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Friday, January 18, 2008 9:07 AM


Fiscal "Stimulus" Doomed To Fail


Lost in the Congressional debate over how to provide stimulus is a more fundamental question: Does anyone remember how we got to where we're at?

The answer is Greenspan put the pedal to the medal by irresponsibly slashing interest rates to 1%. Banks thought this was free money and responded by borrowing short and lending long to finance all kinds of risky endeavors but typically centered around residential and commercial real estate.

Residential real estate has long since imploded. Now, a Glut Of Mall Space Headed Our Way will start an implosion in commercial.

Pointing The Finger At Greenspan

I have been pointing the finger at Greenspan for years. Fingers are now flying from many corners. Economist Anna Schwartz blames Fed for sub-prime crisis.

The high priestess of US monetarism - a revered figure at the Fed - says the central bank is itself the chief cause of the credit bubble, and now seems stunned as the consequences of its own actions engulf the financial system. "The new group at the Fed is not equal to the problem that faces it," she says, daring to utter a thought that fellow critics mostly utter sotto voce.

"There never would have been a sub-prime mortgage crisis if the Fed had been alert. This is something Alan Greenspan must answer for," she says. According to Schwartz the original sin of the Bernanke-Greenspan Fed was to hold rates at 1 per cent from 2003 to June 2004, long after the dotcom bubble was over. "It is clear that monetary policy was too accommodative. Rates of 1 per cent were bound to encourage all kinds of risky behaviour," says Schwartz.

She is scornful of Greenspan's campaign to clear his name by blaming the bubble on an Asian saving glut, which purportedly created stimulus beyond the control of the Fed by driving down global bond rates. "This attempt to exculpate himself is not convincing. The Fed failed to confront something that was evident. It can't be blamed on global events," she says.

The lesson of the 1930s is that swift action is needed once the credit system starts to implode: when banks hoard money, refusing to pass on funds. The Fed must tear up the rule-book. Yet it has been hesitant for three months, relying on lubricants - not shock therapy.
Anna has the right target, unfortunately she has the wrong cure: more of the same medicine that made us sick in the first place. The lesson of the 1930's has not been learned. The proper lesson is that there are eventually enormous consequences for unsound credit bubbles. The Fed has responded to every credit crisis with liquidity. Eventually liquidity fails. It fails when the problem becomes solvency not liquidity.

Although Bernanke has reached a point of recognition about the problem, he has not come to the proper conclusion as to the solution. Tearing up the rule book is simply the wrong idea. That is the lesson from the Greenspan Fed.

Chairman Bernanke's Economic Outlook

Please consider Bernanke's Economic Outlook Testimony before the US House Budget Committee January 17, 2008.
To be useful, a fiscal stimulus package should be implemented quickly and structured so that its effects on aggregate spending are felt as much as possible within the next twelve months or so. Stimulus that comes too late will not help support economic activity in the near term, and it could be actively destabilizing if it comes at a time when growth is already improving.

Thus, fiscal measures that involve long lead times or result in additional economic activity only over a protracted period, whatever their intrinsic merits might be, will not provide stimulus when it is most needed. Any fiscal package should also be efficient, in the sense of maximizing the amount of near-term stimulus per dollar of increased federal expenditure or lost revenue.

Finally, any program should be explicitly temporary, both to avoid unwanted stimulus beyond the near-term horizon and, importantly, to preclude an increase in the federal government's structural budget deficit. As I have discussed on other occasions, the nation faces daunting long-run budget challenges associated with an aging population, rising health-care costs, and other factors. A fiscal program that increased the structural budget deficit would only make confronting those challenges more difficult.
Another Step In The Right Direction For Bernanke

For Bernanke, this speech is another step in the right direction. Professor Depew was the first to congratulate previous steps by Bernanke to fess up to existing problems in Bernanke Hits One Out of the Park.

Ironically, everyone is shouting about the demise of the dollar over Bernanke's approval of stimulus instead of reading what he actually said. Bernanke wants the stimulus to be temporary, immediate in effect, and preclude an increase in the federal government's structural budget deficit.

That latter point is interesting. Bernanke is showing concern over the falling dollar and/or concern over future liabilities that can be met only by raising taxes. Bernanke is also showing concern over the downstream effects of stimulus that comes too late or lingers too long. Greenspan never worried about such concerns.

Piece by piece, those who look close enough can see Bernanke is distancing himself from his infamous speech Deflation: Making Sure "It" Doesn't Happen Here. To reiterate my position: There will be No Helicopter Drop For Failed Banks.

Bernanke's Conditions Will Not Be Met

By asking for fiscal stimulus that is temporary, immediate in effect, and precludes an increase in the federal government's structural budget deficit, Bernanke may as well just say: "I am against fiscal stimulus".

Bloomberg is writing Bernanke Aims to Avoid Greenspan's Stimulus.
Federal Reserve Chairman Ben S. Bernanke may encourage lawmakers today to stimulate the economy while aiming to avoid his predecessor's "regret" of being tied to specific measures. Former Chairman Alan Greenspan "misjudged" the environment in which he endorsed tax cuts in 2001, and had "intense" regret the eventual legislation excluded his specific guidance, he wrote in his 2007 book.

Democratic lawmakers have suggested a package of about $100 billion that includes a rebate for middle-income taxpayers as well as expanded unemployment and food-stamp benefits. "I believe it can be done in 30 days," Hoyer told reporters in Washington yesterday. "Whether it will be done in 30 days is another question."
Enough of this Bernanke Lovefest

It's time to consider Bernanke: Juice the economy 'quickly'.
Bernanke, during the question and answer session, reiterated that he did not believe the economy would enter a recession, but he did say he expected the economy to grow at a "slow pace" this year and possibly into the beginning of 2009. But he added that the contraction in the housing market should finally begin to "wane" later this year.
Excuse me Mr. Bernanke, but if the economy is not headed into a recession then pray tell what's with the panic rate cuts and emergency stimulus proposals? Exactly what is wrong with the economy growing at a slow pace? Are you an inflation fighter or not? Don't you realize you are making it extremely difficult for anyone to believe you? Will the real Bernanke please stand up? Is there a real Bernanke?

Perhaps it takes much more time for a zebra to change its stripes, at least when talking to Congress.

America's Funniest Videos

Professor Zucchi was watching the congressional testimony and had that is to say:
Those watching Bernanke's testimony before Congress were just treated to a socialist diatribe by a congresswoman prepped to embarrass Bernanke as the "former CEO of Goldman Sachs (GS)." Of course the former CEO of GS she was referring to is Treasury Secretary Paulson, resulting in her utter embarrassment rather than Bernanke's. Not to be outdone, a Republican colleague just had to be educated on national television about the basic functioning of the Fed's Term Auction Facility (TAF).

I agree that knowing Bernanke and Paulson's resumes should not be expected of your average person. Nor is the TAF a household concept. But these lawmakers are on the House Budget Panel.

This is not some libertarian tantrum, Minyans. Congress is trying to figure out how to spend a few more hundreds of billions of your dollars "to help the economy", and they don't seem to have a clue of what planet they are on.
Congressional Budget Office Reports On Fiscal Stimulus

Professor Depew carefully poured over a long 35 page CBO PDF on Fiscal Stimulus. Thanks Kevin! This is what Kevin found:
In the CBO report was this vital recognition as it relates to fiscal stimulus targeting consumers:

"In general, tax cuts or increases in transfer payments from the government to people (such as Food Stamps or unemployment insurance benefits) increase household demand by providing consumers with additional spending power."

True, but here's the recognition and caveat from CBO:

"But households do not predictably spend a fixed proportion of the extra income left in their hands when taxes are reduced or transfers are increased. Rather, a household’s propensity to consume appears to vary with its income and depends on expectations of the household of what will happen to that income over the longer term."

In other words, you can lead a horse to credit, but you can't make it consume. That is why the combination of both monetary and fiscal stimulus will inevitably lose out in a deflationary credit contraction and unwinding of debt. Keep the following in mind: Fifteen rounds. Fifteen long rounds.
Thing's That "Can't" Happen

Fifteen long rounds sounds about right. Land prices in Japan fell 18 consecutive years. Supposedly that couldn't happen. Fifteen long rounds is plenty of time for Things That "Can't" Happen to happen.

Treasury against raising GSE loan size limit


Fortunately, the Treasury is against raising the GSE loan size limit.
The U.S. Treasury Department said on Wednesday it would not support raising the size of home loans that Fannie Mae (FNM) and Freddie Mac (FRE) may buy until a comprehensive reform package is passed by lawmakers.

"With the potential for an economic recession increasing, now is the time for all of us to put aside our parochial interests and focus on the job of stabilizing the housing market and getting the economy back on track," said Brian Catalde, president of the home builder group.
I disagree with Catalde and suggest we look at the role GSEs played in creating the housing bubble and dismantle them, perhaps over a period of 5 years or so. For now anyway, this "stimulus idea" is DOA where it belongs.

Bush And Congress March Ahead

Bush and Congress are marching ahead without ever bothering to ask why we are in this mess in the first place. Here we go again. Bush Stimulus Plan Includes $1,600 Rebate, People Say.
The Bush administration is close to completing an economic-stimulus proposal that will include $800 rebates for individuals and $1,600 for households as well as tax breaks for businesses, people familiar with the plan said. Congressional leaders say a stimulus package may be as much as $150 billion.

Businesses would get a tax break under the plan that would allow them to deduct 50 percent of the price of new equipment they purchase this year. Small businesses would be able to deduct as much as $200,000 in new equipment purchases, up from the current $112,000 limit.

Asked about the details, a Treasury spokeswoman declined to comment. A package of $100 billion "would certainly be measurable, it would not be window dressing," said Bernanke.
How Much Stimulus Comes From $100 Billion?

$100 billion sounds like a lot. It is a lot. It is measurable. It is nowhere near enough to matter.

Look at this another way. Banks such as Citigroup (C), Bank of America (BAC), and Washington Mutual (WM), and Brokers like Merrill Lynch (MER), Lehman (LEH), Bear Stearns (BSC), and Goldman Sachs (GS) have written off over $100 billion in capital.

Remember this is capital we are discussing, not spending stimulus. Because of fractional reserve lending, most banks are leveraged 10 to 1. A destruction of $100 billion in bank capital will result in reduced lending power of $1 trillion.

Ambac and MBIA Alone Affect $200 Billion In Losses

Ambac (ABK) and MBIA (MBI) appear headed for bankruptcy. Ambac Odds of Default are 73%, and MBIA 71%.

Losing the AAA stamp would cripple the bond insurers and throw doubt on the ratings of $2.4 trillion of debt the industry guarantees, causing as much as $200 billion in losses.

Consider California

California is just one state. However, if California was rated as a country, it would be the 6th largest economy in the world.

I outlined my budget proposal for California in Mish's California Budget Proposal. Whether or not anyone agrees with that proposal is irrelevant. What is relevant is the state of California is going to reduce spending by 10% by hook or by crook. That is a $14 billion dollar hit right there. How many jobs is that? Expect many more states to be put in a similar situation.

Asymmetric Benefits

Think about California for a second. Look how asymmetric the Bush proposal is. Everyone gets $800. Whoop to do. Double that. It's double whoop to do. Does an extra $133.33 a month constitute stimulus? For who?

It is very helpful for those at the very bottom of the socioeconomic ladder that need income to buy food and gas. But that will not "stimulate" anything. It may mean the difference for some small set of people being able to buy pork chops instead of pork steaks and perhaps go out to dinner once a month on the side. For others it will pay a fraction of a credit card bill.

It will not do much for anyone reasonably well off. Nor will it do anything for anyone in California (or anywhere else) that is about to lose their job in state spending cutbacks, financial cutbacks, retail cutbacks, or any other kind of cutbacks.

Here is the key question: What does a onetime payment of $1,600 mean to someone who just lost a $45,000 job? The correct answer is not much.

We have still not accounted for waves of commercial real estate defaults, rising unemployment, rising credit card defaults, and rising foreclosures on Pay Option ARMs. Furthermore, I still expect a mammoth cascade of collapsing CDS dominoes at some point. There are $500 trillion in derivatives out there. What if 10% of them default? Heck, what if a mere 1% of them default? This is uncharted territory.

In the grand scheme of things, $100-$150 billion spread evenly is irrelevant. Such "stimulus" is doomed from the start.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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