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Going To Hell In A Very Stylish Handbasket.

"El diablo sabes mas por viejo que por diablo" - old Mexican proverb

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Achtung! Das machine ist nicht fur gerfingerpoken und mittengraben. Ist easy schnappen der pringenwerk, blowenfusen, und poppencorken mit spitzensparken. Ist nicht fur gewerken by das dumkopfen, das rubbernecken sightseeren keepen hands in der pockets, relaxen und watchen der blinkenlights.

links:
Tom Paine
The Nation
RGE Monitor
The Economist
Landover Baptist Church
The Onion
Ernie's House of Whoop Ass

This is Jim Sinclair, one of the best known and most loved metals analyst, trader and advisor. He's made a HUGE pile of money buying and selling precious metals and mining stocks over the years, and now he's a rich cranky old fart that answers to nobody. He charges nothing for his advice, and tells it like it is. He's seldom wrong, and never about fundamental movements in gold. He tends to be over the top, but why not, he's earned it.

Today's post from Master Sinclair:

Dear CIGAs,

All levels of debt impact all other levels of debt in a downward spiral. The American consumer lacks personal control, is debt ridden, greed governed and as a group lost in a mental deficiency called total abandonment of responsibility. They cannot and will not support the largest economy in the world which is losing its leading position fast. Skewed statistics representing extra selling days and improper accounting for inflation make statistics look much better than they in fact are. The masters of lies, the spinners, will not be above to spin away the worst credit crisis of your lifetime boiling underneath and weakening the foundation of the entire financial world.

THIS IS IT! ARE YOU PREPARED?

-----

(CIGA stands for "Comrades In Golden Arms". Jim is a little goofy.) When Jimbo sez financial armaggedon is upon us in bold caps, you better believe it's gonna be a bad storm.

Okay kiddies, this is pretty much the start of the FUBAR years.

I predict that things will get very scary for a short while, and then will settle into a slow, slogging, exceedingly painful downward spiral of impoverishment of the vast majority of Americans. The New Depression is headed right for us and will last many many years, possibly a full generation.

Not blood-in-the-streets scary, no. But definitely the kind of scary brought on by cities, states and 'solid' banking institutions going bankrupt, markets collapsing, rampant inflation, massive job losses, increased crime born of desperation, disruption of services, economic turmoil on a global scale never before seen in history, and a very panicked herd mentality.

I myself have now moved all my savings OUT of the US dollar and the US market. I have it sitting in physical gold at the Perth Mint in Australia (where the feds can't get their paws on it), gold share ETFs, a basket of currencies designed to weather against the dollar's fall, and some solid foreign stocks (mostly energy, mining, transportation and telecom) that pay fat dividends in currencies far more solid than greenbacks.

I own two handguns and a rifle. I know that sounds like survivalist lunacy, but I've been in places and times where the thin veneer of 'civilization' has been swiftly and shockingly torn apart. Believe me when I tell you I would rather have weapons and never use them than need them and not have them. I have been in both situations, and the former is always the better bet.

Along that same line of thought, I have my 'hurricane kit' prepped. Basically, everything I need to take care of my family for a month without going to the store or having power, gas, or water. Again, I've been in situations where it took far more than a month for anything resembling civilization to assert itself. Self-sufficiency is not a skill to be ridiculed.

Think of Burt Gummer in the movie "Tremors": when the shit hits the fan, you'll be happy crazy fuckers like me know what to do.

Black Swans and Endogenous Uncertainty

by John Mauldin

December 7, 2007

How does the risk of default in California or Thailand get spread throughout the world, causing problem in money market funds in Europe and Florida? Yes, we can trace the linkages now, but was it possible to predict the crisis beforehand? And can we use what we learn to predict and hopefully hedge ourselves from the next crisis? Why do these things seem to be happening with more frequency? This week we are going to look at some economic theories which will give us some insight into the above questions. As it turns out, the more that individuals hedge their risk in economic markets - the larger the network - the more the entire system is put at risk. There is a lot of ground to cover, so we will jump right in.

Before we get to the economic theory, let's review part of a letter I wrote in April of 2006 discussing chaos theory, as it will give us a useful mind picture to understand the latter part of the letter. This was part of a letter where I laid out my thoughts that we would indeed experience a crisis in the future along the lines we are now seeing.

Ubiquity, Complexity Theory and Sandpiles

We are going to start our explorations with excerpts from a very important book by Mark Buchanan call "Ubiquity, Why Catastrophes Happen." I HIGHLY recommend it to those of you who like me are trying to understand the complexity of the markets. Not directly about investing, although he touches on it, it is about chaos theory, complexity theory and critical states. It is written in a manner any layman can understand. There are no equations, just easy to grasp well-written stories and analogies.

We have all had the fun as a kid of going to the beach and playing in the sand. Remember taking your plastic buckets and making sand piles? Slowly pouring the sand into ever bigger piles, until one side of the pile started an avalanche?

Imagine, Buchanan says, dropping one grain of sand after another onto a table. A pile soon develops. Eventually, just one grain starts an avalanche. Most of the time it is a small one, but sometimes it builds up and it seems like one whole side of the pile slides down to the bottom.

Well, in 1987, three physicists named Per Bak, Chao Tang and Kurt Weisenfeld began to play the sandpile game in their lab at Brookhaven National Laboratory in New York. Now, actually piling up one grain of sand at a time is a slow process, so they wrote a computer program to do it. Not as much fun, but a whole lot faster. Not that they really cared about sandpiles. They were more interested in what is called nonequilibrium systems.

They learned some interesting things. What is the typical size of an avalanche? After a huge number of tests with millions of grains of sounds, they found out that there is no typical number. "Some involved a single grain; others, ten, a hundred or a thousand. Still others were pile -wide cataclysms involving millions that brought nearly the whole mountain down. At any time, literally anything, it seemed, might be just about to occur."

It was indeed completely chaotic in its unpredictability. Now, let's read this next paragraph slowly. It is important, as it creates a mental image that helps me understand the organization of the financial markets and the world economy. [emphasis mine]

To find out why [such unpredictability] should show up in their sandpile game, Bak and colleagues next played a trick with their computer. Imagine peering down on the pile from above, and coloring it in according to its steepness. Where it is relatively flat and stable, color it green; where steep and, in avalanche terms, 'ready to go,' color it red. What do you see? They found that at the outset the pile looked mostly green, but that, as the pile grew, the green became infiltrated with ever more red. With more grains, the scattering of red danger spots grew until a dense skeleton of instability ran through the pile. Here then was a clue to its peculiar behavior: a grain falling on a red spot can, by domino-like action, cause sliding at other nearby red spots. If the red network was sparse, and all trouble spots were well isolated one from the other, then a single grain could have only limited repercussions. But when the red spots come t riddle the pile, the consequences of the next grain become fiendishly unpredictable. It might trigger only a few tumblings, or it might instead set off a cataclysmic chain reaction involving millions. The sandpile seemed to have configured itself into a hypersensitive and peculiarly unstable condition in which the next falling grain could trigger a response of any size whatsoever."

Something only a math nerd could love? Scientists refer to this as a critical state. The term critical state can mean the point at which water would go to ice or steam, or the moment that critical mass induces a nuclear reaction, etc.. It is the point at which something triggers a change in the basic nature or character of the object or group. Thus, (and very casually for all you physicists) we refer to something being in a critical state (or the term critical mass) when there is the opportunity for significant change.

"But to physicists, [the critical state] has always been seen as a kind of theoretical freak and sideshow, a devilishly unstable and unusual condition that arises only under the most exceptional circumstances [in highly controlled experiments]... In the sandpile game, however, a critical state seemed to arise naturally through the mindless sprinkling of grains."

Thus, they asked themselves, could this phenomena show up elsewhere? In the earth's crust triggering earthquakes, wholesale changes in an ecosystem or a stock market crash? "Could the special organization of the critical state explain why the world at large seems so susceptible to unpredictable upheavals?" Could it help us understand not just earthquakes, but why cartoons in a third rate paper in Denmark could cause world-wide riots?

He concludes in his opening chapter: "There are many subtleties and twists in the story ... but the basic message, roughly speaking, is simple: The peculiar and exceptionally unstable organization of the critical state does indeed seem to be ubiquitous in our world. Researchers in the past few years have found its mathematical fingerprints in the workings of all the upheavals I've mentioned so far [earthquakes, eco-disasters, market crashes], as well as in the spreading of epidemics, the flaring of traffic jams, the patterns by which instructions trickle down from managers to workers in the office, and in many other things. At the heart of our story, then, lies the discovery that networks of things of all kinds - atoms, molecules, species, people, and even ideas - have a marked tendency to organize themselves along similar lines. On the basis of this insight, scientists are finally beginning to fathom what lies behind tumultuous events of all sorts, and to see patterns at work where they have never seen the before."

Now, let's think about this for a moment. Going back to the sandpile game, you find that as you double the number of grains of sand involved in an avalanche, the likelihood of an avalanche is 2.14 times as unlikely. We find something similar in earthquakes. In terms of energy, the data indicate that earthquakes simply become four times less likely each time you double the energy they release. Mathematicians refer to this as a "power law" or a special mathematical pattern that stands out in contrast to the overall complexity of the earthquake process.

Fingers of Instability

So what happens in our game? "...after the pile evolves into a critical state, many grains rest just on the verge of tumbling, and these grains link up into 'fingers of instability' of all possible lengths. While many are short, others slice through the pile from one end to the other. So the chain reaction triggered by a single grain might lead to an avalanche of any size whatsoever, depending on whether that grain fell on a short, intermediate or long finger of instability."

Now, we come to a critical point in our discussion of the critical state. Again, read this with the markets in mind (again, emphasis mine):

"In this simplified setting of the sandpile, the power law also points to something else: the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point. What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size."

Now, let's couple this idea with a few other concepts. First, economist Dr. Hyman Minsky points out that stability leads to instability. The more comfortable we get with a given condition or trend, the longer it will persist and then when the trend fails, the more dramatic the correction. The problem with long term macroeconomic stability is that it tends to produce unstable financial arrangements. If we believe that tomorrow and next year will be the same as last week and last year, we are more willing to add debt or postpone savings for current consumption. Thus, says Minsky, the longer the period of stability, the higher the potential risk for even greater instability when market participants must change their behavior.

Relating this to our sandpile, the longer that a critical state builds up in an economy, or in other words, the more "fingers of instability" that are allowed to develop a connection to other fingers of instability, the greater the potential for a serious "avalanche."

A second related concept is from game theory. The Nash equilibrium (named after John Nash) is a kind of optimal strategy for games involving two or more players, whereby the players reach an outcome to mutual advantage. If there is a set of strategies for a game with the property that no player can benefit by changing his strategy while (if) the other players keep their strategies unchanged, then that set of strategies and the corresponding payoffs constitute a Nash equilibrium.

A Stable Disequilibrium

So we end up in a critical state of what Paul McCulley calls a "stable disequilibrium." We have "players" of this game from all over the world tied inextricably together in a vast dance through investment, debt, derivatives, trade, globalization, international business and finance. Each player works hard to maximize his own personal outcome and to reduce their exposure to "fingers of instability."

But the longer we go, asserts Minsky, the more likely and violent an "avalanche" is. The more the fingers of instability can build. The more that state of stable disequilibrium can go critical on us.

Go back to 1997. Thailand began to experience trouble. The debt explosion in Asia began to unravel. Russia was defaulting on its bonds. (Astounding. Was it less than ten years ago? Now Russian is awash in capital. Who could anticipate such a dramatic turn of events?) Things on the periphery, small fingers of instability, began to impinge on fault lines in the major world economies.

Something that had not been seen before happened. The historically sound and logical relationship between 29 and 30 year bonds broke down. Then country after country suddenly and inexplicably saw that relationship in their bonds begin to correlate, an unheard of event. A diversified pool of debt was suddenly no longer diversified. The fingers of instability reached into Long Term Capital Management and nearly brought the financial world to its knees.

And now a different set of fingers of instability are creating an even worse crisis in the credit markets. How do we explain this?

General Equilibrium with Endogenous Uncertainty

In a paper from the August 2006 Journal of Mathematical Economics entitled "General Equilibrium with Endogenous Uncertainty and Default" written by Professor Graciela Chichilnisky of Columbia University and Ho-Mou Wu at the University of Taiwan, the authors demonstrate with some very serious mathematical proofs that the more of a certain type of assets (say insurance or derivatives) that are introduced into a market, while reducing the risks that individual's face, they increase overall systemic risks.

I recently had the chance to discuss this paper and some related work with Dr. Chichilnisky. The following are insights I picked up from our conversations.

Chichilnisky created the term and theory of "Endogenous Uncertainty" about 12 years ago. It is the uncertainty coming from risks that we ourselves create - rather than risks coming from exogenous or outside events (the standard theory of risk management only considers risks that are outside events on which we have no participation in creating). It has to do with risks that we humans ourselves create through our actions, rather than coming from nature. The more the economy is globalized, the larger is human impact globally - the more frequently we will encounter such risks. Now, let's turn to the paper. (I should note that Chichilnisky was one of the creators of the carbon credit markets and is quite involved in the next phase of the Kyoto protocols. This is one very bright lady, with two doctorates in both Mathematics and Economics.)

First, the paper demonstrates that the greater the number of connections within any given economic network, the greater the system is at risk. This is counter-intuitive, but a simplified illustration may help.

Let say I own a $10 million corporate bond from Big Automotive Company (BAC) in my portfolio paying 7%. I can go into the market and purchase a credit default swap (CDS) for (say) 2% of the face value of the bonds from a large investment bank (LIB). Now I am getting a net return of 5%, but my risk is greatly reduced. LIB has insured my risk. Now LIB has a liability of $10,000,000 on its books, which of course reduces its capital. So LIB, clever folks that they are, buy another CDS from someone else on the same bonds for 1%, and thus their books are even. They own both a put and a call on $10 million in BAC bonds, so they take no hit to their capital structure. However, they do make a neat $100,000 (the difference in the buy and sell price) for making a market in BAC credit insurance.

Now, there are hundreds of investment banks and hedge funds making markets in all sorts of credit markets, buying and selling these derivatives to thousands of various investors and funds. It is quite possible that the CDS I bought has been re-shuffled a few times, so that we could have five or ten times the face amount of my bonds in the actual derivatives. I have seen reports that the total amount of CDs written on General Motors bonds are ten time the actual number of bonds.

Why would this be? If a hedge fund or investment bank thinks that default insurance on General Motors is too expensive relative to the risk, they can sell the CDS and hope to make a profit when the cost of insurance goes down. This provides liquidity to the market, but also creates a lot of connections among unrelated parties. By that I mean that I am exposed to the default risk of all the counter-parties of the firm who sold me the original insurance.

How? you might ask. Because if one of LIBs creditors defaults, then that reduces the capital of LIB. Let's say that the $10 billion of total debt in that Big Automotive Company goes bad. I call up LIB and ask for my $10 million. Not a problem, they say. We'll call the person who sold us the protection, who will call the person from whom they bought protection, until we find someone who is "naked long" BAC debt. Then they will pay up. Or we can hope they do.

But if there are several debt events that happen at once, as say generally does happen in a business downturn, there will be funds or banks that may not have enough capital. Why? Because banks and funds do not have to set aside reserve capital for potential losses and can leverage their exposure by a great deal. Technically, they are safe as the assets and liabilities on their books should match. But those assets are only as good as the counter-party who guarantees them.

Thus, we create potential fingers of instability with every new derivative we sell or buy, as we get connected to market players we have never heard of. Let's read the following paragraph from introduction to the Chichilnisky paper:

"Markets can magnify risk. As new assets [like CDS-JFM] are introduced, a creditor who is a victim of default in one transaction is unable to deliver in another, thereby causing default elsewhere. In this manner default by one individual leads, through a web of obligations, to a large number of defaults. Since new instruments create new webs of obligations, financial innovation is the precipitating factor. The transmission of default from one trader to another and from one market to another transmits individual risk and magnifies it into collective risk. Default by one individual leads to a collective risk of widespread default."

And that is what we have seen in the subprime markets. We have taken the risk of a mortgage in California and spread them literally around the world. Now one default or a thousand is no big deal. Those defaults are priced into the bonds. But when we introduce extra risk by inserting mortgages which have little economic rationale (or are outright fraud, as more evidence mounts daily of massive fraudulent activities) then we change the equation of potential systemic risk.

So far, the credit defaults are being handled by the system. That is, banks are writing off large amounts of debt, and I would expect there to be more major write-offs. Soon we will hear of insurance companies that have to take write-downs from the subprime exposure. We have seen several German banks go completely under. A money market pool of various Florida governmental entities (cities, counties, schools) will probably have to take some write-offs. The losses will be spread out and will cause some pain here and there in Florida, but it is highly unlikely that serious damage will be done to any single entity.

In fact, let me sound a note of "optimism." The ever-growing estimates of losses due to subprime may be overstated. According to a study by Goldman Sachs, the ABX indexes suggest about $400 billion in losses. But a $150 billion dollar chunk of that is from AAA rated bonds. They have been marked down an average of 18%. But in order for the AAA tranches to lose money, 50% of the mortgages in the securities would have to go into foreclosure, and those homes would have to drop 50% in value.

So, why the drop in value? Because some of the Residential Mortgage Backed Securities will more than likely face such a serious loss. Others are unlikely to see anywhere close to a 50% foreclosure rate. The problem is that investors cannot figure out which RMBS's are in trouble and which would be good bets. Until there is transparency, it is likely that prices will stay low.

As an aside, if the Bush plan to help out those who cannot make payments because of mortgage resets keeps the market from finding out the true nature of the underlying assets in these RMBS, then that is not a good thing. The devil is in the details.

My thinking is that sometime next year the credit markets start to function, and people will think that things are back to normal. New securitizations and guarantees will be found to allow the placement of debts of all types. We will never face a subprime problem again, as rules will be put in place to avoid such a crisis. The market, like an old general, is pretty good at fighting the last war.

But that does not mean that all will be well. Another conclusion of the Chichilnisky paper is that the more we create new financial instruments, the more likely it is we will have systemic problems. And since we are creating them at an ever faster pace, and tying more and more market players together, we are sowing the seeds for another Black Swan event that will crop up somewhere, leading to yet another crisis.

Does that mean we should stop the train? No, but it does mean that we should be aware of what we are doing. Let's read one last paragraph from the paper:

"The other implication of our results is that they help to formalize a 'multiplier effect' for policy. In a complex economy, financial policies which succeed in preventing default by one agent also prevent, by a chain reaction, a large number of other defaults at no additional cost. Therefore the benefits have a "multiplier effect". Our results provide support for the policy of requiring reserves to enhance financial stability."

I think the next crisis could come from the Credit Default Swaps market. Remember, this is a market which essentially has no reserves to deal with default risk other than the capital accounts of the banks and hedge funds. A worst case scenario would be for the economy to fall into a serious recession next year which would hammer high yield bonds and cause defaults in certain riskier debt, for which CDSs have been bought and sold. With banks having to write down a lot of the mortgage related debt, they would be in poor position to have to handle even greater losses.

The far more likely scenario is that we have a mild recession or slowdown, banks shore up their balance sheets and can deal with a problem in the CDS markets when it happens or with another still hidden black swan of endogenous uncertainty. It would behoove regulators or market participants to figure out how to create more of an exchange type mechanism where there was a central clearing house like the Chicago Board of Trade or NYMEX guaranteeing the CDS rather than a potentially highly leveraged systemic problem. Bank regulators should ask whether to not reserves should be held even for positions which are offset. Yes, that would eat into profits, but I think it is better than the losses which could accrue from another crisis.

But the point is that within a few years there will be yet another crisis. The research shows that the way the system is designed, by connecting ever more participants together in a vast network, practically guarantees another crisis of some kind.

So, what do you do? Pull in your cash and stick it under the mattress? Of course not. Truly diversify your portfolio, use as much hedging possibilities as you can and learn to love the volatility. Make it your friend rather than fight it. Pay more attention to markets where there is irrational behavior. It was easy to discern that there were potential problems in the subprime market a year ago. If you were reading me, you should have checked your portfolio to see if you had exposure and then eliminated it.

These things just don't "happen." We live in a world with "endogenous uncertainty and default." In the future, when you see a problem starting to develop in one part of the world, think about how those problems are connected to the rest of other world. I know I will.

Identity Theft and New York

I don't often do this, but I want to call to your attention a new sponsor for the letter, as they offer a service that I find valuable. Identity theft is becoming an increasing problem in the US, and the criminals are getting more and more sophisticated. It can be a nightmare sorting out a problem if you have one.

ID Theft Assist is a company which offers Identity Theft insurance but with a whole lot more as well. They will monitor daily your credit reports to see if someone is trying to steal your identity and alert you if there is a problem, and they have a staff which will help you do the actual work of sorting out problems if you have one. They charge a reasonable $149 a year, which like most insurance is a waste if you don't need it, but a lifesaver if you do.

You should check them out by clicking on the following link. You can click on the link to "what we do" and especially the letters from satisfied customers. I hope you never have a problem but we live in a day and age when such problems are only going to increase. http://www.idtheftassistsubscription.com

I am writing this letter on Thursday, as I am off to New York tomorrow morning to New York to attend a fund raising party (for kids education) hosted by the folks at Minyanville. My South African partner Prieur du Plessis is also in town with his wife Isabel and we actually plan to go see the Rockettes on Saturday and a few museums over the weekend. I am looking forward to it, as I don't get to be "tourist" in New York very often.

(And of course, I did not finish the letter so now it is Friday and I am at the Hyatt doing one last edit. It is snowing and Christmas in New York and I am off to the Bull and Bear for an adult beverage with friends.)

Have a great week and enjoy the Season.

Your looking forward to being tourist analyst,

John Mauldin

John@FrontLineThoughts.com

Monetary policy is out of synch with reality

By George Magnus, Financial Times UK

December 14 2007

Occasionally, there is an unreal moment on television when the movement of the speaker's lips bears no relation to what you hear. Something very similar is happening as regards the conduct of monetary policy in the downswing of the global credit cycle.

What you can hear is a legitimate expression of concerns by central bankers and some economists about easing monetary policy too fast or at all. But it is out of "synch" with the script, so to speak, which is about something quite different, namely the banking crisis. The early cost estimates approximate those of the Japanese banking crisis in the early 1990s and overshadow any of the other 112 banking crises since 1970, according to a study by the World Bank.

The first argument advanced for caution is that after the exceptional housing boom, prices should be allowed to fall back towards more reasonable levels. But there is little risk that lower interest rates would arrest the adjustment of prices. Up to 60 per cent of the variation in house prices is thought to arise from supply, regulations and inventory, rather than from macroeconomic factors. Rising repossessions are occurring before the economy has slowed down significantly. The US proposal to freeze mortgage rates for subprime borrowers misses the point that most repossessions happen because of unemployment or income constraint, not interest payment adjustment.

The moral hazard argument - to avoid rescuing risk-takers for fear of encourager les autres - is of course an important tenet of monetary policy but there comes a point when democratic societies have to simply cast it aside. We have reached that point. The capital of the banking system is under significant pressure but banks can deal with this, as they can with a decaying credit cycle. The financial system can deal also with market liquidity problems, more limited transactions volume and wider margins between buy and sell rates. What the financial system cannot deal with properly is a drying up of funding liquidity, reflected in exceptionally high interbank rates and the interactions between both types of constrained liquidity. The longer this continues, the greater are the systemic and economic risks.

To address the particular problem of high interbank rates out to three months and beyond, the Federal Reserve announced in midweek that it would provide $40bn of credit and activate $24bn of currency swap arrangements with other central banks to make dollars available. The proposed credit measures are like those pursued by the European Central Bank, but with little success; they probably will not help much on their own. Banks can absorb liquidity but if solvency issues prevent them from wanting to lend on, funding rates are simply going to remain high and sticky. That said, the status quo was not tenable either.

Inflation risk is perhaps the main economic concern for central banks and investors. But whatever the inflation risks in the next few years, it seems unreal to worry about backward-looking food and energy price rises when a nasty deflationary credit crisis is just starting. No banking crisis has ever been followed by rising inflation (except the mid-1970s when oil prices quintupled). Core inflation in most countries remains tame and there has been little pass-through of prices from headline to core rates. Thanks mainly to globalisation, wage rises and pricing power remain subdued. As output growth slows in developed countries, commodity prices are likely to drop.

Unusually expansive credit conditions are reversing. They were associated with extreme changes in consumption behaviour, reflected in the sharp fall in personal savings in the US, UK and other countries and in China's fixed investment boom. As household spending and savings adjust over the coming year and unemployment rises, the risk of higher cyclical inflation seems tiny enough to ignore.

As monetary policy must be forward-looking, it is appropriate to ease monetary conditions pre-emptively. This will not stop house prices and collateral values from falling. It can help, at the margin, to rebuild confidence and liquidity in the functioning of financial markets. It is most unlikely to be compromised by rising inflation. No one knows how bad the credit and housing cycle will get but because of that, better to act now and change policy again later, if needs be, than to recite good but flawed monetary policy mantras that are out of "synch" with what was going on in the economy. This too is a lesson from the Japanese crisis.

The helicopters start to drop money

by Martin Wolf, Financial Times

December 12 2007

The central bank helicopters are planning a co-ordinated drop of liquidity on troubled market waters. The money to be dropped now is not that large. But if this does not work, more will surely follow. The helicopters will fly again and again and again.

One point is clear: central banks must be pretty worried to take such a joint action. For what is remarkable about Wednesday’s statement is that five central banks – the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve and the Swiss National Bank – are co-ordinating their (different) interventions. Their hope must be that this action will trigger not panic (”what do the central banks know that I do not?”) but confidence (”now that the central banks are prepared to intervene in this way, I can at last stop worrying”).

It is easy to understand why central banks should have decided to take heroic action. Confidence has fled the markets in a four-month long episode of “revulsion”. As a result, monetary policy is not being transmitted to the ultimate borrowers as central banks wish. Particularly worrying has been the widening of gaps between three-month inter-bank lending rates and policy rates in the dollar, euro and sterling markets. Spreads in the last of these have recently become enormous (at more than 100 basis points).

Yet this is not the only indication of distress: in the US, for example, the spread between the rate of interest on 3-month treasury bills and AA-rated asset-backed commercial paper has widened to 270 basis points from a mere 30 basis points earlier in the year. This is revulsion, indeed.

So why might Wednesday’s co-ordinated interventions succeed where previous actions have not? In a word, the answer is: stigma.

Central banks have become increasingly worried about the unwillingness of banks to borrow from them. These banks reasonably fear that exceptional borrowing is a signal mainly of distress. The hope of the central bankers is that by auctioning funds to a wide group of institutions such anxiety would diminish, if not disappear. That hope is strengthened by the fact that these actions are joint: they are evidently aimed at lifting sentiment rather than saving specific institutions.

Will this work? The answer is that if the fundamental problem in the markets is lack of liquidity (that is, panic), rather than insolvency, and if central banks are believed willing to offer liquidity to solvent institutions without limit at what the latter consider a “reasonable” discount, then symptoms of stress should indeed disappear.

Yet these are both important provisos. In particular, there is good reason to believe that a good part of the stress is caused by worries over solvency, indeed by the reality of threatened insolvency in at least some cases. True, central banks or, more precisely, the treasuries that stand behind them, could eliminate that concern, too, by buying up every piece of paper, good, bad and indifferent. But that would also be an open-ended, possibly very expensive and certainly unpopular bail out.

Moreover, even if today’s stress is indeed a liquidity problem (something that we do not now know), there remains the question of the scale of the intervention required. Assume, for example, that central banks end up buying a vast amount of paper and so providing liquidity to institutions that have deliberately taken on big risks, by lending long and borrowing short. They have then validated those strategies, after the event.

Why monetary policy easing is warranted even in the current insolvency crisis

by Nouriel Roubini | Dec 15, 2007

Recently I have been repeatedly asked – by commentators on this blog and others - the following questions: If you rightly believe that the current global financial crisis is one of insolvency and not just of illiquidity and is also due to fundamental incentive problems of financial agents in a world of asymmetric information why do you now recommend that central banks aggressively cut interest rates? Since you argue that monetary easing will not prevent the unavoidable hard landing why to support a reduction in policy rates? Wouldn’t this monetary easing imply a bailout of reckless lenders, borrowers and investors, cause another asset bubbles and prevent the necessary – if painful – loss of asset values and restructuring of distressed claims? And wouldn’t this monetary easing risk causing high inflation at a time when such inflationary pressures are already rising? And since – as you correctly argued – the recently announced coordinated monetary policy injection by central banks has so far failed to affect liquidity spread in a significant way – why should easing policy rates make any difference?

The arguments against policy rate easing by central banks are thus threefold:

a) such monetary easing will not prevent a hard landing and will only postpone the necessary restructuring after a reckless credit-boom driven asset bubble;

b) it will cause moral hazard and possibly create future bubbles;

c) it may lead to higher inflation.

Let me argue why monetary policy easing – not just palliatives such as the liquidity injections announced by central banks this week but rather significant cuts in policy rates – are now necessary and warranted.

First of all, as argued here since August, the current global financial crisis is due to insolvency on top of illiquidity and due to fundamental problems in a world of financial globalization; and monetary policy easing will not – in my view – avoid a hard landing of the US economy and a sharp slowdown of global economic growth. Notice that the analysis that this is a financial crisis of insolvency - not just illiquidity is shared by very distinguished commentators such as Martin Wolf, Paul Krugman and George Magnus.

While aggressive monetary policy easing will not prevent a hard landing – as it did not prevent one in 2001 – the length and depth of an economic downturn is affected by monetary policy. And it is both the duty and responsibility of central banks to reduce partly avoidable severe economic downturn that lead to massive losses of jobs, welfare and incomes. The job of a central bank is not to bail out the financial system and/or investors but that of bailing out the real economy. Having millions of workers lose their jobs only to teach a lesson to reckless investors and lenders on Wall Street and the City does not make sense.

And while monetary easing will not prevent a US recession that is now necessary to clean up the credit mess, leverage and excesses that were built up in the last six years such monetary easing may reduce the length of such a recession and dampen its depth. Monetary policy may be impotent in affecting the likelihood of a economic downturn that is unavoidable given fundamental real and financial shocks in an economy; but it is not impotent in affecting how deep and long such a recession will be. And inflicting severe misery and pain and collateral damage on innocent bystanders – i.e. the millions of individuals, workers and households – that were not necessary at fault is not sound economic policy. Thus, a US recession and global slowdown may be unavoidable; but how ugly and painful and protracted it will be does depend on whether the Fed and other central banks start cutting interest rates to dampen its effects.

Second, would monetary policy easing represent a form of moral hazard and risk creating another asset bubble? Not necessarily. At this point the financial losses from the reckless credit bubble of the last few years are mostly unavoidable and will not be avoided by easier monetary policy. Starting in 2001 the Fed cut rates from 6.5% all the way to 1% by 2003; in spite of that the bust of the tech bubble continued: the Nasdaq fell all the way from a level of 5000 to about 1200; other stock indexes in the US and abroad sharply fell; thousands of internet companies that were mostly “vaporware” – i.e. with little revenues, let alone earnings – went belly up and bankrupt. Thus that aggressive monetary easing did not succeed in bailing out investors.

Similarly today home prices that rose in a bubble like fashion by almost 100% in real terms between 1997 and 2006 will fall by at least 20% - if not more – regardless of what the Fed does; given the biggest glut in new and existing homes in US history and the biggest housing recession ever no amount of Fed easing will prevent this collapse in home prices. And the broader financial losses – that will be close to 1,000 billion dollars once you add sub-prime, near prime, prime, auto loans, credit cards, student loans, commercial real estate, leveraged loans and lending to the distressed parts of the corporate sector – will be massive regardless of what the Fed does. And once the unavoidable hard landing becomes clear to market participants the current delusional hope of the stock market investors that the Fed can prevent such hard landing will fizzle out and stock price will sharply fall as well. In a recession there is no room to hide: in a typical US recession – with or without Fed easing – the S&P 500 falls by an average of 28% in nominal terms and almost as much in real terms.

When bubbles go bust the Fed can only minimize the collateral damage to the economy and reduce modestly the severity of the losses; it cannot prevent massive losses and sharp falls in asset prices from occurring as the experience with the S&L boom and bust in the late 1980s and the tech boom and bust in the late 1990s suggests.

So to those who are worried about moral hazard: don’t worry as reckless lenders, borrowers and investors will be severely punished as they are already. Of course if instead of monetary easing the governments were to provide direct subsidies to lenders or borrowers once could formally talk of a bailout; but nothing like that is in the cards. Even the modest Treasury plan to freeze reset rates for some mortgage is neither a bailout of lenders/investors or of borrowers. It does not bail out lenders/investors because, if anything, they will have to accept a lower stream of payments than the original mortgage contract; and it is not a bailout of borrowers as those who are insolvent will default anyone; the plan only helps those who are potentially illiquid but solvent to avoid a default that will be hurting both the borrower and the lender/investor.

Of course the overall losses and fall in asset prices may be smaller – with aggressive monetary easing – than it would be without it; but causing a much more severe and protracted recession that hurts most workers just to maximize the losses of reckless investors/lender is not sensible public policy.

How about the argument that easing a lot now will cause another asset bubble and a bigger mess down the line? After all Greenspan warned in 1996 about irrational exuberance and did almost nothing about it thus feeding the tech bubble of the late 1990s. And when that bubble went bust the Fed cut the Fed Funds rate too much and for too long thus creating the housing bubble. So wouldn’t a strong Fed easing cause another asset bubble and a bigger crisis ahead as the Fed looks like a serial bubble blower? One could cynically notice that the Fed may be running out of asset bubbles to create as even the private equity bubble is now fizzling out. But more seriously: the asset bubbles of the last decades – the real estate bubble of the 1980s, the tech bubble of the 1990s, the housing bubble of the 2000s – were due more to poor supervision and regulation of the financial system than to monetary policy ease.

Those of us who believe that central banks should have a symmetric approach to asset bubbles (see my paper on monetary policy and asset bubbles) – i.e. try to prick/contain them when they are on the way up so as to be able to ease policy and minimize the real collateral damage if/when they burst – rather than the Greenspan/Kohn/Bernanke doctrine of asymmetric response – do nothing on the way up when the bubble is growing while aggressively ease when the bubble burst – do also agree that monetary policy that tries to control asset bubbles on the way up is not necessarily and only based on the use of interest rate policy: poor regulation and supervision of the S&Ls caused that real estate bubble and banking crisis.

Similalry, the tech bubble would have not been stopped with a 50 or even 100 or 150 bps higher Fed Funds rate as manic investors were expecting 100% returns per year at the peak of that tech mania. Rather much larger margin requirement on leveraged investments in the stock markets would have been the more appropriate response. Similarly the latest housing bubble would have been restrained in modest measure if the Fed has reduced the Fed Funds rate less and started raising it earlier and faster. What created this mess was not as much monetary policy easing but rather reckless behavior of regulators and supervisors – including Greenspan and the Fed – who were asleep at the wheel while this reckless lending was occurring and, at times, were active cheerleaders – namely Greenspan – of all the financial innovations that led to such reckless mortgage lending and the increase in the leverage of the financial system.

Thus, the way to deal with the risk of new asset bubble is not to renounce to monetary policy easing that is necessary to reduce the real economy collateral damage of a bursting bubble; it is rather using the appropriate supervision and regulation of the financial system to ensure that a new bubble does not emerge from that monetary policy easing. It is still appropriate and legitimate use of monetary policy easing interest rates when an asset bubble bursts when both monetary and regulatory policies have been used to control a bubble when such a bubble is emerging; so a symmetric approach of monetary/regulatory policy to bubbles – rather than the asymmetric approach advocated by Bernanke/Greenspan/Kohn – is the appropriate way to minimize the risk of moral hazard and to avoid turning the Fed into a serial bubble blower.

Third issue: would monetary policy easing cause a much higher inflation rate and undermine the anti-inflation policy credibility of the central banks? After all inflation rates are now rising around the world thanks to high and rising oil, energy, food and oher commodity prices. My answer to the question above is no as a US hard landing followed by a global slowdown will seriously reduce those inflationary force and would – like in 2001-2003 – rather induce serious deflationary risks. Inflationary pressures may be elevated now but they will fizzle away in short order once the US hard landing is in full swing. Thus, the central banks current concerns with a rise in inflation are misplaced as a US recession will lead to global disinflation (and concerns about deflation as in 2002-2003). There are at least four reasons why these global inflationary forces will abate once this US hard landing occurs:

a) a fall in US aggregate demand relative to supply;

b) a slack in labor market conditions and slowdown in wage growth as the unemployment rates sharply increases;

c) a fall in global aggregate demand as the glut of output from overinvestment in China and some other emerging market economie will face a fall in global demand as the world re-couples with the US hard landing;

d) a sharp fall in oil, energy, food and other commodities prices as a global slowdown emerges.

We are thus set for the repeat of the 2000-2003 cycle when the Fed and other central banks underestimated the downside risks to growth and overestimated the upward risks to inflation and ended up having to aggressively cut rates to deal with the fall in economic activity and the deflation risks that such a US and global recession triggered.

To conclude, I thus repeat what I wrote before the last FOMC meeting and before the coordinated monetary policy injections were announced this week; i.e. I argued against ineffective solutions such as monetary injections at unchanged policy rates and argued in favor of significantly reducing such policy rates:

So the time for band aid measures and clever but ineffective palliatives is over: only a monetary policy ease could make some difference in reducing the level of interbank rates (if not the interbank spreads) and avoid the sharp tightening in monetary conditions and rise in real short term interest rates that the spike in interbank spreads has created.

This author has argued for a while that a Fed easing will not prevent a hard landing as the more fundamental credit problems of the economy will not be resolved by monetary policy alone. That does not mean that policy rates should not be reduced in the US and elsewhere: a US recession will, at this point, occur regardless of how fast the Fed eases but the depth and persistence of such a recession will depend on how aggressive the Fed is. I.e. the Fed will not at this point be able to prevent a recession – for the same reasons why it did not prevent one (in spite of very aggressive easing) in 2001 – but it would be able to put a floor on the depth and length of such a recession.

The same holds for all the other major central banks: ECB, BoE, BoC, BoJ. There is now a serious risk of a global economic downturn in 2008 as the US is inevitably headed towards a recession and this recession is leading to economic recoupling across the globe. Given the lags in the effect of monetary policy – 6 to 9 months – the time to cut rates is now. As central banks have remained on hold – with the exception of the Fed and the BoC today – real short rates faced by financial institutions and all sort of other borrowers (as many private financial contracts are linked to Libor) have gone up by 75 to 125bps in the last few weeks; this is a severe tightening of monetary and credit conditions. Thus, holding nominal policy rates steady means having effectively increased such nominal and real borrowing rates for banks, financial institutions, corporations and even households (as most revolving consumer credit and ARM style of mortgage products are linked to short rates).

So while we should not delude ourselves that cutting policy rates will resolve deep seated credit and insolvency problems among many distressed borrowers – and resolve fundamental problems in a world of financial innovation, globalization and securitization that require fundamental regulatory reforms - that will take years to resolve, the alternative of not cutting policy rate aggressively is the risk of a global economic recession…

And it does not make sense to avoid bailing out the real economy – and preventing a massive global loss of incomes and jobs – just in order to punish reckless lenders and investors in the financial market and thus avoid moral hazard. Moral hazard in financial markets is contained via sensible credit policy and appropriate regulation and supervision of financial markets. In times of economic danger bailing out the real economy with monetary easing may have the by-product of partially reducing the financial losses of reckless lenders and investors (an indirect bailout). But the first order costs of a global recession is much larger than the second order costs of partial moral hazard; such moral hazard will be kept in check by hundreds of billions of dollars of losses that will occur regardless of monetary policy easing and via sounder regulation and supervision of financial markets in the future up-cycle of credit.

To conclude, as it is obvious to any sane person when your home is on fire it is not a good time to sit in front of the burning building to discuss the merits of the moral hazard of fire insurance on your incentive to recklessly smoking in bed or debate the additional damage to your home coming from excessive use of fire hoses (the risk of higher inflation down the line). When your home is on fire and there is serious risk of fire contagion to all of your town and beyond you want the entire fire brigade to provide enough liquidity to avoid entire edifice and town burning to the ground. And using hand-held and hand-carried buckets of water while pondering the intellectual merits of moral hazard of fire insurance in order deal with a major five-alarm fire - rather than using immediately your global fire brigade - is delusional. So it is time for the international central banks’ liquidity fire brigades to turn on the hoses and dealing with this most dangerous global fire.

Unfortunately, this past week the central banks of the world – instead of using their most powerful and effective liquidity hoses – i.e. a reduction in policy rates – have stared at this most dangerous and spreading fire of a global liquidity seizure and decided to continue to use hand-carried and hand-held buckets of water that have proven ineffective before and have been ineffective again as liquidity spread have remained stubbornly high even after these new monetary injections were announced. They will realize in due time that much more effective and radical action – in the form of aggressive reduction in monetary policy rates – may be necessary and warranted. But it looks like they are already behind the curve – most of all the ECB – and what they will do ahead will be too little too late to address a fire that is now spreading without control from country to country.

After the Money’s Gone

By PAUL KRUGMAN, New York Times

Published: December 14, 2007

On Wednesday, the Federal Reserve announced plans to lend $40 billion to banks. By my count, it’s the fourth high-profile attempt to rescue the financial system since things started falling apart about five months ago. Maybe this one will do the trick, but I wouldn’t count on it.

In past financial crises — the stock market crash of 1987, the aftermath of Russia’s default in 1998 — the Fed has been able to wave its magic wand and make market turmoil disappear. But this time the magic isn’t working.

Why not? Because the problem with the markets isn’t just a lack of liquidity — there’s also a fundamental problem of solvency.

Let me explain the difference with a hypothetical example.

Suppose that there’s a nasty rumor about the First Bank of Pottersville: people say that the bank made a huge loan to the president’s brother-in-law, who squandered the money on a failed business venture.

Even if the rumor is false, it can break the bank. If everyone, believing that the bank is about to go bust, demands their money out at the same time, the bank would have to raise cash by selling off assets at fire-sale prices — and it may indeed go bust even though it didn’t really make that bum loan.

And because loss of confidence can be a self-fulfilling prophecy, even depositors who don’t believe the rumor would join in the bank run, trying to get their money out while they can.

But the Fed can come to the rescue. If the rumor is false, the bank has enough assets to cover its debts; all it lacks is liquidity — the ability to raise cash on short notice. And the Fed can solve that problem by giving the bank a temporary loan, tiding it over until things calm down.

Matters are very different, however, if the rumor is true: the bank really did make a big bad loan. Then the problem isn’t how to restore confidence; it’s how to deal with the fact that the bank is really, truly insolvent, that is, busted.

My story about a basically sound bank beset by a crisis of confidence, which can be rescued with a temporary loan from the Fed, is more or less what happened to the financial system as a whole in 1998. Russia’s default led to the collapse of the giant hedge fund Long Term Capital Management, and for a few weeks there was panic in the markets.

But when all was said and done, not that much money had been lost; a temporary expansion of credit by the Fed gave everyone time to regain their nerve, and the crisis soon passed.

In August, the Fed tried again to do what it did in 1998, and at first it seemed to work. But then the crisis of confidence came back, worse than ever. And the reason is that this time the financial system — both banks and, probably even more important, nonbank financial institutions — made a lot of loans that are likely to go very, very bad.

It’s easy to get lost in the details of subprime mortgages, resets, collateralized debt obligations, and so on. But there are two important facts that may give you a sense of just how big the problem is.

First, we had an enormous housing bubble in the middle of this decade. To restore a historically normal ratio of housing prices to rents or incomes, average home prices would have to fall about 30 percent from their current levels.

Second, there was a tremendous amount of borrowing into the bubble, as new home buyers purchased houses with little or no money down, and as people who already owned houses refinanced their mortgages as a way of converting rising home prices into cash.

As home prices come back down to earth, many of these borrowers will find themselves with negative equity — owing more than their houses are worth. Negative equity, in turn, often leads to foreclosures and big losses for lenders.

And the numbers are huge. The financial blog Calculated Risk, using data from First American CoreLogic, estimates that if home prices fall 20 percent there will be 13.7 million homeowners with negative equity. If prices fall 30 percent, that number would rise to more than 20 million.

That translates into a lot of losses, and explains why liquidity has dried up. What’s going on in the markets isn’t an irrational panic. It’s a wholly rational panic, because there’s a lot of bad debt out there, and you don’t know how much of that bad debt is held by the guy who wants to borrow your money.

How will it all end? Markets won’t start functioning normally until investors are reasonably sure that they know where the bodies — I mean, the bad debts — are buried. And that probably won’t happen until house prices have finished falling and financial institutions have come clean about all their losses. All of this will probably take years.