"It's the asset prices, stupid"

In a good post titled 'Why Obama is Winning' Harold James points out that political strategist James Carville's famous "it's the economy, stupid" quip from the 1992 U.S. presidential election campaign has gained a new twist:

...the lesson about the economy’s electoral salience is being subtly reformulated. It is no longer the real state of the economy, but rather the perception of asset markets, that is crucial. And the perception can be far removed from reality, which means that the more the prevailing political wisdom assigns decisive electoral importance to the economy, the greater the temptation to view monetary policy’s impact on asset prices, and not on long-term growth, as crucial.

What James is basically saying is that people feel wealthier when asset prices - stocks, bonds, real estate, etc. - go up in value. This phenomenon -- the so called 'wealth effect' -- can make those who don't read The PolyCapitalist and the other recommended sites listed on the right side of this blog feel like the real, fundamental economy is doing better than it actually is. Or so the theory goes. 

Further, positive feelings about how the economy is trending due to rising asset prices can in turn drive higher consumer consumption and business investment, which in turn can increase GDP. At least in the short (and possibly) medium run.

For how long can this wealth effect ponzi-esque scheme go on? In other words, are programs like QE3 nothing more than an macroeconomic cheap trick?

No one knows for sure because, like much of modern macroeconomic theory, we are conducting a live, empirical test of the theory. And this test has arguably been running since at least 1987 (the year Alan Greenspan became Chairman of the Fed), if not 1971 (the year Nixon severed the U.S. Dollar's anchor to the price of gold).

What this means longer-term, according to James, is further politicization of the Federal Reserve and other central banks around the world:

Republicans will blame their defeat in November on the Fed’s monetary stimulus (if not on the ineffectiveness of Mitt Romney’s blunder-filled campaign). 

Meanwhile, in Europe, many national leaders, looking at Obama and the Fed, may conclude that they would do better with more direct control over the central bank. Given the difficulty of establishing such control over the European Central Bank, the euro’s next great challenge may be growing sentiment in favor of a return to national currencies.

In other words, expect central banks to remain in the politial bullseye following the 2012 U.S. and 2013 German elections, regardless of the their outcomes.

Will major reform be applied to central banks? For example, there has been open discussion of terms limits for the Federal Reserve Chairman.

Perhaps changes like term limits, greater Fed transparency, etc. are in the cards longer-term. But I am personally skeptical that any significant reforms will be enacted at the Federal Reserve prior to the end of the U.S. dollar's global hegemony.

Why is the U.S. Government Still Hiding Financial Crisis Documents?

Here here to former Lazard partner turned Wall St. author/historian William Cohan and his fighting the good fight to obtain public documents from the U.S. government related to financial firms such as Goldman Sachs.

2012 Prediction #4: Romney Will Not Win the U.S. Presidency

It's looking like Romney has the Republican nomination, but I am very doubtful that he can carry the country in 2012 for a whole variety of reasons:

1. U.S. economic figures are showing signs of life, at just the right time.
2. Like Eichengreen, Dalio, and others, I think the next leg down in the ongoing financial crisis won't make landfall until 2013 at the earliest.
3. There is a decided lack of enthusiasm about Romney. He comes across as a Wall St. guy who, policy wise, isn't all that different from Obama. He also isn't well liked by the Republican base. In short, Romney seems positioned somewhere in political no-man's land.
4. There is a reasonable chance for a third party candidate to be a factor, and should that happen it will work against Romney more than Obama.
5. Even if Eurogeddon boils over the world's central banks have plenty of space to deploy more monetary artillery. Central banker hands won't begin to be tied until core inflation starts to increase significantly, and that's unlikely to happen over the next 10 months. Even though Bernanke was appointed originally by a Republican, he would probably prefer that Obama (who reappointed him) be reelected given Romney's and general Republican hostility towards the Fed.
6. An Iranian conflict (perhaps the biggest X-factor in 2012) likely favors the incumbent as it would provide Obama with an opportunity to exercise leadership and look presidential.

What could upset this prediction is any material economic deterioration or a geopolitical flub by Obama.

The Fed's $1.2 Trillion in Secret Bank Loans

Interactive chart detailing previously secret Federal Reserves loans to each bank here. Bloomberg deserves an award for their doggedness and reporting on this issue.

Keynes on Printing Money, and Do Loss-Suffering Central Banks (i.e., ECB, SNB) Need Capital?

Weimar Germany during the early-1920s hyperinflation

A 1924 quote from John Maynard Keynes reflecting on events in Weimar Germany and Lenin's Russia:

"A government can live for a long time, even the German Government or the Russian Government, by printing paper money." 

However, "In the last phase, when the use of the legal tender money has been discarded for all purposes except trifling out-of-pocket expenditure, inflationary taxation has at last defeated itself."

The above quote was excerpted from a 1997 paper by the IMF's Peter Stella titled 'Do Central Banks Need Capital?'

Can Central Banks Go Bust?

Technically speaking, the answer according to Stella is no, central banks do not require a capital buffer to absorb losses in the same sense that a commercial bank does. However, Stella states:

"Weak central bank balance sheets invariably lead to chronic losses, the abandonment of price stability as a primary policy goal, a decline in central bank operational independence, and the imposition of inefficient restrictions on the financial system to suppress inflation. 

...if society values an operationally independent central bank capable of attaining price stability without resorting to financial repression, the transfer of real resources to recapitalize the central bank becomes necessary when chronic losses are sizeable."

In other words, the overarching reason for central banks to hold sufficient capital is that it helps maintain confidence in the soundness of the central bank and the value of the currency it issues.

Has the ECB Become Europe's 'Bad' Bank?

As the European debt crisis has spread and intensified, central banks in Europe have been suffering heavy losses for over a year now.

The Swiss National Bank has reported losses in the tens of billions of swiss francs on its euro purchases over the past 12+ months. Whether or not the Swiss government will move to recapitalize the bank is unclear. So far as I know the Swiss central bank is unique among major world central banks in that it is publicly-traded with both government and private shareholders.

There has also recently been speculation that the relatively thinly-capitalized European Central Bank will need to be recapitalized again if it were to continue to suffer heavy losses on its purchase of European sovereign debt. The ECB recently began purchasing tens of billions in Italian and Spanish debt, which comes on top of the tens of billions in Greek, Irish and Portuguese debt it already holds. The prospect of the ECB needing additional funding is not sitting well with Germany and other rich European nations which will have to foot the bulk of the bill.

Interesting times in the world of central banking.

Why Bankrupt America Needs a Third Political Party

From Boston University Professor Laurence Kotlikoff:

The Republicans and Democrats have done a terrible job of managing our country and economy, transforming the American dream into a nightmare. They’ve squandered our youth and wealth in endless wars we couldn’t win, and spent six decades running an intergenerational Ponzi scheme, racking up huge official and unofficial debts for our children to pay. 

By some measures, the U.S. is now in worse fiscal shape than Greece. True, our official debt is a much smaller percentage of economic output. But our unofficial debt is much larger. The unofficial debt includes primarily the obligation to pay 78 million baby boomers roughly $40,000 a head each year of their very long retirements in Social Security, Medicare and Medicaid benefits. To get our overall fiscal gap under control, the U.S. must cut spending or raise tax revenue by $20 trillion over the next decade, far more than either the president wants or the House Republicans seek.

Full must read op-ed at Bloomberg.

Ken Rogoff to Investors: "The Fed Doesn't Have Your Back"

Interview with Ben Bernanke's close friend below:

The young chess grandmaster

Q: The U.S. hit the $14.3 trillion debt ceiling today, and now the Treasury is moving cash around to stave off default till August. What's that mean for markets?

A: I don't think it means anything immediately, but it doesn't seem like any way to run the government. I think they should raise the debt ceiling unconditionally, despite the fact that some reforms are desperately needed. When you're the world's biggest debtor there are repercussions when you take it to the brink and scare people (with the idea) that you just might consider a default.

Q: You're not in favor of the artificial cap, or debt ceiling, because it threatens creditors. But debt is still your biggest worry about the economy, yes?

A: The greatest concern at the moment is the huge debt overhang. All U.S. government debt, including state and local, is higher than at the end of World War II. But equally significantly, private debt (like mortgages and credit cards) is almost at its all-time high. If you combine the two, there's never been anything like it.

Q: What's the risk in the U.S. having so much debt? Other countries, like Japan, have larger debt burdens.

A: It doesn't automatically cause a crisis, but it certainly weighs on the recovery. Very roughly speaking, when a country has public debt over 90 percent of income, growth is about 1 percent lower for a very long time.

Q: A government can't increase spending as easily if it has too much debt, which you say makes a country vulnerable. How so?

A: That's the fundamental problem. You see it when a country loses tax revenues and needs to borrow money. They have wars and natural catastrophes and need to spend to pay for things, reconstruction, bridges. You don't want to be forced in the middle of a recession to raise tax rates (to pay for those things). That's a disaster.

Q: Politicians use your work to argue for deep spending cuts now to trim our debt. Do you agree?

A: If we tighten too fast, the economy will implode on itself. We didn't get here in two years, and we shouldn't try to get out of it in two years. But at the same time the idea that we can worry about the future later, that's false. It's not just about cutting spending. The tax take probably needs to go up. We need to clean up the tax system.

Q: Where would you start?

A: I'm one of many economists who favor scrapping the current system entirely in favor of some form of a flat tax, with a very high deductible for low-income earners. And you know what? The very wealthy would pay more. They pay less under the current system because there are these smoke and mirrors they can hide behind, all these deductions and all these ways of avoiding taxes.

Q: Your friend and former classmate Ben Bernanke has taken flak for the most recent quantitative easing program, known as QE 2. What do you make of the effort to keep prices from falling through pushing $600 billion into the economy?

A: I thought QE 2 was absolutely right when they did it. But the way quantitative easing works best is you announce a goal and then say you will do whatever it takes (to get there). If you don't have a blank check, it doesn't do much. Because of all the pushback from the Chinese, the Germans and Sarah Palin, they couldn't keep going. The Fed needed a free hand, and it doesn't have one. A second problem was the Fed was not careful enough to tell the market clearly, "This is not going to solve all your problems." The biggest mistake they made was the suggestion that part of the way quantitative easing operates is through the stock market. There are all these traders on Wall Street who said, "This means the Fed's got our back. The Fed is just determined to drive up the market."

Q: What's wrong with traders thinking that?

A: Well, the Fed doesn't have their back. The Fed cares about stable inflation. So the worry now is when these traders see that QE 2 is coming to an end, will they get really depressed and all their trades will unwind? That's the concern.

Q. At Bernanke's first press conference in April, he joked that playing chess with you was a "big mistake." Most people don't know you're an International Grandmaster. Did Bernanke ever ask for a rematch?

A: No. I went cold turkey after leaving graduate school. I teach my children how to play (chess) but that's it. I'm completely addicted and need to guard myself from playing. I still think about chess all the time.

Q: Has your expertise in chess helped inform your work?

A: Chess teaches you to think about what the other person is thinking. Obviously, there are other ways besides chess to come to that. Chess is just a disciplined approach. At the IMF, we had crises in Argentina, Brazil, Turkey and Lebanon. And it helped to put myself in their position: "What are they thinking."

Source: AP

Fed President Hoenig Opens-up on Why He (in Fedspeak) 'Went Off the Reservation'

Kansas City Fed President & FOMC Member Tom Hoenig

FOMC-member Thomas Hoenig explains why he has been the lone dissenting vote against the Fed's zero interest rate policy (ZIRP), which is coming up on an extraordinary three years.

Link to audio recording include Q&A here, and below is a brief bio:

Thomas M Hoenig is president and chief executive officer of the Federal Reserve Bank of Kansas City. He assumed the role of president on October 1, 1991, making him the longest serving of the 12 current regional Federal Reserve Bank presidents. He is senior member of the Federal Reserve System's Federal Open Market Committee, the key body with authority over national monetary policy in the United States.

Video: Ben Bernanke Interview on 60 Minutes (sans ironic Chase ad)

Federal Reserve Chairman Ben Bernanke conducted a post-QE 2 interview on CBS's 60 Minutes program last night (his June 2009 60 Minutes interview can be viewed here).

One similarity and one difference between the two 60 Minutes interviews:

1. Similarity: he still gets nervous when speaking on television (and in front of Congress for that matter).
2. Difference: Bernanke is no longer willing to acknowledge that he's "printing money". In fact, Bernanke now denies it:

"One myth that’s out there is that what we’re doing is printing money. We’re not printing money. The amount of currency in circulation is not changing. The money supply is not changing in any significant way."

The below chart, however, suggests otherwise.

Chart courtesy of Felix Salmon.

So why is Bernanke denying that he's printing money when the Fed has clearly expanded the money supply? Semantics. And why would Bernanke start playing word games now? Because Bernanke has chosen to get political, and in politics semantics matter.

Later on in the interview Bernanke, for the first time, dips his toe into the government fiscal debate currently underway in Congress over tax cuts, the deficit, entitlements, etc. Whether you agree if this is or is not appropriate for a Fed Chairman (or with Bernanke's politics) is not necessarily the most important element here. The change in what Bernanke is openly speaking out about compared to what he's previously remained mum on is perhaps the key observation.

Every single word uttered by a Federal Reserve Chairman is carefully considered and reviewed before being communicated publicly. The reason: the Fed Chairman's words can have a powerful effect on investor psychology and global financial markets. Is it this pressure to stay on script which is making Bernanke so nervous when he knows he's on TV? I haven't spent time with Bernanke in private so unfortunately I can't compare how he communicates in a more informal setting with how he is on television.

Appropriately, the CBS online video version of the interview features an ad for a new Chase Bank card called "Slate", which gives the interview a "Ben Bernanke, brought to you tonight by Chase CEO Jamie Dimon" quality. Appropriate perhaps, and also hard to believe Too 'Bigger' to Fail Dimon wanted his advertising budget used for such rich irony.

I hope you won't mind my sparing you from being subjected to Chase marketing, which is excluded in the below YouTube version of Bernanke's interview.

Federal Reserve Public Relations in the YouTube Age

The Federal Reserve and its policy of quantitative easing (aka printing money) both have serious image problems. Significant controversy and disagreement has been generated recently by the Fed's QE2 program, resulting in an ongoing communications battle between the Fed's advocates and critics.

This amusing cartoon video, which 'explains' quantitative easing and the current economic situation in a rather simplified (and in some instances erroneous) fashion, has already generated nearly 3 millions views on YouTube. The video's appeal is undeniable: we were all children once upon a time and are practically hardwired to trust cute, entertaining cartoon characters.

Meanwhile the Federal Reserve is hardly sitting idly by. Its New York branch has taken a slightly more high-brow approach with this comic book, a medium typically reserved for pre-teens and up. Like the cartoon, the comic book attempts to explain how the Federal Reserve system and monetary policy work to someone unfamiliar with macroeconomics.

The comic book builds on Ben Bernanke's 60 Minutes television interview and Washington Post QE2 op-ed in that both reflect the Fed's understanding that it needs to engage in more public outreach. The historically secretive Fed correctly recognizes that business as usual won't work anymore.

The comic book also demonstrates the Fed's understanding that to get its message across it will need to employ a media strategy that goes beyond its usual menu of press releases, speeches, and well-timed leaks to news reporters like the WSJ's John Hilsenranth.

But how effective are the Fed's new openness and media strategy?And at what point does the Fed's communication cross the propaganda line?

Some, including influential Yale Professor Robert Schiller, argue that government policies should be purposely shrouded in what is effectively 'Newspeak'. For example, Schiller makes the case that "bailouts" should now be called "orderly resolutions". This framing, Schiller states, can help to ensure that the public 'gets it' when the economic going gets tough.

Perhaps more so than at any other point in its history, the Federal Reserve is under the public spotlight. Discussion of putting an end to the Fed's dual mandate of price stability and full employment is openly being considered.

Whether or not the Fed's mandate should or will change is an open question. However, it appears unlikely that Fed secrecy, as it has been historically been practiced, will survive.

Video: Why Printing Money is referred to as 'Quantitative Easing'

Why QE2 Won't Be Announced at Tuesday's Fed Meeting

Amid rampant discussion of further 'quantitative easing' the market's eyes will be fixed on the Federal Reserve when it meets on Tuesday this week.

In understanding why it is unlikely for 'QE2', as it is being dubbed, to be announced at this week's meeting it is helpful to briefly review the Fed's history and the political environment in which it operates.

Argument for Fed Independence

One of the key justifications for the creation of the Federal Reserve was to "keep politics out of monetary policy". In the Federal Reserve Act passed on December 23, 1913 Congress delegated its Constitutional authority over the nation's money supply ("to coin money, regulate the value thereof") to the newly created Federal Reserve System.

The Fed is free to make independent monetary policy decisions -- such as shrinking or expanding the money supply -- without the prior approval of Congress or the President. The logic behind thus empowering the Fed is that the nation is better off with its monetary policy entrusted to an institution that -- unlike Congress and the President -- is not directly accountable to the voting public. (Not exactly a strong vote of confidence in democracy!)

The theoretical problem with allowing elected politicians to directly control monetary policy can be illustrated through the following hypothetical example of a politician seeking reelection:

A politician might deem it advantageous to his reelection chances if there were a well-timed increase in the money supply. The reason? An increase in the money supply can (and often does) boost asset values (i.e., stocks, housing prices). A stock market rally -- prior to an election -- can in turn boost voter confidence. And more confident voters are less inclined to throw an incumbent politician out of office. While economic conditions may in fact make an increase in the money supply imprudent due to the post-election side effects (e.g., housing price crash), a politician's motivation to get reelected may trump economic logic. 

U.S. President Andrew Jackson vs. the Bankers

The above example can also be turned around to show how it can be politically advantageous to decrease the money supply. For example, in 1833 a reduction in the money supply was orchestrated in an attempt to cause President Andrew Jackson to lose reelection.

In theory, the Fed -- by virtue of its inoculation from public elections -- can base its monetary decisions (e.g., whether to shrink or increase the money supply) on the true economic conditions, and not the election calendar.

However, the Fed is not immune from politics. In fact, Fed Board members have their own mini-election gauntlet to run. To be elected to the Fed Board a person must be nominated by the President and confirmed by the Senate. And that final step, as recent events bear witness, is proving problematic.

Senate Stonewalling Fed Appointments?

In April of this year President Obama announced nominations for the three Fed Board openings and so far none have been approved by the Senate. In fact, the last time the Federal Reserve Board had all seven positions filled was back on April 28, 2006.

On Friday came news that Senator Richard Shelby (Republican, Alabama) had rejected President Obama's nomination of Peter Diamond for the Federal Reserve Board stating "it is not clear...that his background is ideally suited for monetary policy, especially given the current challenges facing the Fed".

Of note, Diamond is considered an inflation 'dove' and close Ben Bernanke monetary policy ally. Interestingly, Diamond was also one of MIT professors a then 25-year-old Bernanke thanked for supporting his doctoral dissertation. One perhaps not so outlandish interpretation of Shelby's move is that Republicans are trying to keep the Fed paralyzed.

Diamond's appointment would help Bernanke with what has proven to be a publicly divided Fed. In the face of significant Fed Board dissent, Bernanke's consensus orientation will make him reluctant to activate QE2.

Republicans Want QE2 Postponed Until After November Elections

I've written previously about Chairman Bernanke's well documented plan for dealing with the present challenge of deflation. Put simply, his plan is to print a lot of money.

The announcement of QE2 would likely trigger a rise in stock prices. An autumn stock market rally -- in addition to signaling that the 'Bernanke Put' is every bit as solid as the 'Greenspan Put' -- could be a reelection boon for a Democratic incumbent majority that is in deep trouble.

Shelby's rejection of Diamond delays his appointment at least until Congress returns from recess in mid-September (Obama's other two Fed nominees are on ice until then as well). Don't be surprised to see the Republicans stall further until after November elections. As such, investors timing an imminent announcement of QE2 are likely to be disappointed.