A temporary tariff on Chinese tires still pales in comparison to the estimated 40 percent advantage Chinese exports have as a result of currency manipulation.

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ABC News reports, Pension Fund Approached on Potash Bid:

The head of a major Canadian pension fund says a Chinese sovereign wealth fund is interested in making a joint-bid with a Canadian pension fund for fertilizer-maker Potash Corp. of Saskatchewan Inc.

Leo de Bever, chief executive of Alberta Investment Management Corp., which manages $70 billion Canadian (US$65 billion) in public sector pension funds, said Thursday his fund and other major pension funds in Canada have been approached by an intermediary looking to put together a rival bid to BHP Billiton's $39 billion hostile offer.

De Bever said in an interview on Thursday that he's not interested.

Australia's BHP Billiton Ltd., the world's biggest mining company, launched a hostile $130-a-share takeover on Aug. 18 after Potash directors rejected its offer.

It seems that AIMCo weren't the only ones approached to make a rival bid. CBC reports that PotashCorp takeover bid to get review:

Saskatchewan Energy Minister Bill Boyd said Thursday the province has commissioned an independent review of any takeover of fertilizer maker PotashCorp.

The Conference Board of Canada will analyze the risks and opportunities a deal would present.

Australian miner BHP Billiton launched a hostile $38.6-billion US, or $130-a-share, bid on Aug. 17.

PotashCorp rejected the BHP bid as too low, but a sweetened offer or white-knight bidder has yet to emerge.

The announcement came the same day as a large Alberta-based pension fund said it had been approached by potential rival bidders to help with an offer.

Leo de Bever, CEO of AIMCo, said it has been approached by some government wealth funds and others to make an offer.

De Bever said in a later interview that AIMCo and other funds had been approached by brokers looking to connect Chinese partners with Canadian players, with an eye to taking some kind of run at PotashCorp.

But de Bever cautioned that talks so far had been "academic and preliminary" and that no actual negotiations had taken place.

Chinese, Australian and other companies are also said to be weighing such bids, but they would likely have to line up Canadian financing partners such as AIMCo, the Canada Pension Plan Investment Board or the Ontario Teachers Pension Plan to help facilitate a rival bid.

Generally in these situations, a foreign bidder may seek "local cover" from pension funds to make the bid more "palatable," de Bever said.

AIMCo is one of Canada's biggest investment funds and handles $71 billion in assets on behalf of the Alberta government and its workers.

De Bever said he has had trouble working out an economic justification for a higher bid than BHP's.

"Getting into a bidding war with BHP is not the best way to deploy our capital," he told a news conference in Calgary ahead of the release of the pension fund's annual report.

Maximum benefits

Boyd said the independent review will ensure that the people of Saskatchewan get the maximum benefits from the development of the province's potash industry.

"No matter who owns the potash mines, the people of Saskatchewan own the potash," Boyd said in a release.

The Conference Board will look at how a deal would affect jobs, government revenues, Saskatchewan's position in the global potash industry and its reputation as a place to invest.

The government also wants the review to assess what governments can do to lower risk and increase opportunities.

Boyd said he wants the report done by Sept. 30th and promised to make it public.

He said it will be used in Saskatchewan's submissions to Industry Canada, the federal agency that would review a takeover under the Investment Canada Act.

Boyd Erman of the Globe & Mail reports that these deals are attracting private equity funds to peer down the mine shaft:

The takeover drama unfolding over Potash Corp. of Saskatchewan Inc. has drawn the attention of an unusual tire kicker – the manager of Canada’s national pension plan.

Canada Pension Plan Investment Board has looked at ways to get involved in a bid for Potash, which is hunting for an alternative to a $38.6-billion hostile bid from BHP Billiton. However, it’s a long shot that the pension manager will jump in, sources said.

CPPIB’s private equity arm isn’t the only buyout firm linked to Potash Corp., with China’s Hopu Investment Management Co. reportedly trying to rope together a group to make an offer. Hopu is relatively small, but it has powerful backers, including Singapore’s Temasek sovereign wealth fund.

While it may be tough for any private equity buyer to outgun BHP, the mere fact that funds are nosing around a $40-billion mining takeover battle raises the question: Is this the long-awaited arrival of buyout funds to the mining industry?

The conventional wisdom is that there are a number of obstacles to private equity getting involved with mining. Managers of private equity funds (and their bankers) are wary of political risk from mines in countries with dodgy regimes and of the risk that commodity prices could tank, taking away the cash flow those funds need to pay back loans.

Despite that, as the commodity cycle and private equity boomed in 2007, there were predictions that buyout funds would finally move much more strongly into mining as other sectors became picked over. It never happened. Commodity prices came crashing down as the world slid toward recession, and the credit crisis made it nigh impossible to get loans for any buyout, let alone a cyclical like a miner.

These days, the action in commodities is not in the form of the big headline-grabbing buyouts. Instead, the push has been to invest early in the development cycle. Energy has been busy. Mining less so, but there have been examples such as Inmet Mining Corp. getting $500-million investment from Singapore’s Temasek earlier this year to help finance a new copper mine in Panama.

With early-stage investments, the possible returns are much higher.

“You’re taking a bunch of development risk – capital expenditure, permitting, execution – and so you can get into those at a deep discount,” said Dan Barclay, head of Canadian mergers and acquisitions at BMO Nesbitt Burns. “If you add leverage to that, you can start to see your way to a really good return and a really robust exit scenario: You develop a good mine and you sell it to a big miner.”

For private funds considering large buyouts of existing companies, it’s tougher.

First, there’s not enough access to loans that private equity firms use to increase their returns through leverage. “You can’t get leverage on mining assets like you can on other industrial assets,” Mr. Barclay said. “If you’ve got a mine in the Congo no one is giving you eight times EBITDA for leverage.”

On top of that, it’s tough to compete with buyers who are already in the mining industry and which trade at valuations that make them able to pay more.

Even if it chooses to stay out of the Potash Corp. race, CPPIB is betting that it can make private equity investments in mining and energy work. The fund hired an executive with a mining background who had spent time with BHP Billiton on strategy and acquisitions. The executive, Jeff Donahue, is charged with finding deals in mining and energy.

CPPIB executives, through a spokesperson, declined to talk about the money manager’s strategy in mining, but it’s clear that the pension fund manager has some potential advantages over other buyout shops such as Kohlberg Kravis & Roberts and Blackstone Group.

Those firms have to raise funds from investors and they are expected to return it a few years later. That means selling the investments the funds make, usually in seven years or so. That relatively tight time frame can be risky in a cyclical business.

CPPIB doesn’t need to sell because it has more money pouring in every day from contributions made by Canadian workers. It can hold right through any commodity cycle.

That long hold period also means CPPIB doesn’t necessarily need to shoot for home-run returns right away, so it can sometimes pay more.

Still, it’s unlikely that CPPIB can pay enough to get in on the Potash Corp. bidding against BHP. And if and when CPPIB does show up in the mining buyout game, there’s a good chance it will be the exception rather than the rule.

Will pensions hook up with a Chinese sovereign wealth fund to outbid BHP? Who knows what they've got cooking on this deal? And what about PE funds? The risks are high but the returns are equally attractive. Stay tuned, things are heating up in the commodity space.

I don't like to steal other people's catch phrases (just their posts), but, well, quelle surprise!:

Companies Already Lobbying Fed on Financial Rules, by Michael Crittenden, WSJ: U.S. firms eager to shape newly-passed financial laws have wasted no time in lobbying the Federal Reserve and other agencies, according to new details released Thursday by the central bank. Summaries of 11 meetings involving Fed staff and outside corporations and advocacy groups highlight the high-stakes rulemaking that will occur as U.S. regulators seek to implement the wide-ranging financial overhaul legislation. The meeting log shows representatives from Visa Inc. met with Fed staff just two days after President Barack Obama signed the Dodd-Frank bill into law on July 21. The topics of conversation at that meeting: debit cards and interchange rates charged to merchants. ... The records show Bank of America Corp., J.P. Morgan Chase & Co. and American Express Co. have all met with Fed staff at least once since mid-July to discuss the interchange issue. Firms such as Goldman Sachs Group Inc. and Citigroup Inc. have also discussed tough new rules for derivatives with Fed officials, among others. ... It isn’t just financial firms seeking to discuss the potential changes. The Fed on Aug. 20 hosted a discussion with a group representing firms that use derivatives to hedge risks, so-called “end users”. Those present included executives from Safeway Inc. and Boeing Co., as well as representatives from the American Petroleum Institute and U.S. Chamber of Commerce. ... Notice any interest that aren't being represented here?

The phrase "If they're too big to fail, they're too big to exist" has been heard a lot recently, but I'd add that: "If they're too big for Congress and the Fed to say no to, they're too big to exist."

It appears to me that many firms lobbying Congress and the Fed are, in fact, this big, and the question is whether we will do anything about it. I'm not optimistic that those with the ability to change things will do so as it would involve going against the interests of major campaign contributors. I would love to write a post entitled "Quell Surprise" about how wrong I am about this, I just don't think it's going to happen.

Six months after our last update on the Federal Reserve's balance sheet in visual form, it is time to resume updating readers on what the biggest balance sheet in America looks like, especially since now that Fed is back in the monetization business. So without further ado, here is how Bernanke Capital, LLC looked as of September 1.

• Securities held outright: $2,045 billion 
  • Total Treasury holdings increased from $783 billion to 786 billion, as it bought another $3 billion in USTs as part of QE Lite. Look for this number to grow to well over $1.5 trillion in the next 6 months
  • MBS holdings declined by $8 billion from $1.111 trillion to $1.103 trillion
  • Agency holdings were flat at $157 billion
• Net borrowings: unchanged at $60 billion from the prior fortnight.
• Float, liquidity swaps, Maiden Lane and other assets: $184 billion. FX liquidity swaps are at $44 million. The "value" of Maiden Lane I increased to the highest since November 2008, and was at $16 billion. Maiden Lane II was at $23 billion, while AIA Aurora was $27 billion. 
• The monetary base was $1.995 trillion
• Reserve balances with banks: $1.035 trillion
• Foreign holdings of USTs and MBS hit a fresh weekly high of $3.21 trillion.
• The ratio of Fed assets to the monetary basy was an elevated 1.15x, where it has been for a while.

Yesterday, we discussed Infrastructure spending, following the WSJ article on more tax cuts as a stimulus.

We know from history that rather than temporary tax cuts or spending, its been the big infrastructure projects that leave behind usable assets for the private sector are the biggest bang for the tax backed buck.

Think Interstate Highways, Apollo Space Program, Darpanet (internet), Manhattan Project.

Question: What sort of projects should the US be doing in terms of Infrastructure development?

A couple of quotes from Kathleen Pender at the San Francisco Chronicle: Little support for new home-buyer tax credit"We are not advocating another one. We think it's important for the market to have time to recover on its own," says Walter Molony, spokesman for the National Association of Realtors.
...
"From a political standpoint, with Congress not wanting to increase the debt, it would be too expensive," [Bernard Markstein, senior economist with the National Association of Home Builders] says. "In terms of advisable, we are bordering on where tax credits become ineffective." And HUD Secretary Shaun Donovan said yesterday, via Reuters: No talk of new homebuyer tax credit "It is not high on anyone's list that we have heard. We have not heard Congress talking about renewing it," Housing and Urban Development Secretary Shaun Donovan said in response to a reporter's question about a possible tax credit renewal.

With just one month left in the quarter, most hedge funds continue to underperform the market, not to mention that the vast majority continues to be under their high water mark (most notably Citadel). And with fickle LPs, unbound by lock ups courtesy of the 2008 crash, knowing all too well they can now move their money with the facility of a HFT frontrunner churning AMZN one thousand times a second, threatening redemptions unless something changes in the last month of the quarter, hedge funds are, for lack of a better word, panicking. Yet as we have long been demonstrating, the vicious loop of high correlations and mutual fund withdrawals means that alpha generation is gone the way of the dodo. Which means that HFs will now seek to actively lever up into the market to chase the beta wave over September like never before. This is indeed confirmed by TrimTabs latest Hedge Fund Flow Report, which finds that the percentage of HF managers expecting to raise their leverage exiting August is 21.2%, the highest in 4 months, and possibly all of 2010, and triple the 7.7% responding affirmatively in May. And as riding a leveraged beta wave is nothing but a coin toss on the market with dire consequences if wrong, look for market volatility in September to hit multi-month highs, especially if macro economic conditions continue to deteriorate and investors are forced to buy against the grain. 

The chart below shows the trend of increasing desperation in the hedge fund community:

Here is TrimTabs explanation:

Hedge fund managers are also more inclined to lever up than they were last month. About 21% expect to increase leverage in the next month, sharply higher than 14% in July. Only 11% of managers aim to decrease leverage in the coming weeks, the smallest share since the start of our survey in May. We suspect managers are feeling bolder because recent outflows proved relatively mild. We estimate that hedge funds redeemed only $2.7 billion in June and $3.0 billion in July. Managers were much more reluctant to increase leverage when credit fears in Europe triggered concern about another liquidity crisis.

Additionally, TrimTabs has found that bearish sentiment on stocks in August is the highest it has been since May. Of course, the simplistic contrarian view is that with so many bears out there, the market is poised to rebound.

Hedge fund managers have turned markedly more bearish on equities. About 47% of the 104 managers we surveyed in the past week are bearish on the S&P 500, up sharply from 33% in July. Bullish sentiment decreased to 17% from 34%. The August bearish reading of 47% is the highest since May’s reading of 52%, which bodes ill for equities.

Yet despite the increasing alleged equity bearishness, there was no corresponding increase in NYSE short bets, and in fact, July saw a decline, making one wonder just how truthful the sampled respondents were in their answers:

Bearish sentiment did not prompt a spike in short bets. Indeed, NYSE Short Interest decreased 1.7% in July to land 5.4% south of the June peak. We suspect Short Interest declined because the strength of the July rally took managers by surprise and forced them to cover underwater positions. Our research shows that changes in Short Interest are historically a leading contrary indicator, so we believe the recent decrease in short bets favors lower stock prices.

So what does all this mean? Absolutely nothing. The days when hedge funds (or equity mutual funds) mattered are long gone: the only thing that is relevant these days is on what side of the bed does Bernanke wake up, and what subliminal messages about the imminent date of QE does his blinking pattern telegraph to the primary dealers. Everything else is noise. Yet the increasing leverage is a fact (we have confirmed this via independent conversations with Prime Brokers) and more than anything, it means that just like some hedge funds will make off like bandits in the next 28 days, others will most certainly blow up. Perhaps the administration can just advise where the S&P will close to within a penny of the final price on September 30, so we can proceed straight to the heckling festivities.

 

From AAM Field Coordinator Meghan McKeefry:

This week AAM was out in Michigan.  Coordinator Blue Wilson and myself spent some time in Jackson, MI to start ground work on preparing for a townhall meeting.  We made a stop into Dunkin Donuts to refuel and ended up passing out petitions and “Keep It Made in America” signs and pens while having a discussion about China and unfair trade with the crowded coffee shop.  Among fellow coffee drinkers was Michael Mitchell and Patrick Mitchell, brothers who expressed concern that their grocery store was hurting because a new Dollar store was just opened nearby.  This town is the site of an upcoming town hall meeting in October, and already I sense a great sense of community. 

Stay-tuned to ManufactureThis for updates on our upcoming Town Hall Tour.

##

Except for the puddles.

Most of the investment world is a chatter with trying to discern when the Fed will announce another QE Program. When is it coming? How big will it be? How high will stocks soar when it hits?

 

The “Big Picture” thinkers already know that regardless of what Bernanke says or promises, the END GAME for Fed monetary intervention is at hand. If Bernanke DOES announce some new massive QE 2 program the subsequent spike in equities will only last a short time before stocks enter a free-fall (Europe’s $1 trillion bailout only bought a few days worth of gains back in June).

 

Moreover, the announcement of a massive QE 2 program would also kick the US Dollar off a cliff, sending a huge signal to international investors that the EXTREME moves Bernanker committed during the 2008-2009 Crisis are actually ALL he knows how to do and will remain the norm rather than the exceptional measures they were promised to be.

 

All of this would be HUGELY Dollar negative and ultimately stock negative though we might see a brief spike in equities for a few days.

 

In contrast, if the Fed DOESN’T announce a new QE 2 or some similar monetary intervention, we are very likely heading into another deflationary collapse similar to that of Autumn 2008. Looking at Treasuries, the bond market seems to be favoring this outcome. Indeed, if you only looked at US Treasuries you would think stocks were already in a free-fall akin to that of October-November 2008.

 

 

Thus, regardless of what the Fed does, stocks are likely to tank in the near future.

 

The question is WHEN?

 

Honestly, I cannot predict when Bernanke will unveil QE 2. All I can say is that it largely does not matter in the grand scheme of things. Yes, it will cause some short-term volatility. But ultimately QE 2 will simply be a catalyst that speeds up the processes that are already underway. Those processes are:

 

1)   Systemic collapse

2)   Destruction of fiat money

3)   Massive loss of wealth

 

Good Trading!

 

Graham Summers

 

PS. If you’re worried about the future of the stock market and have yet to take steps to prepare for the Second Round of the Financial Crisis… I highly suggest you download my FREE Special Report specifying exactly how to prepare for what’s to come.

 

I call it The Financial Crisis “Round Two” Survival Kit. And its 17 pages contain a wealth of information about portfolio protection, which investments to own and how to take out Catastrophe Insurance on the stock market (this “insurance” paid out triple digit gains in the Autumn of 2008).

 

Again, this is all 100% FREE. To pick up your copy today, www.gainspainscapital.com and click on FREE REPORTS.

 

By Nic Lenoir of ICAP

We had called for 1,040 to hold in S&P futures and with the spike in volume into Tuesday's close for month end and in an uptick had rightfully assessed it was the start of the pull-back we expected technically towards 1,085/1,100. Here we are already... This market wastes no time. Two things are odd: After a 30 point move yesterday we did not even get a 5 tick retracement today, ahead of a job report tomorrow which cannot be that great if one is to believe ADP. Also today's price action is to put in light of how well supported it was: there are still a few minutes left but so far lower volume than Monday which was the slowest day of the year. Basically no participation in today's follow up.

While we warned last Wednesday of a possible correction in 10s as we reached resistance and had an interesting intraday reversal, it appears we are on an important support here. We need to see acceleration lower otherwise in the very near term the risk is for another squeeze higher especially if the number is weak tomorrow.

Overnight it would make sense to see markets partly retrace today's price action going into the number. Even if we are to test the upper-end of the 1,085/1,100 range, or challenge the 200-dma at 1,112, we should in theory at least pull back down to 1,072/1,075 before that.

Big picture there remains nothing to be ubpbeat about: there is no decoupling and Chinese numbers are bogus, the only thing holding US equity markets is the certainty that the government will not let them fall, we are still running deficits and accumulating debt we someday will have to default on. Cheers!

Good luck trading,

Nic

Gotta love those closing price targets, which were achieved to the penny. As for the market, the no volume meltups are once again back in vogue, as the ES and SPY both trade at two week low intraday cumulative volumes.

One of the stealthier developments over the past months has been the ever wider creep in Greek CDS, especially in the longer-dated part of the curve. In fact, everything to the right of the 3 Year point is now wider than it was both on the eve of the Greek semi-default, and just after the announcement of the European Stabilization Mechanism (ESM). How is it that with so much firepower, better known as free money, thrown at the problem, have spreads not declined? The CFR provides one interpretation, which speculates that once European banks find a firmer footing, that Greece, with the blessing of Europe proper, will be allowed to finally sever its mutated umbilical cord, and default. The catalyst would be Greece getting its primary deficit under control, at which point ongoing bad debt funding would no longer be necessary. Of course, this hypothesis is based on two very critical assumptions: European banks, especially in the periphery, as the second attached study from Goldman indicates, are still locked out. To think that Europe will be able to get to an equal footing for all countries seems like some wishful thinking at this point, especially if the market does consider the implications of what a Greek default will do to peripheral banking. Additionally, the ramifications to the euro in the case of a default will be dire, although that may be precisely what Europe is after all alone. Regardless, that is how the CFR sees things, rightly or wrongly. Keep an eye on Greek spreads in the coming weeks to see if the theory is validated.

From the CFR:

The difference between Greek and German government bond yields can be used to estimate the market’s view of the likelihood of a Greek default. The chart above shows these probabilities over different time frames on three different dates. On April 30th, no European plan was yet in place to address the ballooning Greek debt, and default was considered a real possibility in the short term. On May 11th, just after the European Stabilization Mechanism (ESM) was announced, markets sharply cut their view on the odds of default across all time horizons. However, the market’s analysis of the ESM has become much more nuanced since then. On September 1st, the market’s view of the probability of default within two years was lower than before the ESM was announced, but higher over longer time frames.

Greece will happily borrow from the ESM to avoid having to close its primary deficit (that is, excluding interest payments) too rapidly. Yet if Greece is successful in eliminating its primary deficit, its temptation to default will actually grow, as it can wipe out huge amounts of accumulated debt without any longer needing the financial markets to fund current expenditures. If faced with the choice between paying Greek debts and letting Greece default, its northern neighbors may, once their banks are on more solid footing, find it more attractive simply to let Greece default. This is the story line that the markets are now pricing into government bond spreads.

And for those seeking an update on European funding, here is Goldman with: "ECB’s bank liquidity stays on max, periphery needs it most."

 

And just in case Canada thought it was immune from waterborne crude (and derivatives) invasions, here is CBC reporting that a fuel tanker with 9 million liters of diesel has run aground in the Northwest Passage, on a sandbar close to the Nunavut community of Gjoa Haven. It is unclear if any of the diesel has spilled, although we expect some demonstrative eating of shrimp, penguins, Taq polymerase, or whatever it is that lives in these extreme temperatures, by some world leader, to prove beyond a reasonable doubt that all is well, and there is no need to panic.

A fuel tanker carrying nine million litres of diesel fuel has run aground in the Northwest Passage, the Canadian Coast Guard confirmed Thursday.

The tanker, which is owned by Woodward's Oil, ran aground on a sandbar Wednesday southwest of the western Nunavut community of Gjoa Haven.

It was carrying diesel to resupply Gjoa Haven and other remote communities in the region. No diesel is believed to have spilled, coast guard officials told CBC News.

Transport Canada is working with the company to get the tanker floating again.

The coast guard says it is too early to tell when the ship will be able to move.

→ Washington’s Blog

Fed chief Ben Bernanke told the financial crisis inquiry commission today:

If the crisis has a single lesson, it is that the too-big-to-fail problem must be solved

 

***

 

Too-big-to-fail financial institutions were both a source ... of the crisis and among the primary impediments to policymakers' efforts to contain it ....

That's funny, given that Bernanke has been one of the biggest defenders of the too big to fail banks, arguing strenuously against breaking them up, throwing trillions of dollars their way, and begging the banks to play nice with one hand, while patting them on the back with the other hand and giving them a big wink.

And Christina Romer - Obama's outgoing chief economist and Chair of the Council of Economic Advisers - said in her outgoing speech yesterday, as summarized by Dana Milbank at the Washington Post:

She had no idea how bad the economic collapse would be. She still doesn't understand exactly why it was so bad. The response to the collapse was inadequate. And she doesn't have much of an idea about how to fix things.

Many have tried to explain to the neoclassical economists running the show exactly how bad the economic collapse would be, why it was so bad, and how to mount an adequate response to fix things. But Bernanke, Romer and the rest of the gang ignored them.

Who Knew?

 

As I pointed out in March:

 

Greenspan's big defense is that the financial crisis was caused by a "once-in-a-century" event.

 

 

Forget about the fact that the "once-in-a-century event" couldn't have happened if Greenspan's Fed hadn't:

• Turned its cheek and allowed massive fraud

• Acted as cheerleader in chief for unregulated use of derivatives at least as far back as 1999 (see this and this)

• And for subprime loans

• Allowed the giant banks to grow into mega-banks. For example, Citigroup's former chief executive says that when Citigroup was formed in 1998 out of the merger of banking and insurance giants, Greenspan told him, “I have nothing against size. It doesn’t bother me at all”

• Argued that economists had conquered the business cycle, and that modern, technologically advanced financial markets are best left to police themselves

• Preached that a new bubble be blown every time the last one bursts

• Kept interest rates too low

• And did alot of other hinky things

More importantly, as Nassim Taleb repeatedly points out, financial experts who don't plan for rare events are like pilots who don't know about storms.

 

There are storms out there, Taleb says, and any pilot who doesn't know how to deal with storms shouldn't be flying. Similarly, no one should be in a position of financial leadership if they don't know about - and plan for - the infrequent event:

 

High Priests Shake their Magic Wands Even Harder

As Australian economist Steve Keen wrote last week, mainstream economists have been acting like religious fundamentalists, rather than scientists:

Bernanke’s failure to realize this: it’s a failing that he shares in common with the vast majority of economists. His problem is the theory he learnt in high school and university that he thought was simply “economics”—as if it was the only way one could think about how the economy operated. In reality, it was “Neoclassical economics”, which is just one of the many schools of thought within economics. In the same way that Christianity is not the only religion in the world, there are other schools of thought in economics. And just as different religions have different beliefs, so too do schools of thought within economics—only economists tend to call their beliefs “assumptions” because this sounds more scientific than “beliefs”.

 

Let’s call a spade a spade: two of the key beliefs of the Neoclassical school of thought are now coming to haunt Bernanke—because they are false. These are that the economy is (almost) always in equilibrium, and that private debt doesn’t matter.

Indeed, as I wrote in June:

Most economists don't exercise any independent thinking because economists are trained to ignore reality:

As I have repeatedly noted, mainstream economists and financial advisors have been using faulty and unrealistic models for years. See this, this, this, this, this and this.

And I have pointed out numerous times that economists and advisors have a financial incentive to use faulty models. For example, I pointed out last month:

The decision to use faulty models was an economic and political choice, because it benefited the economists and those who hired them.

For example, the elites get wealthy during booms and they get wealthy during busts. Therefore, the boom-and-bust cycle benefits them enormously, as they can trade both ways.

Specifically, as Simon Johnson, William K. Black and others point out, the big boys make bucketloads of money during the booms using fraudulent schemes and knowing that many borrowers will default. Then, during the bust, they know the government will bail them out, and they will be able to buy up competitors for cheap and consolidate power. They may also bet against the same products they are selling during the boom (more here), knowing that they'll make a killing when it busts.

But economists have pretended there is no such thing as a bubble. Indeed, BIS slammed the Fed and other central banks for blowing bubbles and then using "gimmicks and palliatives" afterwards.

It is not like economists weren't warning about booms and busts. Nobel prize winner Hayek and others were, but were ignored because it was "inconvenient" to discuss this "impolite" issue.

Likewise, the entire Federal Reserve model is faulty, benefiting the banks themselves but not the public.

However, as Huffington Post notes:

The Federal Reserve, through its extensive network of consultants, visiting scholars, alumni and staff economists, so thoroughly dominates the field of economics that real criticism of the central bank has become a career liability for members of the profession, an investigation by the Huffington Post has found.

 

This dominance helps explain how, even after the Fed failed to foresee the greatest economic collapse since the Great Depression, the central bank has largely escaped criticism from academic economists. In the Fed's thrall, the economists missed it, too.

 

"The Fed has a lock on the economics world," says Joshua Rosner, a Wall Street analyst who correctly called the meltdown. "There is no room for other views, which I guess is why economists got it so wrong."

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Read more at: http://www.huffingtonpost.com/2009/09/07/priceless-how-the-federal_n_278805.htmlThe problems of a massive debt overhang were also thoroughly documented by Minsky, but mainstream economists pretended that debt doesn't matter.

And - even now - mainstream economists are STILL willfully ignoring things like massive leverage, hoping that the economy can be pumped back up to super-leveraged house-of-cards levels.

As the Wall Street Journal article notes:
As they did in the two revolutions in economic thought of the past century, economists are rediscovering relevant work.It is only "rediscovered" because it was out of favor, and it was only out of favor because it was seen as unnecessarily crimping profits by, for example, arguing for more moderation during boom times.

The powers-that-be do not like economists who say "Boys, if you don't slow down, that bubble is going to get too big and pop right in your face". They don't want to hear that they can't make endless money using crazy levels of leverage and 30-to-1 levels of fractional reserve banking, and credit derivatives. And of course, they don't want to hear that the Federal Reserve is a big part of the problem.

Indeed, the Journal and the economists it quotes seem to be in no hurry whatsoever to change things:
The quest is bringing financial economists -- long viewed by some as a curiosity mostly relevant to Wall Street -- together with macroeconomists. Some believe a viable solution will emerge within a couple of years; others say it could take decades.

Saturday, PhD economist Michael Hudson made the same point:

I think that the question that needs to be asked is how the discipline was untracked and trivialized from its classical flowering? How did it become marginalized and trivialized, taking for granted the social structures and dynamics that should be the substance and focal point of its analysis?...

To answer this question, my book describes the "intellectual engineering" that has turned the economics discipline into a public relations exercise for the rentier classes criticized by the classical economists: landlords, bankers and monopolists. It was largely to counter criticisms of their unearned income and wealth, after all, that the post-classical reaction aimed to limit the conceptual "toolbox" of economists to become so unrealistic, narrow-minded and self-serving to the status quo. It has ended up as an intellectual ploy to distract attention away from the financial and property dynamics that are polarizing our world between debtors and creditors, property owners and renters, while steering politics from democracy to oligarchy...

[As one Nobel prize winning economist stated,] "In pointing out the consequences of a set of abstract assumptions, one need not be committed unduly as to the relation between reality and these assumptions."

This attitude did not deter him from drawing policy conclusions affecting the material world in which real people live. These conclusions are diametrically opposed to the empirically successful protectionism by which Britain, the United States and Germany rose to industrial supremacy.
Typical of this now widespread attitude is the textbook Microeconomics by William Vickery, winner of the 1997 Nobel Economics Prize:"Economic theory proper, indeed, is nothing more than a system of logical relations between certain sets of assumptions and the conclusions derived from them... The validity of a theory proper does not depend on the correspondence or lack of it between the assumptions of the theory or its conclusions and observations in the real world. A theory as an internally consistent system is valid if the conclusions follow logically from its premises, and the fact that neither the premises nor the conclusions correspond to reality may show that the theory is not very useful, but does not invalidate it. In any pure theory, all propositions are essentially tautological, in the sense that the results are implicit in the assumptions made."Such disdain for empirical verification is not found in the physical sciences. Its popularity in the social sciences is sponsored by vested interests. There is always self-interest behind methodological madness. That is because success requires heavy subsidies from special interests, who benefit from an erroneous, misleading or deceptive economic logic. Why promote unrealistic abstractions, after all, if not to distract attention from reforms aimed at creating rules that oblige people actually to earn their income rather than simply extracting it from the rest of the economy?***
Michael Rivero may have the hardest-hitting critique of all:This seems to be a return to the mindset of the middle ages where only the clergy were allowed to read and interpret the bible and the laity were presumed incapable of comprehending the intricacies and subtle nuances of the faith.

 

And indeed there is a great deal of similarity between economics and [fundamentalist version of] religion in that both depend on the unquestioning faith of the masses that those pretty printed pieces of paper represent something real, albeit invisible.

 

But the advent of the printing press led people to take a closer look at the actual content of [fundamentalist version of] religion and it has been revealed not as a complex and sophisticated system but as a mish-mash of half-baked myths and legends often in contradiction with itself and used to enrich the church ....

 

The same is true of economics. the advent of the blog has led people to take a closer look at the actual content of economics and it has been revealed not as a complex and sophisticated system but as a mish-mash of half-baked theories and math often in contradiction with itself and used to enrich the bankers and conceal their fraud against the public. Athreya is reacting to the blogs the way [fundamentalist] priests reacted to Gutenberg's Printing Press.

 

The fraud and danger of the Federal Reserve system of banking stands exposed to the public eye, sans the "benefit" of correct interpretation by the self-appointed priests of Mammon. The public now understands that when a private bank issues the public currency at interest, debt will always exceed the available money supply. The public now understands that the Federal Reserve is no more Federal than Federal Express. The public now understands that the Federal Reserve is a legalized counterfeiting operation, that creates the money they loan out out of thin air! The public now understands that the Federal Reserve system of banking, since its creation in 1913, has reduced the value of a dollar down to about four cents! The public now understands that the Federal Reserve system is a pyramid scam that only works when ever larger populations of borrowers can be found, and that once an entire nation or planet has borrowed to the max, the system must crash (which is what is happening now).

 

Just as the [fundamentalist] priests, stripped of the arcane scriptures and rituals, stand exposed ... so too the economists, stripped of their arcane equations and theories, stand exposed ....

Karthik Athreya doesn't like that fact that the public sees the Federal Reserve for what it really is.

What Could Possibly Go Wrong?

Not only have our government "leaders" in the Fed, Treasury, Congress and White House ignored the real world, they have taunted it - like monkeys who pull the tail of the lion and then are surprised when the lion attacks:

They have:

• Let the largest U.S. banks go bankrupt repeatedly due to wild speculation, then blessed the speculation and helped cover up the bankruptcies

• Privatized profits and socialized losses, trashed the real value of the dollar, and let corruption run rampant

• Covered up all of the fraud which led to the crisis

• Rewarded looting by the big banks

• Given trillions in bailout or other emergency funds to private companies, but then refusing to disclose to either the media, the American people or even Congress where the money went

• Let banks buy the government lock, stock and barrel (and see this and this)

• Blown bubble after bubble

• Plundered the treasury to effect "a massive redistribution of wealth to the bank shareholders and their top executives"

• Allowed high-frequency trading to completely warp the markets

• Waged unnecessary wars all over the world, so that even our top military commanders are begging to slash defense costs, and otherwise buried our nation under mountains of debt (see this, this, this, this, this and this)

• Failed to take any meaningful steps to stabilize - let alone fix - the economy (see this and this)

Under these conditions, it is impossible to have a decent economy. After pulling these kind of shenanigans, of course the lion of debt and depression is going to eat us alive.

ManufactureThis has posted on the myth that a new trend of onshoring is countering the offshoring that has been going on for years in the United States.  The truth of the matter is, that while onshoring is, indeed, occurring, offshoring is still alive and well and sending thousands of American jobs overseas.

AAM Executive Director Scott Paul published an op-ed in the Huffington Post pointing out that recent data from the Federal Reserve Bank of Philadelphia shows that onshoring has declined over the past two years.

Rob Neilly reflects in Plastics Today on whether or not the onshoring myth is too good to be true. He correctly asserts:

“One delusion gaining ground among the talking heads and pundits involves our manufacturing sector: that there is an onshoring trend—that is, work is coming back to the USA from low-cost areas. There have been many stories about this in the media over the last few months. The president of the United States has made specific reference to it. But believing there is a meaningful change happening is a delusion.”

Neilly, too, references the “hard data” Paul used to prove that the onshoring trend was phony and calls on America to nix the delusion and recognize the “very real problems we face.”

Read more.

##

Adair Turner, Chairman of Britain’s Financial Services Authority, on the too big to fail problem:

Too Much “Too Big to Fail”?, by Adair Turner, Commentary, Project Syndicate: Obviously, the global financial crisis of 2008-2009 was partly one of specific, systemically important banks and other financial institutions such as AIG. In response, there is an intense debate about the problems caused when such institutions are said to be “too big to fail.” Politically, that debate focuses on the costs of bailouts and on tax schemes designed to “get our money back.” For economists, the debate focuses on the moral hazard created by ex ante expectations of a bailout, which reduce market discipline on excessive risk-taking – as well as on the unfair advantage that such implicit guarantees give to large players over their small-enough-to-fail competitors. Numerous policy options to deal with this problem are now being debated. These include higher capital ratios for systemically important banks, stricter supervision, limits on trading activity, pre-designated resolution and recovery plans, and taxes aimed not at “getting our money back,” but at internalizing externalities – that is, making those at fault pay the social costs of their behavior – and creating better incentives. I am convinced that finding answers to the too-big-to-fail problem is necessary... But we must not confuse “necessary” with “sufficient”; there is a danger that an exclusive focus on institutions that are too big to fail could divert us from more fundamental issues. In the public’s eyes, the focus on such institutions appears justified by the huge costs of financial rescue. But when we look back on this crisis in, say, ten years, what may be striking is how small the direct costs of rescue will appear. Many government funding guarantees will turn out to have been costless... All of this implies that the crucial problem is not the fiscal cost of rescue, but the macroeconomic volatility induced by precarious credit supply – first provided too easily and at too low a price, and then severely restricted. And it is possible – indeed, I suspect likely – that such credit-supply problems would exist even if the too-big-to-fail problem were effectively addressed. ... There is therefore a danger that excessive focus on “too big to fail” could become a new form of the belief that if only we could identify and correct some crucial market failure, we would, at last, achieve a stable and self-equilibrating system. Many of the problems that led to the crisis – and that could give rise to future crises if left unaddressed – originated elsewhere.

I mostly oppose large banks due to the political power that they have, the market power that comes with size, the unfair advantage the implicit guarantee of a bailout gives large banks over small banks (since the large banks are perceived as less risky due to the guarantee, they can get funds at a lower cost), and the fact that the implicit guarantee induces large banks to take on too much risk. There's also a worry that size and connectedness amplifies the effects of a crisis. However, I don't think systemic risk falls much by simply breaking the banks into smaller pieces, so this isn't a major part of the reason why I think we should limit bank size. There are plenty of examples of crises involving smaller banks in the U.S. and elsewhere, so breaking banks up does not provide an impermeable defense against systemic issues.

The most frustrating part, though, is the implicit assumption in most of these discussions that big banks are inevitable. I have yet to see an analysis that convinces me that large banks provide a boost to efficiency that more than compensates for the problems their size brings about. I realize we are reluctant to impose per se rules against size for good reason, and that the fact that they may not increase efficiency is not sufficient justification to break them up, but the political power, the excessive risk taking, the economic power that come with size, etc. are. Maybe the problems aren't as large or worrisome as I believe, but it would be nice to have the sense that regulators are at least asking these questions. Instead they seem to be resigned to the fact that large banks are inevitable.

I hope to do more with this speech later -- we'll see if time permits that -- but here's Ben Bernanke talking about this issue earlier today: Notice the assumption in the background that large banks will exist:

"Too Big to Fail"
Many of the vulnerabilities that amplified the crisis are linked with the problem of so-called too-big-to-fail firms. A too-big-to-fail firm is one whose size, complexity, interconnectedness, and critical functions are such that, should the firm go unexpectedly into liquidation, the rest of the financial system and the economy would face severe adverse consequences. Governments provide support to too-big-to-fail firms in a crisis not out of favoritism or particular concern for the management, owners, or creditors of the firm, but because they recognize that the consequences for the broader economy of allowing a disorderly failure greatly outweigh the costs of avoiding the failure in some way. ... In the midst of the crisis, providing support to a too-big-to-fail firm usually represents the best of bad alternatives; without such support there could be substantial damage to the economy. However, the existence of too-big-to-fail firms creates several problems in the long run. First, too-big-to-fail generates a severe moral hazard. If creditors believe that an institution will not be allowed to fail, they will not demand as much compensation for risks as they otherwise would, thus weakening market discipline; nor will they invest as many resources in monitoring the firm's risk-taking. As a result, too-big-to-fail firms will tend to take more risk than desirable, in the expectation that they will receive assistance if their bets go bad. Where they have the necessary authority, regulators will try to limit that risk-taking, but without the help of market discipline they will find it difficult to do so... There is little doubt that excessive risk-taking by too-big-to-fail firms significantly contributed to the crisis... A second cost of too-big-to-fail is that it creates an uneven playing field between big and small firms. This unfair competition, together with the incentive to grow that too-big-to-fail provides, increases risk and artificially raises the market share of too-big-to-fail firms, to the detriment of economic efficiency as well as financial stability. Third, as we saw in 2008 and 2009, too-big-to-fail firms can themselves become major risks to overall financial stability, particularly in the absence of adequate resolution tools. ... The failures of smaller, less interconnected firms, though certainly of significant concern, have not had substantial effects on the stability of the financial system as a whole. If the crisis has a single lesson, it is that the too-big-to-fail problem must be solved. Simple declarations that the government will not assist firms in the future, or restrictions that make providing assistance more difficult, will not be credible on their own. Few governments will accept devastating economic costs if a rescue can be conducted at a lesser cost; even if one Administration refrained from rescuing a large, complex firm, market participants would believe that others might not refrain in the future. Thus, a promise not to intervene in and of itself will not solve the problem. The new financial reform law and current negotiations on new Basel capital and liquidity regulations have together set into motion a three-part strategy to address too-big-to-fail. First, the propensity for excessive risk-taking by large, complex, interconnected firms must be greatly reduced. Among the tools that will be used to achieve this goal are more-rigorous capital and liquidity requirements, including higher standards for systemically critical firms; tougher regulation and supervision of the largest firms, including restrictions on activities and on the structure of compensation packages; and measures to increase transparency and market discipline. Oversight of the largest firms must take into account not only their own safety and soundness, but also the systemic risks they pose. Second, as I already discussed, a resolution regime is being implemented that allows the government to resolve a distressed, systemically important financial firm in a fashion that avoids disorderly liquidation while imposing losses on creditors and shareholders. Ensuring that that new regime is workable and credible will be a critical challenge for regulators.

Finally, the more resilient the financial system, the less the cost of a failure of a large firm, and thus the less incentive the government has to prevent that failure. Examples of policies to increase resiliency include the requirements in the recent bill to force more derivatives settlement into clearinghouses and to strengthen the prudential oversight of key financial market utilities such as clearinghouses and exchanges. ... In addition, prudential regulators should take actions to reduce systemic risks. Examples include requiring firms to have less-complex corporate structures that make effective resolution of a failing firm easier, and requiring clearing and settlement procedures that reduce vulnerable interconnections among firms.

I asked Bernanke if large banks are necessary. Here's what he said:

B. Mark Thoma, University of Oregon and blogger: ...The proposed regulatory structure seems to take as given that large, potentially systemically important firms will exist, hence, the call for ready, on the shelf plans for the dissolution of such firms and for the authority to dissolve them. Why are large firms necessary? Would breaking them up reduce risk? ...Although regulators can do a great deal on their own to improve financial regulation and oversight, the Congress also must act to address the extremely serious problem posed by firms perceived as “too big to fail.” Legislative action is needed to create new mechanisms for oversight of the financial system as a whole. Two important elements would be to subject all systemically important financial firms to effective consolidated supervision and to establish procedures for winding down a failing, systemically critical institution to avoid seriously damaging the financial system and the economy. Some observers have suggested that existing large firms should be split up into smaller, not-too big- to-fail entities in order to reduce risk. While this idea may be worth considering, policymakers should also consider that size may, in some cases, confer genuine economic benefits. For example, large firms may be better able to meet the needs of global customers. Moreover, size alone is not a sufficient indicator of systemic risk and, as history shows, smaller firms can also be involved in systemic crises. Two other important indicators of systemic risk, aside from size, are the degree to which a firm is interconnected with other financial firms and markets, and the degree to which a firm provides critical financial services. An alternative to limiting size in order to reduce risk would be to implement a more effective system of macroprudential regulation. One hallmark of such a system would be comprehensive and vigorous consolidated supervision of all systemically important financial firms. Under such a system, supervisors could, for example, prohibit firms from engaging in certain activities when those firms lack the managerial capacity and risk controls to engage in such activities safely. Congress has an important role to play in the creation of a more robust system of financial regulation, by establishing a process that would allow a failing, systemically important non-bank financial institution to be wound down in an orderly fashion, without jeopardizing financial stability. Such a resolution process would be the logical complement to the process already available to the FDIC for the resolution of banks.

So the only benefit of size he lists is "large firms may be better able to meet the needs of global customers." I can't say I find this argument very convincing.

In addition, I am not at all convinced that the procedures to "resolve a distressed, systemically important financial firm in a fashion that avoids disorderly liquidation" can be made credible. The first time regulators start to use this in a big crisis and markets begin to tank over worries about whether it will work or not, will the administration in power be willing to risk creating a big meltdown? Or will they resort to procedures used in the past that were problematic for all the reasons cited above, but do seem to prevent the most catastrophic outcome? 

Until someone convinces me that there are significant advantages to having mega-banks that cannot be duplicated with banks that are not, by themselves, too big to fail, I will continue to call for them to be broken up. Again, I don't think it makes a big difference in terms of systemic risk, though if Bernanke's right it will reduce the magnitude of the crisis, and that reduction in risk is important to recognize. But I do think breaking them up could make a big difference in terms of addressing all the other problems that size (and connectedness) brings about.

Debtors and creditors are not the same.