It’s glaringly obvious to many people that abortion, sterilization, and similar procedures are a strictly-required component of women’s health. These people often see the opposition of the Catholic Church to these procedures not as a core belief, but rather as a retrograde, pernicious, and even cynical attack on women.

It’s just as glaringly obvious to many other people that religious freedom in America is sacrosanct. Of all the guarantees given in the Bill of Rights, religious freedom is indeed the very first one!

In this case, the Obama Administration has ruled unilaterally that health insurance programs provided by the Catholic Church must pay for abortions. Forget about the welter of discussion about whether the Federal mandate extends beyond those of many states. That’s not the core issue here.

For the government to say, as it has, that its goals are prior to the Catholic Church’s core beliefs, is precisely to say that government power is unambiguously senior to all other claims.

This is radically counter to the doctrines of the American founding. It’s more radical than anything that even FDR said during the New Deal. It quite simply elevates government to the level of a religion.

Personally, it’s clear to me that people on the pro-abortion side of this debate simply don’t understand the stakes. (Notably, that includes Sen. Chuck Schumer, who ought to know better.) If they accept that government is prior to all other claims, they’re opening themselves to the potential for some future government to take away the things that THEY hold as non-negotiable core beliefs.

To put it another way, we’ll have become a society that forthrightly elevates the collective over the individual. Again, radically counter to the doctrines of the founding.

Markets are trading significantly lower this morning, and much is being made of something that I mentioned briefly on Coffee and Markets the other day: right after the accord, Italy’s government went into the bond market to sell an issue of three-year notes, and had to pay 4.93%, well above what they had paid for the same maturity just a few weeks ago. The dogs aren’t eating the dog food.

It seems clear that we’ve averted a serious financial crisis/panic/crash for at least a few months. That much was accomplished. But on further inspection, the plans have deep flaws both from a financial/economic and a political point of view.

The key features of the plan are: to impose strict fiscal discipline on Europe’s banks, in the form of sustained increases in tier-1 capitalization; to impose a 50% write down on something like 100 billion euros of Greece’s outstanding government debt; to increase the size of the EFSF to about a trillion euros; and strong steps to “oversee” the austerity measures that a whole swath of non-German states in Europe will be required to undertake for the foreseeable future.

A word about Europe’s banks: they matter a whole lot more to the Eurozone economy than America’s banks matter to ours, which is why the immediate impacts of this situation are quite severe to the real economy. America’s banks engage in a whole lot of flow trading and barely-concealed market manipulations to achieve profitability. In Europe, however, banks actually lend money to businesses, a function which in America is provided not by banks but by a very deep and liquid range of capital markets. If the US banking sector were to be cut in half overnight, most people wouldn’t even notice. In Europe, economies would stop running.

So the Eurozone authorities scrambled over the weekend to partially walk back last week’s requirement of roughly 150 billion euros in new capital requirements for the zone’s largest banks. (Among the most affected are Commerzbank and UniCredit.) Everyone knows a bank can’t sell common stock when the price is down, so they’ve been substituting a whole raft of substitutes (for example, allowing banks to reclassify certain equity-linked debt as tier-1 capital). Other measures will include Dodd-Frank-like restrictions on dividend payouts and executive pay.

The weakened restrictions mean that the underlying bank-undercapitalization problem arising from the poor quality of sovereign credits, is simply not getting fixed in a convincing way. But the restrictions will still hobble the banking sector’s ability to generate new financing, which in turn puts a lid on growth and job creation. It’s the worst of both worlds.

Meanwhile, the EFSF’s “bailout fund” is being “strengthened” to about one trillion euros. That number wasn’t chosen at random. Greece has something more than 300 billion euros in outstanding debt. But the far larger figure is intended to create a perception that funds would be available in case a need ever emerged to bail out ITALY or SPAIN, in addition to Greece. Those are the elephants in the room, and the question of who will guarantee their debt is first and foremost in the minds of market participants.

But a very strange mechanism is being proposed to improve the credibility of the EFSF. No one is going to make a straightforward one-trillion euro guarantee. Because whoever does, will be crucified by her (or his) country’s voters. So they concocted this “super-leverage” scheme in which the first 20% of losses on any affected debt issue will be guaranteed.

This isn’t satisfying anyone. Does it amount to a put option to sell debt at 80 cents to par? Well, no it doesn’t. At least, that’s not how I’d look at it if I were a bond buyer. To me, it looks more like a put option at 20 cents. Remember, lots of Greek debt is trading way below 80 cents right now, and from the looks of the interest-rate action in Italy, their notes and bonds are going to come under a lot of pressure too.

What I think happened is that no one was willing to write a blank check for a trillion euros, so Merkel and Sarkozy figured they could get away with one fifth that much, and supplement it by forcing banks to raise capital by a somewhat smaller but basically similar number.

It took Jean-Claude Trichet, the retiring president of the ECB, to call a spade a spade. He said that absolutely nothing can be solved unless Europe’s supernational authorities (including the ECB) acquire the powers of a real finance ministry, rather than having to defer to national governments. At this, Sarkozy boiled over, because the French have been hinting strongly at this since the beginning of the crisis.

And that’s something that the Germans simply can’t give on, because at the end of the day it means that Germany, and Germany alone, would need to surrender to non-government entities the power to tax German citizens.

The blistering, blinding, caustic irony of this, is that this is PRECISELY what Germany is in the process of imposing on every other state in the eurozone, including France. This is the meaning of the “oversight” provisions in last week’s plan. Countries from Greece to Spain to Portugal and even to Italy will be required to host “international” observers with power to impose sanctions if fiscal austerity targets aren’t met.

It’s not at all too strong to say this: the fourth German empire is now being established in continental Europe. If nation states must surrender their fiscal decisions to external authorities, they’ve given up their sovereignty. And the point of all this is to prevent exposing Germany’s taxpayers to open-ended bailouts while maintaining the powerful advantages of the euro, which has given Germany 6 percent unemployment while everyone else struggles with much higher levels.

What’s going to happen to Greece isn’t pretty. Even with the 50% haircut on some of their external debt, the continuing austerity ensures that they won’t able to grow their economy, and they’ll end up in just as much fiscal trouble in a few years as they are now. What’s totally hellish is that the same will happen to Spain and Italy, and this is criminal because the Italians are not in serious fiscal trouble. But with the new restrictions on their freedom to run their country, they’ll get there fast. A gold curtain is descending across Europe from Berlin in the north to Athens in the Aegean.

This is why the normally-affable Berlusconi left the conference in such a sour mood. He knows he lost this battle. What’s worse is that Sarkozy is starting to suspect the very same thing himself. Because the same stress will spill over into France, eventually.

The euro is now in an extremely tense position. Its value is being powerfully supported by the welter of financial guarantees that is causing huge amounts of investable funds to flow into euro-denominated government paper. (The same is happening to the dollar and to sterling, by the way.) But at the same time, the single currency is vastly overvalued relative to the economic reality in the zone. And both effects are going to get worse, as austerity starts to really bite everywhere except Germany.

So in effect, the euro is now both under- and overvalued. The tension will eventually tear it apart.

This was an extraordinary statement, containing several rarely-seen features. The first one, of course, was the commitment by the Fed to keep policy interest rates at or near zero until the middle of 2013. Never before to my knowledge has the Fed put a specific schedule on its interest-rate guidance. The expectation by market participants has been that the Fed would start raising rates as soon as economic conditions (notably unemployment) improved, and they could argue over the timing. Yesterday, that changed.

Any interest rate is the risk-adjusted sum of a series of shorter-term interest rates. When the Fed says that policy rates will be zero for the upcoming 24 months, they’re effectively telling the market that the interest rate on the two-year Treasury note is also zero.

That had an instant effect on the capital markets. It jacked the whole front-end of the yield curve down by nearly 30 basis points. The two-year note briefly traded at a record low yield of about 16.5 basis points. The 10-year note, which had been yielding about 2.30% at 2.15pm, suddenly zoomed upward in price, its yield plunging to an all-time low just above 2.03%.

All this happened in a matter of minutes. It was possibly the wildest move in rates that I’ve ever seen. And of course, the stock market followed rates lower, dumping about 350 Dow points in about 30 minutes.

What happened next was remarkable. About 2:45pm, rates suddenly reversed, and stocks came with them, leaping about 600 Dow points to close the session with solid gains. The two-year note finished the day yielding about 20 basis points, an all-time low, and the 10-year finished about 2.24%. After the close, talking heads rushed to explain the sudden reversal by saying that traders took half an hour to digest the Fed’s statements and decide that it was all good news after all.

I’m not buying that. You don’t really have time to think when the 10-year note is racing up to an all-time low yield. The shape of the tape yesterday afternoon just has the classic look of panic buying, followed by a panic reversal. It simply makes no economic sense for the 10-year yield to be near 2%. I also surmise (without direct evidence) that a lot of short covering went on in the final hour of stock trading yesterday.

Was it a “flash crash”? I doubt it. From what we know about flash crashes, they’re characterized by a withdrawal of liquidity as computer algorithms suddenly yank out their bids in market turbulence. But it looks to me that the rally in notes led the collapse in stocks. Lack of bids wasn’t the problem.

The other critically important aspect of the Fed’s announcement yesterday speaks to a new recognition that the problems faced by the US economy are structural in nature, rather than cyclical. This isn’t a garden-variety recession characterized by demand inadequacy, that can be alleviated with government stimulus spending. This is something different.

The Fed is silent on what the difference is. But if you’ve been reading me here at RedState for the past three years, you already know what I think: the consumer sector has to rebuild its personal balance sheets after the housing-bubble collapse. Individuals are trying to deleverage, a process that will reduce demand relative to trend for several years yet to come.

Deleveraging is secular, not caused by politics. But another major headwind in the economy comes from uncertainty among business people about future policy and regulations. It’s no exaggeration to say that the current Administration is the most anti-business in many years. Every time the President of the United States opens his mouth, he talks about raising taxes on business and capital. If you’re responsible for business investments and you have a pretty good idea that your future successes will be punished by higher taxes, wouldn’t you feel discouraged?

The bottom line is that structural changes in the global economy (including the still-huge problems in Europe) are needed to get things moving in the right direction again. A few hundred billion dollars in stupid stimulus spending isn’t going to do it. My interpretation is that the Fed is finally acknowledging this.

One more point, and this is something I’ve stressed repeatedly in private communications lately: we are NOT facing an imminent financial crisis in the manner of the disorders of 2007 and 2008. The liquidity impairments in interbank markets just aren’t there. The stock market in my view might yet have some way to fall, but we’re not at the edge of a meltdown. And the S&P debt downgrade is basically immaterial to the markets. But that’s a story for a different post.

And if you want an intensely contrarian market call, look at the 10-year note. No less recently than the last week of July, it was yielding over 3%. It’s had a simply incredible rally over the past two weeks. This rally might partially reverse over the next few weeks or months.

Congressman Eric Cantor remarked at one point in the debt-ceiling debate that the Democrats (including Obama) were totally stuck on the idea of raising taxes. But Cantor stressed that they never presented an economic rationale for higher taxes. It was all about class warfare, pure and simple.

Class warfare is like catnip to progressives. The problem with class warfare is that it doesn’t give us growth and jobs. At least a few of the Democrats recognize that growth is a mandatory part of a fiscal-reform strategy (higher taxes and spending/entitlement cuts are the other two).

Remember the Bush tax-cut debate last year? Then, Democrats readily admitted the numbers: the Bush tax cuts on high earners were worth an estimated $700 billion in revenues over ten years, while the same cuts on everyone else were worth about $2.8 trillion.

You can raise taxes on high earners, but you don’t solve any economic problem that way. There just aren’t enough rich people to buy candy and bubble gum for everyone else. Plus, you kill job growth by wiping out their incentives to take on economic risk.

So it’s plain and obvious that the ONLY motivation that Obama and the Democrats have for their “balanced approach” is class envy. Economics has nothing to do with it.

Let’s challenge the Democrats on this one. If they’re so committed to the idea that we need higher taxes, then let them propose a broad-based, regressive increase: either a VAT, or a large payroll-tax rate increase (which Reagan also did).

Just do it, Democrats. You want higher taxes? Then propose higher taxes that really will reduce deficits while minimizing the effect on job creation. Otherwise, shut up.

If you’re an investor in Italian or Spanish (or French) debt, your goals are pretty simple: you just want to enjoy the benefits of higher interest rates, while being assured by someone more credible than Spain or Italy that you’ll get your money back. Can’t blame people for wanting a free lunch, especially if Uncle Trichet is scared enough to offer it to them.

There are two enormous problems with Trichet’s announcement:

1) It represents a complete abandonment of the ECB’s iron pledges not to pull national governments out of the fire; and

2) We’re talking about far more debt than the ECB can possibly buy without creating a lot of inflation. They simply don’t have the resources to sterilize it all. And if they stop short, the move won’t have the market impact they’re looking for.

To the first point, the ECB can now forget about their pretense of being a “pure” central bank, or monetary authority concerned about nothing but preventing inflation. This kicks out one of the props supporting the euro as a credible reserve currency.

The second point puts Germany in a terrible bind. The resources needed to backstop Spain and Italy can only come from Germany, where the taxpayers have been getting restless.

What the Germans had hoped to do with the euro is to create a whole raft of captive export markets across the southern tier of Europe, so they could continue to create high-value jobs in Germany. Germans are nothing if not disciplined: for much of the past decade their economy has underperformed as they slowly built up the eurozone toward that goal.

But now they’ve come to find that the Latin economies simply aren’t productive enough to sustain the higher level of external obligations that comes automatically with higher trade deficits.

The euro was supposed to prevent deficit countries from stiffing the Germans the old-fashioned way, through currency devaluations. Instead, the Germans are finding that they now have to stiff themselves, by guaranteeing their debtors’ IOUs. To this, add the very good possibility that they’ll have to accept repayment in depreciated euros.

Still, you have to admit this is better than Germany’s historical solution, which is war.

Trade predation as a strategy is proved yet again not to be sustainable over time. The Chinese have gotten away with it longer because their prey (the US) is bigger and stronger than southern Europe. The US debt downgrade story is proximately caused by US political dysfunction, but trade imbalances instigated by the Chinese are an essential part of how we got here.

Italy’s long-term government debt is now yielding in the high 6s, more than 300 basis points higher than German debt of comparable maturity. Italian CDS prices are very high, up in the 380s. As Trichet embarks on an Italian-debt purchase program, those spreads should narrow. The next thing to watch out for is inflation.

Germans HATE inflation. If that’s what lies ahead for Europe, maybe Germany’s voters will form their own Tea Party.

Even so, today’s media game has been all about deciding who got the better deal. Many of the partisans think they came up short, and are looking to blame their guys. In the media (which sees any legislation as an achievement, no matter how hollow, cynical, or ultimately ineffectual), many are scoring this as a win for both sides. (That’s to say, all of the parties will be able to go back to their respective bases with something to brag about.)

Around the middle of last week, I lost track of the specific content of the deals, which was in constant flux. And the media lost track of it too! The only reporting, it seemed, was about who was up (Boehner, Reid, Obama) and who was down at any point in time. That tells you all you need to know about how cynical and empty this whole process has been.

I’ve given some of my views on the deal that was struck in Coffee & Markets. Suffice to say that the deal is substance-lite. Conservatives will find (or have found) that tax increases and defense cuts are indeed on the table as the fiscal debate continues. Liberals are dismayed that the sacred status of Social Security, Medicare, and Medicaid was not enshrined in first-order language. They fear that cuts may be made to these programs. (Of course, they need not worry, but they will.)

The leadership in Congress, on both sides and in both houses, comes out of this in varying shades of black-and-blue. But ALL of them, even Pelosi, are black-and-blue. This episode won’t go down in history as Congress’s finest hour.

But while the economic and policy objectives of the fight may be clear enough to partisans outside of Congress (and might even be somewhat meaningful to ordinary people), this ultimately was a fight about politics.

And in the political analysis, there is only one player who came out of this with everything he wanted: Barack Obama.

Obama wasn’t trying to advance a policy objective. Not even once did he let the articulation of such a thing pass his lips. Rather he had two specific objectives that he had to get at all costs:

1) To get Republicans to propose specific spending cuts that Democrats can use against them in the coming elections, while not making any such proposals himself; and
2) To silence the fiscal debate until after his election in 2012.

The president won on both counts. Everything else that was at stake in the negotiation was a nice-to-have for him, not a need-to-have.

No one else got their must-have objectives. The Republicans have to face the prospect of tax increases combined with spending cuts that will be phony at best. And the Democrats will have to keep justifying entitlement programs that we can no longer afford.

The downside for conservatives is clear: We’ve lost our last chance for a meaningful discussion on fiscal reform, until there’s another financial or economic crisis.

But liberals have lost even more. It turns out that Obama was only willing to fight hard for his own political objectives. If liberals choose to be honest with themselves, they’ll see that both they and the media made the mistake of conflating their policy interests with Obama’s personal interests.

Obama himself never made that mistake for a second.

I must say that I found it weird to hear John Boehner and others talking about making a deal before the trading week starts. (And if you’re a long-time RedState reader, you know I’m the guy who was watching the market opens every Sunday evening with my heart in my mouth during the 2008 crisis.)

There’s nothing to suggest that a legislative failure today or over the next week would significantly disrupt markets. I think there’s considerably more risk in the other direction. Markets have sold off risk-bearing assets and lowered interest rates in response to the uncertainty, but as soon as there is a deal, I expect markets to recover robustly.

When I say “as soon as there is a deal,” I mean that the monkeys in Washington will stop howling and throwing feces at each other long enough to ink a three-month debt-ceiling extension with no other commitments beyond a promise to keep howling and throwing feces at each other.

I will say that I admire how Boehner has handled the situation over the last few days. I’m confident (for more than one reason) that he fully understands the need to keep financial markets from becoming disrupted. But at the same time, he’s doing his job, which is to lead a fractious Congress. He’s not going to hand the president a cheap victory. Meeting both objectives at the same time is a big lift, and he’s doing it.

It’s going to take a very great deal of work in Washington to arrive at a fiscal-stability framework. If the last few days have proven anything, it’s that this work will need to be done in Congress. Of course this flies in the face of much conventional wisdom, but then conventional wisdom isn’t used to dealing with an indecisive, disingenuous and hyper-partisan US president.

Given all that, the best outcome for markets is a short-term debt-ceiling increase, covenant-lite. Give it three months, and keep the discussion going. The markets will hang in there. (Unless the Greece thing blows apart.)

What markets will NOT react well to is very well known, and has been known all along: a decision by the US to execute a sustained default on outstanding debt. It’s the height of irresponsibility for certain individuals in the Administration to have been floating this as a possibility in order to gain some kind of negotiating edge.

Secretary Geithner, I’m looking at you. Your boss doesn’t know any better, but you do. You sign the dollar bills. America’s creditors are YOUR creditors as long as you’re the Secretary of the Treasury. Shame on you for some of the things you’ve been saying.

Update, about 7pm EDT: energy prices down; precious metals up; dollar is off its lows; stock prices indicating about 1% lower. Still no interest rates. Looking like a weak open but not nasty.

The underlying politics is as follows: the American people are sick and tired of deficit spending. The pundits are completely wrong when they downplay this issue, because deficits are FAR worse now than they ever have been in peacetime (10+% of GDP). And they got far worse at almost the exact moment Obama was elected president.

The practical politics looks like this: Congressional Republicans chose the otherwise-routine moment of a debt-ceiling increase to draw a line in the sand and press the deficit-reduction argument, on behalf of the American people. But by linking two things that don’t really belong together (the political objective of deficit-reduction with the technical objective of funding the government), Republicans have backed themselves into a corner. Their position is strong on the merits but extremely weak in practical terms.

And the practical weakness of the Republican position arises from the economics of the issue. There’s been a lot of argumentation of this point, most of it pure garbage spouted by people (including economists) who know little or nothing about capital-market dynamics or practical finance. I happen to know something about both, and I’m going to tell you the truth about the matter.

Point 1: A US default on debt service is pure unthinkable, FULL STOP. Larry Summers, for once, is absolutely right: a sustained debt default would very likely produce market disruptions comparable to, or worse than, the fall of 2008. However, at only about $200 billion and change per year, avoiding a debt default would be easy. The President, the Treasury Secretary and others are lying by omission when they fail to stress this point.

Point 2: A failure to increase the debt ceiling would produce a deep economic recession, almost instantly. We’re talking about cutting out an amount of spending that’s almost 10% of the economy. The 2007-09 recession only dropped the economy by about 6%. We really DON’T want a failure to increase the debt ceiling.

This leaves us with an unsolvable political dilemma. Neither the White House nor the Congressional Republicans want to back down. Implementing some version of the McConnell plan would be a pure victory for the president, as it would produce the same result as if Republicans had never taken up this fight in the first place: we’d have continuing high deficits, continued high spending, and no movement on the tax issue.

Clearly enough, McConnell is trying to solve the Republican’s political problem in what he thinks is a clever way. He couldn’t be more wrong. The only thing the public will see is that the president, against all prior expectations, somehow found the leadership skills to keep the Republicans from gutting Social Security and Medicare.

So the McConnell plan is, or should be, a non-starter. But so is a grand bargain to reduce deficits by cutting spending and (maybe raising taxes). There just isn’t the time to put that plan together before August 2. Especially not a plan that wouldn’t be like every other deficit-reduction compromise in history (that is, with tax increases now and spending cuts in some future that never seems to arrive).

But the issue of deficit reduction is of critical importance to the country. The president wants to get it off the table any way he possibly can, because the only thing he has to say about it is that our taxes are too low. As Walter Mondale could tell him, that argument won’t get him re-elected.

So here’s what Republicans should consider doing, in light of all the above:

Congress should immediately pass a ONE-MONTH extension of the debt ceiling, authorizing exactly enough additional borrowing to continue funding the federal government, at current spending levels. (No increases, not for COLAs, weather emergencies, war supplementals, or anything.) Include language directing both Congress and the president to continue good-faith negotiations aimed at finding a permanent solution to the problem.

Then, one month from now, DO IT AGAIN. Then in another month. do it yet again. Rinse, lather and repeat every month until either the president changes his mind about true deficit reduction, or the next election comes.

If the president should get fed up with this, or Senate Democrats fail to pass it in any given month, then he and they will have the privilege of explaining their intransigence to the American people.

This is the only way I can think of to avoid a market and economic catastrophe while continuing to keep the deficit-reduction issue front and center. Any other outcome takes the issue off the table permanently (or at least until interest rates blow up), and also hands a gargantuan political victory to the Democrats.

The June number has been widely anticipated because the May number was such a stinker. If these reports are accurate, it looks like the US economy suddenly slammed on the brakes and stopped creating many jobs, late this past spring. Many people believed that the May number was an outlier, and the June number would correct it on the upside.

Instead, the June report looks like a repeat of May. Nearly every sector is continuing trend. Mining, leisure/hospitality, and business services all created jobs, but not in excess of earlier trends. Manufacturing, which had been strong earlier in the year due to the auto industry, has stopped growing. All levels of government are losing jobs rapidly.

Market reaction was swift and negative. Note and bond prices had been quite strongly on the downside ahead of the report, which was released at 8:30 AM EDT. All week, sentiment in markets has been very strong, with many people starting to talk about a return to strong economic growth in the second half of the year.

This report pours cold water all over that story line. Notes and bonds immediately turned upward. The 10-year Treasury note was yielding 3.16% at 8:28 this morning. The yield plunged all the way to 3.06% just a few minutes afterward. Stock-markets had been indicating a mildly higher open, but immediately turned sharply downward. Clearly a lot of people were surprised by this report.

The bottom line, to me, is that the weak economic conditions of the second quarter will continue for some time longer. I’m not reading the report as a reason to panic. It’s not good news, by any means, but it’s not a disaster either.

Unless, of course, you’re a President of the United States who has been trying to convince people that you’re actually doing good things for the economy.

Sarkozy has been trying to arrange for existing lenders to Greece (mostly large French and German banks, too big to fail) to accept rollovers of debt maturing over the next three years, in the form of 30-year Greek bonds backed by strong collateral, or five-year notes backed by nothing.
So if you were a TBTF bank, what would induce you to accept new debt issued by an obviously bankrupt country without demanding a crushing interest rate?

That’s pretty easy. You’d do it if you had a guarantee that someone would stand up and accept your Greek debt as repo collateral, no matter what. And that someone is, of course, the ECB.

The problem at the ECB, however, is its president, Jean-Claude Trichet. He’s eager to protect the value of the euro, which of course is his job. So against nearly everyone else in Europe, he’s been holding out on the default question. He won’t (can’t, really) guarantee that any new Greek paper will be accepted at the ECB’s discount window unless at least one of the ratings agencies declares that the debt swap does not constitute a default.

The “Austrian alternative” (debt swap) plan is being presented as something that Greece’s lenders would accept on a voluntary basis, and hence not really a default. But the truth is that their only alternative is to accept a real default. The terms of the indebtedness are changing materially, in a way not favorable to the lenders. For this reason, the ratings agencies have started saying that they have to consider the swap to be a default of some kind, and that’s what stirred up the markets yesterday.

So now, the agencies, the political authorities (acting on behalf of the banks), and Trichet are negotiating over language that will allow Trichet to consider the “default” a short-term, technical one, rather than a permanent breach of covenants. So far, they’re talking about putting the Greek government itself on a “selective-default” rating, down from its current CCC/Caa1, and not changing the rating of existing securities at all. The selective-default rating would be lifted as soon as the upcoming rollover is completed.

What Trichet has to decide is whether he can accept this rating language, and continue to offer a “money good” pledge to accept Greek paper at the ECB’s discount window.

If they can’t get past this hump, Greece becomes this year’s Lehman Brothers, and the world replays the autumn of 2008.

Because this outcome would suck, you know they’re going to figure something out. But I’d forgive you for considering that the credibility of the euro is now showing some huge cracks. The Europeans are praying that this charade ends with Greece. If Spain or Italy have to negotiate phony debt guarantees as Greece is doing, the dikes won’t hold.

There is something afoot called the “Vienna alternative” under which holders of euro-denominated debt issued by Greece would voluntarily agree to roll over their holdings on terms that are materially less favorable to them, either in terms of maturity, interest rate, collateral covenants, or whatever.

What is this “alternative” an alternative to? There are (at least) two other ways this could go. One is an involuntary restructuring of debt terms, initiated by the Greek government without agreement from its creditors. That’s also known as a default. Various ratings agencies are now in the process of heatedly debating whether the voluntary version should also be considered a default.

The other way this can go is for a broader and permanent version of what happened last year: the supranational monetary authorities (primarily the ECB and the IMF) would make a money-good offer to buy out Greek debt at a certain price, most probably higher than current market, implying a significantly lower interest rate.

This is the full-bailout strategy. If the IMF is a major player, it could be carried out using capital imported from the non-euro zone. The latter outcome would be a big winner among French and German politicians.

And now you know why the Europeans are pushing so hard for a Frenchwoman to take the place of DSK at the helm of the IMF. If the price for US support is to give the presidency of the World Bank to Hilary Clinton, well, that would be congenial to the people now running the US government. Both Clinton and Lagarde are lawyers, not economists or financial experts, and both are European-style socialists.

But as I hinted above, there is a specific interest group that is being cared for above all others, and it’s the current holders of Greek euro debt. A great many of these are banks in France and Germany.

During the past ten years, these banks loaded up on debt issued by Greece at very favorable interest rates, in effect strongly underpricing the risk of this lending. When the Greeks ultimately proved uncreditworthy, the natural effect of the underpricing was to unwind itself, with a sharp increase in interest rates on outstanding debt.

This had two immediate effects: Greece may become unable to roll over its existing borrowings (because of the high rates), threatening it with economic chaos; and its past lenders are facing capital losses on a mark-to-market basis, and even the possibility of default.

You’ll notice more than a few striking similarities in this to the 2008 crisis touched off by the failure of Lehman Brothers. (To point them all out would be another long post.) Then as now, the primary fear of policymakers was to avoid a “credit event” that would produce a cascade of capital losses among large, interconnected financial institutions. In other words, a meltdown.

At the moment, there are no indications anywhere in capital markets that such an event is imminent. This contrasts sharply with the deeply disordered conditions that prevailed from the summer of 2007 right up to the events of September 2008.

At that time, Henry Paulson drew his line in the sand and told the world that Lehman Brothers would not be supported by extraordinary efforts of US policymakers: Lehman would not be bailed out. Paulson and his team went to tremendous lengths to browbeat other institutions into mergers. But no one was willing or able to acquire Lehman.

Paulson here was trying to do the right thing, but he of all people must have understood that he was threatening the most important assumption in the whole global financial system: PRIVATE CREDITORS NEVER TAKE LOSSES.

It only took three days after Lehman failed for it to become evident that the fallout from that event (which directly affected perhaps one trillion dollars’ worth of assets) would be enough to end the global financial system, and quite likely halt the global economy. That’s the situation that was addressed by TARP, and by a whole raft of asset-purchase programs by the Fed.

Conservatives who think they understand finance like to say that TARP was a huge disaster. Very few of them have any clue that the Fed’s programs were a far larger “disaster” of the same type as TARP. And it’s the same type of thing that the ECB and IMF may now be about to undertake on behalf of Greece.

The fundamental nature of all these rescue programs is to use “social” money (which is ultimately guaranteed by taxpayers) to force up the value of assets that are impaired or valueless. The objective of the rescues is to ensure that PRIVATE CREDITORS NEVER TAKE LOSSES.

In the presence of an open-ended official buyer, holders of Greek debt could either tender (and take an enormous capital gain from current market values); or hold their debt and benefit from the huge interest rates without having to reserve large amounts of regulatory capital against it.

Of course, if the full bailout of Greece happens, the people of Greece will take it in the neck, with onerous fiscal-austerity requirements. They’ll suffer a permanent reduction in living standards, in order to pay back their old debts.

Policymakers will strongly prefer this course of action, and primarily for this reason: because it will allow private creditors in France and Germany to avoid taking losses. No one wants to see a big name French or German bank become the next Lehman Brothers.

A great many conservatives would respond to this the same way they responded to TARP: “Let the bankers fail! No one held a gun to their head to force them to make stupid loans.”

Except that this isn’t quite true. Policymakers and politicians DID INDEED encourage private lenders to expand their commitments to Greece; and to many other defaulting countries; and to US homebuyers, etc etc etc.

The point here is that the expansion of credit is what has stood behind the broad-based economic growth of the three decades to 2008. If bankers didn’t take more risk (with implicit government guarantees), then growth would not have been so strong. There has been clear political support for credit-driven growth in the developed economies for decades now.

But as it turns out, the cost of that risk could not be avoided. When we use official money to buy impaired assets at nearly (nominal) par, the effect is to ratify the original overpricing of this risk, and to shift the resulting losses from private creditors to taxpayers. The INEVITABLE result is an effective deflation or austerity.

That explains the position of Greece today; of the US economy after the housing-bubble collapse; and most ominously, of the US in the near future as we come up to a huge expansion in social commitments.

It would be a very interesting experiment indeed for someone to take a step back to sound banking, in which private creditors are actually allowed to fail. One of the thought-experiments I’ve been running is: what if Congress passed a law to allow American homeowners to simply default on their mortgages with no questions asked? You’d lose all the equity in your house and your other assets, but you wouldn’t lose your job, and you wouldn’t lose your ability to go into a rental. And your bank would take the loss.

Unfortunately, no one wants to take the risk of total systemic collapse that this would entail.

Therefore, continued austerity and low economic growth is in our future. Inevitably.

Diamond wants to be a governor of the Federal Reserve. Barack Obama wants the same thing, having nominated Diamond three times now. He had only a small amount of support from Senate Republicans, mostly from Michael Bennett and Judd Gregg. After being dissed by Richard Shelby, Diamond is now withdrawing is candidacy. (There are currently two open Fed governorships.)

Peter Diamond thinks he should be on the Fed’s board of governors because he won the Nobel Memorial Prize in economics last year, for his work in fundamental market dynamics, particularly in labor markets. He’s not going to get the job, and he thinks the reason why is that Republicans are too stoo-pid to be impressed by his Nobel Prize. In the New York Times, he says quite straightforwardly that you’d think a Nobel Prize would be  qualification enough for him to have the job, but that Senate Republicans insist on questioning his candidacy.

Never mind that blind faith in technical expertise over the politically-expressed will of the people is the source of a great many of our nation’s problems. Also never mind that technical accolades aren’t necessarily qualifiers for powerful positions. Should Republicans back Nobelists Paul Krugman or Joe Stiglitz for Fed governorships? Should we back Nobelist Barack Obama for President?

Diamond says, again in so many words, that choosing the leadership of the Fed should not be a politicized process. But what he is doing here is making a post-hoc case for his own candidacy based on a tendentious reading of the Fed’s history and mandates, as well as begging the question relative to his own qualifications.

Ok, let’s get into it.

Peter Diamond is an expert in how labor markets match supply to demand. This turns out to be a sticky and sometimes inefficient process. Well, big surprise. I can see how this would be a revelation to an academic economist, but it’s not news to anyone who is in the trenches, running a business and trying to create jobs. Quite a good  deal of the work that macroeconomists do, including Nobel-quality work, amounts to quantifying common sense. The old crack “that’s all very well in practice but it’ll never work in theory” contains more than a grain of truth.

But I’m entirely happy to grant the value of this work. What matters more is that Diamond faults Republicans for failing to recognize what is obvious to him, which is that understanding labor markets is core to making monetary policy. Well, let me pile on and fail to recognize it as well.

The nugget of rigor in Diamond’s piece comes at this point. He has studied the nature of current unemployment and has determined that it’s cyclical rather than structural. Forget about the fact that this is far from proved. What it means in his view is that fixing unemployment is something the Fed can and should do.

And that means in turn that aggressively accommodative policy is currently what is needed to fix unemployment. With this, Peter Diamond has openly violated the Souter Principle, the cardinal sin of aspirants to high government power: he let the cat out of the bag and told everyone what he really wants to do. In this case, he wants to join the Fed’s dovish wing, with continued low interest rates, quantitative easing, and all the rest.

Diamond makes the case that being a labor specialist is just what qualifies him most for a Fed position. I think it’s extremely dangerous to elevate someone who will take this perspective above all else.

Why? Because I think it was a very bad mistake for Congress to add employment stabilization as an explicit part of the Fed’s mandate in 1977. There is room for a labor-market specialist like Diamond in a policy-making position at Treasury, or perhaps in a research position in the St. Louis or New York Fed banks, but not as a policymaker on the Fed board.

The reason that Congress made this critical error in 1977 is because that was an era of stagflation (which may also be true today). Congress and the Administration were struggling with the fact that they had no clue how to effect countercyclical policy under such circumstances, so Congress decided to “do something” about the problem: they passed a law making it the Fed’s problem.

Subsequent Fed leaders have taken the “dual mandate” very seriously (it’s the law, after all), with sustained deleterious effects on the conduct of monetary policy.

The Fed has two essential jobs: first, and foremost, to be a lender of last resort in times of crisis. Second, to ensure a stable currency for the United States. It has enough to do just with these two tasks.

During the New Deal and subsequently, a third mandate was added to the Fed: to regulate the banking system. With the advent of deposit insurance, the practice of banking suddenly needed strong, central regulation. (You can’t have deposit insurance and laissez-faire banking. They mix about as well as oil and water.) The need for banking regulation is not controversial, but it’s not necessarily the case that the Fed is the best entity for the job. (I won’t take up that argument here.)

And as I mentioned, the fourth Fed mandate (to maintain monetary aggregates at a level consistent with full employment) was added in the late Seventies.

Unfortunately, Diamond glances tangentially off these points of history as well. In swiping at Republicans, he says that the process of choosing the Fed’s leaders should not be politicized, because the Fed’s independence must be protected. And why must it be? As Diamond tells it, because political independence is needed to maintain sound money, and also to effectively regulate banking and foster high employment.

I agree 1000% with the first of these, but I disagree with the second and the third. The very LAST thing we need in the United States is to realize the technocrat’s dream of politically unaccountable regulators making economic policy, on top of the monetary policy which they SHOULD be making. Senator Shelby is right on target here.

And let’s talk about Mr. Diamond’s qualifications in regard to actual monetary management, including what Sen. Shelby referred to as a lack of experience in crisis management. To this point, Diamond is arrogantly dismissive. Perhaps he thinks of Sen. Shelby as an ignorant partisan rather than as a duly-elected representative of the people of Alabama.

But Shelby is right. The two top Fed positions are currently held by policy doves (Bernanke and Yellen), and their management of countercyclical policy has been indifferent at best. We still have over 9% unemployment. Macro policy in times of non-crisis should simply not be the Fed’s job. We don’t need another dove at the Fed, and particularly not another dove who is willing to throw around the weight of his Nobel Prize.

But Ben Bernanke is absolutely the right man to be leading the Fed at this moment. An academic economist himself (though not a Nobelist), he was plucked out from Princeton by President Bush, and put into the hottest seat in the world just before it got hot. Bernanke’s specialization is not labor markets, but rather the credit and financial dynamics of the Great Depression. When the 2007-08 crisis hit, he was perhaps the only person in the world with the knowledge and the insight to do the right things.

And Bernanke did so many of the right things, against so much current prevailing wisdom, that he deserves to go down in history as the man who kept the financial crisis from being a lot worse than it was. Now of course, Barack Obama will tell you that he, not Bernanke, deserves this credit. But that ignores a critical point that goes right to the Peter Diamond case.

The 2007-08 crisis was a financial crisis that eventually devolved into an economic disaster. The specific channels through which this happened is still unclear, and may not be resolved for years to come. (Bernanke himself was among those who elucidated how it happened in the early Thirties, but not until fifty years later.) Bernanke’s bold crisis management alleviated the financial mess, although the economic aftermath is still with us.

It became blindingly clear in the fall of 2008 that the Administration and the Congress were institutionally incapable of handling a fast-moving global crisis. Only the Fed, with its relative freedom of action and the happy accident of effective leadership, could manage the situation.

THE SAME WILL BE TRUE IN THE NEXT CRISIS. Being ready for it is, and should be, the true core objective of the Fed. A guy like Peter Diamond may be eminently qualified for his post at MIT, and even perhaps for the op-ed page of the New York Times. But he doesn’t belong at the Fed.

At least some of this has to be due to the supply disruption caused by the US hitting its debt ceiling. (Existing debt can be rolled over, and the Treasury has continued its weekly auctions, but there are constraints on the creation of net new debt.) This is even though I’ve talked to well-informed people who felt that this effect would be muted at best, because everyone knows that the debt ceiling will be raised, easily, and more or less on time.

I’m frankly not buying the idea that markets are going bananas because of all the rotten economic stats. I’ve been telling people for more than two months that an economic slowdown was on the way, and I’m not the only one who saw it then. It’s not a surprise.

And how does this interact with the end of QE2?

Most of the piece is a recital of stuff that everyone already knows. Leonhardt does touch on the fact that Bernanke will start giving news conferences today, but doesn’t go into what makes this interesting. (There is some new-ish monetary theory out there which holds that public explanations of policy are key to making it work, and for non-obvious reasons.)

Also, we know very well the horrible social and economic consequences of prolonged high unemployment. And, we know the Fed believes inflation is well-controlled. (It is, even if much of the lay commentary on the subject violently disagrees.)

And it’s a very serious misreading of both Bernanke’s personal character and of the nature of his job to suggest that he can (let alone should) steamroll the dissenters on the Fed’s policy-making board, and just step up to be a big-time unemployment fighter.

But forget about all that. The real problem is that Leonhardt assumes there’s something the Fed can do about high unemployment. That’s the part I really wanted him to go into some chewy detail about. But he didn’t.

He says (without links or direct quotes) that Bernanke believes the Fed has the tools to reduce high unemployment. I believe (without proof) that this is a misunderstanding by Leonhardt. Bernanke (and colleagues like Fed vice-chairwoman Yellen) have long insisted that the Fed has the tools to control high monetary inflation, should it appear. But I’ve seldom heard them make a parallel point about unemployment.

Where Leonhardt leaves it is to simply accept the Economics 101 idea that lower interest rates will magically reduce unemployment. That’s not good enough.

Leonhardt suggests that Bernanke could announce a policy of zero policy rates for “several years,” instead of the current formulation (“an extended period,” which has been in place for two and half years with no end in sight). It’s true that a long-duration interest rate is the sum of a series of short-term rates. Making this announcement might have some effect on the middle of the yield curve.

But there are at least three problems with this: first, it would be a minor effect at best. Second, as with QE2, it would have an effect on industrial interest rates only at the high end of the credit-quality scale, where capital is already abundant. This is NOT a solution to the unemployment problem.

And third, the continuation of zero interest rates is creating huge distortions in the normal flow of capital to business and industry. We can’t go even farther in this direction, which is what Dave Leonhardt implicitly suggests. We really have to get off the mat and start into a more normal policy. I do NOT accept that raising the policy rate to, let’s say, 1.25% by the end of this year (the Europeans are already there) will have a significant chilling impact on hiring. I could give you the reasons why I believe this, but that’s another post.

Leonhardt also proposes that the Fed announce a policy of officially tolerating a higher amount of inflation going forward. Trust me, this is not a tiger you want to let out of its cage. You’ll get a big swing in rates in the midcurve and at the long end, with no beneficial impact on economic activity. If Keynesianism is such a good idea, we should be seeing more beneficial effects from all the stimulus we’ve already put on. Instead, we’re getting asset bubbles.

Finally, Leonhardt says that the Fed chairman can simply tell the market that “he considers years of widespread unemployment to be unacceptable.” Let me suppress my true reaction to this idea, and instead ask you how you’d react to that. Would such a statement really cause you to shift your investment and business planning? I didn’t think so.

The bottom line is that the Federal Reserve is not the place to be looking for a way to reduce the extremely serious problem of high unemployment. We should be looking for them to begin a track to normalizing interest rates, congruent with the multi-year goal of allowing the banking system to slowly recapitalize.

And we should be looking to Washington’s other policymakers, in Congress and the Administration, to stop creating the most anti-business tax and regulatory climate that we’ve ever had in this country.

I don’t have a problem with extending the UI benefits. As I’ve said elsewhere, I think there are a few million people out there, mostly middle-aged, who will never see another job at their old rate of pay, and this is because the economy is changing, not because of recession. We’re going to eventually end up with permanent income supports for these people, so get used to it.

I do have a problem with the payroll tax cut: not big enough and not long enough. This cut will feed maybe $85bn or so into the economy next year (by the back of my envelope), but if we eliminate the payroll tax altogether (and both sides of it too), the hit could be more like $700bn. Now that’s stimulus I can believe in.

“But Francis, you hypocrite, you were against the $800bn porkulus last year.” Yes, but this is an altogether different stimulus. Last year’s was fed to Democratic state and local politicians, who passed it on to their union supporters. A full payroll tax holiday would go to ordinary people all over the country. And ordinary people are the ones I want to see empowered, not politicians.

To the deficit question: yes, a payroll tax holiday increases the deficit. Now show me a red-blooded Tea Party type who has a middle-class or low-end job and believes that, for deficit-reduction reasons, she should NOT get an immediate 7% pay hike, together with another 7% later as prevailing wages rise. The people don’t hate deficit spending. They hate deficit spending that provides no clear benefit to them.

Hard-core anti-Social Security types on our side have long wanted to reduce the payroll tax, just to prove to everyone that SS is just another current expense, and not truly an insurance benefit. Heads are exploding on the Left, where SS is one of the Ten Commandments, because none of them ever figured Obama would be the one to let this particular camel’s nose under the tent. This is a side-benefit that I’m happy to get.

The estate-tax reduction is a welcome surprise. No, it’s not enough, but we might get another crack at it later. And this is something that is pure class warfare, since the revenue it generates is trivial. I’m delighted to see the Left get hurt (by Obama, no less!) on this one.

On the income-tax reduction for high earners: Here, there is a deficit-based rationale for doing it the President’s way. But the argument from job-creation trumps it. Sorry, economists, I’m a job-creator myself, and I can tell you that increasing the drag on my company’s earnings most definitely cuts job growth.

And besides, what about Paul Krugman’s column yesterday? He literally told Obama to kiss off the deal and let EVERYONE’S taxes rise at the end of the year, if he couldn’t get a tax hike for high earners. Krugman let his true feelings show with that. He’s not about what makes economic sense. This has been pure class warfare all along.

And finally, on not allowing the capital-gains rate to rise from 15% to 39.6% with a 4% Obamacare surplus on top of that: HALLELUJAH, thank you Jesus! For this, I might even start saying nice things about the Republicans.

Political calculus: do not be surprised if this ends up playing as a win for Obama. He’s going to say that he’s really a moderate leader capable of making the compromises that it takes to govern. My guess is that by giving us so much of what we wanted, he strengthens his political position, not the reverse.

On the economic effects: YES. Removing the uncertainty surrounding tax rates will make a lot of businesspeople feel more confident about planning for growth and hiring. It doesn’t remove the fundamental drag on business performance in the US, which is poor final demand, but it helps.

Credit spreads on so-called “peripheral” European sovereigns are blowing out this morning, and government bonds of Portugal and Spain are falling sharply. Italy managed to tap the credit markets earlier today, but the interest rate was high and the subscription level was disappointing.

This can’t keep up. If investors continue to dial up the interest rates they charge Europe’s governments, there’s little chance of a sustained recovery. And that makes European states even less credit-worthy.

The Germans are in good shape. Switzerland and the Scandinavian states are in decent shape. The UK is on the fence. Everyone else, possibly including even the French, could be looking into the barrel of a gun.

So far, three different QE models have been observed in the wild: the Japanese (2001-06), the British (2008-09), and Bernanke I (2008-10). We’re about to see Bernanke II. All of them are forms of monetary accommodation (“easy money”), exactly as lowering short-term interest rates is.

The specific objectives and techniques vary, and these depend somewhat on the “style” of the monetary authority. For example, the Brits and Euros tend to target monetary aggregates like M2 and M3, while the Fed likes to look at consumer-inflation measures like CPI.

They call it “quantitative” easing because the mechanism involves increasing the quantity of money flowing through the economy. This isn’t the same as increasing the amount of reserves in the banking system (which is what you might do if you were concerned about impaired liquidity). We did the latter in huge amounts in 2008, and it did nothing to improve the overall economy. I’m referring to this distinction when I talk about “bank money” as opposed to “economy money.”

The simplest way for me to express the problem with QE is that it may be mistaking the effect for the cause. If you have a fever, you probably have an infection that caused it. Does it accomplish anything to reduce the fever (which you could do with aspirin or an ice bath)? Or should you be targeting the infection instead?

So if we somehow increase the amount of money in the real economy, will everything magically get better? Or is monetary velocity low for some other, underlying reason?

If the latter is true, then the reason is quite likely to be microeconomic in nature (maybe consumers are worried about their future earning power). If so, then treating it with macroeconomic tools is something like attacking an infection by trying to lower the fever.

Expectations matter TREMENDOUSLY. The Fed wanted nothing about this to be a surprise. For months they went out of their way to choreograph the move, publishing unusually large amounts of dissenting views from inside the Fed itself (not just the occasional sour remark from Hoenig or Lacker). To calm inflation fears, they even did a live-fire exercise to show they could damp it out (this was the unusual 28-day reverse repo completed by the NY Fed a few weeks ago, involving the securities likely to be used in QE2).

And they’ve also been running about $6 billion/week in new POMOs since late August, a continuing operation that exactly coincides with the current stock market rally. If you’re trying to pump the stock market, QE is quite likely to work.

According to the state-of-the-art “New Keynesian” models, microeconomic behavior is STRONGLY influenced by what people expect policymakers to do, and what they predict medium-term inflation and taxes will be. It’s also not considered enough to just announce policy moves. You also have explain the rationale and the dissenting views. That’s why the Fed are trying to be as open as possible about this.

They’ve also been open about the channel through which they hope all this will work: a “wealth effect” created by rising stock prices. In all candor, it just blows my mind that they think this is going to fly, and that tells me it’s a desperation move.

Nothing says it’s going to be the US stock markets that will absorb the newly-created Bernanke Dollars. What if they go sloshing into China and fuel a burst of consumer-commodity inflation there?

Markets are responding, of course, by baking in expectations of future inflation, asset-price volatility, and even higher consumer prices for things like food and fuel. It’s not impossible that the result of all this will be stagflation.

A word about the mechanism: if all you have is a hammer, the world looks like a nail. The Fed’s hammer is an open-market desk in New York City through which they can buy or sell fixed-income securities under well-defined conditions. So they’re going to “print money” by buying up outstanding Treasury debt. (By identity, whenever the Fed buys anything, money is created. Whenever they sell something, money is extinguished.)

The Treasury could put money into the economy more directly by broadly cutting taxes or increasing deficit spending. Politically, those are non-starters. So the Fed is all we have left.

And in any case, you’re still using macro tools to solve a micro problem. Treating the fever instead of the infection.

A view is starting to emerge that this is what Bernanke actually had in mind. Creating a huge amount of new "bank money" obviously did nothing to stimulate the creation of "economy money," and I suspect this came as something of a surprise to Bernanke.

So the idea with QE2 is to actually create "economy money" by bidding up midcurve Treasury paper well past its current value. (If that reminds you of what Fannie and Freddie do with mortgages, give yourself a gold star.)

It’s remarkable that the Fed’s total Treasury-debt purchase plan ($600bn over six months) amounts to more of this paper than is currently outstanding. If they succeed, you can probably expect to see a drastic change in the shape of the yield curve. Think of dropping a bowling ball on it, just left of the center line.

And that metaphor understates the steepening at the long end. Since the Fed doesn’t anticipate buying in the 30-year bond, that maturity has taken it on the chin, rising in yield by nearly 20 basis points over the past two days. (Yields have risen across the curve today with the better-than-expected unemployment report.)

What’s supposed to happen? You, the investing public, are supposed to reason that there’s just no point in holding overpriced risk-free paper, and stampede into the stock market. The resulting bubbling-up of stock prices is supposed to make you feel richer and happier, and in turn induce you to buy more fine consumer goods imported from China.

Never mind that nothing in that theory says that you’ll go to the US stock markets to invest what has now been effectively converted to risk capital. Lots of other markets are potentially more attractive on fundamentals than US stocks. That’s why everyone from Thailand to Brazil, including even Germany, is starting to talk about capital controls.

They’re worried that yield-obsessed Americans will pour Bernanke Dollars into their economies, fueling inflation, asset bubbles, and the kinds of instabilities that, in extreme form, led to the 1997 Asian Flu crisis that tore apart the economies of South Korea, Thailand, and several others.

Have you heard some of the loonier proposals from hotshot economists trying to understand why the private sector economy has become so risk averse? I’ve even heard people talking about a "balance sheet tax," which would take away some percentage of the cash that businesses hold every year. The idea is that you’re supposed to spend it rather than hold it.

But nothing could be more counterproductive. Businesses and individuals aren’t being irrational in their fear of overspending and overinvesting.  If policymakers force them to take more risk than is warranted under current conditions, they’ll find other ways to reduce risk, possibly by liquidating assets. That would be an incredible disaster.

But QE2 is, in a way, a form of the same strategy. The Fed hopes to increase risk-taking not in the correct way, by increasing the real risk-adjusted returns on risk; but in the incorrect way, by taking away the tools that people use to manage risk today. They’re not going to succeed.

So keep in mind that the US stock market bubble that now seems likely for next year will not be based on fundamentals. If you buy it, stay near the exit. And hope that you don’t get run down by the millions of other people standing near the exit, when the bubble bursts.

Nothing that happened on Election Day 2010 was a surprise. The results basically match what non-political junkies been expecting for months.

We’re going to get no fundamental change in the overall approach to policy. (Democrats will not interpret the results as a repudiation of what they want to do). But we’re also going to get a House leadership that will curb the worst excesses of liberal partisans running amok. In a word, stasis.

What that means for the outlook is: no short-term tax or regulatory relief, and no relief from the medium-term entitlement crisis.

The first of these is manageable. Everyone I know expects the Bush tax cuts to extend for at least another year. That’s the path of least resistance. But it’s not real pro-growth tax relief, as a sharp, permanent cut in the cap-gains and top income-tax rates would be.

This is manageable because business will keep doing what we’re already doing: expand in foreign markets and leave earnings and investments overseas. This is now the default, no-brain thing to do.

The entitlement problem is different. For roughly the next generation, the pattern of consumption in the US will shift from producers to retirees. There’s literally nothing that tax changes can do about this, because the shift is inevitable. The returns from working hard and being successful will simply be a lot lower than in the past, because they’ll have to be shared with nonproducers.

I caught myself thinking about this in my own case. Who needs to work 80-hour weeks just for the sugar rush of watching someone else consume 55% of the gains? It’s really not worth it.

There is a handful of people out there with an honest shot at turning some strong vision, hard work, and really good luck into chunks of equity worth $100 million. This will continue to be worth having done.

But the vast run of entrepreneurs, whose best hope is to make ten or so million bucks over twenty years, will face a very
different equation. That kind of outcome is at the fuzzy low end of being "wealthy" (which I define as the freedom to spend your time as you choose). The problem is that society, in its wisdom, can choose to take your wealth away from you too easily.

If you own $100 million and the government decides to take half, you’re still wealthy. If you lose half of $10 million, though, you’re back to working 80-hour weeks. That’s the equation people will face. Why take that risk?

So the broad theme of the next decade will be that, for the vast majority of people, working hard and taking risk doesn’t pay off.

This is going to give us a sclerotic economy that produces few really good jobs. But it doesn’t mean the US will descend into poverty. Just as we funded the consumption boom of the last 30 years with unsustainable increases in private debt formation, we’re going to fund the next 30 years of consumption by non-producers by running down the capital stock
of the US.

All of this is linear trend projection, an exercise that is known to produce incorrect results due to the non-linearity of events. Over long-enough time scales, history is always discontinuous. The positive surprise that messes all this up, is some kind of new industry or business model that produces a sharp increase in overall productivity. By making production itself cheaper, that will make it possible to sustain relative overconsumption by non-producers. I actually have some hope that this could happen.

A change in government policy to favor growth is also possible. But because this requires a Republican President, it’s a medium-term outcome at best. I do NOT believe it’s politically possible in any case for the US to reduce relative consumption by non-producers (retirees, the poor, and government employees), as Britain, France and Germany are.

There’s also the potential for a downside surprise: a widespread, possibly global, war.

Mechanically, the problem is that many people who have initiated foreclosure proceedings don’t have a clear paperwork trail documenting their ownership of the mortgage note, and thus their standing to foreclose.

Lots of people (particularly on our side of the political aisle) say that this is all just a paperwork snafu, even if longstanding rules haven’t been followed and certain law firms seem to have made a systematic business out of forging documents for large banks.

This view holds that, regardless of the screwups, homeowners with mortgages still owe money to… someone, whoever that someone happens to be. (True.) And we ought to trust people who assert a right to foreclose. (Not necessarily.)

In the first place, I’m just not so willing to trust the large banks who now own most of the mortgage originators (like Countrywide) that created the problem. The banks should NOT receive Congressional relief (which Republicans might be inclined to give them) that would absolve them of the need to unambiguously prove their standing to foreclose in each individual case.

It’s not that I assume banks are malicious. It’s that I assume they’re negligent. The volume of foreclosures is now so far above the historical norm that just processing the paperwork has turned into a major bottleneck. And if you can cut corners to get there faster, why not cut corners? As long, of course, as some pesky judge doesn’t insist that your paperwork is all in order.

America’s TARP-supported banks are now as good as part of the government. As such they truly don’t have to care what’s good for their customers, only what’s good for their regulators. Just like government, they can and will do tremendous evil and injustice to individuals. Also like government, they tend not even to see this as a problem, except when it causes bad PR.

In sum, it’s NOT a good assumption that everything is clean and correct when a bank forecloses on someone without clearly documenting their right to do so.

I also don’t necessarily think it’s a good idea to streamline those required chains of paperwork, such as the serial notarized endorsements of a note as it makes its way from origination to the final investor. Doing this electronically isn’t necessarily a problem. Not doing it at all is the problem. We have to insist on proper electronic or paper documentation of each change of ownership. There’s too much potential for real abuse otherwise. If this means losing the assembly-line process of the past few years and getting back to the (more costly) model where your banker knows your situation personally, well, that may not be such a bad thing.

So Yves finishes up by claiming strongly that the paperwork problem is really, really bad. And I agree with her. But there’s an even bigger problem that needs to be emphasized.

The bigger problem is that we still have a huge mismatch between the value of mortgages that have been contracted, and the current value of the underlying properties. Authorities in two administrations have simply found it impossible to deal with this problem, and they’ve been at it for three years now.

The mismatches are going to have to recognized as losses by someone, somewhere. And there are only three classes of people that can do that: homeowners, banks/originators/investors, and taxpayers. The game for people in the first two groups is to shift the losses to one or both of the other groups. The game for taxpayers is to vainly exercise the only power they have, which is to vote for different representatives every couple of years.

To date, the game has been rigged in favor of the originating banks and funding entities like Fannie Mae and Freddie Mac. It’s been rigged against homeowners, taxpayers, and the economy as a whole, as the failure to resolve the mortgage bubble continues to inhibit productive investment and job creation.

Yves suggests an idea that has been around for a long time: come up with a legal framework that allows judges who adjudicate foreclosures and bankruptcies to impose a reduction in the principal amount of the loan. This idea transfers value from banks to homeowners, so at least it takes a clear point of view on who has to take the pain. (One attractive wrinkle is to cede any future equity appreciation from the homeowner to the bank, in effect making the homeowner more like a renter.)

There is a constitutional problem with this idea: it violates the sanctity of private contracts. But Barack Obama has already proved that this is of no concern to him, for example by his actions in the Chrysler takeover.

Another problem is practical: how do you make a law that gives judges broad discretion to rewrite contract terms, in support of what is actually a social goal not of direct interest to the contracting parties? And how do you deal with the unintended consequences? In the worst case, whenever two parties sign on the dotted line, the government will be there as an implicit third party with broad but unspecified rights.

Overall, though, this could end up being a workable approach. Especially since there is a safety valve: TARP. Banks that are forced to write down mortgages to avoid foreclosures will have a clearly justifiable claim on taxpayer money to keep them out of bankruptcy.

And Yves’ final point is completely right: this is pain that is going to hurt the economy. There simply is no choice. Whoever ends up taking losses is just going to have less power to consume. To me, the sooner we resolve this mess, the better.

One more point: this whole foreclosure mess is emboldening a very interesting class of people, namely investors in mortgage-backed securities. These people have been feeling burned since the crash, but they’re all qualified investors who have no good answer when you say “Well, you should have known better.”

So now some of these people are trying to “put” their investments back to their issuers, on the grounds that they’re fraudulent. This isn’t because of the paperwork snafus per se. It’s because the investments were represented as secured, meaning that under distress, the investor would have an unencumbered right to take possession of the loan collateral, namely the house. The paperwork problems mean that the security rights of the investors are clouded at best, ergo they claim that they paid for something they didn’t receive.

If someone brought that case to me, I’d first want to know how owning one one-thousandth of a mortgage in a subordinated tranche of some over-the-counter security conveys a practical right to foreclose in the first place. Does each one-thousandth holder have the power to exercise the security rights of the other 999/1000ths?

But forget about that. These cases will go forward, partly because of who’s making the claims. One of the claimants is the New York Fed.

Yes, that’s right. The New York Fed is seeking the right to put mortgage-backed assets back to their issuers, by way of discharging their fiduciary duty to the taxpayers.

Why? Because of Bear Stearns. Remember how the Fed set up the first Maiden Lane entity to buy $30 billion of mostly mortgage-backed paper from Bear that Jamie Dimon didn’t want because he had no way to value it? Now that the Fed are showing large losses on that stuff (big surprise), they’re trying to make it someone else’s problem.