Nobody has any idea how to manage our economy

I'm beginning to despair at the complete and utter economic cluelessness that's manifesting itself in most agencies and institutions of the United States government. It's so all-encompassing, so gormless, so totally daft that it almost beggars description. The past few days have brought news that boggles the mind - or rather, it should boggle the minds of our leaders, if they had any to boggle! The evidence so far suggests that they don't . . .

First, Treasury bond sales have hit a brick wall.

US Treasuries suffered their biggest two-day sell-off since the collapse of Lehman Brothers, following a torrid month that has seen borrowing costs for western governments soar.

. . .

“You could argue that we are at a new stage where the global cost of capital goes higher and higher,” said Steven Major, global head of fixed income research at HSBC.

. . .

Yields are still relatively low compared with long-term trends but investors are starting to fret that they could continue to move sharply higher. “Yields at this level are clearly unsustainable,” said Paul Marson, chief investment officer at Lombard Odier, the Swiss private bank.

There's more at the link. CNBC agrees, pointing out that the bond market's problems are linked to the just-announced tax breaks.

A proposal to extend Bush-era tax cuts is expected to boost U.S. economic growth by as much as 1 percentage point next year. But the long-term cost to the government from falling tax receipts has worried bond investors and resulted in a disappointing three-year debt auction Tuesday.

. . .

Some investors fear such a tax move could result in more bond purchases by the Federal Reserve, which would boost the government's deficit and stoke inflation.

"This tax agreement is a disaster for the U.S. fiscal situation," said Howard Simons, strategist at Bianco Research in Chicago.

Again, more at the link. I agree - the tax agreement really is a disaster, and I can't for the life of me imagine why either side, Republicans or Democrats, are happy with it. As Megan McArdle points out:

I think this is a terrible deal. I was rooting for gridlock to cause the tax cuts to expire entirely, which would probably have a moderately negative impact on the economy, but would at least somewhat forestall a devastating fiscal crisis down the road. If it was politically necessary to do tax cuts, I wanted them to be as small as possible, not $900 billion over two years.




To be sure, this is a better deal, from my perspective, than it might have been. All the tax cut extensions are temporary, rather than permanent. We get a temporary extension in unemployment benefits, which I favor, given the lousy jobs picture. Some of the tax cuts, especially the temporary cut in the payroll tax, might even be stimulative. Nonetheless, I would much rather they had expired entirely than that we re-fight this battle in two years, when most of the parties are up for re-election. We may get that fiscal crisis even sooner than I thought.

More at the link. Effectively, the tax deal is going to cost the US Government another trillion dollars, on top of the previous 'bailout' and 'rescue' packages that have already cost us - the taxpayers of the USA - a couple of trillion dollars. It's a bad deal . . . and traders in the bond markets recognize that, which is why they're running scared (see the links above).

The effects of rampant, unrestrained US public-sector borrowing are already making themselves felt, devaluing our currency and boosting inflation. To make matters worse, the bond market is carefully watching US State governments. They expect several of them to go into default in the not too distant future (I agree that's very likely). As Jacob Dreizin points out:

I contend that the era of massive stimulus and reasonable credit for states and municipalities is almost over. The [new] Republican Congress will not allow it. For them, it is payback time -- and so the fiscal can will not be kicked any further down the road. 2011 is decision time; expect to see some Irish-style austerity at the state and municipal levels.

More at the link.

If the Federal Government were so insane as to try to issue even more Federal debt in order to bail out bankrupt States, there'd be a bloodbath in the Treasury bond market. The Treasury simply doesn't command the confidence of the market for such a step - and rightly so. Hopefully the incoming Republican-controlled Congress will stop any such moves in their tracks . . . hopefully. I wish I could be more sure about that!

The economy as a whole is still in terrible shape. To quote just one pertinent statistic, 14% of all Americans rely on food stamps; in some states, the figure is over 20%. That's an absolutely ghastly, shocking number. One in eight Americans can't afford to feed themselves - one in five, in some states. And there's no improvement in sight. Unemployment is as high as ever, and the weakening dollar and continuing tight credit market mean that there won't be many - if any - new jobs created soon.

It's no consolation to point out that the rest of the world isn't doing much better . . . so much so that Christmas shipments are being deliberately slowed to crawling speed on the high seas, due to lack of consumer demand. That bodes ill not only for those consumer-driven markets, but for the countries whose economies revolve around producing consumer goods (China, anyone?).

Let the inimitable Karl Denninger have the last word, to tie all these elements together.

... the last time Bernanke did "QE", the so-called "QE1" (now), bond rates actually went up, not down, and now it's happening again.

Surprised?

I'm not.

At all.

Why not? Because there is no exit plan, Bernanke knows it, he's lying, and the market has figured it out.

Here's the problem in the main. Bernanke's only tool to "tighten" monetary policy means selling bonds into the market and taking in cash from the system.

But what happens if he holds bonds that have all gone down in value? He gets screwed, that's what. In an extreme case The Fed could go "bankrupt." Bernanke will avoid this, of course, and he can - but only by not soaking up that liquidity - that is, allowing the cash he printed to remain in the system while the rotting bonds he bought are "absorbed" by The Fed.

The market knows this. It also knows that the duration of his holdings has gone up a lot and that he cannot pull enough liquidity via short-term roll-off to matter - that is, despite his claim of being "100% confident" he cannot tighten policy - not now and not for many years.

The market thus sees risk - that if the economy improves you get inflation, and lots of it, as Bernanke can't do anything about it. If the economy doesn't improve then the only way for the government to continue spending like crazy, which it clearly is going to do, is to continue to devalue the currency, which means interest rates go up too as commodities will continue to skyrocket (priced in dollars) and this will destroy the tax base upon which government funding rests from the bottom up.

I talk a lot about the tax base, which is best-represented as the labor participation rate. It sucks, it is not improving, and it cannot improve so long as commodity prices continue to ramp and the currency devaluation continues.

This was the prime error made during The Depression. Contrary to Bernanke's claims of being "a student" of The Depression he's really the Fool-in-Chief of that time. FDR's devaluation of the currency trashed the tax base and guaranteed sky-high unemployment for the same reason it's happening now - devaluation of the currency destroys the finances of the middle class and below as their spending on essential commodities (food, fuel, clothing) is not only more-or-less fixed in volume (which means their cost to those people ramps as price rises) but as a percentage of income this expenditure is much higher than it is for upper-income earners.

That in turn suppresses entry-level and lower-wage jobs, which holds down the labor participation rate. And it is that labor participation rate that drives the ability of government to collect taxes - you can only tax someone who has income, and only people pay taxes - all attempts to tax any other entity, such as corporations, are simply passed through to people.

. . .

This is the precise dynamic that played out in the 1930s and Bernanke is causing it, not reacting to it.

Again, more at the link. Bold italic print is Mr. Denninger's emphasis.

*Sigh*

I hate having to be the Grinch . . . but I'm not going to sugar-coat the bitter pill. Too many politicians are already doing so. That's how we got into this mess in the first place.

A merry financial Christmas to all my readers.

Peter