Apri l2009

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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

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 Natural ly there were polit ical nuances; for example, si lver mining interests favored bimetal l ism (which would lead to looser money) primari ly because it would increase the demand for si lver. 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 sol icitation or recommendation to buy, sel l or hold securit ies. Certain statements contained herein may be forward-looking. Information contained herein is bel ieved to be accurate and/or derived from sources which Clarium Capital Management LLC believes to be rel iable; however, Clarium disclaims any and al l l iabi l i ty as to the completeness or accuracy of the information contained herein and for any omissions of material facts. This document has not been f i led with the Commodities Futures Trading Commission or any other regulatory body. Graphics contained herein are purely representational and do not ref lect any hypothetical return from an investment in the depicted instruments.

The WonderfulWizard of Oz

© 2009

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The economy and politics in spring 2009 look more like the summer of 1896 than Bernanke’s speech ever contemplated. Goldilocks is gone and the politics of populism has returned. Yet unlike 1896, the conditions are new and everyone is still adjusting to the change. Politicians are realigning their priorities and learning how to navigate the politics. Businesses and households are cutting their spending and adjusting to new economic realities. 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.

The question of inflation versus deflation is the subject of this essay. The analysis unfolds in three parts. The first part describes the policy response to date. The response of the Federal Reserve has been specifically designed to provide liquidity to the credit markets without creating inflation. Together with the policies of the Treasury and the rest of the Obama Administration to address the solvency of the financial system, the goal has been to return to the previous Goldilocks regime by restoring the pre-crisis levels of private credit.

The second part highlights the deficiency of the policy response. In focusing on fixing the financial system, the policy addresses only half the problem. The United States does not just have an overleveraged and undercapitalized financial system; it also has an overleveraged and undercapitalized household sector. Private credit reached an unsustainable level, so its demand must fall even if its supply is restored. In the context of the current policy response, the inevitable credit contraction will be deflationary as the initial fiscal stimulus is too small to bridge the gap.

The third part analyzes the political barriers to a more inflationary response by considering its perceived necessity, desirability and possibility. The ideology of the major policy actors emphasizes the failure of financial oversight as the proximate cause of the crisis, yet overlooks that the Goldilocks they wish to restore relied on unsustainable financial and asset bubbles. As deflation is greatly feared, absent other barriers the desire for economic growth would likely overcome this ideological bias, even at the risk of inflation. However, powerful domestic and international political interests prefer deflation to inflation. Populist rage visibly tightens the Congressional purse strings against profligate borrowing to protect entitlement programs for the middle class, while behind the scenes China maneuvers to protect the value of its vast dollar holdings. Given these constraints, investors must consider carefully whether policy makers will be able to tilt the policy response as much towards inflation as is commonly believed.

Follow the Yellow Brick road

As Fed chairman, Bernanke began implementing the monetary components of the current policy in late 2008, and he articulated the broader policy framework in his January 13, 2009 speech, “The Crisis and the Policy Response.” The fiscal components have been broadly adopted by the Obama Administration generally and the Treasury Department specifically. The focus of the policy is to restore the proper functioning of the financial system without debasing the currency or producing excess inflation2. The goal of the policy is to return the economy to the Goldilocks regime of low, predictable inflation and stable growth.

Monetary Policy

With the federal funds rate effectively at 0%, the Federal Reserve has developed new tools to improve the functioning of credit markets and increase the availability of credit to households and businesses. Bernanke organizes these tools into three categories, which together constitute the monetary policy of “Credit Easing.”

1. 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. All the facilities for auctioning credit and making primary securities dealers

2 “Excess inf lat ion” can be thought of as a rate of inf lat ion exceeding an implicit target of 1.75% – 2.0%.

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and banks eligible to borrow at the Fed’s discount window fall into this category. Bernanke also groups into this category the bilateral currency swap agreements with various foreign central banks to make US dollars more available.

2. Provision of Liquidity Directly to Borrowers and Investors in Key Credit Markets: This includes the purchase of commercial paper and the TALF3. The purchase of commercial paper was designed to stop the run on money market funds, while the TALF is designed to stimulate increased lending directly. In Bernanke’s description, what unites these programs (and potential future programs) into this category is that they address the concerns about capital, asset quality and credit risk that continue to limit the willingness of many intermediaries to extend credit, even when they have the liquidity to do so.

3. Purchase of Longer Duration Securities: This comprises all actions intended directly to lower longer-term lending rates. It includes the completed and planned purchase of Fannie and Freddie mortgage-backed securities and the senior debt of those companies, as well as the planned purchase of longer-duration Treasury bonds.

There has been some confusion around how Credit Easing and Quantitative Easing differ, as well as a general misunderstanding of the conditions under which increasing the monetary base is inflationary. One can generally define any action that purposefully increases the monetary base as a form of “quantitative easing,” since the purpose is to ease conditions by increasing the quantity of money. This is possible at any interest rate, but for obvious reasons a central bank tends to turn to quantitative operations only after it has already pushed the interest rate to zero. 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. Whereas Japan’s Quantitative Easing policy attempted to create inflation in the prices of goods and services by increasing the monetary base, the Fed’s Credit Easing policy attempts to lower the cost of credit by buying specific assets and providing liquidity (i.e. issuing loans) in specific credit markets. Both Quantitative Easing and Credit Easing result in an increase in the monetary base (i.e. reserves on deposit with the central bank), but for different purposes. Quantitative Easing increases reserves simply to create inflation, while Credit Easing increases reserves to fund its operations in the credit markets (buying and making loans) to lower the cost of credit.

Since both Credit Easing and Quantitative Easing increase the monetary base, why don’t they both create inflation? To answer this question one must understand how these operations work. In both Credit Easing and Quantitative Easing, the central bank purchases securities from banks and then credits them with reserves; the increase in reserves is the expansion in the monetary base. In order for this expansion of the monetary base to be inflationary it must make its way into the economy, 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, merely increasing the monetary base will not increase lending; hence it is questionable whether a straightforward Quantitative Easing policy would have any effect at all today in the US. (And there is considerable debate whether Japan’s policy had any effect during the time it operated.) Even further, the Fed is paying an interest rate on 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 those reserves simply sit with the Fed, their mere increase has no inflationary effect on the economy4.

Quantitative Easing is generally associated with the purchase of government debt, while Credit Easing targets specific credit markets to lower borrowing costs. With this in mind there is one way in which Quantitative Easing can be much more inflationary than Credit Easing. 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 securit ies Loan Faci l i ty; this is the faci l i ty that lends against asset-backed securit ies such as student loans, auto loans and credit card loans.

4 Bernanke explained this in detai l in a speech on February 18, 2009, “Federal Reserve Policies to Ease Credit and Their Implications for the Fed’s Balance Sheet.” Bernanke noted there that although M2 has grown at a 15% annual rate on a quarterly basis in Q4 2008, this was due primari ly to investors taking money out of r iskier markets to seek the safety of government insured bank deposits.

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then used either to return money to citizens through tax cuts or to increase federal spending, then the transmission mechanism bypasses the bank credit channel and the increased money makes its way into the economy with an inflationary effect5. Because this policy requires the monetary and fiscal authorities to cooperate it should be distinguished from purely monetary policies, perhaps by calling it Quantitative Fiscal Easing. Bernanke recommended such a policy for Japan in 20036, but he has neither implemented nor proposed anything like it in the present case.

Returning to the effects of the increased monetary base, it is important to note that at some future point the private credit channel will presumably start growing again, at which point the excess reserves would be transmitted into the economy with inflationary effect. 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. Longer-duration assets such as MBS and Treasuries can be sold into the market to sterilize the reserves that fund them7, but the process is trickier to implement, since the resulting rise in interest rates can encourage international capital flows and otherwise distort market signals. The Fed’s decision on March 19 to purchase some $1.15 trillion of MBS, 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. It did not, however, presage inflationary pressure in the present; rather, it highlighted the importance the Fed places on doing whatever it can to stimulate refinancing and mortgage lending. As we will see later, the Fed is right to be concerned.

Fiscal Policy

In his first speech outlining the Fed’s Credit Easing policy response8, 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, but other policy measures will be needed as well. The incoming Administration and Congress are currently discussing a substantial fiscal package that, if enacted, could provide a significant boost to economic activity. In my view, however, fiscal actions are unlikely to promote a lasting recovery unless they are accompanied by strong measures to further stabilize and strengthen the financial system. History demonstrates conclusively that a modern economy cannot grow if its financial system is not operating effectively. …

[W]ith the worsening of the economy’s growth prospects, continued credit losses and asset markdowns may maintain for a time the pressure on the capital and balance sheet capabilities of financial institutions. Consequently, more capital injections and guarantees may become necessary to ensure stability and normalization of credit markets. … In addition, efforts to reduce preventable foreclosures, among other benefits, could strengthen the housing market and reduce mortgage losses, thereby increasing financial stability.

5 Ben Bernanke was making precisely this point in the 2002 speech from which the quote at the front of this essay was drawn, “Deflation: Making Sure ‘It’ Doesn’t Happen Here,” when he said, “A money-f inanced tax cut is essential ly equivalent to Milton Friedman’s famous ‘hel icopter drop’ of money.” This is the quote from which Bernanke’s “Helicopter Ben” nickname originated, and the emphasis placed on this quote reveals the general ly superf icial understanding of his speech. Bernanke borrowed the hel icopter image from Milton Friedman, and he did so to make a technical rather than a policy point.

6 See “Some Thoughts on Monetary Policy in Japan,” May 31, 2003, where Bernanke recommended that Japan combine monetizing f iscal spending with a price level target, i .e. a sustained commitment to restore the price level to the value it would have if instead of deflat ion an inf lat ion of 1% per year had occurred since 1998.

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. This process decreases the monetary base.

8 See “The Crisis and the Policy Response,” op.cit. Note that this speech was given more than a week before President Obama took off ice.

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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. This disparate treatment, unappealing as it is, appears unavoidable. Our economic system is critically dependent on the free flow of credit, and the consequences for the broader economy of financial instability are thus powerful and quickly felt. … 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. (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). Since reducing preventable foreclosures would help increase financial stability, this should be done where possible. Some fiscal stimulus along the way is appropriate, but must not distract from the main focus of fixing the financial system. Although the public is

“understandably concerned” about shoveling so much money into the financial sector, the greater good demands that it be done, so politicians must build and maintain support for restoring the financial sector.

Treasury’s policy response under Tim Geithner is the Financial Stability Plan. The details of each component of this plan continue to unfold, but the plan’s focus and structure are clear and align closely with Bernanke’s prescription. The plan has six components:

1. Financial Stability Trust: A “stress test” will determine the financial fitness of each major financial institution. Where additional capital is needed, every effort will be made to attract private capital; if private capital is unavailable then government capital will be injected.

2. 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.

3. Expansion of TALF: Treasury and the Fed will work together to expand the TALF program.

4. 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, (b) committing to Treasury’s “mortgage foreclosure mitigation programs,” (c) not paying dividends, buying back stock or acquiring “healthy firms” until the government is repaid, and (d) certain limitations on executive compensation.

5. Homeowner Affordability and Stability Plan: Working with the GSEs, the major banks, and various government agencies, Treasury will increase the number of homeowners who can refinance their mortgages and improve the terms of the mortgages for many homeowners.

6. 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.

It is striking how closely Geithner is following Bernanke’s fiscal policy prescription. The first two items inject more capital into the financial system. The third item expands an existing Federal Reserve program. The fourth item addresses Bernanke’s exhortation to assuage political concerns regarding putting more money into financial companies. The fifth item tries to reduce preventable foreclosures. Only the sixth and last item is not a direct Bernanke prescription, although it is obviously consistent with the goal of restoring the normal flows of credit.

In addition to the Treasury response, the Obama administration is acting in two ways. In early February, it persuaded Congress to pass a stimulus bill that spends $501 billion in new money

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and provides temporary tax cuts of $288 billion; and a few weeks later it requested a $750 billion9 “contingent reserve for further efforts to stabilize the financial system.” While the fiscal stimulus package was an initiative predating Bernanke’s speech and Geithner’s appointment to Treasury, the requested contingent reserve is clearly designed to support their efforts. Having spent political capital early on to pass the stimulus bill, President Obama then delegated the policy response to Treasury and the Fed. There is now close coordination between the Fed, Treasury, and the White House around the Bernanke policy response.

there’s No Place like hoMe

There is much debate about how well the efforts of the Federal Reserve and Treasury are proceeding. This debate is critically important, because the financial system is terribly overleveraged and undercapitalized and must be repaired. However, the debate overlooks and crowds out a fundamental issue. Even if the current policy efforts are successful, easing the cost and availability of credit will not restore its flow to prior levels. Credit is contracting not just because its supply is choked off by the illiquid and insolvent state of the financial system; it is also contracting because its demand had far exceeded a sustainable level.

Observe the ratio of the amount of outstanding nonfinancial10 US debt to US GDP. Since 2000, the aggregate ratio jumped from the previously stable level of about 1.85 to 2.35. In contrast to the first jump (from 1981 – 1988), this increase was almost entirely led by households, who increased their debt level in relation to GDP over 40% in just eight years from a ratio of 0.7 to nearly 1.0. (Note also that business debt in relation to GDP edged up to reach its highest level ever.) The increase was primarily driven by mortgages during the housing bubble.

9 From a budgeting perspective, the request asks for $250 bi l l ion because it envisions purchasing assets that wil l return only 2/3 of their cost. Hence the gross f igure requested is $750 bi l l ion, and the net f igure requested is $250 bi l l ion.

10 Financial debt is excluded to avoid double counting. For example, whereas a mortgage is counted, a mortgage-backed security is excluded. Nonfinancial debt measures the degree to which the real economy is leveraged, but it understates the degree to which the f inancial economy ( i.e. banks, etc.) is leveraged.

Fig. 1 US Non-Financial Debt to GDP Ratio Source: Fed Flow of Funds

Total Mult iple

Household Mult iple

Business Mult iple

Government Mult iple

1945 1965 1985 2005

0.00

0.50

1.00

1.50

2.00

2.50

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Yet the trend of worsening US household finances preceded the housing bubble and started in the early 1990s. As recently as 1992 the personal savings rate was still slightly above (i.e. better than) its long-term average, and the ratio of debt to disposable income was only slightly above (i.e. worse than) its long-term average. But the decade and a half that followed saw a significant deterioration of the US household balance sheet. Households basically stopped saving while increasing dramatically the size of their liabilities relative to their available income11.

Speaking in 200512, Ben Bernanke sought to allay concerns about these trends by pointing out that household assets rose even more quickly than household liabilities, and at the time of his speech the ratio of household net worth to household income stood at 5.7, well above its long-run average of about 4.8. However, this ratio later plunged to 4.3 at the end of 2008 with the bursting of the housing bubble and subsequent collapse in the stock market. Given the continued selloff in housing and stocks, this ratio has clearly fallen even further. Indeed, 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.

Households have saved too little and borrowed too much. The end of the housing bubble has left many people underwater on their mortgages. Unemployment is high and increasing, and many more workers justifiably fear their jobs are at risk. Economies around the world are contracting at the fastest rate in generations. In this environment, households will be reducing their borrowings and trying to increase their savings for some time to come.

But since current policy is so focused on restarting the private credit channel, we must consider whether the aggregate numbers are misleading. Many households are under stress, but some are not. 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. However, there is very little equity that can still be leveraged.

11 It is worth noting at this point that this analysis only states what happened and does not try to explain what caused it. The causes are complex and l ie both inside and outside the US. One cause is the dramatic lowering of the cost of capital from the early 1980s and the household reaction to this phenomenon; see Clarium’s Q2 2007 quarterly letter, The Long Goodbye for a detai led analysis. Another cause is the increase in savings in emerging markets and their desire to be invested within the United States, the so-cal led “Global Savings Glut” explanation by Ben Bernanke. Other factors were at work as well. This important topic deserves much more consideration but it l ies outside of the analysis here.

12 “The Economic Outlook,” March 8, 2005

13 Per the Fed Flow of Funds. See also http://www.hoover.org/research/factsonpolicy/facts/38837147.html

Fig. 2 Personal Savings/Disposable Income Source: Fed Flow of Funds Fig. 3 Household Liabi l i t ies/Disposable Income Source: Fed Flow of Funds

Personal Savings / Disposable Income

1946 1966 1986 2006

0%

2%

4%

8%

10%

12%

6%

Household Liabi l i t ies / Disposable Income

1946 1966 1986 2006

0.0

0.4

0.8

1.2

1.6

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Observe the graph of the ratio of potential US mortgage equity to GDP. The top line takes the simple ratio of total outstanding mortgage equity to GDP in the US. The 2009 estimate assumes that housing prices decrease another 10% while GDP remains constant. Even on this simple measure the amount of outstanding mortgage equity available to be leveraged is near its historically lowest level. However, a key point is that underwriting standards deteriorated significantly during the housing bubble. The bottom line adjusts for this by assuming an 80% loan-to-value (LTV) ratio, which has been the historical norm14. On this measure, 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). Given the trajectory of house prices and GDP, it seems likely that this ratio will decline even further in 2010.

The total amount of equity available to be leveraged in 2009 will be below its previously lowest level in 1945. And as the accompanying graph shows, the crucial difference is that in 1945 housing values were at a historically low point, whereas today they remain at historically high levels15. People will not borrow aggressively to buy houses that they think are overvalued and likely to fall further in price.

There is too much housing debt, too little housing equity, and what little equity is left is (still) overvalued. In this environment lowering mortgage rates will have little effect on restarting borrowing. Since housing dominates household credit, no other source of household credit can counteract its effect. Add in the worst economy in living memory, a personal savings rate near zero for almost a decade, household liabilities at a record ratio to disposable income, and the recent decimation of household wealth and it is clear that trying to jawbone the household credit channel faces severe limitations.

Nor will the burden be carried by businesses. 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. While fixing short-term funding mechanisms such as the commercial paper market is certainly necessary, and while it would

14 For the graph of mortgage equity to GDP, the unadjusted calculation takes the aggregate value of the housing stock, subtracts the outstanding value of al l mortgage debt, and then divides the result ing difference by the value of GDP. The 80% LTV calculation uses the same formula, but f irst mult ipl ies the aggregate value of the housing stock by 80%.

15 For the graph of the value of US housing stock to GDP, the 2009 number assumes that housing fal ls by 10% in 2009 while US GDP remains f lat from its end of 2008 value.

16 Early indications are that corporations around the world are hoarding cash by borrowing at low rates and paying down loans wherever possible while cutt ing back on investment and returning less cash to shareholders. See “Concern as Companies Hoard Cash,” Financial Times, March 18, 2009.

Fig. 4 Potential US Mortgage Equity to GDP Ratio Source: Fed Flow of Funds Fig. 5 Value of US Housing Stock/GDP Source: Fed Flow of Funds

Unadjusted 80% LTV

1945 1965 1985 2005

0%

20%

40%

60%

80%

100%

120%Value of US Housing Stock / GDP

1945 1965 1985 2005

0%

40%

80%

120%

160%

200%

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be desirable to lower long-term funding costs for businesses where possible, such measures will not even begin to expand credit to the extent necessary to offset the household credit contraction.

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, before the housing bubble began. Since even in 1998 this ratio was at an all-time high, this does not seem like an onerous assumption. We do not know the trajectory of GDP in 2009 and beyond, so to make the calculation easier we hold GDP constant at its level at the end of 2008. With these assumptions, the household sector needs to pay down $4.2 trillion of debt. If we assume that the business sector holds borrowing and associated spending constant at the same time, this represents $4.2 trillion of lost private sector spending. 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, but it is surely on the order of trillions of dollars if no significant countervailing force is deployed against it.

So far, only $800 billion in fiscal stimulus and tax cuts, both of which occur over several years, have been deployed against this looming private credit contraction. Making credit cheaper and more available will help some households refinance, but given the mortgage negative equity problem described above the effect is likely to be small. Recapitalizing the financial system will have some salutary effect, since if a consumer defaults on a loan and the bank is reimbursed by the government for the default, the effect is similar to providing the consumer the money to pay back the loan19. However, most if not all of the recapitalization is needed to reduce leverage levels of financial companies. Both the financial and the household sectors are overleveraged; reducing the leverage of the financial sector is necessary but does not also count towards reducing the leverage of the household sector. 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, Fannie Mae, Freddie Mac, Citigroup and Bank of America. (The PPIP program, which is part of TARP, is addressed below.) 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 severely overleveraged state of the financial system the amount is probably small at best.

Absent outright monetary inflation, unless the federal government substantially increases its own borrowing and deploys the capital to stimulate the economy20, we must expect trillions of dollars of lost output before the private sector deleveraging is complete. Therefore, without a significant change in policy the outlook for the next several years is deflationary.

the eMerald citY

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 now our analysis must change from the macroeconomic to the political and sociological.

17 The lost economic output should be measured against sustainable trend growth; since trend growth is posit ive it is possible to have lost output even with (weak) economic expansion.

18 For example, i f the spending is withdrawn from financial ly weak f irms that then go bankrupt more economic contraction would occur than if al l f irms could absorb the lost revenue.

19 It is more onerous, however, as the consumer must f irst default and then if the loan is made against an asset the asset must be resold at a depressed price.

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. We also ignore the larger question of whether stimulus maximizes long-term growth or whether it simply smoothes the downturn and subsequent recovery. We are focused purely on whether there wil l be suff icient stimulus to offset deflat ion over the next several years.

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A useful way to analyze the politics behind the policy is to consider the appeal of inflation from three different perspectives:

1. Is inflation necessary? The ideology of policy makers

2. Is inflation desirable? Domestic political factors

3. Is inflation possible? 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. According to this view, monetary policy needs to restore the earlier status quo, only this time with better supervision, regulation and cooperation. Ben Bernanke devoted two paragraphs of his January 13, 2009 speech to the reforms that would “limit the probability and severity of future crises.” His suggested reforms all focused on improving the durability of banks and other financial institutions, which is certainly a good and necessary goal. There was not a word, however, regarding the monetary policies that encouraged asset bubbles or allowed such an enormous buildup of private credit relative to GDP. Indeed, recall from the previous section that when Bernanke addressed the topic of the growth of private debt in 2005, instead of calling attention to it as a worrying trend he actually dismissed concerns about it.

The ideological bias to downplay the significance of the growth of private debt pervades the Obama policy team. In a recent senate hearing21, Professor Christina Romer, Chair of the Council of Economic Advisers had this exchange with Senator Jeff Merkley:

Senator Merkley: You know, one of the things that I’m interested in getting your perspective on is that we not only have substantial governmental debt, but we also have sizable consumer debt. When those are taken together, consumer and government debt, 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, even at the height of the Great Depression?

Professor Romer: I would say we – I mean, I should check the numbers but I’d say we certainly are higher. …

Senator Merkley: I saw a chart in a magazine article a year or so ago that seemed a little surreal to me, 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, the debt to GDP, the combined debt, 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. 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, 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. …

Christina Romer is a learned scholar of the Great Depression who submitted sixteen pages of written testimony for this panel. She is an influential member of the Obama Administration. 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, March 31, 2009

22 The chart to which Senator Merkley referred is almost certainly total US debt – nonfinancial plus f inancial debt – divided by US GDP. See footnote 9 for an explanation of f inancial and nonfinancial debt. Tracking total US debt as a ratio of GDP over t ime is misleading because f inancial debt both overcounts offsett ing f inancial posit ions and undercounts synthetic leverage.

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and general responses23 to Merkley’s questions. Senator Merkley is correct that policy makers “don’t really talk about the combination of consumer [and business] and governmental debt.”

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, then you will rule out an outright inflationary monetary policy response. If you do not understand the unsustainable levels of private credit, then you will underestimate the amount of government stimulus necessary to offset deflation.

However, it would be a mistake to believe these ideological perspectives are unshakeable commitments. Bernanke has studied the Great Depression in detail and has devoted much of his academic career to studying how to prevent its recurrence. Romer, in her written testimony to the Senate hearing referenced above, did not just say that aggressive fiscal expansion is an essential part of the solution, she also explicitly said that stimulus must not be cut back prematurely. In the absence of other political constraints, one could expect that persistent deflation would draw out increasingly more inflationary policy responses.

domestic Politics – No More Money

Defining the problem primarily as a financial crisis has weakened the resolve for collective efforts to solve it, 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. Whether it is the Rick Santelli rant that quickly garnered almost a million views on YouTube, the public backlash against AIG bonuses that caused a punitive tax bill to pass quickly through the House, or whatever the next outrage will be, the public rage demands expression. 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. Income inequality reached historically high levels over many years, which led the middle class to feel increasingly squeezed while it saw the rich get richer. A culture of borrowing and speculation – partly to compensate for stagnant real wages – took hold throughout America. Wall Street became its most arrogant and irresponsible as the finance bubble peaked. 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. Instead, the crisis has been cast as a morality play where Wall Street and irresponsible speculators are villains that hold a virtuous Main Street hostage. In this context, the response is grudgingly to hand over the minimum amount necessary to bail out the financial system while extracting the maximum possible punishment. Taxpayers are in no mood to be told that some of what ails the economy is due to their own irresponsibility, and that much more of their money is needed to minimize the pain.

Furthermore, taxpayer money is needed to pay for the entitlement promises made to the retiring baby boom generation. Social security and Medicare currently owe tens of trillions of dollars in present value terms24. The politics of meeting and funding these commitments will dominate the political landscape for decades. Retiring baby boomers understandably want the political conversation to favor meeting the commitments in full. 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, but the political reality is that each dollar of stimulus competes for a dollar of Medicare and Social Security. The normal funding of these programs will lead to significant future deficits, and those deficits are politically unpopular.

23 The ful l text of Romer’s responses was omitted for space considerations.

24 The 2008 off icial government estimates of the present value of Medicare and Social Security l iabi l i t ies are $16.8 tr i l l ion and $4.3 tr i l l ion, respectively. The calculations of these l iabi l i t ies are extremely sensit ive to many assumptions. See http://www.cms.hhs.gov/reportstrustfunds/downloads/tr2008.pdf (p.197) for the Medicare estimate and http://www.ssa.gov/qa.htm (question #12) for the Social Security estimate.

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A recent and comprehensive analysis25 suggests that the economic crisis will quickly reduce tax revenues and intensify deficit pressures. 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, state and local tax revenues are taken into account. Yet even this estimate is probably too low, as the present crisis may be worse than all the others.

This is not a political recipe to get Congress to approve more funds for additional bank bailouts or aggressive stimulus packages.

Ben Bernanke and the key members of the Obama Administration clearly understand the magnitude of the political challenge. The TV news show, 60 Minutes, asked Bernanke in March, “What are the dangers now? What keeps you up at night?” Bernanke responded:

I think the biggest risk is that, you know, we don’t have the political will. We don’t have the commitment to solve this problem, and that we let it just continue. In which case, you know, we can’t count on recovery.

Tim Geithner has structured the PPIP28 to require as little new money up front as possible. The program supplies market participants with free put options and attractive financing to motivate them to buy impaired assets from troubled banks. Rather than spend money it doesn’t have and is unlikely to get, 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. The obvious goal is to entice private capital in place of public capital by socializing risk. A less obvious but also important goal is to shield bank balance sheets from the volatility of lower marks on their assets, which in turn may help reduce volatility in the markets and the economy more generally.

It remains to be seen, however, whether PPIP will ultimately do as much good to recapitalize the financial system as cold, hard cash. And nobody has yet figured out how to provide fiscal stimulus by writing put options. Whether one admires the PPIP’s creativity or condemns its deceit, from a purely political perspective its structure shows how undesirable Congress finds the idea of providing more taxpayer money for fiscal remedies.

international Politics – the china syndrome

Debtors must be mindful of their creditors, so let us review some basic facts regarding the largest foreign holder of America’s debt. Of the $6.3 trillion in US Treasury debt held by the public (i.e. net of intra-governmental holdings), roughly $3.1 trillion is held by foreign sources as of January 31, 2009, and the largest holder is China with $740 billion. Of the roughly $4.8 trillion of agency

25 See “Banking Crises: An Equal Opportunity Menace,” by Carmen Reinhart and Kenneth Rogoff, published December 17, 2008.

26 These f ive crises are ( in alphabetical order by country): Finland in 1991, Japan in 1992, Norway in 1987, Spain in 1977 and Sweden in 1991.

27 This estimate starts with basel ine federal revenue of $2.524 tr i l l ion in FY 2008. It assumes the US federal government revenue contracts 4% in FY 2009, an addit ional 4% in FY 2010 and an addit ional 3% in FY 2011, result ing in revenue losses of $101 bi l l ion, $198 bi l l ion and $268 bi l l ion respectively. (Note that each f iscal year ends on September 30, e.g. FY 2009 ends September 30, 2009.) See Figure 8c and the associated explanation from Reinhart and Rogoff, op. cit. State and local tax revenues are roughly equal to federal tax revenues ( including general revenue items from sources l ike university tuit ion, hospitals, highways, parking faci l i t ies, etc.) and are assumed to contract at the same rate.

28 Public-Private Investment Program

29 The loan guarantee in the assistance to Cit igroup announced November 24, 2008 is similar.

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and GSE backed debt at the end of Q2, 2008, China held almost $530 billion30. These Treasury and agency holdings are part of the massive $2 trillion foreign exchange reserves held by China, which is twice the size of the second largest holder of foreign reserves (Japan at $1 trillion), and of which some 70% is estimated to be US dollar assets31.

China holds such large foreign exchange reserves in order to control the exchange rate of the renminbi; depending upon how one considers it, this puts China in either a weak or a strong position. From one perspective, China is addicted to purchasing ever more foreign securities32 for as long as it wants to maintain the status quo, and must therefore accept the risk of capital losses on its foreign holdings. Several years ago it was probably correct to say that this put China in a weak negotiating position. Today, however, one can see three different ways that China’s reserves are a source of strength.

First, China’s massive reserves now allow it to use its currency as a strategic tool. As Kevin Harrington explained in Clarium’s Q4, 2008 quarterly letter, The Sovereign Exception, 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, many of which look beneficial to China from both an economic and a geopolitical perspective.

Second, 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. It is possible that we saw an example of this last summer, when China’s purchases of US agency33 debt dropped dramatically. China’s 2008 purchases of US agency debt were, by quarter, $15.8 billion, $21.6 billion, $3.1 billion and $2.9 billion. While overall flows of these securities decreased during the same period, China’s reduction was much greater on a percentage basis. The flow of US agency debt dropped from $672 billion in Q2 to $508 billion in Q3 and $292 billion in Q4, or 57% from Q2 to Q4 as compared to China’s 87% reduction during the same period. Note that China’s purchases of Treasuries were quite high during this period when compared to the average throughout the previous year; China’s actions were specifically targeted at the agency market.

Finally, 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. The most radical change would be to float its currency freely; more moderate changes would include decreasing the dollar portion of its reserves and slowing the growth of its reserves altogether. Several years ago one could assume that such changes would probably not be to China’s benefit. Today China has roughly $1.4 trillion in foreign reserves and American consumption will no longer be supported by profligate borrowing. Thus, 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, the world takes notice34.

So long as China believes that America will eschew an inflationary solution, 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. But if America credibly indicates it will

30 The source is the US Treasury Department. The second largest holder of Treasury and agency debt is Japan with $635 bi l l ion and $270 bi l l ion respectively. In contrast to the growth of China’s holdings throughout the decade, Japan’s holdings have been relatively stable for some years. Note that foreign Treasury holdings as of January 31, 2009 is a prel iminary estimate.

31 The source for China’s foreign exchange reserves is the State Administration of Foreign Exchange of the People’s Republic of China; the source for Japan (and comparison with other countries) is the IMF. The 70% estimate is widely reported, although the actual f igure is not precisely known. See for example, testimony by Brad Setser, Foreign Holdings of US Debt: Is our Economy Vulnerable? June 27, 2007.

32 China’s foreign exchange reserves have grown at an extraordinary rate. The compound annual growth rate from 2000 to 2008 is over 36%, which is only just barely slower than the growth rate of 38.5% from 2000 to 2004.

33 The source for al l numbers in this paragraph is the Fed Flow of Funds.

34 See for example, “China Takes Aim at Dollar,” Wall Street Journal, March 24, 2009. The speech is “Reform the International Monetary System,” published March 23, 2009 by Zhou Xiaochuan.

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pursue genuinely inflationary monetary policy, the prospect of massive capital losses on its dollar reserves may cause China to preempt that action. Given how much America now needs China, it is not clear that America could pursue an outright inflationary policy if China acts to prevent it.

the wizard oF oz

Frank Baum wrote an illustrated children’s novel called The Wonderful Wizard of Oz in 1900. It captured the popular imagination and was turned into a movie in 1939. Today the book and the movie are remembered for the entertaining story, the iconic characters, and the imaginative fantasy world of Oz. 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.

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. In the section, “Follow the Yellow Brick Road,” this essay describes how Ben Bernanke has carefully designed the policy response to avoid inflation. 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.

At the start of her journey on the yellow brick road, Dorothy describes the dreary poverty of her home in Kansas to the Scarecrow. Upon hearing her description he tells her he can’t understand why she would want to leave Oz and return to “the dry, gray place you call Kansas35.” Dorothy replies, “That is because you have no brains. No matter how dreary and gray our homes are, we people of flesh and blood would rather live there than in any other country, be it ever so beautiful. There is no place like home.” Popular culture remembers the final sentence, but forgets the context. Baum was poking fun at Midwesterners who idealized farm life even though the future lay in the migration to the cities. In the section, “There’s No Place like Home,” this essay explains why repairing the financial system will not lead back to Goldilocks. The previous Goldilocks regime was not a happy equilibrium, but instead a highly leveraged and indebted state of affairs. Even a complete restoration of the supply of credit will not forestall a deflationary contraction in its demand. Wherever the path of policy and events will take us, it will not be the “home” of an untenable prosperity where private credit grows faster than our economy.

When Dorothy and her companions arrive at the Emerald City, it appears at first that they have found a utopia of prosperity and good governance. Eventually, however, they learn that the Emerald City is based on lies. The city is not really made of emerald; it only appears green and sparkling because everyone in the city wears goggles that distort their view36. Furthermore, the Wizard lies about his abilities in order to maintain power. He means well, but he is a fraud. Nevertheless, so long as everyone goes along with the charade life is generally good for its inhabitants. The Emerald City represents Washington, DC. In the section, “The Emerald City,” this essay describes the political challenges of changing the policy to be more inflationary. Even if the fear of deflation widens the ideological perspective, politics both at home and abroad may limit what can be done. An angry middle class will demand that Congress tighten its purse strings, while America’s largest foreign creditor will strive to protect its dollar assets.

By 1900, Baum was able to satirize the politics and economics of the 1890s lightheartedly. When William Jennings Bryan gave his famous speech, 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. Because Bryan lost his presidential bid in 1896, the US stayed on the gold standard. Yet to everyone’s surprise, 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. New gold discoveries combined with improvements in mining and refining technology enabled the gold supply to expand steadily,

35 In the movie, this is conveyed by having al l the scenes in Kansas in black and white while al l the scenes in the Land of Oz are in bright Technicolor.

36 This detai l is unfortunately lost in the movie version.

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which caused prices in the United States to rise between 2% and 2.5% per year from 1897 until 191437. Baum published his novel at the beginning of a new Goldilocks regime. Unfortunately, the situation in 2009 is the mirror image of 1900. We are at the end of a long Goldilocks regime that has led to substantial imbalances and indebtedness, 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. Although the character of the Wizard is probably meant to represent President McKinley, in today’s context it is easy to reinterpret him as Ben Bernanke. In the novel, the Wizard could give Dorothy’s companions what they sought – brains for the Scarecrow, a heart for the Tin Man, and courage for the Cowardly Lion – because they already had those qualities. Much like a central banker in normal times, the Wizard mainly needed to supply confidence. But Dorothy’s case was different. When Dorothy asked the Wizard to send her home, he was unable to help her. Unlike the Wizard, Bernanke is honest and capable. But like the Wizard, what is required may lie beyond his abilities. Who today will provide Bernanke with the magic he needs?

paTrICk WOlFF, CFa

Managing Director

Clarium Capital Management llC

37 See Milton Friedman and Anna Jacobson Schwartz, op. cit. Friedman and Schwartz note that this was impossible to foresee at the t ime, and they even go so far as to say that given the impossibi l i ty of predicting this development, abandoning the gold standard might have been the best pol icy to adopt in response to the 1893 panic and subsequent depression, had it been polit ical ly possible to do so.