Opinion

The Great Debate

Institutional failure week

-The opinions are the author’s own-

By the end of this week, the U.S. will face a government that is unable to act to aid the economy and a Federal Reserve that is unable to stop.

The stock market may well rise on this dysfunctional combination, only serving to prove that the economy and market are becoming fundamentally disconnected.

Tuesday’s election may well deliver a split Congress with the Republicans in control of the House of Representatives and the Democrats clinging to a narrow majority in the Senate. This means that there is no chance of further meaningful stimulus and that Democratic timidity will likely harden into an intransigence to match that of the Republicans.

Rather than building bridges, the next two years will be spent dickering over tax codes, and, as the 2012 election nears, fighting trade and currency wars.

Many will argue that this is right, that the election will freeze stimulative spending that is wasteful and unpopular.

from MacroScope:

Did France cause The Great Depression?

Economist Douglas Irwin of Dartmouth College has stirred up a bit of a fuss by concluding in some academic research that it was France, not the United States, that was most to blame for The Great Depression.

Irwin's theory, in a paper posted here by the National Bureau of Economic Research, is that France created an artificial shortage of gold reserves when it increased its share from 7 percent to 27 percent between 1927 and 1932.  Because major currencies at the time were backed by gold under the Gold Standard, this put other countries under enormous deflationary pressure.

To prove his point, Irwin ran a model looking at what would have happened without the French move. The results:

Fed is split but QE2 looks a done deal

- The opinions expressed are the author’s own-

FOMC meetings are usually a strange combination of formality and easy-going familiarity but levity may be in short supply this week. The Fed’s institutional credibility is on the line, and the normal decorum that characterizes relations among committee members has become increasingly strained over the summer.

Divisions between proponents and opponents of a second round of quantitative easing (QE2) have been on display as never before. It is not clear what members will say to one another to fill two days since all the arguments have already been rehearsed in detail and in public over the last six weeks.

In a thinly veiled swipe at his colleagues, Kansas City Fed President Thomas Hoenig has stumped around his patch on the Great Plains denouncing QE as a “dangerous gamble” and “a bargain with the devil”.

Quantitative easing and the commodity markets

-The views expressed are the author’s own-

A warning by an International Energy Agency (IEA) analyst this week that quantitative easing (QE) risked inflating nominal commodity prices and derailing the recovery drew a withering response from Nobel Economics Laureate Paul Krugman, who labelled the unfortunate analyst the “worst economist in the world”.

According to New York Times columnist Krugman “Higher commodity prices will hurt the recovery only if they rise in real terms. And they’ll only rise in terms if QE succeeds in raising real demand. And this will happen only if, yes, QE2 is successful in helping economic recovery”.

Krugman’s criticism is unfair. There are clear links between QE and investor appetite for commodity derivatives and physical stocks (via the Federal Reserve’s “portfolio balance” effect), and from investors’ holdings of derivatives and physical inventories to cash prices (given the relatively inelastic supply and demand for raw materials in the short term).

Markets make prisoner of the Fed

“Market participants should not direct policy,” Kansas City Fed President Thomas Hoenig warned listeners at a town hall meeting in Lincoln, Nebraska, back in August. Unfortunately that is precisely what is now happening.

Hoenig noted that Wall Street’s clamour for cheap money was not disinterested: “Of course the market wants zero rates to continue indefinitely … they are earning a guaranteed return on free money from the Fed by lending it back to the government through securities purchases.”

Now the same pressure groups want the Fed to launch a second round of asset purchases so they can sell U.S. Treasury bonds to the central bank (in effect back to the federal government) at inflated prices.

Weakened Fed mulls threats, promises

As any schoolteacher knows but the Federal Reserve will soon learn, threats and promises are the tools of the weak.

Trapped by interest rates that cannot sink below zero, the Fed, it is becoming clear, is not just preparing to engage in a massive new purchase of securities, or QE2, but is also considering a new communication policy it hopes will convince people that inflation, if not recovery, is just around the corner.

Investors expect a second round of ‘quantitative easing,’ or QE2, will take the form of increased purchases of Treasury debt aimed at keeping long-term rates low and encouraging consumers and businesses to go out and spend.

There is no such thing as inflation

In 1987, UK Prime Minister Margaret Thatcher whipped up a firestorm of criticism from her opponents on the left when she told a magazine reporter that “there is no such thing as society”, only individual men and women, and families.

The interpretation of those comments remains fiercely controversial. From the context it is not certain the prime minister was clear what she was trying to say.

But according to one interpretation the prime minister was encouraging her listeners to look beyond the impersonal aggregate of “society” to the individuals behind it.

The wrong sort of inflation

Chairman Ben Bernanke’s Fed is beset by demons of its own design.

Terrified by memories of the 1930s and Japan’s more recent experience in 1990s and 2000s, the academics who now dominate the Federal Open Market Committee display a hyperactive compulsion to tinker with monetary policy in a bid to solve all the problems besetting the U.S. economy.

But if inflation is always and everywhere a monetary phenomenon, as Milton Friedman argued, Fed policy has a smaller role in solving real-economy problems such as a gaping trade deficit, moribund housing market, sluggish growth and joblessness.

Expectations of another substantial round of quantitative easing (QE2) have gone too far for the Fed to pull back now. The Fed must press ahead or risk a massive, disorderly correction across all asset classes (bonds, equities, commodities and currencies).

QE2 to speed triumph of emerging markets

While “decoupled” is not the same as “immune”, look for growth and investment performance in emerging markets to be better than in the sclerotic developed world.

In the short term emerging markets will be free riders as the U.S. launches the second round of quantitative easing. A portion of the stimulus generated by “QE2″ will inevitably leak cross border, while the risks of the gambit will fall almost entirely on the U.S. and on dollar-denominated assets.

QE2 is designed to work in two ways: to stimulate investment by making it cheaper to borrow money and to lift consumption by boosting asset prices.

Fed is banking on phony wealth effect

The Federal Reserve is committed to enticing Americans into doing once again what worked out so badly in the last decade: spending the phony paper gains engineered by overly loose monetary policy.

That, at least, is the very strong impression given by a speech by Brian Sack, the markets chief of the New York Federal Reserve, a man whose job it will be to implement the second round of large-scale quantitative easing coming after the elections in November.

A round of speeches from key Fed officials has given the clear view that, faced with deteriorating conditions and trapped by the lower bound of zero in its monetary policy, the Fed is preparing to once again buy up large amounts of Treasuries, perhaps even more than the government is issuing on an ongoing basis, in an attempt to drive down market interest rates and stimulate the economy.

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