James Saft

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

The move to reform taxation of billions of dollars in so-called carried interest paid to hedge fund and private equity executives is dead and prominent among the mourners should be investors in U.S. debt.

A country that can’t even get it together to ensure that some of its highest paid people pay as much proportionally in tax as their secretaries and personal trainers is a country with very little hope of effecting meaningful budgetary reform.

Suffice to say that the long bond didn’t sell off on news that U.S. Senate Finance Committee Chairman Max Baucus has dropped a higher carried interest provision from his since-defeated tax bill, a sign that the Democrats have effectively given up hope of the measure. The news should, however, make holders of U.S. debt even more willing to sell to the Federal Reserve, currently buying Treasuries often and in size. The script has been written for tax and spending reform over the next two years and for lenders to the U.S. the story does not end happily.

As it stands private equity and other investment managers pay the lower capital gains rate on “carried interest,” their share of the takings when a holding such as a start-up or turnaround is sold at a profit. That means many pay taxes for the bulk of their compensation for their labor at a lower rate than many middle-class earners, an injustice so patent as to be seemingly unarguable.

Arguable of course it was, and the private equity industry mounted a lobbying campaign that has had a return on investment most of us can only dream of, painting the proposed reforms as an attack on funding for innovative job-creating start-up businesses and even, unbelievably, as against the best interests of pension savers. And while I am sure that the anti-carried-interest lobby is talented, well funded and smart, I doubt very much that they are that much better than the lobbies that will work against most other tax rises or spending cuts over the next two years.

The industry argued both that a rise in tax on carried interest would fall on the savers putting money into the industry and on the businesses that it finances, but this is far from evident.

“The tax on carried interest is a tax on the fund mangers and not the enterprise. In competitive markets the burden of taxation is borne by the employee. If (fund managers) could demand more they would already be doing it,” said Victor Fleischer, an associate professor of law at the University of Colorado, whose work on tax policy underpinned the original effort to reform carried interest treatment in 2007.

“This encapsulates the political problems in our country, this is why it is difficult to get good public policy done.”

A GIANT MISALLOCATION OF TALENT

Some even argued that even if a higher tax on carried interest fell solely on investment managers this was bad policy because it would drive talent from the industry, to the detriment of all of us who are depending on it to earn enough so that we can keep the heat on once we retire.

Besides being maddeningly self serving, this argument is probably just about the opposite of true.

Something that lowers hedge fund and venture capital compensation, especially if it is done via righting an inequity, is precisely what the U.S. needs.

Over the past generation out-sized compensation in financial services has, in combination with other factors, driven an increase in financial engineering and other activity that has not driven growth, has not allocated capital well and has served as an effective tax, or rent charge, on the rest of the economy.

So if you are telling me that eliminating the carried interest tax break means that the smart people won’t go into finance, then I’ll take it. That’s what prevailed in the U.S. in the 1940s through the 1960s, periods when growth was robust, well distributed and less liable to be financed with too much debt. Let those with great quantitative skills go into engineering not securitization, and the best managers go to GM rather than Carlyle Group.

So, the death of carried interest tax reform is indicative of two large negatives for the U.S. economy, and by extension for holders of U.S. debt.

First, despite the crisis there are few signs that the financialization of the economy will be reversed. Indeed, most policy changes since the storm broke are aimed at supporting that industry rather than effectively controlling its size and risk.

Second, the political process in the U.S. shows few signs of being able to effectively grapple with the unpleasant choices presented by the debt built up these last 40 years.

At some point, probably not soon, this will become apparent in the Treasury market.

(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.)

The good news is that the European Central Bank will probably start a massive additional round of quantitative easing to fight the break-up of the euro zone.

The bad news is that they will, as ever, only choose the right policy, as Winston Churchill said of the Americans, after exhausting all of the alternatives.

Global share markets rallied furiously on Wednesday, fed by hopes that the ECB would increase its bond-buying efforts, a possibility raised by its chief Jean-Claude Trichet in an appearance before the European Parliament. Trichet faces stern opposition inside the ECB from fellow central bankers, notably German Axel Weber, who believe that policy should be normalized rather than loosened.

This opposition, in combination with an unsure political climate, means that euro zone authorities will probably continue to try to buttress, enlarge and formalize the bailout mechanism while trying to maintain the fiction that something approaching normality reigns in European money and bank funding markets.

Why would QE be used to fight the break-up of the euro zone, now being widely discussed as the crisis spreads to ever larger member states?

Because QE, or really we should simply call it the monetization of government borrowing, offers some hope of easing the austerity now being imposed on Ireland and soon to come in Portugal and Spain.

Europe has made a choice to not allow member states to default or to allow their weakened banks to default, as default would threaten banks elsewhere. That leaves weakened economies carrying a crushing amount of debt, debt they will attempt to repay by budget cuts. This is a recipe for an economic death spiral, as a smaller and smaller economy becomes less and less able to shoulder its debt service.

Without their own currencies to devalue, the weak of Europe have no other safety valves.

While QE is genuinely dangerous, it will ease conditions and can be directed at peripheral bond markets.Default is a better option, but Europe is unwilling to go there, at least not yet.

So, QE it will be, but the issue becomes when and how large.

“If the political masters in Europe wish to maintain the status quo then the answer lies in the monetization of debt. The ECB, with the ability to print money, can support the market by buying government bonds,” Stefan Isaacs, of fund manager M&G Investments, wrote in a note to investors.

“However what is needed is ‘shock and awe’ rather than tentative, reactionary responses, if indeed the ultimate goal is to support the euro in its current guise. That said, I’m not convinced that an about-turn is likely any time soon. The hawks in the ECB remain, for now, firmly attached to their mandate of price stability.”

EUROPE LOOKS FOR A BAZOOKA
For now, the ECB is likely to do what it can by way of bond purchases and liquidity support while temporizing over the pace and scale of returning the system to normality.

The focus of action, then, will be on increasing the size and prestige of the European Financial Stability Facility,  created in May and so far employed to help both Greece and Ireland. ECB council member Weber suggested in November this could be increased and there have been some indications that both the euro zone and IMF are discussing this.

This strategy is appealing to Weber and to others in Europe because it emphasizes euro zone strength and resolve, taking real money and lending it to allow member states time to pay back their debts, rather than printing up a mess of inflation and euro weakness to ease the pain.

A muscular strategy, but also a failing one. The 750 billion euros was meant to be big and intimidating back in May, but now looks paltry. If Spain needs help would 1.5 trillion euros look much better? Not if the debts of the weak Spanish regional banks are not partly extinguished. The same math of austerity and growth that applies now to Ireland will apply to Portugal and Spain in time.

So, QE, preferably large, from the ECB, but likely not until they are pushed early next year.

If this happens, or rather as its likelihood rises, it will drive a massive rally in risk assets and drive even more liquidity to Asia. Many investors will be giddy that the ECB and Federal Reserve are both driving asset prices higher, while a substantial minority, fearing inflation, will flee government debt and buy energy, commodities and gold.

The big loser, in the near term, will be China, which will have to eat European- and U.S.-exported inflation and will fret over its trillions in euro and dollar reserves.

(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.  email Saft at: jamessaft@jamessaft.com)

From Dublin to Paris to Budapest to inside those brown UPS trucks delivering holiday packages, it has been a tough few weeks for savers and retirees.

Moves by the Irish, French and Hungarian governments, and by the famous delivery company, showed that in the post-crisis world retirees, present and future, will be paying much of the price and taking on more of the risk.

This goes beyond merely cutting back on pension benefits, rising to actual appropriation of supposedly long-term retirement assets to help fund short term emergencies.

Let’s start with Ireland, which is kicking in 10 billion euros from its National Pensions Reserve Fund into an 85 billion euro package of support for its banks.

Trust me, this does not reduce the risk profile of the NPRF, which was set up as a sovereign wealth fund to help pay for state retirement benefits.

Putting aside jokes about sovereignty and wealth, of which there is appreciably less in Ireland than formerly, this is effectively a transfer of wealth from the Irish people to its banks. Or rather, to the institutions, mostly European banks, which hold Irish bank debt, none of whom as senior creditors will share in the pain.

In many jurisdictions if Ireland were a corporation and the NPRF part of the corporation’s pension fund, then making such a move would be illegal, and quite rightly so.

Of course this is not the first time that the NPRF has been used in this way. It has already “invested” 7 billion euros into Irish banks and has pledged another 3.7 billion to struggling Allied Irish Banks.

Also under consideration is a regulatory move that would effectively compel some private Irish pension funds to hold more Irish government debt, thereby providing the state with a captive investor base but hugely raising the risks for savers.

On to Hungary, which is seeking to cut its very high level of public debt as it prepares for entry to a euro single currency which may well self-destruct before it ever gets the chance to join. Hungary’s government last week finalized new rules designed to force members of private pension plans to opt back into a state controlled pay-as-you go option.

The idea, such as it is, is that participants in the private plans will fork over their $14 billion or so in savings, equal to about 10 percent of Hungary’s GDP, to the government in exchange for a pledge of a pension from the state. Hungary plans to use the funds to make pension payments to current retirees this year and next as well as to pay down government debt.

It is, in short, an outrage.

PACKAGES SOMETIMES GET LOST
Earlier this month France launched a move similar to Ireland’s as part of legislation that raised the age of retirement.

France is transferring more than 20 billion euros of assets belonging to its Fonds de Reserve pour les Retraites (FRR), a funded portion of its retirement system, to Cades, a fund designed to be run down to pay for social benefits.

The transfer will take place over a number of years and the mix of assets held by the FRR in the meantime will shift radically, implying a large shift to government debt. Very convenient for the French Treasury but perhaps not so good for future retirees.

Finally, let’s turn to UPS, which earlier this month became one of the most notable of a string of U.S. companies to sell bonds in order to fund its obligations to its underfunded pension fund. UPS sold $2 billion of bonds due in 2021 and 2040, with the longer dated portion yielding about 5.0 percent.

A decade of paltry equity market returns and current low bond yields, which are used to calculate future liabilities to retirees, have left many firms, including UPS, with funding deficits.

Debt financing pension obligations is in essence a plan to try and make a spread between the cost of financing and the returns the company is able to make on its pension assets.

Borrowing to speculate in financial markets to make up for a lack of previous saving; what could possibly go wrong?

To be fair, UPS, which is one of many large U.S. corporations making similar moves, can’t be equated with Ireland or Hungary. UPS has the same legal obligation to its pension fund no matter how it chooses to fund it, so the bond issue from that perspective does not raise the risk for retirees.

That said, a participant in a company pension plan is dependent on the ability of the company to meet its obligations. The more debt the company takes on, the higher that risk is.

Savers of all types are being asked to shoulder risks they did not sign on for, the costs of which they will inevitably bear.

(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.email James Saft at jamessaft@jamessaft.com)

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

HUNTSVILLE, Ala — If you think that the business of America is consumption, then sit back, enjoy the Black Friday sales and take heart from the recent upbeat data on spending and income.

If, on the other hand, you think the future of the U.S. is going to have to be productive industries which throw off the cash flow that funds the paychecks and pays for the $5 made-in-China Barbie dolls at Wal-Mart, then perhaps you had better take note of the sharp slowdown in orders for durable goods.

The contrast between consumption and investment really could not be more stark.

The U.S. Commerce Department said on Wednesday that consumerspending rose by 0.4 percent in October and also upgraded spending growth in September to 0.3 percent. Incomes rose by 0.5 percent in the month, one of the best such showings this year.

This, in combination with fewer first time jobless claims than expected was enough to drive U.S. shares up by more than 1.0 percent on Wednesday, despite continued funding and banking woes in Ireland and elsewhere in Europe.

To be sure, in an economy where consumption accounts for more than 70 percent of gross domestic product, growing income and rising spending are good news, or rather will tend to temporarily mask the underlying issue of too much debt serviced by too little income.

That, it is now crystal clear, is the game being played by the Federal Reserve in launching its second round of quantitative easing, the minutes of the central bank’s most recent meeting show:

“Most participants judged that a program of purchasing additional longer-term securities would put downward pressure on longer-term interest rates and boost asset prices; some observed that it could also lead to a reduction in the foreign exchange value of the dollar. Most expected these changes in financial conditions to help promote a somewhat stronger recovery in output and employment while also helping return inflation, over time, to levels consistent with the Committee’s mandate.”

The key concept in terms of the consumer is the hope that higher asset prices will drive an economic recovery, the unstated idea underlying this being that people will spend more if their retirement savings and houses have risen in value.

It is the same medicine that made the U.S. economy so sick, but the dosage is being upped nonetheless.

DURABLE GOODS, CHANGEABLE CONSUMERS

So, consumers are spending and the Federal Reserve has a plan to entice them to do more, perhaps even driving down the current 5.7 percent savings rate.

What is far less apparent is where the ultimate income will come from to service the debt and finance the consumption.
Perhaps more meaningful over the medium term is other data released by the Commerce Department on Wednesday, a durable goods report that was very poor but which got little attention.

Non-defense capital goods orders excluding aircraft, a shorthand for business investment, dropped 4.5 percent in October after rising by a revised 1.9 percent in September.

Markets had expected about a 1.0 percent increase and indeed, if single economist made a forecast as low as the result I have not been able to find her.

Overall orders for durable goods fell by the most in almost two years, falling by 3.3 percent to a seasonally adjusted $196 billion. Remarkably, all industrial new order components declined, making it hard to argue that this was a fluke in this or that volatile sector.

What seems to be happening is that inventory restocking, building up stores of goods in hopes of future sales, is finally winding down after having driven economic growth for most of the year. Inventories rose by 0.4 percent, rising for the tenth consecutive month, but by a bit more than half the rise in September.

It is extremely hard to see inventories rising in November and December with new orders doing what they are doing. The three month trend is still strong, but that does not preclude the possibility that we are coming to the end of an inventory building recovery. If businesses begin to actually run down their inventories as a defensive measure, it is possible that the fourth quarter will mark the end of what will prove to be the weakest modern U.S. economic recovery ever.

If that happens, the Fed’s decision to buy bonds will be confirmed, but not because it helped employment grow or sparked a consumption-aided acceleration in the economy.

Instead, it will be because QE will prove to be one of the few tools left to fight deflation.

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 pretty good rule of thumb in global financial markets: if you want to know where problems are beyond the reach of policy, look for places where the authorities are blaming “speculators”.

So it was in Europe, where last spring, as the depths of the euro zone’s problems were becoming clear, officials railed at the speculators who had the temerity to point out the obvious: that several nations would not have the money to repay their debts.

Greece and Spain went so far as to put their intelligence agencies on the case of tracking down speculative “attacks.”
So, it would seem, is it now in China, with food prices.

Chinese official media last week reported that the state would aim a “one-two punch” of actions to control food costs, including a crackdown on speculation in agricultural commodities and the imposition of price controls. In addition the commerce ministry warned that it would track down any speculative inflows into China that were trying to pose as foreign direct investment.

While it is certain that there are speculators in the Chinese food market, just as there were hedge funds and others making bets against Greek and Irish debt, the symptoms are not the true problem.

Needless to say, it often makes good sense to bet with the speculators and against the authorities, and it is always a good idea to view the authorities’ ability to control whatever forces are attracting speculators with a particularly beady eye.

The food component of Chinese consumer price inflation rose by more than 10 percent in October compared to a year before, far above the overall reading of a chunky 4.4 percent. Those figures may actually flatter reality; Xinhua, the Chinese news agency, reported that a basket of 18 commonly purchased vegetables was an amazing 62 percent higher in the first 10 days of November against the same period a year ago.

Inflation gets even more intense in China when you turn to delicacies and substances used in traditional medicine. Inflation in substances used in traditional medicine is exploding, according to the Association of Traditional Chinese Medicine, which says that prices of more than a quarter of herbs have risen by between 50 and 100 percent in the past year.

WAVING AT INFLATION AS IT GOES BY

What’s driving all this and will China be more able to rein in its speculators than Europe was? In part, of course, Chinese price rises are driven by local conditions and policies, over which China has more sway than does Europe over the hedge fund community.

A huge stimulus over the past two years and a banking industry which is bankrolling much speculation on property and other assets are some of the domestic culprits. China’s move to raise its bank reserve requirement ratio by 50 basis points last Friday to a record 18.5 percent is evidence of a resolve to stem inflation, with more expected between now and February.

Some, however, of China’s inflation is driven by the Federal Reserve, which is creating global liquidity conditions that are suited, perhaps, to a limping U.S. but utterly wrong for a booming China. Not to mention a policy of quantitative easing which is aimed squarely at driving down the value of the dollar, perhaps as a tweak to China or perhaps simply to make U.S. goods and services more competitive.

Albert Edwards, the prescient strategist at Societe Generale, draws a line between Fed policy and rising food prices in China, as well as the related risk of hunger in China and elsewhere in Asia.

“One consequence of the Fed trashing the dollar is that commodity prices have been surging,” Edwards wrote in a note to clients.

“The surge in China’s inflation rate to 4.4 percent in October was primarily driven by rapid food price inflation and its high weighting in its CPI. This rapid inflation, if it feeds through to wages, will force a more rapid rise in the yuan real exchange rate, despite the nominal exchange rate remaining essentially fixed.”

This is perhaps a subset of a larger problem: capital flows to China and seeking to capitalize on China will remain huge, a function of its strong story and the weakness of the developed world. All of these are far more powerful than some food broker stockpiling garlic in a regional Chinese city, and less receptive to Chinese official bidding.

This scares China, and with good reason. The Chinese unrest which culminated in the bloody crackdown in Tiananmen Square in 1989 was driven partly by a 28 percent jump in inflation.

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.

We’ve all gone down the rabbit hole.

World Bank President Robert Zoellick has lent a certain Alice in Wonderland quality to the financial landscape by saying that the world should consider a return to a modified gold standard of international exchange.

If you’d asked me in 2007 how likely it was that a consummate insider like Zoellick would propose such a thing I’d have said it was only slightly more credible then the head of the National Cattlemen’s Beef Association coming out in favor of giving cows the vote.

The idea that we would move away from or curb a fiat money system — in which the value of money is tied only to faith in a government, buttressed by its policies — was, and probably is, unsupportable, not so much impossible to implement as impossible to agree.

The takeaway from this is not that we will go back to currencies tied to gold but rather that the existing order is dying. When old religions die — and that pretty much is what any monetary system is — fantastic new ones spring up to contend to fill the void.

Zoellick is acknowledging what investors have already figured out — real assets are the place to be when the solvency of the banking system is threatened and the authorities refuse to deal directly with this.

With trillions in bank collateral worth less than where it is marked and with an economy mired in a balance sheet recession, the temptation to magic away issues by creating more backed-by-nothing money is too great. This is exactly what the Federal Reserve is doing in its latest $600 billion round of quantitative easing.

This in turn is an invitation to the rest of the world to print right back. There is no brake on this system other than the ability of nations to cooperate, and right now cooperation is not in everyone’s individual interest.

Gold then can serve as a sort of adult in the global kindergarten dispute because it is finite, sort of. You simply cannot go and print your way out of trouble because we have adopted an arbitrary limit. No gold, no new dollars, or yen, or yuan.

You could argue that where we are now was a likely outcome of the current system. A global reserve currency in a fiat system creates tremendous incentives to take on too much debt. China helped the U.S. along by feeding it capital and keeping its own currency low, but there were many other ways in which this could have happened.

UNLIKELY PROPOSALS

So, the strange thing is not that a fiat system tends towards debasement of the currency — that is always the risk, but rather that someone from inside the system is grappling with that possibility openly.

Of course, you have to understand that Zoellick, who was writing in the Financial Times, made his call for debate over the role of gold at the end of a very long list of proposals, few of which are likely to ever come to fruition: here#axzz14iI6H1gW

That is the job of the head of the World Bank during a currency war that may morph into a trade war — advocate the unlikely until your head disappears beneath the waves.

Zoellick argues first that China and the U.S. should agree on a course of yuan appreciation, as well as committing not to engage in trade retaliations. This happy fantasy having been broached, he goes on to propose that the rest of the major economies join in by agreeing not to intervene in currency markets except when approved by others.

This isn’t going to happen and neither is a new monetary system that uses gold as an “international reference point of market expectations about inflation, deflation and future currency values,” as Zoellick wrote.

There are, of course, huge problems with this. Matching current supply of gold to current supply of money implies a huge appreciation in the metal or huge deflationary pressure. The gold is also not now in the hands it would need to be in to make such a system possible. Further, world trade can only grow as fast as money in supply to make possible the exchanges, so tying to a currency regime to gold means putting what could turn out to be an arbitrary brake on trade growth.

So, the lesson here is not a return to the ancient store of value, but instead that things are so volatile and risky that people in authority might even suggest it.

Runaway inflation is not inevitable, but avoiding it is not a sure thing either. Investors will continue to look for ways to hedge that risk, and that will drive not just gold but the prices of things that can be eaten, combusted, or manufactured with higher.

(Editing by James Dalgleish)

(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)

We’ve entered a new era in global financial markets: the U.S. is intentionally devaluing the dollar.

For the U.S., which has long espoused a strong dollar but in reality had a policy of benign neglect, this is the equivalent of pushing the big red eject button in the jet cockpit: something big is going to happen and we will have to see how it will work out.
The Federal Reserve on Wednesday moved to open a second round of quantitative easing, pledging to purchase a total of $600 billion of longer-dated Treasuries between now and the end of the second quarter of next year. As well, the Fed will reinvest $250-300 billion in the same period, meaning that the central bank will be buying up $110 billion a month in Treasuries and creating a like amount of new money out of the ether.

Perhaps the principal way QE will boost the economy, the Fed hopes, is by lowering effective interest rates, enticing investors to move into riskier assets, some of which may generate inflation and jobs. As well there is the wealth effect; the old canard of spending more because your retirement account and house have gone up in nominal terms.

The bald fact, though, is that by turning on the printing presses the Fed will drive down the value of the dollar absent a similar move in another currency. Much of the new investment created by QE will be made not in the U.S. but will be money borrowed in the U.S., exchanged into a foreign currency, probably an emerging markets one, and invested overseas. That will drive the dollar down, which will help to make U.S. industry more competitive.

There you have it; competitive devaluation, a beggar-thy-neighbor policy. It is not much of a lever, but it is one of the few which the Fed has left to pull.

Don’t expect anyone from the Fed or the Treasury to tell you this in simple declarative sentences, but it’s true nonetheless.

“Devaluation is the intention, and devaluation is what is going to happen,” Avinash Persaud, Chairman of Elara Capital told the Forex Forum conference in New York on Tuesday.

We can surely expect the U.S. to deny this, as Treasury Secretary Timothy Geithner did in October, but the truth will be seen in the foreign exchange markets, where the dollar has been falling and will fall further as the year winds down.

GETTING THE GENIE BACK INTO THE BOTTLE

It is most certainly in the power of the U.S. to begin a period of competitive devaluation. The U.S. dollar is a global reserve currency and the marginal cost to Bernanke of printing more is very low indeed. Less certain are the reactions of the rest of the world.

While the U.S. will surely have prepared the way for QE2 with its major trading partners (and in fact may be deliberately ticking off the Chinese) there remains a strong chance that a falling dollar sets off a range of tit-for-tat reactions. Already Korea and Brazil are moving to stem the appreciation of their own currency. Look too for the possibility of other countries joining in to QE, in part so that the Japanese yen, to name just one, does not rise too much against the dollar.

A currency war blossoming into a trade war has to be one of the outside but significant risks of 2011. If global growth can recover significantly this may be averted, but this is far from promised.

The second and maybe more important risk is that the U.S., having lost control over its own monetary policy many years ago due to recycling of capital by the Chinese, now loses control of its currency. Like going broke, this can happen little by little and then all of a sudden.

On the Fed’s reckoning it will go like this; QE2 and very low rates go on for an extended period, but almost as a matter of mechanics, when the Fed begins to tighten, the dollar recovers. The Fed has used the dollar lever to ease and then uses it to help to tighten. The dollar remains the principal global reserve currency and investors respond to the Fed’s incentives.

The alternative is that QE is not terribly successful in improving U.S. growth but does touch off a round of speculative investment elsewhere, investments that make returns in a shrinking dollar look worse day by day. When the time comes that the Fed, perhaps hurrying to prove its control, decides to stop QE2, bond investors want compensation for holding U.S. debt — a lot of compensation. U.S. equities, which have been held aloft by QE, duly fall sharply, as does the dollar, while yields spike. This is not a central case, but it is a possibility, and as it would be a disaster, one that needs to be watched closely.

Extraordinary times surely call for extraordinary measures, but those measures sometimes bring extraordinary results, and not always the ones we hope for.

(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.

-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.

Perhaps, but economic growth is extremely weak. The initial reading of third-quarter gross domestic product, released on Friday, showed the economy expanding at a faster 2.0 percent rate. Most of the growth, however, was from inventory rebuilding, a process that is very likely to slow. Actual growth in real final sales was an anemic 0.6 percent, making this the weakest such recovery on record, according to economist David Rosenberg of Gluskin, Sheff.

Rosenberg estimates that a 20 percent slowing in the rate of inventory building — and remember that inventories can grow faster than demand for only so long — in the current quarter would take the economy into contraction. Combine this with the fact that the reduced government spending in 2011 as the stimulus is burned through will remove 1.5 percentage points from the trend in GDP growth and you have the recipe for a double dip.

Here is where the Federal Reserve will, unfortunately, step in. Despite the risks to its independence this involves, the Fed seems likely to react to the interplay of a hobbled economy and recumbent government by starting another round of quantitative easing. The Fed will probably confine itself to buying Treasuries and perhaps may buy enough to in effect monetize all of the government’s borrowing needs with freshly created money.

A SHORTAGE OF FAILURE
The Fed will engineer lower interest rates in order to transfer risk to itself, to entice investment, to raise asset prices and to lower the value of the dollar, all forms of stimulus it hopes will help the economy to escape deflation and reenter vigorous, job-creating growth.

There are a lot of problems with this. The Fed, by weighing in when there is not consensus to stimulate through the fiscal process, opens itself up to further political interference, especially if it monetizes the debt. This is not to say that the political gridlock left to itself will bring on the best results, but that proper process and division of powers in a democracy matter.

Even putting that to one side, the resumption of quantitative easing is nothing more than the continuation of the policy the Fed has followed through the Greenspan years and into the reign of Bernanke. When faced with weakness, the Fed stimulates, when faced with bubbles, the Fed fails to act.

During the past decade globalization meant that something quite fundamental was changing in the U.S. economy, raising the natural rate of unemployment as jobs and industries moved overseas to cheaper places of production. Rather than allowing the U.S. to come to grips with this, to cut its cloth or its pie differently, or even to develop new strategies and industries, the Fed eased. This brought on a wasteful and false housing bubble. Labor and capital flooded into housing and homeowners spent as if the money were real.

That leaves the U.S. with a huge cohort of people in real estate and construction whose skills are no longer needed. What’s worse is the lost opportunity: a decade to grow export industries. Think of all the start-ups that never got funded or started because money was flowing to marble counter tops and construction.
On the flip side, think of all the companies that should have failed but didn’t, kept alive by low rates and easy money.

“More disturbingly for investment professionals, (asset price manipulation) changes the normal workings of capitalism and the market,” Jeremy Grantham of fund manager GMO wrote in a note to clients. “Weaker companies need more debt. Artificially low rates that are engineered by the Fed mean that leverage is less of a burden and survival is easier. Similarly, the Great Bailout allowed many companies that normally would have failed and been absorbed by the stronger or more prudent ones to survive.”

Rather than a great moderation, the past 15 years have been a great misallocation, and one which the Fed seems determined to extend and politicians unable to end.

(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. jamessaft@jamessaft.com)

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

A dilemma at the heart of the response to the financial crisis is that the antidote to so many ills actually causes the symptoms to worsen.

Take for examples bank capital levels and the chaos surrounding home mortgage foreclosures.

Both issues are the fruit of the same tree: the desire to do things quickly, cheaply and with minimal safeguards.
And both, if you want to fix them, are probably going to slow the economy and lower asset prices in the short term.

So over the long term, paradoxically, the economy will slow and asset values fall anyway.

Being in possession of a hammer and sighting a nail, Governor of the Bank of England Mervyn King put it bluntly on Monday: “Of all the many ways of organizing banking, the worst is the one we have today.”

He’s not kidding and he’s probably not far wrong – the current system has enshrined too big to fail and the upcoming new banking regulations, Basel III, calculates the need for capital based on losses during the last crisis.

This, as King points out, vastly understates the losses, which would have been horrendously larger if governments had not stepped in to support private banks.

“The broad answer to the problem is likely to be remarkably simple. Banks should be financed much more heavily by equity rather than short-term debt. Much, much more equity; much, much less short-term debt,” King said.

“Risky investments cannot be financed in any other way. What we cannot countenance is a continuation of the system in which bank executives trade and take risks on their own account, and yet those who finance them are protected from loss by the implicit taxpayer guarantees.”

Here’s the amazing thing. Having diagnosed the emergency King then goes on to say that he is fine with the fact that banks are given until 2019 to fully comply with the new regulations which he has trashed as being too weak. He recognizes that the medicine of higher capital will make the symptoms of deleveraging worse and so is willing to put building up proper capital buffers off.

I guess we can call the policy we will run until decent regulation is enforced “moral hazard in the public interest”, but, as the label implies, everyone has huge incentive to game the system to their own best interests, from bank executives, to fund managers to savers themselves. Like Basel II, Basel III may never be tested because it is overtaken by the next crisis before it is even in place.

DETAILS, DETAILS
The evolving foreclosure crisis, centering around evidence that major banks may have committed fraud during the process of repossessing houses, is in a lot of ways a problem with a similar origin to the problem of bank capital and regulation.

To grossly simplify, banks may have been testifying that they have documents they have not found, or ones that were never produced when the loans were originated back in the go-go days.

This places not just the foreclosure in limbo, but potentially the entire securitization of which a given loan is a tiny part. Of course, many of the loan originators who wrote and sold the loans no longer exist, having taken the money and run when the crash came.

A proper accounting of who owns what, a concept at the heart of the rule of law, would seem to be called for but is unlikely to come. Why? Because the last thing the U.S. economy needs is a nine month real estate market holiday.

Again, we have evidence of a system that operated, both on the way up and on the way down, with public support and tried to do so at the minimum possible cost.

There are two opposing ways to think about this. One is to use the example of the first commercial jet airplane, the de Havilland Comet, which suffered a series of catastrophic failures in its early days.

The issue wasn’t that there was a fundamental problem with commercial jet flight but simply that we had gotten a little bit in front of the engineering. The engineering caught up, and the jet age blossomed. On this viewing of history, banking has suffered a saluatory crisis, “fixes” will be implemented and the securitization machine and its “originate and distribute” model will soon be up and working again.

The other view is that innovation in finance is not like innovation in the rest of the economy, that the moral hazard inherent in state insurance has provided incentive for innovation that bears a striking resemblance to looting.

On this view, we’d be better off with a return to slow banking, though that implies a period of slow growth and a hit to asset prices.

(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. email: jamessaft@jamessaft.com)

Hedge funds sponsored by the U.S. Treasury are reporting eye-popping returns, but the costs to taxpayers and households could end up being massive.

Funds created under the Public-Private Investment Program reported annualized net internal rates of return averaging 36 percent through Sept. 30, the Treasury announced on Friday, a figure that could encourage the belief that the banking bailout was a shrewd investment rather than a transfer of wealth.

The PPIP was created in 2009 to allow private investors to partner with the public purse to purchase distressed assets from the banking system, using cheap loans from the government for leverage.

Eight of these funds were created, with the Treasury having a 50 percent equity stake in each but providing all of the debt funding at extremely low rates averaging just over 1 percent a year.

It’s hard to know which to debunk first: the returns of the PPIP, which are the outputs of the “models” we’ve come to know and love; the structure, which privatizes profits and retains for the public the bulk of the risks; or the conception of the whole enterprise, which is aimed at propping up asset values to avoid more direct subsidies to banks.

First off, the return figures. The 36 percent is an average, and an annualized one at that. For the taxpayer, who is earning a leveraged return on half of the equity but who is saddled with all of the debt, the overall return thus far is more like 5.6 percent, according to Linus Wilson, professor of finance at the University of Louisiana in Lafayette.

Also note that the returns are based on opaque mark-to-model calculations by the Treasury, estimates which could turn out to be, as they were for Bear Stearns and so many others, highly optimistic.

While the returns are putative, the dividends the funds are paying to their shareholders are all too real, meaning there may be less capital available to make whole the taxpayer if the things turn sour later.

“These are mark-to-model returns. The U.S. Treasury so far has allowed the investment funds to pay $159 million in dividends based on mark-to-model profits,” Wilson said in an email exchange.

“This is irresponsible when taxpayers will be lending $14.7 billion of extremely low interest loans. Dividends should not be paid out until the private investors’ debt to taxpayers is paid in full.”

So, it may well be good to be an equity-only investor in the PPIP, but success is far less assured for the rest of us.

WHO IS THE CLIENT?
Even if the returns end up being accurate, they in no way reflect the total costs of a policy of which the PPIP is only a small part: a decision to support asset prices, particularly housing, at all costs. This has allowed the U.S. to avoid having to take over or massively and nakedly subsidize large insolvent banks, but done so by distorting the economy and channeling funds from households and taxpayers.

The support of house prices, by tax breaks, by loans via the Federal Housing Administration and especially via wards-of-the-state lenders Fannie Mae and Freddie Mac, has been huge.

If you want a taste of the long-term costs of this, just a taste, look at the report last week from the Federal Housing Finance Agency which is projecting Fannie and Freddie may need anywhere from $142 billion to $363 billion through 2013.

Any way you slice it, the taxpayer will be on the hook for hundreds of billions in support of the housing market, money that means higher taxes or diminished services in the years to come.

Almost worse is the fact that homeowners, or renters for that matter, are going to have to continue to pay a relatively higher percentage of their income for housing in order to keep prices inflated. This is especially true for the many people getting mortgage modifications that, truth be told, are not in their own best interests. These modifications commit them to continuing to pay too much of their income to lenders, income that could otherwise stimulate the economy in the form of consumption, or be invested, perhaps even in the type of export-oriented businesses that ultimately must be the solution for the U.S. economy.

Narrowly defined, the PPIP is a success, as is TARP. A government with a fiat currency and a printing press can always successfully support its banking industry.

The larger question remains unanswered: is the government there to support the banks, or are the banks there to support the 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.