Secretary of Bailouts

A Treasury pick who was present at the creation of the panic.

Barack Obama’s widely leaked selection of Timothy Geithner as his Treasury Secretary is certainly a sign of the financial times: About Mr. Geithner’s views on taxes and economics, the world knows very little. His specialty at the Clinton Treasury and as President of the New York Federal Reserve has been negotiating bailouts and otherwise navigating through financial panics.

[Review & Outlook] AP

Timothy Geithner with Ben Bernanke.

His first and primary task, in other words, will be to serve as Secretary of Bailouts. For that job, Mr. Geithner is probably the best choice short of Paul Volcker, and he guarantees the smoothest transition from the current Treasury team. He won’t have to be introduced to the various Wall Street and Federal Reserve players, and he knows as well as anyone which banks are vulnerable and likely to threaten the larger financial system.

This continuity is especially important given that the credit markets have taken a major step backward since Barack Obama’s election. Stocks are off some 15%, credit spreads have widened again, and bear raids are once more targeting Citigroup and other financial companies. The uncertainty over Mr. Obama’s team and its direction has itself been fueling the lack of confidence, so we’re glad to see the President-elect getting on with the show.

Mr. Geithner’s political style is to listen first, which by itself makes him a better choice than Harvard economist Larry Summers, who would find a way to condescend to Albert Einstein. Mr. Summers is reportedly slated to run Mr. Obama’s National Economic Council in the White House. The Treasury Secretary has typically been the most prominent Administration voice on the economy, but Mr. Summers is not the sort merely to play honest broker. Mr. Geithner, who once worked for Mr. Summers, will have to work to avoid being seen as second fiddle.

Mr. Obama’s political adviser, David Axelrod, also sent a useful signal yesterday by hinting on “Fox News Sunday” that an immediate tax increase may be off the table. In his Saturday radio address, Mr. Obama said that his first priority will be a huge new spending and middle-class tax cut “stimulus” — perhaps as large as $500 billion. “The main thing right now is to get this economic recovery package on the road, to get money in the pockets of the middle class, to get these projects going, to get America working again, and that’s where we’re going to be focused in January,” added Mr. Axelrod.

The prospect of a tax hike during a recession has been a prominent source of investor anxiety. The President-elect would be smarter still if he announced that he won’t allow the lower Bush tax rates to expire after 2010 as they are scheduled to do. The last thing frightened investors want to see now is a lower after-tax return on risk-taking and investment.

What Mr. Geithner thinks about taxes is something of a mystery — and that’s not the only one. As a protégé of Mr. Summers and Robert Rubin, the 47-year-old may share their view that tax rates don’t matter much to investment choices. On the other hand, he hasn’t declared himself in public on the issue as far as we know.

For that matter, most of his work in public life has been done in backrooms or as a loyal Sancho Panza. During the Clinton years, he assisted Mr. Summers on various international bailouts. And during the current panic, he has properly deferred in public to Fed Chairman Ben Bernanke or Treasury Secretary Hank Paulson. Now Mr. Geithner will have to become the Administration’s chief financial spokesman, so it will be useful for the Senate to sound him out during confirmation hearings.

All the more so because some of his bailout decisions have been less than successful. Mr. Geithner was the driving force behind the government takeover of insurance giant AIG — a “rescue” that has itself twice had to be rescued with more taxpayer capital. The most frustrating part of the AIG episode has been the New York Fed’s lack of transparency, both about the nature of the “systemic risk” that required the takeover and why it was superior to bankruptcy. This is another subject worthy of confirmation scrutiny, not least as an indication of Mr. Geithner’s standards for future interventions.

Mr. Geithner was also on the Fed’s Open Market Committee when it made its fateful decisions to keep real interest rates negative for so long, fueling the credit mania that has since turned to panic. Those monetary decisions are typically led by the Fed Chairman, but Mr. Geithner never dissented. While a Treasury Secretary doesn’t directly make monetary policy, his private advice can be critical to Fed decisions. This is another area ripe for Senate exploration.

We suppose in that sense there is some rough justice in Mr. Geithner’s nomination. Having been present at the creation of the current mess, he can help clean it up by avoiding some of the same mistakes.

The Fed Is Out of Ammunition

A discredited dollar is a likely outcome of the current crisis.

With an estimated $4 trillion in housing wealth and $9 trillion in stock-market wealth destroyed so far in the United States, there is little doubt that we are witnessing a classic debt-deflation bust at work, characterized by falling prices, frozen credit markets and plummeting asset values.

[Commentary] Chad Crowe

Those who want to understand the mechanism might ponder Irving Fisher’s comment in 1933: When it comes to booms gone bust, “over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money.”

The growing risk of falling prices raises a challenge for one of the conventional wisdoms of the modern economics profession, and indeed modern central banking: the belief that it is impossible to have deflation in a fiat paper-money system. Yet U.S. core CPI fell by 0.1% month-on-month in October, the first such decline since December 1982.

The origins of the modern conventional wisdom lies in the simplistic monetarist interpretation of the Great Depression popularized by Milton Friedman and taught to generations of economics students ever since. This argued that the Great Depression could have been avoided if the Federal Reserve had been more proactive about printing money. Yet the Japanese experience of the 1990s — persistent deflationary malaise unresponsive to near zero-percent interest rates — shows that it is not so easy to inflate one’s way out of a debt bust.

In the U.S., the Fed can only control the supply of money; it cannot control the velocity of money or the rate at which it turns over. The dramatic collapse in securitization over the past 18 months reflects the continuing collapse in velocity as financial engineering goes into reverse.

True, this will change one day. But for now, the issuance of nonagency mortgage-backed securities (MBS) in America has plunged by 98% year-on-year to a monthly average of $0.82 billion in the past four months, down from a peak of $136 billion in June 2006. There has been no new issuance in commercial MBS since July. This collapse in securitization is intensely deflationary.

It is also true that under Chairman Ben Bernanke, the Federal Reserve balance sheet continues to expand at a frantic rate, as do commercial-bank total reserves in an effort to counter credit contraction. Thus, the Federal Reserve banks’ total assets have increased by $1.28 trillion since early September to $2.19 trillion on Nov. 19. Likewise, the aggregate reserves of U.S. depository institutions have surged nearly 14-fold in the past two months to $653 billion in the week ended Nov. 19 from $47 billion at the beginning of September.

But the growth of excess reserves also reflects bank disinterest in lending the money. This suggests the banks only want to finance existing positions, such as where they have already made credit-line commitments.

Monetarist Bernanke and others blame Japan’s postbubble deflationary downturn on policy errors by the Bank of Japan. But he and others are about to find out that monetary gymnastics are not as effective as they would like to think. So too will the Keynesians who view an aggressive fiscal policy as the best way to counter a deflationary slump. While public-works spending can blunt the downside and provide jobs, it remains the case that FDR’s New Deal did not end the Great Depression.

There are no easy policy answers to the current credit convulsion and intensifying financial panic — not as long as politicians and central bankers are determined not to let financial institutions fail, and so prevent the market from correcting the excesses. This is why this writer has a certain sympathy for Treasury Secretary Henry Paulson, even if nobody else seems to. The securitized nature of this credit cycle, combined with the nightmare levels of leverage embedded in the products dreamt up by the quantitative geeks, means this is a horribly difficult issue to solve.

Virtually everybody blames Mr. Paulson for the decision to let Lehman Brothers go. But this decision should be applauded for precipitating the deflationary unwind that was going to come sooner or later anyway.

The Japanese precedent also remains important because the efforts in the West to prevent the market from disciplining excesses will have, as in Japan, unintended, adverse, long-term consequences. In Japan, one legacy is the continuing existence of a large number of uncompetitive companies which have caused profit margins to fall for their more productive competitors. Another consequence has been a long-term deflationary malaise, which has kept yen interest rates ridiculously low to the detriment of savers.

Meanwhile, the most recent Fed survey of loan officers provides hard evidence of the intensifying credit crunch in America. A net 83.6% of domestic banks reported having tightened lending standards on commercial and industrial loans to large and midsize firms over the past three months, the highest since the data series began in 1990. A net 47% of banks also indicated that they had become less willing to make consumer installment loans over the past three months.

Consumers are also more reluctant to borrow. A net 48% of respondents indicated that they had experienced weaker demand for consumer loans of all types over the past quarter, up from 30% in the July survey. This hints at the Japanese outcome of “pushing on a string” — i.e., the banks can make credit available but cannot force people to borrow.

What happens next? With a fed-funds rate at 0.5% or lower in coming months, it is fast becoming time for investors to read again Mr. Bernanke’s speeches in 2002 and 2003 on the subject of combating falling inflation. In these speeches, the Fed chairman outlined how policy could evolve once short-term interest rates get to near zero. A key focus in such an environment will be to bring down long-term interest rates, which help determine the rates of mortgages and other debt instruments. This would likely involve in practice the Fed buying longer-term Treasury bonds.

It would seem fair to conclude that a Bernanke-led Fed will follow through on such policies in coming months if, as is likely, the U.S. economy continues to suffer and if inflationary pressures continue to collapse. Such actions will not solve the problem but will merely compound it, by adding debt to debt.

In this respect the present crisis in the West will ultimately end up discrediting mechanical monetarism — and with it the fiat paper-money system in general — as the U.S. paper-dollar standard, in place since Richard Nixon broke the link with gold in 1971, finally disintegrates.

The catalyst will be foreign creditors fleeing the dollar for gold. That will in turn lead to global recognition of the need for a vastly more disciplined global financial system and one where gold, the “barbarous relic” scorned by most modern central bankers, may well play a part.

Mr. Wood, equity strategist for CLSA Ltd. in Hong Kong, is the author of “The Bubble Economy: Japan’s Extraordinary Speculative Boom of the ’80s and the Dramatic Bust of the ’90s” (Solstice Publishing, 2005).

Obama Will Get Stimulus Bill First Day, Democrats Say

Nov. 23 (Bloomberg) — Congress will send President-elect Barack Obama an economic stimulus package the day he takes office Jan. 20, two Democratic lawmakers said today.

Senator Charles Schumer of New York said on ABC’s “This Week” program that the package will be between $500 billion and $700 billion. House Majority Leader Steny Hoyer, of Maryland, said on “Fox News Sunday” that he believed the Inauguration Day goal would be met, but he declined to put a price tag on the bill.

“I think Congress will work with the president elect starting now and will have a major stimulus package on his desk by Inauguration Day,” Schumer said. “I think it has to be deep. My view it has to be between five and $700 billion.”

Obama said yesterday he aims to save or create 2.5 million jobs in his two-year plan to stimulate an economy facing a “crisis of historic proportions.”

The U.S. economic slowdown has been exacerbated by the worst credit crisis in seven decades. More firings will weigh on the economy and consumer spending will pressure Obama and Congress to agree on legislation that will stimulate growth, economists say.

Economic Team

Obama is moving quickly to assemble his economic team.

Timothy Geithner, head of the Federal Reserve Bank of New York, will be nominated Treasury secretary, and Lawrence Summers will head the National Economic Council, Democratic aides said. Summers served as President Bill Clinton’s last Treasury chief.

House Speaker Nancy Pelosi today said any stimulus package must be several hundred billion dollars. “The sooner we do one, the smaller it can be,” she said on the CBS “Face the Nation” program.

Senator Richard Shelby, the Alabama Republican who is the ranking member of the Senate Banking Committee, said he wants to see the details of a stimulus package before deciding whether to back it. “I want to support things that are meaningful for the economy,” Shelby told ABC.

Obama’s stimulus plan involves an infusion of cash for middle-class tax cuts, rebuilding roads, bridges and schools, building broadband Internet access and investing in clean energy.

Tax Cut Expiration

Obama strategist David Axelrod suggested that Obama might consider delaying a repeal of Bush administration tax cuts for the wealthy by allowing them to expire as scheduled at the end of 2010. “Those considerations will be made,” he said.

The president-elect is “committed to getting middle-class tax relief in the pipeline quickly, and there’s no doubt that we’re going to have to make some hard decisions in order to pay for the things we need,” Axelrod told Fox today. “The main thing right now is to get this economic recovery package on the road, to get money in the pockets of the middle class.”

Senator Carl Levin, a Michigan Democrat, opposed allowing the tax cuts “for the upper brackets” to expire, saying on CNN’s “Late Edition” program that Congress should move more quickly to end them. “We just can’t afford to continue them,” he said.

House Republican Leader John Boehner of Ohio pushed for cutting the capital-gains tax to stimulate the economy.

Capital Gains Tax

“If we’re really serious about creating jobs, what we ought to do is we ought to eliminate the capital-gains tax,” Boehner said on Fox. “Why not lower capital gains taxes for — and corporate income taxes for corporations in America to help keep jobs here?”

Senator Joe Lieberman, an independent from Connecticut argued for action before President George w. Bush leaves office Jan. 20.

“I’m concerned that we’re between presidents now, and in the meantime, the economy continues to cycle down, and, to a lot of people, out of control,” Lieberman said on CNN’s “Late Edition” program.

Policy makers have “to get banks to start lending money again,” Lieberman said. “They’re not lending money, and, until they do, this economy is going to go nowhere.”

Yen Gains as U.S. Government Weighs Up Citigroup Rescue Plan

Nov. 24 (Bloomberg) — The yen climbed against the dollar and the euro as discussions over a possible U.S. government bailout of Citigroup Inc. prompted investors to shun higher- yielding overseas assets funded from Japan.

Japan’s currency also advanced against the Australian and New Zealand dollars, two favorites of so-called carry trades, as U.S. regulators held talks with Citigroup to limit the lender’s potential losses on more than $100 billion of toxic assets after the bank’s shares plunged 60 percent last week.

“The fact that we’re waiting for further news on official support for Citigroup is leaving markets a little bit on the defensive,” said Tony Morriss, a senior currency strategist at Australia & New Zealand Banking Group in Sydney. “These issues around Citi are a particularly U.S. problem.”

Japan’s currency rose 0.8 percent to 95.15 per dollar as of 10:08 a.m. in Tokyo from 95.94 in New York on Nov. 21. It climbed 0.8 percent to 119.75 per euro. The dollar was little changed at $1.2587 per euro. Foreign-exchange movements may be exaggerated because trading volumes are lower than usual due to a Japanese public holiday today, Morriss said.

The yen climbed 2 percent to 59.48 versus the Australian dollar and 1.9 percent to 50.44 against the New Zealand dollar. Japan’s benchmark interest rate of 0.3 percent is the lowest among major economies.

The Federal Reserve and Treasury Department were locked in discussions with Citigroup and other regulators throughout the weekend and a deal may be reached before the start of trading this week in New York, according to people familiar with the talks. The non-performing assets would remain at Citigroup, with the government agreeing to assume losses beyond a specified amount, two of the people said.

U.S. Stock Futures Gain After Fed, Citigroup Weigh Loss Limits

Nov. 24 (Bloomberg) — U.S. stock futures rose on speculation the government will help Citigroup Inc. weather mortgage losses and after Democratic lawmakers pledged to agree on an economic stimulus package by January.

December futures on the Standard & Poor’s 500 Index climbed 3.3 points, or 0.4 percent, to 795.3 as of 10:08 a.m. in Tokyo. The benchmark gauge dropped 8.4 percent to 800.03 last week and closed at an 11-year low of 752.44 on Nov. 20.

Citigroup, which lost 60 percent last week to $3.77, and U.S. regulators are in talks about a plan to limit the bank’s potential losses from toxic assets, people familiar with the matter said. Futures were also boosted after Senator Charles Schumer of New York said Democrats will propose between $500 billion and $700 billion of federal stimulus.

“With Citigroup hanging in the low single digits, the market was calling for either a breakup or some kind of resolution,” said Jack Ablin, who helps manage about $60 billion as chief investment officer of Harris Private Bank in Chicago. “This is going to be the main focus of market activity. It should be good news.”

South Korea’s Kospi Index gained 0.6 percent. Japanese markets are closed for a holiday.

The S&P 500 tumbled 46 percent this year, poised for its biggest annual decline since 1931, after almost $1 trillion of bank losses shrunk the economy and corporate profits fell for five straight quarters. Concern Citigroup may need a government takeover sent bank stocks in the S&P 500 down 24 percent last week, the steepest slide in at least 19 years.

Citigroup Talks

Regulators, including the Federal Reserve and Treasury Department, were locked in discussions with Citigroup this weekend, according to three people who declined to be identified because the negotiations are confidential.

More than $7 trillion was erased this year from U.S. equity markets. Concern the recession is worsening was spurred last week after jobless claims approached the highest level since 1982, prices paid to U.S. producers plunged by the most on record and the Federal Reserve said manufacturing in the Philadelphia area shrank at the fastest pace in 18 years.

Stocks rallied Nov. 21, pushing the S&P 500 up 6.3 percent, after President-elect Barack Obama picked New York Federal Reserve Bank chief Timothy Geithner to head the Treasury.

Geithner will be nominated Treasury secretary, and Lawrence Summers will head the National Economic Council, Democratic aides said. Summers served as President Bill Clinton’s last Treasury chief.

Stimulus Package

House Speaker Nancy Pelosi said any stimulus package must be several hundred billion dollars. “The sooner we do one, the smaller it can be,” she said on the CBS “Face the Nation” program.

The S&P 500 fetches 9.2 times analysts’ forecast for next year’s earnings, the cheapest compared with historical profits since 1998, according to data compiled by Bloomberg and S&P.

In aggregate, earnings fell 18 percent for the 479 companies in the S&P 500 that reported third-quarter results through Nov. 20, according to data compiled by Bloomberg. Companies scheduled to report this week include Campbell Soup Co., Deere & Co. and Tiffany & Co.

As Treasuries rose, the dividend yield on the S&P 500 exceeded the benchmark 10-year note’s yield for the first time since 1958. The 10-year yield declined to 3.20 percent from 3.74 percent, and touched 2.99 percent, the lowest since the government began regular issuance of the securities.

A measure of the cost of using options to insure against declines in the S&P 500 gained 9.6 percent last week and rose to a record 80.86 on Nov. 20. The VIX, as the Chicago Board Options Exchange Volatility Index is known, fell on Nov. 21 to 72.67 as stocks climbed.

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