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For Today Let’s Pretend It Will All Work Out

A fairly busy news day made lots of people happy.

Housing Starts came in at 575k, with an upward revision to last month’s figure to put it at 611k. Yay! Builders are probably pleased with the first pan-600k number in over a year (but see yesterday’s comment for the deep significance – not – of the 600k level).

Owners of Euro currency were delighted that a meeting of EU finance ministers produced a “strategy for emergency loans to Greece.” These loans will not be extended right now. And we don’t know how much is being pledged. And we don’t know what will trigger the extension of those loans, and whether the ministers can change their minds. We aren’t even sure that the finance ministers have the legal ability to actually deliver on the strategy. The market seems to think it’s better than a sharp stick in the eye, and I suppose that is true, but it looks to me like a fairly transparent ploy to persuade investors to buy Greek bonds in April and May when many billions of Euro of Greek bonds mature and will need to be rolled. “If they think we’re backstopping them, then we won’t actually need to backstop them; if they don’t think we’re backstopping them, then the investors won’t show up and we’ll have to do something more dramatic.” It seems to me like a cheap option (because talk is cheap); if Greece still founders then the EU is in the same position it was in before, except with a vague promise in place that they may need to deliver on.

My cynicism aside, I have pointed out many times that institutions have a strong survival meme, and we have many examples over the last decade or two that we can point to in order to illustrate the proposition. Not least among these, of course, are the extraordinary actions – of debatable legality – taken by the Federal Reserve during the recent crisis with no real objections, but the list is long. We could include the suspension from time to time of mark-to-market rules when those rules may have made plain some of the more-serious damage the crisis had done to some firms (and the suspension of which rules, in fact, healed no one but amounted to a wink and a nudge), the adoption in the early 2000s of Fannie Mae’s “skip a payment” policy, which greatly improved delinquency optics since missing a payment was no longer automatically a delinquency, the entire phenomenon in Japan of “zombie firms” in which banks keep lending to dead firms to pay off their existing loans rather than recognizing the loss, and so on. But the point is that, as empty as the EU finance ministers’ gesture actually is, the market understands that the institution of the EU is willing to bend some rules (such as the rule against bailouts) when necessary, and it is dangerous to play cards with someone who might change the rules on you. (This is also, of course, why respect for the Rule of Law is so important, since in the long run the people who are leaving the table because the EU is willing to change the rules may not return to the table. There is, for example, no guarantee that these folks will actually buy Greek debt).

But for now, the dollar’s run-up is looking tired. This is a good thing for the Greece, as it prepares to sell a few tens of billions of Euro debt. It is not such a good thing for a country that has a few trillion in debt to sell and has benefited from currency unit strength that has helped dampen inflation pressures.

Stocks and bonds both enjoyed (the S&P to the tune of 0.8%; TYM0 by 16/32nds) the Fed’s decision to stand pat on rates and to repeat its “exceptionally low levels of the federal funds rate for an extended period” construction. Not surprising. Rates in the short end are going nowhere fast, despite Mr. Hoenig’s protestations (he dissented to the statement, preferring to remove the ‘extended period’ language, but as I said yesterday I doubt the Fed feels like now is the time to experiment very much). And, as rates are nailed to the floor at the short end, rates at the long end are somewhat constrained if only because it is very profitable at these spreads to buy bonds at 4%, pledge them as collateral on a repo loan at 0%, and lever that a few times for “easy money.” This carry trade, like all carry trades, contains the seeds of a future blow-up, since once the Fed begins to tighten short rates it isn’t going to be very easy for everyone to get out of the carry trade at once. Think Orange County, or…well, any carry trade.

With the sort of economic slack we currently have in labor and land markets, either there will not be any inflation for several years (Keynesian model) or there will be inflation once the velocity of money starts to recover, regardless of what the output gap is. If the monetarists are right, then there is a sinister side to the beginning of the tightening campaign. By killing the carry trade and provoking banks to lend money rather than to earn carry, a hike in rates could plausibly cause inflation to increase at least at first, as such a development would help generate an increase in money velocity.

This is just one of the interesting twists we may have to navigate as we exit this recession. And we are going to get some interesting “experimental data” as well that we don’t normally get to see. One of the reasons that Keynesians can claim that growth in excess of capacity causes inflation while monetarists say that inflation is caused by excessive money growth is that in normal recessions, these things occur more or less at the same time (given the lags inherent in the inflation-generating process, they don’t need to be simultaneous, just close, for us to have trouble disentangling the effects). We have experiments in other countries where there are large output gaps and too much money, or negative output gaps and not enough money, and it seems to me that these experiments support the monetarist view…but this will be the first time in a while that we may have a discernable difference in the US economy. In this case, the upturn in the rate of growth and the increase in lending and velocity will ultimately occur, when it does, while there is still a very large output gap. If inflation follows, then the Keynesians will have a difficult time explaining how; if inflation does not follow until the output gap is fully closed, then monetarists will have a tougher time of it.

None of this will have anything to do with PPI, though. The Producer Price Index (Consensus: -0.2%/+0.1%) being reported tomorrow is not a very useful inflation indicator for most applications but amounts to the major data release of the day.


One more idle observation: I heard on the radio that there is a move afoot to get the Nobel Prize committee to award the Peace Prize to … the Internet. This strikes me as crazy, since not many inventions have done more to encourage global friction than the Internet. Ask the Danish artist who caricatured Mohammed if the Internet contributed to peace. To say nothing, of course, of the financial crises that have been encouraged by the increased inter-asset correlations made possible mainly by light-speed information exploitation. Would Greece’s meltdown have happened, at least in the manner it happened, without the Internet? A faster news cycle is not a contributor to peace. Flames must be fanned or they go out. A faster and more global news cycle is a contributor to war.

Categories: Uncategorized
  1. Andy
    March 17, 2010 at 5:49 am

    Here is an interesting discussion of velocity of money, thought it was apros pos to your comments

    • March 17, 2010 at 7:13 am

      I had seen this, and it is well done; the only problem is the unsubstantiated assertion by Lacy Hunt that “velocity is mean-reverting over long periods of time.” There’s no reason to think that is true, and if it is NOT true then Hunt’s argument is weakened considerably.

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