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Niall Ferguson’s most recent column in the Financial Times is surely not as controversial as his penmanship this past summer. However, the more recent column misses the mark in its accuracy. Mr. Ferguson portrays Greece as the start of a new round of sovereign contagion, much like the runs on investment banks in 2008. His prediction is that the round will finish at the doorsteps of the US, apparently swamped with public debt.

Comparing Greece is easiest when examining East Asian countries, Thailand, South Korea, Malaysia, which suffered severe GDP contracting events in the 1990’s. Those countries ran current account deficits much like Greece but worse, and I stress much worse, they borrowed heavily in foreign currency in short term durations.

Greece however has the luxury of borrowing in its own currency, the Euro. True, it has run a large current account deficit, but its main import partners are also in the European Union, with the same currency. This then makes the Greece situation far different from those countries which suffered horrible fates in years past.  Greece’s share of European Union GDP is a mere 2%, slightly more than the EU’s aggregate current account deficit and more than the interest currently paid by US taxpayers on net debt.

Ferguson laments that if Greece controlled its own currency, a simple devaluation could have saved the day. Perhaps. But this would only work if domestic private savings supported public deficits. If not, foreign capital, much like in times past, would have left the country in advance, readjusting the supply/demand for money in favor of domestic savors, all the while forcing a massive  negative shock to the domestic economy. In short, modern times are too complex for such a simple posit.

Ferguson then dismisses the current EU plans for saving Greece. While they are not in final form, the EU is acting to stem current fears. Perhaps in the future, the continent will behave more like Canada, where the provincial governments have strong autonomous rights, but also share a single currency. Or perhaps countries will cede power in more drastic terms, similarly as the United States currently do. But countries banning together should be celebrated, not dismissed.

And that brings us to our second to last point. Ferguson dismisses the role of government spending, mainly the US’s recent efforts, as they spell impending doom.  But most of the US stimulus and much of the European government spending has been in the form of “automatic stabilizers”: State Aid (where most of the several must balance their budgets), unemployment benefits, tax cuts, and the like. In short: funding that has preserved jobs or provided additional income so people could keep paying rents, mortgages, and bills, and not sinking the economy further into depression.

No one argues that in the long run, the public should spend more than it takes in. But linking or identifying a country in far better shape, given its support network, than countries in times’ past as the start of a sovereign contagion event is frankly inappropriate. These problems are incredibly complex and I would expect someone of Mr. Ferguson’s caliber to be offering solutions rather than doomsday scenarios.

The Financial Times and Goldman Sachs have put forth their long list for Business Book of the Year.  The  winner amongst the many terrific nominees should be Lords of Finance by Liaquat Ahamed.

That its richness in detail flows as easily as a Harry Potter novel is certainly laudable. It is the presentation of the cause and effect of monetary policy, its struggle to co-exist independently with its fiscal policy counterpart, and the depiction of the US Central Banking system in its infancy that make it mandatory to read in detail today. The composite presentation of key actions, key “inaction” and ignorance of bubble causing behavior are reticent today not only for comparing the similarities of the times, but further as a reminder of how fragile our institutions can truly become when put through such stress. As Mr Ahamed concludes in his final chapters, the story is further a stark reminder of the effects of prolonged economic despair.

If you have not done so, you must read Lords of Finance. It certainly is Business Book of the Year.

Robert Samuelson, (who in full disclosure was a former neighbor) writes in the Washington Post today blaming economists for misreading the current crisis, failing to give proper warning. Instead, they were “out to lunch”.

In my opinion, a more thoughtful, introspective, and productive piece on the same subject was written some SEVEN months ago by Martin Wolf of the Financial times.

Judge for yourself.

Martin Feldstein’s column, (June 29, 2009) on inflation opines that while federal stimulus is still necessary, a combination of looming deficits, federal reserve bond purchases, and skittishness of foreign investors are pushing yields on the 10 Year Treasury up to alarming levels.

Feldstein’s major premise is detailed in the second paragraph of his column: Higher Yields have led to higher mortgage rates, reducing home buying, depressing net worth tremendously in the last six months. Further, lower home prices have caused more defaults and “weakened bank balance sheets”.

Lets correct some facts: Between 2006 and Six Months ago (December 2008), house prices dropped 27 percent. From December 2008 to March 2009 - the latest month of data,  housing prices fell comparatively 7%. Further, August 2009 Futures for Case-Shiller Composite index is currently trading at 152.0 slightly above where the index level stood in December of 2008, bookmarking the recent rise in treasury yields.

Feldstein, in his column, notes that the current spread between 10-year TIPS and 10 year Treasuries shows an inflation expectation of 2% annually. That inflation predictions have “jumped” to slightly over 2% per year is hardly alarming. 2% is often seen as an inflation target. That the jump in rates is perpetrated by fears foreign investors may no longer continue to buy US debt is simply not true.

China, most notably, while making loud noises is in a “dollar trap”, argued most notably by Paul Krugman. Fail to purchase US Treasuries, and decline the dollar’s value, making our goods cheaper and China’s goods more expensive, ending China’s competitive advantage in manufacturing.

At a high-level, if manufacturing in China continues to keep durable good costs down, and the Federal Stimulus package will improve roads and cargo lines, reducing transportation costs, price increases outside of energy spikes are hard to imagine for durable goods measured in CPI.

Perhaps Feldstein’s view of investor skittishness and his call for the Fed to assure the markets it will curb future “inflationary lending” are really directed at asset inflation: Perhaps investors believe that while policy makers are acting vigorously, nothing structurally has or is going to change to prevent another asset bubble similar to house price inflation witnessed over this past decade.

Asset inflation, be it houses or equities, is much harder to prevent than inflation in durable goods. Let us hope our fiscal stimulus and monetary policy are giving the economy surer footing to produce more, sharing those productivity gains across a wider spectrum, ensuring a diverse economy in the odds of preventing future asset bubbles.

The Federal Reserve released its combined 2008 Financial Statements on April 20, 2009. 2008 was stunning, with the balance sheet growing from $915 billion to $2.245 trillion. The major increases were in the commercial paper facility, foreign currency swaps, and term asset backed facility. Essentially - stabilizing mechanisms for short term market operations (both foreign and domestic) to continue.

The increase of $1.33 trillion is slightly larger than the gain in US GDP from $13.178 trillion to $14.264 trillion from 2006 to 2008. Essentially, the gains in US GDP from 2006 - when the Case-Shiller Composite Housing Index reached its peak - to 2008 are now sitting on the Fed’s books when they should be out in the private economy, on the balance sheets of companies, creating the next wave of products and services.

There are those who have argued the Fed’s actions will cause tremendous inflation. It is important to remember the major actions of the Fed are all preventing short term credit disruptions, which if not collectively implemented,  would have all lead to price declines, deflation.

Currency Swaps, worth roughly $553 billion or 1% of world GDP, are held against a basket of G-20 currencies, have most likely prevented an increasing demand for dollar. In the fall of 2008, the demand for the dollar reached a recent record high. Further appreciation would have further pressured US producers, unable to compete on price for various goods/services. The only solution would have been to cut costs to reduce prices.

Commercial Paper, worth $333 billion, is necessary to keep working capital afloat. Without it, the only solution to meet existing funding needs or return previously funded commercial paper would have been to liquidate existing inventory at reduced prices.

Term Asset-Backed Facility (TAF), worth roughly $450 billion, is further short term financing to allow banks to continue liquidity while suffering losses on their longest duration assets - CMOs. Without access to short term financing, again the only choice would be asset liquidation, further forcing price declines.

True, CPI did not increase in 2008. But added together, the Commercial Paper and TAF are roughly 5% of US GDP. As most companies were levered to the tilt, if the Federal Reserve funding was not there, the US price and consequentially unemployment situation would have been far worse.

As to worries of runaway inflation, the jury is still out. My belief is that the capital these facilities are replacing - in a sense - is now shoring up the balance sheets of various banks and companies. By increasing  equity ratios at companies and banks, future invested dollars from these newly shored up institutions will need higher returns on capital (all else equal), which is equivalent to the Fed raising fed funds rates to control inflation.

Until a recovery though, it is a good thing our economy has not faced deflation, certainly a real possibility in the fall of 2008.

Paul Krugman writes this week about the Irish Economy. In his column and blog, Paul notes Ireland is painfully transitioning, raising taxes to keep its fiscal position in line.

Let’s pause. If you have not read Lords of Finance yet by Liaquat Ahamed, stop reading this blog (or any other) and give the book a go. It is the cornerstone to understanding the current economic/financial crisis and comprehending possible solutions of both short and long duration.

In Lords of Finance, Ahamed writes of an eerily similar situation during the 1920s when Great Britain, starved for credit to funds its fiscal deficits, had to seek tacit approval from the House of Morgan on its proposed budget. Upon approval, Morgan helped raise a consortium of funding to help Great Britain stay afloat.

No doubt the same conversation was probably occurring in Ireland before it made its proposed increase in taxes. In the months since the world Financial Meltdown, Ireland raised debt in November 08 ($4bn),  January (Euro 6bn), and February (Euro 4bn). Then on March 30, 2009 Standard and Poors dropped Ireland’s sovereign credit rating from AAA to AA+ with a negative outlook. Since then, Ireland has not tapped the capital markets and has now tightened its fiscal belt.

This is now the choice of Ireland and other European Countries with current account deficits.  There is an immediate need to shore up the balance sheet, repay existing debts, and wait until domestic prices decline to a point where goods and services are competitive enough to be readily exported, regrowing the economy.  But waiting for prices to decline is a very painful phenomenon. Prices only decline when demand drops and a drop in demand across the board is synonymous with higher unemployment.

Ireland may be a small country (GDP wise), but its decisions are no different than California’s or many other states and municipalities here in the US. Without complete currency control, acting prudently (although potentially not economically), is the only choice to continue to tap existing capital markets, paying teachers, fire fighters and policemen. Economies in trouble and with a net debt position and complete currency control would either see a currency devaluation (in the form of a crash) or would choose to devalue their currency. Currency devaluation would hopefully occur faster than responsive domestic inflation allowing goods to be exported at a more competitive basis. Yet without currency controls, deflation is the only mechanism to getting prices to a point where exports can repay existing net debts (assuming those debts are denominated in the domestic currency).

Ireland is being used as an example of when economies are too reliant on the financial sector. To be clear, robust capital markets are critical to any functioning economy. Yet it is also important to note the following function: The limits to the magnitude (1x, 2x, 3x) of a sale of any business are equivalent to its estimated Rate of Return on Assets divided by its weighted average cost of capital - In a simpler Mogdliani Miller world this is the rate of asset return divided by the sum of the funding spread above the risk free rate and the risk free rate of return. In other words, the numerator to any business sale is the Rate of Return on Assets and the denominator is the return a new buyer is willing to accept. In the last eight years, we’ve grown because of the denominator: capital became cheap and offered increasingly attractive multiples for business transactions. In the next eight years, we must focus on the upper bound, the return on assets, the productivity of the country and its ability to make goods and services, representative of its currency.

Paul Krugman, in a blog post last week, offers an explanation for how private investors would think about asset purchases under the treasury plan. With no disrespect, here is my explanation:

Assume the purchase of a “legacy asset” (or purchase of a toxic asset, or the purchase of a pool of subprime mortgage) is a the purchase of cash flows for a period of 20 years. Many mortgages go out beyond 20 years, but let’s keep this at 20 for argument’s sake.

How much would I be willing to pay?

Well, a review of march-27-world-bond-yields, with at least an A rating, that go out 20 years, make me think I should get at least 8%. So, if I buy that asset for $100.00 (for which it is valued on the banks books), I’m expecting annual cash flows of $10.25 for the next 20 years.

It is fair to say, that given the horror stories everyone has heard about subprime mortgages, one would need a return far greater than 8% in order to buy one your own.

So the Treasury and the FDIC step in, and debt financing for up to 85% of the assets, with a matching equity contribution.  Assume then that the FDIC is able to offer 85% of the price on a non-recourse basis (meaning no other assets of me, as the the investor, would be touched eg - my home, my car should I be unable to service the debt). Then assume the FDIC offers 5% financing for the full 20 years. This, however, is a big IF, based on the Legacy Loan Terms sheet offered by the Treasury. Rates and Length could be far less generous.

Yet, if I were to receive 5% and 20 years of FDIC debt, my pre-tax return as the equity investor would be ~21%.

Assuming the FDIC offers these terms, the question then is, is a 21% pre-tax return to equity enough to entice investors to buy bank assets at their listed price? Secondly, is the program, with loans and equity contributions enough to remove the glut on bank books and get lending activity going again?

If the answer to either question is no, then the program has not (by itself) done enough to re-gain control of the credit markets, restart lending, and grow the economy.

But back to the 21% return for a second. In an article earlier this month in the FT, there were some pretty grim statistics about households behind on their mortgages. Nearly 12% of all home loans were either a month behind or in foreclosure. This statistic across of all households, but imagine what it is for those carrying “subprime” mortgages. Was this statistic modeled into the asset, valued at $100, on the bank’s books? That is not clear. As the equity investor, if I stress tested not receiving 12% of my cash flows annually, just to be conservative, my equity return under this scenario drops down to 12%. Given that this is a subprime mortgage pool, it could be fair to say, this investment is now not worth it.

Suppose then that a 21% return is the magic number. How much, assuming my stress test, would I offer a bank then for a $100 asset? The answer is $90, or a 10% haircut. The final question then is: Is losing 10% enough to to entice banks to still sell and remain solvent? Again, if the answer is no, then the program has not helped get lending going again.

Reading over this plan, it is my assessment that it will take time to start this program and get it functioning. The key then will be: what might happen in the mean time to banks and the economy and will we need a new set of assumptions to value these assets at that time?

If you want to read about the econonic downturn, leverage (and over leverage) in the sports world, you must read Bill Simmons latest column. It is amazing and scary at the same time. And he’s right about the refs. Simmons however is not right this is just an American phenominom:  a lot of European Football clubs are going through the same problems.

The Fed mulls an inflation target, to stabilize the economy. Robert Shiller and George Akerlof, in their new book Animal Spirits, argue for a “credit target”, a level of lending to keep the economy near full employment. In the middle is an old question - Should Central Banks consider Asset Bubbles a form of inflation?

Look at the 2008 Commodities Bubble:

• January 2nd, 2008 - According to the Financial Times, One month Oil Futures on the NYMEX were $99.62
• July 2nd, One month Oil Futures were $144.26
• December 30, One month Oil Futures were $39.03

That the Fed insists on Core Inflation, excluding energy, made it miss how energy moves all consumers prices. Consumers pulled back on gasoline purchases in the short term and in the long term, terminated SUV purchases, crippling GM and Chrysler.

Yet during oil’s rise, the Fed had to reduce the Fed Funds rate as the effects of Bear Stearns was first on its mind. It’s not clear the Fed could have raised rates to prevent oil’s rise, without crippling the economy.

Preventing the Housing Bubble though could have eliminated what we currently witness: Global de-leveraging and massive reassessment of household wealth. The sheer amount of leverage also helped fuel stock market booms (of which some was real) giving consumer confidence in 401k statements. Add to this the house market boom, household behavior such as reverse mortgages, credit card spending, an overall negative savings rates would probably not have occurred.

Yet the Fed’s role in determining over-investment is tricky, politically controversial. Without world-wide coordination for world wide bubbles, false arbitrage opportunities such as the Carry Trade can wreak havoc on international trade/commerce.

What Shiller, Akerlof, and all concerned about asset bubbles really want is an economy where the Financial Sector does not a) contribute the most to GDP growth and b) rise too disproportionately in terms of total GDP. This was our economy prior to this crisis. The economy must have real growth, not growth due to paper assets. Once perception is pricked on over priced assets, no one knows an assets true worth, causing trust and lending stop.

If Central Banks can not politically prevent asset bubbles, then our government must improve its risk management program. Two logical improvements are as follows:

1. Regulation and oversight must increase. Madoff’s false profits now cause hospital wings  to go without funding. Mortgage Originators are forcing real family pain on false interest rate promises.  And we all witness a loss in market confidence.
2. Running government surpluses in healthy economic times. 90 years ago, John Maynard Keynes worried about this very issue we now face. Certainly, government surpluses up until now would reduce our worry over how much debt we must now raise.

Only a start, but planning for the future must occur to prevent a future colapse of this proportion.

On February 10th, Secretary Tim Geithner announced the next wave of bank bailouts. The press - from the New York Times to major blogs, ripped the Obama Administration for “not enough detail”.

What does “not enough detail” mean? This is a plan roughly $2 trillion in size. Roughly equivalent in size to California’s GDP. How can “enough detail” satisfy those commenting on a proposed solution to a  problem this complex to write 200 accurate words on it? The problem’s sheer size , the moving pieces, makes it incredibly hard for anyone to understand. But lets start with the largest part: banks holdings of assets, largely those in housing.

Houses and underlying property must be viewed as derivatives, not underlying assets. Houses and property are merely reflective of economic activity occurring on the square feet. As economic activity rises, so should the house. As economic activity falls, so too should the value of that same house. Should I buy a house, I am buying it because:

• I can afford the monthly payments
• I believe my wages will continue to rise above the monthly payments, inflating away the payment burden
• My wages will rise due to my improved performance
• My performance is due to my company’s continuing ability to sell its product to other companies or consumers
• Or my performance is good enough to find another job in the same area

If the company can not sell product, I can not earn a living. If I can not find another job, I can not earn a living. If I can not earn a living, I can not afford my house. If I can not afford my house, it must no longer be worth what I paid for it. Unless someone else buys it for what I originally paid. But if the house’s location prevents this, again, it must no longer be worth what I paid for it.

The key to any communities’ housing values appreciating is its ability to export goods and services to other communities.  No exporting means no chance of true economic appreciation, and no concurrent increase in underlying value. Today’s domestic economy however has been running current account deficits for years - exporting far less than importing. Thus the derivatives that are houses have been completely overvalued for years.

Which brings us back to the banks. If banks hold leveraged derivatives on their books in the form of subprime mortgages bonds, then it is clear they are holding assets valued far more than their true worth. Given the over-leveraged position of most banks, Nationalization is coming and coming soon for some banks. Painful at first, but best in the long run. This is why Geithner left his position open and why he will not make the same mistakes others have made in the past. “Not enough detail” is easy to write, but fixing this correctly takes far more skill.