Felix Salmon

From a narrow sovereign credit and ratings perspective, said Fitch’s David Riley, the huge spike in the US government deficit “is the right policy response”. His point was that we’re in a historically very rare period when both companies and households are deleveraging — they’re not borrowing, they’re not spending, and the government has to step in and make up the difference, lest we suffer an even worse recession and the destruction of massive amounts of value and potential economic growth.

If you’re worried about the ratings agencies’ view of the US government, then, (which you shouldn’t be), don’t worry about Fitch. Or at the very least, to the degree that Fitch does get worried about US creditworthiness, it would be even more worried were it not for the fact that the government is going to run a $2 trillion deficit this year.

David Riley, the head of sovereign ratings at Fitch, gave the first big presentation at the Fitch banking conference today — and quite rightly, too. The future of banking is inextricable from public finance and macroeconomics: looking at things on a bank-by-bank level ensures that you’ll miss the big picture. His presentation was a good one, and definitely worth blogging.

Riley’s message was simple, after a recap of what happened in the Great Depression and in Japan and in Sweden: the faster that governments move the better, and the stronger their initial response the better. Don’t worry, at least in the short term, about inflation, in an environment such as this one which is fundamentally disinflationary: instead, worry about a multi-year decline in the total quantity of bank credit, which will continue even after the recession has ended, and which will put a medium-term cap on future growth.

Riley was not impressed, in hindsight, with the ad hoc way in which policymakers first addressed the crisis, before Lehman’s collapse: the way they tried to put out fires at places like the monolines or Northern Rock or Bear Stearns, without really tackling the problems of the financial sector more generally.

After Lehman, however, there was much more system-wide intervention, with deposit guarantees being raised, the Fed injecting huge amounts of liquidity into the banking system and the economy as a whole, and the Treasury playing along too with TARP and all the rest. Post-Lehman, said Riley, the international policy response “has been pretty impressive, and well coordinated across countries”.

Interestingly, Riley noted that European households are much more reliant on bank financing than US households are: historically about 80% of their financing comes from the banking sector, compared to about 30% in the US. That probably explains why the Fed has been doing so much in the capital markets (and why the government needed to nationalize Fannie and Freddie), while the ECB hasn’t bothered. But Riley’s charts also showed that Europe is continuing to borrow — at lower rates than in the past, to be sure, but still significant sums — while the US household sector is actually paying down its debts these days, for the first time in living memory.

Riley said he’s not worried about inflation just yet, but that he will be worried about inflation if the government waits too long before unwinding its current fiscal stimulus efforts. On the other hand, it can’t do that too soon, either.

“I think that there is a serious risk that we get a W-shaped recession”, he said, with the current fiscal stimulus running its course over the next year and the economy falling back into recession. “As we saw in Japan,” he said, “if you tighten policy too soon, if you leave it too late, then you start getting concerns about solvency and inflation risk.” Guess he’s happy he’s not a central banker these days.

One of the more challenging and interesting aspects of being a financial journalist is trying to define terms like convexity and covariance for a lay audience — it’s not easy. So I was particularly taken with Justin Fox’s one-sentence definition of alpha in his new book on the efficient markets hypothesis:

Alpha is a portfolio’s performance minus the performance of a hypothetical benchmark portfolio of equivalent risk.

Elegant, eh? It’s a shame, in a way, that it arrived just as the reputation of CAPM is hitting new lows and the race for alpha is looking increasingly laughable.

Since moving onto Twitter, I’ve pretty much stopped the daily linkfest, moving the quick hits onto there. But there’s no reason they shouldn’t continue to exist in blog format too. So here are some of my most recent tweets. Is there an easy way to automate this kind of thing?

# Pequot Capital closing. End of an era, but there won’t be too many tears.    

# My new strapline, explained by Andrew Leonard

# Sotomayor’s a foodie! My mouth is watering, I could do with some lengua y orejas de cuchifrito right now

# The Manichean history of teabags and douches

# Moody’s said that the USA’s Aaa rating is stable “even with a significant deterioration in the US govt’s debt position.”

# I wouldn’t pay $2 at the newsstand for a print version of the daily NYT. Who would?

# Martin Feldstein knows from recessions. And he reckons this one won’t be over until 2010

# Mark Thoma has your daily Sachs vs Easterly-and-Moyo links. All very predictable and boring.

# Warren Buffett’s long-time excuse for not paying a dividend doesn’t work any more. But he’s still not paying a dividend.

# The comptroller of the currency is “totally unsuccessful”. Time for the entire OCC to go.

# Obama’s White House is just as addicted to needless secrecy as any other administration

# Silicon Valley discovers the recession

# It has been Far Too Quiet of late… “maybe we are on the verge of a financial Krakatoa“

# Interesting S&P500/gas price chart — but what’s the significance of the 403 level?

# I like this, on student debts; I wonder how is it related to this

# David Brooks Fail: Brad DeLong brings Godwin’s Law down on the hapless columnist

# Top 10 Electronic Police States

Allison Hoffman of the Jerusalem Post brings us up to speed on the Brandeis affair — if you haven’t been following it, the small Jewish university decided last year to close down its art museum and sell off its contents, only to backpedal desperately in the face of a massive public backlash. Where are we now? Well, the Rose is essentially dead — its donors have rescinded their pledges, artists are asking for artwork back, the director has been fired, and it has no chance of being able to raise a penny in new money any longer. That’s the downside, for Brandeis, whose own reputation has been trashed in the process. And the upside? Pretty much nonexistent: no art has been sold, no art will be sold for the next couple of years at least, and confusion reigns on campus and beyond.

A case study, in other words, in how not to make and implement hard decisions in the face of an economic crunch. Now, remind me why Jehuda Reinharz is still president?

Ryan Chittum quite rightly brings the hammer down on a ridiculous “story” from Bloomberg today, which runs under the headline “U.S. Inflation to Approach Zimbabwe Level, Faber Says“, and which starts like this:

May 27 (Bloomberg) — The U.S. economy will enter “hyperinflation” approaching the levels in Zimbabwe because the Federal Reserve will be reluctant to raise interest rates, investor Marc Faber said.

Prices may increase at rates “close to” Zimbabwe’s gains, Faber said in an interview with Bloomberg Television in Hong Kong. Zimbabwe’s inflation rate reached 231 million percent in July, the last annual rate published by the statistics office.

“I am 100 percent sure that the U.S. will go into hyperinflation,” Faber said.

This is basically Bloomberg taking a silly journalistic staple — the let’s-quote-someone-just-because-he’s-rich story — and elevating it to the level of utter farce. Yes, there are people who are genuinely worried that US monetary policy will mean high inflation down the road. But hyperinflation on the order of 230 million percent? (And that actually vastly understates the real rate of inflation, which, last time I looked, was actually closer to 89.7 sextillion percent, or about 38 trillion times 230 million.)

Marc Faber is not a policymaker, and if news agencies get into the habit of quoting people whenever they say something outrageous and just because they say something outrageous, that only encourages a culture of unhelpful, nonsensical, hyperbolic, and fundamentally ridiculous sound-bites. (Or CNBC, as it’s also known.)

As for Faber being “100% sure” about what’s going to happen in the future, that’s a classic signal to ignore what he’s saying, since it’s proof in and of itself that he’s bullshitting and posturing rather than saying anything substantive. Shame on Bloomberg for encouraging him in this manner.

How fabulous is Ecocomics, a new blog about the economics of comic books? Well, here’s a taster:

In the world of comic books any individual who has more than 5 million dollars in saving or assets immediately becomes bat-shit insane. It’s a strange rule, but it seems that every independently wealthy individual in superhero comics decides that fighting/committing crime is the best way to spend their free time. They ignore possible hobbies like golfing, yachting, and collecting antique cars and go straight into wearing a mask and creating a global organization designed to save/destroy/conquer the world. The examples in comic book fiction are nearly limitless.

Of course, the author ignores the problem of sampling error: millionaires in comic books cannot be considered a representative sample of millionaires in the alternative worlds they inhabit. But still, he has a point.
(Via)

What’s going to happen to the Dow once GM files for bankruptcy? Matthew Hougan has a few ideas:

If I were a betting man, I’d say that the good folks at Dow Jones do a bit of a clean-up of the index, replacing not just GM but Citigroup (NYSE: C), too. If that happens, the smart money says that Wells Fargo will enter the index as a new financial representative, with Goldman Sachs (NYSE: GS) a distant second bet.

Beyond that, it’s an open race. I still think Amgen would be an interesting choice, but Nike (NYSE: NKE), Apple (Nasdaq: AAPL), Google (Nasdaq: GOOG) and a few others probably make the short list as well.

I don’t think that we’ll see a Citi-for-Wells Fargo exchange — swapping into a higher-priced company in the same industry seems to be asking for trouble. I also don’t think that Goldman is likely to make it into the average. Yes, the Dow is arguably “short” financials now that AIG has been swapped out for Kraft, but to no greater an extent than the economy as a whole. I think that adding Google — arguably the strongest stock-market brand in the world these days — makes a lot more sense.

On the other hand, GM is a hugely-important industrial company, and having a Dow with no automakers feels weird. Dow Jones could definitely be excused for just replacing GM with Ford.

The Taylor Rule ran smack into the zero bound back in October — and kept on falling. Now, according to the Fed’s Glenn Rudebusch, “in order to deliver a degree of future monetary stimulus that is consistent with its past behavior, the FOMC would have to reduce the funds rate to -5% by the end of this year”:

Rudebusch says that when a central bank can’t loosen monetary policy by implementing negative nominal interest rates, then that only serves to lengthen the amount of time that it is forced to keep interest rates at zero:

According to the historical policy rule and FOMC economic forecasts, the funds rate should be near its zero lower bound not just for the next six or nine months, but for several years. The policy shortfall persists even though the economy is expected to start to grow later this year. Given the severe depth of the current recession, it will require several years of strong economic growth before most of the slack in the economy is eliminated and the recommended funds rate turns positive.

But what about all that quantitative easing? Doesn’t that have the same effect as lower nominal interest rates? Not really: it “has likely only partially offset the funds rate shortfall”, says Rudebusch, and in any case the Fed’s balance sheet is going to have to shrink as the crisis abates — which will serve to act as an effective rise in interest rates. And which will only force the Fed funds rate to stay at zero for that much longer. Maybe it’s time for Bernanke to just set rates at zero and head to the beach for the summer — monetary policy seems to be pretty clear for the foreseeable future.

One of the problems with the banking bailout in both the UK and the US is that it’s set up a massive moral hazard trade. Bank debt is trading at a massive discount to face value, and investors have been buying it in the hope and expectation that the governments of the two countries won’t let any major financial institution default on its debt after seeing the repercussions of the Lehman and WaMu defaults.

Given that many banks need a lot of recapitalization, the fact that their bonds are trading at a discount presents a great opportunity: they can swap those bonds for equity, or otherwise retire the debt below par, thereby reducing the bank’s liabilities and increasing its capital base. But bondholders will be averse to selling or swapping at the current levels unless they believe there’s a credible threat of default, even in the face of reassurance from the authorities that defaults won’t be allowed to happen.

So it’s great news that Bradford & Bingley has defaulted on its subordinated debt and that, as Neil Collins notes, “there’s nothing the holders can do”. Subordinated debt is meant to have equity-like characteristics, after all, including the risk that interest payments will be missed without the bank being considered to be in default. The fact that B&B’s customers are unaffected by this move is very welcome: in the US, I suspect the FDIC would intervene to take over any bank which defaulted on its subordinated debt*. In this case, by contrast, there’s still a chance that B&B might be able to continue indefinitely as a going concern. Sheila Bair, take note.

*Update: B&B has actually been taken over by the government once, so this is not a very good example. Although, as JH notes, it’s heartening all the same that the government doesn’t feel obliged to pay out on all of B&B’s remaining obligations, Anstaltslast -style.

If you invest a large chunk of your 401(k) in the stock of just one company, your actions are fraught with peril. If that stock performs badly — which is always possible — then you could end up with a significantly diminished standard of living in retirement. But at least there’s a possible upside: if the stock does spectacularly well, you can end up in clover.

By contrast, there’s no reason whatsoever to invest a large chunk of your 401(k) in the bonds of just one company. You still have the same downside — the company can default on its debt — but there’s no upside at all: the best-case scenario is just that you muddle through getting your coupon payments until the bonds mature.

The WSJ editorial page today features a complaint from one Dennis Buchholtz, however — a man who did just that:

I am an American retiree. Like many small investors, I am relying on “safe” investments…

I purchased GM bonds in 2005 and own $91,000 worth. These bonds account for a very sizeable portion of my retirement income, and so it is absolutely devastating to watch GM’s problems bring the once venerable company to the brink of failure. My standard of living is truly in jeopardy.

It’s not easy, as a retail investor in America, to purchase individual series of corporate bonds. It’s possible, of course, and GM did make an attempt to target such investors. But thankfully most stockbrokers and financial advisors will tell you that if you want credit risk in your 401(k) then by far the best way of doing that is to buy a bond fund, which minimizes your exposure to any one credit. As a result, there are — happily — precious few people in Buchholtz’s situation. Most bond investors are large institutions which watch their portfolios carefully and make sure they’re diversified at all times.

Now the UAW retirees, it’s worth noting, do not have a similar way of diversifying their GM exposure. As such, if you’re worried about the well-being of retirees, it makes perfect sense to treat the UAW’s retirees better than those who either have a small amount of exposure via their bond funds, or those who actively sought out GM exposure by buying its bonds. “The government’s proposed restructuring plans benefit one class of retirees at the expense of another,” complains Buchholtz — and it’s entirely proper that they do so. Buchholtz has no one to blame for his current predicament but himself: caveat emptor, and all that. That can’t be said of the UAW retirees.

John Taylor is a genuinely eminent economist who has a fundamentally sensible point to make — that a step-change in the US debt-to-GDP ratio from about 40% to about 80% is not a good thing and is something with systemic consequences.

I don’t understand, then, why he has to lard his comment with stuff like this:

A 100 per cent increase in the price level means about 10 per cent inflation for 10 years…

100 per cent inflation would, of course, mean a 100 per cent depreciation of the dollar. Americans would have to pay $2.80 for a euro; the Japanese could buy a dollar for Y50; and gold would be $2,000 per ounce.

The first statement is simply false: a 100% increase in the price level means about 7% inflation for 10 years. One would expect that John Taylor, of all people, understands the concept of compound interest.

But the “of course” in the second statement is even weirder. The connection between inflation and depreciation is far from clear; it depends very much on the country’s balance of trade, and even more on the amount of inflation which has gone on in other countries. Does Taylor really expect 0% inflation over the next decade in both the Euro zone and Japan? And does he really think that real gold prices have ever stayed remotely constant?

As Mark Thoma points out, though, the most disingenuous part of the entire column is something Taylor doesn’t mention at all — that he was very recently calling for permanent tax cuts to stimulate the economy. It’s pretty much impossible to square that with this:

While there is debate about whether a large deficit today provides economic stimulus, there is no economic theory or evidence that shows that deficits in five or 10 years will help to get us out of this recession. Such thinking is irresponsible.

Or maybe deficits caused by permanent tax cuts are somehow to be preferred to deficits caused by temporary stimulus spending?

The Epicurean Dealmaker has invented a new parlor game: match financial-market participants to Russian national stereotypes circa 1865! Can I play too?

Incidentally, the stereotypes age well. Have you met a French investment banker? A Bank of England technocrat? Nouriel Roubini (who counts as Italian for these purposes)? Josef Ackermann?

But of course there’s still a burning question: Why is the American self-assured?

I’m not sure how often you feel sorry for a judge, but after years of handling the nightmare that is the litigation surrounding Argentina’s sovereign debt situation, the Southern District’s Thomas Griesa is now finding himself making key decisions in the Chrysler litigation, too. So far he seems to have avoided anything Lehman-related, but GM is coming down the pike — and the lack of available bankruptcy lawyers might start being matched only by a lack of available bankruptcy judges. How many monster litigations can any one judge handle simultaneously?

John Kemp has a very handy summary of exactly how emissions allowances are going to be allocated under the Waxman bill. And it turns out that while only 15% of the allowances are certainly going to be auctioned — at least in the first instance — another 14% or so are going to go towards pushing clean-energy objectives. As Kemp notes, this is

in effect granting valuable, saleable rights to companies promoting new technologies such as carbon sequestration and storage, energy efficiency and renewables, and clean vehicle technologies.

We’re talking a lot of money here: the “clean vehicle technology” line item gets 139 million tons of emissions allowances in 2012 alone, on top of 440 million tons slated to go to “energy efficiency and renewables”. Your guess is as good as mine when it comes to the secondary-market value of emissions rights in 2012, but we’re talking billions of dollars annually here.

I like the way that this clean-technology subsidy rises is essentially tied to the successful passage of Waxman-Markey — that’s a good way of aligning incentives. But isn’t the whole point of a cap-and-trade bill that it provides a way to monetize clean energy even without dedicated subsidies? And if we go down this road, aren’t we going to get even more sillybuggery surrounding the reclassification of various forms of energy as “clean” or “renewable”?