Wednesday, June 30, 2004

Monetary Policy: What Does Successful Policy Look Like?

In two words: not sexy. In one word, stodgy. The single word to avoid? Superstar. Central banking when properly conducted is utterly boring. There is no cult of personality. There is no celebrity. There is no worship of an individual who runs around "saving the situation". A proper central bank strategy is entirely unexciting, and unnoteworthy except in one single respect - namely that nothing noteworthy has occurred.

What do I mean by this? The Financial Times reports that the central bank has successfully contained inflation.

The eurozone's annual rate of inflation fell to 2.4 per cent in June from 2.5 per cent in May, suggesting price pressures had peaked.

The "flash" estimate on Wednesday by Eurostat, the European Union's statistical unit, appeared to vindicate the European Central Bank's "wait and see" stance on interest rates. May's figure had been driven higher by oil prices but economists now expect inflation to ease in the second half of 2004 and into 2005.

Nevertheless, inflation this year is still likely to exceed for the fifth consecutive year the ECB's price stability target of below but close to 2 per cent. The bank has a rate setting meeting on Thursday , when Wedneday night's decision by the US Federal Reserve will be reviewed. Although the Frankfurt-based central bank is expected to hold rates steady on Thursday an increase in rates is expected later this year by many ECB-watchers who assume the pick-up in economic activity will continue and feed through into the labour market - an indicator of whether a recovery is established.

But Jacques Cailloux, economist at JP Morgan, said the ECB "will only hike when they are confident that the recovery is sustainable" and some economists think rates might yet be cut. Robert Prior at HSBC said the fragile economic recovery and a possible slowdown elsewhere in the world, together with the prospect of inflationary pressures easing and possible economic upsets in the US, meant "our view is that the next move could still be downwards".

Now this isn't "exciting". People don't throw parties when inflation is contained. However what containing inflation means is that while we are going to go through a recession turning down after a year of sputtering force-fed growth, Europe with it's turtle approach compared to our hare is going to gradually pull into a genuine and healthy economic growth stage. The primary purpose of a Central bank is to act as a lender of last resort, insure liquidity, provide credit for economic growth, and price the asset base. All these things sound different but they're just different aspects of the same thing.

The genuine wealth of the country lies in assets - intellectual property assets, human resource assets, property assets, production assets - and the characteristic of an asset is that it has realizable future value. If you can cash it in, it's an asset. The Central bank except insofar as making credit available to businesses and entrepeneurs, cannot create wealth. Wealth is maintained by a positive balance of production against consumption. People use up stuff. It get's old. It needs to be replaced. Or other people need new stuff and services.

Deflation happens when consumption contracts because of structural reasons. People can consume no more (in the long run) than their structural production exchange value. You work, do stuff, make stuff, etc. and you trade that to other people. In exchange you get what you want and/or need. And around and round it all goes.

The idea that the threat of the economy in the last few years has been of deflation has been at once true and laughable. It's laughable because by fighting against it the Federal Reserve has created one of the largest fiscal and financial debacles of all time. When someone is in trouble, there's three ways it can end.

(a) They can continue consuming more than they produce structurally and accrue liabilities. Inevitably they can no longer service ("juggle") their liabilitie and obligations and the house of cards comes down. This is the road of bankruptcy and default. Because of the tendency to make more promissory notes than one can later pay off, it's also the road of inflation and hyperinflation.

(b) They can contract their structural consumption base to meet their production case. One cuts back on spending, to make ends meet from one's income and a bit more to produce a tiny surplus. Using this surplus one pays off one's liabilities and then undergoes slow growth after the contraction. This is the deflation scenario.

(c) One can borrow more money, but not use it for consumption (or speculation) but invest it to produce income producing assets and opportunities. By increasing one's production/income one gains a better financial portfolio and can eventually pay off one's debts. This is the FDR/WWII scenario.

If we had taken the last four years, and reworked Social Security and Medicare, fixed the highways, invested in new scientific research, made our governments more efficient, made the corporations clean up their management, etc. then we would have come out of this situation in a much stronger situation. Only we didn't, so we squandered all the money we borrowed and are even in a worse position financially as a nation than before. We continued consuming at an unsustainable rate without redressing production and income questions. We have lived beyond our means.

In the process we have created a speculative bubble of massive proportions (FT-news) whose first warning signs are only just now being felt.
Freddie Mac profits falls 52%
New York, June 30 (Reuters)

US mortgage finance provider Freddie Mac, struggling to straighten out its books and its reputation after an accounting scandal, on Wednesday reported its 2003 profit fell 52 per cent.

Freddie Mac said the decline was due to a drop in the value of derivatives it uses to hedge against interest rate swings, and warned of similar fluctuations in the future.

"To the extent changes in interest rates continue to be significant, our overall net income will remain volatile," it said in a statement. Freddie Mac in 2003 earned $4.9 billion, or $6.79 per share, down from $10.1 billion, or $14.18 per share, in 2002.

Analysts polled by Reuters Estimates were expecting a 2003 profit of $5.90 per share, with estimates ranging from $5.70 to $6.56 per share.

The government-sponsored mortgage enterprise issued restated earnings through 2002 in November, but delayed financial reports since then while it redesigned its accounting

In a reflection of continued reverberations from the restatement, Freddie Mac said that in preparing its 2003 financial statement, it discovered "immaterial errors" in previous earnings reports but that none of the mistakes would change net income.

"These errors evidence the higher level of operating risk that we are addressing," the company said in a statement.

Freddie Mac and Fannie May control trillions in US real estate loans that are exposed because of both the interest rate situation and the speculative bubble in housing prices. If those households purchasing the mortgages should default and the price of housing fall, then the underlying asset values of those properties will sharply decline. The losses could be in the hundreds of billions, quite easily. At that point the number of household bankruptices, already high, and foreclosures will skyrocket and it won't matter if the government chooses to bail the companies out or not. Inevitably the losses will be large.

This exposure is also just the tip of the iceberg. Because the asset base has become overpriced, a correction in the pricing at the same time the cost of credit is rising will cause large numbers of people to default. Consumer credit is already at an all time high. This could have been avoided, by either demanding as the price of further credit a consolidation of spending or a investment in future income. However in the face of the political failure to do either, restrict spending or invest in strurtural wealth creation, then the central banks duty was clear. It was to refuse to accomodate the political environment and therefore guide the country through an extended economic contraction that would have forced consumption and production to structurally realign.

It should have embraced deflation as consolidation if it would not promote production/income through genuine investment. The cost of allowing this easy money has been the fueling of the speculative asset bubbles that when the market corrects the prices of such it will begin a beggaring of America.


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