Well, well, well. Here at the Agency we have spent a couple of years waiting for the US economic establishment to go public with the Deflation / Depression Recovery Plan, what we call The Eggertsson Theory and this week we got it.

Lucky subscribers can now take solace in the fact that the author was right and the small quarterly payments were worth the effort. I can take great pleasure in saying "I told you so", not because I want to inflate my ego but because I know some people took note of what I said and prepared their portfolio accordingly. That gives me a warm feeling inside, unlike Gordon Brown I didn't "save the world" but I did help some individuals.

Enough of the touchy feely stuff and back to the subject at hand, the public announcement that you, the public, will accept the threat of inflation because it's "less painful" than any other solution.

• "May 19 (Bloomberg, Rich Miller) -- What the U.S. economy may need is a dose of good old-fashioned inflation.

  So say economists including Gregory Mankiw, former White House adviser, and Kenneth Rogoff, who was chief economist at the International Monetary Fund. They argue that a looser rein on inflation would make it easier for debt-strapped consumers and governments to meet their obligations. It might also help the economy by encouraging Americans to spend now rather than later when prices go up.

  "I'm advocating 6 percent inflation for at least a couple of years," says Rogoff, 56, who's now a professor at Harvard University. "It would ameliorate the debt bomb and help us work through the deleveraging process."

  "Anybody who has been a central banker wouldn't want to see inflation expectations become unhinged," says Marvin Goodfriend, a former official at the Federal Reserve Bank of Richmond. "The Fed would have to create a recession to get its credibility back," adds Goodfriend, now a professor at Carnegie Mellon University's Tepper School of Business in Pittsburgh.

  Bernanke, 55, said the risk of deflation was receding and that the Fed was ready to reverse course when needed to maintain stable prices and prevent an outbreak of undesired inflation. The Fed has implicitly defined price stability as annual inflation of 1.5 percent to 2 percent, as measured by a price index based on personal consumption expenditures.

  Given the Fed's inability to cut rates further, Mankiw says the central bank should pledge to produce "significant" inflation. That would put the real, inflation-adjusted interest rate -- the cost of borrowing minus the rate of inflation -- deep into negative territory, even though the nominal rate would still be zero.

  If Americans were convinced of the Fed's commitment, they'd buy and borrow more now, he says.

  Faster inflation might be preferable to increased unemployment, or to further budget stimulus packages that push up the national debt, says Mankiw

  "There's trillions of dollars of debt, in mortgage debt, consumer debt, government debt," says Rogoff, who was chief economist at the Washington-based IMF from 2001 to 2003. "It's a question of how do you achieve the deleveraging. Do you go through a long period of slow growth, high savings and many legal problems or do you accept higher inflation?"

  John Makin, a principal at hedge fund Caxton Associates in New York, wants the Fed to go further and target the level of prices instead of simply a rate of inflation. Such a policy would mean that if inflation fell short of 2 percent over a period of time, the Fed would have to push inflation above that rate subsequently to make up for the shortfall and keep prices rising on the desired trajectory.

  While that might sound radical, it's the same sort of policy that Bernanke advocated Japan follow in 2003 to fight deflation. In a speech in Tokyo that year, then-Fed Governor Bernanke called on the Bank of Japan to adopt "a publicly announced, gradually rising price-level target."

  Warren Buffett, chairman of Berkshire Hathaway Inc. in Omaha, Nebraska, suggested that faster inflation was all but inevitable.

  "A country that continuously expands its debt as a percentage of GDP and raises much of the money abroad to finance that, it's going to inflate its way out of the burden of that debt," he told the CNBC financial news television channel on May 4, adding, "That becomes a tax on everybody that has fixed- dollar investments."

Eggertsson Theory shows that the adoption of Quantitative Easing and Zero Interest Rate Policy is not enough to engender a defence against deflationary forces. What is needed is a change in the perceptions of market players, from the top to the bottom, allowing a change in spending and saving patterns.

I refer readers to this excerpt from The Future Actions of The Federal Reserve And US Govt Are Known, An interpretation of The Deflation Bias and Committing to Being Irresponsible by G B Eggertsson, made public in April 2008:

• Let me explain why, for the Fed and Government, there was no "Minsky Moment" but rather a progression of an already foreseen problem. To do this we need to look at why the Japanese Government and Bank of Japan failed to break out of a deflationary scenario. Again I quote from G B Eggertsson:
  • "The deflation bias is closely related, and in some sense, a formalization of, a common objection to Krugman's policy proposal for the BOJ. To battle deflation he suggested that the BOJ should announce an inflation target of 5% for 15 years. Responding to this proposal, Kunio Okina, director of the Institute for Monetary Studies at the BOJ, said in DJN (1999): "Because short-term interest rates are already at zero setting an inflation target of say 2% would not carry much credibility." Similar objections were raised by economists such as, e.g., Dominiguez (1998), Woodford (1999), and Svensson (2001)"

  At face value the remarks above would seem to support the Keynesian approach, that at low nominal interest rates, Government deficit spending and quantitative easing failed to ignite the inflation required to break out of a deflationary spiral.

  Within the quote though is the important point of inflation expectations. It is here that the importance of Bernanke's discussion of a targeted inflation rate and subsequent Fed warnings about inflation expectations remaining anchored becomes central to the main thrust of policy direction."
  

• "As FDR took office, there was a noticeable turnaround in expectations. Firstly, lets see what the baseline was, according to Eggertsson:
  • "The reason for the collapse is that the central bank cannot lower interest rates enough to accommodate deflationary shocks, due to the zero bound on interest rates and is unable to change expectations about future policy. This creates a strong deflation bias. The deflation bias helps explain the severity of the Great Depression, because real interest rates were excessively high in 1929-33 due to double digit deflation. This choked spending, especially investment. "Money was king" during this period. Nobody was interested in investing when the returns from stuffing money under the mattress were 10-15 percent in real terms. People gained more, in other words, from holding money than spending it."

  Or as I said, why spend today when it will be cheaper tomorrow? It is clear that to make the Eggertsson Theory work, the baseline conditions of the economy should be depressed before allowing the already prepared stimulus to be released. Compare the conditions in 1933 to those today:
  • "The short-term nominal interest rate was close to zero during the Great Depression. The yield on three month Treasuries, for example, was only 0.05 percent in January 1933. Further interest rate reductions were clearly not feasible. Open market operations, in themselves, had no effect, since money and government bonds were perfect substitutes. This explains why several observers at the time were skeptical of the effectiveness of monetary policy and believed that open market operations were just like "pushing on a string".

    Despite this, however, monetary policy was far from powerless. While increasing the money supply at zero interest rate has no effect, expectations about higher future money supply (once deflationary pressures have subsided and interest rates are positive again) have large effects because they change people's expectations about the future price level, thus reducing real interest rates. What was needed to end the Depression was a regime shift that changed expectations about future policy in a credible way. This is precisely what FDR achieved."

  With current 3 month yields at at 1.13% and inflation measures well above, it can be seen why the Fed/US Govt fear a deflationary scenario. The requirement for a credible policy that will result in rising inflation expectations is absolute, to ensure that neither the consumer or business is discouraged from spending or investing. (This has far-reaching consequences, for instance it would not be in the Fed interest to suppress the price of gold)

  With this in mind, let us look at some of the effects that FDR policy regime change had post 1933:

  

  

  

  

Dow Futures June 09:

Bonds issuance:

CPI - All Urban Consumers (B of LS):

Continuous CRB Index (CI ICE / NYBOT) - TFC charts:

Are we seeing the "FDR effect" take hold? It's an important question, remember back in 1933 the problems were not over for the general economy but that didn't stop the reflation of various markets. We are seeing a very similar pattern today which must be due to the same reason as the rise in 1933, the result of a credible expectation of future inflation.

It is no wonder we are seeing so many articles on blogs, sites and now in the main stream media talking of inflation.

Right now, for the medium term, I am looking for a higher low (a downturn this summer would do the trick) and on a breakout of the recent high I would look to take a position. However, if the Fed move to a tightening stance in the future I would return to capital preservation mode, anticipating a 1937 scenario.

Readers will have noticed I haven't been in the public realm for awhile. There are 2 reasons for this, firstly I have been extremely busy and not had the time for longer articles aimed at what the future holds, therefore I have been writing only for my subscribers. Secondly I have been suffering from a form of econo-writers block. This has been very difficult to deal with and is caused by my wish to tie up so many threads that need to be weaved together to produce the whole tapestry, causing a lack of focus.

However such mental itching usually means that we are in a transition period where the concentration of risk is shifting or that we have moved a further step forward in the Eggertsson Theory. (Click on the link to read the articles, no subscription required)

It's becoming clear that both situations have arisen. We have a transition in risk and the first signs that the core idea in the Eggertsson Theory has reached the public conscious.

What you may ask is Eggertsson Theory? When I found the work of GB Eggertsson, I realised that Ben Bernanke had a copy slap bang in the middle of his desk and was using the work as the basis for an anti-deflation plan. Much has been said about the failings of the Ministry of Finance and the Bank of Japan to resolve the decades long deflationary forces affecting the Japanese economy, it is a scenario the Fed and Bernanke have studied in-depth. The work of GB Eggertsson identified the solutions required to change the outcome of the Japanese Quantitative Easing / Zero Interest Rate Policies, allowing the US to enable a recovery if a deflationary scenario occurred.

As we all know the Fed, US Treasury and the Government have instigated the same plan that the Japanese adopted, a combination of QE, ZIRP and fiscal spending in an attempt to lessen the effects of de-leveraging, credit contraction and the subsequent lack of liquidity.

However, as mentioned, the strategy did not work in Japan. The banks sucked in enormous amounts of government created finance to service massive toxic debt, they refused to lend and lived only to make profit whilst exposing themselves to little or no risk. The lack of credit creation caused the Japanese consumer to have to save for purchases, reducing spending and leading to price deflation that continues to this day. In effect the bailout of Japanese banks and the adoption of QE in a deliberate ZIRP environment made the Japanese government the bid in all markets as they controlled the buying of shares, yen, bonds and any other asset they deemed to be in their national interest.

So why is the U.S following what has been shown to a very problematic solution to the failure of credit?

I need to remind you that GB Eggertsson's work was titled "How to fight deflation in a liquidity trap: committing to being irresponsible". The idea is for a credible expectation of inflation to be implanted in the psyche of consumers and business through the apparently irresponsible actions of the Fed et al:

• "So how can a government make it unattractive to save an appreciating asset? It has to change the expectation that the asset is worth keeping, it needs to encourage (all) savers to change their behaviour and conclude it is better to spend than save. To do this the government must be seen as irresponsible but credible.

  It is irresponsible to massively increase government debt to buy toxic assets, to bail out broken banks and failed businesses, to make huge tax cuts and bail out defaulting mortgage holders. Why would good money be thrown into a black pit of losses, especially if the money created to do this increases the debt burden and the eventual liability to the tax payers? Even in the face of criticism the government continues to expand its debt obligations through fiscal and monetary policies, happily quoting figures that end in the word trillion, rather than the old fashioned billion.

  How on earth does the government expect to pay off this debt in the future? Surely the only way such sums can be paid off is by monetising the debt, lowering the capital burden through the mechanism of deliberate inflation, allowed by low/no Federal Reserve Fund Rates. Did you nod when you read the last sentence? Good, you have a credible expectation that the government will inflate the amount of currency (including bonds) it produces to pay off the increased debt.

  By acting irresponsibly, the government actions will make you credibly expect inflation to appear and increase in the future. By you I mean everyone including banks, businesses, consumers and foreign investors. " (Weekly Report 22 Feb 09)

It is this credible expectation of inflation that makes the current actions of the US different from the actions of the Japanese in previous years. However even the Japanese have realized that QE and ZIRP will not re-inflate an economy unless the mindset of the economic participants is radically changed. The following is from an article by Edward Hugh at J@pan.Inc which shows the beginning of an acceptance that Japan will have to engender a credible expectation of future inflation:

• "Among proposals they have on the table are Y30,000bn of the new money to fund programmes supporting new industries and infrastructure projects, including doubling the size of Tokyo's Haneda airport. The remaining Y20,000bn would be earmarked for government purchases of stocks and real estate.

  "We are facing hyper-deflation, so we need a policy to create hyper-inflation. We have to do something to undermine the central bank and government's credibility or else we won't be able to halt the yen's rise. So, while we know this is drastic medicine, we will do it," said Koutaro Tamura, an upper house Diet member who will chair the new group."
  

The move toward an acceptance of a need to monitor for inflation is beginning to appear in the writings of some, here Colin Twiggs of Incredible Charts looks at the Inflation Outlook:

• "Monetary Base

  The massive surge in the monetary base in late 2008 was largely offset by a rise in excess reserves with the Fed. Normally the rising monetary base would indicate upward pressure on prices, as more money chases the same quantity of output, but so far the Fed's actions have not gained any traction. Simply because banks are unable to find suitable borrowers. Both individuals and the private sector are increasing savings and reducing debt in response to falling asset prices. There is not much demand for credit - forcing banks to deposit surplus money back with the Fed as excess reserves."

Courtesy Colin Twiggs

Colin has also spotted the pressures in long term treasuries which we at An Occasional Letter have been keeping an eye on for well over a year. What we have been waiting for is the recognition of such pressures in the writings of others, that the credibility of the US irresponsibility is accepted:

• Treasury Yields

  The long-term view is different. The Fed decision to buy government securities, in order to lower long-term mortgage rates, appears to be achieving the exact opposite. The purchase of $1.25 trillion of mortgage-backed securities, $200 billion of agency debt and $300 billion of treasury securities will expand the monetary base, raising long-term expectations of inflation . Which is driving up long-term treasury yields rather than lowering them.
  

So not only are the watchers seeing the effects of the US actions, more importantly the US T-Bond market is reacting in a belief that the current irresponsible approach will lead to higher inflation in the future.

With yields rising in the long end of the bond market upward pressure on future mortgage rates will become apparent. The Fed will have to decide if suppressing commercial rates through continued buying of long end treasuries takes priority over the wish to encourage an inflationary expectation. More likely I expect the Fed to attempt to keep long end yields (10 year and 30 year) within a band, selling when yields go too low and buying when yields rise too high:

Courtesy of StockCharts.com

Looking at last week's reversal we may have had the upper level for yields identified. Somehow, I don't expect the Fed or bond markets to make life so easy for us, the situation requires careful watching.

At least the Fed has a plan and is instigating the actions required, along with the US Treasury and government, to try and offset deflationary forces and avoid the dreaded Japanese scenario. Even the Japanese are showing signs that they may also adopt the appearance of irresponsibility to engender future inflation expectations.

However in the EU the story is different:

• May 14 (Bloomberg) -- European Central Bank policy makers clashed over the bank's asset-buying program and prospects for a recovery less than a week after President Jean-Claude Trichet engineered a truce.

  Vice President Lucas Papademos said in Vienna today that a recovery may come sooner than previously thought. Minutes earlier, Dutch council member Nout Wellink said economists shouldn't get too optimistic about "green shoots." That came a day after Germany's Axel Weber and Slovenia's Marko Kranjec reopened a split over the size of the ECB's bond-purchase plan.

  "The ECB Governing Council looks like a battlefield," said Laurent Bilke, a former ECB forecaster who now works for Nomura International in London. "It would be simply ridiculous if we weren't already in the middle of the worst recession in postwar history. But now it has more dramatic consequences. Trichet will have to restore some order."
  

• By Edmund Conway and Angela Monaghan at The Daily Telegraph "Germany's economy shrank by 3.8pc in the first three months of the year - a record contraction that is almost double the fall of Britain's gross domestic product in the first quarter. The figures sparked attacks on Germany's government, which has repeatedly shown reluctance to bail out either its economy or financial system.

  In figures described by economists as "disastrous", Eurostat also reported that Italy shrank by 2.4pc, Austria and the Netherlands by 2.8pc, Spain by 1.8pc and France by 1.2pc.

  The export-reliant country has been hit hard as world trade nose-dived in the latter months of last year. Charles Dumas of Lombard Street Research said: "German economic policy is bankrupt, and the Mediterranean countries stuck in EMU are also condemned to ongoing economic collapse.

  "Already we have real GDP levels that are up only about 3pc from 2000 in Germany and Italy - ie growth has been only a little over ¼pc a year - making this a lost decade for much of continental Europe on a worse scale than Japan in the 1990s."
  

Simply put, you either fully commit to the Eggertsson Plan or do something else. Attempting to cherry pick, implementing QE and ZIRP without fiscal stimulus or an implicit inflation target is an exercise in copying the Japanese experience.

We look again at German GDP:

A year of contraction has returned GDP to a fraction above the 2000-03 recession. Without a recovery within the EU or the US Germany is set to resemble Japan in the '90s. The strictures placed upon Germany as a member of the EU and Eurozone, coupled with a resistance to further fiscal stimulus will cripple its ability to adopt measures to reflate. The Euro will eventually have to reflect this situation.

Much talk this week has been about the Dollar taking a dip, however a look at the bigger picture reveals a different story:

Courtesy StockCharts.com

The red line is the Dollar, used as a baseline to see the movement of other currencies against it. Still think the dollar is collapsing? With the emergence of what could be the Euro Crisis (if the situation continues to develop) betting against the dollar and US Bonds long term now might be premature.

Whilst commentators look at short term movements and talk of green shoots, demise of the dollar or emerging market reflation, we cannot ignore 2 simple facts:

Short duration bonds are not showing an expectation of inflation.

GDP, almost worldwide, is still contracting.

Whilst the great inflation/deflation debate continues (its deflation that wins, the inflationistas are being misled by the Fed's actions with its bail out facilities) we need to look at some startling new facts and projections that have appeared in the public arena. My worry, as you can gather from the title of this article, is that we face a global depression that cannot be avoided even if the events discussed below favour the results that the Central Banks et al seek.

Events are moving to a point were attempts to disguise the effects of certain outcomes can no longer be hidden.

The Federal Reserve.

"The Federal Reserve on Tuesday announced the extension through October 30, 2009, of its existing liquidity programs that were scheduled to expire on April 30, 2009. The Board of Governors and the Federal Open Market Committee (FOMC) took these actions in light of continuing substantial strains in many financial markets.

• The Board of Governors approved the extension through October 30 of the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), the Commercial Paper Funding Facility (CPFF), the Money Market Investor Funding Facility (MMIFF), the Primary Dealer Credit Facility (PDCF), and the Term Securities Lending Facility (TSLF). The FOMC also took action to extend the TSLF, which is established under the joint authority of the Board and the FOMC.

  In addition, to address continued pressures in global U.S. dollar funding markets, the temporary reciprocal currency arrangements (swap lines) between the Federal Reserve and other central banks have been extended to October 30. This extension currently applies to the swap lines between the Federal Reserve and each of the following central banks: the Reserve Bank of Australia, the Banco Central do Brasil, the Bank of Canada, Danmarks Nationalbank, the Bank of England, the European Central Bank, the Bank of Korea, the Banco de Mexico, the Reserve Bank of New Zealand, the Norges Bank, the Monetary Authority of Singapore, the Sveriges Riksbank, and the Swiss National Bank. The Bank of Japan will consider the extension at its next Monetary Policy Meeting. The Federal Reserve action to extend the swap lines was taken by the Federal Open Market Committee.

  The current expiration date for the Term Asset-Backed Securities Loan Facility (TALF) remains December 31, 2009. Other Federal Reserve liquidity facilities, such as the Term Auction Facility (TAF), do not have a fixed expiration date.

  The AMLF provides loans to depository institutions to purchase asset-backed commercial paper from money market mutual funds. The CPFF provides a liquidity backstop to U.S. issuers of commercial paper. The MMIFF supports a private-sector initiative to provide liquidity to U.S. money market investors. The PDCF provides discount window loans to primary dealers. Under the TSLF, the Federal Reserve Bank of New York auctions term loans of Treasury securities to primary dealers. The TALF will support the issuance of asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. Under the TAF, Reserve Banks auction term discount window loans to depository institutions."

Fear not readers for the Fed is readying itself for the next stage of the battle to defeat deflation, as the Chairman so presciently foresaw:

• "However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. As I will discuss, a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero.

  U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

  Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior). Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities.

  So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure --that is, rates on government bonds of longer maturities. There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields . If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.

  Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years . Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association)."

  
  Quotes from "Deflation: Making Sure "It" Doesn't Happen Here" Ben Bernanke November 2002. (Red highlights mine)

The US Treasury:

• Washington, DC - Treasury is announcing the following changes to the issuance calendar:

  A new monthly 7-year note, with the first auction occurring in February 2009.

  A regular reopening of the quarterly 30-year bond in the month following the initial new offering, with the first reopening occurring in March 2009.

  Details of the February Refunding

  We are offering $67 billion of Treasury securities to refund approximately $36.3 billion of privately held securities maturing or called on February 15 and to raise approximately $30.7 billion. The securities are:

  A new 3-year note in the amount of $32 billion, maturing February 15, 2012;

  A new 10-year note in the amount of $21 billion, maturing February 15, 2019;

  A new 30-year bond in the amount of $14 billion, maturing February 15, 2039.

  During the last several months, changes in economic conditions, financial markets, and fiscal policy, as well as a decline in nonmarketable debt issuance have contributed to an increase in Treasury's marketable borrowing needs.

  Treasury has responded to the increase in marketable borrowing requirements by raising issuance sizes of regular weekly and monthly bills, increasing the frequency and issuance sizes of cash management bills, increasing the issuance sizes of nominal coupon security offerings, and adjusting the securities offering calendar, including adding monthly 3-year notes, a second reopening of 10-year notes, and introducing newly issued 30-year bonds on a quarterly basis.

  Introduction of a monthly 7-year note: Treasury is announcing the addition of a monthly new-issue 7-year note. The monthly 7-year notes will have an end-of-month settlement along with the 2-year and 5-year notes. The first auction of the 7-year notes will occur on Thursday, February 26, 2009

  Introduction of a regular 30-year bond reopening: Treasury is announcing the addition of a regular reopening of the 30-year bond in the month following the initial quarterly offering. This will result in eight 30-year bond auctions a year. The first auction of the reopening of 30-year bonds will occur on Thursday, March 12, 2009

With the increase of debt issuance upward pressure will be exerted upon yields. This counter-acts the Feds attempts to keep both short term rates and those further out along the curve at a level the Fed perceives as conducive to encouraging credit markets to allow the flow of funds to re-start. The real test of course is whether buyers turn up at the auctions. A failure will force the Fed to enact its statement from the last FOMC minutes:

• "The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets."
  

Courtesy of StockCharts.com

Bond yields are in a move higher as you would expect, bond buyers know what the increase in market supply will do to prices if no one (in essence foreign buyers) turns up for the auctions and bond yields are acting accordingly as long positions are closed.

The Fed will end up reacting to the results of the auctions; if buyers insist on higher yields (by setting lower prices) the Fed will step in and start buying across the curve, indeed if they are looking at the yields across the curve now they may well be feeling some concern that the plan to hold rates at low levels may already be under attack.

If the Fed fails to react to higher yields or failed auctions (when not enough bids are received to cover the issuance) bond markets will take fright as the Feds credibility to back up the words from the FOMC minutes is destroyed. Without a buyer of last resort supporting the market then a bout of panic selling, even dumping could take place. In some ways this would suit the Fed as it would begin its intervention at a lower price level and if the policy is successful the balance sheet would benefit from appreciating prices as yields fall back.

Why do I think Fed intervention is inevitable?

IMF

The ability of Foreign Central Banks to buy US issued debt has been a function of increasing dollar flows taken in payment for exports to the US and re-circulated back (to stop domestic inflation) by buying US debt.

As the IMF says "Global output and trade plummeted in the final months of 2008". The requirement to re-circulate dollars back into US debt will also be severely curtailed just at the time when the US wishes to raise debt issuance. The need for the re-circulation of dollars is not going to increase anytime soon:

Indeed a further contraction of "available" dollars, produced in exchange for goods imported into the US, is more likely that the chart above suggests. The IMF has a tendency to be optimistic in its views. To enable the US Treasury to issue new and increasing amounts of debt in an environment of decreasing need, when world trade has almost halved, leaves the Fed no alternative but to put its words into action.

If however the Fed decides not to deploy the printing presses and its unconventional policies then the result will be as the IMF states:

• "Downside risks continue to dominate, as the scale and scope of the current financial crisis have taken the global economy into uncharted waters. The main risk is that unless stronger financial strains and uncertainties are forcefully addressed, the pernicious feedback loop between real activity and financial markets will intensify, leading to even more toxic effects on global growth.

  In addition, the risks of deflation are rising in a number of advanced economies, while emerging economies' corporate sectors could be badly damaged by continued limited access to external financing. Furthermore, while fiscal policy is providing important short-term support, the sharp increase in the issuance of public debt could prompt an adverse market reaction, unless governments clarify their strategy to ensure long-term sustainability."
  

The IMF have the risk indicator flattening off in 2009, again this seems optimistic considering that the downside risks are much, much greater than any possible upside to the current situation. As it happens, the IMF do have an important caveat to the indicator, which may:

• "underestimate the risks today relative to those for earlier episodes, as it does not consider house prices. In 2002/03, housing markets were very strong, with low interest rates boosting prices and construction, helping pull the global economy out of its weak patch. Also, the indicator does not do full justice to the credit crisis because it does not consider quantitative indicators of financial conditions other than bank credit, which is being buoyed by temporary forces. Spreads on bonds, for example, are much wider today than during 2002-03 in advanced economies and have reached levels similar to those prevailing in 2002-03 in emerging economies."
  

• "This section proposes to analyze deflation vulnerability with the help of the IMF staff's Global Projection Model (GPM), which explicitly considers the implications of the zero interest floor (ZIF) for monetary policy. The most intractable deflation problem occurs when policy interest rates reach the ZIF for a prolonged period of time because if a zero interest rate fails to close the output gap, downward pressure on prices is reinforced.

  Unless other policies are implemented to raise aggregate demand, this could result in a downward deflationary spiral. The model incorporates three country models, for the United States, the euro area, and Japan (the G-3); and it covers output and unemployment, the rate of inflation, the exchange rate, and, with a modified Taylor rule, the monetary policy interest rate.

  26. Figure 4 shows the current World Economic Outlook (WEO) baseline outlook (black line) and GPM-based fan charts for the G-3 economies (see also IMF, 2009a).

• To sum up, the WEO baseline projection, in itself, does not contain an unduly serious deflation problem. However, the GPM-based fan charts reveal a significant probability of much more negative deflationary outcomes, and hence a deeper and more prolonged recession in the G3."
  

I see nothing that supports a hyperinflationary environment in the G3 in the medium term. If the IMF red projection line (mid 50th percentile) is accurate, inflation, growth and price levels will not engender a credible expectation of future inflation and monetary and fiscal stimulus will fail. That failure will lead to a period of extended deflationary forces acting upon the global economy.

The initiation of increased debt issuance by the US Treasury begins next week. Any sign of weakness in the Fed's response to low prices or failure at the auctions will cause major disruption in the bond market. However such disruption should be short term as long as the Fed responds vigorously to put right its previous inaction.

Even if the Fed is successful and keeps interest rates along the curve artificially low, there is no guarantee that the expected result of increased inflation expectations will occur in the future. Without the future threat of inflation business and consumer spending patterns will remain "tight" and a continuing hoarding of cash and cash like assets will remain attractive, even in an environment where real interest rates are negative. Only when a point is reached when cash, held as an asset, shows a depreciation will it become viable to swap cash for other assets that will give a higher return. This is why many schemes are failing, the dollar has become an asset in its own right:

Coutesy of StockCharts.com

Looking at the chart, is it just me or is the Dollar waiting for news?

Some have put forward an idea that US taxes should be cut for Businesses who wish to repatriate overseas profits, allowing an injection of cash into the US domestic economy. However with the main theme of investing already focused on highly liquid uptrends (see US Treasuries until recently) the increase in demand for Dollars as profits are converted from other currencies would cause further appreciation of the Dollar. This would make the hoarding of cash more attractive and negate the attempts to loosen the flow of funds. Indeed the suggestion of such a repatriation, especially from the US Treasury, would cause longs to take positions prior to the event occuring, pre-emptively causing the uptrend to strengthen, encouraging an acceleration of savings. Thus such a scheme would encourage the very conditions that the Fed and US Treasury are attempting to thwart.

Until economic conditions are conducive to the deployment of savings to allow profitable investment then the hoarding of cash and cash like assets will continue. I very strongly suspect we will have to live through a global depression before such economic conditions appear.

This is my last article for 2008, so instead of a Weekly Report I have decided to write An Occasional Letter. As readers of my stuff know these articles tends to be long, so get a coffee and some munchies whilst I take you on a journey through macro-economics.

Before we start I want to re-visit a call made at the end of May '08. Like many eco-writers and bloggers I get the odd email disagreeing with my views. I don't mind those that question my viewpoint, without such discussion the game isn't worth playing. However, occasionally I get an insulting email, questioning my integrity. This one arrived in early June '08:

• Deflation?

  So let's see. A week ago you publish this "What then has me bearish on gold and reinforces my deflationary outlook? The following chart is from a member of Livecharts who has spotted a rather delicious set up. Here is Sarah's chart:" and sure enough there was the chart. Only one problem; whenever some clown notices that kind of resemblance, it stops working.

  But what makes me want to open a window to relieve the stench produced by your "analysis" is this. You wrote: "Do I have any other data that helps support my bearish gold stance?" The freebie ended there, but no doubt you did. In other words, you saw what looked like a bearish chart (which it really wasn't of course) and trawled around for deflationary arguments to support the chart. Or vice versa, it doesn't really matter. Of course now that gold has broken out to the upside, you will ditch (surreptitiously, naturally) you bearish interpretation and trot out all the fine reasons there are to be bullish gold.

  Investment writers already have a tawdry reputation, but you really are a piece of work.

  
  Michael ********

  Brookline

  
  USA

Here are the charts:

Courtesy of George Slezak @ www.stockindextiming.com

This was the chart that Sarah saw which was dated April '08. Mr Slezak, that was a great call.

However, I had gone short gold, to hedge my physical holdings, back in March '08 as it broke down from a sharp uptrend support line and took out support at $987. Anyone who reads my stuff knows I look well ahead and this trade was not designed to be a standalone entry, it was a method of preserving the inflationary gains made in physical gold as we tipped over into a proto-deflationary environment. Here is the chart I used to make my decision (Daily):

As you can see, I didn't look for much more that support and resistance. I received the email in the week after that chart had been published. Gold rallied and re-tested the old support at $987 in July, confirmed that it was now resistance and headed south for the deflationary winter.

So why do I mention this? Did I confirm my own sentiment by using selective articles or charts to back up my view?

No, I added this part of the article to demonstrate that taking a longer view, by studying the macro environment can and does deliver its own rewards. What it also showed was that sharing information and ideas, even pointing out a potential set up in the public arena did not change the trend, if an asset is going up or down then writers and bloggers are not about to make things any "different". By the way, this "piece of work" remains bearish on gold and I will continue as such until I think circumstances have changed. If those circumstances do change and I move to a bullish view, I'll let you know. Here is my current view about gold (Weekly), the red vertical line corresponds to my "tawdry" observations:

Have a happy Christmas, Michael.

Recently I changed the scenario, the economic events and conditions that I think will affect us in the future. Some of those events are already taking shape, some seem only a failed bail out away. Here is the new scenario:

• Deflation, credit contraction, Conglomerate destruction, nationalisation, mis-placed rejection of sound shares, Bank asset hoarding, historically low base rates, wide spreads to commercial rates, low/no access to credit, sovereign default and bankruptcy, widespread poverty, increase in regional wars, Quantitative Easing in the US/UK, attempted reflations, savings growth, debt repudiation, FX re-pricing, non-governmental intervention from IMF and BIS, co-ordinated protectionism, a new form of capitalism leading to profit sharing through true ownership/part ownership and not based on risk transference...... eventual emergence of new trading and commercial environments.
  

Not all these events will happen in the order they are listed, some will occur more than once and some will overlap. Some are already in play, we see signs of deflation all around, banks hoarding assets, lack of credit and Conglomerates teetering on the brink of bankruptcy or nationalisation. Base rates continue to fall and in the US and the UK quantitative easing has become the adopted escape route. As we move into 2009 the pace of the global recession will quicken and its effects will deepen further. Whilst this seems to be a very gloomy outlook we should remember there will always be opportunities to profit in such circumstances. As you can see at the end of the scenario I hope that we will be able to benefit from the next stage of capitalist evolution.

What we as investors must do is ensure we are not exposed to the possibility of capital destruction. This is not a "naked" buy and hold environment for assets, no one should be either fully long or short. We have to become sophisticated and adopt methods of trading that have 2 rules:

1. Protect capital and returns

2. Educate yourself and become aware.

Does this make investing an onerous task, increasing the research and thought required to be successful? Yes it does but to be frank, this is nothing new, investors should have been doing the same in the bull market. Human nature being what it is means it's easier to jump on the trend rather than look into what is driving that trend. I can look at the statistics of each article I publish to see what gets the biggest hit ratio. Without doubt if there is a chart or series of charts in the article the hit rate is higher. Does a picture tells a thousand words or is it just easier to look rather than read?

Why did I buy gold in the first place? To protect against the inflationary processes at work in the fiat monetary regime of course. The trick was to ensure that those inflationary gains were protected when that trend broke. It costs to protect, I have to pay for the short but when compared to the original profits it is a small price to pay. Why did I make such a decision, was it because of a chart or reading a blogger? No, it was because I read widely and educate myself constantly. These articles were born because I thought others might be interested in what I had found.

We all had been warned that financial derivatives were a disaster waiting to happen but how many investors bothered to find out how they worked and why they were so dangerous? We have to apply the rules for any upside moves too, we need to look at what we are trading and understand it and the reasons why people are buying it. The only way to understand a trend is to look at the causes, not the direction.

Right now I believe the effects of the US (and to a lesser extent the UK) adopting a Quantitative Easing (QE) policy cannot be ignored and should be at the forefront when considering an investment. Why has the US, through the Federal Reserve and the Treasury, moved to a QE stance? Because Bernanke, the student of the Great Depression, believes we are in the circumstances that can make a recession into a depression:

The following quote is from Ben Bernanke's work "Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression" as used in "New Keynesian Economics"(Mankiw and Romer Ch 29):

• "The effect of this credit squeeze on aggregate demand helped convert the severe.....downturn of 1929-1930 into a protracted depression"

Banks refuse to lend and are hoarding assets, cash and cash like instruments to bolster their reserves. However with yields on Treasury Bills now dropping into negative territory we see further signs that banks are now unwilling to hold cash because they consider the cost and risk of having cash in banking accounts to be too high. This is the inevitable conclusion to the fluctuations in LIBOR earlier this year. If banks don't trust each other to lend to each other, why would they want to save money in their own or others accounts beyond a certain level?

Eventually the only asset available that can be treated as near cash, has a massively liquid market and where the holdings can be left with the Fed is US treasuries. What about the fact that banks are paying the Fed for the privilege of owning T-Bills? It comes down to costs, if its cheaper to pay a negative interest rate than to buy insurance or pay for the costs involved in holding massive amounts of cash, then it makes sense to buy T-Bills in the current environment. Of course we cannot discount one other possibility, that the insurance to cover the holding of cash is no longer available or isn't trusted to perform.

The implications are widespread and without education difficult to understand. This where I and others enter the fray. What I write is not necessarily what I believe, quite often it is the relaying of information that those in charge of monetary policy, or those that write about the topic let into the public arena. I am not talking about the writings of other analysts or bloggers, though I have been critical of some when my ire reaches its ceiling. No, I go for to the source of the knowledge that Central Bankers and Treasury personnel use when they formulate policy.

Why is this important? I give you a quick example, I disagree with Peter Schiff, even though I read his stuff and respect his views. However I do not take his writings as an authority on what will happen, his (and my) words are an interpretation of the actions of those with the real power. What I like to do is take the words of the Central Bankers and their economists and apply them to the current and future situation. So off I go and google all sorts of strange names, references and paper titles and read. I have spent the past 18 months getting into the thoughts of Bernanke and Co, before him I used to translate the words of AliG from Fedspeak (remember that?) to English. I don't do this as a confirmation of the correct action to take, I do it to see what the thinking is behind the current and future policy enactment. I understand the trend. Without this you cannot see the pitfalls in their methods or the possible scenarios that can and will occur.

Its time to refresh that coffee.

Zero bound. That is a phrase which is currently worrying Bernanke and now that I have mentioned it I suppose you want an explanation? Fair enough, here is a simple description.

Zero bound refers to a situation where interest rates fall to a level, in a low or no inflationary environment usually caused by previous Central Bank policy, where normal monetary policy (the adjustment of the Fed Fund Rate, for example) no longer has an effect on stimulating the economy. However this is only half the story. We need to examine why such a trend in thought or inaction is occurring. With rates so low lending should be cheap, re-invigorating the credit mechanisms and allowing expansion (and inflation) to grow. Clearly this has not happened. Banks (and people) are hoarding cash and cash like assets and refusing to allow the injections of cash they received to pass on into the economy.

So the next tool to be used is an expansion of money supply. Is the Fed following the usual policy that its own members and economists say is necessary?

The figures for personal saving are only available to October '08 so I have adjusted the monetary base back to compare. The Base has since increased further from $950Billion to a current level of $1500Billion. I have included savings because it is that hoarding of cash on a personal and business/banking level, in a zero bound environment, that has caused the Fed et al to increase the monetary base. It is an attempt to re-invigorate the economy by increasing reserves beyond what is required by banks. However it looks to me that instead of risking the cash in the economy, banks are happier to hold short term T-Bills. Unless this changes the infusion of cash will not have the desired effect.

For Bernanke and other Central Bankers the current situation is more than just a credit crunch or a recession. Right now they are applying Monetarist theory to attempt to overcome a liquidity trap. This is the grand experiment of Friedman's "cure" for the Great Depression. Thus we return to the Eggertsson articles:

• From G B Eggertsson "The Deflation Bias and Committing to Being Irresponsible" the fundamental question is:

  "Can the government lose control over the general price level so that no matter how much money it prints, it's actions have no effect on inflation or output? Economists have debated this question ever since Keynes' General Theory. Keynes answered yes, Friedman and the monetarists said no."

  "Keynes argued that increasing the money supply has no effect at low nominal interest rates. This has been coined as the liquidity trap."
  

Bernanke has not implemented the various bail outs schemes on an ad hoc basis, he is following a plan of action, a plan that started earlier than many think. The following is from "Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment" by Ben S. Bernanke, Vincent R. Reinhart, and Brian P. Sack, 2004, a Staff working paper in the Finance and Economics Discussion Series (FEDS):

• Our results provide some grounds for optimism about the likely efficacy of nonstandard policies. In particular, we confirm a potentially important role for central
  bank communications to try to shape public expectations of future policy actions. Like Gürkaynak, Sack, and Swanson (2004), we find that the Federal Reserve's monetary policy decisions have two distinct effects on asset prices.

  These factors represent, respectively, (1) the unexpected change in the current setting of the federal funds rate, and (2) the change in market expectations about the trajectory of the funds rate over the next year that is not explained by the current policy action. In the United States, the second factor, in particular, appears strongly linked to Fed policy statements, probably reflecting the importance of communication by the central bank. If central bank "talk" affects policy expectations, then policymakers retain some leverage over long-term yields, even if the current policy rate is at or near zero.

  We also find evidence supporting the view that asset purchases in large volume by a central bank would be able to affect the price or yield of the targeted asset.

Why was Bernanke so interested in having an inflation target? He tried to push the agenda in public and at FOMC meetings during his time before and just after he became Chairman, he obviously feels it is important. This should be prompting you to re-examine the timescale of the current measures of Central Bank bailout actions, remember he thinks that communication is vital for the prevention of a deflationary period that could lead to a zero bound environment. Why is a known inflation target so important?

Again, from the same paper we see why:

• " Despite our relatively encouraging findings concerning the potential efficacy of non-standard policies at the zero bound, caution remains appropriate in making policy prescriptions. Although it appears that non-standard policy measures may affect asset prices and yields and, consequently, aggregate demand, considerable uncertainty remains about the size and reliability of these effects under the circumstances prevailing near the zero bound.
  
  The conservative approach-maintaining a sufficient inflation buffer and applying preemptive easing as necessary to minimize the risk of hitting the zero bound-still seems to us to be sensible. However, such policies cannot ensure that the zero bound will never be met, so that additional refining of our understanding of the potential usefulness of nonstandard policies for escaping the zero bound should remain a high priority for macroeconomists." (italics are my emphasis)

• "We first note that, while the recent improvement in the global economy and the receding of near-term deflation risks may have reduced the salience of the ZLB today, this constraint is likely to continue to trouble central bankers for the foreseeable future. Central banks in the industrial world have exhibited a strong commitment to keeping inflation low, but inflation is unpredictable. Although low inflation has many benefits, it also raises the risk that adverse shocks will drive interest rates to the ZLB." (ZLB - zero lower bound)

The buying of such large amounts of bonds, across the curve and from different Agencies (not just Treasuries) will force a change to the composition and size of the Feds holdings. This is a function of Quantitative Easing, where the Fed swap bonds for cash, flooding the system with excess liquidity in an unorthodox attempt to reflate. To work the policy and actions must be seen as credible and long term, allowing banks to pass on the liquidity in the knowledge that if the loans are defaulted upon, further unlimited liquidity at low/no yield will be available.

It was from such policies, including the Zero Interest Rate Policy, initiated by the Bank of Japan that caused the Carry Trade in Yen. Whilst it is early days for emergence of a US dollar (and even earlier for a possible Sterling) carry trade, it cannot be ignored and we should be preparing for such an environment. The carry trade is the use of a low yielding currency to buy higher yielding currencies or assets priced in such currencies and profiting on the difference in the yields, allowing for currency depreciation. It can be viewed as an exporting of inflation, causing other Central Banks to have to adopt sterilization methods to keep their own currency aligned to the dollar.

The US dollar faces the same problems that the Yen faced during Japans deflationary experience. Indeed with the expected return of Japan to recession and a possible move back to QE like policies, the fight for high yielding assets could become severe. I expect the US Fed and Treasury (and the Bank of Japan and Bank of England) to become active in the forex markets, either through direct intervention or by implication that such action will occur at certain exchange levels.

Whilst the long term outcome of such forex interventions is unclear, in the short term it will be seen as a credible attempt to cause inflation through the devaluation of the domestic currency. This would leave the Euro, which is currently not expected to see interest rate cuts as deep as the US, UK and Japan as the natural first target of the Carry Trade. Of all the members of the Eurozone, Germany with its reluctance to follow Keynesian/Monetarist easing policies could be the first recipient of this injection of foreign investing.

Will QE work? That is exactly the question all Central Bankers are asking themselves right now. Other than the Japanese experience and one or two minor episodes of zero bound in the US there is no real model to measure against. However, one nation has made a mistake in the engendering of expectations and this could give us a different model to compare the US too.

QE must be accompanied by fiscal measures designed to allow the excess liquidity to feed into the economy, either through tax cuts or "make work" projects or expansion of public services. However, to stop this excess liquidity being saved rather than spent the fiscal programmes must have a credible expectation to last for a considerable period. As Bernanke et al put it:

• "A second possible channel for quantitative easing to influence the economy is the fiscal channel. This channel relies on the observation that sufficiently large monetary injections will materially relieve the government's budget constraint, permitting tax reductions or increases in government spending without increasing public holdings of government debt (Bernanke, 2003; Auerbach and Obstfeld, 2004).

  Effectively, the fiscal channel is based on the government's substitution of the inflation tax (a tax with little or no deadweight loss in a deflationary environment) for direct taxes such as income taxes. Auerbach and Obstfeld (2004) provide a detailed analysis of both the macroeconomic and welfare effects of the fiscal channel and find that these effects are potentially quitesubstantial.

  These authors also note, however, that the fiscal effect of quantitative easing will be attenuated or absent if the public expects today's monetary injections to be withdrawn in the future. Broadly, if the public expects quantitative easing to be reversed at the first sign that deflation has ended, they will likewise expect that their money financed tax cuts will be replaced by future tax increases as money is withdrawn, an expectation that will blunt the initial impact of the policy.

  Thus, it is crucial that the central bank's promises to maintain some part of its quantitative easing as the economy recovers be perceived as credible by the public. Auerbach and Obstfeld show that, if the central bank is known to be willing to tolerate even a very small amount of inflation, the promise to maintain quantitative easing will be credible. A similar result would likely obtain if the central bank associates even a relatively small cost with publicly reneging on its promises. Thus, it seems reasonable to expect that the fiscal channel of quantitative easing would work if pursued sufficiently aggressively."

The country in question is the UK. Gordon Brown, the Prime Minister, announced a small fiscal stimulus for individuals of a cut in VAT rates from 17.5% to 15%. However the cut has only a limited timespan and it was announced that the cut would be reversed in December 2009. Worse still the Opposition are campaigning on a platform that fiscal and monetary stimulus will lead to higher taxation, probably after an election. Then came a leak of a memo from the UK Treasury, stating that not only would the cut be reversed but that the level of VAT would be raised to 18%+.

Brown is running scared, he is unsure of his own bail out plan and has a natural reluctance to allowing QE to follow its inherent aggressive path. Yet by not allowing QE to be fully enabled he will not be seen as operating credible inflationary policies to offset the effects of deflation. Thus Sterling becomes unattractive to hold as yields are cut further to the future expected levels of 0.5-1%. Without an inflationary effect on assets, caused by monetary and fiscal liquidity injections, the UK will not be attractive as a destination for a carry trade, reducing the possibility of inward investment.

Of all the economies in the G7 the UK is most at risk of a deflationary spiral, caught in a sustained period of zero bound interest rates, as a non-credible, half-hearted attempt is made to reflate. Brown cannot let go of the traditional approach to government debt, he is proud of his "Prudence" moniker. Unless he can move beyond his fears and embrace the ideology behind QE he will not be able to persuade others that the UK will return to a growth scenario.
Are there further deflationary signs in the UK economy?

Sources: Halifax, Nationwide, ONS and Bank calculations.

The traditional ratio of lending to house prices for a working couple is around 4 times earnings. As we can see current levels are falling but are still on a multiple of around 6.5. Prices have a lot further to fall if wages remain at current levels. Asset depreciation on this scale is very deflationary.

As of the Bank of England's November report M4 was showing signs that a concerted effort was being initiated to increase cash but:

Other Financial Corporations (OFC) have seen a massive increase in liquidity but we see continued tightening for cash for private non-financial corporations and the household sector. This shows the current bind for Brown's government, Banks are hoarding and despite threats from Brown, Darling and others credit availability remains extremely tight. I suspect Mr Brown may be left with no alternative but to nationalise Banks if they continue in this manner, he cannot justify the burden placed on the UK taxpayer when it is realised how much the Banks hold of the monetary and fiscal stimulus cake.

I suspect this chart hasn't changed either:

Intermediate OFC's are explained by the bank of England like this:

• "(OFCs) rose by £59.6 billion and M4 lending (excluding the effects of securitisations etc) to OFCs rose by £48.7 billion in October. The majority of these increases reflected banks' business with intermediate OFCs. That covers banks' dealings with non-bank financial companies that are part of the same banking group - for example securitisation special purpose vehicles - and transactions with central clearing counterparties."

Mr Brown made a comical slip at Prime Minister's Question in Parliament this week, he alluded that he "had saved the world" (he meant to add banks, allegedly) which of course caused much mirth in the House. However I believe his confidence is badly misplaced, I doubt he has managed to save his own Country, let alone anyone anywhere else. Unless he realises that he needs to fight the deflationary forces with a massive, credible and continued fiscal injection that works in concert with, as opposed to balanced against the monetary policy, then the UK may well find itself in the worst of all situations, a deflationary depression.

Watching how the UK economy reacts to Mr Brown's indecisiveness may well be useful in helping to understand if QE will work.

I would like to wish all subscribers a very happy and peaceful Christmas and thank you for your continued support. Next year is going to be as difficult as this and I hope I can keep on helping you to see what may be coming our way.

Welcome to An Occasional Letter, the third part of the development of the new scenario that I believe will play out over the next 5 or so years. In the last 2 articles we looked at the new themes emerging from the pyre that was Financial Innovation, in this article its time to develop the new road ahead.

Although the media refuse to acknowledge the similarities between the 1920s-30s and the 1990s-2008 it cannot be ignored that the symptoms are the same as are the present cures. Therefore to expect an outcome that would be different now, compared to the recovery post 1938 would require something radical.

With Monetarism and Keynesian economic theories debunked, surely we have seen enough evidence that for a true change in the macro-economic environment the adoption of the Austrian School of Economics would be required. However, let's face reality, the Austrian model is not bank friendly, it argues against all the methods banks, corporations and indeed the public wish to employ in their search for wealth. The chances of Mises becoming the next figurehead for global finance is nil, it is alien to the current "want it now" generations and the banks (and governments) would find it rather easy to persuade the public not to follow the Austrians.

We also cannot ignore the Japanese experience since the 1990's, were the failure to allow true capitalistic forces to cull worthless banks, instead deliberately inflating the money and bond supply in an attempt to destroy deflation, failed miserably.

So, no new way, just the long march to the inevitable outcome stretches ahead of us. We are already witness to the model being followed by the US and the UK and being adopted by more governments by the week. I refer of course to the articles I wrote about the Eggertsson Theory. If you haven't already committed them to memory then I urge you to re-visit them.

The past 60 years have been remarkable in one particular way. The lack of deflation or the willingness to allow deflation to take hold:

We can go back over 400 years and view regular swings between periods of inflation and deflation and yet during all those past 400 years we have seen humankind expand its trade, commerce and production at a rate that made the previous 100,000 years look like a flat-line on a chart. The nuance that deflation is bad is only apt for those that hold and service debt. Deflation does not stifle growth and expansion as the Fed et al would have you believe. Indeed a debt free business that re-invested profits for expansion and saved further profits would be in an enviable position.

However, our economic world is built upon the idea that you can borrow money and use it to make enough profit to service the debt, pay wages, buy materials and services and pay dividends. Even if the business model didn't work, you just roll the borrowing over on new terms and with the help of creative accounting (not including losses as losses for instance) kept the sham going. We see the results of this all around us now with government bailouts being the last line of credit available for outdated manufacturing, banking, insurance and investment methods. We have reached the point were the final wave of credit, through securitization of debt, has failed. Not only has the original debt turned toxic but the investments based upon that debt have imploded, truly the credit candle is burning at both ends.

I want to show you 3 charts, all are very important to me and hold clues for the future. The first 2 act as road maps, firstly the Nikkei from 1988 to present:

Now the Dow 1928-48:

Finally Dow current:

The point of these charts is that even if we formed a bottom around 8000 this year it doesn't bode well as a buy and hold or pension enhancing future for stocks unless you are in a period of no inflation / deflation. To see what I mean look at the Dow 1928-48 chart, specifically the last 5 years into '48. Then scroll up to the shorter range inflation chart posted earlier. The Dow flat lined as inflation rose to near 20%.

Even more obvious is the same comparison carried out from 1932-38. Stocks rose in a deflationary environment and stagnated as inflation re-occurred. Now how many economists or governments told you about that in the past 60 years?

Deflationary environments are not necessarily bad for investments. The charts may look somewhat less spectacular than in late bull markets but without the hidden devaluation of inflation returns can be good, even great. Only if debt needs to be serviced is deflation an evil to be fought at all costs. Until recently those that had debt in huge amounts were governments and banks, specifically Investment Houses (RIP). It was in their own interests to ensure inflation continued and devalued the debt burden over time.

As we all know that has changed, the consumer has been gifted the same power to create a debt burden as those traditional holders and they will suffer the same result.

Some time ago I wrote this Gone in Sixty Seconds, originally written in June 2007:

• If you have debt you are bending over and picking up the soap.

  Straightforward, no nonsense, in the prison block showers, soap collecting. Hopefully coffee has been spat at screens, wives/delicate husbands have been offended and stopped reading within 60 seconds. Because what I'm about to impart to you should make you feel this way. You, Joe Public, are about to be ridden into the oblivion. No one can save you, no one really cares. Big boyz, from companies like mine are going to take your possessions away. Faceless corporations are going to take your home away. All because you have debt."

Now, I have banged on enough about debt, more importantly I hope you now see why I have been encouraging readers to hold cash and to continue saving. In a deflationary environment cash is king but it becomes an Emperor when it can be used to invest.

With that in mind, what do I see on the long march ahead of us? Well here is the new scenario, the potholes and opportunities that we will see:

• Deflation, credit contraction, Conglomerate destruction, nationalisation, mis-placed rejection of sound shares, Bank asset hoarding, historically low base rates, wide spreads to commercial rates, low/no access to credit, sovereign default and bankruptcy, widespread poverty, increase in regional wars, Quantitative Easing in the US/UK, attempted reflations, savings growth, debt repudiation, FX re-pricing, non-governmental intervention from IMF and BIS, co-ordinated protectionism, a new form of capitalism leading to profit sharing through true ownership/part ownership and not based on risk transference...... eventual emergence of new trading and commercial environments.

Remember these events are not listed in a strict chronological order, they will overlap and in some cases occur more than once. I am also looking to the optimistic side of the coin in that I believe eventually the macro-economic picture will benefit from the rejection of debt when coupled with faulty risk models.

I think we have enough there to keep us busy over the next few years........

Welcome to An Occasional Letter. This week we pick up from the end of this article as we begin the process of peering into the future to assemble the next stage of the scenario I have followed over the past 6+ years.

However before we start I have recently had numerous e-mails asking to join my mailing list. I thank those people for their interest but I no longer run a mailing list since converting to a subscription only website. If you would like to know more, visit An Occasional Letter for details.

To find out why I think the US Federal Reserve (and all the Keynesian based Central Banks) will fail we have to re-visit the series of articles I called The Eggertsson Theory in which I laid out the blueprint for current and future US Fed and Treasury actions in combating a credit based deflation that morphs into a deflation of cash and cash assets. The articles were written without my personal bias. I wrote them as though I accepted that what the Fed did was the right thing to do. Within the articles is a seemingly simple method of avoiding a deflationary episode or a repeat of the Japanese experience.

I quote from "The future actions of the Federal Reserve and US Government are known" which is an interpretation of the work of G B Eggertsson in "The Deflation Bias and Committing to Being Irresponsible":

• "Let me explain why, for the Fed and Government, there was no "Minsky Moment" but rather a progression of an already foreseen problem. To do this we need to look at why the Japanese Government and Bank of Japan failed to break out of a deflationary scenario. Again I quote from G B Eggertsson:
  • "The deflation bias is closely related, and in some sense, a formalization of, a common objection to Krugman's policy proposal for the BOJ. To battle deflation he suggested that the BOJ should announce an inflation target of 5% for 15 years. Responding to this proposal, Kunio Okina, director of the Institute for Monetary Studies at the BOJ, said in DJN (1999): "Because short-term interest rates are already at zero setting an inflation target of say 2% would not carry much credibility." Similar objections were raised by economists such as, e.g., Dominiguez (1998), Woodford (1999), and Svensson (2001)"

  At face value the remarks above would seem to support the Keynesian approach, that at low nominal interest rates, Government deficit spending and quantative easing failed to ignite the inflation required to break out of a deflationary spiral.

  Within the quote though is the important point of inflation expectations. It is here that the importance of Bernanke's discussion of a targeted inflation rate and subsequent Fed warnings about inflation expectations remaining anchored becomes central to the main thrust of policy direction.

  As we have seen, since 2000 the US Government has run a deficit whilst enabling tax cuts and rebates. The Fed allowed looser lending standards and brought down interest rates, in response to a business led recession. Rather than attempt to hide any inflationary tendencies inherent in these policies, the Fed has become more vocal about inflation ranges with the rhetoric pointing to overshoots of the target range. Inflation expectations amongst business and consumers have, somewhat naturally, been kept high.

  The Fed is often measured by its inflation fighting credentials. I believe this is misplaced. The Fed should be viewed as a credible deflation fighter. The Fed had to establish an inflation target, either implicit or within a range, to ensure that further inflation was to be expected in the future.
  Why? It is all down to inflation expectations. Japan is unable to break out of its deflationary scenario because no one expects inflation to happen and therefore business, credit and the consumer act accordingly, ensuring demand is constantly put off to a later date. (Why buy today if it is cheaper to buy tomorrow). "

In other words Bernanke believes that if he sets an inflation expectation in the minds of Banks, Business and the Public they will react by planning their spending and investment to match such an environment. However if the inflation expectation is not believed then spending will not happen, cash and cash like assets will be hoarded (saved) in expectation that such assets will appreciate. This will remove cash and cash like assets from circulation in the economy (and when talking about the dollar we have to look at the global economy) and any increase in monetary supply will also be absorbed into savings.

This has major implications moving forward when combined with expected future losses on credit based asset derivatives (IMF - Assessing risks to global financial stability):

We are in the first wave of a 3 fold reset of debt. Whilst previous resets have been enabled by a large pool of mortgage products available to the public, that pool has now dried up.

This answers a variety of current behavioural patterns seen in the Banking sector. We are not just suffering from the effects of a rebuilding of reserves after current write-downs, we are seeing banks preparing for the future by continuing to build reserves in anticipation of future write-downs.

The following diagram for the IMF shows why Greenspan (and others) was so wrong about innovative derivative products spreading risk:

As one would intuitively expect the flows have to go through the Banks to be re-distributed and so does the risk. A breakdown in the flows and therefore an increase in risk must reflect on the Banks abilities to continue to allow the business model to work. The securitization of debt into various innovative packets has not removed the risk or decentralised the effect of default. The very reason for such securitization, to spread risk so as to avoid a concentration of the effect of default has spectacularly failed.

Despite the claims of the US Fed, the Treasury and all other Central Banks and Governments that the bailout of banks was/is/will be necessary it is clear to see that the funds supplied will go no further than bolstering the reserves of the Banks to offset current and future losses. Those funds will not re-invigorate lending, the left hand side of the chart above has closed down for business until the right hand side of the chart can be assessed and the possible default / write-down events have passed. Looking at the first chart we can see that the potential length of this credit bubble deflation will last until 2011/2.

Without Banks willing to lend until they can see the light at the end of the tunnel, any attempt to reflate or inflate the global economy will fail. Any cash or cash like assets made available will be hoarded, not just by Banks but by business and the public. We are facing a global economy that will resemble Japan's so called lost decade (or 2).

At this point I would like to issue a warning about those who say Europe has a bigger exposure to the US mortgage market than the US:

There are no avenues left to explore if Banks wish to off load mortgage debt, the risk takers have problems of their own as they unwind leveraged bets. Funding for future purchases will be unavailable, most Hedge Funds will disappear.

Without the inflationary expectations of a continued introduction of cash and credit into the economy, rather than just the bolstering of Banks reserves (and those corporations with large scale credit lending liabilities) then spending patterns will not follow the usual recovery pattern. Spending current income is only made possible if prices in the future are expected to be higher.

If those goods and services do not appreciate in price or, as I believe will happen, fall as competition for a scarcer cashflow intensifies then cash will not be put into the economy. Asking for more now is not the action of a hungry boy desperate for nutrition; it is the prudent act of acquiring an asset that may well appreciate in the future. I do not expect any future tax rebates to revive consumer spending, instead we will see either a reduction of debt and/or an increase in savings.

Many ask what the next bubble is. I suspect it may well be already building, only this time there are no derivatives or commodities are involved. The accumulation of cash in an environment were Banks are required to continue to seek the same asset to bolster reserves and offset losses might well be the smartest move over the next 3 years or so.

Next week we start to bring together the various strands of thought and look to map the road ahead.

This week an Occasional Letter From The Collection Agency looks at what might be on the horizon as we peer into the macro-economic future.
As ever we start with a reminder of the scenario that I have been following over the past 6 years or more:

• bubble, easy money, inflation in fiat money supply, inflation in commodities and hard assets, inflation, fear of inflation, rising rates, YC inverting, flattening, rising and inverting again, tightening, withdrawal of liquidity, corrections, crashes, talk of stagflation, FEAR, withdrawal of speculative funds, further corrections and crashes, demand collapse.......Deflation.

That means a deflationary recession or depression is looming in our near future, caused by those currently feted as the saviours of the capitalist system. In 6 months time I doubt the public will think of the current crop of politicians and central bankers as saviours.

To get some idea of why I blame government and central bank intervention for the final destination of the global economy you may wish to visit an article I wrote in March '08 in reply to John Mauldin here.

Enough of the past, now is the time to look forward, to see what will be waiting for us in the future. Let me start by saying I am at a bifurcation point, that is I have 2 views in play right now. My majority report says that we are staring into a very deep, dark abyss that will result in a new form of capitalism, regulated and governed in ways many have yet to fathom. My minority report says we are staring into a very deep, dark abyss that will destroy capitalism as the tool used to trade assets.

Is capitalism sacrosanct, will it endure as they only method of trading? That is a big question and worthy of very deep analysis but as I have limited time and resources I am not going to enter the debate. With the amount of intervention occurring and the efforts that will be made in the future to keep capitalism functioning it might be a moot point in the end, hence my minority tag.

Instead I want to look at a path that leads from our current circumstances which accepts that capitalism in a new form will continue to govern the macro-economic future.

Firstly I have to assume that the global economy is about to enter a very deep recession or depression. If this assumption is wrong then that doesn't mean the problems are fixed and we set sail for economic nirvana aboard the USS Bernanke. It just means that the inevitable arrival at a global financial conflagration is delayed until the system allows some idiot to invent a new financial innovation that will destroy the banks et al.

On a macro level we are already seeing the decoupling events, the G10 have the means to re-capitalise by accessing an enormous pool of centrally controlled cash liquidity. However beyond this group we are seeing major financial strains appearing as the reserves (especially $) of governments are stretched to cover the withdrawal of G10 based foreign investment. Only those who truly saved inward $ investment, such as China, possibly Russia and some Oil States have the ability to defend their own economies from the worst effects of what is to come.

This has created a real demand for the $, as countries, banks, corporations and increasingly smaller companies require $'s to service or repay $ denominated debt. The liquidation of the global carry trade and other $ or Yen based financial investments has caused a flight to cash, resulting in a strengthening of these 2 currencies at the expense of the rest of the world. It clearly shows that the 2 Central Banks that allowed monetary easing and credit creation to stave off previous rounds of financial crisis have been the main catalysts for the coming debacle.

As we can see, cash is king, we do not see the re-investment of $ or Yen in their domestic markets over the past 90 days:

(Courtesy of Stockcharts.com)

What we see is a typical confirmation of a deflationary effect, as a currency becomes stronger due to a lack of availability then the assets priced in that currency fall in price. This will continue until the appreciation of the currency is complete. Only then will the price of assets in those currencies stabilise and become more affected by supply and demand.

As I stated in the past the amount of money in circulation can be reduced by means other than government or central bank intervention, what we are seeing is "mattress stuffing" on a global scale. This is why the bail out attempts will fail. Rather than explain it again, here is a reply to a trading buddy at Livecharts.co.uk:

• Easy times - 4100 of 4102

  CA, so the tracker mortgages will be a thing of the past with 2.5% base rates and 5 to 6% lending rates? Any ideas of when we'll see these rates of say 8%+ and how long they would remain at those levels. I'm locked in at 5.6% for 2 years but it's getting scary if after that they jump to say 10%. Means that mortgage payers are going to have to slash their mortgages by repaying capital as fast as possible.

  collection agency - 4102 of 4102

  Hi ET,

  The banks will steepen the curve as much as possible, some have already raised rates this past week even after the base rate cut.

  Borrow short and cheap and roll, lend long and high is still what they think will save them. This is just an income stream idea though, still ponzi related. The real worry for them is the capital depreciation on loans made. There comes a point were default on debt will mean higher Tier 2 and 3 assets, meaning Tier 1 will have to be re-capitalised....again.

  When a bank makes a loan it becomes an asset because it earns income. So far we have seen the effects of what happens when the income on an asset (remember these assets are bundles of different grades of debt - MBS etc) is degraded, next up is when the assets become worthless in the face of mass default.

  I am not surprised by the current behaviour of banks; they are after every penny they can get. If we go by the rate differentials seen in the US (and we seem to be following the same pattern) then the mortgage rate for prime will be 3%-4% above base, minimum. Anything else, if you can get it, will be 5-7% above base.
  However I suspect this will become a political hot potato with pressure being placed on banks to cap the steepening of their curve.

  This is why the whole bail-out system adopted by Euro/UK/US will fail. If the Trillions had been used to offset the asset depreciation, i.e. lower the amount owed by direct government relief on debt (e.g. pay off a lump sum of each mortgage in a swap arrangement for a % ownership of the asset, which could be bought back over time or paid off when the property is sold) then the lower debt level could be serviced and the public would have had a direct monetary stimulus, without money going through the pricing mechanism, its non-inflationary. House prices could then re-set to realistic levels linked to real income.

  This method would allow a deflation to occur without leaving the onerous debt burden in place that was set in an inflationary atmosphere. Whilst shared equity on houses sounds socialist (part-owned etc) it is a better alternative to mass default and renting a bed sit or B&B room to house families.....

  Instead they gave the money to banks and others to bolster capital reserves and Tier 1 assets. That means the cash remains on the books and in the vaults, there is no virtuous circulation of cash and therefore no relief for the root cause of the problem, high debt servicing in a low income environment.

  All the banks et al have done is add to their margin after a call, they have not adjusted the positions, just added to losing ones.

  Most think that deflation is an evil to be avoided. It is a necessary method, in conjunction with debt relief, to restore the confidence and ability of a fiat monetary and fiscal system to re-set and remains viable.

Therefore we can look for the effects of deflation, the unavailability of currency. However right now we are looking at the unavailability of the global reserve currency and its nearest competitor. Without access to the global reserve currency, the $, you either cannot trade or you have to use domestic currency to buy $'s to enable trade. In the current and future climate, very few domestic currencies will be accepted directly in exchange for goods. We already have anecdotal evidence that insurance, or lines of credit, to guarantee payment of exports upon delivery has dried up. Global trading is grinding to a halt:

(Courtesy of Stockcharts.com)

It closed at 1102, a 90% devaluation in 4 months.

Demand for shipping has collapsed and has yet to be reflected in the statistics governments and central banks use to forecast future actions. It is this that allows the minority report to have a breath of life. If mistakes are made at this juncture, if policy does not reflect the true need, then capitalism may indeed be doomed.

I expect to see many large scale bank failures as the bail outs fail. One of the lessons a wise trader takes on board is not to add to a losing position. There may be times when doubling up on a loser pays off but in the end it will go wrong and wipe out your account. Governments and Central banks have just doubled up on losing bank positions. This is not the first time they have done this and where in the past they may have got away with it, this time the position is so large, the margin so deep and the capital so expensive that the very nature of the intervention will worsen the crisis. We are seeing the trade of last resort.

We are going to see a severe slowdown in global trade in many assets and commodities. Only those companies and countries that are cash rich and able to use savings to invest in profitable enterprise will have the ability to produce and export goods. Attempting to use domestic currency to purchase imports will prove prohibitively expensive, unless you happen to be the US or Japan.

The lack of credit at sustainable borrowing rates will force a realignment of business funding. Reliance on credit has been the backbone of expansion but the global economy is now in a full nelson, screaming for submission as the cracking and popping of joints get louder.

We are going to see a protracted period of negative "growth" in nearly all corners of business. However those companies that followed sensible business strategies and continue to invest without using credit will be well placed for the future.

Banking will never be the same again. The use of depositor's funds to make investments will be heavily regulated, hopefully including rules such as equal maturity, where investments mature at the same time as deposits become released for savers. If banks can only operate using deposits then they must be fit for purpose, properly capitalised and transparent to ensure confidence is restored. We must be prepared to allow banks to fail, removing the safety net of nationalisation. That will encourage depositors to look carefully before entrusting funds, taking responsibility for their investment decisions.

Those Hedge Funds that are not in cash will be lucky to survive. With essentially the same bets in place that the defunct Investment/Broker Banks had but without the bail out facilities available to them the future looks bleak. Even if they have successfully de-leveraged the lack of returns will see a massive increase in redemptions.

The inability of many countries to import goods will lead to 2 results. Some will attempt to print more currency to purchase either $'s or $ (and yen) priced goods and we know where that will lead. Others will look inward and begin the process of rebuilding manufacturing and R&D to allow home grown substitutes to replace those imports that are no longer available.

Some countries will be better placed than others to make such a move, others will be rich in assets and poor in ability, new trading groups and partnerships will evolve. The Eurozone may not be able to survive such change; it is unlikely that the current membership of the Euro will remain in place. Weaker economies will not be able to support the requirements needed to comply with membership. Much of the Southern Mediterranean EU will be bankrupted, along with other countries in old Europe, Africa the Middle and Far East and Latin America.

I expect attempts to be made to peg smaller currencies to a $/Y basket. These 2 currencies will remain strong for the foreseeable future as long as demand for a reduced supply exists. Eventually there will a centrally controlled orchestrated move to develop regional currencies linked to a peg that is not a currency, such as the IMF SDR's (special drawing rights). The movement of currency from one region to another will be after a conversion to "SDR" and controlled by the Bank of International Settlements.

Finally in this part of What's That Coming Over The Hill is a chart from Bloomberg by Espen Furnes of Storebrand Asset Management that neatly sums up and displays why the credit crisis will morph into something much worse (I had a similar chart but not as good as this!):

(Courtesy of Bloomberg & Espen Furnes of Storebrand Asset Management)

Notice the lag in capital raised compared to losses sustained and remembering back to the summer of '07 how small the losses were compared to the damage wrought.

I haven't seen a better chart that shows why there is a need to suck wealth from the global economy to "save" the system and why the expansion of the bail out is not inflationary.

More next week.

It is time for a short update to the series of artices that started with The Future Actions of The Federal Reserve And US Govt Are Known

Many people have been wondering what the cost of all this intervention may be. I firmly believe that Bernanke, Paulson and the US Government are following the ideas laid out in Eggertsson's work "An interpretation of The Deflation Bias and Committing to Being Irresponsible".

The following is from the work that Eggertsson did and I interpreted. It shows that the plan to buy assets was long in place before the current problems. One of those credited in the paperby Eggertsson is Ben Bernanke:

What Eggertsson means is if tax cuts are so large as to cut govt spending by 10% (tax breaks forever?) then to keep an inflationary bias as a credible outcome (keep inflation expectations in the mind of Institutions, Business and Joe Public) would require the use of a sum equivalent to 70% of US GDP to buy "real assets".

Or, as I said in April:

• "If Bernanke and Co keep with the blueprint (it would be difficult to see how they could deviate now without destroying carefully implanted expectations) we can expect to see continuous and expanding intervention in what was previously thought to be off limit areas.

  Treasury bond issuance should rise and does not have to have a defining limit. Tax rebates will continue and grow, expanding beyond traditional areas. Use of current GSEs to expand government debt will be encouraged and may well lead to the formation of "Super GSE's" that could take on second lien loans on property, for example.

  The Fed will expand its facilities, including more market participants and widening the range of assets that can be used, including stocks. The facilities will become permanent but will be allowed to run down in use as circumstances dictate. It will be imperative to remove any stigma associated with the use of such facilities, possibly by converting the facilities to a type of GSE, or more likely, a Fed Sponsored Enterprise.

  Concerted and possibly international intervention in Forex markets should be given a high level of probability. This will allow a slow and orderly re-pricing lower of the dollar and a continued bias toward inflation."

In that light remarks such as these now make sense:

• Sept. 23 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke signaled that the government should buy devalued assets at above-market values to make its proposed $700 billion rescue package most effective in combating the financial crisis.

  ``Accounting rules require banks to value many assets at something close to a very low fire-sale price rather than the hold-to-maturity price,'' Bernanke said in testimony to the Senate Banking Committee today. ``If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price, there will be substantial benefits.''

and this:

• Sept. 23 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke said the U.S. economy will shrink if markets don't begin functioning normally, joining Treasury Secretary Henry Paulson in urging skeptical lawmakers to quickly pass a $700 billion rescue for financial institutions.

  ``I believe if the credit markets are not functioning, that jobs will be lost, the unemployment rate will rise, more houses will be foreclosed upon, GDP will contract, that the economy will just not be able to recover,'' Bernanke told the Senate Banking Committee today. ``My interest is solely for the strength and recovery of the U.S. economy.''

The last line is a white lie. His sole interest is to avoid deflation, at all costs.

So, what are the possible ranges of increase in deficit spending/asset buying that may be required?

A recap of the scenario:

bubble, easy money, inflation in fiat money supply, inflation in commodities and hard assets, inflation, fear of inflation, rising rates, YC inverting, flattening, rising and inverting again, tightening, withdrawal of liquidity, corrections, crashes, talk of stagflation, FEAR, withdrawal of speculative funds, further corrections and crashes, demand collapse.......Deflation.

• "Bernanke then goes on to state that as the real costs of intermediation rose some borrowers found credit to be expensive and difficult to obtain. He then states:
  • "The effect of this credit squeeze on aggregate demand helped convert the severe.....downturn of 1929-1930 into a protracted depression"

  Bernanke goes on to identify various problems from the '20s that made the 29-30 downturn (which included the expansion of debt) and in 1930 the move by banks out of the loan markets into more liquid instruments. Indeed the 1932 National Industrial Conference Board survey of credit conditions reported that the shrinkage of commercial loans in 1931 and the first half of 1932 represented pressure from the banks on customers for repayment and refusal by banks to grant new loans. The worry is that the Fed Chairman saw no cure better than the one used in the '30s New Deal and the large scale intervention of the federal Govt:
  • "home mortgage market...function....was largely due to the direct involvement of the federal government....establishing ...FSLIC...federally chartered savings and loans....government "readjusted" existing debts....and substituted for recalcitrant private institutions in the provision of direct credit. In 1934.....Home Owners' Loan Corporation made 71 percent of all mortgage loans extended"
    

  It looks to me that Bernanke has already instituted the measures he believes will help avoid a repeat of '29-'33 by delivering the medicine now rather than later. As we have seen earlier in this article, the medicine does not seem to be affecting the patient. Credit availability continues to contract due to the policies of banks. Ben Bernanke now finds himself in a situation where he has delivered all he can to no avail. Does he sit back and wait for a change in credit conditions to become apparent or is there more that he can do?

  Whatever he does, unless lending conditions change markedly and rapidly in this quarter, it will be ineffective. Bernanke will no longer have to refer to history to see a deflationary depression, he will be living it."
  

The above quote is from The Bernanke Conundrum written on the 8th May 08 and has come to pass. We hear today that the US Treasury is monetizing the debt taken on by the Fed for the nationalization of AIG:

• "Sept. 17 (Bloomberg) -- The Treasury will sell more debt to enable the Federal Reserve to expand its balance sheet, a sign of the strains created by the biggest extension of central-bank credit to financial companies since the Great Depression.
  The program starts today with a $40 billion auction of 35- day bills, a day after the government agreed to take over American International Group Inc., the Treasury said in a statement in Washington.
  The proceeds will ``provide cash for use'' by the Fed as it seeks to boost liquidity in credit markets struggling from $515 billion in writedowns and losses since the start of last year."
  

• "Boy you could here the squeals of pain all the way down Wall St. Getting caught by the auditors is the risk you take when you start playing with exotic instruments and "forget" to let the accountants know things may have changed. PricewaterhouseCoopers applied the pressure, uncovering "material weakness" in the way AIG accounted for it's Credit Default Swaps.
  The material weakness was to under-estimate the losses on CDS by 400%. AIG say the losses of $4.88Bn occurred in October and November '07 on CDS sold to protect fixed income assets. Which, of course, means that January to March '08 figures are not going to be any better taking into account the current turmoil in the bond and derivative markets."
  

• "Amongst those assets are ILFC, an aircraft leasing company, 21st Century Insurance Company, American International Assurance, a near 10% holding in the Peoples Insurance Company of China, Stowe Mountain resort, the Bulgarian Telecom Company and Vivatel, a mobile network, AIG American General (insurance) which owns Matrix Direct Insurance Services and finally Ocean Finance a UK loans company specialising in mortgages and re-mortgages.

  A sale of assets or a move by Fund Managers or Hedge Funds to force a release of "value" cannot be discounted. If that does happen, I wonder where AIG will be in the Forbes Global 2000?

  By the way, be careful of who you listen to. This was one of the comments I saw on Bloomberg about the AIG drop:

  "Investors eventually will look back at yesterday's announcement and conclude they overreacted, said David Katz, chief investment officer for New York-based Matrix Asset Advisors, who supports Sullivan (the CEO)." Must be a coincidence........"

Capitalism is screwed, more precisely the US / Anglo Saxon model is screwed. That means we are all screwed too. In the space of just over a week the main drivers behind the credit boom have imploded, brokers have gone down and the biggest insurer of debt has folded softly into the arms of the Fed. I wrote Pre-emptive Warning of a Major Banking Crisis back in March '08 which concluded:

• "How can the Fed plan fail? The risk is with the dollar. If the action taken by Bernanke is seen as a massive dilution of the strength of the dollar then it and its derivatives will all fall in price, regardless of any concerted cooperation by Central Banks.

  If the markets believe the treasuries constantly introduced into the market are being used to shore up massive losing positions then the risk of default will increase. This will cause a fall in the price, placing the PDs (Primary Dealers) with a further tranche of "sold low, buyback high" assets. With a lower pricing on dollar derivatives, the dollar will suffer the same fate as underlying loans have in MBS derivatives. The mechanism is the same.

  With the Fed placing itself in a position were it holds lower worth assets than the treasuries it issued, the risk of a default by a PD becomes a risk to the Fed. In default the PD will have to hand over the treasuries used as collateral, leaving the Fed no better off than an SIV stuffed full of toxic debt that is unable to raise funds in commercial paper markets. The risk would be a loss of confidence with the Fed as an Institution."
  

The moral hazard invoked by the Fed, US Treasury and Congress is beyond anything ever seen in the past 1000 years. The very structures of daily life, of daily subsistence have been placed in jeopardy to save the banking and brokerage fraternity.

A deep recession or depression would have carried out its duties by purging mal-investment and bad credit. It would have been painful and unpalatable but the financial system would have survived. No doubt it would have changed and the power structures controlling it would have moved but, it would have survived.

Most readers know I see a deflationary depression in our futures. Now I see something different becoming a possibility. What if the US produces large scale, short term Treasury debt on a rolling basis to fund the long term debt incurred by the multi bailouts?

Some are thinking it would be inflationary, monetizing debt by the use of credit. As we have seen in numerous examples issuing short term debt to fund long term borrowing is a mugs game, it has been the downfall of Fannie, Freddie, Northern Rock, HBOS, Bear Stearns, Merrill Lynch, Lehmans, AIG, Countrywide and so on.

What on earth makes that risky, flawed model any different for the US as a whole? The assets taken in exchange for this increased short term government debt are toxic, useless, untradeable and riddled with legal complexity. Why would anyone want to buy short term debt issued by the most debt riddled country in the world?

Its beginning to look like the "insurance" on debt is also about to disappear:

• "Sept. 17 (Bloomberg) -- Deutsche Bank AG is taking steps to slow credit-default swap trades that expose it to the risk of failure among Wall Street firms, according to three investors told of the policy.

  Germany's largest bank is requiring risk managers to approve trades where the company takes over an investor's contract with another dealer, said the people, who declined to be identified because they do business with Deutsche Bank. Signing off on so-called novations can take an hour, deterring investors from the trades with the Frankfurt-based institution, they said.

  Financial companies are seeking to limit exposure to competitors after New York-based Lehman Brothers Holdings Inc. went bankrupt and the government seized American International Group Inc., sparking concern that other dealers may fail. Credit-default swaps based on Goldman Sachs Group Inc. and Morgan Stanley surged to a record today."
  

Dear Gordon Alistair,

Firstly I would like to say thank you for giving me the opportunity to lead the Bank of England for another term. Now that I am securely in post, I feel I can relax a little and say more of what is on my mind. Of course that may not sit comfortably with you but I am sure you agree that I have to be seen as independent from the Government, which may entail the odd snippet of bad news.

Speaking of bad news, it looks like I am going to have to keep interest rates at the current levels. In fact, I may have to raise them if prices continue to rise.

One the positive side, banks will be able to make higher profits by borrowing short and lending long and the consumer still doesn't understand that inflation causes rising prices rather than the other way around. I am sure the Prime Minister will see that with prices rising and wage levels stagnating, the Bank of England is able to conduct the wealth withdrawal policy that his government had to drastically reverse the other day.

On balance it could be seen that the current "inflation" that is reducing consumer discretionary spending is a net offset from the re-introduced tax hand outs. This can only be good for the medium term. Indeed if further public monies are introduced into the economy, a counterweight rise in inflation would be welcomed by big business and banks.

We must however ensure that the public is not surprised by this redistribution of wealth from the poor to the rich. Therefore a continuing blizzard of pro-inflationary propaganda should be encouraged until the public shows signs of capitulation. By then we fully expect most banks to have recapitalised their reserves.

A good example of how to accomplish this is the following quote, where we blame the end of the good times on a bumpy road, rather than the policies of the Bank or the Government:

• ``The Monetary Policy Committee is facing its most difficult challenge yet,'' King told reporters in London today. ``We are traveling along a bumpy road as the economy rebalances. Monetary policy shouldn't try to prevent that adjustment.'' It ``must focus on bringing inflation back to the target in the medium term.''
  The Bank of England has been reluctant to cut rates as fast as the Fed, which has reduced its benchmark seven times since September, for fear of stoking inflation too much.
  ``We did not fall prey to the sirens to cut interest rates further as some other central banks have done,'' King said. (Bloomberg)
  

This helps the public to focus ahead, rather than reviewing past actions and deflects attention from any current policy "mistakes". I would congratulate Caroline Flint for the marvellous placement of the "bad housing outlook" into the public's mind, a masterstroke of using the paparazzi combined with product placement. She should be considered for advancement.

As you can see from my statement, I have ruled out doing anything to help the situation. Instead I have pointed out how dangerous such action would be and how it might stop me from focussing on inflation. Of course the icing on the cake is the threat of one or two periods of negative growth. Some call it recession, it's a very good tactic to use when you want to put the skids under job prospects. It helps keep wage demands down.

All in all, I think the policy of stripping wealth out of the general economy and concentrating it amongst the banks and financial institutions is going well. The only fly in the ointment is the stubborn refusal of gold to climb to new highs. As long as the public don't notice this counter indication, the policy should still run smoothly.

It is at this point I have to warn you that the following chart should have a 30 year gagging order placed upon it. As you can see, we think inflation is peaking, if the public find out and decide to start saving, gathering higher interest now to use in a "cheaper" future environment, we could ignite a consumer spending deflation pattern. Of course we would have to blame the instability in Government taxation policies for causing such a scenario.

Yours,

Merv.

PS. Inflation is above 3%.

With the US Federal Reserve cutting its Fed Fund Rate to 2%, presumably to aid the cost of borrowing and allow an expansion of lending that will lift the US economy from the doldrums you would expect to see an expansion of bank business. Not so according to the latest Fed's Senior Loan Officer Opinion Survey which shows that banks are now actively avoiding the expansion of credit and it can be shown are deliberately causing a credit contraction.

This has profound meaning for the US and the wider global economy.

Let's look at the evidence. The following 3 charts show the Bernanke Conundrum as it applies to business. Yes, business - its not just consumers getting squeezed:

How important is this? Very, I mean crash imminent (Q2/3) very important. It is clear to see that borrowing conditions for business have not improved even with the Fed liquidity/solvency actions and the cutting of rates. Around 60% of domestic banks are making it difficult or impossible (likely the latter for all but the highest quality of business) to borrow. In fact conditions for business requiring credit have deteriorated substantially even in the face of a higher demand since the last survey.

Why am I worried about a crash? Simply this, notice the increase in demand for loans (third chart above) is a good leading indicator of the direction of the economy and the markets. This is probably a function of using credit to expand business / productivity in anticipation of an acceleration of growth overall.

Having said that and looking at the chart above you are probably wondering why I am not saying the good times are just around the next quarter or 2. It would seem foolish to say its different this time.

Yes, you guessed it:

The problem for Bernanke is made no easier by the same predicament facing consumers:

No, they do not. Loans and credit cards have tightening standards and there is no willingness to allow consumer instalment loans. The bottom of the consumer barrel has been scraped and there is no wish to return for the crumbs.

When compared to the last downturn and recession ('00-'03) you can see how much more difficult it is for consumers to borrow now, compared to then. No consumer and no business borrowing. What's a Fed chairman to do eh?

Am I saying its different this time? Oh yes, without a doubt. Look again at the charts above, focussing on the last quarter of '99. Look how lending standards and costs rise as we tipped over into the weakening economy and eventual recession to come, yet lending demand from business contracted. This is the "natural" state of affairs, even back in '90/91 when demand for loans and the price above the banks borrowing costs rose, standards were dropping rapidly, business could borrow, it just cost more.

This is clearly not happening now. We have an environment were business needs to borrow but banks are unwilling or unable to lend.

Bernanke's conundrum is simple to see, after all the easing of rates and invention of facilities to enable credit markets to continue and even with the de facto underwriting of the whole fiat monetary system, banks will not lend.

How big a problem is this? Unless business can borrow (either to offset costs, rollover previous borrowing or get ready for expansion) then 1929-33 looms large.

This though is not the final state we have achieved. By now all market participants know that the Fed will go to extraordinary lengths to keep the current system operating. The conundrum for Bernanke is what can he do to make banks loosen standards and lower costs?

You see, For Ben Bernanke the current situation isn't "news"

Bernanke has already studied the conundrum. I quote from "Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression" as used in "New Keynsian Economics"(Mankiw and Romer Ch 29):

• "An interesting aspect of the general financial crises - most clearly, of the bank failures-was their coincidence in timing with adverse developments in the macroeconomy"

  "The present paper builds on the Friedman-Schwartz work by considering a third way in which the financial crises (in which we include debtor bankrupties as well as failures of banks and other lenders) may have affected output".".....because markets for financial claims are incomplete, intermediation between...borrowers and....lenders required nontrivial market making and information gathering".

Bernanke then goes on to state that as the real costs of intermediation rose some borrowers found credit to be expensive and difficult to obtain. He then states:

• "The effect of this credit squeeze on aggregate demand helped convert the severe.....downturn of 1929-1930 into a protracted depression"

Bernanke goes on to identify various problems from the '20s that made the 29-30 downturn, which included the expansion of debt and in 1930 the move by banks out of the loan markets into more liquid instruments. Indeed the 1932 National Industrial Conference Board survey of credit conditions reported that the
shrinkage of commercial loans in 1931 and the first half of 1932 represented pressure from the banks on customers for repayment and refusal by banks to grant new loans. The worry is that the Fed Chairman saw no cure better than the one used in the '30s New Deal and the large scale intervention of the federal Govt:

• "home mortgage market...function....was largely due to the direct involvement of the ferderal government....establishing ...FSLIC...federally chartered savings and loans....government "readjusted" existing debts....and substituted for recalcitrant private institutions in the provision of direct credit. In 1934.....Home Owners' Loan Corporation made 71 percent of all mortgage loans extended"

It looks to me that Bernanke has already instituted the measures he believes will help avoid a repeat of '29-'33 by delivering the medicine now rather than later. As we have seen earlier in this article, the medicine does not seem to be affecting the patient. Credit availability continues to contract due to the policies of banks. Ben Bernanke now finds himself in a situation where he has delivered all he can to no avail. Does he sit back and wait for a change in credit conditions to become apparent or is there more that he can do?

Whatever he does, unless lending conditions change markedly and rapidly in this quarter, it will be ineffective. Bernanke will no longer have to refer to history to see a deflationary depression, he will be living it.

The past three Occasional Letters have been quite an in-depth discussion about the path taken by the Federal Reserve and recently by the Bank of England in their attempts to deal with the deflationary forces unleashed by the credit crash. Since those discussions we have seen evidence that supports my view as seen recently in the Weekly Reports.

This Occasional Letter will further expand upon that evidence and show why the plan, which I dubbed Eggertsson Theory, may already be showing signs of failure.

Firstly a little recap to refresh readers memories. GB Eggertsson wrote a paper for the Federal Reserve in which he supported the Monetarist view that deflation could be avoided by a combination of fiscal and monetary expansion combined with a credible expectation that the polices were inflationary. This would lead the private sector (business and consumer) to act in a manner that reflected such expectations and to respond to them accordingly.

It is the expectations of inflation that were of importance to Eggertsson, without it the plan to reflate would fail, as seen in Japan over the past 2 decades. Indeed, Eggertsson goes as far as to say (along with Bernanke) that the failure of the Bank of Japan to adopt an inflation target, either actual or implicit led to the current malaise affecting their economy.

As I mentioned in the previous articles, the Ben Bernanke Fed along with the US Govt and Treasury have adopted the measures espoused by Eggertsson and have implemented them. We have ample proof of the stimulus, tax rebates and new Fed Facilities, all designed to add liquidity in the form of cash and credit enabling structures to stave off a slowdown. During this period we have had constant reiteration of a hawkish view on inflation and the possible decoupling of inflation expectations to the upside.

Importantly then, have we seen an increase in inflation expectations in the people and the private sector? April Consumer Confidence as measured by The Conference Board dropped to 62.3 from 65.9 showing that the economy has yet to bottom. Within the report were 2 interesting figures:

• 1 year inflation expectations were 6.8% up from 6.1% in March.

Does this mean consumers expect to spend more? No it does not and as we shall see later, it would appear that rather than consumers stepping up to higher prices, they are buying less.

Here are a couple of snippets from the Consumer Confidence report that show more evidence of a lack of spending power and an increasing fear:

• Jobs Hard to Get 27.9% up from 24.5% in March, and Jobs Plentiful 16.6% down from 19.2% in March.

  The number of respondents planning holidays (vacations) are at a 10 year low.
  

Now expectations are one thing, actual changes in habits are another. We can see that the public perception of inflation is growing and by some measures could be viewed as having decoupled from the Fed expressed inflation expectations. This could only be seen by most as highly inflationary and that rises in workers compensation would have to go up to maintain equilibrium.

A self fulfilling prophesy, engendered by Fed/US Govt policies, that causes a rise in compensation and prices and a move away from deflation seems to be in the throws of creation. If we take the consumer inflation expectation at 6.8% and compare it to Fed Fund Rates at 2.25% then real rates are a negative 4.55%.

Yet the consumer does not seem to be interested in grasping this opportunity, even to fund a holiday.

• GDP +0.6%, but real final sales -0.2% (1st drop since -0.5% in Q4:2005). Consumption slowed on dip in durables & nondurables spending (only services were up), & investment fell except for inventories.
  

More from Thompson financial:

• (Thomson Financial) - The U.S. economy continued to sputter in the first three months of the year as consumers cut back on spending to their slowest pace since the mild recession of 2001, the Commerce Department said today.
  

Consumer spending grew at 1% yet reported Personal Consumption Expenditures rose 3.5%. Core PCE rose 2.2%. Now we have a dilemma for the Fed, in that although inflation expectations have risen, PCE and core PCE have not. In fact it they slipped back by 0.2% and 0.1% from Q4. (core excludes food and energy)

So by the Feds own measures, (it prefers core PCE) inflation is moderating. Now before I get a bunch of emails about using Fed data let me explain one thing. The Fed use Fed data. If you want to know what the Fed are thinking don't impose statistics that the Fed doesn't use.

So what does this tell us about consumers? It tells us they have stopped spending. Goods might cost more but they are not being bought in the same quantity. Remember, you can put whatever price you want onto an asset, it doesn't mean someone will be willing (or able) to pay it.

Blue = Real retail and food services sales. Red = CPI all urban consumers, all items. Green = CPI all urban consumers less energy.

What about business, did it continue to view the economy as it did in Q4?

• Exports grew 5.5 % after rising 6.5% in Q4 . Inventories added 0.81% growth after subtracting 1.79% in Q4.
  

No, it did not. Business decided to replenish inventories in Q1 '08 despite the evident slowdown under way and it wasn't to boost exports. Why would business do this, why change tack before real signs of change in the economy? Again we have to look at the Fed and US Govt and the constant rhetoric that favoured upside surprises in growth and inflation. It looks like business took them at their word. That might prove to be an extremely costly mistake if that inventory cannot be passed on to consumers.

The following chart shows why I am puzzled by the way Business conducted itself in Q1:

Clearly something has changed in the accounting of unfilled orders. Is it a ruse to push forward production into the accounts without actually realising the sales? Secondly, new orders and shipments are stagnating or declining and would not be conducive to an inventory build.

More worryingly for business is the consumer perception about the jobs market:

• Jobs Hard to Get 27.9% up from 24.5% in March, and Jobs Plentiful 16.6% down from 19.2% in March.
  

Even if the consumer is wrong, the expectation that jobs are under threat or that finding a job has become much more difficult will cause a retrenchment in spending. The tax rebate cheques hitting doormats may well find their way into savings accounts or the pay down of non secured debt rather than being used to buy consumer goods. If this does happen, business will find itself with a large inventory overhang and a lack of orders going forward.

Which brings us to cause and effect. What caused the consumer to retrench, to slow spending growth to below that of PCE? Simple, someone turned off the credit tap. Without doubt we are not seeing spillover effects from the credit crunch into the real economy, we are seeing a flood, a deluge of deflationary waves crashing into the cliffs of consumer spending. We know what happens next, the cliff crumbles and the waves move further inland, threatening greater erosion.

You see deflation is not just a negative reading of money/credit production or even a reading of falling prices. Deflation and inflation can be seen as the amount of money/credit available to purchase goods and pay for services.

It does not matter how the availability of money is affected, the result is the same. Taking money out of an economy, either through higher taxation, higher interest rates, higher prices or increased savings reduces the amount of money available to be spent on discretionary items or services. Only the basic necessities can have pricing power and even then the consumer may decide the necessity can be cut back.

Savings under an Austrian model economy are only useful if they are used to invest in production. For instance if the savings are hoarded, to bolster capital requirements, then no expansion of useful production is possible. In a deleveraging credit based economy, where the accumulation of capital is the highest priority, then credit based expansion becomes impossible.

We have seen this with housing and automobiles and now we are beginning to see it with all purchases outside of the service sector (BEA):

• Real personal consumption expenditures increased 1.0 percent in the first quarter, compared with an increase of 2.3 percent in the fourth. Durable goods decreased 6.1 percent, in contrast to an increase of 2.0 percent. Nondurable goods decreased 1.3 percent, in contrast to an increase of 1.2 percent. Services increased 3.4 percent, compared with an increase of 2.8 percent.
  

The economy is stumbling along on one good leg. If it twists the overburdened limb it will come to an instant and painful stop.

As the consumer "drives" GDP we need to see what the trend is in their habits (BEA):

• Disposable personal income increased $127.3 billion (5.0 percent) in the first quarter, compared with an increase of $103.4 billion (4.1 percent) in the fourth. Real disposable personal income increased 1.4 percent, compared with an increase of 0.1 percent.

  Personal outlays increased $106.8 billion (4.2 percent) in the first quarter, compared with an increase of $148.0 billion (5.9 percent) in the fourth.

  Personal saving -- disposable personal income less personal outlays -- was $20.2 billion in the first quarter, in contrast to a negative $0.3 billion in the fourth.

  
  The personal saving rate -- saving as a percentage of disposable personal income -- was 0.2 percent in the first quarter; in the fourth quarter, the personal saving rate was 0.0 percent.

Spending less, saving more.

The economy now finds itself staring at the last true hope for salvation, the tax rebates. Will the consumer spend those tax rebates or will the money, delivered directly to the consumer (as per Eggertsson Theory) be used to pay off debt and/or be placed into savings?

It is clear that even the Fed/US Govt isn't sure on the outcome. Yet another "save the mortgage" scheme is being muted:

• US HOUSING: Federal Deposit Insurance Corporation Chairman Sheila Bair outlined in an Op-Ed piece in today's Financial Times a proposal that would assist one million homeowners who are facing foreclosure. The plan proposes that Congress authorize the U.S. Treasury to use $50 billion to make loans to borrowers with unaffordable mortgages to pay down up to 20 percent of their principal. The repayment and financing costs for these Home Ownership Preservation (HOP) loans would be borne by mortgage investors and borrowers. This approach is scaleable, administratively simple, and will avoid unnecessary foreclosures to help stabilize mortgage and housing prices.
  

For the Fed et al time is running out. With PCE inflation measures showing signs of moderation the credibility of the touted inflationary policies becomes more difficult to defend. Consumers have been fed a diet of higher inflation expectations and are reflecting as such but there seems to be resistance to actually commit to higher spending. That resistance will grow if signs of further moderation in inflation appear and spending will be suspended until prices fall to acceptable levels.

If spending does not increase business may decide that the Feds inflationary expectations are misplaced when compared to what their till receipts tell them. If business then decides to cut overheads and raise productivity by cost savings, allowing prices to fall to attract sales, the Fed will have failed and a deflationary environment will be established.

Having written 2 in-depth articles about the rationale behind the Federal Reserve and US Govt plans to bail out the financial system some readers of the last couple of Occasional Letters may well have wondered if I was about to change my outlook. This article should put paid to any such thoughts.

Previously I looked at the evidence that supported the view that the Fed and US Govt (along with the Bank of England) are following a monetarist approach, adapted by GB Eggertsson , to attempt to re-inflate the economy through non traditional means. As we have seen, especially recently in the UK, all the mechanisms required for the plan are in place and are being instigated.

In this article I want to look at why the monetarist approach will fail and what the results of that failure will be. (Yes, this is the article you have been waiting for). In doing so, I may quote from others but I shall make it clear when I am doing so.

First and most importantly, I must stress that my long term outlook remains unchanged:

• A recap of the scenario: bubble, easy money, inflation in fiat money supply, inflation in commodities and hard assets, inflation, fear of inflation, rising rates, YC inverting, flattening, rising and inverting again, tightening, withdrawal of liquidity, corrections, crashes, talk of stagflation, FEAR, withdrawal of speculative funds, further corrections and crashes, demand collapse.......Deflation.

Now the next bit might sound a little patronising for which I apologise in advance, I know my readers are a clever bunch and this could be seen as pointing out the obvious.

Read the scenario again. Within it is a wisdom that could form a theory all of its own (I know, I'm getting carried away) and would explain many of the observations about the economy and stock/bond markets.

Here is the patronising bit. To circumvent the final outcome of the scenario, which is the biggest fear of the Fed et al, the central planners have a "cut out". Simply put, when they judge circumstances may lead to the dreaded conclusion; they stop the process by resetting it to the beginning. They rewind the tape.
Is this my way of saying that the deflation will not happen? No, it will occur when the tape snags and breaks. What we are living through now is an attempt by the Central Banks, in cooperation with their Governments to reset conditions back to "easy money". In other words every attempt to avoid a deflationary period results in a series of actions that make the requirement for the same actions to reoccur, the only difference being that the size of each "action" has to be larger than the previous one.

It is the infinite Ponzi scheme. Whereas a normal Ponzi scheme requires investors to keep ploughing in new money, the infinite scheme is only regulated by the pace of newly created money introduced to the scheme as the fiat system guarantees supply.

Let us see this in action by examining other periods when the tape was rewound.

Firstly here is a chart of inflation/deflation swings from Jan 1914 - Mar 2007. Although a year behind, it shows well the current long term trend (Dept of Labor/BLS):

Most noticeable is the smoothing of inflation peaks and deflation lows, with the elimination of deflation by the mid-50's. This remarkable achievement is even more apparent in this chart (using McCusker to 1913 then as per previous chart):

Never has the elimination of deflation or such a sustained period of inflation been seen in the past 350 years. We truly are in an age of innovation. Without doubt, it is the elimination of deflation that is the Fed mandate, accomplished by a continuing inflation which is controlled in its acceleration by the application of interest rate policies:

Now for most that read my Letters none of this is particularly earth shattering news, for the uneducated public though this would come as a shock. The recognition that the past 50 years are aberrant, not the norm, is like saying the deflationary outcome of the 30's crash was "unexpected". There is no doubt that the deflationary period in the Great Depression was not unusual. What is unusual is the persistence of inflationary conditions since the mid-50's.

Some will say that it was the loss of a gold or silver backed currency that caused this unusual inflation, others that the social and economic ills of the 30's made episodes of deflation unacceptable to the politicians and public.

Although both points could offer contributory causes to the current inflation, it would not explain the acceptance and appearance of both inflation and deflation prior to the mid-50's. What may explain the disappearance of deflation is the rapid and innovative use of debt.

Who initiates and allows the accumulation of debt?

The above chart show recessions marked with gray columns. You can now see why I compared the current Fed conundrum to 1937 and not 1933. Notice the acceleration of debt at each recession. The one time that debt accumulation slowed, in the very late 90's, it led to the closest meeting with deflation since....the mid 50's.

It is the increase in debt, the enabling of "easy money" coupled with a falling real interest rate environment that allows a new wave of inflation to begin. The trigger is any threat that a deflationary period might occur, regardless of the cause of the recessionary events.

Why, in the face of such evidence, do I then hold onto a deflationary outcome? Am I saying "its different this time" ? Or have you already forgotten that the current conditions have only existed for the past 50 years?

Unlike any period since the 30's we are now living with a credit contraction, were even extraordinary measures carried out by Central Banks and Governments are only able to keep the status quo. Expansion of debt from its originator is now used to shore up positions (the Bank of England has forbidden any new positions be taken with Treasuries borrowed from the latest scheme) rather than initiate a further velocity of lending, a fractional enlargement of debt. Current debt is being rolled over, with the new collateral provided by the Central Banks. The acceleration of debt has been massively retarded, if not stopped completely.

It is this that has caused such extraordinary manoeuvres to have happened over the past 8 months, leading to a socialisation of the capitalist system. It is not bank losses or even closures that worries the Fed, it is the breakdown of the benign inflation mechanism by the withdrawal of credit mechanisms from the economy.

The following excerpt is from the August 2000 FOMC minutes (pg 82):

• "MR. JORDAN. Thank you. I agree that leaving the funds rate unchanged at this point is the right thing to do. I am also sensitive to the communications issues involved; it would not be desirable to communicate the expectation that we are not going to raise the funds rate in the foreseeable future or to imply that the next change might be down rather than up. But it is a challenge as to how to avoid communicating that.

  Regarding the language on the balance of risks, part of me would like to say that the statement should always be that an unavoidable, permanent feature of a fiat money system is a balance of risks toward higher inflation. [Laughter] If it ain't going down it's going up.

Some readers might remember the Mogambo Guru published a similar extract in one of his articles some time ago. It was I who sent it to him.

You noticed the laughter. It is poignant as much as alarming. It shows that the committee accept the words of Mr Jordan as a truism. It also means that any threat to an inflationary environment is seen as a threat to the very existence of a fiat money system.

The Fed is no inflation hawk, it is no defender of inflationary expectations. Inflation is a necessary tool to keep the monetary system alive. The Fed is a fighter of deflation, not inflation.

Inflationists are even now pointing out that all the Fed/US Govt needs to do is create new money or nominal interest rate bonds (as put forward by Eggertsson/Bernanke/Friedman) to allow new credit to be created. Indeed I fully expect such measures to be taken in the future.

There is however one difference between the current situation and that of the 30's. I give you this as an example:

• "BANGKOK (Thomson Financial) - Japan has turned down 60,000 tons of rice from Thailand after the asking price nearly doubled in the space of a month, the Thai Rice Exporters Association said Wednesday.

  Chookiat Ophaswongse, president of the association, said Thailand on Tuesday offered the Japanese government 100 percent white rice at $1,300 per ton -- up from the $720 it paid in March.

  "This time, Japan turned it down, saying that the price was too high for their budget," Chookiat said, adding that Japan did not want to be seen as a country pushing up global rice prices.
  

The implications of such actions by importers cannot be under-estimated. This is Japan turning down a staple food requirement for its populace because the price is too high. The reasoning is not important, it is the action and the implications for other exporters of other commodities that is.

We are seeing the beginning of price controls by buyers. If Japan is successful and eventually gets its rice at a cheaper price, the lesson will not be lost on other purchasers and not just those buying food stuffs.

If such actions become commonplace, price inflation and therefore inflation expectations would decouple from the requirements of the Central Banks. If prices start falling price inflation measures, already at peak y-o-y readings would drop drastically, undermining the Feds inflation rhetoric and therefore its plan to raise inflation expectations would lose credibility.

It is this loss of a credible inflation threat that would make further debt issuance by the Fed untenable. I refer you to this from "The Future Actions of The Federal Reserve And US Govt Are Known":

• "Again, I quote from G B Eggertsson: (the Markov equilibrium is covered later in this letter)

  "The third key result of the paper is that in a Markov equilibrium the government can eliminate deflation by deficit spending. Deficit spending eliminates deflation for the following reason: If the government cuts taxes and increases nominal debt, and taxation is costly, inflation expectations increase (i.e., the private sector expects higher money supply in the future). Inflation expectations increase because higher nominal debt gives the government an incentive to inflate to reduce the real value of the debt. To eliminate deflation the government simply cuts taxes until the private sector expects inflation instead of deflation."
  

The private sector will not expect inflation in the face of declining prices, if buyers follow the actions begun by Japan. During a period of recession it would be politically unacceptable to try and stop prices from falling from their currently elevated levels. It would not matter that the public and private business did not recognise the difference between price inflation and monetary inflation. Because of the carefully nurtured confusion over the 2 forms, the Fed would have great difficulty explaining why it was attempting to raise (monetary) inflation in a recession.

The Eggertsson plan would fail and deflationary forces would prevail sounding the death knell for the infinite Ponzi scheme.

Unless, of course, the Fed entered the commodities markets and bought everything it could. Then again, I doubt the US Govt has the stomach to be blamed for mass-starvation.

An Occasional Letter From The Collection Agency

presents

It is 1937 for the Federal Reserve

This Letter is a follow on from my article The Future Actions of The Federal Reserve and US Govt are known in which, using the work of GB Eggertsson, we showed that the Fed/US Govt is following a plan to stimulate the economy and avoid a deflationary episode. Essentially the plan is to avoid the mistakes of the Depression and those of Japan in the 90's by using increased Government debt, monetized by the Fed, targeted directly at consumers. By employing a credible threat of an inflationary stance the Fed/US Govt hope to raise inflation expectations and therefore raise the price of assets.

Whilst the groundwork for such actions are already in place as discussed previously, I now wish to concentrate on the effects such actions will have in the future.

Again, I have to write this article without recourse to my own thoughts to keep an objective viewpoint. I will be using GB Eggertsson again as a reference point. Although it would appear to narrow the perspective the fact that his Theory is in play and he is a member of the New York Fed staff would lend weight to his other work in this regard. In December 2005 Eggertsson published a paper entitled "Great Expectations and the End of the Depression" in which he laid out how the policies of President FD Roosevelt allowed the economy to depart from a deflationary environment.

What I want to show is that Eggertsson has based his theory on the successful polices and methods employed by FDR and what effect those policies had on the economy. Within the paper Eggertsson lays out arguments that support the FDR policies as the only credible approach to economic stimulus during a period of deflation. I believe that those policies are now being used to circumvent the current threat of a deflationary period caused by the credit crash.

Before we begin, I would like to show you a quote from the time as FDR enacted his policy change, referred to as a "regime change" (Sargent 1983 and Temin & Wigmore 1990):

"It is hard to overstate how radical the regime change was. "This is the end of Western civilization," declared Lewis Douglas, Director of the Budget, for example.(2) During FDR’s first year in office several senior government officials resigned in protest.(3)"

(2)Cited in Davis (1986), p. 107. (3)These included Lewis Douglas. The acting Secretary of the Treasury, Dean Acheson, was forced to resign due to his oppisition to unbalanced budgets and the abolishment of the gold standard.

Clearly it was not the end of western civilisation at that time. What we do see is the turmoil that was created by adoption of the new regime. Such events could be compared to the arguments put forward by the recently retired US Comptroller General David M Walker.

History

Without going too deep into history we need to compare the performance of the overall economy during the FDR presidency with the previous 4 year period. Within the following quote from Eggertsson is an interesting observation about the growth of the monetary base:

"The effect of the FDR regime shift is clearly evident in the data. When FDR was inaugurated in March 1933 excessive deflation turned into modest inflation. There was little change in the trend growth of the monetary base around this turning point. Money growth did not start on a sustained upward trend until several months after prices started to rise. Similarly, the fiscal expansion happened with a substantial lag.

This evidence suggests that the recovery was driven almost exclusively by expectations about future policy. The comparison between FDR’s first term in office (1933-37) and President Herbert Hoover’s last (1929-33) is striking. Hoover’s last term resulted in 26 percent deflation, while FDR’s first registered 13 percent inflation. Similarly, output declined by 30 percent from 1929-1933. This was the worst depression in US history. In contrast, 1933-1937 registered the strongest output growth (39 percent) of any four year period in the US history outside of war."

As can be seen in the following table (Eggertsson) 1933 marked the end of the contraction in GDP in dollar terms and the beginning of a large scale expansion of public debt. Noticeable is the acceleration in the growth of the monetary base that begins in 1934, lagging the increase in public debt:

This would support the argument that the increase in debt raised inflation expectations, leading to an increase in monetary demand.

Form this we can infer, without reference to historical writings, that FDR was seen as credible in his regime change. it was this credible approach that allowed inflation expectations to be seen as correct and for monetary requirements to change accordingly.

The Effects

As FDR took office, there was a noticeable turnaround in expectations. Firstly, lets see what the baseline was, according to Eggertsson:

"The reason for the collapse is that the central bank cannot lower interest rates enough to accommodate deflationary shocks, due to the zero bound on interest rates and is unable to change expectations about future policy. This creates a strong deflation bias. The deflation bias helps explain the severity of the Great Depression, because real interest rates were excessively high in 1929-33 due to double digit deflation. This choked spending, especially investment. "Money was king" during this period. Nobody was interested in investing when the returns from stuffing money under the mattress were 10-15 percent in real terms. People gained more, in other words, from holding money than spending it."

Or as I said, why spend today when it will be cheaper tomorrow? It is clear that to make the Eggertsson Theory work, the baseline conditions of the economy should be depressed before allowing the already prepared stimulus to be released. Compare the conditions in 1933 to those today:

The short-term nominal interest rate was close to zero during the Great Depression. The yield on three month Treasuries, for example, was only 0.05 percent in January 1933. Further interest rate reductions were clearly not feasible. Open market operations, in themselves, had no effect, since money and government bonds were perfect substitutes. This explains why several observers at the time were skeptical of the effectiveness of monetary policy and believed that open market operations were just like “pushing on a string”.

Despite this, however, monetary policy was far from powerless. While increasing the money supply at zero interest rate has no effect, expectations about higher future money supply (once deflationary pressures have subsided and interest rates are positive again) have large effects because they change people’s expectations about the future price level, thus reducing real interest rates. What was needed to end the Depression was a regime shift that changed expectations about future policy in a credible way. This is precisely what FDR achieved.

With current 3 month yields at at 1.13% and inflation measures well above, it can be seen why the Fed/US Govt fear a deflationary scenario. The requirement for a credible policy that will result in rising inflation expectations is absolute, to ensure that neither the consumer or business is discouraged from spending or investing. (This has far-reaching consequences, for instance it would not be in the Fed interest to suppress the price of gold)

With this in mind, let us look at some of the effects that FDR policy regime change had post 1933:

Price Levels

Investment

Commodity Prices

Stocks

Again, it is clear to see that the expectations of rising inflation based on a credible policy had an almost instant effect on assets and prices before fiscal and monetary policy had time to make their actual changes felt.

Comparisons to Today

This also backs up my assertion that the Fed/US Govt have been following Eggertsson's Theory for longer than most realise. Here are the same charts for today:

CPI

CRB Index - Commodities

S&P 500 - Stocks

It would appear that inflation expectations are building, despite the evident slowing of the economy (GDP). What is most noticeable is that current conditions are not comparable to the situation in 1932/33. Whilst there has been a fall in stocks and overall commodities, we have not seen a drop in CPI and certainly not the deflationary contraction of the period.

Why then are the Fed/US Govt pursuing the current course? It is here we have to begin to realise that the Fed/US Govt are following a preventative course, rather than applying Eggertsson Theory as a recovery programme. With Ben Bernanke well versed in the Depression and Japan 90-current, it can be assumed he would act quickly to prevent the full effects of a credit based deflation from taking hold. It could be said he has "jumped the gun". As we saw in my previous article, this would be by appearance only, the Fed has been actively planning for a breakdown in credit markets for sometime. Current new policy innovation is the second stage of the plan, one that began back in 2001/2.

The reflation under Alan Greenspan has much more in common with 1933 than the current circumstance but started from a higher base. It could be seen that the use of innovative mortgage solutions and equity withdrawal from 2002 onwards is comparable with the cash/asset swap carried out by FDR with his gold purchase programme, a way of exchanging savings for a direct cash injection.

What we are seeing today is more akin to the recession in 1937/8. This becomes important as the causes of the '37/38 recession were not dissimilar to the reasons for the current situation. Here again from Eggertsson:

"Another useful observation is that there was a short but severe recession in 1937-38, which resulted in a slowdown in growth in 1937 and an output contraction of 5 percent in 1938. If not for this contraction the economy could have fully recovered as early as 1938. In this case a full recovery from the worst depression in US history, which reduced output by a third, left a quarter of the population unemployed, and devastated the capital stock, would have taken only 5 years.

Explaining the slow recovery, therefore, is to a large extent to explain the recession in 1937-38. The most convincing explanation for the depression in 1937-38 is given by Friedman and Schwartz (1963). They argue that the Federal Reserve’s increase in reserve requirement of commercial banks in May 1937 was responsible for the contraction. Following this the economy went into tailspins of deflation and output losses. This explanation is often criticized on the grounds that banks were already holding large excess reserves so that imposing these requirement did not have any real effects (interest rates rose only modestly in response). The model of this paper, however, supports Friedman and Schwartz’s hypothesis and to some extent strengthens it by taking the expectation channel into account. The increase had such a disastrous effect because it changed expectations from being inflationary to being deflationary. It was the expectation that the Federal Reserve would stand ready to stamp down any further inflation that caused the collapse in 1937-38 rather than the new reserve requirement itself.

Interestingly, the disastrous effect of this policy had already been predicted by market participants as early as 1935. S. Parker Gilbert, a partner in J.P Morgan & Company, warned the Federal Reserve in the New York Times in December 1935 that an increase in reserve requirements would strangle the recovery because it would be interpreted as if the Federal Reserve had reversed its inflationary policies.23 The recovery did not resume until 1938, when FDR forced the Federal Reserve to reverse its policy and the Treasury simultaneously embarked on further fiscal expansion"

Like today, it was a change in bank reserve requirements that caused a rapid reversal of economic fortune. Whilst in 1937 it was the Fed who mandated such a change, in 2007 it was the implementation of Basel 2. Again from Eggertsson:

"Historical evidence indicate that the Treasury reacted strongly to this action precisely because it was inconsistent with the policy regime suggested above. Marriner Eccles, the governor of the Federal Reserve, described the reaction of the Secretary of Treasury, Henry Morgenthau, to the increase in interest rates in May 1937 which was due to an increase in reserve requirements (see Eccles (1951) p. 292).

Although we have yet to see massed calls for the reversal of Basel 2 regulations there has been dissent and recent advice from the US SEC in how to price certain assets:

“Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability.”

In other words if the bank decides prices are due to forced liquidation or distressed sales it does not have to mark assets to observable prices. When placed into context with 1937/8 it allows a relaxation of capital requirements as did the pressure placed upon the fed to reverse its decision.

Has the Fed/US Govt laid the groundwork for a critique of Basel 2? Indeed it has, in " Basel 2: The Roar That Moused " by George G Kaufman, written under the auspices of Loyola Univ Chicago and The Federal Reserve Bank of Chicago 2003.

"This paper supports much of the criticism of proposed Basel II, particularly with respect to pillar 1. However, regardless of the complexity or desirability of RBC computed according to pillar 1, the provisions of pillars 2 and 3 are inadequate to enforce them. Although pillar 2 discusses the need for supervisors to intervene promptly if either a bank’s capital or the model used to compute capital are perceived inadequate and impose remedial action, no powers are explicitly recommended for supervisors to effectively enforce this mandate."

It should be expected that a campaign to reverse Basel 2, removing the requirement to comply for the largest "internationally active banks". It also shows that the current targeting by the Fed to bolster reserves and capital assets of Banks and Primary Brokers may well be the first step to undermining Basel 2, removing the restrictions and allowing previous practises to return.

Policy changes designed to feed cash or equivalent assets directly to consumers via tax rebates or Federal and Govt sponsored "respite" programmes along with the undermining of Basel 2 "restrictions" would appear to be the main weapons in use in an attempt to cushion the effects of the current recessionary tendencies that might interrupt the recovery from 2000-03.

The cooperation of the Federal Reserve, US Treasury and the Government in fighting against any deflationary forces resulting from the credit crash is the biggest regime change seen since 1933. Whilst the policies are now in place and active, showing a credible approach to re-inflation, the real test lies ahead.

Will the concerted actions have the desired effect upon consumers and business and allow their inflation expectations to grow?

We shall see.

Introduction.

This is going to be a long letter. It will attempt to explain the rational behind the current and future US Federal Reserve intentions from the point of view of Central Bank thinking. Firstly, you will need a coffee, a comfortable chair and an open mind.

I am going to take you on a journey which will require many explanations. You will have to concentrate but you will be rewarded by gaining knowledge of what the Fed is doing, why its doing it and how it will affect the future.

I intend to make extensive use of Federal Reserve material and will be quoting extensively. Remember, the views and assumptions you see in this article are not necessarily in agreement with mine. This is an attempt to get inside the thinking of the Fed.

Background.

Without doubt the current methods being employed by the Fed are on a par with those seen in the 1930's. There is fear at the Fed felt specifically with Ben Bernanke that, through inaction or policy mistakes, another re-occurrence of a deflationary recession/depression is allowed to happen again. We remember Bernanke apologising for the mistakes in the 1930's and promising (Friedman) that they wouldn't allow it to happen again. It is my intention to show that this fear is the main driving force behind recent Fed actions and will shape the future path of monetary policy in the future.

The Federal Reserve Makes a Choice.

We can assume that Bernanke is fully aware of the risks and is shaping policy to ensure an outcome that will be neither a Japanese '90s or '30s America scenario. He has studied both periods extensively and probably feels he can chart a course through the hard times and ensure an equitable outcome.

To do this he will try to enact Fed mechanisms that allow counterbalancing forces to be released to combat any deflationary threat. We know that this is his course of action because of decisions already made and suggestions put forward.

Is Bernanke following a Keynesian or Friedman (monetarist) approach in the solution of the current problems? (Here we have to assume that Bernanke sees a problem, current use of new Fed Facilities would reinforce this view).

Although this sound a rather academic based question, it is central to understanding Bernanke's approach. From G B Eggertsson "The Deflation Bias and Committing to Being Irresponsible" the fundamental question is:

• "Can the government lose control over the general price level so that no matter how much money it prints, it's actions have no effect on inflation or output? Economists have debated this question ever since Keynes' General Theory. Keynes answered yes, Friedman and the monetarists said no."

Remember, I do not intend to get into the rights and wrongs of Keynesian/Monetarist approaches here, I am attempting to uncover the path that Bernanke has chosen. If Bernanke was following a Keynesian approach then any attempt to improve liquidity would be doomed to fail:

As GB Eggertsson put it:

• "Keynes argued that increasing the money supply has no effect at low nominal interest rates. This has been coined as the liquidity trap."

If Bernanke had been following a Keynesian solution then he would have believed that any increase in money supply would have been ineffective. Yet we see constant attempts to increase liquidity flows. It is clear then that the policies evolving to combat the threat of credit and liquidity contraction are monetarist based. This makes Bernanke’s apology the first signpost on his intended path.

Therefore we cannot look at the actions of the Federal Reserve alone. Any action by the Fed would, according to monetarists, be futile without support from the Government. It also supposes that deflation is caused by a negative demand shock that the then current policies where unable to combat. Indeed the current circumstances in credit markets are seen as a Minsky Event, an unexpected shock to the financial system.

However, it would appear that the Fed and the Government were already enacting policies prior to the credit market dislocation last summer. What happened after the dislocation was not an attempt to stop the problem occurring but was the second required tranche of policy that could only be enacted when the problem surfaced.

Let me explain why, for the Fed and Government, there was no "Minsky Moment" but rather a progression of an already foreseen problem. To do this we need to look at why the Japanese Government and Bank of Japan failed to break out of a deflationary scenario. Again I quote from G B Eggertsson:

• "The deflation bias is closely related, and in some sense, a formalization of, a common objection to Krugman's policy proposal for the BOJ. To battle deflation he suggested that the BOJ should announce an inflation target of 5% for 15 years. Responding to this proposal, Kunio Okina, director of the Institute for Monetary Studies at the BOJ, said in DJN (1999): "Because short-term interest rates are already at zero setting an inflation target of say 2% would not carry much credibility." Similar objections were raised by economists such as, e.g., Dominiguez (1998), Woodford (1999), and Svensson (2001)"

At face value the remarks above would seem to support the Keynesian approach, that at low nominal interest rates, Government deficit spending and quantative easing failed to ignite the inflation required to break out of a deflationary spiral.

Within the quote though is the important point of inflation expectations. It is here that the importance of Bernanke's discussion of a targeted inflation rate and subsequent Fed warnings about inflation expectations remaining anchored becomes central to the main thrust of policy direction.

As we have seen, since 2000 the US Government has run a deficit whilst enabling tax cuts and rebates. The Fed allowed looser lending standards and brought down interest rates, in response to a business led recession. Rather than attempt to hide any inflationary tendencies inherent in these policies, the Fed has become more vocal about inflation ranges with the rhetoric pointing to overshoots of the target range. Inflation expectations amongst business and consumers have, somewhat naturally, been kept high.

The Fed is often measured by its inflation fighting credentials. I believe this is misplaced. The Fed should be viewed as a credible deflation fighter. The Fed had to establish an inflation target, either implicit or within a range, to ensure that further inflation was to be expected in the future.

Why? It is all down to inflation expectations. Japan is unable to break out of its deflationary scenario because no one expects inflation to happen and therefore business, credit and the consumer act accordingly, ensuring demand is constantly put off to a later date. (Why buy today if it is cheaper to buy tomorrow).

Again, I quote from G B Eggertsson: (the Markov equilibrium is covered later in this letter)

• The third key result of the paper is that in a Markov equilibrium the government can eliminate deflation by deficit spending. Deficit spending eliminates deflation for the following reason: If the government cuts taxes and increases nominal debt, and taxation is costly, inflation expectations increase (i.e., the private sector expects higher money supply in the future). Inflation expectations increase because higher nominal debt gives the government an incentive to inflate to reduce the real value of the debt. To eliminate deflation the government simply cuts taxes until the private sector expects inflation instead of deflation. At zero nominal interest rates higher inflation expectations reduce the real rate of return, and thereby raise aggregate demand and the price level. The two main assumptions underlying this result is that there is some cost of taxation which makes this policy credible and that (2) monetary and fiscal policies are coordinated.

Because of raised inflation expectations, deficit spending by the US Government has the same effect as dropping money from helicopters. It is expected that because assets have been introduced into the economy inflation must rise. (It is useful to have a few members of the Fed that are inflation hawks and vocal in warning about increased spending leading to inflationary pressures).

However, if such funding is directed straight into current money supply it will not increase prices. Again I have to quote from G B Eggertsson:

• "Deficit spending has exactly the same effect as the government following Friedman's famous suggestion to "drop money from helicopters" to increase inflation. At zero nominal interest rates money and bonds are perfect substitutes. They are one and the same: A government issued piece of paper that carries no interest but has nominal value. It does not matter, therefore, if the government drops money from helicopters or issues government bonds. Friedman's proposal thus increases the price level through the same mechanism as deficit spending. Dropping money from helicopters, however, does not increase prices in a Markov equilibrium because it increases the current money supply. It creates inflation by increasing government debt which is defined as the sum of money and bonds. In a Markov equilibrium, it is government debt that determines the price level in a liquidity trap because it determines expectations about future money supply."
  

Dropping money from helicopters and cutting taxes are not the only options available and the following paragraph from Eggertsson may jog a few memories:

• "The government, however, can increase its debt in several ways. Cutting taxes and dropping money from helicopters are only two examples. The government can also increase debt by printing money (or issuing nominal bonds) and buying private assets, such as stocks, or foreign exchange. Ina Markov equilibrium, these operations increase prices and output because they change the inflation incentive of the government by increasing government debt (money & bonds). Hence, when the short-term nominal interest rate is zero, open market operations in real assets and/or foreign exchange increase prices through the same mechanism as deficit spending in a Markov equilibrium."

As an aside, you can see why this paper is central to my article. It is clear that a copy of it sits on Bernanke's desk.

It is becoming clear that Fed and US Govt policy have been in lockstep for some time and that the groundwork for fending off a deflationary attack was laid out over 7 years ago. The actions we have seen since August '07 are not the beginning of the attempted fix but the second stage.

Since 2000:

• The US Government has run an increasing deficit.

  The Fed has allowed the movement of interest rates to compliment a notionally low interest rate environment. The withdrawal of M3 increased inflationary expectations.

  The loosening of regulatory oversight allowed a wider use of debt and increased consumption.

  
  

Since mid 2007:

• The US Government has explicitly talked of increasing govt debt through tax rebates and targeting relief at overburdened indebted homeowners through the expanded use of Govt Sponsored Enterprises.

  The Fed cut interest rates aggressively below rates of inflation and introduced facilities to engender the outright purchase as well as the long and short term loans of cash and US Govt Bonds.

  The US Treasury does not rule out making the new Fed facilities permanent.

  
  

I believe at this point I have made a good case that I have identified the policy and framework that the Federal Reserve and the US Govt are pursuing and that such policies are co-ordinated and have been in place for much longer than most suspect. It is the expectation that such actions are inflationary in nature that encourages spending and investment (Buy today because it will be more expensive tomorrow).

The Future

We now turn our attention to the future. At this point we have to examine something previously mentioned in our article, a Markov equilibrium. Again from Eggertsson:

• I analyze equilibrium under two assumptions about policy formulation. Under the first assumption, which I call the commitment equilibrium, the government can commit to future policy in order to influence the equilibrium outcome by choosing future policy actions (at all different states of the world). Rational expectations require that these commitments are fulfilled in equilibrium. Under the second assumption, the government cannot commit to future policy. In this case the government maximizes social welfare under discretion in every period, disregarding any past policy actions, except insofar as they have affected the endogenous state of the economy at that date (defined more precisely below). Thus the government can only choose its current policy instruments, it cannot directly influence future government actions. This is what I call the Markov equilibrium.

Essentially policy is either forward looking and adaptive or it works only in the "here and now" and cannot innovate.

Clearly my reading of the current situation is that the Fed and US Govt is committed to a future policy in its actions and has displayed the ability to be adaptive. Therefore we shall take that path to find what future developments may await us.

Again we rely on Eggertsson to lay out the groundwork:

• "deflation can be modelled as a credibility problem if the government is unable to commit to future policy and it's only instrument is open market operations. This....illustrates how the result changes if the government can use fiscal policy as an additional policy instrument. I first explore if deficit spending increases demand. When the government coordinates fiscal and monetary policies it can commit to future inflation and low nominal interest rate by cutting taxes and issuing nominal debt. I then use the result to interpret the effect of open market operations in a large spectrum of private assets, such as foreign exchange or stocks."

It is without doubt the most forward looking statement I have seen. Or is it? Again we must look at this from behind Bernanke's desk to truly appreciate what we are reading. The statement is forward looking because it has been adopted as policy. We are living with these actions right now and we know that they will exist for at least 6 months as has been made clear in statements from the Fed. Expectations of a continuing inflationary bias must be deeply entrenched in the psyche of anyone connected to asset markets.

Eggertsson continues:

• "Friedman suggests that the government can always control the price level by increasing the money supply, even in a liquidity trap. According to Friedman's famous reductio ad absurdum argument, if the government wants to increase the price level it can simply "drop money from helicopters." Eventually this should increase the price level-liquidity trap or not. Bernanke (2000) revisits this proposal and suggests that Japanese government should make "money-financed transfers to domestic households-the real-life equivalent of that hoary thought experiment, the "helicopter drop" of newly printed money." This analysis supports Friedman and Bernanke's suggestions. The analysis suggests, however, that it is the increase in government liabilities (money & bonds), rather than the increase in the money supply that has this effect."
  

• "Since money and bonds are equivalent in a liquidity trap dropping money from helicopters is exactly equivalent to issuing nominal bonds. If the treasury and the central bank coordinate policy the effect of dropping money from helicopters will have exactly the same effect as deficit spending. Thus this paper's model can be interpreted as establishing a "fiscal theory" of dropping money from helicopters. The model can also be extended to consider the effects of the government buying foreign exchange (or any other private assets).
  

• It is often suggested that the central bank can depreciate the exchange rate and stimulate spending by buying foreign exchange (and similar arguments are sometimes raised about some other private assets and their corresponding price). Due to the interest rate parity (and similar asset pricing equations for other private assets), however, buying foreign exchange should have no effect on the exchange rate unless it changes expectations about future policy (since the interest rate parity says that the exchange rate should depend on current and expected interest rate differentials).

• Will such operations have any effect on expectations about future policy? Open market operations in foreign exchange (or any other private asset) would lead to a corresponding increase in public debt defined as money plus government bonds. This gives the government an incentive to create inflation through exactly the same channel as I have explored in this paper and, therefore, leads to a corresponding depreciation in the nominal exchange rate hand-in-hand with the rise in inflation expectations. An advantage of buying private assets, as opposed to cutting taxes, is that it does not worsen the net fiscal position of the government. It only changes the inflation incentive of the government.
  

If Bernanke and Co keep with the blueprint (it would be difficult to see how they could deviate now without destroying carefully implanted expectations) we can expect to see continuous and expanding intervention in what was previously thought to be off limit areas.

Treasury bond issuance should rise and does not have to have a defining limit. Tax rebates will continue and grow, expanding beyond traditional areas. Use of current GSEs to expand government debt will be encouraged and may well lead to the formation of "Super GSE's" that could take on second lien loans on property, for example.

The Fed will expand its facilities, including more market participants and widening the range of assets that can be used, including stocks. The facilities will become permanent but will be allowed to run down in use as circumstances dictate. It will be imperative to remove any stigma associated with the use of such facilities, possibly by converting the facilities to a type of GSE, or more likely, a Fed Sponsored Enterprise.

Concerted and possibly international intervention in Forex markets should be given a high level of probability. This will allow a slow and orderly re-pricing lower of the dollar and a continued bias toward inflation.

A campaign of "anti-inflationary" bias will continue and be ramped up if necessary. Rates could be raised without affecting the fight against deflationary forces because expectations would require such a move. A constant attempt will be made to anticipate a move higher in growth.

Is the path hyperinflationary?

To be blunt, no. These are anti deflationary measures that will give the Fed credibility in fending off the dreaded scenario. The threat to the policies is an acceptance of deflationary expectations by private money and consumers.

Hyperinflation would be unable to form as an expectation as long as the Fed continues to display a hawkish approach to inflation. As we have seen the delivery of fiscal debt, in the form of "helicopter drops" would bypass the pricing mechanism. Expectations of hyper-inflation would be negated.

Conclusion. Is it working?

It is at this stage that I can happily say that it would be unfair for me to judge whether the policy is working or not. This because the whole scenario, the playing out of the policy, is to do with perception. The only way that it can be measured by individuals when attempting to answer the question is to screen what they see through this article (or G B E's Fiscal Theory). As the writer if I answer the question I might colour an individual's perception.

What I can say is that with the framework exposed and on public view we have the advantage of spotting potential failure of policy. The potential for failure is increased by discussion and the recognition of the long term policy objectives (avoiding deflation) if such discussion raises the expectation of deflation.

I should remind readers that this article is my interpretation of G B Eggertssons' work. I believe it is the blueprint being used by the Fed and US Govt. Therefore I claim no superior knowledge to Eggertsson, just an understanding and the ability to navigate.

What should be remembered is the title of G B Eggertsson's paper:

The Deflation Bias and Committing to Being Irresponsible

In other words the future actions of the Fed and US Govt may appear "wrong" unless we understand what they truly fear.

Click here for part 2 "It is 1937 for the Federal Reserve"

I have been, and still am, a long time fan of John Mauldin (JM). I enjoy his take on the bigger picture, even if there are areas I disagree with, from time to time. Generally my disagreements are more to do with the severity of a particular problem or the benefits of a highlight. For instance, JM might allude to a recession but think that it will be mild and happen over a certain time scale, fitting his “muddle through” model. I would agree with the talk of recession but not necessarily the depth, timing or effect. You get the point.

However the JM article “Let’s Get Real About Bear” has somewhat shocked me at a fundamental level and it deserves a reply. Let me say this from the beginning, I do not intend to start a war of words or change JMs thinking. Neither approach is constructive or conducive to open discussion of a truly fundamental part of the US and Global economy. This not a good vs. bad scenario, I have little or no doubt that JM is a well read, intelligent, honest and thoroughly nice bloke. I am a trader/blogger that very few have heard of or know, using the internet to foster thought. (As an aside, I asked JM to have a look at my writings and consider maybe using an article in the OTB edition. The answer is within his Bear article. Sometimes trying to be a “platform start up” has its knock backs. So no hidden agendas and yes, I fully expect to be viewed as the “Darkside”. Ahh the fun of blogging.)

Here is a link to the JM article at Investor Insight. Please read it before going further. I am not going to discuss the 2 other articles appended to JMs writing.

JM is an investor/advisor who looks to get real returns beyond the effect of inflation. He operates in the free markets, looking for advantages that return above the “norm”. He searches for new, innovative technology that may become the “next big thing”. He is a capitalist, using the capitalist mechanism. He knows the risks and tries to avoid being on the wrong side or if that fails to mitigate the risk to his capital. I do the same as do most investors and traders. It is the way of the financial world. There are upsides and downsides, we know the risks and rewards, and the rules of the game are simple.

Unless, that is, you decide that the rules can be bent to accommodate failures, to mitigate the downside. Such an approach leads to tyranny, it destabilises the system causing feedback loops, encourages excessive risk taking and allowing that risk to be ignored and causes confidence in the financial structure to erode.

This is big picture stuff. It is not about 17000 jobs at Bear Stearns; it is not about a loss on share portfolios suffered by employees. Protecting a company and its share price is never a reason for intervention and the introduction of moral hazard.

Bear and its employees would not be in their current circumstances if they had obeyed the rules and understood the game.

Bear Stearns went bust because of a lack of confidence in its collateral used to finance its lending. Customers and Lenders walked away because the risk of staying was perceived as too great. It was the risk that Bear Stearns took using its business model and allowing exposure to be greater than its ability to pay. The Capitalist System did its job; it rooted out a bad business model and laid it low. If you took losses, I am genuinely sorry for you but you knew the risks. We all take a loss sometime. If it wiped you out then you did the same as BS, you allowed exposure to a risk to grow well beyond acceptable limits.

Does this sound harsh, a bit heavy-handed? It probably does but it isn’t me saying it, it’s the free market shouting loud as it does every trading day.

JPM have stepped in and offered $2 a share for BS. We have seen such action before, a fast move to grab assets perceived as cheap. It happens in the capitalist marketplace. The risk is transferred to JPM equity holders, JPM write-down $6Bn to acknowledge that risk. The trouble is the whole JPM move was not a function of the free market. Without The Federal Reserve accepting who knows what BS assets as collateral on a $30Bn loan this deal would not have taken place. Even worse JPM get rewarded by asset grabbing at an extremely cheap price. (I suspect we have not heard the last of that either).

JM contradicts himself within the article as he attempts to align the adoption of allowing a moral hazard to exist within the market. I quote:

“And I can understand the sentiment, as it appears that tax-payer money may have been used to bail out a big Wall Street bank that acted recklessly in the subprime mortgage markets. But that is not what has happened. This is not a bailout.”

But just a few lines later he is forced to acknowledge the underlying fear his readers have emailed him about:

“Yes, tax-payers may eventually have to cover a few billion here or there on the Bear action. But the time to worry about moral hazard was two years ago when the various authorities allowed institutions to make subprime loans to people with no jobs and no income and no means to repay and then sold them to institutions all over the world as AAA assets. And we can worry in the near future when we will need to do a complete re-write of the rules to prevent this from happening again.”

You cannot expect market participants to accept such reasoning unless you believe intervention is right and proper. If you do think that way then your perception of risk has to be misplaced.

So, it is more than possible that Tax-payers will face a bill for this bailout. The moral hazard, as the UK Govt discovered after Northern Rock is that if you “cover one bet, you cover them all”. The extension of liability and assumed enlargement of risk becomes burdensome and affects the fundamentals underlying the national economic base.

Today in the UK, there are rumours, denied by the BofE and the bank in question, that a Bank may or has a requirement for emergency funding. Regardless of the truth or otherwise, this has directly affected Sterling vs., of all things, the dollar:

The ellipses are the main points when rumour surfaced and re-surfaced. This is what acceptance of a moral hazard can do to a currency. I picked the $ as a comparison because it is weak, it shows the inherent weakness of Sterling under such circumstances. This is not a theory of mine, based around musings of economic facts and figures. This is market action telling us a story. Ignore the tale at your peril.

Should Bear have been allowed to go bust? Without doubt the answer is yes and to some extent JM agrees:

“If it was 2005, Bear would have been allowed to collapse, as the system back then could deal with it, as it did with REFCO. But it is not 2005. We are in a credit crisis, a perfect storm, which is of unprecedented proportions. If Bear had not been put into sounds hands and provided solvency and liquidity, the credit markets would simply have frozen this morning. As in ground to a halt. Hit the wall. The end of the world, impossible to fathom how to get out of it type of event.”

A very scary (and quite possible) scenario. JM is saying that current market conditions are not conducive to failure of a Financial Institution.

Well I’m sorry but these events happen because of the prevailing circumstances. Banks don’t go broke at the top of the cycle, failures occur when times are getting hard. It is the nature of the beast. To say the System cannot tolerate such an event is to deny the reality of capitalism. It encourages the acceptance of a safety net, a guarantee that regardless of the poor decisions and risk calculation taken there will be no failure.

This is truly a refutation of a capitalist, free market. No wonder CEOs take what seem to be enormous risk free assumptions about the future and the effects of their actions and decision upon the prospects of the company. They have nothing to fear. CEOs get their compensation, shareholders get a ride, and all is well. Until the cycle turns. The CEO has departed by then, either as part of a merger or retirement with an enormous compensation package. The shareholders are the weak hands, the strong hands sold at the top. Who cares what happens to the weak hands? Moral hazard isn’t just about tax payers.

JM quantifies what he thinks the damage to stock markets could be:

“The stock market would have crashed by 20% or more, maybe a lot more. It would have made Black Monday in 1987 look like a picnic. We would have seen tens of trillions of dollars wiped out in equity holdings all over the world.”

Again, I agree that losses of 20% or more could happen and still might. The reason it would have made Black Monday look like a picnic is because it was a picnic. In 1987 we didn’t have the massive expansion of innovative financial instruments, back then Futures and Options were complicated! If the free market decides it needs to provide a re-pricing then it should be allowed. After all, no one worries about the same mechanism working to the upside.

Would credit markets have closed, seizing up under the financial stresses? We don’t know. Let us assume that they would. So what? The weak debt would have been expunged, albeit on a massive scale. Would there be pain? Yes, massive amounts of pain would ripple through the global economy. Would it be the end of the world? No, it would not, prices would reset on the re-opening, risk would have been priced in - in full. Markets would continue to function, even if the players had changed or some disappeared. Eventually all this will happen and the outcome will be the same, we are living it right now. Delaying the inevitable whilst a transfer of liability occurs does nothing but risk the underlying fundamentals of the economy to further attacks and stress.

Does the acceptance of an enormous level of moral hazard have a justification? Again I quote JM:

“But for now, we need to bail the water out the boat and see if we can plug the leaks. Allowing the boat to sink is not an option. And get this. You are in the boat, whether you realize it or not. You and your friends and neighbors and families. Whether you are in Europe or in Asia, you would have been hurt by a failure to act by the Fed. Everything is connected in a globalized world. Without the actions taken by the Fed, the soft depression that many have thought would be the eventual outcome of the huge build-up of debt would in fact become a reality. And more quickly than you could imagine.

As I have repeatedly said, recessions are part of the business cycle. There is nothing we can do to prevent them. But depressions are caused by massive policy mistakes on the part of central banks and governments. And it would have been a massive failure indeed to let Bear collapse. I should note that this was not just a Fed action. Both President Bush and Secretary Paulson signed off on this.”

Quite simply (and JM touched upon this) intervention has exacerbated the conditions we live in. What was a normal business recession has been morphed into a possible depression. Not by capitalism or free markets but by centralist, socialistic interference.

Remember, last year when Bear closed down and re-capitalised the failed Hedge Funds? This was viewed as one of the problems that required action by the Fed. The intervention failed. All it achieved was a redistribution of risk to the Tax payer and JPM shareholders. The risk is not diminished; adding capital to a margin call does not make the position “safer” or profitable. It just risks more capital.

Trying to justify intervention by invoking fear may work at a human level but free markets ignore such reasoning’s. As far as the markets are concerned the game rules say you are responsible for your own risk management. If you fail to play the game well, you will lose or be given a disadvantage. Attempting to change the rules to favour one side breaks the game. The consequences of that are with us now.

JM defends his stance by pouring scorn on those who believe in free markets. It may also be the reason he didn’t like my writings. (This is fair enough, not every viewpoint that is contradictory to your own needs to be accepted).JM:

“I repeat, this was a good trade from almost any perspective, unless you are from the hair-shirt, cut-your-nose-off-to-spite-your-face camp of economics.”

I am a bear in the current climate, I have been a bull in the past and I trade both ways. In other words I am a realist, I may be bearish on macro-economic fundamentals but I can ride an uptrend when I see one. To use such an expression as JM has written to pooh-pooh those who believe in free markets shows a lack of argument. I have news for you all, regardless of your economic “bent”, unless you are prepared for events now you will all have your noses cut off.

Finally we look at the outcome of the current turmoil. Again JM is specific:

“It is precisely because the Fed is willing to take such actions that I am modestly optimistic that we will "only" go through a rather longish recession and slow recovery and not the soft depression that would happen otherwise.”

Does that qualify as “muddle through”? JM was looking for a muddle through scenario until very recently. I don’t think a longish recession and slow recovery qualifies. Muddle through to me was below average growth not contraction. There is no blame to attach here, it is just recognition that realism is useful and has a place in financial thinking. It is realistic to believe that if a moral hazard in the UK can affect the worth of that country’s currency, the same should be applied to any other government that accepts moral hazard can be introduced into the game rules. As we have already seen, intervention begets a further expansion of intervention.

JM makes a final point that the problem is so large and the effects on the “small guys” would be so great (i.e. small guys do not know about risk?) that a true re-pricing event would cause devastation. He also says that a lack of intervention caused the current turmoil. Other than a non-acceptance of capitalist free markets as a true reflection of worth, the blame appears to land at the door of the Government and the Fed. Boy they can’t win in this discussion.

Regulation is what JM is alluding too, or the lack of it. At what level though, the relaxation of credit lending standards? (Surely a bank decision). A lack of oversight in mortgages? (Greed from all parties overrode risk appraisal, including the consumer). A lack of transparency in credit markets? (Transparency is there, you just have to pay for it).

What exactly were the Fed and Govt agencies supposed to do? Regulate every transaction? Greed finds away around regulation, be it loopholes or flat out illegality. You can regulate for every function but it does not stop attempts to circumvent it.

If you want to correct an interventionist prone capitalist system then allow it to purge itself and reset the boundaries of its influence based on truth. If you want to get a rating on a debt package you wish to sell in the marketplace then tell the truth. Open the books, show the risk and accept the price that the market sets. You even save money on not paying a Ratings Agency.

Only this will restore confidence in the markets. If it means prices are lower (or higher for the good stuff) so be it. Its not the price that wipes you out, it’s the re-pricing when the truth comes out. Attempting to interfere and tinker will just cause greater imbalances and risks and lead to further opaqueness.

Maybe JM has forgotten how he worried about the costs of today being visited upon future generations. Intervention will ensure that such passing on of the debt will happen.

When asked what represented the greatest challenge for a statesman, British Prime Minister Harold Macmillan responded in his typically languid fashion, "Events, my dear boy, events."

I wonder if any of the Fed Committee members recalled that quote during the video-conference held the day before the announcement of the "new" Term Securities Lending Facility (TSLF). It seems events are occurring at a faster pace than the Fed anticipated, causing more emergency plans to be put into operation.

One of the quirks of investing and trading is that news becomes old hat or familiar in a short space of time and actions that were seen as emergency responses become accepted after a few days or weeks. Not that surprising I suppose when the emergency is among the Banks and Institutions required to make the monetary system work.

After an increase in the size and frequency of repos, including the introduction of two 14 day rolling repos and discount rate cuts; the next crisis was met with the introduction of large cuts to the Fed Funds Rate and the introduction of Term Auction Facilities (TAF) and dollar lending facilities to other Central Banks. Then this week, after further rate cuts, the Fed enlarges the TAF, increases the dollar lending and introduces TSLF.

So here we are, 8 months since the sub-prime implosion morphed into a credit market crunch that ate Bank capital reserves at a phenomenal rate and the Fed launches another lifeboat from stricken USS Irresponsible Lender. Only this time there is no pretence of rescuing the passengers on the stricken liner, this lifeboat is exclusively for the Bankers, the crew of the USS Irresponsible Lender.

Let us first look at the new lifeboat, the TSLF. Here is the Fed statement on the matter:

"The Federal Reserve has announced that the Open Market Trading Desk ("Desk") will expand its securities lending program and initiate a Term Securities Lending Facility ("TSLF"). Under the TSLF, the Desk will lend up to $200 billion of Treasury securities held by the System Open Market Account to primary dealers secured for a term of 28 days by a pledge of other collateral. The Desk's current overnight Securities Lending operation will continue with no changes to program terms.

Weekly TSLF auctions will alternate collateral schedules resulting in a bi-weekly cycle for each pool of eligible collateral. In the first auction, the Desk will arrange an auction for a loan of Treasury securities against a pledge of all collateral currently eligible for repurchase transactions currently arranged by the Desk. In the second auction, the Desk will auction Treasury collateral for loan against a pledge of AAA/Aaa-rated private-label residential MBS not on review for downgrade, as well as collateral currently eligible for Desk repurchase transactions. Loans and collateral will be exchanged free of payment between securities accounts at the dealer's designated clearing bank. Loans will settle on a T+1 basis.

Each TSLF auction will be for a fixed amount announced ahead of the auctions. The first auction is scheduled for March 27, 2008, at 2:00 p.m. Eastern Time and results will be posted to the Federal Reserve Bank of New York shortly after the auction close.

The TSLF will be a single-price auction, where accepted dealer bids will be awarded at the same fee rate, which shall be the lowest fee rate at which bids were accepted. Dealers may submit two bids for the basket of eligible Treasury general collateral announced at each auction. At the TSLF auction, each dealer aggregate award and each individual bid will be limited to no more than 20 percent of the offering amount.

The Desk will consult with the primary dealers on technical design features of the TSLF in the coming days and specific auction details may be adjusted based on these conversations, experience in the initial auctions and market conditions." (My emphasis).

Primary dealers (PD) get treasuries in exchange for other types of bonds they cannot use due to current credit market conditions.

There is however another factor that was pretty much ignored in the most recent developments. The Fed introduced a series of Permanent Open Market Operations, selling treasuries to PDs. So far there have been 2 POMO's (double the number for the whole of 2007), the first for $10bn and the latest for $15Bn. These are cash transactions; the Fed received $25Bn in cash and gave out Treasuries from the System Open Market Account (SOMA).

There can be little doubt that the current crisis is centered on the PDs and is directly related to a lack of usable collateral to enable PD borrowing to take place. That is, no one is willing to lend if the collateral is not AAA government debt. The Fed is attempting to relight lending by swapping usable collateral (treasuries) for other AAA/Aaa debt that is not at risk of downgrade.

If the Fed allowed free market forces to operate then the PDs would have to buy treasuries from the market to possess the collateral required to borrow. This is clearly beyond their ability as the losses realized from selling low and buying high would obliterate their balance sheets. The Fed has decided to meet the Bankers margin call.

You may ask "why didn't the PDs just buy the treasuries from the Fed?" A fine question that deserves a simple, observational answer.

The Fed has conducted two 1 month TOMOs in recent days, lending out cash and taking mortgage backed collateral in exchange. The amount lent out is $30Bn. So to raise the cash to buy the treasuries from the POMO, the PDs borrowed from the TOMO. What does that tell us?

Quite simply the PDs have no cash reserves. They are bankrupt. When I mentioned in the recent Weekly Reports that the Fed had temporarily nationalized the Banks/Brokers, this is what I meant. The Fed is allowing PD assets to be moved off the balance sheet and into a new investment vehicle. The only difficulty is how do you make the make the words "Federal Reserve" and "Structured Investment Vehicles" into a new acronym?

Right now the PDs are purely a front, emperors without clothes. Ben Bernanke is literally behind the curtain, pulling the levers. The problem for the Bernanke is the lack of levers, the SOMA is a finite resource, which I estimate to have $600Bn (ish) of usable collateral available. After using that resource the Fed would either have to buy newly issued treasuries from the US Government or issue its own bonds. That would mean either the printing of new dollars to buy the treasuries or the invention of a new dollar derivative to use in the credit markets. Either choice has inherent risks to the dollars worth. Other new initiatives may well be viewed as panic moves, the goodwill of market participants may have been eroded to zero on this latest "boost" in the stock markets.

Why did stocks go up? Maybe the Hedge Funds stopped getting pressurized on their leverage and margin, allowing them to buy. If it is down to such a tenuous reason then the rally will last until the next squeeze on the lenders capital. Maybe I'm wrong, maybe it was just seen as a good buying opportunity by one and all.

None of these measures help Corporate America or the US public other than to allow the continuation of further debt accumulation, hence Bernanke floating ideas such as debt relief on mortgages. I await his solution for Corporate America with baited breath.

The yield curve tells a story that things are not different. Click on the image below to see what the yield curve did at the beginning of the decade through to the current day. Press animate on the lower menu to start.

With thanks to Stockcharts.com

Take a snapshot of the curve toward the '01'02 divide and compare it to current conditions. You can see how long it took after late'01 for stocks to eventually bottom. Remember, post 9/11 the Fed was extremely active, especially helping the Banking/Broker sector recover. Maybe it's NOT different this time, maybe the reality is that long end rates have gone as low as they will?

This is central to the future prosperity of the US. With the Fed pushing treasuries into the market place, prices are now more likely to fall, causing yields to rise. Fed rate cuts are only affecting the short (duration) end by steepening the curve, allowing a borrow short to lend long trade - just like the strategy used in the Commercial Paper markets prior to the credit crisis.

Whilst such a mechanism might help the Banks etc, it will force rates higher on loans, credit cards and mortgages. It will also require higher yields on corporate debt. Here is the rub, to recharge the reserves of the Banks; the money has to come from outside of the banking system. That means higher costs to the public and Corporate America. That means a domestic US deflation as the money supply is reduced.

For consumers that has already begun:

Even with rising CPI - including energy and food, the consumer is now spending less on a y-o-y basis.

For Corporate America you can see the problem:

Notice the beginnings of a move higher for both Aaa and Baa debt even after the new premium built in by the fall in treasury rates.

Thus we are left with 2 possibilities for events further ahead.

If the measures taken by the Fed are long term (and I cannot see how they can be viewed any other way for them to be effective) then rates will rise as treasuries flood into the market and the dollar suffers further devaluation. This will stifle new lending and causing an increase in default on current lending. It should not be forgotten that if paper, other than treasuries, is no longer acceptable collateral to facilitate lending then the credit markets will remain frozen for everyone other than those with treasury holdings.

The US (and World) financial system is reliant on credit to enable production, where borrowings are used to increase productivity returns beyond the capital borrowed and the cost of servicing the debt. It is when an expansion plan fails that debt has to be rolled over by Corporations.

Eventually the cost of the increasing burden of servicing debt coupled with a false measure of productivity meets an event, the inability to roll debt forward due to a lack of lenders. At this point the Corporation defaults. Corporations with strong cash reserves and low/no borrowing will survive, employing their savings (cash reserves) to expand productivity.

The consumer has already reached the event moment. The consumer's productivity is rewarded by wages. If however assets are bought using debt and the future payment of that debt is reliant on asset appreciation, then the risk of asset depreciation requires even higher productivity from the consumer or further lending to push out the timescale to allow the appreciation to occur.

If we discount the ability for many to borrow then the only recourse is to earn more and either service a higher percentage of the debt (increase payments) or save until the asset price is met. If consumers are in unproductive jobs then the expansion of wages is unlikely, indeed the risk will be a curtailment of employment. Both situations result in a deflation of the amount of money circulating an economy.

Both the consumer (public) and Corporations will survive albeit without some current participants. The debt will have been cleansed and true savings and investment will allow the purchase of assets and proper investment. The only downside is the loss of revenue for the Bank/Broker sector, whose survivors will return to more stringent and traditional methods of banking.

If the Fed plan fails and credit markets become even more chaotic then the disruption will spread to all sectors of the global economy.

How can the Fed plan fail? The risk is with the dollar. If the action taken by Bernanke is seen as a massive dilution of the strength of the dollar then it and its derivatives will all fall in price, regardless of any concerted cooperation by Central Banks.

If the markets believe the treasuries constantly introduced into the market are being used to shore up massive losing positions then the risk of default will increase. This will cause a fall in the price, placing the PDs with a further tranche of "sold low, buyback high" assets. With a lower pricing on dollar derivatives, the dollar will suffer the same fate as underlying loans have in MBS derivatives. The mechanism is the same.

With the Fed placing itself in a position were it holds lower worth assets than the treasuries it issued, the risk of a default by a PD becomes a risk to the Fed. In default the PD will have to hand over the treasuries used as collateral, leaving the Fed no better off than an SIV stuffed full of toxic debt that is unable to raise funds in commercial paper markets. The risk would be a loss of confidence with the Fed as an Institution.