Policy failures

This entire episode should be looked at as a demonstration of how overconfidence in knowledge leads to inherently bad decisions.

The "bailout" package was hailed by our political leaders as "action" in the face of a crises. Unfortunately, the market knows better and has said something like the following: "you should have studied how the bailout plan would effect aggregate demand and thus correct the underlying problems in this economy". A $700 Billion asset swap does not do that.

So the U.S. political leaders have been exposed as ordinary people on a sinking ship, panicking instead of thinking about the underlying problem and the best course of action to take in order to maximize surviveability. It also helps if one is prepared for this sort of outcome or has experience with same. It is truly unfortunate that Ben Bernanke, a celebrated student of the depression, does not see that the issue is a rapid decline of aggregate demand.

Deficit spending must happen statim. Tax breaks, infrastructure projects, etc. The markets are going to remain locked up until the only player left can get the wheels moving again. Remember, dear readers, the ability of the U.S. Government to expand the budget deficit (with fiat currency) is NOT CONSTRAINED by tax revenue. We should simply declare a moratorium on income taxes for an indefinite period. The Fed should do their part as well. Equity markets have lost trillions in (as yet unrealized) value. House prices have fallen by over 20% in some areas.

Stop treating symptoms as they arise and strike at the cause.

Compression...

...of interest rates in developed (G20) countries.(especially those using the dollar as defacto reserve currency) is inevitable. Emerging markets will resist doing so as attracting capital in this environment needs special inducement.

Deflation has been the trajectory for this economy for some time, and it is interesting to note that the mainstream press has just now picked up on the meme.

Oct. 6 (Bloomberg) -- As Federal Reserve Chairman Ben S. Bernanke and his global colleagues fight the worst financial crisis since the 1930s, one danger is looming larger by the day: deflation.

With asset markets tumbling, commodity prices plunging the most in 50 years and banks keeping a tighter grip on credit, the ingredients for a sustained period of falling prices are coalescing. While inflation is still a concern for many policy makers only months after oil and food prices peaked, the risk is their patchwork of rescue and stimulus packages will fail, and prices will start to fall throughout the broader economy.

``The ghost of deflation could be dragged out of the closet again in coming months,'' says Joerg Kraemer, chief economist at Commerzbank AG in London.

A global recession is already looking more likely, with the credit freeze stirring memories of Japan's decade-long struggle with deflation in the 1990s. So European Central Bank President Jean-Claude Trichet and Bank of England Governor Mervyn King may be forced to follow Bernanke, whose Fed has chopped its benchmark rate by 3.25 percentage points since August 2007 to 2 percent -- its most aggressive round of easing in two decades.

The EU is Unraveling

As I said in a previous post, EU external debt is unraveling very quickly and it lacks the institutional mechanisms to deal with their funding crisis.

The only way to halt the decline is for EU members to offer deposit insurance for all members. This process, like everything in Brussels, will take time.

Unfortunately, time is not a luxury the EU has at the moment. This is the kind of thing that brings down governments.

Markets are responding. Peripheral members of the EU (I hesitate to use the acronym "PIGS" again) are suffering mass withdrawals from their banking systems.

And, since every other financial person is using a the patient-doctor analogy, I will weigh in with one of my own:

"The contagion is spreading, and amputation should not be ruled out at this point"

Clearly, policy formation in the EU has its first real trial by fire. We shall see if countries willingly cooperate at the EU level when it no longer benefits their populace.

Trichet: Lets talk about throwing in the towel

Trichet and the ECB finally recognize the gravity of their predicament. My thesis of interest rate compression in developed countries has certainly not been refuted by the outcomes.


Oct. 2 (Bloomberg) -- European Central Bank President Jean- Claude Trichet's balancing act may be drawing to a close.

With the euro-region sliding toward its first recession since the single currency began trading in 1999, Trichet's ECB is finding it increasingly difficult to fight inflation and at the same time protect its 15-nation economy from the global credit crunch.

The result may be a move toward lower interest rates as financial turmoil damps growth and reduces inflation pressures. The crisis reached new heights in Europe this week, with governments forced to help bail out five banks and credit costs soaring to records as financial companies hoard cash.

``The ECB's Governing Council will have had a serious wake- up call in recent days,'' said Juergen Michels, a London-based economist at Citigroup Inc., who expects the bank to cut rates in December. ``The credit crunch has arrived on its doorstep.''

While the Frankfurt-based ECB left its benchmark rate at a seven-year high of 4.25 percent today, economists at Deutsche Bank AG, Goldman Sachs Group Inc. and JPMorgan Chase & Co. this week followed Citigroup in predicting a rate cut before the end of the year. Trichet is due to hold a press conference at 2:30 p.m.

Repatriation in Nippon

A veritable mountain of overseas cash could be repatriated in short order given these proposed taxation changes. However, one should be very careful deriving this conclusion from the below news article as the Japanese Ministry of Finance understands recursive systems very well. In this case, repatriation will lead to massive purchases of Yen to benefit from lower taxation. The demand for Yen will likely crowd out the inflationary effect of lower taxes. I am sure the MoF will wish to study the trade-off effects prior to rubber-stamping this measure.

Japan prefers a weaker Yen in order to prop up their export markets, and despite attempting to engineer controlled inflation for a decade, domestic demand remains weak. The U.S. remains the consumption engine for the world.

TOKYO (Nikkei)--Prime Minister Taro Aso told lower house lawmakers Wednesday that his government will consider including incentives for Japanese companies to repatriate profits earned abroad in a tax reform package for fiscal 2009.
"There's a wide range of tax issues we need to tackle, starting with creating an environment conducive to overseas subsidiaries' profits flowing back to Japan," Aso said in response to a question posed by ruling Liberal Democratic Party Secretary-General Hiroyuki Hosoda.

Japanese firms are increasingly leaving their profits abroad, where tax rates are often lower than at home. The Ministry of Economy, Trade and Industry has proposed exempting domestic companies from taxes on dividends from overseas affiliates in which they hold stakes of 25% or more, arguing that doing so would help boost domestic investment.
On other tax matters, Aso reiterated support for tax cuts during the current fiscal year and said that breaks for energy-saving technologies and other incentives will be considered. He also said that increasing the consumption tax is "unavoidable" but added that "it would be difficult in the current economic situation."
Lawmakers will begin debating fiscal 2009 tax reforms later this year.
As for economic stimulus measures, the prime minister stressed the need to pass the fiscal 2008 supplementary budget as soon as possible.

Brussels and Fiscal spending

Expect "revisions" to the Maastricht treaty. The markets will force their hand much as it forced the hand of our own politicans during this latest imbroglio. The "revisions" will be couched in terms of increased subsidiarity to the EU members, but will in reality seek to strip more economic sovereignity from its members. This will fail.

With individual countries having self imposed constraints on budget deficits, they cannot spend to address faltering domestic demand, and the PIGS certainly cannot issue more debt. Brussels has no fiscal authority among the several countries and does not insure bank deposits in the several countries. External debt can unwind VERY quickly.

We see that the Euro area is aping the U.S. "rescue package", and it has failed, at least initially. Recall that the Treaty has never been battle tested. We will see what it is made of.

And it is in serious trouble at the moment. The area needs US dollar funding more than their domestic currencies. The UK has also felt this lack of liquidity, but they of course can deficit spend as required to maintain aggregate demand.

The ECB is speaking strictly from a self-preservation standpoint (the reason detre of beurocrats) when it calls for order in the global markets.

My largest fear (longish term)is a return to conventional warfare. Europe has been at peace for 50+ years (not counting recent troubles in the Balkans). That is longest period of peace in over 1000 years. I am an Economic Determinist (Marx did have some good analytical tools, even if I think he came to some terrible conclusions) and when the chips are down, the Euro area does not exactly have the best record for picking themselves back up in a peaceful, collaborative manner.

Don't Panic.

Over the past several days, I have received all manner of dire predictions regarding this economy, the role of government leading up to and during this crisis, and the future of America.

My advice is always "Don't panic". Investment is as much an emotional pursuit as it is an analytical one.

During times like these, there are impassioned pleas of national solidarity - "we" must all get through this, etc. I have been told that the Democrats will benefit from this during the upcoming elections.

The Government is peforming its assigned role of chief meddler excellently...and they have succeeded in stopping some of the more pernicious recursions from which the economy suffers.

U.S. Equities are like a coiled spring.