Thursday, July 29, 2010

July 29 2010: Deflation Revisited (The Studio Version)

Unknown Lunch among the ruins Winter 1862-63
"Ruins of railroad bridge at Blackburn's Ford, Bull Run, Virginia"
From photographs of the main Eastern theater of the war, Second Battle of Bull Run (Battle of Second Manassas)

Ilargi: Deflation has become a favorite topic for economists and finance writers overnight. But, obviously, talking about it is not the same as understanding. Stoneleigh explains The Automatic Earth's take on the issue below. I called her essay The Studio Version in order to leave me the option to have an unabridged go in due time at the appalling lack of comprehension among "experts" and "professionals", in a possible Uncut (Director’s) Version.

Stoneleigh: The Automatic Earth has been predicting a devastating deflationary period for as long as we've been in existence, and prior to that we did so at The Oil Drum Canada. We have always and consistently said that worrying about inflation in the next few years is completely misguided.

The debt deflation that is already underway will be so destructive to our lives and societies that we must be aware of what is coming in the short term and what we can do to prepare for it, instead of worrying about a possible inflationary period that may or may not follow afterwards.

The deflation issue has recently become much more topical, as the idea is spreading now that the larger trend in the markets has turned down. It is time to review the mechanism and rationale for deflation, given that the mainstream press is suddenly all over it. Like for instance John Hilsenrath in the Wall Street Journal:
Deflation Defies Expectations - and Solutions
The old bogeyman of deflation has re-emerged as a worry for the U.S. economy. Here's something else to fret about: After studying more than a decade of deflation in Japan, economists have slowly realized they have no idea how it works....[..]

"This is the most significant economic issue there is out there," Mr. Gertler says. The good news is that the Fed might not need to fear a Depression-style deflationary spiral. The bad news is that if the U.S. does fall into deflation, it could be stuck there for many years like Japan, and suffer the subpar growth that has gone with it. And because deflation is so poorly understood, policy makers could discover they have no good solutions.

Next, Don Lee has the following in the Los Angeles Times:
U.S. may face deflation, a problem Japan understands too well:
The White House prediction Friday that the deficit would hit a record $1.47 trillion this year poured new fuel on the fiery argument over whether the government should begin cutting back to avoid future inflation or instead keep stimulating the economy to help the still-sputtering recovery. 

But increasingly, economists and other analysts are expressing concern that the United States could be edging closer to a different problem — the kind of deflationary trap that cost Japan more than a decade of growth and economic progress. And as Tokyo's experience suggests, deflation can be at least as tough a problem as the soaring prices of inflation or the financial pain of a traditional recession.

When deflation begins, prices fall. At first that seems like a good thing. But soon, lower prices cut into business profits, and managers begin to trim payrolls. That in turn undermines consumers' buying power, leading to more pressure on profits, jobs and wages — as well as cutbacks in expansion and in the purchase of new plants and equipment.

Also, consumers who are financially able to buy often wait for still lower prices, adding to the deflationary trend. All these factors feed on one another, setting off a downward spiral that can be as hard to escape from as a stall in an airplane.

For now, the dominant theme of the nation's economic policy debate remains centered on the comparative dangers of deficits and inflation. However, economists across the political spectrum — here and abroad — are talking more often about the potential for deflation [..]

But the Fed's chief, Ben Bernanke, appears to think deflation fears are overblown. During his semiannual testimony to Congress last week, he told senators that he didn't view deflation as a near-term risk. In the Fed's latest forecast, core inflation is projected to stay at the current pace this year, then gradually rise toward 1.5% in 2012. Should deflation occur, the central bank has the tools to reverse it, he said. But many question whether the Fed can do much more, given that it already has pushed interest rates to historical lows and pumped more than $1 trillion into the financial system.

Ambrose Evans-Pritchard at The Telegraph has changed his tune significantly in the last month. In June he appeared to believe that, while the situation is dire, the Fed has the tools to combat, and prevent, deflation:
RBS tells clients to prepare for 'monster' money-printing by the Federal Reserve
There is no doubt that the Fed has the tools to stop this. "Sufficient injections of money will ultimately always reverse a deflation," said Bernanke. The question is whether he can muster support for such action in the face of massive popular disgust, a Republican Fronde in Congress, and resistance from the liquidationsists at the Kansas, Philadelphia, and Richmond Feds. If he cannot, we are in grave trouble.
More recently he has been sounding much more alarmed:
Stress-testing Europe's banks won't stave off a deflationary vortex
I suspect that Fed chair Ben Bernanke knows the economy buckled around the Ides of June, but is stymied by hawks at the regional Feds. All he can do for now is to talk down credit costs through hints of more quantitative easing, or QE2. In this he has succeeded. The yield on two-year Treasuries fell to an all-time low of 0.5765pc on Friday. It's Weimar, all right: circa 1931, not 1923.

And Fauxbel -Fake Nobel- laureate Paul Krugman produces the term of the day:
downward nominal wage rigidity literature

which is part of this tortuous (pretend-) academic exercise:
Mysteries Of Deflation (Wonkish):
So here’s the underlying puzzle: since Friedman and Phelps laid out the natural rate hypothesis in the 60s, applied macroeconomics has relied on some kind of inflation-adjusted Phillips curve, along the lines of: Actual inflation = A + B * (output gap) + Expected inflation,  where the output gap is the difference between actual and potential output, and A and B are estimated parameters. (The output gap is closely correlated with the unemployment rate). Expected inflation, in turn, is assumed to reflect recent past experience. 

This relationship predicts falling inflation when the economy is depressed and the output gap is negative, rising inflation when the economy is overheating and the output gap is positive; this prediction works fairly well for modern US experience, explaining in particular the disinflation of the Volcker recession of the 1980s and the disinflation we’re experiencing now.

But here’s the thing: the inflation-adjusted Phillips curve predicts not just deflation, but accelerating deflation in the face of a really prolonged economic slump. Suppose that the economy is sufficiently depressed that with expected inflation at 3 percent, actual inflation comes out only 1; expectations will actually eventually catch up, so that if the economy remains depressed we’d expect inflation to go to -1; but if the economy remains depressed even longer, we’d expect inflation to go to -3, then -5, and so on.

In reality, this doesn’t happen. Prices fell sharply at the beginning of the Great Depression, when the real economy was collapsing; but they began rising again when the economy began to recover, even though there was still a huge negative output gap. Japan has been depressed since before incoming freshmen were born, but its chronic deflation has never turned into a rapid downward spiral.

Stoneleigh: It is surprising how many commenters, many of whom have for the longest time dismissed the possibility of deflation, often in a smugly superior manner, are ignorant of what it actually is. They look at Japan and ask how a country can become mired in a long and drawn-out deflation, and why the Japanese experience is so different from the rapid and accelerating deflationary spiral of the Great Depression.
They assume that central bankers possess the tools to prevent deflation, which suggests that they think those in control in other times or places must simply be too stupid to employ them. If it were so simple to prevent deflation then it would never have occurred anywhere, and yet it has.

Many persist in viewing deflation as a price phenomenon, rather than as the monetary phenomenon it always is. They cling to the notion of the fundamentals driving the credit markets, and then wonder why it is impossible to make accurate predictions. In short, the causation runs the other way. The availability of credit drives the real economy, because credit expansions are Ponzi schemes that generate large swings of positive-feedback (self-fulfilling prophecies) in both directions. It is only the context and scale that are different.

Japan's experience of deflation has been blunted, so far, by the enormous quantity of money that they had available to burn through, which enabled them to put off addressing the bad debt in their banking system, and by the availability of a booming global economy, which allowed them to generate wealth from exporting goods to consumer societies. We do not have these luxuries. In place of a vast pile of money, we have a vast sinkhole of debt at every level - personal, corporate, governmental. 

We will not have the ability to export, partly because we produce very little of value, but also because the global market will not have the purchasing power to allow the export model to survive in any case. We will be fully exposed in the short term to the logic of our credit expansion business model, which creates primarily virtual wealth, whereas Japan was not. We will resemble Argentina (only worse), not Japan.

It is not that deflation is poorly understood, except by the mainstream, which unfortunately includes most economists. There are very clear and comprehensive explanations available for what deflation is and therefore why it is inevitable. We here at TAE have consistently, since our inception, pointed out the mechanism behind this critical aspect of our future. See for instance At the Top of the Great Pyramid, on the nature and critical importance of Ponzi dynamics, or The Big Picture According to TAE

We have pointed out that credit expansion creates multiple and mutually-exclusive claims to the same pieces of underlying wealth-pie, thereby creating a fictitious wealth that will implode once people realize its existence and reality. Deflation is the chaotic elimination of excess claims to underlying real wealth - the collapse of a money supply that has come to be dominated by ephemeral credit and debt.

For those who are interested, one of the most concise formulations of inflation and deflation has been available for many years in the form of JK Galbraith's A Short History of Financial Euphoria, a history of the periodic rediscovery of leverage (and the consequences thereof) written in 1990. It is short, very clear and readable, and highly recommended. Galbraith points out that financial innovation has led to the formation of many bubbles throughout history, and that the collapse of the unpayable debt thereby created, which is deflation by definition, always follows.
JK Galbraith: "A point must be repeated: only the pathological weakness of the financial memory...allows us to believe that the modern experience in any way a new phenomenon."

Our current credit expansion is different only in scale, in quantity, not in quality, from what has happened time and time again in human history.
Robert Prechter, author of Conquer the Crash (2002), has been explaining deflation to anyone who would listen for many years.
A trend of credit expansion has two components: the general willingness to lend and borrow and the general ability of borrowers to pay interest and principal. These components depend respectively upon (1) the trend of people's confidence, i.e., whether both creditors and debtors think that debtors will be able to pay, and (2) the trend of production, which makes it either easier or harder in actuality for debtors to pay. 

So as long as confidence and productivity increase, the supply of credit tends to expand. The expansion of credit ends when the desire or ability to sustain the trend can no longer be maintained. As confidence and productivity decrease, the supply of credit contracts....[..]

When the burden becomes too great for the economy to support and the trend reverses, reductions in lending, spending and production cause debtors to earn less money with which to pay off their debts, so defaults rise. Default and fear of default exacerbate the new trend in psychology, which in turn causes creditors to reduce lending further. A downward "spiral" begins, feeding on pessimism just as the previous boom fed on optimism. The resulting cascade of debt liquidation is a deflationary crash. 

Debts are retired by paying them off, "restructuring" or default. In the first case, no value is lost; in the second, some value; in the third, all value. In desperately trying to raise cash to pay off loans, borrowers bring all kinds of assets to market, including stocks, bonds, commodities and real estate, causing their prices to plummet. The process ends only after the supply of credit falls to a level at which it is collateralized acceptably to the surviving creditors.

(Prechter has a free e-book on deflation available (free registration required) here).

Investment analyst John Mauldin, among others, has recently started to view deflation as a threat, even though he doesn't appear to understand exactly why he should:
Deflation dissected
Saint Milton Friedman taught us that inflation is always and everywhere a monetary phenomenon. That is, if the central bank prints too much money, inflation will ensue. And that is true, up to a point. A central bank, by printing too much money, can bring about inflation and destroy a currency, all things being equal. But that is the tricky part of that equation, because not all things are equal. The pieces of the puzzle can change shape. When the elements of deflation combine in the right order, the central bank can print a boatload of money without bringing about inflation. And we may now be watching that combination come about.

Stoneleigh: The role of credit is not clear here in this excerpt. Inflation is the expansion of the supply of money and credit versus available goods and services. Some 95% (or more) of our money supply is credit, and by no means all of it was created by any central bank. There have been numerous engines of credit expansion during the mania years - fractional reserve banking, the whittling away of reserve requirements, lack of attention paid to credit-worthiness, securitization, derivatives, the development of the shadow banking system, conflict-of-interest at the ratings agencies, fraud etc. When the all-inclusive credit Ponzi scheme crashes - meaning that the overwhelming supply of virtual wealth disappears and we are left with only real wealth - we will have insufficient money to run our global economy. 

When the money supply is inadequate, we will be trying to do the equivalent of running a car with the oil light on, which is to say that we will be trying to run an economy with insufficient lubricant in the engine. Money is the lubricant in the engine of the economy in the same way that oil is the lubricant in the engine of a car. Without enough lubricant, the engine will seize up, and then it will not be possible o connect buyers and sellers purely for want of money, exactly as happened in the Great Depression.

The credit contraction we are seeing is an early warning signal for the real economy. Since the large-scale trend change of late April (counter-trend rallies not withstanding), we are witnessing a change of perspective among the commentators, reflecting a loss of confidence and increased fear. Confidence IS liquidity in a very real sense, and as the contagion of fear spreads, liquidity will disappear. The suspension of disbelief that the long rally brought is over, and that will lead to the next phase of the on-going liquidity crunch.

Some commentators do understand at least part of where we are going and why, like Max Keiser:
The Market Is a Hologram Masking Deflation 
At first it looked like the liquidity stimulus was going to revive the economy and there was an anemic bounce in 2009, but that death rattle has now expired and the primary trend of falling real estate prices, falling wages, and deteriorating bank balance sheets has reasserted itself and threatens to take the economy down again dramatically (read: depression). The question of a 'double dip' is misleading. The economy started down a depressionary slide in 2008 and hasn't looked back.

Stoneleigh: Extend and pretend cannot persist forever. There'll come a time when that proverbial kid will holler: "He has no clothes on!". At some point we will see investors trying to sell distressed assets, and then we will realize what they are actually worth (i.e. what someone will actually pay for them). When we see that they are worth pennies on the dollar, and that whole asset classes need to be repriced overnight, we will see the reality of deflation. That, almost at a stroke, will mark the destruction of the virtual wealth created during the long expansion years.

Deflation Defies Expectations—and Solutions
by Jon Hilsenrath - Wall Street Journal

The old bogeyman of deflation has re-emerged as a worry for the U.S. economy. Here's something else to fret about: After studying more than a decade of deflation in Japan, economists have slowly realized they have no idea how it works. Deflation is usually associated with a Great Depression-like drop in demand. Consumer prices, incomes and asset prices fall. Interest rates go to zero, as low as they can go. As prices and incomes fall, the cost to borrowers of servicing debt does not, sucking life out of the economy and pushing prices down further. A bad situation, in short, gets worse.

In 1932, U.S. consumer prices fell 10% and between 1929 and 1933 they fell 27% in all. But Japan's experience has looked nothing like this. Rather than being deep, destructive and concentrated in a few years, deflation has been a surprisingly mild, drawn-out affair. Consumer prices have been falling in Japan for 15 years, but never by more than 2% in any single year. Japan's deflation has been a morass, but not the destructive downward spiral many economists predicted. Why? And what does it portend for the rest of the world today?

Economists don't have good answers. "We don't know how deflation works," says Adam Posen, a member of the Bank of England's monetary policy committee who has been studying Japan since 1997. "We don't have a way of rationalizing steady, several-year flat deflation," he says. This is a pressing issue for the U.S. Federal Reserve and other central banks. Ireland is already experiencing deflation. Spain has flirted with it. The Fed's preferred inflation gauge was up 1.3% in June from a year earlier, below its informal target of 1.5% to 2%. Some officials worry prices could go negative if the recovery falters.

On paper, Japan looked like a candidate for a deflationary spiral. The economy consistently grew slower than estimates of its capacity to grow. Unemployment rose from 2.1% in the early 1990s to more than 5% a decade later. That growing economic slack should have driven prices down and down. Large burdens of delinquent loans at banks should have exacerbated the debt burden on society. But that didn't happen. Old textbook tradeoffs between unemployment and inflation might not be working the way they used to. The standard Phillips Curve theory, named after Alban William Phillips who helped explain it, is that when unemployment rises, inflation falls.

Fed officials saw evidence in the U.S. before the crisis that this dynamic might have gotten less powerful over time, meaning a big rise in unemployment might not create the kind of deflationary shock it would have in the past. Japan's experience reinforces that view. Mr. Posen cautions that this might help explain short-run shifts in unemployment and inflation behavior, but Japan remains a puzzle because its problems persisted so long. Perhaps economists misread how much slack there was in the economy in the first place.

Another explanation turns on the psychology of households and businesses, which modern economists believe plays a big role in driving inflation. If people believe inflation is going to rise a lot, they will demand higher wages and push up prices. If people believe prices won't move or they expect them to fall, they will act accordingly and create the environment they expect. Japan might be stuck in a slow deflation because over time it is what Japanese households and business became conditioned to expect. Even when the economy recovered between 2002 and 2007, prices kept falling.

Government plays a role, too. Japanese officials responded to their crisis, but many U.S. economists complained officials failed to cut interest rates quickly enough early in the crisis, pulled back fiscal stimulus too soon and were too slow to clean up banks and restructure inefficient industries. Government intervention might have helped to keep Japan's economy from going through the floor, but it might not have been aggressive enough to truly revitalize the economy and set it in a different direction, says Mark Gertler, a New York University economist who studied Japan's malaise with Ben Bernanke in the 1990s.

There are other explanations. Japan's aging consumers, for instance, might have been more inclined to save for retirement and more reluctant to spend, undermining consumer demand and weighing on prices. For the U.S., there are good and bad implications in this. "This is the most significant economic issue there is out there," Mr. Gertler says. The good news is that the Fed might not need to fear a Depression-style deflationary spiral. The bad news is that if the U.S. does fall into deflation, it could be stuck there for many years like Japan, and suffer the subpar growth that has gone with it. And because deflation is so poorly understood, policy makers could discover they have no good solutions.

U.S. may face deflation, a problem Japan understands too well
by Don Lee - Los Angeles Times

The White House prediction Friday that the deficit would hit a record $1.47 trillion this year poured new fuel on the fiery argument over whether the government should begin cutting back to avoid future inflation or instead keep stimulating the economy to help the still-sputtering recovery. But increasingly, economists and other analysts are expressing concern that the United States could be edging closer to a different problem — the kind of deflationary trap that cost Japan more than a decade of growth and economic progress.

And as Tokyo's experience suggests, deflation can be at least as tough a problem as the soaring prices of inflation or the financial pain of a traditional recession.

When deflation begins, prices fall. At first that seems like a good thing. But soon, lower prices cut into business profits, and managers begin to trim payrolls. That in turn undermines consumers' buying power, leading to more pressure on profits, jobs and wages — as well as cutbacks in expansion and in the purchase of new plants and equipment. Also, consumers who are financially able to buy often wait for still lower prices, adding to the deflationary trend. All these factors feed on one another, setting off a downward spiral that can be as hard to escape from as a stall in an airplane.

For now, the dominant theme of the nation's economic policy debate remains centered on the comparative dangers of deficits and inflation. However, economists across the political spectrum — here and abroad — are talking more often about the potential for deflation. So how likely is the problem?

The latest U.S. data are sobering: Consumer prices overall have declined in each of the last three months, putting the inflation index in June just 1.1% above a year earlier. The core inflation rate — a better gauge of where prices are going because it excludes volatile energy and food items — has dropped to a 44-year low of 0.9%. That's well below the 1.5%-to-2% year-over-year inflation that the Federal Reserve likes to see, and some Fed policymakers have raised concerns about the rising risk of a broad decline in prices.

Private economists and financial experts have expressed much greater concern. "I think we have to take it seriously," said John Mauldin, president of Millennium Wave Advisors in Dallas, who puts the probability of deflation at more than 50%. Among the reasons he cites: a lot of unused labor and production capacity, increased savings and the low speed at which money is changing hands. "It's a good bet that by some measures we'll be seeing deflation by some time next year," Paul Krugman, the Nobel laureate economics professor, said this month in his New York Times column. He went on to scold the Fed for standing idle while the nation is "visibly sliding toward deflation."

But the Fed's chief, Ben Bernanke, appears to think deflation fears are overblown. During his semiannual testimony to Congress last week, he told senators that he didn't view deflation as a near-term risk. In the Fed's latest forecast, core inflation is projected to stay at the current pace this year, then gradually rise toward 1.5% in 2012. Should deflation occur, the central bank has the tools to reverse it, he said. But many question whether the Fed can do much more, given that it already has pushed interest rates to historical lows and pumped more than $1 trillion into the financial system.

Also, Bernanke said, America's economy is more vibrant and productive than Japan's was, and its labor force isn't declining, whereas Japan's has been for much of the last decade. Japan also was much slower in addressing problems with its banking sector than the U.S., he said.

Japan's aging population and rigid business and political systems have clearly contributed to the country's long economic malaise, which began in the 1990s. But there are some notable similarities with America's latest economic slump. In both cases, real estate bubbles burst after years of rapid growth and low unemployment, exposing poor loans and serious problems with financial institutions and regulations. In both countries, the crash led to a sharp fall in real estate prices and financial markets and to soaring unemployment.

Yet the scope and economic fundamentals of the two crises are very different, said Richard Katz, editor of the Oriental Economist Report, a New York newsletter focusing on Japan and U.S.-Japan relations. Commercial land prices in Japan's six largest cities soared 500% from 1981 to 1991, Katz said, and the bust took them down below 1981 levels. The U.S. housing slump has been bad, but nowhere near that severe.

And whereas bad debts pervaded Japan's entire economy, Katz argued, the U.S. recession wasn't the result of structural flaws but rather of excesses in the financial system that came from deregulation and other policy mistakes that he sees as correctable. "The policymaking response in the U.S. is better, in part because of the precedence of Japan," Katz said, noting that it took Japan's central bank nearly nine years to do what the Fed in essence did 16 months: bring short-term interest rates to zero.

But like Japan, some analysts suggest, the U.S. is heading into a long period of stagnant growth, in large part because of high unemployment and an overhang of debts that will restrain consumer spending — now at 70% of the nation's gross domestic product. Those factors tend to hold down wages, putting more downward pressure on prices. And once deflation sets in, consumers may hoard cash or try to pay off their debts faster, fueling the downward spiral of spending and growth.

Bernanke said bond-market measures and consumer surveys show little change in expected inflation. "And that stability of inflation expectations is one important factor that will keep inflation from falling very much," he said. Some economists remain skeptical, saying such expectations can turn very quickly or conditions can change in stealthy ways. "People don't see it coming," said John Makin, a visiting scholar at the conservative American Enterprise Institute. He said he doesn't take much stock in consumer surveys about inflation expectations because most people have been ingrained to expect inflation in the future, not deflation.

Makin also thinks some price declines are indirect and not reflected in government reports. Many online retailers now provide free shipping, and more businesses are offering specials such as "buy two, get the third free" — the functional equivalent of price cuts. In one measure that Makin calls a "flashing red light," yields on 10-year Treasury bonds, which rise with inflation worries, have slipped to less than 3% from 4% in April.

Among businesses, many restaurants are feeling the squeeze because they're finding it tough to pass higher costs along to customers. Prices for restaurant food rose 1.2% this June from June 2009, much slower than the 3.8% rise during the year-earlier period. Meanwhile, the purchasing cost for restaurant operators this June was up 4.7% from June 2009, said Hudson Riehle, chief economist at the National Restaurant Assn.

Charlotte Kubsh, a 55-year-old St. Louis-area homemaker, would not be surprised that businesses have little power to raise prices. She said her husband, who works for a trucking firm, didn't get a raise last year. They've long been strong savers, she said, and with their income seemingly frozen, they don't plan any big spending any time soon.

Drip after drip of deflation data
by Ambrose Evans-Pritchard - Telegraph

Today’s release on manufacturing activity by the Richmond Fed is pretty ghastly, as you would expect given that the effects of fiscal stimulus are now wearing off at accelerating pace – before the happy handover to the private sector is safely consummated – and given that the structural East-West imbalances that lay behind the global crisis are getting worse again.
The expectations index for the US 5th District is crumbling:

This follows yesterday’s horrendous fall in the Texas business activity index from the Dallas Fed, which fell from -4 in June to -21 in July. "Thirty-one percent of firms reported a worsening of activity, up from 22 percent in June," said the bank.
  • Texas New Orders were -9.6 in July, -8.2 in June, and +15.8 in May.
  • Capacity Utilization was -0.6 in July, +2.7 in June, and +18.7 in May.

This of course is why Fed chair Ben Bernanke has been giving strong hints of QE2 (helicopters again) if necessary.

Forgive me if I am becoming a "leading indicator" bore but these turning points in the cycle are fascinating. The US Conference Board’s index of consumer confidence fell again in July to 50.4 after plunging in June. "Concerns about business conditions and the labour market are casting a dark cloud over consumers that is not likely to lift until the job market improves. Given consumers’ heightened level of anxiety, along with their pessimistic income outlook and lackluster job growth, retailers are very likely to face a challenging back-to-school season," said the Board.

This follows the fall in the ECRI leading indicator for last week to -10.5, a level that has always been followed by recession in the post-war era. The Economic Cycle Research Institute is careful not to jump the gun, waiting for further confirming data before issuing a formal recession call that would hurt its credibility if proved wrong by events. All of this squares with the fall in truck shipments and rail car loadings over recent weeks.

"What we’re looking at is an invisible wall, which we’ve run into here. Which, essentially, as far as I can see, is a typical pause that occurs in an economic recovery," said Alan Greenspan earlier this month. "I will grant you that this is not a normal economic recovery. We’ve just come out of what I believe is the most extraordinary and virulent global financial crisis that the world has ever seen." "I don’t know where the end game is. Something has got give here. One possibility is there are fewer members of the European Monetary Unit," he told CNBC.

The bond markets behaving in a way that is entirely consistent with these leading indicators. Two-year US Treasuries are still near historic lows at 0.63pc. The 10-year yield is at 3.03pc. Thirty-year mortgage rates have fallen to the lowest ever, which bleeds the profits of banks surviving on the internal "carry trade" – borrowing at super-low short-rates to buy safe agency bonds with a fat yield.

As David Rosenberg at Gluskin Sheff reminds us eloquently every week, the bond markets are telling us that we are already in a deep and intractable depression – which does not preclude Japanese-style rallies, technical recoveries, and bursts of growth, all within a Kondratieff Winter. I have no idea what assets prices will or will not do. My area of curiosity is the global economy, and where it intersects with political, cultural, and historical forces. But here is a note I received today from Tom Porcelli at RBC Captial Markets that puts uber-bullish earnings rhetoric in a proper context.
It seems like on a daily basis the headlines point to yet another company beating earnings expectations. The tally thus far shows 142 companies out of 172 have surprised to the upside for a significant 8pc beat-rate. On the face of it this seems promising.

But the sales figures (i.e. the part that measures organic growth) have been less than stellar. Thus far, they have shown just over 9pc growth versus last year’s figures. But sales were down nearly -14pc in 2Q09 – hardly a tough comp to best! While 68pc of companies have beaten sales estimates, this is hardly anything to get overly excited about. Back in 2Q08, 69pc of companies had beaten sales estimates. We all know where the economy headed shortly thereafter.

The numbers should be taken with a grain of salt. Below the surface, the earnings reports continue to confirm what we have been saying – that this recovery is anaemic at best.

In the end, the global macro economy will dictate the outcome. So watch the Chinese banking system. Watch Japanese exports. Watch OPEC as it keeps cutting output to hold up the oil price. Watch Euribor rates and the continued contraction in eurozone lending to companies. Watch French industrial output. Watch Polish sovereign debt (that’s a new one).

Watch the M3 money supply in the US as it contracts at a 10pc annualized rate. And for goodness sake watch the Fed Board. Then sit in a deep leather arm-chair with a good Calvados, listen to Bach Fugues, and think.

The Deflation Question
by John Mauldin - Thought from the Frontline

The debate over whether we are in for inflation or deflation was alive and well at the Agora Symposium in Vancouver this week. It seems that not everyone is ready to join the deflation-first, then-inflation camp I am currently resident in. We will look at some of the causes of deflation, the elements of deflation, if you will, and see if they are in ascendancy.

For equity investors, this is an important question because, historically, periods of deflation have not been kind to stock markets. Let's come at this week's letter from the side, and see if we can sneak up on some answers.

Even on the road (and maybe especially on the road, as I get more free time on airplanes) I keep up with my rather large reading habit. This week, the theme in various publications was the lack of available credit for small businesses, with plenty of anecdotal evidence. This goes along with the surveys by the National Federation of Independent Businesses, which continue to show a difficult credit market.

Businesses are being forced to scramble for needed investments, generally having to make do with cash flow and working out of profits. This is an interesting quandary for government policy makers, as 75% of the "rich" that will see the Bush tax cuts go away are small businesses.

There was a great graphic (that I now cannot find) showing that all net new jobs of the past two decades have come from small businesses and start-ups. And yet as of now, when structural employment is over 10% (if you count those who were considered to be in the work force just a few months ago), we want to reduce the availability of revenues to the very people we want to be hiring new workers, and who are cash-starved as it is.

It is not just that taxes will go from 35% to just under 40%. It is the increase in Medicare taxes coming down the pike, too. We are taking money from private hands, where it has the potential to increase productivity, and putting it into government hands, where it will do nothing for growth of the economy. There is no multiplier for government spending. And tax increases reduce potential GDP by a multiplier of at least one and maybe three, depending on which study you want to cite.

I understand that taxes have to go up. I get it. But we would be better off having a discussion of where we want to tax dollars to come from before we risk hurting an economy that will barely be growing at 2% in the 4th quarter, and may be well below that. It is the increase in taxes that has me concerned about a double-dip recession.

That being said, the announcement by several prominent Democratic senators that they think we should extend the Bush tax cuts is significant. As I said a few weeks ago, we should not experience a double-dip recession absent policy mistakes. A slow-growth world, yes. But an actual double dip is rare.

If Congress were to extend the Bush tax cuts for at least a year, until the presidential commission on taxes is done with its work and THEN have the debate, it would make me far more optimistic. And it would be quite bullish for stocks, I think. Businesses would know how to plan, at least, for a year, and the economy would be given more time to actually recover. I am not ready to channel my inner Larry Kudlow, but from what we see this summer it would make me more optimistic and reduce the chances of a double-dip recession significantly.

Some Thoughts on Deflation

Inflation in the US is now just below 1%, whether you look at the CPI, the Cleveland Fed's measure, or the Dallas Trimmed Mean CPI. The Fed's favorite, the PCE, is also approaching 1%. The Dallas numbers are a little behind, but they are at all-time lows.

One month PCE

Six month PCE

12 month PCE

The classic definition of deflation is an economic environment that is characterized by inadequate or deficient aggregate demand. Prices in general fall, and normal economic relationships start to fall apart.

Deflation Dissected
by John Mauldin - Thought from the Frontline

I am a big fan of puzzles of all kinds, especially picture puzzles. I love to figure out how the pieces fit together and watch the picture emerge, and have spent many an enjoyable hour at the table struggling to find the missing piece that helps make sense of the pattern.

Perhaps that explains my fascination with economics and investing, as there are no greater puzzles (except possibly the great theological conundrums, or the mind of a woman, about which I have only a few clues).

The great problem with the economic puzzles is that the shapes of the pieces can and will change as they rub against one another. One often finds that fitting two pieces together changes the way they meld with the other pieces you thought were already nailed down, which may of course change the pieces with which they are adjoined; and suddenly your neat economic picture no longer looks anything like the real world.

(Which is why all of the mathematical models make assumptions about variables that allow the models to work, except that what they end up showing is not related to the real world, which is not composed of static variables.)

There are two types of major economic puzzle pieces.

The first are those pieces that represent trends that are inexorable: they will not themselves change, or if they do it will be slowly; but they will force every puzzle piece that touches them to shift, due to the force of their power. Demographic shifts or technology improvements over the long run are examples of this type of puzzle piece.

The second type is what I think of as "balancing trends," or trends that are not inevitable but which, if they come about, will have significant implications. If you place that piece into the puzzle, it too changes the shape of all the pieces of the puzzle around it. And in the economic super-trend puzzle, it can change the shape of other pieces in ways that are not clear.

Deflation is in the latter category. I have often said that when you become a Federal Reserve Bank governor, you are taken into a back room and are given a DNA transplant that makes you viscerally and at all times opposed to deflation. Deflation is a major economic game changer. You can argue, as Gary Shilling does, that there is a good kind of deflation, where rising productivity and other such good things produces a general fall in prices, such as we had in the late 19th century. We have experienced that in the world of technology, where we view it as normal that the price of a computer will fall, even as its quality rises over time.

But that is not the kind of deflation we face today. We face the deflation of the Depression era, and central bankers of the world are united in opposition. As PIMCO Managing Director Paul McCulley quipped to me this spring, when I asked him if he was concerned about inflation, with all the stimulus and printing of money we were facing, "John," he said, "you better hope they can cause some inflation." And he is right. If we don't have a problem with inflation in the future, we are going to have far worse problems to deal with.

Saint Milton Friedman taught us that inflation is always and everywhere a monetary phenomenon. That is, if the central bank prints too much money, inflation will ensue. And that is true, up to a point. A central bank, by printing too much money, can bring about inflation and destroy a currency, all things being equal. But that is the tricky part of that equation, because not all things are equal. The pieces of the puzzle can change shape. When the elements of deflation combine in the right order, the central bank can print a boatload of money without bringing about inflation. And we may now be watching that combination come about.

The Elements of Deflation

Just as every school child knows that water is formed by the two elements of hydrogen and oxygen in a very simple combination we all know as H2O, so deflation has its own elements of composition. Let's look at some of them (in no particular order).

First, there is excess production capacity. It is hard to have pricing power when your competition also has more capacity than he wants, so he prices his product as low as he can to make a profit, but also to get the sale. The world is awash in excess capacity now. Eventually we either grow the economy to utilize that capacity or it will be taken offline through bankruptcy, a reduction in capacity (as when businesses lay off employees), or businesses simply exiting their industries.

I could load the rest of this post with charts showing how low world capacity utilization is, but let's just take one graph, from the U.S. Notice that capacity utilization is roughly in an area that we associate with the bottom of past recessions (with one exception).

Capacity utilization

Deflation is also associated with massive wealth destruction. The credit crisis certainly provided that element. Home prices have dropped in many nations all over the world, with some exceptions, like Canada and Australia. Trillions of dollars of "wealth" has evaporated, no longer available for use. Likewise, the bear market in equities in the developed world has wiped out trillions of dollars in valuation, resulting in rising savings rates as consumers, especially those close to a wanted retirement, try to repair their leaking balance sheets.

And while increased saving is good for an individual, it calls into play Keynes' Paradox of Thrift. That is, while it is good for one person to save, when everyone does it, it decreases consumer spending. And decreased consumer spending (or decreased final demand, in economic terms) means less pricing power for companies and is yet another element of deflation.

Yet another element of deflation is the massive deleveraging that comes with a major credit crisis. Not only are consumers and businesses reducing their debt, banks are reducing their lending. Bank losses (at the last count I saw) are more than $2 trillion and rising.

As an aside, the European bank stress tests were a joke. They assumed no sovereign debt default. Evidently the thought of Greece not paying its debt is just not in the realm of their thinking. There were other deficiencies as well, but that is the most glaring. European banks are still a concern unless the ECB goes ahead and buys all that sovereign debt from the banks, getting it off their balance sheets.

When the money supply is falling in tandem with a slowing velocity of money, that brings up serious deflationary issues. I have dealt with that in recent months, so I won't bring it up again, but it is a significant element of deflation. And it is not just the U.S. Global real broad money growth is close to zero. Deflationary pressures are the norm in the developed world (except for Britain, where inflation is the issue).

Global growth

Falling home prices and a weak housing market are one more element of deflation. This is happening not just in the U.S., but also much of Europe is suffering a real estate crisis. Japan has seen its real estate market fall almost 90% in some cities, and that is part of the reason they have had 20 years with no job growth, and that the nominal GDP is where it was 17 years ago.

In the short run, reducing government spending (in the U.S. at local, state, and federal levels) is deflationary in the short run. Martin Wolfe, in the Financial Times, wrote the following last week (arguing that that the move to "fiscal austerity" is ill-advised):

"We can see two huge threats in front of us. The first is the failure to recognize the strength of the deflationary pressures ... The danger that premature fiscal and monetary tightening will end up tipping the world economy back into recession is not small, even if the largest emerging countries should be well able to protect themselves. The second threat is failure to secure the medium-term structural shifts in fiscal positions, in management of the financial sector and in export-dependency, that are needed if a sustained and healthy global recovery is to occur."

Finally, high and chronic unemployment is deflationary. It reduces final demand as people simply don't have the money to buy things. Deflation that comes from increased productivity is desirable. In the late 1800's the U.S. went through an almost 30-year period of deflation that saw massive improvements in agriculture (the McCormick reaper, etc.) and the ability of producers to get their products to markets through railroads. In fact, too many railroads were built and a number of the companies that built them collapsed. Just as we experienced with the fiber-optic cable build-out, there was soon too much railroad capacity, and freight prices fell. That was bad for the shareholders but good for consumers. It was a time of great economic growth.

But deflation that comes from a lack of pricing power and lower final demand is not good. It hurts the incomes of both employer and employee, and discourages entrepreneurs from increasing their production capacity, and thus employment.

That is why it will be important to watch the CPI numbers even more closely in the coming months. The trend, as noted above, is for lower inflation. If that continues, the Fed will act.

If the U.S. gets into outright deflation, I expect the Fed to react by increasing their assets and by outright monetization, buying treasuries from insurance and other companies, as putting more money into banks when they are not lending does not seem to be helpful as far as deflation is concerned. More mortgages? Corporate debt? Moving out the yield curve? All are options the Fed will consider. We need to be paying attention.

One final thought before I hit the send button. Recessions are by definition deflationary. One of the things we learned from This Time is Different by Rogoff and Reinhart is that economies are more fragile and volatile and that recessions are more frequent after a credit crisis. Further, spending cuts are better than tax increases at improving the health of an economy after a credit crisis.

I think we can take it as a given that there is another recession in front of the U.S. That is the natural order of things. But it would be better to have that inevitable recession as far into the future as possible, and preferably with a little inflationary cushion and some room for active policy responses. A recession next year would be problematic, if not catastrophic. Rates are as low as they can go. Higher deficits are not in the cards. Yet unemployment would shoot up and tax collections go down at all levels of government.

That is why I worry so much about taking the Bush tax cuts away when the economy is weak. Now, maybe those who argue that tax increases don't matter are right. They have their academic studies. But the preponderance of work suggests their studies are flawed and at worst are guilty of data mining (looking for data that supports your already-developed conclusions.)

Professor Michael Boskin wrote recently in the Wall Street Journal:

"The president does not say that economists agree that the high future taxes to finance the stimulus will hurt the economy. (The University of Chicago's Harald Uhlig estimates $3.40 of lost output for every dollar of government spending.) Either the president is not being told of serious alternative viewpoints, or serious viewpoints are defined as only those that support his position. In either case, he is being ill-served by his staff."

I find it very encouraging that there is a movement among Democrats to think about at least postponing the demise of the Bush tax cuts until the economy is in better shape. Those who advocate letting them lapse are in effect operating on our economic body without benefit of anesthesia. If they are wrong, the consequences will be most severe.

We need to think any tax increase through very thoroughly.

The Market Is a Hologram Masking Deflation
by Max Keiser - Huffington Post

Since the global financial crisis started in earnest in 2008, there has been a debate raging in economic circles. Is the economy experiencing inflation or deflation? The first consideration in solving this riddle is to agree on terms. Rising or falling prices at your local grocery store is 'price inflation' but not inflation as defined in terms of an expanding money supply.* In other words, retail prices moving up and down are the secondary effects of an expanding or contracting money supply; the primary component in understanding the 'flations.'

Getting back to what happened in 2008, when the markets hit the skids, the government reacted by increasing the money supply; just as they did after the 1987 crash, the Long Term Capital Management crisis, the dot-com crash, 9/11, and the sub-prime crash. But unlike any of those instances, the money supply kept shrinking and prices kept deflating (notwithstanding the price of a few items).

At first it looked like the liquidity stimulus was going to revive the economy and there was an anemic bounce in 2009, but that death rattle has now expired and the primary trend of falling real estate prices, falling wages, and deteriorating bank balance sheets has reasserted itself and threatens to take the economy down again dramatically (read: depression). The question of a 'double dip' is misleading. The economy started down a depressionary slide in 2008 and hasn't looked back.

Will we ever see inflation? If we're talking about the next 5 to 10 years, the deflationists don't think so. They point to the rise in the bond market and the relatively strong performance of the US dollar. While the inflationists -- licking their wounds after being wrong for years -- believe they will be right eventually. My view is that both camps are basically wrong.

Understand Price Discovery, or lack of it.
Price Discovery -- the result of buyers and sellers simultaneously transacting in the market with the result being Adam Smith's 'Invisible Hand' -- means goods and services move around in the economy at mutually advantageous prices for all. It also means that everyone holding similar items have a benchmark or 'price signal' that tells them what these items are worth.

It is my thesis that the inflation, deflation debate is flawed because we no longer have reliable price signals. The overwhelming domination of program trading on various exchanges has fundamentally changed the way prices are created and represented in the economy. All 'efficient market' theories are dead.

In place of reliable price signals (based on the supply and demand of buying and selling) we have price signals that are generated by computer algorithms; i.e., computers executing program trading, high frequency trading and algorithmic trading -- that account for up to 70% of the trading activity on the NYSE (or 100%, if you consider any shares traded -- not involved in program trading -- can't buck the pricing monopoly of the computers).

Program traders have a virtually infinite line of credit, pay virtually zero commissions, and are backed by banks on Wall St. with strong political connections who are ready to bail out any losing bets these computers make. Plus, the computers are able to do something normal buyers and sellers can't do. They can pick a price they want a security to trade at and then fill in all the necessary trading volume needed to get the price of the security to that point. In other words, you can program computers to rig markets.

In this new rigged market capitalist model, the corrupt bank picks the price it wants a security to trade at and the computers buy and sell with each other until that price is reached; thus providing an audit trail of trades that looks on the surface like actual price discovery. And each price manufactured by computers generates a reaction price in every other security and commodity as the rigged market price signal ripples throughout the interconnected securities market around the world.

What's being masked is that the actual supply of money in the system is falling. The major measures of money supply have all turned down. Credit has evaporated. The velocity of the multiplier effect of fractional reserve lending has disappeared. The volume of fake trades is inflating while the actual supply of money and credit is deflating. In place of an exchange where buyers and sellers transact with each other to their mutual advantage, we now have 'Simflation,' a hologram of fake price signals masking the worst deflationary depression since the 1930's.

The only market that inches higher in real terms at the moment -- as the financial hologram and the U.S. dollar -- the fundamental economic particle of this economic hologram disintegrates -- is gold.
This explains the seeming paradox of gold rising during real deflation. Fake price signals and rigged market capitalism have set the dials of economic monitoring into a Bermuda Triangle of confusion and loss. Only gold points the way out of this mess.

* Austrian School of Money Supply Definition

Wall Street's death wish: Venus vs. Alpha-males
by Paul B. Farrell - MarketWatch

Unless women take control of Wall Street and America, 'The End' is near

Yes, Wall Street has a death wish, secretly trying to self-destruct. Can't stop. Don't get it. Wall Street's culture, mindset, brain, psyche -- whatever you call it -- has a saboteur locked deep in the unconscious. Not only are they hell-bent on self-destruction, they're taking America down with them. Why? It's a "guy thing." Alpha-males have the power. Worse, their death spiral can't end till Venus conquers Mars and its killer instinct -- until we see a new era where women rule not only Wall Street, but Washington and Corporate America. This is a race against time: Alpha-males versus Venus and the feminine mystique. Guys love games. Are women up to it? To win, they must change the rules of the game.

Skepticism surrounds stocks
First, the historical context: Why did we nod yes when we read Stephen Gandel's summary of a new Wall Street in Time? "Of all the causes of the financial crisis, one of the biggest was a power shift on Wall Street that left the traders in charge," and "with a trader, the goal of every minute of every day is to make money ... So if running the economy off the cliff makes you money, you will do it, and you will do it every day of every week."

Traders are the "guy thing" on steroids. Imagine a million little Napoleons. Wall Street's macho ego trip went ballistic after 2008 when they scammed Congress, the Fed and Treasury out of trillions. Then they accelerated to warp speed recently, overpowering Washington, sucking the life out of financial reform with hundreds of millions of dollars and thousands of lobbyists.

Alpha-males: little boys, Oedipus complex, testosterone overdose
The Alpha-males running America are textbook examples of the Oedipus complex in action.

Men? No, inside they're still little boys who secretly want to win mommy's favor by knocking off big daddy.

Basic psychology, except they're overdosing the real world with too much edgy testosterone ... aggressive, arrogant, narcissistic ... bullies on the playground overcompensating for an inferiority complex ... they love games, fights, contests, winning, deals, risks, wars, anything to prove they're king-of-the-hill ... like owning truckloads of money, enough for several lifetimes ... think Liar's Poker, they play for bragging rights, to tell "the guys" how they beat "the other guys" on the playing field ... but psychologically they really are just little boys in big-boy costumes playing "grown-up" ... especially the new breed of Wall Street traders gambling in history's greatest casino, the $700 trillion global shadow banking system for derivatives.

This conclusion needs no esoteric psycho-babble. Anyone who's read "Men Are From Mars, Women Are From Venus" is way ahead of little boys inhabiting the brains of Blankfein, Paulson, Summers, Bernanke, Geithner and all the other so-called leaders whose secret, collective death-\ wish is taking America down with their childish games: Beating daddy, winning mommy's favor. Yes, too much testosterone is killing our world.

In our 'Denial of Death can we 'Escape from Evil'
Yes, Wall Street's in a death spiral that's accelerated rapidly since my investment banking days at Morgan Stanley. My first year I read "The Denial of Death" and "Escape from Evil" by Pulitzer Prize-winning psychologist Ernest Becker. Recently I was drawn back, reread them. They reveal Wall Street's dark secret, their psychological pathology.

How? Becker goes deeper than Wall Street's aggressive, narcissistic and dangerously obsessive inner child. Becker's views expose Wall Street's blind, insatiable death wish ... why it exists ... why they deny it ... why it's growing ... and ultimately why this "guy thing," their out-of-control macho testosterone culture is hell-bent on more than self-destruction ... why Wall Street secretly wants to destroy American capitalism and democracy ... and why, unless Venus conquers Mars ... unless women gain more power on Wall Street, Washington and Corporate America ... unless a new collective Venus triggers a paradigm shift, soon ... Mars, Wall Street, the Alpha-male will continue winning ... and killing capitalism and democracy.

Becker's opening paragraph cuts deep: "The prospect of death ... woefully concentrates the mind ... the idea of death, the fear of it, haunts the human animal like nothing else. It is the mainspring of human activity -- activity designed largely to avoid the fatality of death, to overcome it by denying in some way that it is the final destiny of man."

Get it? Humans will do anything to avoid death. Hate thinking about death. "The Denial of Death" exposes the sin Wall Street is hiding. Our hatred of death. "Emotional Intelligence" author Daniel Goleman, captured this overpowering human fear in "Vital Lies, Simple Truths: The Psychology of Self-Deception:" "Thousands of years ago in the ancient epic, the "Mahabharatta," a sage poses a riddle, 'What is the greatest wonder of the world.' The answer: 'That no one, though he sees others dying all around, believes he will die.'"

Achieve immorality: Be a hero, bury your terror of death
The philosopher Sam Keen, author of thought-provoking works as "Fire in the Belly" and "Faces of the Enemy," builds on this eternal truth in his foreword to Becker's book, challenging us to read and deny his message, if we can:
"The world is terrifying ... the basic motivation of human behavior is our biological need to control our basic anxiety, to deny the terror of death. Human beings are naturally anxious because we are ultimately helpless and abandoned in a world where we are fated to die ... the terror of death is so overwhelming we conspire to keep it unconscious ... Every child borrows power from adults and creates a personality by introjecting the qualities of the godlike being. If I am my all-powerful father, I will not die."

So we bury this "terror of death" deep in our minds. Then we cover the grave with heroic ventures, in a world where everyone is playing this same game: "Society provides a second line of defense against our natural impotence by creating a hero system that allows us to believe that we transcend death by participating in something of lasting worth. We achieve ersatz immortality by sacrificing ourselves ... conquer an empire ... build a temple ... write a book ... establish a family ... accumulate a fortune ... further progress and prosperity ... create an information society and a global free market." Why? Because "the main task of human life to become heroic and transcend death."

In the broader context, "The Denial of Death" exposes how "businesses and nations may be driven by unconscious motives that have little to do with their stated goals" where "making a killing in business has less to do with economic need or political reality than with the need for assuring that we have achieved something of lasting worth." Warning, there are untended consequences: Even "heroic projects that are aimed at destroying evil have the paradoxical effect of bringing more evil into the world."

Why? Because "the root of all humanly caused evil ... is our need to gain self-esteem, deny mortality, and achieve a heroic self-image." In short, the sad irony is that as individuals and as a nation, armed with modern technology, our insatiable hero rituals are actually accelerating us faster toward what we so elaborately try to deny ... our inevitable death.

Our last great hope: Venus rules with powerful new women leaders
"Men are from Mars, Women from Venus" is more than a self-help slogan. When working on an earlier book, "The Millionaire Code," my research revealed a key fact about gender personalities: 75% of men had left-brain characteristics -- logical, rational, math, science, systems, concrete facts, details, objective, ordered, knowledge, strategies, impulsive, authoritative, rules, analytical, practical, pattern-seeking, safety, focused on the past, on today, short-term thinkers, warriors. That's the "guy thing" on steroids, the aggressive, narcissistic Alpha-male, the inner-little boy with an unresolved Oedipus complex.

On the other hand, 75% of women tend to have right-brain characteristics: Intuitive, subjective, meaning, philosophical, feelings, creativity, imagination, images and symbols, possibilities, alternatives, forward-thinking, more aware of the future, with a strong sense of long-term benefits and consequences, the big picture, peacemakers.

But unfortunately, Alpha-males, left-brain thinkers run America, get us into messes, like 2008's meltdown. Legendary money manager, Jeremy Grantham, whose firm manages $106 billion worldwide, said it best in an early 2008 quarterly letter commenting on how America's governmental and banking leaders are "impatient ... management types who focus on what they are doing this quarter or this annual budget."

Grantham warns that long-term leadership "requires more people with a historical perspective who are more thoughtful and more right-brained ... but we end up with an army of left-brained immediate doers. So it's more or less guaranteed that every time we get an outlying, obscure event that has never happened before in history, they are always to miss it." Our leaders have loser-brains.

Yes, America is a nation ruled by Alpha-males with a death wish, yet blind to their fatal self-destructive flaw. The warnings are everywhere, loud. But once again, few will listen. As Grantham put it, "the three or four dozen-odd characters screaming about it are always going to be ignored," much as Greenspan, Paulson, Bernanke and Congress did for many years before the 2008 meltdown. Our Alpha-male leaders always ignore signs of a coming system failure, denying every new, bigger meltdown and collapse ... until it's too late.

Can we dodge our fate? Redirect the "guy thing?" America is ruled by high-testosterone Marsian, Alpha-male little boys motivated by a killer instinct and an Oedipus complex, trapped in a myopic left-brain culture. The only way to avoid America's fate would be a shocking paradigm shift creating a new consciousness that thrusts more right-brain thinkers -- more women -- into leadership roles. But will it happen in time? Long odds.

The Aftermath of the Global Housing Bubble Chokes the World Banking System. Only a Coordinated Loan Massacre Could Defeat a Japanese-Style Dead-and-Dying-of-Debt Kamikaze. Hell Approaches Us All, But Only For An Extended Period
by Michael David White -

Sometimes the complexity of the world is a ruse, and seeing the overwhelming future of our fortunes is strangely simple. Our past and future credit crisis is but one case in point. Remember when fear and failure wrecked markets wising up to the fallout of debt given to anybody for anything, but especially for buying houses?

Naturally our financial leaders around the world took the radical steps required to reduce the debt created in a massive credit bubble. Oh, sorry, that was my fantasy world I was talking about. What our leaders are doing is correcting a severe cyclical recession. What our reporters are doing is covering a severe cyclical recession. What sublime kabuki theater.

Back in the real world, the destruction of debt required to cure a credit bubble hasn’t been done. That means the reason for the new credit crisis is no different than during that past time of fear and failure – except that now we have new magnificent malignant clusters of sovereign debt serving as a sort of hand-held fan covering the unclothed emperor. Does that count as cover?


There is a prism I use to see the world. It is in houses. Look immediately above to see housing prices (the global housing bubble chart). Let me tell what I see when I look at this: We had one wicked housing bubble in the United States, but apparently we were the conservative party poopers. It looks like the funner countries are Ireland, Britain, Spain, Sweden, France, Norway, Denmark and Italy.

I know mortgages are used to buy houses. Yet they also represent not just the largest financial asset category, but the use of debt to buy anything including companies and commercial real estate and credit-card receivables. What are the futures of these debt assets? If we know the fate of mortgages do we know the fate of them all?

Oh and I also wonder about the sovereign kind? Luckily those debts are backed by the likes of honest hard-working Greeks who live to protect their impeccable reputation for being always good-and-true to their word. “Pass the Ouzo Aristotle. Do you have a cigarette? Did you have to pay any taxes this year?”

The strange case (Or is it the normal case?) is the residential mortgage market in the United States. Look immediately above. Values of the equity asset have fallen more than 30 percent, but the values of the debt asset (mortgages) used to buy the equity asset (homes) have fallen two percent. Both of these investments have a right to title to the same asset, but one has fallen FIFTEEN TIMES further than the other. Is this the real world or is it make believe?


While it’s possible that this anomaly may hold, the 15 percent of residential mortgage borrowers who are now behind points toward the debt mortgage balances and the equity home values moving closer to each other.

That’s a complicated way of saying that mortgage balances logically should fall in value in a ratio very much like the fall in value of the house asset itself. Has not happened yet, but isn’t it true that the world is logical?

We know that the fall in property values is real and we know that the United States bubble in values was far greater than any bubble of the last 120 years (See chart above and pay close attention to the amazing “X” bubble. That’s historical.). Thus now do you see the pattern of Armageddon gathering force and deciding when and where to explode and paint a picture of gore all across the world.

The American market in housing went totally off the deep end. A flood of negative equity now invades our land. Yet look yonder to strange and distant shores. Look at Italy and Denmark and Norway and France and Sweden and Spain and Great Britain and Ireland.


Their real estate market got bubbled worse than ours, but surely their central bank and treasury are more honest, courageous, and knowledgeable than ours?

Oh, I’m sorry. That’s another scary discovery. Admit the ruthless incompetence of the Fed and the Treasury in the management of our massive credit bubble, but give them credit for being rather like the publishers of Consumer Reports where their evasions and deceptions are surely trivial when compared to old world freaks like Italy and Spain who publish Penthouse for its unending internet offshoots. Did you read the prospectus?


Just when you think it’s impossible for dishonesty to be taken to the next level in the American housing market, you see a chart like this one, which, if true, means that bank-owned properties are being held like abandoned castles (See the chart above showing huge numbers of bank-owned properties lying hidden in your local bank’s burka. The banks owns the properties, but they don’t sell the properties.). I had always assumed that the shadow inventory was just bungling bankers failing to stay on top of their foreclosure cases. I didn’t think of the sale of a foreclosure as boiling poison and certain death. Then I saw this chart and interpreted it as an executioner’s song titled “My Bank Sold My Home and Went Belly Up Big Time. Ain’t Pay Back a Bitch”.

One on top of the other, I saw then this stupendous headline in Forbes: "Six Giant Banks Made $51 Billion Last Year; The Other 980 Lost Money."

And then I said to myself: "Well, if I owned a bank and my bank would go out of business if I sold my foreclosure collateral, would I just hold it then to live for another day?" The answer was obvious: Yes, I would just hold it like an old abandoned castle.


It takes me aback. It staggers me. Our housing market is a true obstacle course for an honest thinker. The federal government is making every mortgage loan to forestall radical crashing, and our local banks are pretending to solvency by going into the castle and museum business (holding foreclosures as investments).

My suggestion therefore is that you look in to the John Paulson subprime-mortgage trade. Read up on what that was all about. See if there is some form of echo housing-bust credit-crisis high-multiple sovereign-credit-default derivative which you can use to really get the chance to do it big this time. This is the best trade ever. It’s easy. It’s obvious. It’s real.

The center cannot hold. America is a bubble, and no plan has been suggested to kill the bubble debt. The world is a bigger bubble, and no word has started the global debt-destruction project. It’s like the whole world has turned Japanese (I really think so.).

We and the world and the debt behind mania will break. Hell will rule then, but remember, we will only have to live with it for an extended period.

Europe's €30 trillion funding headache
by Ambrose Evans-Pritchard - Telegraph

European banks have amassed €30 trillion in liabilities and face a serious funding threat over the next two years as authorities withdraw emergency support, according to a new report by Standard & Poor's. The rating agency said banks are at risk of a vicious circle as sovereign debt fears and financial stress feed off each other. "Banking sector woes are eroding sovereign credit-worthiness, which is in turn reducing the real and perceived capacity of governments to support weak banks," said S&P.

"The collective funding needs of Europe's banks are vast. The industry is much larger than America's or Asia's. Most of their mortgages and other personal loans stay on their balance sheets and require funding. This contrasts with the US, where financial institutions securitize (these) loans and which do not require balance sheet funding," said Scott Bugie, S&P's credit strategist. Total liabilities are €23 trillion for the eurozone and €8 trillion for the UK, Sweden, and Denmark.
S&P said the European Central Bank's emergency lending had inadvertently created a snare. Its three-month loans have had the effect of concentrating roll-over risk for large amounts of debt. Banks will eventually have to refund these loans in a crowded market, competing with debt-hungry states. "ECB loans have contributed to a shortening of liability maturities. The result is a growing funding mismatch for the European banking industry. This is happening as regulators prepare to introduce tougher liquidity standards. This is one of the greatest vulnerabilities of the industry," it said.

The Netherlands has already ended state debt guarantees, forcing its banks to go the market as bonds fall due. Others are following suit. Roughly €1 trillion of such debt in the eurozone and Britain will come due by 2012. "The need to refinance the maturing guaranteed-debt looms over many banks," said the agency. Stronger banks can cope: weaker ones will be left floundering in "a two-tier funding market".

S&P said Greek banks have seen a leakage of €10bn to €20bn in customer deposits since the crisis began, or 5pc to 10pc of the total. They are shut out of the capital markets. The ECB is propping up the country with €140bn of exposure to Greek debt in one form or another. It has €126bn of exposure to Spain and €71bn to Ireland, mostly in loans to weaker lender such as Spain's cajas. The exit from this will be a minefield.

The EU's €750bn "shock and awe" rescue has gained time but not conjured away underlying concerns about the fiscal health of the EU states themselves. The report came as the ECB's latest bank survey showed that credit conditions had tightened sharply in the second quarter, with a net 11pc of lenders restricting loans. The survey was carried out in late June, after the €750bn rescue but before the stress tests for banks.

"What it shows is that the sovereign debt crisis had a measurable effect on lending," said Silvio Peruzzu from RBS, adding that rebound will lose steam if the banks are unable to boost lending as companies exhaust their cash buffers and start to borrow again. "There is a risk of a double-dip in 2011." Mr Peruzzo said the eurozone is at a delicate juncture. Germany has been powering ahead, lifting the much of the eurozone with it, but the recovery is not yet entrenched. There are signs of a slowdown in the US and Asia that could prove infectious.

The risk is that a renewed growth lapse would put the spotlight back on the austerity policies in Club Med. "Fiscal consolidation is not a one-off event. They go on for years. If down the line the markets start to question the debt trajectories of these countries, the banking systems will be tested again. There is €1 trillion of private debt in Spain linked to just one asset: property," he said. Much depends on whether the global recovery lasts long enough to lift Europe's weakest states off the reefs, rescuing their banking systems.

Consumer Confidence Falls As Corporate Profits Rise
by Anne d'Innocenzio - Huffington Post

The disconnect between Wall Street and Main Street is growing. Americans' confidence in the economy faded further in July, according to a monthly survey released Tuesday, amid job worries and skimpy wage growth. That's at odds with Wall Street's recent rally fueled by upbeat earnings reports from big businesses such as chemical maker DuPont Co. and equipment maker Caterpillar Inc. That's because the pumped-up profits are being fueled by cost cuts like layoffs and overseas sales. In fact, big companies have shown few signs they're ready to hire.

The Consumer Confidence Index came in at 50.4 in July, a steeper-than-expected decline from the revised 54.3 in June, according to a survey the Conference Board. The decline follows last month's decline of nearly 10 points, from 62.7 in May, and is the lowest point since February. It takes a reading of 90 to indicate a healthy economy – a level not seen since the recession began in December 2007. "Consumers have a much different view of the economy than the stock market does, and their views matter more to the economy," said Mark Vitner, an economist at Wells Fargo. The index "tells me the economy is heading for slower growth in the second half. We have low expectations for back-to-school."

Joel Naroff, president of Naroff Economic Advisors, agreed, noting that the fatter profits have shown that companies have been able to squeeze out higher productivity from workers, but that also means that "households are not benefiting." The profit picture is "good news for Wall Street, but not good for workers," he added.

The survey was taken July 1-21, beginning just before the Standard & Poor's 500 index hit a nine-month low of 1,022.58 on July 2. It had risen 4.5 percent by July 21 and has since climbed an additional 4 percent as upbeat earnings reports from key manufacturers have made investors more convinced that the economic recovery isn't stalling as much as they had originally thought. The Dow Jones industrial average rose 12 points Tuesday, although broader stock measures slipped, after three days of big gains, as investors digested the confidence data as well as a slowdown in regional manufacturing reported by the Richmond Federal Reserve. Stocks rose moderately at the open because of strong earnings from chemical maker DuPont Co. and European banks UBS and Deutsche Bank.

DuPont, which has announced thousands of job cuts over the past year, reported that second-quarter income nearly tripled, as revenue surged in most of its businesses. The results were led by revenue gains in the Asia Pacific region. DuPont didn't announce any hiring plans.

A rapid, sustainable recovery can't happen without the American consumer. And the second straight month of declining confidence following three months of increases is worrisome, economists say. Economists watch confidence closely because consumer spending accounts for about 70 percent of U.S. economic activity and is critical to a strong rebound. Both components of the index declined. They measure how people feel about the economy now, and their expectations for the next six months.

The index – which measures how Americans feel about business conditions, the job market and the next six months – had been recovering fitfully since hitting an all-time low of 25.3 in February 2009. The index typically falls before the economy slows down, and on the way out of a recession, the expectations component, which accounts for 60 percent of index, rises sharply, said Lynn Franco, director of The Conference Board Consumer Research Center. "It's all about jobs. That's still the primary source of income," Franco said. "Until we see the pace of job growth pick up and consumers are confident that this is sustainable, we are not likely to see a significant pickup in confidence."

The Conference Board survey, based on a random survey mailed to 5,000 households, showed that consumers' assessment of the job market was more negative than the month before. Those claiming that jobs are "hard to get" increased to 45.8 from 43.5 percent, while those saying jobs are "plentiful" remained unchanged at 4.3 percent. Michelle Banks, 38, a teacher from Bloomfield, N.J., said she's more worried about job security than she was last year because of rampant state budget cuts. So she started saving money for back-to-school items for her 5-year-old son in January. She plans to spend $200, evenly divided between school supplies and clothing. "I'm buying clothes that will last, not fall apart," she said.

Economists say the index's expectations component tends to track stock market movements, but Vitner noted that the market's big plunge in May has made such an imprint on consumers that the recent rebound hasn't registered. Retailers had a surprisingly solid start to the year, but business has been slowing since April. With unemployment stuck near 10 percent, Americans are expected to remain skittish through the back-to-school and Christmas season.

Concerns are also rising about the housing market. While the S&P/Case-Shiller 20-city home price index released Tuesday showed a 1.3 percent rise in May from April, the home buyer's tax credit, which expired April 30, helped pull more buyers into the market. In fact, the report warned that the recent gains in home prices are not likely to last.

Deficits Don’t Matter as Geithner Gets Lowest Yield
by Daniel Kruger and Rebecca Christie - Bloomberg

For all the criticism of record budget deficits, President Barack Obama can take comfort knowing that for the first time in half a century, government bond yields are declining during an economic expansion and Treasury Secretary Timothy F. Geithner is selling two-year notes with the lowest interest rates ever. The combination of record-low yields on two-year notes, 10- year rates below 3 percent and a deficit projected to surpass $1.4 trillion for a second consecutive year is a signal that the bond market is less concerned with government spending than with getting the economy back on track.

"The U.S. has been granted more time," said Anthony Crescenzi, a portfolio manager and strategist in Newport Beach, California, at Pacific Investment Management Co., which oversees more than $1 trillion in assets. "Because of the concerns in Europe, money has flowed to the U.S., and so it does allow the U.S. to play the game for longer, and kick the can down the road on deficit reduction."

Yields on two-year notes fell to 0.5516 percent on July 23, the lowest since regular sales of the securities began in 1975, on signs the expansion that began in the third quarter of 2009 is losing steam. Ten-year yields dropped to a 15-month low of 2.85 percent on July 21 as Federal Reserve Chairman Ben S. Bernanke said the economic outlook is "unusually uncertain" and the central bank is prepared to take more policy actions.

Highest on Record
While investors forced European governments to cut spending and grapple with their sovereign debt crisis and pushed yields on two-year Greek debt to 18 percent, demand at Treasury auctions is the highest on record. By keeping borrowing costs near record lows, investors are providing the Obama administration with the opportunity to pursue additional stimulus measures before demanding a reduction in the deficit.

Yields on 10-year notes rose 7 basis points last week to 2.99 percent as higher-than-estimated corporate profits reduced concerns the economy may drop back into recession. Rates on the notes are still down from a high for the year of 4 percent on April 5, according to BGCantor Market Data. Two-year yields ended last week at 0.58 percent. The 10-year yield rose 1 basis point to 3 percent at 10:23 a.m. in New York.

Lowest Since 1955
The last time yields were this low as the economy expanded was in 1955, when Ray Kroc founded McDonald’s Corp. and Bill Haley’s ‘Rock Around The Clock’ topped the music charts. The 10- year note yield averaged 2.65 percent that year, according to monthly data compiled by the Fed, while the economy grew 6.4 percent, consumer prices for the year declined 0.4 percent and the government ran a fourth consecutive budget deficit.

That period has similarities with today in that bank demand for the most easily traded assets helped hold 10-year yields below 3 percent for most of the 1950s, said David Jones, 72, who rose to vice chairman during his 30 years at Aubrey G. Lanston & Co., one of the original primary dealers that trade with the central bank. It differs in that "we’re coming out of this great crisis," said Jones, who serves as a consultant from Denver. "You can contrast that with the post-World War II period where economic potential seemed limitless."

Investor Concerns
Investors are concerned that the recovery will falter more than a year after Obama signed the $787 billion stimulus package and the Fed cut its target interest rate for overnight loans between banks to a range of zero to 0.25 percent. The Obama administration so far has pushed for targeted additional aid, and some economists anticipate the government will be required to enact further stimulus measures.

"Expectations of growth over the next couple of years have indeed come down," Alan Blinder, former Fed vice chairman, and economics professor at Princeton University, said in a telephone interview. "There is still plenty of fear out there in the world financial markets, which has investors all over the world scurrying into Treasuries, even though they get paid very little." Average increases of 100,000 private sector jobs a month this year has been "insufficient to reduce the unemployment rate materially," Bernanke said before the Senate Banking Committee July 21. The Fed cut its growth outlook as Europe’s fiscal crisis has led to "a broad-based withdrawal from risk- taking in global financial markets," he said.

Open Letter
Blinder joined Nobel prize-winning economist Joseph Stiglitz and Mark Zandi, chief economist at Moody’s, in signing an open letter calling on the government to increase spending to bolster the economy, published July 19 by the Daily Beast website. "There’s definitely room in the economy" for more stimulus, said Blinder, who worked with Bernanke when he was chairman of Princeton’s economics department from 1996 to 2002.

Critics of U.S. spending plans, such as Wall Street financier Peter G. Peterson, say debt is the biggest threat to Americans’ future well-being. Peterson has committed $1 billion of the fortune he made as co-founder of the New York-based private-equity firm Blackstone Group LP to raising the alarm about the $13 trillion national debt. The U.S. economy grew at a 2.5 percent annual rate in the second quarter, down from the 2.7 percent in the prior three months, the Commerce Department will report July 30, according to the median estimate of 68 contributors in a Bloomberg survey.

More Optimistic
Equity investors are more optimistic. U.S. stocks rose last week, almost wiping out the Dow Jones Industrial Average’s 2010 loss, after better-than-estimated earnings at companies from United Parcel Service Inc. to Apple Inc. and Ford Motor Co. Treasury investors would accept more stimulus without driving yields higher "if there’s a credible longer-term plan to cut the deficit," said Christopher Bury, co-head of fixed- income rates in New York at Jefferies & Co., one of the 18 primary dealers that are also required to bid on Treasury sales.

"The populist view is that the government has essentially saved the banking industry, saved Wall Street, but at what cost," Bury said. "If they’re going to come back with more stimulus it’s got to be targeted more towards Main Street." The Obama administration has said it will target assistance to state governments and small business lending. So far, there are no plans for a broader stimulus program, like last year’s, whose cost the Congressional Budget Office revised to $862 billion in January.

Treasury said in May that it had "flexibility" in financing a budget deficit the Obama administration projected would reach $1.47 trillion this fiscal year, which ends on Sept. 30. In a survey provided to the Treasury before the May auctions, bond dealers predicted a $1.38 trillion shortfall in fiscal year 2010 and a $1.18 trillion deficit in 2011. The U.S. has already begun scaling back debt auctions, and will end July having sold $173 billion of fixed-coupon notes and bonds compared with $192 billion in April. Demand has risen 18 percent this year to a record high, with bidders offering $2.95 for every dollar of debt sold compared with $2.50 last year, Treasury data compiled by Bloomberg show.

Government debt has returned 5.7 percent this year, the best performance at this point since 1995, according to Bank of America Merrill Lynch indexes. The rally has been led by investors seeking longer-term securities as inflation excluding food and energy prices held at a 44-year low since April. The difference between yields on two- and 10-year notes narrowed to 2.42 percentage points last week from a record 2.94 percentage points in February. The U.S. budget deficit in 2009 was 9.9 percent of GDP on Sept. 30, the end of the fiscal year, compared with a six-year high of 7.4 percent in Japan. The ratio in Japan peaked at 11 percent in 1998.

Trimmed Forecasts
Fed policy makers trimmed their forecasts for growth and raised unemployment projections at their June 22-23 meeting. For 2011, officials expect growth ranging from 3.5 percent to 4.2 percent, down from 3.4 percent to 4.5 percent, and a fourth- quarter unemployment rate of 8.3 percent to 8.7 percent, up from 8.1 percent to 8.5 percent. "If we continue to see weaker data I think we can continue to see yields go lower," said Michael Materasso, co-chairman of the fixed-income policy committee at Franklin Templeton Investments in New York, which oversees $215 billion of bonds. "The concern is if reports come in too weak that it really upsets the equity markets as well as the credit markets. You may have a risk-off trade and it becomes more solely a Treasury rally."

Global Growth
Geithner said low interest rates show markets want the U.S. to focus on growth instead of agonizing over short-term spending. In his meetings with Group of 20 policy makers this year, the Treasury secretary has pushed for global growth to take priority over concerns in all but the most cash-strapped nations. The U.S. will eventually need to rein in its deficit, Geithner said in a July 21 interview on the Charlie Rose show. Because that fact is so accepted, markets are not pressuring the U.S. to make the kinds of immediate cuts required in Spain, Portugal and Greece.

"If you look at financial markets, say, look at how much the Treasury is paying to borrow today, there is a lot of confidence, not just of Americans but investors around the world, that we’re going to find the political way to do it," Geithner said. "There’s no alternative for us. We’ll be able to do that."

Nassim Taleb: Government Deficits Could Be the Next 'Black Swan'
by Ben Steverman - Bloomberg

The Black Swan: The Impact of the Highly Improbable is a philosophical treatise on uncertainty that managed both to entertain readers and to predict the financial meltdown of 2008. Nassim Nicholas Taleb—the book's author, who is also a trader and university professor—has reissued his 2007 best seller in a second edition that includes a new 73-page essay, "On Robustness and Fragility." interviewed Taleb in early July about his views on investing and the dangerous Black Swans—i.e. unpredictable events with big consequences—that could lie in wait for financial markets. Edited excerpts from the conversation follow:

Q: The new edition of The Black Swan includes what you call "10 principles for a Black-Swan robust society." One of them is: "Citizens should not depend on financial assets as a repository of value and should not rely on fallible 'expert' advice for their retirement." Can you explain what you mean?
The problem is that citizens are being led to invest in securities they don't understand by people who themselves don't quite understand the risks involved. The stock market is probably the best thing in the world, but the true risks of the stock market are vastly greater than the representations. And this leads to extremely strange situations in which, say, someone has a bakery, is extremely paranoid about suppliers, very careful about risks, and protects his business with appropriate insurance. Then, at some point, he puts his $122,000 in savings in a fund that he knows nothing about, based on risk measures he knows nothing about, in companies very few people know much about.

People use "risk measures," but you're really not measuring anything like you measure temperature or distance. You are making a speculative assessment of a future event. That's not measuring, that's estimating. And as we saw with BP, with the banking system, and with Toyota, companies themselves are hiding risks from the security analysts. They're cutting corners. Companies have a tendency to hide risks. So someone extremely careful and prudent in the management of his own affairs will be completely careless with the half of his savings invested in the stock market. I'm saying: Don't use the stock market as a repository of value. It has vastly more risks than you think.

I was at an investment conference last week with mutual fund managers and financial advisers. There were a surprising number of mentions of the possibility of "Black Swans," and your name came up. Do you think those people understand the concept?
No, they don't get it. My Black Swan idea is very different: There are events that you can't forecast, and you need to be robust to these events. If I think that someone doesn't understand Black Swans, I'm sure that whatever bad news happens to him will be Black Swans for him but "white swans" for me.

What should you do with your savings?
We have this culture of financialization. People think they need to make money with their savings rather with their own business. So you end up with dentists who are more traders than dentists. A dentist should drill teeth and use whatever he does in the stock market for entertainment.

People should have three sources of variation in their income. The first one is their own business that they understand rather well. Focus on that. The second one is their savings. Make sure you preserve them. The third portion is the speculative portion: Whatever you are willing to lose, you can invest in whatever you want. In the second category—preservation of value—you should have the consciousness that there is something called inflation. You should avoid some classes of investments that are very fragile.

What are are potential sources of fragility or danger that you're keeping an eye on?
The massive one is government deficits. As an analogy: You often have planes landing two hours late. In some cases, when you have volcanos, you can land two or three weeks late. How often have you landed two hours early? Never. It's the same with deficits. The errors tend to go one way rather than the other. When I wrote The Black Swan, I realized there was a huge bias in the way people estimate deficits and make forecasts. Typically things costs more, which is chronic. Governments that try to shoot for a surplus hardly ever reach it.

The problem is getting runaway. It's becoming a pure Ponzi scheme. It's very nonlinear: You need more and more debt just to stay where you are. And what broke [convicted financier Bernard] Madoff is going to break governments. They need to find new suckers all the time. And unfortunately the world has run out of suckers.

You're saying that what is supposed to be the safest place to invest, government debt, is in some ways the most dangerous?
Unless you invest in your own home currency in very short-term Treasury bills. Because governments can print more of their own currency, the risk comes from a rise in interest rates rather than a government default. When you have hyperinflation, deficits, or debt problems, with short-term bills you can catch higher interest rates to compensate you for the inflation or whatever return you've missed.

I think some people get confused about Black Swans and think you're saying that you can't predict what's going to happen. But you can see some big consequential events coming down the road.
A Black Swan for the turkey is not a Black Swan for the butcher. For someone very naïve, some events may be Black Swans. For someone warned, they're not going to be Black Swans if you know they can be possible and you hedge against them.

Do you have any thoughts on the U.S. financial reform package?
I don't like complicated regulation. I think we should not need financial reform. What we need is definancialization. What we need to do is break the financial community's grip on society. And you can do it very easily by transformation of debt into equity. Banks have an interest in building debt, but equity in society is vastly more stable than debt. So the problems have not been addressed. They're making something that was complicated even more complicated. We need some fundamental reforms rather than a very, very precise guideline on how you should behave.

What are you working on now?
My next [book] is about beliefs, mostly. How we are suckers and how to live in a world we don't understand.

World splits in two as East tightens while West stays super-loose
by Ambrose Evans-Pritchard - Telegraph

India has raised interest rates and issued a stark warning on inflation dangers, joining China, Brazil, and other tiger economies in concerted moves to tighten policy. The central bank raised its reverse repo rate a half point to 4.5pc, still far below the level of inflation. Food prices have been rising at 16pc. "Inflationary pressures have exacerbated and become generalized. Real policy rates are not consistent with the strong growth that the economy has been witnessing. It is imperative that we continue to normalise our policy," said the bank, which also raised its repurchase rate a quarter point to 5.75pc.
"The bank is fiddling while Rome burns: this is little more than a token gesture," said Maya Bhandari from Lombard Street Research. The combined fiscal deficit of the central government, states, and hidden subsidies has been running at 11pc, despite a boom that has flattered the deficit figures when adjusted for the cycle. Ms Bhandari said rises in public wages have increasingly been "monetised" by the ultra-loose policies of the central bank. Inflation is now at risk of spiralling out of control. Primary articles inflation, watched as a leading indicator, is already at 16.5pc.

India has run into serious capacity constraints, relying on rickety infrastructure and an outdated energy grid that cannot sustain break-neck industrialization. By contrast, China has invested heavily in roads, railways, airports, and power plants. Its excess credit growth has created a different set of threats, chiefly a property bubble in key cities and an overhang of bad debts from local governments. The central bank is using "financial repression" to curb property speculation, but strains are already emerging. A banking regulator said almost a quarter of $1.1 trillion of loans to local governments are at risk of default.

Brazil has gone furthest in slamming on the brakes, raising rates last week by half a point to 10.75pc. "Brazil’s central bank is the most aggressive in the world right now," said Daniel Tenengauzer from Bank of America. "We expect a big drop in BRICS growth (Brazil, Russia, India, China) from monetary tightening. Asia seems most vulnerable to a global growth slowdown because it is the most leveraged region," he said. The ratio of credit to GDP has reached 127pc in China. The bank has cut its growth forecast next year to 9pc for China and 4pc for Brazil.

Australia has raised rates five times already since the financial crisis. Malaysia, Korea, and Thailand have also tightened. Israel raised rates for the fourth time this week to 1.75pc to choke off a housing bubble. The contrast with convalescent OECD states in the West has rarely been starker. Both the US Federal Reserve and the Bank of England have hinted at further asset purchases or quantitative easing if the recovery falters over coming months.

Meanwhile, the European Central Bank began to buy sovereign debt for the first time in May to support the bond markets of Greece, Portugal, and Spain. The concern is that the emerging world will be forced to tighten even harder before the West has recovered enough to pick up the growth baton. That would risk tipping Europe and the US into deflation.

What's next for housing finance, Fannie and Freddie?
by Kevin G. Hall - McClatchy Newspapers

With the overhaul of financial regulation in the bag, the Obama administration Tuesday said it'll focus next on housing finance — another key cause of the recent deep economic downturn — with an eye to deciding the fate of mortgage finance titans Fannie Mae and Freddie Mac. The administration said in a statement that it would hold a Conference on the Future of Housing Finance at the Treasury Department on Aug. 17. It'll seek input for legislation to reform the rules governing mortgage finance and the markets for bonds backed by U.S. mortgages.

The Bush administration placed Fannie Mae and Freddie Mac in government conservatorship in September 2008. Uncertainty about what to do with them was ostensibly the reason why most Republicans voted against the recent overhaul of financial regulations. The White House pledged Tuesday to send Congress legislation in January to revamp housing finance.

"The future of our housing finance system is critical not only to our economic recovery, but also to millions of American homeowners in every corner of our country," said Treasury Secretary Timothy Geithner in the statement. "The Obama administration is committed to delivering a comprehensive reform proposal that protects taxpayers, institutes tough oversight, restores the long-term health of our housing market, and strengthens our nation's economic recovery."

The announcement didn't quiet critics. "Better later than never," said Alex J. Pollock, a scholar at the American Enterprise Institute, a conservative research group. "It is still my opinion that you cannot write a 2,300 page bill and not address Fannie and Freddie on the somewhat dubious excuse that it is too complicated." President Barack Obama has said he'd tackle Fannie and Freddie, which are both chartered by Congress, separately from Wall Street, reluctant to make significant changes while the housing market remains weak and continues to slow the economic recovery. Existing home sales fell 5.1 percent in June and are expected to decline again this month. Most economic analysts now expect the housing market to bottom in 2011, five years after the crisis began.

Fannie Mae was created in 1938 to boost home ownership after the Great Depression, while Freddie Mac was created in 1970 to provide more competition to Fannie Mae. The two congressionally chartered private entities traditionally buy mortgages originated by lenders and pool them into bonds backed by U.S. mortgages. This frees banks and other mortgage lenders from having to retain the loans on their books, and allows them to keep lending to homebuyers. Together, Fannie and Freddie guarantee about 31 million U.S. mortgages, collectively representing roughly $5 trillion in mortgage debt.

Early in this decade, Wall Street banks aggressively pushed their own secondary market for mortgage bonds, called private-label mortgage-backed securities. These banks captured significant market share from Fannie and Freddie, in part because lending standards eroded significantly and Wall Street entities had looser controls and fewer demands on mortgage originators than did the quasi-government entities. Together the Wall Street banks, Fannie and Freddie supported a massive and ultimately unsustainable expansion in homeownership during the first half of the past decade. When the national housing market began to implode in 2006, reverberations shook housing finance to its core and led the government to seize Fannie and Freddie.

Big players in mortgage bonds on Wall Street, namely investment banks Bear Stearns and Lehman Brothers, collapsed in 2008. Investors in Fannie and Freddie mortgage bonds, once thought as safe as Treasury bonds, began clamoring for an explicit government guarantee. These financial instruments were always thought to be implicitly backed by the U.S. government. Absent an explicit guarantee, investors began to shun this vital secondary market, which is needed for U.S. housing finance to function. Then-Treasury Secretary Henry Paulson concluded that if investors were to get such a guarantee, then Fannie and Freddie should be in government hands.

"Our economy and our markets will not recover until the bulk of this housing correction is behind us," Paulson said on Sept. 7, 2008, announcing the historic government takeover. "Fannie Mae and Freddie Mac are critical to turning the corner on housing. Therefore, the primary mission of these enterprises now will be to proactively work to increase the availability of mortgage finance" for ordinary Americans.

At the time, Paulson said Fannie and Freddie would buy up even more mortgages in 2009, and then begin to shrink their portfolio of mortgage bonds by 10 percent a year beginning in 2010. However, the housing downturn has been so severe and the crisis in credit markets so deep that the private sector's secondary market remains shut. That's left Fannie and Freddie the only game in town — the only place for mortgage originators to unload their loans in order to keep lending to homeowners.

"Continuing to provide financial support to Fannie Mae and Freddie Mac was the right decision then for the mortgage market and for our economic recovery — and it has played a critical role in stabilizing the housing industry during a period of crisis," said Jeffrey Goldstein, Treasury undersecretary for domestic finance, in a White House blog Tuesday. "Even today, private capital has not yet fully returned to this market. Fannie Mae, Freddie Mac and other government entities guarantee more than 90 percent of newly originated mortgages. They are practically the only game in town."

Critics of Fannie and Freddie want the government eventually out of the mortgage finance business. "At the end of this thing, there needs to be a private conforming mortgage market. It's never existed," Pollock said. He said that conventional mortgages given to safe borrowers should be pooled together by private firms. Fannie and Freddie's advantage as quasi-government entities allowed them to bundle the safest loans that represented the brunt of the mortgage market.

Appearing Sunday morning on NBC, Geithner envisioned some government role at the end of the housing-finance overhaul process. "I think we're not going to preserve Fannie and Freddie in anything like their current form. We're going to have to bring fundamental change to that market. But I think there's going to be a good case for taking a look at a preserving or putting in place a carefully designed guarantee so, again, homeowners have the ability to borrow to finance a home even in a very difficult recession," he said.

Who They Are
Federal National Mortgage Association, or Fannie Mae: Created in 1938 during the Great Depression era to promote home ownership through purchases of mortgages insured by the Federal Housing Administration. In 1968, it was taken off the federal budget and made into a congressionally chartered private corporation owned by shareholders. In 1970, it was authorized to buy private mortgages.

Federal Home Loan Mortgage Corporation, or Freddie Mac: Created by Congress in 1970 to compete with Fannie Mae and foster a more robust secondary market.

How They Operate
Fannie and Freddie purchase mortgages from banks and other mortgage lenders, pooling those home loans for sale in a secondary mortgage market as a special bond, called a mortgage-backed security. This secondary market for loans means lenders don't have to hold a loan on their books, freeing them up to do more lending to home buyers.

Their Impact
Together, Fannie and Freddie today guarantee about 31 million U.S. mortgages. Those mortgages represent a combined $5 trillion in mortgage debt. With the private sector impaired, Fannie and Freddie currently repurchase roughly 9 out of every 10 new mortgages.j

Stock Buying Hits Bull Market Record at Mutual Funds
by Lynn Thomasson - Bloomberg

Mutual funds, pensions and endowments are spending more on stocks than at any time since the start of the bull market, just as individuals grow the most pessimistic in a year.
Institutions pushed equities up to 68 percent of their holdings in July, the highest level in 15 months, from 63 percent in April, a Citigroup Inc. survey showed. The ratio of bullish to bearish respondents in a survey by the American Association of Individual Investors has fallen to 0.68, the lowest level since July 2009, based on a four-week average.

The last time money managers and individuals were this far apart was at the beginning of 2009, before the Standard & Poor’s 500 Index began its 63 percent rally, according to data compiled by Bloomberg. It may signal another buying opportunity after concern the U.S. economy will fall into a recession wiped out $1.5 trillion from American equity values since April, according to Fritz Meyer, a Denver-based senior market strategist at Invesco Ltd., which oversees $558 billion. "That’s good news," Meyer said. "The retail guy has gotten it wrong more than gotten it right. The odds favor a continued, reasonably healthy economic expansion."

Economic Expansion
The U.S. equity benchmark has posted an average return of 8.8 percent in the 12 months after individuals’ skepticism rose this high in the past 23 years, according to data compiled by Bloomberg. Bulls are betting that forecasts for the fastest U.S. profit growth in 15 years and economic expansion averaging 3 percent through 2012 will help equities recover after the S&P 500 fell 13 percent in May and June.

Stocks rallied today after new-home sales in the U.S. topped the median economist forecast and FedEx Corp., the Memphis, Tennessee-based package-delivery company, raised its earnings projection. The S&P 500 climbed 1.1 percent to a one- month high of 1,115.01 at 4 p.m. New York time. Bonds are a better investment than stocks, Jamil Baz, who helps oversee $23 billion as chief investment strategist for London-based hedge fund GLG Partners LP, told Bloomberg Television’s "InsideTrack" on July 22. Government reports this month showing private employers in the U.S. added fewer jobs than forecast in June and the lowest level of housing starts in eight months raised concern the economic recovery will falter.

UPS Forecast
Equities advanced last week as the S&P 500 gained 3.6 percent, poised for the biggest monthly increase since July 2009. Companies from Atlanta-based United Parcel Service Inc., the world’s largest package-delivery company, to Dallas-based AT&T Inc., the biggest U.S. phone company, climbed after increasing profit forecasts. The rally trimmed the index’s loss since April 23 to 9.4 percent. Equities slid the most since the bull market began in May and June on concern Europe’s debt crisis would derail the global economic recovery. Shares rebounded in the past three weeks as 84 percent of the 149 S&P 500 companies that reported results since July 12 topped the average analyst earnings estimates, Bloomberg data show.

Profits may rise an average 35 percent in 2010 and 17 percent in 2011, according to forecasts tracked by Bloomberg. More than 160 S&P 500 companies are scheduled to post quarterly results this week, including Irving, Texas-based Exxon Mobil Corp., the biggest U.S. oil producer.

Market Rout
Confidence among smaller investors was shaken by the May 6 plunge that erased $862 billion from the market value of U.S. stocks in 20 minutes and the last bear market, said Frederic Dickson, chief market strategist at D.A. Davidson & Co. Professional investors are more likely to base decisions on the prospects for the biggest two-year advance in earnings among S&P 500 companies since 1995, according to Invesco’s Meyer.

"My money is on the institutions getting it right," said John Lynch, chief equity strategist at the Wells Fargo Funds Management division of San Francisco-based Wells Fargo & Co. that oversees $465 billion. Smaller investors "are reluctant to get back in until there is a clearer path, and we know that once the path is clear, it becomes a ‘greater-fool’ theory because the institutions will have already anticipated it." The AAII measure of pessimism peaked on July 8 at 57 percent, the most since March 5, 2009. Bullishness has averaged 29 percent during the past four weeks, compared with 45 percent who were bearish, according to the weekly survey.

Start of Rally
The last time optimism fell this low relative to pessimism was July 17, 2009, one week after the S&P 500 began a 27 percent rally through today, data compiled by AAII and Bloomberg show. The Chicago-based group takes answers from a few hundred people each week through its website on whether they are bullish, bearish or neutral on the stock market for the next six months, according to editor Charles Rotblut.

"Individual investors were spooked by the May 6 flash crash and they’re wondering if the stock market is a fair game," said Dickson, chief market strategist at Great Falls, Montana-based D.A. Davidson, which oversees $25 billion. "Professionals realize there have been changes in the market to prevent a repeat of that. I don’t think that’s been communicated broadly to the retail investor." The May 6 selloff briefly sent the Dow Jones Industrial Average down 9.2 percent, the biggest intraday loss since 1987, before it pared the drop to 3.2 percent. A "mismatch of liquidity," selling in exchange-traded funds that fed into stocks, and the use of market orders turned an orderly decline into a rout, a report by federal regulators said May 18.

SEC Test
The Securities and Exchange Commission is testing a program through December that pauses trading for 5 minutes when an S&P 500 stock rises or falls 10 percent or more in less than 5 minutes. U.S. exchanges also offered rules last month to standardize the process for canceling erroneous stock trades. Individuals may limit gains in the S&P 500 as concerns about the economy and Europe’s debt crisis keep them out of the market, said Leo Grohowski of BNY Mellon Wealth Management. Federal Reserve Chairman Ben S. Bernanke said the economic outlook remains "unusually uncertain" in testimony to the Senate Banking Committee on July 21.

Investors have withdrawn $41.2 billion from mutual funds that hold U.S. stocks since April 2009, while piling more than $470 billion into bond funds, according to data compiled by the Washington-based Investment Company Institute. Individuals accounted for the majority of U.S. mutual fund assets in 2009, owning 84 percent, the data show.

Hedge Funds
Hedge funds that wager on both gains and losses in equities have boosted speculation shares will fall, according to Bank of America Corp. The lightly regulated private pools of capital have on average 27 percent more money in bets on rising prices than falling prices, below the historical average of 35 percent to 40 percent, based on data from the Charlotte, North Carolina- based bank.

"You’re seeing equities struggle because valuations and fundamentals look pretty good to the institutional investor, but the policy headwinds, the questions around sovereign debt, the macro concerns, are really worrying individual investors," said Grohowski, who oversees more than $150 billion as chief investment officer at BNY Mellon Wealth Management in Boston. "There’s not one right and one wrong. We think the market is pretty reasonably valued." The S&P 500 trades at 15.4 times annual earnings, compared with an average of 16.5, according to data compiled by Bloomberg that dates back to 1954. The index is cheaper relative to estimated earnings for the next 12 months, with a multiple of 12.2, the data show.

Stocks Rally
Mutual funds, endowments, hedge funds and pensions say they’re preparing for a rally, according to Citigroup’s questionnaire from 120 respondents among those groups. Fifty- four percent said U.S. equities may gain 10 percent to 20 percent, compared with 50 percent in the previous reading.

Bill Miller, chairman and chief investment officer of Legg Mason Capital Management, said in a letter to investors last week that this is a "once-in-a-lifetime opportunity" to buy stocks of large U.S. companies. BlackRock Inc., the world’s largest asset manager, is "overweight" U.S. equities, said Bob Doll, vice chairman and chief equity strategist of the New York- based firm in a July 20 interview on Bloomberg Television’s "Morning Call with Susan Li."

"It’s been the individual investor that’s been a good contrarian indicator," said Mark Luschini, chief investment strategist at Janney Montgomery Scott LLC, which oversees $50 billion in Philadelphia. "The stock market will continue to advance. It may be a grinding process, but it will continue to advance, ultimately pulling along retail investors that are notorious for buying high and selling low."

HAMP Report Revised After Analysts Question New Metric
by Shahien Nasiripour - Huffington Post

The Obama administration has revised its latest monthly report on its signature foreclosure-prevention plan, deleting a heavily-criticized performance metric used to measure whether assisted homeowners are re-defaulting on their taxpayer-financed mortgages. The Treasury Department claims that Fannie Mae, which administers its Home Affordable Modification Program, screwed up. As a consequence, the public can no longer tell whether homeowners with HAMP modifications, which limits monthly payments to 31 percent of income, are being placed in sustainable mortgages. A voicemail message left on the cellphone of a Fannie Mae spokesman seeking comment was not returned.

The report on the Home Affordable Modification Program -- an effort promised to lower mortgage payments for three to four million Americans -- details the number of homeowners who have signed up for trial modifications, how many have received five-year mods, the number of homeowners bounced from the program, also known as HAMP, and the amount of money the affected homeowners are saving, among other metrics. However, one key detail -- the pace at which HAMP homeowners are falling behind on their new lower monthly payments and re-defaulting -- had been missing until last week, when the administration unveiled it in its report on the program's progress through June.

The rate was remarkably low, which raised eyebrows among some housing analysts. While about 42 percent of homeowners in mortgages modified prior to HAMP had fallen at least 60 days delinquent six months after their mortgages were altered, the administration reported that just under six percent of HAMP homeowners were at least 60 days late six months after their mortgages were modified, according to data maintained by federal bank regulators and the Treasury Department. Six months is considered to be a key metric for judging homeowners' ability to keep up with payments. Herbert M. Allison Jr., Treasury's assistant secretary for financial stability, highlighted the rate on a conference call with reporters last week, praising it as "very low."

In an otherwise bleak report on the state of the program -- more homeowners have been bounced from HAMP than have received permanent relief -- the re-default rate was seen as overwhelmingly positive. But economists and Wall Street analysts weren't impressed. In a Wednesday note to clients, Sandeep Bordia and Jasraj Vaidya of Barclays Capital wrote that the data was "misleading." Celia Chen, an economist and specialist in housing for Moody's, said in an interview that the incredibly low re-default rate "just doesn't sound right to me."

The problem they identified had to do with how Treasury was calculating the rate. In the report, Treasury stated that a "HAMP permanent modification is canceled for nonpayment if it is more than 90 days delinquent." To the Barclays Capital analysts, it appeared that Treasury was thus not including those homeowners with five-year modifications who were kicked out of the program. More than 8,600 homeowners have been bounced from HAMP. The Barclays analysts said the move made the re-default rate look "too low" and "fail[s] to capture the full magnitude of re-defaults from these modifications." Treasury caught on.

"Subsequent to releasing the report, Treasury received inquiries regarding the calculation methodology used in this table," spokesman Mark Paustenbach said Tuesday. "These inquiries were related to the treatment of modifications that are cancelled from HAMP and ultimately become ineligible for TARP incentives after 90 days delinquency. "In an effort to review and better explain the methodology, we learned from our program administrator, Fannie Mae, that not all cancelled loans were included in the underlying information provided to Treasury," Paustenbach continued. "The error caused inconsistent reporting of permanent modifications during the snapshots reported. These omissions have impacted our previous analysis... with respect to the performance of HAMP permanent modifications."

A Treasury official added that the agency had approved a methodology that included cancelled modifications, but Fannie Mae's coding error led to those mods not being included in their calculation of re-default rates. The official added that Treasury will release the revised data when it's confident in its accuracy.

Some dated figures are available, though. Through March, federal bank regulators report that about 7.7 percent of HAMP homeowners were 60 or more days delinquent on their modified mortgages three months after the modified mortgage took effect. Overall, 11.3 percent of modifications completed during the last three months of 2009 were at least 60 days late after three months, according to the June 23 report by the Office of the Comptroller of the Currency and the Office of Thrift Supervision.

Mortgages modified during the fourth quarter of 2009 have exhibited lower re-default rates, bank regulators note. By comparison, homeowners with reworked loans during the fourth quarter of 2008 were falling at least 60 days behind on their payments after three months at a 29.9 percent clip. Regulators attribute the lower re-default rates to the significantly lower payments newly-modified loans require, according to their June 23 report. Experts say HAMP played a large role in the change.

In place of the now-deleted table, in a revised report posted Monday to their Web site, Treasury said:

"Since the Making Home Affordable report was posted on July 20th, Fannie Mae, which administers the program, has reported to Treasury an issue in its implementation of the delinquency statistic methodology used to report performance of permanent modifications. Fannie Mae is now revising the data, and Treasury has retained a third-party consultant to provide additional review and validation. Upon completion of that independent review, a revised table will be provided."

Meanwhile, last month analysts at Fitch Ratings projected that as many as 75 percent of HAMP modifications will ultimately result in re-default -- despite the lower monthly payments. In their note last week, the Barclays analysts said they're sticking to their original re-default projection of about 60 percent.

'Systemic risk' theory gains in stature as way to prevent the next bubble
by Howard Schneider - Washington Post

Americans might be counting on the day when home and retirement-fund values start to rise again, but anyone expecting to benefit from a future boom in prices should take note: Economic policymakers around the world are looking for ways to make sure that doesn't happen, or at least not with such intensity that it risks the kind of bust that usually follows.

In studying how to respond to the recent crisis and create a more stable system, central bankers, international officials and others have been focusing on a concept known as "systemic risk." That's the type of falling-domino problem that allowed mortgage defaults in the United States to lock up the global financial system because of the complex connections among banks, investment companies, insurers and other firms around the world. The phenomenon is not fully understood.

"We sort of know vaguely what systemic risk is and what factors might relate to it. But to argue that it is a well-developed science at this point is overstating the fact," said Raghuram Rajan, a former International Monetary Fund chief economist and author of "Fault Lines," which explored the role of U.S. real estate and credit bubbles in the crisis. A recent IMF paper described study of the field as "in its infancy." Still, some central bankers and regulators are devising ways to try to control systemic risk, and one of the things they are focusing on is its connection to fast run-ups in the prices of real estate or other investments, or a quick expansion of credit and lending.

When to step in?
Before the recent crisis, regulators assumed that markets with large numbers of people with enough information and the ability to move money freely could assess the risks of different investments and look out for themselves. That thinking guided U.S. policy under then-Federal Reserve Chairman Alan Greenspan, creating the conditions that allowed millions of Americans to buy homes and borrow money under loose credit terms. Sometimes consumers profited if they sold property at the right time, but sometimes they became saddled, along with their bankers, with unaffordable mortgages or houses that declined sharply in value.

But that approach did not adequately account for systemic risk. Policymakers in the United States and Europe and at organizations such as the IMF are discussing how government agencies could best step in when markets appear to get overheated. It is not easy to tell the difference between a risky "bubble" and a healthy economic expansion, and confusing one for the other could mean slower growth and lost opportunities.

Yet the cost of the recent crisis in terms of lost production and high unemployment has convinced a broad array of officials, regulators and analysts that government should do more to "lean against" markets that are thought to be growing too fast, and in the process try to ensure that the United States, Europe and other key areas don't again surge in an unsustainable way -- or crash in the aftermath.

"The benefits of successfully moderating both phases of the credit and asset price cycle are clearly worth pursuing," the Switzerland-based Bank for International Settlement said in a recent report. The BIS serves as a grouping of the world's major central banks, including the U.S. Federal Reserve, and is an influential voice in financial regulation. The current discussion involves some of the basic principles of how markets should work in a post-crisis age. It throws open a range of sensitive questions such as whether the Fed and other central banks should use interest rates or other tools for such actions as restraining home prices that are judged to be rising too fast.

"I think there has been a massive change in the debate," said Andrew Smithers, founder of the London-based Smithers & Co. economic consultancy. "Simply ignoring asset prices is so demonstrably silly that it will not carry on either side of the Atlantic." Although Fed Chairman Ben S. Bernanke and others speak warily about using interest rates or the other "very blunt" tools of the central bank to address problems in specific parts of the economy, he also has said he remains "open-minded" to the idea.

Other ideas under discussion include imposing higher capital requirements on banks under certain conditions to slow lending, as well as steps such as forcing potential home buyers to make larger down payments -- familiar to Asian regulators who have had to cope with rapid increases in real estate values.

A new bureaucracy
Overheated markets or dangerous levels of credit and borrowing are hardly pressing issues in the current climate, in which concern is centered on keeping a shaky recovery on track in the United States and Europe. But the attention given systemic risk is apparent in the new bureaucracy growing up around it. The legislation signed into law last week by President Obama includes a Financial Stability Oversight Council, with powers to study and move against possible sources of systemic risk in the United States.

Europe is establishing a European Systemic Risk Board; the BIS has set up a Financial Stability Board to study and make recommendations about the issue; and the IMF has proposed a central role for itself in monitoring systemic risk on a global scale. In recent papers, both the IMF and the BIS discussed the chance that a wrong policy choice might slow otherwise healthy economic growth. But they also said the depth of the recent downturn showed that central banks and other government agencies need to expand their traditional focus on such issues as inflation and employment, and to be more attuned to controlling systemic risk and ensuring general financial stability.

Central banks in the developed world have learned how to keep prices stable, but "there was a gaping hole in the system," which ignored financial stability concerns, IMF financial counselor Jose Vinals wrote in a recent essay. Although he said central banks need to keep inflation as their chief focus on monetary policy, he also called for "more 'leaning' in good times and the need for 'less cleaning' in bad times once bubbles explode."

Spain shines on stress test, Germany flunks
by Ambrose Evans-Pritchard - Telegraph

Europe's stress tests for banks have greatly reduced pressure on Spanish lenders but have so far done little to ease broader strains in the interbank credit markets. Three-month Euribor rates have crept up to a one-year high of 0.889pc. The "Libor-OIS spread", watched as a key gauge of stress in the system, also nudged up to 26 basis points. The refusal of some Landesbanken and German lenders to reveal exposure to EMU sovereign debt has raised suspicions that they have something to hide. Credit default swaps measuring bond risk jumped from 140 to 150 points for HSH Nordbank, with smaller rises for LB Berlin (154), West LB (127), Norddeutssche LB (125) and Deutsche Postbank (121).
If the original purpose of the tests was to unlock interbank lending and head off an incipient credit crunch, the jury is still out. A report last week by the International Monetary Fund said eurozone lending had "nosedived" during the global crisis and "has yet to recover". The IMF said this was asphyxiating small business, which generates most job growth. As analysts sift through the wealth of new detail from the tests, they are baffled by the chaotic criteria.

"We have a ludicrous worst-case scenario that Greek house prices fall by 2pc in 2011: when you first read it you think their must be a typo," said David Owen from Jefferies Fixed Income. Austria's worst-case is a 2.7pc rise in house prices, or zero for Poland, and -2pc for Italy. Mr Owen said these assumptions would be demolished by a serious recession. Yet the tests assume that all eurozone states would contract at the same rate in a downturn. In reality, Club Med states and Ireland would almost certainly fare worse since they are already coping with the triple effects of debt-deleveraging, lost competitiveness, and fiscal tightening.

Spain was rewarded by the markets for the high quality of its tests, which cover 95 of its banks and include a 28pc fall from peak-to-trough for finished houses, and 61pc for development land. Yields on 10-year Spanish bonds dropped 11 basis points to 4.24pc on Monday, outperforming the eurozone. The cost of bond insurance fell for Spanish Cajas. These savings banks are already being restructured. The US buy-out firm JC Flowers has agreed to inject €450m (£377m) into Banca Civica.

Bank of America said in its half-year global outlook that the stress tests had cleared the air. "Today is the beginning of a return to normality," it said. "Greece is staging an impressive fiscal turn-around. Spain has come through its July peak funding with flying colours. Europe can and will get its problems under control," said Holger Schmieding, chief Europe economist. Dr Schmieding said a slowdown over coming months will be a breathing spell in an entrenched upswing as Europe enjoys the benefits of a competitive euro – and from "pro-growth" fiscal discipline based on spending cuts. "The eurozone is poised to enjoy a major cyclical rebound," he said.

Yet views remain polarized. Alastair Whitfield from RBC said a large number of lenders would have failed if the Tier 1 capital ratio had been raised from 6 to a more credible 7, including Deutsche Post Bank, Monte dei Paschi, Espirito Santo, Piraeus, and Allied Irish. Credit Suisse said the entire Greek banking system and a string other lenders would have failed if "core" Tier 1 had been used, disallowing hybrid capital. At least the results provide analysts with a wealth of data on Europe's banks, which is a key step to restoring trust. "We can all conduct our own stress tests now," said Mr Owen.

Spain is caught up in self-delusion
by Desmond Lachman - Financial Times

A basic problem in the eurozone’s periphery is that it is experiencing a commonplace emerging market-style crisis – yet its policymakers are oblivious to that fact. This recent observation, from an old hand in emerging markets at the International Monetary Fund, is perhaps nowhere truer than in Spain, where a virtual sudden stop in foreign bank lending has forced the country to become highly dependent on European Central Bank borrowing to stay afloat.

On Wall Street trading desks, the joke used to be that the longest river in the emerging markets was De-Nile. Yet in a manner disturbingly all too reminiscent of Greece earlier this year, the Spanish authorities appear to have deluded themselves into believing that the Spanish economy is about to rebound and that Spain can muddle through without an IMF-European Union bail-out package.

Denial is also all too much in evidence with respect to the Spanish banks. The Spanish authorities keep up the pretence that their banking system is sound and they engage in shameless loan-loss forbearance to paper over the system’s difficulties. Sadly, in this endeavour they now seem to be being aided and abetted by the recently released results of the stress test for eurozone banks. By confining itself to singling out five relatively small Spanish saving and loan banks as unsound, that test gives the overall Spanish banking system a virtual clean bill of health. And it does so despite the system’s patent overexposure to the very troubled construction sector.

The Spanish authorities justifiably take great pride in how well they managed the country’s public finances prior to the 2008-2009 Great Recession. They point to the small budget surpluses Spain recorded prior to the crisis as well as to Spain’s relatively low ratio of public debt to gross domestic product.

In stressing these positives, however, the Spanish authorities happily gloss over the fact that Spain experienced a massive housing boom in the past decade, which saw a trebling in Spanish home prices and an increase in the construction sector to a staggering 18 per cent of the economy. The Spanish authorities also prefer to ignore how Spain managed to lose about 20 per cent in international competitiveness*. That loss in competitiveness contributed to a ballooning in Spain’s external current account deficit and to an increase in its gross external debt to around 135 per cent of GDP.

Since September 2008, the bursting of the Spanish housing bubble together with the onset of the Great Recession has revealed the weak underbelly of the Spanish economy. As housing-related tax revenue collections plummeted, Spain’s budget position dramatically swung from a small surplus to an 11? per cent of GDP deficit by 2009. At the same time, in large measure due to structural rigidities in the labour market, unemployment surged from less than 10 per cent prior to the crisis to more than 20 per cent at present.

More disturbing still, the incipient housing market bust has drawn market attention to the fact that the Spanish banks in general, and the cajas in particular, are overly exposed to Spain’s crumbling housing sector. Construction loans made by the Spanish banking system are estimated to be the equivalent of 45 per cent of the country’s GDP. Unsettled by this large exposure, foreign banks have virtually stopped lending to Spanish banks and companies. This has forced the ECB to have to rediscount about €125bn ($162bn, £104bn) in Spanish bank loans to forestall a full-blown Spanish funding crisis.

Spain now finds itself in a similar conceptual predicament to that faced by Greece. It is forced to engage in severe budget-cutting to bring its budget deficit down to a more sustainable level without the benefit of a cheaper currency to boost exports so as to cushion the economic blow of budget retrenchment. Similarly, Spain is forced to go down the painful path of price deflation to restore international competitiveness even though that path will compound the country’s public and private debt problems.

Further complicating Spain’s policy challenges is the fact that Spain will have to engage in serious budget tightening at a time when unemployment is already at about 20 per cent and when the domestic housing bust still has a long way to go. After having run up threefold, Spanish home prices have only declined by about 15 per cent to date.

Trying to talk up the markets is the right thing for the Spanish authorities to do provided they do not fall into the trap of believing their own rhetoric. It would be very much more constructive were Spanish policymakers to recognise the huge policy challenges that lie ahead and were they to go soon to the IMF for much needed financial support. It would also help if they took serious measures to recapitalise their savings and loan banks.

As the Greek authorities painfully learnt earlier this year, it is better to get ahead of the policy curve than to wait for the markets to force a country to have to approach the IMF in the midst of a full-blown financing crisis.

The Death of Paper Money
by Ambrose Evans-Pritchard - Telegraph

As they prepare for holiday reading in Tuscany, City bankers are buying up rare copies of an obscure book on the mechanics of Weimar inflation published in 1974. Ebay is offering a well-thumbed volume of "Dying of Money: Lessons of the Great German and American Inflations" at a starting bid of $699 (shipping free.. thanks a lot). The crucial passage comes in Chapter 17 entitled "Velocity". Each big inflation -- whether the early 1920s in Germany, or the Korean and Vietnam wars in the US -- starts with a passive expansion of the quantity money. This sits inert for a surprisingly long time. Asset prices may go up, but latent price inflation is disguised. The effect is much like lighter fuel on a camp fire before the match is struck.

People’s willingness to hold money can change suddenly for a "psychological and spontaneous reason" , causing a spike in the velocity of money. It can occur at lightning speed, over a few weeks. The shift invariably catches economists by surprise. They wait too long to drain the excess money. "Velocity took an almost right-angle turn upward in the summer of 1922," said Mr O Parsson. Reichsbank officials were baffled. They could not fathom why the German people had started to behave differently almost two years after the bank had already boosted the money supply. He contends that public patience snapped abruptly once people lost trust and began to "smell a government rat".

Some might smile at the Bank of England "surprise" at the recent the jump in Brtiish inflation. Across the Atlantic, Fed critics say the rise in the US monetary base from $871bn to $2,024bn in just two years is an incendiary pyre that will ignite as soon as US money velocity returns to normal. Morgan Stanley expects bond carnage as this catches up with the Fed, predicting that yields on US Treasuries will rocket to 5.5pc. This has not happened so far. 10-year yields have fallen below 3pc, and M2 velocity has remained at historic lows of 1.72.

As a signed-up member of the deflation camp, I think the Bank and the Fed are right to keep their nerve and delay the withdrawal of stimulus -- though that case is easier to make in the US where core inflation has dropped to the lowest since the mid 1960s. But fact that O Parsson’s book is suddenly in demand in elite banking circles is itself a sign of the sort of behavioral change that can become self-fulfilling. As it happens, another book from the 1970s entitled "When Money Dies: the Nightmare of The Weimar Hyper-Inflation" has just been reprinted. Written by former Tory MEP Adam Fergusson -- endorsed by Warren Buffett as a must-read -- it is a vivid account drawn from the diaries of those who lived through the turmoil in Germany, Austria, and Hungary as the empires were broken up.

Near civil war between town and country was a pervasive feature of this break-down in social order. Large mobs of half-starved and vindictive townsmen descended on villages to seize food from farmers accused of hoarding. The diary of one young woman described the scene at her cousin’s farm. "In the cart I saw three slaughtered pigs. The cowshed was drenched in blood. One cow had been slaughtered where it stood and the meat torn from its bones. The monsters had slit the udder of the finest milch cow, so that she had to be put out of her misery immediately. In the granary, a rag soaked with petrol was still smouldering to show what these beasts had intended," she wrote.

Grand pianos became a currency or sorts as pauperized members of the civil service elites traded the symbols of their old status for a sack of potatoes and a side of bacon. There is a harrowing moment when each middle-class families first starts to undertand that its gilt-edged securities and War Loan will never recover. Irreversible ruin lies ahead. Elderly couples gassed themselves in their apartments. Foreigners with dollars, pounds, Swiss francs, or Czech crowns lived in opulence. They were hated. "Times made us cynical. Everybody saw an enemy in everybody else," said Erna von Pustau, daughter of a Hamburg fish merchant.

Great numbers of people failed to see it coming. "My relations and friends were stupid. They didn’t understand what inflation meant. Our solicitors were no better. My mother’s bank manager gave her appalling advice," said one well-connected woman. "You used to see the appearance of their flats gradually changing. One remembered where there used to be a picture or a carpet, or a secretaire. Eventually their rooms would be almost empty. Some of them begged -- not in the streets -- but by making casual visits. One knew too well what they had come for."

Corruption became rampant. People were stripped of their coat and shoes at knife-point on the street. The winners were those who -- by luck or design -- had borrowed heavily from banks to buy hard assets, or industrial conglomerates that had issued debentures. There was a great transfer of wealth from saver to debtor, though the Reichstag later passed a law linking old contracts to the gold price. Creditors clawed back something. A conspiracy theory took root that the inflation was a Jewish plot to ruin Germany. The currency became known as "Judefetzen" (Jew- confetti), hinting at the chain of events that wouild lead to Kristallnacht a decade later.

While the Weimar tale is a timeless study of social disintegration, it cannot shed much light on events today. The final trigger for the 1923 collapse was the French occupation of the Ruhr, which ripped a great chunk out of German industry and set off mass resistance. Lloyd George suspected that the French were trying to precipitate the disintegration of Germany by sponsoring a break-away Rhineland state (as indeed they were). For a brief moment rebels set up a separatist government in Dusseldorf. With poetic justice, the crisis recoiled against Paris and destroyed the franc.

The Carthaginian peace of Versailles had by then poisoned everything. It was a patriotic duty not to pay taxes that would be sequestered for reparation payments to the enemy. Influenced by the Bolsheviks, Germany had become a Communist cauldron. partakists tried to take Berlin. Worker `soviets' proliferated. Dockers and shipworkers occupied police stations and set up barricades in Hamburg. Communist Red Centuries fought deadly street battles with right-wing militia.

Nostalgics plotted the restauration of Bavaria’s Wittelsbach monarchy and the old currency, the gold-backed thaler. The Bremen Senate issued its own notes tied to gold. Others issued currencies linked to the price of rye. This is not a picture of America, or Britain, or Europe in 2010. But we should be careful of embracing the opposite and overly-reassuring assumption that this is a mild replay of Japan’s Lost Decade, that is to say a slow and largely benign slide into deflation as debt deleveraging exerts its discipline.

Japan was the world’s biggest external creditor when the Nikkei bubble burst twenty years ago. It had a private savings rate of 15pc of GDP. The Japanese people have gradually cut this rate to 2pc, cushioning the effects of the long slump. The Anglo-Saxons have no such cushion. There is a clear temptation for the West to extricate itself from the errors of the Greenspan asset bubble, the Brown credit bubble, and the EMU sovereign bubble by stealth default through inflation. But that is a danger for later years. First we have the deflation shock of lives. Then -- and only then -- will central banks go to far and risk losing control over their printing experiment as velocity takes off. One problem at a time please.

Goldman reveals where bailout cash went
by Karen Mracek and Thomas Beaumont - Des Moines Register

Goldman Sachs sent $4.3 billion in federal tax money to 32 entities, including many overseas banks, hedge funds and pensions, according to information made public Friday night. Goldman Sachs disclosed the list of companies to the Senate Finance Committee after a threat of subpoena from Sen. Chuck Grassley, R-Ia. Asked the significance of the list, Grassley said, "I hope it's as simple as taxpayers deserve to know what happened to their money."

He added, "We thought originally we were bailing out AIG. Then later on ... we learned that the money flowed through AIG to a few big banks, and now we know that the money went from these few big banks to dozens of financial institutions all around the world." Grassley said he was reserving judgment on the appropriateness of U.S. taxpayer money ending up overseas until he learns more about the 32 entities.

Goldman Sachs received $5.55 billion from the government in fall of 2008 as payment for then-worthless securities it held in AIG. Goldman had already hedged its risk that the securities would go bad. It had entered into agreements to spread the risk with the 32 entities named in Friday's report. Overall, Goldman Sachs received a $12.9 billion payout from the government's bailout of AIG, which was at one time the world's largest insurance company.

Goldman Sachs also revealed to the Senate Finance Committee that it would have received $2.3 billion if AIG had gone under. Other large financial institutions, such as Citibank, JPMorgan Chase and Morgan Stanley, sold Goldman Sachs protection in the case of AIG's collapse. Those institutions did not have to pay Goldman Sachs after the government stepped in with tax money. Shouldn't Goldman Sachs be expected to collect from those institutions "before they collect the taxpayers' dollars?" Grassley asked. "It's a little bit like a farmer, if you got crop insurance, you shouldn't be getting disaster aid."

Goldman had not disclosed the names of the counterparties it paid in late 2008 until Friday, despite repeated requests from Elizabeth Warren, chairwoman of the Congressional Oversight Panel. "I think we didn't get the information because they consider it very embarrassing," Grassley said, "and they ought to consider it very embarrassing."

The initial $85 billion to bail out AIG was supplemented by an additional $49.1 billion from the Troubled Asset Relief Program, known as TARP, as well as additional funds from the Federal Reserve. AIG's debt to U.S. taxpayers totals $133.3 billion outstanding. "The only thing I can tell you is that people have the right to know, and the Fed and the public's business ought to be more public," Grassley said. The list of companies receiving money includes a few familiar foreign banks, such as the Royal Bank of Scotland and Barclays. DZ AG Deutsche Zantrake Genossenschaftz Bank, a German cooperative banking group, received $1.2 billion, more than a quarter of the money Goldman paid out.

Warren, in testimony Wednesday, said that the rescue of AIG "distorted the marketplace by turning AIG's risky bets into fully guaranteed transactions. Instead of forcing AIG and its counterparties to bear the costs of the company's failure, the government shifted those costs in full onto taxpayers." Grassley stressed the importance of transparency in the marketplace, as well as in the government's actions. "Just like the government, markets need more transparency, and consequently this is some of that transparency because we've got to rebuild confidence to make the markets work properly," Grassley said.

AIG received the bailout of $85 billion at the discretion of the Federal Reserve Bank of New York, which was led at the time by Timothy Geithner. He now is U.S. treasury secretary. "I think it proves that he knew a lot more at the time than he told," Grassley said. "And he surely knew where this money was going to go. If he didn't, he should have known before they let the money out of their bank up there." An attempt to reach Geithner Friday night through the White House public information office was unsuccessful. Grassley has for years pushed to give the Government Accountability Office more oversight of the Federal Reserve.

U.S. Rep. Bruce Braley, a Waterloo Democrat, said he would propose that the House subcommittee on oversight and investigations convene hearings on the need for more Federal Reserve oversight. Braley is a member of the subcommittee. Braley said of Geithner, "I would assume he would be someone we would want to hear from because he would have firsthand knowledge." Braley also noted that the AIG bailout was negotiated under President George W. Bush, a Republican.

He said he was confident that the financial regulatory reform bill signed by President Obama this week would help provide better oversight than the AIG bailout included. "There was no regulatory framework in place," Braley said. "We had to put something in place to begin reining them in. I'm confident they will begin to be able to do that."

Why "Sovereign Debt" is an Oxymoron
by Ellen Brown, Web of Debt

We did not hear much about sovereign debt until early this year, when Greece hit the skids.  Investment adviser Martin Weiss wrote in a February 24 newsletter:
On October 8, Greece’s benchmark 10-year bond was stable and rising. Then, suddenly and without warning, global investors dumped their Greek bonds with unprecedented fury, driving its market value into a death spiral.

Likewise, Portugal’s 10-year government bond reached a peak on December 1, 2009, less than three months ago.  It has also started to plunge virtually nonstop.

The reason: A new contagion of fear about sovereign debt!  Indeed, both governments are so deep in debt, investors worry that default is not only possible — it is now likely!

So said the media, but note that Greece and Portugal were doing remarkably well only 3 months earlier.  Then, suddenly and without warning, global investors furiously dumped their bonds.  Why?  Weiss and other commentators blamed a sudden contagion of fear about sovereign debt.

But as Bill Murphy, another prolific newsletter writer, reiterates, Price action makes market commentary.  The pundits look at what just happened in the market and then dream up some plausible theory to explain it.  What President Franklin Roosevelt said of politics, however, may also be true of markets: Nothing happens by accident.  If it happens, you can bet it was planned that way.

That the collapse of Greece’s sovereign debt may actually have been planned was suggested in a Wall Street Journal article in February, in which Susan Pullian and co-authors reported:
Some heavyweight hedge funds have launched large bearish bets against the euro in moves that are reminiscent of the trading action at the height of the U.S. financial crisis.

The big bets are emerging amid gatherings such as an exclusive ‘idea dinner’ earlier this month that included hedge-fund titans SAC Capital Advisors LP and Soros Fund Management LLC. . . .
It is impossible to calculate the precise effect of the elite traders’ bearish bets, but they have added to the selling pressure on the currency—and thus to the pressure on the European Union to stem the Greek debt crisis.

There is nothing improper about hedge funds jumping on the same trade unless it is deemed by regulators to be collusion. Regulators haven’t suggested that any trading has been improper.

Regulators hadn’t suggested it yet; but on the same day that the story was published, the antitrust division of the U.S. Justice Department sent letters to a number of hedge funds attending the dinner, warning them not to destroy any trading records involving market bets on the euro. 

Represented at the dinner was the hedge fund of George Soros, who was instrumental in collapsing the British pound  in 1992 by heavy short-selling.  Soros was quoted as warning that if the European Union did not fix its finances, the euro may fall apart.  Was it really a warning?  Or was it the sort of rumor designed to make the euro fall apart?  A concerted attack on the euro, beginning with its weakest link, the Greek bond, could bring down that currency just as short selling had brought down the pound.

These sorts of rumors have not been confined to the Greek bond and the euro.  In The Financial Times, Niall Ferguson wrote an article titled A Greek Crisis Is Coming to America, in which he warned:
It began in Athens. It is spreading to Lisbon and Madrid.  But it would be a grave mistake to assume that the sovereign debt crisis that is unfolding will remain confined to the weaker eurozone economies.

America, he maintained, would suffer a sovereign debt crisis as well, and this would happen sooner than expected. 
The International Monetary Fund recently published estimates of the fiscal adjustments developed economies would need to make to restore fiscal stability over the decade ahead. Worst were Japan and the UK (a fiscal tightening of 13 per cent of GDP). Then came Ireland, Spain and Greece (9 per cent). And in sixth place? Step forward America, which would need to tighten fiscal policy by 8.8 per cent of GDP to satisfy the IMF.

The catch is that the U.S. does not need to satisfy the IMF . . . . 

Sovereign Debt is an Oxymoron
America cannot actually suffer from a sovereign debt crisis.  Why?  Because it has no sovereign debt.  As Wikipedia explains:
A sovereign bond is a bond issued by a national government.  The term usually refers to bonds issued in foreign currencies, while bonds issued by national governments in the country’s own currency are referred to as government bonds.  The total amount owed to the holders of the sovereign bonds is called sovereign debt.

Damon Vrabel, of the Council on Renewal in Seattle, concludes:
[T]he sovereign debt crisis . . . is a fabrication of the Ivy League, Wall Street, and erudite periodicals like the Financial Times of London. . . . It seems ridiculous to point this out, but sovereign debt implies sovereignty.  Right?  Well, if countries are sovereign, then how could they be required to be in debt to private banking institutions?  How could they be so easily attacked by the likes of George Soros, JP Morgan Chase, and Goldman Sachs? Why would they be subjugated to the whims of auctions and traders?  A true sovereign is in debt to nobody . . . .

Unlike Greece and other EU members, which are forbidden to issue their own currencies or borrow from their own central banks, the U.S. government can solve its debt crisis by the simple expedient of either printing the money it needs directly, or borrowing it from its own central bank, which prints the money.  The current term of art for this maneuver is quantitative easing, and Ferguson says it is what has so far stood between the US and larger bond yields – that, and China’s massive purchases of U.S. Treasuries.  Both are winding down now, he warns, renewing the hazard of a sovereign debt crisis. 
Explosions of public debt hurt economies . . . , Ferguson contends, by raising fears of default and/or currency depreciation ahead of actual inflation, [pushing] up real interest rates.

Market jitters may be a hazard, but if the U.S. finds itself with government bonds and no buyers, it will no doubt resort to quantitative easing again, just as it has in the past – not necessarily overtly, but by buying bonds through offshore entities, swapping government debt for agency debt, and other sleights of hand.  The mechanics may vary, but so long as Helicopter Ben is at the helm, dollars are liable to appear as needed.

Hyperinflation: A Bogus Threat Today
Proposals to solve government budget crises by simply issuing the necessary funds, whether as currency or as bonds, invariably meet with dire warnings that the result will be hyperinflation.  But before an economy can be threatened with hyperinflation, it has to pass through simple inflation; and today the world is struggling with deflation.  The U.S. money supply has been shrinking at an unprecedented rate.  In a May 26 article in The Financial Times titled US Money Supply Plunges at 1930s Pace as Obama Eyes Fresh Stimulus, Ambrose Evans-Pritchard observed:
The stock of money fell from $14.2 trillion to $13.9 trillion in the three months to April, amounting to an annual rate of contraction of 9.6pc. The assets of institutional money market funds fell at a 37pc rate, the sharpest drop ever.

So long as workers are out of work and resources are sitting idle, as they are today, money can be added to the money supply without driving prices up.  Price inflation results when demand (money) increases faster than supply (goods and services).  If the new money is used to create new goods and services, prices will remain stable.  That is where quantitative easing has gone astray today: the money has not been directed into creating goods, services and jobs but has been steered into the  coffers of the banks, cleaning up their balance sheets and providing them with cheap credit that they have not deigned to pass on to the productive economy.

Our forefathers described the government they were creating as a Common Wealth, ensuring life, liberty and the pursuit of happiness for its people.  Implied in that vision was an opportunity for employment for anyone wanting to work, as well as essential social services for the population.   All of that can be provided by a government that claims sovereignty over its money supply.    

A true sovereign need not indebt itself to private banks but can simply issue the money it needs.  That is what the American colonists did, in the innovative paper money system that allowed them to flourish for a century before King George forbade them to issue their own scrip, prompting the American Revolution. 

It is also what Abraham Lincoln did, foiling the Wall Street bankers who would have trapped the North in debt slavery through the exigencies of war.  And it is what China itself did successfully for decades, before it succumbed to globalization.  China got the idea from Abraham Lincoln, through his admirer Sun Yat-sen; and Lincoln took his cue from the American colonists, our forebears.  We need to reclaim our sovereign right as a nation to fund the Common Wealth they envisioned without begging from foreign creditors or entangling the government in debt.

Jim Rogers predicts a new recession in 2012
by James Quinn - Telegraph

Jim Rogers, the market sage, has warned the global economy is just two years away from another recession, but remains ill-prepared to cope with the after-effects. Mr Rogers, the respected currency trader and hedge fund pioneer, cautioned that when the downturn takes hold "the world is going to be in worse shape because the world has shot all its bullets."

Speaking in an interview with business television channel CNBC, the septuagenarian investor said that "since the beginning of time" there has been a recession every four-to-six years, and that's mean another one is due around 2012. However, he said that due to the extraordinary measures already adopted by central banks and governments around the world, the arsenal of available tools to combat the next recession is somewhat lacking. With reference to Ben Bernanke, chairman of the US Federal Reserve, he said: "Is Mr Bernanke going to print more money than he already has? No, the world would run out of trees."

Meanwhile, Robert Shiller, co-creator of the Standard & Poor's/Case-Shiller house price index, warned that the next downturn may come even sooner. "For me a double-dip is another recession before we've healed from this recession. The probability of that kind of double-dip is more than 50pc. I actually expect it," he said. His prediction came despite the S&P/Case-Shiller index for May showing a 4.6pc year-on-year increase in house prices in 20 major US conurbations.

Uncle Sam has worse woes than Greece
by Laurence Kotlikoff - Financial Times

The spectre of Greek default continues to rattle global financial markets. Greek long-term government bond yields are running 700 basis points above comparable US Treasuries. The inference is that America is in far better fiscal shape than Greece. Nothing could be further from the truth.

Greek debt totals 120 per cent of gross domestic product, twice the US figure. But debt alone tells us little about a country’s fiscal condition. Economists call this the labelling problem, because governments can describe receipts and payments in any way they like. Payroll taxes to fund pensions and healthcare can, for instance, be labelled as borrowing, with the future benefits called repayment less a future tax. Measured thus, the US budget deficit is 15 per cent of GDP, not 9 per cent.

Chile’s pension reform of the early 1980s re-labelled that country’s deficits in this way. Receipts, which had previously been called taxes, were funnelled into private pension funds, from which the government then borrowed to cover the pensions themselves. Voilà. The same money was still flowing from workers to retirees but was now called borrowing. The economists’ change in language let them block spending, including on an aircraft carrier, claiming "the" deficit was too high. So Chile’s long-term fiscal position improved, despite reporting more debt.

Argentina subsequently "reformed" its pensions, albeit with no underlying fiscal tightening. Recently it nationalised its pension funds, calling the confiscated assets revenue, while keeping the future liabilities off the books. Thus Argentina sold IOUs for current cash. Greece did much same in selling anticipated fees from airports and proceeds from lotteries. But then so did France, when it confiscated France Télécom pension assets (while retaining the pension obligations) to meet the deficit criteria to join the euro.

But all these countries have something to learn from the real labelling master: Uncle Sam. During the past half-century, the US has sold tens of trillions of unofficial IOUs, leaving it with liabilities to pay Social Security, Medicare and Medicaid benefits that total 40 times official debt. So is US debt actually 40 times larger than reported? Is this year’s deficit 15 per cent of GDP or 9 per cent? It’s your pick, since we are in a fiscal wonderland of measurement without meaning.

In economics, as in physics, certain concepts are not well defined. In physics it is absolute time and distance, whose measurement depends on direction and speed through space. This frame of reference determines how we perceive the time of day or the length of a desk. In economics, every dollar a government takes in or pays out can be referenced with different words or labels, to produce almost any level of official debt one wishes to present. As a result, using debt levels to assess a country’s fiscal sustainability, as the Group of 20 nations just did, is like driving in Los Angeles with a map of New York.

Fortunately, theory suggests a label-free measure of fiscal status: the fiscal gap, or the present value difference between all future expenditures and receipts. The Greek fiscal gap is staggering. Calculations developed with my colleagues at Freiberg University put it at 11.5 per cent of the value of Greece’s future GDP. And this huge figure already incorporates Greece’s recently legislated fiscal policy retrenchment. But the US figure, based on the Congressional Budget Office’s just-released projections, is even larger: 12.2 per cent.

Clearly, Greece is in terrible fiscal shape. To get its books in order it would have to pull in its belt each year by another 11.5 per cent of GDP. This provides new meaning to the word draconian. But the US is in much worse shape, because the CBO’s projections that reveal the 12.2 per cent fiscal gap already assume a 7.2 per cent of GDP belt-tightening by 2020. But the assumptions underlying this 7.2 per cent adjustment are highly speculative, including a substantial rise in the share of taxpayers facing the Alternative Minimum Tax, once called the "millionaires tax" for targeting only the rich.

The CBO also assumes that real wage growth will push all workers into much higher tax brackets, and that Congress will slash discretionary spending as well as greatly limit growth in Medicare and Medicaid benefits. Each supposition runs counter to recent experience. Wishing won’t fix America’s fiscal mess. The US is one foot away from a deep and permanent economic grave. It is far past time to do meaningful long-term fiscal planning, level with the public, and implement radical reforms that permanently put America’s fiscal house in order.

The writer is professor of economics at Boston University. The analysis underpinning this article was developed along with Christian Hagist, Stefan Moog and Bernd Raffelhüschen, all at Freiburg University

Average Home Transaction Prices In Shanghai Plunge 48.4%

The average home transaction price in Shanghai tumbled 48.43 percent week-on-week to 9,787 yuan per square meter in the week ended July 25, reports Oriental Morning Post, without citing any source. The average home transaction price in Chongming district plunged 94.1 percent last week to 2,493 yuan per square meter. Average home transaction prices in Huangpu district and in Pudong fell 70.91 percent and 62.85 percent, respectively.

In the same period, the transaction volume of commercial residential properties in Shanghai soared 366.93 percent week-on-week to 4,246 units. The transaction volume in Chongming district skyrocketed 8,380.86 percent week-on-week while the transaction volume in Zhabei and Yangpu districts soared 4,465.45 percent and 1,419.08 percent week-on-week, respectively. The transaction volume in Minhang district and in Pudong rose 600 percent and 700 percent week-on-week. Shares of Shanghai Lujiazui Finance and Trade Zone Development (600663) dropped 1.16 percent to close at 17.91 yuan today.

California Attorney General Jerry Brown Subpoenas Records of City Paying Manager $800,000 a Year
by Christopher Palmeri - Bloomberg

California Attorney General Jerry Brown subpoenaed hundreds of employment, salary and contract records from the city of Bell, whose manager was paid almost $800,000 a year and resigned last week. Brown said he is considering whether to initiate civil or criminal action against city leaders. Hundreds of citizens marched through city streets yesterday to demand the resignation of the mayor and other council members.

"This smells to high heaven," Brown said at a Los Angeles press conference. "These outrageous pay practices are an insult to the hard-working people of Bell and have provoked righteous indignation in California and even across the country."

Bell, 10 miles (16 kilometers) southeast of Los Angeles, has a largely Latino population with income of $24,800 per person in 2008, according to the city’s 2009 annual report. More than a quarter of its residents live below the poverty level, according to the website The city’s chief administrative officer, Robert Rizzo, resigned July 22 after the Los Angeles Times reported his total compensation was almost $800,000 a year and that Bell’s part- time council members took in almost $100,000 annually, mostly by serving on city-affiliated boards and commissions.

The City Council issued a statement saying that the mayor and three council members will drastically cut their pay at a meeting later today, according to the Associated Press. Brown, 72, a former California secretary of state and governor, is running as the Democratic gubernatorial candidate against former EBay Inc. Chief Executive Officer Meg Whitman, who is on the Republican ticket. "I’m determined to get to the bottom of these exorbitant payouts and protect the state’s pension system against such abuses," Brown said of his investigation of Bell.

Schwarzenegger threatens to leave office without signing budget
by Shane Goldmacher and Anthony York - Los Angeles Times

Nearly four weeks into the fiscal year without a budget, Gov. Arnold Schwarzenegger suggested Monday that California might have to wait until his successor is sworn in next year to get a spending plan — unless lawmakers give him everything he wants. Schwarzenegger has said the Legislature must curtail public pensions and change California's taxation and budgeting systems before he will sign the next budget, his last as governor. He leaves office in January.

"If I do not get all of the things that we need … I will not sign a budget, and it could actually drag out until the next governor gets into office," Schwarzenegger told reporters after an event at the Los Angeles Area Chamber of Commerce, according to a recording provided by his office. Senate President Pro Tem Darrell Steinberg (D- Sacramento) responded in a statement Monday that he was "prepared to grant his wish" if Schwarzenegger "continues to insist on granting billions in corporate tax cuts financed by drastic cuts to public education and programs for working mothers and their children."

The state faces a $19.1-billion deficit for the fiscal year that began July 1. Rank-and-file lawmakers went on recess weeks ago as talks between top lawmakers and the governor showed little progress. Schwarzenegger blamed them for the tardy spending plan, saying they "go on vacation." Lawmakers are set to return to the Capitol next week.

Schwarzenegger also said Monday that he opposes giving legislators the power to pass a budget with a simple-majority vote, or any proposal that would make it easier to raise taxes or fees. "I even don't believe in doing the budget" by majority vote, he said. Schwarzenegger said lowering the vote threshold would ensure that "one party will make all the decisions" in Sacramento.

Voters will decide on such a plan in November. Proposition 25 would change the two-thirds vote requirement to a simple majority vote for passing budgets but maintain a supermajority threshold to raise taxes. The measure is backed by labor unions and other Democratic groups and opposed by the state Chamber of Commerce.

Nevada's Economic Misery May Be America's Future
by Ryan Grim and Arthur Delaney - Huffington Post

So many homes in Las Vegas have been foreclosed upon that banks rarely bother to hang a "For Sale" sign on the front lawn anymore. Instead, visitors identify bank-owned properties by the brown grass and the 8.5 x 11-inch sheet of paper taped to the front door or the garage. On a cul-de-sac in the once-pleasant neighborhood of Silverado Ranch, Larry Wood is the last remaining resident. Two of the four homes are in foreclosure and a third is a "party rental" only occupied by rowdy tourists on weekends. One of his neighbors made a few bucks before abandoning the home, he says. "They sold all the palm trees and just walked away from it," says Wood, sporting a "Freedom Isn't Free" T-shirt. "It's a great neighborhood. I guess that people weren't financially set up to get through the crash."

Wood takes little comfort in being the last resident. "Sometimes it's scary. There's a possibility someone would try to rob me and I wouldn't have any neighbors to help me," he says, recounting a previous attempted intrusion when his then-neighbor called to warn him not to answer the door because there was a group of thugs knocking. Armed and ready, he huddled near the door but the gang gave up and left. Walking away is becoming a habit among law-abiding residents too. It's hard to find a home bought before 2009 that isn't underwater and very few landlords, when running credit checks, look for foreclosures or short-sales on a tenant's record. Otherwise, a manager couldn't fill a building.

Nevada has a greater concentration of economic misery than any other state. The state's unemployment rate, which in June edged up to 14.2 percent, has risen faster during the past year than it has anywhere else, and nearly six percent of all homes across the state's desert landscape received a foreclosure filing in the first six months of the year. While the concentration of misery may be greater in Nevada, it was caused by the same unchecked housing bubble and unregulated financial gambling that brought pain to the rest of the country. If present trends go unchecked, Nevada is America's future. The jobless rate would likely be much higher, say residents, if Nevada were not such a transient state. When folks lose their jobs and their homes, they often pack up and move in with relatives.

Others, though, have roots in the state. Robert Garcia, 58, moved to Vegas more than a decade ago to take a job with what is now MGM as a video producer. Back in Salt Lake City, Utah, he'd met his wife, an anchorwoman, on the set. She went to work for US Airways in Las Vegas. The couple, who have two kids, divorced several years ago and sold their home at a healthy profit, which they split. Garcia put $100,000 into a new home that he bought for $350,000. Making nearly six figures, he said, he had no problem covering the mortgage and the $2,400 in alimony and child support. In 2008, things took a turn for the worse. He has been able to weather the downturn, he says, because he always lived within his means -- no credit card debt, no car payment. He has a "junky car," he says, that his kids are embarrassed to ride in.

"It's funny," Garcia adds, pausing. "Just before I was laid off, I was gonna buy a BMW." He pauses for another long moment as his eyes well up. Asked where he is living now, he breaks down instantly, tears pouring down his cheeks, knocking his contacts out. "Actually, I'm looking for a place. I'll be right back," he says, leaving to compose himself. When he returns, he says that he's still in his home, which is more than 50 percent under water, but will be leaving as soon as the bank approves a short sale. He had an offer several months ago, but the buyer, a teacher, backed out at the last minute. She'd been laid off.

Garcia has applied for 200 jobs all across the country but, at his age, employers want younger workers, leaving him to scrape by on freelance work. He has nothing left, but one bright spot is that the devastation in Vegas is so profound that landlords tell him they no longer check credit reports for short sales or foreclosures. Garcia's wife, meanwhile, has been laid off by the airline, as fewer tourists fly into town. She's now on welfare, he says, and, as a consequence, half his wages are garnished. (Welfare policy requires such payments to be made through garnishment.) He doesn't mind, he says. His bigger fear is that the only job he'll be able to find will require him to leave Vegas and his children.

Meanwhile, the debate in Washington enrages him. It particularly galls him that Republicans say help for the unemployed must be offset with spending cuts elsewhere. Garcia, in fact, volunteers the term "offset," expressing a better grasp of economics than most of the deficit hawks in Washington. "It drives me crazy when they say that. There's nothing to take from! Where are they going to offset it?! What's the phrase? You can't get blood from a turnip," he said.

"This is my hometown and I've watched it struggle and go through so many challenges, particularly over the past two years," says Julie Murray, president of Three Square, a food bank in Vegas that distributes food to more than 300 partner programs and schools around town. "The way that this economic downturn has been different from others is that I've never seen the gaming industry be impacted. Our community would suffer when the economy suffered but gaming was always resilient."

Three Square delivered 10 million pounds of food in 2008; this year the food bank is on track to distribute twice that amount (some of the increase, Murray said, owes to the fact that Three Square is growing; the nonprofit was founded in 2006). Murray said corporate donations to the food bank have been down during this recession, but individual and foundation giving has remained steady. "We've been able to sustain distribution of food in a recession because of the sheer will and passion of the community," she said. "Things are dire -- we have more children who are struggling with hunger and more seniors and more families and more middle class families who never thought they'd need social services -- however, Las Vegas is rallying."

"Nevada was pretty much a growth economy for most of the past two decades," says Steven Horsford, the Nevada State Senate's Minority Leader, a Democrat who represents North Las Vegas. "When the financial crisis hit, it disproportionately affected Las Vegas because of our growth rate." Horsford says the local economy is struggling not because fewer tourists are coming to Vegas, but because the people who do come are spending less money. (A cab driver complains that he doesn't have many fewer customers, just more families haggling over the $60 fare.) Horsford said Vegas needs to switch from relying on casino tourism to green energy and medical tourism.

"We were used to being able to help virtually all segments of our population get a job if they wanted a job, have benefits, earn money to put their kids through college -- we called it the Las Vegas dream," he says. "From a leadership standpoint, knowing that two-thirds of all homes are either upside down or are in foreclosure is one of the most humbling realities we are dealing with."

The decay in Vegas doesn't stay there: It reverberates throughout the state. "Coming Soon" signs have been pulled down across the city, because nothing is coming soon other than more foreclosures. The Nevada landscape is pockmarked by empty condos and casinos, some of them fully built and sitting there empty, others are shells frozen in time. When analysts talk abstractly about Wall Street sucking capital out of the real economy, these stalled construction projects are the on-the-ground reality. "60% Reduced Prices" promises one empty condo development.

The $3.1 billion Fontainebleau Las Vegas construction project sits nearly complete but the lender pulled out and everybody is suing everybody else. The first Ritz-Carlton in the company's history to shut down is in Las Vegas. The city's dance clubs aren't empty, but there's less money circulating. "Saturn," an exotic dancer at Spearmint Rhino, says she and her fellow dancers are making roughly half what they were two years ago. The house she bought for more than $450,000 on an interest-only loan is now worth a third that. She's negotiating a short-sale with the bank. The Dunkin Donuts that opened in Fabienne Chalaye's neighborhood five months ago is already empty. "Dunkin Donuts... It's all empty. Everything is empty," she marvels, while giving a HuffPost reporter a tour of the city.

Chalaye, a chauffeur, says her business is down roughly 60 percent over the last two years. It slowed down almost imperceptibly after 2006, then fell off a cliff in 2008. She hasn't made a mortgage payment in 15 months and expects to be booted from her home, along with her husband, her adult daughter and her daughter's boyfriend any day now. She bought the house in 2008 on an interest-only loan for $313,000; it's now worth $117,000 and her interest rate shot up to 12 percent. Both she and Garcia, however, say they're leaning toward voting for Harry Reid to return to the Senate, because they have no faith in his opponent, Sharron Angle. "'I wanna get rid of Social Security,'" Garcia quotes Angle saying. "How stupid is that?"

Garcia says a friend of his in the crane business told him he was offloading the hulking useless tools to builders in China because it isn't worth the cost of storing them. "Office Space Available" blares a sign next to a stalled office project. A five-bedroom home with Spanish tile and a game room sits vacant on half an acre of land. "This property is Bank-owned. We reserve the right to prosecute any and all trespassers illegally accessing the property. Thank you for your cooperation."

The Nugget Casino in tiny Searchlight (population: 576), about an hour from Vegas, laid off a third of its 85 employees in the past two years to cope with reduced demand for the Nugget's slot machines and chicken fried steaks, says owner Verlie Doing, 86. "We had a great banker when we built this place," says Doing, who opened the Nugget with her husband in 1979. Now, Doing says, she doesn't think Wells Fargo will give her a loan to fix the three air conditioners that recently failed. "I'm not gonna talk to the bank. I'm not even gonna bother to waste my time with 'em." Doing, a friend and supporter of Harry Reid, is optimistic. "It's gradually getting better," she says. "Not noticeably a bunch better -- but it's getting better."

Sarcastic references to President Obama's 2009 stimulus bill can be seen throughout the Las Vegas area, from glossy Keno fliers at Vegas hotels to the mysterious sign by the front entrance to the Nugget advertising a "Great opportunity" to "stimulate yourself" and make money. "You won't need a bailout. Call Barry." Reached by phone, Barry Bunnell of Chloride, Ariz. -- a town even smaller than Searchlight -- explains that he's been trying to hire people to sell his Easy Out Fire Protector product, a bottle of fire retardant liquid that's handy for snuffing out small pan fires, especially in RV trailers. Bunnell needs people who can go door-to-door demonstrating the product.

He says he received 37 responses to the Searchlight flier, but nobody was interested in sitting down for an Easy Out interview after Bunnell described the job. He suspects they'd rather stay on unemployment benefits and use the Easy Out inquiry as an easy way to prove to the state they're still looking for work. (That the unemployed would rather draw benefits than look for work is a common argument among congressional Republicans, even though there are nearly 15 million people looking for three million available jobs.) "You can sell two for $39 and keep $20," says Bunnell of his product, "and people won't do it because it's beneath their dignity."

Criminal probe of oil spill to focus on 3 firms and their ties to regulators
by Jerry Markon - Washington Post

A team of federal investigators known as the "BP squad" is assembling in New Orleans to conduct a wide-ranging criminal probe that will focus on at least three companies and examine whether their cozy relations with federal regulators contributed to the oil disaster in the Gulf of Mexico, according to law enforcement and other sources.

The squad at the FBI offices includes investigators from the Environmental Protection Agency, the U.S. Coast Guard and other federal agencies, the sources said. In addition to BP, the firms at the center of the inquiry are Transocean, which leased the Deepwater Horizon rig to BP, and engineering giant Halliburton, which had finished cementing the well only 20 hours before the rig exploded April 20, sources said.

While it was known that investigators are examining potential violations of environmental laws, it is now clear that they are also looking into whether company officials made false statements to regulators, obstructed justice or falsified test results for devices such as the rig's failed blowout preventer. It is unclear whether any such evidence has surfaced.

One emerging line of inquiry, sources said, is whether inspectors for the Minerals Management Service, the federal agency charged with regulating the oil industry -- which is itself investigating the disaster -- went easy on the companies in exchange for money or other inducements. A series of federal audits has documented the MMS's close relationship with the industry. "The net is wide," said one federal official who spoke on the condition of anonymity because he was not authorized to speak publicly.

The Justice Department investigation -- announced in June by Attorney General Eric H. Holder Jr. and accompanied by parallel state criminal probes in Louisiana, Mississippi and Alabama -- is one of at least nine investigations into the worst oil spill in U.S. history. Unlike the public hearings held last week in Kenner, La., by a federal investigatory panel, the criminal probe has operated in the shadows. But it could lead to large fines for the companies and jail time for executives if the government files charges and proves its case.

Justice Department officials declined to comment Tuesday. Holder, in an interview with CBS News this month, confirmed that investigators are conducting a broad probe. "There are a variety of entities and a variety of people who are the subjects of that investigation," Holder said. In an additional avenue of inquiry, BP disclosed in a regulatory filing Tuesday that the Justice Department and the Securities and Exchange Commission are looking into "securities matters" relating to the spill, although no more details were included.

Scott Dean, a spokesman for London-based BP, said the company "will cooperate with any inquiry the Justice Department undertakes, just as we are doing in response to other inquiries that are ongoing." Brian Kennedy, a spokesman for Transocean, a former U.S. firm now based in Switzerland, declined to comment, as did Teresa Wong, a spokeswoman for Houston-based Halliburton. Halliburton informed its shareholders about the Justice Department probe in its July 23 quarterly report to securities regulators. It also noted that the department warned the company not to make "substantial" transfers of assets while the matter is under scrutiny.

The probe is in its early stages, with investigators digging through tens of thousands of documents turned over by the companies, beginning to interview company officials and trying to determine the basics of who was responsible for various operations on the rig. Although lawyers familiar with the case expect that environmental-related charges -- which have a low burden of proof -- will be filed, some doubted that investigators can prove more serious violations such as lying or falsifying test results. "That's hard to prove," said one lawyer, who spoke on the condition of anonymity because details of the investigation are not public. "It's hard to show that somebody who could have died on the rig was malicious and reckless and intentionally did something that jeopardized their own life."

The emerging focus creates potentially awkward interactions on several levels. Investigators are probing companies, especially BP, which the government has been forced to work with in cleaning up the oil that cascaded into the gulf. And the former Minerals Management Service, which sources said has attracted the attention of criminal investigators, is helping to lead the federal panel that conducted last week's hearings in Louisiana.

Federal auditors have in recent years documented a culture at the MMS in which inspectors improperly accepted gifts from oil and gas companies, moved freely between industry and government and, in one instance, negotiated for a job with a company under inspection. After the most recent investigation was released in May, Interior Secretary Ken Salazar said he had asked his department's acting inspector general, Mary Kendall, to expand her inquiry to include whether MMS failed to adequately inspect the Deepwater Horizon rig or enforce federal standards.

One law enforcement official said criminal investigators will look for evidence that MMS inspectors were bribed or promised industry jobs in exchange for lenient treatment. "Every instinct I have tells me there ought to be numerous indictable cases in that connection between MMS and the industry," said this official, who spoke on the condition of anonymity because the investigation is unfolding. Melissa Schwartz, a spokeswoman for the former MMS (now called the Bureau of Ocean Energy Management, Regulation and Enforcement), declined to comment.

FBI agents and other investigators are working with prosecutors from the environmental crimes section of the Justice Department, along with local U.S. attorney's offices. Officials would not provide details about the new squad starting in the FBI's New Orleans office. Sources said it is known internally as "the BP squad," though it will examine all companies involved with the Deepwater rig.

After learning what is in the thousands of documents, investigators plan to "start trying to turn one witness against the other, get insider information," said the law enforcement official. The official said that no decisions on criminal charges are imminent and that "you can bet on it being more than a year before any kind of indictment comes down."