01_

The Wonderful Wizard of Oz

You come to us and tell us that the great cities are in favor of the gold standard. ... If they dare to come out in the open field and defend the gold standard as a good thing, we shall fight them to the uttermost. Having behind us the producing masses of this nation and the world, supported by the commercial interests, the laboring interests, and the toilers everywhere, we will answer their demand for a gold standard by saying to them, you shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold. – William Jennings Bryan, Democratic National Convention, 1896 I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States, and, moreover, that the US central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief. … [U]nder a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is zero. … [T]he US government has a technology, called a printing press (or today, its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost. – Ben S. Bernanke, National Economists Club, 2002

April 2009

The debate over the gold standard had raged for nearly twenty years when William Jennings Bryan electrified the Democratic National Convention of 1896 to capture his party’s nomination for president. Businessmen and bankers favored the gold standard as responsible monetary policy. But the gold standard had kept money tight during a period of rapid expansion in the productive capacity of the country, which led to declining prices and a series of deflationary booms and busts. The Panic of 1893 and the subsequent depression of 1893 – 1897 was an especially severe period. Falling crop prices combined with a rapid increase in farm loans left many farmers in desperate straits, while the working classes had endured falling wages and terrible unemployment; hence farmers and workers wanted looser money. Populist rage inflamed the politics of inflation and deflation1. Ben Bernanke’s speech was made in a very different historical context and to a very different audience. The preceding twenty years from 1982 – 2001 had been a golden age of central banking, started by the defeat of the Great Inflation of the 1970s. The prestige of central banks depended upon the confidence that a “Goldilocks” regime of mild inflation (perhaps 2% per year) could be maintained indefinitely with only brief, small deviations. At the time of his speech, there were gathering worries that the United States might enter a deflationary period similar to the one Japan had then endured for over a decade.Yet the issue was still too remote to penetrate the body politic broadly; Bernanke’s immediate audience was his economist peers, and even his broader audience was limited to the business and financial elite.The message was confident: deflation would probably be prevented, but if 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 Federal Reserve.
1 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 Jacobson Schwartz, and Democracy in Desperation, the Depression of 1893, Douglas Steeples and David O. Whitten.
This document is confidential and not for further circulation. This is not a solicitation or recommendation to buy, sell or hold securities. Certain statements contained herein may be forward-looking. Information contained herein is believed to be accurate and/or derived from sources which Clarium Capital Management LLC believes to be reliable; however, Clarium disclaims any and 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. Graphics contained herein are purely representational and do not reflect any hypothetical return from an investment in the depicted instruments. © 2009

02_ The economy and politics in spring 2009 look more like the summer of 1896 than Bernanke’s speech ever contemplated. The goal of the policy is to return the economy to the Goldilocks regime of low. the Federal Reserve has developed new tools to improve the functioning of credit markets and increase the availability of credit to households and businesses. The third part analyzes the political barriers to a more inflationary response by considering its perceived necessity. the policy addresses only half the problem. investors must consider carefully whether policy makers will be able to tilt the policy response as much towards inflation as is commonly believed. while behind the scenes China maneuvers to protect the value of its vast dollar holdings. it also has an overleveraged and undercapitalized household sector.” The fiscal components have been broadly adopted by the Obama Administration generally and the Treasury Department specifically. so its demand must fall even if its supply is restored. The United States does not just have an overleveraged and undercapitalized financial system.Yet unlike 1896. Populist rage visibly tightens the Congressional purse strings against profligate borrowing to protect entitlement programs for the middle class. the inevitable credit contraction will be deflationary as the initial fiscal stimulus is too small to bridge the gap. Fo llow t h e Y el low B rick roa d As Fed chairman. The second part highlights the deficiency of the policy response. However. Investors are trying to understand the financial consequences and anticipate the circumstances under which the future would more likely lead either to inflation or deflation. Given these constraints. The response of the Federal Reserve has been specifically designed to provide liquidity to the credit markets without creating inflation. “The Crisis and the Policy Response. Bernanke organizes these tools into three categories. Provision of Short-Term Liquidity to Sound Financial Institutions: This assures market participants that financial institutions can meet demands for cash without resorting to fire sales of assets. The analysis unfolds in three parts. The focus of the policy is to restore the proper functioning of the financial system without debasing the currency or producing excess inflation2. Together with the policies of the Treasury and the rest of the Obama Administration to address the solvency of the financial system.75% – 2. the goal has been to return to the previous Goldilocks regime by restoring the pre-crisis levels of private credit. the conditions are new and everyone is still adjusting to the change.” 1. powerful domestic and international political interests prefer deflation to inflation. The first part describes the policy response to date. and he articulated the broader policy framework in his January 13. . absent other barriers the desire for economic growth would likely overcome this ideological bias. yet overlooks that the Goldilocks they wish to restore relied on unsustainable financial and asset bubbles. predictable inflation and stable growth. All the facilities for auctioning credit and making primary securities dealers 2 “Excess inflation” can be thought of as a rate of inflation exceeding an implicit target of 1. As deflation is greatly feared. In focusing on fixing the financial system. Private credit reached an unsustainable level.0%. Businesses and households are cutting their spending and adjusting to new economic realities. 2009 speech. Bernanke began implementing the monetary components of the current policy in late 2008. M o n e t a r y Policy With the federal funds rate effectively at 0%. In the context of the current policy response. Politicians are realigning their priorities and learning how to navigate the politics. desirability and possibility. The ideology of the major policy actors emphasizes the failure of financial oversight as the proximate cause of the crisis. The question of inflation versus deflation is the subject of this essay. Goldilocks is gone and the politics of populism has returned. which together constitute the monetary policy of “Credit Easing. even at the risk of inflation.

The purchase of commercial paper was designed to stop the run on money market funds. In Bernanke’s description. the central bank purchases securities from banks and then credits them with reserves. 4 Bernanke explained this in detail in a speech on February 18. auto loans and credit card loans.e. (And there is considerable debate whether Japan’s policy had any effect during the time it operated.) Even further. the Fed’s Credit Easing policy attempts to lower the cost of credit by buying specific assets and providing liquidity (i. 2. 3. Since both Credit Easing and Quantitative Easing increase the monetary base. Purchase of Longer Duration Securities: This comprises all actions intended directly to lower longer-term lending rates.03_ and banks eligible to borrow at the Fed’s discount window fall into this category.” since the purpose is to ease conditions by increasing the quantity of money. what unites these programs (and potential future programs) into this category is that they address the concerns about capital. Bernanke also groups into this category the bilateral currency swap agreements with various foreign central banks to make US dollars more available. their mere increase has no inflationary effect on the economy4. Provision of Liquidity Directly to Borrowers and Investors in Key Credit Markets: This includes the purchase of commercial paper and the TALF3. which explicitly motivates the banks to leave the reserves on deposit with the Fed. It includes the completed and planned purchase of Fannie and Freddie mortgage-backed securities and the senior debt of those companies. If the central bank and the federal government work together to monetize an increase in federal debt that is 3 TALF stands for Term Asset-backed securities Loan Facility. as well as a general misunderstanding of the conditions under which increasing the monetary base is inflationary. Both Quantitative Easing and Credit Easing result in an increase in the monetary base (i. the Fed is paying an interest rate on excess reserves equal to what banks could expect to make on them by lending them overnight. reserves on deposit with the central bank). while Credit Easing increases reserves to fund its operations in the credit markets (buying and making loans) to lower the cost of credit. With this in mind there is one way in which Quantitative Easing can be much more inflationary than Credit Easing. merely increasing the monetary base will not increase lending. In both Credit Easing and Quantitative Easing. this is the facility that lends against asset-backed securities such as student loans. but for different purposes.e. and the mechanism for doing this is for banks to make more loans against the increased reserves. But in conditions where bank lending is weak. issuing loans) in specific credit markets. but for obvious reasons a central bank tends to turn to quantitative operations only after it has already pushed the interest rate to zero. As long as those reserves simply sit with the Fed. Quantitative Easing is generally associated with the purchase of government debt. . Bernanke explicitly distinguishes the Federal Reserve’s current Credit Easing policy from the Japanese Central Bank’s policy of Quantitative Easing earlier in the decade. One can generally define any action that purposefully increases the monetary base as a form of “quantitative easing. the increase in reserves is the expansion in the monetary base. as well as the planned purchase of longer-duration Treasury bonds. asset quality and credit risk that continue to limit the willingness of many intermediaries to extend credit. In order for this expansion of the monetary base to be inflationary it must make its way into the economy. This is possible at any interest rate. Quantitative Easing increases reserves simply to create inflation. while the TALF is designed to stimulate increased lending directly. even when they have the liquidity to do so. why don’t they both create inflation? To answer this question one must understand how these operations work.” Bernanke noted there that although M2 has grown at a 15% annual rate on a quarterly basis in Q4 2008. Whereas Japan’s Quantitative Easing policy attempted to create inflation in the prices of goods and services by increasing the monetary base. this was due primarily to investors taking money out of riskier markets to seek the safety of government insured bank deposits. “Federal Reserve Policies to Ease Credit and Their Implications for the Fed’s Balance Sheet. while Credit Easing targets specific credit markets to lower borrowing costs. hence it is questionable whether a straightforward Quantitative Easing policy would have any effect at all today in the US. 2009. There has been some confusion around how Credit Easing and Quantitative Easing differ.

then the transmission mechanism bypasses the bank credit channel and the increased money makes its way into the economy with an inflationary effect5. rather. presage inflationary pressure in the present. Bernanke recommended such a policy for Japan in 20036. efforts to reduce preventable foreclosures.e. and he did so to make a technical rather than a policy point. “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” op. however. where Bernanke recommended that Japan combine monetizing fiscal spending with a price level target. thereby increasing financial stability. perhaps by calling it Quantitative Fiscal Easing. could provide a significant boost to economic activity. History demonstrates conclusively that a modern economy cannot grow if its financial system is not operating effectively. however. Bernanke borrowed the helicopter image from Milton Friedman. Consequently. It did not. Fisc al Policy In his first speech outlining the Fed’s Credit Easing policy response8. if enacted. The incoming Administration and Congress are currently discussing a substantial fiscal package that. it is important to note that at some future point the private credit channel will presumably start growing again. This process decreases the monetary base. but other policy measures will be needed as well. but he has neither implemented nor proposed anything like it in the present case. 7 When the assets are sold into the market the Fed receives cash in return and then matches the cash against the reserves to extinguish both. 6 See “Some Thoughts on Monetary Policy in Japan. . more capital injections and guarantees may become necessary to ensure stability and normalization of credit markets. Note that this speech was given more than a week before President Obama took office.cit. Longer-duration assets such as MBS and Treasuries can be sold into the market to sterilize the reserves that fund them7. i. Bernanke has designed Credit Easing to minimize this inflationary effect by tilting many of the Fed’s operations towards providing short-term credit facilities that can be turned off quickly and purchasing short-term assets that can be run off within months. but the process is trickier to implement. … In addition. could strengthen the housing market and reduce mortgage losses. since the resulting rise in interest rates can encourage international capital flows and otherwise distort market signals. and the emphasis placed on this quote reveals the generally superficial understanding of his speech.” May 31. In my view. the Fed is right to be concerned. … [W]ith the worsening of the economy’s growth prospects. As we will see later.” when he said. fiscal actions are unlikely to promote a lasting recovery unless they are accompanied by strong measures to further stabilize and strengthen the financial system.04_ then used either to return money to citizens through tax cuts or to increase federal spending. Returning to the effects of the increased monetary base. continued credit losses and asset markdowns may maintain for a time the pressure on the capital and balance sheet capabilities of financial institutions. a sustained commitment to restore the price level to the value it would have if instead of deflation an inflation of 1% per year had occurred since 1998. agency debt and Treasuries was therefore significant as it signaled that the Fed is willing to risk future troubles unwinding its operations in order to have maximum effect on bringing down long-term (and especially mortgage) rates now. Because this policy requires the monetary and fiscal authorities to cooperate it should be distinguished from purely monetary policies. 8 See “The Crisis and the Policy Response. 2003. “A money-financed tax cut is essentially equivalent to Milton Friedman’s famous ‘helicopter drop’ of money.15 trillion of MBS. 5 Ben Bernanke was making precisely this point in the 2002 speech from which the quote at the front of this essay was drawn. at which point the excess reserves would be transmitted into the economy with inflationary effect. it highlighted the importance the Fed places on doing whatever it can to stimulate refinancing and mortgage lending. The Fed’s decision on March 19 to purchase some $1. Bernanke explicitly stated his policy prescription for the incoming Obama administration and the new Treasury Secretary: The Federal Reserve will do its part to promote economic recovery. among other benefits.” This is the quote from which Bernanke’s “Helicopter Ben” nickname originated.

In early February. 3. Expansion of TALF: Treasury and the Fed will work together to expand the TALF program. In addition to the Treasury response. (b) committing to Treasury’s “mortgage foreclosure mitigation programs. Some fiscal stimulus along the way is appropriate. the major banks. 6. this should be done where possible. Where additional capital is needed. The fourth item addresses Bernanke’s exhortation to assuage political concerns regarding putting more money into financial companies. This disparate treatment. Treasury’s policy response under Tim Geithner is the Financial Stability Plan.Treasury will increase the number of homeowners who can refinance their mortgages and improve the terms of the mortgages for many homeowners. the greater good demands that it be done. Public-Private Investment Program: Treasury will provide seed capital and partner with the Federal Reserve to provide favorable financing to entice private capital to purchase the toxic assets of banks and other financial institutions. 2. although it is obviously consistent with the goal of restoring the normal flows of credit. and various government agencies. buying back stock or acquiring “healthy firms” until the government is repaid. 4. Small Business and Community Lending Trust: Treasury will work together with the Obama administration and the Small Business Administration (SBA) to arrest and reverse the recent dramatic decline in SBA lending. the Obama administration is acting in two ways. The first two items inject more capital into the financial system. The third item expands an existing Federal Reserve program. Only the sixth and last item is not a direct Bernanke prescription. if private capital is unavailable then government capital will be injected. 5. but the plan’s focus and structure are clear and align closely with Bernanke’s prescription. so politicians must build and maintain support for restoring the financial sector. and the consequences for the broader economy of financial instability are thus powerful and quickly felt. Although the public is “understandably concerned” about shoveling so much money into the financial sector.05_ The public in many countries is understandably concerned by the commitment of substantial government resources to aid the financial industry when other industries receive little or no assistance. appears unavoidable. Our economic system is critically dependent on the free flow of credit. Transparency and Accountability Agenda: Financial firms that receive government assistance will be subject to various conditions such as: (a) detailing how government capital is used.” (c) not paying dividends. Since reducing preventable foreclosures would help increase financial stability. but must not distract from the main focus of fixing the financial system. Financial Stability Trust: A “stress test” will determine the financial fitness of each major financial institution. … Responsible policymakers must therefore do what they can to communicate to their constituencies why financial stabilization is essential for economic recovery and is therefore in the broader public interest. It is striking how closely Geithner is following Bernanke’s fiscal policy prescription.The fifth item tries to reduce preventable foreclosures. every effort will be made to attract private capital. it persuaded Congress to pass a stimulus bill that spends $501 billion in new money . The details of each component of this plan continue to unfold. unappealing as it is. The plan has six components: 1. and (d) certain limitations on executive compensation. Homeowner Affordability and Stability Plan: Working with the GSEs. (Emphasis added) The Bernanke fiscal prescription is to inject as much capital as is necessary to stabilize the financial system and do so in a way that returns it to normal (keep it in the private sector and avoid policies that would chill lending).

This debate is critically important. There is now close coordination between the Fed.00 1945 1965 1985 2005 9 From a budgeting perspective.50 0. who increased their debt level in relation to GDP over 40% in just eight years from a ratio of 0. it is also contracting because its demand had far exceeded a sustainable level. whereas a mortgage is counted.” While the fiscal stimulus package was an initiative predating Bernanke’s speech and Geithner’s appointment to Treasury.00 0. Treasury. Having spent political capital early on to pass the stimulus bill.e. 10 Financial debt is excluded to avoid double counting.35. the request asks for $250 billion because it envisions purchasing assets that will return only 2/3 of their cost. Fig. the debate overlooks and crowds out a fundamental issue. However. 1 US Non-Financial Debt to GDP Ratio Source: Fed Flow of Funds 2. etc.7 to nearly 1.06_ and provides temporary tax cuts of $288 billion. Observe the ratio of the amount of outstanding nonfinancial10 US debt to US GDP. Hence the gross figure requested is $750 billion. the requested contingent reserve is clearly designed to support their efforts. t h er e’s N o Pl ace lik e h o M e There is much debate about how well the efforts of the Federal Reserve and Treasury are proceeding. easing the cost and availability of credit will not restore its flow to prior levels. a mortgage-backed security is excluded.0. President Obama then delegated the policy response to Treasury and the Fed. Since 2000. but it understates the degree to which the financial economy (i. (Note also that business debt in relation to GDP edged up to reach its highest level ever.50 1. For example. Nonfinancial debt measures the degree to which the real economy is leveraged. and the White House around the Bernanke policy response.) The increase was primarily driven by mortgages during the housing bubble.50 Total Multiple Household Multiple Business Multiple Government Multiple 2. and a few weeks later it requested a $750 billion9 “contingent reserve for further efforts to stabilize the financial system. Credit is contracting not just because its supply is choked off by the illiquid and insolvent state of the financial system. and the net figure requested is $250 billion. the aggregate ratio jumped from the previously stable level of about 1.00 1. this increase was almost entirely led by households. . because the financial system is terribly overleveraged and undercapitalized and must be repaired. Even if the current policy efforts are successful. banks. In contrast to the first jump (from 1981 – 1988).85 to 2.) is leveraged.

but some are not. The end of the housing bubble has left many people underwater on their mortgages.8. See also http://www.07_ Yet the trend of worsening US household finances preceded the housing bubble and started in the early 1990s. Indeed. we must consider whether the aggregate numbers are misleading. Could the credit of households that can still borrow expand enough to offset the credit contraction of the rest? Mortgage debt accounts for roughly 80% of total household debt13 so any expansion of household credit would operate primarily through this channel.7.3 at the end of 2008 with the bursting of the housing bubble and subsequent collapse in the stock market. In this environment. Another cause is the increase in savings in emerging markets and their desire to be invested within the United States. there is very little equity that can still be leveraged.e. Other factors were at work as well. better than) its long-term average.e. Speaking in 200512. the so-called “Global Savings Glut” explanation by Ben Bernanke. households will be reducing their borrowings and trying to increase their savings for some time to come.” March 8.html . and at the time of his speech the ratio of household net worth to household income stood at 5. However. But the decade and a half that followed saw a significant deterioration of the US household balance sheet. well above its long-run average of about 4. The Long Goodbye for a detailed analysis.6 Source: Fed Flow of Funds 10% 1. 12 “The Economic Outlook. this ratio later plunged to 4.hoover. Economies around the world are contracting at the fastest rate in generations. 3 Household Liabilities/Disposable Income 1. But since current policy is so focused on restarting the private credit channel. it is precisely the over-reliance on assets rather than cash flow to offset debt that now makes the US consumer and associated economy so vulnerable to declining asset values in the face of the existing debt burden. However. Unemployment is high and increasing. The causes are complex and lie both inside and outside the US. Fig. This important topic deserves much more consideration but it lies outside of the analysis here. this ratio has clearly fallen even further. see Clarium’s Q2 2007 quarterly letter. As recently as 1992 the personal savings rate was still slightly above (i. worse than) its long-term average.4 2% 0% 1946 Personal Savings / Disposable Income 0. 2 Personal Savings/Disposable Income 12% Source: Fed Flow of Funds Fig. Households have saved too little and borrowed too much. One cause is the dramatic lowering of the cost of capital from the early 1980s and the household reaction to this phenomenon.8 4% 0. Households basically stopped saving while increasing dramatically the size of their liabilities relative to their available income11. and many more workers justifiably fear their jobs are at risk. Given the continued selloff in housing and stocks.0 2006 1946 Household Liabilities / Disposable Income 1966 1986 1966 1986 2006 11 It is worth noting at this point that this analysis only states what happened and does not try to explain what caused it.org/research/factsonpolicy/ facts/38837147. 2005 13 Per the Fed Flow of Funds. and the ratio of debt to disposable income was only slightly above (i. Ben Bernanke sought to allay concerns about these trends by pointing out that household assets rose even more quickly than household liabilities. Many households are under stress.2 8% 6% 0.

too little housing equity. and the recent decimation of household wealth and it is clear that trying to jawbone the household credit channel faces severe limitations. but first multiplies the aggregate value of the housing stock by 80%. Since housing dominates household credit. subtracts the outstanding value of all mortgage debt. which has been the historical norm14. whereas today they remain at historically high levels15. Business debt in relation to GDP is already at a historically high level and will not be expanded in the face of a worldwide recession when corporate spreads are pricing in the expectation of record defaults16. and while it would 14 For the graph of mortgage equity to GDP. a key point is that underwriting standards deteriorated significantly during the housing bubble.” Financial Times. There is too much housing debt. the 2009 number assumes that housing falls by 10% in 2009 while US GDP remains flat from its end of 2008 value. While fixing short-term funding mechanisms such as the commercial paper market is certainly necessary. . a personal savings rate near zero for almost a decade.08_ Fig. household liabilities at a record ratio to disposable income. Even on this simple measure the amount of outstanding mortgage equity available to be leveraged is near its historically lowest level. The total amount of equity available to be leveraged in 2009 will be below its previously lowest level in 1945. 4 Potential US Mortgage Equity to GDP Ratio 120% Source: Fed Flow of Funds Fig. Given the trajectory of house prices and GDP. it seems likely that this ratio will decline even further in 2010. Nor will the burden be carried by businesses.The bottom line adjusts for this by assuming an 80% loan-to-value (LTV) ratio. And as the accompanying graph shows. the unadjusted calculation takes the aggregate value of the housing stock. the crucial difference is that in 1945 housing values were at a historically low point. and then divides the resulting difference by the value of GDP. However. 5 Value of US Housing Stock/GDP 200% Source: Fed Flow of Funds Unadjusted 80% LTV Value of US Housing Stock / GDP 100% 160% 80% 120% 60% 80% 40% 40% 20% 0% 1945 1965 1985 2005 0% 1945 1965 1985 2005 Observe the graph of the ratio of potential US mortgage equity to GDP. and what little equity is left is (still) overvalued. 15 For the graph of the value of US housing stock to GDP. the amount of housing equity available to be leveraged in 2009 will be slightly less than 20% of US GDP (assuming no change in US GDP from its end of 2008 level). The top line takes the simple ratio of total outstanding mortgage equity to GDP in the US. 2009. The 2009 estimate assumes that housing prices decrease another 10% while GDP remains constant. See “Concern as Companies Hoard Cash. 16 Early indications are that corporations around the world are hoarding cash by borrowing at low rates and paying down loans wherever possible while cutting back on investment and returning less cash to shareholders. Add in the worst economy in living memory. no other source of household credit can counteract its effect. People will not borrow aggressively to buy houses that they think are overvalued and likely to fall further in price. On this measure. The 80% LTV calculation uses the same formula. March 18. In this environment lowering mortgage rates will have little effect on restarting borrowing.

09_ be desirable to lower long-term funding costs for businesses where possible. So far. 18 For example.) Given the lack of transparency it is impossible to estimate exactly how much of this capital could be counted as a roundabout way to recapitalize the household sector. but given the mortgage negative equity problem described above the effect is likely to be small. since trend growth is positive it is possible to have lost output even with (weak) economic expansion.With these assumptions. How much economic output will be lost to this credit contraction? Assume that the household sector needs to deleverage to the same ratio of debt to GDP that existed in 1998. such measures will not even begin to expand credit to the extent necessary to offset the household credit contraction. both of which occur over several years.2 trillion of lost private sector spending. We are focused purely on whether there will be sufficient stimulus to offset deflation over the next several years. We do not know the trajectory of GDP in 2009 and beyond. this represents $4. we must expect trillions of dollars of lost output before the private sector deleveraging is complete. (The PPIP program. only $800 billion in fiscal stimulus and tax cuts. Freddie Mac. The total amount allocated to recapitalizing the financial sector so far is $700 billion in TARP and the hundreds of billions paid out or committed to the weakest firms such as AIG. . as the consumer must first default and then if the loan is made against an asset the asset must be resold at a depressed price. since if a consumer defaults on a loan and the bank is reimbursed by the government for the default. most if not all of the recapitalization is needed to reduce leverage levels of financial companies. this does not seem like an onerous assumption. 19 It is more onerous. so now our analysis must change from the macroeconomic to the political and sociological. however. Recapitalizing the financial system will have some salutary effect. Making credit cheaper and more available will help some households refinance. have been deployed against this looming private credit contraction. Both the financial and the household sectors are overleveraged. but given the severely overleveraged state of the financial system the amount is probably small at best. t h e eM er a ld ci t Y What has produced the current policy response? What would it take to change the policy to produce an inflationary outcome? How could one recognize the preconditions of such a change before it takes effect? These are the critical questions investors must ask. so to make the calculation easier we hold GDP constant at its level at the end of 2008. is addressed below. without a significant change in policy the outlook for the next several years is deflationary. 20 For this discussion we ignore the technical question whether stimulus is done more effectively by maintaining government spending levels and reducing tax rates or keeping tax rates constant and increasing government spending.2 trillion of debt. However. unless the federal government substantially increases its own borrowing and deploys the capital to stimulate the economy20. the effect is similar to providing the consumer the money to pay back the loan19. Absent outright monetary inflation. If we assume that the business sector holds borrowing and associated spending constant at the same time. the household sector needs to pay down $4. We also ignore the larger question of whether stimulus maximizes long-term growth or whether it simply smoothes the downturn and subsequent recovery. before the housing bubble began. which is part of TARP. It is difficult to estimate the amount of lost GDP17 associated with this lost spending since we can’t know how quickly it will occur or which specific expenditures will be cut18. reducing the leverage of the financial sector is necessary but does not also count towards reducing the leverage of the household sector. if the spending is withdrawn from financially weak firms that then go bankrupt more economic contraction would occur than if all firms could absorb the lost revenue. Therefore. 17 The lost economic output should be measured against sustainable trend growth. Citigroup and Bank of America. but it is surely on the order of trillions of dollars if no significant countervailing force is deployed against it. Since even in 1998 this ratio was at an all-time high. Fannie Mae.

The ideological bias to downplay the significance of the growth of private debt pervades the Obama policy team. … Senator Merkley: I saw a chart in a magazine article a year or so ago that seemed a little surreal to me. 2009 speech to the reforms that would “limit the probability and severity of future crises. . which is certainly a good and necessary goal. And she was unfamiliar with very basic data on consumer debt levels and was able only to give vague 21 Hearing of the Economic Policy Subcommittee of the Senate Banking Committee. instead of calling attention to it as a worrying trend he actually dismissed concerns about it. reached about two and three quarters times the GDP22 … Those numbers are not – I don’t normally hear those numbers in the debate because we don’t really talk about the combination of consumer and governmental debt. In a recent senate hearing21. and I believe that what it showed – and it was combining consumer debt and governmental debt – was that during the height of the Great Depression. however. regulation and cooperation. regarding the monetary policies that encouraged asset bubbles or allowed such an enormous buildup of private credit relative to GDP. recall from the previous section that when Bernanke addressed the topic of the growth of private debt in 2005. Tracking total US debt as a ratio of GDP over time is misleading because financial debt both overcounts offsetting financial positions and undercounts synthetic leverage. March 31. the debt to GDP. 3. but we also have sizable consumer debt. monetary policy needs to restore the earlier status quo. When those are taken together. 2. one of the things that I’m interested in getting your perspective on is that we not only have substantial governmental debt. But – let’s say this is – are we out – is it in the ballpark that we may be well over three times the GDP with the combination and – and if so. Chair of the Council of Economic Advisers had this exchange with Senator Jeff Merkley: Senator Merkley:You know. is there any parallel to the Great Depression in terms of percent of GDP or are we way beyond the level of debt that was carried. Professor Christina Romer. … Christina Romer is a learned scholar of the Great Depression who submitted sixteen pages of written testimony for this panel.10_ A useful way to analyze the politics behind the policy is to consider the appeal of inflation from three different perspectives: 1. only this time with better supervision. consumer and government debt. See footnote 9 for an explanation of financial and nonfinancial debt. Indeed.” His suggested reforms all focused on improving the durability of banks and other financial institutions. According to this view. the combined debt. There was not a word. She is an influential member of the Obama Administration. even at the height of the Great Depression? Professor Romer: I would say we – I mean. Is inflation necessary? Is inflation desirable? Is inflation possible? The ideology of policy makers Domestic political factors International political factors ideology – Back to Goldilocks The definition of the crisis and the design of the policy response have been developed under the belief that central banking policy has been successful since Paul Volcker tamed the Great Inflation of the 1970s. and that the financial crisis has mainly been caused by the irresponsible behavior of other people. Ben Bernanke devoted two paragraphs of his January 13. I should check the numbers but I’d say we certainly are higher. 2009 22 The chart to which Senator Merkley referred is almost certainly total US debt – nonfinancial plus financial debt – divided by US GDP. how does that really constrain our ability to recover in this economic downturn? Professor Romer: I think on the numbers I’d just have to – to go back and check them so it’s not one that I have on – on the top of my head.

then you will underestimate the amount of government stimulus necessary to offset deflation. did not just say that aggressive fiscal expansion is an essential part of the solution.8 trillion and $4. the crisis has been cast as a morality play where Wall Street and irresponsible speculators are villains that hold a virtuous Main Street hostage. and those deficits are politically unpopular.” If you believe that monetary policy has been successful in maintaining price stability and the source of the problem is failed oversight of the financial system. domestic Politics – No More Money Defining the problem primarily as a financial crisis has weakened the resolve for collective efforts to solve it. Social security and Medicare currently owe tens of trillions of dollars in present value terms24.htm (question #12) for the Social Security estimate.ssa.gov/reportstrustfunds/ downloads/tr2008. Taxpayers are in no mood to be told that some of what ails the economy is due to their own irresponsibility. A culture of borrowing and speculation – partly to compensate for stagnant real wages – took hold throughout America. See http://www. and that much more of their money is needed to minimize the pain. which led the middle class to feel increasingly squeezed while it saw the rich get richer. or whatever the next outrage will be. she also explicitly said that stimulus must not be cut back prematurely.3 trillion. 24 The 2008 official government estimates of the present value of Medicare and Social Security liabilities are $16.197) for the Medicare estimate and http://www. the response is grudgingly to hand over the minimum amount necessary to bail out the financial system while extracting the maximum possible punishment. The normal funding of these programs will lead to significant future deficits. but the political reality is that each dollar of stimulus competes for a dollar of Medicare and Social Security.Whether it is the Rick Santelli rant that quickly garnered almost a million views on YouTube. Income inequality reached historically high levels over many years. in her written testimony to the Senate hearing referenced above. Retiring baby boomers understandably want the political conversation to favor meeting the commitments in full. 23 The full text of Romer’s responses was omitted for space considerations. taxpayer money is needed to pay for the entitlement promises made to the retiring baby boom generation. The politics of meeting and funding these commitments will dominate the political landscape for decades. . If you do not understand the unsustainable levels of private credit. the public backlash against AIG bonuses that caused a punitive tax bill to pass quickly through the House.hhs. Underlying the rage is this belief: You caused this – you profited obscenely while I was left behind and now you are taking my money! There are understandable reasons for these cultural and class divisions. In the absence of other political constraints. Wall Street became its most arrogant and irresponsible as the finance bubble peaked. Senator Merkley is correct that policy makers “don’t really talk about the combination of consumer [and business] and governmental debt. Romer. the public rage demands expression. Instead. One can make an academic argument that engaging in massive stimulus could increase the ability to meet those commitments over the long run by maximizing economic growth.cms. one could expect that persistent deflation would draw out increasingly more inflationary policy responses.11_ and general responses23 to Merkley’s questions. If the economic crisis were understood socially on a more nuanced level then these legitimate grievances could be addressed within a wider commitment to address all parts of the problem. The calculations of these liabilities are extremely sensitive to many assumptions. and policymakers have increased the resentment by failing to explain satisfactorily why those who seem to be at fault must be subsidized by the public. In this context.gov/qa.pdf (p. However. respectively. then you will rule out an outright inflationary monetary policy response. Bernanke has studied the Great Depression in detail and has devoted much of his academic career to studying how to prevent its recurrence. Furthermore. it would be a mistake to believe these ideological perspectives are unshakeable commitments.

State and local tax revenues are roughly equal to federal tax revenues (including general revenue items from sources like university tuition. The obvious goal is to entice private capital in place of public capital by socializing risk. we can’t count on recovery. so let us review some basic facts regarding the largest foreign holder of America’s debt. It assumes the US federal government revenue contracts 4% in FY 2009. It remains to be seen. A less obvious but also important goal is to shield bank balance sheets from the volatility of lower marks on their assets. highways. 2009. . Yet even this estimate is probably too low. Of the roughly $4. international Politics – the china syndrome Debtors must be mindful of their creditors.3 trillion in US Treasury debt held by the public (i.) See Figure 8c and the associated explanation from Reinhart and Rogoff. Japan in 1992. etc. The program supplies market participants with free put options and attractive financing to motivate them to buy impaired assets from troubled banks. 2008 is similar. $198 billion and $268 billion respectively. Whether one admires the PPIP’s creativity or condemns its deceit. 2008. whether PPIP will ultimately do as much good to recapitalize the financial system as cold. state and local tax revenues are taken into account. Spain in 1977 and Sweden in 1991. asked Bernanke in March. published December 17. you know.The TV news show.g. In which case.e. 2009. 28 Public-Private Investment Program 29 The loan guarantee in the assistance to Citigroup announced November 24. as the present crisis may be worse than all the others. an additional 4% in FY 2010 and an additional 3% in FY 2011. however. hard cash. roughly $3. 60 Minutes. Treasury is partnering with the FDIC (which receives no Congressional appropriations) to provide free insurance whose claims come due later and whose costs can be obscured from the general public29.8 trillion of agency 25 See “Banking Crises: An Equal Opportunity Menace. and the largest holder is China with $740 billion. which in turn may help reduce volatility in the markets and the economy more generally. 27 This estimate starts with baseline federal revenue of $2. we don’t have the political will. This is not a political recipe to get Congress to approve more funds for additional bank bailouts or aggressive stimulus packages. Norway in 1987.1 trillion is held by foreign sources as of January 31. Of the $6. And nobody has yet figured out how to provide fiscal stimulus by writing put options. resulting in revenue losses of $101 billion.12_ A recent and comprehensive analysis25 suggests that the economic crisis will quickly reduce tax revenues and intensify deficit pressures.” by Carmen Reinhart and Kenneth Rogoff. (Note that each fiscal year ends on September 30. parking facilities. Tim Geithner has structured the PPIP28 to require as little new money up front as possible. FY 2009 ends September 30. “What are the dangers now? What keeps you up at night?” Bernanke responded: I think the biggest risk is that.) and are assumed to contract at the same rate. cit. Rather than spend money it doesn’t have and is unlikely to get.524 trillion in FY 2008. net of intra-governmental holdings). We don’t have the commitment to solve this problem. hospitals. Ben Bernanke and the key members of the Obama Administration clearly understand the magnitude of the political challenge. you know. from a purely political perspective its structure shows how undesirable Congress finds the idea of providing more taxpayer money for fiscal remedies. 26 These five crises are (in alphabetical order by country): Finland in 1991. and that we let it just continue. e. Merely contracting at the average rate of the five largest financial crises in advanced economies after World War II26 would result in the US government having a net (in real terms) revenue reduction of over $1 trillion over just three years27 (and possibly more after that) when the loss of federal. op.

the world takes notice34.9 billion.As Kevin Harrington explained in Clarium’s Q4.” Wall Street Journal. testimony by Brad Setser. Foreign Holdings of US Debt: Is our Economy Vulnerable? June 27. While overall flows of these securities decreased during the same period. The most radical change would be to float its currency freely. when China’s purchases of US agency33 debt dropped dramatically. and of which some 70% is estimated to be US dollar assets31. or 57% from Q2 to Q4 as compared to China’s 87% reduction during the same period. 2008 quarterly letter. China’s actions were specifically targeted at the agency market. there is the possibility that China may decide to change altogether its foreign reserves policy if it decides the current policy is no longer in its interest. although the actual figure is not precisely known. 2009. 32 China’s foreign exchange reserves have grown at an extraordinary rate.The flow of US agency debt dropped from $672 billion in Q2 to $508 billion in Q3 and $292 billion in Q4. March 24. Finally. 33 The source for all numbers in this paragraph is the Fed Flow of Funds.6 billion. The compound annual growth rate from 2000 to 2008 is over 36%. Today. 2008. $21. which is only just barely slower than the growth rate of 38. . Several years ago it was probably correct to say that this put China in a weak negotiating position. one can see three different ways that China’s reserves are a source of strength. it will remain in China’s interest to buy the US debt that must fund America’s coming shortfall in tax revenues and the entitlement commitments that stretch for decades. by quarter. which is twice the size of the second largest holder of foreign reserves (Japan at $1 trillion). 2009 by Zhou Xiaochuan.These Treasury and agency holdings are part of the massive $2 trillion foreign exchange reserves held by China. China is now a large enough “customer” that it can start to dictate terms to its “suppliers” by shifting which securities it will buy and what price it will pay.” published March 23. China’s massive reserves now allow it to use its currency as a strategic tool. The 70% estimate is widely reported. The speech is “Reform the International Monetary System. It is possible that we saw an example of this last summer. Thus. 34 See for example.5% from 2000 to 2004. In contrast to the growth of China’s holdings throughout the decade. Note that foreign Treasury holdings as of January 31. The second largest holder of Treasury and agency debt is Japan with $635 billion and $270 billion respectively. many of which look beneficial to China from both an economic and a geopolitical perspective. Today China has roughly $1. and must therefore accept the risk of capital losses on its foreign holdings. China held almost $530 billion30. 31 The source for China’s foreign exchange reserves is the State Administration of Foreign Exchange of the People’s Republic of China. China’s 2008 purchases of US agency debt were. First. China’s reduction was much greater on a percentage basis.8 billion. however. when the governor of China’s central bank gives a speech suggesting that a new currency should eventually replace the dollar as the world’s reserve currency. more moderate changes would include decreasing the dollar portion of its reserves and slowing the growth of its reserves altogether. this puts China in either a weak or a strong position. See for example.1 billion and $2. “China Takes Aim at Dollar. China is addicted to purchasing ever more foreign securities32 for as long as it wants to maintain the status quo. Note that China’s purchases of Treasuries were quite high during this period when compared to the average throughout the previous year. $15. Japan’s holdings have been relatively stable for some years. the source for Japan (and comparison with other countries) is the IMF.13_ and GSE backed debt at the end of Q2. China holds such large foreign exchange reserves in order to control the exchange rate of the renminbi. 2009 is a preliminary estimate. depending upon how one considers it. The Sovereign Exception. But if America credibly indicates it will 30 The source is the US Treasury Department. Second.4 trillion in foreign reserves and American consumption will no longer be supported by profligate borrowing. So long as China believes that America will eschew an inflationary solution. From one perspective. $3. 2007. Several years ago one could assume that such changes would probably not be to China’s benefit. China’s decision to stop the steady appreciation of the renminbi versus the dollar and keep it rigidly pegged since July 2008 has had profound deflationary effects.

t h e w iz a r d o F oz Frank Baum wrote an illustrated children’s novel called The Wonderful Wizard of Oz in 1900. politics both at home and abroad may limit what can be done. it only appears green and sparkling because everyone in the city wears goggles that distort their view36. the US stayed on the gold standard. “There’s No Place like Home.” this essay describes the political challenges of changing the policy to be more inflationary. Even if the fear of deflation widens the ideological perspective. be it ever so beautiful. Upon hearing her description he tells her he can’t understand why she would want to leave Oz and return to “the dry. When William Jennings Bryan gave his famous speech. By 1900. When Dorothy and her companions arrive at the Emerald City. One can fancifully think of it as a twenty-first century version of a “fiat money gold standard” that attempts to solve our economic crisis and deliver us to prosperity by staying on a path of monetary responsibility. they learn that the Emerald City is based on lies. 35 In the movie. Even a complete restoration of the supply of credit will not forestall a deflationary contraction in its demand. . In the section. the iconic characters. however. it appears at first that they have found a utopia of prosperity and good governance. gray place you call Kansas35. the Wizard lies about his abilities in order to maintain power. Less appreciated are the historical context and political overtones of the story dealing with the struggle around the gold standard and the battle between inflation and deflation. Baum was poking fun at Midwesterners who idealized farm life even though the future lay in the migration to the cities.” this essay describes how Ben Bernanke has carefully designed the policy response to avoid inflation. we people of flesh and blood would rather live there than in any other country. DC. after 1897 adherence to the gold standard was no longer deflationary and instead began a period of mild inflation that lasted until World War I. so long as everyone goes along with the charade life is generally good for its inhabitants. “That is because you have no brains. In the section.” this essay explains why repairing the financial system will not lead back to Goldilocks. The previous Goldilocks regime was not a happy equilibrium. and the imaginative fantasy world of Oz. Wherever the path of policy and events will take us. The yellow brick road is an obvious reference to the gold standard: a golden path that keeps one safe and delivers one to the prosperity of the Emerald City so long as it is faithfully followed.” Dorothy replies. while America’s largest foreign creditor will strive to protect its dollar assets. The city is not really made of emerald. He means well. At the start of her journey on the yellow brick road. There is no place like home. Because Bryan lost his presidential bid in 1896. Given how much America now needs China. this is conveyed by having all the scenes in Kansas in black and white while all the scenes in the Land of Oz are in bright Technicolor. the nation had given up any hope of reaching a state of Goldilocks and was instead locked in a struggle between choosing inflation or deflation.Yet to everyone’s surprise. “Follow the Yellow Brick Road.14_ pursue genuinely inflationary monetary policy. it will not be the “home” of an untenable prosperity where private credit grows faster than our economy. An angry middle class will demand that Congress tighten its purse strings. No matter how dreary and gray our homes are. the prospect of massive capital losses on its dollar reserves may cause China to preempt that action. It captured the popular imagination and was turned into a movie in 1939. Furthermore.” Popular culture remembers the final sentence. Dorothy describes the dreary poverty of her home in Kansas to the Scarecrow. but forgets the context. Nevertheless. Eventually. New gold discoveries combined with improvements in mining and refining technology enabled the gold supply to expand steadily. “The Emerald City. but he is a fraud. Baum was able to satirize the politics and economics of the 1890s lightheartedly. The Emerald City represents Washington. 36 This detail is unfortunately lost in the movie version. Today the book and the movie are remembered for the entertaining story. it is not clear that America could pursue an outright inflationary policy if China acts to prevent it. In the section. but instead a highly leveraged and indebted state of affairs.

5% per year from 1897 until 191437. and courage for the Cowardly Lion – because they already had those qualities. Although the character of the Wizard is probably meant to represent President McKinley. . and we are only beginning to come to grips with the new economic and political realities. One final parallel with the novel is worth noting. had it been politically possible to do so. But like the Wizard. and they even go so far as to say that given the impossibility of predicting this development. the Wizard could give Dorothy’s companions what they sought – brains for the Scarecrow. he was unable to help her. op. Bernanke is honest and capable. When Dorothy asked the Wizard to send her home. in today’s context it is easy to reinterpret him as Ben Bernanke. Who today will provide Bernanke with the magic he needs? paTrICk WOlFF. We are at the end of a long Goldilocks regime that has led to substantial imbalances and indebtedness. Friedman and Schwartz note that this was impossible to foresee at the time. CFa Managing Director Clarium Capital Management llC 37 See Milton Friedman and Anna Jacobson Schwartz. Much like a central banker in normal times. cit. what is required may lie beyond his abilities. Unlike the Wizard. abandoning the gold standard might have been the best policy to adopt in response to the 1893 panic and subsequent depression. Baum published his novel at the beginning of a new Goldilocks regime. Unfortunately. a heart for the Tin Man.15_ which caused prices in the United States to rise between 2% and 2. the Wizard mainly needed to supply confidence. But Dorothy’s case was different. the situation in 2009 is the mirror image of 1900. In the novel.

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