Thursday, December 18, 2008

ZIRP & The Economy To Emerge

In this attempt to get the economy going again a deep breath and a bit of thought seems in order. If the problem today is that consumers are too levered and in fact the economy is built on too much debt relative to national income, then the solution is to make debt cheaper? I know policymakers are trying to avoid depression, a valued goal, but it seems to me that they are now replacing consumer leverage with government leverage to get the economy back to the pre-recession level of economic activity. Considering all the talk about de-leveraging the U.S. economy because it is living beyond its means then shouldn't we be managing the shrinking of the economy through debt relief and loan modification to prevent wholesale asset sales rather than desparately trying to pump the air back into the balloon?

Perhaps a better solution to the current situation is to let the dollar fall. Now I know there are many of you who consider the currency's strength as an indicator of economic fortitude -- well this is an "old Europe" (to borrow a phrase) idea and certainly not an Asian one. And yes, competitive devaluation is overall destructive. My suggestion is not devaluation so much as letting the dollar fall to its fair price. Or, in other words, let the other currencies rise to theirs.

The whole story is a lot longer and this being a blog my promise is to keep it short. Looking at the markets, the rush for Treasurys continues unabated and the TIPs continue to price near term deflation. The so-called Treasury bubble is being created by two market forces of demand. First off, the Fed is buying. Second, and more important, no one wants to show anything in their portfolios other than Treasurys. Third, the rest of the world isn't doing so well and a lot of foreign buyers prefer the safety of U.S. Government securities. Once the year turns I would expect Treasurys to cheapen some but not a whole lot.

Tuesday, December 16, 2008


ZIRP reads more like one of those words in a Don Martin cartoon in Mad Magazine. You know, several panels of some funny looking guy eating all sorts of stuff and then in the last panel he puts his hand over his mouth and he goes "ZIRP!!!!"

I am not exactly sure what the cartoon character would have been eating but the Zero Interest Rate Policy, what ZIRP means here in the real world, means the Fed is going to digest a whole lot of Treasurys, Agencies, and Agency MBS. They also announced today that they are staying with this program for a long time to come. Inflation is no longer a concern. Amazing, isn't it, that this is the same group that in the spring was hinting at a rate hike at this point in the year because inflation was stubbornly high. Now it has decided to throw everything it got into the market.

To what effect? To punish investors for holding cash and government related securities. They are going to force the risk spread so wide that speculators first and investors second will begin to buy credit and return liquidity to a frozen market. The Fed is also saying to President Obama that they are standing aside and supporting, whole hog (so to speak), an enormous fiscal initiative. Which is obviously the second and necessary action if anyone is going to put up cash behind the belief that more credit will survive than go bust.

There is also the dollar play here, in other words a weaker one at first but, counter intuitively a much stronger one later on once growth takes hold and again global investors see this economy as the world's most important consumer.

Hate to throw cold water on the party, and while the Fed is doing the best it can under circumstances made worse by its gross misread of the economy when it was booming and when it started going bust. What got us into this mess is too rapid credit expansion, housing this time, high tech in the 90s, who knows what's next. All of it was fueled by an ever increasing inflow of foreign capital. The Fed, and here it is complicit in all this, chose to ignore the credit growth and the trade deficit believing the dollar would correct all of it. No such luck, the dollar is effectively fixed against our major trade surplus countries and so it was and is up to the Fed to do what a free exchange rate market would have done -- raise the real cost of capital in this country.

Enough history, looking forward policy today smacks a little bit like the hair of the dog on New Years Day. If the solution is to try and put the economy back together where it was, we will be here again. So a hair of the dog is okay considering the immediate alternative, but if we don't decide to stop drinking nothing will have been accomplished. And don't be surprised if the economy comes roaring back faster than expected. Remember those forecasting gloom were forecasting anything 12 months ago. There are other reasons, more solid ones than that, but I leave that for another post.