*These remarks were prepared for small luncheon group in Dallas on July 29. 

For perspective, the housing boom peaked in 2006.  The financial fallout of tons of subprime mortgages embedded in mortgage backed securities came to the public's attention about a year ago, in July 2007.  The subprime crisis became front page news in late July and early August.  On August 5, the Fed's Federal Open Market Committee had a regular meeting and failed to ease policy or even to shift its focus of greatest danger away from inflation to neutral or to a greater danger from the financial crisis and its likely spillover into the real economy.  In retrospect, that showed the Fed to be behind the curve. 

Strong adverse market reaction in the days following woke the Fed up and its first reaction was to allow the Federal Funds rate to trade below its official target of 5.25 percent - which was termed a "stealth easing."  Federal Funds are bank reserves on deposit at the Fed that are traded daily among banks.  The annualized interest rate is called the Federal Funds rate, which supposedly reflects the relative scarcity of bank reserves needed for new loans and investments and new money creation.

The Fed's short run policy tool is to use open market operations in government securities to affect the level of federal funds and keep the FF rate close to its target.  It understands, however, that in the long run, money supply growth is a better gage of monetary policy.  The goal there is to keep the growth of the money supply in line with the capacity of the economy to grow in real terms.  If the labor force growth trend is around 1 percent per year and productivity (output per hour) is growing around 3.5 to 4.0 percent per year, then the money supply should grow (adjusted for velocity changes) around 3.5 to 4.0 percent per year.

The Fed began its formal program of aggressive policy ease in early September with a surprise reduction in its discount rate of half a percentage point, enabling banks to borrow newly created reserves cheaper and hopefully passing the lower rates on to their customers.  At the September 18th meeting the FOMC began a series of cuts in its Fed Funds and discount rates.  These cuts continued until the Discount rate had declined from 6.25% to 2.25% and the Fed Funds rate had declined from 5.25% to 2.00%.  All along the way the markets were clamoring for more, faster.

These traditional policy tools weren't working as well as hoped because the fundamental problem in the financial markets was not just a lack of liquidity but fear of not being paid back. Plus, banks were reluctant to borrow at the traditional discount window lest people think they were in trouble.  To help overcome that reluctance, and to get money to where it was most needed, the Fed created several special facilities to auction off pre-announced amounts of reserves.  Importantly, the FOMC greatly liberalized the terms of that lending - extending the duration of the loans and liberalizing collateral requirements to allow banks use as collateral illiquid securities that weren't trading and which banks needed to unload.  Even though the Fed gave the collateral a significant haircut, hopefully their value will return if and when markets normalize.  The Fed had waiting time and could be more patient that banks under the circumstances, especially those forced into mark the securities to market, thus reducing capital.

Many large commercial and investment banks reported large losses and write-downs which impaired their capital cushions.  This kept the markets nervous and encouraged the hoarding of reserves.  The Fed pumped them in but they weren't fully utilized, a phenomenon sometimes called "pushing on a string.  The answer to that is more, more.

Early on, Merrill Lynch had two hedge funds fail, and organizations like Merrill, Citigroup, UBS and many others continued to report very large write-downs requiring large capital raises - diluting the capital held by previous share owners as well as depressing financial stock prices.

A potential flashpoint came in March 2008 when customers and counterparties, without apparent reason, suddenly lost confidence in Bear Stearns.  Bear had always been more highly leveraged than even other investment banks, but, other than that, the triggering event is not known for sure.  Could it have been rumors planted by short sellers?  Naked short sellers?  I don't know whether it is true or not, but it is plausible that the firm was sound a week before its sudden collapse.   

As we all know, no banks, even very sound banks, are liquid enough to withstand a run without an external source of liquidity.  However, while commercial banks have deposit insurance that protects them against most runs, investment banks do not. Nor did they have access to the discount window.

As you know, the Fed facilitated the sale of Bear to J.P. Morgan Chase, in part by lending Chase $29 billion on highly illiquid securities.  Chase agreed to take the first billion dollars of any losses that occurred.  The Fed's role in this was very controversial, as you know, on moral hazard grounds and on general free-market principles against bailouts.

However, just as there are no atheists in fox holes, there probably are no libertarians when they have to deal with a crisis. (I owe that line to Jeffery Frankel of Harvard.)  If Bear was not clearly "too big to fail," it was certainly too inter-connected and inter-twined with other financial organizations in the financial system.  A sudden closing of Bear would have had great adverse systemic consequences that the Fed, as guardian of the financial system, just couldn't allow to happen.

Two points in defense of my old institution, the Fed:  First, it wasn't technically a bailout.  The managers and owners and many employees of Bear lost virtually everything.  Second, the idea behind moral hazard is not to reward risky behavior lest you encourage more of it in the future.  I don't think Bear's risky behavior was rewarded in this case.  Future leaders of investment banks are not going to look back at this episode and be encouraged to emulate Bear.

Just after Bear's rescue, the Fed opened its discount window to investment banks, which was probably the watershed event in beginning to overcome the financial crisis.  Financial markets began improving very slowly after that March event until interrupted by the recent flare-up about mortgage giants Fannie Mae and Freddie Mac.  Of course, the Fed was also criticized for offering to open the discount window to Fannie and Freddie as part of Treasury Secretary Paulson's program to restore confidence in Fannie and Freddie.  Nobody liked doing it, but without those preventive measures there was a good chance of investments banks falling like dominoes.

After Bear Stearns, speculation shifted to "whose next" and Lehman Brothers was emerging as the consensus candidate; so I find it ironic that a negative report on Fannie and Freddie from a Lehman analysis helped trigger sudden concerns about their viability.  I say sudden concerns because nothing had really changed.  People like Alan Greenspan have been arguing and testifying for years that Fannie and Freddie should be "reigned in" to slow or reverse their explosive growth - which has resulted in their participation in about half the mortgages in the United States, with their agency securities, mostly mortgage backed, being held in large quantities by financial institutions all over the world.

The problem was that since they were "government sponsored enterprises" investors assumed their debt was backed by the U.S. government; so they could borrow at low rates, somewhere between the treasury market and the private sector.  Those favorable borrowing rates allowed virtually unlimited growth potential and their "sponsorship" by the government presumably made sufficient their thin capital cushion and great leverage.  That worked until it suddenly didn't.  It turned out that even Fannie and Fannie required confidence no matter their balance sheet realities.

This prompted Secretary Paulson to ask for congressional authority to expand the Treasury's $2.5 billion line of credit to Fannie and Freddie by whatever amount might be needed and Mr. Bernanke to offer access to the discount window, if needed.  The reasoning is that the open-ended nature of these back stops will reduce the chances they will be needed.  I hope that is the case because, with all their flaws, we need Fannie and Freddie to help us out of the mortgage mess.  Now is not the time to hobble them.  We need them, including their cheap access to capital.

As for the "real" economy, it looks like we won't have the two consecutive months of negative real GDP that is the popular rule of thumb for a recession.  Real GDP in the 4th quarter 2007 was plus 0.6 percent, but would have been plus 2.4 percent without the drag of inventory depletion.  The 1st quarter for 2008 is now estimated at a growth rate of plus 1.0 percent, but only after benefiting from a partial inventory rebound.  A consensus is developing that the 2nd quarter, ended in June, will be 2.0 percent or more.  One caution:  benchmark revisions in the past three years of GDP numbers will take place on July 31.  Some of our small positive quarters could be revised away.

The business cycle dating committee of the National Bureau of Economic Research, however, isn't bound by the two-quarter rule of thumb, and there is better than a 50-50 chance that they will eventually declare a recession, most likely beginning last December.  However it comes out, it is remarkable that the economy is still showing positive overall growth give the depth of the housing and mortgage bust.

While our attention has rightly been on the financial crisis and the weakening economy, inflation has risen and the dollar has weakened somewhat more.  The Consumer Price Index was up 5 percent in June from a year ago.  The Core CPI that excludes food and energy was up a more modest 2.4 percent, but that also is too high.

The recent growth in GDP has been based on productivity growth (output per hour) rather than employment growth.  Payroll employment has declined by an average 92,000 jobs per month for the past six months.  This Friday, we'll probably learn of another decline in July.  The unemployment rate is currently 5.5 percent and is likely to drift higher. A 5 percent inflation rate added to a 5.5 percent unemployment rate has put the "misery index" into double digits, at 10.5 percent.  That's low only by ‘70s standards.

The most important thing needed for a return to economic health is for housing prices to bottom out and for home sales to start rising again.  That isn't likely real soon even if financial markets improve markedly (to use a Greenspan word), but financial markets are still suffering even after all the Fed has done to liquefy it and open up the bottle necks.  I believe mortgage rates are higher now than they were before Fed easing began a year ago.

Looking ahead, the greatest danger could be the election on November 4th.  The likely winner, and the party more likely to expand its numbers in Congress, have both vowed to let the Bush tax rate cuts expire. Taxes on regular income don't expire until 2010, although they can be changed by legislation any time.  Taxes on capital - on capital gains and dividends - expire after this year.  Ironically, wages and the standard of living of "working people" depend greatly on how capital is taxed, since the demand for labor and wages grow with the capital stock.  Taxing capital reduces its accumulation and slows the growth in labor income.

The long shot candidate for president has promised to keep the Bush tax-rate cuts in place and to cut the corporate tax rate from 35 percent, which is the second highest in the world, to 25 percent.  Both, however, would need the acquiescence of a more liberal Congress.

I don't know to what extent this bad news is already priced into the stock market - probably most, but not all.  However, unlikely things can happen.  John Kennedy pushed for the largest marginal rate tax cut in our history, and Richard Nixon went to China.

This Friday I was guest host, substituting for James Whiddon, on the radio show that he and Lance Alston of JWA Financial Group do weekly on News/Talk WBAP 820 AM.  Lance and I discussed a broad range of economic issues. You may hear the discussion here.

"Rich men smoke big cigars; so, I'm going to buy myself a big cigar and be rich"

Back in the olden days when I studied international economics, the exchange rate was determined by supply and demand in foreign exchange markets. The supply of dollars derived from our demand for foreign goods and services.  The demand for dollars derived from foreign demand for U.S. goods and services.  If the supply of dollars in the foreign exchange market rose relative to the demand for dollars, the dollar depreciated to restore equilibrium.  If the demand for dollars in the foreign exchange market rose relative to the supply, the dollar appreciated to restore equilibrium.

Note that it's the supply and demand for dollars in the foreign exchange market that determine the dollar exchange rate, not the amount of dollars supplied in the domestic economy.  There may be some correlation between the two, but the relationship is not direct.  Contemporary commentary generally misses that point and go directly to the creation of money by the Fed to a decline in the exchange rate for the dollar.  The value of the dollar in terms of goods and services may be related to but is not the same as the value of the dollar in terms of foreign currencies.

Back to international economics in the olden days: If the U.S. begins to grow faster than our trading partners, our demand for imported goods and services would rise relative to the foreign demand for our exports, and the dollar would weaken to restore balance in trade.  If our growth lagged behind that of our trading partners, our import demand would decline relative to foreign demand for our exports, and the dollar would strengthen to restore balance in trade.  In other words, other things equal, a stronger economy led to a weaker dollar and a weaker economy led to a stronger dollar.  Today, we hear that a strong economy leads to a strong dollar, but the mechanism through which that happens is not spelled out.

Other things equal, if foreign demand for our goods and services increases, causing the foreign currency demand for dollars to increase, appreciation of the dollar would coincide with a stronger domestic economy.  The dollar appreciation doesn't cause the economy to strengthen; instead, both result from a common cause — the increased foreign demand.  To repeat: If foreign demand for U.S. exports increases, the resulting improvement in our trade balance will strengthen the domestic economy.

If foreign demand for our exports declines, so would the foreign demand for dollars in the foreign exchange market, and, other things equal, the dollar would depreciate as the economy weakens due to its "declining" trade balance.  Thus, if the impetus is from foreign demand, the dollar and the economy strengthen or weaken together, both reacting to the same external change.

Contemporary arguments that a stronger dollar would lead to a stronger economy is true only if the dollar strength results from greater external demand.  Yet, foreign demand, or, indeed, foreign trade is rarely mentioned.  Instead, it is assumed that dollar strength would result from having the dollar "talked up" or supported by the Secretary of the Treasury, the Chairman of the Federal Reserve Board or the President.  I call that strength through levitation, which, were levitation possible, would have the opposite of the desired effect.  The levitated dollar would weaken our exports, increase our imports, and reduce GDP growth. 

Contemporary discussions of the dollar on financial TV include few references to trade.  More emphasis is placed on monetary policy — either too-low interest rates or too much monetary expansion.  Leaving the interest-rate discussion for later, I will just point out again that there is no direct link between money creation by the Fed and the price of the dollar in foreign exchange markets.  Not all newly created money finds its way to foreign exchange markets where exchange rates are determined.  While there may be a loose correlation between too much money creation in general and too many dollars trying to buy foreign currencies, that second step is necessary but is never mentioned.  But, I contend, that a levitated dollar unrelated to foreign export demand would weaken the economy rather than strengthen it.

What if the dollar strengthens because the Fed raises short-term domestic interest rates relative to foreign interest rates and attracts capital from abroad?  While the net overall impact on the U.S. economy would depend in part on how the capital is used, the impact on the economy from foreign trade would be negative since the higher dollar would encourage imports relative to exports.

A frequently heard recent argument is that the Federal Reserve has created too many dollars (usually called liquidity) which has directly reduced the dollar's value in foreign exchange markets. I'll examine the growth rates of money later, but for now let me just say that I'm not convinced there has been too much money creation.

Most of the bank reserves created by the auctions have been offset or "sterilized" by open market operations Second, even if the best measure of money — I'm not sure which measure that is these days — has grown more rapidly recently than before, the velocity of that money has obviously declined, offsetting its impact on real GDP.  I say "obviously" because real GDP has increased at less than a one percent annual rate for the past six months.  An effort by the Fed to slow money growth to boost the dollar would, in my opinion, tank an economy that is barely limping along.  In terms of the equation of exchange, MV=PQ, a growth in M doesn't cause inflation.  It takes growth in MV.

The reduction in velocity is rarely mentioned these days, but a "freeze-up" of credit markets is mentioned often.  It appears inconsistent to me to say that financial institution are hoarding rather than lending money and, at the same time, to argue that the Fed is creating too much money.  When velocity plummets, the Fed should step up money growth to offset it rather than slow money growth to reinforce its impact on the economy.

My comments above assume that the best measure of the stance of monetary policy is money growth.  If the Federal Funds Rate is the better measure, we would get different results, since it is currently negative in real terms.  I don't think it is the better measure, especially since the link between the Federal Funds rate and more relevant longer term rates seems to have broken down.

Since I drifted a bit, let me just restate my principal point: A stronger dollar resulting from a rising demand for our exports relative to our imports will lead to a stronger economy.  A stronger dollar created by other means would likely weaken the economy.  Conversely, a stronger economy made stronger by non-trade forces, would be more likely to weaken the dollar than strengthen it.

The late, great Lewis Grizzard taught us the difference between nude and naked.  Nude is when you don't have any clothes on. Naked is when you don't have any clothes on and you're up to something. It's the same with naked shorts. 

Inflation is too high and getting higher.  The consumer price index is running, as some headlines put it, "hotter than expected."  The headline rate was up 1.1% for June, the largest one-month increase in 26 years.  Once again, the largest gains were in energy and food.  The Core CPI, which excludes those volatile components, was up 0.3%, which is a 3.6% annual rate without compounding.

June's Producer Price Index was even worse at the headline level, although producer prices are unlikely to be fully reflected in future consumer prices given that labor and other factors are embedded in consumer prices.  The headline PPI was up 1.8% in June, while the Core PPI was only up 0.2%.

The FOMC recognizes the seriousness of the inflation problem, but, at the moment, it has more urgent problems to deal with.  The first is the weak economy, which has been losing payroll jobs at a rate of 91,000 per month for the past 6 months.  The second, even more urgent, problem is the continued fragility in the credit markets, as evidenced most recently by concerns over Fannie Mae and Freddy Mac.  The third problem is the weak dollar.  Some people would include oil as an additional separate policy concern, but the price of oil is determined in international markets, and I doubt it can impacted significantly by Federal Reserve actions.  

Financial talking heads made much of the Fed having three target goals and only one policy tool.  I would argue that it's really only two to one, even though that is bad enough. The reason is that actions to restore financial stability would likely also help stabilize or stimulate the weak economy; therefore, those two goals aren't in conflict to my mind.

So, the Fed has to decide whether to place priority on financial markets and a weak economy on the one hand or inflation and the weak dollar on the other hand.  In his semi-annual testimony and report to Congress earlier this week, Chairman Bernanke indicated that he currently has to give priority to the former, especially the stability of financial markets.  He restated the FOMC's continued belief that, as economic weakness continues, the slack in the economy will help pull inflation back down without direct Fed action.  He also believes that oil and other commodity prices are in bubbles that are likely to burst of their own accord.  I agree, but I acknowledge that it's only a hunch and a hope.

There is a school of thought on financial TV that the Fed's first priority should be to raise the target Federal Funds rate at least once, and soon, which they expect to result immediately in a stronger dollar, which in turn would strengthen the economy.  I will examine that assertion in a separate blog. Meanwhile, to raise interest rates in the midst of the current financial turmoil and fragile economy is, in my opinion, too risky an experiment to try. 

With all we have going on right now, I doubt that a quarter-point narrowing of the interest rate differential between the U.S. and the Euro zone, which is the relevant comparison, would make much difference in the exchange rate.  The dollar's weakness is primary with the Euro.  I would even quibble that the problem is more a too-strong Euro than a too-weak dollar.

As I've said before, but it bears repeating, I want a stronger dollar, but one that is made stronger by exports growing faster than imports resulting in a narrowing of our trade deficit.  Dollar strengthening through export-led growth does not put the domestic economy at risk as would increasing U.S. interest rates to narrow interest-rate differentials to attract capital.      

The more competitive dollar has already begun to improve our trade balance, which, in turn, has been crucial in keeping our economy from slipping into recession.  Exports are growing nicely, but the improvement has been only modest because of the higher prices paid for imported oil.  As I've said before, give us a strong dollar, but not just yet. We still need a competitive dollar to keep us out of recession.

I was part of a panel discussion on CNBC's Power Lunch earlier today discussing Fed President Ben Bernanke's testimony to the Senate Banking Committee.  To see clips from the discussion, click here and here.

To read Alan Greenspan's prescient testimony on the need for regulatory reform of Fannie Mae and Freddie Mac before the Senate Committee on Banking, Housing, and Urban Affairs on April 6, 2005, click here.

This morning I was on CNBC's Squawk Box, weighing in on the dollar and the markets.  To see the clip, click here.

Don't Do Right at the Wrong Time

Originally appeared in July 5th edition of:

Shortly after coming to the Lone Star State, I bought the classic book of Texas wisdom, "Don't Squat with Your Spurs On!" One of its many useful pearls was "No matter who says what, don't believe it if it don't make sense."

That's easier said than done, of course, when everyone seems to agree on something I'm still trying to make sense of. Many examples arise from the tendency of lawmakers and regulators to do during a crisis what should have been done earlier to prevent the crisis. Too-late smart may not be smart at all. Fixing the barn door after the horses escape doesn't do much good, and it may keep the horses from returning.

Example: The argument that we should raise gasoline taxes to help wean drivers from too much driving in their gas guzzlers. If that was ever a good idea, it was before the recent rise in gasoline prices. Now it would just make a bad situation worse. Suspending gasoline taxes this summer is probably not a good idea either, but it makes more sense than raising them, and is more consistent with the common sense of making hay while the sun shines.

In another example, the Fed and others have argued for years for reforms of Fannie Mae and Freddie Mac - including clarifying that their debt is not backed by the full faith and credit of the U.S. government, and capping their growth to limit the distortions caused by their artificially low borrowing costs and thin capital. The current reforms under way, including raising their capital, may have been needed. But they should be expedited to facilitate, rather than inhibit, the important role Fannie and Freddie can play in resolving the credit crisis. Let's postpone our hand wringing over their government-sponsored credit ratings and cost advantages, and take opportunistic advantage of them in the current crisis. We need them, as well as the Federal Housing Administration, to do more of what they do, not less.

To me, the most serious example of doing the right thing at the wrong time is overly strict adherence to "mark to market" accounting rules. Most of the write-downs of securities that are creating capital shortages in financial institutions don't result from actual losses, or even expected losses. They result from having to mark down assets, many or most of which could easily be held to maturity and redeemed at par. This includes securities issued or guaranteed by Fannie and Freddie and other investment-grade securities, especially those graded triple A.

Holders of mortgage-backed securities point out that marking them to market is currently impossible because there is no market. Moreover, identifying those that can easily be held to maturity, and classifying them as such, makes more sense than marking them down to levels that never need to be realized. Book losses if and when they are realized - not before. Eliminating unnecessary mark-to-market losses would go far toward resolving the current crisis.

While mine is no doubt a minority view, it is supported by William Isaac, former chairman of the Federal Deposit Insurance Corporation. He says that mark to market is overdone and is pro-cyclical, since regulators limit the ability of banks to reserve during good times, but insist on increased reserves during bad times. Even some supporters of mark to market acknowledge that it was not intended for over-the-counter, hard-to-value assets.

Accounting purists would call this forbearance and frown. But forbearance in shooting the sick and wounded with good recovery prospects is no sin in my book. The greater sin would be to let a "rules is rules" mentality continue to make a bad situation worse.