Fiscal Bailout, US Monetary Policies To Ensure Inflation Transmission To Global Economies

``It seems clear that much of the current crisis has been exacerbated by mark-to-market accounting, which has created massive, and unnecessary, losses for financial firms. These losses, caused because the current price of many illiquid securities are well below the true hold-to-maturity value, could have been avoided. The current crisis is actually smaller than the 1980s and 1990s bank and savings and loan crisis, but is being made dramatically worse by the current accounting rules." Brian Wesbury, FT Advisors, Mark-to-Market Mayhem

As we have repeatedly been saying, the US Federal Reserve hopes to inflate the world through its currency pegs or dollar links in the hope that the monetary stimulus applied will revive global growth to support its export sector as the local economy is being battered by the deflating debt storm.

Chairman Ben Bernanke understands that without exports the US economy would even be more vulnerable. Thus, the United States’ over reliance on foreign trade underscores the need for such stimulus transmission. It had been an unintended consequence before it looks like an unstated policy goal today.

Of course, another reason for passing the inflation buck is that EM countries have been more than willing to take on the real currency and interest rate risk-which means EM economies can afford to suffer from real value losses (via inflation) of their US portfolio holdings.

Since the Bretton Woods II framework has been driven by political objectives-for EM countries keeping currency undervalued for mercantilist goals- than by economic ones, as EM economies continue to support the US economy by buying into US treasuries despite the extremely low yields or expensive bonds, the risk is that perhaps the changing political objectives might lead to a shift in the global currency framework and consequently a US dollar crisis.

In the same plane, the fundamental reason why the US financial markets are being rescued is probably because Chairman Ben Bernanke understands that the current account deficit has been continuously plugged by foreign financing via the acquisition of paper claims on US assets. First it was Fannie and Freddie. Next it was AIG.

Now signs of growing political heft by foreigners into shaping domestic US policies, from an article in the New York Times,

``Foreign banks, which were initially excluded from the plan, lobbied successfully over the weekend to be able to sell the toxic American mortgage debt owned by their American units to the Treasury, getting the same treatment as United States banks.”

Another reason why? Because Chairman Bernanke understands that the US needs to get its feet back on the ground by having foreigners to provide the much required recapitalization of its severely impaired banking system aside from its present actions to cobble enough resources for a system wide bailout long enough to buy time for the world to recover.

From Kenichi Amaki of Matthews Asia, ``This week, two Japanese financial institutions stepped out of the shadows of the past to pick up stakes in some of their more recognized competitors. Japan's largest securities firm and investment bank announced the acquisition of Lehman Brothers' Asia Pacific, European and Middle Eastern businesses, including Lehman’s 5,500 employees in those regions, for an undisclosed amount. At the same time, Japan’s largest bank, announced that it had agreed to take an equity stake of up to 20% in Morgan Stanley for roughly $8.5 billion. These deals are expected to significantly boost both firms’ investment banking capabilities in geographic regions traditionally weak for them.”

Think of it this way, if the overall outstanding mortgage debt on non farm homes is $11.2 trillion where Fannie and Freddie holds $5.4 trillion, a 10% loss is easily equivalent to $1.12 trillion. This does not include the $2.4 trillion of “other mortgage debt” (corporate farms et. al.) and the $2.5 trillion outstanding consumer credit, which could likewise be impacted by a slowing economy and the ongoing credit crunch (hat tip: Brad Setser). So the proposed $700 billion package for the bailout will probably be insufficient.

Figure 4: The Economist: Cost of Previous Bailouts

Anyway, there had been greater amounts of bailouts as measured by the fiscal cost in % the GDP. According to the Economist,

``CONGRESS is under pressure to approve the Treasury's proposed $700 billion rescue package. Lawmakers, however, are conscious of the cost to the taxpayer: together with loans to AIG and Bear Stearns, public backing so far approaches 6% of GDP. This is well above the 3.7% of GDP of the savings-and-loan bail-out in the late 1980s and early 1990s. But some 6% of GDP is still much less than the average cost of resolving banking crises around the world in the past three decades, which a study by Luc Laeven and Fabian Valencia, of the IMF, puts at 16%.”

In nominal terms the present bailout would be gargantuan but the justifications using historical average cost of 16% could mean there might be more in store in the future as the weakness in US economy spreads.

Thus, my view is slanted towards the idea that any possible rescue package will tacitly be directed to stimulate global economies to enable them to fund the US current account deficit by buying into US financial claims on a guarantee aside from attracting potential financing flows from overseas state and private institutions to recapitalize the floundering US banking system.

There has been a barrage of thoughtful solutions on how to go about the bailout scheme some of which had been suggested by noteworthy figures as Raghuram Rajan suspend dividends and rights offering on solvent banks, Nouriel Roubini New HOLC, Luigi Zingales Debt for equity swap and debt forgiveness, Charles Calomiris Preferred stock assistance, Steve Waldman nationalization, Brian Wesbury temporary suspension of FAS 157 mark-to-market rules and Bill King create a new system parallel with the existing dysfunctional system and decentralization of liquidity (hat tip: Barry Ritholz) among the others.

It’s a wild guess on how the US Congress will go about configuring this package.

Nonetheless, it does seem that most of the world markets have been anxiously awaiting for the details of the US Congress led fiscal bailout of the US banking system.

This poignant New York Times quote from an anonymous Wall Street broker seems to have captured the essence of the markets abroad (highlight mine), ``People have definitely been saying that this is no longer an investor’s market, nor even really a trader’s market — it’s all entirely speculation on what the government is going to be doing next…Anyone who thinks they have a handle on where things are going is deluding themselves.” Indeed, since the credit crisis surfaced last year, the market has been living off from the onslaught of speculations to what government actions would be to done to stave off to magically vanquish the crisis.

Unfortunately, after over a year and upon waves after waves of government actions through assorted means of bridge financing and rescue takeovers this hasn’t prevented its financial markets or of most of the world markets from falling.

However, I think that as the contagion selling should eventually wear off despite the continued pressures in the US markets, aside from the indirect policy stimulus applied to foreign economies, which might give rise to a recovery of ex-US markets first in 2009.

Besides, the streak of selling has been ferocious enough to bring valuations to extremely oversold levels, see our last chart figure 5 from Daily Wealth,

Figure 5: Daily Wealth: Markdown on Emerging Market Valuations In Overshoot Mode!

From Chris Mayer ``The selloff is making things striking on the valuation front... which makes me bullish here. As you can see from the chart below, emerging markets haven't looked this cheap on a forward earnings basis in 20 years...”