Wednesday, August 31, 2011

Bernanke's silence provokes market thunder, Lagardes thunder provokes market silence.

My mother used to tell me that if you can't say anything nice then don't say anything at all. I wonder if that aphorism might not have been going through the mind of Ben Bernanke as he wrote the speech which he delivered in Jackson Hole on Friday. In his much anticipated speech Bernanke did not announce any new policy measures. Indeed, he was at pains to point out the limits of monetary policy. In his public statement Bernanke is always extremely cautious about getting involved in policy debates, particularly policy debates which are the responsibility of the US Congress. In his most recent testimony, which happened to be during the recent bitter budget debate, each side tried to corner him into supporting their position and he simply refused to take a side. His actual words were: “I'm not going to tell you what to do, that's your job to decide. That's why you get paid the big bucks.” I love this guy. So for a man so careful not to get into the business of Congress the closest he can get to taking a shot at them is to simply describe the limits of his own power which was the main point of his speech.

He did point out that the recovery was very weak and that there are serious problems in the real economy that need to be addressed with long term policy. Precisely the kind of policy which Congress seems totally incapable of producing. When the markets read this part of the speech, they dove. But then, interestingly for a speech which was primarily about how little the Fed can do, Bernanke also mentioned that the next Fed meeting would last an extra day. Wait a minute? An extra day? Why whatever for, you've just got done telling us that there is little the Fed can do to address the long term structural problems facing the economy. Hmmm.... Perhaps that means you're going to be thinking extra hard about what policy options you have RIGHT NOW while we wait for Congress to sort itself out. Then the conventional wisdom became that the Fed would take some kind of action and the markets have been screaming higher ever since.

The market rocketship got even more fuel when the minutes of the Fed meeting were released on Tuesday. If you recall at the last Fed meeting the policy announcement was that the Fed would keep interest rates at the current low levels until mid 2013, that is they put a date to their “extended period” language. When the Fed releases its decision it also discloses how many of them agreed with the policy and how many dissented. It does not, however, say WHY they dissented until the minutes are released. At the time, I thought the dissenters were more Hawkish about inflation and therefore thought that the easing was unnecessary. I could not have been more wrong. One of the dissenters did not like the nature of the signaling. He felt that the The other dissenters dissented not because they thought monetary stimulus was unnecessary but that the structural factors in the economy were so severe that it might not even do any good and but would contribute to inflation. It was pretty grim.

Strangely this has put the markets in an unusual position. Since mid-summer the markets have come off quite a lot. The decline has been driven by concerns about Europe, the budget debate, the and the downgrade. It has also been driven by negative economic data. The markets are now at a level where the news has a sort of goldilocks aspect to it. If the data shows the economy is strengthening then the markets will think earnings will be better and the stocks should be higher. If the data is bad then the Fed will be painted into a corner by the time of its two day meeting in September and will likely easy monetary policy further in some creative way. Thus the markets have the same response to good news and bad: they go up. So, Bernanke did not say too much but the markets have heard plenty.

At the same time they seem to be ignoring something else, in particular a quite shocking speech given by Christine Lagarde the new head of the IMF. The speech was especially shocking to be because of an argument I got into a few years ago at a University of Chicago alumni event. The event was a talk by a noted Chicago alum about the financial crisis and the role of the state in it. It was an enlightening talk and the Q&A session led to a lively debate. The debate turned to the subject of what the government could have done to forestall the crisis. A man in the front of the room who was extremely critical of the government generally and the Fed in particular said that obviously the thing to have done was to have the Fed order the banks to raise capital in the summer of 2008. The problem by then was clearly one of solvency, not liquidity, that is to say the the problem was not a short term cash crunch but that the banks did not have enough capital to absorb the losses they would take when the sub-prime writedowns had to be taken.

I could see why the man felt this was a good idea but I thought it was totally impractical. I stood up and argued that if the Federal Government announced to the world that the US banking system was in such deep trouble, and indeed it was not possible at the time to know precisely how deep, that it needed a massive infusion of capital that the capital would not be forthcoming. I felt this way because I remember working in the middle east at the time and watching as a parade of US banks sought out capital infusions from wealthy Arabs and sovereign wealth funds. By the summer of 2008, investor appetite for additional bank capital infusions had waned substantially. My argument was that while it would have been desirable for the banks to recapitalize, no one in their right mind would have put their money into a bank if the banks own regulators were so concerned about its solvency that it was being forced to raise capital.

The man at the front of the room turned around and gave me a look of death, he was obviously not someone used to being argued with, and said “Well, they did all raise capital eventually didn't they.” Smug smile. To which I replied: “Yes, from the taxpayers! And the taxpayers only contributed to it because you go to jail if you don't pay your taxes!”

Well this story has two surprise endings. First the man at the front of the room was Cliff Assness the billionaire founder of hedge fund AQR. For the record, I am not a billionaire. The second is that this past weekend, Christine Lagarde, the head of the IMF called for the European banks to be forced to raise capital. In my opinion this is by far the most important thing to come out of the Jackson Hole conference. Far more important than the non-comments by Bernanke. I would even go so far as to say, that, if the speculative attack on the Eurozone is renewed and is successful, people will be talking about this speech for years to come and Christine Lagarde will become a very important historical figure for being ahead of the curve. The response of the ECB and the EU was to deny that this was necessary and the markets have been listening far more to what Bernanke has not said than to what Lagarde did say.

They should listen more closely. More than anything else what has driven the markets lower this summer is the fear that a major fiscal problem is brewing. The US downgrade is part of this but while this is embarrassing for the US it is potentially fatal for Europe. What the markets are afraid of is that the once the ECB is done with its bond purchases, the speculative attack will resume and it will ultimately succeed in bringing down a European sovereign. If this happens there is going to be an ABSOLUTELY MASSIVE banking crisis in Europe. This is because the Eurozone has created a continental market for banks but, because the ECB is has no taxing power, any attempt at a TARP like bank rescue would have to be funded by individual countries. The problem here is that because they operate across the entire Eurozone the banks are MUCH MUCH larger than the countries which would have to rescue them.

In the US the balance sheets of the top 3 banks are about 60% of US GDP. In France, the balance sheets of the top three banks are 600% of GDP. That's right, the top three banks have assets outstanding equal to six times the size of the French GDP. Remember the TARP? That was 5% of US GDP. It was a big number but the US could borrow it. Now imagine a world in which Spain has gone bankrupt and the French banking system is on the verge of collapse so France decides to implement its own TARP, it would have to be 50% of GDP, or put another way, France would have to instantly borrow as much money as it has in the past fifteen years combined. Do you think there is any chance that this would actually happen? No there is not. What would happen is that those banks would fail and would therefore wipe out the savings of their depositors as well as damage any banks to which they owed money. Keep in mind this is not just France, this is the case in every country. So if there is a major sovereign default the European banking system cannot be saved.

Christine Lagarde's idea is to get in front of this and force the European banks to raise more capital from private sources before the storm breaks so that they have a better chance of weathering it. I take my hat off to her for raising it. That said, as was the case with Cliff Asness, I don't think it can be done though for different reasons. The reason that in 2008 the banks could not be recapitalized in practice was that though there was enough money to do it, no one knew what precisely the scale of the problem was. In this case, we do know what the scale of the problem is but not only is there not enough money in practice to do it, there's not enough money even in theory.

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