Rolfe Winkler

The public debt will likely pass $12 trillion this week, up another trillion since March. With Obama’s left flank calling for a second stimulus – which is really a third stimulus if you count George Bush’s tax rebates – there’s still no serious discussion about how to deal with debt. The bond market is telling us not to worry. But if history is any guide, the bond market is wrong.

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I’m referring to Treasury Inflation Protected Securities, TIPS for short, in particular those that reflect long-run inflation expectations. The current spread tells us to expect annual inflation averaging a bit over 2 percent for the next 30 years. That would be fairly benign. And fairly wrong.

Why? Because it assumes U.S. political leadership will put the country on a sustainable fiscal path. I highly doubt it will happen.

In a note to clients last month, Société Générale strategist Dylan Grice explained the connection between debt and inflation. Turning Milton Friedman on his head, Grice argued that “inflation is always and everywhere a fiscal phenomenon.” Money printing may be the vehicle, but the “root cause” of inflation tends to be “a government unable to pay its way.”

You see the real inflationary threat isn’t the $12 trillion public debt, which on its own is serviceable. The problem is $63 trillion worth of unfunded obligations for healthcare and social security. Putting these figures in context, the U.S. government’s total liabilities are 19 times current tax receipts. “Bear in mind that the U.S. consumer is widely seen as dead in the water with debt at 1.3 times income,” says Grice.

There are three ways to confront this mountain of debt.

Scenario 1: We essentially default, like Argentina, refusing to pay our debts once they’ve become too burdensome to service. The dollar would crash as the United States loses access to capital markets. The government would be forced to print money to pay expenses.

Unlike Argentina, however, we print the currency in which our debt is payable, so this scenario most likely won’t happen.

Scenario 2: We default through inflation. Policymakers are so desperate to avoid Japan-style deflation that the Fed will keep printing money to buy risky assets while Treasury pours on the stimulus to keep people employed. The Fed says it won’t run the printing press to pay the debt, but if the only alternative is default, they’ll have no choice.

Scenario 3: We put Medicare and Social Security on a sustainable path, cutting benefits or raising taxes dramatically. This would require a level of political will we’ve never demonstrated.

Right now, TIPS are betting on Scenario 3. I hope they’re right, but just in case, I’m planning for Scenario 2.

Would inflation be good for stocks?

With the monetary and fiscal spigots open wide, some investors say equities are a good place to be. But David Einhorn of Greenlight Capital has warned that inflation could compress price-to-earnings multiples. A look back to history suggests his fears are warranted.

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The Federal Reserve has lowered rates to virtually zero and expanded its balance sheet significantly, stuffing banks with excess reserves that are available to lend. If the market picks up, banks will find themselves surrounded by creditworthy borrowers again and excess reserves could quickly flow into the real economy, increasing inflation.

In the meantime, many analysts argue that the government is likely to keep printing money to finance runaway fiscal deficits and large unfunded obligations for Medicare and Social Security, increasing inflation.

The Fed will tell you that deflation is the primary risk facing the economy as the private sector continues to de-lever. And inflation is hardly guaranteed. There’s still time for the Obama administration to get America’s fiscal house in order and the Fed can choose to tighten monetary policy. Highly unlikely both, but nevertheless possible.

If inflation is in the cards, why might that be bad for stocks? One reason is that investors will pay less for future earnings.

Historically, according to Howard Silverblatt of Standard & Poor’s, investors have valued stocks of the S&P 500 at about 17 times earnings. If a company stands to earn a dollar per share in a given year then investors will tend to pay $17 for a share of its stock.

But if you add inflation to the mix, future earnings lose their purchasing power, which means investors won’t pay as much for them.

Einhorn, at the Value Investing Congress on Monday, said that if we wind up with significant inflation, distant earnings will be discounted at higher rates, meaning “P/E ratios will collapse.”

We see this relationship in action if we compare the average P/E multiple of the S&P 500 with inflation as measured by the Consumer Price Index. In the 1960s, when inflation was low, P/E multiples were high. In the 1970s, when inflation was high, P/E multiples were low. After Paul Volcker beat back inflation in the early 1980s, P/E multiples began a two-decade expansion.

To be sure, investors use expected inflation rates when discounting future earnings. That said, when building their models they tend to extrapolate the future based on the present.

Depending on its relative impact on revenues and costs, inflation may or may not be good for company earnings, but it will certainly shrink the multiple investors are willing to pay for them.

(Cartoon from The Economist, click to enlarge)

NEW YORK, July 29 (Reuters) – The sound money set remains concerned that the Federal Reserve’s emergency actions to corral collapse could ignite hyperinflation.  In particular, they point to the explosion of excess reserves inside the banking system, which they call dry tinder just waiting for the spark of recovery.  Bill Dudley, president of the Federal Reserve Bank of New York, says this isn’t an issue because the Fed now pays interest on excess reserves.  It’s a good argument, but only in the short run.

To liquefy the banking system, the Fed drastically expanded its balance sheet, which, as you can see in the chart to the right, has led to an explosion of excess reserves at banks.

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For decades they never rose above $10 billion. Now they’re above $700 billion. To understand why this level of excess reserves has some worried about hyperinflation, it helps to understand what they are.

The Fed requires banks to keep a certain level of assets in reserve against deposits, either cash in the vault or reserves held at the Fed.  Reserves held over this required amount are referred to as “excess” reserves which banks are free to lend out.

When banks lend money into the economy, the money borrowed typically ends up as a deposit in another bank.  Say I borrow to buy a house; the mortgage I get from the bank is money I give to the seller, who then deposits the cash in his own bank.

Lent money turns into a new deposit, which turns into more lent money, which turns into another deposit, and so on.  As the supply of money multiplies, you get inflation.  If it multiplies too quickly, you get hyperinflation. The multiplication of money that might come from banks lending out over $700 billion of excess reserves is the stuff of inflationary nightmares.

But banks aren’t lending it out.  Why not?  As Dudley points out in his speech, it’s because the Fed is now paying them an interest rate.

Before last October, banks lent out all their excess reserves.  After all, excess cash in the vault earns the bank no profit.  But then Congress gave Ben Bernanke the power to pay interest on excess reserves, which means banks now can earn a return by keeping them on deposit at the Fed. Money that could be lent isn’t, inflation remains a potential threat, not a kinetic one.

But there’s a catch. When the economy recovers banks won’t any longer want to keep their excess reserves on deposit at the Fed, not unless the Fed is willing to pay a much higher interest rate.

Walker Todd of the American Institute of Economic Research argues that “the economy won’t be able to handle the high interest rates the Fed will be forced to charge in order to keep excess reserves immobilized in its vault.”

The Fed argues it has other tools to shrink its balance sheet when the time is right. For one, its emergency lending facilities are priced high enough such that banks will stop drawing on them when the economy recovers. But even after its lending facilities are wound down the Fed acknowledges the level of excess reserves will still be huge. To keep them immobilized will require substantially higher rates.

But raising rates will cause asset prices to plummet. Weak balance sheets will collapse and the financial crisis could return in full force. This is the conundrum the Fed faces.

Democratic Congresswoman Laura Richardson has even Hillary Clinton beat for selective memory problems. Remember how Hillary kept repeating the Bosnia story? That she dodged sniper fire, etc.? She always knew it was a lie, but she needed a concrete example of her foreign policy experience. It was telling that that was the only story she could come up with. I hope the Clintons (and the Bushes) disappear from American politics permanently.

But I digress. Here’s what Richardson said of her property in Sacramento in a statement this past Wednesday:

the residential property in Sacramento California is not in foreclosure and has NOT been seized by the bank.

Moreover:

I have worked with my lender to complete a loan modification and have renegotiated the terms of the agreement — with no special provisions. I fully intend to fulfill all financial obligations of this property.

These are bald-faced lies. According to the WSJ:

The Sacramento home of Rep. Laura Richardson was sold in a public auction two weeks ago for $388,000….James York, the Sacramento broker who bought the three-bedroom, 1.5-bathroom home, rejected the idea that the home hadn’t been seized. The sale of the home was announced in March. “She’s walked away from the property,” he said. “I would be happy to resell her the home for the $535,000.”

Recall from the original story:

The Southern California Democrat bought the house for $535,000 with no money down in January 2007 and owed nearly $575,000 to Washington Mutual when the mortgage was sold earlier this month at a significant loss to Red Rock Mortgage Inc.

And there is additional irony here:

Richardson didn’t vote on the housing rescue deal that passed the House of Representatives two weeks ago and in a statement attributed her absence to her father’s funeral. But Richardson did vote last fall in favor of the Mortgage Forgiveness Debt Relief Act, which passed and prevents the federal government from charging income tax on debt forgiven as a consequence of foreclosure.

Let us pause for a moment of silence in memory of the institution that WAS the Wall Street Journal. As a long-time subscriber to the paper, I’ve noticed it’s devolution since Rupert Murdoch took over. Here’s a clue from the paper itself:

News Corp. Chairman Rupert Murdoch named Wall Street Journal Publisher Robert Thomson as the paper’s new managing editor, succeeding Marcus Brauchli, who left under pressure last month….The move is expected to speed the pace of change at the nation’s second-largest newspaper, creating a more direct pipeline from News Corp. to the paper’s editors….

For the first few months under the new ownership, Mr. Brauchli ran the operations of the paper. Mr. Thomson remained in the background….

Mr. Brauchli presided over a number of changes — more general news, a more urgent and splashy front page, shorter stories — but Mr. Murdoch decided that change wasn’t happening as quickly as he would like…..

Indeed. Now the news page is littered with “general interest” stories: daily updates on the Myanmar Junta refusing aid for cyclone survivors, multiple articles per day about the recent Chinese earthquake. We get it, the Burmese Generals don’t want aid and an earthquake killed lots of Chinese.

I don’t mean to make light of those stories. But the fact is, if I wanted daily updates on those topics, then I’d read the New York Times.

And that’s the point: Murdoch wants to move the Journal away from its roots covering all-things business so that it can compete with the Times more effectively in general interest news.

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The BBC reports on the latest subprime writedown at a major bank. The conventional wisdom is that most of the subprime related credit losses that have to be taken already have been. Going forward, a larger problem for bank net income will likely be increasing provisions for loan losses, as opposed to straight writedowns on holdings gone South. Here’s a list of writedowns to date for major banks worldwide:

MAIN CREDIT LOSSES SO FAR

• Citigroup: $40.7bn
• UBS: $38bn
• Merrill Lynch: $31.7bn
• HSBC: $15.6bn
• Bank of America: $14.9bn
• Morgan Stanley $12.6bn
• Royal Bank of Scotland: $12bn
• JP Morgan Chase: $9.7bn
• Washington Mutual: $8.3bn
• Deutsche Bank: $7.5bn
• Wachovia: $7.3bn
• Credit Agricole: $6.6bn
• Credit Suisse: $6.3bn
• Mizuho Financial $5.5bn
• Bear Stearns: $3.2bn
• Barclays: $3.2bn

Source: Bloomberg and company reports

The main impact of credit losses is that they reduce bank lending. A handy way to think about it, is that banks typically lend out $10 for every $1 in capital on the books. So credit losses of this magnitude can be incredibly DEflationary.

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The bad news on housing keeps coming:

WASHINGTON — U.S. new-home sales slid further in March to their lowest level since 1991 while the supply of homes for sale soared to nearly a three-decade high, suggesting little prospect of any near-term turnaround.

Sales of single-family homes slumped 8.5% last month to a seasonally adjusted annual rate of 526,000, the Commerce Department said Thursday. That’s the lowest level since October 1991. Economists had expected a much smaller drop of 1.9%, according to a Dow Jones Newswires survey.

February new-home sales fell 5.3% to an annual rate to 575,000. Originally, the government said February sales dropped by only 1.8% to 590,000. Year over year, new-home sales were down 36.6%.

Other recent data confirm the headwinds the housing sector faces. Earlier this week, the National Association of Realtors said sales of pre-owned homes fell 2% in March. Prospects for a recovery in the broader economy are closely tied to housing, given its effect on construction, employment and consumer spending. With housing still under pressure, Federal Reserve officials are likely to lower official interest rates again when they meet next week.

The median price of a new home decreased by 13.3% to $227,600 in March from the previous year, according to Thursday’s report. The average price tumbled by 11.3% to $292,200 from a year earlier.

Regionally last month, new-home sales decreased 12.5% in the Midwest and 19.4% in the Northeast. Sales fell 4.6% in the South and 12.9% in the West.

The month’s supply of homes for sale rose last month to 11 months, the highest since September 1981.

Inventories of various housing assets (single-family homes, condos, etc.) are the key to determining the path or prices. High inventories mean supply is outstripping demand, putting the onus on sellers to cut prices in order to bring buyers back to the market.

Didn’t think I’d see an op-ed like this in the Journal. The editors themselves hate Fed easing, and for good reason. Inflation hurts everyone in the economy except for those in debt; those who, financially-speaking, have behaved most irresponsibly. But this opinion piece says the Fed shouldn’t feel ashamed about printing money in order to get us through the housing crisis.

The author’s fundamental argument is that if the Fed just prints money, and lots of it, that the ensuing inflation will rescue the housing market and, thus, the economy. He says this would be preferable to nationalizing the housing market, which seems to be the only alternative in his mind.

Nationalizing the housing market may be a fait accompli…..but done correctly it probably doesn’t have to be a huge burden for taxpayers. Lenders who want to be bailed-out should be forced to take massive writedowns on the bad loans they want to pawn off on taxpayers. If the Treasury buys bad home loans at a really good price, taxpayers don’t have to lose that much in the long-run….

If the Fed “prints money”, the ensuing inflation would only serve the interests of those in debt by reducing the value of their debts in real terms.

Inflation happens when the supply of money increases relative to the supply of goods and services in the economy. More paper currency chasing the same amount of goods and services means each individual unit of currency has less purchasing power; it has less value. Savers lose because the dollars they’ve saved buy less after a period of inflation. Debtors win b/c the debts they owe are smaller in real terms after that same period of inflation.

Say I take out a $100,000 loan due next year. To make the math easy, let’s assume my lender isn’t going to charge interest….a rich uncle perhaps. If the value of the dollar declines 6% over the year, then $94,000 of today’s dollars will be sufficient to pay back the $100,000 loan next year.

Of course, most lenders do charge interest and if they EXPECT inflation will decrease the value of the dollars with which they’re paid back, they’ll simply charge HIGHER interest rates to offset the loss in value of those dollars.

Folks who have already taken out loans at fixed interest rates would benefit from higher inflation. New borrowers and those with adjustable rates would be forced to pay higher interest rates.

More inflation could also spark a run on dollar assets.

But perhaps the main reason this is foolish is that if the Fed lets inflation run wild now, it will just take more draconian monetary measures to get it back under control in the future. Take a look at the steps Paul Volcker was forced to resort to in order to tame inflation back in the early 80s. To beat inflation he had to increase the Fed Funds rate to 20%(!) by late 1980. It’s at 2.25% now. How many of my readers who bought a house in the early 80s recall what mortgage rates were back then? Would you believe they got as high as 18% for a 30 year fixed rate mortgage?

According to Wikipedia, raising rates that high to tame inflation “contributed to the significant recession the U.S. economy experienced in the early 1980s, which included the highest unemployment levels since the Great Depression.”

So far Bernanke has laid off the inflation lever. All of us who avoided overpaying for a house should pray that he continues to.

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Arthur Kimball-Stanley published a fascinating op-ed on Credit Default Swaps in the Providence Journal on Monday. I spoke with the author and he gave me permission to republish his piece in its entirety. A 30-page version of this argument was accepted for publication in a law journal to be published this fall. The author gave me a recent draft, though the article below offers the essential elements of the argument. Hopefully it gets traction……

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