Now here’s the scary part: Even though more than half of all American households now own equities directly or through mutual funds, an increase in equity prices does not figure into the Fed’s calculation of inflation. So while measures of core inflation (which exclude food and energy) carefully register minute gains in the price of a fixed basket of goods and services meant to reflect what a typical family buys to achieve a minimum standard of living, they ignore massive price surges in what has effectively become a widely held consumer good: stocks.

Moreover, the Fed’s inflation-targeting approach overlooks price increases for real estate and rising commodity prices. Don’t even mention gold, which has gone from $707 to $1,114 since a year ago.

Even if the Fed seems blithely unaware of the havoc it may be wreaking through its irrationally loose monetary policy, in tandem with the distortions of moral hazard inflicted by intrusive government, Americans seem willing to accept the insanity of boom-and-bust cycles. Sure, we could be facing the latest Fed-induced bubble””but so what?

We need the eggs.

Read it all.

The threats hanging over the central bank could compromise its independence, warn Fed watchers. Several crucial decisions are approaching, including how to continue phasing out its emergency efforts to support the economy. The Fed has already said it will wind down the purchases of mortgage securities in March after buying about $1.25 trillion worth. In the more distant future, to avoid the risk of inflation, the central bank will need to raise its target interest rate above the current level near zero.

Rate increases are always unpopular, particularly when the unemployment rate is still high. But the political environment could make the decision even tougher.

“The current unpopularity of the Fed will make it more difficult for them to raise interest rates when the economy recovers,” said Karen Dynan, a former senior Fed economist who now heads the economic studies program at the Brookings Institution. “With the Fed under such close scrutiny, any move to raise interest rates will be challenged even more strongly than in the past.”

Read it all.

The fiscal 2009 budget deficit, triple that of 2008, was 10 percent of GDP. Lawrence Lindsey says probable policies will produce deficits of 7 percent of GDP for a decade. Ronald Reagan’s worst deficit was 6 percent of GDP and for only one year.

Lindsey — a former member of the Federal Reserve board of governors and director of George W. Bush’s National Economic Council (2001-02) — says Americans’ net worth has dropped at least $13 trillion since the recession began in December 2007. What is to be done?
Americans could suddenly begin saving substantially more, but this would deepen and prolong the recession. Alternatively, America could reflate the value of its assets by printing money. Lindsey says it is already doing that — printing bonds promiscuously and lending money to banks at negligible rates, money that banks can use to buy the bonds. This sharply increases the money supply, which sets the stage either for inflation — too much money chasing too few goods — or for recovery-snuffing higher interest rates to try to prevent inflation. Or for something like Japan’s lost decade — banks pouring money into government bonds rather than the real economy.

America, says Lindsey, will not be Weimar Germany, where hyperinflation caused people to rush to stores with satchels of rapidly depreciating currency. But, he adds, no country has successfully behaved the way the United States is behaving.

Read it all (emphasis mine).

In The Warning, veteran FRONTLINE producer Michael Kirk unearths the hidden history of the nation’s worst financial crisis since the Great Depression. At the center of it all he finds Brooksley Born, who speaks for the first time on television about her failed campaign to regulate the secretive, multitrillion-dollar derivatives market whose crash helped trigger the financial collapse in the fall of 2008.

“I didn’t know Brooksley Born,” says former SEC Chairman Arthur Levitt, a member of President Clinton’s powerful Working Group on Financial Markets. “I was told that she was irascible, difficult, stubborn, unreasonable.” Levitt explains how the other principals of the Working Group — former Fed Chairman Alan Greenspan and former Treasury Secretary Robert Rubin — convinced him that Born’s attempt to regulate the risky derivatives market could lead to financial turmoil, a conclusion he now believes was “clearly a mistake.”

Take the time to watch it all and take special note of who the key characters are.

For the past eight years, the dollar has increasingly become less revered. Its value has been volatile. As the rest of the world saw the United States struggling with a failing war and soaring budget deficits, many who had large dollar holdings began to reduce those reserves (or increase them less than they otherwise would have). All this put downward pressure on the dollar. And thus began the first signs of a vicious circle. The strength of the dollar is becoming riskier and riskier. The growing U.S. deficit and the ballooning of the Federal Reserve’s balance sheets leave many worried that in their wake will come inflation, undermining the long-term attractiveness of the U.S. currency.

In this article, I try to explain why the dollar is in trouble, but ask””should we care? What are the consequences?

Read it all.

Over the last three months, banks put 63 percent of their new cash into euros and yen — not the greenbacks — a nearly complete reversal of the dollar’s onetime dominance for reserves, according to Barclays Capital. The dollar’s share of new cash in the central banks was down to 37 percent — compared with two-thirds a decade ago.

Currently, dollars account for about 62 percent of the currency reserve at central banks — the lowest on record, said the International Monetary Fund.

Bernanke could go down in economic history as the man who killed the greenback on the operating table.

After printing up trillions of new dollars and new bonds to stimulate the US economy, the Federal Reserve chief is now boxed into a corner battling two separate monsters that could devour the economy — ravenous inflation on one hand, and a perilous recession on the other.

“He’s in a crisis worse than the meltdown ever was,” said Peter Schiff, president of Euro Pacific Capital. “I fear that he could be the Fed chairman who brought down the whole thing.”

Read it all.

First, consumer indebtedness is still too high relative to income expectations and credit availability, particularly in the US and the UK. This inconsistency will hold back any sustainable bounce in the most important component of aggregate demand.

Second, some banks’ balance sheets are still too geared for the comfort of regulators or their own managers. This will inhibit them from lending to the real economy at a time when certain sectors (such as commercial real estate, but also residential housing) still require significant refinancing, and when consumers need time to work down their excessive debt loads.

Third, unemployment has risen well beyond expectations, and is likely to prove unusually protracted. It will take years for US unemployment to return to its natural rate, even after the natural rate shifted upwards. This will dampen the recovery of consumption and investment, stress social contracts that assume flexible labour markets, and endanger political support for essential structural reforms.

Finally, public debt has grown so rapidly as to spark concerns about future debt dynamics….

Read it all.

Barack Obama is committing the same mistakes made by policymakers during the Great Depression, according to a new study endorsed by Nobel laureate James Buchanan.

His policies even have the potential to consign the US to a similar fate as Argentina, which suffered a painful and humiliating slide from first to Third World status last century, the paper says.

There are “troubling similarities” between the US President’s actions since taking office and those which in the 1930s sent the US and much of the world spiralling into the worst economic collapse in recorded history, says the new pamphlet, published by the Institute of Economic Affairs.

In particular, the authors, economists Charles Rowley of George Mason University and Nathanael Smith of the Locke Institute, claim that the White House’s plans to pour hundreds of billions of dollars of cash into the economy will undermine it in the long run. They say that by employing deficit spending and increased state intervention President Obama will ultimately hamper the long-term growth potential of the US economy and may risk delaying full economic recovery by several years.

Read it all.

Nouriel Roubini, a leading economist who predicted the scale of global financial troubles, said a U-shaped recovery is possible, with leading economies undeperforming perhaps for 3 years.

He said there is also an increasing risk of a “double-dip” scenario, however.

“I believe that the basic scenario is going to be one of a U-shaped economic recovery where growth is going to remain below trend … especially for the advanced economies, for at least 2 or 3 years,” he said at a news conference here.

“Within that U scenario I also see a small probability, but a rising probability, that if we don’t get the exit strategy right we could end up with a relapse in growth … a double-dip recession,” he added.

Read it all.

Yes, we have avoided a depression. But let us count the costs.

Financial firms that made irresponsible and imprudent decisions have been rescued, propped up and bailed out.

AIG has received about $180 billion. That is almost $2,000 for every American household. That money has gone to sustain the bonuses of AIG and the financial health of its counterparties, such as Goldman Sachs. This is an obscene travesty.

The Fed currently holds $600 billion worth of Fannie, Freddie and Ginnie mortgage-backed securities. I am not optimistic about how that will turn out.

The Fed has injected hundreds of billions of reserves into member banks. This will fuel future inflation unless Bernanke is willing to raise interest rates when the recovery begins. There will be tremendous political pressure on him not to do so. So inflation is likely to come along with any recovery.

Read it all.

President Obama will reappoint Ben S. Bernanke as chairman of the Federal Reserve, administration officials said Monday night, electing to maintain continuity in the nation’s most powerful economic policymaking job in a time of crisis.

The decision, expected to be announced Tuesday morning, ends speculation about the fate of the nation’s top banker. Bernanke won praise for the unprecedented actions taken to contain the recession, but came under withering criticism from lawmakers for not preventing the financial meltdown that dragged the country and the rest of the world into a deep downturn.

If the Senate confirms him, Bernanke would serve a second four-year term when his current one ends on Jan. 31. He would, in his second term, begin the difficult task of unwinding the Fed’s extensive interventions in the economy.

A senior White House official said Obama has been impressed by Bernanke’s handling of the economic crisis over the past year and wants to maintain a steady hand in place as the economy begins to recover.

Read it all.

In late September all eyes will be on the world’s leaders as they gather in Pittsburgh for the Group of Twenty (G20) meeting. Their last gathering at the London Summit in April was hailed as the most important economic meeting since the Great Depression. In my view, the forthcoming G20 meeting is as important, for two key reasons.

First, it is vital that the imminent but fragile global recovery is not blown off-course by premature policy tightening. Second, the global imbalances that contributed to this crisis threaten to be as big an issue in coming years as in the recent past.

World leaders may feel genuinely upbeat when they meet. Policy works, recessions end, may be their message. Yet they must not be complacent, particularly leaders from the West. The recovery, so far, is centred on emerging economies, such as China, where the policy stimulus has been significant.

In contrast, last week both the US Federal Reserve and the Bank of England sent cautious messages. They were right to do so.

Read it all.

Still, as Wessel shows, the Fed in general and Bernanke in particular were hardly blameless in the buildup to the crisis. Under former Fed chairman Alan Greenspan, the central bank probably kept interest rates too low for too long in the wake of the 2001 recession, fueling the housing boom whose bust in the second half of 2007 brought on the Great Panic. The Fed’s policy under Greenspan reflected the intellectual influence of none other than Bernanke, Wessel writes, whose fear of a downward spiral made him “a strong ally of Greenspan’s in making the case that the Fed should keep interest rates low and say so publicly.” Bernanke on that occasion was not necessarily well served by his lifelong focus on depression economics: When you’re a hammer, every problem looks like a nail.

A final verdict on Bernanke’s performance will have to wait until the Fed finishes the job he started. If the U.S. economy has stopped sinking, it is because of the flood of artificial liquidity, released by Bernanke, that has borne it up. The Fed’s next job will be the perfectly timed withdrawal of all that extra money, so as to avoid either roaring inflation or a relapse of deflation. Bernanke’s term ends in 2010, and it’s clear he is itching for a chance to finish what he began, even though President Obama will be sorely tempted to replace him with a Democrat such as Larry Summers, the White House economic adviser (and Bernanke’s longtime intellectual competitor).

A second term for Bernanke would be a good call for Obama if he wants to preserve continuity at the Fed, and if he concludes that Bernanke’s belated but creditable actions merit a reward. But in a sense, the Fed’s job for the next half-decade has already been determined by the course Bernanke chose in the past 18 months. Whoever takes the helm will face the greatest liquidity mop-up in history. And only if the Fed pulls it off can there be a happy ending to the Great Panic, whose scary beginning David Wessel has so effectively narrated.

Read it all.

In concrete terms, the difference between the situation that the Obama advisers predicted and the one that has come to pass is about 2.5 million jobs. It’s as if every worker in the city of Los Angeles received an unexpected layoff notice.

Read it carefully and read it all.

He discusses the Obama administration’s fiscal policy, the U.S. government’s debt and proposed changes to the financial regulatory system.

I happened to catch this yesterday morning. Note especially the concern about the mounting national debt and the mention of the historical parallels with the 1930’s (he sees significant discontinuities there). Watch it all (a little over 10 1/2 minutes).

In three hours of grueling questions from lawmakers armed with e-mail messages and internal documents, the Fed chairman flatly denied accusations that he had threatened to oust the bank’s top management if it pulled out of the deal.

He also denied that the Fed had maneuvered to postpone public disclosures about Merrill Lynch’s spiraling losses until after the merger was completed on Dec. 30, and he denied that Fed officials had kept other financial regulators in the dark about plans to bail out Bank of America in January.

But Mr. Bernanke did not appear to satisfy lawmakers from either party. Republicans accused Mr. Bernanke of strong-arming a private company, which one lawmaker called “socialistic.” Democrats complained that Mr. Bernanke had not been tough enough, and had perhaps been bamboozled into bailing out Bank of America.

Read it all

Not since the second world war have so many governments borrowed so much so quickly or, collectively, been so heavily in hock. And today’s debt surge, unlike the wartime one, will not be temporary. Even after the recession ends few rich countries will be running budgets tight enough to stop their debt from rising further. Worse, today’s borrowing binge is taking place just before a slow-motion budget-bust caused by the pension and health-care costs of a greying population. By 2050 a third of the rich world’s population will be over 60. The demographic bill is likely to be ten times bigger than the fiscal cost of the financial crisis.

Will they default, inflate or manage their way out?

This alarming trajectory puts policymakers in an increasingly tricky bind. In the short term government borrowing is an essential antidote to the slump. Without bank bail-outs the financial crash would have been even more of a catastrophe. Without stimulus the global recession would be deeper and longer””and it is a prolonged downturn that does the greatest damage to public finances. But in the long run today’s fiscal laxity is unsustainable. Governments’ thirst for funds will eventually crowd out private investment and reduce economic growth. More alarming, the scale of the coming indebtedness might ultimately induce governments to default or to cut the real cost of their debt through high inflation.

Read it all.

Despite a slow start, the program could soon expand broadly. Next week, the Fed will add commercial real estate mortgages ”” a vast market ”” to the list of loans it will buy. Eventually, officials say, the TALF program could provide as much as $1 trillion in financing.

Fed officials say they, too, are uncomfortable with their new role and hope to end it as soon as credit markets return to normal. When R.V. manufacturers recently sought a meeting, senior Fed staff members refused to see them in person and instead heard their pleas in a conference call.

The central bank is increasingly having to make politically sensitive choices. For example, it is weighing whether loans to people who buy speedboats and snowmobiles are as worthy of help as those to people who buy cars. And it is being besieged by arguments from R.V. manufacturers and strip-mall developers that they play a crucial role in the economy and also deserve help.

Many of the decisions could have political repercussions. On Feb. 9, President Obama traveled to Elkhart, Ind., a Republican stronghold that Democrats hope to convert to their column. Elkhart is also home to much of the R.V. industry, which has been battered by the recession.

Count me among the deeply uncomfortable. Speedboats? This is nuts. Read it all–KSH.

President Obama was getting his daily economic briefing one recent morning when a fly distracted him. The president swatted and missed, just as the pest buzzed near the shoes of Lawrence H. Summers, the chief White House economic adviser. “Couldn’t you aim a little higher?” deadpanned Christina D. Romer, the chairwoman of the Council of Economic Advisers.

Mrs. Romer was joking, she said in an interview, adding, “There are only a few times that I felt like smacking Larry.” Yet few laughed in the president’s presence.

If the Oval Office incident was meant as a lighthearted moment, it also exposed the underlying tensions that have gripped Mr. Obama’s economic advisers as they have struggled with the gravest financial crisis since the Depression, according to several dozen interviews with administration officials and others familiar with the internal debates.

Read it all.

The Federal Reserve chairman, Ben S. Bernanke, said on Wednesday that the United States needed to develop a plan to restore fiscal balance, even as the government builds huge budget deficits as it tries to spend its way out of the worst economic crisis since the Great Depression.

In remarks to the House Budget Committee, Mr. Bernanke said that the government must address the immediate problems of a crippling recession that has erased trillions of dollars in household wealth, hobbled investment portfolios and raised unemployment to its highest levels in a generation. Still, he said, the government needs to think about putting its fiscal house back in order.

“Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth,” he said.

Read it all.

Another, more helpful way of looking at what is happening is to see it as a change in perception of where risk lies. Of course, there is risk in equities ”“ how could there not be with the prospect of the once-mighty General Motors filing for bankruptcy? But there is also risk in bonds, including dollar bonds issued by AAA governments. So, as you can see in the graphs, the dollar/sterling rate has come sharply back, reflecting a change in the relative perception of risk between the two countries. More significant still has been the rise in the interest rate on 10-year bonds issued by the US, the UK and eurozone governments. As you can see, the interest rate on 10-year US bonds spun down from about 4 per cent in the middle of last year, to close to 2 per cent at the turn of the year. Now it is heading back to 4 per cent again. Those are astounding swings. If you have bought at the right moment last summer, and then sold at the right moment, you could just about have doubled your money. December buyers would now be facing a large loss.

Now look ahead. What will happen over the next decade, particularly in the US? Tax revenues have collapsed, while spending has soared, as the third graph shows. The US federal government is raising only about 55 cents in taxation for every dollar it spends. The rest has to be borrowed, either from foreign countries such as China and Japan, or by artificially creating the stuff by borrowing from the US Federal Reserve system. In the latter case the debt is being “monetised”, the practice that normally happens only in wartime or in Latin America and which threatens massive inflation (the US mechanism for monetising debt is slightly different from our own “quantitative easing”, but the effect is pretty much the same).

This cannot go on, as President Barack Obama acknowledges. “We are,” as he puts it, “out of money.” So what will happen?

It is very hard to know because there are no obvious precedents.

Read it carefully and read it all.

If the US government had a FICA score it would be around 245 according to University of Washington Professor Telda Wang.

The Federal Reserve’s latest forecasts for the U.S. economy are gloomier than the ones released three months earlier, with an expectation for higher unemployment and a steeper drop in economic activity.

The Fed’s forecasts, released as part of the minutes from its April meeting, show that its staff now expects the unemployment rate to rise to between 9.2% and 9.6% this year. The central bank had forecast in January that the jobless rate would be in a range of 8.5% to 8.8%, but the unemployment rate topped that in April, hitting 8.9%.

Read it all.

Where does this leave us? The Federal Reserve is caught; policymakers are warily watching the economy, worried that their liquidity injections will catch fire. On the other hand, they suspect that the economy will demand greater stimulus, if their estimates of the Taylor Rule are any guide. Caught, they want to remain flexible, and hence are unwilling to commit to numerical targets, either money growth or long rates. Hard to blame them; for the last decade, excessive easing has always caused something seemingly good that was followed by something very bad. But with the output gap certain to widen, the bias will be on the side of additional easing, while the timing will be data dependent. The green shoots story is looking a little tired today; a wide swath of indicators in the commodities market suggests that overall demand remains subdued. That will not stop a segment of market participants from playing up the green shoots story – they want to get ahead of the next big move. I remain wary that there is any room for an easy bounceback; I can’t shake off memories of 2001-2003, and I don’t see where we get another asset bubble in the US to crank up the wealth engine.

Read it all.

Mr. Obama is betting that the totality of economic policies his team and the Federal Reserve have put in place will act, like radiation therapy, to halt the spread and reduce the size of the cancerous tumors eating away at our financial system ”” and stimulate enough new growth and optimism so that Phase II will be small enough to get past Congress and the public.

As Treasury Secretary Timothy Geithner told ABC News, “If we get to that point” ”” where more funds are needed ”” “we’ll go to the Congress and make the strongest case possible and help them understand why this will be cheaper over the long run to move aggressively.”

Have no doubt, Phase II is coming. At best, it will require hundreds of billions of dollars more, at worst more than a trillion, to deal with more bad loans and toxic assets weakening the economy ”” problems that Phase I can’t fully absorb. Because unemployment is still rising ”” ensuring that the initial spate of mortgage defaults, which came from loans to people who could never repay, will be followed by another spate of defaults from those who could repay but now can’t because the deteriorating economy has stripped them of their jobs, their businesses or their credit lines.

Read it all.

Without a doubt, this crisis is now Ben Bernanke’s war.

Bernanke has become the country’s economist in chief, the banker for the United States and perhaps the world, and has employed every weapon in the Federal Reserve’s arsenal. He has overseen the broadest use of the Fed’s powers since World War II, and the regulation proposals working their way through Congress seem likely to empower the institution even further. Although his actions may be justified under today’s circumstances, Bernanke’s willingness to pump money into the economy risks unleashing the most serious bout of U.S. inflation since the early 1980s, in a nation already battered by rising unemployment and negative growth.

If he succeeds in restarting growth while avoiding high inflation, Bernanke may well become the most revered economist in modern history. But for the moment, he is operating in uncharted territory.

Read it all.

Here is the real plan that now seems odds on to succeed.

The Plan: Dump $500 billion of toxic assets on to unsuspecting taxpayers via a public-private partnership in which 93% of the losses are born by the taxpayer.

—Mish in his latest analysis of the Geithner “plan”

Take a look.

The Obama administration will detail on Thursday a wide-ranging plan to overhaul financial regulation by subjecting hedge funds and traders of exotic financial instruments, now among the biggest and most freewheeling players on Wall Street, to potentially strict new government supervision, officials said.

The Treasury secretary, Timothy F. Geithner, will outline the broad revamping of the regulatory system, which goes further than expected, in a hearing on Thursday. He is expected to say that the new rules are necessary to prevent a repeat of the excesses that nearly wrecked the global financial system and plunged the economy into a recession.

The plan, which would require congressional approval, would give the government vast new powers over “systemically important” banks and other financial institutions that are so big that their collapse would jeopardize the economy as a whole.

Read it all.

…[DONALD MARRON] I hope the government has set it up that, once it gets going, they can change the terms, as the market gets more comfortable, as more confidence this thing is actually going to work, isn’t as concerned about what the Congress is going to do as they are in the case of TALF.

So this is getting things going. There needs to be flexibility in the future. I’m assuming Tim Geithner and Larry Summers have thought that through. So once we get it started, we can make sure it becomes a positive continuing force and not some kind of a windfall.

JEFFREY BROWN: Well, Mr. Krugman, go ahead. Argue back. That’s the argument is, you need to attract investors, so…

PAUL KRUGMAN: I don’t think that’s the issue, really. I mean, there’s a lot of people who’ve got money parked in the banks. The problem is that people — it’s the banks as institutions that are the issue, not whether people are willing to buy these particular assets.

In a way, we’d like to make the whole story of these assets go away. The only reason that they’re there, the only reason it’s an issue is because the banks have lost so much money that they are not effective at their job of passing funds from one end of the economy to the other.

This is not going to change that. I mean, it’s going to make some of the stuff sell for a slightly better price, but the banks are still going to be deep underwater, at least the troubled ones are going to be. It’s going to convey some windfall benefits to people who are holding some of this paper who are not actually crucial financial intermediaries.

Read it all. I am on the Paul Krugman side of the argument, believing this treats symptoms rather than the disease. I would love to be wrong–KSH.