talking about inflation and Fannie/Freddie bailouts in Sawbones post in BOTF and Revrick's post in Moneybox, has maybe furnished us with some debatable questions.

First inflation. I have copied the important parts of their arguments.

Run: The Arabs do not care what the Fed does as far as interest rates. If they do not like the dollar, they will just switch to the Euro as Iraq did pre-911 and as Iran was ready to do also. Print more money or cheap[en] the dollar and the price of oil goes up regardless.

In 1973, Fed Chairman Arthur Burns asked that oil, and eventually food (for other reasons than imports), be excluded from the CPI to not influence Fed policy. If the Fed did include both commodities in the CPI calculation fo policy decisions, should we be increasing interest rates to control the impact of oil and food upon it? One other president did just such in the late twenties and the result of that action helped lead to the worst recession ever experienced in this country . . . The Depression.

WE CAN NOT CONTROL OIL PRICING OR FOR THAT MATTER FOOD PRICING. Too much of either is imported and interest rates have no impact. The Fed removed them from the Chained CPI index for that reason. Those inflationary factors do show up in other ways. Without the Fed being expansionary, we would have faced the same issues as during The Depression with Hoover in office. If the Fed increased rates due to increases in oil and food, we would have slipped into The Depression. Think about it and forget "Boy-George Bush."

The Social Security payouts will be reflected upon what truly impacts the US and what we can control [my bold]. Social Security is solvent, is not bankrupt, and will be there in the 22ns century regardless of oil.

Distilling Run's arguments, he seems to be saying the following:

1. The Arab oil exporters do not care what the Fed does, and hence, what value of the dollar is. [This seems to contradict the numerous statements of the Algerian oil minister, who equated a 1% fall in the dollar to a $4 rise in the price of oil--and vice-versa]. Alternatively, the price of oil will rise despite a rising dollar or despite what OPEC thinks about the dollar.

2. If the Fed used food and energy to set its interest rates, we would have another depression.

3. We have no control over food and energy inflation, hence the Fed shouldn't concern itself with headline inflation. Neither should Social Security recipients be 'rewarded' by spikes in costs which we can't control. SS is solvent perhaps for this very reason.

Gregor: This place is full of chronic malcontents and grievance mongers who see a vast government conspiracy under every rock.

Real crude prices have dropping since the mid-80s and real food prices have been dropping since as long as anyone can remember. Excluding them would have looked like a recipe for increasing reported inflation and government obligations until a few years ago, so malicious intent is hard to prove. Incidentally, if the Fed underestimates inflation, its monetary policy will be more expansionary (pro-growth), which liberals have traditionally wanted and conservatives opposed.
There is considerable evidence, both from Europe and America, that conservative administrations are more vigilant on inflation and tolerant of unemployment, and liberal ones the other way round. Faced with deep recession, both types will cut interest rates or seek fiscal boost, just that for social democrat types, that point usually comes earlier.

It's true that much of Bush's economic rhetoric has been surprisingly Keynesian, but that's probably more a bait-and-switch than pandering. He makes the liberal argument for short term tax cuts in the hope that he can push through permanent cuts in that guise.

The CPI does include rent and imputed rent, just not the price of housing as an asset. It's hard to argue it should be otherwise, since it's supposed to be the cost of living, not the cost of accumulating stuff.

Distilling Gregor's arguments, he seems to be saying the following:

1. Real commodity prices have been dropping for over 20 years; to include them would in fact understate inflation, at least up until "a few years ago", so malicious intent on the part of the Fed to downplay inflation is hard to prove.

2. If the Fed understates inflation, that allows for a more expansionary policy--which has traditionally been the preserve of Democrats, not the Republicans.

3. Bush's rhetoric is Keynsian, but it's a bait and switch for tax cuts [as evidenced by the 2001 and 2003 tax cuts which will sunset shortly. A nice little recession might provide cover for extending them permanently].

4. As CPI is concerned with the cost of living, using imputed owner's rent is more suitable than actual home prices or the cost of owning a home [despite the fact that 2/3 of Americans own homes].

Finally, Revrick has some thoughts about the F&F bailouts.

Revrick: If we become major shareholders of F & F, we suddenly come into possession of $770 billion worth of garbage (all those subprime and Alt-A mortgages that will never be repaid). Do we foreclose on the 'owners' leaving us with all those future slums, I mean property? Do we throw all this unwanted housing onto the market at fire sale prices, thus causing an even greater decline in the value of homes and putting even more 'homeowners' under water? Do we just continue the charade that some day, somehow, they'll be repaid, thus leaving the housing market as a festering, sick sector for decades? Do we 'pay off' the mortgages with a huge injection of cash, courtesy of the Fed, thus guaranteeing that nobody, but nobody will want to hold any US bonds?

To which Run replies: What other gov in the world guarantees their bonds. If the US defaults then we have a world crisis today.

If was expected that Feddie, Fannie, and the FHA would be buying up these mortgages from lenders. It is also expected that those banks making bad loans will get those loans returned to them for further work. The cost to rescue Fannie and Freddie is $80 billion as compared to how much spent in Iraq and how much given to Israel?

The good reverend seems to have the following points:

1. If the govt. takes over F&F it gets possession of $770 B worth of junk mortgages, to which it can:

a) foreclose and get slums;

b) liquidate and drive housing prices even lower;

c) sit on 'em a la Japan during the lost decade of the 90s and SE Asian countries after the 1997 contagion; or

d) pay off the mortgages, diluting the dollar even more, and pissing off our major creditors? It's Hobson's choice.

Implication: maybe it would be better to let F&F go under.

Run's first point is that we shouldn't worry about Uncle Sam defaulting on Treasury bonds; if it happens, that's the end of the world as we know it. Implication: what's a little inflation among friends?

His second point is that banks making bad loans will get those loans returned to them for "further work", i.e., selling them off to gullible idiots or just sitting on them and waiting.

Finally, Run says that the cost of a F&F bailout is peanuts compared to the war. [Of course, there have been and will be other bailouts, and some have estimated the total at over a trillion].

While I probably can't conceal my doubt about some of Run's views, I think he is in the mainstream of the Dem Party Congress and possibly the rank and file--unfortunately. Moral Hazard just doesn't count with Run. He's more concerned about families making $175K having to pay AMT than he is about seniors living on $20K getting ripped off on their SS COLAs. Gregor makes some valid points, but I think under-estimates the extent to which the GOP has been following a bastardized Keynsian program to win votes--and very successfully, too, I would add. Revrick's points are pretty much in alignment with my own.

Seems to me that, taken all together, their comments add up to a new twist to the tale of the blind men and the elephant. In this version, whatever part they feel, they are all unanimous in their opinion: "This is one sick puppy!"

I think almost everyone must understand that we have managed, in the space of around eight years, to get ourselves into a financial mess that there is really no good escape from. I think the undoing started with the rapid collapse of the calamitously architected NASDAQ average, which plunged like a burst balloon when a small number of vastly overbought stocks were seen to be shams. The trigger was, of course, the obvious brilliant future of the Internet, which was responded to by a public that foretold that all of the contenders for the small number of top spots available would be winners. That first crescendo of stupidity rang through the system like a bell as financial plan after financial plan was laid waste, with effects spreading to far quarters which truly had no involvement. The ineptitude of the incoming Bush administration led to a fatal series of bad moves which drove the economy ever farther from any chance of reaching equilibrium. The wreckage is now strewn over the entire financial landscape and it is doubtful that either of the major parties has the plans or the skill to reassemble it into any approximation of a working economy.

Unfortunately, I don't think your premise is all that valid, and here's why.

The NASDAQ index peaked on March 10, 2000 at about 5,040.

Greenspan raised the Fed Funds rate from 6% to 6.5% two months later--after the NASDAQ had fallen to 3,500. Thus, he raised rates from an already high six percent to six and a half as the NASDAQ had already fallen 30% in two months. Had G wanted to avoid a perceived financial mess brought about by cratering internet stocks, he would have slashed rates, not raised them. So I suspect he wanted to get a Republican into office and figured that those 6.5% rates would slow the economy sufficiently to do just that. Indeed, by early 2001 we were in recession, right on schedule.

I have seen no evidence in the last 20 years that the Fed operates other than to hurt Democratic incumbents and help Republican incumbents. Must be those tax cuts.

That I agree with the remainder of what you said. It is only the "trigger" (tech stock crash) that I was questioning.

Here are some Fed Funds numbers for your delectation.

1992: Jan to July, 3.75%; July onward 3.25%

1994: a series of rate hikes in the weakest recovery on record to 5.75%--just in time for Gingrich's Contract On America.

1996: 5.25% fails to kick Clinton out of office (the one act of mercy G bestows on the Dems).

2000: Jan to May, 6%; May to December 6.5% (see above). G cuts several times in 2001 and the FF is 3.75% by August (before 9/11). By Jan, 2002 it's 1.75%.

2004: entire year up to November below 2% re-electing Bush. In fact, the FF is below 2% for 35 months from 2001 to 2004.

B takes over from G and has to live down his helicopter reputation and show his inflation bona fides. He raises in 2005-6 to 5.25% from 4.5%. Economy weakens, Dems take Congress.

Again, as in 2002, the Fed cuts into negative real territory by the beginning of 2008, helping Republicans. But it won't work this time, as housing and the consumer are tapped out. Myriad injections and bailouts worth upwards of $1 trillion are done to revive the patient (electorate).

CPI and inflation and GDP have to be measured without interference from passions, ideologies, biases.

Resultant COLAs have to correspond to inflation and the SS system's ability to pay out cash.

Money supply should follow a slow but steady growth pattern/

Interest rates (on savings accounts) have to start at the inflation rate plus 20% (income tax allowance), or savers lose.

Deviate from these fundamentals (and two or three others) and you get a mess.

Import prices have to be adjusted for effects of VAT, rigged currency, and low wages-benefits.

People doing the control process have to know arithmetic and follow rules and limits.

Genedio summarizes Revrick's options on the Fannie Mae/Freddie Mac situation as follows:

1. If the govt. takes over F&F it gets possession of $770 B worth of junk mortgages, to which it can:

a) foreclose and get slums;

b) liquidate and drive housing prices even lower;

c) sit on 'em a la Japan during the lost decade of the 90s and SE Asian countries after the 1997 contagion; or

d) pay off the mortgages, diluting the dollar even more, and pissing off our major creditors? It's Hobson's choice.

LeRoy: I point out that this is not an accurate example of a Hobson's choice situation, where you have only two options. It was named after the owner of a livery stable in Cambridge, England, who, in order to rotate his horses, gave his customers two choices: they could either have the horse in the stall nearest to the door, or none at all. A Hobson's choice is usually thought of as a 'take it or leave it' choice. In this case, with these four rather undesirable outcomes, I would choose choice (b) liquidate. The economy will not even begin to recover until the housing market has found its equilibrium--and that will not happen as long as we continue to try to artificially prop up housing prices.

As for Run, I think he is a pretty traditional Keynesian Democrat, who are generally more worried about unemployment than they are about inflation. Genedio may be a bit unfair to Run when he portrays him as being "more concerned about families making $175K having to pay AMT than he is about seniors living on $20K getting ripped off on their SS COLAs." I think Run is very concerned about families making $20K losing their jobs. He has written frequently (and eloquently) about the problems of the inner cities. Someone who is only concerned about folks making $175K a year would be an unlikely candidate for that. But I differ from Run in being an old-fashioned monetary conservative who thinks there is a great danger that inflation can get out of hand, and who generally wants the flames stamped out before it turns into a raging inferno. I am in fact willing to tolerate rather shockingly high unemployment for a time, if that is what it takes to wring inflation out of the system. Which is what Volcker did in the early 1980s, and I point out that those restrictive monetary policies did help to arrest food and energy prices. Just because certain products are imported does not mean that our monetary policies have no effect on their prices or on the level of worldwide inflation. I argue that in fact our monetary policies are the predominating factor behind the recent global burst of inflation, precisely because the U.S. dollar is (still) the world's major international reserve currency. [But for how much longer, especially if we continue to pursue these inflationary policies?]

Thanks for the clarification on HC. I think I was aware of it being a choice between two almost equally bad options, and I really see the govt. having two basic options: buy up Fannie's and Freddie's bad mortgages, or cut them loose. That was the missing #2. a,b,c,and d are what they might do after choosing option #1. You might prefer option 2, but it would have ill effects in that mortgages would be much harder to come by, as F&F have been supplying about 70% of recent mortgages. Of course, we might think that a drop in housing prices is just what the doctor ordered for our ailing and malinvested economy, but that is decidedly a minority position. Few are prepared to bite the bullet and starve the fever, even if it would lead ultimately to a renaissance. So the two suboptions are basically 90s Japan or debt monetization. This is a real Hobson's choice. I suppose the divide between us posters is here; I would favor 90s Japan over papering over the bad debts with diluted dollars and higher interest rates down the road. Run and Gregor would probably favor monetization, which is really socialism of the losses.

Now, your second point, was I unfair to Run? He made 6 points, to wit:

1. OPEC doesn't care about interest rates, and thus, the value of the dollar; oil prices are independent of the dollar.

2. If the Fed used food and energy to set its interest rates, we would have another depression.

3. We have no control over food and energy inflation, hence the Fed shouldn't concern itself with headline inflation.

4. We shouldn't worry about Uncle Sam defaulting on Treasury bonds; if it happens, that's the end of the world as we know it. Implication: what's a little inflation among friends?

5. Banks making bad loans will get those loans returned to them for "further work", i.e., selling them off to gullible idiots or just sitting on them and waiting.

6. The cost of a F&F bailout is peanuts compared to the war.

#1 and #3 seem demonstrably mistaken to me, judging from market action over the past several years. In fact, the weakness in the dollar has now led to global inflation in commodities.

#2 is a scare tactic which has and might be true in certain cases, but cannot be standard practice because it would justify negative real rates and a perpetually weaker dollar. We cannot be perpetual inflation doves because we are afraid of another depression. Depressions are usually preceded by debt-manias. That is the real issue.

#4 is the opposite of #2; it minimizes the danger--in this case, of default. Of course, Weimar Germany didn't default if it could print up billions of Deutschmarks to pay its creditors. We may eventually have to borrow in Euros or Yen if we abuse the printing press.

#5 is wishful thinking.

#6 is true, but again, like #4, minimizes the cost. Run is thinking $80 billion, and I'm thinking $1 trillion when you add up the $300 billion in 'AAA' rated mortgage crap the Fed has exchanged for treasuries and the other hundreds of billions in loans and swaps, plus, no doubt future bailouts. Where does it all end?

Sorry, I don't think I was too hard on Run. I realize that he has fought the good fight on some other issues, but I wish he would read Roubini and get some religion.

Seems to me that bankruptcy law provides well for this sort of situation:

The stockholders will be left with nothing. That's not always the case, but this time, it is probable.

The bondholders will receive such restitution as is possible. In this case, the mortgage instruments which underlie the bonds would be distributed among the bondholders according to the relative sizes of their loans to the failed agencies.

The mortgage holders of note would be informed of the new creditors to whom receipts should be forwarded.

The mortgaged homeowners would continue with whatever they were doing.

Not a perfect solution, but at least an orderly one, and one for which provision has already been made.

Inflation is running at 4%, 8%, or 12% depending on who is talking. Interest on savings is 1%, 2%, 3%, or 4% depending on the account-name you wrangle. Then half the interest or maybe just 1/3 goes to tax.

There it is! INSANE economic policy at the bedrock. Amurrikans can't do arithmetic!

Against this mistake, every other effort loses.

And people with money will shovel it into the commodities furnace. Next, war supplies.

LeRoy:

Several things are taking place now, that this economy has not seen before. I believe Phelps did a pretty good job of analyzing the phenomena in the sixties and subsequently won a Nobel prize in 2006 . . . maybe because it was taking place?

• If you believe unemployment is still 5.5%, I can offer you a nice, century old bridge in NYC with a view of Sov's residence. Participation Rate has still not returned to what it was in 1996 before the economy took off or immediately after the 2001 recession, when it is traditionally at it lowest. BLS theory claims it is babyboomers retiring, women leaving the work force, etc. Most babyboomers are just starting to retire on their meager funds now and will probably not enjoy the same type of retirement that people like Sov and Phil enjoy. Women leaving the work force? How? when it takes two incomes to make a go of it. At any rate, 6 tenths of 1% equates to 1.5 to 1.6 million people on the side lines, unemployed, and most wanting work. Any inflation we experience will not be led by rising wage demand as we saw in the seventies, which also makes this period somewhat different than then. It is an excellent counter to inflation as a large labor pool holds wage demand in check. Furthermore, in high inflation and low inflation periods over the last 8 years, unemployment - true unemployment- and job growth has not changed. The labor pool is essentially the same since 2001 and after the recession . . . large.
• In the late twenties, the Fed (Harrison) moved quickly with generous credit to tide banks over in a collapsing economy which prevented the additional bankruptcies of banks. When the Fed tightened its purse strings around 1935, what was an ~60 failures a month grew to over 300 a month in November and December of 1935. It was bad timing for tightening the purse strings as it made the issue worse. We will see low Fed Rates until Fall with no further drops to counter a much further slump in an economy that has been dismal at best for "payroll-wage-labor." The income increases are being made in dividends and capital gains. It is not the time to tighten interest rates s it will make the situation worse.
• Globalization has made the recovery of the US economy difficult. Labor and Overhead is far cheaper overseas than in the US. Subsequently, job creation has kept up with population growth at best. We are still bleeding jobs overseas although with higher energy costs and cheap dollars, I "think" more companies will source products in the US over time as the costs to move product here is soaring. Corporations have a monopsony power in this global economy and they are using it to rein in US payroll-wage-labors by shifting work across the ocean thereby pressuring labor. For a long time, we have had a new plateau of labor that is out of work and wants work. A level not seen since the eighties.
• Food and Oil: The only way Fed rates will arrest the continued increases in prices of them will be by cutting the demand of them through higher prices. In which case, those that can afford either, will buy them and those who can no longer afford to buy them, will drop from the market. Those dropping from the market will be the lower income brackets, those who have already have not experienced increases in payroll wages since 2000. Decreasing Fed Rates helps for cheaper dollars in the market place and Greenspin told the world earlier in this decade not to look to the US as a place of investment, Many of those dollars went to the mortgage investors of Wall Street thereby setting up the conditions for the haphazard underwrting of mortgages we have seen as of late. To many yen and ruan and pounds chasing too few investments in the largest market in the world. I will repeat again, the Arabs are not stupid and if we contiinue to devalue the dollar though our poor governmental practices, the prices will continue to increase. Even Friedman in his econometric models (which I studied) showed that interest rates had little impact on a run-away economy when money supply was growing. The Fed has one other tool in its arsenal that it has persistently not used and which will rein in the economy, change the bank reserve rate. However, this will not impact the Bear-Stearns of the world and they need to be brought under the same regs. This action would be counter to the gov's haphazard money supply growth requirement in order to fund its deficit spending. Voelker's interest rates of 20% did crash the economy in the seventies and everything stopped dead in its tracks; but, such actions today, I believe would cause far more harm to the "payroll-wage-workers" than solving the actual problem at hand.
• Fannie and Freddie: These two institutions buy up mortgages from banks and institutions. They and the FHA have been tasked with doing so recently. The thought also is that bad loans may be returned to banks for rewrites and solution. Not to bail out these two instutions would put enormous pressure on "payroll-wage- workers" and do nothing to solve the problem. The lingering death of Glass-Steagall as orchestrated by the great maestro "Greenspin" in killing "section 20" and increasing the amount of funds that can be invested on Wall Street by banks has contributed greatly to today's problems. While the Fed can increase bank reserves, Bear Stearns and other such institutions, is free and clear of Fed regs. We need to rein them in and bring them under the same regs.
• Government versus the common Citizen: We are the perpetuators of our own problems. We elected a government that has cut taxes before spending. 99% of the taxpayers were bought off by miniscual tax breaks. In the last 8 years, Boy-George Bush managed to increase the income for those in the upper 1% of the taxpayers while 95% lost in income and 4% remained stagnant during the greates economic slump since The Depression. At least under Hoover, everyone suffered income loss. This gov is pro capital gains and divs and will arrange a tax system denying them of being taxed as income.

Anyhoo, I am done.

You never once mention the decline of union membership and influence over the years as a major contributor to the upward redistribution of wealth. That surprises me.

Hmmmm Phil????

Maybe I figured someone else would mention it or considered it inherent and obvious to the demise.

First of all, genedio, thank you for including me in the heady company of run and gregor, guys who have earned their chops over a long period. Me, I'm a rank amateur by comparison.

My own take on this matter is quite clearly that we smack into a brick wall no matter what choice we make and that whatever we do choose, the future will be bleak. I don't see any happy outcomes.

What we are facing is not only a credit/solvency crunch afflicting the likes of the Big Boyz, but also a simultaneous commodities inflation... and it's whacking not just us. Housing bubbles are popping in England, Ireland, Spain and Australia as well, so asset values are tanking all over the place, just as costs for basic materials are soaring. The traditional approach to credit crises has been to inject liquidity into the system. But that risks exacerbating the commodities inflation, which sooner or later penetrates even the tough hide of the core inflation number.

I will note once more the wisdom of Jacksonian working class economics, which advocated a strict tight money policy, for two reasons --

1). The working class benefits little from the frothy upswing of a boom and gets clobbered the worst when boom turns bust;

2). Plutocracies are undemocratic, so plutocrats and plutocrat wannabes need to be kept on the shortest leashs possible.

Following those rationales, I might be inclined to let the banks fail, followed by nationalizing their corpses.If we have to pony up top clean up this mess, the maximum pain should go to those who derived the max benefit. I'd undo the Bush tax cuts and would even remove all tax privileges extended to unearned income. Also phase out the mortgage interest deduction, starting at the top with an absolute dollar cap. {To those who whined about how this harms those who take risks, I would lock them up in a room where they'd have to watch endless episodes of World's Deadliest Catches and Dirty Jobs. (Okay, that's more a fantasy wish).}

Since the effects of those steps would be hugely deflationary, I would counter with a massive jobs program focused on rebuilding the railroads and a crash building program of wind and solar energy (with concomittent upgrading of the electricity grid), together with the redevelopment of small cities and towns.

"... phase out the mortgage interest deduction, starting at the top with an absolute dollar cap."

There is already a cap, although it is not as straightforward as you seem to want. It is a cap on the amount of the mortgage for which the interest is being paid. There is an exception for mortgages taken out before Oct 13, 1987 where the amount deductable is unlimited. Otherwise the limit is a $1,000,000 mortgage. At a 6% interest rate, that would be $60,000 per annum, of which, at the top federal tax rate, $21,000 would be deductable.

Obviously, the special status of the grandfathered mortgages could be eliminated, which probably catches only a few rich people playing games since hardly anybody had a million dollar mortgage in 1987, Thus, this change would not disrupt the economy.

The limit could, in general, be reduced or removed immediately. I would counsel a gradual reduction since relatively many families would be affected. Perhaps trimming it to nothing over a period of 3 to 5 years might be reasonable.

I think it would be reasonable to nationalize the electrical grid and then proceed to upgrade it using government funds. After all, just about everybody and every place of business uses electricity, so the grid is as much a part of everyman's life as the interstate system. I am not so sure about the railroads, although nationalizing the rights-of-way would be philosophically similar to nationalizing the electric grid or the current status of the interstates.

",,, the redevelopment of small cities and towns."

I am pleased to see that you are not urging that these communities be raised and the occupants moved to the skyscrapers of the big cities. I happen to think that the cities and towns are both socially and environmentally more viable than the big cities. I think that a reasonable mass transit grid could leave those who don't work locally with a solo drive of only a mile or two to the mass transit carrier that will take them to work.

Nor do I have any need to.