Bernanke Ponders the "Nuclear" Option

Rolling the Dice
By MIKE WHITNEY

Ben Bernanke's speech on Friday in Boston could turn out to be a real barnburner. In fact, there's a good chance the Fed chairman will announce changes in policy that will stun Wall Street and send tremors through Capital Hill. Along with another trillion or so in quantitative easing, Bernanke is likely to appeal to congress for a second round of fiscal stimulus, this time in the form of a two-year suspension of the payroll tax. That's what he figures it will take to jump-start spending and rev-up the flagging economy. It could be an extraordinary intervention.

Bernanke laid out the details in a speech he gave in May 2003 to the Japan Society of Monetary Economics, in which he outlined the policies Japan should enact to beat deflation. Here's what he said:

“Rather than proposing the more familiar inflation target, I suggest that the BOJ consider adopting a price-level target, which would imply a period of reflation to offset the effects on prices of the recent period of deflation. Second, I would like to consider an important institutional issue, which is the relationship between the condition of the Bank of Japan's balance sheet and its ability to undertake more aggressive monetary policies.... Finally, and most important, I will consider one possible strategy for ending the deflation in Japan: explicit, though temporary, cooperation between the monetary and the fiscal authorities."

There it is. Bernanke is planning to reflate asset prices, purchase more government bonds, and enlist congress's support to pump liquidity into the broader economy. It's an ambitious strategy that could push the dollar over the edge, but the alternatives are equally bleak. Bernanke knows that "at best" GDP will hover around 1 to 2 per cent through 2011 while the public grows increasingly restless about soaring unemployment. He also knows that when interest rates are stuck at zero the only way the central bank can zap the economy back to life is by increasing inflation expectations. That means, the Fed has to persuade people they've “lost it” and are planning to destroy the currency via the printing presses. It's all baloney. The Fed won't destroy the dollar. They just want to use the element of surprise to give the economy a good jolt. Gold bugs think the Fed is steering the country towards hyperinflation, but they're mistaken. It's all part of a larger calculation.

Bernanke may be a died-in-the-wool class warrior, but he's no moron. His policies are designed to overshoot in order to change expectations and get consumers out of their funk. He even says so in the speech. Here's a clip:

"A concern that one might have about price-level targeting, as opposed to more conventional inflation targeting, is that it requires a short-term inflation rate that is higher than the long-term inflation objective."

The only way to stimulate economic activity is to convince people that the dollar they presently have in their pockets will be worth less tomorrow. That's what puts the Jones's back into the minivan scuttling off to the mall. But what seems like profligate spending on the Fed's part, (QE) is really just a way of restoring the pre-crisis price level. Call it asset inflation if you want, but the bottom line is, Bernanke is not going to sit back while disinflation turns to deflation, the real value of personal debts rise, and the bankruptcies, defaults and foreclosures continue to mount. He's going to pull out all the stops and carpet bomb the economy with monetary and fiscal stimulus. Here, again, is how Bernanke lays out his thesis:

"One possible approach to ending deflation in Japan would be greater cooperation, for a limited time, between the monetary and the fiscal authorities. Specifically, the Bank of Japan should consider increasing still further its purchases of government debt, preferably in explicit conjunction with a program of tax cuts or other fiscal stimulus."

Good. So Bernanke realizes that he can't go it alone. He has to get congress on board if he wants to succeed. (which is probably why the Fed's meeting was scheduled after the midterms)

Bernanke again:

“... Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt--so that the tax cut is in effect financed by money creation. Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent.

Under this plan, the BOJ's balance sheet is protected by the bond conversion program, and the government's concerns about its outstanding stock of debt are mitigated because increases in its debt are purchased by the BOJ rather than sold to the private sector. Moreover, consumers and businesses should be willing to spend rather than save the bulk of their tax cut: They have extra cash on hand, but--because the BOJ purchased government debt in the amount of the tax cut--no current or future debt service burden has been created to imply increased future taxes. Essentially, monetary and fiscal policies together have increased the nominal wealth of the household sector, which will increase nominal spending and hence prices."

This is truly radical, but it could work. And, the quickest way to engage the policy would be by slashing the payroll tax which would, in effect, give every working man and woman in the country a raise in pay.

Bernanke's comments are also a tacit admission that the banking system is still dysfunctional and cannot provide the credit needed for the next expansion, so he is bypassing the privately-owned system altogether and transferring money to consumers directly. Naturally, this will have a positive effect on spending and on any prospects for a recovery.

The cagey Bernanke has even concocted the public relations rationale for fending off the deficit hawks who will undoubtedly point to his plan as an example of wasteful government spending.

Bernanke:

"Isn't it irresponsible to recommend a tax cut, given the poor state of Japanese public finances? To the contrary, from a fiscal perspective, the policy would almost certainly be stabilizing, in the sense of reducing the debt-to-GDP ratio. The BOJ's purchases would leave the nominal quantity of debt in the hands of the public unchanged, while nominal GDP would rise owing to increased nominal spending. Indeed, nothing would help reduce Japan's fiscal woes more than healthy growth in nominal GDP and hence in tax revenues.....More generally, by replacing interest-bearing debt with money, BOJ purchases of government debt lower current deficits and interest burdens and thus the public's expectations of future tax obligations."

The Bernanke plan seems to do everything except whiten teeth. But wouldn't it make more sense to restructure the banking system so the toxic assets can be removed and the banks can lend freely again? And wouldn't it be better to strengthen labor unions (so that wages keep pace with productivity) so workers can generate sufficient demand to keep the economy running smoothly without panicky injections of emergency stimulus? Of course, that would mean a truce in the ongoing class war which wouldn't fly with plutocrats who take joy in seeing the unemployment lines wind from one side of the country to the other.

Bernanke's plan could work. Congress could pass emergency legislation to suspend the payroll tax for two years stuffing hundreds of billions of dollars into the pockets of struggling consumers. The Fed could make up the difference by purchasing an equal amount of long-term Treasuries keeping the yields low while the economy resets, employment rises, asset prices balloon, and markets soar. As the economy rebounds, the dollar will steadily lose ground triggering a sharp rise in commodities and an increase in exports that will spark a clash with foreign trading partners. Then what?

Yes, Bernanke's "nuclear option" could help to resuscitate economy, but it could also erode confidence in the dollar leading to the untimely demise of the world's reserve currency. It's all a roll of the dice.

How to Reverse a Deflation

It's Time for Helicopter Ben to Drop Some Money on Main Street By ELLEN BROWN

In 2002, in a speech that earned him the nickname “Helicopter Ben,” then-Fed Governor Bernanke famously said that the government could easily reverse a deflation, just by printing money and dropping it from helicopters. “The U.S. government has a technology, called a printing press (or, today, its electronic equivalent),” he said, “that allows it to produce as many U.S. dollars as it wishes at essentially no cost.” Later in the speech he discussed “a money-financed tax cut,” which he said was “essentially equivalent to Milton Friedman’s famous ‘helicopter drop’ of money.” You could cure a deflation, said Professor Friedman, simply by dropping money from helicopters.

It seems logical enough. If there is insufficient money in the money supply (deflation), the solution is to put more money into it. But if deflation is so easy to fix, then why has the Fed’s massive attempts to date failed to do the job? At the Federal Reserve’s Jackson Hole summit on August 27, Chairman Bernanke said he would fight deflation with his whole arsenal, including “quantitative easing” (QE) – purchasing longterm securities with money created on a computer. Yet since 2008, the Fed has added more than $1.2 trillion to “base money” doing just that, and the economy is still in a serious deflationary spiral. In the first quarter of this year, the money supply actually shrank at a record annual rate of 9.6%.

Cullen Roche at The Pragmatic Capitalist has an answer to that puzzle. He says that as currently practiced, quantitative easing (QE) is not really a money drop. It is just an asset swap:

“[T]he Fed doesn’t actually ‘print’ anything when it initiates its QE policy. The Fed simply electronically swaps an asset with the private sector. In most cases it swaps deposits with an interest bearing asset.”

The Fed just swaps Federal Reserve Notes (dollar bills) for other assets (promissory notes or debt) that can quickly be turned into money. The Fed is merely trading one form of liquidity for another, without raising the overall water level in the pool.

The mechanics of how QE works were revealed in a remarkable segment on National Public Radio on August 26, describing how a team of Fed employees bought $1.25 trillion in mortgage bonds beginning in late 2008.

According to NPR:

“The Fed was able to spend so much money so quickly because it has a unique power: It can create money out of thin air, whenever it decides to do so. So . . . the mortgage team would decide to buy a bond, they’d push a button on the computer – ‘and voila, money is created.’

“The thing about bonds, of course, is that people pay them back. So that $1.25 trillion in mortgage bonds will shrink over time, as they get repaid. Earlier this month, the Fed announced that it will use the proceeds from the mortgage bonds to buy Treasury bonds – essentially keeping all that newly created money in circulation. The decision was a sign that the Fed thinks the economy still needs to be propped up with extraordinary measures.”

“Extraordinary measures” was a reference to Section 13(3) of the Federal Reserve Act, which allows the Fed in “unusual and exigent circumstances” to buy “notes, drafts and bills of exchange” (debt instruments) from “any individual, partnership or corporation” satisfying its requirements. The Fed was supposedly engaging in these extraordinary measures to “reflate” the money supply and get credit flowing again. Yet the money supply continued to shrink. The problem, as Roche explains, is that the dollars were merely being swapped for other highly liquid assets on bank balance sheets. That this sort of asset swap will not pump up a collapsed money supply has been shown not only by the Fed’s failed experiments over the last two years but by two decades of failed QE policy in Japan, an economy which remains in the deflationary doldrums. To reverse deflation, it seems, QE needs to be directed somewhere else besides the balance sheets of private banks. What we need is the sort of helicopter drop described by Bernanke in 2002 – one over the towns and cities of the real economy.

There is another interesting lesson suggested by two decades of failed QE: it might actually be possible for the government to “print” its way out of debt, without triggering the dreaded hyperinflation long warned of by pundits. Swapping dollars for debt hasn’t inflated the circulating money supply to date because federal debt securities already serve as forms of “money” in the economy.

The Textbook Money Multiplier Model . . .

Beginning with some definitions,“quantitative easing” is explained in Wikipedia like this:

“A central bank . . . first credit[s] its own account with money it has created ex nihilo (‘out of nothing’). It then purchases financial assets, including government bonds, mortgage-backed securities and corporate bonds, from banks and other financial institutions in a process referred to as open market operations. The purchases, by way of account deposits, give banks the excess reserves required for them to create new money, and thus a hopeful stimulation of the economy, by the process of deposit multiplication from increased lending in the fractional reserve banking system.”

“Deposit multiplication” is the textbook explanation for how credit expands as it circulates through the economy. In the textbook model, banks must retain “reserves” equal to 10% of outstanding deposits (including deposits created as loans). With a 10% reserve requirement, a $100 deposit can support a $90 loan, which gets deposited in another bank, where it becomes an $81 loan, and so forth, until a $100 deposit becomes $1,000 in credit-money.

The theory is that increasing the banks’ reserves will stimulate this process, but both the Federal Reserve and the Bank for International Settlements (BIS) now concede that the process has not been working in the textbook way. (The BIS is “the central bankers’ central bank” in Basel, Switzerland.) The futile effort to push more money into bloated bank reserve accounts has been compared to adding more apples to shelves that are already overstocked with apples. Adding more reserves to a banking system that already has more reserves than it can use has no net effect on the money supply.

The failure of QE either to increase bank lending or to inflate the money supply was confirmed in a March 24 paper by Federal Reserve Vice Chairman Donald L. Kohn, who wrote:

“The huge quantity of bank reserves that were created [by quantitative easing] has been seen largely as a byproduct of the purchases [of debt instruments] that would be unlikely to have a significant independent effect on financial markets and the economy. This view is not consistent with the simple models in many textbooks or the monetarist tradition in monetary policy, which emphasizes a line of causation from reserves to the money supply to economic activity and inflation.”

The textbook model is obsolete because banks don’t make lending decisions based on how many reserves they have. They can always get the reserves they need. If customers don’t walk in the door with new deposits, the bank can borrow deposits from other banks, something they can now do at the very low Fed funds rate of .2% (1/5th of 1%). And if those deposits are not available, the Federal Reserve itself will supply the reserves. This was confirmed in a BIS working paper called “Unconventional Monetary Policies: An Appraisal”, which observed:

“[T]he level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans. . . .

“The aggregate availability of bank reserves does not constrain the expansion [of credit] directly. The reason is simple: . . . in order to avoid extreme volatility in the interest rate, central banks supply reserves as demanded by the system. From this perspective, a reserve requirement, depending on its remuneration, affects the cost . . . of loans, but does not constrain credit expansion quantitatively. . . . [A]n expansion of reserves in excess of any requirement does not give banks more resources to expand lending. It only changes the composition of liquid assets of the banking system. Given the very high substitutability between bank reserves and other government assets held for liquidity purposes, the impact can be marginal at best.”

Again, one form of liquidity is just substituted for another, without changing the overall level in the pool.

If bank reserves do not constrain bank lending, what does? According to the BIS paper, “the main . . . constraint on the expansion of credit is minimum capital requirements.” These capital requirements, known as “Basel I” and “Basel II,” were imposed by the BIS itself. It is interesting that the BIS knows that the main constraints on bank lending are its own capital requirements, yet it is talking about raising them, in an economic climate in which lending is already seriously impaired. Either the BIS is talking out of both sides of its mouth, or its writers don’t read each other.

A Solution to the Federal Debt Crisis?

Another interesting aside arising from all this is the suggestion that the government could actually print its way out of debt – it could print dollars and buy back its bonds -- without creating inflation. As Roche observes:

“[Quantitative easing] in time of a balance sheet recession is not actually inflationary at all. With the government merely swapping assets they are not actually ‘printing’ any new money. In fact, the government is now essentially stealing interest bearing assets from the private sector and replacing them with deposits. . . . [T]his policy response would in fact be deflationary – not inflationary.”

Roche concludes, “the inflationistas have been wrong and the USA defaultistas have been horribly wrong.” The “inflationistas” are the pundits screaming that QE will end in hyperinflation, and the “defaultistas” are those insisting that the U.S. must eventually default on its debt. Representing both camps, for example, is Richard Russell, who writes:

“In my opinion, the US MUST default on its debt. There are two ways to default. One is simply to renege on the debt. . . . The other way to default on the debt is to inflate it away. I’m absolutely convinced that this is the path that the US will take. If the US inflates enough, then over time (many years) the devalued dollar will tend to reduce the power of the debts.”

The failed QE experiments in Japan and the U.S. suggest, however, that there is a third alternative. Printing dollars to pay the debt (referred to by Russell as “inflating the debt away”) might actually eliminate the debt without creating inflation. This is because federal bonds and Federal Reserve Notes are interchangeable forms of liquidity. Government securities trade around the world just as if they were money. A $100 bond represents a claim on $100 worth of goods and services, just as a $100 bill does. The difference, as Thomas Edison said nearly a century ago, is merely that “the bond lets money brokers collect twice the amount of the bond and an additional 20%, whereas the currency pays nobody but those who contribute directly in some useful way. . . . Both are promises to pay, but one promise fattens the usurers and the other helps the people.”

The Fed’s earlier attempts at QE involved swapping $1.25 trillion in mortgaged-backed securities (MBS) for dollars created on a computer screen. As noted in the NPR segment, many of those securities have come due and have gotten paid off, putting cash in the Fed’s till. The Fed now proposes to use this money to buy long-term Treasury debt rather than MBS. That means the Fed will, in effect, be buying the government’s debt with dollars created on a computer screen. The privately-owned Federal Reserve is not actually an arm of the federal government, but if it were, the government would thus be printing its way out of debt – just as Helicopter Ben proposed in 2002. Recall that he said, “the U.S. government has a technology, called a printing press” – the U.S. government, not the central bank that has done all the QE to date.

Running the government’s printing presses to pay its bills has not seriously been tried since the Civil War, when President Lincoln saved the North from a crippling war debt at usurious interest rates by printing Greenbacks (U.S. Notes). Other countries, however, have tested and proven this model more recently. They include Germany, which pulled itself out of a massive financial collapse in the early 1930s by printing a form of currency called “MEFO bills”; and Australia, New Zealand and Canada, all of which successfully funded public works in the first half of the twentieth century simply by advancing the credit of the nation. China, Malaysia, Guernsey, Jersey, India, Argentina and other countries have also revived their economies at critical times by this means. The U.S. government could do this too. It could print dollars (or type them into electronic bank accounts) and spend the money on the sorts of local public projects that would put people back to work and get the economy rolling again.

How to Reverse a Deflation

The government could pay its bills by issuing Greenbacks as Lincoln did, but it probably won’t, given the current deadlock in Congress. Today only the Federal Reserve Chairman seems to be in a position to act unilaterally, without asking anyone’s permission. Chairman Bernanke could execute his own plan and generate the credit needed to get the economy churning again, by aiming his “quantitative easing” tool at the states. After all, if Wall Street (which got us into this mess) can borrow at .2%, underwritten by the Fed as “lender of last resort,” then state and local governments should be able to as well. Chairman Bernanke could credit the Fed’s account with money created ex nihilo (out of nothing) and swap it for state and municipal bonds at the Fed funds rate.

A “state” might not qualify as an “individual, partnership or corporation” under Section 13(3) of the Federal Reserve Act, but a state-owned bank would. Bruce Cahan, an attorney and social entrepreneur in Silicon Valley, California, proposes that the Fed could diversify its role by buying long-term bonds in existing or newly-chartered state-owned banks. These banks, which would have a mandate to serve state and local communities, would more quickly and accountably lend for in-state purposes than private banks do now. They could be required to use accepted transparency accounting standards to trace how the proceeds of their loans flowed into the economy. Local needs would thus determine how best to jumpstart and keep alive businesses and households that the “too big to fail” megabanks no longer want to fund on fair credit terms. Adding a state-owned bank would also bring competition to regional banking markets such as that of the San Francisco Bay area, which are now dominated by out-of-state megabanks. By funding state-owned banks, the Fed could inject “liquidity” where it is most needed, in local markets where workers are hired and real goods and services are sold.

Why Lessons From The First Great Depression Mean The Next Four Months Will Be Very Painful For Stockholders

Source: Zero Hedge

Published on 09-03-2010

Scott Minerd, CIO of Guggenheim Partners, parses through the years of the Great Depression, and focuses on the pivotal 1936, which contained in it the seeds for the destruction of the period of relative economic growth and stability from 1932 to 1936, and resulted in a plunge in the economy in the second great recession of the Depressionary period: that of 1937 and 1938. While the first period saw “GNP grow at an annualized rate of 10 percent, the Dow rose approximately 20 percent per annum, and unemployment declined from as high as 25 percent in 1933 to as low as 11 percent in 1937″ the second and much more dire phase of 1937-1938 . saw a unprecedented plunge in economic data: “national output declined by 5.4 percent, unemployment skyrocketed from 11 percent back to 20 percent, the Dow Jones Industrial Average declined 49 percent, and four years of healthy price recovery receded into 3 percent annual deflation.” What precipitated the second collapse? “The short answer is that it was a confluence of factors, a perfect storm of monetary and fiscal policy mistakes” yet the immediate catalyst, if one can be defined was “the fiscal policy missteps of the Roosevelt Administration, who, in an effort to balance the budget after six years of deficits, implemented a series of tax increases in 1936 and 1937 that caused output, prices, and income to fall and sent unemployment skyrocketing.” We are currently faced with precisely the same juncture, and unfortunately for America, things now have a far lower probability of occurring “just as they should” in order for the country to emerge in one piece on the other side of the tunnel. Here is why.

First a question – what caused Rooselvelt to flip out and commence on a series of disastrous economic policies? Minerd explains:

In response to such Republican criticism of his fiscal policies, Roosevelt fired back by issuing the following points in the Democratic Party platform of 1936 (my paraphrase, followed by direct excerpts originally published June 23, 1936):

1. Deficit spending was a result of the crisis inherited from the previous Administration: “We hold this truth to be self-evident – that 12 years of Republican leadership left our Nation sorely stricken in body, mind, and spirit; and that three years of Democratic leadership have put it back on the road to restored health and prosperity.”

2. The Democratic Party restored confidence in America, thus the cost of deficit borrowing had declined to extremely low levels: “We have raised the public credit to a position of unsurpassed security. The interest rate on government bonds has been reduced to the lowest level in 28 years.”

3. The Democratic Party would still balance the budget through the austerity of limited growth in government and by higher taxes: “We are determined to reduce the expenses of government…Our retrenchment, tax, and recovery programs thus reflect our firm determination to achieve a balanced budget and the reduction of the national debt at the earliest possible moment.”

Does any of this seem familiar? It shoud, as should the fact that in his several years in office the budget deficit had soared, and the attempt to balance it resulted first and foremost in an explosion in unemployment, as the chart below demonstrates:

What specifically went wrong to cause the 1937-1938 episode?

Someone once asked me what Roosevelt did that was so bad leading up to the recession of 1937-38. The answer I give is simple: “He attempted to balance the budget at the wrong time.” More specifically, he attempted to balance thebudget by increasing tax revenues at a time when the economy was still finding its footing and the Federal Reserve was attempting to reverse policy. Even after the four years of recovery following the Great Depression, when Roosevelt began his series of tax increases unemployment remained over 12 percent, which on its own would be considered the worst labor market in modern U.S. economic history.

If the Roosevelt Administration’s driving purpose was to prove to the world that it could balance the budget, it was successful. In 1937, the budget deficit declined by 1.9 percentage points in relation to GNP. In 1938, that trend continued with the deficit declining another 1.4 percentage points in relation to GNP. By December of 1938 the Roosevelt Administration had essentially achieved its goal of a balanced budget.

But what was the cost of such actions? According to data from BCA Research, the unemployment rate went from 11.2 percent in May of 1937 to 20.0 percent just 14 months later. Data from the Federal Reserve Bank of Minneapolis shows the overall economy contracted 5.4 percent in 1938. The Dow Jones Industrial Average fell 49 percent from March 1937 to March 1938. Two years later, in March of 1939, the equity market remained depressed, still 30 percent below its March 1937 levels. The U.S. economy, which had whipped unemployment down from 25 percent in 1933 to 11 percent in 1937, limped into the 1940s with unemployment hovering just over 15 percent. The silver lining of all this economic carnage? For one month in 1938 the budget deficit was reduced to just $89 billion dollars – nearly, but not quite balanced.

So have we learned anything from the past? And even if we have, will the imminent expiration of the tax cuts be the equivalent of the tax hike the rapidly plunged America into the biggest economic deterioration at the tail end of the Great Depression? Alas, the answer is probably yes.But not before the Fed embarks on a proper QE strategy, one that has the potential to not only spike asset prices as the Primary Dealers bid up everything that is not nailed down, but this would happen in a time of surging unemployment. With the true unemployment rate already in the 20% ballpark as calculated by objective, non-governmental estimates, will the outcome of the tax changes of 2011 result in the biggest economic catastrophe in US history? We should look back in time for the answer…

It’s evident from Chairman Ben Bernanke’s speech in Jackson Hole last week that the Fed stands ready to continue to provide quantitative easing if necessary. I believe it will be necessary since the economic data in the next few months is likely to be pretty ugly and the rhetoric out of Washington is likely to devolve into a nightly news highlight reel of partisan feuding.

Yet despite the Fed’s commitments, some of the same issues that occurred in 1937 loom on the horizon today. For instance, in the first quarter of 2011 the United States faces massive tax increases. Similar to the mid-1930s, many have argued that deficits must be tamed now and that the economy is healthy enough to sustain austerity measures. Under such political pressure, it appears unlikely that even a portion of the Bush tax cuts will be extended.

There are a host of economic forecasts about the potential size of the fiscal drag that would result from a full expiration of the Bush tax cuts. Macroeconomic Advisers, for instance, believes it will subtract 0.9 percentage points off GDP. ISI Consulting thinks it could be even larger, around 1.2 percentage points. Arthur Laffer, the famed supply-side economist, prefers a number significantly larger, predicting as much as 6 percentage points of fiscal drag. Any way you slice it, if estimates for economic growth in 2011 range from 2 to 3 percent, these tax increases could result in flat to anemic growth and elevate the risk of recession due to the slightest bit of economic turbulence.

In addition to the expiration of the Bush tax cuts, there is the additional cost of healthcare reform. While some would argue that healthcare reform is just a transfer payment program, the fact remains that there will be no incremental healthcare benefits available in the next three years. Therefore, the transfer payments, which are intended to be revenue neutral over the next 10 years, actually create a fiscal drag between 2011 and 2013 before becoming modestly stimulative when the benefits become available from 2014 to 2020.

So what does this imminent change to tax expectations mean for investors in practical terms? Very bad things, especially for those who anticipate a run up in stocks into the mid-term elections: “One clear consequence of the repeal of the Bush tax cuts will be an urgency to accelerate taxable income into 2010. This will have a number of impacts on the market, the most direct being a desire to liquidate positions in equities and other financial assets to realize capital gains before the New Year. This will continue to put downward pressure on equities and increase volatility.”

That’s right: equity liquidations, meaning the long expected second major leg down in stocks is at most 4 months away.

There’s more:

Last week, Bernanke also referenced the importance of a “baton pass” from the economic boosts of government spending and inventory replenishing to the more sustainable support of consumer spending. If equity prices decline in conjunction with the renewed pressure on the housing market as tax incentives are removed, the net effect is likely to be an adverse impact to already fragile consumer sentiment and spending. In essence, the economy is in danger of a fumbled baton pass from 2010 to 2011.

In the face of this uncertainty, and in light of the Jackson Hole remarks, it appears Chairman Bernanke and the FOMC will find it necessary to increase their holdings in long-term securities and increase the size of their balance sheet. This will ultimately lead to lower interest rates and a need to maintain low long-term rates for several years in a hope to prop up the housing market by maintaining record low mortgage rates (see my recent commentary on “The Story in Housing”). What remains to be seen is how severe the economic headwinds will be as a result of the fiscal tightening going into 2011, and how dramatically the Fed will move once it reaches the decision to continue to grow its balance sheet.

In the short run, given the amount of purchases that the Fed will have to make, quantitative easing will most likely swamp the amount of incremental borrowing required by the government, which means that financing the deficit won’t be a problem. Ultimately, however, the U.S. economy will come to the end of the road and inflation concerns will reemerge.

Once the market collapse has transpired, then, and only then, once we enter the proverbial revulsion stage in equities, will the stage be set for an actual bull market:

I believe further quantitative easing is likely to take place in the near term. I also believe there is a strong probability that there will be some form of additional fiscal stimulus passed by the government as it yields to mounting pressure to address the nation’s historically high unemployment rate. After these two events take place, the stage should be set for the green shoots of recovery to reappear in 2011. Once these harbingers of economic health appear, the Fed will come under pressure to convince the market that it has a sound exit strategy to unwind its massive balance sheet. Simultaneously, pressure will reemerge for fiscal austerity and deficit reduction.

As we approach the presidential election of 2012, monetary and fiscal policymakers will be faced with their greatest challenge: whether to reverse the emergency policies applied up to that point, and if so, at what pace and timing to conduct such measures. The risks surrounding these decisions are even greater than the risks that surround the near-term policy decisions about further fiscal stimulus and quantitative easing – taking away support is always more difficult than giving it. The dangers will be strikingly similar to the risks that faced the economy in 1936. Remember, it was Roosevelt’s dash to fiscal discipline in 1936 – combined with the Fed’s misguided decision to tighten monetary policy by doubling the required reserve ratio for banks – that resulted in the severe fiscal drag on aggregate demand and economic output that pulled the economy back into a deep recession.

While I remain optimistic that the current economic “soft patch” will not unravel into a full-blown recession, my concern increases when I look ahead to the challenges the economy will face once it regains its footing. The parallels to 1936 grow increasingly striking the closer one looks to 2012, especially if the green shoots of economic recovery take hold between now and then, which I believe they will thanks to additional policy actions later this year and in early 2011. Oddly enough, the foundation for the recession of 1937-1938 was laid in the election year of 1936. The question remains, will the presidential election of 2012 lay the foundation for a parallel series of events? Given the unprecedented monetary and fiscal policies enacted in recent months, as well as those that are likely to be enacted in the near term, the opportunities for future errors of policy judgment loom large. In light of this, whether it’s in relation to 2010 or 2012, the lessons of 1936 are stark and disturbing.

And while America in 1938 and onward was a different country, whose manufacturing industry and thus real economic output potential, was only starting to stretch its wings, further having the rather tragic benefit of World War II as an unprecedented attractor for record economic activity, the current outlook is far more bleak. The US consumer is on average far older, the pension system is on the verge of bankruptcy, the US’ chief export (at least on a relative basis) is services, and the spectre of a war at this juncture would have far more dire ramifications: a small regional conflict that avoids the participation of the superpowers may have a marginal boost to the economy, but likely nowhere near enough. A full blown collapse into another world war leads to consequences too dire to even imagine. Which is why we agree with Minerd, that while the intermediate steps that occurred in the immediately preceding 1937 period are all in line, and which the government will only have itself to blame if it screws up on the transition to a smooth glide slope, the events on the other end of the tunnel look far bleaker.

Does Our Economy Really Have to Run on Fraud?

The Angelides Commission Squints Back at the Bank Bailout and the Fall of Lehman
By MICHAEL HUDSON

What is the difference between today’s economy and Lehman Brothers just before it collapsed in September 2008? Should Lehman, the economy, Wall Street – or none of the above – be bailed out of bad mortgage debt? How did the Fed and Treasury decide which Wall Street firms to save – and how do they decide whether or not to save U.S. companies, personal mortgage debtors, states and cities from bankruptcy and insolvency today? Why did it start by saving the richest financial institutions, leaving the “real” economy locked in debt deflation?

Stated another way, why was Lehman the only Wall Street firm permitted to go under? How does the logic that Washington used in its case compare to how it is treating the economy at large? Why bail out Wall Street – whose managers are rich enough not to need to spend their gains – and not the quarter of U.S. homeowners unfortunate enough also to suffer “negative equity” but not qualify for the help that the officials they elect gave to Wall Street’s winners by enabling Bear Stearns, A.I.G., Countrywide Financial and other gamblers to pay their bad debts?

There was disagreement last Wednesday at the Financial Crisis Inquiry Commission now plodding along through its post mortem hearings on the causes of Wall Street’s autumn 2008 collapse and ensuing bailout. Federal Reserve economists argue that the economy – and Wall Street firms apart from Lehman – merely had a liquidity problem, a temporary failure to find buyers for its junk mortgages. By contrast, Lehman had a more deep-seated “balance sheet” problem: negative equity. A taxpayer bailout would have been an utter waste, not recoverable.

Lehman CEO Dick Fuld is bitter. He claims that Lehman was unfairly singled out. After all, the Fed lent $29 billion to help JPMorgan Chase buy out Bear Stearns the preceding spring. In the wake of Lehman’s failure it seemed to gain the courage to say, “Never again,” and avoided new collapses by bailing out A.I.G. – saving all its counterparties from having to take a loss.

Was this not a giveaway? .Fuld implied. Why couldn’t the Fed and Treasury do for Lehman what they did with other Wall Street investment firms and stock brokers: let it reclassify itself as a bank so it could pawn off its junk mortgages at the Fed’s discount window for 100 cents on the dollar, sticking taxpayers with the loss? (And by the way, will these firms ever be asked to buy back these mortgages at the price they borrowed against from the government? Or will they be allowed to walk away from their debts in a Wall Street version of “jingle mail”?)

This is the soap opera that Americans should be watching, if only it weren’t conducted in the foreign language of jargon and euphemism. At issue is whether Lehman’s crisis was merely a temporary “liquidity problem,” that time would have cleaned up; or, did the firm suffer a more deep-seated “balance sheet problem” (negative equity), as Federal Reserve Chairman Ben Bernanke claims – a junk balance sheet, composed of assets that not only had no buyers at the time, but had no visible likelihood of recovering their market price even after the $13 trillion the Treasury and Federal Reserve have spent to bail out Wall Street.

Insisting that Lehman should have shared in Washington’s $13 trillion giveaway, . Fuld testified that his firm was just as savable as Countrywide or A.I.G. – or Fannie Mae for that matter. Lehman was perversely singled out, he claims. Was it not indeed as savable as the Fed and Treasury claim the U.S. real estate sector is? Like over-mortgaged homeowners, all it needed was enough time to finish selling off its portfolio, given enough loan support to tide it over.

The problem, of course, is that the securities that Lehman hoped to pawn off were fraudulent junk. American homeowners are victims, not crooks. Wall Street bailed out crooks at Countrywide and its cohorts. The credit-rating agency Fitch has found financial fraud in every mortgage package it has examined. And these are the packages that have made Wall Street rich and powerful enough to gain Washington bailouts to establish them as a new ruling class, bailouts to use for buying up Washington politicians and lawmakers, and for buying out the popular press to tell people how necessary Wall Street financial practice is to “support” the economy and “create wealth.”

Could any other daytime telecast have a more typecast villain than Fuld? A novelist would be hard-put to better personify greed, arrogantly playing bridge with his boss while Lehman burned. Yet his testimony has a certain logic. If the negative equity suffered by a quarter of U.S. homeowners can be saved, as the Fed claims it can, where should the line be drawn?

Or to put this question the other way around, why are ten million American homeowners being treated like Lehman, if the Fed believes that they are as savable as Countrywide and A.I.G.?

Huge sums are at stake, because the bailout has left little for Social Security, and nothing to bail out the insolvent states and cities, or for more stimuli to pull the national economy out of depression.

Most relevant in Fuld’s self-pitying defense before the Angelides Committee is not what he said about his own firm, but his accusation that the Fed and Treasury rescued the rest of Wall Street. Weren’t other firms just as bad? Why was Lehman singled out?

The Fed’s witnesses gave a devastating reply. They drew a clear distinction between a temporary “liquidity problem” and outright negative net worth – the “balance-sheet problem” of insufficient assets to cover one’s debts. Lehman was so badly managed, the Fed claimed, so reckless and arrogant in its belief that it could cheat its customers by selling junk at a huge markup, that it could not have been rescued except by an outright taxpayer giveaway. As the Fed’s Chief Counsel, Scott Alvarez, put matters: “I think that if the Federal Reserve had lent to Lehman … in the way that some people think without adequate collateral … this hearing and all other hearings would have only been about how we had wasted the taxpayers’ money – and I don’t expect we would have been repaid.” Like the city of Oakland, in Gertrude Stein’s derisive phrase, there wasno “there” there.

Included in the hearings’ evidence is an exasperated e-mail sent by Treasury Secretary Hank Paulson’s chief of staff, Jim Wilkinson, on Sept. 9, 2008: “I just can’t stomach us bailing out Lehman. Will be horrible in the press.” Five days later, on Sept. 14, he added that unless a private buyer could be found (e.g., as JPMorgan Chase stepped forward to buy Bear Stearns), “No way govt money is coming in … also just did a call with the WH [White House] and usg [U.S. Government] is united behind no money … I think we are headed for winddown.” (1)

Lehman’s problem was not just temporary illiquidity. It had a fatal balance-sheet problem: Its assets were not worth anywhere near what it owed. So with poetic justice, it was in the same position as the subprime borrowers whose junk mortgages it had underwritten and sold to investors gullible enough to believe Moody’s and Standard and Poor’s AAA ratings. This fraudulent junk was supposed to be as safe as a U.S. Treasury bond. But it turned out to be only as safe as Social Security and state pension promises are in today’s “Big fish eat little fish” world.

Yet . Fuld is correct in pointing out that not only Bear Stearns and A.I.G., but also Morgan Stanley and Goldman Sachs would have failed without state support. So the question remains: Why bail out these firms (and their counterparties!) but not Lehman?

This is too narrow a scope to pose the proper question. What needs to be discussed is the result of Washington arranging for Wall Street to repay its TARP, A.I.G. and other bailout money – including that of Fannie Mae and Freddie Mac – by “earning its way out of debt” at the “real” economy’s expense. Why has Washington refused to write down the bad debts of homeowners, states and cities, and companies facing bankruptcy unless they annul their pension promises to their employees? Why is Washington is treating the American economy like it treated Lehman and telling it to “drop dead”?

The explanation is that a double standard exists. The wealthy get bailed out – the creditors, not the debtors. And even the fraudsters, not their victims.

Sidestepping the Fraud Issue

Recent federal bankruptcy proceedings have exposed Lehman’s deceptive off-balance-sheet accounting gimmicks such as Repo 105 to conceal its true position. No fraud charges have yet been levied, but this is the invisible elephant in the Washington committee rooms. “Everyone was doing it,” so that makes it legal – or what is the same thing these days, non-prosecutable in practice. To prosecute would be to disrupt the financial system – and it is Fed doctrine that the economy cannot survive without a financial system enabled to “earn its way out of debt” by raking off the needed wealth from the rest of the economy?

So the Fed, the Treasury and the Justice Department have merely taken the timid baby step of pointing out that Lehman suffered from such bad management that no firm was willing to buy it out. Barclay’s was interested, but . Fuld was so greedy that he found its offer not rich enough for his taste. So he ended up with nothing. It is a classic morality tale. But evidently not fraud.

The fraud issue lies as far outside the scope of the financial committee meetings as the question of how the economy should cope with its unpayably high mortgage, state and local debts in the face of its inadequately funded pension obligations. Fed Chairman Bernanke testified on Thursday, September 2, that “the market” itself breeds what most people would call fraud. Widening the market for home ownership necessarily involves lowering loan standards, he explained. But as the Lehman failure illustrates, where should we draw the line between “illiquidity” and insolvency on the one hand, and higher risk and outright fraud?

The Fed argues that the economy cannot recover without a solvent financial system. But what about that large part of the financial system based on fraud? Would the economy fall apart without it – without mortgage fraud, without deceptive packaging of junk mortgages, and for that matter without computerized gambling on derivatives? What of the credit-ratings agencies whose AAA writings were as much up for sale as the conscience and honesty of politicians on the Senate and House Banking Committees? Do we really need them?

And does the economy need more credit (that is, debt)? Or does it need jobs? Does it need to un-tax the banks and give tax-favoritism to Wall Street (“capital gains” tax rates) to enable it to earn its way out of debt at the expense of the production-and-consumption economy?

The question that Washington financial committees should be asking (and economics textbooks should be posing) is whether wider home ownership is really dependent on easier and looser lending standards. After all, the effect of easy credit is to enable borrowers to bid up housing prices. Is this really how to make the U.S. economy more competitive – given the fact that industrial labor now typically pays 40 per cent of its wage income for housing?

Or, does the Fed’s easy-money policy deregulation of oversight open the way for asset-price inflation that puts home ownership even further out of reach – except at the price of running up a lifetime of debt to the banks that write the loans on their keyboard at steep markups over their cost of funding from the compliant Fed?

Qui bono?

Who is to benefit from the Fed’s easy money policy – consumers and homeowners, or Wall Street? This is the broad issue that should be discussed. What would have happened without the bailout? (Remember, Republican Congressmen opposed it – before that fatal Friday when “maverick” John McCain rushed back to Washington and said he would not debate . Obama that evening unless Congress approved the bailout of his Wall Street backers.) What if it had been the debtors who were bailed out by a write-down of bad debts, instead of the lenders who had made bad loans and the large institutions that bought them?

The bailout has saddled taxpayers not only with $13 trillion that now must be sacrificed by the economy at large (but not by Wall Street), with the cost of a decade-long depression resulting from keeping the bad debt on the books. This is what rightly should be deemed criminal.

Defenders of Wall Street insist that there was no alternative. And the committee hearings are carefully only listening to such people, because these are very respectable hearings. They are writing mythology, almost as if they are crafting a new religion. In this new ethic, Wall Street financial institutions – “credit creators,” that is, debt creators – are supposed to fund industry, not strip assets or make bad loans. Without rich people, who would “create jobs”? Such is the self-serving logic of Wall Street. For them, Wall Street is the economy. The wealth of a nation is worth whatever banks will lend, by collateralizing the economic surplus for debt service.

What the Angelides Commission really should focus on is whether this is true or false. That would make it a soap opera worth watching. The Fed so far has stonewalled attempts to discover just who was bailed out in autumn 2008? But most important of all is, what dynamic was bailed out? What class of people?

The answer would seem to be, financial firms employing and serving the nation’s wealthiest 1 per cent? Any and all fraudsters among their ranks? (There has not been a single prosecution, as Bill Black reminds us.) Or the remaining 99 per cent of the population – their bank deposits and indeed, their jobs themselves?

Academic textbooks pretend that the economy is all about production and consumption – factories producing the things their workers buy. The distribution of wealth does not appear, nor is it regularly tracked in statistics. But in Washington and at the hearings, the economy seems to be all about lending and debt, all about balance sheets.

I believe that the beneficiaries were fraudsters, and that the system cannot be saved. Trying to save it by keeping the debts in place – and letting Wall Street banks “work their way out of debt” at the U.S. economy’s expense – threatens to lock the economy in a chronic debt deflation and depression.

At issue is the concept of capital. Does money that is made by short-term, computer-driven financial trades qualify as “capital formation” and hence deserving of tax breaks? Are the billions of dollars of “earnings” reported by Wall Street speculators to be taxed at the low 15 per cent “capital gains” rate? That is only a fraction of the income-tax rate that most workers pay – on top of which is piled the 11 per cent FICA wage withholding for Social Security and Medicare that all workers have to pay on their salaries up to the cut-off point of about $102,000. (This cut-off frees from this tax the tens of millions of dollars that hedge fund traders pay themselves.) Or should these trading gains – a zero-sum activity where one party’s gain is, by definition, another’s loss (usually one’s customers) – be taxed more highly than poverty-level income of workers?

A short while ago the Blackstone hedge fund’s co-founder, Stephen Schwarzman, characterized the attempt to tax short-term arbitrage trading gains at the same rate that wage-earners pay as analogous to Adolph Hitler’s invasion of Poland in 1939. It is a class war against fraudsters and criminals – an unfair war as serious as World War II. In Schwarzman’s apocalyptic vision the Democrats are re-enacting the role of Adolph Hitler by mounting a fiscal blitzkrieg to force billionaires to pay as high a tax rate as workers. Are not Wall Street firms doing “God’s work,”as Goldman Sachs chairman Lloyd Blankfein, put it last fall? And if they are, then are not those who would tax or criticize Wall Street “God-killers”?

If religion can be turned on its head like this – where the Invisible Hand of Wall Street (invisible to the Justice Department, at least) is elevated to a faux-Deist moral philosophy – is it any surprise that economic orthodoxy and formerly progressive tax policy are succumbing? The rentiers are fighting back – against the Enlightenment, against Progressive Era tax policy, and against hopes for U.S. economic recovery. Given today’s florid emotionalism when it comes to discussing Wall Street finances, it hardly is surprising that the Angelides hearings do not dare venture into such territory as to ask whether the bottom 90 per cent of the U.S. economy might need to be bailed out with debt relief just as Wall Street’s elites were.

On Thursday, Fed Chairman Bernanke tried to put the financial flow of funds that led up to the crisis in perspective. In his testimony before the Financial Crisis Inquiry Commission he described a self-feeding process that actually started with the U.S. balance-of-payments deficit that made foreigners so flush with dollars. They understandably wanted yields higher than the Treasury was paying, as the Fed was flooding the economy with credit to keep asset prices afloat to save the banks from having to take loan write-downs and admit that debt creation was not really the same thing as Alan Greenspan euphemized in calling it “wealth creation.” So foreign financial institutions became a large but overly trusting market for packaged junk mortgages.

When asked just who was pushing the great explosion of mortgage lending, Bernanke pointed to the mortgage packagers – Wall Street profiting from the commissions and rake-offs it was making by pretending that the loans were not bad. However, he reminded his audience, there also had to be popular demand for housing. People were panicked. They worried that if they did not buy a home back in 2005, they could not afford to buy in the future. And they were cajoled with financial televangelists assuring them that they would always enjoy the option of selling at a profit. But Bernanke said nothing about fraud in all this. To widen the market for home ownership, banks had to write more mortgages, and this required lowering their standards.

So they did it all for us, for “the people” – and the backers of Fannie Mae and Freddy Mac who egged them on.

Where does “lowering loan standards” turn into outright fraud? Has that simply become part of “the market”? This is what the commission seems to fear to address. But it is getting late – already we are in September, and the report is scheduled for December. So is this really going to be “it”? This would be like a soap opera ending in the middle of the desert, with the main protagonists stranded. This seems to be where the Commission is leaving the U.S. economy as it waits for the recommendations of the Joint Commission to Roll Back Social Security, or whatever the name of Obama’s Republicanized Democratic commission is more formally called. The result is more like the cliffhanger of a serial, leaving the viewer to try and imagine how the protagonist – in this case, the economy – will ever manage to be saved.

Afraid of Deflation?

Try Some Medicine
By PAUL J. LIM
Published: August 7, 2010

AS chatter has grown about the possibility of a double-dip recession, so, too, have fears about another “D” word: deflation.

Late last month, Jeremy Grantham, the chief investment strategist at GMO, an investment firm based in Boston, issued a warning about deflation after worrying for months that inflationary pressures were brewing. Mr. Grantham told GMO clients recently that as the recovery has slowed, “downward pressure on prices from weak wages and weak demand seems to me now to be much the larger factor.”

In doing so, he joined a growing list of prominent analysts — including William H. Gross, the co-chief investment officer of Pimco — who’ve raised concerns that consumption may be postponed and growth thwarted if price declines occur throughout the economy.

Long periods of deflation are quite rare. In fact, before Japan’s on-again, off-again experience with deflation starting in the 1990s, you have to go all the way back to the Great Depression to find another sustained bout of this trend in the developed world.

As a result, if deflation were actually to strike in the United States — and that is a big “if” — investors might not be able to draw from their own experience to determine how best to position their portfolios.

So what are investors to do?

One textbook strategy is to buy long-term Treasury bonds, which many people already appear to be doing as a hedge against general economic troubles. Yields on 10-year Treasury securities have plunged to 2.8 percent from about 3.8 percent in late April.

In the 1930s, this strategy proved successful in combating deflation, as long-term government bonds generated nominal total returns of nearly 5 percent a year, versus annualized losses of 0.1 percent for equities during that decade, according to Ibbotson Associates.

Strategists who’ve expressed concerns about deflation aren’t necessarily predicting a return to protracted, Depression-era downward price spirals. “We’re certainly not positioning for a Japan-like scenario,” said Ben Inker, a colleague of Mr. Grantham’s who is GMO’s head of asset allocation.

Robert D. Arnott, chairman of the asset management firm Research Affiliates in Newport Beach, Calif., said that while a brief bout of modest deflation was a threat in the short run, inflation — or rising prices that eat away at consumers’ purchasing power — remained the bigger long-term menace.

He said that growing fears over deflation made it more likely that policy makers would overreact in their attempts to stimulate growth in the economy. And that, in turn, means that “inflation is still what you have to worry about down the road,” he said.

As a result, Mr. Arnott isn’t focusing entirely on near-term deflation. Rather than buying long-term Treasuries, he suggests an investment in Treasury inflation-protected securities, or TIPS.

Mr. Arnott argues that if inflation begins to become a threat two or three years down the road, having the inflationary hedge of a TIPS bond will protect an investor against rising prices — which is something that a regular Treasury bond won’t do.

In the meantime, individual TIPS are still government bonds backed by the full faith and credit of Uncle Sam. And even if Mr. Arnott is wrong and deflation persists for years, investors who buy individual TIPS will at least have the security of being able to recoup the face value of their bond at maturity, while still earning a yield of around 1.2 percent a year.

Now that’s 1.6 percentage points less than what regular Treasuries of equivalent maturities are paying. But, Mr. Arnott asks, “What are the chances of inflation being less” than that for a decade?

If you truly fear deflation, fixed-income securities — because of their relative safety and the income they throw off — will most likely be better than equities, money managers say. But they note that investors need to be choosy about the types of bonds they buy.

Among corporate securities, investors should pay attention to companies’ balance sheets. “You want to avoid highly leveraged companies,” said Carl P. Kaufman, manager of the Osterweis Strategic Income fund. In a deflationary environment, a debt-ridden company would have to pay back obligations with increasingly valuable dollars. “In inflation, you’re cheapening the value of dollars over time,” Mr. Kaufman said. “In deflation, it’s the opposite: dollars become dearer over time.”

Fixed-income investors may want to focus on high-quality companies that routinely generate tons of cash. The same argument goes for equity investors as well.

Sam Stovall, chief investment strategist at Standard & Poor’s, says that in deflationary times, some stocks could actually post gains. Throughout the 1990s, when the Japanese stock market began to crater under the weight of deflationary forces, technology, telecommunications and health care shares rose on local markets.

INVESTORS who want to maintain their stock weightings should consider “high-quality, large, blue-chip companies that have balance-sheet strength,” said Brian McMahon, chief investment officer at Thornburg Investment Management in Santa Fe, N.M. He said companies like Google and Microsoft often have an added advantage: dominance over their industries, enabling them to maintain their prices even if others in the industry start to lower theirs.

Stocks that pay dividends would also make sense, because the cash thrown off by these shares would be quite valuable in a deflationary environment.

In fact, said Mr. Inker of GMO, if investors really fear deflation, they might consider increasing the cash in their portfolios. “There’s a strong case for building up dry powder,” he said. “If something bad happens economically — whether it’s deflation or inflation — that’s generally provides a good buying opportunity for investors who have some cash to put to work.”

The Death of Paper Money

As they prepare for holiday reading in Tuscany, City bankers are buying up rare copies of an obscure book on the mechanics of Weimar inflation published in 1974.

By Ambrose Evans-Pritchard

Ebay is offering a well-thumbed volume of "Dying of Money: Lessons of the Great German and American Inflations" at a starting bid of $699 (shipping free.. thanks a lot).

The crucial passage comes in Chapter 17 entitled "Velocity". Each big inflation -- whether the early 1920s in Germany, or the Korean and Vietnam wars in the US -- starts with a passive expansion of the quantity money. This sits inert for a surprisingly long time. Asset prices may go up, but latent price inflation is disguised. The effect is much like lighter fuel on a camp fire before the match is struck.

People’s willingness to hold money can change suddenly for a "psychological and spontaneous reason" , causing a spike in the velocity of money. It can occur at lightning speed, over a few weeks. The shift invariably catches economists by surprise. They wait too long to drain the excess money.

"Velocity took an almost right-angle turn upward in the summer of 1922," said Mr O Parsson. Reichsbank officials were baffled. They could not fathom why the German people had started to behave differently almost two years after the bank had already boosted the money supply. He contends that public patience snapped abruptly once people lost trust and began to "smell a government rat".

Some might smile at the Bank of England "surprise" at the recent the jump in Brtiish inflation. Across the Atlantic, Fed critics say the rise in the US monetary base from $871bn to $2,024bn in just two years is an incendiary pyre that will ignite as soon as US money velocity returns to normal.

Morgan Stanley expects bond carnage as this catches up with the Fed, predicting that yields on US Treasuries will rocket to 5.5pc. This has not happened so far. 10-year yields have fallen below 3pc, and M2 velocity has remained at historic lows of 1.72.

As a signed-up member of the deflation camp, I think the Bank and the Fed are right to keep their nerve and delay the withdrawal of stimulus -- though that case is easier to make in the US where core inflation has dropped to the lowest since the mid 1960s. But fact that O Parsson’s book is suddenly in demand in elite banking circles is itself a sign of the sort of behavioral change that can become self-fulfilling.

As it happens, another book from the 1970s entitled "When Money Dies: the Nightmare of The Weimar Hyper-Inflation" has just been reprinted. Written by former Tory MEP Adam Fergusson -- endorsed by Warren Buffett as a must-read -- it is a vivid account drawn from the diaries of those who lived through the turmoil in Germany, Austria, and Hungary as the empires were broken up.

Near civil war between town and country was a pervasive feature of this break-down in social order. Large mobs of half-starved and vindictive townsmen descended on villages to seize food from farmers accused of hoarding. The diary of one young woman described the scene at her cousin’s farm.

"In the cart I saw three slaughtered pigs. The cowshed was drenched in blood. One cow had been slaughtered where it stood and the meat torn from its bones. The monsters had slit the udder of the finest milch cow, so that she had to be put out of her misery immediately. In the granary, a rag soaked with petrol was still smouldering to show what these beasts had intended," she wrote.

Grand pianos became a currency or sorts as pauperized members of the civil service elites traded the symbols of their old status for a sack of potatoes and a side of bacon. There is a harrowing moment when each middle-class families first starts to undertand that its gilt-edged securities and War Loan will never recover. Irreversible ruin lies ahead. Elderly couples gassed themselves in their apartments.

Foreigners with dollars, pounds, Swiss francs, or Czech crowns lived in opulence. They were hated. "Times made us cynical. Everybody saw an enemy in everybody else," said Erna von Pustau, daughter of a Hamburg fish merchant.

Great numbers of people failed to see it coming. "My relations and friends were stupid. They didn’t understand what inflation meant. Our solicitors were no better. My mother’s bank manager gave her appalling advice," said one well-connected woman.

"You used to see the appearance of their flats gradually changing. One remembered where there used to be a picture or a carpet, or a secretaire. Eventually their rooms would be almost empty. Some of them begged -- not in the streets -- but by making casual visits. One knew too well what they had come for."

Corruption became rampant. People were stripped of their coat and shoes at knife-point on the street. The winners were those who -- by luck or design -- had borrowed heavily from banks to buy hard assets, or industrial conglomerates that had issued debentures. There was a great transfer of wealth from saver to debtor, though the Reichstag later passed a law linking old contracts to the gold price. Creditors clawed back something.

A conspiracy theory took root that the inflation was a Jewish plot to ruin Germany. The currency became known as "Judefetzen" (Jew- confetti), hinting at the chain of events that would lead to Kristallnacht a decade later.

While the Weimar tale is a timeless study of social disintegration, it cannot shed much light on events today. The final trigger for the 1923 collapse was the French occupation of the Ruhr, which ripped a great chunk out of German industry and set off mass resistance.

Lloyd George suspected that the French were trying to precipitate the disintegration of Germany by sponsoring a break-away Rhineland state (as indeed they were). For a brief moment rebels set up a separatist government in Dusseldorf. With poetic justice, the crisis recoiled against Paris and destroyed the franc.

The Carthaginian peace of Versailles had by then poisoned everything. It was a patriotic duty not to pay taxes that would be sequestered for reparation payments to the enemy. Influenced by the Bolsheviks, Germany had become a Communist cauldron. partakists tried to take Berlin. Worker `soviets' proliferated. Dockers and shipworkers occupied police stations and set up barricades in Hamburg. Communist Red Centuries fought deadly street battles with right-wing militia.

Nostalgics plotted the restoration of Bavaria’s Wittelsbach monarchy and the old currency, the gold-backed thaler. The Bremen Senate issued its own notes tied to gold. Others issued currencies linked to the price of rye.

This is not a picture of America, or Britain, or Europe in 2010. But we should be careful of embracing the opposite and overly-reassuring assumption that this is a mild replay of Japan’s Lost Decade, that is to say a slow and largely benign slide into deflation as debt deleveraging exerts its discipline.
Japan was the world’s biggest external creditor when the Nikkei bubble burst twenty years ago. It had a private savings rate of 15pc of GDP. The Japanese people have gradually cut this rate to 2pc, cushioning the effects of the long slump. The Anglo-Saxons have no such cushion.

There is a clear temptation for the West to extricate itself from the errors of the Greenspan asset bubble, the Brown credit bubble, and the EMU sovereign bubble by stealth default through inflation. But that is a danger for later years. First we have the deflation shock of lives. Then -- and only then -- will central banks go to far and risk losing control over their printing experiment as velocity takes off. One problem at a time please.

An Avoidable Depression

(Whenever someone says the word "recovery" pertaining to the current US economy, they are lying or they are stupid. Bet on the former, not the latter...--jef)

***

Land of Squandered Opportunity
By MIKE WHITNEY

The economy has gone from bad to worse. On Friday the Commerce Department reported that GDP had slipped from 3.7% to 2.4% in one quarter. Now that depleted stockpiles have been rebuilt and fiscal stimulus is running out, activity will continue to sputter increasing the likelihood of a double dip recession. Consumer credit and spending have taken a sharp downturn and data released on Tuesday show that the personal savings rate has soared to 6.4%. Mushrooming savings indicate that household deleveraging is ongoing which will reduce spending and further exacerbate the second-half slowdown. The jobs situation is equally grim; 8 million jobs have been lost since the beginning of the recession, but policymakers on Capital Hill and at the Fed refuse to initiate government programs or provide funding that will put the country back to work. Long-term "structural" unemployment is here to stay.

The stock market has continued its highwire act due to corporate earnings reports that surprised to the upside. 75% of S&P companies beat analysts estimates which helped send shares higher on low volume. Corporate profits increased but revenues fell; companies laid off workers and trimmed expenses to fatten the bottom line. Profitability has been maintained even though the overall size of the pie has shrunk. Stocks rallied on what is essentially bad news.

This is from ABC News:

"Consumer confidence matched its low for the year this week, with the ABC News Consumer Comfort Index extending a steep 9-point, six-week drop from what had been its 2010 high....The weekly index, based on Americans’ views of the national economy, the buying climate and their personal finances, stands at -50 on its scale of +100 to -100, just 4 points from its lowest on record in nearly 25 years of weekly polls...It's in effect the death zone for consumer sentiment."

Consumer confidence has plunged due to persistent high unemployment, flat-lining personal incomes, and falling home prices. Ordinary working people do not care about the budget deficits; that's a myth propagated by the right wing think tanks. They care about jobs, wages, and providing for their families. Congress's unwillingness to address the problems that face the middle class has led to an erosion of confidence in government. This is from the Wall Street Journal:

"The lackluster job market continued to weigh on confidence. The share of consumers who expected the job market to improve in the next six months fell to 14.3% in July, the second-straight monthly drop and the lowest reading since March...Views of business conditions also worsened. The share of people who expected conditions to improve over the next half-year fell to 15.9% in July, the lowest since April 2009." ("Home prices rise but outlook for sector dims", Conor Dougherty, Wall Street Journal)

No one believes that the U.S. is the land of opportunity anymore or that their children will have a better life than they did. As the slump deepens, pessimism will turn to desperation, higher crime and social unrest. Everyone pays for long-term unemployment.

Factory orders, household purchases and personal consumption expenditures (PCE) are all in the dumps. New mortgage applications and home sales have plummeted to historic lows. Housing prices are expected to follow the downward trend in sales. Still, the stock market lunges upward in fits-and-starts utterly disconnected from the underlying "real" economy where personal balance sheets are in a shambles and where 6 applicants battle for every new job opening.

This is from Naked Capitalism:

"A Wells Fargo/Gallup survey of 604 small business owners conducted in early July showed a plunge in already negative readings to new lows. This gloomy outlook matters because small businesses were the biggest source in job creation in the last upturn and are expected again to be the main source of hiring.

Even worse, small business owners expect things to get worse. The main reason for the decline in the index was the decay in the Future Expectations subindex, which is the first time business owners as a whole have been negative about their companies’ prospects for the upcoming year."("Small Business Sentiment Hits New Low", Naked Capitalism, Yves Smith)

Washington has sold out its small businesses to Wall Street and the multinationals. America's jobs-generating engine is kaput. Expect more outsourcing, more offshoring, more tax-dodging, and more middle class bloodletting for the foreseeable future.

Unlike stocks, the bond market reflects the true condition of the economy. 2-year Treasuries are at historic lows, while the 10-year has dipped below 3%. The flight-to-safety is pushing bond yields down even while equities continue to surge. Deflationary pressures are building. Bondholders are not taken-in by the cheery news of green shoots. They know how to read the data--spending is down, credit is tight, unemployment is headed higher, the banks are hiding their red ink, Europe's in trouble, manufacturing is about to slide, housing is in freefall, the money supply is shrinking, and the Fed is sitting on its hands doing nothing. When industry-leader Proctor & Gamble missed analysts estimates on Tuesday, it became clear that product prices would be slashed in an effort to retain market share. When prices fall, inventories are reduced and workers are laid-off. That's how the downward spiral begins.

The next leg down will be falling wages and collapsing asset prices. That will increase unemployment and put more pressure on bank balance sheets leading to another round of bank closures. The Fed will be forced to restart quantitative easing (QE)--the central bank's bond-purchasing program designed to pump liquidity into the economy when interest rates are stuck at zero. Here's an excerpt from the New York Times:

"Pay cuts are appearing most frequently among state and local governments, which are under extraordinary budget pressures and have often already tried furloughs, i.e., docking pay in exchange for time off.....Some businesses are also cutting workers’ pay, often to help stay afloat or to eliminate their losses, although a few have seized on the slack labor market and workers’ weak bargaining power to cut pay and thereby increase their profits and competitiveness…

Factory owners sometimes warn that they will close or move jobs to lower-cost locales unless workers agree to a pay cut. In its most recent union contract, General Motors is paying new employees $14 an hour, half the rate it pays its long-term workers.

Sub-Zero, which makes refrigerators, freezers and ovens, warned its workers last month that it might close one or more factories in Wisconsin and lay off 500 employees unless they accepted a 20 percent cut in wages and benefits." ("More Workers Face Pay Cuts, Not Furloughs", Steven Greenhouse, New York Times).

The economy is slipping fast into deflation, but there's still time to act. The bond market is telling us that the economy needs more fiscal stimulus. The labor market is telling us that the economy needs more fiscal stimulus. The housing market s telling us that the economy needs more fiscal stimulus. Manufacturing, consumer spending, consumer credit and bank lending are all telling us that the economy needs more fiscal stimulus. Every sector and data-point is telling us the economy needs more fiscal stimulus. But congress, the White House, and the myriad far-right think tanks and foundations won't budge. They want debt consolidation, austerity measures, structural adjustment and belt-tightening. "That is what the market demands", they opine. Here is a response from economist J.Bradford DeLong from his blog "Grasping Reality With Both Hands":

"What else does history tell us? It tells us that in 1925 Chancellor of the Exchequer Winston Churchill was ill-served when he rejected the arguments of John Maynard Keynes and accepted the arguments of his Treasury staff that Britain required retrenchment and austerity: Churchill thus gave Britain a three-year head start on suffering from the Great Depression.

It tells us that from 1930-1936 the belief of government after government of France’s Third Republic that if only they retrenched a little longer that the confidence of world capital markets in France would be so great that it could escape the Great Depression unscathed: the length of the Great Depression and the class war thus engendered in France weakened it enormously in the late 1930s.....” 

It teaches us that Weimar German SPD leader Rudolf Hilferding was extremely ill-advised to commit the SPD to policies of retrenchment and austerity when his labour economist Wladimir Woytinsky was calling for the SPD to develop a plan for a New Deal for Germany. And it teaches us that in his memoirs U.S. President Herbert Hoover, who was bitter about many things, was bitterest that he had let Treasury Secretary Andrew Mellon hamstring Hoover’s progressive impulses and lead the Hoover administration to policies of retrenchment and austerity.

History teaches us that when none of the three clear and present dangers that justify retrenchment and austerity--interest-rate crowding-out, rising inflationary pressures on consumer prices, national overleverage via borrowing in foreign currencies--are present, you should not retrench and austerity: don’t call the fire truck when there is no smoke. And history teaches us that when economies suffer from high unemployment, enormous excess capacity, incipient deflation, businesses terrified of a lack of customers, and an enormous excess demand for high quality assets, then is the time for expansion and stimulus: when the deck is awash, start bailing. ("Jean-Claude trichet rejects the counsels of history", J.Bradford DeLong, "Grasping Reality With Both Hands")

Policymakers are determined to drag the country into another Depression. And that's the tragedy.

Looming Changes at the Fed

Will the US Repeat Japan's Mistakes?
By MIKE WHITNEY

The Fed is mulling over its options for dealing with an outbreak of deflation. For a long time, Fed chairman Ben Bernanke dismissed the idea that deflation could be a problem because, as he noted, "The Fed has a technology called the printing press which allows the Fed to produce as many dollars as it wished at no cost." That's true, but increasing the money supply has not worked as planned. Bernanke has stuffed the banks with $1.7 trillion in reserves, but lending is still in the tank, consumer credit is shrinking at 5% per annum, and M3 has slipped into negative territory (- 6%). True, there's plenty of money, but it's not circulating fast enough (velocity) through the economy to produce a robust recovery. That's why Bernanke is looking for new ideas.

Last Thursday, James Bullard, President of the Federal Reserve Bank of St. Louis, issued a paper titled "Seven Faces of 'The Peril'" which warned that the US economy "may become enmeshed in a Japanese-style deflationary outcome within the next several years." The presentation surprised many because, up until then, Bullard had been more concerned about inflation. Now he's joined the deflationistas. As one of the central bank's brightest stars, Bullard's recommendations are worth considering as they are likely to shape future monetary policy.

Regrettably, Bullard is locked in the same ideological box as Bernanke and is equally committed to the same type of Friedmanite monetarism. Here's a key quote from the document which summarizes his analysis of the problem the economy faces: "I emphasize two main conclusions:

(1) The FOMC's "extended period" language may be increasing the probability of a Japanese-style outcome for the US, and

(2) on balance, the US quantitative easing program offers the best tool to avoid such an outcome." ("Seven Faces of 'The Peril'", James Bullard, The Federal Reserve Bank of St. Louis)

Bullard figures that the Fed's "extended period" (of zero rates) language is sending the wrong message to consumers and, thus, and lowering inflation expectations. This is critical, because the Fed wants people to believe that the currency in their wallets today will be worth less tomorrow. That way, they'll be more inclined to spend freely and give the economy a much-needed boost. But now--according to Bullard-- everyone assumes the Fed will keep rates at rock bottom for the foreseeable future, so the policy has become counterproductive. The solution: Change the language and adjust the policy so it reflects the Fed's determination to achieve its target rate of inflation. To do that, the Fed must "credibly raise the inflation target" which means restarting the Fed's bond purchasing program (quantitative easing).

Bullard is persuasive, but his analysis ignores the central problem, which is that people are so far in debt they need time to dig out before they can spend again. For Bullard, the fact that people are broke is a minor inconvenience that can be resolved by luring them into taking on more debt. In fact, the Fed's manipulation of inflation expectations is a subtle form of social engineering that works like this: The Fed expands its balance sheet by exchanging trillions in reserves for government (or, perhaps, corporate) bonds which scares the bejesus out of ordinary working people who figure the government is deliberately debasing the currency to create hyperinflation. Naturally, people figure that their best choice is to maximize their buying power by spending their money as soon as possible. This is the Bullard/Bernanke remedy; getting people to buy more things they don't need with money they don't have.

Bullard fails to mention that Bernanke's first round of quantitative easing never sparked a credit expansion or even increased inflation expectations. In fact, the dollar has grown stronger, bond yields have plunged, and deflationary pressures have continued to mount. Where's the beef? Bullard's thesis may sound convincing, but there's zero evidence that it will work.

Bullard does not put a price-tag on his plan, but the costs are bound to be significant. Every economist who has explored the issue, believes that to "credibly raise the inflation target" will require many trillions of dollars. Keep in mind, that the Fed's objective is to convince people that it is debauching the currency by "monetizing the debt". In reality, it is just exchanging one asset for another. The Fed can drain reserves as it pleases. There's no immediate danger of inflation.

As for the costs; here's an excerpt from a post by economist Bradford DeLong who puts a price on what is being called "QE2":

"The Federal Reserve has already increased the monetary base to a previously unimaginable extent and has doubled its balance sheet to $2 trillion. Even though there is good reason to think that further increases in the money stock alone will have little effect on the economy--that conventional monetary policy is tapped out--the Federal Reserve could always further increase its balance sheet to $3 trillion or $4 trillion. Such quantitative easing would be highly likely to eliminate fears of possible deflation or other lower tail risks and act as a powerful spur to investment. Such an enormous expansion of the balance sheet would produce a qualitative improvement in the assets held by the private sector, which would greatly reduce risk spreads and make funding available to American companies on much more attractive terms."

("A Keynesian voice crying in the wilderness", Bradford DeLong, Grasping Reality with Both Hands)

It is worth mentioning that Bullard rejects the Keynesian approach which would implement massive fiscal stimulus to sustain positive growth while the private sector repairs its balance sheet. The St. Louis Fed chief argues that to achieve that goal, the government would have to (credibly) "threaten to behave unreasonably" for a long period of time. (to change inflation expectations) Considering the gridlock on Capital Hill over budget deficits and "austerity measures", Bullard sees little possibility that congress would support such a strategy. He's probably right.

Bullard is correct in anticipating a "Japanese-style deflationary outcome", but his grasp of what happened in Japan appears to be sketchy at best. The Japanese tried quantitative easing, but the bond purchasing program failed to revive the economy or reignite consumer spending. Bullard thinks that Japan's central bank just threw in the towel too soon; that if they stuck with it, eventually the plan would have succeeded. But is the Fed really willing to make a multi-trillion dollar leap of faith on such flimsy evidence?

Nomura's chief economist, Richard C. Koo, has written brilliantly on Japan's battle with deflation, ("US Economy in Balance Sheet Recession: What the US can learn from Japan's Experience 1990-2005") labeling the phenomenon a "balance sheet recession", which means that people have reoriented their behavior from "profit maximization" to "debt minimization" strategies. Koo understands that consumer spending is not an inexhaustible resource that can be tapped into by merely lowering rates or adjusting inflation expectations. There are limits to how much debt people will take on. This is a lesson that neither Bullard nor Bernanke seem to grasp.

Koo's razor-sharp analysis is invaluable for anyone who wants to understand the present state of the economy. He provides a blueprint for easing the effects of deleveraging and for lifting GDP from the doldrums. His Keynesian solutions are the exact opposite of Bullard's, in fact, he states unequivocally that, "Fiscal policy is the only real remedy for balance sheet recession". Koo insists that once the government commits to fiscal stimulus, it must sustain deficit spending until the private sector has patched its collective balance sheet and is able to spend again at precrisis levels. That will take a long time and require political consensus.

The Fed doesn't have the tools to reverse the slide into deflation or to stop the hellstorm of debt liquidation and default. Low interest rates have lost their traction and another round of QE won't help. The economy has reset at a lower level of activity and monetary policy alone cannot create sufficient demand to sustain the recovery. When the private sector is deleveraging, fiscal remedies are needed to make up for flagging consumer spending and dwindling business investment. The best monetary policy can do, is make money cheaper (lower interest rates) and increase reserves at the banks by purchasing long-term government bonds. But increasing reserves does not put money in the hands of the people who will spend it and generate growth. In fact, there are times when people will not borrow no matter how cheap or available money is, which is why the Fed is unsuited for the task ahead. It's time for Obama to step up and do what's needed.

Koo notes that it took 15 years for Japan to muddle through its balance sheet recession, mainly because the problem had not really been understood before. "Now that the experience of Japan is available for anyone to see," Koo opines, "there's no reason for the US to repeat the same mistake."

Koo's "must read" report can be found here: "US Economy in Balance Sheet Recession: What the US can learn from Japan's Experience 1990-2005", Richard C. Koo, Chief Economist, Nomura Research Institute

(NB--Pay special attention to the graphs which show the effects of Quantitative Easing.)

That Big Sucking Sound in the Economy Is the Threat of Serious Deflation

Members of the Fed have started warning that full-blown monetary deflation may be coming. That, not the deficit, could really put the US economy in ruin.
By William Greider, The Nation
July 31, 2010

The economic specter stalking Barack Obama is not the nonsense debate that captivates deficit hawks and witless political reporters. It is the threat of a full-blown monetary deflation that would truly put the US economy in ruin. In a general deflation, everything falls--prices, output, wages, profits. Unchecked, this can lead to another Big D--the Depression Obama claims he has avoided.

Depression was the fate that befell Herbert Hoover after 1929 and the outlines of this larger catastrophe are present again. It is easy to dismiss deflation warnings from curbstone critics, including from me. But it is more significant--and truly scary--when senior policy makers of the Federal Reserve begin to express the same fear, as the New York Times reported today [1]. The Fed has done quite a lot in the last two years to prevent this disaster from unfolding, but some officials are now worried the Fed hasn't done enough.

The central bank understands this danger far better than the over-confident technicians of the Obama administration because deflation led to the Federal Reserve's historic disgrace after 1929. Fed officials then did not understand their wrong-headed policy moves were directly driving the economy into the Great Depression of the 1930s. Today's central bankers do not wish to experience the same shame again.

The Times story reveals a rump group of decision makers within the Fed who are focused on the threat and urging their colleagues to consider more dramatic measures to reverse the deflationary pressures.

Most notably, James Bullard, president of the St. Louis Federal Reserve Bank, warns that Fed policy is putting the US economy at risk of "a Japanese-style deflation within the next several years." This is striking because the St. Louis Fed is traditionally the home of "hard money" monetarists. Their intellectual mentor, Milton Friedman, famously assailed the central bank for its historic failure to reverse the deflation 80 years ago. Liberals and conservatives who compare notes on this subject can come out at roughly the same place.

At least two other regional bank presidents--William Dudley of New York and Eric Rosengren of Boston--share Bullard's concern. They will soon be joined by three new governors, Obama appointees to the Federal Reserve Board in Washington, who are much more sympathetic to liberal anxieties about jobs and the stuttering economy. Janet Yellen, president of San Francisco Fed, is the new vice chair. Peter Diamond and Sarah Raskin will be new governors.

In short, we may be witnessing the opening of an authentic economic debate--one that truly addresses the nation's historic predicament. Let's hope. The terrible trap of deflation gripped Japan for nearly 15 years after its financial collapse in 1989. Japan's economy struggled to restart, but repeatedly fell back into recession. That is one definition of Depression--an economy that cannot get out of the ditch.

Deflation essentially tells everyone to hunker down and wait. Instead of buying big-ticket items, consumers wait for prices to fall further. Instead of investing in new production, companies wait for cheaper opportunities, cheaper labor. The paralysis feeds on itself, once it gets started.

Actually, our situation is more dangerous than Japan's was. The Japanese culture and its economic system are shaped by a functioning commitment to social solidarity that does not exist in the United States. In its worst years, Japan's unemployment rate never rose much above 5 percent. Protective cultural values, embedded in the economic system, would not tolerate it.

The American system, by contrast, readily throws people over the side in the name of free-market efficiency. The pain is distributed first to the weak and defenseless,as we now witness, but the losses creep upward on the social ladder as the recession continues. Deflation would generate the pain more widely, more ferociously.

There is one small silver lining in this grim news. If the Federal Reserve steps up to the deflationary threat, its warnings and actions can give President Obama and Congress a strong opening to change their economic policy too. Forget the stupid deficit scare-mongering. Government must embrace more aggressive fiscal measures--bigger deficits, not little bitty gestures. New stimulus spending is needed to fight off the downward pressures.

That, of course, will require the president to acknowledge what he now denies. The nation is not out of the danger zone. The government must act because it is the only sector in the economy that can lead the way.

Right now, though people are increasingly skeptical, the president is sticking to his optimistic assurances. Prosperity is right around the corner. That was Herbert Hoover's line and it doomed him.