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April2009

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You come to us nd te us tht the get cities e in vo o the godstndd. ... I they de to come out in the oen ed nd deend thegod stndd s  good thing, we sh ght them to the uttemost.Hving behind us the oducing msses o this ntion nd the wod,suoted by the commeci inteests, the boing inteests, nd thetoies eveywhee, we wi nswe thei demnd o  god stnddby sying to them, you sh not ess down uon the bow o bothis cown o thons. You sh not cuciy mnind uon  coss ogod.– Wiim Jennings Byn, Democtic Ntion Convention, 1896I m condent tht the Fed woud te whteve mens necessyto event signicnt deftion in the United Sttes, nd, moeove,tht the US cent bn, in cooetion with othe ts o thegovenment s needed, hs sucient oicy instuments to ensuetht ny deftion tht might occu woud be both mid nd bie. …[U]nde  t (tht is, e) money system,  govenment (in ctice,the cent bn in cooetion with othe gencies) shoud wys bebe to genete incesed nomin sending nd inftion, even whenthe shot-tem nomin inteest te is zeo. … [T]he US govenmenths  technoogy, ced  inting ess (o tody, its eectonicequivent), tht ows it to oduce s mny US dos s it wishest essentiy no cost.– Ben S. Benne, Ntion Economists Cub, 2002

The debate over the gold standard had raged or nearly twenty years when William JenningsBryan electried the Democratic National Convention o 1896 to capture his party’s nominationor president. Businessmen and bankers avored the gold standard as responsible monetary policy.But the gold standard had kept money tight during a period o rapid expansion in the productivecapacity o the country, which led to declining prices and a series o deationary booms and busts.The Panic o 1893 and the subsequent depression o 1893 – 1897 was an especially severe period.Falling crop prices combined with a rapid increase in arm loans let many armers in desperatestraits, while the working classes had endured alling wages and terrible unemployment; hencearmers and workers wanted looser money. Populist rage inamed the politics o ination anddeation

.Ben Bernanke’s speech was made in a very dierent historical context and to a very dierentaudience. The preceding twenty years rom 1982 – 2001 had been a golden age o central banking,started by the deeat o the Great Ination o the 1970s. The prestige o central banks dependedupon the condence that a “Goldilocks” regime o mild ination (perhaps 2% per year) could bemaintained indenitely with only brie, small deviations. At the time o his speech, there weregathering worries that the United States might enter a deationary period similar to the one Japanhad then endured or over a decade. Yet the issue was still too remote to penetrate the body politicbroadly; Bernanke’s immediate audience was his economist peers, and even his broader audiencewas limited to the business and nancial elite. The message was condent: deation would probablybe prevented, but i it was not, the central bank could quickly return the economy to Goldilocks.The speech helped convince the political class that Bernanke had the expertise to lead the FederalReserve.

Naturally there were political nuances; for example, silver mining interests favored bimetallism(which would lead to looser money) primarily because it would increase the demand for silver.See

A Monetary History of the United States

, 1857 – 1960, Milton Friedman and Anna JacobsonSchwartz, and

Democracy in Desperation, the Depression of 1893

, Douglas Steeples and DavidO. Whitten.

This document is confidential and not for further circulation. This is not a solicitation or recommendation to buy, sell or holdsecurities. Certain statements contained herein may be forward-looking. Information contained herein is believed to be accurateand/or derived from sources which Clarium Capital Management LLC believes to be reliable; however, Clarium disclaims anyand all liability as to the completeness or accuracy of the information contained herein and for any omissions of material facts. This document has not been filed with the Commodities Futures Trading Commission or any other regulatory body. Graphicscontained herein are purely representational and do not reflect any hypothetical return from an investment in the depictedinstruments.

The WondeuWizd o Oz

02_

The economy and politics in spring 2009 look more like the summer o 1896 than Bernanke’sspeech ever contemplated. Goldilocks is gone and the politics o populism has returned. Yet unlike1896, the conditions are new and everyone is still adjusting to the change. Politicians are realigningtheir priorities and learning how to navigate the politics. Businesses and households are cuttingtheir spending and adjusting to new economic realities. Investors are trying to understand thenancial consequences and anticipate the circumstances under which the uture would more likelylead either to ination or deation.The question o ination versus deation is the subject o this essay. The analysis unolds in threeparts. The rst part describes the policy response to date. The response o the Federal Reserve hasbeen specically designed to provide liquidity to the credit markets without creating ination.Together with the policies o the Treasury and the rest o the Obama Administration to address thesolvency o the nancial system, the goal has been to return to the previous Goldilocks regime byrestoring the pre-crisis levels o private credit.The second part highlights the deciency o the policy response. In ocusing on xing the nancialsystem, the policy addresses only hal the problem. The United States does not just have anoverleveraged and undercapitalized nancial system; it also has an overleveraged and undercapitalizedhousehold sector. Private credit reached an unsustainable level, so its demand must all even i itssupply is restored. In the context o the current policy response, the inevitable credit contractionwill be deationary as the initial scal stimulus is too small to bridge the gap.The third part analyzes the political barriers to a more inationary response by considering itsperceived necessity, desirability and possibility. The ideology o the major policy actors emphasizesthe ailure o nancial oversight as the proximate cause o the crisis, yet overlooks that the Goldilocksthey wish to restore relied on unsustainable nancial and asset bubbles. As deation is greatly eared,absent other barriers the desire or economic growth would likely overcome this ideological bias,even at the risk o ination. However, powerul domestic and international political interestspreer deation to ination. Populist rage visibly tightens the Congressional purse strings againstproigate borrowing to protect entitlement programs or the middle class, while behind the scenesChina maneuvers to protect the value o its vast dollar holdings. Given these constraints, investorsmust consider careully whether policy makers will be able to tilt the policy response as muchtowards ination as is commonly believed.

Follow the Yellow Brick road

As Fed chairman, Bernanke began implementing the monetary components o the current policyin late 2008, and he articulated the broader policy ramework in his January 13, 2009 speech, “TheCrisis and the Policy Response.” The scal components have been broadly adopted by the ObamaAdministration generally and the Treasury Department specically. The ocus o the policy is torestore the proper unctioning o the nancial system without debasing the currency or producingexcess ination

. The goal o the policy is to return the economy to the Goldilocks regime o low,predictable ination and stable growth.

Mny Py

With the ederal unds rate eectively at 0%, the Federal Reserve has developed new tools toimprove the unctioning o credit markets and increase the availability o credit to households andbusinesses. Bernanke organizes these tools into three categories, which together constitute themonetary policy o “Credit Easing.”1.

Provision o Short-Term Liquidity to Sound Financial Institutions

: This assures marketparticipants that nancial institutions can meet demands or cash without resorting to resales o assets. All the acilities or auctioning credit and making primary securities dealers

“Excess inflation” can be thought of as a rate of inflation exceeding an implicit target of 1.75% – 2.0%.

03_

and banks eligible to borrow at the Fed’s discount window all into this category. Bernankealso groups into this category the bilateral currency swap agreements with various oreigncentral banks to make US dollars more available.2.

Provision o Liquidity Directly to Borrowers and Investors in Key Credit Markets

: This includesthe purchase o commercial paper and the TALF

. The purchase o commercial paper wasdesigned to stop the run on money market unds, while the TALF is designed to stimulateincreased lending directly. In Bernanke’s description, what unites these programs (andpotential uture programs) into this category is that they address the concerns about capital,asset quality and credit risk that continue to limit the willingness o many intermediariesto extend credit, even when they have the liquidity to do so.3.

Purchase o Longer Duration Securities

: This comprises all actions intended directly to lower longer-term lending rates. It includes the completed and planned purchase o Fannie andFreddie mortgage-backed securities and the senior debt o those companies, as well as theplanned purchase o longer-duration Treasury bonds.There has been some conusion around how Credit Easing and Quantitative Easing dier, as wellas a general misunderstanding o the conditions under which increasing the monetary base isinationary. One can generally dene any action that purposeully increases the monetary base as aorm o “quantitative easing,” since the purpose is to ease conditions by increasing the quantity o money. This is possible at any interest rate, but or obvious reasons a central bank tends to turn toquantitative operations only ater it has already pushed the interest rate to zero. Bernanke explicitlydistinguishes the Federal Reserve’s current Credit Easing policy rom the Japanese Central Bank’spolicy o Quantitative Easing earlier in the decade. Whereas Japan’s Quantitative Easing policyattempted to create ination in the prices o goods and services by increasing the monetary base,the Fed’s Credit Easing policy attempts to lower the cost o credit by buying specic assets andproviding liquidity (i.e. issuing loans) in specic credit markets. Both Quantitative Easing andCredit Easing result in an increase in the monetary base (i.e. reserves on deposit with the centralbank), but or dierent purposes. Quantitative Easing increases reserves simply to create ination,while Credit Easing increases reserves to und its operations in the credit markets (buying andmaking loans) to lower the cost o credit.Since both Credit Easing and Quantitative Easing increase the monetary base, why don’t theyboth create ination? To answer this question one must understand how these operations work.In both Credit Easing and Quantitative Easing, the central bank purchases securities rom banksand then credits them with reserves; the increase in reserves is the expansion in the monetary base.In order or this expansion o the monetary base to be inationary it must make its way into theeconomy, and the mechanism or doing this is or banks to make more loans against the increasedreserves. But in conditions where bank lending is weak, merely increasing the monetary base willnot increase lending; hence it is questionable whether a straightorward Quantitative Easing policywould have any eect at all today in the US. (And there is considerable debate whether Japan’spolicy had any eect during the time it operated.) Even urther, the Fed is paying an interest rateon excess reserves equal to what banks could expect to make on them by lending them overnight,which explicitly motivates the banks to leave the reserves on deposit with the Fed. As long as thosereserves simply sit with the Fed, their mere increase has no inationary eect on the economy

.Quantitative Easing is generally associated with the purchase o government debt, while CreditEasing targets specic credit markets to lower borrowing costs. With this in mind there is one wayin which Quantitative Easing can be much more inationary than Credit Easing. I the centralbank and the ederal government work together to monetize an increase in ederal debt that is

TALF stands for Term Asset-backed securities Loan Facility; this is the facility that lendsagainst asset-backed securities such as student loans, auto loans and credit card loans.

Bernanke explained this in detail in a speech on February 18, 2009, “Federal Reserve Policiesto Ease Credit and Their Implications for the Fed’s Balance Sheet.” Bernanke noted there thatalthough M2 has grown at a 15% annual rate on a quarterly basis in Q4 2008, this was dueprimarily to investors taking money out of riskier markets to seek the safety of governmentinsured bank deposits.

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Upload Date:	04/29/2009
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