Cezary Salad

Open up any paper today and you’re sure to read something along the lines of “the government’s leverage over US banks is weakening” because so many of them are exiting the Troubled Asset Relief Program (aka the bailout fund). With Citi and Wells Fargo announcing within hours of each other that they will be paying back their bailout packages, the banking sector as a whole will have paid back $161 billion of the $245 billion it received from the bailout fund, according to the Wall Street Journal.

To be sure, there is no denying that by repaying their bailout funds the banks are freeing themselves from the kind of scrutiny and tight control over pay and perks that comes with being a taxpayer-supported entity.

But let’s not kid ourselves: the US never really had much - if any - leverage over the banks it bailed out. I realized as much last week when I went to hear William Dudley, President of the Federal Reserve Bank of New York and a key behind-the-scenes player for bailout of insurer AIG, speak at my university (video available on the Columbia World Leaders Forum website).

Think back to September 2008. When Fed Chairman Ben Bernanke and former Treasury Secretary Hank Paulson went to Capitol Hill to ask Congress for the bailout funds, their rationale was simple: the very existence of the US financial system is at stake. As Dudley put it:

“The choice that faced us was financial Armageddon or saving the financial system. It was a choice between two bads and we picked what we thought was the less bad. But it wasn’t a great outcome - we agree with that.”

The reason it wasn’t a great outcome, of course, is that there was seemingly no way to separate saving the financial system from saving the financiers who nearly felled it. As a recent inspector general report uncovered, the US Treasury made its initial $85 billion loan to AIG last year knowing full well that substantial chunks would be used to make payments to the bankers it dealt with - i.e. Société Générale, Goldman Sachs, Merrill Lynch, Banc of America, among others.

Providing the loan was necessary to avoid the aforementioned Armageddon. But it also resulted in the so-called “backdoor bailout” of these banks, as they got their money and they got it at 100 cents on the dollar. So now that many of them are doing better and have either awarded or are about to award billions of dollars in taxpayer-funded bonuses, “wasn’t a great outcome” is putting it lightly.

Dudley acknowledged as much; he said multiple times that this was unfair, adding “if there were some way that we had the tools to save the financial system and not save the bankers, that would have been a better way to go. But we didn’t have that choice.”

New York Times columnist Paul Krugman thinks they did. In a scathing November 19 editorial, he accused the Fed of treating the financial industry with “kid gloves” because Dudley and his team did not exact concessions from the bankers who got AIG’s - rather, the taxpayers’ - money.

Krugman’s “kid gloves” comment was on my mind when I asked Dudley why he couldn’t wrestle even the slightest concession from, say, Goldman Sachs. After all, the investment bank held a call with business reporters in early March to say, in essence, that it had hedged its bets well enough that it did not need the $13 billion it received from AIG. Dudley was curt in his answer:

“If you’re preventing a bankruptcy, you’re supporting all the counterparties. You cannot pick and choose. And so whether Goldman Sachs was well hedged or not was immaterial.”

In other words, at the point when you say, “we’re going to avoid a bankruptcy,” you lose your leverage. The normal rules of the financial system apply and everyone gets paid what they’re owed, as opposed to a bankruptcy situation, where the senior creditors would have gotten their money first and counterparties like Goldman would likely have ended up empty-handed.

“To put it starkly, power in a negotiation comes either from being able to issue a credible threat or from coercion,” Dudley said in his prepared remarks. He freely admitted that the Fed clearly had neither tool at its disposal.

And so the financial system was saved - as were the bankers.

Lesson learned? Well, if the US gave $85 billion to an insurance company that then went on to post a world record $61.6 billion quarterly loss and reward the executives responsible for the loss with bonuses, that doesn’t say much about our ability to attach strings to bailout funds to limit these not-so-great-outcomes. Indeed, as with AIG, so with the other TARP recipients, who took when they needed and haven’t much changed their behavior.

And why should they? To paraphrase Dudley, power in negotiation comes from leverage. And the only leverage the US has these days is $12 trillion in national debt.

I originally wrote this as one post reflecting on the trends and catalysts behind the rapid increase in oil prices. But after receiving feedback from readers, I decided to split it up into three shorter posts that examine each of the long-term trends more in-depth. The following post examines the first trend: dollar depreciation.

As oil prices continued their drop today, falling more than $18 since last Friday, analysts and commentators began to question whether oil is finally in retreat thanks to any one of a variety of pet causes and issues blamed for its dramatic rise.

But much to the chagrin of scapegoaters everywhere, unlike in years past - such as in 1973, when the OPEC oil embargo caused prices to spike - there really isn’t any one central factor that we can squarely pin the blame on for rising oil prices. Instead, three long-term trends that have been converging since the early 2000s - dollar depreciation, tightening global oil supply combined with rising demand, and increasing commodity price speculation - provided the powder keg, while the fallout from the credit crunch lit the fuse that caused oil prices to explode so fast and furiously.

Over the next three posts, I will examine each of these trends in turn - beginning with Congress’s current favorite: the depreciating dollar.

Mind the gap

As fears over Fannie Mae and Freddie Mac recently brought the dollar within a penny of its record low against the Euro, members of Congress have increasingly focused on the depreciating dollar as the source of and solution to all our woes. Witness Congressman Ron Paul (R-TX) informing us at Tuesday’s biannual Humphrey-Hawkins hearing that we don’t need “a world-class regulator that is going to solve all our problems” but rather “a world class dollar - a dollar that is sound, not a dollar that continues to depreciate.”

To be sure, as Chairman Bernanke acknowledged in his testimony, the falling dollar has definitely played a role in oil’s spectacular rise over the last year. To see why, just look at the gap that’s been slowly emerging between the price of oil in dollars vs. gold:

While the price of oil in dollars has nearly doubled, the price of oil in gold has risen by 50% over the same period. This discrepancy becomes an even more jarring 3-to-1 if we turn the clock back to late 2001, when the dollar began its tumble. Small wonder that in January of this year the Financial Times crowned gold as “the new global currency.”

This has led some economists - notably Stephen P.A. Brown at the Federal Reserve Bank of Dallas - to estimate that the depreciation of the dollar is responsible for a large percentage of the rise in oil prices over the last seven years. “If the U.S. currency had held its 2001 value against the Euro, oil would have traded at about $80 a barrel in early 2008, about $21 below its actual price,” Brown wrote in May. And as if that weren’t high enough, in early July - sourcing Brown - New York Times business columnist David Leonhardt cited this gap as $31.

Symptoms of addiction

The dollar depreciation trend only became exacerbated by the onset of the credit crunch, which forced the Fed to slash interest rates at a time when federal banks around the world were hiking interest rates to stem inflation pressures. Consequently, the already-weakened dollar plunged even more and the changes in dollar-denominated oil became even more pronounced.

To see why, think back to America’s “addiction” to foreign oil. The United States currently imports over 70% of its oil as a way to meet its energy needs. During times of elevated oil prices, this dependency leads to large capital outflows from the U.S. to the rest of the world (what Texas oil tycoon-turned-environmentalist T. Boone Pickens called “the largest shift of money in the history of mankind” in a recent interview with the Chicago Tribune editorial board). And just as strong capital inflows tend to strengthen the dollar - as they did throughout the 1990s and early 2000s when central banks around the world were selling their gold reserves and buying up dollars - strong capital outflows tend to weaken it. The result: a vicius cycle in which oil becomes more expensive but the U.S. continues to buy it at a higher price, adding more downward pressure on the dollar, upward pressure on oil, and so on and so on.

Possible cure

Naturally, one way to break that cycle is for the U.S. to import less oil. But as global oil demand from places like India and China surges, decreased domestic demand is unlikely to make a big dent in the price of oil. Oil demand is, after all, highly correlated to income and, as Brown of the Dallas FRB points out, China’s GDP per capita rose from $1,103 in 1990 to $4,088 in 2005 while India’s went from $1,202 to $2,222 over the same period (adjusted for inflation and purchasing power parity). Couple this with the sober fact that non-OPEC supplies of oil have consistently been lower than what the industry has expected and what results is the second long-term trend that’s been driving oil prices higher: tight global supply and demand conditions.

More on this in my next post in this series.

Yesterday most major U.S. stock indexes finished the day either flat or slightly lower as markets await with anticipation to see what action the Fed will take at the end of its two-day policymaking meeting that starts today.

It’s a sort of nervous quiet-before-the-storm that comes whenever the markets anticipate a change in direction in Fed policymaking. But this is not just a drizzle; investors are curious to learn how what the Fed’s next step will be in tackling what seems to be the perfect storm of sky-rocketing commodities costs, soaring inflation and a plummeting dollar.

After nine months and 325 basis points of easing, fed funds futures are overwhelmingly pointing to a halt in easing - to be exact, an 87% probability (as of June 20th) that the FOMC will leave the Federal Funds Rate target unchanged, as calculated by the Cleveland Fed.

This comes as no surprise since most economic indicators still point to an uncomfortable netherworld between contraction and expansion that seems to call for a pause and rethink of where the economy is going. The index of Leading Economic Indicators (LEI) - a composite of a group of 10 macroeconomic statistics that are known to change in advance of a contraction or expansion - despite moving higher by a slight .1% last month, gave us little insight since six of the ten components moved down and October through February marked a period of -1.8% contraction in the LEI that fell just shy of predicting a recession (according to the rule of thumb of 2% decline in the index over six months and a majority of components moving lower).

No matter what it decides to do, the Fed will likely highlight this uncomfortable netherworld situation in its statement on Wednesday, warning us of the continuing downside risk and the need to monitor the inflation situation closely.

Important as this may be, though, the real words to watch for in its statement - given recent statements by Treasury Secretary Paulson and Fed Chair Ben Bernanke - will be the dollar and commodities, both of which have been enjoying increasing popularity on Capitol Hill and the campaign trail lately, and for obvious reasons.

Since Mr. Bernanke has taken over as the chairman of the Fed, the dollar has depreciated in value against most of the world’s major currencies (this clever graphic from the Telegraph says it all) - a decline that has only thrown more fuel on flame-hot commodity prices, which have become increasingly correlated with the depreciating dollar over the last year. This should come as no surprise: after all, with credit markets frozen and falling interest rates at home, where were investors to park their money except foreign currencies and a booming commodities market?

Still, as anyone who regularly reads the FOMC’s carefully-crafted and blandly worded policy statements knows, the Fed is unlikely to make a big splash about commodities and the dollar. Nonetheless, investors are curious to know whether all the talk of bolstering the dollar and reigning-in commodities prices really has any policy teeth behind it - which is why the reason behind the Fed’s staying the course, if it does so, will be particularly illuminating.

If it cites the threat of inflation as its primary policymaking motivation, then the case could be made for a prolonged wait-and-see approach since inflation is a lagging economic indicator. On the other hand, if it cites worries about the plummeting dollar and its impact on soaring commodities prices, then there is a strong argument to be made that there is little time to waste since both are already at historic lows and highs, respectively. As a result, the Fed will be expected to raise rates sooner rather than later, (in which case expect to see the implied probability of a 25 bps increase in August edge higher than the current ~20%).

But whether it’s soaring commodity prices, inflation, or a plummeting dollar, at the root of each - as well as their after-shocks in the over-heated housing markets - lies the 2001-2004 Fed easing cycle carried too far and too long. This is why some economists, including Dr. Benn Steil, Director of the International Economics Council on Foreign Relations, have wisely begun to point out that we are currently experiencing not so much the beginning of (yet!) another bubble, this time in commodities, but rather the aftermath of a previous, much larger currency bubble. As Steil testified two weeks ago in front of the Senate Committee on Homeland Security and Governmental Affairs, “the Federal Reserve pushed rates too low and held them too low for too long, and has since last autumn been exceptionally aggressive in driving them well below the rate of inflation.”

The “since last autumn” part is, of course, how we got to this spot in the first place, and doing so again will only continue to widen the yield gap between the United States and the rest of the world, including oil-rich states like Saudi Arabia, which last year for the first time refused to lower its interest rates in lock-step with the U.S. Federal Reserve.

A telling sign of the times? Certainly; but more so a reminder not to repeat the mistakes of the past - even in the face of the perfect storm.