“The recession isn’t over”

Martin Feldstein interviewed on Bloomberg Radio 17/12/2009

In our opinion, there was nothing in today’s US Labor Department statistical release to cause the esteemed Harvard Professor to change his views. Moreover, the statistics offered little cheer to those pundits in the recovery camp who have been predicting a swift V-shaped upturn in response to the Fed and Treasury’s unprecedented Monetary and Fiscal stimulus. Indeed, the drop in  payrolls of 85,000 and the record-setting decline in consumer credit also reported today, only served to reinforce the calls of unrepentant Keynesians such as Paul Krugman who have been calling for another vast round of fiscal stimulus. Does this advice make any sense when there is no evidence whatsoever that monetary expansion and government spending programs can cure the ill effects of past financial excesses?

Instead, we have to ask ourselves is whether, by applying massive stimulus, the Fed and Treasury have built a “Roach Motel” (i.e. you can get in, but you cannot get out!) for themselves in terms of the vulnerability of the US economy to new shocks and their future policy flexibility; rather than setting the stage for a durable and reasonably robust recovery.

 Chief among our concerns is that the vast increase in the Fed’s balance sheet has seriously compromised the independence of the central bank. In this regard we note that every hyperinflation in history has featured situations where (a) the central bank has meddled with private sector financing decisions (beyond the setting of the policy rate) and (b) the government ran budget deficits that the political system could not remediate. We note that the entire raison d’ètre of the Fed’s new lending facilities is to redirect capital to specific perceived priorities under the general suggestion that unelected Fed officials are better able to make such decisions than the private sector. This does not square with the generally accepted view of how the world should work (unless you are living in the USSR of 1955). We also observe that  in the U.S. today, with over 100 million voters dependant on handouts from the government (food stamps, welfare, unemployment benefits and the like) there is little question that repaying the projected deficits with tax increases or spending cuts will be extremely difficult, if not impossible, politically.

 The “Super-sized” Fed balance sheet has also handicapped the Fed’s ability to fulfill its primary mission, which is promoting a stable and predictable low rate of inflation. It is easy to foresee that special interests and political pressures may make it harder to terminate the ad hoc programs in a timely manner, thus making it difficult to shrink the Fed’s balance sheet and avoid policy error.

We note further that despite the well known solvency issues at the aggregate level, in the US, banks there have been keen to pay off TARP liabilities. What seems to have escaped the attention of the mainstream media is that many of these banks are still far from having marked all of their crappy assets to market and that in the event of another shock to the system, that they may be ultimately forced to reveal the illiquid and insolvent state of their balance sheets and then turn to Fed for help yet again. We note in addition that there is now no further room to cut rates, only to inflate the money supply more.

 Back when the Fed held $900 billion in Treasuries, these were a liability of the Treasury and an asset of the Fed. In effect, the Treasury’s liability would never cost taxpayers a cent. In the present situation, the Fed has taken on significant private sector risk for which the taxpayers are potentially on the line,  distracts the Fed from its primary mission and subjects it to even more political pressures than it usually has to bear.

 Moreover, should the markets begin to suspect that because of the policy gridlock as relates to the unwinding of fiscal stimulus and the needed shrinkage of the Fed’s balance sheet, that the US will attempt to inflate itself of its debt and deficit problems, then term rates will rise very fast and very sharply. This would further complicate debt management generally for households, businesses and governments.

 Typically Sovereign debt crises are triggered when debt servicing costs as a proportion of total budget expenditures reach levels around 15-25%. By this measure the US appears OK, but that is only if one ignores the Off Balance Sheet obligations of the US Government, as the markets have been doing for some years. However numerous other nations are not currently so fortunate. We are already seeing the effects of the raids by bond vigilantes in the Baltics, the PIIGS, and central Asian countries. In these economies the “going-in” position to the GFC was far weaker than that of the more developed economies, China and the Asian Tigers. Multiple debt crises are looming, accompanied by social dislocation and political strife.

 The risks associated with Chairman Bernanke’s strategy are thus significant. Should Bernanke’s bet go wrong, the nexus of finance and politics suggests that preeminence of the US and the role of the dollar as the key international reserve currency could unravel far more quickly than anyone in the mainstream currently thinks possible. In this scenario the US could end up facing significant and more immediate challenges to its hegemony from China and its rapidly growing roster of client states as well as others. Volatility and carnage would likely follow in many investment markets throwing the Global Economy into another severe down-leg. This outcome might also very well be accompanied by military adventurism in a variety of places and an emboldened array of terrorist plotters for the US Globo-Cop to contend with simultaneously.

 In the meantime, we expect the unfolding Sovereign Debt Crisis story to remain prominent in the headlines for 2010 and beyond. PIMCO and other large scale investors recently announced that they are trimming bond exposures to the US Treasury and other government bond markets. We expect this trend to continue, pressuring rates in the belly of the US Treasury curve and beyond. For this reason we expect equity markets in most economies to experience a downward adjustment in 2010. Equities will also be pressured generally in response to downwardly revised expectations for economic growth,  top-line revenues and profits. Finally, the continuing weak economic profile and rising term rate environment will not allow banks to recapture, or begin to limit, loan loss provisions as many of them have been expecting. Our view is that most banks will likely experience even greater distress ratios in their asset portfolios and pressure on their capital cushions and efficiency ratios.

This entry was posted on Friday, January 8th, 2010 at 2:38 pm and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.