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Quantitative Easing Has Been A Monetary Failure; Persistent Deflation Means More Fed Intervention Coming Soon
by Tyler Durden

As more and more pundits discuss the spectre of inflation, with gold flying to all time highs which many explain as an inflation hedge, not to mention stock price performance which is extrapolating virtual hyperinflation, the market "truth" as determined by Fed Fund futures and options is, and continues to be, diametrically opposite. In fact, compared to even a month ago, the percentage of market participants who see the probability of the Fed rate as determined by the June 23, 2010 FOMC decision, at 0.5% and/or below is 88.4%, nearly double the 46.2% on October 1. In a little over a month, the inflationists have gone from being a majority to being barely over 10%! Whether this is due to the continued "exceptional" language in the most recent FOMC statement, or due to the continued deflationary deterioration in the economy, is frankly, irrelevant.

Another way to observe just how much credibility Mr. Geithner has with his daily claims of "dollar strength support" is the below chart tracing the convictions of those believing the Fed Fund rate will be at or below the current baseline of 0-25 bps. As one can see the yellow and red line have hit records: virtually nobody believes that even in 6 months the Fed will do anything to increase rates, regardless of how much liquidity they pump into the system, regardless of what happens to M2 and M3, regardless of whether gold or the S&P hits the 2,000 mark (and one or the other very well might).

The most graphic way to visualize this is based on actual Fed Fund futures and options: the below charts demonstrate the path of highest probability determined by actual traded instruments. It is one thing to parade on TV how inflation has gripped the economy and how people should spend, spend, spend or in the worst case speculate, speculate, speculate by buying GE stock that trades with the volatility of a Tasmanian devil on crystal meth.

The rate probability determined by the futures spot curve a year from now suggests a Fed fund rate of about 0.65% (yellow line). The most likely path probability (thick red line) ends at about 0.75% a year from today. The Fed is certain to do nothing to the rate until June of next year.

Yet even expectations may not be reflecting reality, when reality is massaged and doctored courtesy of factually plain wrong or "adjusted" economic releases by the government. The reason why even micro-inflationists may be wrong is that if one takes the Taylor Rule and extrapolates into the future, based on realistic assumptions, the outcome is quite shocking.

The chart below demonstrates what the implied Fed Fund rate should be today based on the Taylor Rule: a whopping -6.15%! In other words, due to the Fed's inability to charge people money to hold monetary assets (negative rates), QE is expected to inflate assets to the point where the deteriorating economic data drowns out the implied negative number. In practice, the Taylor result means that the economy is still bogged down in a deep deflationary slump. One side effect: look for Excess Reserves to keep rising so long as the direct threat of deflation not wiping out trillions of bad debts at bank balance sheets, persists. Another side effect: look for the Fed's "assets" to start growing exponentially quite soon as the deflationary threat truly takes hold.

What few people realize and what is most troubling, is that despite the Fed's QE program, the current Taylor implied Fed Fund Rate of -6.15% is in fact lower than what it was in January 2009: as we discussed at the time, the Taylor implied rate then was a deja vuish -6%. And this was just as Ben Bernanke was finalizing the $1.7 trillion Quantitative Easing inflation/liquification program. It stands to reason that Quantitative Easing has been not only a failure, but has resulted in a monetary environment that is actually worse than it was at the peak of the crisis. That's what central planning intervention will do an otherwise efficient economy.

So what happens if we project into the future? There is no sense in trusting the government to provide objective data: recall that recently the BLS itself stated that it was going to reduce payroll data by over 800 thousand. As a result we perform a hypothetical extrapolation into the future, using David Rosenberg's estimate of a baseline 13% unemployment into 2010. While the number is likely aggressive (yet real unemployment is materially worse: plugging the U-6 number of 17.5% into the Talor equation and you get a ridiculous, and hopefully, unrealistic deflationary number), we believe we are too generous with CPI estimates, which will likely continue being persistently low for a long time, especially with such government subsidy packages as Cash For Clunkers. As a result we get a Taylor implied rate of -4.2% by October 2010.

All this means is that Bernanke is very likely about to unleash Quantitative Easing 2: If the $1.7 trillion already thrown at the problem has not fixed it, you can bet that the Chairman will not stop here. Furthermore, as the Fed has the best perspective on the economy, which is certainly far worse than is represented, the Fed has to act fast before things escalate even more out of control. Which is why Zero Hedge is willing to wager that not only will the agency/MBS program not expire in March as it is supposed to, but that a parallel QE process will likely begin very shortly.

The end result of all these actions, of course, is that the value of the dollar is about to plummet: when Bernanke announces that not only will he not end QE but that he will launch another version of the program, expect the dollar to take off on its one way path to $2 = €1. And when that happens, look for global trade to cease completely. In its quest to continue bailing out the banking system and rolling the trillions of toxic loans it refuses to accept are worthless (for if it did, equity values in the banking system would go, to zero immediately), the Fed will promptly resume destroying not only the US middle class, but the entire system of global trade built through many years of globalization. Look for America to end up in an insulated liquidity bubble in a few short years, trading exclusively with its vassal master: the People's Republic of China.

Muni Market Absorbs $8.4 Billion in One Week

U.S. state and local governments sold $8.4 billion of bonds this week, revised data compiled by Bloomberg show, as investor demand allowed Connecticut and a California agency to expand their offerings. The number of new issues fell from $10.7 billion last week as bond markets closed Wednesday for Veterans’ Day, Bloomberg data show. Yields on top-rated 30-year general obligation bonds tracked by Municipal Market Advisors of Concord, Massachusetts, were little changed, slipping by 0.01 percentage point to 5.02 from a week earlier. The daily index is 28 basis points higher than the year’s low reached Oct. 1 after a rally in prices.

“Over the last couple of weeks, they’ve been pushed up, but if you look at it in the totality of the year, we’ve had a big rally,” said Michael Walls, who oversees $540 million in high-yield municipal bonds for Waddell & Reed Financial Inc. in Overland Park, Kansas. “There has been some profit taking.” Municipal bonds soared this year as investors poured money into tax-exempt mutual funds, pushing down the yields that local governments needed to offer to raise money. While prices have slipped since September, municipal bonds still have 13 percent return for the year, marking the best performance since a 17 percent gain during all of 2000, according to Merrill Lynch & Co. indexes.

Connecticut officials, after getting $355 million of bond orders from small buyers led by state residents, expanded the size of its offering this week to forgo a planned second sale of its so-called economic recovery notes. After initially offering $600 million, the state sold $1.08 billion, raising funds to replenish cash used to close last year’s budget deficit and finance school construction projects. “Investors’ reaction to our sale was more than we had expected,” Connecticut Treasurer Denise Nappier said in a release today. “In just one transaction, we were able to negotiate very attractive pricing and, as a result, take advantage of economies of scale.”

A public authority in California sold $1.9 billion of bonds on behalf of local governments whose property tax revenue was tapped to help the state close its budget deficit. The debt, maturing in 2013, is backed by California’s requirement to repay the money, giving the securities the same credit rating as the state government, the lowest among its peers. The sale added to a flood of borrowing by California, with almost $12.5 billion of long-term debt tied to the state issued since Oct. 5. The bonds sold this week by the California Statewide Communities Development Authority yielded 4 percent, compared with a yield of 3 percent the agency estimated last week.

“New issues have been priced cheaper than they have in the past and thus have been well received,” Walls said. The California Statewide Communities Development Authority’s 5 percent securities due in June 2013 rose to about 104.5 cents on the dollar today to yield 3.64 percent, 36 basis points less than at issue, data reported to the Municipal Securities Rulemaking Board show.

FDIC Moves Forward With $45 Billion Plan To Refill Fund

The Federal Deposit Insurance Corp. moved Thursday to refill its fund protecting consumers' deposits, finalizing a plan to raise $45 billion by having banks prepay three years of premiums. The agency's five-member board gave final approval to a multi-step program that will require U.S. banks to prepay their quarterly assessments for 2010 through 2012 when they pay their fourth-quarter premiums at the end of 2009. Additionally, banks will face a three-basis-point increase in their premium rates beginning in 2011.

The move comes in response to the rising number of bank failures, which hit 120 for the year last Friday and are at levels not seen since the savings-and-loan crisis. The FDIC currently estimates that the cost of bank failures will reach $100 billion from 2009 through 2013, an estimate that has repeatedly been revised upward. Those failures have put a strain on the FDIC's deposit insurance fund. Agency staff said Thursday that its liquidity needs would outpace its assets on hand beginning in the first quarter of 2010 without changes to the premium plan, and that through 2011 "liquidity needs could significantly exceed liquid assets on hand."

That does not mean the FDIC doesn't have cash available; the agency had roughly $22 billion in liquid assets as of June 30, though subsequent failures have reduced that figure. Staff did make some changes to the rule that was introduced in late September. The FDIC will repay banks any unused premiums beginning in June 2013, rather than December 2014 as originally proposed, and eased the process for banks requesting an exemption from the prepayment plan.

FDIC officials said the plan would allow it to replenish its liquidity without being too onerous on the banking industry during a time of weakness. An alternative would have been to assess a second special fee on the industry--$5.6 billion was already collected earlier this year--but that plan was abandoned because of the potential negative effect on banks. Banking industry groups lauded the FDIC's decision. "It strikes the right balance between making sure the FDIC has the cash necessary to meet its obligations and not unduly impairing banks' ability to meet their obligations to their communities," said James Chessen, chief economist for the American Bankers Association.

Citigroup, JPMorgan, Wells Fargo End Extra Checking Insurance

Citigroup Inc., JPMorgan Chase & Co. and Wells Fargo & Co. will stop insuring checking accounts in the U.S. above the standard $250,000 limit, a year after the government set up the program to ease fears of deposit runs. The banks will exit the Federal Deposit Insurance Corp.’s Transaction Account Guarantee Program on Dec. 31, spokesmen for the three companies said today. The program was among emergency measures created in October 2008 to shore up confidence in the banking system and avert a collapse of financial markets. Bank of America Corp. had said Oct. 16 it would opt out.

In August, the FDIC said it would increase fees for banks that stay in the TAG program past Dec. 31. U.S. officials are trying to wean banks off bailout programs and guarantees that were intended to be temporary. Banks may declare plans to exit partly because staying in would signal weakness, Standard & Poor’s analyst Tanya Azarchs said. “It’ll be construed as a sign of being worried about something,” Azarchs said.

The checking-account insurance program is set to end on June 30, 2010, and the FDIC ended its guarantees of bank bonds on Oct. 31. New York-based Citigroup, the third-biggest U.S. bank by assets, was the leading user of that program, selling $65 billion of FDIC-backed debt over the past year. It accepted a $45 billion bailout last year. “As the economic environment normalizes, and with Citi now one of the best-capitalized financial institutions in the world with a deliberately liquid and flexible balance sheet, certain temporary programs have served their intended purpose,” Citigroup spokesman Alex Samuelson said. He declined to say how much the bank will save in fees.

Citigroup plans to notify corporate customers this week and next, Samuelson said. Visitors to the branches will see posters and other signs explaining the change, he said. The bank posted a notice on its Citibank Online sign-on site. The TAG program covers non-interest-bearing accounts, such as checking, when balances exceed the $250,000 cap available for standard deposit insurance. About 7,100 banks signed up, and about $700 billion of deposits were covered that otherwise wouldn’t have qualified for insurance, according to the FDIC.

Charlotte, North Carolina-based Bank of America, the biggest U.S. bank by assets, disclosed plans to opt out of the program in October. Christine Holevas, a spokeswoman for No. 2 JPMorgan, said in an e-mail today that the New York-based lender will opt out. San Francisco-based Wells Fargo, the fourth- biggest bank, also will exit, spokeswoman Richele Messick wrote in an e-mail. U.S. Bancorp, based in Minneapolis, and New York-based Bank of New York Mellon Corp. said Nov. 2 they would opt out as of Dec. 31.

Banks have complained about the cost of the guarantees, Azarchs said. In Citigroup’s case, the extra insurance might be unnecessary because most corporate customers believe the government won’t let the bank fail, she said. “The environment around them has improved a lot, and people generally feel that the government ownership provides a lot of comfort,” Azarchs said. “It is simply an economic cost-benefit analysis, as to whether they think they’re getting enough value for the price that the guarantee carries.”

In November 2008, following a run that forced Wachovia Corp. to seek a rescue, Citigroup had to seek $20 billion of bailout funds, on top of $25 billion received the previous month from the Troubled Asset Relief Program. Both regulators and Citigroup officials worried at the time that the bank might run short of funds needed to pay obligations and meet expected withdrawals, according to a Nov. 6 report by the Congressional Oversight Panel. Citigroup has raised $93 billion of capital since late 2007, including government funds. It has almost doubled its cash to $244.2 billion, the biggest such stockpile of any U.S. bank.

Patchy Euro-Zone Recovery Reflects Imbalances

European economies are showing a two-speed recovery from the 2008-2009 economic recession, with industrial countries in the region's economic core setting the pace. Fresh data released Friday showed Germany and France posting their second quarter of economic expansion in the third quarter. And Italy experienced its first quarterly growth in gross domestic product since the downturn began. But Greece, Finland and Spain were still contracting. The new European Union members in the Baltics and along the trading bloc's periphery also remained mired in recession, having been hit hardest by recent financial crisis.

Data released by the Eurostat statistics office, the 27-country EU economy expanded by 0.2% in the quarter from the previous period. The smaller grouping of 16 countries sharing the euro currency rose by a faster 0.4% rate. The recovery followed a year of massive fiscal and monetary stimulus programs by governments and central banks to turn around the region's worst recession in 60 years. But the emerging recovery is patchy, traceable to national differences ranging from fiscal policies to industry profiles. It also could suffer a relapse if rising unemployment chills a nascent rebound in consumer spending, as government officials have warned.

"The bad times are over but the good times have not started, yet," said ING economist Carsten Brzeski. In the euro zone, Germany's export-oriented economy is benefiting from the resurgence in global demand, a trend also helping French and Italian industry. Spain is held back by a 19% unemployment rate after its housing market collapsed a year ago. Greece extended its economic contraction in the third quarter, and at a time when the government is under EU pressure to dramatically throttle back spending to reduce budget deficits.

The two-track recovery in Europe poses challenges for the European Central Bank, which already is beginning to consider the timing and pace of withdrawing monetary stimulus that had supported the euro-zone economy and banking system over the past year. "The European Central Bank faces the major challenge of balancing a return to growth in the stronger, large euro-zone economies with ongoing weakness in economies like Spain, Greece and Ireland," said Charles Davis, senior economist for the Centre for Economics and Business Research Ltd. in London.

Among the other EU countries, available third-quarter GDP data shows less promise. The U.K. economy contracted 0.4% -- a reflection of how dependent it is on financial services, which were hit particularly hard. And U.K. officials are warning of a slow and gradual comeback. "From a U.K. perspective, today's figures do not make pleasant reading," said Mr. Davis. "According to the data only Cyprus, Estonia, Hungary and Romania suffered larger quarterly contractions in GDP than the U.K. in the third quarter."

For the EU as a whole, economists had expected a stronger outcome for the last period given large production gains in industrial nations such as Germany and Italy. "This GDP growth [is] entirely a windfall from a policy-induced spurt of activity in the auto sector," said Carl Weinberg, chief European economist for high frequency economics. Euro-zone GDP could even contract again in the final three months of the year as car subsidies are phased out, he said. The ravages of the global downturn were still vivid in the third-quarter data.

Both Italian and German GDP were down by more from a year earlier -- 5.9% and 5.8% respectively -- than the 4.8% yearly contraction for the euro zone as a whole. Both countries have run tighter fiscal policies than their peers in the currency union this year. The broad absence of positive news about domestic demand supports the view that the euro-zone economy is far from healed. Sluggish household demand and business investment makes Europe vulnerable to a slowdown in the global recovery, said Aurelio Maccario, chief euro-zone economist for UniCredit. "It's not easy to see what could trigger a sustainable upswing," he said.

Morgan Stanley’s Roach Says Yuan Concern 'Overblown'

Concerns over China’s currency policy are “seriously overblown” and critics should let the country decide how it wants to manage the yuan to ensure growth, Morgan Stanley Asia Chairman Stephen Roach said. The world’s third-largest economy is still dependent on exports for its recovery and a “sharp appreciation” in the yuan would jeopardize the rebound, Roach said in an interview in Singapore today. The government will probably maintain stimulus measures until threats to rising unemployment and social stability have faded, he said.

Pressure is rising on China to abandon the currency’s fix to the dollar that policy makers implemented in July 2008. Analysts say a stronger yuan would help shift China’s economy toward domestic demand and away from a reliance on exports. “The desire on the part of Chinese authorities to maintain a relatively stable anchor is a very important aspect of China’s own stability in this post-crisis climate,” Roach said. “The world should turn its attention elsewhere and let China really figure out the right currency policy for its sustainable growth.”

Roach said at a business summit in Singapore today that recent trade tension between the U.S. and China “needs to be addressed immediately,” speaking a day before President Barack Obama arrives in Shanghai. China’s economic rebalancing will put upward pressure on the yuan, though a currency adjustment isn’t a prerequisite for the changes to take place, International Monetary Fund Managing Director Dominique Strauss-Kahn said yesterday. He added that the nation had the “right way” of addressing the global crisis and reorienting its economy.

China has no plans to alter its policy of step-by-step changes in the value of its currency, Assistant Finance Minister Zhu Guangyao said in Singapore Nov. 12. It has maintained the yuan’s value at around 6.83 against the dollar since July 2008. Gross domestic product expanded 8.9 percent in the third quarter from a year earlier, boosted by a 4 trillion yuan ($585 billion) stimulus package and record lending. China may introduce another fiscal stimulus package in mid- 2010 as the effects of the current plan taper off, Roach said. In the longer term, the nation will reduce its reliance on exports, he said.

“You’re going to see a new China -- a China that rises to the challenge imparted by this crisis,” Roach said at the business conference. The financial turmoil and global recession have been a “wake-up call” for the region, he added -- proving that Asian economies can “no longer depend on the vigor of the American consumer.”

Virtuous Bankers? Really!?!

The Great Vampire Squid has gotten religion. In an interview with The Sunday Times of London, the cocky chief of Goldman Sachs said he understands that a lot of people are “mad and bent out of shape” at blood-sucking banks. “I know I could slit my wrists and people would cheer,” Lloyd Blankfein, the C.E.O., told the reporter John Arlidge.

But the little people who are boiling simply don’t understand. And Rolling Stone’s Matt Taibbi, who unforgettably labeled Goldman “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money,” doesn’t understand. Banks, Blankfein explained, are really serving the greater good. “We help companies to grow by helping them to raise capital,” he said. “Companies that grow create wealth. This, in turn, allows people to have jobs that create more growth and more wealth. It’s a virtuous cycle. We have a social purpose.”

When Arlidge asked whether it’s possible to make too much money, whether Goldman will ignore the people howling at the moon with rage and go on raking it in, getting richer than God, Blankfein grinned impishly and said he was “doing God’s work.” Whether he knows it, he’s referring back to The Protestant Ethic and The Spirit of Capitalism — except, of course, the Calvinists would have been outraged by the banks’ vicious — not virtuous — cycle of greed and concupiscence.

Blankfein’s trickle-down catechism isn’t working. Now we have two economies. We have recovering banks while we have 10-plus percent unemployment and 17.5 percent underemployment. The gross thing about the Wall Street of the last decade is how much its success was not shared with society. Goldmine Sachs, as it’s known, is out for Goldmine Sachs. As many Americans continue to struggle, Goldman, Morgan Stanley and JPMorgan Chase, banks that took government bailout money after throwing the entire world into crisis, have said they will dish out $30 billion in bonuses — up 60 percent from last year.

The saying used to be, whatever happens, the lawyers win. Now, it’s whatever happens, the bankers win. Under pressure from regulators, who were trying to ensure that long-term performance was rewarded, the banks agreed to award more in stock, deferring cash payments. But as The Times reported this week, the Goldman executives who got stock options instead of bonuses last year, at market lows, got a windfall — so it had nothing to do with bank employees’ performance.

“The company gave its general counsel, for example, 104,868 stock options and 14,117 shares in December, when the bank’s stock was around $78,” Louise Story wrote for The Times. “Now the bank’s shares have more than doubled in value, making that stock and option award worth nearly $12 million.” As one former Goldman banker told Arlidge, the culture there is “completely money-obsessed. ... There’s always room — need — for more. If you are not getting a bigger house or a bigger boat, you’re falling behind. It’s an addiction.”

It’s an addiction that Washington has done little to quell. President Obama has not been strong on the issue, and Timothy Geithner coddles the wanton bankers whenever they freak out that they might not be able to put in their new pools next summer. The bankers try to dismiss calls for regulation as populist ravings, but the insane inequity of it cannot be dismissed. No sooner had the Senate Banking Committee Chairman Chris Dodd announced his plan to overhaul financial regulation Tuesday than compensation experts declared it toothless.

The banks and their lobbyists wheedled concession after concession out of Washington and knocked down proposed inhibition after inhibition. Now the banks are laughing all the way to the bank. “Saturday Night Live” was tougher on Goldman Sachs than the government, giving the firm flak about commandeering 200 doses of the swine flu vaccine — the same amount as Lenox Hill Hospital got — while so many at-risk Americans wait.

“Can you not read how mad people are at you?” demanded Amy Poehler. “When most people saw the headline ‘Goldman Sachs Gets Swine Flu Vaccine’ they were superhappy until they saw the word ‘vaccine.’ ” Seth Meyers chimed in: “Also, Centers for Disease Control, you sent the vaccine to Wall Street before schools and hospitals? Really!?! Were you worried the swine flu might spread to the Hamptons and St. Barts? These are the least contagious people in the world. They don’t even touch their own car-door handles.” And as far as doing God’s work, I think the bankers who took government money and then gave out obscene bonuses are the same self-interested sorts Jesus threw out of the temple.

Ukraine credit rating sinks; state firm seeks debt help

Fitch cut Ukraine's credit rating on Thursday and said a delay in IMF funding coupled with a huge budget gap would lead to more instability, a warning underscored by another state firm seeking to restructure its debts. Ukraine is in the grip of a deep economic recession which has been made worse by political rivalry, intensified in the run up to a January presidential election, that has derailed Kiev's co-operation with the International Monetary Fund.

Prime Minister Yulia Tymoshenko has already warned a delay in the IMF's release of $3.8 billion this month would make life "extremely difficult" for Ukraine and other ministers have said Kiev's ability to make timely payments for Russian gas could be affected. Such warnings unnerve European leaders who want to avoid another energy row between Kiev and Moscow during the winter similar to January when Russia cut gas supplies, including those intended to transit Ukraine, and left hundreds of thousands in the cold.

Tymoshenko blames the IMF delay on President Viktor Yushchenko, a bitter rival in the election, because he approved a minimum wage rise that the fund opposed. He accuses her of driving the country to ruin through populist policies funded by borrowed billions. Fitch estimated this year's budget gap would balloon to 11 percent of gross domestic product -- including government aid given to state energy company Naftogaz which purchases the gas from Russia. The IMF funds would have helped cover that gap.

But now, "Fitch sees an elevated risk that Ukraine could resort more heavily to monetary financing via central bank providing liquidity to banks -- effectively printing money. "This would in turn risk undermining the fragile confidence in the currency and the banking system, and/or a rapid loss of foreign exchange reserves." Fitch spelled out the dire figures behind its 'Negative' outlook for its B- rating: the national currency, the hryvnia, has fallen 60 percent in a year; GDP contracted more than 18 percent in the second quarter compared with a year ago; and bad loans amount to 30 percent of all lending.

State railway company Ukrzalyznitsya has approached its creditors to restructure its dollar loan just a week after Naftogaz, often at the centre of the gas rows with Russia, managed to change the terms of its foreign debts. Acting Finance Minister Ihor Umansky said on Thursday the firm failed to repay $118 million of the $550 million syndicated loan that had been organised by Barclays.

The railway company "should have paid $110 million of the debt and $8 million in coupon payments," Umansky told reporters. "Ukrzalyznitsya has made some proposals to the holders of the debt, which was organised by Barclays." The loan was organised in July 2007 and matures next year, according to Thomson Reuters Loan Pricing Corp data. It had a 2-year grace period, which would have run out this summer.

Umansky said the size of the loan was $440 million after the company made some of the principal payments. Ukrzalyznitsya itself was not immediately available for comment. Analysts believe the debt did not have a state guarantee. The government did not guarantee Naftogaz' $500 million Eurobond, whose looming maturity at the end of September sparked the company's restructuring talks.

But some worry this loan has clauses that would force the company to repay other debts in the event of a default, including a $700 million loan that may have a state guarantee. Naftogaz finally issued a $1.595 billion 5-year Eurobond with a sovereign guarantee in exchange for its earlier Eurobond and three bilateral loans.

Minsky to Bernanke: "Size Matters!"

Size matters. And it particularly matters when the size of the financial system grossly exceeds the productive capacity of the underlying economy. Then problems arise. Surplus capital flows into paper assets triggering a boom. Then speculators pile in driving asset prices higher. Margins grow, debts balloon, and bubbles emerge. The frenzy finally ends when the debts can no longer be serviced and the bubble begins to unwind, sometimes violently. As gas escapes; credit tightens, businesses are forced to cut back, asset prices plunge and unemployment soars. Deflation spreads to every sector. Eventually, the government steps in to rescue the financial system while the broader economy slumps into a coma.

The crisis that started two years ago, followed this same pattern. A meltdown in subprime mortgages sent the dominoes tumbling; the secondary market collapsed, and stock markets went into freefall. When Lehman Bros flopped, a sharp correction turned into a full-blown panic. Lehman tipped-off investors that that the entire multi-trillion dollar market for securitized loans was built on sand. Without price discovery, via conventional market transactions, no one knew what mortgage-backed securities (MBS) and other exotic debt-instruments were really worth. That sparked a global sell-off. Markets crashed. For a while, it looked like the whole system might collapse.

The Fed's emergency intervention pulled the system back from the brink, but at great cost. Even now, the true value of the so-called toxic assets remains unknown. The Fed and Treasury have derailed attempts to create a public auction facility--like the Resolution Trust Corporation (RTC)--where prices can be determined and assets can be sold. Billions in toxic waste now clog the Fed's balance sheet. Ultimately, the losses will be passed on to the taxpayer.

Now that the economy is no longer on steroids, the financial system needs to be downsized. The housing/equities bubble was generated by over-consumption that required high levels of debt-spending. That model requires cheap money and easy access to credit, conditions no longer exist. The economy has reset at a lower level of economic activity, so changes need to be made. The financial system needs to shrink.

The problem is, the Fed's "lending facilities" have removed any incentive for financial institutions to deleverage. Asset prices are propped up by low interest, rotating loans on dodgy collateral. While household's have suffered humongous losses (of nearly $14 trillion) in home equity and retirement savings; the financial behemoths have muddled through largely unscathed. The Fed handed Wall Street a golden parachute while ordinary working stiffs were kicked to the curb. That's why household spending has plunged while the big brokerage houses are gearing up. Here's an excerpt from an article by former Morgan Stanley analyst Andy Xie which explains what's really going on:

"First, let’s look at the most basic objective of deleveraging the financial sector. Top executives on Wall Street talk about having cut leverage by half. That is actually due to an expanding equity capital base rather than shrinking assets. According to the Federal Reserve, total debt for the financial sector was US$ 16.5 trillion in the second quarter 2009 — about the same as the US$ 16.6 trillion reported one year earlier. After the Lehman collapse, financial sector leverage increased due to Fed support. It has come down as the Fed pulled back some support, creating the perception of deleveraging. The basic conclusion is that financial sector debt is the same as it was a year ago, and the reduction in leverage is due to equity base expansion, partly due to government funding." (Andy Xie, "Why One Good Bubble Deserves Another", Caijing.com)

See? The financial Goliaths are still leveraged to their eyeballs.

Fed chair Ben Bernanke has bent-over-backwards to preserve the system in its present form. That's why the lending facilities should be viewed with a degree of skepticism. They weren't set up merely to rescue the system from disaster, but to keep asset prices artificially high so institutions could continue to maximize profits via risky investments. And, it's worked, too. The S&P 500 is up over 60 percent since March 9. Still, even though Bernanke has succeeded in resuscitating the flagging financial sector, investors remain pessimistic. According to Bloomberg News:

"An eight-month, 68 percent rally in global stocks failed to convince investors and analysts that it’s time to take on more risk or dispel their concerns about U.S. economic policies and its banking system.

Only 31 percent of respondents to a poll of investors and analysts who are Bloomberg subscribers in the U.S., Europe and Asia see investment opportunities, down from 35 percent in the previous survey in July. Almost 40 percent in the latest quarterly survey, the Bloomberg Global Poll, say they are still hunkering down. U.S. investors are even more cautious, with more than 50 percent saying they are in a defensive crouch.

“The doubt and the pessimism just won’t go away,” says James Paulsen, who helps oversee $375 billion as chief investment strategist at Wells Capital Management in Minneapolis." (Bloomberg News)

Few people seem to believe in the much-ballyhooed economic recovery. And even though the media triumphantly announced the "end of the recession" last week (when GDP came in at 3.5 percent) a closer look at the data, leaves room for doubt. Goldman Sachs analysts put it like this:

"How much of the rebound in real GDP was due to the fiscal stimulus, and where do we stand in terms of the effects of stimulus thus far? Although precise answers are impossible at this juncture, several aspects of the report are consistent with our estimates that the fiscal package enacted in mid-February as the American Recovery and Reinvestment Act (ARRA) would have accounted for virtually all of the growth reported for the third quarter." ( http://www.zerohedge.com/article/hedging-their-bets )

Positive growth is an illusion created by government spending. In fact, the economy is still flat on its back. Consumer spending and credit are in sharp decline. Unemployment is steadily rising (although at a slower pace) and wages are flatlining with a chance of falling for the first time in 30 years. Deflationary pressures are building. The talk of a "jobless recovery" is intentionally misleading. Jobs ARE recovery; therefore a jobless recovery merely points to asset-inflation brought on by erratic monetary policy. Surging stocks shouldn't be confused with a real recovery.

Bernanke is a scholar of the Great Depression. He is familiar with Hyman Minsky and Minsky's "Financial Instability Hypothesis" (FIH), which states that, "A fundamental characteristic of our economy is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles."

Boston Globe Correspondent, Stephen Mihm, summarized Minsky's theory in his article "When Capitalism Fails":

"In the wake of a depression, he noted, financial institutions are extraordinarily conservative, as are businesses. With the borrowers and the lenders who fuel the economy all steering clear of high-risk deals, things go smoothly: loans are almost always paid on time, businesses generally succeed, and everyone does well. That success, however, inevitably encourages borrowers and lenders to take on more risk in the reasonable hope of making more money. As Minsky observed, “Success breeds a disregard of the possibility of failure.”

As people forget that failure is a possibility, a “euphoric economy” eventually develops, fueled by the rise of far riskier borrowers - what he called speculative borrowers, those whose income would cover interest payments but not the principal; and those he called “Ponzi borrowers,” those whose income could cover neither, and could only pay their bills by borrowing still further. As these latter categories grew, the overall economy would shift from a conservative but profitable environment to a much more freewheeling system dominated by players whose survival depended not on sound business plans, but on borrowed money and freely available credit.

Once that kind of economy had developed, any panic could wreck the market. The failure of a single firm, for example, or the revelation of a staggering fraud could trigger fear and a sudden, economy-wide attempt to shed debt. This watershed moment - what was later dubbed the “Minsky moment” - would create an environment deeply inhospitable to all borrowers.

The speculators and Ponzi borrowers would collapse first, as they lost access to the credit they needed to survive. Even the more stable players might find themselves unable to pay their debt without selling off assets; their forced sales would send asset prices spiraling downward, and inevitably, the entire rickety financial edifice would start to collapse. Businesses would falter, and the crisis would spill over to the “real” economy that depended on the now-collapsing financial system." (When Capitailsm Fails, Stephen Mihn, Boston Globe)

Stability leads to instability. By zeroing in on capitalism's genetic flaws, Minsky countered the prevailing orthodoxy that markets are fundamentally efficient and rational. He not only showed that capitalism was inherently crisis-prone, but also, that it was most vulnerable during those periods which seemed to be most stable. (like during Greenspan's "Great Moderation") Stability invites speculation and risk-taking. Investors are buoyed by market euphoria and fat returns; borrowing to purchase dodgy equities turns into a mania which distorts prices and leads to massive credit bubbles. Eventually, the foundation cracks and debts cannot be rolled over. Then markets tumble.

The point is, Bernanke knows that a bloated financial system poses unnecessary risks to the economy; just as he knows he should wind-down existing lending programs (which just encourage more speculation) and focus on rebuilding household balance sheets. The only way to put the economy back on a solid foundation is by helping struggling workers get back on their feet so they can create more demand. The objective should be full employment and broad, sustained wage growth, which is precisely what Minsky's recommended.

Stephen Mihm again: "The government - or what Minsky liked to call 'Big Government' - should become the 'employer of last resort,' he said, offering a job to anyone who wanted one at a set minimum wage. It would be paid to workers who would supply child care, clean streets, and provide services that would give taxpayers a visible return on their dollars. In being available to everyone, it would be even more ambitious than the New Deal, sharply reducing the welfare rolls by guaranteeing a job for anyone who was able to work. Such a program would not only help the poor and unskilled, he believed, but would put a floor beneath everyone else's wages too, preventing salaries of more skilled workers from falling too precipitously, and sending benefits up the socioeconomic ladder." ("Why Capitalism Fails, by Stephen Mihm, Boston Globe)

Minsky's analysis not only sheds light on the causes of the current crisis, but also provides a practical way to fix the system. Too bad Bernanke's not paying attention.

Gordon Brown to apologise for Britain's 'shameful' child migration policies

Britain is to join Australia in issuing an official apology for the "shameful" export of tens of thousands of children to Commonwealth countries with the promise of a better life, only for many of them to end up abused and neglected. In what Ed Balls, the children secretary, described as "stain on our society" the child migrant programmes saw poor, orphaned and illegitimate children sent to Australia, Canada and other former colonies until as recently as the late 1960s, often without the knowledge of their families.

Many ended up in institutions, many suffered abuse and neglect and many others were used as "slave labour" on farms. Now after years of campaigning from pressure groups, Gordon Brown has agreed to meet with representatives of the surviving children before making a formal apology next year. Mr Balls said the apology would be "symbolically very important". "I think it is important that we say to the children who are now adults and older people and to their offspring that this is something that we look back on in shame," he said. "It would never happen today. But I think it is right that as a society when we look back and see things which we now know were morally wrong, that we are willing to say we're sorry."

The government has estimated that a total of 150,000 British children may have been shipped abroad under a variety of programs that operated between the early 19th century and 1967. A 2001 Australian report said that between 6,000 and 30,000 children from Britain and Malta, often taken from unmarried mothers or impoverished families, were sent alone to Australia as migrants during the 20th century. Some of the children were told, wrongly, that they were orphans. The migration was intended to stop the children being a burden on the British state while supplying the receiving countries with potential workers.

A 1998 British parliamentary inquiry noted that "a further motive was racist: the importation of 'good white stock' was seen as a desirable policy objective in the developing British Colonies". Mr Balls said that while an apology would not "take away the suffering" it was important to the victims to admit it was wrong and to make sure lessons are learnt. He said the government was talking to the victims' organisation to work out how to frame the apology. "These were children who were shipped out of the country, often without their parents even knowing, went on to be labourers thousands and thousands of miles away, suffered physical and sometimes sexual abuse as well and it was something that was sanctioned by government and that is no way to treat children," he said,

"I think there have been discussions going on for some months about how to do this but to be honest it’s a matter of shame for our country and countries around the world that this terrible policy happened for so many years and decades and was actually government policy." The issue of the UK child migrants was investigated in 1998 by the Commons health select committee, a process which led to the Department of Health drawing up guidance for families to trace those sent away. Kevin Barron, the chairman, said Mr Brown wrote to him over the weekend to confirm he would issue an apology in the new year.

The Prime Minister told him "the time is now right" for the UK government to apologise for the "misguided policies" of previous governments. However some survivors felt the apology was too little too late. Harold Haig, the secretary of the International Child Migrants Association, said he was appalled that the Australian apology has come before any British apology. "Gordon Brown should hang his head in shame," he said. "He is allowing the country that we were deported to to apologise before the country where we were born. It is an absolute disgrace. He should hang his head in shame."