Now For The Hard Part...

The past couple of weeks have felt vaguely comforting: stocks rose, some economic data, both here and abroad, seemed a bit less dire than it could have been, the government appeared to be getting a handle on the banks and - more importantly - came up with a plan for regulation of derivatives that finally showed leadership, ditching the fiction in place since 2005 that industry-led efforts would be sufficient to ensure proper market functioning. After the ravages of the post-Lehman months, the global economy heaved a sigh of relief.

But the relief won't last. Already, the first signs of problems (slowing Chinese exports, plunging U.S. retail sales, desperately bad numbers from the euro zone, not to mention a realization that the banks remain a possible source of more instability) are hurting sentiment. We're now finding out that the landscape at the bottom of the cliff is not exactly a hospitable place. It's strewn with large rocks, and it's very hard to see what lies behind those boulders. It's not at all what we are used to - as citizens, investors and policy makers. It's one thing to see a slow, gradual recovery - that at least implies progress, even if only at snail's pace - and devise policy accordingly. It's another to plot policy for a course that goes round in circles at times, heads up, then down again, and occasionally runs into dead ends.

But critics of the massive deficits and the Federal Reserve's monstrously inflated balance sheet have smelled blood. It's true the Fed and the government are taking a massive gamble, and if things don't pan out, the fallout could be extremely painful for many, many generations to come. But those who want the Fed to start shrinking its balance sheet and the government to cut spending now live in cloud cuckoo land. They fail to understand how much leverage still has to come out of the U.S. system - not just at banks and households, but also at corporations (remember, the years preceding the crisis saw massive LBO activity, shareholders clamoring for buybacks, and several mergers - not just in the auto industry - that shouldn't have happened.) The global economy is showing extreme strains as it tries to adapt to U.S. consumers' new-found frugality. The tried and trusted method of exiting a recession through exports doesn't work in a world where financing is scarce and demand even scarcer.

We must not forget that this is a financial and an economic crisis - on a global scale. In this case, the past is really no guide to the future. Storm clouds are already gathering once again - it's another two weeks to June 1, the deadline for GM. Even if the U.S. economy manages to weather that event, it would be premature to think that our problems are over. The inflection point spied by some policy makers could yet turn out to be but a short-lived reprieve.

What To Expect From The Fed On Wednesday

The Federal Reserve's rate setting committee meets on Wednesday - what should we expect from the statement? It's unlikely to be as explosive as the March 18 one (when despite clear signals to the contrary - including a very definitive statement by New York Fed President Bill Dudley 10 days earlier - the FOMC opted to significantly ramp up its mortgage purchase program and to start buying Treasurys to manipulate the yield curve); it could sound a little bit less concerned on the economic front, if the Beige Book and Fed Vice Chair Donald Kohn are anything to go by (but see above, one might want to be careful when reading Fed tea leaves.)

The Treasury market is inclined to push yields higher and test the Fed's mettle - already Friday, the 10-year yield briefly poked its head back above the 3% mark. The thinking is that the Fed will have to buy more than $300 billion worth of government debt to keep long-dated yields in check - and though the consensus seems to be for now that policy makers won't want to announce an expansion of the program, we've learnt our lesson on that (see once again above).

What's more, there are good reasons why the Fed might want to announce an expansion of its purchases now: if policy makers do see some kind of stabilization in the economy, why not double down and make sure the 10-year yield stays below 3% to ensure it stays that way? That's particularly as the consumer remains the weakest link: job losses will continue to rise - April's unemployment rate could touch 9% (it was 5% in April 2008, just for comparison) - and don't be fooled by those who say jobs are a "lagging indicator". That's only a comfort when there's another source of demand (typically exports) that can help get the economy growing again - but remember, this time, we're in a synchronized downturn so that historical leg of recovery won't be of much help.

A freaked-out consumer, terrified of losing his/her job, a global economy mired in a lack of demand - maybe adding another $750 billion to its Treasury purchase program might not be the worst thing the Fed could do.

A High-Stakes Gamble, In China and the U.S.

A long post on China Financial Markets brings a timely reminder not to get too euphoric about the recent turbo-charged economic numbers - everything from bank lending to car sales took a big jump in the first quarter - regardless of the official cheerleading. Key to whether China's economy is really recovering is whether all that money is creating jobs. Hard to know - but as the blog points out, even among officials there is the realization that the stimulus plan's impact could be temporary and a second round could still be necessary.
Meanwhile, in the U.S., talk of a second stimulus package - mooted as recently as in February - has all but withered away as the economy appears to have stopped falling in a straight line. That's no grounds for complacency, though - while China might see a W-shaped recovery, the risk in the U.S. is an L-shaped one (though U remains the favored forecast, for now).
China needs, as CFM notes, to see more private than public sector growth - but that doesn't seem to be happening, if the numbers quoted are correct. It still needs a prospering export industry, even as it seeks to reduce its dependency on foreign demand and become more reliant on domestic consumption. All the while, there's the issue of its massive foreign exchange reserves and how to manage them.
The U.S. problems are just as daunting: it has to do the reverse of the Chinese - reduce consumer demand and become more competitive in the global market place; it also has to reduce the share of its financial industry (which even last year accounted for 28% or so of domestic corporate profits) in the overall economy and find something to replace the lost business with. As consumer demand shrinks, Americans' reliance on debt should also diminish - doing away with the need for the securitization markets which lie at the heart of the financial crisis and which the authorities seem hellbent on restoring - even though if we've learnt one thing, it's the fallacy of the grandiose notion of democratizing credit.
The point is this: the Leviathans of the global economy - China and the U.S. - are both facing wrenching structural changes. Both governments are working on making the changes bearable and limiting the pain to their populations, but let's be realistic: it's a high-stakes gamble - there are no blue prints; plus the sobering thought that the last time we got out of a similar economic desaster, the world was engulfed in warfare.

Is The PPIP Pure Piffle?

Pity Timothy Geithner - it seems that no plan that bears his imprint will ever meet the approval of the nattering nabobs. At least today, he has the comfort of having won the blessing - albeit temporary - of the markets.

But is his plan as bad as the critics claim? Does it really fail to address the key issue, as some say -namely that it's the state of the banks as a whole, not that of certain groups of assets (home loans, commercial real estate etc.) that needs to be addressed? That some banks are just in such bad shape that they need to be nationalized, then wound down - and that the Treasury's public-private investment program is just postponing the day of reckoning?

What the critics overlook is that the financial markets are still a train wreck. True, the stock market is up. Also true, investment-grade bond issuance is at a record for the current quarter. But equally true is that Asian investors have packed up and left the mortgage-backed securities market - and they aren't about to return. Private label mortgages - ones not guaranteed by the government in the form of Fannie Mae or Freddie Mac guarantees - are moribund, commercial real estate is in dire state - and a lot of those loans and securities sit on bank balance sheets. We aren't out of the woods yet; it's just that the markets that are visible have picked up some. And let's not forget the reason for that wasn't pontificating, it was vigorous government and central bank action. Meantime, starved of the oxygen of finance, the global economy is heading toward a full-scale recession this year.

So the Geithner plan is first and foremost a plan to help restart markets that, more than 18 months into the crisis, are still not working (remember, it was the early August 2007 admission by BNP that it was temporarily freezing three investment vehicles because it wasn't possible to value the asset-backed securities these vehicles held that got the ball rolling) and are doing untold harm to the economy. The key goal is to get private capital moving again.

Certainly, the signs are auspicious for the one leg of the Treasury's plan, the auction process for wholesale loans held by banks. As to the other leg, the one dealing with securities backed by home loans and commercial real estate loans, that will take a while to get going. But what the plan does do is get the credit machine rolling again. It will help the banks too, chiefly by buying them time to get their house in order.

Some banks could still fail - we are still in the thick of the woods. It's to be hoped that Congress makes good use of the room that Treasury has created to come up with a legislative framework for the bankruptcy and unwinding of a large financial institutions. It's been a year since Bear Stearns hit the skids - and the absence of such a framework became painfully obvious.

Downsizing The Global Economy

Reading about AIG bailout number 3, I was struck by the end to a column by BusinessWeek's Diane Brady, who wrote: "The former $100 billion-a-year giant will be smaller, humbler, and less of a force in the marketplace." AIG is in good company - what we are currently seeing is a downsizing of the global economy as a whole. This is not just a temporary phenomenon; the explosion of growth and consumption of the past decade was just as unsustainable from a financing perspective as it was from a climate-change viewpoint.

Here's what I mean: The chief economist of CIBC wrote Monday in a note that the problem with the U.S. carmakers is not that they make the wrong cars, but that they make too many of them. He thinks that in five years time, there will be 25 million fewer cars on the road in the U.S. and that the companies need to shrink to reflect that much smaller market.
Same thing with housing: prices keep declining because there is too much housing stock around, while the pool of people who can and want to buy keeps shrinking. It's similar on a global scale: Chinese textile factories are making too many socks and T-shirts, Swiss watchmakers too many watches, everybody wants more, expects better living standards, more consumption. We have long known that this life style is not sustainable, now we are learning that it isn't financeable either.

Recovery will come when supply and demand find a balance again, but that will be at a much lower level than policymakers appear willing to accept (though planet Earth for one will probably heave a great sigh of relief.) At the moment, all efforts are aimed at restoring what we had before by helping to restart lending. Those trillion-dollar efforts are aimed, particularly in the U.S., at restarting home and consumer lending; at silencing the populist cry that the banks must be fixed so that they can lend again. Credit card companies and shaky auto finance companies turned themselves into bank holding companies and got TARP money - all in the name of restarting lending and helping the economy back on its feet.

These efforts will all be in vain: the grand credit machine of the pre-August 2007 world cannot and should not be resuscitated. It died because it was unsustainable. We should not seek to bring it back to life; the democratization of credit - as one banker once boasted - is nothing but a chimera. The global economy will shrink, and the shrinkage will be led by the developed world, because it was the developed nations that gorged on too much easy credit. Those in the developed world that didn't - the Germans and the Japanese - allowed their addiction to exports to blind them to the necessity of structural reform. Moreoever, much of the developed world's credit addiction was fueled by the surplus funds that other, more frugal countries, had piled up. They too will discover that hoarding reserves cannot replace sustainable domestic development.

Much has been made of the wealth that has been destroyed by the Dow's downward spiral which took the index today back to levels not seen since 1997. We should remember that much of this wealth was not real, but conjured out of the thin air of securitization plus leverage. That funny money is gone, and the world might be better off if it never comes back.

Business As Usual Is Not An Option

Ben Bernanke, our unruffled Federal Reserve chairman, was asked today whether spending trillions of dollars is the right answer given that it was overspending that got us into trouble in the first place. And his answer was clear - but also goes to the heart of the widespread unease that many feel right now: We cannot afford not to spend. Without aggressive measures, the downturn will become much worse. We need to get through this crisis, then only can we start talking about being fiscally responsible. For sure, there has to be a plan to address the ballooning budget deficit; but now is not the time to be prudent - and he cited St. Augustine's famous "God let me be moral - only not just right now."


The rub with this though is that St. Augustine knew what he had to achieve, and more importantly, what he had to do to fulfill God's demands. It was more or less in his own hands. But it's far from obvious that any of the world's governments have any coherent notion of how to get to the blessed state of sustainable deficits, both external and internal. We need to rethink the premise of a global economy that is driven chiefly by consumer spending in the largest economy, the U.S. Rebalancing the global economy will require the U.S. to curb consumption and invest more in education, transportation, clean technology and many other areas that have been neglected in the past decades. Japan, China and Germany (numbers 2-4 of the global economy) must wean themselves off the exporting fix - these economies must find a way to stimulate private consumption. None of this will be achieved overnight; the scale of the challenge we are facing is daunting.

Conventional wisdom says that the housing market in the U.S. lies at the root of the current crisis - that is partly true. But a different statement would also be correct: it was the massive global imbalances that created the havoc we are now struggling to contain. The G7's conciliatory tone toward China - rather than the usual yuan bashing - was a first step; but the forum that will prove decisive in outlining the post-crisis economic order should ideally be the G20 - where emerging and developed nations come together - which next gathers in London in early April. It has been mostly a talking shop, a handy place for national grandstanding. But under the new U.S. leadership, it has to be hoped that this will change, because we cannot emerge on the other side of the crisis with the same or similar imbalances in the world economy. We cannot afford business as usual.

Wanted: Philosophers, Writers, Thinkers

Are we in danger of losing sight of the forest for all the trees? The long-term view is that the global economy has entered a lengthy period of painful adjustment, but we, the human actors in the economy, have yet to fully grasp what this means: a profound change in the way our society works. This is not about right or wrong, socialism versus capitalism, optimist versus pessimist. This is about the intellectual foundations that underpin society and the economy - both of which are forms of human activity based on a common understanding of and agreement on goals, and on the path to take to achieve these goals.

Both are up for renewal, need a rethink - and the new definitions should not be left to the cable talk shows or businesspeople, the World Economic Forum, and economists, no matter how many Nobel prizes they may have won collectively. It is time we recognize not just that an inordinate desire for wealth and riches, a poverty of ideas and ideals, have brought the world to the brink of collapse and will levy a hefty price on us all, but mainly on the poorest of this world. We must also recognize that those who led us down this path - the proponents of efficient markets, small government, the dominance of profit as society's leitmotiv, the peddlers of false slogans backed by seemingly unshakeable historical trends (such as: there has never been a nationwide decline in U.S. house prices) - are snake oil doctors at worst, fallible humans at best and that no one has any claim to superior wisdom or special insights (not even Warren Buffett, as he would be the first to admit).

Now is the time for the philosophers, the writers, the thinkers rather than the pontificators to step to the fore, to remind us that the pursuit of happiness means more than three cars and a luxury condo in Miami, that future generations have an inalienable right to an inhabitable world, that upholding human rights must trump business interests. Those are the gauges by which we must measure the success of the trillions of dollars that the U.S. alone will spend to right the economy and return the financial system to health. If we end up where we were before the crisis (unaffordable education, lack of healthcare for many, wretched public transportation, and more generally, an "every man for himself" attitude), the money will have been spent for naught.

It was the recognition by 52% of U.S. voters that going backward was not an option that carried Barack Obama to the presidency - now he must keep the country (and more importantly, a Congress cocooned in a palace of smoke and mirrors) on this path. The success of the nearly $800 billion stimulus package will only be partly determined by the number of jobs saved or created, the statistics that measure the state of the economy - even if these will garner all the attention. It will be determined mainly by the progress made toward a new understanding of what binds society as a whole. The gauntlet has been thrown down; it is ours to pick up and meet the challenge.

Beware The Cheerleaders

The search is on for a silver lining - see today's NYT (Jan 3, 2009), which managed to juxtapose "Stocks Rally, Will January Be An Omen?" and "Manufacturing Suffering In All Corners" in a feat of considerable irony, to name but one. We'd all do well to reread The Great Crash by JK Galbraith as a reminder of how the desire to see an upturn just around the corner blinded so many of the socalled experts and reporters (the book also has a fine Madoffian cast of crooks and criminals, speculating bankers - and accords leverage a prime role in the crash - a blueprint for the events of 2008...)

Let's not forget that without massive infusions of cash from the Fed and the government, there would be no markets at all for anything except U.S. government bonds. Mortgage rates are only so low because the Fed said it would buy this year's entire net new supply of mortgage-backed securities; I've given up trying to count the number of times a recovery in the commercial paper market - where only highly-rated companies can borrow anyway - has been forecast - it's been on life support for the past three months, and is likely to stay on life support from the Fed for the whole year. The Treasury announced a program Friday that implies it will guarantee any bank's bad debts - along the lines of the Citigroup rescue. The government bond market is wondering who on earth is going to buy $2 trillion of supply - there are already more than $5 trillion outstanding.

The world is coming off a massive debt binge - and yes, it is a global issue: the big export nations were just living off the U.S. consumers' reckless spending. Rebalancing the global economy is going to take much longer than six months - and any recovery in the economy, so necessary for a sound basis to any longer-term uptrend in stocks, is going to be a messy, volatile process. The big difference this time around lies in the interconnectedness of all markets across all regions, and the complete breakdown of the financial transmission mechanisms - trade finance has evaporated. How the wealthy Asian exporters and the large oil exporting nations weather the current storm matters a lot more than it did in the 1980s - they're the ones with current account surpluses that need to be reinvested, but some of them also face very fragile domestic outlooks. The euro doomsayers will be proven wrong, but that doesn't mean there won't be strains in the euro zone, the European Union and neighboring countries. Russia is walking a tightrope, yet again.

Rather than hunting around for silver linings on the basis of one day's trade, we might do better to seriously consider just how much it is going to take to resolve this mess - in terms of global political leadership, government spending and sheer luck.