01_

The Wonderful You come to us and tell us that the great cities are in favor of the gold
Wizard of Oz standard. ... If they dare to come out in the open field and defend the
gold standard as a good thing, we shall fight them to the uttermost.
Having behind us the producing masses of this nation and the world,
supported by the commercial interests, the laboring interests, and the
toilers everywhere, we will answer their demand for a gold standard
by saying to them, you shall not press down upon the brow of labor
this crown of thorns. You shall not crucify mankind upon a cross of
gold.

– William Jennings Bryan, Democratic National Convention, 1896

I am confident that the Fed would take whatever means necessary

to prevent significant deflation in the United States, and, moreover,
that the US central bank, in cooperation with other parts of the
government as needed, has sufficient policy instruments to ensure
that any deflation that might occur would be both mild and brief. …
[U]nder a fiat (that is, paper) money system, a government (in practice,
the central bank in cooperation with other agencies) should always be
able to generate increased nominal spending and inflation, even when
the short-term nominal interest rate is zero. … [T]he US government
has a technology, called a printing press (or today, its electronic
equivalent), that allows it to produce as many US dollars as it wishes
at essentially no cost.

– Ben S. Bernanke, National Economists Club, 2002

April The debate over the gold standard had raged for nearly twenty years when William Jennings
2009 Bryan electrified the Democratic National Convention of 1896 to capture his party’s nomination
for president. Businessmen and bankers favored the gold standard as responsible monetary policy.
But the gold standard had kept money tight during a period of rapid expansion in the productive
capacity of the country, which led to declining prices and a series of deflationary booms and busts.
The Panic of 1893 and the subsequent depression of 1893 – 1897 was an especially severe period.
Falling crop prices combined with a rapid increase in farm loans left many farmers in desperate
straits, while the working classes had endured falling wages and terrible unemployment; hence
farmers and workers wanted looser money. Populist rage inflamed the politics of inflation and
deflation1.

Ben Bernanke’s speech was made in a very different historical context and to a very different
audience. The preceding twenty years from 1982 – 2001 had been a golden age of central banking,
started by the defeat of the Great Inflation of the 1970s. The prestige of central banks depended
upon the confidence that a “Goldilocks” regime of mild inflation (perhaps 2% per year) could be
maintained indefinitely with only brief, small deviations. At the time of his speech, there were
gathering worries that the United States might enter a deflationary period similar to the one Japan
had then endured for over a decade.Yet the issue was still too remote to penetrate the body politic
broadly; Bernanke’s immediate audience was his economist peers, and even his broader audience
was limited to the business and financial elite.The message was confident: deflation would probably
be prevented, but if it was not, the central bank could quickly return the economy to Goldilocks.
The speech helped convince the political class that Bernanke had the expertise to lead the Federal
Reserve.

1 Naturally there were political nuances; for example, silver mining interests favored bimetallism
(which would lead to looser money) primarily because it would increase the demand for silver.
See A Monetary History of the United States, 1857 – 1960, Milton Friedman and Anna Jacobson
Schwartz, and Democracy in Desperation, the Depression of 1893, Douglas Steeples and David
O. Whitten.

This document is confidential and not for further circulation. This is not a solicitation or recommendation to buy, sell or hold
securities. Certain statements contained herein may be forward-looking. Information contained herein is believed to be accurate
and/or derived from sources which Clarium Capital Management LLC believes to be reliable; however, Clarium disclaims any
and all liability as to the completeness or accuracy of the information contained herein and for any omissions of material facts.
This document has not been filed with the Commodities Futures Trading Commission or any other regulatory body. Graphics
contained herein are purely representational and do not reflect any hypothetical return from an investment in the depicted
instruments.
© 2009
 02_

The economy and politics in spring 2009 look more like the summer of 1896 than Bernanke’s
speech ever contemplated. Goldilocks is gone and the politics of populism has returned.Yet unlike
1896, the conditions are new and everyone is still adjusting to the change. Politicians are realigning
their priorities and learning how to navigate the politics. Businesses and households are cutting
their spending and adjusting to new economic realities. Investors are trying to understand the
financial consequences and anticipate the circumstances under which the future would more likely
lead either to inflation or deflation.

The question of inflation versus deflation is the subject of this essay. The analysis unfolds in three
parts. The first part describes the policy response to date. The response of the Federal Reserve has
been specifically designed to provide liquidity to the credit markets without creating inflation.
Together with the policies of the Treasury and the rest of the Obama Administration to address the
solvency of the financial system, the goal has been to return to the previous Goldilocks regime by
restoring the pre-crisis levels of private credit.

The second part highlights the deficiency of the policy response. In focusing on fixing the financial
system, the policy addresses only half the problem. The United States does not just have an
overleveraged and undercapitalized financial system; it also has an overleveraged and undercapitalized
household sector. Private credit reached an unsustainable level, so its demand must fall even if its
supply is restored. In the context of the current policy response, the inevitable credit contraction
will be deflationary as the initial fiscal stimulus is too small to bridge the gap.

The third part analyzes the political barriers to a more inflationary response by considering its
perceived necessity, desirability and possibility. The ideology of the major policy actors emphasizes
the failure of financial oversight as the proximate cause of the crisis, yet overlooks that the Goldilocks
they wish to restore relied on unsustainable financial and asset bubbles. As deflation is greatly feared,
absent other barriers the desire for economic growth would likely overcome this ideological bias,
even at the risk of inflation. However, powerful domestic and international political interests
prefer deflation to inflation. Populist rage visibly tightens the Congressional purse strings against
profligate borrowing to protect entitlement programs for the middle class, while behind the scenes
China maneuvers to protect the value of its vast dollar holdings. Given these constraints, investors
must consider carefully whether policy makers will be able to tilt the policy response as much
towards inflation as is commonly believed.

Fo llow t h e Y el low B rick Roa d

As Fed chairman, Bernanke began implementing the monetary components of the current policy
in late 2008, and he articulated the broader policy framework in his January 13, 2009 speech, “The
Crisis and the Policy Response.” The fiscal components have been broadly adopted by the Obama
Administration generally and the Treasury Department specifically. The focus of the policy is to
restore the proper functioning of the financial system without debasing the currency or producing
excess inflation2. The goal of the policy is to return the economy to the Goldilocks regime of low,
predictable inflation and stable growth.

M o n e t a r y Policy

With the federal funds rate effectively at 0%, the Federal Reserve has developed new tools to
improve the functioning of credit markets and increase the availability of credit to households and
businesses. Bernanke organizes these tools into three categories, which together constitute the
monetary policy of “Credit Easing.”

1. Provision of Short-Term Liquidity to Sound Financial Institutions: This assures market

participants that financial institutions can meet demands for cash without resorting to fire
sales of assets. All the facilities for auctioning credit and making primary securities dealers

2 “Excess inflation” can be thought of as a rate of inflation exceeding an implicit target of

1.75% – 2.0%.
 03_

and banks eligible to borrow at the Fed’s discount window fall into this category. Bernanke
also groups into this category the bilateral currency swap agreements with various foreign
central banks to make US dollars more available.

2. Provision of Liquidity Directly to Borrowers and Investors in Key Credit Markets: This includes
the purchase of commercial paper and the TALF3. The purchase of commercial paper was
designed to stop the run on money market funds, while the TALF is designed to stimulate
increased lending directly. In Bernanke’s description, what unites these programs (and
potential future programs) into this category is that they address the concerns about capital,
asset quality and credit risk that continue to limit the willingness of many intermediaries
to extend credit, even when they have the liquidity to do so.

3. Purchase of Longer Duration Securities: This comprises all actions intended directly to lower
longer-term lending rates. It includes the completed and planned purchase of Fannie and
Freddie mortgage-backed securities and the senior debt of those companies, as well as the
planned purchase of longer-duration Treasury bonds.

There has been some confusion around how Credit Easing and Quantitative Easing differ, as well
as a general misunderstanding of the conditions under which increasing the monetary base is
inflationary. One can generally define any action that purposefully increases the monetary base as a
form of “quantitative easing,” since the purpose is to ease conditions by increasing the quantity of
money. This is possible at any interest rate, but for obvious reasons a central bank tends to turn to
quantitative operations only after it has already pushed the interest rate to zero. Bernanke explicitly
distinguishes the Federal Reserve’s current Credit Easing policy from the Japanese Central Bank’s
policy of Quantitative Easing earlier in the decade. Whereas Japan’s Quantitative Easing policy
attempted to create inflation in the prices of goods and services by increasing the monetary base,
the Fed’s Credit Easing policy attempts to lower the cost of credit by buying specific assets and
providing liquidity (i.e. issuing loans) in specific credit markets. Both Quantitative Easing and
Credit Easing result in an increase in the monetary base (i.e. reserves on deposit with the central
bank), but for different purposes. Quantitative Easing increases reserves simply to create inflation,
while Credit Easing increases reserves to fund its operations in the credit markets (buying and
making loans) to lower the cost of credit.

Since both Credit Easing and Quantitative Easing increase the monetary base, why don’t they
both create inflation? To answer this question one must understand how these operations work.
In both Credit Easing and Quantitative Easing, the central bank purchases securities from banks
and then credits them with reserves; the increase in reserves is the expansion in the monetary base.
In order for this expansion of the monetary base to be inflationary it must make its way into the
economy, and the mechanism for doing this is for banks to make more loans against the increased
reserves. But in conditions where bank lending is weak, merely increasing the monetary base will
not increase lending; hence it is questionable whether a straightforward Quantitative Easing policy
would have any effect at all today in the US. (And there is considerable debate whether Japan’s
policy had any effect during the time it operated.) Even further, the Fed is paying an interest rate
on excess reserves equal to what banks could expect to make on them by lending them overnight,
which explicitly motivates the banks to leave the reserves on deposit with the Fed. As long as those
reserves simply sit with the Fed, their mere increase has no inflationary effect on the economy4.

Quantitative Easing is generally associated with the purchase of government debt, while Credit
Easing targets specific credit markets to lower borrowing costs. With this in mind there is one way
in which Quantitative Easing can be much more inflationary than Credit Easing. If the central
bank and the federal government work together to monetize an increase in federal debt that is

3 TALF stands for Term Asset-backed securities Loan Facility; this is the facility that lends
against asset-backed securities such as student loans, auto loans and credit card loans.

4 Bernanke explained this in detail in a speech on February 18, 2009, “Federal Reserve Policies
to Ease Credit and Their Implications for the Fed’s Balance Sheet.” Bernanke noted there that
although M2 has grown at a 15% annual rate on a quarterly basis in Q4 2008, this was due
primarily to investors taking money out of riskier markets to seek the safety of government
insured bank deposits.
 04_

then used either to return money to citizens through tax cuts or to increase federal spending, then
the transmission mechanism bypasses the bank credit channel and the increased money makes its
way into the economy with an inflationary effect5. Because this policy requires the monetary and
fiscal authorities to cooperate it should be distinguished from purely monetary policies, perhaps by
calling it Quantitative Fiscal Easing. Bernanke recommended such a policy for Japan in 20036, but
he has neither implemented nor proposed anything like it in the present case.

Returning to the effects of the increased monetary base, it is important to note that at some future
point the private credit channel will presumably start growing again, at which point the excess
reserves would be transmitted into the economy with inflationary effect. Bernanke has designed
Credit Easing to minimize this inflationary effect by tilting many of the Fed’s operations towards
providing short-term credit facilities that can be turned off quickly and purchasing short-term
assets that can be run off within months. Longer-duration assets such as MBS and Treasuries can
be sold into the market to sterilize the reserves that fund them7, but the process is trickier to
implement, since the resulting rise in interest rates can encourage international capital flows and
otherwise distort market signals. The Fed’s decision on March 19 to purchase some $1.15 trillion
of MBS, agency debt and Treasuries was therefore significant as it signaled that the Fed is willing to
risk future troubles unwinding its operations in order to have maximum effect on bringing down
long-term (and especially mortgage) rates now. It did not, however, presage inflationary pressure
in the present; rather, it highlighted the importance the Fed places on doing whatever it can to
stimulate refinancing and mortgage lending. As we will see later, the Fed is right to be concerned.

Fisc al Policy

In his first speech outlining the Fed’s Credit Easing policy response8, Bernanke explicitly stated his
policy prescription for the incoming Obama administration and the new Treasury Secretary:

The Federal Reserve will do its part to promote economic recovery, but other policy
measures will be needed as well. The incoming Administration and Congress are currently
discussing a substantial fiscal package that, if enacted, could provide a significant boost to
economic activity. In my view, however, fiscal actions are unlikely to promote a lasting
recovery unless they are accompanied by strong measures to further stabilize and strengthen
the financial system. History demonstrates conclusively that a modern economy cannot
grow if its financial system is not operating effectively. …

[W]ith the worsening of the economy’s growth prospects, continued credit losses and asset
markdowns may maintain for a time the pressure on the capital and balance sheet capabilities
of financial institutions. Consequently, more capital injections and guarantees may become
necessary to ensure stability and normalization of credit markets. … In addition, efforts to
reduce preventable foreclosures, among other benefits, could strengthen the housing market
and reduce mortgage losses, thereby increasing financial stability.

5 Ben Bernanke was making precisely this point in the 2002 speech from which the quote at
the front of this essay was drawn, “Deflation: Making Sure ‘It’ Doesn’t Happen Here,” when he
said, “A money-financed tax cut is essentially equivalent to Milton Friedman’s famous ‘helicopter
drop’ of money.” This is the quote from which Bernanke’s “Helicopter Ben” nickname originated,
and the emphasis placed on this quote reveals the generally superficial understanding of his
speech. Bernanke borrowed the helicopter image from Milton Friedman, and he did so to make
a technical rather than a policy point.

6 See “Some Thoughts on Monetary Policy in Japan,” May 31, 2003, where Bernanke
recommended that Japan combine monetizing fiscal spending with a price level target, i.e. a
sustained commitment to restore the price level to the value it would have if instead of deflation
an inflation of 1% per year had occurred since 1998.

7 When the assets are sold into the market the Fed receives cash in return and then matches the
cash against the reserves to extinguish both. This process decreases the monetary base.

8 See “The Crisis and the Policy Response,” op.cit. Note that this speech was given more than
a week before President Obama took office.
 05_

The public in many countries is understandably concerned by the commitment of substantial

government resources to aid the financial industry when other industries receive little or no
assistance. This disparate treatment, unappealing as it is, appears unavoidable. Our economic
system is critically dependent on the free flow of credit, and the consequences for the
broader economy of financial instability are thus powerful and quickly felt. … Responsible
policymakers must therefore do what they can to communicate to their constituencies why
financial stabilization is essential for economic recovery and is therefore in the broader public
interest. (Emphasis added)

The Bernanke fiscal prescription is to inject as much capital as is necessary to stabilize the financial
system and do so in a way that returns it to normal (keep it in the private sector and avoid policies
that would chill lending). Since reducing preventable foreclosures would help increase financial
stability, this should be done where possible. Some fiscal stimulus along the way is appropriate,
but must not distract from the main focus of fixing the financial system. Although the public is
“understandably concerned” about shoveling so much money into the financial sector, the greater
good demands that it be done, so politicians must build and maintain support for restoring the
financial sector.

Treasury’s policy response under Tim Geithner is the Financial Stability Plan. The details of each
component of this plan continue to unfold, but the plan’s focus and structure are clear and align
closely with Bernanke’s prescription. The plan has six components:

1. Financial Stability Trust: A “stress test” will determine the financial fitness of each major
financial institution. Where additional capital is needed, every effort will be made to
attract private capital; if private capital is unavailable then government capital will be
injected.

2. Public-Private Investment Program: Treasury will provide seed capital and partner with the
Federal Reserve to provide favorable financing to entice private capital to purchase the
toxic assets of banks and other financial institutions.

3. Expansion of TALF: Treasury and the Fed will work together to expand the TALF
program.

4. Transparency and Accountability Agenda: Financial firms that receive government assistance
will be subject to various conditions such as: (a) detailing how government capital is
used, (b) committing to Treasury’s “mortgage foreclosure mitigation programs,” (c) not
paying dividends, buying back stock or acquiring “healthy firms” until the government is
repaid, and (d) certain limitations on executive compensation.

5. Homeowner Affordability and Stability Plan: Working with the GSEs, the major banks, and
various government agencies,Treasury will increase the number of homeowners who can
refinance their mortgages and improve the terms of the mortgages for many
homeowners.

6. Small Business and Community Lending Trust: Treasury will work together with the Obama
administration and the Small Business Administration (SBA) to arrest and reverse the
recent dramatic decline in SBA lending.

It is striking how closely Geithner is following Bernanke’s fiscal policy prescription. The first two
items inject more capital into the financial system. The third item expands an existing Federal
Reserve program. The fourth item addresses Bernanke’s exhortation to assuage political concerns
regarding putting more money into financial companies.The fifth item tries to reduce preventable
foreclosures. Only the sixth and last item is not a direct Bernanke prescription, although it is
obviously consistent with the goal of restoring the normal flows of credit.

In addition to the Treasury response, the Obama administration is acting in two ways. In early
February, it persuaded Congress to pass a stimulus bill that spends $501 billion in new money
 06_

and provides temporary tax cuts of $288 billion; and a few weeks later it requested a $750 billion9
“contingent reserve for further efforts to stabilize the financial system.” While the fiscal stimulus
package was an initiative predating Bernanke’s speech and Geithner’s appointment to Treasury, the
requested contingent reserve is clearly designed to support their efforts. Having spent political
capital early on to pass the stimulus bill, President Obama then delegated the policy response to
Treasury and the Fed. There is now close coordination between the Fed, Treasury, and the White
House around the Bernanke policy response.

T h er e’s N o Pl ace lik e H o m e

There is much debate about how well the efforts of the Federal Reserve and Treasury are
proceeding.This debate is critically important, because the financial system is terribly overleveraged
and undercapitalized and must be repaired. However, the debate overlooks and crowds out a
fundamental issue. Even if the current policy efforts are successful, easing the cost and availability
of credit will not restore its flow to prior levels. Credit is contracting not just because its supply is
choked off by the illiquid and insolvent state of the financial system; it is also contracting because
its demand had far exceeded a sustainable level.

Observe the ratio of the amount of outstanding nonfinancial10 US debt to US GDP. Since 2000,
the aggregate ratio jumped from the previously stable level of about 1.85 to 2.35. In contrast to the
first jump (from 1981 – 1988), this increase was almost entirely led by households, who increased
their debt level in relation to GDP over 40% in just eight years from a ratio of 0.7 to nearly 1.0.
(Note also that business debt in relation to GDP edged up to reach its highest level ever.) The
increase was primarily driven by mortgages during the housing bubble.

Fig. 1 US Non-Financial Debt to GDP Ratio Source: Fed Flow of Funds

2.50
Total Multiple Business Multiple
Household Multiple Government Multiple
2.00

1.50

1.00

0.50

0.00

1945 1965 1985 2005

9 From a budgeting perspective, the request asks for $250 billion because it envisions purchasing
assets that will return only 2/3 of their cost. Hence the gross figure requested is $750 billion,
and the net figure requested is $250 billion.

10 Financial debt is excluded to avoid double counting. For example, whereas a mortgage
is counted, a mortgage-backed security is excluded. Nonfinancial debt measures the degree
to which the real economy is leveraged, but it understates the degree to which the financial
economy (i.e. banks, etc.) is leveraged.
 07_

Yet the trend of worsening US household finances preceded the housing bubble and started in the
early 1990s. As recently as 1992 the personal savings rate was still slightly above (i.e. better than) its
long-term average, and the ratio of debt to disposable income was only slightly above (i.e. worse
than) its long-term average. But the decade and a half that followed saw a significant deterioration of
the US household balance sheet. Households basically stopped saving while increasing dramatically
the size of their liabilities relative to their available income11.

Speaking in 200512, Ben Bernanke sought to allay concerns about these trends by pointing out
that household assets rose even more quickly than household liabilities, and at the time of his
speech the ratio of household net worth to household income stood at 5.7, well above its long-run
average of about 4.8. However, this ratio later plunged to 4.3 at the end of 2008 with the bursting
of the housing bubble and subsequent collapse in the stock market. Given the continued selloff in
housing and stocks, this ratio has clearly fallen even further. Indeed, it is precisely the over-reliance
on assets rather than cash flow to offset debt that now makes the US consumer and associated
economy so vulnerable to declining asset values in the face of the existing debt burden.

Households have saved too little and borrowed too much. The end of the housing bubble has left
many people underwater on their mortgages. Unemployment is high and increasing, and many
more workers justifiably fear their jobs are at risk. Economies around the world are contracting at
the fastest rate in generations. In this environment, households will be reducing their borrowings
and trying to increase their savings for some time to come.

But since current policy is so focused on restarting the private credit channel, we must consider
whether the aggregate numbers are misleading. Many households are under stress, but some are not.
Could the credit of households that can still borrow expand enough to offset the credit contraction
of the rest? Mortgage debt accounts for roughly 80% of total household debt13 so any expansion of
household credit would operate primarily through this channel. However, there is very little equity
that can still be leveraged.

Fig. 2 Personal Savings/Disposable Income Source: Fed Flow of Funds Fig. 3 Household Liabilities/Disposable Income Source: Fed Flow of Funds

12% 1.6

10%
1.2
8%

6% 0.8

4%
0.4
2%

Personal Savings / Disposable Income Household Liabilities / Disposable Income

0% 0.0

1946 1966 1986 2006 1946 1966 1986 2006

11 It is worth noting at this point that this analysis only states what happened and does not try
to explain what caused it. The causes are complex and lie both inside and outside the US. One
cause is the dramatic lowering of the cost of capital from the early 1980s and the household
reaction to this phenomenon; see Clarium’s Q2 2007 quarterly letter, The Long Goodbye for a
detailed analysis. Another cause is the increase in savings in emerging markets and their desire
to be invested within the United States, the so-called “Global Savings Glut” explanation by
Ben Bernanke. Other factors were at work as well. This important topic deserves much more
consideration but it lies outside of the analysis here.

12 “The Economic Outlook,” March 8, 2005

13 Per the Fed Flow of Funds. See also http://www.hoover.org/research/factsonpolicy/

facts/38837147.html
 08_

Fig. 4 Potential US Mortgage Equity to GDP Ratio Source: Fed Flow of Funds Fig. 5 Value of US Housing Stock/GDP Source: Fed Flow of Funds

120% 200%
Unadjusted 80% LTV Value of US Housing Stock / GDP

100%
160%

80%
120%

60%

80%
40%

40%
20%

0% 0%

1945 1965 1985 2005 1945 1965 1985 2005

Observe the graph of the ratio of potential US mortgage equity to GDP. The top line takes the
simple ratio of total outstanding mortgage equity to GDP in the US. The 2009 estimate assumes
that housing prices decrease another 10% while GDP remains constant. Even on this simple
measure the amount of outstanding mortgage equity available to be leveraged is near its historically
lowest level. However, a key point is that underwriting standards deteriorated significantly during
the housing bubble.The bottom line adjusts for this by assuming an 80% loan-to-value (LTV) ratio,
which has been the historical norm14. On this measure, the amount of housing equity available to
be leveraged in 2009 will be slightly less than 20% of US GDP (assuming no change in US GDP
from its end of 2008 level). Given the trajectory of house prices and GDP, it seems likely that this
ratio will decline even further in 2010.

The total amount of equity available to be leveraged in 2009 will be below its previously lowest
level in 1945. And as the accompanying graph shows, the crucial difference is that in 1945 housing
values were at a historically low point, whereas today they remain at historically high levels15.
People will not borrow aggressively to buy houses that they think are overvalued and likely to fall
further in price.

There is too much housing debt, too little housing equity, and what little equity is left is (still)
overvalued. In this environment lowering mortgage rates will have little effect on restarting
borrowing. Since housing dominates household credit, no other source of household credit can
counteract its effect. Add in the worst economy in living memory, a personal savings rate near zero
for almost a decade, household liabilities at a record ratio to disposable income, and the recent
decimation of household wealth and it is clear that trying to jawbone the household credit channel
faces severe limitations.

Nor will the burden be carried by businesses. Business debt in relation to GDP is already at
a historically high level and will not be expanded in the face of a worldwide recession when
corporate spreads are pricing in the expectation of record defaults16. While fixing short-term
funding mechanisms such as the commercial paper market is certainly necessary, and while it would

14 For the graph of mortgage equity to GDP, the unadjusted calculation takes the aggregate
value of the housing stock, subtracts the outstanding value of all mortgage debt, and then
divides the resulting difference by the value of GDP. The 80% LTV calculation uses the same
formula, but first multiplies the aggregate value of the housing stock by 80%.

15 For the graph of the value of US housing stock to GDP, the 2009 number assumes that
housing falls by 10% in 2009 while US GDP remains flat from its end of 2008 value.

16 Early indications are that corporations around the world are hoarding cash by borrowing
at low rates and paying down loans wherever possible while cutting back on investment and
returning less cash to shareholders. See “Concern as Companies Hoard Cash,” Financial Times,
March 18, 2009.
 09_

be desirable to lower long-term funding costs for businesses where possible, such measures will not
even begin to expand credit to the extent necessary to offset the household credit contraction.

How much economic output will be lost to this credit contraction? Assume that the household
sector needs to deleverage to the same ratio of debt to GDP that existed in 1998, before the
housing bubble began. Since even in 1998 this ratio was at an all-time high, this does not seem like
an onerous assumption. We do not know the trajectory of GDP in 2009 and beyond, so to make
the calculation easier we hold GDP constant at its level at the end of 2008.With these assumptions,
the household sector needs to pay down $4.2 trillion of debt. If we assume that the business sector
holds borrowing and associated spending constant at the same time, this represents $4.2 trillion of
lost private sector spending. It is difficult to estimate the amount of lost GDP17 associated with this
lost spending since we can’t know how quickly it will occur or which specific expenditures will
be cut18, but it is surely on the order of trillions of dollars if no significant countervailing force is
deployed against it.

So far, only $800 billion in fiscal stimulus and tax cuts, both of which occur over several years, have
been deployed against this looming private credit contraction. Making credit cheaper and more
available will help some households refinance, but given the mortgage negative equity problem
described above the effect is likely to be small. Recapitalizing the financial system will have some
salutary effect, since if a consumer defaults on a loan and the bank is reimbursed by the government
for the default, the effect is similar to providing the consumer the money to pay back the loan19.
However, most if not all of the recapitalization is needed to reduce leverage levels of financial
companies. Both the financial and the household sectors are overleveraged; reducing the leverage
of the financial sector is necessary but does not also count towards reducing the leverage of the
household sector. The total amount allocated to recapitalizing the financial sector so far is $700
billion in TARP and the hundreds of billions paid out or committed to the weakest firms such as
AIG, Fannie Mae, Freddie Mac, Citigroup and Bank of America. (The PPIP program, which is part
of TARP, is addressed below.) Given the lack of transparency it is impossible to estimate exactly
how much of this capital could be counted as a roundabout way to recapitalize the household
sector, but given the severely overleveraged state of the financial system the amount is probably
small at best.

Absent outright monetary inflation, unless the federal government substantially increases its own
borrowing and deploys the capital to stimulate the economy20, we must expect trillions of dollars
of lost output before the private sector deleveraging is complete. Therefore, without a significant
change in policy the outlook for the next several years is deflationary.

T h e Em er a ld Ci t y

What has produced the current policy response? What would it take to change the policy to
produce an inflationary outcome? How could one recognize the preconditions of such a change
before it takes effect? These are the critical questions investors must ask, so now our analysis must
change from the macroeconomic to the political and sociological.

17 The lost economic output should be measured against sustainable trend growth; since trend
growth is positive it is possible to have lost output even with (weak) economic expansion.

18 For example, if the spending is withdrawn from financially weak firms that then go bankrupt
more economic contraction would occur than if all firms could absorb the lost revenue.

19 It is more onerous, however, as the consumer must first default and then if the loan is made
against an asset the asset must be resold at a depressed price.

20 For this discussion we ignore the technical question whether stimulus is done more effectively
by maintaining government spending levels and reducing tax rates or keeping tax rates constant
and increasing government spending. We also ignore the larger question of whether stimulus
maximizes long-term growth or whether it simply smoothes the downturn and subsequent
recovery. We are focused purely on whether there will be sufficient stimulus to offset deflation
over the next several years.
 10_

A useful way to analyze the politics behind the policy is to consider the appeal of inflation from
three different perspectives:

1. Is inflation necessary? The ideology of policy makers

2. Is inflation desirable? Domestic political factors
3. Is inflation possible? International political factors

Ideology – Back to Goldilocks

The definition of the crisis and the design of the policy response have been developed under the
belief that central banking policy has been successful since Paul Volcker tamed the Great Inflation
of the 1970s, and that the financial crisis has mainly been caused by the irresponsible behavior
of other people. According to this view, monetary policy needs to restore the earlier status quo,
only this time with better supervision, regulation and cooperation. Ben Bernanke devoted two
paragraphs of his January 13, 2009 speech to the reforms that would “limit the probability and
severity of future crises.” His suggested reforms all focused on improving the durability of banks
and other financial institutions, which is certainly a good and necessary goal. There was not a
word, however, regarding the monetary policies that encouraged asset bubbles or allowed such
an enormous buildup of private credit relative to GDP. Indeed, recall from the previous section
that when Bernanke addressed the topic of the growth of private debt in 2005, instead of calling
attention to it as a worrying trend he actually dismissed concerns about it.

The ideological bias to downplay the significance of the growth of private debt pervades the
Obama policy team. In a recent senate hearing21, Professor Christina Romer, Chair of the Council
of Economic Advisers had this exchange with Senator Jeff Merkley:

Senator Merkley:You know, one of the things that I’m interested in getting your perspective
on is that we not only have substantial governmental debt, but we also have sizable consumer
debt. When those are taken together, consumer and government debt, is there any parallel
to the Great Depression in terms of percent of GDP or are we way beyond the level of debt
that was carried, even at the height of the Great Depression?

Professor Romer: I would say we – I mean, I should check the numbers but I’d say we
certainly are higher. …

Senator Merkley: I saw a chart in a magazine article a year or so ago that seemed a little
surreal to me, and I believe that what it showed – and it was combining consumer debt
and governmental debt – was that during the height of the Great Depression, the debt to
GDP, the combined debt, reached about two and three quarters times the GDP22 … Those
numbers are not – I don’t normally hear those numbers in the debate because we don’t
really talk about the combination of consumer and governmental debt. But – let’s say this
is – are we out – is it in the ballpark that we may be well over three times the GDP with
the combination and – and if so, how does that really constrain our ability to recover in this
economic downturn?

Professor Romer: I think on the numbers I’d just have to – to go back and check them so
it’s not one that I have on – on the top of my head. …

Christina Romer is a learned scholar of the Great Depression who submitted sixteen pages of
written testimony for this panel. She is an influential member of the Obama Administration. And
she was unfamiliar with very basic data on consumer debt levels and was able only to give vague

21 Hearing of the Economic Policy Subcommittee of the Senate Banking Committee, March 31,
2009

22 The chart to which Senator Merkley referred is almost certainly total US debt – nonfinancial
plus financial debt – divided by US GDP. See footnote 9 for an explanation of financial and
nonfinancial debt. Tracking total US debt as a ratio of GDP over time is misleading because
financial debt both overcounts offsetting financial positions and undercounts synthetic
leverage.
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and general responses23 to Merkley’s questions. Senator Merkley is correct that policy makers
“don’t really talk about the combination of consumer [and business] and governmental debt.”

If you believe that monetary policy has been successful in maintaining price stability and the
source of the problem is failed oversight of the financial system, then you will rule out an outright
inflationary monetary policy response. If you do not understand the unsustainable levels of
private credit, then you will underestimate the amount of government stimulus necessary to offset
deflation.

However, it would be a mistake to believe these ideological perspectives are unshakeable

commitments. Bernanke has studied the Great Depression in detail and has devoted much of his
academic career to studying how to prevent its recurrence. Romer, in her written testimony to
the Senate hearing referenced above, did not just say that aggressive fiscal expansion is an essential
part of the solution, she also explicitly said that stimulus must not be cut back prematurely. In the
absence of other political constraints, one could expect that persistent deflation would draw out
increasingly more inflationary policy responses.

Domestic Politics – No More Money

Defining the problem primarily as a financial crisis has weakened the resolve for collective efforts
to solve it, and policymakers have increased the resentment by failing to explain satisfactorily why
those who seem to be at fault must be subsidized by the public.Whether it is the Rick Santelli rant
that quickly garnered almost a million views on YouTube, the public backlash against AIG bonuses
that caused a punitive tax bill to pass quickly through the House, or whatever the next outrage
will be, the public rage demands expression. Underlying the rage is this belief: You caused this – you
profited obscenely while I was left behind and now you are taking my money!

There are understandable reasons for these cultural and class divisions. Income inequality reached
historically high levels over many years, which led the middle class to feel increasingly squeezed
while it saw the rich get richer. A culture of borrowing and speculation – partly to compensate
for stagnant real wages – took hold throughout America. Wall Street became its most arrogant
and irresponsible as the finance bubble peaked. If the economic crisis were understood socially
on a more nuanced level then these legitimate grievances could be addressed within a wider
commitment to address all parts of the problem. Instead, the crisis has been cast as a morality play
where Wall Street and irresponsible speculators are villains that hold a virtuous Main Street hostage.
In this context, the response is grudgingly to hand over the minimum amount necessary to bail
out the financial system while extracting the maximum possible punishment. Taxpayers are in no
mood to be told that some of what ails the economy is due to their own irresponsibility, and that
much more of their money is needed to minimize the pain.

Furthermore, taxpayer money is needed to pay for the entitlement promises made to the retiring
baby boom generation. Social security and Medicare currently owe tens of trillions of dollars in
present value terms24. The politics of meeting and funding these commitments will dominate
the political landscape for decades. Retiring baby boomers understandably want the political
conversation to favor meeting the commitments in full. One can make an academic argument
that engaging in massive stimulus could increase the ability to meet those commitments over the
long run by maximizing economic growth, but the political reality is that each dollar of stimulus
competes for a dollar of Medicare and Social Security. The normal funding of these programs will
lead to significant future deficits, and those deficits are politically unpopular.

23 The full text of Romer’s responses was omitted for space considerations.

24 The 2008 official government estimates of the present value of Medicare and Social Security
liabilities are $16.8 trillion and $4.3 trillion, respectively. The calculations of these liabilities
are extremely sensitive to many assumptions. See http://www.cms.hhs.gov/reportstrustfunds/
downloads/tr2008.pdf (p.197) for the Medicare estimate and http://www.ssa.gov/qa.htm
(question #12) for the Social Security estimate.
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A recent and comprehensive analysis25 suggests that the economic crisis will quickly reduce tax
revenues and intensify deficit pressures. Merely contracting at the average rate of the five largest
financial crises in advanced economies after World War II26 would result in the US government
having a net (in real terms) revenue reduction of over $1 trillion over just three years27 (and possibly
more after that) when the loss of federal, state and local tax revenues are taken into account. Yet
even this estimate is probably too low, as the present crisis may be worse than all the others.

This is not a political recipe to get Congress to approve more funds for additional bank bailouts or
aggressive stimulus packages.

Ben Bernanke and the key members of the Obama Administration clearly understand the magnitude
of the political challenge.The TV news show, 60 Minutes, asked Bernanke in March, “What are the
dangers now? What keeps you up at night?” Bernanke responded:

I think the biggest risk is that, you know, we don’t have the political will. We don’t have the
commitment to solve this problem, and that we let it just continue. In which case, you know,
we can’t count on recovery.

Tim Geithner has structured the PPIP28 to require as little new money up front as possible. The
program supplies market participants with free put options and attractive financing to motivate
them to buy impaired assets from troubled banks. Rather than spend money it doesn’t have
and is unlikely to get, Treasury is partnering with the FDIC (which receives no Congressional
appropriations) to provide free insurance whose claims come due later and whose costs can be
obscured from the general public29. The obvious goal is to entice private capital in place of public
capital by socializing risk. A less obvious but also important goal is to shield bank balance sheets
from the volatility of lower marks on their assets, which in turn may help reduce volatility in the
markets and the economy more generally.

It remains to be seen, however, whether PPIP will ultimately do as much good to recapitalize
the financial system as cold, hard cash. And nobody has yet figured out how to provide fiscal
stimulus by writing put options. Whether one admires the PPIP’s creativity or condemns its deceit,
from a purely political perspective its structure shows how undesirable Congress finds the idea of
providing more taxpayer money for fiscal remedies.

International Politics – The China Syndrome

Debtors must be mindful of their creditors, so let us review some basic facts regarding the largest
foreign holder of America’s debt. Of the $6.3 trillion in US Treasury debt held by the public (i.e.
net of intra-governmental holdings), roughly $3.1 trillion is held by foreign sources as of January
31, 2009, and the largest holder is China with $740 billion. Of the roughly $4.8 trillion of agency

25 See “Banking Crises: An Equal Opportunity Menace,” by Carmen Reinhart and Kenneth
Rogoff, published December 17, 2008.

26 These five crises are (in alphabetical order by country): Finland in 1991, Japan in 1992,
Norway in 1987, Spain in 1977 and Sweden in 1991.

27 This estimate starts with baseline federal revenue of $2.524 trillion in FY 2008. It assumes
the US federal government revenue contracts 4% in FY 2009, an additional 4% in FY 2010
and an additional 3% in FY 2011, resulting in revenue losses of $101 billion, $198 billion and
$268 billion respectively. (Note that each fiscal year ends on September 30, e.g. FY 2009 ends
September 30, 2009.) See Figure 8c and the associated explanation from Reinhart and Rogoff,
op. cit. State and local tax revenues are roughly equal to federal tax revenues (including general
revenue items from sources like university tuition, hospitals, highways, parking facilities, etc.)
and are assumed to contract at the same rate.

28 Public-Private Investment Program

29 The loan guarantee in the assistance to Citigroup announced November 24, 2008 is similar.
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and GSE backed debt at the end of Q2, 2008, China held almost $530 billion30.These Treasury and
agency holdings are part of the massive $2 trillion foreign exchange reserves held by China, which
is twice the size of the second largest holder of foreign reserves (Japan at $1 trillion), and of which
some 70% is estimated to be US dollar assets31.

China holds such large foreign exchange reserves in order to control the exchange rate of the
renminbi; depending upon how one considers it, this puts China in either a weak or a strong
position. From one perspective, China is addicted to purchasing ever more foreign securities32 for
as long as it wants to maintain the status quo, and must therefore accept the risk of capital losses on
its foreign holdings. Several years ago it was probably correct to say that this put China in a weak
negotiating position. Today, however, one can see three different ways that China’s reserves are a
source of strength.

First, China’s massive reserves now allow it to use its currency as a strategic tool.As Kevin Harrington
explained in Clarium’s Q4, 2008 quarterly letter, The Sovereign Exception, China’s decision to stop
the steady appreciation of the renminbi versus the dollar and keep it rigidly pegged since July
2008 has had profound deflationary effects, many of which look beneficial to China from both an
economic and a geopolitical perspective.

Second, China is now a large enough “customer” that it can start to dictate terms to its “suppliers”
by shifting which securities it will buy and what price it will pay. It is possible that we saw an
example of this last summer, when China’s purchases of US agency33 debt dropped dramatically.
China’s 2008 purchases of US agency debt were, by quarter, $15.8 billion, $21.6 billion, $3.1 billion
and $2.9 billion. While overall flows of these securities decreased during the same period, China’s
reduction was much greater on a percentage basis.The flow of US agency debt dropped from $672
billion in Q2 to $508 billion in Q3 and $292 billion in Q4, or 57% from Q2 to Q4 as compared
to China’s 87% reduction during the same period. Note that China’s purchases of Treasuries were
quite high during this period when compared to the average throughout the previous year; China’s
actions were specifically targeted at the agency market.

Finally, there is the possibility that China may decide to change altogether its foreign reserves policy
if it decides the current policy is no longer in its interest. The most radical change would be to
float its currency freely; more moderate changes would include decreasing the dollar portion of its
reserves and slowing the growth of its reserves altogether. Several years ago one could assume that
such changes would probably not be to China’s benefit. Today China has roughly $1.4 trillion in
foreign reserves and American consumption will no longer be supported by profligate borrowing.
Thus, when the governor of China’s central bank gives a speech suggesting that a new currency
should eventually replace the dollar as the world’s reserve currency, the world takes notice34.

So long as China believes that America will eschew an inflationary solution, it will remain in
China’s interest to buy the US debt that must fund America’s coming shortfall in tax revenues and
the entitlement commitments that stretch for decades. But if America credibly indicates it will

30 The source is the US Treasury Department. The second largest holder of Treasury and agency
debt is Japan with $635 billion and $270 billion respectively. In contrast to the growth of China’s
holdings throughout the decade, Japan’s holdings have been relatively stable for some years.
Note that foreign Treasury holdings as of January 31, 2009 is a preliminary estimate.

31 The source for China’s foreign exchange reserves is the State Administration of Foreign
Exchange of the People’s Republic of China; the source for Japan (and comparison with other
countries) is the IMF. The 70% estimate is widely reported, although the actual figure is not
precisely known. See for example, testimony by Brad Setser, Foreign Holdings of US Debt: Is
our Economy Vulnerable? June 27, 2007.

32 China’s foreign exchange reserves have grown at an extraordinary rate. The compound
annual growth rate from 2000 to 2008 is over 36%, which is only just barely slower than the
growth rate of 38.5% from 2000 to 2004.

33 The source for all numbers in this paragraph is the Fed Flow of Funds.

34 See for example, “China Takes Aim at Dollar,” Wall Street Journal, March 24, 2009. The
speech is “Reform the International Monetary System,” published March 23, 2009 by Zhou
Xiaochuan.
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pursue genuinely inflationary monetary policy, the prospect of massive capital losses on its dollar
reserves may cause China to preempt that action. Given how much America now needs China, it
is not clear that America could pursue an outright inflationary policy if China acts to prevent it.

T h e W iz a r d o f Oz

Frank Baum wrote an illustrated children’s novel called The Wonderful Wizard of Oz in 1900. It
captured the popular imagination and was turned into a movie in 1939. Today the book and the
movie are remembered for the entertaining story, the iconic characters, and the imaginative fantasy
world of Oz. Less appreciated are the historical context and political overtones of the story dealing
with the struggle around the gold standard and the battle between inflation and deflation.

The yellow brick road is an obvious reference to the gold standard: a golden path that keeps one
safe and delivers one to the prosperity of the Emerald City so long as it is faithfully followed. In
the section, “Follow the Yellow Brick Road,” this essay describes how Ben Bernanke has carefully
designed the policy response to avoid inflation. One can fancifully think of it as a twenty-first
century version of a “fiat money gold standard” that attempts to solve our economic crisis and
deliver us to prosperity by staying on a path of monetary responsibility.

At the start of her journey on the yellow brick road, Dorothy describes the dreary poverty of her
home in Kansas to the Scarecrow. Upon hearing her description he tells her he can’t understand
why she would want to leave Oz and return to “the dry, gray place you call Kansas35.” Dorothy
replies, “That is because you have no brains. No matter how dreary and gray our homes are, we
people of flesh and blood would rather live there than in any other country, be it ever so beautiful.
There is no place like home.” Popular culture remembers the final sentence, but forgets the context.
Baum was poking fun at Midwesterners who idealized farm life even though the future lay in
the migration to the cities. In the section, “There’s No Place like Home,” this essay explains why
repairing the financial system will not lead back to Goldilocks. The previous Goldilocks regime
was not a happy equilibrium, but instead a highly leveraged and indebted state of affairs. Even
a complete restoration of the supply of credit will not forestall a deflationary contraction in its
demand. Wherever the path of policy and events will take us, it will not be the “home” of an
untenable prosperity where private credit grows faster than our economy.

When Dorothy and her companions arrive at the Emerald City, it appears at first that they have
found a utopia of prosperity and good governance. Eventually, however, they learn that the Emerald
City is based on lies. The city is not really made of emerald; it only appears green and sparkling
because everyone in the city wears goggles that distort their view36. Furthermore, the Wizard
lies about his abilities in order to maintain power. He means well, but he is a fraud. Nevertheless,
so long as everyone goes along with the charade life is generally good for its inhabitants. The
Emerald City represents Washington, DC. In the section, “The Emerald City,” this essay describes
the political challenges of changing the policy to be more inflationary. Even if the fear of deflation
widens the ideological perspective, politics both at home and abroad may limit what can be done.
An angry middle class will demand that Congress tighten its purse strings, while America’s largest
foreign creditor will strive to protect its dollar assets.

By 1900, Baum was able to satirize the politics and economics of the 1890s lightheartedly. When
William Jennings Bryan gave his famous speech, the nation had given up any hope of reaching a
state of Goldilocks and was instead locked in a struggle between choosing inflation or deflation.
Because Bryan lost his presidential bid in 1896, the US stayed on the gold standard.Yet to everyone’s
surprise, after 1897 adherence to the gold standard was no longer deflationary and instead began
a period of mild inflation that lasted until World War I. New gold discoveries combined with
improvements in mining and refining technology enabled the gold supply to expand steadily,

35 In the movie, this is conveyed by having all the scenes in Kansas in black and white while all
the scenes in the Land of Oz are in bright Technicolor.

36 This detail is unfortunately lost in the movie version.

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which caused prices in the United States to rise between 2% and 2.5% per year from 1897 until
191437. Baum published his novel at the beginning of a new Goldilocks regime. Unfortunately, the
situation in 2009 is the mirror image of 1900. We are at the end of a long Goldilocks regime that
has led to substantial imbalances and indebtedness, and we are only beginning to come to grips
with the new economic and political realities.

One final parallel with the novel is worth noting. Although the character of the Wizard is probably
meant to represent President McKinley, in today’s context it is easy to reinterpret him as Ben
Bernanke. In the novel, the Wizard could give Dorothy’s companions what they sought – brains
for the Scarecrow, a heart for the Tin Man, and courage for the Cowardly Lion – because they
already had those qualities. Much like a central banker in normal times, the Wizard mainly needed
to supply confidence. But Dorothy’s case was different. When Dorothy asked the Wizard to send
her home, he was unable to help her. Unlike the Wizard, Bernanke is honest and capable. But like
the Wizard, what is required may lie beyond his abilities. Who today will provide Bernanke with
the magic he needs?

patrick wolff, cfa

Managing Director
Clarium Capital Management LLC

37 See Milton Friedman and Anna Jacobson Schwartz, op. cit. Friedman and Schwartz note
that this was impossible to foresee at the time, and they even go so far as to say that given the
impossibility of predicting this development, abandoning the gold standard might have been
the best policy to adopt in response to the 1893 panic and subsequent depression, had it been
politically possible to do so.