Ultimately of course life is never that easy. I only need to invoke the M3 measure in the Eurozone to show this. For those of my readers who don't get the wonky joke here, the ECB is formally targeting a growth rate in the M3 somewhere between 3-4%. As far as I know, it has been way above this throughout the Eurozone's history (and it still is even though we are heading straight into über recession mode; latest figure for October is 8.7% yoy non-seasonally adjusted). I am sure some of you will have similar examples with other of those famous central bank gauges.

More generally the art of central banking and by consequence the focus on monetary policy have undergone quite a tumultuous development in the context of the current spectacle in financial markets. Consequently, up until that illusive butterfly flapped its wings and brought us into the current predicament, central bankers were buoyed by what was later to be coined as the great moderation. High growth in productivity as well as the much hailed positive supply shock from the big emerging markets meant that central bankers only needed to point and aim. Of course, history may not be so kind towards the idea of the great moderation since it is clear that the capacity of some emerging economies were greatly exaggerated. Add to this that some central bankers (most notably Alan Greenspan in the US) have moved from the ashes into fire as they have been blamed by many for the predicament we are in by not recognising the inflationary effect of their policies.

At the current juncture, the discussion of the importance of monetary policy and conduct of central bankers have never been more important. Sure, we have had the BOJ flirting with the zero-bound for the better part of two decades, but now that the Fed is at it too and potentially dragging the rest (kicking and screaming) with it, the importance, meaning and crucially consequences (given diverse fundamentals) of the zero-bound issue becomes crucial.

At some point I will have more to say about this, but for now let me stand on the shoulders of one of the real giants in the context of theorizing on monetary policy and central banking. In case, you are wondering, I am talking about Princeton's Alan S. Blinder.

His paper from 2006 entitled Monetary Policy: Sixteen Questions and About Twelve Answers is still, by far, one of the best pieces I have read on monetary policy in a general sense. I often find myself returning to this to refresh my memory in connection to what we should expect (and shouldn't) central bankers to do.

Recently, Blinder and co-authors (who by no way should be neglected) present three new papers on central banking and monetary policy and specifically about central bank communication.

Making Monetary Policy by Committee

by Alan S. Blinder Princeton University CEPS Working Paper No. 167 June 2008

It seems probable that more thinking has gone into the question of what a monetary policy committee should look like over the last decade than over the preceding century. While we have not yet reached agreement on everything, and may never do so, one way to sum up this talk is to ask what might be considered “best practice” right now. If you were a country currently thinking about redesigning your monetary policy apparatus, what sort of monetary policy committee would you set up? Posing this question is probably also a good way to provoke my discussants into disagreements.

Talking about Monetary Policy: The Virtues (and Vices?) of Central Bank Communication

by Alan S. Blinder Princeton University CEPS Working Paper No. 164 May 2008

Central banks, which used to be so secretive, are communicating more and more these days about their monetary policy. This development has proceeded hand in glove with a burgeoning new scholarly literature on the subject. The empirical evidence, reviewed selectively here, suggests that communication can move financial markets, enhance the predictability of monetary policy decisions, and perhaps even help central banks achieve their goals. A number of theoretical drawbacks to greater communication are also reviewed here. None seems very important in practice. That said, no consensus has yet emerged regarding what constitutes “optimal” communication strategy—either in quantity or nature.

Central Bank Communication and Monetary Policy: A Survey of Theory and Evidence

by Alan S. Blinder, Princeton University Michael Ehrmann, European Central Bank Marcel Fratzscher, European Central Bank Jakob De Haan, University of Groningen and CESifo David-Jan Jansen, De Nederlandsche Bank CEPS Working Paper No. 161
March 2008

Over the last two decades, communication has become an increasingly important aspect of monetary policy. These real-world developments have spawned a huge new scholarly literature on central bank communication.mostly empirical, and almost all of it written in this decade. We survey this ever-growing literature. The evidence suggests that communication can be an important and powerful part of the central bank¡¯s toolkit since it has the ability to move financial markets, to enhance the predictability of monetary policy decisions, and potentially to help achieve central banks¡¯ macroeconomic objectives. However, the large variation in communication strategies across central banks suggests that a consensus has yet to emerge on what constitutes an optimal communication strategy.

All four are surely well worth more than a quick glance.

This from Money Morning:

The U.S. housing market is already being pounded by the “perfect storm.” And the outlook for the New Year is for the stormy weather to continue – and probably to get worse.

As if a locked-up credit market and tidal waves of foreclosures weren’t already enough, we’re now watching unemployment climb and consumer confidence plunge.

But even when the housing market is taking on water, there are ways to stay afloat. Indeed, investors nimble enough to maneuver can even make money.

The watchword on this…

This from The Daily Reckoning:

To give you an idea of the wild measures undertaken by the feds, we look at what is happening at the world’s leading bank – the US Federal Reserve.

The short form of how the Fed operates is this: it holds a certain amount of securities in its vault; this is the cornerstone capital – or monetary base – of the whole banking structure. How does it get this capital? It buys it, creating the money to pay for it as necessary.…

This from The Daily Reckoning:

Obama is lucky he wasn’t elected a year ago. At least now it is clear that he’s innocent. He comes to the office facing problems not of his own making. Instead, they were made by his predecessors – notably, Alan Greenspan and George W. Bush. Working together, the two bumblers squandered America’s fortune, drove off her industry, and put just about everyone deeper in debt than ever…

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Like a parent dispelling a childhood nightmare, FDR soothed the masses with the assurance that they had nothing to fear but fear itself. To this day, he is revered for turning a depression into the Great Depression. In the aftermath of the dot-com bubble, Fed Chairman Alan Greenspan came to the rescue with a brand-new bubble in real estate.

Even if there was someone out there who could pull off one more illusionary rescue, it would only delay…

Like a parent dispelling a childhood nightmare, FDR soothed the masses with the assurance that they had nothing to fear but fear itself. To this day, he is revered for turning a depression into the Great Depression. In the aftermath of the dot-com bubble, Fed Chairman Alan Greenspan came to the rescue with a brand-new bubble in real estate.

Even if there was someone out there who could pull off one more illusionary rescue, it would only delay…

I am thinking to myself that I would love to get a piece of that luscious arbitrage action where I buy the gold and/or silver futures at a low price while simultaneously selling the same gold and/or silver bullion at a higher price, telling the buyers that they must pay in advance and then wait up to a few months for me deliver their gold and silver, pocketing a hell of a lot of money…

– Greenspan said it was a “mistake” to believe that banks operating in their self-interest would be enough to protect their shareholders and themselves. He also called the current crisis “once in a century credit tsunami” that he and other policy makers didn’t see coming.

– Isn’t that the problem with policy makers in the first place? They never see things coming. That…

For a man who was once remarkably hard to decipher, Alan Greenspan is now as clear as an empty Lehman Brothers office.

Then we look at the counter to that view. Are we at the bottom, or is there more pain? And given the current state of affairs, how should we then invest? Where do we put our money to…

This from The Daily Reckoning:

If you want to know the Real, Real Reason (RRR) why we are being subjected to a $700 billion bailout of the economy, which is just the beginning, it is because the despicable Alan Greenspan, during his foul 18-years as chairman of the loathsome Federal Reserve, created all the money and credit that financed the stock market boom, the bond market boom, the housing boom and (worst of all) the growth-in-government boom.

And now, all those things are bid up waaaAAAaaaayyyyy past their real values, and buyers are scarce while sellers are many. So the owners of those depreciating assets suddenly realize that they either have to hold onto them and go bust, or find some moron with a lot of money to buy them. Oops!

Tragically, while stocks can go bust, and bonds can go bust, and houses can go bust (and they are), the growth-in-government boom cannot be allowed to go bankrupt, because half of the people in the country now receive a government check of some kind as their income every month (Social Security, welfare, etc.), AND the governments collectively "employ" half the workers in the country because half the nation's workers have incomes that derive from government spending either directly or indirectly!

So, the real reason is: Governments need the money! It's as simple as that!

I know you find it hard to believe me, since Total Payrolls is officially listed as $145.5 million, while government payrolls is shown as $22.5 million - but it's true, nonetheless.

Firstly, these "government payrolls" do not variously count such things as firemen, policemen, teachers or any of myriad "contracted out" services, which means that the contracting private-sector provider is a private company that gets all of its income from government, thus they are indirectly, but totally, employed by government.

Now, add in ALL of those "contracted" services that government buys, such as building maintenance, lawn services, office supplies, equipment providers, equipment servicing contractors, rented office space, security services, pornography downloads, storage space, and parking areas, all of which is counted as being "private employment", when in fact it is Pure Public Payroll (PPP).

Now, we apply the multiplier as these incomes provided by the government are received and then spent, providing another income to someone else, which is also spent, providing another income to someone else, which is also spent, providing another income to someone else, over and over, all the while being whittled down by taxes.

Since all multipliers range between 3 and 7, even a multiplier of 3 will be enough to enlarge the official 22.5 million government employees to 67.5 million, which is almost half of the total 145.5 million employed in the whole freaking country!

As proof, I offer the Energy & Scarcity Investor newsletter, where we get the report that "Last year, the Pentagon spent $316 billion on contracts with private firms", which is "more than it spends on actual weapons to fight wars."

So, not only do "military contractors account for more than half of all Defense Department spending - 57.6%", but there are a lot of these "private employees" in the "47,000 companies to choose from - running the gamut from blue chips to start-ups" that are getting, and living on, government money.

Ergo, the government desperately needs money, the Federal Reserve will create the money the government wants, the fresh government debt will be bought up, the money supply will increase, the value of the dollar will continue to fall, and gold will rise along with, and almost certainly more than, the rise in all other prices! Whee! This investing stuff is easy!

Source: Government Spending Spree

This from Justice:

FOR BOTH: Given that the U.S. has spent its money, bled its blood, strained its economy, blown up its budgets, and ballooned its deficits on the Iraq War, what are we going to do with Iraq once that war is won -- if it ever is? In other words: We've already made ourselves into imperialists, so can't we just keep the oil? If not, why not... and by the way, how will you respond when a nuclear-tipped Iran comes into play?

FOR OBAMA: In April, you conceded the fact that reductions in capital gains tax rates have historically spurred both economic growth and increased revenue. So how can you square your stated desire to raise capital gains taxes by 20%-28% with your stated desire to boost America’s economy and reduce its deficits? Is that what I can look forward to with Obama-nomics? Do you use water instead of lighter fluid to start your charcoal grill?

FOR MCCAIN: In the past, you’ve talked a lot about The Incredible Disappearing Issue: Immigration Reform. We’ve heard you endlessly advocate “border security,” but what does that really mean? In the spring of 2007, you said, “We’re not going to erect barriers and fences,” yet in Mexico City in July of this year, you said, “The American people want our borders secured... That will require some walls.” You've advocated AND opposed paths to citizenship for illegals already in the U.S. You’ve been on both sides of the guest worker issue -- and even invented some new ones. Do tell, Senator: How do we feel about immigration reform THIS week?

FOR OBAMA: Even in your too-short-to-be-president political career, you’ve managed to amass one of the most lopsidedly hostile records against firearms rights in American political history. Do you not understand the U.S. Constitution, or are you simply willing to ignore it? How am I supposed to defend myself against the jack-booted revenuers you’ll be sending out to collect on all your new taxes? Should I beat them over the head with my phonebook-sized copy of the Emergency Economic Stabilization Act of 2008?

FOR MCCAIN: In recent years you have had some very nice things to say about Fed Chairman Alan Greenspan. Most memorably you said that if Greenspan died in office, you would want to give him dark sunglasses and prop him up a la Weekend at Bernie’s. Humor aside, it is now plain to see that Greenspan was a huge culprit in creating this steaming financial mess we’re in. “The maestro” never came across a deregulation plan he didn’t like; touched off multiple bubbles even while denying they existed; dropped interest rates to 1% and held them there for a year; amassed a remarkable track record as one of the worst forecasters in economic history; and then, as the piece de resistance, suddenly learned plain English in the nick of time to blame everything on his successor! Question being, have you gotten any more savvy with all that’s happened, or are you still willing to let these two-bit financial wizards blow smoke in your ear?

FOR OBAMA: Senator Obama, you are all about “change.” Your campaign has soared above the clouds on the refreshing rhetoric of change. It’s in your slogan: “Change we can believe in.” It’s in all your make-‘em-swoon speeches, woven into delicious phrases like “We are the ones we’ve been waiting for.” And yet how is it, Senator Obama, how can it be, that you came up through one of the most corrupt, glad-handing, backroom-deal-ridden political systems in American history -- I’m speaking here of the infamous Chicago political system -- without actually changing a damn thing? Not only did you fail to repudiate the “Chicago way,” sir; you actually embraced it. You were a staunch backer of Richard Daley, a candidate for the political corruption hall of fame. You made no waves on the way to the top -- only friends. You even won a primary contest by getting a team of lawyers to throw your opponents off the ballot! With all due respect, Senator Obama, you are one of the great rhetoricians of our time. But where is the evidence of this “change” you speak of?

FOR MCCAIN: Earlier this year you flatly stated that Russia should be kicked out of the G8. You were also lightning quick to side with the alarmingly brash Mikheil Saakashvili in the Russia-Georgia conflict, boldly declaring that “We are all Georgians now.” You seem ready and willing to crank up a new cold war with Putin’s Russia, one that could turn “hot” with the wrong misstep... and Russia seems happy to oblige. Putin has already stepped up money and technology transfers with Venezuela and Iran, and shows zero intention of backing down. Senator McCain, we know that you are a “maverick” who “relishes a fight”... but how exactly do you intend to take on a Russian strategy of “dissension and discord” (i.e., wreaking havoc via outside agents like Venezuela and Iran) when American blood and treasure is all but spent? Furthermore, given your legendary belligerence, your shaky medical history and, quite frankly, your 72-year-old heart, why, oh why, did you pick perhaps the least appropriate running mate possible when it comes to following your footsteps on the path to war?

FOR BOTH: Nowhere on your campaign Web sites does it list your reading speed in words per minute. How fast can you read 451 pages of legalese? It must be really fast, because you’re both on record in instant support of the “bailout bill” -- sorry, the Emergency Earmark Act -- damn, I mean the Emergency Economic Stabilization Act -- at every one of its incarnations, from three pages to 451. Do you think the American people are so stupid that they don’t realize that both of you Econ 101-flunking goofballs are endorsing something you don’t fully understand, before you’ve even attempted to read and understand it? And by the way, how do you feel about the billions in funding for things like “mental health treatment,” “rural school aid” and makers of “wooden toy bow-and-arrow sets”? Is this the kind of “fiscal responsibility” we can expect from both of you?

Whew! That felt good.

Source: What Would YOU Ask the Presidential Candidates? (Now's Your Chance...)

They still believed that the stock market was going to produce 15% per annum returns for the foreseeable future. September 2008 and he ended that mantra. On September 3, the Dow Jones Industrial Average was where it had been at its peak in 2000: 11,700. The Standard & Poor's 500 index was lower: 1280 vs. 1529 (close). Subtract from that over 20% price inflation.

The experts on CNBC on September 1 still clung to the illusion that there was no recession, the boom was still in
force, and everything would work out just fine. By the end of September, all that lay in ruins. There is no optimism on CNBC today. There is a kind of stiff upper lip determination not to panic.

It should have been obvious in August 2007 that the end of post-2003 stock market recovery was over. Bernanke had tightened money from the day he took over as chairman of the Board of Governors of the Federal Reserve system in February 2006.

Real estate was the driving force of the expansion, and real estate was in decline. It was obvious to me in late 2005 that the bull market in real estate was over. I said so at the time. It was surreal estate. A handful of us saw this coming, but it seemed so far-fetched at the time that virtually nobody paid any attention. They now pay attention.

Real estate from 2001 to late 2005 was the largest bubble in American financial history. It dwarfed the bubble of the stock market in the 1920s, because that bubble had involved only a tiny fraction of American investors. The residential real estate bubble involved two-thirds of the population, all of whom owned homes. The other third were affected because of rising rents.

People thought that they were going to get rich with leveraged real estate. Instead, something in the range of 40% of all mortgage debtors in the United States will be under water in their mortgages by the end of 2009. People were told by the experts that "this time it's different." It wasn't different. It was just more extreme. The consequences will be felt over the next decade.

In September, confidence was at long last shattered. At the beginning of the month, Secretary of the Treasury Henry Paulson was still assuring people that the banking system was perfectly sound. On Sunday, September 7, he unilaterally announced the Federal government was taking over Fannie Mae and Freddie Mac, along with their $5 trillion of mortgage debt. He did not ask Congress. Congress did not complain. That act ended anything
resembling a free market in housing. Falling equity takes away the credit that Americans need to borrow money to live the good life. They will soon feel betrayed. A widespread sense of betrayal is dangerous for politicians.

A LOSS OF FAITH

We are living in a time in which the fundamental religion of our era has been faith in the redemptive power of the State. Whenever there is a crisis, citizens call upon the State to bail them out. They are convinced that the State has a separate existence which enables it to intervene into the affairs of men, thereby improving the life of almost everyone under its jurisdiction.

This religion of State redemption has been fading in recent years. It gained almost universal acceptance during the Great Depression. The fundamental purpose of the State is no longer seen as justice, but rather to serve as the source of guidance for the free market, without which the economy supposedly cannot sustain long-term economic growth.

There is enormous faith by the public in the ability of bureaucrats to collect data, interpret data, make accurate
predictions, establish incentives that encourage growth, and enforce these incentives without bias. People generally do not believe that God intervenes into the economy with the same frequency and reliability that the State does.

The great redeemer since 1987 has been Alan Greenspan. He had the power of the printing press behind him, and he used it. People concluded that in an economic crisis, under Greenspan's guidance, the Federal Reserve System would be able to overcome all economic setbacks. This faith escalated from 1987 until his retirement in January 2006.

We are now seeing the undermining of this confidence in the ability of the Federal Reserve System to compensate for the downturns in the markets. People are beginning to figure out that Bernanke is in over his head, and the Federal Reserve System seems impotent to overcome the worst economic crisis since the Great Depression.

It is significant that this assessment, namely, that this really is the worst financial crisis since the Great Depression, is now becoming widespread in the media. The assumption that theFederal Reserve, when assisted by the U.S. Treasury, and funded by an extra couple of trillion dollars of Federal debt, will be able to deal with any crisis is now becoming shaky. There are whispers of discontent. Some people are saying that this crisis is more fundamental than what Paulson admitted in the week of September 15.

But Martin Hutchinson says the failure of the bill is a blessing for the economy. Propping up a rotten system will only reward failure and block creative innovation.

The worst case scenario now is that we'll see the the Dow slump to 5,000 points. This makes a defensive portfolio a must. Martin recommends invest in counter-market plays such as the SPDR Gold Trust ETF (NYSE:GLD) or the Rydex Inverse Gov Long Bond Strategy C (MUTF:RYJCX).

This from Money Morning:

At this point, it sure looks as if we can thank the good sense of the U.S. House of Representatives, and hope against hope that it will adjourn for electioneering without passing this legislation – or anything else that’s anything like it.

Back in December 1929, then-U.S. Treasury Secretary Andrew W. Mellon – one of the greatest to serve in that role, and the only treasury secretary to serve under three U.S. presidents – announced that the problem of the Wall Street crash could be met by liquidation: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate… purge the rottenness out of the system.”

The opposite path was taken by President Herbert Hoover with his Reconstruction Finance Corp. (RFC) – to a notably more unhappy result – just as the opposite path was chosen by Paulson and his acolytes. Borrowing $700 billion to invest in mortgage paper that has shown itself to be virtually worthless; it just reinforces failure and starves success of the capital it needs, which is the exact opposite of the recipe for success in a free market system.

The great Austrian economist Joseph Schumpeter said that capitalism was a process of “creative destruction.” You cannot have the one without the other, so pouring money down a rat-hole to prevent further destruction will kill creativity and turn the economy into a Soviet-style mess.

As for the stock market, it is becoming increasingly clear that it has been suspended for the last decade at an artificially high level by the immense bubble of cheap money created by Federal Reserve chairmen Alan Greenspan and Bernanke since 1995. U.S. stocks, therefore, were poised for a drop, to an equilibrium level that could be as low as 7,500 on the Dow (I arrived at that potential nadir by measuring from early 1995, and calculating based upon a belief that stock prices should increase approximately in line with gross domestic product, or GDP), or even 5,000, should the market’s “animal spirits” find themselves to be exceptionally depressed.

Yesterday’s sharp drop could mark the beginnings of a realization by the market that the world has changed since 2006, that the subprime mortgages and securitized assets it thought so solid in 2006 were speculative toys, or outright junk, and that a world of lower asset prices can still be a world of increasing incomes and economic growth.

Once stock prices are so low that stocks yielding 6% can be found everywhere, the U.S. middle classes will once again begin saving and investing in stocks. Only then will the U.S. payments deficit disappear (because imports will no longer be artificially inflated) and the funding problems of government will become manageable.

This will bring about other benefits. New-growth businesses in the U.S. economy will find funding from domestic savings, something that’s non-existent right now. Emerging markets will have higher costs of capital than the United States, because of their smaller capital bases in a world of scarcer money, so that outsourcing jobs and investments to them will take place only when there is a true comparative advantage in the poorer country, including proper recognition of the higher costs of capital there.

As I discussed last week, the optimal current investment strategy is a defensive one, with inverse Treasury bond funds (such as the Rydex Juno Inverse Government Long Bond Fund (RYJCX)), some gold, and maybe some other carefully chosen counter-market plays.

However, the failure of the bailout package, if it persists without a “rescue,” has made the moment when optimism returns considerably closer. For that we can be thankful.

Source: Although the Bailout Bill Was Rejected, It’s No Time to Panic

First, what is the source of the crisis? Is it as is asserted here in this statement from John McCain today?

....

There are certainly plenty of places to point fingers, and it may be hard to pinpoint the original event that set it all in motion. But let me give you an educated guess. The financial crisis we're living through today started with the corruption and manipulation of our home mortgage system. At the center of the problem were the lobbyists, politicians, and bureaucrats who succeeded in persuading Congress and the administration to ignore the festering problems at Fannie Mae and Freddie Mac.

These quasi-public corporations lead our housing system down a path where quick profit was placed before sound finance. They institutionalized a system that rewarded forcing mortgages on people who couldn't afford them, while turning around and selling those bad mortgages to the banks that are now going bankrupt. Using money and influence, they prevented reforms that would have curbed their power and limited their ability to damage our economy. And now, as ever, the American taxpayers are left to pay the price for Washington's failure.

...

I certainly concur with the first sentence. But I do wonder about the assertion that the problem started with and is fundamentally driven by Fannie Mae and Freddie Mac. After all, neither of these two institutions were at the heart of the massive surge in subprime mortgages that are the most toxic component of these asset backed securities. Smarter people than me (Justin Fox, Tanta at CR h/t Mark Thoma) have been similarly dubious.

Moreover, the originating entities for these subprime mortgages were not Fannie Mae and Freddie Mac, by large, but rather the banks that the Federal government refused to let state agencies regulate. Or the ones the Treasury's OTS itself failed to regulate. To refresh memories, consider this article from December 18, 2007 NYT:

WASHINGTON-- Until the boom in subprime mortgages turned into a national nightmare this summer, the few people who tried to warn federal banking officials might as well have been talking to themselves.

Edward M. Gramlich, a Federal Reserve governor who died in September, warned nearly seven years ago that a fast-growing new breed of lenders was luring many people into risky mortgages they could not afford.

But when Mr. Gramlich privately urged Fed examiners to investigate mortgage lenders affiliated with national banks, he was rebuffed by Alan Greenspan, the Fed chairman.

In 2001, a senior Treasury official, Sheila C. Bair, tried to persuade subprime lenders to adopt a code of "best practices" and to let outside monitors verify their compliance. None of the lenders would agree to the monitors, and many rejected the code itself. Even those who did adopt those practices, Ms. Bair recalled recently, soon let them slip.

And leaders of a housing advocacy group in California, meeting with Mr. Greenspan in 2004, warned that deception was increasing and unscrupulous practices were spreading.

John C. Gamboa and Robert L. Gnaizda of the Greenlining Institute implored Mr. Greenspan to use his bully pulpit and press for a voluntary code of conduct.

"He never gave us a good reason, but he didn't want to do it," Mr. Gnaizda said last week. "He just wasn't interested."

Today, as the mortgage crisis of 2007 worsens and threatens to tip the economy into a recession, many are asking: where was Washington?

An examination of regulatory decisions shows that the Federal Reserve and other agencies waited until it was too late before trying to tame the industry's excesses. Both the Fed and the Bush administration placed a higher priority on promoting "financial innovation" and what President Bush has called the "ownership society."

...

On Tuesday, under a new chairman, the Federal Reserve will try to make up for lost ground by proposing new restrictions on subprime mortgages, invoking its authority under the 13-year-old Home Ownership Equity and Protection Act. Fed officials are expected to demand that lenders document a person’s income and ability to repay the loan, and they may well restrict practices that make it hard for borrowers to see hidden fees or refinance with cheaper mortgages.

It is an action that people like Mr. Gramlich and Ms. Bair advocated for years with little success. But it will have little impact on many existing subprime lenders, because most have either gone out of business or stopped making subprime loans months ago.

...

The Fed was hardly alone in not pressing to clean up the mortgage industry. When states like Georgia and North Carolina started to pass tougher laws against abusive lending practices, the Office of the Comptroller of the Currency successfully prohibited them from investigating local subsidiaries of nationally chartered banks.

Virtually every federal bank regulator was loathe to impose speed limits on a booming industry. But the regulators were also fragmented among an alphabet soup of agencies with splintered and confusing jurisdictions. Perhaps the biggest complication was that many mortgage lenders did not fall under any agency's authority at all.

...

And for some more concrete examples of how deregulatory zeal had an effect, consider this account from the WSJ (March 22, 2007):

Regulators appointed by President Bush often have been more sympathetic to industry concerns about red tape than their Clinton administration predecessors. When James Gilleran, a former California banker and bank supervisor, took over the OTS in December 2001, he became known for his deregulatory zeal. At one press event in 2003, several bank regulators held gardening shears to represent their commitment to cut red tape for the industry. Mr. Gilleran brought a chain saw.

He also early on announced plans to slash expenses to resolve the agency's deficit; 20% of its work force eventually left. When he left in 2005, Mr. Gilleran declared that the OTS had "exercised increased diligence in its review of abusive consumer practices" while reducing thrifts' regulatory burden. But his successor, Mr. Reich, a former community banker, has reversed many of Mr. Gilleran's cuts. Citing "understaffing," he hired 80 examiners last year and plans to add 40 more this year. A spokeswoman for Mr. Gilleran, now chief executive of the Federal Home Loan Bank of Seattle, said he wasn't available to comment.

So, from my perspective, locating the source of the current crisis in corruption/influence peddling surrounding Fannie and Freddie exhibits a misreading of recent history. (More important might have been lax monetary policy and the saving glut, and exemptions from capital requirements for certain investment banks... [see Ritholtz])

Second, how hard will the rescue be given the reckless decisions of the past? It seems that whatever entity is established to purchase these bad assets will require some fiscal outlay. Estimates are all over the place, given that there is so much uncertainty over how much the assets will be bought for and eventually sold; here is one account:

U.S. Debt May Grow $1 Trillion on Rescue, Barclays' Pond Says

By Sandra Hernandez

Sept. 19 (Bloomberg) -- The U.S. may have to borrow an extra $700 billion to $1 trillion to fund the biggest rescue of the financial system since the Great Depression, according to Barclays Capital Inc.'s Michael Pond.

Federal takeovers of Fannie Mae, Freddie Mac, and American International Group Inc.; the central bank's expansion of lending to financial firms; and a slowing economy will add $455 billion to the Treasury's borrowing needs, the New York-based interest-rate strategist estimated. Pond said Treasury Secretary Henry Paulson's plan to rid banks of "hundreds of billions" of troubled assets would bring the amount to $700 billion assuming the plan costs $200 billion.

"We could easily add up to an additional trillion to the outstanding Treasury debt just from the initiatives announced over the past couple of weeks," said Pond, ranked the best Treasury Inflation-Protected Securities analyst in 2008 by Institutional Investor magazine.

The government's liabilities swelled in past weeks as policy makers sought to arrest a growing financial crisis by taking over financial institutions threatened by a shortage of capital.

The Treasury on Sept. 7 took over mortgage-finance companies Fannie Mae and Freddie Mac and said it would buy mortgage-backed debt in the open market. The Fed this week boosted its Treasury auctions to bond dealers by $25 billion, loaned $85 billion to the insurer AIG, and quadrupled the amount of dollars foreign central banks can auction to $247 billion. Paulson today said the government will buy illiquid assets from banks' balance sheets and insure money-market mutual fund holdings.

Deficit Widens

"The odds of the deficit becoming enormous are certainly there," said Nils Overdahl, a bond fund manager in Bethesda, Maryland, at New Century Advisors, which oversees $500 million. "I suspect you will see issuance at a variety of maturities."

The deficit will likely widen to $650 billion in fiscal 2009 because of the U.S. rescue of Fannie and Freddie, analysts at JPMorgan Chase & Co. wrote in a Sept. 12 report.

Over the next decade, the gap between spending and receipts will swell to $5.3 trillion, Goldman Sachs Group Inc. analysts wrote Sept. 10, revising a previous forecast of $3.6 trillion. The non-partisan Congressional Budget Office forecast a record $438 billion deficit for 2009 on Sept. 9.

"The deficit will soar to enormous proportions,'' said Lou Crandall, the chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. ``Even before this week's events, estimates based on visible factors were pointing to a deficit above $500 billion next year, with the prospect of billions of mortgage- backed securities on top of that."

See also this Bloomberg article.

Here, I want to return the issue I've brought up countless times before. We cut taxes, and we embarked upon a war of choice, and in addition to the opportunity and fiscal costs, this constrained our range of actions for the future. Even if you thought the Bush tax cuts of 2001 and 2003 "benefitted" the US economy on net, we know that the war in Iraq has cost on the order of $653 billion nominal dollars from FY03-FY0-09 [2] -- in current dollars that's even more given inflation. Those dollars could have been spent fixing the financial system. Now, we'll have to either borrow or tax to to finance the operation.

So, if you wanted the McCain extension of the Bush tax cuts, and the additional $1.3 trillion tax cuts, then you might wonder about the impact on US borrowing rates. If you were hoping for more domestic initiatives, perhaps to give tax relief to the lower and middle income households, or to invest in infrastructure, the borrowing constraints will be more binding than they otherwise would have been.

Perhaps that's obvious, but sometimes in the midst of crisis, the obvious bears repeating. Here's a picture to illustrate the budget balance outlook pre-intervention....

The purple square is just for illustrative purposes. If you think the Treasury will only have to borrow $350 billion in FY2009, then the orange square is relevant. Further, if we're lucky (and Brad Delong is right), in future years we will recoup all and more of these outlays, so the deficit will be smaller than otherwise. But, in the short run, we'll have to take a hit (of unknown magnitude) now and hope for the best.

Technorati Tags: , subprime, Fannie Mae, Freddie+Mac, and deregulation, Office of Thrift Supervision, and tax cuts.

First, what is the source of the crisis? Is it as is asserted here in this statement from John McCain today?

....

There are certainly plenty of places to point fingers, and it may be hard to pinpoint the original event that set it all in motion. But let me give you an educated guess. The financial crisis we're living through today started with the corruption and manipulation of our home mortgage system. At the center of the problem were the lobbyists, politicians, and bureaucrats who succeeded in persuading Congress and the administration to ignore the festering problems at Fannie Mae and Freddie Mac.

These quasi-public corporations lead our housing system down a path where quick profit was placed before sound finance. They institutionalized a system that rewarded forcing mortgages on people who couldn't afford them, while turning around and selling those bad mortgages to the banks that are now going bankrupt. Using money and influence, they prevented reforms that would have curbed their power and limited their ability to damage our economy. And now, as ever, the American taxpayers are left to pay the price for Washington's failure.

...

I certainly concur with the first sentence. But I do wonder about the assertion that the problem started with and is fundamentally driven by Fannie Mae and Freddie Mac. After all, neither of these two institutions were at the heart of the massive surge in subprime mortgages that are the most toxic component of these asset backed securities. Smarter people than me (Justin Fox, Tanta at CR h/t Mark Thoma) have been similarly dubious.

Moreover, the originating entities for these subprime mortgages were not Fannie Mae and Freddie Mac, by large, but rather the banks that the Federal government refused to let state agencies regulate. Or the ones the Treasury's OTS itself failed to regulate. To refresh memories, consider this article from December 18, 2007 NYT:

WASHINGTON-- Until the boom in subprime mortgages turned into a national nightmare this summer, the few people who tried to warn federal banking officials might as well have been talking to themselves.

Edward M. Gramlich, a Federal Reserve governor who died in September, warned nearly seven years ago that a fast-growing new breed of lenders was luring many people into risky mortgages they could not afford.

But when Mr. Gramlich privately urged Fed examiners to investigate mortgage lenders affiliated with national banks, he was rebuffed by Alan Greenspan, the Fed chairman.

In 2001, a senior Treasury official, Sheila C. Bair, tried to persuade subprime lenders to adopt a code of "best practices" and to let outside monitors verify their compliance. None of the lenders would agree to the monitors, and many rejected the code itself. Even those who did adopt those practices, Ms. Bair recalled recently, soon let them slip.

And leaders of a housing advocacy group in California, meeting with Mr. Greenspan in 2004, warned that deception was increasing and unscrupulous practices were spreading.

John C. Gamboa and Robert L. Gnaizda of the Greenlining Institute implored Mr. Greenspan to use his bully pulpit and press for a voluntary code of conduct.

"He never gave us a good reason, but he didn't want to do it," Mr. Gnaizda said last week. "He just wasn't interested."

Today, as the mortgage crisis of 2007 worsens and threatens to tip the economy into a recession, many are asking: where was Washington?

An examination of regulatory decisions shows that the Federal Reserve and other agencies waited until it was too late before trying to tame the industry's excesses. Both the Fed and the Bush administration placed a higher priority on promoting "financial innovation" and what President Bush has called the "ownership society."

...

On Tuesday, under a new chairman, the Federal Reserve will try to make up for lost ground by proposing new restrictions on subprime mortgages, invoking its authority under the 13-year-old Home Ownership Equity and Protection Act. Fed officials are expected to demand that lenders document a person’s income and ability to repay the loan, and they may well restrict practices that make it hard for borrowers to see hidden fees or refinance with cheaper mortgages.

It is an action that people like Mr. Gramlich and Ms. Bair advocated for years with little success. But it will have little impact on many existing subprime lenders, because most have either gone out of business or stopped making subprime loans months ago.

...

The Fed was hardly alone in not pressing to clean up the mortgage industry. When states like Georgia and North Carolina started to pass tougher laws against abusive lending practices, the Office of the Comptroller of the Currency successfully prohibited them from investigating local subsidiaries of nationally chartered banks.

Virtually every federal bank regulator was loathe to impose speed limits on a booming industry. But the regulators were also fragmented among an alphabet soup of agencies with splintered and confusing jurisdictions. Perhaps the biggest complication was that many mortgage lenders did not fall under any agency's authority at all.

...

And for some more concrete examples of how deregulatory zeal had an effect, consider this account from the WSJ (March 22, 2007):

Regulators appointed by President Bush often have been more sympathetic to industry concerns about red tape than their Clinton administration predecessors. When James Gilleran, a former California banker and bank supervisor, took over the OTS in December 2001, he became known for his deregulatory zeal. At one press event in 2003, several bank regulators held gardening shears to represent their commitment to cut red tape for the industry. Mr. Gilleran brought a chain saw.

He also early on announced plans to slash expenses to resolve the agency's deficit; 20% of its work force eventually left. When he left in 2005, Mr. Gilleran declared that the OTS had "exercised increased diligence in its review of abusive consumer practices" while reducing thrifts' regulatory burden. But his successor, Mr. Reich, a former community banker, has reversed many of Mr. Gilleran's cuts. Citing "understaffing," he hired 80 examiners last year and plans to add 40 more this year. A spokeswoman for Mr. Gilleran, now chief executive of the Federal Home Loan Bank of Seattle, said he wasn't available to comment.

So, from my perspective, locating the source of the current crisis in corruption/influence peddling surrounding Fannie and Freddie exhibits a misreading of recent history. (More important might have been lax monetary policy and the saving glut, and exemptions from capital requirements for certain investment banks... [see Ritholtz])

Second, how hard will the rescue be given the reckless decisions of the past? It seems that whatever entity is established to purchase these bad assets will require some fiscal outlay. Estimates are all over the place, given that there is so much uncertainty over how much the assets will be bought for and eventually sold; here is one account:

U.S. Debt May Grow $1 Trillion on Rescue, Barclays' Pond Says

By Sandra Hernandez

Sept. 19 (Bloomberg) -- The U.S. may have to borrow an extra $700 billion to $1 trillion to fund the biggest rescue of the financial system since the Great Depression, according to Barclays Capital Inc.'s Michael Pond.

Federal takeovers of Fannie Mae, Freddie Mac, and American International Group Inc.; the central bank's expansion of lending to financial firms; and a slowing economy will add $455 billion to the Treasury's borrowing needs, the New York-based interest-rate strategist estimated. Pond said Treasury Secretary Henry Paulson's plan to rid banks of "hundreds of billions" of troubled assets would bring the amount to $700 billion assuming the plan costs $200 billion.

"We could easily add up to an additional trillion to the outstanding Treasury debt just from the initiatives announced over the past couple of weeks," said Pond, ranked the best Treasury Inflation-Protected Securities analyst in 2008 by Institutional Investor magazine.

The government's liabilities swelled in past weeks as policy makers sought to arrest a growing financial crisis by taking over financial institutions threatened by a shortage of capital.

The Treasury on Sept. 7 took over mortgage-finance companies Fannie Mae and Freddie Mac and said it would buy mortgage-backed debt in the open market. The Fed this week boosted its Treasury auctions to bond dealers by $25 billion, loaned $85 billion to the insurer AIG, and quadrupled the amount of dollars foreign central banks can auction to $247 billion. Paulson today said the government will buy illiquid assets from banks' balance sheets and insure money-market mutual fund holdings.

Deficit Widens

"The odds of the deficit becoming enormous are certainly there," said Nils Overdahl, a bond fund manager in Bethesda, Maryland, at New Century Advisors, which oversees $500 million. "I suspect you will see issuance at a variety of maturities."

The deficit will likely widen to $650 billion in fiscal 2009 because of the U.S. rescue of Fannie and Freddie, analysts at JPMorgan Chase & Co. wrote in a Sept. 12 report.

Over the next decade, the gap between spending and receipts will swell to $5.3 trillion, Goldman Sachs Group Inc. analysts wrote Sept. 10, revising a previous forecast of $3.6 trillion. The non-partisan Congressional Budget Office forecast a record $438 billion deficit for 2009 on Sept. 9.

"The deficit will soar to enormous proportions,'' said Lou Crandall, the chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. ``Even before this week's events, estimates based on visible factors were pointing to a deficit above $500 billion next year, with the prospect of billions of mortgage- backed securities on top of that."

See also this Bloomberg article.

Here, I want to return the issue I've brought up countless times before. We cut taxes, and we embarked upon a war of choice, and in addition to the opportunity and fiscal costs, this constrained our range of actions for the future. Even if you thought the Bush tax cuts of 2001 and 2003 "benefitted" the US economy on net, we know that the war in Iraq has cost on the order of $653 billion nominal dollars from FY03-FY0-09 [2] -- in current dollars that's even more given inflation. Those dollars could have been spent fixing the financial system. Now, we'll have to either borrow or tax to to finance the operation.

So, if you wanted the McCain extension of the Bush tax cuts, and the additional $1.3 trillion tax cuts, then you might wonder about the impact on US borrowing rates. If you were hoping for more domestic initiatives, perhaps to give tax relief to the lower and middle income households, or to invest in infrastructure, the borrowing constraints will be more binding than they otherwise would have been.

Perhaps that's obvious, but sometimes in the midst of crisis, the obvious bears repeating. Here's a picture to illustrate the budget balance outlook pre-intervention....

The purple square is just for illustrative purposes. If you think the Treasury will only have to borrow $350 billion in FY2009, then the orange square is relevant. Further, if we're lucky (and Brad Delong is right), in future years we will recoup all and more of these outlays, so the deficit will be smaller than otherwise. But, in the short run, we'll have to take a hit (of unknown magnitude) now and hope for the best.

Technorati Tags: , subprime, Fannie Mae, Freddie+Mac, and deregulation, Office of Thrift Supervision, and tax cuts.