The administration has focused on five key areas:

• Raising capital and liquidity requirements for all institutions, consolidated supervision by the Federal Reserve for "too big to fail" firms and establishing a council of regulators for better coordination
• Robust reporting requirements on the issuers of asset-backed securities, reducing reliance on credit-rating agencies, harmonizing the regulation of futures and securities, and strong oversight of "over-the-counter" derivatives
• Stronger framework for consumer and investor protection
• Resolution mechanism for the orderly resolution of "too big to fail" financial holding companies
• Improving regulation and supervision around the world

As a result, the financial institutions were able to shift risky products to less-regulated entities or entities having favorable accounting treatment. This calls for consolidated supervision of parent companies and all related entities as well as better coordination among all regulators.

The OTC derivatives include credit default swaps that caused the near-collapse of AIG (AIG). In view of the enormous size of the market and the threats these instruments pose to the financial system, their regulation is long overdue.

Also required is stronger coordination with regulators of other countries so as to effectively regulate financial giants like Citigroup (C), Bank of America (BAC) and JP Morgan Chase (JPM), which have operations all over the world.

Bets that the economy is turning a corner have lifted stocks off their year lows hit in March, even as the US government and the Federal Reserve have intensified efforts to end the recession by pledging trillions of dollars.  The S&P 500 index has jumped 39% since hitting its low on March 9.  However, the three-month old market rally, which has added more than 2,200 points to the DJIA, is surprising analysts and some say investors are shedding the caution too early. Not many are ready to agree that the economy is on a path to recovery, in the backdrop of ballooning government spending, Treasury yields facing upward pressure from increasing supply, and rising commodity prices heightening risk of inflation.  The recent jump in commodity prices has also been fueled in part by expectations for a stimulus-driven rebound in China's economy. Year-to-date crude prices have soared 53.45%, gold prices 8.85%, copper 61.99%, and silver 40.73%.   

Markets this week are nevertheless expected to take a cue from a number of posts, among which consumer confidence is likely to prove vital.  On Friday the University of Michigan's June measure of consumer confidence is expected to record its fourth monthly increase, from 68.7 to 69.2, as the index continues its advance from 56.3 posted in February.  Investors are also likely to follow data emerging from China, with Thursday seeing reports on fixed-asset investments and May industrial production statistics due on Friday. 

On Friday, San Francisco Fed President Janet Yellen voiced concern over rising bond yields.  Yellen noted if the increase in Treasury yields are driven by fears of rising inflation, it would be "disconcerting."  Fed fund futures now show a 40% chance the Central Bank will lift interest rates at its September meeting; only a week ago the odds were a mere 13%. This week's Treasury auction calendar shows $19 billion in 10-years and $11 billion in 30-years.

Also, according to the Washington Post, the Obama Administration may announce a greater number of financial firms would be allowed to repay government funds.  Such a move would not only undermine fears of nationalization, but also suggest a growing optimism in the strength of the financial sector, whose credit crisis initiated the global economic recession.

I have some more discussion at the Washington Post as well as the following links:

• Full statement of my testimony
• Background supportive research
• Website for the JEC session

In her testimony before the Joint Economic Committee today, Dr. Romer, Chair of the CEA, presented an explication of the progress of the financial crisis and the economic downturn, the anticipated effects of the measures undertaken and planned, and the outlook going forward. On most points, we're in agreement, so I'll only highlight some key issues of interest.

I would characterize the description of the economic outlook as guardedly optimistic. We can't say much more, since Dr. Romer -- in line with historical practice -- did not provide specific forecast numbers associated with her testimony. She did indicate that the CEA forecast is in line with the Blue Chip forecast, of -2.1% annualized growth in 2009Q2 and leveling off in 2009H2. What specifically "in line" means is up for some debate; in early March, I observed that -- given the dispersion in individual private sector forecasts -- the CEA's short term outlook seemed well within the consensus range.

I think Dr. Romer is right to be guardedly optimistic with regard to this near term outlook, despite the fact that yesterday's annualized GDP growth rate of -6.1% was toward the bottom of the range of forecasts. In addition to the factors she identified, including housing starts and consumer confidence, I would look to the point Jim Hamilton highlighted, namely that inventory disinvestment accounted for negative 2.8 percentage points of the growth rate. To the extent that inventories are now at quite low levels, production is more likely to ramp up next quarter. In addition, the rebound of consumption growth suggests that there will be some demand to sustain continued increases in production.

Is (was) there a credit crunch?

The testimony devotes some attention to describing the unfolding of the crisis. It's a narrative I largely agree with. One notable passage contains to this retrospective glance:

Last fall, there was some debate about whether credit was actually all that important. Some pundits suggested that we should just let the financial system fend for itself because it really didn't matter. The horrific falls in employment and production over the last five months have largely ended that debate. Shuttered factories across the country simply scream that Main Street and Wall Street do indeed intersect.

As one who heard a surprising number of academic macroeconomists dismiss the importance of the freeze in the credit markets, I think this particular quote calls for some economists to reassess the usefulness of their theoretical framework for assessing this particular downturn. It should also signal that, going forward, in determining who we pay attention to, we should look to their previous record of statements.

While I agree with the view there is some cause for optimism, especially after the passage of the ARRA, I do believe there are two major risks to the outlook. The first concerns the effectiveness of interventions aimed at restoring the solvency of the banking sector, and spurring the resumption of lending. In light of the increase in the IMF's estimate of financial institution losses ($2.7 trillion vs. January estimate of $2.2 trillion for assets and loans originating in the United States), it is not at all clear that the US government currently has sufficient resources to recapitalize the system, and thereby restart lending.

Dr. Romer's testimony clearly indicates an intellectual understanding of the perils confronting us:

...Japan's experience in the 1990s shows the costs of skimping on bank rescue. Until banks are cleansed of highly uncertain assets and robustly capitalized they will be hesitant to lend, and lending is what we need them to do...

So far, we can't be sure that the appropriate steps to avoid this path will be taken, given the popular resistance to further resource transfers. Certainly, the incipient rebound in financial sector bonuses, and bank management resistance to additional regulation, seems likely to make it harder to build up a constituency for the difficult choices that will likely have to be made in the near future.

As Dr. Romer pointed out, there is a synergistic aspect to the measures undertaken; stimulus without repair of the financial system will, on its own, be insufficient to pull the economy out of recession. Similarly, repair of the financial system will be much more difficult if asset prices continue their decline. On the first point, we have little experience with measuring the effectiveness of fiscal policy in conditions of severe financial distress. The range of estimates that the CBO uses in generating its high-low forecasts pertain to the results obtained over periods when the financial system was operating in a normal or near normal manner. As one can see from the CBO's assessment of the effects of the ARRA, this range of impacts is quite large:

Figure 1 from CBO, Estimated Macroeconomic Impacts of the American Recovery and Reinvestment Act of 2009, March 2, 2009.

In times of financial sector stress, households and firms may opt to rebuild balance sheets instead of increase consumption and investment, thereby short-circuiting the Keynesian multiplier process. A recent IMF analysis suggests that two years after a peak in output, on average output will be 3 percent lower in a recession occurring in conjunction with a financial crisis compared to a recession occurring in the absence of financial crisis. (I will note as an aside that if one believes this effect is operative, then government purchases of goods and services is then a relatively more effective mode of stimulus than tax cuts, unless those tax cuts are directed to highly liquidity constrained households -- see here)

We have not witnessed declines of this magnitude for over 30 years.

It's clear that we have some challenging times ahead of us. In my view, the Administration's made the first right steps. But in some respects, the biggest challenges lay ahead.

The second major concern is the international economic outlook. The IMF’s most recent estimates project world output growth this year (q4/q4) to be -0.6%. World trade is predicted to shrink by 11%.

The contractionary impact on the United States was highlighted in yesterday’s advance GDP release. Annualized real export growth was an estimated -30%, following a -24% rate in the last quarter of 2008. The trade deficit continued its precipitous decline mostly because imports continued its even more rapid decline; non oil goods imports were down by an estimated 39% (on an annualized basis) in the first quarter.

Portfolios Malkiel, Swedroe And Others Suggest

In this interesting story in the Washington Post, Bob Frick of Kiplinger.com notes that cutting fund costs is important in volatile times like these. Index funds and exchange-traded funds, he says, are great ways to go.

He talks to Burton Malkiel and Larry Swedroe, among others, about how they use index funds and ETFs and lists model portfolios that they're actually using. 

You can read the story here. 

Examining Put/Call Options & Indexes

An index put/call ratio can be an effective tool in predicting short-term market moves, concludes this RealMoney analysis on TheStreet.com. 

But there are some caveats that investors should keep in mind, says the author. He takes readers through an example of how well these metrics hold-up under closer scrutiny. 

You can read the story here.

ETFs Holding Relative Strength

In this new Investor's Business Daily piece, markets reporter Trang Ho looks at ETFs that are positive this year and have the best relative strength and accumulation/distribution technical ratings as defined by the CAN SLIM investment methodology. 

You can read the story here.

Another Big Options Play On Utilities ETF

For the second time in nearly a week, a large options trade took place on Wednesday involving the Utilities Select Sector SPDR (NYSE: XLU).

You can read about the bullish activity in this Reuters story here.