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DYLAN GRICE: The Next Crisis Will Be Born Out Of The US Treasury Market

SocGen investment strategist Dylan Grice does not think “safe-haven” assets are very safe.

In Grice’s latest note to clients, he compares the illusion of safety created by faulty regulation before the 2008 financial crisis to the new, impending wave of financial regulation on the table like Dodd-Frank in the U.S. and Basel requirements on a global scale.

Grice warns “madness is going on in the government bond markets” today, furnishing this long term chart of US Treasury yields going back to 1800:

From the note:

The regulations which told banks that AAA-rated bonds were “risk free” were designed to make markets safer. But they created an artificial demand for such bonds, which created an incentive for issuers to dress up bonds as “risk free” when they were anything but. The regulations effectively incentivized ratings agencies to rate them as “risk free” when they clearly weren’’t. And today, the same madness is going on in the government bond markets.

It’s very difficult to see how government bonds are anything other than “risk assets” (let’s face it, all assets are). Yet insurers are buying them because they’’ve been told to “take less risk” (whatever that means) by the regulators. So they are taking more risk, and they will one day suffer the consequences. Banks in the eurozone are bust because they own so much of their local sovereigns’’ debt. But they were told it was OK to do that by the regulators. So they let their guard down.

Indeed, having told banks that they were of sound balance sheet before the crises (Lehman Brothers Tier 1 risk-weighted capital ratio was 11% five days before bankruptcy), those same regulators today scratch their heads and wonder how banks became too big to fail. It’’s all embarrassing really.

Source

Economists fiddle with theory as world burns

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Andy Mukherjee (The Straits Times)
The Asia News Network
Thu, 10/06/2011 10:46 AM

Civility has been one of the less-mourned casualties of this financial crisis.

Radically different viewpoints on what will put the world economy back on a stable growth path have split the profession of economics into two warring tribes.

You are either with Mr Paul Krugman, the Princeton University professor who won the 2008 Nobel Memorial Prize in economic sciences for his seminal work on trade theory, and a few like-minded economists of deep Keynesian persuasion. Or you are their enemy. There is no middle ground.

Most people equate Keynesian thinking with government control of the economy. The more modern variant of the economics profession that seeks its inspiration in Adam Smith’s invisible hand is equated with private enterprise and free markets.

That is a caricature.

The real difference is that Keynesianism, with its roots in the Great Depression of the 1930s, is concerned with the here-and-now of an economy: When Keynesians see a fire, they want to put it out first and ask questions later.

The non-Keynesians believe that the present is inexorably connected with the future, and unless one can permanently change expectations about the future, tinkering with the present makes no sense. Putting out a flame in one corner of a burning building merely brings the blaze back in another.

It is one thing for physical sciences to live with sharp differences in opinion. Whether light is particle or wave was hotly debated for four centuries. But Mr Thomas Edison’s light bulb did not have to wait for that debate to end.

By contrast, economics is a social science that allocates resources between members of a society and between today’s citizens and future generations. In the absence of a theory that justifies why Peter must be robbed to pay Paul, elected politicians have no basis to enact policy.

Say, United States President Barack Obama, desperate to stimulate the economy, faces a choice. He can spend US$1 million to build a road by taxing Mr Warren Buffett, or he can give Mr Buffett a US$1 million tax break. Mr Obama should select the course of action that gives a bigger boost to the economy. But do tax cuts have a bigger multiplier effect than government spending?

Sadly, economists cannot agree. Indeed, prominent economists like Mr John Taylor, who worked in the George W. Bush administration, did not even buy the claim in 2009 by the Obama economics team that a 1 per cent increase in government spending would increase inflation-adjusted US gross domestic product by 1.6 per cent from what it otherwise would be. The effect would be much smaller, he said.

When Mr Obama recently presented a proposal for cutting payroll taxes, Mr Taylor expressed doubts about Moody’s Analytics chief economist Mark Zandi’s claim that it will create 1.9 million jobs.

“This is the same type of model simulation that predicted the very similar 2009 stimulus package would create millions of jobs, and the same type of simulation that claimed that that package worked,” Mr Taylor noted on his blog last month.

Mr Krugman agrees that the Obama stimulus did not do the job. But in his opinion, it was too small to work.

Nowadays, Mr Krugman, who writes an op-ed column in The New York Times, uses his blog to rain punches on anybody who dares to disagree with Keynesian prescriptions for fighting the economic inferno. As the crisis has deepened, the list of his enemies has grown.

Those at the receiving end of his blows include former Fed chairman Paul Volcker, who recently wrote that the US Federal Reserve was sowing the seeds of future inflation. “Volcker, I am sorry to say, is worrying about refighting the 1970s when we are actually refighting the 1930s,” Mr Krugman responded.

In the 1970s, the US experienced economic stagnation along with galloping prices. Mr Volcker raised interest rates all the way to 20 per cent to kill inflation.

The other side – the non-Keynesians – is not taking Mr Krugman’s assault lying down. “Paul isn’t doing his job. He is supposed to read, explain and criticize things economists write, and preferably real professional writing, not interviews, op-eds and blog posts,” said University of Chicago economist John Cochrane.

The US is hurtling towards another recession, Europe is flirting with a sovereign-debt meltdown, China is slowing and the rest of the world is looking to economists to show the way. And here is what Mr Krugman and Mr Kenneth Rogoff, a former chief economist at the International Monetary Fund, were debating around mid-August on the CNN show Fareed Zakaria GPS:

Mr Krugman: “If we discovered space aliens were planning to attack and we needed a massive build-up to counter the space alien threat, and inflation and budget deficits took secondary place to that, this slump would be over in 18 months.”

Mr Rogoff: “And we need Orson Welles, is what you are saying.”

Mr Krugman: No, there was a Twilight Zone episode like this…”

Now, The War Of The Worlds, the radio drama about an alien threat that Welles directed and narrated, spooked Americans by its realism. Equally startling is this war of words between economists. It is turning sillier by the day. The debate is now so caught up with settling scores that men with practical ideas stand no chance of being heard. That is dangerous for policy.

The global economy is seriously ill, and the doctors are debating whether John Maynard Keynes was right to assume that consumption was a function of current income or whether Milton Friedman’s intuition that consumption depends on a consumer’s sense of her “permanent income” is a better theory.

The society at large has to express its disappointment: The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, which is due to be announced on Monday, must be axed. It will not be, but it should.

Anti-intellectualism is an ugly trait. But with their bloodletting, economists have left us with little choice.

Original Article

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