Friday, May 8, 2009

Of Mice And Men

Stress Tests are over, loan loss provisions will be spread over years, accounting treatment has been relaxed, and nationalization will be left to the Swedes. While Bank of America and Wells Fargo capital needs are larger than expected, they fit within the Treasury's paradigm: earnings, asset sales, private sector capital raises and convertible TARP preferred stock will re-capitalize U.S. banks to deal with what lay ahead.

"Mission Accomplished"? Let's see; there are $11.3 trillion of U.S. bank liabilities. Between FDIC deposit guarantees (including $1.4 trillion that the FDIC describes as "Temporary"), guarantees for buyers of short-term bank paper, guarantees covering 93% of long-term debt issued since last November, and PBGC guarantees on pension liabilities, there's not that much bank risk left. The best measure of the Fed's success will be when these programs are scaled back without incident. Until then, the Libor rally is less a reflection of improving bank solvency, and more a function of government backstops.

There's also something unsettling about the Fed having free license to print money (or Switzerland, whose monetary base is up 118% y/y). Conventional wisdom is that inflation cannot co-exist with excess manufacturing and labor capacity. Sounds reasonable, except for fall 1974, when inflation hit 12% in spite of excess capacity of both. Yes, it was the end of the gold standard, the oil crisis was monetized, etc. But should we really rely on economic theory after the largest/fastest expansion of the World's reserve currency in 100 years? On the fiscal side, private sector de-leveraging is partly achieved through wartime levels of public sector leverage; some risks go away, but others appear. We already see how it will be paid for: in addition to higher taxes on individuals, tax reform also targets U.S. multinationals, as the U.S. is among the last countries left that subject companies to worldwide rather than territorial taxation. There is no road map for the consequences of unfunded guarantees, money-printing and stimulus this large.

In searching for one, I thought of Richard Nixon, who in 1972 wanted to bring unemployment down to the 3.5% levels which prevailed at the end of the 1960's. He found a co-conspirator in Fed Chairman Arthur Burns[1], who resisted FOMC calls for a higher discount rate, supported wage and price controls, and oversaw an 11% expansion in the money supply (the fastest since WWII, until today's episode which is 10x larger). It ended in higher unemployment, inflation and a decade of 0% real returns on both stocks and bonds. I don't doubt that the Fed has a more coherent exit strategy for this monetary expansion; but it will need to be 10x better, and not collide with the needs of a massive fiscal deficit.

As for other unintended policy consequences, consider Chrysler and General Motors. One day a book will be written about what's going on between the government, the creditors, the unions, Section 363 sales and the bankruptcy court (it's ugly). Throwing creditors on the pyre in the broader interest of employment and economic stability may be a sound strategy in the short term, and fits with a full-court press approach to combating a deep recession. But what about other companies with large retiree populations or large unionized work forces; how will bondholders and banks now lend on a secured basis to them? The leapfrogging of employee VEBA plans over senior and pari-passu creditors may have consequences not-so-far down the road. This should be of particular concern to an administration that intends to enact "Card Check Legislation", which could increase unionization rates by 10%, right back to 1970s levels. Lenders to such companies may be wary, and for good reason. Whether its mega-deficit spending, a 250% increase in the monetary base or a suspension of bankruptcy norms, the Administration should remember its Robert Burns...."the best laid plans of mice and men often go awry..."

[1] Burns’ assent was under duress. When Burns resisted pressure to guarantee full employment, the White House planted negative stories about him in the press. Nixon’s people also floated stories about diluting the Fed Chairman’s power by doubling the Board’s members. Nixon wrote to Burns: “There is no doubt in my mind that if the Fed continues to keep the lid on with regard to increases in money supply and if the economy does not expand, the blame will be placed squarely on the Fed.” In 1971, H.R. Haldeman spoke about the effectiveness of Nixon’s strategy: “We have Arthur Burns by the [expletive deleted] on the money supply".

Big Hat Tip Mike and JPM. Sphere: Related Content
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