Will the Bretton Woods 2 (BW2) Regime Collapse Like the Original Bretton Woods Regime Did? The Coming End Game of BW2

Author: Nouriel Roubini · July 6th, 2008 · 2529202008-07-06+23%3A26%3A38Nouriel+Roubini › Share This Print

Will the Bretton Wood 2 Regime of fixed and/or heavily managed exchange rates in many emerging market economies collapse in the same way as the Bretton Woods 1 regime (the “dollar standard” regime that ruled after 1945 in the global economy) collapsed in the early 1970s? What are the similarities and differences between those two regimes? It is interesting to note that the same factors – U.S twin deficit, U.S. loose monetary policies and fixed pegs to the U.S. in the dollar standard regime of Bretton Woods (1945-1971) – that led to the commodity inflation and goods inflation in the early 1970s and thus to the demise of the Bretton Woods 1 regime (in the 1971-73 period) are also partially the same factors that are leading now to the rise in commodity and goods inflation in emerging markets that are pegging to the U.S. dollar and/or heavily managing their exchange rates.

Thus, like the rise of commodity and goods inflation led to the demise of BW1 the current rise in commodity and goods inflation in emerging market economies may be the trigger that will lead – as argued in my 2005 BW2 paper with Brad Setser and a more recent 2007 paper of mine – to the demise of BW2. It is true that BW2 is still alive as the massive ongoing reserve accumulation by BRICs, GCC and other emerging markets suggests. But the rise in inflation that these exchange rate policies are causing may soon lead to its demise: abandoning pegs and/or letting currencies appreciate at a faster rate will be the necessary step to control inflation in such emerging market economies.

Let us flesh out this comparison between BW1 and BW2 in more detail…

First, note that there are a number of similarities between the current US recession and rising inflation (a stagflationary episode) and the episode of rising inflation in the early 1970s that, by the fall of 1973, erupted into a full fledged global stagflationary shock following the Yom Kippur war and the ensuing spike in oil prices. Indeed. there has been a debate on how much the of the 1974-75 global recession was due to the supply side stagflationary shock of 1973 and how much of it was due to a rise in global inflation and commodity prices that started in 1970 and accelerated in 1973.

Note that the rise in inflation in the 1970s started much earlier than the supply side shock of 1973. Rather, the breakdown of the Bretton Woods (BW) regime was an important factor behind the rise in global inflation before the oil shock of 1973. This collapse of BW1 in the early 1970s has some uncanny similarities to the rise in global inflation that the current Bretton Woods 2 regime of fixed rates or heavily managed rates has triggered in the last few years. Like in the current episode – where a number of countries heavily managed their currencies relative to the US dollar by keeping them weak via aggressive partially sterilized intervention and thus caused excessively low interest rates and excessive growth of base money and of credit that eventually led to asset inflation and goods inflation in 2008 – a similar phenomenon occurred in period that led to the demise of Bretton Woods 1 in the early 1970s.

Indeed, in the late 1960s the U.S. was running large twin fiscal and current account deficits caused by the costs of the Vietnam War and an increasingly overvalued US dollar (while today the twin deficits are also partly related to the Iraq war/homeland security spending and a strong dollar until the early 2000s). The members of Bretton Woods 1 – formally a regime of fixed pegs to the U.S. – were instead running current account surpluses – Germany, most of Europe, Japan – and thus accumulating foreign reserves to prevent their currencies from appreciating relative to the U.S. dollar. Eventually that excessive reserve accumulation and ensuing monetary growth led to a rise in domestic inflation and a rise in commodity prices as global monetary conditions were too loose given the U.S. policies. And many of the creditors of the U.S. – especially France – became restless about accumulating larger and larger reserves of dollar assets that were yielding low returns and were effectively not convertible to gold at the set price by the “dollar standard” regime as it was increasingly clear that the supply of dollar assets created by the US external deficits was massively outstripping the gold backing the “dollar standard” regime. Eventually by 1971 those growing imbalances led to the collapse of the Bretton Woods dollar standard regime, a move to managed rates by 1971 and by 1973 a move to a full float of major currencies. That collapse in Bretton Woods 1 then fed the commodity bubble of the early 1970s as the ensuing weakness of the U.S. dollar following the breakdown of BW1 led to a further rise in commodity prices that were already rising before because of excessive U.S. and global monetary growth.

The same is happening today as the exchange rate policies of China, the GCC, Russia, India, Argentina and other informal members of BW2 – have fed the commodity inflation and the domestic inflation in many emerging market economies, a rise in inflation that is now spilling back to the U.S., Europe and other advanced economies. In the early 1970s the tensions created by the fix pegs to the US dollar – in the presence U.S. twin deficits and loose U.S. monetary policies – led to the breakdown of BW1 as Germany, France, Japan and other economies decided to abandon the pegs and revalue their currencies to prevent even further rise in their inflation rates. But the by product of that abandonment of pegs was further dollar weakness, further loosening of monetary policies in the U.S., further commodity inflation that – by the time of the 1973 stagflationary oil shock – led to an ugly U.S. and global stagflation.

Similarly, today the rise in commodity and goods inflation that U.S. twin deficits, loose monetary policy (to deal with the recession and the financial crisis) and the exchange rate policies of the BW2 members has created is likely to lead to the demise of BW2. In my 2005 paper with Brad Setser and in the follow-up papers on BW2 we argued that the demise of BW2 would be triggered – among other reasons – by the rise in asset inflation and goods inflation that these exchange rate policies of partially sterilized interventions would entail. That rise in asset inflation and goods inflation has now occurred in emerging market economies – with over 30 of such economies now having double digit inflation. Also, the asset inflation – in equity markets and real estate in countries such as China, the Gulf States, India, Russia, etc. – that the BW2 policies created has now started to go bust at least in the equity markets of the China, India, Gulf States and other emerging markets (where equity markets are already in a 20% bearish downturn).

In May of 2007 I wrote a paper titled “Asia is Learning the Wrong Lessons from Its 1997-98 Financial Crisis: The Rising Risks of a New and Different Type of Financial Crisis in Asia” that presented a more recent assessment of the vulnerabilities of BW2 and the risks of rising asset and g
oods inflation in that regime.

Then I wrote in that paper:

[Asia] has learned some wrong lessons from that [1997-98] crisis and – in trying to address that crisis – planted the seeds of new and different financial vulnerabilities that could lead to a different crisis in the medium term, or even in the short term if global shocks such a US hard landing take place. Paradoxically, part of the policy responses to the 1997-98 crisis were mistaken and created excessive liquidity and asset bubbles that will come to haunt the region once external shocks take place.

So, what are the problems with the current Asian economic, currency and financial model? The answer is, in brief, the effective return to fixed exchange rates in spite of the rhetoric of a move to floating rates. In other terms the problem of Asia today is its membership of the Bretton Woods 2 (BW2) and the economic distortions, and financial and asset bubbles that this BW2 regime generates. Let me elaborate. After the 1997-98 Asia only formally moved to a regime of flexible exchange rates. Effectively, instead, most countries in the region tried to avoid the appreciation of their currencies that had collapsed during the crisis, were thus severely undervalued and were thus subject to appreciating pressures once their economies and external balances recovered…That new model of growth was first and foremost chosen by China. And following the Chinese bandwagon most of the East Asian countries joined this BW2 model of fixed rates and undervalued currencies leading to export-led growth with current account surpluses and reserve accumulation attempting to prevent nominal and real appreciation…

One may then ask: what is wrong with that BW2 growth model if it has led to high growth in China and East Asia and strong and well performing financial and asset markets? The answer is clear.

First, this new economic and financial model is leading to excessive monetary and credit growth, asset bubbles in stock markets, housing markets and other financial markets that will eventually lead to a build up of financial vulnerabilities – like the capital inflows and bubbles the preceded the Asian crisis of 1997 in a region of semi-fixed exchange rates – that could trigger a financial crisis different from that of 1997-98 but that could be potentially as severe.

Second, reliance on an economic growth model based on rising growth of net external demand and domestic investment aimed at rising capacity for such exports; low reliance on domestic demand and production for domestic markets, especially private consumption and production of necessary non-tradable public and private services. This model of growth with excessive reliance on net exports and production of capacity for exports is dangerous for several reasons: it makes Asia – that used to rely in the 1990s on capital flows from the rest of the world for its growth – now reliant on US and global demand from outside Asia for its growth; given the current risks of a US hard landing or even a serious US growth slowdown this is a dangerous and vulnerable model of growth. Moreover, reliance on an ever increasing level of next exports (both absolute and as a share of GDP) increases the risks of a protectionist backlash in the US and Europe. Thus, this export-led only growth model is unsustainable and a more balanced growth pattern with greater reliance on domestic demand is essential to ensure long run growth stability.

Let me elaborate on why the wholesale acceptance – with a few exceptions – of BW2 and of its related export-led growth model is dangerous for China, East Asia and the whole of the Asian continent. Notice also that many other economies outside of East Asia are following this BW2 regimes of fixed exchange rate, aggressive attempt to prevent appreciation via reserve accumulation and export-led growth. These include countries as far as India, Russia, Argentina, the GCC countries and other Middle East countries that are oil exporters and, until recently, even Brazil and other parts of Latin America. So the problems and financial vulnerabilities that we will outline below are relevant not just for East Asia but also for a broader group of emerging market economies around the world…

Here are ten points and observation on how Asia has not learned the true lessons of the 1997-98 crisis and how its policies are creating the basis of a future financial crisis in the region.

First, notice that BW2, fixed rates, easy monetary condition and low interest rates, asset bubbles and excessive reliance on export-led growth are all interconnected. Weak currencies, aggressive forex intervention to prevent appreciation in spite of current account surpluses and capital inflows lead to distorted relative prices – an undervalued real exchange rate – that punishes domestic private consumption and production of productive non-tradable services and rewards exports, investment for exportables, and investment in not-directly productive real estate and housing.

Second, the move to flexible exchange rate after the 1997-98 crisis was only temporary and soon these economies returned to effectively fixed or semi-fixed exchange rates in the new BW2 regime. Before the crisis the currency levels were somewhat overvalued; today they are grossly undervalued. Moreover, the attempt to prevent the necessary nominal and real appreciation of currencies – that are both undervalued and under appreciation pressure because of current account surpluses and net private capital inflows in the form of FDI, capital inflows in equity and bond market and hot money short term inflows – is leading to a massive and unprecedented increase in forex reserves in all of Asia…

Third, the ability of these economies to sterilize their forex reserve accumulation is severely limited…

Fourth, partially sterilized intervention is leading to lower than equilibrium interest rates, massive growth in the monetary based and massive growth of bank lending and credit growth. China has been attempting to control credit growth and the ensuing investment and asset bubbles that it generates via administrative controls on credit and real investment. But such controls are increasingly ineffective and source of further distortions in the allocation of savings to investment. Excessively low policy rates and short term interest rates and the accompanying credit bubbles are now becoming pervasive throughout Asia, especially the effective members of BW2.

Fifth, these monetary and credit growth and easy financial conditions are leading to inflationary pressures in these economies. Since the real exchange rate is undervalued relative to its much appreciated equilibrium level there are only two ways via which the actual real exchange rate can appreciate towards the stronger equilibrium one: either a nominal exchange rate appreciation or via domestic inflation. Since in most countries – with Korea, Thailand and Indonesia being partial exception – the nominal appreciation is prevented the real appreciation is often occurring via an increase in domestic inflation…in other economies where labor markets are not as flexible and/or where energy subsidies have been phased out inflation is rising: both in BW2 economies in East Asia and among effective members of BW2 outside that region (specifically in India, Russia, Argentina, GCC countries and other Middle East countries, etc.).

Sixth, these monetary and credit growth and easy financial conditions are leading to asset price inflation, especially in countries like China where goods inflation is limited, but more generally a
mong most BW2 economies.

…easy credit has led to a massive surge in leveraged investments in stock markets in many of these economies. In China alone it is estimated that retail stock market investors – most clueless about the financial risks that they face – are now estimated to be over 100 million; day-trading of the type observed during the US dot.com bubble in the late 1990s are now common throughout Asia. Similar housing and stock market bubbles – and at times temporary busts – have been observed in India, Russia, Mid-East oil exporters, Argentina and other BW2 member countries. Of course, some of the increases in equity prices and in other asset prices are related to the much improved economic fundamentals. But there are now increasing signals of asset price overheating and bubble conditions, as recent episodes of stock market turmoil in China, India, and the Middle East suggest.

Seventh, the fiscal and financial costs of forex accumulation and partial sterilization are increasing…

Eighth, undervalued currencies and rising current account surpluses imply that Asia is excessively reliant on US growth and growth outside of Asia and too little on domestic demand…

Thus, while the US is the consumer of first and last resort with its spending well in excess of its income (leading to a massive current account deficits), China is the producer of first and last resort with its spending well below its income (leading to massive current account surpluses). More importantly, via the trade with China, most of East Asia depends on net exports and on the health of the US economy as much as China does.

Ninth, the currency and economic policies of China and East Asia have contributed – among many other factors – to unsustainable global current account imbalances whose rebalancing now risks becoming disorderly rather than orderly. Global imbalances have many causes and sources including – crucially – the low levels of US private and public savings. But China and Asia have had an important role in aggravating these unsustainable imbalances…

Tenth, the excessively easy monetary and credit conditions caused by BW2 and partially sterilized forex intervention, as well as low global nominal and real interest rates generated by this Asian excess of savings over investment have created conditions that exacerbated the excess of spending over income in the US and have fed global assets bubbles in a variety of risky assets, be it equities, credit spread, sovereign emerging market spreads, worldwide housing bubbles, commodity price booms. Low long term interest rates (Greenspan’s bond market conundrum) from excessive savings and low short interest rates given partially sterilized massive forex intervention together with the slosh of global liquidity that forex intervention, easy money in Japan and massive yen carry trade and excessive savings create excessive liquidity in the global economy that is behind the asset bubbles, credit boom, excessive leverage among private equity, hedge funds and other leveraged institutions that we are observing today. These excesses have led to an imbalance global economies where real (global current account imbalances and excessive global dependence on now fragile US growth) and financial imbalances (credit booms, risky leverage, and asset bubbles) are growing.

In summary, BW2 was always a disequilibrium for Asia and the global economy; but now from a stable disequilibrium is becoming an unstable one. Partially sterilized intervention is feeding risky credit and asset bubbles; undervalued currencies that are prevented from appreciating via massive and increased interventions are causing both goods and asset inflation and bubbles. Policies of export led growth and undervalued currencies are causing growing global imbalances that are becoming unsustainable and increasing the dependence of China and Asia on a fragile and now faltering US economic growth as the risk of a US hard landing is rising. They are leading to excessive liquidity, asset bubbles and disequilibria not just in the region but also globally. And they are increasing the risks of protectionism in the US and Europe. Thus, this economic growth model is unstable for China, for East Asia and for the world economy. A more balanced global economy requires greater domestic demand in China and Asia and smaller global imbalances…

To achieve all this [rebalancing of the global economy and of domestic demand in BW2 economies] a more flexible exchange rate regime and greater currency flexibility is necessary in Asia and throughout Asia. The policy dilemma that China and Asia faces today is the classic Triffin’s inconsistent trinity: no country can have fixed exchange rates, an independent monetary and credit policy and capital mobility with no capital controls. In China, in spite of formal capital controls, capital mobility is widespread as such controls on inflows are very leaky. Thus, China by trying to keep an effective currency peg (as the rate of currency crawl is at a snail’s pace) has completely lost control of monetary and credit policy as interest rates are forced to be much lower than they should be given the overheating of the economy. And the desperate attempts of the Chinese to control the overheating via administrative controls on credit are failing given that excessive liquidity moves from controlled to uncontrolled sectors (from a boom in capex investment to a boom in housing investment; from a bubble in housing prices to a bubble in stock prices). The only solution to regain monetary and credit policy independence is to allow greater exchange rate flexibility. Similarly throughout Asia and among other BW2 members – India, Russia, the Middle East, Argentina – the same inconsistent trinity problems are emerging causing credit booms, economic overheating, goods inflation and asset bubbles.

As in the case of the Asian crisis where overheating, massive capital inflows, fixed exchange rates, credit booms and asset bubbles in equities and housing eventually led to financial imbalances before 1997 and an eventual crisis in 1997-98, the seeds of the next financial crisis are being planted today in Asia and in the other parts of the unstable BW2 system. It is true that today – compared to 1997 some vulnerabilities are different: we have current surpluses, large stock of foreign reserves, low stocks of short term foreign currency debts. Thus, a financial crisis coming from the unraveling of BW2 would not take the form – as it did in 1997 – of an external debt crisis. But like in the 1995-97 period, attempts to follow the US dollar and maintain fixed rates are feeding capital inflows, monetary creation and asset bubbles. It is easily forgotten that what triggered the Asian crisis were global conditions: then a strong dollar, a weak yen and carry trade that eventually unraveled; concerns about a global slowdown after 1995 and negative terms of trade shocks. This time around, as long as the US economy growing at a good rate the stable disequilibrium of BW2 could be maintained. But the trigger for its unraveling is likely to be, as in 1996-97, a change in global conditions external to Asia, specifically today the risk of a US hard landing as the housing recession is now spreading to the rest of the economy, creating a credit crunch and leading to a slowdown of private consumption.

As long as the US achieves a soft landing in 2007 the stable disequilibrium of BW2 can continue for a while longer. But a US hard landing (in the form of a growth recession or outright recession) will tip the BW2 disequilibrium from a stable one to an unstable one for many reasons.

First, a US hard landing would imply a sharp reduction of Chinese growth given the d
ependence of China on net exports and investment to produce exportables…

Second, a US hard landing of either type would not only lead to a painful growth slowdown in Asia and around the world. It would also undermine the basis of the BW2 regime. That regime in which China and Asia provide cheap goods to the US and, at the same time, the financing of the US current account deficit (a system of “vendor financing”) is stable only as long as Chinese and Asian growth can continue via ever expanding net exports. The US hard landing undermines that key condition for vendor financing, a rise in US imports from China and Asia. Also, while US imports would fall in a US hard landing scenario the US current account deficit would not shrink as now net factor income payments in the US current account are negative and increasing (as the stock of foreign debt is rising and the interest payments on US liabilities rising). Thus, while until now a system of vendor financing was financing an increase in Asian exports to the US, a US hard landing would imply Asian to continue financing the increased US foreign debt and its factor income servicing rather than growing exports to the US. Thus, the willingness of Asia and other BW2 regime members to finance the US would be undermine at the time that downward pressures on the US dollar from the US hard landing lead to greater expected capital losses on holdings of dollar reserves and dollar assets.

Third, in a US hard landing protectionist pressures that are already high in a soft landing outlook would become severe with tensions on currency values turning into increasingly acrimonious trade conflicts and trade wars. In a US hard landing the US would want China to let the RMB to appreciate even more that it is pressing for it now; but in that lower growth environment where Chinese growth suffers even more, China would resist even more strongly further RMB appreciation. Thus, the outcome of this currency conflict would be a trade war between the US and China.

Fourth, a US hard landing would lead to the unraveling of the bubbly conditions in financial markets, of the credit booms and leveraged investments that that fed Asian and global asset bubbles. Risk aversion would sharply rise and investors’ confidence would sharply fall. In the spring of 2006 an inflation scare in the US led to sharp market turmoil in G7 equity markets and in emerging markets’ financial markets. In February and March 2007 a growth scare in the US following the subprime carnage led to another episode of financial turmoil in G7 and emerging markets. Now, if instead of growth “scare” we were to experience a real US growth “downfall” that takes the form of a hard landing (either a growth recession or an outright recession) the consequences for financial markets and real economies would be severe. Economies would sharply slow down, financial markets and risky assets would be shaken, global imbalances would not shrink as both US imports and exports would fall with the slowdown in global growth, dollar weakness and currency tensions would increase, and the risks of a protectionist trade war would increase.

Economic fragilities, boom and busts in housing, and policy weaknesses in the US are at the core of global economic imbalances that are leading to the risk of a US hard landing and a disorderly rebalancing of global imbalances. But it is also true that Asian currency and financial policies have fed such US imbalances creating a climate of global excess liquidity, low policy rates and easy monetary conditions (including easy money in Japan and massive yen carry trades), low global interest rates given the excess of savings over investment that have fed the US imbalances via an easy financing of the US fiscal deficits and the feeding of the US housing bubble, low private savings and consumption boom that is now under threat given the bust of the housing bubble.

In the meanwhile the Asian policies have both fed the US bubbles and imbalances and made Asian growth even more hostage to US economic growth. The entire Asian economic development for the last six years has been based on creating and feeding the US excesses that are now at risk of unraveling, a system of global imbalances that is now in danger of falling apart. In the short run Asia can do little to resolve this fragile disequilibrium. If the US hard landing occurs in 2007 the consequences for China and Asia would be painful even if easing of fiscal and monetary conditions would allow the region to partially absorb the US shock.

The key to this rebalancing of Asian growth is a faster rate of appreciation of the RMB, greater currency flexibility in China and the ensuing generalized appreciation of Asian currencies relative to the US dollar once China allows a greater appreciation of the RMB. Until recently most Asian economies have been wary to allow their currencies to appreciate too much because of the persistent Chinese policy to maintain an effective RMB peg with a very small and slow rate of upward crawl.

Most Asian economies realized that maintaining an effective peg to the US dollar (or equivalently to the RMB) is costly: it leads to excessive forex reserve accumulation with its ensuing short run fiscal costs and long run large capital losses; it leads to excessive monetary growth – via partial sterilization – and credit booms that feed asset bubbles. Thus, there is increasing Asian economies’ uneasiness with staying inside BW2. But as long as China keeps on pegging its currency most Asian economies can ill afford to get off the BW2 unstable train as the loss of competitiveness of their currencies relative to the RMB, relative to the other Asian currencies and relative to the G7 currencies would be serious and cause a loss of competitiveness and growth.

A few countries tried to get off the BW2 regime given the current and expected costs of staying in this regime and accumulating a dangerous stock of excessive forex reserves: these are Korea, Thailand and Indonesia that allowed some significant appreciation of their currencies in the last few years…

At the same time other East Asian economies such as Hong Kong, Taiwan, Singapore, Malaysia – as well as members of BW2 as far as India, Russia, Middle East/GCC, Argentina – have decided so far to stick with BW2, in Asia because China is still shadowing the US dollar and these economies in East Asia think they can ill afford to allow a loss of competitiveness of their currencies relative to the RMB given their direct and indirect trade links with China. But this continued membership of BW2 is leading to a continuation of the imbalances and financial vulnerabilities generated by BW2.

These policy dilemmas and tensions will remain as long as China decides to remain the leading economy of this BW2 and maintains its effective peg to the US dollar (as the rate of upward crawl of the RMB is extremely small and slow). But these economic and financial imbalances and vulnerabilities generated by BW2 are serious and building over time increasing the risks of a new and different type of financial crisis in Asia once the unraveling of BW2 becomes disorderly rather than orderly.

Thus, even leaving aside the risks of protectionism in the US, it is of tantamount importance that China realizes that its exchange rate regime is creating economic and financial instability in its own economic and creating serious problems for its trading partners in Asia…

In conclusion, Asia should now worry about not fighting the last war rather than getting prepared to deal with the next war or next financial stresses that will hit the region given its current financial and currency policies..

This policy of semi-fixed exchange rates supported by massive forex reserve accumulation is creating massive financial imbalances – excessive monetary and credit growth, a variety of financial asset bubbles, an excessive dependence on net exports and on US economic growth, an imbalanced pattern of aggregate demand – that will eventually end in a a new and different type of financial crisis, a crisis that would occur sooner rather than later if the US experiences a growth hard landing.

Thus Asia appears to have learned only some of the lessons of its 1997-98 financial crisis (the need to have sound macro and financial policies). It has not learned the real lessons of the crisis, i.e. that fixed exchange rates and poorly managed financial markets eventually lead to a build-up of vulnerabilities that can cause financial crises. The return to effectively fixed exchange rate and massive forex reserves accumulation in a good part – but not all – of East Asia is thus a worrisome sign that the lessons of the past have not been appropriately learned. Current financial and currency policies in East Asia have the risks of planting the seeds of its next financial crisis, a crisis that will have features and characteristics that will be different from those of 1997-98. Such a crisis can be avoided but it will take East Asia accepting a true move to more flexible exchange rate regimes and a significant and rapid phase-out of the current reckless policy of accumulating forex reserves in ways that are excessive and financially dangerous for East Asia.

Today, a year after I wrote that paper on the risks that Asia and other members of BW2 faced, the main predictions and implications of that paper – that the BW2 regime will lead to asset bubbles and goods inflation that would put a severe strain on that regime – have developed exactly as then predicted.

As argued then the rational response for these economies was then to let their currencies to appreciate at a faster rate (and/or phase out their pegs) to avoid the further rise in asset and goods inflation. Some degree of extra exchange rate flexibility did occur in China, India, Russia, and Brazil but not in the GCC countries or Argentina. But even that greater flexibility was not significant as very aggressive forex reserve accumulation occurred among the BRICs and other emerging market economies at rates that actually accelerated in 2008 relative to 2007. Thus, by early 2008 inflationary pressures became severe – with rising and/or double digit inflation in a large set of emerging market economies – and some asset bubbles started to deflate sharply (especially equity markets in China, Asia, GCC and other emerging markets).

By now inflation has become so high in so many emerging market economies that – in some dimensions – it is almost too allow these currencies to appreciate: inflation is so high that only an abandonment of pegs or of heavily managed rates and a very sharp nominal exchange rate appreciation would be able to control inflation Even in that case nominal appreciation would not be enough to control expected inflation: a much tighter monetary and credit policy – that is feasible only if enough exchange rate flexibility is allowed – would be necessary to control actual and expected inflation. But now the global economic outlook has much worsened with the US recession and the sharp economic slowdown in most advanced economies. The need to control inflation with a stronger currency and much tighter monetary policy in emerging markets is happening at a time when downside risks to growth are emerging in these countries because of the US recession and the slowdown in the advanced economies growth rate. Thus, emerging market policy makers face a serious dilemma: controlling inflation requires exchange rate flexibility and much tighter monetary and credit policy. But such policy may exacerbate the growth landing of these economies at the time when global conditions are leading to a sharp slowdown of growth in advanced economies that – in due time – will slow down exports and growth of the emerging market economies.

Thus, it is not obvious that the members of BW2 will decide to phase out this regime and move to greater currency flexibility and tighter monetary and credit conditions. Rising oil, energy and food inflation in these economies is already leading to popular unrest, riots and – in some cases – ruling governments being toppled. Thus, the last thing that these economies need is a sharp growth slowdown on top of socially unpopular rising inflation. That is why – while the rational choice would be phasing out BW2, allow greater exchange rate flexibility, regain monetary autonomy, allow currencies to appreciate and tighten monetary/credit conditions – many of these BW2 may be reluctant to follow this painful policy path.

Indeed, while some monetary tightening has occurred in emerging market economies it has been so far well behind the curve: the rise in policy rates has been much less than necessary to control actual and expected inflation. If – as possible – these economies refuse to do what is necessary to control the rise in inflation the outcome will be one in which inflation will rise further and become entrenched in these economies. If that were to be the case these economies will accept a higher – and possibly double digit – inflation rate as a way to avoid a sharp growth slowdown. Indeed, the recent rise in inflation in emerging market is becoming a true test of whether these economies are able and willing to stick to low inflation policies and/or to formal inflation targeting. In most emerging markets with inflation targets such targets have now been breached big time and in some of them – namely Turkey – formally abandoned as being unrealistic.

Also, if these economies will decide to accommodate most of the rise in inflation rather than fight it as a way to prevent an excessive growth slowdown the outcome will be one where the real appreciation of their currencies will occur through this process of rising inflation. Thus, letting inflation remain high will effectively erode the competitiveness that the pegged or heavily managed currencies policies of BW2 had tried to maintain. Eventually the real appreciation had to occur: and since it was mostly not allowed to occur via a nominal appreciation it will occur – and it is now occurring – via a rise in inflation.

When this rise in inflation becomes significant and persistent three additional outcomes will emerge. First, the competitiveness will be eroded by rising inflation. Second, downward pressures will occur on currencies that from undervalued become – via high inflation – overvalued; an example of that is the case of Argentina. Third, the rise in commodity and goods inflation in emerging markets will lead to an ensuing rise in inflation in advanced economies. This may be thus the beginning of the end of the period of “great moderation” in the global economy where growth was high and inflation low. This great moderation was indeed in part due to the low inflation that the rise of China, India and other emerging markets – with their production of cheap goods and services – had generated. Imported inflation is certainly rising in the US because of rising import prices for goods from China and Asia, a weak dollar and commodity. And it is rising in other advanced economies – even in those whose currencies are rising relative to the US dollar – because of rising prices in emerging markets and in commodity markets.

Thus, even if the BW2 economies were to resist further their currency appreciation and desperately hold on BW2 – as the rate of accelerated forex accumulation in 2008 so far suggests – the result, like the demise of BW1 shows, would be a rise in global inflation that would – at som
e point – destroy BW2 as rising inflation would erode the competitiveness of the BW2 club. Thus, either way we are now closer to the end game of BW2: formally BW2 is still alive and well as the reserve accumulation is as aggressive as ever or even more aggressive than in 2006-2007 among many – but not all – members of the BW2 club. But continuing with BW2 is leading now – with certainty – to inflation becoming so unhinged in the BW2 club that the basis of undervalued currencies and export-led growth will be destroyed by the real appreciation that a rise in inflation induces. So the delusion – exposed by the proponents of BW2 – that this regime would last for 20 years or more is rapidly being challenged. Either way, we are now much closer to the end game of BW2.

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252920159 Responses2008-07-06+23%3A26%3A38Nouriel+Roubini to “Will the Bretton Woods 2 (BW2) Regime Collapse Like the Original Bretton Woods Regime Did? The Coming End Game of BW2”

Anonymous • July 6th, 2008 at 11:51 pm

Another excellent article by Prof. Nouriel

Guest • July 6th, 2008 at 11:52 pm

First! suckas

Anonymous • July 6th, 2008 at 11:58 pm

Bridgewater Associates says bank losses could be $1.6 Trillionhttp://jtaplin.wordpress.com/2008/07/06/bank-losses16-trillion/

Yankee • July 7th, 2008 at 12:25 am

Is it just my area or do you all see reductions in people on the road, in grocery stores, etc.?

Anonymous • July 7th, 2008 at 1:26 am

I live in Los Angeles, and I have definitely noticed that the freeways are MUCH less congested.

Allan Bloomg • July 7th, 2008 at 3:36 am

I enjoy your critical work Mr. Roubini, but I suggest you change the photo. You are not such a tough looking man, and why not just look natural and relaxed. This pensive tension comes off conceited and slightly pompous. Doesn’t do your work credit. Allan Bloom

Guest • July 7th, 2008 at 4:11 am

How can his photo possibly affect the content of his articles or even the intelligent readers interpretation there of in anyway what so ever? This isn’t a dating site and he isn’t trying to get you to like him, he’s just telling us how he thinks it is!

London Banker • July 7th, 2008 at 7:02 am

I predicted (in writing, printed in a global journal) the collapse of Bretton Woods 2 in early 2005 as a result of instability arising from the inflationary pressures of deficit spending related to financing the Iraq War. My reasoning was that the Iraq War seemed to parallel events of three decades earlier. The ballooning war debt from the Vietnam War in the late 1960s led to the collapse of Bretton Woods in 1973 led to rampant global inflation through the 1970s led to the Third World Debt Crisis of the 1980s. The Iraq War was by 2005 leading to massive dollar deficit finance, leading me to expect the collapse of Bretton Woods 2 and massive global inflation, and probably a huge debt deflation as the credit crisis leads to greater economic and financial dislocation.History doesn’t repeat itself, but it sure does rhyme.

Rich R • July 7th, 2008 at 7:37 am

Another great post, Sir. @London Banker Yes the similarities are great between the 70s and now. There are hidden economic consequences to the debt and war. In the 70s we lost our Aerospace Engineering capabilities to pay for Viet Nam. It is no wonder to me, having gone to school with re-tooling Aerosopace Engineers cut at the pinnacle of success (Think Apollo program), that the space shuttle has blown up twice and was allowed to continue into service through next year! I said then and believe it more today that no civilized nation with a plan would have ever allowed that innovative group to be decimated. The most unbelievable part is that we are doing it again!! This time its our basic NIH funded bio medical research that would produce new treatments, vaccines that wouldn’t cost 100,000 per year per patient. Recent looks at the DOE labs showed they are, well, largely an illusion. Again no plan for alternative energy capabilities (albeit private equity is assisting this time; finally).The space shuttle blowing up multiple times is in my mind no doubt related to this. Ditto Boeing outsourcing much of its manufacturing on the 787 program.So, the timing of this train wreck is measured in months and years. Many of us have seen it coming, but couldn’t predict when the imbalance would get to a crisis point. It seems we are getting much closer.@yankee Yes I have noticed a bit less traffic out there and have previously reported unusual phone calls and offers from Marriott and Sheraton to drum up business. Virgin and BA have sent deep discount offers a bit earlier in the Summer than previous years (think how many Investment Bankers aren’t going back and forth the pond this year). The Italian hotel in Florence where I’ll be staying later this month still has ample room availability. Most unusual.

Guest • July 7th, 2008 at 8:03 am

Idiots payed for talkin Shit:Deutsche, UBS Fight History Forecasting Best S&P 500 Since 1982By Eric Martin and Michael TsangJuly 7 (Bloomberg) — Deutsche Bank AG, Lehman Brothers Holdings Inc. and UBS AG say the Standard & Poor’s 500 Index will gain the most in 26 years during this year’s second half. That isn’t going to happen, if history is any guide.The S&P 500 will rise 18 percent by January, according to the consensus projection of 10 U.S. strategists surveyed by Bloomberg. The forecasts are based partly on estimates that profits will jump 50 percent in the fourth quarter after falling for the past year. …..http://www.bloomberg.com/apps/news?pid=20601087&sid=aTjWQbjpkpxk&refer=home

Guest • July 7th, 2008 at 8:10 am

..The forecasts are based partly on estimates that profits will jump 50 percent in the fourth quarter after falling for the past year.Maybe they are right.50 per cent from zero is zero.

Guest • July 7th, 2008 at 8:26 am

Guest on 2008-07-07 04:11:57This isn’t a dating siteWhat? Bummer. There surely would have been many intelligent dates here.

Mohit Satyanand • July 7th, 2008 at 8:35 am

An excellent piece – as always. But I find it difficult to digest China and India being lumped together – one is a huge net exporter of goods and services, and most would agree has an under-valued currency; the other is a net importer, with the current account deficit rising sharply as oil gains. It would be difficult to contend tha the Indian rupee is under-valued.

Free Tibet • July 7th, 2008 at 8:39 am

Lucid analysis, Sir. I had hoped that you would be proven correct in your contention of last year that a slowing of US & global economies would preclude inflation. I believe that it is clear now – and you indicate as much above (“Imported inflation is certainly rising in the US because of rising import prices for goods from China and Asia…) – that it hasn’t and won’t. Left unaddressed then is the appropriate US policy response to the eminent demise of BWII. Reducing interest rates, as you advocated last year, and Treasury buying/underwriting of bad real estate debt (expanding US budget deficit), as you advocated more recently, exacerbates the current global imbalances. That can’t be a good thing. First rule of holes: when you’re in one, quit digging!

Medic • July 7th, 2008 at 8:45 am

@ Guest on 2008-07-07 08:03:57The article is more kool-aid for the masses. Welcome to Jonestown – the outcome here will be no different. The only ones out alive will be those smart enough to escape before it’s too late.

Guest • July 7th, 2008 at 8:57 am

ok, I am tired of waiting.I want some right-wingers or other control types to come with a scheme to save us from this situation. Something along the lines of "from now on, UN sets worldwide rules on the financial market". Something that would be a nice companion to recent government surveillance laws passed in the western nations.Think its too early? Come on, I think Americans start about being ready for it. In any case the British are more pro-UN, so feel safe to start with an article in either the Financial Times or The Telegraph.

JGU • July 7th, 2008 at 9:31 am

Nice post, Professor.

Greenspam Legal Tenterhook • July 7th, 2008 at 10:05 am

C’mon we know the losses will actually be in the gajillion range. Bridgewater, ha-ha, funny name for a company underwater. I hear Milton Bradley is having trouble printing enough banknotes to represent just the banking losses. Me?, I just pencil in another 3 zeros on my banknotes. I have instructed my wife to call me MR. Central Banker. Why Laugh! My efforts are as real as global CBs.

Gabor • July 7th, 2008 at 10:09 am

Possible typo here:Second, downward pressures will occur on currencies that from undervalued become – via high inflation – undervalued; an example of that is the case of Argentina.should read from undervalued to overvalued I guess.anyways how about the autonomous effect of inflation on growth? there is a reason why inflation is the greatest enemy of the advanced economies, perhaps because inflation kills investment and growth like nothing else ?

Guest • July 7th, 2008 at 10:09 am

11:03 Fed’s Yellen: Things could get worse before they get better11:03 Commodities one of three factors dogging U.S., says Yellen

Medic • July 7th, 2008 at 10:26 am

Missing a bunch of comments here from earlier. What gives?

Guest • July 7th, 2008 at 10:29 am

Looks like the trading desks have their marching orders to protect 11,350 on the Dow at all costs today…

Stuart • July 7th, 2008 at 10:31 am

This does tie into the willingness, so far, of foreign central banks to fund the CA deficit. Still, the evil of inflation is a terrible price to pay and passing it on through increased export prices does not serve the host populace well history would show.

Guest • July 7th, 2008 at 10:39 am

11:27 More companies slashing dividends: S&P

Play On • July 7th, 2008 at 10:47 am

Oil down $4! They finally saw the "July 4 weekend driving season #s"

4822 • July 7th, 2008 at 10:59 am

I’ll be SO happy when oil gets back down to where it was @ $125 / barrel !

Nouriel Roubini • July 7th, 2008 at 11:05 am

Gabor, thanks for noticing the typo on undervalued/overvalued. I fixed it.Nouriel

Guest • July 7th, 2008 at 11:08 am

Hussman sees $60 oil a possiblity:"In my view, the problem will emerge a few months from now, as a) economic demand softens further, b) planned production hikes actually emerge, and c) weakening price momentum encourages speculators to close long positions instead of rolling them forward. At that point, I expect that net speculative positions will plunge by 10-15% of open interest and we’ll see a sudden glut on the market for spot delivery. It should not be surprising if this speculative unwinding takes the price of crude below $60 a barrel by early next year." http://www.hussmanfunds.net/wmc/wmc080707.htm

Guest • July 7th, 2008 at 11:15 am

"the price of crude below $60 a barrel by early next year."you are crazy and delusional. i don’t see that happening until there is global depression where unemployment shoot up to 10%, people jumping off building or bridge, more homeless people on street, various crimes go up, various countries unpeg to dollar, and interest rates from various countries shoot up to 10%. yep, you are delusional

Play On • July 7th, 2008 at 11:20 am

Guest @ 2008-07-07 11:15:57You cannot have $145 oil and 3.90% 10 yr. yield! Either the oil market is wrong or the bond market is wrong! Both cannot be right and my $$$ is on the bond market!

Guest • July 7th, 2008 at 11:27 am

WOW! Oil took out $140 and stock cratered, all indexes red now!

Guest • July 7th, 2008 at 11:28 am

Oil down $5.64/brl now!

randy • July 7th, 2008 at 11:30 am

Anyone hear anything about fannie mae? The stock is tanking on no news!!! down 20% in the past few hours.

Guest • July 7th, 2008 at 11:34 am

Anyone see any news/reason for stocks to sell off 200 points from the highs? Does the tank job in oil confirm US recession to the non believers?

Guest • July 7th, 2008 at 11:41 am

Fannie and Freddie out to the wood shed!! Here comes nationalization of the 2 firms to a thatre near you! It appears as though Fannie warned it was having trouble raising the necessary capital to bring its ratios in line before they issue earnings.

Guest • July 7th, 2008 at 11:41 am

PPT laying a turd this morning? Geez!

Guest • July 7th, 2008 at 11:43 am

By Jody Shenn July 7 (Bloomberg) — Yields on agency mortgage securitiesrelative to U.S. Treasuries rose to the highest since March 13amid new concerns that banks may need to sell off the debt. The difference between yields on the Bloomberg index forFannie Mae’s current-coupon, 30-year fixed-rate mortgage bondsand 10-year government notes widened 7 basis points, to 204 basispoints. The spread has climbed 18 basis points since June 18. Investors are speculating that Bank of America Corp., thesecond-largest U.S. bank, may need to sell assets after buyingCountrywide Financial Corp., Kenneth Hackel, the managingdirector of fixed-income strategy at RBS Greenwich CapitalMarkets in Greenwich, Connecticut, said in note to clients. Otherfinancial firms may also be shunning the debt as they look tobolster capital ratios, Hackel said in a telephone interview. “Balance sheets are constrained and that’s making mortgagesanything less than attractive right now,” Hackel said, referringto agency mortgage bonds. Agency mortgage bonds, among the most liquid fixed-incomesecurities, are guaranteed by government-chartered Fannie Mae andFreddie Mac or U.S. agency Ginnie Mae. Simple spreads between 10-year Treasuries and bonds backedby Fannie Mae reached a 22-year high of 238 basis points on March6. An increase boosts the cost of new mortgages for the mostcreditworthy consumers. A basis point is 0.01 percentage point. Fixed-rated agency mortgage bonds returned 73 basis pointsless than Treasuries with maturities similar to their expectedlives in the first three days of this month, according to LehmanBrothers Holdings Inc. index data.

London Banker • July 7th, 2008 at 11:43 am

Hmm. Seems a bunch of early comments have disappeared. Mine boasted that I predicted collapse of BW2 in early 2005 – in print. Oh well, I guess only the Professor gets to say "I told you so" on his blog!

John Robb • July 7th, 2008 at 11:44 am

Edit?"By now inflation has become so high in so many emerging market economies that – in some dimensions – it is almost too allow these currencies to appreciate: "I suspect you mean:"it is almost too late to allow these currencies to appreciate…"

Guest • July 7th, 2008 at 11:44 am

12:41[FRE] Freddie Mac shares slump 20%12:41[FNM] Fannie Mae shares fall 13%

Guest • July 7th, 2008 at 11:45 am

$BKX getting pummled-down almost 5%

Randy • July 7th, 2008 at 11:47 am

@LB:is that sour grapes? I thought you were above that.

Lost Me Prop • July 7th, 2008 at 11:58 am

Hindenburg…Hindenburg…Hindenburg. I was carrying my stock certificates when I stumbled on a greased teflon floor covered in ball bearings. Here let me get up and…crash!

K J Foehr • July 7th, 2008 at 12:05 pm

This could be it boys and girls: capitulation. Freddie and Fannie are crashing.

Guest • July 7th, 2008 at 12:06 pm

http://www.foxnews.com/story/0,2933,376871,00.htmlThe reason? More than 85% of the available addresses have already been allocated and the OECD predicts we will have run out completely by early 2011.

Guest • July 7th, 2008 at 12:12 pm

Nouriel Roubini’s excellent dissection of BW2 is in reality the untangling of a planned global economy created by central banks and diverse government heads – in short, the camel that is the horse designed by a committee, galloping on debt and driven by incompetence and greed. Markets don’t need central bankers and fiat money.Who can forget the Dickens-like image of what brought on the French revolution. A gilded carriage and resplendent team of horses halts when a peasant child is crushed under a carriage wheel, and the haughty be-wigged and be-jeweled occupants are disgusted merely with the delay. The despotism of the French monarchy helped bring on the revolution, and contributed to the “reign of terror” in the revolution’s final stage. But the primary turning point from monarchy to revolution developed in the years before the Bastille fell.It was the familiar national condition known as debt — mountains of national debt. America may not be headed toward a reign of terror, but the U.S. government and its masters are abusing fiat money in much the same excesses as the Eighteenth French government used bank loans…spend, spend spend…steal, steal, steal. The plight of the poor in France, though miserable, was not as bad as in some other European monarchies. But the ignorance, isolation and selfishness of the French ruling class allowed economic problems to become unmanageable. Louis XVI, on the throne during the revolution, inherited an economy already headed for bankruptcy.With a sense of duty at the first, he resolved to begin fixing the problems, making the accomplished statesman Turgot Controller General. And as outlined in Gerald P. Dartford’s book “The French Revolution,” Turgot immediately and frankly informed his 21-year-old soverign what he must do to avoid economic disaster:“First, he said, ‘no bankruptcy’ since this would destroy all confidence in the government’s ability to reform itself; second, ‘no increase in taxes’ since those who were being taxed were already crushed beneath the burden they bore; and third, ‘no loans’ because more borrowing would only bring worse trouble in the future. ‘To meet these three points,’ he wrote, ‘there is but one means. It is to reduce expenditures below revenue, and sufficiently below it to insure each year a saving of two million livres, to be applied in the redemption of old debts. Without that, the first gunshot will force the state into bankruptcy.’”Turgot’s reforms, with the King’s backing, began to work right away and the first budget was balanced. But before long, Louis’ support began to waver as his brothers, his courtiers and Queen Marie Antoinette, feeling the mounting pressure from various parts of the ruling class, fought bitterly against any further reduction in spending. One especially wasteful cost involved a private corporation’s role in collection of indirect taxes — a privilege given after paying the King a fee and spreading gifts to prominent officials – that allowed some corporations and individuals to keep up to a third of their collections.The King, becoming weak and indecisive, gave into the pressure and Turgot’s reforms were turned back. Dartford records Turgot’s prophetic reminder to the King as the crisis worsened: “Do not forget, Sire, that it was weakness that brought the head of Charles I to the block.” Turgot was eventually dismissed. In the beginning he had inherited a deficit of 50 million livres, but in the five years following his ouster, Dartford says five and six hundred million livres was believed to be added to the national debt. That first shot leading to bankruptcy that Turgot had warned against came as France participated in the British-American war. A succession of finance ministers brought on the final orgy of borrowing. And the breakdown finally came in 1788 when the King called for a “States-General,” a countrywide election device unused in 175 years. This brought on several wonderful months of representative government in the making with increasing concessions from the monarchy. But, with the downward spiral in the economy, came the eventual fights for power and the mobs streaming from the slums of Paris (a teeming city of 600,000 at the time). And, in the end, the guillotine.The excesses of the French monarchy, with the seat of government in the vast palaces and gardens at Versailles (a major expense in the French budget), bears a resemblance to the way the U.S. central government rules from Washington, D.C. Individual Americans are as removed from influence over their big spending central government as residents of 18th Century Paris were as removed from Versailles, 15 miles away. And now, with America’s modern day courtiers carrying the U.S. treasury away to their palaces, who can say when we’ll finally meet the quiet, calm Maximilien de Robespierre?In the end, as Mises would say, it’s individual “human action” and its consequences that determines free markets, and it’s the violent and coercive action of economic intervention and its consequences that determines socialistic markets.

Guest • July 7th, 2008 at 12:14 pm

http://mrmortgage.ml-implode.com/IndyMac: Significant Seizure Chatter – Is This the End? Finally!Posted on July 6th, 2008 in Daily Mortgage/Housing News – The Real Story, Mr Mortgage’s Personal Opinions/ResearchNote: At this point in time this story is RUMOR as is has not been made official by IndyMac or regulators. I am reporting it from what I have been personally told by people familiar with the matter. And I am not short this stock or trying to start rumors to drive down the price. How much further can it drop! Its at 67 cents. Just remember that when stories like this have come out in the past, there is a flurry of positive spin and in the end, 99.9% are true.My sources put regulators at IndyMac this weekend doing the deed. I am being told an announcement will come tomorrow first thing, that IndyMac is no more and at least their wholesale operation is gone effective immediately.

Guest • July 7th, 2008 at 12:17 pm

Looks like the selling frenzy has abated for now….

Guest • July 7th, 2008 at 12:21 pm

http://www.minyanville.com/articles/UPS-FDX-BBY-nke-FO-GE/index/a/17888You can’t handle the truth!!!!!

Guest • July 7th, 2008 at 12:31 pm

@ London Banker: “Hmm. Seems a bunch of early comments have disappeared. Mine boasted that I predicted collapse of BW2 in early 2005 – in print. Oh well, I guess only the Professor gets to say "I told you so" on his blog! ”It’s an obvious glitch. Please repost as I look forward to reading your analyses. When the Professor makes a prediction, he puts his reputation on the line: he’s not apprehensive concerning our predictions – or those of his colleagues.I hope others will repost, also, as their comments probably cannot be retrieved.

London Banker • July 7th, 2008 at 12:31 pm

@ RandyNo sour grapes here. I’m grateful to the Professor for this blog of his that always covers topics that interest me, my chums here in the comment sand box, and my own little corner blog on Fridays. I’m curious as to why the comments were removed, but not so much that it will keep me up nights. Much more interesting today is renewed speculation that UAE may be angling to drop the dollar peg due to rocketing inflation. UAE is finding it harder to attract and keep expats with inflation rocketing there by 20 percent a year and the dollar devaluing against expats’ home currencies. Most expats in Dubai are from UK, Europe and Australia – none of which are dollar pegged – so that as the dollar tanks their mortgages back home get relatively higher at the same time the cost of living squeezes them in Dubai. Since most compensation packages are fixed for three year contracts, they’re really hurting. Sooner or later that’s going to impact the various mega projects underway in the region.

Guest • July 7th, 2008 at 12:37 pm

Rather than the U.S. bailing out the rest of the world, Fleck says today “Global economy won’t bail out the US.”http://articles.moneycentral.msn.com/Investing/ContrarianChronicles/GlobalEconomyWontBailOutTheUS.aspx

Guest • July 7th, 2008 at 12:46 pm

1:36[FRE] Lehman says possible rule change may force GSE capital raise1:36[FRE] GSEs likely to get exemption from any rule change: Lehman 1:36[FRE] Change could leave Fannie, Freddie undercapitalized-Lehman What does Lehman say about Lehman??

Guest • July 7th, 2008 at 12:49 pm

I wish the financial pundits would quit saying we’re on the “edge of a bear market”; it’s obvious this is nothing more than a closet bull market.

Guest • July 7th, 2008 at 1:03 pm

bond market is wrong.

Guest • July 7th, 2008 at 1:06 pm

like i said, until there is global depression. oil will not go to $60/brl. bond market is wrong.

Guest • July 7th, 2008 at 1:09 pm

First, the bond market is NEVER wrong and second, the last 4 major sell-offs saw the VIX peak at an average of 31.29, with the March "low" hitting 32.24. Even now, being at a new low, and the Dow now off 156 points, the VIX stands at 26.87. We are no where near capitulaiton!

Guest • July 7th, 2008 at 1:10 pm

Crude is lwtting you know the global recession is now upon us…

Guest • July 7th, 2008 at 1:14 pm

"What’s in a name? That which we call a rose by any other name would smell as sweet." Ah, so, a market that lumbers like a bear, smells like a bear, must be a bear. The bull is down.

Guest • July 7th, 2008 at 1:20 pm

The buying frenzy is here a little early today…

randy • July 7th, 2008 at 1:25 pm

@LB:Glad to hear it. Thanks for the tip on UAE and the dollar peg. I think it’s just talk, don’t you? If they de-peg I think that could be the catalyst for a big swing down in equities. Your thoughts?

Play On • July 7th, 2008 at 1:25 pm

Guest on 2008-07-07 13:06:13Boeing is down from $107 to $63 in 48 weeks! What else do you need to know about world growth? Oh EADS is also at a 52 week low! World growth 7end out!

Guest • July 7th, 2008 at 1:25 pm

On Monday, a note from Lehman Brothers analysts said a pending change to a Financial Accounting Standards Board rule could result in Fannie Mae needing to raise an extra $46 billion in capital and Freddie Mac needing to raise $29 billion. The Lehman Brothers analysts also said they believe it is likely Fannie and Freddie would be granted an exemption to the FASB rule change. "A literal interpretation of their minimum capital requirements would suggest that the GSEs would become significantly undercapitalized, and it would be very difficult for them to raise the capital needed," the analysts wrote. Egan-Jones Ratings, a ratings agency paid by investors, said Monday that Freddie Mac has a market capitalization of $7.2 billion but probably needs more than $5 billion in capital to rebuild its capital base. "As the mortgage market deteriorates, we expect more charge-offs," the agency warned. "The model of the U.S. guaranteeing Freddie’s debt and shareholders benefiting from the upside might change," the agency also said in a note to clients. Spokespeople for both companies weren’t immediately available for comment.

Guest • July 7th, 2008 at 1:26 pm

A worthwhile early warning website I found while reseraching IndyMac:Columbia Journalism Review:"Ryan Chittum is a former Wall Street Journal reporter, a staff writer for CJR’s business section, The Audit, and the mastermind behind Opening Bell, our early-morning guide to the day’s top business stories. He reads as widely as is possible at 3 a.m."http://www.cjr.org/the_audit/opening_bell

Guest • July 7th, 2008 at 1:33 pm

Backup to Roubini:“Crippling effect of inflation in poor countries” (SF Chronicle)July 6, 2008….Prices in one in four countries, many of them in emerging markets, are accelerating at a double-digit pace, which puts them at least two and a half times the 4 percent annual U.S. headline inflation rate, according to new research from Morgan Stanley.That should be a wake-up call for anyone counting on investments abroad to prop up their portfolios as U.S. stocks teeter on the edge of a bear market.Sure, the "decoupling" strategy worked for investors in the recent past. Foreign holdings fared better because international economies were outperforming U.S. growth.The U.S. economy has slowed to nearly a standstill in the last year because of the mounting inflation and the collapse in the housing and mortgage markets. Other industrialized countries have seen about a 2 percent average rate of growth while emerging economies have topped 7 percent.That growth is now being threatened by inflation. And remember: In the developing world, a larger portion of household expenditures tends to go to the most inflationary items – food and fuel.Food prices have jumped 39 percent from February 2007 to 2008, led by wheat, soybeans, corn and edible oils, according to the International Monetary Fund.That hits residents of emerging markets much harder than those living in more advanced economies. People in countries like Vietnam, Russia, Egypt and India put at least 30 percent of their spending toward food, well above the 6 percent allotment for U.S. households, according to U.S. Department of Agriculture.That’s why Morgan Stanley economists Joachim Fels and Manoj Pradhan said they were flabbergasted by their findings that 50 countries had double-digit inflation rates. On that list were six of the 10 most populous countries in the world, including India, Indonesia, Pakistan, Bangladesh, Nigeria and Russia.In total, those facing such pricing pressures accounted for 42 percent of the world population.Soaring inflation is not easy to tame. Some countries, such as India where inflation is running at around 11 percent, may have no choice but to boost interest rates. Others, however, will balk at tightening monetary policy because they don’t want their currencies to surge, which would then raise the price of their exports.Many emerging-market economies also link their currencies to the dollar, and because of the Federal Reserve’s loose monetary policy right now – the central bank has aggressively cut interest rates in response to the credit crisis – that has helped feed inflationary pressures.The longer inflation remains elevated, the more damage it will do to long-term economic growth."There is plenty of reason to worry about the continuation of the bull story for emerging markets, especially in those countries that have seen a sharp acceleration in inflation, are unable or unwilling to tighten policy sufficiently and are commodity consumers rather than producers," the Morgan Stanley economists wrote.But even as prices surge, earnings forecasts aren’t coming down in many global markets. That may give investors false hope that many countries will bypass the inflation storm.For instance, in Asian countries outside Japan, earnings forecasts are still for 11.6 percent growth over the next 12 months and 15.1 percent growth in calendar year 2009, according to Barclays Capital.Those estimates "are implicitly assuming that inflation will either miraculously disappear on its own accord or that central banks are not going to bother doing anything about it. Neither is particularly believable," wrote Tim Bond, head of global asset allocation at Barclays.Barclays is recommending that investors either avoid owning stocks in that region or that they short shares, meaning bet they will decline."Although the area is currently outperforming in terms of economic growth, the inflationary environment is not far short of disastrous," Bond said.http://www.sfgate.com/cgi-bin/article.cgif=/c/a/2008/07/06/BUR711I32T.DTL&feed=rss.business

Anonymous • July 7th, 2008 at 1:51 pm

Indy Mac is closing TODAY. The entire Marlton NJ office is apparently being shut down and their other operations offices are closing. All wholesale operations are gone."As this news rolls across the country, we will keep you updated on developments. One source says as many as 4,000 people will be laid off. It’s early in the day, but an official announcement is expected within hours as to the extent of the shutdown.Bloomberg is showing trading halted

Guest • July 7th, 2008 at 2:01 pm

WOW! Volitile trading here-who is going to win this battle, do we magically erase the day’s losses or do we make fresh lows?? The final hour PPT bell just rung, lets see what happens…by the way, as I type, the dow just rocketed 50 points higher!!! Magic isn’t it…

Guest • July 7th, 2008 at 2:03 pm

DOW LOSSES CUT IN HALF IN 2 MINUTES!!!

PhilT • July 7th, 2008 at 2:07 pm

Bravo Professor !But what of BW3 ? What does it look like from your vantage point ?

Guest • July 7th, 2008 at 2:11 pm

A 30+ point drop is the NASD has been all but been eliminated, dow only down 65 points now-just when you thought the criminals had been locked up…

Guest • July 7th, 2008 at 2:12 pm

PPT! PPT! PPT! I wish I had access to cahs in the $B’s anytime I wanted it!

Guest • July 7th, 2008 at 2:19 pm

market is going green-unbelievable!

Guest • July 7th, 2008 at 2:29 pm

We are gong to close up on the 3 major indexes-wow…

milimo • July 7th, 2008 at 2:33 pm

Thank you for interesting contribution Professor,What from here on? Japan was in similar situation back in early 80′s as China is today. And then when US have sky high intersest rates, Japan still was doing excelent. Nikkei was up 5 times and Yen (vis a vi bascet of currencies) appreciated two fold in roughly 8 years. Today in emerging market arena you have a lot of nations that are populous as US or even more with desires to consume and have all the things that we have in US or Europe. I still belive that if these countries start appreciate their currencies and get rid of very high inflation rate, their growth can be based on inter-trade between themselves (in the meantime that US and EU are in crisis) the downturn in those emerging world will be not as severe as it look now. I would appreciate your toughts on this in the future.

Guest • July 7th, 2008 at 2:40 pm

ALL GREEN NOW!

Guest • July 7th, 2008 at 2:51 pm

asia and europe market up. today, usa market green. cheers. $60/brl for oil??? delusional.

K J Foehr • July 7th, 2008 at 3:01 pm

S&P500 closes in bear market territory, No capitulation, yet.

Guest • July 7th, 2008 at 3:16 pm

One way to look at this, the major losses of last week stayed in place. They did not recoup. The S&P wants to go down. You know why? It’s a bear market. The bear is back… and he is MAD.

FF • July 7th, 2008 at 3:18 pm

It appears that the long rates are directly correlated to the stock market performance (i.e. compare the 10-year yield to the S&P 500) over the last year. I assume, based on this blog’s forecast, that long rates should continue lower as the market weakens. This however contradicts the stagflation argument, unless the correlation breaks. Any help on this topic would be appreciated.

K J Foehr • July 7th, 2008 at 3:21 pm

Well, I have to correct my post about the S&P reaching “official” bear market status today. The number, according to my calculation is 1252.12 and we settled above it after the close to end the day at 1252.31.How convenient…Nevertheless, sooner or later, we will get there, and significantly lower, IMO.

FF • July 7th, 2008 at 3:37 pm

Additionally, why are the long rates indirectly correlated to the commodity performance? I would think that commodity inflation would result in increased inflation expectations and, thus, rising rates. Are commodities (i.e. Gold/Silver) now acting as a monetary refuge from credit deflation?

K J Foehr • July 7th, 2008 at 3:42 pm

Indymac Issues Stakeholder LetterPASADENA, Calif., Jul 07, 2008 — Indymac today issued the following letter to its stakeholders:Dear Indymac Stakeholders:In this very difficult and challenging environment, any of the actions that we take to keep Indymac safe and sound unfortunately have negative consequences to some important constituency. As we stated in our financial update on May 12, 2008, we have been working with our investment bankers to raise additional capital. To-date, we have not been successful with these efforts, and, while we will continue these efforts with our bankers and others, we don’t expect to be able to raise capital until there is more stability and less uncertainty in the housing and mortgage markets. While some shareholders may believe it is in their best interests that we not raise capital right now given the significant dilution that it would cause, there are consequences of not being able to raise more capital and, therefore, actions that we now must take.……Without an external capital raise, the traditional way to improve safety and soundness is to sell assets and shrink the balance sheet, which in normal times generally has the effect of improving capital ratios and bolstering liquidity. Yet in this environment, where either there are no bids for most of IMB’s mortgage loans and securities or the bid/ask spreads are abnormally wide, "fire-selling" assets would actually deplete capital further. As a result, the most realistic and cost-effective way to shrink both our balance sheet and ourservicing rights asset (which, as discussed in previous communications, is up against the regulatory cap limit), is to curtail most new loan production. In addition to needing to shrink our assets to improve our capital ratios, we also need to do so to ensure that we maintain prudent operating liquidity. A consequence of falling below well-capitalized is that we are no longer permitted to accept new brokered deposits or renew or roll over existing ones, unless we get a waiver from the FDIC. While we have submitted a waiver application, it is uncertain as to whether such a waiver will be granted.As a result of the above, we have made the difficult decision, effective July 7, 2008, that we will no longer accept any new loan submissions or rate locks in our retail and wholesale forward mortgage lending channels, except for our servicing retention channel. ……Unfortunately, the above actions will necessitate the reduction in our presentworkforce from approximately 7,200 to roughly 3,400 or so over the next coupleof months, which should reduce our operating expenses by roughly 60%. Very truly yours,Michael W. PerryChairman and Chief Executive Officer

ptm • July 7th, 2008 at 4:32 pm

K J Foehr on 2008-07-07 15:42:07 – Indymac Issues Stakeholder LetterThank you for that piece of info. Here is what Wikipedia says about Indymac.Indymac Bancorp, Inc. is the holding company for Indymac Bank, F.S.B., the largest savings and loan in the Los Angeles area and the 7th largest mortgage originator in the nation. Indymac Bank, operating as a hybrid thrift/mortgage banker, provides financing for the acquisition, development, and improvement of single-family homes. Indymac Bank also provides financing secured by single-family homes and other banking products to facilitate consumers’ personal financial goals.With Indymac going into hibernation and the rumblings around Fannie & Freddie, it looks like things are starting to fall apart faster than expected. I think the earliest anyone had put a time line on this was at the end of 2008 or out in 2009?

CPDS • July 7th, 2008 at 5:33 pm

Useful analysis. One point to consider is that there is an additional risk factor in current situation compared with BW1 era in that those countries with exchange rates fixed low against $US that generate large current account surpluses and rely on US as consumer of last resort are mainly in Asia (especially Japan and China). And the character of East Asian economic / financial / monetary systems seems to be such (ie involving coordination of economic activities through social relationships rather than concern for return on capital) that they need to maintain current account surpluses to avoid financial crises due to bad balance sheets like the 1997-1998 Asian crisis – see more detail at http://cpds.apana.org.au/Teams/Articles/Financial_instability.htm#Imbalances

Softwarengineer • July 7th, 2008 at 5:47 pm

I’D SUM IT UP SIMPLYI know we’re in a global economy, albeit higher and higher oil prices are making domestic sources more and more cost effective with time, irrespective of a $15/20 hr difference in factory wages. That’s the good news for America.Albeit, the rest of the world is the frame and wheels of the global economy vehicle, while America is the prime "consuming engine". When we stop consuming, the global economy vehicle’s engine is essentially dead.

J. • July 7th, 2008 at 6:26 pm

@Guest on 2008-07-07 12:12:29,Unless it is imagined that markets are simply relations between people and things, markets are necessarily "socialistic" since they are relations between people. Through both production and market, the capital system simultaneously socializes and makes private.

Forensic economist • July 7th, 2008 at 7:11 pm

OUTSOURCING ARCHITECTUREA little off topic, but I thought this might be of interest:At a fourth of July party, I was talking with a friend of a friend, who was involved in a new web business called houseplans.com. It sells professionally designed home plans for a modest price; you can then arrange to have the stock plans modified as you desire and to fit your lot. The modifications are done by architects in India.Unfortunately for my interlocutor, he admitted that his timing was terrible since people who aren’t building custom houses this year don’t need his plans. It seems like a good idea, but I am sorry to see professional jobs leaving the US.

Guest • July 7th, 2008 at 7:15 pm

From Alan Abelson’s July 7 column “End of an Era” in Barrons’s:[The Bank for International Settlements –BIS] doesn’t much hold with the notion, so firmly held in Wall Street and Washington, that the concoction known as ‘core’ inflation, which eliminates such insignificant stuff as the cost of food and energy, is the proper measure of inflation. Instead, the bank is convinced that in the U.S. and the Eurozone, headline inflation—which, of course, much to the chagrin of the no-inflation claque, includes prices of food and energy—has become a much better predictor of inflation.As to whether the economy is done in by a violent flare-up of inflation in a redux of the 1970s or by the insufferable weight of debt aggravated by the brutal credit crunch, the BIS ventures with admirable impartiality that those on both sides of the argument might in the fullness of time be proved right. Which pretty much echoes our feeling that the current surge of inflation will worsen ponderably and be followed by a painful period of deflation. The bank warns that resorting to ‘gimmicks and palliatives’ to support asset prices and stymie an impulse among consumers to save will only make things worse.The BIS lays the blame for the current financial mess we find ourselves in squarely on the vast buildup of debt over the years that has instilled in various global economies a dangerous tendency, fed by easy credit, to magnify booms and busts. From here on, in other words, you might as well kiss those comparatively mild recessions and moderate expansions that we’ve recently had goodbye.[As Philippa Dunne and Doug Henwood at the Liscio Report] sum up the message in the BIS annual report, it increasingly looks ‘like the evermore freewheeling financial environment that we’ve taken for granted for the last 25 years is behind us.’ Or, as the Bank declaims, ‘has run its course.’

Medic • July 7th, 2008 at 8:20 pm

So does the whole Indy Mac thing (no new loans, 2nd QTR losses larger than 1st, cutting staff in half, etc.) mean the housing issues have finally hit bottom? Whew! I’m glad that’s over. What?! Look out below?! No, wait! They said it was over…….SUCKERS!!!!! The unwind is in the VERY early stages. There is nowhere to go from here except down. Have a safe trip everyone.

Guest • July 7th, 2008 at 8:21 pm

In the article below, I question Bloomberg’s assumption that Paul Volcker is good for “emerging markets” but anathema for the U.S., while we sit here on near-zero negative interest rates as double digit inflation rages like the Big Sur fire — and don’t try to tell me differently – summarizing Volcker thusly: “Volcker pushed interest rates as high as 20 percent and drove the U.S. into its deepest recession since the 1930s.” Rates touched 20% for such a short flash that practically no one but a few insiders ever saw them. But, like a laser, they cured inflation – until it flared again.And surely it is stretching it for Bloomberg to compare a recession that began July 1981 and ended in November 1982 (a recession that few living then can even remember) with the 1929-1939 Great Depression that was checked in its devastation only by a war deployment of 13,104,355 men and women into United States forces and a war economy employing millions more:“Bernanke’s Emerging-Market Disciples May Need to Follow Volcker” by John Fraher and Shamim Adamhttp://www.bloomberg.com/apps/news?pid=20601087&sid=a2JbN2uUWXQI&refer=homeJuly 7 (Bloomberg) — Policy makers in emerging economies from Russia to Vietnam may have to start acting less like Ben S. Bernanke and more like Paul Volcker if they want to bring inflation under control.With currencies tied to the U.S. dollar, officials in many developing countries have had to keep their monetary policies linked to the Federal Reserve’s. Now, after chairman Bernanke led the Fed’s most aggressive easing in two decades, their central banks find themselves with interest rates too low for their economies and the worst bout of inflation in a generation.“There’s a lack of independent monetary policy; it’s been inappropriately stimulative,” says Nariman Behravesh, chief economist with Global Insight in Lexington, Massachusetts. The answer, he says, may be to “tighten credit more aggressively,” the way then-chairman Volcker did in the early 1980s.Such a policy shift would mean pushing borrowing costs above the level of inflation and keeping them there even at the cost of a steep slowdown that might send commodity prices into a tailspin. Faced with inflation that approached 15 percent in 1980, Volcker pushed interest rates as high as 20 percent and drove the U.S. into its deepest recession since the 1930s.Prices are now surging across the developing world. China’s inflation rate stayed near a 12-year high of 8.7 percent in May; prices in Vietnam jumped 27 percent in June and Indian wholesale prices increased 11.6 percent last month, the fastest in 13 years. Inflation exceeds benchmark lending rates in China, Russia, India and at least a dozen other emerging economies.Doing Something“They can’t sit on their hands any longer, and need to start reacting in order to be seen to be doing something,” says Robert Prior-Wandesforde, an economist at HSBC Holdings Plc in Singapore. “Interest rates do need to go a lot higher.”Rate increases big enough to slow down some of the world’s fastest-growing economies would help Bernanke, 54, and European Central Bank President Jean-Claude Trichet in their own inflation fights by cooling the commodity-price boom…GUEST ASIDE: Bernanke’s “own inflation fight?” Would someone please explain – in detail please?

joseph • July 7th, 2008 at 8:34 pm

BW3 could be gold.

Guest • July 7th, 2008 at 8:41 pm

More Abelson – July 7, 2008:“But if you’re the diehard equity type, as so many of us innocents are, you suffered the agonies of poor old Job. For the sad truth is, to find an equal to how bad June’s stock market was, you need to go all the way back to 1930, when the fall-out from the Great Crash was wrenchingly evident and the bodies were still hitting the pavement on Wall Street.“If it’s any consolation, the elite billionaires as well as we poor investment peasants have been roughed up by this year’s cruel and vicious market. We can offer you that solace, thanks to the efforts of crack research Teresa Vozzo, who secured the date from an interesting Website dubbed GuruFocus.com.“As its fairly repellent name may give you a hint, GuruFocus tracks the stock picking performance of 55 mostly famous (and usually rich) investors including the likes of Warren Buffett, George Soros, Dave Williams, Glenn Greenberg, Carl Icahn, Ron Baron, David Dreman, Edward Lampert, Bill Miller, Marty Whitman and Seth Klarman. We know a number of the fine gents and even like a few of them.“According to GuruFocus, in the first half of this year, only four of the 55 bought stocks that collectively scored a gain. This lucky quartet was headed by T. Boone Pickens, the oil maven, whose stock purchases in the first half of the year were up a nifty 23%; Ken Heebner, whose equity buys averaged a 14.5% rise; Steve Mandel, who enjoyed a 10.1% average gain on the shares he bought in the opening six months, and David Winters, who posted a 3.8% appreciations.“The worst losers were Marty Whitman, whose first-half picks were down 43.9%; Mohnish Pabrai, whose buys were down an average of 41.9%; and Bill Miller, whose purchases, on average, lost 38.5%. No need, we hazard, to pass the collection plate…”

AfA • July 7th, 2008 at 8:49 pm

@ Medic"There is nowhere to go from here except down."Nothing scientific, but as a person suffering from Acrophobia and Nyctophobia, I am getting dizzy these days while trading on US markets. I just need to look at the high P/E ratio and the opaque trading markets to get my blood frozen and have trouble breathing. I am afraid to look below, but I look to Chinese and other asian stock markets and I ask myself, where is the landing floor that will make this a hard one.

Guest • July 7th, 2008 at 8:51 pm

TIPS Flunk Inflation Test as Fuel, Food Overtake CPI (Update2)http://www.bloomberg.com/apps/news?pid=20601213&sid=arn8wSHvKTiU&refer=homeJuly 7 (Bloomberg) — Treasury Inflation Protected Securities aren’t living up to their name for bond investors who say they can’t trust the way the U.S. government calculates the rising cost of consumer goods.Morgan Stanley, the second-biggest securities firm, and FTN Financial, a unit of Tennessee’s largest bank, are telling clients to pare holdings of TIPS, whose principal amount rises with the Labor Department’s consumer price index. Morgan Stanley says derivatives tied to inflation expectations are a better bet, while FTN recommends corporate and agency bonds because the index doesn’t reflect the actual rate of U.S. inflation.The $500 billion TIPS market’s 5 percent returns this year have beat a 2.2 percent gain for Treasuries, according to Merrill Lynch & Co. indexes. TIPS should pay more, because the consumer price index downplays the 39 percent increase in gasoline and a 133 percent rise in corn in the past year, investors say. Yields on TIPS relative to Treasury debt, a gauge of traders’ inflation bets, barely changed over the past 18 months even as consumer expectations for prices climbed to 3.4 percent, the highest since 1995.“The consumer price index underestimates inflation,” said Jeremy Wolfson, who oversees $8.5 billion as chief investment officer at the City of Los Angeles Department of Water and Power Pension Fund…

Anonymous • July 7th, 2008 at 9:04 pm

I tried to post something here abotu 2 weeks ago. Everything was ready, and then it just didn’t get posted. A genuine effort down the toilet.Anyways, I mentioned in that article my intention to respond to one poster’s thoughtful writings about the inflation/deflation debate.Let me start by saying that, as a Marxist, I believe that capitalism’s internal "mechanics" are responsible for the boom-bust cycle. I also see a general tendency within capitalism towards overinvestment, overcapacity, overproduction and thus, deflationary busts.I still feel that is where we are going … but not tomorrow. Probably after a year, maximum.The Fed, I feel, prevented an absolutely catastrophic meltdown of the financial system via its rescue of Bear Sterns and through the development of all manner of creative methods for injecting liquidity into the diverse "tubes" of the financial system.The very real risk of a financial implosion and thus a severe recession was — a least for a short time — overturned via the expansionary monetary policy.However, the increased liquidity seems to not have done much more than keep the dollar very weak and pushed energy and other commodity prices further up. The increased liquidity appears to have gotten mainly into the hands of financial, currency and commodity market speculators. A very severe deflationary collapse was avoided — at the cost of having substantially higher inflation over the course of the 3-4 following months.I disagree with those "free-market" supporters who see the Fed as working hand-in-hand with "irresponsible," free-spending liberal politicians; according to this right-wing conspiratorial view, the latter — who don’t want to directly raise taxes — are given cover by the former, who buy up bonds and financial instruments with "fiat money," thus inflating the money supply and increasing inflation.This view is, as I see things, incorrect, because it misses how bankers and money lenders (who obviously tend to be richer than the average person) are hurt by high inflation. Paying a rich banker 5% interest a year when the inflation rate is 9% is not good for said capitalist moneybags.The Fed is now caught between a rock and a hard place with a weak real economy and higher inflation. The banks, financial institutions, money-lenders of all sorts — finance capital in Marxist terms — cannot tolerate an interest rate that is barely above the rate of inflation for too long. The small (or even negative) difference between the rate of interest and the rate of inflation helps borrowers who, taken as a group, have relatively low incomes. The Fed does not exist to help the poor and penalize the rich money-lenders. The Fed exists for the former and, at best, is indifferent to the interests of the latter. Interest rates are just this low because anything higher would likely induce a deep recession.The most modest signs of a recovery in real economic activity will be used by the Fed to jack up interest rates. I cant imagine this will happen before the very end of this year, and probably later. When this happens, a deep recession will develop. As more and more workers are thrown onto the scrap heap, nominal wages for the entire US economy may start to fall. The collapse of spending will mean deflation or, at the very least, disinflation. So, deflation is on the horizon. But not at the moment. Within the next 6-12 months, it actually is likely. Until the Fed raises rates, inflation is likely to gradually trend higher.This is what capitalism has to offer us at this stage. I, for one, cannot accept this.

Medic • July 7th, 2008 at 9:13 pm

Afa;MY sincere hopes that this week is better to you than last my friend…..As for investing and or trading this or any market – I am happy to be out. I have no need to make money on investments because I simply have none. I have placed what I had in gold and silver and will be happy to simply let it sit and not depreciate at break-neck speed like so many equities. My home will be warm (fuel is in my garage), we will continue to eat (freezer stocked with 25lb bags of rice and meats) and my job is relatively safe for the moment (it’s hard to find experienced ER nurses around here). Today, I am merely watching and trying to plan our next move. Lucky for me, the daily swings of this market won’t wipe me out.I do not anticipate much good to happen in the next year or so – with the one exception being the end of the Bush administration.

K J Foehr • July 7th, 2008 at 10:01 pm

ptm on 2008-07-07 16:32:38“With Indymac going into hibernation and the rumblings around Fannie & Freddie, it looks like things are starting to fall apart faster than expected. I think the earliest anyone had put a time line on this was at the end of 2008 or out in 2009?”Well it seems to have taken a very long time to me; I have been waiting for things to fall apart since March 2007. And due to the continual slide of financials recently, I have been thinking for about three weeks that something was coming to a head with financials. I suspected it would be a big regional bank or maybe Lehman, but nothing happened, until today. Now we may be seeing the beginning of the next chapter, with Bear being the first. As someone said on Bloomberg today, FRE and FNM belong to the federal government now, it’s just that stockholders don’t realize it yet – or some words to that effect. I suspect the Indymac story, even if it fails, will not rock the market. But FRE and FNM would, and probably will, at some point.

Anonymous • July 7th, 2008 at 10:19 pm

Our leaders have known this for years but will not touch this politically hot potato. we BOOMERS ARE SCREWED and so are our children and this country if we dont do something real soon. GET IT, ITS OVER IF WE DONT DO SOMETHING!!!!! THE DIRTY LITTLE SECRET EVERYONE IN WASHINGTON KNOWS http://www.youtube.com/watch?v=OS2fI2p9iVs

Guest • July 7th, 2008 at 10:52 pm

anon..its too lateaccept your fatein times of changes who survives?its not the smartest people, its not the strongest or the wealthiest (if you hold on to paper money, in the end its only a piece of paper) its those who adopt to the changes FASTthose are the people who survive

Guest • July 7th, 2008 at 10:53 pm

@Guest “Prices in one in four countries, many of them in emerging markets, are accelerating at a double-digit pace, which puts them at least two and a half times the 4 percent annual U.S. headline inflation rate, according to new research from Morgan Stanley…”Headline inflation? The 4 percent U.S. headline inflation?As Dorothy Parker would say, “What fresh hell is this?”In other words, another lie.The widely discredited measure of rising prices called core inflation, discredited because it did not measure any real items of inflation, apparently has given way to the newest inflation pretense, ironically called headline inflation. This alleged inflation measure would include rising food and gas costs but obviously not real food and energy, otherwise, as any American knows, inflation could not be a lowly 4 percent. “Headline inflation” reminds one of headline news — dramatic, Hollywood-like and largely untrue.

JLC • July 7th, 2008 at 11:54 pm

Thanks for your analysis professor.It seems the entire planet is caught on the horns of dilemma. Raise rates (or drop the peg) and risk killing the economy. Lower rates (print like mad to keep the peg) and risk further unleashing the inflationary beast.Damned if you do and damned if you don’t.Checkmate.

Alessandro • July 8th, 2008 at 3:11 am

JCL: "Raise rates (or drop the peg) and risk killing the economy."The real economy is as good as dead since a long time. The only thing that you risk killing (faster) is the insane Ponzi scheme that they call economy and that is going to die a painful death anyhow.

Prt1stAskQLater • July 8th, 2008 at 4:22 am

@Written by JLC on 2008-07-07 23:54:38Checkmate. Since you’re onto chess analogies, you’ed rather call it Zugzwang. http://en.wikipedia.org/wiki/ZugzwangIt's quite simple actually:1. Any country that tries to depreciate versus the dollar on purpose will be clumped by Ben on the head with high inflation.2. Any country that tries to appreciate versus the dollar on purpose will be clumped by Ben on the head with deflation. Rest of World – take your pick!@LB, I told you so too @ http://www.rgemonitor.com/blog/roubini/226654/ on 2007-11-15 02:47:33Excerpt:When Ben boards the helicopter to save the banks, here’s what will happen: 1. Dollar will tank taking Yuan down with it. 2. China will maintain the peg (and the China Price), allow rampant inflation within to continue to move 14 million people to urban areas for employment to prevent a revolution. The Yuan appreciates, employment in China dies a quick death. 3. Europeans will cease exports and go into depression. Airbus must have given the farm away to the Saudi’s recently because Boeing has a winner in the Dreamliner. Because at 1.6x of Dollar they might as well be toast. 4. Rest of the world will go into depression (having already surrendered the peg) Print First Ask Questions Later.

Prt1stAskQLater • July 8th, 2008 at 4:28 am

@Guest on 2008-07-07 12:06:39 wrote:More than 85% of the available addresses have already been allocated and the OECD predicts we will have run out completely by early 2011.Yikes! After oil, looks we’re set to have another supply side shock in ether. Now ethereal inflation begins to sound like Y2K alarm and dot-com eyeball demand shock. Halp! We need to print more addresses …@Guest on 2008-07-07 12:12:29 wrote: the U.S. government and its masters are abusing fiat money in much the same excesses as the Eighteenth French government used bank loans…spend, spend spend…steal, steal, steal.Clearly, you don’t know that France was a serial defaulter – i.e. had sub-prime credit quality. When in doubt about the US’ credit quality look to the career battle groups.@Guest on 2008-07-07 20:41:50 wrote: This lucky quartet was headed by T. Boone Pickens, the oil maven, whose stock purchases in the first half of the year were up a nifty 23%; Ken Heebner, whose equity buys averaged a 14.5% rise; Steve Mandel, who enjoyed a 10.1% average gain on the shares he bought in the opening six months, and David Winters, who posted a 3.8% appreciations.At the risk of hubris, you can add me to the list. My portfolio is up 30% for the year. I owe it completely to Prof. Damodaran. Helped me avoid becoming a lemming. Print First Ask Questions Later.P.S. Prof. Roubini, I lost a post late last week. Please could you look into the Mystery of the Missing Post? Thank for your guidance and great analysis.

Wild Bill • July 8th, 2008 at 4:38 am

In the event that any of you believe that the professor is the only voice crying in the wilderness, here is a view from Bill Bonner of the Australian Daily Reckoning: "*** Politicians know better than to talk about real issues. Instead, they argue about which one goes to church more often…or who is best able to fight "terrorists"…or whose taxes will be raised. Of course, they might want to talk about the real threats to the nation, but they know the voters wouldn’t stand for it."Who are you going to vote for?" asked a well-meaning friend from New Zealand."Vote…I never vote.""Why not?""Statistically, it is a waste of time," we explained. "Barack Obama will be elected Grand Wizard of the Ku Klux Klan before my vote makes any difference in a presidential election. But there’s a moral reason too. Suppose my man wins? Then, I bear some responsibility for what he does. I have no idea what he might do…and no control whatever over him… ""But isn’t this an important election?""Maybe, maybe not. Economically, the cake has already been baked. The next president isn’t going to like it very much. And he’ll do all he can to avoid having to eat it. All these rebates and bailouts – I suspect that we haven’t seen anything yet. Whoever is elected…we’re probably going to see $1 trillion deficits…and the collapse of the dollar, along with the post-Bretton Woods financial system…""Oh…"Until tomorrow,Bill BonnerThe Daily Reckoning"

Prt1stAskQLater • July 8th, 2008 at 4:52 am

On sighting lemmings …http://w4.stern.nyu.edu/news/news.cfm?doc_id=6607Enjoy the ride!Print First Ask Questions Later.

Alessandro • July 8th, 2008 at 7:09 am

Bernanke asks more power for the FED.http://www.marketwatch.com/News/Story/Story.aspx?guid={F957AF5A-D21E-446C-8024-4B4096BC35F9}&siteid=mktwWhy? They can do a lot more damage with the powers they already have. I’d give them more powers only after they demonstrate that they exhausted the ways to damage the US within current powers.

JOHN KATZ • July 8th, 2008 at 7:27 am

Nouriel,Thanks for your current comments on Bretton Woods 2 – the Asia lends and America spends arrangement. BW2 proponents claim that following this arrangement Asia will be underwriting the US for the foreseeable future. You also said last year at the IMF you were not sure, even following a hard landing in the US, that creditors would ‘pull the plug’ on the US as it would also damage their own interests.Do you still subscribe to that view?

Play On • July 8th, 2008 at 8:21 am

Oil getting creamed again today! With Boeing and EADS both down 40% from their highs, the verdict on "world growth" and decoupling is in! Gotta love how Indian engineers making 25K a yr. can buy oil at $4 a gallon but a US factory worker making 80K cant! The point being that demand destruction is slowly taking place just as all these new investments in energy are taking hold.

Guest • July 8th, 2008 at 9:39 am

PASADENA, Calif., Jul 07, 2008 (BUSINESS WIRE) — Indymac today issued the following letter to its stakeholders: Dear Indymac Stakeholders: In this very difficult and challenging environment, any of the actions that we take to keep Indymac safe and sound unfortunately have negative consequences to some important constituency. As we stated in our financial update on May 12, 2008, we have been working with our investment bankers to raise additional capital. To-date, we have not been successful with these efforts, and, while we will continue these efforts with our bankers and others, we don’t expect to be able to raise capital until there is more stability and less uncertainty in the housing and mortgage markets. While some shareholders may believe it is in their best interests that we not raise capital right now given the significant dilution that it would cause, there are consequences of not being able to raise more capital and, therefore, actions that we now must take. Given the continued downward trend in home prices and a resulting increase in our forecasted credit losses and the related downward trend in the pricing of all mortgage related assets in the capital markets, especially mortgage-backed securities where we have experienced significant rating agency downgrades this quarter, we expect our loss for the second quarter to be larger than Q108, but it is difficult at this time to be more precise given the significant uncertainty surrounding accounting estimates, fair value accounting and other accounting matters. In light of the current environment and related deterioration of our financial position since last quarter, we have been working closely with our federal banking regulators with respect to the actions that they and we must take to meet our mutual goal of keeping Indymac safe and sound through this crisis period. In that respect, based on information we have provided to our regulators, they have advised us that we are no longer "well capitalized", which we stated on May 12 was a possible scenario. Our regulators have also asked us to submit to them a new business plan for their review and approval, something on which we have been working with them for some time. We have agreed on the basic elements of the plan, and the regulators have directed us to begin executing on it. An important element of our plan is to improve our capital ratios. Without an external capital raise, the traditional way to improve safety and soundness is to sell assets and shrink the balance sheet, which in normal times generally has the effect of improving capital ratios and bolstering liquidity. Yet in this environment, where either there are no bids for most of IMB’s mortgage loans and securities or the bid/ask spreads are abnormally wide, "fire-selling" assets would actually deplete capital further. As a result, the most realistic and cost-effective way to shrink both our balance sheet and our servicing rights asset (which, as discussed in previous communications, is up against the regulatory cap limit), is to curtail most new loan production. In addition to needing to shrink our assets to improve our capital ratios, we also need to do so to ensure that we maintain prudent operating liquidity. A consequence of falling below well-capitalized is that we are no longer permitted to accept new brokered deposits or renew or roll over existing ones, unless we get a waiver from the FDIC. While we have submitted a waiver application, it is uncertain as to whether such a waiver will be granted. As a result of the above, we have made the difficult decision, effective July 7, 2008, that we will no longer accept any new loan submissions or rate locks in our retail and wholesale forward mortgage lending channels, except for our servicing retention channel. We plan to honor all of our existing rate-locked loans and will continue to fund these loans in the coming weeks. While the managers and employees in these units have worked incredibly hard, these units are not currently profitable due to the continuing erosion of the housing and mortgage markets. At the same time, these operations take up significant balance sheet capacity and "feed" growth in the servicing asset, an asset we need to shrink given its size relative to our existing capital. In closing our forward mortgage business, we will refocus our lending efforts on supporting and building within regulatory constraints Financial Freedom, our reverse mortgage unit (FHA production only), and on continuing the retention activities associated with our servicing portfolio. Combined, we currently expect these units to produce roughly $5 billion to $10 billion per year of new FHA/GSE loans. Thus, our core business model will include (1) Financial Freedom, one of the largest reverse mortgage lenders in the Country; (2) a top ten mortgage loan servicing operation, with a solid retention production unit; and (3) a Southern California retail bank branch network, including 33 branches and roughly $18 billion in deposits, of which over 96% is fully covered by FDIC insurance. In addition, when this housing and mortgage crisis abates and we return to health, we would also hope to be an investor in mortgage loans and mortgage-backed securities and might re-enter the national forward mortgage production business with a low-cost, non-commissioned-based business model. Unfortunately, the above actions will necessitate the reduction in our present workforce from approximately 7,200 to roughly 3,400 or so over the next couple of months, which should reduce our operating expenses by roughly 60%. We will retain about 1,100 employees in loan servicing in Kalamazoo and Austin; 350 in our servicing retention group in Irvine and Kansas City; 800 at Financial Freedom, primarily in Irvine, Sacramento, and Atlanta; 400 in our Southern California retail and web bank; 500 in portfolio management and administration, largely in Pasadena; and 250 in discontinued businesses. In building Indymac up from 4 employees in 1993 to its present size, we have had to retrench and then rebuild several times over the past 15 years, but clearly these are the largest and most difficult staff reductions we have ever had to make. If we had another alternative, we clearly would have chosen it, as we understand how painful these workforce reductions can be for the affected employees and their families. Given Indymac’s current financial position and these significant layoffs, I strongly believe it is appropriate that I further materially reduce my own compensation. As a result, I have requested of Indymac’s Board of Directors that they reduce my base salary by 50%. With respect to severance, our policy has always been that the fair and right thing to do is to provide our departing employees with a generous severance program to ease their transition to the next stage of their career. Our severance program, which provided one month of pay and one month of Indymac-paid COBRA insurance coverage for each year of service, was clearly the most generous in the mortgage industry, if not among most of the Fortune 500. I very much regret that the reality today, however, is that we can no longer afford this program given our need to preserve capital and return to profitability. Therefore, we will be providing employees with a minimum 30-day notice of the termination of their employment (effectively, 30 days severance), with employees covered under the Federal WARN Act and similar state statutes ("WARN") receiving 60 days of advance notice prior to the effective date of the their termination. Affected employees with five or more years of service will receive a minimum $20,000 severance, including any compensation payments made during the notice period. With all of the above said, in this environment plans can change often and quickly (e.g. ability to raise capital and/or liquidity, regulatory actions, etc.). All we can do is continue to work hard and do our very best to keep Indymac safe and sound, so that we can rebuild our workforce and shareholder value when
the housing and mortgage markets stabilize. We will be providing more information on our plans and prospects when we release Q208 earnings. Very truly yours, Michael W. Perry Chairman and Chief Executive Officer

Nouriel Roubini • July 8th, 2008 at 9:39 am

Due to a technical glitch some of the comments on this blog item posted on Sunday and Monday morning were automatically erased by our system. My apologies for that. The RGE tech folks are working to recover them all. Sorry again for this purely technical glitchThanks for all of your most interesting commentsBestNouriel

Guest • July 8th, 2008 at 9:54 am

Bank losses from credit crisis may run to $1,600bn, warns BridgewaterBy Ambrose Evans-PritchardLast Updated: 1:59am BST 08/07/2008Bridgewater Associates has issued an apocalyptic warning to clients that bank losses from the worldwide credit crisis may reach $1,600bn (£800bn), four times official estimates and enough to pose a grave risk to the financial system.The giant US hedge fund said that it doubted whether lenders would be able to shoulder the full losses, disguised until now by "mark-to-model" methods of valuing structured credit."We are facing an avalanche of bad assets. We have big doubts as to whether financial institutions will be able to obtain enough new capital to cover their losses. The credit crisis is going to get worse," said the group in a confidential report, leaked to the Swiss newspaper SonntagsZeitung.advertisementBank losses on this scale would have far-reaching effects. Lenders would have to curtail loans by roughly 10-to-one to preserve their capital ratios. This would imply a further contraction of credit by up to $12,000bn worldwide unless banks could raise fresh capital.It would be almost impossible to attract or even find such sums from investors. While sovereign wealth funds command roughly $3,000bn in funds, this money is mostly committed already. The funds have grown extremely wary of Western banks with sub-prime exposure after burning their fingers so many times already.# The credit crisis in fullBridgewater said true losses would mushroom if the banks were compelled to use "mark-to-market", which foretells a much crueller haircut for investors in the outstanding pool of structured debt from mortgages, credit cards, car loans and such like, together worth $26.6bn.The International Monetary Fund has estimated bank losses of roughly $400bn. A chunk has already been covered by fresh infusions of capital, allowing the lenders to continue lubricating the global financial system without having to squeeze credit too hard.The great unknown is whether this is the end of the debacle. A number of hedge funds believe the alleged losses – typically measured by the ABX index – may overstate the likely level of defaults. They are buying the spurned securities for as little as eight cents on the dollar.If Bridgewater is anywhere near correct, governments alone have the wherewithal to rescue the system. This would mean the de facto nationalisation of the banking systems in the US, Britain and Europe.

Flanders • July 8th, 2008 at 10:18 am

Nice post, indeed. Thank you professor.

Guest • July 8th, 2008 at 10:30 am

11:25 Office Depot shares drop as much as 37% on lowered outlook

Guest • July 8th, 2008 at 10:34 am

Bloomberg says today: “The Federal Reserve may hold off on its first interest-rate increase since 2006 until policy makers judge that financial markets are stable enough to allow the central bank to withdraw its lending backstop for Wall Street…”Bernanke ‘s not going to be able to, IMO. He’s trying to hold the financials through the election, to keep them from pulling the Dow down a 1000, i.e. The Big One. They all knew originally how bad it was going to be. In a battle, to save losses, you engage a managed, orderly retreat — so the troops don’t panic into a rout. If I’m right, from the beginning Bernanke and Paulson have known how deep this is. I ask, is it a surprise to them that Freddie and Fannie and the investment banks are going to need considerably more infusion than originally reported?

Free Tibet • July 8th, 2008 at 10:39 am

@ KJU.S. Stocks Slump Won’t End Until VIX Index Jumps (Update1)- Bloomberghttp://www.bloomberg.com/apps/news?pid=20601087&sid=ajZPADscrrB4&refer=homeSee? You’re right.

Guest • July 8th, 2008 at 10:46 am

"Oil getting creamed again today!"hey moron, you dont think oil just go up without correction, do you? anyway, as long as oil is still in uptrend, oil bull market, or rather commodities bull market will continue. you noob are just annoying.

Prt1stAskQLater • July 8th, 2008 at 10:50 am

@Prof. Roubini, Thanks for the update on the missing posts. Also request your permission to enable HTML Hn tags and li, ul tags. Formatting will be better.Thanks for your generosity.Best,Print First Ask Questions Later.

Forensic economist • July 8th, 2008 at 10:59 am

To the Marxist above:Marx was wrong in general, but under certain circumstances his analysis still holds, and it is important to know when it holds.My understanding of the basic Marxist theory is that 1) capitalists want to maintain their level of profit; 2) capitalists want to accumulate capital; therefore the amount of profit must rise in every period in order for the rate to stay constant. According to Marx, the only way this can happen is that the share of income going to the capitalist must rise and the share going to the workers must shrink. As the workers get less, they are unable to buy the goods produced by the capitalists, giving rise to recurrent crises.As Keynes said, Marxism is obsolete as economic theory, but still has a future as a religion.The Marxian analysis treats capital as unproductive, and technology as fixed. For much of the last two centuries, there were productivity improvements such that wages and profits rose simualtaneously. Ironically, Marx was describing a world before the industrial revolution.However, when the productivity increases stop, we are back in a Marxian world. If capital is used unproductively – by building houses no one needs, web sites no one buys from, or by trading assets among hedge funds — there are no productivity gains. If "productivity" gains are the result of outsourcing to low wage countries, we are back in the Marxian world.By some measurements (look at BLS’ Average Weekly Earnings) real wages have been stagnant since the mid ’70s. We may be in a crisis now as predicted by Marxist theory.

Softwarengineer • July 8th, 2008 at 11:03 am

THIS WEB PAGE DOES HAVE A POST COMMENT ANOMALYI noticed a long time ago the "remember me" for user ID and P/W works for web page access, but if you want to post a comment, logoff first, then logon again; or your post disappears in the Twilight Zone.Before hitting any anomalous web page send button [and possibly kissing a well typed post good-bye], select your post and copy in your browser’s memory; you can always quickly re-post, if it fails to send the 1st time.

Guest • July 8th, 2008 at 11:08 am

Hey, it’s not the shorts that are causing it: it’s his weakened animal of a company that’s causing it and the shorts are tracking it:”Psst! Hear the Rumor of the Day?” by ANDREW ROSS SORKIN“I will hurt the shorts, and that is my goal,” Richard S. Fuld Jr. fumed.It was April, and Mr. Fuld was blaming short sellers, one of the most maligned tribes on Wall Street, for spreading rumors about Lehman Brothers, the troubled investment bank he runs. Shorts bet against stocks, and Lehman, they were whispering, looked like the next Bear Stearns.Mr. Fuld must have been irate again last week, when Lehman’s stock price plunged 11 percent in the space of three hours for no apparent reason. The shares opened that June 30 morning at $22.25, drifted higher — and then took an abrupt turn around 1:30 p.m. Lehman closed that day at $19.81, its lowest level since 2000.This time, the rumor du jour wasn’t that Lehman was going to be forced into bankruptcy. No, this time the talk was that Lehman was about to be sold to Barclays, the big British bank. It was eerily reminiscent of Bear Stearns’s fire sale to JPMorgan Chase in March. And when it comes to Lehman, the shorts have bet right lately: the stock has lost almost 70 percent of its value this year.The rumor turned out to be wrong, as rumors often do. But this one even had an exact price:…http://biz.yahoo.com/nytimes/080708/1194792683900.html?.v=4

Guest • July 8th, 2008 at 11:20 am

@Guest on 2008-07-08 09:54:58Bank losses from credit crisis may run to $1,600bn, warns BridgewaterBy Ambrose Evans-PritchardLast Updated: 1:59am BST 08/07/2008Bridgewater Associates has issued an apocalyptic warning to clients that bank losses from the worldwide credit crisis may reach $1,600bn (£800bn), four times official estimates and enough to pose a grave risk to the financial system….If Bridgewater is anywhere near correct, governments alone have the wherewithal to rescue the system. This would mean the de facto nationalisation of the banking systems in the US, Britain and Europe.ah, good old Ambrose Evans-Pritchard. Who else. And yes, of course it is a "worldwide credit crisis". The article just fails to mention that 80% of the damage is within the Anglo-American system. And with that of course anything becames "worldwide".No wonder we need a full nationalisation of the banking systems in the US, Britain and Europe.Would have been easier if US and UK had protected their credit markets with proper lending standards in the first place. But no, it was more important to boost the GDP. Calling it a worldwide credit crisis just serves to obscure the source of the problems.

Guest • July 8th, 2008 at 11:20 am

12:16 U.S. gasoline prices to remain above $4 until late 2009: EIA

Guest • July 8th, 2008 at 11:36 am

OK, so how long do we have to wait?Isn’t it time for the control types (American right wing, European social-democrats, and others) to start coming with a nice "total" rescue package? Something in which the spirit would match the recent laws in the western countries, allowing for increased surveillance by the government.Don’t say it is too early, as I am sure the American people are suffering enough to accept nearly anything. Even if it now was some "worldwide response" that sets the UN in charge of worlds financial markets. Just start with a nice document that outlines the severity of the situation and give it to some journalist in the UK (after all, they are more pro-UN there). And don’t forget to add that it’s all from a leaked confidential report. Makes it sound so much more important.

Guest • July 8th, 2008 at 11:40 am

12:32 Lacker: See ‘legitimate’ concerns about economy12:32 Lacker: Makes sense to raise rates as risks fade12:32 Lacker: Risks of severe downturn have receded12:32 Fed’s Lacker: Inflation ‘unacceptably high’

Guest • July 8th, 2008 at 11:55 am

LOLOL VIX is crashing! Down over 4%-if this isn’t complacency, I don’t know what is!

Guest • July 8th, 2008 at 12:02 pm

1:00[JPM] Dimon calls for equal application of capital requirements12:59[JPM] Dimon dismisses concept of "too big to fail"12:58[JPM] Morgan CEO warns of regulations’ "uninteneded consequences" 12:58[JPM] Bear bankruptcy could have been "catastrophe" for U.S.:Dimon

Guest • July 8th, 2008 at 12:46 pm

Revolutionary Guard(Iran)begins military exercise, says U.S. ships in Persian Gulf and Tel Aviv will be ‘set on fire’ if Iran attacked

Capone • July 8th, 2008 at 12:54 pm

Professor, still have not had time to get through this GREAT article in its entirety. It takes the novice a while to digest… initially happy to at least see mention how all the players played their part in this and it is NOT purely the US’ fault… it all sort of feels like a debate between forms of governnment, for example, a truly benevolent dictator may be better than a democratically elected President if the dictator is truly benevolent versus a corrupt elected president. it seems to me whatever system we end up with, will either excel or be limited to the people, central banks and governments who operate within it and how they behave. Thanks for writing such an essential piece for the times. This FNM and FRE activity REALLY brings things forward IMHO…short term prognosticators here, i am torn between two thoughts now on where we go immediately from here on the indices at least. oil down BIG and market still barely up seems like a SELL signal from a contrarian perspective. as we should be up big on the oil sell off and we are not. additionally, many expect a bounce soon and if we don’t get it, we just may have our capitulation.however, against that, i think an aweful lot of people are looking for a spike in the VIX and expecting more downside right now since we have not gotten it yet – this in itself from a contrarian standpoint is actually a BUY signal in my paranoid, twisted contrarian mind… reminder this is short term as in right now – thoughts ?

Guest • July 8th, 2008 at 1:02 pm

2:00 Russia says action if U.S. shield near its border: reports1:59 Russia vows military action vs U.S. missile shield: reports

Guest • July 8th, 2008 at 1:05 pm

Capone-you will see capitulation and a spike in the VIX when 2nd quarter eranings show the reality of what is happening around us and guidance does not reflect a 2nd half recovery like so many anticiapte. Stocks (S&P500) must come down at least another 7% in my estimation to reflect the reality of the rest of this year. Then, after the election, if Obama wins and more congressional seat go Demo, then you will see the S&P drop to around 900 during 2009-2010.

Guest • July 8th, 2008 at 1:08 pm

Ecuador’s Dollar Bonds Plunge as Finance Minister Ortiz Quits By Lester PimentelJuly 8 (Bloomberg) — Ecuador’s bonds tumbled after Finance Minister Fausto Ortiz resigned, renewing concern the government may default on about $10 billion of debt. The extra yield investors demand to own Ecuador’s debt rather than U.S. Treasuries jumped 39 basis points, or 0.39 percentage point, to 6.5 percentage points at 12:30 p.m. in New York, according to JPMorgan Chase & Co.’s EMBI Plus index. The so-called spread is the widest since March 31. Ortiz resigned after government officials decided last night to seize 195 companies, including television stations, in a bid to collect debts stemming from a 1990s banking crisis, Ecuavisa TV reported. Ortiz had allayed investors’ concern last month that Ecuador would default after President Rafael Correa threatened to annul debt deemed “illegitimate” by an auditing commission.

Guest • July 8th, 2008 at 1:08 pm

2:04 SEC finds some fault with credit-rating firmsNOOOOOOOOO….REALLY??? Gosh, thanks for enlightening us sheeple Mr. SEC!

Guest • July 8th, 2008 at 1:13 pm

What a bull/bear fight here (with a little support from the PPT maybe?)to keep the indexes positive….

Capone • July 8th, 2008 at 1:23 pm

i think even the PPT may be surprised at the selling being attempted with oil down soo much so quickly… it sure feels as though things are being held here – maybe they have to drag it out past july expiration next week ?…

Guest • July 8th, 2008 at 1:26 pm

Ambac up over 50% now! LOLOLOL The end of our troubles MUST be over!

Guest • July 8th, 2008 at 1:38 pm

Stocks charging higher now, VIX down over 5%!

Guest • July 8th, 2008 at 1:46 pm

PPT coming in early to day to catch shorts off gaurd into the close?

Guest • July 8th, 2008 at 1:46 pm

VIX in freefall, dounw 6.5% now

Guest • July 8th, 2008 at 2:00 pm

"Ben Bernanke say in a speech the central bank might extend its lending efforts to investment banks"that mean, helicoptor Ben is gonna do more liquidity pumping.

Play On • July 8th, 2008 at 2:09 pm

Triple bottom holding at S&P 1260?

Guest • July 8th, 2008 at 2:36 pm

LOLOL-hank paulson come out and says housing prices over-estimate uglyness of housing market just becuase Hovnanian chairman bought some stock!!! LOLOL NO wonder the USPeso is in such dispair! Whats worse, the jump in stocks correspond to his statement! LOLOL I guess time to take the long side of the trade as the tripple bottom has helod for now-good job PPT!

Guest • July 8th, 2008 at 2:53 pm

Bank stocks are mysteriously up 8% now!! ($BKX)

kilgores • July 8th, 2008 at 2:56 pm

This is surprising:"Ambac Financial Inc. (ABK) soared more than 50% after the bond insurer disclosed collateral-posting requirements for its guaranteed investment contract business were smaller than some investors had feared."http://money.cnn.com/news/newsfeeds/articles/djf500/200807081502DOWJONESDJONLINE000532_FORTUNE5.htmSWK

Anonymous • July 8th, 2008 at 3:25 pm

Survival. http://www.cnbc.com/id/15840232?video=788549383&play=1

Guest • July 8th, 2008 at 3:31 pm

You may have to toss the VIX along with the TED spread. Somehow TPTB have a work around, and can squash shorts using those as main dashboard dials.

K J Foehr • July 8th, 2008 at 3:32 pm

AA earnings 66 cents versus est. of 65 cents.Sales $7.62B beating expectationsProfit lower.Trading higher AH

Guest • July 8th, 2008 at 3:52 pm

Thank goodness ALcoa profits were only down 24% LOLOLOLOLOL. They are going to milk this "better than worse" news angle plus the PPT induced tripple bottom on the S&P to give a false sence that all is well and to pitch off shares to the sheeple before the next leg down…

K J Foehr • July 8th, 2008 at 3:58 pm

IndyMac May Become Seller Of Mortgage Bonds, Depressing Mkt By Aparajita Saha-Bubna excerpt NEW YORK (Dow Jones)–IndyMac Bancorp Inc. (IMB), the troubled mortgage company and savings-bank operator, may be forced to sell its holdings of mortgage securities – and that selling can’t be good news for the already beleaguered mortgage securities market. IndyMac, of Pasadena, Calif., isn’t a gigantic holder of mortgage securities. But there is concern that added selling pressure at a time when bonds linked to residential real estate are out of favor will further damp their value in the marketplace. "Anytime an entity goes by the wayside that has been a buyer of mortgage-backed securities, it does not help the sector," said Walt Schmidt, manager of structured products strategy at FTN Financial in Chicago. … As of the first quarter, IndyMac held in its portfolio $6.6 billion of these mortgage securities, which are mostly rated investment grade. Nearly half are made up of Alt-A loans. Alt-A mortgages, a category between prime and subprime, are made to borrowers with generally strong credit but are loans lacking adequate verification, for instance, of income or assets. In 2006, $429 billion of mortgage bonds made up of Alt-A loans were issued, according to LoanPerformance, while in 2007, there were an estimated $270 billion. During the housing boom, IndyMac specialized in lending these types of mortgages. … "There is very little appetite for Alt-A," said Roelof Slump, an analyst at Fitch Ratings. As a result, IndyMac had already scaled back on its Alt-A lending – the bulk of its business during headier times in real estate – before its announcement Monday that it was quitting mortgage lending. Thus, its announcement won’t have "any immediate impact on the borrower base," said Slump. … But there is concern that IndyMac will have little choice but to sell mortgage securities, including those backed by Alt-A loans, that it holds as investments. The potential fire sale will come at a time when Alt-A-related securities are performing poorly, underscoring the point that the mortgage meltdown isn’t confined to only those with weak credit. Worst affected are bonds that are made up of the more aggressive type of Alt-A mortgages, such as interest-only loans that allow homeowners to postpone principal payments, and loans issued in 2006 and part of 2007, when lending standards were loosened. … "It would actually be destructive if they tried to sell the securities," said Arnold. "Dumping securities into a market already flooded with them will make prices lower than where they are now." … July 08, 2008 16:50 ET

K J Foehr • July 8th, 2008 at 4:08 pm

Alcoa 2Q Net Down 24% But Shrs Up As Results Beat Estimates Alcoa Inc.’s (AA) second-quarter net income dropped 24% as aluminum prices failed to keep pace with climbing costs. Still, shares rose 4% in after-hours trading as the results beat Wall Street’s expectations. Shares were at $33.65 after hours after the Dow component’s stock closed down 3.2% at $32.33 in regular trading. …U.P.O.D.Laughable; isn’t it?It’s the absurdity of it all!

Stormy • July 8th, 2008 at 6:39 pm

"Third, in a US hard landing protectionist pressures that are already high in a soft landing outlook would become severe with tensions on currency values turning into increasingly acrimonious trade conflicts and trade wars. In a US hard landing the US would want China to let the RMB to appreciate even more that it is pressing for it now; but in that lower growth environment where Chinese growth suffers even more, China would resist even more strongly further RMB appreciation. Thus, the outcome of this currency conflict would be a trade war between the US and China."Until Chinese indigenous firms actually account for the bulk of Chinese exports–to date, foreign firms account for the bulk of exports (up to 60% generally; in IT, more)–, I do not see a trade war happening. Too many foreign multinationals–including are own–have an interest in continuing the status quo. These firms will keep pressure off the "trade war trigger" for as long as possible; they have a great deal at stake. The game will continue as foreign firms seek ever cheaper sources of production. Oil is the wild card–and in all likelihood will dominate, creating inflationary pressures greater than the loose currency peg and increasing production and transport costs. China and other industrializing nations will have increasing difficulty maintaining any kind of subsidy on oil, for its price affects the price of everything, from plastics to fertilizer.Demand destruction will have a "containing effect" on the price of oil; unfortunately, that means that we will continue to bump up against that wall for quite a while, certainly until new production comes on line. Unfortunately, existing major oil fields seem to be in decline–or at best stable. Costs will rise until demand destruction takes hold. But we have to look beyond demand destruction. Everytime world growth tries to stutter forward, availability of oil will be the problem–at least in the near future (4 or 5 years minimum).In short, oil, I suspect, will trump all discussions of BW2.

ptm • July 8th, 2008 at 6:40 pm

Was watching the NBC nightly news where Brian Williams & Jim Cramer were discussing today’s announcement by the Fed’s offer to backup investment banks, the ~$10.00/barrel (30 cents/gal) drop in oil prices over the last two days, and the stock market was up as well today. Then the two idiots told the American public that all was fine; the Fed will be able to fix bank failures and gas will not go over $5/gallon ($166/barrel). So all is good!?!What they failed to mention to the unsuspecting public is that the problem is much more wide spread that a few investment banks and the Fed will have to create a lot of dollars to cover the coming, give or take, 1,000 bank failures and all that extra money in the system will compete for an essentially static world-wide oil supply. That means more inflation, a lot more inflation.As I pointed out in an earlier post, by comparing the average yearly price of gas/gal since 1999 and comparing it to the average yearly price of gold/gram during the same period we get:Year, $/gal, GoldGram/gal1999, 1.36, 0.142000, 1.69, 0.182001, 1.66, 0.182002, 1.56, 0.162003, 1.78, 0.152004, 2.07, 0.162005, 2.49, 0.182006, 2.81, 0.142007, 3.03, 0.142008, 3.55, 0.122008, 4.00, 0.132008, 5.00, 0.172008, 5.50, 0.18Take your pick of gas prices in 2008, but as you can see they have to reach $5.50/gal to cost the same as a gallon of gas did in 2005.The real question is: What will the price of gold/oz be when gas does reach $5.50/gal? And this is what Brian Williams & Jim Cramer know, but did not tell the American public – inflation has us chasing our own tails like a silly puppy.

K J Foehr • July 8th, 2008 at 6:50 pm

Free Tibet on 2008-07-08 10:39:39“U.S. Stocks Slump Won’t End Until VIX Index Jumps (Update1)- Bloomberg…See? You’re right.”Maybe, but on the other hand, at times like this I often think about this statement made many years ago by my father’s favorite stock market analyst,“When you finally figure out the key to the stock market some jerk comes along and changes the lock.” Richard Ney (1915 – 2004) — He wrote three highly critical books about Wall Street, asserting that the market was manipulated by market makers to the detriment of the average investor. The first of these, The Wall Street Jungle, was a New York Times bestseller in 1970. The second and third are The Wall Street Gang and Making It in the Market.All in, I plan to continue to sell the rallies until we have a powerful capitulation (with or without VIX confirmation) or a 30% peak to trough decline in the S&P500.

Yankee • July 8th, 2008 at 9:16 pm

Fed to curb shady home-lending practicesTuesday July 8, 9:24 pm ETBy Jeannine Aversa, AP Economics WriterFed to curb shady home-lending practices; may give Wall Street more time to tap emergency fundWASHINGTON (AP) — The Federal Reserve will issue new rules next week aimed at protecting future homebuyers from dubious lending practices, its most sweeping response to a housing crisis that has propelled foreclosures to record highs.Fed Chairman Ben Bernanke spoke of the much-awaited rules in a broader speech Tuesday about the challenges confronting policymakers in trying to stabilize a shaky U.S. financial system. To that end, Bernanke said the Fed may give squeezed Wall Street firms more time to tap the central bank’s emergency loan program. yada yada yadawho are they to issue rules after the fact? too little, too late idiots!

Guest • July 8th, 2008 at 9:50 pm

OIl is on the upside again!!they are frickin toyin with us, look how gold was hammered this/last weekIm out..

Mark • July 9th, 2008 at 12:07 am

How can US markets be perky with stuff like this looming?Fannie, Freddie Downgraded by Derivatives Traders Over Capitalhttp://www.bloomberg.com/apps/news?pid=20601087&sid=akjraOGxIkJU&refer=home[excerpt:]Traders are overlooking the government’s tacit guarantee of the debt as credit losses grow and concern rises that the companies don’t have enough capital to weather the biggest housing slump since the Great Depression. Even an implied guarantee isn’t enough to convince credit investors that there’s little risk to owning Fannie Mae and Freddie Mac debt, said Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California.“Investors are viewing even an implicit guarantee from the government as potentially troublesome,” Backshall said.Mark

Medic • July 9th, 2008 at 5:25 am

The facade is coming down piece by piece. They have managed to slow the unwind, but they will not stop it. Remember this is the same government that managed the Iraq invasion. Competent? Hardly.The earnings for Q2 will show that making a profit is difficult in an economy based on consumerism when consumers have no money left. The only people left in the US who are not struggling are the upper class – and there are not enough of them to prop this thing up. No, the illusion is about to fade; but that does not mean the public will catch on very quickly. As I have suggested before, the losses will continue in Q3 and when boomers see their 401k statements in October, look out. Cash will fly out of the markets as they try and salvage whatever is left and put it somewhere safe. The problem will be that there is no safe haven – really.The US is bankrupt, banks are insolvent, oil is on the decline, and we have 78 million people who will start to expect / demand SS / MC benefits anytime now. The biggest problem is that with a negative savings rate and the vast majority of Joe Public’s wealth tied up in retirement accounts that are invested in make believe, there will be very little to fall back on. The second largest issue we have, and the one that will hit hard, is the awful healthcare system in the US. It must be fixed or it will also fade away. There is no doubt that if it remains on its current course, it will implode under the additional stress of more patients and less funding.I grow less and less optimistic everyday that real changes will come soon enough to lessen the blow. It is already too late to stop what is coming, and in our Special Interests led government, I do not believe the chnages necessary will happen for a long while. Many voting cycles will have come and gone before enough worthless legislators are replaced with uncorrupted and competent ones. There. Now I’ve done my impression of Gloomy today. If only we were wrong……

Play On • July 9th, 2008 at 7:39 am

If I woke up this morning with oil gapping down another $2, I could then really believe that the triple bottom was in place at S&P 1260! But as it is oil is up $2 and futures are up?

J. • July 9th, 2008 at 2:12 pm

@Forensic economist on 2008-07-08 10:59:33Have you ever read the three volumes of Capital or only what modern textbooks’ interpretations which most always are made through the lense of neoclassic assumptions rather than an understanding of Marx’s theory of value and profit?He considered fixed and circulating constant capital to be unproductive since, unlike living labor, means of production can create no more value than they contain and has been paid for, i.e. they cannot be a source of surplus value. The fact that surplus created by labor within the process of production can only be realized as profit through sale of that which has been produced dialectically connects production and market, which is not some equilibrium relation but one of changing asymmetries (much closer to reality than neoclassic notions). Since realization takes place on the market, some are deluded into believing the market itself is productive.Would you agree that individual firms mattempt to maximize – not simply maintain – their particular profits?Would you agree that this takes form as competition and that this relates to change in levels and quality of fixed capital relative to workers employed, i.e. that the drive towards higher productivity is system inherent?Would you agree that changing capital:labor ratios have been/are an at least relative displacement of living labor with mass of capital growing more rapidly than the number of productive employees required and that this tends to change the mass of surplus value:capital ratio?If you agree with these, you also agree there is an inherent tendency for the rate of profit to fall. (Only a tendency since there are various countervailing forces but nevertheless a tendency which has over the last two centuries often becomes visibibly real right up on the surface).If you agree with these, then you also agree there is what Marx termed a changing composition of capital (which, contrary to your claim that he saw ‘technology as fixed’, very much includes/helps explain changes in the technologies of production. In fact, for Marx there was no such thing as ‘fixed’ but, instead, ongoing change. He was not a neoclassic economist nor was he a classical economist. Read Capital’s entire title).Your first paragraph has to do with underconsumptionist theories which, either in effect or directly, deny overproduction of capital relative to the surplus value required. By placing excess weight on the role of demand, underconsumptionists are often led to the false conclusion that crises may be averted through demand management policies no matter that the most these have ever accomplished has been some degree of mitigation. Marx’s overproduction/overaccumulation of capital/falling rate of profit argument better captures what actually transpires (which obviously includes change in effective demand as firms attempt to counter a falling rate through reduction in wages, reduction in number employed, and greater intensity of labor among those remaining employed. I should note that the attempt to offset also manifests as greater speculative activities. You might want to read through this short note:What is a crisis of overproduction?http://www.marxmail.org/faq/overproduction.htm