Crisis Note 2011-1: Twist..ing in the Wind, or Nothing has changed

10/11/2011

First, the usual disclaimer: THESE ARE ENTIRELY MY OPINIONS. They are not those of any of my employers, present or past. Some of my recommendations are way out there, and their purpose is to hopefully generate some out-of-the-box thinking and discussions of how to solve this crisis, since the conventional thinking is certainly not working.

My take on the world has not changed. I view the past 3 years as having been a waste of time, with nothing of significance having occurred besides the squandering of capital and the further involuntary indebting of taxpayers, current and future. 

(I do not view unprecedented amounts of stimulus, and the surge in asset inflation it created, as significant, as I view it as misdirected and never likely to hit its primary target, unemployment. It was also

a) to be expected from a Keynesian Fed, 
b) totally predictable in what it did accomplish, and
c) lacking in an understanding of the problem.

In previous Crisis Notes, I’ve already covered many of the topics that are of interest today, so rather than plagiarize myself, I am inserting excerpts from previous notes where appropriate. In them, I identify things that are likely to happen, and my recommendations for solving various parts of the crisis. Some of my predictions and recommendations have in fact occurred, some are in the process of unfolding, and some have not been ‘adopted’, resulting in outcomes which were predictable. At the end, I’ve also included some predictions and recommendations that I’ve made previously, and are worth re-reading, which did not fit in the flow of this narrative.

Quoting from my 4/8/2008 crisis note:

“All the stuff the Fed has done this year has not really been worth commenting on; it’s been like using a very large BB gun to shoot at a charging rhino! It may look like you’re doing something, but you’re better off praying or running. This is a large part of the reason I’ve not yet put out a Crisis Note this year - all I’d have said every time the Fed did something is that it will not work - it has all been a massive waste of taxpayer money”.

Kind of says it all.

Let’s look at the latest “twist” operation performed by the Fed. It will not work.

What purpose does the swapping of short term debt accumulated by the Fed during QE I & II, for longer term debt, serve? There are 3 possibilities that come to mind:

1) The Banks are still undercapitalized, and maybe Ben wanted to give them a shot of capital gains, by getting the treasury to issue longer duration liabilities, (after signaling its intention to purchase them), which are then purchased by primary dealers, who are then immediately given a 10+% gain upon the announcement of the Twist. And, I think the banks still have capital losses carried forward on their books, so they are unlikely to be paying taxes on these gains! And, don’t forget, mortgage refis are also a good source of fees and earnings for the big 4 mortgage originators - JPM, C, BAC, and WFC.

Let’s do the math: 10 points (that’s what the 30yr UST went up last week by, from around $110 to over $120) on approximately 400bb Twist = $40bb!  If you look at the period from August however, when this was suggested, the 30yr went from $99-00 to $120-18! That’s 22 points; ~$90bb!! (The 10 year went up 11 points from approximately 3% yield to 1.74% yield).

Granted, not all the USTs are held by the primary dealers - overseas investors and US money managers are the primary holders, and they were just given large capital gains too.

However, it does appear that the primary dealers have been front running Ben, with Dealbook estimating an increase in UST dealer holdings of $90BB - more than ¼ of the Twist. So, the dealers maybe got a $10-$20 BB windfall transfer of wealth from us.


Note: Since I started writing this, some of the twist has come undone - as of 9/29/11, the long bond has sold off to approximately 114, and FN 3.5 have reversed from $104 to $102-16 - anyone that tried to front run the Fed AFTER the announcement of the twist, and before its implementation (October 3rd, 2011) has gotten their hands a little singed.

2) The Fed is still under the delusion that the free fall in home prices are a mortgage rate issue, and lowering mortgage rates will lead to a housing recovery, (which in turn will lead to employment and GDP growth).  The twist should lead to refis on recently originated mortgages. The belief that refis could lead to home price stabilization, let alone appreciation, especially after the failure of QE 1 & II’s MBS purchases, is a sign of insanity. (Einstein: “Insanity: the belief that one can get different results by doing the same thing.”) More on this below.

3) The Chairman believes that the United States is a great nation, and that if we only had confidence we would go out and borrow and spend, increasing aggregate demand, and once again be great. So, like all good Chairmen, he is taking it on himself to make us confident. He’s spent months telling us that he has all the tools he needs, and that we should not worry, but just trust him and the Fed. He said as much at Jackson Hole in August 2011:

“In addition to refining our forward guidance, the Federal Reserve has a range of tools that could be used to provide additional monetary stimulus. We discussed the relative merits and costs of such tools at our August meeting. We will continue to consider those and other pertinent issues, including of course economic and financial developments, at our meeting in September, which has been scheduled for two days (the 20th and the 21st) instead of one to allow a fuller discussion. The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools as appropriate to promote a stronger economic recovery in a context of price stability.”
So, by taking 2 days for a Fed meeting, instead of one, and by stating that the Fed has tools to guide us, he trusts that we won’t notice that, instead of bringing forth a secret weapon that had never been deployed before, he pulls out a dud from the 60s.

I think Ben’s been reading Winston Churchill:
“Attitude is a little thing that makes a big difference.”
“If you're going through hell, keep going.”
“Success consists of going from failure to failure without loss of enthusiasm. “
Unfortunately, what he has revealed instead is that he no longer has any tools to deal with the crisis, resulting in today’s stock market rout (9/22/11).  He essentially contradicted himself at Jackson Hole 2011, but it was not believed. “Most of the economic policies that support robust economic growth in the long run are outside the province of the central bank.”  So much for building confidence.

So, what is the benefit to the ‘ordinary American’ for this transfer of wealth to the banks and other UST holders?

First, let’s look at the wealth effect from the capital gains described above. Some of this is merely zero-sum: pensions, corporations, and wealthy individuals with money under management, get the capital gains, while they are precisely the same parties that fund the US government through taxes, current and future - moving money from one pocket to another. However, by reducing future income flows and yield in their pensions, you are increasing their propensity to save, as they will need more invested dollars at lower yields to fund retirements, which tend to be in fixed income assets (and bank accounts). Rather than re-invest in risky assets, which the central bank is trying to make us do (similar to what the Japanese government tried),  they are more likely to invest in safer assets (just more of them by saving more), or even more likely, export their capital and create inflation overseas (as the Japanese did). If this is the case, (and I think it is), lowering interest rates in the US does more harm than good for the economy.

Banks with the capital gains, are likely to use them to offset losses against ‘assets’ that are still mismarked, like bridge loans and second liens, or in their Level 3 categories.

Second, they might get to refinance their mortgages. Along with the Twist, the Fed also slipped in a program to reinvest the runoff from the SOMA mortgage portfolio in MBS. So, the SOMA portfolio will remain the same size, except, it will reinvest at a lower rate, as its higher coupon MBS get prepaid by the actions of its manager.

Certainly a proportion of recent mortgagors will refinance, leading to prepayments in newer MBS. This will simply take away yield based income from the pension system, as portfolio managers roll down in coupon on their MBS holdings by reinvesting prepayments.  Similar to the impact described above, I think this increased disposable income to the borrower from a lower mortgage rate will be offset by reduced income from their pension and savings account portfolios, and will thus lead to greater savings to offset reduced future income, and thus have little-to-no impact on consumption or riskier domestic investment. Did I mention who has a trillion dollars of such newly originated mortgages bought at premiums, that will get now get prepaid? That’s right, we do, through our SOMA holdings! A 5 point premium loss on $1.25T is $62.5B. Can this be considered an unaccounted for stimulus?

However, the majority of mortgagees in this country face great impediments to refinancing and REFI.GOV (as the prospect of QE3 was called in the MBS markets, referring to a mass refinance of all outstanding mortgages; thanks Russ) is unlikely to happen, due to issues of (lousy) borrower credit (including unemployment) and lack of equity in the homes. We’ve already hit unprecedented lows in mortgage rates, and anyone that could have, has refinanced already, as has anyone that was willing and able to purchase a home during a period of falling home prices.

To understand what Bernanke expects us to do, read the following interview from December 2009. (It is a good read).


“And in doing those purchases, we have succeeded in reducing the national 30-year fixed-rate mortgage rate from about 6-1/2% to about 4.8%. By lowering mortgage rates that way, we have helped to stabilize the housing sector, to help stabilize the housing crisis, and allow people to refinance, to buy homes. And that, obviously, should get construction started again and house prices stabilizing, and people being able to meet their mortgages. That's obviously going to be helpful. “
It's not so obvious, Ben.

There are $13.7T of mortgages in the US. Of those, $8.5T are in mortgaged backed securities, and of those, $7T are Agency MBS. The Fed has purchased $1.25T in the SOMA account, over 17% of all outstanding agency MBS (!!), amounting to almost 2 years of normal origination, to lower mortgage rates, in order to stimulate the housing market.

Did the SOMA purchases help to get “construction started again”, or to “allow people to buy homes”, or make to “house prices stable”? Did delinquencies go down as people ‘met their mortgages”? Not at all. “The people” have been meeting their bankers instead, to negotiate short sales and modifications.

Does the Fed not look at the re-default rate of modifications? Even with lower balance, lower interest rates, extended maturities, modifications don’t work - borrowers re-default. And most of the modifications were supposed to have been vetted for likelihood of repayment by the agencies created by the government, and by the banks, through trial periods, etc. Lowering mortgage rates and mortgage payments is not remotely in the same ballpark as a solution to this crisis.

Thus my comment above: this belief by the Fed defines insanity.

What's really sad, is that this action by the Fed was totally predictible. I put on a friendly bet with a client that, before Nov 2012, we would see FNMA 3s trade over $100. This was in August 2009, when FNMA 4.5s were the current coupon, and 3s were not even a glimmer in anyone's eyes. This milestone toppled last week.

The Fed still toils under the fallacious belief that lower mortgage rates translate to higher prices for real estate. While this might make sense in theory - Bernanke and all the other economists are forgetting the fine print in their own textbooks - the theory only works “AT THE MARGIN”! It does not work when there is excessive supply of both housing and home square footage that far outweighs demand (and certainly income adjusted demand).  We are nowhere near “the margin”, as the markets are NOT BEING ALLOWED to be efficient, and the demand and supply curves are not intersecting as a result.  We have not finished ‘repricing’ and readjusting supply to meet demand. The supply curve still needs to move more to the left before the 2 curves will intersect in a meaningful way. (I’ve discussed possible ways to get the supply curve to move to the left in previous Crisis Notes - excerpts below).

And, Ben, please don’t bail out home builders one more time (although that may have been Hank Paulson and Tim Geitner’s doing)- they only add to the problem by building more homes.

In the 1/21/2009 Crisis note, I have a section on the implications of Lowering Mortage Rates, reprinted here:

1/21/2009 - Lowering Mortgage Rates

The government has made the decision that a 4.5% mortgage rate will cure all ills, and allow home prices to appreciate once again. By directly purchasing billions of Agency MBS from the market, they hope to drive mortgage rates down. They will succeed in lowering mortgage rates. But in my opinion, it is unlikely to have an significant impact on home prices.

Micro Economics anyone? Prices of assets are determined by the demand for and supply of assets. If you can increase demand, while holding supply constant, prices will go up. If you can decrease supply, prices will go up. Increasing credit availability, and reducing the price of credit can only help to increase prices if you hold supply constant, or reduce supply.

As discussed above, there has been no serious attempt to reduce supply in housing. Thus housing is in a downward spiral - unemployment and unqualified homeowners (that bought homes that were too big for their incomes), continue adding to the supply of houses for sale. In addition, by simultaneously providing tax breaks to home builders (in the name of maintaining employment in the home building sector), you are allowing them to offload their portfolios of unsold homes via subsidies, thus further increasing housing supply.

In any case, it is questionable how many more homes can be sold or resold by lowering the cost of mortgages. It is hard to imagine that the demand for home ownership has not been fully met over the past few years, when even down payments were not required. The only remaining potential new homeowners might be new immigrants, or new entrants to the employment markets (college grads and other young adults leaving their parents homes). These marginal consumers of home ownership are likely to face more stringent underwriting standards than in the past, and my opinion is that only a small percentage of them will qualify for a mortgage.

One can argue that the reason for lowering mortgage rates is to get the universe of current mortgage borrowers a lower monthly payment, in order to put more disposable income in their bank accounts, which might reduce foreclosures, and also stimulate the economy if the savings of a lower mortgage payment are spent on consumption instead of being saved. Again the key question is: with home prices having declined about 25% or more so far, how many borrowers will be able to qualify for a refinancing without putting up more money? Unless underwriting standards are abandoned, or LTV requirements are ignored, it is my opinion that many borrowers are unlikely to be able to refinance their existing mortgage balances. We are likely to see a short burst of refinancing activity, as those capable of re-qualifying for a new mortgage (exactly the people that don't need help) go ahead and refinance, while the rest of the existing borrowers discover that they cannot refinance without putting more equity into their homes. Could the refinance application process lead to an unintended consequence - an increase in in jingle mail and foreclosures, as people are confronted with how little equity they have left in their homes?

The unintended consequences are much greater. At present, the market is already discussing the risk of crowding out of longer Treasuries. With stock markets declining, where will our pension plans invest? MBS has traditionally been a way for pension plans and insurance companies to earn yield. How will they now achieve their required return to meet their future pension obligations when MBS yield 4.5%? This lowering of yields is likely to make pension plans even more underfunded in the future. And, if the government ever tries to sell their half-trillion MBS portfolio in the future, agency MBS prices will decline, further increasing the pain for pension plans, especially if they followed Bill Gross' recommendation to invest along with the government.

As I’ve said numerous times in meetings with clients, even if the US government gave us 0%, interest only, 50 or 100 year loans, home prices will still continue their decline, as the TOTAL cost of home ownership is still not affordable at current US income levels (and it is only going to get worse - US wage levels are too high for us to be globally competitive manufacturers). This is primarily due to energy costs faced by homeowners, which are a function of how and where we live.

For more details, see my crisis notes from 2/22/09 “The Route of all Evil”

Here’s a new recommendation - actually an expansion of a previous thought that nuclear was the answer to the energy issues of the housing and labor markets:  Until the US government gives us free heating and gasoline, the issues of an overhang of housing supply will remain unchanged.

The way to do this is to build nuclear plants all over the country, and not charge for generated electricity that is used for heating, cooling, and charging electric cars. This will lead to dramatic increase in both the supply of electric cars and construction demand for converting home heating to electrical, thus nipping the costs of home-ownership and commuting in the bud, which in turn will lead to demand for massive houses once again. And create manufacturing jobs.

It costs about $5-6B for a nuclear plant, and possibly about 3-5 years to go online, if you can get through the red tape, regulations and expressions of democracy, that prevent plants from being built in the US. (I don’t know how reliable this is, but I read on the web that there are claims of 36 months completion time for the new Westinghouse AP600/AP1000. China has 4 of these under construction. Some are underway in the US as well.) The $2.6+T in current SOMA holdings (including Treasuries) could instead have built us 50+ nuclear plants, which could have been up and running by now!

Alternately, as implied in the Feb 2009 Crisis Note, we will need to move out of suburbia into cities, to live vertically, close to our jobs. In either case, we would decrease our marginal costs of working, allowing our wages to decline, and thereby making our products more competitive globally, while increasing our savings and capital formation rates.

Coming back to the wealth effects, creating price appreciation and capital gains for MBS via lower yields does not, and will not, translate into real estate price appreciation and transactions. From the 1/09 Crisis Note “Bonds are not assets”:

Securitized credit flows through a one way valve. When credit is available, assets get built, especially if there are other considerations - bull markets that never appear to end, low risk premiums, pressure on CEOs from equity analysts to maximize ROE, etc.

However, taking securities off financial balance sheets (that are accounted for as assets) and hiding them in acronyms that start with T or P, cannot make the underlying excess assets disappear. You cannot play the securitization film in reverse!!! The various underlying excess assets are still out there, and as long as they are non-economical, their prices will continue to decline. And with them, the prices of the bonds that are collateralized by them.

Bonds are like a mirror. The bonds will always reflect the value of the underlying assets. Throwing a towel over the mirror will not change the price of the underlying assets.”
ZIRP Forever - and Inflation.

I have been telling people for years, that the only path the Fed would take is ZIRP (Zero Interest Rate Policy) Forever, and this statement frequently resides on my Bloomberg header. I believe that as long as the Keynesians run the central banks, this policy, along with quantitative easing, is going to be their only policy option, and they will slavishly stick to it. The argument I get back is ‘won’t printing money create inflation and cause rates to rise at some point?’

Here is a point that people, and economists, miss: there are 2 types of inflation - price inflation, and wage inflation. Historically, these have been correlated, and I will explain why shortly. But, since the early 1990s, these have diverged, with many unintended consequences. In today’s world however, this divergence will explain why a Keynesian will get flabbergasted and at a loss to explain why his easy monetary policy will not lead to inflation - Paul Krugman, I’m talking to you!

What causes prices to rise? Too much demand relative to supply, of course. Printing money should accomplish this - the common understanding, attributable to the great Milton Friedman is that, "Inflation is always and everywhere a monetary phenomenon." The standard economic theory is that as prices rise, manufacturing will increase to meet the demand, creating demand for labor, and thus a rise in wages.

The problem arises from the fact that this economic theory, as with most others, is a ‘single economy’ theory - it only works this way in a closed economy.

Since the late 1980s, with the onset of deregulation, money has easily flowed between most capitalistic countries, and the world can no longer be modeled as a single closed economy. Economists and central banks have failed to understand this.

I discuss this in an uncompleted Crisis Note - This is not an Economic Crisis, This is an Economics Crisis.

When a country today prints money, the money flows to the highest return - markets are efficient. When rates are cut to zero and money is printed, this usually means that money printed will flee to countries with higher returns, and the domestic central bank can print away till it squanders all its future tax revenues, and more, and it will not cause inflation in its own country, as the money is not being deployed domestically. Often, the opposite happens, as in the case of Japan – the citizens see the money being printed, and realize that their future tax liabilities will be higher, and increase their savings rate by spending less. This is why Japan has had a deflation problem for the past 20 years – its ‘lost decade’, repeated a second time, and now on its third iteration.

Friedman, however was right, money printing will always cause inflation. However, in today’s world, it will cause inflation in other countries.

This is called the Carry Trade, and the US has been the world’s greatest recipient of it, from Japan, starting in 1994, till 2007, with only a handful of missed years (which I call the Greenspan Carry era, when Greenspan started the printing presses). Japan’s lack of inflation from all its money printing, along with the mysterious appearance of a sudden and long lasting economic boom in the US, and subsequently in other western nations, is explained by this.

Yes, Paul Krugman, in your MIT papers you wonder why Japan could not generate inflation, even though you saw that as the solution to Japan’s problems. It is because of Japan’s export of capital. The inflation Japan created was in the US! You have to follow the money to find the inflation! It is not because Japan did not “signal” that it intended to print money for the long term.


In my various Crisis Notes, I go into great length at describing the Yen Carry Trade, so please read the old CNs for more details. You probably need to read them all to gather all the pieces.

Back to inflation. Japan has proven that it is possible to print money, remain in QE mode, and keep rates at 0, for 20+ years, without leading to any domestic inflation. But which type of inflation are they referring to - price or wage?

If one recalls the McDonald’s index, and various other anecdotal price measures, one is always  hearing about Japan being a very expensive place. Things, in general, are very expensive. So, there must be price inflation there.

So, why does Japan keep printing money? It is because Japan cannot generate wage inflation. The money printing has not lead to new jobs, and the government has had to resort to Keynesian stimulus to keep people employed - construction projects, bridges with no traffics, airports with no flights, paying corporations to hire people to be window watchers (i.e. so the windows don’t fall out), etc.

Japan has succeeded in generating price inflation, however, but mostly in imported goods. This is primarily a function of currency depreciation - printing money leads to investors shunning the currency, and if the population resorts to capital export to generate returns on their savings, the purchase of other currencies will lead to further currency depreciation. This is why, starting in 1995 to 1998, the yen weakened from about 83 to 145, and this trend was only broken when LTCM blew up, and with it US markets, leading to a period of easing from the US, and a repatriation of the yen. When things calmed down again in 2000, the yen carry trade resumed again. You can correlate (I prefer the term explain) US stock market rallies with Yen depreciation/export. 

I’ll repeat it: Money printing in Japan led to inflation in the US, first asset inflation, then wage inflation. But, since the US was not running a particularly easy monetary policy at the time, we missed this inflation coming from overseas, and instead patted ourselves on the back for creating a “service economy” driven by “efficiencies”. In reality, the failure of Japan’s monetary policy and its quantitative easing
meant that the Fed lost control of US money supply, and failed as well. Asset inflation was not in the lexicon back then, and Greenspan was loath to admit it.

It is wage inflation that most concerns a central banker. So far, all our recent stimulus has failed to generate any job or wage growth, and thus our central bankers will keep trying to print money, either directly, as in QE I and II, or surreptitiously, as in the Twist (it is still QE3 by my accounting). By the time the decade is out, I expect we will have experienced QE17 or QE20 in some form or the other - we are not getting out of this without more drastic measures, which I have discussed before, but will summarize shortly. And we will have ZIRP Forever as a result.

Various US economists are now suggesting that the Fed break with its pledge to keep inflation low and allow it to rise.

Liberals need to push for more inflation, writes Mike Konczal: "For many on the right, low inflation is not a matter of good policy, but an ideological dogma: inflation must always be fought, regardless of the state of the economy, and regardless what the data tell us...Credibility works like capital--you build it up in good times so you can spend it in bad times. This is the logic of many professional economists who are ordinarily inflation hawks, but now are arguing for the logic of higher inflation. Harvard economist and former Federal Reserve economist Kenneth Rogoff explicitly used this logic when he called for a period of sustained, higher inflation of 4 to 5 percent. He notes that the credibility the Federal Reserve has built as an inflation fighter over the past several decades should be used to now fight the current recession."


So, why has US stimulus failed at generating the wage inflation we so desperately need to make our mortgages affordable? It is because we are now the suppliers of the carry trade. Our money printing is creating inflation in the Emerging Markets - directly - by allowing our US banks to export and deploy capital overseas – and more importantly, indirectly - by not giving the Japanese a return on their capital, leading to their re-patriation and re-deployment elsewhere of their savings that to date have been invested in the US.

Hint: Look at the Brazil Real in Yen terms. More on this in the next section on Brazil.

If you think that we are not exporting capital, take a harder look. JP Morgan recently applied for an overseas license so it can compete with Citibank and Goldman in exporting capital. JP Morgan also started some kind of hedge fund unit in Brazil.  Certainly all the Investment Banks are pursuing overseas investments, and it is quite likely commercial banks will try as well - what else will they do with their cheap deposits? Emerging markets have been flooding the US with $ denominated issues via our freshly bailed out investment banks, and we are thereby creating inflation, jobs and wealth overseas, with our hard earned savings that are earning close to 0 in our bank accounts.

This can be seen in the Fed's own data. Please see this link:

Dead Link:  http://www.census.gov/compendia/statab/2012/tables/12s1204.pdf

Thanks to the WayBackMachine, we have it here:

Please look at the 2nd table - 1204. U.S. Holdings of  Foreign Stocks and Bonds by Country 2008-2010.  

Stock holdings went up by $1.7T, $2.7T to $4.48T, while bonds holdings went up from $1.2T to $1.7T, 500BB, totalling $2.2T in capital exports! 

This does not include 2011. Guess what the amount of stimulus was via SOMA - whereby the Fed drained reserves and injected cash into the banking system. Its currently at $2.6T! Almost all the cash that was put into the US economy by the Fed went overseas, maybe all of it, and more, once we get the 2011 capital export data.           

We certainly got exports going by weakening the dollar. But, of the wrong kind - we exported capital! 
                                                              
We’ve been suffering from price inflation, however, in commodities pricing, all from dollar depreciation. It has been offset periodically by safe haven demand for the dollar. And against most fiat currencies, the dollar has held its own, or appreciated. But against (what I call) fungible currencies - those with substantial savings per capita - Yen, Swiss Franc, Norwegian Krone, gold - the dollar has weakened.

What does it take to generate simultaneous wage and price inflation (i.e., old fashioned inflation)? In today’s world, with capital flight available at the click of a button, there are two ways to do so.

Countries that want to ease or even print money need to implement capital controls, so the money does not fly out, to other higher yielding countries. Banks, hedge funds and other shadow finance organizations must be prevented from exporting capital. Only then will money printing lead to domestic price inflation that might generate production and subsequently wage growth, as the theory predicts. (This is working very well in China at the present - they are printing even more money than we are, but it’s all being retained and used domestically, creating GDP growth and inflation). This will be very hard to implement in the US, and I don’t believe there is the political and economic understanding to do so - we have been the champion of open and free markets - and there are certainly many benefits to be accrued from these – and if we reverse course, it will become impossible for us to ever berate China on economic policy or its weak currency. Historically, too, closing of markets has usually led to trade wars and often physical wars - this is discussed in the older Crisis Notes - and this makes WWIII a possible outcome, and no longer an impossibility.

An alternative is to raise interest rates if more economic activity is desired. I recommended that the Bernanke take this action in my one of my earliest crisis notes of 8/29/2007 “Rate cuts will not work”. (Too late now for a reserve requirement cut, however – the banks effectively got it).

Well, how about RAISING the Fed funds rate simultaneously. Now, I'm not only out on a limb, but over a precipice!

The reserve requirement cut will allow banks to find the balance sheet for all the trillions in excess assets that we've created over the past 5 years. And the RATE RISE, will help dampen inflation, and also allow Mrs. Watanabe (and the hedge fund community) to happily continue shorting the yen to support our stock markets. This will defer the yen carry trade liquidity problem for some time, and allow the central banks of the world to deal with it later. In fact, it may allow the BOJ to raise rates, as it has been hinting it wants to do.

The other alternative is a single global unmanaged currency, whereby there is a fixed amount of fiat money floating around, with deposits guaranteed, but not banks, and interest rates being set by market forces and competition. Again, this has been discussed a number of times in previous Crisis Notes.

When this happens, I suspect we will end up with a single currency and central bank. It will be like restarting a game of monopoly, except with different countries starting off with different amounts of cash. The goal will be to eliminate distortions and leverage from cross border financing and currency mispricing, which have been fundamental in causing this crisis (see my ramblings on the Yen Carry trade).

But, since I don’t view the Fed or our economists as capable of understanding the problem, or making the hard decisions to solve the problem, I expect ZIRP forever!

Since this Crisis Note was so lenghty, I decided to split it up. It is continued here.
​​Samir Shah, 10/01/2011