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.

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.

Much concern exists over Obama’s proposal to make tax cuts a major portion of fiscal stimulus.  Through a tax cut, we (the government) are increasing the income of those still employed. Hopefully, tax savings will buy goods and services, increasing GDP. In today’s environment, we’re not enacting a stimulus to buy goods, we’re enacting a stimulus to buy jobs.

GDP = government spending + investment + consumption + net exports. The marginal dollars in a tax cut will either be saved or spent.

While savings should be encouraged in the long term, a savings glut currently exists. Fed Funds rate trades near zero, while cash reserves within the Fed have ballooned.

More damaging, marginal spending could be directed at imported goods. From Martin Wolf to Warren Buffet, many shudder at no improvement in our trade balances. Dollars used for imports are either locked up as foreign reserves or exchanged for investments in future US cash flows. Those future cash flows are either US tax receipts or profits distributed as interest or dividends. Those tax receipts could have put new teachers in the class room. Those profits could have built new factories. Those cash flows will never to be re-invested in the US.

By definition then, an increasing current account deficit means the same standard of living - GDP - costs more. If this is not the purest form of inflation, I do not know what is.

Many believe  too great a mismatch exists between jobs lost and jobs needed for “shovel ready”.  Cokie Roberts on “This Week” opined on finance professionals helping on infrastructure: “Well maybe instead of going to their personal trainers, they can actually get out there and start digging.”

The purchase of infrastructure projects buys jobs across the food chain.  Almost every project will go out for private competitive tender. Forget defunct residential home construction (shovel ready employees), companies bidding will require talent to prepare bids, obtain financing, manage payroll, and review costs. Every contract guarantied by the government (state or federal) will give lenders the confidence to finance, spurring new growth.

The long term benefits (aside from jobs) are then improved transportation, reduced energy costs and reduction of barriers to education. Thus reduction of risks for future runaway inflation - those risks prevalent in increasing current account deficits. Faith in government is presently difficult yet now we must make our congress the direct investors of last resort.

What will 2009 look like? This blog offers key spreads to examine routinely for signs of economic recovery. In chronological order

• The Fed Funds Effective vs. Target Spreads.
• The TED Spread
• LIBOR vs. Investment Grade Bonds

Fed Funds Spread

The Fed Funds Spread, the difference between the “Target Rate” and the “Effective Rate” for Federal Funds is essentially the measure of slack in the economy. Today, the Target Rate is set to 0.25% and the “Effective Rate” for overnight funds trades at 0.11%: banks can not find enough opportunities (or see too much risk) to lend. Instead, banks choose to keep excess funds within the Federal Reserve.

This is the first spread to watch. When the “effective rate” trades at the “target rate”, the economy is performing to its potential in the current interest rate environment.

The TED Spread

The TED Spread, the difference between three month LIBOR and three month US Treasuries, is essentially the measure of trust between the private and public sector. According to the Financial Times, three month LIBOR trades at 1.47%. Three-month Treasuries trade at 0.0014% (zero). That’s a big spread.

This spread can not converge until overnight LIBOR -which mirrors the Fed Funds “effective rate” - trades at the Fed Funds Target rate: Effective Rate vs. Target Rate convergence implies upward pressure on treasury yields, making overnight treasuries trade at a minimum of 0.0025%.  This is the start to redeeming trust in the private sector vs. the public sector.

LIBOR vs. Investment Grade Bonds

This spread measures competition and confidence in the private sector’s ability to earn income. Today, one year LIBOR trades at 2.09%. Reviewing Global Investment Grade Bonds from the Financial Times, most trade at ~6.00% yield.

global-investment-grade

This is the final spread that will show uptick in the economy. When this spread converges, trust in corporate earnings is restored: the public market respects corporate earnings enough to offer a suitable substitute to banks as a source of debt funding.

The LM Curve as Perspective

Reviewing the LM curve, demand for money equals the supply money at a given output and interest rate - in this case a zero interest rate environment.  Output could increase in a zero interest rate environment, with expansion of the money supply (as the Fed is currently doing) and with expansion of the government spending (as Obama is planning). Given we are in a contractionary economic environment, one could argue the US has only slid down the LM curve - money supply expansion has not worked -, awaiting a shift in the IS curve with new fiscal expansion.

However, a healthy economy has demand for money at positive rates. For this we look to the convergence of the spreads listed above.

Robert Shiller, in his book The Subprime Solution offers a risk management tool for governments. It is a “Trill” and it pays a perpetual share of GDP.

As GDP increases, the instrument pays a higher coupon. During a recession, it pays less. Quite the floating instrument. Shiller assumes each share would pay roughly $15, believing perpetual GDP would average $15 trillion annually. (Hence the “Trill”). Each Trill would be worth roughly $300. This assumes the US Risk Free rate is 5%. The risk-less rate of the US economy is 5%.

The “Risk” that is managed is during hard times, the government obviously owes less in debt service costs. In times of plenty, the government can afford to pay more. But in bad times, governments would have more cash on hand to handle a crisis (such as today).

The Pros.

• This instrument allows the market to truly estimate GDP growth. In some ways, the instrument is worth issuing simply to have a market view (a great view) of GDP growth.
• One now has the ability- with TIPS, Treasuries, and Trills- to estimate real GDP growth given  market views.
• Instead of perpetual Instruments, it could be more beneficial to issue “Trills” expiring annually, similar to TIPS and Treasuries. This way, one could have the market truly predicting GDP growth.

The Reasons for Pause:

• Reviewing the LM curve, as output grows, interest rates rise. As the economy falters, interest rates fall. Even in today’s crisis, this relationship holds true. The Trill’s desired hedge already exists. Further, this means the government has the ability to re-finance higher yielding paper in tougher times.
• The Hedge: Shiller’s main reason for the GDP indexed Trill is to provide government “room to spare” should a contraction occur. As GDP declines, so would tax receipts, lowering government revenue. It then is hard to argue the Government would have spare cash to attack a crisis.
• Other Financings: GDP, remember, is defined as Consumption + Investment + Government Expenditure + Net Exports. GDP could remain stable year on year, but Imports could still rise. In this example, Investment (Foreign Direct Investment) remains unchanged meaning the Current Account Deficit is in the form of domestic bonds and stocks, essentially payments to foreigners from US income. Trill payments could remain unchanged, but the country as a whole would pay more to maintain the same standard of living (in the short run).

Robert Shiller is one of our smartest thinkers on real property. Let’s work on the Trill as it has definite promise as a positive instrument for US Debt.

Is the liquidity crunch over?

Here is my thinking:

Let’s review treasury rates (aka, the “riskless” rates) for the US and UK over the next six months. According to the Financial Times data on November 14^th, 2008:

• US treasuries set to expire in six months yield 87 basis points (Deflation).
• UK treasuries set to expire in six months yield 199 basis points (who knows)
• One British Pound today is worth 1.4827 US Dollars
• One British Pound’s worth in six months as of today’s spot forward is 1.4807 US Dollars

The rates for sovereign taxpayer debt and the interlinking value in currency should display the differences in risk of each country.

• $100 invested in US treasuries vs. $100 invested in UK treasuries and converted at the corresponding spot and forward rates should yield the same rate of return.
• Converting $100 to pound equivalents, investing in UK treasuries, and returning those pounds to US Dollars six months from now returns a dollar more (.98 US cents) in value.

In normal times, no way. Someone in any trading house would be looking for the “blips” to quote Michael Lewis from Liar’s Poker. Here are a two observations why this opportunity exists today:

• As discussed in previous posts, we’ve witnessed massive flight to quality recently, as capital has left emerging markets and safe harbored itself in US Treasuries
• The REPO market continues to be stressful. Again, as discussed in previous posts, the lack of shorting treasury opportunities has caused massive spreads differences in otherwise equally risky cash flows.

What is interesting though is that the link between currency and risk still exists for the most part. For the UK though, that means its current treasury yields are tied far more to the US and the Dollar than they are to their own interest rate policy (currently at 3.00%). While the Bank of England has been aggressive in rate reductions, its own government bonds in no way reflect this.

Since the bailout was enacted, three-month LIBOR declined from highs of 4.75% to 3.52%. Further, three-month LIBOR dropped 90 basis points in this last week.

Room to drop?

The market votes yes. Three-month Eurodollar contracts closing in December (the three-month LIBOR futures rate) is pricing at 2.63%. By June, three-month LIBOR is expected to decline to 2.48%.

Context on the market prediction is critical. We must understand how much risk is priced into spreads.

TED Spreads, the base spread of risk between private capital and riskless funds, remain large.

• Today, three month treasuries yield .93%.
• Investing in treasuries today for returns in March 31st, 2009 yields 1.2125%.
• The implied treasury yield matching the Dec EuroDollar Contract is therefore .72%.
• Further, for three month March LIBOR, projected at 2.50%, equivalent three month Treasuries yield .22%.

So, good news and bad news. LIBOR is declining, but the TED spread remains wide.

As a side note, it is now obvious that Treasury Yields have priced a massive rate cut over the coming months.

Since last we spoke, the government invested $125 billion into the nine biggest banks and will invest $125 billion into an additional number of banks, potentially other financial companies. The investments, up to $25 billion or 3% of risk weighted assets into any specific company, are supposed to ease liquidity issues, and reduce cost of funds between banks.

The Treasury can choose how to finance this purchase.

First though, the plan gives us insight into when Treasury foresees the US Economy recovering. If all preferred shares are callable in three years, but only redeemable through equity (and not debt) prior to, then in essence, Treasury believes we will not fully calm the credit markets until three years from now.

At present, The Treasury issues 2 Years, 5 Years, and 10 Years. Yet Treasury must know most banks will call the preferred shares by year five when the dividend percentage increases from 5% to 9%.

Yet how many banks will take out the preferred shares prior to year three? Probably not many.

The safest debt instrument then is a five year treasury debt instrument. Here is why:

• The Yield on Five Year Treasuries is 2.609%, cheap money.

• No refinance risk. The preferred shares are retired back piece by piece through the next five years. While there is a chance of buying back treasuries at a premium when the debt is retired, the debt is so cheap; this problem is hard to imagine.

• Isolates the problem to the current administration. No doubt, models exist predicting when various banks will pay back the preferred shares, estimating duration and a possible combination of two year debt, five year debt and accept some refinance risk if funding is further needed.

Since the First Note, The Government’s Credit Committee, with members Barney Frank, Chris Dodd, and Richard Shelby took more time to get comfortable with Hank Paulson’s proposal.

While the debate in Washington raged on, one month LIBOR increased from 3.19% to 3.70%. Three month LIBOR increased from 3.21% to 3.76%. Commercial Paper increased from 2.50% to 2.70%. Letter of Credit facilities are not expanding. Essentially the way balance sheets are funded is grinding to a halt.

So, how could most corporations raise capital faced with this problem? One answer would be to short treasury securities of the same duration. Simply borrowing the securities, selling them into the market for cash, with the promise to deliver those securities later would do the job.

And why not? Treasury securities expiring on Dec 31 are yielding a paltry 1.02%. Treasury securities expiring on Dec 15 are yielding .68%. Would a betting man believe yields would increase or decrease in the next week? Considering inflation increased over the past year and that the US will sell an additional $700 Billion of debt into the market, yields will most certainly rise.

So, given the demand to short and the rational argument that yields will increase, the fact that the spread is so significant is in fact very significant. Money that normally would buy commercial paper and be infused into interbank offerings is now moving to “quality”. That quality is the United States government backed bonds and notes.

We can quickly examine the balance sheet and income statement of the US Government to know the following:

1. Liabilities just increased by close to $1 trillion, including Fannie Mae, Freddie Mac, AIG and the proposed bailout.
2. Projected top line tax revenue is expected to decline as housing values sink and oil relief is still far off.
3. Inflation is still a huge risk.

So how is this quality? The simple answer is that it is not. And if the US Government is not quality, then imagine how much mistrust is in the private market right now. And this is exactly why those shorting trades are not occurring and not helping to re-balance the spread, lowering TED.

For all of 2008 until now, we heard and read the financial sector was amuck, but corporate American remained strong. Yet now, we are conceivably in a macro-economic death-spiral.

1. If companies continue to be faced with high interest rates and refusal of credit, they will stop expanding.
2. Further, for all those companies who did not hedge exposure (and with lack of quality counter-parties, it is conceivable this is a lot), they will be forced to pay higher rates of interest now on all existing loans and notes.
3. To meet higher rates, companies will have to cut expenses, essentially wages. Reductions of wages will depress the economy further.
4. Consumer spending will continue to decline, making more companies unable to meet existing obligations.
5. Credit spreads will increase for fear of company credit and the cycle will continue.

This week will be as wild as the last one….