Collapsing home prices and credit markets continue to put
downward pressure on consumer spending, forcing the Federal Reserve to take
even more radical action to revive the economy.
Last week, Fed chief Ben Bernanke raised the prospect of
further monetizing the debt by purchasing more than the $1.75 trillion of
Treasuries and mortgage-backed securities (MBS) already committed. The
announcement sent shockwaves through the currency markets where skittish
traders have joined doomsayers in predicting tough times ahead for the dollar.
Foreign central banks have been gobbling up US debt at an
impressive pace, adding another $60 billion in the last three weeks alone. That�s
more than enough to cover the current account deficit and put the greenback on
solid ground for the time being. But with fiscal deficits ballooning to $3
trillion in the next year alone, dwindling foreign investment won�t be enough
to keep the dollar afloat. Bernanke will be forced to either raise interest
rates or let the dollar fall hard.
Export-led nations are looking for an edge to revive
flagging sales by keeping their currencies undervalued. But the strong dollar
is making it harder for Bernanke to engineer a recovery. He�d like nothing more
than to see the dollar tumble and reset at a lower rate. That would reduce the
debt-load for homeowners and businesses and send consumers racing back to the
shopping malls and auto showrooms.
Perception management is a big part of stimulating the
economy. That�s why the financial media have been airbrushing articles that
focus on deflation and shifting the attention to inflation. It�s an effort to
kick-start consumer spending by convincing people that their money will be
worth less in the future. But deflation is still enemy number one. Rising
unemployment, crashing home prices, vanishing equity and tighter credit; these
are all signs of entrenched deflation.
Bernanke faces three main challenges to put the economy back
on track. He must remove the hundreds of billions in toxic assets from the
banks� balance sheets, reignite consumer spending to offset the sharp decline
in aggregate demand, and fix the wholesale credit-mechanism that provides 40
percent of the credit to the broader economy.
Treasury Secretary Timothy Geithner has taken over the
distribution of the remaining TARP funds, and created a new program, the
Public-Private Investment Partnership (PPIP), for purchasing toxic
mortgage-backed assets. The PPIP will provide up to 94 percent �non-recourse�
government loans for up to $1 trillion of assets which are worth less than half
of their original value at today�s prices. The Treasury�s plan is an attempt to
keep asset prices artificially high so that the losses will not be realized
until they�ve been shifted onto the taxpayer.
Here�s how John Hussman of Hussman Funds summed up Geithner�s
PPIP: �From early reports regarding the toxic assets plan, it appears that the
Treasury envisions allowing private investors to bid for toxic mortgage
securities, but only to put up about 7% of the purchase price, with the TARP
matching that amount -- the remainder being �non-recourse� financing from the
Fed and FDIC. This essentially implies that the government would grant bidders
a put option against 86% of whatever price is bid. This is not only an
invitation for rampant moral hazard, as it would allow the financing of largely
speculative and inefficiently priced bids with the public bearing the cost of
losses, but of much greater concern, it is a likely recipe for the insolvency
of the Federal Deposit Insurance Corporation, and represents a major end-run
around Congress by unelected bureaucrats.
�Make no mistake -- we are selling off our future and the
future of our children to prevent the bondholders of U.S. financial
corporations from taking losses. We are using public funds to protect the
bondholders of some of the most mismanaged companies in the history of
capitalism, instead of allowing them to take losses that should have been their
own. All our policy makers have done to date has been to squander public funds
to protect the full interests of corporate bondholders. Even Bear Stearns
bondholders can expect to get 100% of their money back, thanks to the generosity
of Bernanke, Geithner and other bureaucrats eager to hand out the money of
ordinary Americans.� (John Hussman, �The Fed and Treasury -- Putting off Hard
Choices with Easy Money, and Probable Chaos, hussmanfunds.com)
The second part of the Fed�s plan is to fix the wholesale
credit-mechanism, which means restoring the securitization markets where pools
of loans are transformed into securities and sold to investors. Until Bernanke
is able to lure investors back into purchasing high-risk debt-instruments
comprised of student loans, mortgage securities, auto loans and credit card
debt, the credit markets will continue to sputter and growth will be flat.
Structured-debt creates the asset base which is leveraged though traditional
loans or complex derivatives. Credit expansion maximizes profit, inflates asset
prices and establishes the structural framework for shifting wealth to
financial institutions via speculative asset bubbles. This is the basic
financial model that US banks and financial institutions hope to export to the
rest of the industrial world to ensure a greater portion of global wealth for
themselves and a stronger grip on the political process.
Bernanke�s Term Asset-backed Securities Loan Facility (TALF)
provides up to $1 trillion in non-recourse loans to financial institutions
willing to buy AAA-rated debt-instruments backed by consumer and small business
loans. So far, the response has been tepid at best. For all practical purposes,
the market is still frozen. Bernanke knows that there will be no recovery
unless the credit markets are functioning properly. He also knows that the TALF
won�t succeed unless he provides guarantees for the underlying collateral,
which are loans that were made to applicants who have no means for paying them
back. Bernanke�s guarantees will cost the taxpayer billions of dollars without
any assurance that his plan will even work. It�s a complete fiasco.
From the Federal Reserve Bank of San Francisco Economic
Letter, �US Household Deleveraging and Future consumption Growth� by Reuven
Glick and Kevin J. Lansing: �More than 20 years ago, economist Hyman Minsky
(1986) proposed a �financial instability hypothesis.� He argued that prosperous
times can often induce borrowers to accumulate debt beyond their ability to
repay out of current income, thus leading to financial crises and severe
�Until recently, U.S. households were accumulating debt at a
rapid pace, allowing consumption to grow faster than income. An environment of
easy credit facilitated this process, fueled further by rising prices of stocks
and housing, which provided collateral for even more borrowing. The value of
that collateral has since dropped dramatically, leaving many households in a
precarious financial position, particularly in light of economic uncertainty
that threatens their jobs.
�Going forward, it seems probable that many U.S. households
will reduce their debt. If accomplished through increased saving, the
deleveraging process could result in a substantial and prolonged slowdown in
consumer spending relative to pre-recession growth rates. Alternatively, if
accomplished through some form of default on existing debt, such as real estate
short sales, foreclosures, or bankruptcy, deleveraging could involve
significant costs for consumers, including tax liabilities on forgiven debt,
legal fees, and lower credit scores. Moreover, this form of deleveraging would
simply shift the problem onto banks that hold these loans as assets on their
balance sheets. Either way, the process of household deleveraging will not be
painless.� (The Federal Reserve Bank of San Francisco Economic Letter, �US
Household Deleveraging and Future consumption Growth� by Reuven Glick and
Kevin J. Lansing)
The economy is in the grip of deflation. Commercial banks
are stockpiling excess reserves (more than $850 billion in less than a year) to
prepare for future downgrades, write-offs, defaults and foreclosures. That�s
deflation. Consumers are cutting back on discretionary spending; driving,
eating out, shopping, vacations, hotels, air travel. More deflation. Businesses
are laying off employees, slashing inventory, abandoning plans for expansion or
reinvestment. More deflation. Banks are trimming credit lines, calling in loans
and raising standards for mortgages, credit cards and commercial real estate.
Still more deflation.
Bernanke has opened the liquidity valves to full-blast, but
consumers are backing off; they�re too mired in debt to borrow, so the money
sits idle in bank vaults while the economy continues to slump.
In an environment where businesses and consumers are
rebuilding their balance sheets and paying off debt, there�s only one option;
inflation. Bernanke will keep interest rates low while increasing monetary and
fiscal stimulus. The ocean of red ink will continue to rise. Still, the system
wide contraction will persist despite the Fed�s multi-trillion dollar lending
programs, quantitative easing (QE) and Treasury buybacks. The �Great Unwind� is
irreversible; the era of limitless credit expansion is over.
David Rosenberg, chief economist and strategist at Gluskin
Sheff & Associates, believes that the equities markets have undergone a �gargantuan
short-cover rally� and that stocks will retest the March 9 low, which was a 12-year
low for the S&P 500 Index. Rosenberg said he doesn�t expect the economy to
recover in the second half of the year.
�I�m seeing no revival of consumer spending in the second
quarter,� Rosenberg said. (Bloomberg)
The conditions that supported the explosive growth of the
last decade no longer exist. The credit markets are in a shambles, the banking
system is hanging by a thread, and the consumer is out of gas. Traders are
clinging to the slim hope that the worst is over, but they could be mistaken.
There�s probably another leg down and it will be more vicious than the last.
Whitney lives in Washington state. He can be reached at email@example.com.