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Simon Johnson and James Kwak are beating the inflation drum again.  As my post of a couple days ago reveals, I don’t disagree about the risks to inflation.  The Fed’s aggressive posture towards increasing liquidity through monetary supply expansion (both directly and through ancillary monetization of bank assets) creates a tinderbox than can explode at the slightest spark.  The alternatives, obviously, are far worse.  Facing the uncertainy of collapsing markets, Im not sure what exactly people expect the man with his hand on the monetary policy lever to do but expand the money supply. 

I see it a bit differently, however.  Much of the ARRA that recently passed both houses will flow to infrastructure projects, which have longer spend out periods.  That aggregate demand, assuming it is real, could potentially come at a time when organic demand is returning to normal and unemployment is reverting to (closer to) full employment. My concern is that the secondary effect of the stimulus may come later, when it is less needed and when in fact it may even be dangerous.  If we do succumb to inflationary forces, Bernanke will undoubtedly be pilloried.  Unfortunately, he will so suffer even if fiscal profligacy pushes us over the edge.  In any event, people will forget the precsriousness of our position in the second half of last year and the first half of this year.


Simon Johnson notes in a recent post that which caused me concern in a recent posting about the threat of inflation.  I agree that this could be a big threat and I also agree that the Fed’s actions are very appropriate under the circusmtances.   I also agree that inaction is probably far worse than the current actions undertaken by the Fed and the Obama adminsitration.

Where I differ with Simon Johnson (and lets face it, he’s much smarter and more experienced than I) is in his casting of the US as an emerging market.  I accept his drawn similarities between the US and emerging markets in terms of typical macroeconomic indicators and I even acknowledge his qualitative parallel that focuses on the role of elites in emerging markets and the role of the US financial sector as one of those elites.  However, I think that those similarities are superficial and much more easily addressed in the US than in Indonesia, Russia or any other emerging market that Mr. Johnson parallels with the US.

I base this disagreement on my belief that the US has stronger institutions that inhibit prolonged dominance by elites.  We have strong interest groups across all areas of the American political process, so to say that one dominates is misguided.  Even in terms of economic power, Im not sure that Wall Street carries the same weight as the oil and gas complex in Russia, for example.  Perhaps policymakers have recently become awestruck by Wall Street, but the US budget does not rely heavily on tax revenues from Citi the way the Russians rely on Gazprom. As result, that control by the elites is more easily severed.

Moreover, we have a vibrant middle class (which in my opinion should stifle most comparisons to emerging markets which are generally poorer and lack a middle class) that can return to a robust policial process to set things straight.  naturally, the middle class has to conciously awaken and pressure its representatives, but I find it hard to believe that a dentist in Singapore is as empowered to influence the role of elites as a dentist in Nebraska.

But that’s just one credit analyst’s opinion.

I was reading the Comments on Credit blog ( discussing the need for cashflow in lending and de-emphasizing collateral.  They are right, collateral is very chancy.  But they dont go far enough.  So ill pick up the baton.

Relying on collateral is risky for several reasons. First, established manufacturing companies, those more likely than not to provied assets for ABL structures, are very exposed to a synchronized downturn resulting from a cycle trough or exogenous shock.  This means that earnings will become strained as the industry is declining (cyclically or secularly). As a result, the demand for the hard assets (we will deal with current assets in a moment) will be at a low point, as the industry for which the M&E is designed or the real estate is best suited is generating lower cashflows.  Simulataneously, the synchronized downturn will flood the market with similar use equipment.  The combined increase in sully and decline in demand will yield lower liquidation values.

Moody’s recently published a report demonstrating that revolvers tend to rise as companies approach distress.  For revolving lenders, this means that excess availibility declines and the collateral cushion thins.  This also means that other secured lenders who might have a second lien on other assets (think about a lender with a lien on M&E who is starting to realize that the supply/demand imbalance in distress is depressing collateral value) will see collateral cushions disapear.

In the end, what matters is the ability of the assets to generate cashflow and that is driven by the microeconomics of the industry. 

At least, that’s just one credit analyst’s opinion.

The White House hasnt finalized their plans, be it the TARP, TALF or PPIP and pundits of all stripes are debating the impact on our fiscal position, the dollar and general demand.  It really is very difficult to guess what will happen, but one thing is highly likely: the return of inflation and the debut of a bond bear market.

I need to dig up the graphs on M1 and M2 and the budget deficist and post them later because theyreally show an uptick in the manufacture of money.  This is something that the White House has little power to influence.  While pursuing the Keynesian grail, the Fed has really pumped an enormous amount of liquidity into the system, the recent uptick in consumer savings notwithstanding.  Currently the banking system is constipated with this liquidity as banks continue to ration, nay, hoard, credit.  Assuming the recent fiscal stimuli start to do the trick, banks should start lending again.  That release of capital combined with any demand generation could seriously press inflation upward.

The Treasury’s debt raising plan will drive interest rates higher, which may cool inflation. This relationship is vitally important to the US’ economic health and the bond market.