Mao and the rise of Deng Xiaoping has it managed to right itself, gradually moving to a market economy.

But while capitalism has saved China, the end of communism seems to have slightly unhinged America. We lost our two biggest ideological competitors — Beijing and Moscow. Everyone needs a competitor. It keeps you disciplined. But once American capitalism no longer had to worry about communism, it seems to have gone crazy. Investment banks and hedge funds were leveraging themselves at crazy levels, paying themselves crazy salaries and, most of all, inventing financial instruments that completely disconnected the ultimate lenders from the original borrowers, and left no one accountable. “The collapse of communism pushed China to the center and [America] to the extreme,” said Ben Simpfendorfer, chief China economist at Royal Bank of Scotland.

The Madoff affair is the cherry on top of a national breakdown in financial propriety, regulations and common sense. Which is why we don’t just need a financial bailout; we need an ethical bailout. We need to re-establish the core balance between our markets, ethics and regulations. I don’t want to kill the animal spirits that necessarily drive capitalism — but I don’t want to be eaten by them either.

Fed cut rates to almost ZERO

Fed's earlier announcement (highlights are mine):

The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent. 

Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined.  Financial markets remain quite strained and credit conditions tight.  Overall, the outlook for economic activity has weakened further.

Meanwhile, inflationary pressures have diminished appreciably.  In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability.  In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time. 

The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level.  As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant.  The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities.  Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.  The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Christine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 75-basis-point decrease in the discount rate to 1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Cleveland, Richmond, Atlanta, Minneapolis, and San Francisco.  The Board also established interest rates on required and excess reserve balances of 1/4 percent. 

Economist's reactions:

Economists React: 'Who Could Ask for Anything More?'

  • Today's FOMC statement will go down in the annals of Fed history along with Paul Volcker's Saturday announcement going to reserve targeting in 1979. Volcker's press conference was called the "Saturday Night Massacre." I nominate this one to be called the "Who Could Ask for Anything More?" statement. The Fed is throwing everything in its arsenal at the economic/financial situation. –Stephen Stanley, RBS Greenwich Capital
  • The core was restrained The FOMC statement was more aggressive than anticipated, indicating that policymakers "will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability." The vote was unanimous. In our view, here are the three most surprising aspects of the statement: 1) The official target rate was reduced all the way to 0.0% to 0.25% (let's call it 0.125%)… 2) A conditional commitment to keep the policy rate low "for some time." … 3) An indication that the Fed is considering the purchase of long-term Treasuries." –David Greenlaw, Morgan Stanley
  • In practical terms, the decision to slash the target rate will do almost nothing to boost economic activity. However, it does send a strong message to the markets that the Fed means business, particularly when combined with the commitment to leave rates at near zero for some time. With official interest rates now as close to zero as they are going to get, the Fed's focus has already switched to quantitative easing. –Paul Ashworth, Capital Economics
  • So here we are: Rock bottom. We take no satisfaction from the vindication of our view that one basis point is the right rate for the U.S; it is a reflection of an utterly desolate economic picture, which will persist for the foreseeable future as the wrenching adjustment in household finances continues… The Fed's objective now is to "employ all available tools" to fix the economy… If zero rates don't work, they will try anything; good. But this is a terrible, chastening day. –Ian Shepherdson, High Frequency Economics
  • Assuming that fed funds will not trade below 0%, there will be no interest rate constraint on accelerating the pace of the Fed's balance sheet expansion. Rather, the 0.25% upper end of the target range will be serve as a ceiling, proximity to which will signal that more aggressive liquidity infusions are warranted. –Alan Levenson, T. Rowe Price
  • The action taken today and the quantitative easing moves to come speak volumes about just how petrified policymakers are that the economy is in danger of sliding into a deflationary spiral that would be disastrous considering the highly leveraged condition of the economy. Monetary policy is going to do whatever it can to try to avoid this outcome, and further substantial fiscal stimulus is also in the works. –Joshua Shapiro, MFR Inc.
  • The Federal Reserve wants to stabilize the financial system and prevent the economy from a deeper and protracted recession. It also is trying to make sure that the probability of a debilitating deflation is very low. However, this type of unconventional monetary stimulus has risks. Even though inflation is in remission for now, there is a meaningful risk of an inflation bubble later, especially if the central bank is successful in stimulating the economy. For now, Helicopter Ben has to put out the big fire and worry about the inflation bubble later. –Sung Won Sohn, Smith School of Business and Economics
  • The Fed has signaled that it is formally switching to a quantitative easing strategy that will further increase the size of its balance sheet. The Fed suggested that it would potentially up-size its purchases of GSE debt (currently set at $100 billion) and Agency MBS (currently set at $500 billion) and that it will roll out the Term Asset-Backed Securities Loan Facility in early 2009. The Fed also said that it is weighing the benefits of purchasing long-dated Treasuries—though we judge this step is still an unlikely one for the Fed to take (since it is trying to narrow the spread between MBS and Treasuries). Support for economic growth needs to come from fiscal policy at this point and we expect passage of a massive stimulus package in the first quarter of 2009. –RDQ Economics
  • The cause of rising income inequality

    Source: the NBER Digest

    It's one of the biggest socioeconomic questions in America today: Why is income inequality rising in the United States, especially between the top 10 percent of workers and everybody else? In Controversies about the Rise of American Inequality: A Survey (NBER Working Paper No. 13982) , authors Robert J. Gordon and Ian Dew-Becker provide a comprehensive survey of seven aspects of rising inequality that are usually discussed separately: changes in labor's share of income; inequality at the bottom of the income distribution, including labor mobility; skill-biased technical change; inequality among high income groups; consumption inequality; geographical inequality; and international differences in the income distribution, particularly at the top.

    They conclude that changes in labor's share of income play no role in rising inequality of labor income: by one measure, labor's income share was almost the same in 2007 as in 1950.

    However, there are gender differences in income inequality: between 1979 and 2005, for example, the income gap between women working for the median wage (the 50th percentile) and low-earning women (at the 10th percentile) grew much more than it did for men at those income levels during the same period. That suggests that the decline in the real value of the minimum wage over that time played a causal role, the authors argue. That's not surprising, in one sense, since women are, roughly speaking, twice as likely to work for the minimum wage as men are.

    If women were more affected by the minimum wage, men bore the brunt of the decline in unionization over the least three decades, the survey finds. One study the authors cite suggests that the fall in organized labor's share of the workforce can explain 14 percent of the rise in the variance among male wages between 1973 and 2001 (but it had no apparent effect on the variance of female wages).

    There is little evidence on the effects of imports. And, the ambiguous literature on immigration implies a small overall impact on the wages of the average native-born American, a significant downward effect on the wages of high-school dropouts, and a potentially large impact on previous immigrants who work in occupations in which immigrants specialize.

    The authors introduce two new issues, disparities in the growth of price indexes and in life expectancy between the rich and the poor. "While the poor may do better when price indexes are corrected, they do much worse when their health outcomes are considered," the authors write. They cite evidence that between 1980 and 2000 the life expectancy of the bottom 10 percent of earners increased at only half the rate of the top 10 percent. "This may be the most important single source of the increase in inequality in the United States, and it combines not only unequal access to medical care services and insurance, but also to differences in personal habits and environment related to education and income," the authors conclude.

    The most controversial section of the survey looks at the question of why the rich have gotten so much richer. In a 2005 study, the authors found that the top 10 percent of earners saw their share of overall income rise from 27 percent in 1966 to 45 percent in 2001. But that study also documented that fully half of that increase came from the relative gains made at the very top of that spectrum – those at the 95th percentile and above. That study also distinguished between "superstars," whose incomes were market-driven, and CEOs, whose incomes were "chosen by their peers." In their new survey, the authors carve out a third group – high-income professionals, especially lawyers and investment bankers, whose pay is market-driven but who don't enjoy the benefits of "audience magnification," whereby the superstars can fill entire arenas or sell recordings to millions of people. Their point: income inequality is growing even among the top 10 percent of earners as the superstars an! d CEOs increase their pay faster than lawyers and investment bankers. But at least the pay of the superstars, lawyers, and investment bankers is market-driven. The pay of CEOs is not.

    Their review of the CEO debate places equal emphasis on the market, in showering capital gains through stock options, and an arbitrary management-power hypothesis based on numerous non-market aspects of executive pay. "CEOs, through compensation committees and inbreeding of boards of directors, have a unique ability to control their own compensation," the authors write. "Furthermore, if a director approves a higher compensation package, that may subsequently lead her to receive more compensation at her own firm."

    They cite one study of 1,500 firms that found that the compensation earned by the top five corporate officers in 1993-5 equaled 5 percent of their firms' total profits during that period; by 2000-2, that ratio had more than doubled to 12.8 percent. The trend was caused in equal parts by arbitrary pay decisions by corporate boards and by the showering of stock options on CEOs, they conclude.

    Furthermore, the survey cites a study showing "ample evidence that firms work to disguise the magnitude of CEO pay," such as lifetime healthcare, below-market-rate loans, and above-market-rate loans when CEOs defer their compensation, to lessen shareholder outrage. Such research "is important because it tells shareholders what to expect and where their outrage constraint should be set," the authors write.

    This skewing of pay at the very top in the United States contrasts with other countries, especially Japan. There, the income share of the top 0.1 percent peaked at 9.2 percent in 1938, reached stability of close to 2.0 percent after 1947, and ended up at 1.7 percent in 1998. Initially, America also saw an initial peak (8.2 percent in 1928) fall to a low (1.9 percent in 1973). But then the income share of America's top 0.1 percent rebounded (7.3 percent in 2000). Canada and the United Kingdom mimicked the U.S. pattern, though their most recent upturns were less dramatic. France, like Japan, has seen the income share of its very top earners stay quite stable since the mid-1940s.

    Why the disparity? America's CEOs have had their pay inflated by generous stock options and having their pay set by peers on corporate boards, the survey finds, as well as institutional differences between the United States and other nations, including such things as regulations, unions, and social norms.