If this sounds like I’m talking about 2008, CDO syndication of sub-prime debt, and AIG and others offering Credit Default Swaps, or CDSs, as derivates used to hedge against CDO losses¹, you have a good memory, but I’m not.  I’m actually talking about the new European Bailout Fund which was much-hyped towards the end of last week. ²  Maybe the EU finance ministers missed the whole 2008 crisis, but even if they did, it’s hard to believe they expect the rest of us to buy their bonds based on the exact same false premises.  Fool me once, shame on you; fool me twice—oh, never mind.  Here’s the problem:

The Irish government needs a bailout.  They can’t borrow at anything but a junk bond rate.  So the EU announces to much fanfare that the big Trillion Dollar Bailout fund will come to the rescue.  But wait, it’s not a fund.  It’s a “facility,” and it doesn’t currently have a single cent in it. ³   Instead, it’s a facility that will issue bonds itself to other investors.  So the Irish debt has a lousy rating, but magically the bonds the Bailout facility issues turn into AAA securities.  How?  Because the remaining EU member states (those not recipient of bailout funds) put their “full faith and credit” behind the facility and guarantee it.  Heard that one before?  Yes, that’s the phrase everyone thought applied to the US government’s support Fanny and Freddie, but didn’t (and that worked out well, didn’t it?), but it’s also directly analogous to the commitment AIG made in the form of its CDSs before the meltdown.  AIG provided derivatives worth trillions of dollars of CDOs without much regard to whether, if those bundles of CDOs eventually defaulted at higher rates than projected, they would have the capital to post as the collateral required to support those CDS policies. ⁴

Here’s why this European facility looks just like the CDS crisis:  the guaranteeing countries guarantee the debts of the bailed out countries.  But some of those guaranteeing countries (Spain, Portugal, Italy, etc.) are already teetering on the brink.  Which means they may default.  And need bailouts themselves, guaranteed by the remaining countries.  The collateral requirement balloons far bigger than the original Irish crisis:  now it includes failures in Spain and Italy and Portugual as derivate problems of the core crisis.  Just as AIG’s derivatives policies forced AIG to post collateral far greater than the underlying CDOs.  So who ends up holding the bag?  AIG—I mean Germany.  For exactly how long do you think the Germans will guarantee the debts of the mismanaged Mediterranean (and Irish) economies?  This isn’t just counterparty risk, it’s political risk.  The future of the EU itself hangs in the balance.  If the Germans pull out, precisely who would guarantee these debts?

Like any other native New Yorker, the theater-going part of me used to dread the announcement that was occasionally heard just as the house lights went down:  “In this evening’s performance, the role of King Lear, normally played by Sir Anthony Hopkins, will be played by Justin Bieber.”  Everybody in the audience groans.  A few leave.  I’m having that same reaction to today’s performance of the European Bailout Fund.  “In today’s performance, the role of the Guarantor usually played by AIG will be played by Germany.”  We all groan.  You can see the bond fund managers leaving for the doors already.  Oh, look, there goes Alliance Bernstein.  And there goes CALPERS.  I wonder whether PIMCO will stay for the second act….

1. There was also straight out insurance against CDO losses, offered by such firms as FSA;  for more details, read Michael Lewis’s excellent The Big Short: Inside the Doomsday Machine
2. The facility has actually existed since May of this year; last week’s announcement marks the first deployment of the facility.  It becomes a permanent feature of the EU in 2013—if the EU makes it that long!
3. For a some great background information on the European Bailout facility, listen to Friday’s NPR Planet Money podcast.  I can’t recommend Planet Money enough.
4. The problem for AIG was not paying out on these insurance policies, since that was the job of FSA and MBIA.  Instead, it was the hugely inflated requirements of AIG to post collateral as a requirement of the CDS agreements which itself was too much for AIG to handle.

First, a quick refresher from my “Monetary Policy is Working–A Little” post back in November 2008:

1. 1. The Fed did everything it could to fuel the money supply¹  in late 2008.  In 2 months, it increased the base money supply by 43%

      

   2. The Fed’s efforts dwarfed analogous (but much smaller) efforts after 9/11 to keep the economy from tanking:

      

   3. At the time, everyone understood that, while the Fed could increase the base money supply, it can only effect “narrow money,” and it would take a while for the broader money supply (including credit) to feel the impact.

So, what were the results. ::drum roll::

You will be forgiven for thinking that the results are a whole lot of nothing.  They basically are:  a completely unprecedented, roughly $1.5 trillion increase in the money supply, and zero noticeable impact?! What gives?  Our expectations.  ed note 7/5/2010:  stay tuned for a post explaining why the Fed’s printing money didn’t work.

I’ll close with one more interesting statistic:  thanks to the John Williams at Shadow Government Statistics, we can track an old friend.  For the past three months, M3, the broadest measure of the money supply, and a statistic no longer tracked by the Fed, has been growing increasingly slowly.  Just this month, it stopped growing altogether.   M3 contains all of the money supply measured by M2 but also includes all other CDs (large time deposits, institutional money market mutual fund balances), deposits of eurodollars and repurchase agreements.

What’s going on here?  Unfortunately, it is clear that the Fed’s monetary expansion simply didn’t result in a broader money supply increase. In fact, there was a contraction. One could argue that the money multiplier was therefore negative.

ed note 7/5/2010: stay tuned for a post about why monetary base expansion worked better in China than the US.

1. For an excellent explanation of all these money supply measures, see http://www.shadowstats.com/article/money-supply.

source¹

To listen to Robert Nardelli (Chrysler, formerly CEO of Home Depot), his company has minutes remaining.  I’ve certainly expressed a sense of urgency before in my job when working to close a deal, but it’s impossible to listen to him and not sense something profound.  Three of our great industrial giants are willing to speak publicly about endgame.  Rick Wagoner (GM) seriously discussed a “pre-packed” Chapter 7 bankruptcy (surely a trial balloon alternative if ever I’ve heard one) by quoting marketing studies which show consumers are overwhelmingly unwilling to buy a car from a bankrupt company.  When was the last time you heard the CEO of a major non-financial company speaking about such potential downsides alongside his competitors? Extraordinary times indeed.

But not extraordinary enough.

Towards the tail end, Alan Mullaley (Ford, formerly Boeing) was asked whether his company would exceed the new CAFE fuel economy standards.  His response?  That Ford would barely be able to make them, and would not be able to exceed them.  The others agreed with him.  That one response convinced me that any bailout of US automobile manufacturers should 1) be totally focused on saving jobs (millions of them, potentially), and 2) must be so severely punitive of the companies themselves that they don’t get out of jail free.  These three companies have succeeded in lobbying their way out of innovation legislation (fuel economy, safety, public transport, etc.) for decades.  Consumers have responded by choosing foreign manufacturers preferentially (e.g. Toyota who pushed hybrid technology as a differentiator).  US manufacturers drop to the bottom of the list of consumer choices because of the manufacturers’ complacency, and then a contraction comes along and endangers the bottom of the barrel.  Surprise, GM, Ford, Chrysler, you now inhabit the bottom of the barrel precisely because of your complacency!

A little capitalist Darwinism is in order here.  If these guys had worked on fuel economy and alternative technologies 20 years ago, CAFE standards would be unnecessary now.  For want of those prior investments, it is not the Government’s job to subsidize their lack of business skills.  Do what we need to to save the jobs (lest we further endanger the economy), but otherwise I vote let these companies suffer the fate of others who stick their heads in the sand.

1. Businessweek online, “Auto Execs in the Hot Seat” http://www.businessweek.com/bwdaily/dnflash/content/nov2008/db20081118_113319.htm?chan=rss_topStories_ssi_5

To get a sense for what the Fed has done recently, take a look at the utterly unprecedented jump in the adjusted monetary base²:

Your eyes are not deceiving you:  the Fed has pumped an unbelievable amount of money into the monetary base.  Classic monetary policy at work, right?  Well, it’s certainly an implement out of the classic monetary policy toolbox, but this is an unprecedented action:

Now the critical question:  is it working?  Well, a little.  In comparison to the monetary adjustments made after 9/11 to offset the economic shock, the current adjustments are three to four times bigger, but they’ve had a substantially smaller impact on the broader money supply³:

Compare the two red arrows in the second figure to the orange arrows in the figure immediately above.  The absolute adjustment to the monetary base (red arrows) in 2001 was somewhere between a quarter and a third as big as the utterly unprecedented influx the Fed just let loose, but the results (orange arrows) is barely noticeable.  What’s going on?  The simplest explanation I’ve heard comes from Bob Brinker, who explains that M2 has seen the impact of the past two months’ massive evaporation of wealth, while the absolute currency (monetary) base hasn’t.  To my eyes, we can therefore visualize the “spread” between BASE and M2 on the right-hand side above as that very evaporation itself

Speaking of spreads, it looks like there’s another indicator that the Fed’s policies are working a little.  The TED spread⁴ has improved dramatically:

Recent TED Spread history. ⁵

All of this points towards a similar conclusion to the one I hinted at in my post earlier this week:  monetary policy alone isn’t going to solve this problem.  A solution will require some time and some fiscal policy—both of which will have to wait for the end of the lame-duck period and thus for 2009.

1. the St. Louis Fed reports most of its major money supply “observations” every week, on Fridays
2. the Fed series is called “BASE” and you can find it, and the rest of the measures (“series”) I am referring to in this post on FRED at http://research.stlouisfed.org/.  The BASE data, for example, can be found at http://research.stlouisfed.org/fred2/series/BASE.
3. as measured by a different Fed series, called M2, which is physical currency (M0) plus demand deposits such as checking (M1) plus all manner of time deposits (savings, CDs, etc.).  For an explanation of the various money supply measures, see http://en.wikipedia.org/wiki/Money_supply.
4. difference between LIBOR and the 91-day Treasury Bill, roughly indicating the price of the credit supply
5. source: Bloomberg, http://www.bloomberg.com/apps/cbuilder?ticker1=.TEDSP%3AIND