Monday, March 16, 2009

Summers, Bernanke, and the new Obama song list 

Our single most important priority is bringing about economic recovery and ensuring that the next economic expansion, unlike it�s predecessors, is fundamentally sound and not driven by financial excess.

This is Larry Summers Friday at the Brookings Institute. Set aside the fact that he is dismissive of the Bush expansion that was "driven by financial excess". If you are going to say that, you'd have to include the late 1990s tech bubble when the Treasury secretary was the same Larry Summers. And set aside the errant apostrophe. (Grading papers this weekend, guess I'm hypersensitive.)

And leave aside for a time the fact that a month ago he expected job loss for some time going forward. He's just singing from the new Obama hymnal that all is well now; if there's one thing this administration does well, it's deploying messengers (even those who've been in trouble in the past.)

No, what I find interesting about that sentence is that there's something fundamentally different about the expansion planned by the Obama economic team from the last two. A huge amount of spending has to be financed; normally this would set off higher interest rates. That's deadly for banks still on their backs, if they have to raise rates to keep deposits while having their mortgages pushed down as the Obama plan tries to relieve homeowners. The only way that can work is to transfer money either to homeowners or to the banks, and where is that money going to come from, if not another bubble?

Brown Brothers Harriman points out the size of the problem simply: Where do you sell $2.5 trillion of government debt? (h/t: Craig Newmark)

One group of likely buyers of US Treasuries that is not fully appreciated by market participants, who have focused on international demand, are Americans themselves. The household savings rate is trending higher, the current account deficit is trending lower, and investors have been terribly burnt by the equity market. Investors are all stripes may be attracted to the security of the US Treasury market.

US individuals owned a little less than $90 bln of US Treasuries as of the end of Q3 08 and have increased their holdings for each of the first three quarters of 2008. Mutual funds held by individuals, including non-Americans, held about $155 bln of Treasuries as of the end of Jan, a 16% increase in the past year, according to Morningstar Inc.

Unless you assume a huge shift outward of savings supply (I am thinking in terms of loanable funds theory in my head -- if you want to debate the theory there's your starting point) via Ricardian equivalence or portfolio repair, you have to think real interest rates are headed north. Nominal rates may be held down by deflationary pressure, but with as much money as Bernanke acknowledged last night, that cannot last. I have a running joke with my colleagues that I have every confidence that the Fed has not forgotten how to create inflation.

China's concerned, and the G-20 meeting of finance ministers and central bankers came up a cropper after the U.S.' desire to get help with restarting the locomotive for world economic growth ran up against the Europeans' fear of financial meltdown. Bernanke's soothing tones last night on that point won't convince the EU to join in singing from the Obama hymnal; one can see this morning that markets took the message fairly well, but I doubt it lasts longer than the first negative comment from Europe or China. Those folks know too what the Fed hasn't forgotten.

P.S. I had Twittered my surprise that Bernanke went with the savings glut/bad regulation story to explain the boom-bust. His explanation is a good fit with Michael Mandel's last week.

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