January 2009 Archives

Ok, so Mitch McConnell, of all people, is talking about a new Federal program to offer 4% mortgages to anyone "credit-worthy." (If anything like this happens while Barney Frank is in power, "credit-worthy" will be defined as "has a pulse.")

What will happen if we do this? It's basically the opposite of the things being discussed to fix the banking system. Wouldn't you assume that everyone in America will dash to refinance at 4%? This obviously wouldn't do anything for housing values per se, because of the overcapacity that still exists. But it would certainly make every mortgage more affordable.

I'm not entirely sure yet, but my gut is that it wouldn't necessarily slaughter the banks and other holders of toxic MBS.

Those securities are toxic for a long chain of reasons, but the head of the chain is default risk. If every mortgage in America becomes issued and guaranteed by the government (well, more likely issued through the nationalized banking system, so we can feed some of the profits back to the bank share and debtholders), then the default risk becomes replaced by market (interest rate) risk.

But hasn't mortgage securitization always contained features to hedge against market risk (which in the case of mortgages takes the form of prepayments)? You basically expect that anyone who lends money for mortgages is holding a large slug of 10-year T-notes, or swaps, or some other derivatives, which would show offsetting capital gains in case of prepayments.

Bottom line, this move might not be too destabilizing in the near term. Plus, there's historical precedent, because the New Deal in essence socialized all mortgages.

The real risk here is that to fully socialize US housing finance (worth more than $10 trillion in all), you MUST MUST MUST never allow the 10-year T rate to rise above some historically-appropriate spread to the 4% mortgage target rate. (Today's spread is anomalously high, well over 200 basis points, which is why mortgages "feel" unaffordable now, even though the prevailing market rate, about 5.1%, is far below typical rates during the bubble.)

So if we pin long rates where they are now, you're creating a classic economic imbalance, just like the Chinese undervaluing their currency. The stress will come out somewhere, somehow, unless we get really lucky. The stress will show if we have to keep deficit-spending at extraordinary levels for years to come. It will either show as high inflation, or a collapse of the dollar.

There's been an awful lot of attention focused on the bonus-based compensation of Wall St. and banking professionals, and the controversy is explosive. A big part of the mishugas comes from the fact that a lot of the companies paying out tens of billions of dollars in total bonuses, are receiving massive assistance from US taxpayers, via the TARP and other programs.

Here's a useful precis of the arguments. (You'll notice that a lot of the quotes are from Davos. This is the one week out of the year when all of the business news gets reported out of there, as the global news corps follows the bigshots.)

Now I know as well as anyone that the bonus-compensation model is part of the financial industry's DNA. It's also a part of every sales organization in the world. You reward the people who bring in the money.

But there are some very important points here that do deserve careful scrutiny. Incentive compensation is awarded every year, ostensibly for performance achieved in that year.

But many (most?) investment strategies play out over multiple years. If you put on a trade (like, oh I don't know, making a leveraged bet on increasing US housing values), it could pay off brilliantly one year, and bankrupt your whole firm the next.

The landline provider in my neighborhood in New York City is Verizon. I'm in the middle of a support incident with Verizon that I'll describe in a bit of detail, for a couple of reasons. First, because it happens on an infrequent but regular basis. Second, because it vividly illustrates how a government-protected industry deals with its customers.

Why does this matter? Because we're now talking about taking vast chunks of American industry into that happy zone where they have little to fear from market competition, or even from their shareholders and debtholders. Today, Verizon is in that place. Almost immediately, they'll be joined by the Detroit automakers, and by America's largest and most powerful banks. Sometime before Obama's first term ends, America's healthcare delivery system will also be there.

I was in the middle of a phone call yesterday morning, when the line went dead. Fair enough, this happens all the time. I live in New York City, where our infrastructure was once the most advanced in the world. And today, we still have exactly the same infrastructure. The central office that handles my phone service is now more than 100 years old. A lot has changed: Ernestine the telephone operator no longer works there, and they've painted over the windows.

Up tomorrow morning is the initial reading of GDP for Q4 2008. Most of the estimates are centering around contraction at an annual rate of 5.5% or a little more.

The long-term growth trendline over the last several decades has been about 2%, with the better periods running closer to 3%. This is a little better than the demographic increase. If you still believe anything Alan Greenspan says (I do), we benefited from a multi-year period of above-trend productivity improvements in the Nineties, and from globalization in this decade.

I think it's somewhat more likely that the GDP reading (which will be revised twice over the next two months) will surprise on the upside. I think a reading of minus-3% isn't out of reach. It's less likely that we'll see a surprise on the downside.

In any case, if the reading surprises, it will almost certainly change the color of the policy debate. Devotees of Macroeconomics-101, including Nobel Laureate Paul Krugman and recent convert Christina Romer, are using negative-growth expectations to scale the amount of deficit spending they think we should enact.

To spare you a lot of arithmetic and questionable assumptions, the idea is to take the expected contraction in the economy, divide by a multiplier (typically about 1.5), deficit-spend that much on anything other than tax cuts, and subsequently expect a decline in unemployment rates predicted by Okun's Law.

Some orthodox economists are calling for fiscal-deficit package of about 8% of GDP, about twice the size that Obama has proposed.

If tomorrow's GDP reading is significantly different from minus-5.5%, look for some people to revise their numerology.

http://www.politico.com/news/stories/0109/18068.html

Quotes a New York-based hedge fund manager, Andrew Schiff: "Our standard of living needs to come down to the point where it can be supported by organic output."

Dang, that's pithy and totally true. I've written thousands of words for months now, usually including the word "deflation," groping for exactly that point.

I know that several of my friends disagree quite strongly with this view. What he's really saying is that we've been supplementing our consumption by importing spending power in the form of personal and public indebtedness. We've quite rationally been taking advantage of the fact that other countries demand an exceptionally low rate of interest for lending money to us.

Now, the chain has run out on low-cost private indebtedness. There's nothing left in that tank. But if anything, public indebtedness has become even more attractive as long-term interest rates remain preternaturally low. As a result, we're quite rationally going to suck on that tank until it runs dry too.

The only way to overcome behavior that's short-term rational and long-term destructive, is to be king. If I were king of the US, I'd take Schiff's advice and start looking for ways to make the US economy radically more productive. Eliminating the business income tax and the capital gains tax would be awesome places to start. Outlawing unions and dismantling the regulatory state would be next

Say, has anyone noticed that the stimulus projects which are getting the most negative attention from the press and the public, actually are the ones that orthodox Keynesianism suggests are the best ones to do?

I admit that striking the $600 million for condoms hurts no one but the people in China who would have manufactured the condoms. That one is a good strike, because it's transparently a giveaway to the pro-abortion lobby.

But spending $21 million to re-sod the National Mall is exactly the kind of make-work that fiscal stimulus is all about. The objective isn't to create a capital asset that will pay off in increased productivity later on, although that's often adduced as a bonus. The idea, as someone like Paul Krugman will readily tell you, is simply to reflate the economy by putting money into circulation and causing it to have a little velocity.

If you were to state this case baldly to the people, they'd probably laugh at you. What consumers want to do more than anything in the world at this point in time, is to SAVE A FEW BUCKS. But orthodox economists hate this idea because it creates no velocity, no additional GDP, and thus (according to orthodox theory) no additional employment. What all the smart people are missing is that you can't work your way out of a depression led by impaired consumer demand unless you increase consumer confidence. A major tax cut is what the people need. And it would have to have radical features to be effective, chief among them a sharp reduction in the payroll tax, not just the income tax as proposed weakly by Congressional Republicans.

And even the case that fiscal stimulus generates capital investment is suspect. You don't get much more utility out of a freshly-painted museum that no one goes to, than you do out of re-sodding the National Mall. (By the way, you can employ 1000 people at well over $10 an hour for a whole year, for $20 million. This isn't about re-sodding the Mall. It's about featherbedding.)

But we're all arguing the wrong things here. Let me tell you what the fiscal stimulus will REALLY accomplish. Except for the tax cuts (should significant ones actually materialize), the money will all be disbursed to the control of state governors and possibly some big city mayors. And what will they do with it? Yes, certainly, they'll fund some make-work ("shovel-ready") projects like bike paths, bridges to nowhere, new paint and air conditioners for government buildings, and (my personal favorite) Museums of the Great Depression.

But the thing these governors need more than anything else, is to fill in gaps in their state budgets. To a first approximation, the fiscal stimulus will be used to pay for healthcare and teacher salaries. The most direct effect of the stimulus will be to relieve states and cities of the need to raise taxes.

Don't hear anyone talking about that, do you?

For the Democrats to be willing enough to strip this stuff out under political pressure tells you that they really don't have the courage of their convictions here. This stimulus legislation is rotten to the core.

It would be an absolutely remarkable thing, and would be talked and written about for decades, if we execute a TARP II, or a Bad Bank, or any such thing. This is the outline: we would be taking a failed banking system (which at this point consists of a conflation of the large banks and what used to be known as investment banks), and subtracting its mistakes out of it. It would be recapitalized via public funds, much in the manner of WPA works of shlock art in the Thirties.

But none of the existing stakeholders (common equity and debt, much of which is held by very influential non-Americans including Saudi princes and the Chinese government) will have to suffer more losses than they have already. The American public will literally forgive their mistakes, and create a basis for some already-wealthy people to start getting much wealthier again.

Something tells me that when Obama comes back after his re-election to tell us all that the hard workers among us will need to dig deep and pay much higher taxes, he's not going to put the touch on Prince Al-aweed.

And the banks are going to see massive restrictions placed on their activities, and THAT will be seen as the payback for the public assistance rather than wiping out the existing equity and debt.

And what would this bizarre facsimile of a banking system be engaged in? Not any kind of economy-building finance. It would be involved primarily in mortgage finance, all of which will be guaranteed by the already-nationalized Fannie Mae and Freddie Mac (which last week signaled that they're insolvent too and will quietly be getting funded by a few dozen billion dollars, which was about the total size of their equity capital last summer).

But this isn't necessarily a negative for the economy. Big businesses for decades now have been getting their finance from the CP market rather than from banks. It's going to be hell for small businesses, who will start operating on real money rather than credit lines. This can most certainly be done (I've done it for years) but it means you have smaller businesses that take less risk, and will be far quicker to lay people off.

Expect to see massive public support for two sectors of consumer finance that have traditionally lacked it: auto loans and credit cards. Already the Fed is talking of buying up securitizations of these kinds of loans. Also expect the already-large support for student loans to be beefed up.

The American public is going into the business of consumer finance with both feet. This isn't necessarily bad or evil, except for one problem: the people we get to run our public banking system will be government employees. Getting a car loan or a credit card will be a lot like dealing with the Post Office, the DMV, or the IRS.

And just wait until green-technology cars come along. The banks will be offering much cheaper loans to buy those cars than the traditional kind.

And what of the sheiks and Chinese bureaucrats who will be enjoying the earnings streams from the public banks? Might not be a bad idea to join them now. Although I'm not giving investment advice here, recall that I've been flirting with the idea of buying up bank debt for a while now.

Like a lot of Wall Street types, I think of the financial industry as split between the buy-side and the sell-side. Both sides of the industry have undergone radical changes over the past eighteen months of crisis.

Much more change is coming. We've come through the phase of tearing down ways of understanding our business that have held for decades. We haven't yet begun to approach the question of what will replace those ways.

The buy-side exists in order to use financial raw materials (primarily debt securities) for the purpose of constructing and marketing a range of products known generically as retirement. The sell-side exists in order to match people who have capital with people who use capital, to discount risk, and therefore to provide the finance needed for a modern economy.

But over the several recent decades in which the theories of modern portfolio management have come to dominate the practice of finance, a different objective has come to the fore, on both the buy-side and the sell-side: seeking alpha.

Intuitively, alpha is a return on investment activity that exceeds, on a risk-adjusted basis, the expected return on the market as a whole. The goal of finance has become to "beat the market." But modern finance is based on a set of mathematical theories which assume that beating the market is impossible over long periods. (If you accept that markets process information efficiently, then the market, which definitionally possesses more information than any individual, will always win.)

As I write, the public debt (sometimes called the national debt) of the US stands at $6.3 trillion, roughly 40% of GDP. (You've heard many people say that the debt is actually about $10.6 trillion, but that's fictional, as I explain below.)

As we know, the question of who will pay off the debt is an interesting and urgent one. Especially now that, through a combination of fiscal stimulus, existing entitlements, declining tax revenues, and new programs like universal healthcare and a "green" economy, the public debt is going to skyrocket in each year of the coming administration.

It seems more likely than not that we'll be adding between one and two trillion dollars in new debt to the outstanding total in each of the next four years. It took President Bush eight years to add $3 trillion to the public debt. Obama will probably add twice as much debt, in only half as much time.

And as I'll explain, it's good and likely that we'll be adding large amounts of new debt in the years after the next four, as well.

One of the most critical problems facing the US economy is the "credit crunch," which shows up as an extreme reluctance by banks and other financial intermediaries to lend money. Without a normal flow of credit, no sector of the economy can function up to its capacity, and that of course leads to lower output and higher unemployment.

You've read a lot about the TARP and a raft of other ad hoc Treasury and Fed programs to stabilize the financial system. In practice, the objective of these historic and unprecedented measures has been to prevent a "meltdown," which can happen if the failure of a sick institution triggers a cascade of failures in healthier ones.

The way that banks, investment banks, and other institutions avoid a meltdown is to stop extending short term credit to each other. This is rational because in a time of extreme crisis like last March or last September, you literally can't be sure that any institution won't fail by morning. So you don't want to have lent anyone half a billion dollars the night before.

The problem with that, to use Ben Bernanke's stark phrase, is that it can cause the economy to come to an end. You saw the beginning of that process in late September as the commercial paper and institutional money markets nearly froze.

We're experiencing an economic recession as a result of several global economic imbalances that have been building for years now.

Since sometime in the Clinton Administration, growth in US consumption has been funded by steady increases in the private "balance sheet," or the net level of indebtedness. During the Bush years, growth was also supported by accomodative monetary policy and fiscal deficits.

Since the early Clinton years, we've been running a growing current account deficit with the rest of the world. Countries like China, Japan, and the oil-exporting states run corresponding surpluses. In effect, surplus countries need to import demand from deficit countries.

Over the last three or four years, we've allowed this imbalance to become extreme. Yet, continuing, steady increases in private credit formation have made this sustainable. Now, however, the global credit crunch which began in mid-2007 has caused net private indebtedness in the US to fall by something approaching $2 trillion.

That has an automatic, negative impact on our ability to consume, and on economic output overall. That produced a recession with rising unemployment in the US.

But since the surplus countries depend on us for the demand that keeps their economies growing, they've hit the wall as well. Now it turns out that China, in particular, probably will not suffer any decline at all in its surplus position. That's because their economy is so export-driven (perhaps about 40%), that imports of raw materials and intermediate products have fallen even more sharply than exports have. Their dollar reserves will probably continue to grow, even as unemployment and the potential for social unrest also grow.

Much has been made of the need to get banks to start lending money to consumers again. But there's been extraordinary damage to the US banking sector, caused both by declining asset values, and also by the government response. (If every bank is too big to fail, then eventually every bank is the US government. And we don't know if the US government knows how to be a banker, although the betting is that they don't.)

Therefore, there's no clear path to get a healthy flow of credit back into the economy. (That could change, of course.)

Perhaps the most distinctive and broadly-observable change in the public-policy milieu as we enter 2009, is this: America has a new faith in the power of experts to cure whatever ails us.

It's a season not only for big ideas (very few of them new) in public policy. It's also a season in which we'll try out a lot of them, in the naive hope that society will become a much better place as a result.

Why is this a naive hope? Because the most recent episodes of grand faith in technocracy (the New Deal and the Great Society) produced results that, while sometimes interesting, were always supremely costly. It takes a hubristic government, infatuated with its own capabilities, to spend the kind of dollar amounts that are simply beyond comprehension. The current debate over fiscal stimulus proves that yet again.

The other way for society to innovate, of course, is through private enterprise. This never goes out of style, although government has very effective tools at its disposal for weakening and defunding it. When allowed to work, however, it always produces results that are very interesting and economically very efficient.

We can see this dichotomy yet again in one of the most important items that we'll all be discussing for the next few years: how to encourage a green/hybrid economy in the US.

With characteristic hubris, the New Technocrats who are coming to power in Washington refer not to encouraging green technology, but indeed of transforming the whole US economy to a green/hybrid one.

What can this mean? To judge from past statements by such as Rahm Emanuel, the objective is for the US to consume one half as much gasoline ten years from now as we do today.

That's it in a nutshell. We'll know we have a green/hybrid economy when we stop using gasoline. Let's unpack this along a few dimensions.

It's pretty clear to everyone that the financial industry is not doing what it normally does, which is to extend credit and lend money. Just as clearly, the decline in new credit formation leads to deflation in risk-bearing financial assets, and a sharp contraction in overall economic activity.

Less clear are the implications for policy and for business forecasting.

Businesspeople are simply confused about the future direction, and waiting for signs of a bottom.

But policymakers are seeking to deny reality. They imagine that the financial system is just hitting a bump in the road, and that it's somehow possible to return to the world of 2006, but with better regulation.
 
There are two fundamental factors which are reducing the amount of credit being extended by banks and other financial intermediaries: the end of the housing bubble, and the end of highly leveraged financing models. Both effects are permanent rather than cyclical.
 

There are reports out that bond yields in certain European nations are starting to rise well above the norms for the stronger nations, Germany in particular.

Countries at risk of becoming unable to borrow large amounts of euros include Spain, Italy and Greece, as well as some of the EU-wannabe states.

The deep global recession is putting the worst strains on Europe's monetary union that it has experienced to date.

One of the theories behind the euro was that the financial credibility of Germany would create a halo-effect that would benefit countries with much weaker fiscal histories. (Italy, I'm looking at you.)

But in this time of recession, Germany is being true to its nature and protecting its money. They can do this because they're a surplus nation. But investors, annoyingly rational creatures that they are, are bidding down debt issued by the weaker countries.

In effect, currency union is making it much harder for the deficit countries to bring in capital just when it's most needed.

And you have to start asking, when are the finance ministers of Spain, Greece and others going to start whispering that they can no longer afford the euro?

This morning, we'll get accelerated earnings announcements from Citigroup and Bank of America. They basically have to do this because the whispering and the uncertainty about both enterprises is starting to get really hard to ignore.

And BAC just became the recipient of a government-assistance deal much like what Citi got in December: $20 billion in new preferred equity, and a guarantee of $118 billion in bad assets.

This ad-hoc approach to dealing with bank near-failures has become the new normal. At some point very, very soon, regulators will have to decide how small a bank has to be before it can simply be allowed to go out of business.

You have to figure the answer is something like: "If there's a bigger bank available that we can merge this piece of garbage into, then we'll fail it. If there isn't, we'll nationalize it.

Very reminiscent of Japan in the early Nineties, what obviously isn't being considered is to simply let banks fail altogether, under the weight of large clumps of toxic assets. But the way we're doing this really isn't that much different, as the equity of "rescued" or "assisted" banks goes more or less to zero.

Of course, it remains to be seen whether the ad hoc-bailout model will result in major transfers of taxpayer wealth to stakeholders of assisted banks (either the debt or the equity). One suspects the answer to this question will not be no.

Clearly, for all the hand-waving over the economic recession, we still haven't solved the deep and worsening banking crisis that was the trigger for the recession in the first place. There is talk that we need to add more than another trillion dollars' worth of "assistance" (in effect, new equity) to American banks.

It's interesting that tax cuts have taken a central role in the fiscal-stimulus debate.

(We really should be debating whether a massive fiscal stimulus is even the correct approach to the current economic, housing and financial crises. But since conventional wisdom has already hardened around that, forget about it.)

In orthodox Keynesianism (perhaps last seen during the Kennedy Administration), tax cuts were the accepted way of generating demand in economies deemed to be performing below capacity. (Of course, it turns out that giving consumers more money to spend without giving producers an incentive to produce more, generates not stimulus, but rather inflation. Forget about that, too.)

And the other big problem with taxes (as the Keynesians in the Johnson Administration learned, quite to their surprise) is that taxes are easy to cut, but not easy to raise. So they leave something to be desired as an instrument of economic policy.

Nonetheless, Obama's bold, aggressive experiment in economics ("Borrow Big! Spend Big! Get Happy!") has included proposals to "cut taxes" by about $300 billion dollars. What does he have in mind?

The cynic in me thinks as follows: For one thing, there really aren't enough pork-barrel projects on state governors' wish lists to consume the kind of money he wants to spend. So he needs to fill up the hole with something, and tax cuts are an easy way to do that.

For another thing, Obama's whole model is to lead by being unthreatening. He'd rather have someone else make the tough decisions and take the political heat, and he figures that tax-cut proposals will work like catnip on Republicans in Congress. And therefore, they'll have the big fights with the Congressional Democrats that Obama would prefer not to have.

Congressional Republicans should examine carefully what's being offered here.

Yesterday, Obama asked President Bush to formally request Congress to approve the second $350 billion tranche of the TARP fund. Bush complied, and sent his letter to Congress last night.

This little dance is necessary because Congress split up the $700 billion TARP fund into two halves. The first $350 billion has all been committed or spent now, with the last of it serving as a downpayment on the coming, still-indeterminate Detroit Three bailout.

The two-step process was a fig-leaf added to the original TARP back in October, so that Congress could claim they were overseeing the program in the uniquely tough, objective, fair-minded and knowledgeable way that we've come to expect from them. Now that the President has requested the second tranche, Congress has fifteen days in which to grandstand, cluck over how poorly the money has been spent, haul Paulson et al in for a tongue-lashing, and wring their hands over how much the American people hate the idea. Their work of oversight done, they will then approve and release the second tranche.

Partly this is nice for Obama because Congress can have their media circus before he takes office. And partly he can start the 15-day clock now, so the rest of the TARP fund is available sooner.

But Obama made several statements in his remarks that indicate a very big problem we need to be concerned with. He's rewriting the objectives of the TARP in an evil way. And he's getting away with it because most people who aren't finance experts don't really understand what TARP was intended to achieve in the first place.

The last crash happened because systemic risk was pervasively underpriced. People failed to discount the possibility that home prices can move downward as well as upward. Removing this risk from the overall pool of risk that gets sliced and diced in a billion different ways means that there was too much risk to match the returns generated by the system.

Now people are streaming back into debt securities that have some kind of exposure (direct, indirect, through spread, or through swap) to explicit government guarantees or to an expectation of government support. The risk management that should be imposed by people performing good old-fashioned credit-quality analysis, is instead being provided by the promise of government liquidity.

This is a system made of moral hazard. The people who benefit from it, by definition, are the ones who game the system. Traditional retail investing is now a sucker's game, and the intrinsic value of our money is now highly questionable.

It's quite possible to sustain for a very long time a system in which business and financial risk is implicitly underwritten by monetary authorities. Rather than being taken by stockholders of banks and investment firms, losses will ultimately be borne by low-end consumers, who will experience either contraction in the economy, or high inflation, or both.

It won't be sustainable if there is another bubble somewhere. Bubbles happen when the risk of loss becomes decoupled from the risk of gain. Bubbles are automatically prevented in normal times by people who stand to lose money if they make bad decisions. There's no intelligence required. It's a stable feedback loop.

But in the nascent world of socialized risk, you can easily get bubbles, and the only thing that can stop them is for government authorities to see them coming and stop them ahead of time. Much knowledge, intelligence and luck is required. It's NOT a stable system.

The overall size of the North American market for cars and light trucks is a critical number in determining the capital, or shall we say the bailout requirements of the Detroit automakers.

For years, the average market size has been about 16 million vehicles with an average price of about $26,000. In the better years, the number has crept close to 17 million.

The number for 2008 will come in at about 13 million, and projections for 2009 (by the automakers themselves and by industry analysts) are coming in the range of 10 to 11.5 million.

That's some very major contraction in demand for this industry. And it's going to change a lot of things.

And of course keep in mind that demand reduction affects all of the dozen of so automakers who sell in North America, not just the Detroit Three.

Unit-volume reduction of more than one third, in one year. That's the kind of transition in a market that really separates the survivors from the losers.

From various statements, it seems that Detroit's executives are wrestling with the question of whether the demand destruction is permanent, or just a cyclical feature of the current recession. In any event, they've been losing so much money over the last few years (which were halfway-decent years for the economy, and decidedly good years for the competition), that they don't have the financial cushion needed to get through this weak spell.

For a century, Detroit has navigated boom and bust cycles, usually on a fixed schedule of about seven years. This time they came up empty.

I had this thought while I was trying to decide whether a huge Keynesian stimulus will be likely to trigger an unhealthy amount of inflation (as pre-monetarist Keynesian theory actually suggests).

The major effect that is transforming finance in a fundamental way is de-leveraging. (The major effect that is transforming finance in a cyclical way, on the other hand, is the destruction of bank equity.) By "de-leveraging," I mean the end of financing models based on huge amounts of short-term borrowing, constantly rolled over, at very low interest rates.

A leveraged financial system behaves just like a leveraged physical one: small changes in inputs produce large changes in outputs. (The difference in finance, of course, is that the changes are usually nonlinear.) Leverage is a beautiful thing when you're making money, because you can make more money than would be suggested by the amount of nominal risk you take.

Leverage is an evil thing when you start losing money, because every adverse movement is magnified, and you quickly get into situations where you no longer have freedom over your actions. (Margin calls force you to sell good assets, which means that everything becomes undervalued at once. Across the whole global economy, this is exactly what produces panics, as in 1998 and 2007.)

So you could well argue that financial de-leveraging is ultimately a good thing. It will certainly (and necessarily) produce economic pain, because it means that nominal returns on capital will be lower. (Footnote: I keep talking about "nominal" returns rather than risk-adjusted ones, as a way of acknowledging that high leverage, as practiced in recent years, actually masked rather than reduced overall investment risk, a fact that didn't become evident until 2007.) But if the system is less susceptible to cascades of forced asset sales, that can only make it more stable, and more resilient. It will behave more like markets theoretically behave, discounting available information correctly, rather than exhibiting obviously erroneous undervaluations.

But I'm thinking that rather than allowing the financial world to de-leverage, the response of policy makers around the world has been to pursue desperate measures to keep markets more or less where they are, or at least not to let them fall farther. Obviously, they're responding to the political distress that happens when millions of people see their life savings suddenly sliced in half.

What if there's a law of conservation of leverage? Rather than being based on inexpensive short-term borrowings, the system is now dependent on blanket risk-guarantees by governments and monetary authorities. And the US economy will very soon be getting a great deal of its demand generated by a quite small number of people in the White House and in Congress.

And the biggest overvalued asset class of all, US housing, is stubbornly refusing to lose value because Congress, the Fed, and the FDIC won't let it.

There still is a tremendous amount of leverage in the financial system. It's just moved from one place to another. The leverage is now contained in the fact that decisions made by a very small number of very powerful people will disproportionately affect the system. Small inputs produce large outputs. The fact that these decisions will be made from political rather than economic motivations is hair-raising.

Highly-leveraged nonlinear systems exhibit wild, unpredictable and rapid swings in behavior. The economic projections that are the basis of the stimulus proposals aren't likely to come anywhere near the truth. This year might be as economically dramatic as last year. Welcome to our strange new world.

Historic days lie ahead, and not because the occupant of the Oval Office will soon be of an atypical color.

The United States, throughout its early history, has been the only major trading nation to carefully avoid extensive government involvement in economics and finance. We went for more than 100 years without even a central bank (meaning, an official lender of last resort). And when the need for the Federal Reserve finally became undeniable in the wake of the Panic of 1907, its architects conceived it in secret meetings, and with a quasi-private structure, because they knew even then that Congress would never go for another attempt to establish a "Bank of the United States."

During the New Deal, the role of the Federal Reserve was expanded to include regulatory control over the US banking system. In 1951, the Fed finally established its full independence from the US Treasury (in the sense that they could refuse to monetize issues of public debt), and entered the modern period of its history.

But in keeping with the American tradition of relatively light control over financial matters, the Fed's objectives have always been primarily to maintain confidence in the value of the dollar, and to ensure the integrity of the interbank payments system.

They have long held a balance sheet consisting almost entirely of risk-free US Treasury securities. At times, like any lender of last resort, they have made funds available to their correspondent banks, but generally for the shortest possible terms, at relatively high "penalty" interest rates, and requiring collateral of the very highest quality.

In short, the Fed has never been a risk-taking entity. To take risk (and, equivalently, to intermediate credit) has always been the function of the private sector.

Until 2008.

It's the season for debating the effects of a historic increase in government spending on the economy.

The proposal on the table from Obama, is to increase government spending by about $775 billion over the next two years. About $300 billion of this would come as tax cuts of various kinds, and the rest as handouts to state and local governments and pork-barrel spending.

Why are we doing all this? Well, to make the economy better, of course. But precisely what does it mean to "make the economy better"?

I told you yesterday that, although the global economy and the global financial system face deep, systemic imbalances that have nothing whatsoever to do with the business cycle, the perception by policymakers and ordinary people is very different. The common view is that our biggest problem is an economic recession. And even more specifically, an increase in unemployment that results from reductions in industrial output, or GDP.

As I said, the whole situation is being oversimplified as a need to change two widely-reported statistics. The objective of the largest proposed increase in government spending for decades is not to do anything long-term positive for the the economy. Rather, it's to increase reported GDP and to reduce reported unemployment.

So in this context, let's try to understand the claims that are being made by advocates of increased spending. (I'll leave for another time the issues of increased national indebtedness, misallocated resources, and increased government control over the economy, since the neo-Keynesians have already told us that we should sweep those effects under the carpet for now.)

The basic theory is contained in something called Okun's Law. This is the empirical relationship between real GDP and the unemployment rate. In plain language, Okun posits that a 1% change in the unemployment rate is correlated with an inverse change of between 2% and 3% in real GDP.

Note that there's nothing causal or even rigorously theoretical about this relationship. It's just an observation obtained by regressing historical US data over the last fifty years or so. This hasn't stopped even Nobel-Prize winning economists from invoking it to justify a massive increase in government spending.

Here are two ways this might work.

Everyone's attention has temporarily shifted away from the automaker bailout, to consideration of a vast Keynesian stimulus program, with some side-distractions relating to the personnel of the US Senate.

Don't worry about the automaker situation: it'll be back on the front-burner next month as both GM and Chrysler LLC will have burned through last month's bailout money and will be back for more. A lot more.

Instead, let's take a closer look at the New New Deal, which was hurriedly pulled out of a hat immediately after the Presidential election as Barack Obama's answer to the musical question: "Omigod, the economy is falling apart! WHAT ARE WE GOING TO DO???"

Exactly what is the New New Deal? More importantly, exactly what problems does it purport to solve? Not the ones you think.

But the first question to answer is, how did we get where we are?

Back in September, we were in the thirteenth month of sustained disturbances in capital markets and in the banking sector, all around the world. Through mechanisms which will be the subject of debate for many years to come, the financial crisis abruptly boiled over into the "real world" and touched off a full-fledged global recession.

As a result of heroic but highly-controversial measures by all of the world's monetary authorities, led by our Federal Reserve, the financial crisis is now showing abundant signs of stabilization. The patient is still in very deep trouble, but the defibrillators worked and his heart is beating again.

But the global economy, the world of jobs, goods, services and trade, is just starting its cycle of trouble and disruption. Since I've been using the phrase "Great Depression II" in these pages for well over a year now, I'll save for some other time an analysis of how this moment is like and unlike the early Thirties.

It's the economic crisis, not the financial one, that got the attention of policymakers and the punditocracy. The big problem that everyone desperately wants to address is expressed in two numbers: the unemployment rate, and the economy's rate of growth (or GDP).

Here's a brief story in the Financial Times about the US Venture Capital industry, affectionately [sic] known as "Sand Hill Road" to those of us who deal with it.

The story quotes Michael Moritz of Sequoia Capital to the effect that, because there are so few "exits" now for venture-funded companies, the VC industry as a whole will suffer a severe shakeout.

(A venture-funded startup has to pay back its backers with some kind of a "liquidity event," in which the investors' stock is swapped for something that has a public market value. Either you go public in an IPO, or you sell yourself to an already-public company.)

If you were paying attention back around 2001 and 2002, you remember the exact same thing happened then, as the Internet bubble busted. A lot of VC firms disappeared then, but the big names held on, even closing new funds, and then more or less sitting on their money.

USD at $1.38, coming off a huge collapse in the Treasury market the last two days.

Some people are seeing signs that risk aversion is starting to abate in capital markets around the world. It's a hard case to make, because it depends on success by the US in stimulating our economy. The way this line of reasoning goes, interest rates will stay at near-zero in the developed economies, but the US fiscal stimulus will work. That will revive interest in the emerging economies, resulting in capital flight from the US, a much lower dollar, and a much steeper yield curve.

The contrary case is that extreme risk aversion will continue as financial institutions around the world seek ever-higher capital ratios in a world that feels like no one is really in charge. That scenario calls for a continued flat yield curve with unprecedented low rates for Treasury debt, a possibly strong dollar rally, and a threat of deflation.

So by the end of 2009, will the dollar be closer to $1.20 or to $1.60?

Tossup.

It seems clear enough to a great many people that there are a lot of overpaid people in America, notably among corporate chieftains and Wall St. managing directors. It also seems that the political moment is ripe for making a change to how the top people get compensated.

Free markets and free trade are good. But society as a whole has a say in how to use the material well-being that free markets produce.

There's a fine balance between market freedom, and socially-desirable outcomes. Too much of the former and you get pressure to redistribute wealth away from those who produce it. Too much of the latter, and you stop producing enough wealth in the first place.

This is the forum where we find the balance. We present news from the business and finance world, and from the policy and government world. And we give you the jargon-free interpretations you need to put the news in perspective.

If you make business and investment decisions for a living, and you have to navigate an ever-changing policy and regulatory landscape, then Markets And Policy is your essential daily read.

Welcome to our world!