If you’ve been watching financial markets for the past three weeks, they’re now emphatically telling us the recession is over and it’s all smooth sailing from here on.

No one ever wants to be the one guy bucking the crowd, which someone ends up doing during every market upswing. (That’s also the answer to the perennial but stupid question people ask during every bust: why didn’t you see this coming?) Consequently, you’re even starting to hear recent bears like Alan Greenspan and Nouriel Roubini say that an economic recovery is just around the corner. Nobody pays attention to you (or pays you consulting fees) when you’re saying what no one wants to hear.

What are the sources of the imminent recovery? For one thing, the economic statistics will show recovery as soon as the economy stops falling. That’s because GDP and other statistics are measured on a quarter-to-quarter basis. Compare this quarter to Q3 ‘08 and it will look horrible. Compare it to Q2 ‘09 and it won’t look bad. The change might even be positive.

But if there is to be real economic growth, where will it come from? The hunch is that China and other emerging economies are now growing robustly again. But since those economies are export-driven (although China has had a lot of government stimulus recently), they need a source of demand in order to sustain growth.

The U.S. consumer has traditionally provided that demand. But consumer demand is now down by about 2 percent from its peak in 2007. So far, the Cash for Clunkers program is the only measure shown to increase it, and that’s a government subsidy. That point contains the answer to the overall question. The U.S. government, through massive deficit spending, is providing the final demand that could be powering the beginning of a global recovery. Keynesianism is working.

This is borne out in the Commerce Department’s initial reading of Q2 GDP, which was released last Friday. It shows very significant increases in government spending, notably in the defense sector, as Obama steps up the war in Afghanistan.

In essence, public demand is replacing private demand in the global economic mix, and you have to ask yourself whether this development is sustainable. For a clue, remember that U.S. final demand from the mid-90s until 2007 was sustained well above trend by a strong increase in cheap credit available to consumers. Credit-fueled growth is obviously over and done with, but one borrower is still not having the slightest bit of trouble accessing credit at quite affordable rates of interest. Who? The U.S. Treasury, of course.

We’ve started inflating another asset bubble by financing economic activity with the same dynamic that led to the Internet bust and the Great Recession. The place right now where I see certain asset prices growing to borderline unreasonable levels is in high-rated corporate bonds. Watch them. Many are now pricing at spreads comparable to Treasury rates that are inside LIBOR.

So that’s one overall risk factor. Another is that inflation still remains a complete question mark. According to current inflation measures, real interest rates (nominal rates minus inflation) are at historically high levels, which squares up with the lack of private-sector growth. If the private sector recovers, we’ll be facing quite a mess on the inflation front.

In a perverse way, this situation could give Obama a reason to keep the private sector from recovering strongly. Slow growth on the private front would render the incipient government-led recovery more sustainable. It would also explain the sudden talk of middle-class tax increases from Tim Geithner.

Fed Chairman Bernanke is up for reappointment next year, and the questions are beginning in earnest about how he’s handled monetary policy. Some of the best-informed people out there insist that the cause of the housing bubble and the subsequent crash was an episode of low interest rates during 2003 and 2004, as the U.S. economy was recovering from the post-9/11 recession. Alan Greenspan was the Fed Chairman at that time, but Bernanke was prominent among the Fed’s governors, and fully supported the loose policy.

It’s always fun to look into the past for someone to blame, but the more important question is what this means for monetary policy going forward. To a careful observer, there can be no question that the crisis had many causes, and was greatly exacerbated by complex interactions that no one could have predicted.

For their part (and I agree with them), Bernanke and Greenspan have both pointed many times to the “savings glut,” a vast accumulation of dollar reserves by the governments of emerging nations. Its effects have been apparent since the mid-Nineties, as the excess capital reduced interest rates and excess production reduced inflationary expectations. Did the savings glut make possible the burst of financial technology that greased the skids of the financial system? No, it didn’t. But without the glut, there would have been far less incentive to find clever (and ultimately unsustainable) ways to increase investment yields.

We haven’t had such a strong deflationary episode since the early Thirties. Bernanke was absolutely right in seeing that coming. (We had more than enough clues from the various financial crises of the Nineties.) I simply have a hard time believing that twelve months of expansive monetary policy in 2003-04 triggered a housing bubble that arguably started up almost ten years ago and peaked in 2006.

Bubbles are blindingly obvious in retrospect, but very difficult to see when you’re in them, as counterintuitive as that may sound. When markets are rising, everyone who doesn’t pile on gets left behind, and that matters, because they lose their clients and go out of business. Greenspan and Bernanke would have been crucified for raising rates in ‘03 and ‘04 and prolonging the recession we were just recovering from. It’s always easier for a policymaker to let the party run on too long. Their indecision during the critical 2005-06 period shows in contemporary remarks by Greenspan that housing looked a little “frothy,” but probably not enough to be of concern.

But the question now is whether loose monetary policy is again setting us up for a crash. To compare quantitative easing to the low-interest rate policy of late 2003, is a lot like saying that the ocean is like a mud puddle because both are wet. We’re witnessing an extraordinary pulse of money creation, specifically intended to avoid repeating the grave policy errors of 1928-1932, a much bigger undertaking than counteracting a cyclical recession.

Market participants are now nearly unanimous in fearing powerful inflation ahead, as a result of the Fed’s current policy, and also because they see trillion-dollar budget deficits for years to come. Markets are violently uncertain on exactly how much and when, as can be seen in the daily see-saw of medium-term interest rates, commodity prices, and the dollar exchange-rate. But still: when everyone agrees on something, you  always have to ask what they’re missing.

The huge amount of money the Fed has created since last fall isn’t finding its way into the economy, and it isn’t fueling real inflation. (Things like crude oil and gold respond at least as much to market expectations as they do to reality.) The principal effect of all that excess money has been to repair the interbank lending markets, which are now looking quite close to normal. And this is a reminder that the Fed’s chief priority last fall was not the economy, but rather to prevent a financial meltdown. In this, they’ve succeeded commendably.

But what about the economy? What if final demand ticks up, and banks start putting money to work again? First off, it’s not a foregone conclusion that this is even possible. There’s no much wreckage in the financial system that no one really knows if the patient will start breathing on his own again, after the life support comes off.

But even if that does happen, the Fed has the tools to quickly wipe out huge amounts of excess liquidity. There are two questions: first, will they do it if/when the time comes? And second, will it matter?

The first, candidly, is a political question as much as an economic one. The government will doubtlessly apply pressure on the Fed to keep the party rolling, especially at a time when Bernanke is up for reappointment, and the historic independence of the Fed itself is being called into question.

But what if inflation appears, the Fed acts to quell it, and it doesn’t matter? This is a haunting and unanswerable question. The value of money is all about confidence. In history, hyperinflation has proved stubbornly unresponsive to actions by policymakers, especially in cases where  those same policymakers were seen as the cause of the problem.

We’re in uncharted territory, and it’s quite impossible to confidently predict how things will go from here, either in regard to the course of policy or to the course of events.

Today’s big story from Washington will be the release of a “comprehensive plan” for re-regulating the world of finance. The White House floated out an 85-page paper evidently meant to serve as a blueprint for a new regulatory structure. In keeping with this administration’s model of management-by-trial-balloon, the report appears in this morning’s New York Times and Washington Post.

It may not be worth examining the document in great detail, because (again in keeping with Obama standard practice) it most of the implementation details to Congress. So what is in here isn’t going to be close to what we’ll eventually get. But there are several things to note about the process and the philosophy at work.

The single most illustrative thing isn’t in the document at all, but in Obama’s own remarks, delivered in his trademark halting, somewhat diffident manner. The New York Times quotes him as saying:

Did you know, any considerations of sort of politics play into it? We want to get this thing passed, and, you know, we think that speed is important. We want to do it right. We want to do it carefully. But we don’t want to tilt at windmills.

In other words, it’s more important to get something out there and move on than it is to get it right. The president wants to do this quick and dirty.

You heard the same thing in January about the economic stimulus package. You heard it with the GM and Chrysler bankruptcy. You can see it in the president’s impatient desire to disengage from the truly hard problems in foreign policy, which have no quick and dirty solutions. And most of all, you see it in health care, which the president wants to completely reform before the end of July.

What was the process by which this paper was produced? It bears absolutely no marks of authorship. If Tim Geithner is the principal architect, his fingerprints don’t show. What Obama evidently did was to give every stakeholder in the financial industry a chance to express their desired outcome. Then he applied a political filter (”who are the people with the most powerful Senators on their side?”). And then he averaged the result.

What is the operative philosophy at work here? It’s evident from the paper that the blame for the financial crisis is being placed squarely on a lack of proper oversight by Federal regulators, of both financial firms and of financial markets. There’s no recognition of the role played by a powerful combination of low global interest rates caused by emerging-market reserve accumulation, together with rampant technical innovation that sharply increased the liquidity of financial instruments. There’s tangential recognition of the conflicted position of rating agencies, and also that there is such a thing as a “shadow banking system.”

But the real emphasis in the White House report is that there weren’t enough regulators minding the store, so they want to add a lot more of them. There is also a lot of talk about “protecting consumers and investors from financial abuse.” Now that’s so loaded that I don’t know where it really wants to go.

The bottom line is that the White House intends to tighten regulations on the financial system in accordance with the priorities of newspaper headline writers, while being careful not to step on the interests of the financial industry too much. An alternate, and preferable, approach would have been to take the time (even if measured in years) to actually understand the roots and the dynamics of the crisis and respond appropriately.

If you parse Barack Obama’s statements, and the talking points spouted in recent days by his surrogates all over Medialand, Blogostan, and Universitopia, you could be excused for thinking that health insurance companies are evil incarnate. Obama and his acolytes are saying that private health insurers need a massive government-funded competitor, in order to force them to reduce waste, embrace more risk, and be less profitable.

In recent days, I’ve been paying attention to the four largest publicly-owned health insurers: UnitedHealth Group, WellPoint, Cigna International, and Aetna. I’m curious for one thing to know just how much money Obama can save by forcing these companies to operate without making a profit. Answer: well below $10 billion a year. Considering that Obama’s own lowball bid for national health insurance is $1 trillion in new spending over the next ten years, he’s going to get less than 10% of what he needs by wiping out the common shareholders of these four companies.

So you’d guess they’re in big trouble, right? Think again. As I write around 1pm EDT on Tuesday the 16th, all four of those stocks are up sharply, anywhere from 3 to almost 7 percent. The other dominant companies in health insurance are the “Blues,” Blue Cross and Blue Shield. It’s harder to get financial information on them.

Something is going on here. I’ll let you know as soon as I figure it out.

That some should be rich shows that others may become rich,” said Abraham Lincoln, “and hence, is just encouragement to industry and enterprise.” Barack Obama has made it quite clear he wants to be seen as Lincoln’s heir. But in this instance, he is an heir in open rebellion. He is promising a range of policy initiatives that will have the effect of closing off new pathways to wealth, to the detriment not only of our economy but of our national life as well.

It’s a matter of some debate among economists whether the private generation of wealth is a necessary precondition for providing the means for a decent prosperity that can be shared by all. Clearly, there are and always have been societies throughout the world in which a small class of wealthy families controls the wealth of their nation or region and does little or nothing to spread it around. In those cases, usually in economies that maintain aspects of feudalism or that run along mercantilist lines, the rules of the marketplace are rigged in their favor.

But what of economies organized along market principles, like ours? These are a very different matter. Milton Friedman and his intellectual forebears in the Austrian School famously argued that free-market capitalism, in which people engage in largely ungoverned commercial activity that places them in active competition with each other, produces maximal prosperity for all levels of society in the aggregate.

This argument has always struck many people as a counterintuitive leap of faith, and yet over the past 30 years it has become the dominant economic view across the globe. After years in which the term “capitalism” was treated almost as a pejorative and the “free market” conjured up images of plutocrats and sweatshops, it became an axiom that “markets work.” China changed its financial course and set loose the fastest-growing economy in the history of the world when its post-Mao leader, Deng Xiaoping, declared, “To be rich is glorious”—a startling declaration for a Communist regime. In the United States in the 1990s, the party that had historically stood against the idea that the market should be left to work on its own was led by a President who not only embraced the idea of the free market but evangelized for it.

Click here to read the rest of this article from the June issue of COMMENTARY.

Fed Chairman Bernanke, in Congressional testimony today: “Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth.”

This is worth parsing. Bernanke’s talking about deficits. Earlier in the same speech, he said that it’s “necessary and appropriate” to spend heavily in deficit today, because of the urgent need to stabilize both financial companies and the economy itself. But he’s issuing a strong warning that continued heavy borrowing will create problems ahead.

Bernanke is engaged in an effort to stimulate an economic recovery by using monetary tools to reduce the level of medium and long-term interest rates (”quantitative easing”). The Treasury is trying to add to the effort by using fiscal tools (Keynesian stimulus). What everyone hopes will happen is that the economy will pick up and start generating its own momentum, so that by the time interest rates start ticking up by themselves, we’ll be able to lay off both the quantitative easing and the stimulus spending.

The danger, however, is that expectations for economic recovery will cause investor dollars to flow away from Treasury debt and dollar-denominated investments altogether, before the job has been done. As medium and long-term interest rates rise, Bernanke finds himself under considerable pressure to expand the quantitative easing program, which he’s very reluctant to do because of the danger of runaway inflation.

That leaves the Treasury needing to keep borrowing gargantuan amounts of money for a long time to come, probably years. And that keeps steady upward pressure on interest rates in the economically-sensitive medium and long range segments of the yield curve.

As a side point, there is a lively debate among economists and policymakers about the scope and size of the Federal government. Left-leaning people like Paul Krugman and Jeffrey Sachs have long championed a much larger government, in terms of its share of the economy, primarily to fund social-policy objectives. In a perverse way, these people are not helped if the economy recovers strongly, because interest rates will rise and make it more difficult for the Treasury to keep borrowing at high levels.

What Bernanke worries about in the long term is that permanent high deficits are unsustainable. In today’s environment of low private demand for credit, government can keep borrowing at relatively low rates. If demand for credit never picks up, then heavy borrowing is sustainable, but the result will be permanent low growth. If demand does pick up and interest rates rise, then government borrowing will push them up even farther, endangering financial stability (and incidentally necessitating strong policy responses from the Fed). That’s the expanded form of the sentence from Bernanke that I quoted above.

At this point in his testimony, Bernanke stopped. What I wanted to hear him say was: “…and given the need for real fiscal discipline rather than the phony kind that the President has been talking about, here are your alternatives…”

Bernanke’s job is to make monetary policy, not fiscal policy or social policy, so I can see his reluctance to connect the dots. I, however, am not so constrained.

Since we must scale back fiscal borrowing as we move into the future, there are only two alternatives: to accept far higher levels of taxation, or to accept a U.S. economy that is significantly smaller and slower-growing than it would otherwise have been. (The consequences of the latter, of course,are high unemployment and less material well-being for individuals.)

What would be a logical way to navigate between those alternatives? Adopt a high-tax policy that does as little as possible to burden highly-productive individuals, businesses and capital, thus lessening the impact on the size and dynamism of the economy.

But we already know that the President wants to do exactly the opposite. Faced with an evil choice between much higher taxes and a smaller economy, Obama is on track to give us both.

A week ago in this space, I alerted you to some unusual doings in the bond market. A very sharp decline got started in medium and long-dated U.S. Treasury debt on the same day that S&P made adverse comments about the sovereign debt of the UK. Some very knowledgeable people suggested the U.S. would be next. The decline gathered momentum and turned into a rout by last Wednesday afternoon. The yield on the 10-year T-note briefly went as high as 3.76%.

At that point, the stock market and the mainstream media got wind of the story. Stocks plunged 2% late in the afternoon on Wednesday, and a slew of news stories appeared about “bond market vigilantes beating up on Obama.” But as usual, the stock market and the press were late to the party, and bonds reversed almost immediately. On Thursday and Friday, we saw a rocket-propelled rally that took the 10-year yield all the way down to the mid 3.40s. The spate of bond market insanity stories has continued in the generalist media which doesn’t bother mentioning the rally. It must not fit the storyline, or something.

This morning, notes and bonds have reversed again and are declining, rather energetically, although not as in the middle of last week. However, this time the dollar has plunged and gold is soaring. The economic news background is full of optimistic signs, including indications that strong recoveries are underway in China, Australia, and, of course, in the U.S. The price of copper (which is heavily demanded in China for construction and power generation) just hit a multi-month high.

What the heck was going on in the bond markets? The best answer I can give you is that a highly technical readjustment took place among mortgage investors. These people appear to have decided en masse to hedge against extending durations in mortgage-backed securities and agency debt. This hedging is accomplished largely by selling or short-selling medium-range Treasury debt, particularly the 10-year note.

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There was a serious decline in the U.S. Treasury market on Thursday and Friday, accompanied by a sharp drop in the U.S. dollar, which backed over $1.40 against the euro. The 10-year T-note traded to yield 3.45% on Friday, and the 30-year bond almost reached 4.40%.

Yields are down slightly this morning, and the dollar is a bit stronger. (There is speculation that jitters over the North Korean nuclear blast are behind some of this action.) But it’s hard to miss a sense that sentiment is changing in this extremely important market.

Treasury securities have traded in a rather narrow range for weeks now, more or less since the stock market started rallying in early March. Typical yields for the 10-year note have ranged from 2.75 to 2.95 percent or so. (This maturity is the most critical for the economy and for the housing market.) But over just a few days, we’ve seen a sudden breakout to much higher yields in both the 10-year and the 30-year, while shorter-term yields have not moved as much. Thus, the yield curve has sharply steepened.

On Thursday morning, Standard and Poor’s changed their outlook on British government debt from “stable” to “negative.” These are terms of art which signify that S&P may at some point reduce its AAA rating on the UK. The stated reason was a lack of confidence that Britain would be able to square the circle of high public spending and poor prospects for economic growth.

That news story was followed quickly by a remark from Bill Gross (PIMCO’s chief investment officer, and one of the best bond traders in the world), that the U.S. might someday face the same fate.

About the same time, Tim Geithner was quoted as saying that medium and long-term Treasury debt is falling in price not because of a lack of confidence in the U.S. government, but rather because the economy is now recovering, and investors are ready to come out and start taking some real risk again. Have you noticed that when Geithner talks people have a tendency to assume the opposite of what he says?

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I’m astounded at how much really intelligent stuff is being written by people who are avowedly left-wing. For international-finance geeks, Brad Setser at CFR is a must-read, and Steven Waldman always has something thought-provoking. There are many others.

On the free-market side, most of what gets written is some variant of “Government is evil. Private actors may be anywhere from stupid to evil, but we prefer their stupidity and evil to government’s evil.” We already know that, so a lot of this material gets old pretty fast.

Finance commentators who are left-wing are generally unafraid to see that strict free-market outcomes aren’t necessarily for the good. They tend to be quite comfortable with exercising state power to constrain market behavior. On the right, people like me are generally very reluctant to embrace state power for two reasons: it leads to corruption; and it’s incredibly hard to get right.

I think the truth is somewhere in the middle. A strict, pure free market would allow any and all manner of financial arrangements among private parties. Although nothing remotely like this has ever existed in human history, I’m inclined to expect that such a state of nature would be fully self-policing. The key aspect of it that’s missing from today’s world is failure. Under strict free markets, you go out of business when you fail. You also risk failing when you do business with someone else who fails. And that induces everyone to carefully consider who they do business with and on what terms.

A very complex system has evolved for dealing with the consequences of free markets. Business failure isn’t always just. Think of Bear Stearns, which was fully solvent when rumors of its pending insolvency became self-fulfilling and destroyed a venerable firm in seven days flat. There’s a lot of structure in our legal system intended to prevent the full impact of free-market failures from hitting firms, stakeholders, and counter-parties under circumstances deemed less than fair.

But we may have taken this too far, into the realm of unwritten rules. Consider the discussion in regard to companies that are “too big to fail.” In these cases, agencies of government are entirely willing to expend enormous amounts of taxpayer money in order to prevent systemic disruptions due to business failures. The whole global financial system is now stabilized by government promises of this nature. Private actors no longer need to think very hard about doing business with weak counter-parties who bear the mark of “systemic importance” and for whom failure is (politically) not an option. Since this is quite unprecedented, we have no idea (yet) how brittle this environment is, or how susceptible to shocks like asset bubbles and their collapses.

The bottom line is we don’t have a free-market system. Such a thing is in fact quite impossible in practice, because of the ease with which powerful financial actors can influence and corrupt governments. Favored entities like Citigroup and Goldman Sachs will never be exposed to the full consequences of their actions, and will thus remain a permanent source of systemic risk.

To their immense credit, financial commentators on the left recognize what’s happening: huge amounts of taxpayer money are getting shoveled into the maws of politically-connected people and organizations who are rewarded for taking risks they would never take if they were fully exposed to the consequences of their practices. To oppose this is really a kind of populism (reminiscent of left-wing currents of the past, like the Free Silver movement), rather than the shibboleth of thoroughgoing state control (”socialism”) that is so feared on the Right.

I worry that those on the Right, with their emphasis on low regulation and fragmented government power, are enabling the Goldmans of the world to keep gaming the system in their favor. The proper alternative would not be a system of government control over the economy, but rather a system of strict financial regulation that makes it largely impossible for people to take risks with other people’s money.

How to do that without suffering the evil of government corruption, a risk that is underestimated on the Left? That’s another story.

U.S. stock markets have bounced off their lows of early March by a good 30%, from about 670 on the S&P 500 index to yesterday’s close just below 920. Three-month dollar LIBOR has just broken below 1% (from 5% last October). The U.S. Treasury yield curve has steepened sharply over the last several days. The 10-year Treasury note (whose interest rate creates a baseline for commercial credit rates throughout the economy) is now yielding 3.15%, up from 2% at the beginning of the year.

These signs add up to a very substantial return of willingness by private investors to take risk in the current environment, and to make capital available to private businesses.

In short, corporate finance has been on fire. Since about the middle of March, new issuance of corporate debt, from high-yield to investment-grade, has shot ahead. And if yesterday’s action (the best day in several years, by some measures) is any indication, the party is just getting started.

In normal times, one would observe such action, with sharp tightening in the yield spreads between risk-bearing and risk-free debt (that’s jargon for “bonds are getting more expensive”), and expect to see money moving from its normal home in the bond market into the stock market. Although that traditional pattern would explain the recent stock market rally, I’m hesitant to connect those dots just yet, because these are not normal times, and the dynamic underlying the stock rally could well be something different. Indeed, bond market commentators have indicated often enough in recent months that bonds are taking their cues from stocks, which is the reverse of normal.

Obviously, the questions related to the stock market are: does this rally have legs? Is it the real thing, or is it a deceptive “bear market rally” destined to fizzle and break all of our hearts? This post is too short to get at an answer to those questions, and anyway there’s no shortage of people in the media and the blogosphere who pretend to have the answer for you. (If there’s a consensus of opinion out there, it’s probably close to “buy now, with both hands, but make sure you sell before the market falls again, so you don’t blame me for giving you bad advice!”)

Let me tell you what concerns me. Yes, indeed, we’re seeing large flows of new capital into business corporations, and it’s a very good sign that investors are newly willing to lend to them again. (And of course the frozen zombie banks have little to do with this, except possibly as buyers of new debt, although whether that is true is not yet clear.) But why are businesses borrowing money? There are no indications that they are borrowing in order to fund new business activities. Reread that sentence before you go on. It’s very important.

Businesses are now borrowing in the current financing window as long as it remains open (which may not be forever), in order to improve their balance sheets. They’re looking to line up additional sources of liquidity, and to improve the efficiency of their capital structures by retiring shorter-term debt and replacing it with longer-term debt. They want investors to stop worrying that they will have to refinance in the short-to-medium term, under conditions that could well be far worse than today’s. That they are willing to lock in relatively high interest rates to do all this is indicative of a mindset that owes more to caution than to animal spirits.

What does that say about stock prices? Very simple. Equity investors today are willing to pay a significant premium for companies that have strong balance sheets or are strengthening them. That’s probably a major reason the stock market is going up. It could be the major reason.

What does it say about the economy? Nothing terribly good. Until businesses start demanding credit for the purpose of expansion and investment, rather than to reduce their overall leverage, economic conditions will remain slow. This could persist for years to come. We may be looking at the early stages of a period in which financial markets outperform the broader economy.

Another term for such a period is: “asset bubble.”

In a remarkable editorial, the New York Times informs us that Senate Republicans are blocking the economic recovery by impeding legislation that would allow bankruptcy judges to modify the terms of troubled mortgages.

Let’s begin by examining the Times’s unquestioned assumptions. The biggest, ugliest one is that we must prevent mortgage foreclosures at all costs. This error is very important to understand, because it’s shared by Sheila Bair at the FDIC, Barney Frank at the House Finance Committee, and nearly everyone else who’s engaged in making policy.

The high incidence of distress in home mortgages is happening for a very good reason: housing is still overvalued, both in an absolute sense, and relative to household income. We simply built too many houses during the bubble, and that oversupply needs to be worked off over time. And now that equity values have stopped rising every month, people have nothing but their incomes to fund their mortgage liabilities and, on average, that’s not enough.

Therefore, to say that we must apply policy to prevent foreclosures is to deny economic reality. The effect of government’s multifarious efforts to keep people in their homes is to prevent the housing bubble from fully deflating, which must happen for us to start directing economic resources rationally again and get a recovery under way.

And yes, I’m well aware of the argument that an endpoint housing deflation can permanently equilibrate the market at far lower levels. Guess what? That’s a pretty accurate description of a low-leverage, expensive-capital world. And how is that any different from the real private sector economy we have today? To suppose that policymakers can counteract this is to believe you can stop water flowing downhill: in reality, you can only slow it down, and you’ll get awful wet in the process.

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The stock market has stopped falling (for now), and the banking crisis hasn’t generated any major new headlines for several weeks now. Policymakers from Ben Bernanke on down have been talking about “green shoots” appearing in the economy. Meantime, the published statistics and many of the corporate-earnings reports continue to show an economy in a deep funk.

It’s still far too early to say whether the economy is beginning to recover from the body blow delivered to it by the shutdown of new private-credit formation. But even if discretionary consumer spending remains comatose for an extended period (possibly stretching into years), there is still a lot of basic economic activity that must take place.
The private economy will find ways to muddle through and start growing to some extent, even with a non-functioning banking sector.

The nascent reality businesses must deal with today, and that economists and policymakers will recognize tomorrow, is that we now live in a capital-constrained world. Alan Greenspan often said the real benefit of financial innovation is the creation of more usable capital. In that sense, it’s like any other kind of technology.

Whole books will be written on the subject of how best to control the future advance of financial innovation. But many now believe that the last twenty-five years have seen explosive growth in financial engineering, based on the idea that magic happens if you don’t try to control financial instruments. That idea is now in full retreat.

It will be a while before consensus emerges among policymakers about whether Wall Street should be clamped in regulatory irons, even as taxpayer dollars are used to keep the crisis’s culprits in business.

In the meantime, of course, financial innovation is at a standstill because investors and financial institutions have to rebuild from all the losses they’ve suffered. Even without regulatory inhibition keeping financial innovation in check, we’re not experiencing much on that front right now.

And as Greenspan suggested, we’re all feeling the crunch in terms of reduced capital availability. I don’t believe this effect is entirely cyclical, because measures of private credit formation started plummeting in early 2007, long before the economic recession started. We face secular declines in capital availability that will persist even after the current recession ends. Combine today’s uncertainty with tomorrow’s new regulations, and the problem gets worse, not better.

Who benefits the most from that? In an odd twist, the United States does.

Capital always seeks out the highest risk-adjusted rate of return. For over a decade, returns were far better in emerging countries than in developed ones (in non-risk-adjusted terms, the ratio may have been 5 to 1 or higher).

But why would you invest in emerging economies? In order to gain exposure to their development of manufacturing and other productive capacities.

And what’s the point of developing production in places like Vietnam, Thailand, China, and Brazil? To make stuff to export to the United States and the EU.

Everything depends on consumers in the U.S. and the EU — the regions that generate most of the world’s final demand. Consumers may retrench permanently in the face of today’s uncertain economy and tomorrow’s higher budget deficits and taxes, as we struggle to provide healthcare and wind-generated electricity for all. If that happens, then it will make less and less sense to invest scarce capital in emerging countries.

What capital there is will tend to stay in the developed economies, and particularly in the U.S. Rampant financial innovation has been an engine that has lifted hundreds of millions of people out of poverty. As the engine sputters out, the effects in the emerging world will be very serious indeed.

If you look at the domestic initiatives currently on the table, they are all geared (with one major exception) toward reducing uncertainty and risk from ordinary people’s lives. This is a far cry from the older conception of government’s role, which was to enforce contracts and some other basic rules and then get out of the way.

In times of broad economic uncertainty, it’s understandable that We The People would vote for the candidate who’s most focused on dispelling our fears. In the present case, this impulse has left us with a new activist government that’s eager and ready to pursue broad ends. This government must now ensure that it has the means to pursue those ends, but in doing so it must strike an important balance between private incentives that keep the economy running and government-imposed stability.

The major policy initiatives being discussed are: universal health-care (or at least universal health insurance); sweeping re-regulation of business and finance; and the replacement of carbon-based energy sources. The first two are all about eliminating uncertainty over the material circumstances of life. Green energy policy is the exception, and it’s no surprise that it’s the only major Obama initiative that doesn’t (at least superficially) command broad popular support.

We’re passing through a major social crisis in America. For several decades now, we’ve accepted that people freely acting in their own best interests will produce prosperity, if not stability. That equation is now in question. The people seem ready (as they were in 1932) to accept broad curbs on private freedoms in order to attain stability.

In other words, having suffered large losses in their home values and in the stock market, the people are looking for assurance that such things can never happen again. While they’re at it, they want to know that they’ll be able to send their kids to college, secure the health-care they need, and retire in comfort. They need to feel like someone is in charge. Market capitalism assures us that “it’s all up to you; if you work hard enough and smartly enough, everything will be great.” These assurances now ring hollow to many.

Therefore, the next few years will see a new openness to very different social arrangements. The objective is to deliver to everyone, or nearly everyone, a basic level of material well-being, including housing, healthcare, and access to higher education. And just as FDR did with Social Security (which in his famous words could never be taken away), Obama is trying to seize this opportunity to guarantee the essentials of middle-class life for everyone.

But not every individual produces at the same level consistently throughout his or her life. To ensure basic sustenance for all, we must stand ready to provide it by redirecting resources (including goods and services) in comprehensive ways. Finally delivering on the promises of the New Deal and the Great Society means that government will necessarily have the power to dispose of far more of society’s aggregate productivity than Americans have ever tolerated before in peacetime.

What comes next you’ve heard many times before. Government by itself doesn’t produce anything, or at least it doesn’t do so efficiently. Communism doesn’t actually work. If we want to provide an economic baseline for everyone, we still need to preserve private incentives for those who are highly motivated to produce efficiently. If we really want to go down this road (and I still think there are better ways to go), then we need a new American corporatism.

I’ve proposed at various times a compromise plan for how this might work. We need to ensure that economically productive investments continue to be made, while at the same time ensuring that most of the people can enjoy expanded benefits provided by the state. Taxes on business income and capital gains must be eliminated. The payroll tax and the income tax should be merged together, and eliminated entirely for every individual earning less than, say, $250,000 a year. For everyone above that level, tax at a flat 50%, but never allow that percentage to go any higher.

Is the Obama administration prepared to take these kinds of measures to institute the economic security it thinks necessary? We’ll just have to wait and see.

It’s interesting that, to a lot of people in the non-specialist press, the key question respecting the banking system is the “N” word: whether or not we should nationalize troubled large banks. There’s quite a lot more to the story.

It’s true that we have a lot of large financial institutions at or near the fuzzy edge of insolvency, given the losses they’ve experienced on mortgage-backed assets. It’s also true that we’re having a recession characterized by a sharp decline in the amount of credit available to consumers and smaller businesses.

So it seems pretty simple: fix the first problem, and you automatically fix the second, right? Not so fast.

Most of the discussion centers on what it might take to open up the balance sheets of the largest banks. They’re holding vast portfolios of assets that have declined sharply in value on a current market basis, but have declined only moderately in terms of their stable long-term value.

What does that mean? It means that if you sell a mortgage-backed security today, you’ll receive a fire-sale price. But if you hold it to maturity, you’ll realize almost the entire value of the asset.

(Part of the calculus here is that Congress and the FDIC have deemed it politically unacceptable for people to default on mortgages. So there’s an arbitrage between the real default risk of a typical mortgage, which is reflected in its current market value, and the realizable value in the long term. The government won’t let these assets lose value.)

So on a hold-to-maturity basis, most of the large banks are not likely to fail. (Citigroup is an exception because it’s half bank and half broker/dealer. Arguably, Citi is functionally insolvent now, absent massive government support.)

So why would we want to even consider nationalizing these entities? Because they’re at the edge of their asset-carrying capacity now, and can’t raise new capital. That translates into little or no net new credit for economy. The nationalization idea (and neither-fish-nor-fowl ideas like Tim Geithner’s toxic-asset rescue plan) contemplates recapitalizing the banks with public money.

You could argue against this on free-market grounds, but free markets seem like a gauzy memory now anyway.

What’s more important is that the loss of new bank credit isn’t what’s driving the credit crunch in the first place.

Up until 2007, banks provided perhaps one-third of the credit in the United States. The rest came from the asset-securitization markets (the so-called “shadow banking system”), which has now come to a near-complete halt. We should be asking what it will take to bring securitization back.

Let’s say we follow through on one of the various plans to finance the huge wad of overpriced mortgages that are currently in force with public money. And let’s assume just for fun that we can print or borrow enough money to do that without consuming too much of the world’s private capital.

Does that mean we’re going to encourage companies like Bank of America and JP Morgan Chase to start expanding powerfully, into the gap left by the retreat of securitization? Weren’t we already concerned that they were too big to fail?

And in any case, shadow-banking finance depended greatly on the use of extremely high leverage ratios, once available to hedge funds and Wall Street firms, but never available to banks for on-balance sheet assets, and certainly not today. That financing model won’t be coming back either.

Bottom line, nationalization isn’t going to do much harm, or much good either. What we really need to do is prepare for a world in which capital is scarce and expensive, compared to the recent past.

Here’s a post from Robert Reich, who was Bill Clinton’s Labor Secretary, and is a union sympathizer and all-around nice guy.

Reich’s thesis is very simple. He says that the economy is now in a depression, with the “fully loaded” unemployment rate (including people who have stopped looking for work and people working part-time) at 15.6%. The top unemployment rate in the Great Depression was 25%.

Reich’s prescription is equally simple. The government has to spend far, far more than it has been. Like Paul Krugman, he faults Obama not for being a radical, but for not being radical enough. Obama, in other words, needs to spend more.

Spend on what? All the same stuff you’ve been hearing about. Solar panels and windmills. Universal health care. Public transportation systems. Reich, refreshingly, goes the full Keynesian mile and speaks what others have merely fantasized about: he also wants to put Americans to work weatherizing other people’s homes and building more (unneeded) buses and trains with Detroit’s unused car-making capacity. In short, it’s the old “pay someone to dig a hole and then fill it up again” idea, refuted by Bastiat and embraced by Keynes.

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This is very interesting. It sheds a certain amount of light on the actual objectives of the public-private investment plan that Tim Geithner is trying to push as a solution for the banking crisis.

It’s all about finding the least painful place to stash the losses from the collapse of the housing bubble and the subsequent destruction of leveraged financial procedures.

For every borrower, there’s a lender. When people default on their mortgages (or when they become statistically more likely to default because of deflation), the lenders face losses too. Most of those prospective losses are locked up inside the packages (”securitizations,” or MBS) that are now such a large part of the asset portfolios of major banks.

What makes these assets “toxic” is that they can’t be sold or marked to market, because the current value of a typical mortgage is now a small fraction of its face value. So the largest banks are stuck holding these assets.

But observe that the vast majority of mortgages won’t default. There’s a reason why everyone wants to invest in mortgages: ordinary consider it a matter of morality to pay their debts. So if a bank paid $100 to buy a mortgage that’s now priced in the market at $15 or $20, they have the option of holding the mortgage for the next five years or so. Adjusting for default risk, they might end up realizing $85 or $90 (in nominal dollars) at the end of that period.

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It’s now clear that the next step forward for GM (”Federal Motors,”although they’ll probably keep their existing ticker symbol) will be very similar to bankruptcy. It’s also clear that, in a move of breathtaking audacity (not to mention hubris), the President of the United States has chosen to become the de facto CEO of the largest (by revenue) American corporation.

GM’s future is much like a bankruptcy because of two things: contract renegotiation, and financing. Its future is unlike bankruptcy in that there will be no enforced performance metrics. And the whole exercise is a radical shift in direction for governmental involvement in private affairs.

Everyone has their pet theory about why GM is failing. People who hate unions blame antiquated, high-cost labor contracts. People who want nationalized health care blame the fact that GM is obliged to buy gold-plated coverage for over a million retirees and their families. And people who hate GM blame its marketing.

All true to some extent. But the proximate reason GM went over the edge, is a collapse in the North American vehicle market. As recently as November, GM executives were saying that they expected the market to return to 16 or 17 million units a year by 2010 or shortly thereafter.

Horsefeathers. Reality will be in the neighborhood of 9 or 10 million units for the foreseeable future, and perhaps beyond. This is the kind of structural transformation in a market that flushes away the older and less-efficient production capacity. We don’t need GM to stay in business.

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When we last visited with General Motors, it was the time of Hanukkah nights and Christmas greetings. GM came within a whisker of running out of cash last December, and was bridged by a quick infusion of TARP cash, in Henry Paulson’s waning days as Treasury Secretary. As a condition of that hurriedly-arranged bridge loan, GM was required to come up with a viable business plan, or else be forced to return the TARP money. That was the headline, anyway. And the plans were due on… March 31.

As I wrote in a series of blog posts back then, there was no way on earth for GM to present a viable, standalone operating plan. Why not? Because the GM menagerie includes one stakeholder that enjoys near-complete political protection: the United Auto Workers.

GM has been losing money for years. It became apparent last summer that they faced a serious cash crunch which would require them to arrange new financing, new capital, or both. Their burn rate at the time left them with 12 to 16 months of runway. That was last summer. Starting in October, the North American vehicle market suddenly collapsed, and has not recovered. In each month since then, not only GM but every major automaker operating in the U.S. has seen declines in sales of anywhere from 20% to over 50%. That’s a shockingly rapid deterioration in such a enormous market.

And just as shockingly, GM went from burning about $1 billion a month to more like $5 billion, by my own calculations (which have been borne out by subsequent events). It was evident by early December that GM was out of cash by New Year’s Day.

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There is an easy way to re-inflate the economy. Just abate everyone’s income, business and payroll taxes for a year, two years, or even longer if necessary.

Policy right now has become a mad scramble to get money flowing through the veins and arteries of the economy. We have Congress passing huge spending bills that depend on fiscal deficits. We have the Treasury trying to convince us that securities based on existing mortgages are worth much more than everyone knows. We have the FDIC trying to convince us that people in distressed mortgages shouldn’t be allowed to default. And we have the Fed monetizing hundreds of billions of dollars’ worth of Treasury debt.

Why does all of this inflationary activity have no effect on prices? Because credit intermediation is still frozen at levels far below the norms of recent years. Inflation isn’t too many dollars; it’s too many dollars chasing too few goods. The roughly two-thirds of retail and business credit that has been being supplied by asset securitizations is now gone, and there’s no way for it to come back except at much higher interest rates. Which is to say, it won’t happen, because those higher rates cut against the logic of borrowing money in the first place.

We’re caught in a deflationary cycle which may or may not be every bit as bad as that of 1930-32. There’s no way to actually know that, because today’s monetary authorities, with Ben Bernanke at the head of the list, understand how important it is to counteract deflation. They’ve ginned up a gale of inflation, blowing in the opposite direction from the gale of deflation, and they’re roughly canceling each other out. (We are starting to see some asset bubbles begin to re-form, of course. Keep your eyes on oil and gold again, as well as U.S. Treasury debt.)

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Congress debated a very important subject this past week: how to regulate the financial industry in order to reduce what is called “systemic risk.” Although the debate was overshadowed by the flap over bonus payments at AIG, the insurance industry is playing an important behind-the-scenes role.

Senators Dodd and Shelby (respectively the Chairman and ranking minority member of the Finance Committee) are involved in the debate, but the key individual is Chairman Barney Frank of the House Financial Services Committee. Questions have been raised about the degree to which Dodd is even interested in the debate, and, as a Republican, Shelby hasn’t much of a voice anyway.

But Frank is engaged, highly knowledgeable, and determined to aggressively re-regulate the financial sector. The problem with Frank is that, as he disclosed in vivid public statements last week, he doesn’t trust private enterprise to get things right.

The insurance industry badly wants to escape new curbs on its activities from the ineluctable wave of new regulations Frank will lead. Insurance companies are regulated by the states rather than by the federal government. They don’t take deposits from the public so they escape the purview of the FDIC.

But the emergency bailout of AIG last September was engineered by the Federal Reserve, which is perhaps the only entity on earth that could conjure up an $85 billion credit line on a single day’s notice. Thus the question for Frank is which federal agency should be given the task of regulating systemic risk: the Fed? The SEC? The FDIC? All of the above? Some totally new, as yet uncreated agency?

Insurance-industry lobbyists have been making the case to Frank that he should find a way to manage systemic risk before he goes about regulating individual sectors of the financial industry. They want him to find a way to prevent coordinated collapses across many markets before he starts rewriting the rules for their industry.

But the lobbyists rolled snake-eyes this week, with the vicious flap over AIG. It’s perfectly clear insurance companies that participate heavily in the shadow banking system, contribute to systemic risk.

Many suppose we need to prevent financial companies from getting too big (and by extension, to prevent their employees from making unseemly amounts of money). If no one is allowed to become Too Big, then no one can become Too Big To Fail, and thus no future bailouts will be required.

But this ignores that systemic risk can arise when nearly every financial actor (large or small) makes a similar bet, in this case that mortgage-backed securities purchased with borrowed money would not collapse in value. There simply isn’t enough capital in the world to reserve against such a “meta-systemic” configuration of risk, especially when market liquidity disappears, as it reliably does in times of crisis.

To Barney Frank, the problem is designating a regulator for systemic risk so that he can get on with whatever will come next. But after he does so and declares the systemic-risk problem to be definitively solved, we’ll still be left with no one knowing what the next source of systemic risk will be.

Investors aren’t in business to lose money. They already know enough to avoid the specific errors that led to this crisis. But systemic risk is a built-in feature of highly-liquid financial markets, and it doesn’t disappear just because Congress says so. Naming a regulator simply papers over the fact that no one knows how to mitigate systemic risk, short of outlawing financial innovation altogether.

The Federal Reserve announced a momentous shift in policy yesterday. Its import was easy to miss because, as always with the Fed, it was written in a jargon only superficially resembling English. But its intention is to take actions that will deeply shift the policy landscape, probably to a much greater extent than Congress’s various stimulus plans.

The Fed announced an American version of what has been called “quantitative easing,” or QE. The Japanese have done this before, and the British got into it a few weeks ago. You can think of it, with no loss of accuracy, as inflation.

QE is what monetary authorities resort to when policy interest rates go to zero, which is where they are now. If you can’t reduce the price of money any further, you simply increase the amount of money. The Fed will be monetizing (purchasing) about $750 billion in mortgage-backed securities and about $300 billion in straight Treasury debt.

They’ve purchased mortgage paper before (last December), but the Treasury debt purchases are new. And the bond market’s reaction to the news was electric, as interest rates fell sharply, particularly for the 10-year note. Inflation-sensitive commodities like oil, gold and copper also shot up 5% or more in price, and are holding those gains this morning. The news is also a mild positive for the stock market, which can benefit from inflation.

What is Fed Chairman Ben Bernanke really trying to do? He wants to unfreeze the “credit crunch” that is making it too expensive or even impossible for U.S. consumers and businesses to borrow money, which was the trigger for the current recession. The Fed directly controls only the shortest-term interest rates. But consumer purchases (including mortgages) and business investments are sensitive to longer-term interest rates. QE is the Fed’s way of trying to reduce real interest rates in the 2 to 10-year range of the spectrum.

This is also the biggest experiment in monetary policy in history. Milton Friedman is known for having explained the genesis of the Great Depression in monetary terms. Bernanke, a close student of the early Depression, is determined to prevent the wicked asset deflation of 1930-32 that ruined so many lives. At what cost? Well, the Fed’s balance sheet just grew by $1.15 trillion: it’s now 50% bigger than it was a day ago. That’s a scary amount of inflation.

What no one really knows yet is the exact linkage between the formation of new money, and the formation of new credit. Bernanke and his Fed are gambling that a giant pulse of monetary inflation will reignite private lending. We can only hope they’ve pointed their fire hose at the right problem.

For every lender, there’s a borrower. The Fed will succeed if the problem in credit markets is the reluctance of lenders to write new loans. But if the problem turns out to be a lack of demand for credit, then all we’ll get out of this is stagflation.

It seems like a relatively small amount of money: a $165 million partial payment to a few hundred traders and managers on AIG’s London derivatives desk. And according to the company, the money is contractually owed the recipients. Besides, incentive pay like this is needed to retain the best performers.

But AIG lost just shy of $100 billion last year. They funded the lion’s share of those losses with an extraordinary credit facility from the New York Federal Reserve Bank (headed at the time by Tim Geithner).

If the Lehman Brothers bankruptcy was the match that touched off the global financial conflagration last September, AIG Insurance was the dry powder in the room. AIG had quietly (and lucratively) contrived to guarantee the credit quality of debt securities in portfolios around the world, and when Lehman went down, the collateral calls on AIG were incredibly large. In the vast rogue’s gallery of malfeasance, idiocy, and wishful thinking that has become global finance in recent years, AIG stands out. It is a very special case, both in the audacity of its actions and in the scale of the damage its failure caused.

And now, the behavior of AIG’s executives with regard to bonus payments sets them apart yet again in a season of extreme public anger at financial practitioners of all kinds, from Bernie Madoff to the most prudent bank managers.

The NY Fed’s deal with AIG, hurriedly struck over the course of a single hectic day, has been modified many times. The U.S. Treasury now owns securities issued by AIG that are convertible into just under 80% of the company’s common stock. The Treasury owns AIG for all ends and intents.

And by my reading of the relevant term sheets and subsequent covenants, there is indeed a case to be made that the Treasury can induce AIG’s management to rescind the payment of bonuses to the very traders and managers who caused all the damage. The contractual issues are real and will be litigated, but again, AIG is a very special case and deserves the attention.

It’s quite remarkable, and indicative of the public mood, to hear Iowa Senator Charles Grassley demand that the managers of AIG publicly apologize and then either resign or commit suicide. He literally said it!

There’s much to debate about the way government should deal with the financial companies it has rightly chosen to assist through extraordinary means. I had every confidence that people like Henry Paulson and Ben Bernanke fully understood the critical importance of returning private businesses to private control as soon as possible. But I have very little confidence that Congress and the new administration have the same understanding.

Be that as it may, AIG is made special by the depth of its  sins and the reach of its  impact. It deserves no sympathy. AIG’s core insurance businesses are well-regulated, healthy and very profitable. They should be divested as soon as possible, with the proceeds to benefit the Treasury rather than current shareholders. But the toxic mess that is the AIG credit-default swap portfolio will unavoidably be the government’s problem for several more years to come.