lifestyle leader

There are probably very few activities which are shared by both schoolchildren and our fiscal & monetary policymakers, but blowing bubbles is one of them. The difference being that the kids' bubbles usually consist of soap, are far more entertaining, and cannot cause ruin to entire economies when they pop. But it's the metaphorical asset bubbles that I am more interested in.

Metaphorical bubbles and their non-metaphorical problems
Which brings us to the lead story in last week's The Economist. The editorial worries that the loose monetary policies adopted by major economies (printing money; very low interest rates) has created an environment vulnerable to further asset bubbles. In the short term, the side-effect of cheap money on asset prices is being welcomed by many: the profits are helping the market rebound from its earlier downward spiral and firms' balance sheets are being strengthened as a result.

But there are longer-run issues to be concerned about. As the articles explains, "The problem for [investors] is not just that valuations look high by historic standards. It is also that the current combination of high asset prices, low interest rates and massive fiscal deficits is unsustainable." Eventually the cheap money is going to run out when governments scale back their extraordinary measures - this is not a secret. What is not known, however, is whether the process of scaling back is going to be smooth or volatile. History suggests that we cannot assume a smooth transition.

Carry Trade 2009-?
Not all the evidence points to asset bubbles - see The Economist's other article - at least not for the wealthiest economies. Emerging markets, however, are the destination of a lot of this cheap money, which creates its own challenges. To understand why this is so, let's look back to Nouriel Roubini's November editorial about the Mother of All Carry Trades that began in 2009. The "carry trade" is the practice of borrowing in a cheap currency (the USD, with a near-zero - and sometimes negative - interest rate) and investing in risky assets with higher return. Here's Roubini:

"Let's sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March [2009]....
Yet, at the same time, the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight... By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets.

Does that bolded sentence sound familiar? It should if you've been following the financial crisis at all. The perception of decreasing risk due to lower volatility can be misleading.

Bear in mind that this carry trade is contingent on cheap borrowing. When (not if) borrowing in USD becomes more expensive, this effect will have to reverse itself or shift to a new currency, like the Yen. If this happens suddenly, Roubini believes there will be a stampede "as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments."

So maybe this bubble will pop, as Roubini argues it will. Maybe it will simply deflate. The fact is that nobody can say for certain - but the risk is there. Remember the story of Icelandic people blowing up their Land Rovers to avoid paying them off after the krona tanked? That's a dramatic but useful illustration of what happens when the carry trade reverses itself rapidly.

In the meantime, as I alluded to above, the consequences of cheap money flowing to emerging markets are being felt in a number of areas. I'll look at some of the implications in the next installment.

Bernanke's speech in Atlanta last week spread throughout the blogosphere like wild fire, and the reaction was not positive. The Fed chief defended US monetary policy in the run-up to the financial crisis and claimed that lax regulation, not interest rates, inflated the housing bubble. A chairman of the Fed defending the bank's record and competence against a backdrop of political hostility and regulatory reform is not surprising. Bernanke's position that prolonged low interest rates played no role in the housing bubble is more so.

But after reading the Fed staff working paper that accompanied Bernanke's speech, the folks at Free Exchange believe that, interest rate correlation aside, the Fed's worldview has been quietly transformed. The Fed's analysis featured three names: Shiller, Kindleberger and Minsky. For those unfamiliar with these men, they are three of most prominent advocates of the idea that markets are imperfect, unstable and subject to psychology (hence the title of Kindleberger's book Manias, Panics and Crashes). This is downright antithetical to the Fed's prevailing ideology, and their acceptance could represent an important shift in the Fed's understanding of markets and its role in influencing them. I can assure you that Alan Greenspan would have neither reached nor endorsed their conclusions, and a search of the Fed's website by Free Exchange found only two previous references to Minsky and just one to Kindleberger.

Paul Krugman agrees with Bernanke that there were compelling reasons for 2002-2006 monetary policy. But this doesn't mean that the policy didn't contribute to the housing bubble, or that the Fed failed to act on the warning signs. Krugman faults Bernanke for not acknowledging the inadequacies of the Fed's prevailing wisdom before the crisis and admitting that they all missed the housing bubble. On this measure his speech was disappointing, particularly for those of us who support a second-term. But by digging beneath the headlines, Free Exchange has highlighted an important shift in the Fed's institutional understanding of markets, regulation and monetary policy, one that is hopefully diffused throughout the policy and academic establishment.

Last week, the Dow surpassed the 10,000 point mark. A meaningless number, but to many an important psychological marker of the recovery. The financial markets are back...or not?

In a FT op-ed, Stephen Roach presents 'The case against Bernanke.' Roach calls the reappointment 'short-sighted'; I think his criticism is too fixed on the now distant past.

He argues that despite Bernanke's aggressive and creative response to the crisis, his weaknesses and ideological orthodoxy helped create this mess:

It is as if a doctor guilty of malpractice is being given credit for inventing a miracle cure.

He goes on to say that the jury is still out on whether the Fed's crisis response will work in restoring growth and stability. This is a sensible argument, but surely Bernanke deserves the chance to finish the job. A more appropraite criticism would be that Bernanke's 'philosophical conviction' is ill-suited to influence and implement financial sector reform. But even on this point Roach's argument falls short, as Bernanke has demonstrated an incredible intellectual flexibilty and ability to depart from the pre-crisis orthodoxy.

A second-term should not be seen as rewarding the failures of pre-crisis Bernanke. Instead, it should be welcomed as a vote of confidence in a man transformed by the crisis and using every measure in his monetary toolbox (and making some new tools up along the way) to end it.

US President Obama will reportedly nominate Fed chief Bernanke to a second term this week, ending intense speculation over the reappointment.

Bernanke still has to gain the approval of a not-so-friendly Congress, but after the obligatory grandstanding that will undoubtedly come.

This is the right choice in my opinion; I've often expressed here my admiration for the Fed's response to the crisis. But Bernanke's second term will be anything but a victory lap following his central role in preventing another depression. The challenges he will face in unwinding the Fed's extraordinary response to the crisis, exercising some measure of systemic oversight, and defending monetary policy autonomy may be no less difficult than the challenges his first term brought.

No, not my own. The Newshour with Jim Lehrer, the nightly news program on America's public broadcasting station (PBS), has held an hour-long discussion with the Fed chairman entitled, 'Bernanke on the Record.' I highly recommend it (hopefully the link is available outside of the US, we have had the problem before of posting US-based content subject to distribution restrictions. Apologies in advance- scour YouTube).

The more Bernanke speaks in an open, frank forum (Americans might remember his much-lauded interview on '60 Minutes'), unencumbered by Fed-speak and congressional grandstanding, the more I am convinced that there is no better American to be steering the country's monetary policy/systemic reform/inflationary death spiral(?!?) than Bernanke. He's not only gotten the policies right (well mostly, minus one very very big exception), but has the unique ability to articulate the complexity of the crisis in a manner that enables lay audiencies to make sense of the madness around them. Imagine if a less imaginative or aggressive chief had been at the helm over the past two years. Where would we be?

Following a not-so-brief sabbatical from these fine pages...your Wednesday quick hits and pink picks:

-While the financial markets are cautiously optimistic the US economy may be stabilizing, some prominent figures are still anticipating Armageddon: John Taylor, of Taylor Rule fame, thinks the Fed is dangerously loose with its monetary policy and has "caused, prolonged, and worsened" the financial crisis. He challenges the Fed's assurances that it can quickly shrink its balance sheet to prevent an inflationary tsunami on the upswing. In a potent dose of IPE, he points to the likely, and severe, political constraints such steps would face. If Taylor is correct, the Fed has little room left to stimulate credit/growth before a rapid, and sharp, tightening of monetary policy is necessary. A second alarm has been sounded by David Walker, formerly director of the Government Accountability Office, who warns the US' triple-A credit rating is at serious risk. He identifies two primary risk factors: health care reform and poor post-crisis fiscal constraints. Walker acknowledges that health care reform is critical to correcting the country's fiscal imbalance and driving down the cost to individuals, but contends that we should focus on reforming the massively unfunded liabilities we are already living with, namely Medicare. Second, like Taylor he worries that political constraints will limit the political will to impose fiscal discipline after the flood. There's also that tricky little issue of tax increases.

-In an admittedly lightweight piece for Vanity Fair.com, Matt Pressman identifies four reasons why Newsweek and Time will never be The Economist. The US newsweeklies are looking to the emulate the print media's shining star, a sentiment so widely held in the industry that Pressman likens it to the ever-present "10 secrets to perfect abs." While the analysis could be much better, the article does identify a critical gap in the US media landscape, intelligent international affairs reporting, and in a way challenges the print media's death knell. There are publications, like The Economist and FT, both of which have seen US circulation numbers steadily rising over the past decade, who are still growing amidst print's great decline. While Pressman is correct that "do as The Economist does" has become an industry cliche rarely realized in circulation or quality, he is wrong to suggest that The Economist's reporting/analysis/"snob appeal" cannot be emulated. Much of the US media talks to Americans like they are their worst stereotype: isolated, ignorant, superficial and uninterested in the world around them. Newsweek and Time should thus be applauded, not mocked, in their efforts to emulate The Economist, whether ultimately viable or not. A final point: is it a coincidence that thriving print publications are seemingly all British?

-It is once again the CIA v. Congress, a battle seemingly waged once every other decade. Isn't blame/failure in such instances always systemic? And is this stunning reversal related?

-Over the past year, we have tried to highlight some of less visible victims of the credit crunch, be it sport or contemporary art. Yachts and independent films could be added to list, as this year's Cannes Film Festival kicks off under a cloud of financial uncertainty.

-The Finnish government is merging the country's top three universities to form a single, new institution of higher education: Aalto University. The new school will endeavor to approach innovation from a multidisciplinary track. Seed Magazine examines its vision.

Now that the Bank of England has followed the Fed and embarked on "quantitative easing", readers may be asking themselves: what exactly does that mean?

Via FT Alphaville, the Telegraph provides a handy overview in "Printing money: an easy guide to quantitative easing."

UPDATE: The FT had a handy graphic/demonstration as well last month. You can find it here.

Dave's ongoing coverage of the crisis in Central and Eastern Europe has highlighted not just the economic and political ramifications for the countries in turmoil, but the exposure of countries like Austria, Sweden and really all of Western Europe (the world if you ask Rogoff) to their problems. The weight of the crisis shouldn't be understated: it risks spurring rapid contagion, providing a political opening for the far-right (and Russia) in many countries and accelerating the moral collapse of capitalism's post-Berlin Wall workshop.

Yet not all is lost amidst the fear and uncertainty. A few developments provide hope that the crises will be met with an effective political response. The most immediate is a report by Alan Beattie of the FT that a group of multilateral institutions will announce on Friday a coordinated lending package of €25bn to the region's banks. This follows a report earlier this week that foreign banks were pumping cash into their subsidiaries in the region. The lending is key because the IMF simply lacks the resources to tackle the crisis on its own; it also masks the failures of Western European governments to follow through on anything but rhetorical promises of support. At the most basic level, however, an influx of Euros is desperately needed, and it looks like we are finally moving in the direction of a coordinated response.

The second promising development is more of a discussion than trend at this point. The merits and timing of Eurozone accession are hotly debated in the region (and Western European capitals). But it seems the attraction of the common currency's relative security has crystallized under the current crisis; Slovakia and Slovenia are perceived to be safe, for now, a feat many attribute to Euro membership. The Polish government has reportedly entered discussions for an accelerated accession to the ERM II (though, the Polish central bank was quick to temper those ambitions when it bluntly warned against joining the Euro too quickly). Even debate in the UK (I know, not in the region, just making a point) has started to discuss the merits of joining. Many, including us at IPE Journal, have opined on the threats posed to the common currency by the present crisis. But is it possible that the Euro could emerge from all the turmoil if not stronger, at least larger? Wolfgang Munchau and others argue its in fact preferable, a necessary step to stabilizing Central and Eastern Europe. But accession criteria, such as the ERM II timeframe and reference rate of inflation, would have to be scrapped (again, preferable).

On the political front, many of the governments in the region have demonstrated over the past week that they recognize the way out. In what should be held up as a lesson to the leaders of their western neighbors, the central banks of Poland, Hungary, Romania and the Czech Republic issued coordinated statements denouncing the currency instability and effectively pledging to defend their currencies. This intervention signalled to many a commitment to monetary discipline, affirmed by Hungary's decision to hold steady at 9.5%. Forward-rate contracts are now averaging in a 60 basis-point increase over the next three months. The choice is a stark one for the governments in the region: defend the currency or growth. Given the political pressure, defending the currency won't be an easy choice. But its the right one.

A final point- the countries in the region have tended to be lumped under the acronym CEE for Central and Eastern Europe (by myself included, just look above). It's rhetorically convenient, but many are calling it intellectually lazy (even irresponsible), and they have a point. Slovakia's circumstances are different than Hungary's, whose policy options may be different than the Czech Republic's. Dave rightfully noted this variance in his post above. Lumping these countries together not only fails to distinguish their relative circumstances, but risks indirectly stoking the contagion everyone hopes to avoid.

Does it matter if an already worthless currency is abandoned?

- "The mood is going to be somewhat sober" at the Davos World Economic Forum this year, which starts on Wednesday. No kidding. In that vein, the WEF's opening speaker is someone not known for his overwhelmingly upbeat rhetoric: Vladimir Putin.

- John Hempton at Bronte Capital thinks we should stop fiddling around with metaphors and literally drop money from helicopters to induce inflation fears. Sure some people may accidentally die from the falling money packages, says John, but it might also induce consumer spending. Or, you know, cause foreign investors to dump all their US assets.

- A good discussion over at Free Exchange over whether the euro-zone is a modern day gold bloc - referring to the rigid constraints of the interwar gold standard that delayed economic recovery in 1930s Europe and beyond. The short answer is no, it is not. The takeaways:

"...because the break-up of the eurozone would involve unacceptable financial damage, the ECB and member governments are committed to the rescue of flailing national economies. Europe cannot allow Ireland or Spain to collapse, and so presumably, international capital will treat those states differently than they might Britain, which is stuck out there by its lonesome."

Moreover, the gold standard had no institutional equivalent of the ECB to help facilitate coordinated monetary easing - something that was a real sticking point. This doesn't mean the euro-zone is entirely in the clear, just that it has a set of challenges distinct from any historical precedent.

- Democracy woes from the pages of the WaPo: social unrest in Eastern Europe, and Bolivia's new constitution.

First off, read Rory's piece on Fed policy then check out the new Federal Reserve No-Limit Credit Card. We laugh because it's good satire, but how is this really different from what American consumers have been doing for a decade?

Except of course that the interest will be paid, not by the Fed, but by anyone and everyone who holds dollar-denominated assets.

I have been bullish on the dollar for some time (here and here and here).

As of 3:15pm, I am a dollar bear.

In a unanimous vote, the US Federal Reserve slashed the Fed funds rate from 1% to a range of 0.00-0.25% (apparently they can set a range, something I was admittedly unfamiliar with). This is the lowest range in Fed history, and the statement made it clear that rates would remain near zero for "some time" to come (a "commitment" until the economy reverses). The Fed also indicated that it will take unorthodox measures to combat the deepening recession, throwing out convention and undertaking broad quantitative easing through increasing reserves and expanding its balance sheet. I also believe it signaled a fear that we have entered a liquidity trap (as Krugman explains it, "that awkward condition in which monetary policy loses its grip because the nominal interest rate is essentially zero, in which the quantity of money becomes irrelevant because money and bonds are essentially perfect substitutes"). The Fed will likely purchase mortgage debt to influence their yields (as opposed to directly setting target rates) and T-bills.

If you believe the likes of Keynes, Friedman and Bernanke, the Fed has just prevented a depression.

How you ask? One perspective would argue that the great depression was deepened by the reluctance of monetary policymakers to bring rates to zero. An official attachment to the prevailing gold standard orthodoxy is a common explanation in IPE for this hesitation (see Eichengreen). Bernanke and co. have just squashed that fear (but an argument might be made that it is too much too late, that Bernanke went against his own instinct and balked). A second perspective thinks the effect of the interest rate tool is overstated. It instead focuses on the lack of liquidity provision as the determinant factor in plunging the world into depression. The argument is that by directly expanding the money base the value attached to cash and other short term securities falls to a level at which investors will move into higher yielding assets and consumers/banks will spend again. Well, Bernanke and co. has that base covered as well. Start priming the printing presses, cause we're about to see a whole lot of dollars. What, then, if we are in a liquidity trap, and neither policy option is sufficient alone or in combo? That's where the creativity comes in. It won't be easy, but the Fed is finally saying to the world, "We will do anything it takes to turn this thing around".

In my humble opinion, we should all be thankful that the real Benjamin Shalom Bernanke has finally shown up.

A funny side note- the folks at Fast Money on CNBC (a show I personally find obnoxious, but am sick in bed and dealing with it) recognized that Ben Bernanke's nickname is no longer appropriate. Bernanke is known as "Helicopter Ben". This stems from his scholarship on the depression, and his argument that monetary policymakers should figuratively dump money from a helicopter if necessary to fight deflation (derived from Milton Friedman's 'helicopter money' concept). The Fast Money crew noted that the Fed's actions have gone well beyond a "dump", and that a "Carpet bombing Ben" moniker would be more fitting.

Politique
-US President-elect Barack Obama unveils details of his "21st century New Deal". The Economic Recovery Plan is preliminarily based on 5 pillars: energy, roads and bridges, schools, broadband, and electronic medical records. Many, including prominent members of his own party, are becoming increasingly frustrated with his "there is only one president at a time" line, as the sitting President appears to have checked out while Rome burns.
-The terrorist attacks on Mumbai end, the Indian investigation expands, and at least 29 people die from a car bomb in the Pakistani city of Peshwara. Blame for the attacks has focused on Pakistan-based Lashkar-e-Taiba (the likely perpetrators), the Indian government (early warnings, poor response, failure to hold Pakistan accountable), and the Pakistani regime (failure/inability to address sources of terrorism and militancy within its borders).
-A deliciously intriguing affair in the British House of Commons has ignited a fierce debate over Parliamentary independence, opposition politics, and police powers. Meanwhile, Canada has its own legislative controversy to deal with (find Dave's take here).

Economia
-The US learned it has been in recession since December 2007 (something everyone but this guy has been well aware of) and lost 533,000 jobs in November, the largest jobs decline in 34 years.
-Angela Merkel grew increasingly isolated in Europe as French President Sarkozy unveiled a €26bn stimulus package. UK Prime Minister Brown and Sarkozy will meet in London on Monday to renew their call for a coordinated European stimulus.
-An historic week in European central banking: BoE cuts 100 basis points to 2.0% (lowest level since 1951), ECB goes with 75 basis points to 2.5% (its largest single cut ever), and Sweden slashes a record 175 basis points to 2.0%.

The Rest
-In the Prem: Arsenal continue form following famous win at Stamford Bridge, Liverpool stay top, and ManU and Spurs on track for Carling Cup final. In Europe: Cristiano Ronaldo wins Ballon d'Or, reveals he was "an inch away" from being a Gunner in 2003.
-This week in Japanese innovation: omelets with the Motoman SDA10.
-"Experienced bandits" steal €85mn in luxury jewels from Harry Winston store in Paris. According to Reuters, the heist occurred almost a year to the day of a similar $16mn robbery at the store.

Are you a city tired of waiting for an effective national response to the economic recession? In desperate need of economic stimulus, but nowhere to turn? Well, Milwaukee, USA has a solution for you.

Two Milwaukee neighborhoods are considering printing their own money for local exchange.

Before the dollar rally, there was some worry about a run on the greenback. The thought was that the credit crunch, fiscal expansion, and a general collapse in confidence would undermine the dollars reserve currency status, as well as the willingness of countries like China to purchase Treasuries. But as I predicted at the time, the exact opposite has occurred: the dollar has surged to multiyear highs as investors sprint to safety, the bursting of the commodity bubble withdraws hot money from commodity currencies, and emerging markets plummet.

With foreign investors clearly content in low-yielding dollar investments, could the biggest risk to the greenback be Americans themselves? Of course not. But it is pretty amusing to think of local currencies sprouting up all over the US. Apparently, this is not without precedent, and Ron Paul would surely be happy.

In August we pointed out that summertime worries over inflation were probably overstated. Since then, a collapse in commodity markets and consumer spending has vindicated this view - so much so that the new worry is deflation. Deflation is by most accounts worse than inflation because of the difficulty in reversing the trend. First, a backgrounder:

Deflation is "A general decline in prices, often caused by a reduction in the supply of money or credit.... Declining prices, if they persist, generally create a vicious spiral of negatives such as falling profits, closing factories, shrinking employment and incomes, and increasing defaults on loans by companies and individuals. To counter deflation, [central banks] can use monetary policy to increase the money supply and deliberately induce rising prices, causing inflation."

The trouble is, central banks have been attempting to increase the money supply by lowering interest rates with less-than-stellar success. Besides, there are inherent limits to monetary policy - limits which seem to be approaching quickly.

So what to do? John Kemp argues forcefully that the best way to deal with deflation is to stop trying to fix it. Que? Based on his reading of previous depressions, deflation is the symptom of a severe decline in the business cycle, not the cause. The full article is very interesting (so is this one), but the conclusion reads as follows:

Rather than worrying about a modest decline in the price level, policy needs to focus on guaranteeing households and businesses against the worst aspects of the downturn to minimize the decline in spending and investment. Policies that create demand and jobs, while limiting foreclosures and bankruptcies, rather than fight the deflation chimera or worry about falling asset values are now the urgent priority.

That means fiscal stimulus! But rather than rely upon the government for everything, Dr. Boli recommends that consumers also do their part (via Megan McArdle):