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

Rather than vainly trying to refloat the shadow banking system, the U.S. would be better off grappling with the inevitable ultimate solution — debt destruction and inflation.

The common denominator of policies like the Term Asset-Backed Loan Facility (TALF) that was detailed on Tuesday, is that they try to solve fundamental problems with indebtedness by attempting to float asset prices high enough that they are back in proportion with the debt.

Even more, they use the same structures that worked out so poorly — highly levered hedge fund like vehicles and securitisation — but this time substitute government funding and leaves the taxpayer as main bag-holder if the deals go bad.

With up to $1 trillion, the TALF is designed to re-start parts of the securitization market such as auto, business and student loans. This followed the plan to avoid foreclosures and further house price falls by cutting borrowers, many of whom made silly borrowing decisions, a break on their interest rates.

Next up: a public-private plan to buy up toxic legacy assets from banks, which should be detailed in the next two weeks. Again, that program will provide government money at sub-market rates to investors to entice them to pay more than the market price for assets that would otherwise sink many banks.

The higher the leverage supplied the higher the price hedge funds and other investors will pay for doubtful assets. After all, like a Florida condo flipper, if the asset declines in value they can just walk away and throw the metaphorical keys at the Federal Reserve and U.S. Treasury.

“We want to make sure that the prices of the assets that are purchased reflect true market values that are not overpaid. So the idea between the public-private partnership would be that there would be both public and private money involved and that the pricing decisions would be made by private-sector specialists, not by public bureaucrats,” Fed Chairman Ben Bernanke told Congress on Tuesday.

“If the government is willing to provide longer-term lending, or leverage, there are many investors who presumably would be willing to buy under those circumstances who are unwilling to buy without the credit, without the lending they need to finance those purchases.”

I simply cannot reconcile the first part of that statement with the second. What do we mean by “market values” in a situation where the government provides financing not otherwise available? Vary the leverage and achieve any price you like.

LIVING IN A CASH FLOW WORLD

The TALF is slightly more defensible. There is a market failure when reasonably good credits can’t raise money under any circumstances. But before we try to re-start securitization and the shadow banking system, let’s recall what the problems were in the first place. For one thing the TALF relies upon imprimaturs from the credit ratings agencies which have been found wanting. That’s not yet changed, but government participation simply papers it over.

Even the obsession with banks almost seems beside the point.

“You won’t revive the economy through debt,” said Albert Edwards, global strategist in London at Societe Generale.

“Banks aren’t the problem, they are a symptom of the problem.”

The problem is that asset prices are out of line with their ability to generate cash flow. Falling prices do impose a risk premium but the real issue, for stocks or for houses, is that their prices are not in the proper proportion to the debts they carry and to their ability to generate cash. That happened in part because of the shadow banking system and was a mistake.

So, what’s the implication? Some debt will be repaid but a lot will just be destroyed via default. An organized write-down seems impossible. That will be a huge problem for the banking system and the country, and you can understand why the government does not wish to meet it head on.

University of Oregon economics professor Tim Duy thinks the U.S. will ultimately end its romance with financial engineering and get down to working through unsupportable debt the old-fashioned way — inflation.

“And therein lies the key to predicting when the Fed shifts gears; When Bernanke abandons the notion that proper credit market functioning is alone sufficient to restore housing values (asset values more generally) to their former glory and support acceptable growth,” Duy writes.

“At that point, the Fed will again consider the wisdom of what it has defined as quantitative easing, an expansion of the balance sheet via a deliberate expansion of liabilities.”

That is a dangerous and difficult to govern process, and the U.S. shows every sign of being willing to pay a very high price to avoid it.

But ultimately, the price will be too great and we will have to inflate and default in some mixture.

– 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. –

– John Kemp is a Reuters columnist. The views expressed are his own –

After an 8-year period of remarkable stability, the ratio between gold and oil prices has broken down spectacularly.

The relative rise in gold is consistent with other indications that the market is bracing for a delayed upturn in inflation between 2010 and 2012.

From 2000 to 2008 one ounce of gold bought between 6 and 15 barrels of light sweet crude oil but for months the markets have been moving in opposite directions. In recent weeks, one ounce of gold has bought as many as 27 barrels of oil (https://customers.reuters.com/d/graphics/OILGOLDRATIO.pdf).

If both gold and oil prices encapsulate a view about prospects for the world economy and inflation, the divergent price moves present a seeming contradiction.

The surge in gold prices suggests investors are anxious to protect their capital against inflation, currency depreciation and bank failures. But weak or falling prices for oil and other commodities suggest investors are also bracing for a prolonged period of economic weakness and deflation.

How to reconcile these views?  They cannot both be right.

If the massive liquidity injections into the banking system as a result of rescue packages and quantitative easing causes inflation to pick up, oil prices reflected in the forward curve will turn out to be far too low. If the world economy falls into a long deflationary slump, gold will be too high.

In either event, it ought to be able to trade the ratio, selling expensive gold futures to buy cheap oil ones, and wait for the ratio to converge back to more “normal” levels.

But such trades are more dangerous than they look.

Ratios can be remarkably stable and show strong trend-reverting properties for long periods of time. But when they break down, divergences often go further and last longer than most anticipate.

John Maynard Keynes warned that the market can remain irrational longer than the average investor can remain solvent. All but the strongest investors with deep pockets will struggle to meet margin calls until the ratio corrects and profits are made.

Moreover, it is impossible to be certain until afterwards whether the shift in the ratio represents a temporary divergence that will be corrected in time, or the start of a fundamental structural break.

TIMING DIFFERENCES

In any case, the current divergence in gold and oil prices may not be as irrational as it looks. It probably reflects differences between institutional and retail investors about the timing of future inflation rather than the probability.

Both types of investor have recently shown interest in commodities as a hedge against inflation, currency depreciation and bank insolvencies.

But unlike large institutional investors, who can protect themselves from inflation and currency risks through inflation and currency swaps, inflation-protected government bonds, or futures positions in oil and industrial metals, retail investors have fewer options. Owning physical gold is one of the few ways they can protect capital in an inflationary environment.

Much of the heightened interest in gold has come in forms favoured by retail investors, such as coins, bars and holdings in exchange-traded funds (ETFs) (which give private investors an opportunity to “own” physical gold more or less directly through shares in a trust vehicle quoted on equity exchanges).

Different views about inflation embedded in gold and oil futures may therefore mark different views between retail and institutional investors, with the retail base more worried about an upturn in inflation, and professional investors more sanguine.

It probably also captures differences about timing. The whole objective of quantitative easing is to generate more inflation over time to counter the deflationary tendencies within the economy as a result of the slump.

But an upturn in consumer prices is unlikely to occur until a cyclical recovery is well underway, and could therefore be several years away.

Less sophisticated retail investors focused only on the longer-term inflation threat risk piling into commodities too early, paying several years worth of storage and financing costs (contango, or negative roll yield) before seeing an eventual upturn. Institutional investors seem content to wait until signs of a cyclical recovery and pick up of inflation become more imminent.

Gold is also a much more convenient and cheaper way than crude oil to buy medium-term protection from inflation.

Because of the huge storage charges, the cost of buying cheap oil at the bottom of the cycle and financing and storing it until prices and inflation pick up in two or three years time, is prohibitively high.
Gold is much easier and cheaper to store. The cost to buy gold or gold futures now and hold them until inflation picks up is little more than the cost of finance, which in a world of near-zero interest rates is almost nil.

For both retail and institutional investors, gold has therefore emerged as the vehicle of choice for protecting capital against a deferred break out in inflation rates in 2010-2012.

The stretched oil-gold ratio is a perfectly rational reflection of timing differences (deflation in the short term, inflation in the long term) and storage charges (high for oil, low for gold).

The current constellation of commodity prices does indeed send a carefully coded warning about the prospects for a pick up in inflation — but not for another 2-3 years.

– John Kemp is a Reuters columnist. The views expressed are his own –

Every budding economist is taught the distinction between nominal variables (expressed in terms of contemporary cash values) and real variables (adjusted for inflation and expressed in constant-dollars).

An oil price of $50 per barrel in 1980 is not the same as an oil price of $50 a barrel in 2009 because inflation has steadily eroded the purchasing power of the currency in the intervening years. Moreover, economists are taught that real values are more important than nominal ones — because “money is a veil” (to use the phrase of the Austrian economist Joseph Schumpeter).

Prices are important because they perform a signaling and allocating function, encouraging supply and rationing demand. What matter are relative prices not absolute ones.

If all prices and wages double, there is no impact on the distribution or quantity of production and consumption because the relative prices remain unchanged. Money is a veil and focusing on nominal values risks succumbing to money illusion — believing that purchasing power or wealth has increased simply because it is expressed in more units of a devalued currency.

When the US Department of Commerce releases its updated National Income and Product Accounts at the end of each month, investors focus on the real growth rate in GDP, adjusted for inflation. You would be hard pressed to find the nominal GDP growth rate on dealing screens, or for that matter in the Commerce Department’s press release.

But surely that doesn’t matter, because we are only interested in how much output is produced, how many cars, how many homes, not their selling value.

Wrong.

Because one set of important relationships in the economy is almost always expressed in nominal terms, not real ones: debt.

If household incomes double in nominal terms, and the price of a representative basket of goods also doubles, purchasing power has not changed. But the proportion of household income spent servicing and amortizing old debts is halved.

Nominal values become crucially important in a dynamic economy where time as well as price is important, and where debt contracts such as mortgages and firm loans are fixed in nominal terms rather than indexed.

Prices have two functions: a static function allocating resources among producers and consumers; and a dynamic function generating incomes, saving and a flow of payments on debt contracts. For the static function, what matters is real or relative prices. But for the dynamic one, nominal prices are more important because they determine the sustainability of the fixed debt contracts.

NOMINAL GDP GROWTH STALLS

The nominal income or cash flow received by households determines how easily they can repay debt contracts fixed in nominal terms. In the same way, the nominal income or cash flow received by companies determines how easily they can repay debt contracts in fixed currency.

At the most general level, nominal GDP is in some sense the “national cash flow” — and determines how easily the economy as a whole can support an overall debt structure fixed in nominal terms. Nominal GDP growth becomes exceptionally important, especially at times when debts are at a high level.

The attached charts show quarter-on-quarter and year-on-year growth in GDP in both nominal and real terms since 1947.

Chart 10 (below) shows the quarter-on-quarter growth in real GDP (expressed at annualized rates). Real GDP growth is very variable. Declines in real GDP during recessions are common. Real output has fallen in 37 quarters since 1947 (about 15% of the time) and risen in 207 quarters (about 85% of the time).

But look at Chart 11, which shows the quarter-on-quarter growth in nominal GDP. Nominal output has only fallen 13 times since 1947. The last quarter-on-quarter decline in nominal GDP was in Q3 1982.

Before that, you have to go back to Q4 1960 to find a quarter in which GDP declined in nominal terms.
Chart 12 shows nominal GDP growth on a four-quarter or year-on-year basis. Nominal GDP growth has not been negative year-over-year since Q1 1961.

From the late 1960s through until the current decade, relatively high rates of inflation ensured that GDP continued to grow in nominal terms even when it fell in real ones during cyclical recessions. Even during the deep recessions of the 1970s and 1980s, nominal GDP was generally growing because the decline in real output was more than offset by relatively high rates of price and wage inflation.

Payment ability for households which experienced unemployment and firms that experienced a sharp drop in demand for their products was often severely impaired. For these few, homes were often repossessed and individuals and companies could be made bankrupt.

But for the majority of households that remained employed, and for companies that experienced only a moderate decline in demand, wage and price inflation continued largely unabated, continued to raise their nominal cash flows, and make it easier to pay off debts incurred during the previous boom.

The combination of falling output with rising prices (labeled “stagflation” ) is usually seen as the worst possible outcome for the economy. Well, the worst except one: debt-deflation.

Because stagflation in the 1970s and 1980s ensured that, for most people, the real burden of debt remained manageable, or even improved, despite the recessions. The misery was borne by the minority of workers who became unemployed and the minority of firms that became insolvent. For the rest, inflation continued to boost nominal cash flows and increase debt-service capacity.

The strong, consistent growth of nominal GDP between the late 1960s and the late 1990s was mostly the product of persistent inflation. Before the mid 1960s, in the 1940s and 1950s, inflation rates were much lower, and nominal GDP growth was much more variable, turning negative on ten occasions between 1947 and 1960.

But in the current lower inflation world, the risk of nominal GDP turning negative has increased. During Q4 2008, nominal GDP growth turned negative for the first time in 25 years. Inflation (essentially zero) was not enough to offset the decline in output in real terms (-0.9% compared with the previous quarter).

Output looks set to decline further in Q1 and probably Q2 2009, and price inflation will probably turn negative. So at some point during H1 2009, nominal GDP growth will turn negative year-on-year for the first time since 1961.

NEED TO REKINDLE INFLATION

It is the sudden shrinkage of GDP in nominal terms which presents the greatest threat to the solvency of the banking system and the rest of the economy in the coming year. Because if GDP starts shrinking persistently in nominal terms, the already high burden of servicing debt contracts fixed in nominal terms will rise further.

Every job that is lost and every factory that is closed or put on short-time reduces real output. But every wage cut and price reduction is also reducing the cash flows which households and firms need to pay their debts, deepening the crisis.

Governments and central banks are now under intense pressure to sustain nominal GDP, and restart nominal growth, by boosting employment and fueling at least a modest pick up in inflation.

The target is shifting from restarting real growth to restarting nominal growth. Economist Samuel Brittan has written previously in the “Financial Times” about the need for the government and the Bank of England to have a target for nominal GDP growth (rather than a narrow focus on consumer price inflation). But the same is true for the other G20 economies.

Fiscal and monetary policy needs to create enough real demand and inflation; sustain employment and wage levels; raise output and prices.

In some sense, rekindling inflation has become a necessary and inevitable part of the solution to the current crisis.

Chart10: https://customers.reuters.com/d/graphics/Chart10.pdf
Chart11: https://customers.reuters.com/d/graphics/Chart11.pdf
Chart12: https://customers.reuters.com/d/graphics/Chart12.pdf