(James Saft is a Reuters columnist. The opinions expressed are his own)

Don’t expect the year-long rally in risky assets to be undermined any time soon by the Federal Reserve becoming concerned about inflation.

The old metaphor — that the Fed’s job is to take away the punchbowl just when the party starts getting good — just doesn’t apply in the current circumstances. That’s not to say inflation isn’t a threat in the medium term — it is virtually a promise.

But punchbowl thinking dates from a time when firstly the Fed was presumed to have a degree of control over events we now know is not true and secondly to an era when asset prices were the caboose rather than the engine of the economic train.

Even with an economy that is now growing, the risk of a self-reinforcing de-leveraging spiral is enough to ensure that the Fed will not pull the trigger on tightening any time soon.

“Asset prices are embedded not only in our psyche, but the actual growth rate of our economy. If they don’t go up, economies don’t do well, and when they go down, the economy can be horrid,” Pimco bond chief Bill Gross writes in his most recent letter to investors.

Gross argues that leverage inflated the price of assets even as investment in the U.S. real economy flagged. As this happened the U.S. economy became ever more dependent on asset prices and on the sectors, such as finance, which intermediated the borrowing. When the debt and asset bubble is pinched, the whole edifice is threatened, leading to a response like the one we’ve seen: massive and overwhelming aid trained on markets irrespective of the costs.

Pimco data shows that the prices of assets in the United States over the past 50 years have gone up 1.3 percent a year more than would have been expected given nominal growth in the economy, leading to a putative 100 percent overvaluation if you reason that the assets which depend on the economy for income shouldn’t outgrow it.

Unsurprisingly, the real outperformance of asset prices against economic growth has come in the past 30 years, since when debt growth has accelerated.

There are other explanations for why asset prices have outpaced economic growth. For one thing, off-shoring and outsourcing have both suppressed wages in the United States, leading to higher returns on capital, and increased the income that U.S. assets receive from overseas.

It’s obvious that the past 25 years have not been kind to labor, and as its share of GDP has declined the share going to asset owners has increased. In that sense increasing asset prices make economic sense, though there seems to be every chance that workers start to recapture some of what they have lost.

GROWTH, DEFAULT OR INFLATION?

Taxes on capital and profits have also fallen in the United States, and, like wages, this is a trend that could easily be reversed in coming years, especially given the huge amount of public debt that will have to be paid back.

This brings us to the other very strong reason the Fed may have for not pulling away the punchbowl — or water bowl as perhaps we had better see it — even when the party turns inflationary: public debt.

Since the United States have taken a decision to not allow too much of the private debt to default, it has taken on a corresponding increase in public debt which will have to be repaid ultimately. U.S. debt as a percentage of GDP will exceed 60 percent, a level not seen since World War II.

But unlike the post-war period, Europe doesn’t need  rebuilding and though Asia will grow hugely those profits won’t flow to U.S. coffers.

So, if growth doesn’t allow the United States to repay debts, there are two options, neither pretty; default or inflation.

“No policymaker in the developed world — and, by now, few in the developing world — would want to countenance default as an option,” writes economist Spyros Andreopoulos of Morgan Stanley in London in a note to clients.

“This leaves inflation.”

To be sure, the Federal Reserve takes its mandate to control inflation and its independence seriously, but it is going to find itself in a very difficult squeeze, partly of its own making. The debt is high, growth will be poor and the time for private defaults is past. Threats to its independence will only grow.

Given that, and the dependence of the economy on asset prices, it’s not hard to bet that the evil we will be left with is inflation. Whether it is engineered or just kind of happens is less interesting than the reasonably high likelihood that it will happen at all.

For a time at least, that would argue that risky assets, particularly real assets and emerging markets, do well.

Longer term, things get stickier and stickier.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

(James Saft is a Reuters columnist. The opinions expressed are his own)

There are encouraging signs that shareholders are becoming more assertive in defending their interests.

The Financial Times reported on Monday that some of Britain’s largest institutional shareholders - including Standard Life, Legal & General and M&G - are working on a plan to bypass investment banks by creating a club to underwrite new issues of equity by small and medium-sized British companies, a move that could save hugely on fees.

What, you may wonder, took them so long?

Second only to taxpayers, investors have been the great patsies of the financial crisis, paying massive costs to a financial services industry which has, to put it mildly, not served them well.

Activist shareholders and investors could be a key force in fixing what is wrong with the financial system. Unleashing their power to act in their own best interests should be a main thrust of new regulation.

The British investor group, reportedly being assisted by mergers and acquisition advisors Lazards, would effectively cut out the middle men by agreeing to take up any unwanted new shares in an offering. This is an idea which if successful could save companies and their owners huge amounts in fees and at the same time deal a blow to investment banking profitability.

Fees charged by banks for equity underwriting in Britain have more or less doubled in the aftermath of the crisis to 3.5-4.0 percent of the amount being raised, with the lions share going to banks rather than to the institutional investors who sub-underwrite.

While banks may argue, and in part be correct, that this is because the past two years have demonstrated the risks of capital market underwriting, it is also patently because there are now fewer banks competing for this business.

To be sure, a club approach is better suited for small and medium sized underwritings and would face huge difficulties for a major share issue involving global investors. But if a test run proves successful it would place pressure on fees for transactions of all sizes.

Even before the crisis hit, fees for investment banking services seemed not to follow with the same fidelity the laws of economics which hold such sway in microchips, steel or even tax preparation.

And it’s not just investors, who consume investment banking products, who have been ill-served. Shareholders in companies, particularly in banks, have provided the capital but have not had their fair share of the fruits.

FOR WHOSE BENEFIT IS THIS ZOO BEING RUN?

That has led to bad decisions, decisions often designed to maximize the benefit to employees at the expense of the shareholders who run disproportionate risk.

Paul Myners, a British Treasury official with special responsibility for financial services, gave an absolutely scathing address last week to the Worshipful Company of International Bankers, assembled for dinner in the Mansion House in the City of London.

Myners, who is reported to be considering holding a competition inquiry into banking fees, took aim at the bonus and compensation culture in the industry.

“It could be argued that some shareholders in banks have been left holding not the ordinary shares they originally purchased, but a new form of subordinated, participating, non-cumulative equity that ranks behind rewards for the senior management, and executives of the firm in which they invested have a prior claim. This cannot be right,” Myners said.

“In case anyone needs reminding, the profits of banks belong to their owners; not their managers and traders.”

I imagine that the bankers were a little less worshipful on their way out then they were on the way in.

I would also argue that what Myners said about banking also holds true - to a lesser extent - in other publicly traded companies, where management is able to extract compensation out of proportion to their likely contribution.

Shareholders, and we are really talking about institutional shareholders, have allowed management to get away with it for years because they thought what they were supposed to be doing was outperforming the market by picking winners.

Much of what passed for skilled investment over the last 20 years has been little more than riding the waves of a debt-fueled economy which seemed capable of providing six to ten percent returns on an unleveraged basis.

Adding value too often meant little more than adding leverage to increase returns. When the current rally ends, as it surely will, investors should take a long look at their long term returns. What they will usually see is that they are poor.

A better strategy for the next 10 years may be to spend as much effort protecting your economic interest in what you own as you do in choosing what to own.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. )

–James Saft is a Reuters columnist. The opinions expressed are his own.–

When the U.S. dollar ultimately loses its status as the world’s premier reserve currency it will be painful for all involved, almost certainly disorganized, and very possibly a very good thing.

World Bank President Robert Zoellick outlined the risks to the dollar’s status in a speech in Washington on Monday.

“The United States would be mistaken to take for granted the dollar’s place as the world’s predominant reserve currency. Looking forward, there will increasingly be other options to the dollar,” he said.

Zoellick went on to emphasize how choices in the United States on inflation, fiscal policy and financial system reform would help to influence the dollar’s fate.

Quite true. The U.S. cannot simply devalue its way to competitiveness, nor can it appear to be inflating away its debts without risking a run on the currency. The Chinese and others would sell dollars or fail to buy up new debt if they felt the U.S. was behaving both cynically and irresponsibly.

China has good reasons not to force a crisis and devalue its holdings of dollars, but not immutable ones. The two nations are like two men trying to swim to shore while dragging a heavy box of gold, the difference being that the U.S. is tethered to the box while China is only holding on. If China decides the water is too rough it can let go, sacrifice its dollar holdings and swim for it. The United States is not so lucky.

“Exorbitant privilege” is a term coined by an understandably embittered French Finance Minister Valery Giscard d’Estaing to describe the fact that under the old Bretton Woods currency system the United States, unlike everyone else, could simply print dollars to cover current account deficits.

Bretton Woods is gone, but the arrangements which replaced it also tended to underwrite U.S. overconsumption, as purchases of U.S. dollars as reserves by other nations kept funding rates lower despite household or government profligacy.

“The United States is incredibly fortunate that the dollar enjoys this special status,” Zoellick said. “When I work with countries struggling to pay for budgets or finance trade deficits, I reflect on how Americans do not spend a moment considering the unique advantages of being able to issue bonds and print money freely.”

My best guess is that Americans will spend quite a few moments in coming years considering that unique advantage, and that while they will miss it, they should also be sorry they ever enjoyed the right to borrow freely and seemingly without consequence.

THERE’S NO “G20″ IN “TEAM”

Of course the U.S. current account deficit has contracted massively, standing at about 3 percent of gross domestic product in the first quarter as compared to 6.5 percent of GDP in 2006. That’s the result of plunging global trade and steep falls in investment in the United States. And while the personal savings rate has jumped in the United States, which after all it had to since credit was no longer easy, the government has stepped up massively as a borrower, overwhelming households’ efforts to save.

Barclays Capital calculates that the United States now needs to attract 46 percent of the world’s net savings, i.e. the sum of all current account surpluses, as opposed to 54 percent before the crisis broke.

That 46 percent figure is an improvement, but it too is ultimately unsustainable. It’s also arguably starving lots of other places of investment that could ultimately produce higher returns.

The newly empowered G20 group of nations has meanwhile resolved to rebalance the global economy, using peer pressure to force the irresponsible to shape up and the overly tight to start spending at home.

The world’s central bankers and politicians just received an object lesson in what a good idea it is to have a bunch of reserves piled up against a bad day. Even putting China aside, responsible leaders in places like India will have a very tough time trusting in an international body to protect their own best interests. And because that body doesn’t have any real power to compel, it will be ignored. That means that there is a good risk, G20 or not, that everyone is trying to simultaneously keep their currencies low and exports high.

The only body seemingly exempt from market discipline, the United States, is not going to be in a position to resume eating up everybody’s exports. This is a recipe for very slow growth and for rising international economic tension. That doesn’t make the changes proposed at the G20 a bad idea, but they are not sufficient and threaten to be a resolve-softening time waster.

So not so much as rebalancing but a re-basing of growth expectations. Look for continuing dollar weakness alongside that, with the real drama being not the decline but the rate of decline.

–At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.–

–James Saft is a Reuters columnist. The opinions expressed are his own.–

Financial markets have plenty to be worried about but their latest concern — a trade war between the United States and China — should not be on the list.

Aligned self interest and a knowledge on both sides of the causes of the Great Depression should limit matters to a kind of trade war Kabuki, a highly stylized piece of theatre in which the United States shakes its fist and China responds in kind but no blows land.

The Obama administration on Friday slapped tariffs of 35 percent on the import of auto tires from China, reacting to a surge in imports and complaints from the United Steelworkers union. It also acted on the recommendation of the independent U.S. International Trade Commission.

China duly responded, announcing investigations into subsidies made to U.S. chicken producers and auto products, as well as vowing to take its case to the World Trade Organization.

Shares around the world sold off on Monday at least partly in response to the dispute, which awakened memories of the 1930 Smoot-Hawley tariffs and the trade war that ensued, a key cause of the Great Depression.

What’s worse, the United States is not just spitting into the wind of history but also into the face of its largest creditor. China holds about $1.8 trillion of Treasuries and any decision on their part to lighten up would send the dollar into a steep decline and torpedo U.S. plans to fund its fiscal deficit.

That’s just it. The United States and China need one another, and both sides are big enough and mature enough to understand this. China cannot dump U.S. investments without walloping its own portfolio, nor can either side accomplish any of their economic goals without the other as a client.

It is best to understand the U.S. move not as the first salvo in a war, but as a relatively small sop thrown to a domestic constituency, organized labor, that President Obama needs for other purposes, notably health care. It is also, in an odd way, a sign not of weakness but of the stabilization of the global economy. It is only now that things have calmed down that the United States would dare to appease a domestic special interest in this way. Had they done this in February, financial markets would have fallen over in a dead swoon.

The dollar, tellingly, actually rose as a first reaction to the fuss, hardly the reaction you would expect if the Chinese were preparing to dump dollars. Treasuries lost ground, but nothing extraordinary.

STUPID BUT PROBABLY HARMLESS

Technically, the United States is probably within its rights to impose the duties. WTO rules allow this if a surge in imports threatens a domestic industry, even if the trade is not unfair.

Rights and laws aside, the duties are indefensible. They protect less efficient makers and simply punish China, not for unfair trade practices, but for success. They also punish U.S. consumers, arguably hurting living standards more than the loss of the jobs the tariffs are presumably meant to protect.

Expect China to make a lot of noise about this. They also have domestic audiences, and theirs are rightly aggrieved. Expect too the rest of the G20 leaders who will assemble this week in Pittsburgh to say all the right things in public and to play peacemakers in private.

What I would not expect is for this to accelerate into something damaging and destabilizing. The stakes are too high and the political rewards domestically for a trade war are tiny in comparison.

There are, however, longer-term issues which are unsettling. China’s interests and those of the United States are diverging and over time there will be serious conflicts to be negotiated. The system of China trading goods for Treasuries which did so much to raise living standards in China and fill garages with stuff in the United States is no longer tenable.

The U.S. will consume less of China’s stuff and must even compete with China more effectively for exports, probably in areas like military technology where sales will be doubly unsettling for the Chinese.

China, over time, will not want to subsidize U.S. borrowing rates and will want to diversify its currency holdings. This will not be easy or pleasant for the United States but, broadly speaking, is probably in its own long-term interests.

All of this could blow up, especially if it undermines confidence in Treasuries and the dollar. It has not yet, and I think the two protagonists will put off the serious business of working out their conflicting interests until either the global economy returns to robust growth or things in the United States stay bad long enough to change the political math of a real trade war.

We are not there yet, and for at least another year probably won’t be.

–At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.–

–James Saft is a Reuters columnist. The opinions expressed are his own–

Rest in peace, Great American Consumer. We will not see your like again.

“Cash-for-clunkers” aside, consumers seem bent on actually paying back debt rather than racking it up, a change that if sustained, as it is likely to be, will dampen economic growth not for months but for years, and not just in the U.S.

Outstanding U.S. consumer borrowing fell by a jaw-dropping $21.6 billion in July, according to data released this week by the Federal Reserve, five times more than analysts expected and the second largest monthly drop since the end of World War II.

June’s borrowing was revised to negative $15.5 billion from what had been an impressive minus $10.3 billion.

Over the past year, the stock of consumer loans outstanding has dropped by 4.2 percent, or nearly $110 billion, leaving the total now lower than it was before the crisis began in 2007.

Over the long term, this is exactly what needs to happen. With household wealth badly hit by the housing and stock market crashes balance sheets are stretched. And with a huge baby boomer cohort hurtling towards retirement age also, spending and borrowing were bound to be curtailed.

The question really becomes how entrenched the trend towards the new frugality becomes.

“Memories of debt are very powerful. The generation that grew up in the 1920s and 1930s, was wary of getting into debt as it - and its parents - had experienced two periods of deflation,” Lombard Street Research economist Gabriel Stein wrote in a note to clients.

“We are now in another period of debt repayment and deflation. The thought that US households will forget 2007-2009 and begin to borrow and spend as they did in the early 2000s, is fanciful at best.”

For years the mantra on Wall Street was “don’t bet against the American consumer,” a creature so fabulously resilient as to be almost super human.

Wars and recessions did little to brook consumption and the debt that grew alongside. Even the September 11 attacks saw healthy month on month growth in borrowing in the aftermath.

Whole industries, some now vanished, were predicated on Americans continuing to borrow and spend. It’s an overstatement, but only a slight one, to say that the global economy was predicated on U.S. consumption, which in turn was predicated on consumers borrowing.

THE NEW FRUGALITY

It is doubtless true that lenders of all stripes are making credit harder to get. But there is a good bit of evidence that individuals are changing their preferences. Much of the cash from stimulus handouts earlier this year was used to pay down debt rather than goosing consumption.

A Gallup poll asking Americans how much they had spent in the past day, not including major purchases or normal household bills hit $63 when most recently measured, down from above $100 a year ago.

Now on the face of it, that reduction must be overstated. If consumption had fallen by that magnitude, we’d be in a depression rather than debating the strength of a recovery.

But of course the Gallup poll is a self reported one, and I would be willing to bet that people are now exaggerating how frugal they are, where once they would have exaggerated how much they were spending. That in itself is an important marker of a social trend. Once you wanted the nice people at Gallup to think you were a big shot leaking money, now you probably want them to see you as a saver.

Gallup also looked at the data by generational group, and found that it was not just those in or approaching retirement who were cutting back on self-reported spending. So-called Generation Xers and Millennials, who followed the boomers into the workforce, are also cutting back in similar scale.

But the issue isn’t the rate of savings but the stock of savings as compared to liabilities. While it is reasonably possible to cut back on spending and so increase your savings rate that is far different from suddenly becoming financially robust.

The other thing to bear in mind is that there is a huge difference between stocks and flows. A person can quite quickly raise her savings rate - as we have seen - but that does not mean that her debts are quickly paid off.

If U.S. consumers cut debt as quickly as Japanese corporations did in the 1990s, it will still take them until 2018 to get their debt down to 100 percent of GDP from recent peaks of 130 percent, according to a study from the San Francisco Federal Reserve.

If the trend in consumer borrowing continues, it will not be long before the conversation will turn back to stimulus, quantitative easing, and a relapse for the U.S. economy.

–At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.–

–James Saft is a Reuters columnist. The opinions expressed are his own.–

The effort to rein in banking bonuses, outrageous as they may be, is akin to banning glue sniffing because you are worried about the effects of intoxication.

There are, as the kids in the alley behind the high school can tell you, other ways of getting high.

Train your regulatory fire instead on requiring more and better bank capital and you will arguably do a great deal to control excessive compensation as well as doing much more to protect taxpayers and the economy.

Financial leaders from the Group of 20 rich nations agreed the skeletal outlines of a plan to reform banking last weekend in London. Included was the idea of claw backs on bonuses if earnings evaporate, forcing more pay to be deferred for longer, and more disclosure of top pay.

This may have some effect; bankers will have to wait a while for their money and some risky bets may not be made. But the out-sized rewards are the result of people within finance having an informational advantage over their shareholders and regulators and the ability to play with huge amounts of other people’s capital. Combine this with an implied government guarantee for the too-big-to-fail and you end up with a crisis every ten years or so. Just making bankers wait longer for their money does nothing to affect the competition for deals and assets to leverage.

Besides the folks who brought you the CDO squared will be well able to find workarounds to ensure that money leaks out in one way or another.

More promising by far are proposals to force banks to increase the amount and type of capital they hold. Central bankers and regulators from the Basel Committee on Banking Supervision are calling for a host of measures to bolster capital, including saying that common shares and retained earnings must be the mainstay of capital, introducing a leverage ratio and minimum standards for funding liquidity. All three will make banking and the economy more stable. All three will also, in so far as they reduce the amount of borrowed money available for investment, tend to push asset prices lower.

LEVERAGE IN, LEVERAGE OUT

Kansas City Federal Reserve President Thomas Hoenig points out that the largest 20 U.S. banks have equity capital equal to only 3.5 percent of their assets, as against an average of 6 percent for their middle sized competitors.

“They have an implied guarantee, which affords them an enormous advantage in terms of their use of leverage and their ability to accumulate assets to unprecedented levels,” Hoenig said in a speech to bankers made in August but released last week.

The large U.S. banks, it is worth mentioning, in turn face competition from their big trans-Atlantic peers, many of whom have leverage far in excess of theirs.

Forcing large banks around the world to raise enough capital, or dump enough assets, to put them on a level with their smaller peers would do a great deal to put an end to the rolling bubbles and bailouts.

The Basel committee also said it would consider the need for a capital surcharge to “mitigate the risk of systemic banks.” If by this they mean a tax on size above a certain level, this would be a fantastic start to counterbalancing the unfair advantage enjoyed by the too-big-to-fail, not to mention the threat they pose to the public purse. It would make good sense to impose a tax on size and to phase it in over several years, so that banks would have both the time and the incentive to shed assets without resorting to a fire sale.

Control leverage and size and you will do more to control destructive risk taking than any programme can which simply makes bankers wait a few years until they can get their payouts.

If you are really worried about unfair compensation in banking you have to define who is being badly treated by it. Moderating the effect of a taxpayer subsidy by limiting size and controlling risk taking is a start, but there are still shareholders and consumers of financial services to be protected. Both of these groups suffer because they don’t really understand the complex products being produced and sold by the industry. This allows consumers to be overcharged or oversold and shareholders to be chiseled out of part of their portion of the gains generated.

It is strange to say, but bank customers and owners may want to make common cause over the issue of simplicity in financial services. Simple banks with simple products might in the long run generate better outcomes for their owners and clients, just as simple index funds now do for investors. Will regulators be able to accomplish all of this? Probably not, but they would do well to concentrate their limited resources and creativity on the foundations of banking rather than the salaries on the top floor.

–At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. –

(James Saft is a Reuters columnist. The opinions expressed are his own)

There is a long list of outfits which have done well out of the banking bailout, but the U.S. Treasury and Federal Reserve are not among them.

According to calculations made for the New York Times, the Treasury’s Troubled Asset Relief Program (TARP) has reaped profits of about $4 billion, or 15 percent annualized, as eight of the largest banks to participate have fully repaid what they owe.

Meanwhile unnamed Federal Reserve officials told the Financial Times that the central bank’s liquidity facilities have generated a “gain” of $14 billion since August of 2007.

The notion of TARP profits is only true if looked at in the narrowest sense, and even then may prove to be a return as real as those of the Florida condo flippers in the summer of 2007.

The Fed, on the other hand, incontrovertibly has earned more by buying and lending against poorer quality paper, but they did it by taking on more risk - a leaf out of the book of the industry they were helping to rescue.

Wait until the Fed starts making payday loans or gets into the reconditioned small appliance finance business, then you will see what kind of “gains” a bank with a printing press and the power to create money can really generate.

I suppose the idea is to make taxpayers and voters grateful that they had the opportunity to participate in such profitable ventures - doing well by doing good, or some similar fluff.

A number of leading banks have repaid their loans made under TARP, and the government has profited by warrants it held under the deals, but this is really only a bit of runoff from the great jet of liquidity that the government has concentrated on the industry as a whole.

“What this is more appropriately described as is a return of capital; to call this a profit is to ignore trillions of dollars in taxpayer monies that have been spent, lent, guaranteed, drawn against and otherwise consumed in what will likely be the greatest transfer of wealth in the planet’s history,” Barry Ritholz, of research firm Fusion IQ, wrote on his blog.

It is one thing to justify an enormous outlay and subsidy - and make no mistake this is what the bailouts were - on the basis that it was a needed evil, but it borders on the offensive to sell it as a successful investment.

DOING WELL FROM DOING LESS

The first to repay within any loan portfolio are by definition the strongest; it is only later that the laggards show the losses. We do not know how the TARP and other programs of support will look in three or four years time, but it is likely to be worse than they look today.

Moreover, the whole idea of rigging the game and then declaring a profit is wrong. Governments can ever and always create the conditions under which their financial sectors can turn nominal profits.

They do this in a number of ways; through lax regulation, by engineering low interest rates with a sharply sloping yield curve, by limiting competition, or by providing term financing when the markets won’t do so.

These profits though are effectively a tax on the rest of the economy, and I am betting that the taxpayer and government are not getting their fair share, which is virtually all of it.

Billions and billions of dollars are flowing elsewhere - to investors, to borrowers and to employees.

There is also the bald fact that, given that there were no effective funding markets at the time that many of the loans and investments were made, the government could have extracted far higher compensation for its support.

And what about opportunity cost? How would the government and taxpayer have fared if instead of rescuing the banks, and thereby privatizing much of the profit, it seized them and sold them off in the normal fashion? Or what about if the trillions of dollars in support were used in different ways, for different purposes, or even, heaven forfend, not spent at all?

As for the Fed and its gains, the key point is that this money, which represents the extra earned above what three-month Treasury bills would have generated, is not risk adjusted.

The Fed isn’t, and shouldn’t be, a hedge fund — leveraging up and going out the risk curve to generate profits.

It too, conceivably, can allocate credit to a particular part of the economy, say housing, and thereby make the loans it makes to that sector perform and generate “profits.” But this begs two questions; is it right for them to allocate credit in this way and are the profits real or symptoms of a bubble?

This will work for a while, but as we have seen, not forever.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

(James Saft is a Reuters columnist. The opinions expressed are his own)

Activity in the U.S. housing market has bottomed - a huge plus for the economy - but a recovery in prices will not be sustained and the threat from real estate to bank capital remains acute.

We are over the worst, but only because of massive official support, support that will soon ebb. That could lead to a relapse, especially among more expensive houses, but nothing along the lines of what we have suffered so far.

The news has been good.

Newly built homes sold in July at the fastest pace in ten months, up 9.6 percent, in U.S. Commerce Department data on Wednesday. This echoes a fairly good showing in last week’s data on sales of existing homes which are selling at the fastest pace in almost two years.

Miraculous to say, prices now look to be rising, at least as recorded by the Case-Shiller home price index which rose 2.9 percent between the first and second quarters, the biggest jump in close to four years.

This all comes as a huge relief. You can construct an argument that we are now most of the way through the most painful adjustment in house values and sales activity since around the time great clouds of dust blanketed the mid-west in the 1930s.

There is no doubt that a pickup in activity, even from very low levels, will be helpful for the economy and will gently support the services and construction sectors as well as theconsumption of durable goods.

But the supply of housing, though it has dropped, remains high and is probably under-measured given a large “shadow” inventory of both repossessed houses and houses of frustrated sellers which will come back on to market to meet and probably exceed any pickup in demand.

In the more bombed out areas of the U.S. - think Las Vegas and Cleveland - it is easier to come to terms with the idea that prices will now rise.

Demand is coming not just from first time buyers but more importantly from cash investors looking, not to flip as prices rise, but to get a decent income stream from renting. These investors are a healthy part of the process of turning a marginal group of house-owners back into renters.

It is hard to look at the national data, especially at the higher end where inventory in many areas is measured in years of supply not months, and conclude that we will not see any more falls.

“Perhaps a respite is in order, but with the true underlying unsold inventory near 12 months’ supply, which is double what would typify a balanced housing market, it would seem like wishful thinking that we have suddenly achieved a fundamental low in real estate values,” David Rosenberg, of Gluskin, Sheff told clients.

THE GOVERNMENT GIVETH…

The recovery in housing, such as it is, has to be seen in the context of the absolutely heroic support it has received from government.

The Federal Reserve has slashed interest rates to unfathomable lows, and not content with that, also intervened directly in mortgage markets, buying something on the order of $750 billion net of mortgage securities in an attempt to drive down mortgage rates.

The Fed has a 2009 target of buying up to $1.25 trillion of agency mortgage backed securities, $300 billion of Treasuries, and $200 billion of agency debt, all of which is keeping effective borrowing rates 0.5 to 1.0 percentage points lower than they would otherwise be. That program may be extended into next year, but not in size, given a well justified fear by the Fed that such intervention invites tighter political oversight.

So, all things being equal, mortgage rates may rise relative to prevailing rates, unless of course the securitization machine rises from the dead.

An $8,000 tax fillip for first time buyers is definitely a factor behind increased turnover and improving prices, particularly at the lower end. But that program is due to expire November 30.

Like the “cash-for-clunkers” plan for cars these programs partly encourage pent up demand to get off the sidelines but also simply move some activity forward in time. Look for a bit of a slump as the effect, which is now at its height, wears off.

Late paying borrowers are proving far less likely to get back on track than they were in previous cycles, according to a recent report from ratings agency Fitch. This argues for a continuing supply of houses coming back onto the market as foreclosures, especially in light of the poor success of mortgage modification programs.

To be sure, things are better now than they have been and the very steep falls in price make housing less of a one way bet.

The real estate market is usually seasonal, with a spring spurt and a winter freeze. This year we’ve seen the return of the spurt, but the freeze to come may buckle some foundations.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. )

(James Saft is a Reuters columnist. The opinions expressed are his own)

A proposal to give banks, hedge funds and private equity firms “affordable” credit default swap-based insurance against market panics will be very effective: it will effectively encourage even more risk taking and turn the next crisis into one about government credit.

Global central bankers assembled at the Jackson Hole conference last week heard the proposal, by two Massachusetts Institute of Technology economists Ricardo Caballero and Pablo Kurlat. Their idea is that most of the damage in panics is due to a combination of investors overestimating the damage during a market seizure and policy-makers being too slow to pull the trigger on bailouts.

The solution, therefore, is to send the banks into the next panic ready armed with a Fed-backed get out of jail free card which the authorities can activate at a moment’s notice.

This is akin to looking at a bunch of toddlers riding motorcycles and deciding that what will really improve the situation is putting them all in crash helmets.

The proposal emphasizes “Knightian uncertainty,” which it says impairs markets during panics, as investors price in the worst about those risks which they cannot measure.  Remove this uncertainty, and hey Presto, you’ve cheapened the cost of the whole bubble business.

“The main antidote to fear is prime, government-backed insurance against what investors fear,” according to Caballero and Kurlat.

“The silver lining of this diagnosis is that providing such insurance is inexpensive for the government, as once the panic subsides the real losses are much smaller than those initially feared by investors.”

There are a few assumptions there, so let’s take them one by one.

First, we don’t know that markets were wrong to assume last year that bank losses would be catastrophic. Banks are performing better, but only within a context of having either an explicit or implicit government guarantee. We do not know how well their underlying assets will ultimately perform, or even if the assumptions made in the stress test will prove true. We only know that in making those assumptions and standing behind them, the government has removed risk for private investors.

Second, we do not know that the level of these losses will be affordable for governments to bear. Look at Iceland for a prime example of what can happen. The U.S. has taken on very real and very scary public liabilities in order to end the crisis. There is no guarantee that these are affordable or that U.S. creditors will keep faith.

THE FUTURE IS MORAL HAZARD

Caballero and Kurlat also say that the cause of panics is fundamentally unknowable, a surprise. While its hard to say now where the next one will come from, there are plenty of people out there who were patiently explaining where this one was going to be centered: real estate. People who ignored this advice did so for many reasons, but one thing in common many shared was that they were getting rich out of the bubble or hoped to.

This brings us to the main reason not to create these crisis swaps; they will only encourage people to take on more risk. If we effectively assume that all panics are essentially false alarms we will encourage an unwarranted confidence in risk managers and investors. Add in prospect of profits and bonuses and you have a prescription for ever expanding leverage, bubbles and crises.

The authors say that policy makers react too slowly, and compare their plan to placing defibrillators in public places to save the lives of heart attack victims. But unlike human beings, all of whom we want to save, sometimes its better if banks are allowed to die, much less hedge funds. Shareholders and bondholders, unlike life, are not sacred.

The proposal also argues that leverage in the system was not excessive, at least when compared to the last recession in 2001. But of course by 2001 the amount of leverage had already began to expand, helped along the way by deregulation. Try running the numbers compared to 1985 or 1965 and you will reach a different conclusion.

None of this is to say that financial innovation is a bad thing, or that leverage is to be altogether eliminated. But there is in markets a growing hope that we are all awakening from a bad dream. That’s a delusion.

Financial panics are not nightmares to be ignored, but like chest pains, warnings to be heeded.

“In the end, the conventional common sense response to financial crisis - better regulation, rein in leverage, increase transparency, etc., is not such a bad one,” Harvard economist Ken Rogoff wrote in response to the proposal.

I couldn’t agree more. Let’s get the kiddies off the bikes, and the sooner the better.

( At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

– James Saft is a Reuters columnist. The opinions expressed are his own –

The explosion in company pension fund shortfalls in Britain nicely illustrates issues which will dominate economics and investment in coming years: the re-pricing of risk, a disillusionment with equity markets, and the boom in savings these shortfalls will help to drive.

Under current accounting rules, the pension funds of companies in Britain’s FTSE 100 index are together 96 billion pounds ($170 billion) underfunded, more than double the deficit of a year ago and an all-time record, according to a report from pension fund consultants Lane, Clark & Peacock.

This is partly for the very positive reason that people are living longer but principally because of the dire performance of financial markets, especially equities, over the past year.

To make matters worse, the surge in corporate bond spreads, which are used to calculate the current value of pension plans’ future liabilities to retirees, has actually minimised how underfunded British pension plans look when accounting measures are applied. Minimised how underfunded they look, but not how underfunded they are.

One of the net results of all this is that companies are getting out of the pension providing business as fast as they can, pushing employees into plans where the saver takes all of the investment risk and the company is purely a contributor and a facilitator.

Individuals are less able to take the long view and hold riskier assets like equities during downturns, meaning they are more likely to hold more in cash and bonds than are company pension plans.

Individuals are also going to be increasingly aware of the shortfalls of the pensions they have coming, which will push the savings rate still higher.

A growing awareness that we are going to live a very long while will also support this. It’s nice to live to 90, but it takes savings to fund that old age, even if you plan to work until you are 70.

Put simply financial markets have been fantastically volatile during the past two years, making it difficult to figure out how much to save and even tougher to figure out how much those savings might earn over the longer term.

Amazingly, more companies in the Lane, Clark survey raised their estimates of long-term returns from equities than cut them in the past year. But even after a huge rally in recent months, five and ten year returns in many of the world’s equity markets look pretty uninspiring, especially if you apply any kind of penalty for the very extreme level of volatility.

Assumptions about equity market returns will likely fall in coming years and more pension funds and individual retirement savers will ease up on the percentage of their portfolios they allot to shares.

SAVINGS UP, CONSUMPTION DOWN

One of the key false assumptions of the pre-credit crisis age was that we lived in a newly tame economic era. This conditioned people to save less and take on more risks, as borrowers, lenders or investors. This leveraged economy grew more quickly than a more conservative one, and we rationalised away the risk by saying that better macro-economic policies meant we were in a new era where rainy days were fewer and less severe.

That obviously has been proved wrong, and the results are written in the pension plans deficits. We live in a more volatile, riskier world than we believed. As that realisation spreads, and as many retirees find they have too little in savings, behaviour will change in important ways.

A growing awareness of the fragility of growth and the volatility of markets will not just change the behaviour of investors but also others.

Banks, as we’ve already seen, are going to want more security and a better margin. That will crimp growth. Companies will be more cautious in how they borrow, invest and expand. That too will crimp growth. This is not a bad thing, but it is bad if you have a business or personal plan that is predicated on very high growth.

All investors will be less comfortable with equity risk, and as individuals will bear more of those risks alone, they will accentuate a trend away from equity investment.

But more powerfully, the fact that there is no benevolent company or government which can fund our 25 year retirements will push all of us to save more, as well as to be more cautious with how we invest the money we do save.

This will have a big dampening effect on economic growth, especially in the ageing West, and isn’t likely to be very helpful to long term equity valuations either.

Monetary and fiscal policy can work against these forces, as we’ve seen, and can ease the transition, but they can’t do it by themselves forever.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. )