September 8, 2008

It’s The End Of The GSE’s As You Know Them (Do You Feel Fine?)

The Federal government has officially seized control of Fannie Mae and Freddie Mac, and once again, no plugged-in person should have been caught by surprise. The question now, how will this move impact on the local market?

While near-term liquidity in the mortgage markets should increase as the implicit goes explicit, we expect to see a continued tightening of lending standards for conforming loans (which will continue to reduce the pool of potential buyers). Over the long-term (and beginning in 2010), both entities will be reducing their own investment portfolios (which could have the opposite effect on liquidity). And in terms of rates, we’ll wait and see.

One thing is for certain, that $25 billion Congressional Budget Office estimate for rescuing the two GSE's is now even more likely to be just the tip of the iceberg.

First Published: September 8, 2008 7:30 AM

Comments from "Plugged In" Readers

They have done the takeover.

Upon review of their accounting, they were heading towards bankruptcy but using accounting to cover it up.

To answer diemos' very valid question, the guy they put in charge of Fannie was at TIAA-CREF.

When the tide in Mortgage Backed Securities had gone out, and no one could sell any subprime (meaning you could see what they had when the tide went out because they were all stuck with it), TIAA-CREF put out a statement that they didn't have any subprime. That tells me this guy knew the crap that was going on and wanted no part in it, in spite of the artificial AAA ratings and high yields, which would have been the siren song to a pension fund like the teacher's retirement pension fund TIAA-CREF.

From their November 30, 2007 announcement (Herbert Allison, the guy they are putting in charge of Fannie, left in April of 2008):

"TIAA-CREF has no direct exposure to any subprime mortgage securities in any of its three money market portfolios: those of the CREF Money Market Account, the TIAA-CREF Institutional Mutual Funds Money Market Fund or the TIAA-CREF Life Funds Money Market Fund."

David Moffett, former head of U.S. Bancorp, who will head Freddie, similarly identified the problems, and had an almost non existent subprime profile compared with other similar banks. From a July 2007 article:

"US Bancorp has sidestepped credit issues, because its total subprime exposure amounts to 2.8% of its portfolio."

This tells me that Paulson didn't bring in people to increase risky bets of the GSEs. Although it could happen later on, it probably won't happen soon. These were conservative guys who didn't heed the greed and go after high interest high risk bets.

I understand diemos' point: they couldn't continue to make risky bets (or any bets) without help, so this help could let them go back to business as usual. That is certainly possible, but based on the very earliest of signs, which could change, it's not likely they would have used this guy to get there.

Posted by: tipster at September 7, 2008 11:54 AM

Speaking of golden parachutes for our friends at Fannie and Freddie, here are a few choice excerpts:

"Under the terms of his employment contract, Daniel H. Mudd, the departing head of Fannie Mae, stands to collect $9.3 million in severance pay, retirement benefits and deferred compensation...."

"Mr. Mudd has already taken home $12.4 million in cash compensation and stock option gains since becoming chief executive in 2004...."

"Richard F. Syron, the departing chief executive of Freddie Mac, could receive an exit package of at least $14.1 million, LARGELY BECAUSE OF A CLAUSE ADDED TO HIS CONTRACT IN MID-JULY AS HIS COMPANY'S TROUBLES DEEPENED. He has taken home $17.1 million in pay and stock option gains since becoming chief executive in 2003." (emphasis added - it's nice to see that he was taken care of two months ago - I mean, hocoodanode?)

"Mr. Mudd’s predecessor at Fannie Mae, Franklin D. Raines, took home more than $52 million while he was chief executive from 1999 to 2004...." (Raines is the Clinton appointee who presided over the accounting fraud scandal)

"Even though Fannie Mae was forced to restate its earnings, Mr. Raines walked away with at least $25 million in pension benefits...."

Under the conservatorship, you can be sure that the overpaid rank and file fools at Fannie and Freddie will NOT go down to Federal GS pay scales. With the USG now guaranteeing positive net worth, I wouldn't be surprised to see them all get raises.

Posted by: Satchel at September 8, 2008 6:11 AM

You can bet on large "retention bonuses" to now be paid out to all upper management -- as are common in big bankruptcies -- justified by the argument that we need to retain top people during this time of turmoil (because, you know, there is such a huge demand for executives experienced in losing billions of dollars and they would be sure to get snapped up by other employers).

And FRE and FNM share prices are now down to about a buck -- the option price of a gamble that some miracle may turn around the ship some time in the next decade or so. I can think of better ways to waste a buck.

Posted by: Trip at September 8, 2008 7:17 AM

Socialism is alive and doing very well in America, and has been for decades. Get over it.

Posted by: sf at September 8, 2008 8:25 AM

Just an FYI, Daniel Mudd of Fannie and Richard Syron of Freddie stand to make $9.3 million and $14.1 million respectively when they "gracefully" bow out from the spotlight.

Posted by: badlydrawnbear at September 8, 2008 8:26 AM

privatizing the gains, socializing the losses...

The big winner here is actually Ben Bernanke and the Fed. I mean, boy, Greenspan and Volkler have nothing on this guy. I'm just waiting for him to get the power to suspend habeas corpus.

The election of the next President may be off interest to many, but the most powerful man in America is now Ben.

And when the Fed finally chooses to inflate, they now have the perfect cover under which they may do so - purchasing mortgage-backed securities. And of course the taxpayer will be the one buying the mortgage backed security.

So to follow the cycle (for those scoring at home):

10,000 500k mortgages written by the bank du jour to consumers/investors of varying degrees of credit worthiness. Package of 10,000 500k mortgages sold to the Fed for 5 million. Bank gets $5 million. Repeat 200 times = $1 billion.

But where did the $1 billion come from? :)

Posted by: enonymous at September 8, 2008 9:11 AM

The former head of Fannie Mae's name is Mudd. Yes, indeed it is!

The remarks about bailout and sheeple trivialize what is going on. This is like a snake eating the pyramids: not pretty. It isn't clear the government has this money, so actually making this happen could involve keeping these institutions alive as zombie alligators. With huge line items competing with health care, social security, and endless war this will be a thorn in our sides for years, possible decades.

All this stuff about socialism is profoundly ignorant. Society didn't get any real funding through this. It was all corruption, and mostly between cronies of one sort or another. Mere corruption does not count as socialism no matter how upset you get. This is a really bad time to be abandoning reason. Seriously, if you don't want socialists dictating the rules for finance, then a good step might be to avoid dictating what socialism from the point of view of a financier.

Posted by: Mole Man at September 8, 2008 9:11 AM

All I'm faintly hoping for is that the 10-year/mortgage spreads drop enough so that my savings from refinancing will cover my inevitable tax hike. Not too hopeful on that though. But I can always hope...

Posted by: David at September 8, 2008 9:25 AM

So in 2010 do you think the gov't will also declare a "Clean Slate" for everyones credit score that has tumbled down the tubes because "In 07-08 everyones scored droped"

"Everyone lost their home, so lets just start everyone off with a new high credit score, and erase all their bad choices so that they can start all over again with their foolish mistakes!"

At this point is seems likely watching all these bailouts take place.

Posted by: Ryan at September 8, 2008 9:36 AM


"10,000 500k mortgages written by the bank du jour to consumers/investors of varying degrees of credit worthiness. Package of 10,000 500k mortgages sold to the Fed for 5 million. Bank gets $5 million. Repeat 200 times = $1 billion.

But where did the $1 billion come from? :) "

I like that formulation! I definitely understand your concern over the potential for inflation through monetary printing. But perhaps I could extend the analogy just a bit?

Suppose that there is a moderate size city with 100,000 housing units, each having an average (note, not mean, and this includes rental properties/apartments) value of $500K. This "value" in all respects acts like money, doesn't it? People use it as a "store of wealth", they can "trade" it for other assets (by selling of course), and they can even borrow against it, acting like a mini-bank for themselves by playing off their forecasts of real versus nominal financing costs! Can't we really say that this "value" is money? I mean, it certainly acts like it and fulfills the classical definitions of the function of money doesn't it? (It may be a LITTLE difficult to access and trade, but certainly nowhere near as difficult as those giant stones the Yap tribe used as money, so that "illiquidity" shouldn't concern us too much!)

Now, suppose that these units undergo a 10% across the board reduction (average), or $50K "loss". So, $50K * 100,000 = $5 Billion just died and went to money heaven. In your analogy, the Fed acting in its godlike "benificence" just resurrected 20% of it. Do you think that will stoke the fires of inflation?

To extend this, we've got something like 30 TRILLION of excess debt that cannot be supported or repaid (at current leveles of living standards). Do you really think the Fed is going to "print" enough?

There is NO way out of an asset deflation. That's why it is so tricky.

Posted by: Satchel at September 8, 2008 9:41 AM

"All this stuff about socialism is profoundly ignorant. Society didn't get any real funding through this. It was all corruption, and mostly between cronies of one sort or another."

Lol Mole Man! So, how does this exactly differ from every other implementation of socialism in recorded history?

(And please, no arguments about Cuba. My wife's family fled from there, all her sisters were born there - my wife was born in Dominac Republic - and they maintain limited contacts with some of the people back there in Cube. The corruption and theft from the population (especially if you happen to have had the misfortune of being born with the "taint" of slave blood) is beyond belief.)

Posted by: Satchel at September 8, 2008 9:48 AM

there is a difference between socialism and crony capitalism. we have the latter. all of course IMO.
as for the topic of the post: there isn't a man alive who can tell you what mortgage rates will do now. The reason: it is all part of the govt, which means it is dictated by governmental whim.

if the govt chooses to allow loose lending then that's what F&F will do. If the govt chooses to tighten up ship and reduce F&F and later break them up, then that's what they will do. It's all politics now. And what we do now may be very different than what we do in January 2009 when we have a new administration.

the govt need not adhere to market principles, because it isn't concerned with market philosophies (such as profitability). the govt cares about re-electability... so F&F will likely do whatever they are needed to do in order to re-elect our superiors

the one true driver of all of this however will be foreign central banks. we still have a massive budget deficit. we need someone to lend us money to keep govt open. that "someone" are the Foreign Central Banks since the American citizens don't have the required savings. Thus, the govt will need to kow-tow to the FCB's to keep them happy, otherwise they'll cease purchasing US debt which would be quite the pickle indeed.

that is what really drove this announcement. China and other governments were ceasing to buy F&F bonds, and were even starting to sell. the govt had no choice but to take them over to see if they can get the FCB's to reinvest.

Posted by: ex SF-er at September 8, 2008 10:31 AM


Yes credit = money (in our system). No argument here. And certainly no argument that the asset depreciation in housing is an overwelming deflationary force. I've made this argument repeatedly - i.e. that we are currently deflating (though OT your willingness/desire to ignore this fact when looking at the GDP deflator regarding the revision of recent GDP numbers did not make sense to me).

Here is where I disagree. First and foremost, liquidity matters. 5 years ago, the value of of one's home was nearly a perfect store of value. In your fictional city, the 100,000 housing units were worth 500k each, and yes the drop in value 'burned' the money equivalent. But perhaps more importantly, when the homeowner who chose not to sell found out that he could not borrow against the value of his home 'equity,' that owner found the value of his home dropped to zero (for the purposes of your equating value to money). The lack of liquidity of the home in our fictional fair city (a process that has ocurred and is of course ongoing) effectively reduced the value of the home to zero. I would argue then that yes, for years in the past, the value of a home was the same as money. Currently, it is not. Operationally, this either functions as (massive) deflation either way. My point is simply that the drop in value of the home is actually the smallest of problems (though it was the problem that started the dominoes falling). The big problem is that the value of one's home used to function as money, and now it does not. That is the giant sucking sound you hear.

But wait, I hear chopper blades in the distance. Ah yes, Helicopter Ben is coming. He can create money from his perch. Watch as he 'securitizes' new loans (credit=money) for all sorts of borrowers (credit worthy or not). Watch as he writes checks to all of the good banks in our fair city. Watch as more loans get written. Watch as more housing units get built. Watch as we reflate (when and if he so chooses).

The power to buy MBS is the newest power to inflate, and write the checks from the taxpayers pockets. Satchel, he won't have to support 30 Trillion. He just needs to support enough to make people believe that they should support the rest. And when this happens - voila! All of those housing units that became worthless 'stores of value' overnight, well they suddenly are returned to their former status. Money is being destroyed rapidly at present. When and if he chooses, Ben now has an incredibly powerful option to create money quietly and surreptiously. This isn't socialism. This is autocracy. Let's just hope he's benevolent.

Posted by: enonymous at September 8, 2008 10:49 AM

Well said, ex SF-er. In the short run, interest rates will almost certainly go down as the spreads disappear. Of course, the spread is on treasuries, which will go higher, erasing any benefit.

Do I think the dems will allow the portfolios to decline 10% per year. Nope. Do I think, however that the lending standards will go up. Yes.

Two reasons for that. One is the reason at the top of this thread: those two guys who are now running the show understand that you can't run a business on top of a ponzi scheme for very long.

But the second reason is more speculative. I think we'll find out over the coming months that the whole shebang was a ponzi scheme. Meaning, that they kept making riskier and riskier loans to keep the money coming in to allow them to make good on their guarantees on loans that were failing. They were desperate for cash, and like Mr. Delorean selling cocaine in the 80s when he was desperate to keep his car company afloat, I think we'll find that they were engaging in more and more of this near the end, which is ultimately why the plug got pulled on what were probably the most powerful corporations in America.

That type of lending will thus contract sharply. When it gets exposed, the other institutions who were doing the same thing for mostly the same reasons will be forced to stop too. That's going to have the biggest impact on SF and other places where prices are completely unhooked from salaries.

That will then be counterbalanced by a "foreclosure holiday" the dems will put in place. That won't stop anything, but it will slow it down. And so begins our lost decade.

I don't think anyone of the above will feel they have any choice to act the way I described it.

Posted by: tipster at September 8, 2008 10:50 AM

and no, i don't feel fine

Posted by: enonymous at September 8, 2008 10:56 AM

Two reasons for that. One is the reason at the top of this thread: those two guys who are now running the show understand that you can't run a business on top of a ponzi scheme for very long.

I agree with these points, that the two they chose seem to be "good" choices who would understand the quandry in which we currently find ourselves. however, personal beliefs are often trumped by politics.

I will use James Lockhart as example. Early on he was a critic of F&F and recommended more oversight and a reduced portfolio and higher capital reserve requirements. However over time the political machine got to him, and he dropped his objections.

His ORIGINAL position was obviously the correct one. But because he went to the dark side he is now the director of an even larger more powerful agency. (FHFA instead of OFHEO)

in other words: he was rewarded to look the other way.

There is no doubt in my mind that if he would have held firm in his early convictions he would be summarily dismissed. The same thing may or may not occur with Mudd and Moffett...

sure, they saw this coming. They are smart as a whip. Now will congress/Treasury/Fed/President allow them to do what they need to do?

right now they serve 2 masters
1) increase liquidity to the mortgage market to help stop the housing downturn
2) reduce the systemic risk that F&F pose

these are 2 opposite functions. which one will be dominant? in the end it will depend on how the political winds blow IMO...

Posted by: ex SF-er at September 8, 2008 11:12 AM

You act as if the US government is its own arbiter of destiny. Unfortunately the US government itself is highly leveraged and so the ultimate "boss" is the people who own the bonds. As Treasuries rise with the increased debt load it will be impossible for the feds to do much.

If I had to guess I would say the 2010's will be a repeat of the 90's - a democratic administration inherits a high cost of servicing debt and therefore makes fiscally conservative choices to deal with it. In addition, given the class warfare aspect of democratic administrations if they had to choose one group to punish it would be "high cost areas."

Posted by: Jay at September 8, 2008 11:52 AM

Just a few thoughts, based on some of the above comments.

1. Of course, politics are always a consideration. However, this doesn't change the laws of economics (unfortunately, we only have an imperfect knowledge of those laws). The US in the 1930s politically did not want a depression, but they got one. The USSR in 1989 politically did not want a collapse of their system, which among other things caused life expectancy to fall from the high 70s to the mid-50s, but that's what they got. Japan did not want a "lost decade" and fought it tooth and nail. China recently did not politically want their stock market to fall more than 60%(!), but that's what they got.

Any belief that our outcome can be shaped politically by the "people" to an outcome that won't crush them requires a belief that we are smarter. I'll take the other side of that bet every time. (If we were smarter, why are we in this pickle?)

2. Hyperinflation doesn't work. In a highly leveraged system, hyperinflation leads to the complete inability to finance (because lenders cannot forecast with any confidence real returns). This CRUSHES asset prices. In the 1970s, we were MUCH less highly leveraged. Inflation "worked" (but if you remember those days, not so well for average people - notice a pettern here?). Policy makers avoid this outcome to the extent possible, if only for self-preservation reasons (sometimes, there simply is no choice, as in Weimar after WWI, or maybe Zimbabwe today).

3. Hyperinflation often (perhaps always?) leads to change of government and replacement of the central bank. Do you think they want to give up their goodies just yet? Deflation works the opposite way. Government gets stronger, always and everywhere in the modern era. The population looks to the government to "salve" their pain. Low interest rates allow the government to borrow to increase their influence. Politics works (again) to crush the population.

4. Increased governmental control over the mortgage market is a form of price control, which will lead to credit rationing, as all price controls do. This will NOT help asset prices (although the generally low interest rate environment that deflation provides can lead to some support for prices, moderating their fall).

5. Last, now the population wants the USG to control all health care? Good luck with that. It will lead to rationing and ultimately the USG choosing who lives and who dies. For anyone in their 30s or 40s now who has the means, my recommendation FWIW is to amass assets (preferably outside the control of the USG) for the eventuality that you may need to seek medical treatment for you and your loved ones outside the US in a more free system (or at least have the means to bribe the gatekeepers of the US system). Don't be like those poor elderly fools in Russia in the early 1990s who had no options when the government promises evaporated, and just went off and did what economics told them they had to do, namely, they died.

Posted by: Satchel at September 8, 2008 12:38 PM


"I've made this argument repeatedly - i.e. that we are currently deflating (though OT your [Satchel's] willingness/desire to ignore this fact when looking at the GDP deflator regarding the revision of recent GDP numbers did not make sense to me)."

About the GDP numbers, I just didn't feel like arguing the point extensively back then on that thread with NVJ. Obviously, I think there is significant deflation going on. But the report was all internally inconsistent, which leads me to believe it was wrong (perhaps intentionally, or maybe they're just fools at the BEA, who knows?)

For instance, the deflator was 1.2% annualized (I know you understand the signiificance of this in getting to the 3.3% phony growth number). But look at the release. The general price indices (not just CPI-U) was up at 4.2% (look at the table in the middle of the link below), and PPI up at greater than 10% rates. But we are to believe that something like "owner equivalent rent" or some other "plug" figure gets us from +4.2%, +5% (CPI) or +10%+ to a deflator of less than 2% Does that sound right?

Did you notice also that the GDP accounts estimated that profits to financial companies INCREASED:

"Domestic profits of financial corporations increased $24.7 billion in the second quarter, compared
with an increase of $37.3 billion in the first."

So, financial companies have been MAKING money these last two quarters? Quick, someone tell the stock market! Does this sound right?

Last, +3.3% real growth is actually slightly higher than US trend growth in the postwar period. After 7 (now 8) months of declining employment (and the numbers are much worse than the BLS is reporting), are we really to believe that our economy is operating at full potential output?

That GDP number was a joke. But it did play its role. I hear all sorts of soundbites touting the great growth in the second quarter, etc.

Posted by: Satchel at September 8, 2008 1:03 PM

Satchel, re your #5, I think you've given in to doom & gloom with your health care apocalyptic scenario. Not sure what you mean by "USG to control all health care", but surely whatever you envision can't be any more socialized than most European countries or even Canada. Well, can anyone honestly point to those systems, look at their average per capita health spending and the results, compare it to the figures in the US and still find one reason to stay with our current system?

Then again, it may still be that I totally misunderstood your post and just made a fool of myself. In that case, ignore me!

Posted by: asiagoSF at September 8, 2008 1:19 PM

Thanks everyone for the many informative postings! This is a really big issue with many aspects.

Regarding deflation versus inflation, which seems a most relevant question, what is happening at the moment looks a lot like deflation. Many housing markets are way down, and no solid bottom yet. A strong indicator of this are the M3 money supply estimations going around which suggest that a really large amount of money has suddenly gone away. We can probably make a good guess as to where exactly it all went and why.

Regarding the socialism label side issue, I'd briefly state that in the well known examples of socialism run amok much material was confiscated from business interests and handed over to common people directly. Socialism involves the illusion that the workers can do everything without bosses, and fails when improvised boss substitutes fail. Other approaches such as confiscating wealth using taxes get used in other situations. With cronyism the power relationships are inverted with bosses attempting to take all power for themselves, only to fail when they eventually need to engage workers. To speak in terms of specific places in comparison I'd say what we are saying looks a lot less like Cuban history than it looks like the Argentina pattern.

Posted by: Mole Man at September 8, 2008 3:14 PM

Bailout could cost taxpayers $500 billion. A la Mort Zukerman:

Posted by: sf at September 8, 2008 4:06 PM

Of course, politics are always a consideration. However, this doesn't change the laws of economics (unfortunately, we only have an imperfect knowledge of those laws).

Be that as it may, it doesn't change MY point, which is that we have no idea what govt will attempt to do.

I agree with you that almost anything the govt does will fail to "save" housing. However, there is still much they could (foolishly) try. even though it is destined to fail.

Foolish people (and governments) do foolish things. I will use Japan as an example. Japan was hit with overvalued real estate and a banking system saddled with overleverage and bad debt. The cure would have been to de-lever and unwind them, and allow some to fail. that is what "should" have been done.

but instead, the Japanese went to a zero interest rate policy and allowed the banks to "account" their way out of the mess, creating the so-called "zombie banks". despite what they "should" do, they are STILL following (essentially) a zero interest rate policy, nearly 2 decades later! why? the political will was to continue the status quo, regardless of how fundamentally bad the status quo was.

clearly, ZIRP did not keep RE aloft, nor did it help Japan avert its recession. but they tried it anyway.

Similarly, I hear people arguing about what will happen to Mortgage Rates, and they use economic fundamental analysis to support their claims. But we cannot do this because the Federal Government is not totally beholden to those laws. specifically because there is NO REASON why F&F need worry about profits or losses, so long as the political will exists to keep them in their current existence.

For all anyone knows, the Federal Govt could decide to prop F&F for decades, losing hundreds of billions of dollars per year. Sure, eventually the govt would go BK, and it's doubtful they'd do that overtly... but it doesn't mean they're not stupid enough to try it.

There have been a LOT of very stupid things done thus far both in the private sector and the public sector. I see no reason why govt (or many of the for-profit companies) will suddenly see the light right now.

Everything that has been done to date has been done to try to avert decreases in housing prices, and to give the banks breathing room to re-capitalize. Until the political will changes, this is what they will continue to do IMO.

and this game can continue so long as
-our political leaders will it (they do)
-the Foreign Central banks will it (evidently, they do for now)

China is our master, but we are theirs as well. Without China we could not continue living off of their savings. Without our over-spending, China risks an open rebellion as their 900 million peasants are not yet out of poverty. it is a very sick symbiosis indeed.

so our leaders may decide to let F&F lose 100's of billions of dollars per year, AND to buy Mortgage Backed Securities, AND it is possible that the chinese and other FCB's will continue the dollar recycling program plowing their money right back into the mess that already is.

or perhaps one day someone in charge will decide to finally let housing fail, or perhaps the Chinese will feel that they have enough markets to export their products to without the US and they'll stop recycling.

who knows? it's all politics.

Posted by: ex SF-er at September 8, 2008 4:16 PM

ex SF-er

could not have said it any better myself

though one small fine point

the US is already as bankrupt as it can be - its just that those sucking our blood have forced us to undergo uncontrolled heamtopoiesis to sate them

a financial leukemia. i hope they enjoy it before it kills us.

Posted by: enonymous at September 8, 2008 4:42 PM

Satchel, I don't see how you can complain that the GDP deflator is too low in one paragraph and then claim that we are in a deflationary environment in the next.

I already explained as best as I can how the CPI-U and GDP deflator measure different things, namely that the rising cost of imports is reflected in the former and not the latter.

Here is a post from a blog I read by a U of Oregon Economist. Don't read the comments section if you are offended by blatant liberalism :-)

Posted by: NoeValleyJim at September 8, 2008 5:41 PM

"clearly, ZIRP did not keep RE aloft, nor did it help Japan avert its recession. but they tried it anyway."

Japan is a fascinating case study. I was there with some colleagues and one of them was holding forth with just how badly the Japanese had mismanaged their economy. How they had been trapped in a devastating deflation for 20 years. And I looked around at the happy well dressed people, bustling restaurants and shops, gleaming new infrastructure and I said, "If this is a devastating deflation, can I have some?"

The Japanese made a choice. One consistent with their cultural values. They choose to maintain full employment with make-work schemes so that everyone could have enough money to put food on the table and a roof overhead. Since they were net exporters and net creditors they could get away with that.

I think a lot of analysis on the Japanese deflation goes wrong because people assume that the intention of the interventions was to prop up asset prices. It wasn't. The interventions were just meant to slow down the decline and minimize the pain felt by the Japanese people.

Governments don't have the power to stop the pain of deflation but they have an enormous power to decide who gets to feel that pain and how fast the pain gets dished out.

The Japanese "powers that be" decided that the pain would be born by business and investors. I have no doubt that ours will decide to heap it on the workers.

Posted by: diemos at September 8, 2008 5:51 PM

I mostly agree with ex SF-er but am not as gloomy about it. As long as we can convince the Chinese to give us back the money we give them to "buy" their goods, we are fine. They need to keep their population employed as well.

They are not very happy with the fact that we have devalued the dollar and left them stuck with a bunch of bonds that are not really AAA. In fact, I am pretty sure that the main reason F&F was nationalized was to keep the Chinese money flowing.

The Fed will just keep printing money: so far they have successfully walked the precipice between deflation and "real" inflation, the kind where wages go up, not just prices, quite well. And they not only have the Chinese government on their side, they also have the Bank of Japan, which has been propping up the US dollar for decades. If nothing else, they can just print dollars and inflation be damned. The latter is what I think is the most likely outcome, btw. It won't be "hyper" inflation, like Argentina experienced, but high single digit is likely and in the teens is now out of the question. And once that train gets moving, it is very hard to stop.

What we really need is some stimulative government policy at this point, but with our current divided government and lame duck President, this is impossible. We got the $600 checks, which is part of why Q2 looked so good, but that is about it. If Obama wins, expect lots of Big Government infrastructure projects to put people to work. I have no idea what McCain's plan would be, probably a war with Iran.

Posted by: NoeValleyJim at September 8, 2008 5:52 PM

good one NVJ

I for one agree with you.

They are different indexes, and measure things different ways, and because of that, produce different numbers. Neither is particularly good in volatile environments, and in the current one, the GDP deflator does a much better job of capturing the true massive deflation we are experiencing.

If only we didn't have to guess at M3. The estimates in the collapse in M3 are shocking enough, but man, if only the real numbers were still out there.

Posted by: enonymous at September 8, 2008 5:54 PM

30 year fixed and jumbo rates have plummeted

for those looking to refi (assuming you have good credit etc etc), there are certain credit unions (national/local) with 30 year jumbos under 6% now...

Posted by: enonymous at September 9, 2008 2:08 PM

I have been thinking about this some more and I realize that inflation in imports will tend to make reported GDP go up. This is because imports are a negative component to GDP and they are reduced by their deflator. So if say, imported oil is going up in price, it would have to be reduced by the value of its inflation rate before it was subtracted from GDP.

This is all kind of counter-intuitive, I know, but how else would you measure GDP?

Economics is no more a perfect way of understanding the world than politics, religion or banking, but it does occasionally have its insights.

Posted by: NoeValleyJim at September 10, 2008 12:24 AM

NVJ & enonymous,

You guys are right on this. I dug into the numbers the other day, and tried to figure out what is going on, and the implications are not pretty at all for the US. The situation is a little more dire than I thought (I had always said that I was only "moderately" earish US equities - mostly on valuation and low interest rate grounds - but I think it's going to be pretty bad now).

Here's the deal. We all know that GDP = C + I + G + (X - Imports), and the GDI = GDP. (Consumption + Investment + Government expenditure minus Net Exports).

I went to the BEA price deflator components, and calculated the implicit deflators for each of those components (Table 1.1.9 at the BEA), and here they are (annualized - I did the calc quickly); the second percentage is the percentage of GDP represented by the component:

C +4.2% 71%
I +1.7% 14%
G +6.9% 20%
X +10.9% 13%
Imp +28.48% 18% (this is a negative component)

So, look at what we have.

Inflation running 4.2% for broad domestic purchases (PCE). Government (of course) wasting money and paying 6.9% inflation. Exports (at 10.9% deflator annualized) really NO MORE than the annualized change in the dollar over Q2, meaning that US exporters ARE NOT really "profiting" here from "world growth" at least on a price basis (they cannot raise prices in foreign currency terms). Import prices EXPLODING up in Q2 (no doubt becasue of the spike in oil in Q2, which is now collapsing), but NO ability to pass any of that on for corporates (that's why PCE is running relatively low - below CPI - domestically, and not in exports either - except for dollar depreciation, which has also reversed BTW). Basically disinflation in the private investment (I) compoent.

Add all this up, and you reach two conclusions. First, final demand (domestically) is very tenuous, and corporates have no pricing power. There is tremendous deflation going on here, because these guys aren't restraining prices out of the goodness of their hearts. Second, we are stil maintaining a trend (full output) growth rate, even though there have been something like 1 million job losses in the private sector this year, leading to the conclusion that there is large potential slack in the labor market. I originally thought that unemployment would not rise too dramatically in this recession as it deepens, but I don't think that anymore.

My bet is that next quarter GDP will print extremely weak - dramatically in recession territory - because the deflator for imports is going to collapse (although a bit of this will be offset by the deflator change in exprts).

I'm putting my money wher my mouth is. I bought more US treasuries the morning of the announcement of the GSE bailout, adding to an already large position in USG debt. Treasury rates should have gone up a little on the GSE news - and they did for about 4 trading hours on Monday morning (when I added) - but I think traders are coming around to the conclusion that anything the USG tries to do here is going to worsen the outcome.

Posted by: Satchel at September 10, 2008 6:09 AM

ex SF-er,

"China is our master, but we are theirs as well. Without China we could not continue living off of their savings. Without our over-spending, China risks an open rebellion as their 900 million peasants are not yet out of poverty. it is a very sick symbiosis indeed.

so our leaders may decide to let F&F lose 100's of billions of dollars per year, AND to buy Mortgage Backed Securities, AND it is possible that the chinese and other FCB's will continue the dollar recycling program plowing their money right back into the mess that already is.

or perhaps one day someone in charge will decide to finally let housing fail, or perhaps the Chinese will feel that they have enough markets to export their products to without the US and they'll stop recycling.

who knows? it's all politics."

I don't want to write a whole book here (like I usually do), but I think this is a critical issue. China is NOT "saving" all this money that we are spending, and so they do not face simply a political decision. As you wrote, China is a poor country, one that is rapidly industrializing. There is enormous need for capital there, but not the savings base necessary (because GDP per capits is something like $3K, or maybe $5-7K at most on a PPP basis).

Here is what happens. The US creates money by extending credit. Most of this happens in the private sector (the Fed is NOT printing money so far!! - if it was, you would see it in the monetary base figures or M1).

This credit/money goes to China (mostly to exporters, but some as FDI). These exporters go the Chinese central bank and offload this "credit". The bank shrugs its shoulders, thinks "now, what are we going to do with this?" and sends it right back to the USG (and the GSEs), for which it gets new pieces of paper (bonds). They buy a little gold too.

But the exporter needs cash because he needs to SPEND his money on expansion, retooling, etc. Where does this money come from? China PRINTS it! In exchange for those dollar export credits, China "prints" yuan out of thin air. It is exactly the OPPOSITE of what people think. The Fed is NOT printing, but the Chinese are! That's why money supply growth is off the charts there (in all of the "dollar recyclers", BTW).

When this yuan goes into circulation, inflation explodes in China. In the early stages it leads to a boom, but eventually this inflation destroys the "benefit" that China was getting, and their corporates start to get crushed. This is why the Chinese stock market has been annihilated this year, and why I recommended getting out of Chinese stocks on SS last November and December. This cycle always happens in emerging Asia and is basically what happened in Thailand, Malaysia, Indonesia, etc in the 1990s (then, it was Japanese yen recycling because Japan was flooding the world with yen). It doesn't require any great insight to see how the movie ends - it always ends the same way. Deep recession coming in China, with possibility of civil unrest (but recession in China will be like going to 0% growth rates, not the collapse seen by the ASEAN economies in the 1990s because China's external accounts picture is much better).

My basic point is that the Chinese leaders are facing an economic reality here, and they can't just "politically" do what they want. They are hemmed in by what is happening with inflation, and they will respond to it the way all governments do, namely price controls and rationing, which will make everything worse. This is what they were taught at Harvard (Keynes has done tremendous damage to the world!).

They DID face a political choice a while ago. China could have chosen to issue bonds to "sop up" all that yuan that they were printing, and then they wouldn't be in the inflation pickle they are now in. But the trade-off would have been lower (but more balanced and sustainable) growth, higher equilibrium real interest rates, and higher USG rates (and so lower growth in the US which would have been ok - we needed to work off the excesses of the 1990s anyway).

I hope that helps your thinking (well, I guess I did write another book after all).

Posted by: Satchel at September 10, 2008 6:56 AM

They are hemmed in by what is happening with inflation, and they will respond to it the way all governments do, namely price controls and rationing, which will make everything worse. This is what they were taught at Harvard (Keynes has done tremendous damage to the world!).

I don't know why you have to drag poor dead Keynes into this: except during wartime he never advocated price controls. It is true that the exceptional, probably never to be equaled again performance of the American economy under a strict command model during WWII did give some people a foolish idea of what was possible with things like ration stamps and price controls, but that is hardly his fault.

I think you will appreciate his ideas on inflation:

Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers,’ who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

Too bad he wasn't around to see the Twin Bubbles. I wonder what he would have had to say about them!

Posted by: NoeValleyJim at September 11, 2008 6:03 PM

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