–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)

The simplest way to end the imbalances in the world’s economy is also sadly perhaps the most likely: for the Chinese to stop buying U.S. debt.

This is not going to happen anytime soon, for one thing deleveraging in the U.S. will for a time make U.S. Treasuries look good value, but a buyer’s strike is a heck of a lot more likely than the orchestrated rebalancing the U.S. will push at this week’s G-20 meeting of leading nations.

The U.S. plans to advance a plan at the Pittsburgh summit to fundamentally change the balance of the global economy, which over the past 15 years or so has been characterized by over-borrowing and consumption in the West provided and financed by savers and workers in Asia.

That state of play kept going, as is the way of these things, until it stopped, or rather until one of its wheels fell off. It wasn’t that Asians stopped saving or buying U.S. debt but that speculators, usually in Europe, stopped buying securities, often minted in London, which were being created to front run the flow of capital from Asia to the west.

That popped the asset price bubble and the flow of finance to consumers in the U.S. who, with much gnashing of teeth, began to save again and consume more guardedly.

But the debt bubble hasn’t really popped, it has only shifted shape. Before we had private debts which only could be repaid if assets, mostly real estate, continued to go up in value. Now, a new wave of public borrowing is cushioning the downturn. Asians buy some of the debt and some of the money raised buys goods from Asia.

Theoretically, China and other investors in U.S.  Treasuries buy them because they believe that the U.S. will ultimately tax more, spend less and make good. In reality, it is more vendor financing and a good money after bad attempt to protect earlier investments.

The U.S. points out, in a letter to its G20 partners, that if the savings rises in the deficit countries persist and there is no rise in consumption in the savings-bloc, global economic growth will be poor. The idea, it seems, is for IMF-led international coordination to, on the one hand, jawbone the borrowers so they remain credible while at the same time somehow inducing the savers to allow their currencies to appreciate and induce their citizens to spend.

WILL SOVEREIGNS BE THE NEW SUBPRIME?

A new study of global imbalances by economists at the Bank of England points out that Asian savers will only carry on buying western debt so long as they believe it to be high quality.

“In the short run, increased supply of government bonds resulting from the expansionary fiscal policies pursued in deficit countries has provided an ongoing source of asset supply to meet the investment demand from surplus countries,” according to the Bank of England.

“However, to the extent that savers in surplus countries may become more reluctant over time to invest funds in deficit-country government bonds this would tend to raise the cost of borrowing in deficit countries. This shift in the relative cost of borrowing could be an important part of the process by which a rebalancing of demand from deficit to surplus countries is achieved over the medium term.”

In other words, if Asian savers lose faith in Treasuries or gilts, they will stop buying, causing interest rates to spike. This would cause demand to be rebalanced, all right, but mostly by suppressing it in the U.S. and other highly indebted countries like Britain.

This kind of loss of faith in markets can be very sudden. You could draw a parallel to the way in which investors in securitized debt lost faith in the value of a AAA rating, except this time the loss of faith will be in sovereign borrowers and we really will not be able to blame the ratings agencies as enablers.

China and other exporters of course have good reason to want to avoid this. They are stuck with trillions of dollars in Treasuries and they certainly don’t want to kill the U.S. goose while it is still more profitable to sell it goose food.

There may also come a time when the world’s savers calculate that they can earn more by investing at home.

Essentially much of what a controlled rebalancing would do - weaken the dollar and build opportunity for domestic-oriented investment in Asia - creates incentives for a rapid reallocation out of Treasuries.

Ultimately the rebalanceing must happen. The U.S. for very good reasons wants this to happen little by little, but it does not have to happen that way. Past attempts at a controlled rebalancing have failed and it is hard to see what will make this one different.

(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–

If and when China makes its currency convertible and opens its financial system the stage will be set for a bubble that should make the dotcom and housing booms look tame.

China has recently signaled its key aspirations: for a greater international role for the renminbi and for Shanghai to become a great financial capital. Neither is imminent, but both imply, if not require, a series of steps that, taken in combination with China’s legitimately great potential for growth, could lead to a bubble of magnificent and dangerous proportions.

Magnificent in that, like the dotcom bubble or the railroad boom in the U.S. in the 19th century, a bubble in domestic China is directionally right and will build useful things which will change the world. A bubble, after all, needs a good story and China has one of the best ever.

Dangerous because, like the housing bubble, it will inevitably go too far and could take down banks and banking systems globally.

Perhaps rather than dotcom or housing, the most useful template for China is closer to home; namely the Japanese bubble which preceded its ongoing malaise, according to Dylan Grice, a strategist at Societe Generale in London.

“In the medium term we face the mother of all asset bubbles in China. The fundamental story is a good one; there are just lots and lots of people to sell to,” Grice said.

“If you drop a ton of liquidity on people it is possible that they will do rational things with it, but more likely they will do something pretty stupid.”

The parallels are strong. Both China and Japan successfully industrialized and opted for high-savings, low-consumption economies which concentrated on exports, exporting capital and keeping their currencies artificially weak. The result in both cases was a huge stockpile of U.S. Treasuries.

Both, too, scared their western clients and competitors witless. Remember U.S. autoworkers ritually burning Japanese cars? This of course was mingled with admiration and a sense that the global balance of power was changing, giving bubble thinking a strong push.

Japan slowly and over a long period liberalized its capital account; allowing the yen to float freely and deregulating financial markets.

Grice points out that during some of the 1980s the world fell in love with the yen, figuring that Japan’s new ascendancy meant that it would rise and rise. As a result Japan Inc. could in effect borrow in dollars, swap it into yen and get paid for the privilege. Much of the money found its way into the stock market, sending stocks to stratospheric levels and reinforcing the bubble illusion.

The Nikkei index of stocks went to the moon and Tokyo residents ended up needing 100-year mortgages to afford tiny apartments.

GOOD AND BAD BUBBLES

Of course, that is not where it ended with Japan, which had its bust and which is still struggling with deflation, though that is in part a function of a shrinking workforce.

Japan liberalized its financial system and currency arrangements under strong pressure from the United States.

China almost certainly has more relative real power today and there is every sign that it will open up on its own terms and to its own schedule.

But open it probably will.

Chinese officials have expressed a desire for the renminbi to play a great role in world trade, naming 2020 as a date by which it can play the role of a reserve currency.

That is almost certainly going to require deregulation of financial markets, something also needed if Shanghai is to become a global financial capital.

China now buys Treasuries not because it thinks they are good value, but because those purchases maintain a competitive currency, not to mention protecting existing holdings. As that ends, much of the money will seek out high returns, and as the renminbi strengthens international capital will doubtless pile on and pile in.

That kind of liquidity and deregulation, in combination with strong national pride and a legitimately fantastic story, is a step-by-step recipe for a bubble. So it proved in Japan, so it likely will be in China.

A look at recent experience in China only underlines this. Speculation is rife and billions in government mandated loans have leaked into stock market bets.

China’s government undoubtedly understands all of this and is surely determined to maintain control. They may not find it that easy. Getting rich, as we’ve seen in the United States, is a heady business and it is easy to start to believe your own press.

As the momentum builds and the money rolls in it will be easy to see it as a great country meeting its prosperous destiny.

Given the size of the opportunity and the strength of the story, China’s bubble will be huge. Investors would do well to avoid being in the immediate vicinity when it bursts.

–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)

Investors met the news that Japan’s economy has emerged from a bone-breaking recession calmly and rationally: they sold shares quickly and in large amounts and made bets that consumer prices are going to be falling for years to come.

That’s because Japan’s recovery, coming as it does after a global bubble in the production of what I call, for lack of a more technical term, “stuff,” is really not sustainable.

The fact that the consumer portion of the recovery is only a reflection of income transfers from government to individuals isn’t very encouraging either.

More importantly, given that hopes for Japan were low anyway, the vulnerability of its recovery point to some important challenges the nascent rebounds in the U.S. and Europe now face.

Japan grew at a 3.7 percent seasonally adjusted annual rate in the second quarter, in data reported on Monday, quite a contrast with the almost 12 percent annual rate of contraction in the three months before.

The recovery was heavily dependent on consumer spending, goosed by government subsidies for buying hybrid cars and green appliances, as well as a heavy public works spending.

Public spending in a downturn is a good thing, but it needs to set the stage for private investment and consumption later, and in Japan this does not seem to be happening.

“Japan’s return to growth in the second quarter is a prime example of a ‘feel bad’ recovery,” Lombard Street Research’s Michael Taylor told clients.

“Recovery may prove to be rather short-lived, as so far there are precious few signs that Japan is capable of sustained, domestically-driven GDP growth. The continued accumulation of inventories in Q2, albeit at a more modest pace than in recent quarters, also casts doubt on growth prospects through the second half of the year.”

The underlying figures were ugly. Private capital investment fell 4.4 percent compared to the first quarter, and real investment in housing fell by nearly a tenth. Cash earnings for Japanese workers has fallen 7.1 percent in the year to June.

The recovery in Japan is like a long lost and reputedly rich uncle who, now that he has come home, proves to be a poor bedraggled thing who rather than bringing hope and gifts only really wants to cadge a meal and a place to sleep.

WHY THIS TIME IS JUST NOT NORMAL

In a typical economic recovery, inventories, having been run down are rebuilt. This should prompt companies to make capital investments to gear up new production. People get hired, they spend money and so do others who are less fearful for their jobs. Companies become more profitable and the cycle reinforces itself.

But in Japan, and perhaps elsewhere, this recovery isn’t really working that way. Capital expenditure isn’t coming back. Company profits are being hit. Whatever profitability improvements we see globally are largely down to cost cutting.

This squeeze hurts already nervous workers who in their turn aren’t spending much money. Unless, of course, they need to in order to get their share of a government handout.

Even with inventories being restocked, the amount of spare capacity in the global economy is very substantial. Company managers too will have been taught a lesson about leveraging up to expand: not only is demand not always there sometimes the banks want their money back unexpectedly and usually at the most inconvenient time.

Consumers, and not just in Japan, aren’t very confident in the future of property and decide that what once looked like a prime investment now looks like avoidable consumption.

Policy makers in Japan and elsewhere understand these dynamics and they have made heroic efforts to break the cycle. Up to a point, they have succeeded.

It’s not so much that the policies - huge increases in liquidity and massive stimulus - aren’t appropriate but that our expectations for what they can do has been too high. We are no doubt better off than we would have been, but we have shifted the burden of re-making the economy and paying down the debt out in time. It will be a longer, slower process and will disappoint many investors who think we are back to the good old days.

One advantage Japan does have is its position in Asia, where it may be able to benefit if Chinese domestic demand takes off. But overall Japan is linked to global trade, which while it has bottomed, has made its recovery due to government spending which some day soon will have to be replaced.

As for Japan domestically, the fiscal stimulus will peter out in the first quarter of next year. What will arrive to take its place I cannot tell you, but if nothing does it will prove to have been a brief, miserable recovery.

(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. )