10 September 2008

Letter from Washington

Our chief economist, Steven Andrew, and I are just back from a research trip to Washington. To some extent our visit was overtaken by this weekend's events and the government bailout of the GSEs (Freddie Mac and Fannie Mae), but there was tangible nervous excitement in the air that anticipated that something big was about to happen - plus we'd had the shocking rise in US unemployment out on Friday morning that took the jobless rate to 6.1%, already higher than it was during the 2001 US recesssion.

The majority of our conversations were not for attribution - this is election year after all, with a new boss coming in November, and nobody wants to make a career-limiting statement in today's job market - but we saw senior officials at a number of Federal departments and the mood was one of serious fear and despair. Treasury Secretary Hank Paulson summed it up in a press conference following the GSE bailout - "This is the first time in my career I had trouble sleeping".

Fears about inflation have quickly disappeared - the inflationary pressures of high commodity prices were absorbed into corporate profitability, which allowed the authorities to breathe a sigh of relief. Deflation talk is back, as is talk about Keynesianism and the Federal government having to embark on a Japanese style infrastructure building programme to keep people in jobs and to get a multiplier effect going. There is little hope that the boost to second quarter GDP from exports is a repeatable event given the significant slowdown in European and Asian growth in the last month or so. The scariest comment of our trip came during our most important meeting, with a senior economist. He said "This is what happened in the Great Depression. We are replaying the early stages of the Great Depression".

We also had meetings with private sector bodies, including both right and left wing think tanks (one of which will be the economics brain of Barack Obama if he gets elected). We talked about the possibility of a bailout for the GSE's. One view (from the right) was that support for senior debt holders in Freddie and Fannie would have to materialise - not because the government thought that this would stimulate domestic demand or stop house prices from falling, but to stop capital flight from the United States. The big holders of senior debt in the GSEs are the Asian Central Banks, who believed that this stuff was as good as US Treasuries, but with a slightly higher yield. Increasing nervousness that this was not the case could have jeopardised not just the mortgage backed markets, but also led to a flight out of US assets full stop, including the dollar and government bonds (who pays for the Keynesian economics if nobody buys US Treasuries?). The events that transpired perhaps support this idea; only senior debt holders should feel completely comfortable, and there is little prospect of the rescue plan significantly increasing the supply of mortgages to the US housing market. This saves the overseas investors, it helps the US banking system which also owns senior GSE debt, and it allows the government to fund itself in future - but it doesn't do anything for the US consumer.

A topic that we tried to investigate was the potential for the United States to lose its AAA credit rating given the massive increase in fiscal spending that comes as tax revenues start to collapse (income tax receipts are down 3% so far this fiscal year, and corporate receipts down 15% already - see the CBO's website for more details). There was little support for this view (and the head of bond trading at an investment bank told us that the stupidest trade he sees all day long at the moment is people buying protection of the US government (paying 20 bps a year as insurance against a US sovereign default). His point was that if the US government isn't there to pay its debts, his investment bank will have long gone bust! Remember that Japan was downgraded from AAA to A+ during it's long deflation, but although the prospect of US deficits of $600 billion a year is a real one, the deficit probably still needs to be twice that to be in as bad a state as Japan. Also remember that Japanese bonds rallied down to 0.5% yields, despite those downgrades!

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