Feelings Drive Policy?

Grease is the time
Is the place
Is the motion
Grease is the way we are feeling

-Frankie Valli

Ok. That was too easy.

The sovereign teeterings we are seeing these days should not be too surprising given all the government support programs put into place over the last two years. But what is really going on here?

I believe the challenge we face is more cultural than financial.

Today, the inhabitants of our global society "feel bad" when their efforts fail. That is only natural, but we've now taken this tendency to a new level where society attempts to forbid failure.

Certainly systemic risks were on the rise in late 2008 when it seemed a few well-placed bankruptcies would bring down the entire global financial sector. Our response — again, globally — was to write checks to the at-risk institutions, taking money from the broad tax base in order to "save the system."

Unfortunately, when filling holes, the dirt must come from somewhere.

Contributing billions in direct support and providing insurance programs in the trillions does have a cost. In the U.S. and elsewhere, governments borrowed to fund these bailouts at an ever-increasing pace. There was little concern regarding lender participation as investors ran for the safest investments around: government securities.

But, of course, not all government securities are alike.

What we are seeing now in Greece is a second level bailout — the first referring to massive spending on the part of the Greek government. European governments are now looking at their Greek brethren and are concerned that a bailout without a local cost will only encourage the moral hazard we all know exists today.

Unfortunately, allowing a failure could create a domino effect across other European nations (and thus the creation of colorful acronyms like PIIGS — Portugal Italy Ireland Greece Spain — and PUKE — Portugal, UK, EU). So once again, the powers that be are faced with a difficult decision: rescue the bad seed or let it fail?

The EU, for its part, is concerned that providing such a rescue would put the entire union at risk if investors become concerned about out-of-control spending with insignificant future revenue stream increases. The self-fulfilling prophesy rears its ugly head.

The story is no different in the U.S. — we just have some extra cushion. In fact, on a regular basis, the ratings agencies warn that our AAA-rating may be in jeopardy. (Tim Geithner's recent response was a promise that the U.S. will "never" lose its AAA rating, but didn't he also promise to pay his taxes when he went to the IMF some years ago?)

At the end of the day, it seems that letting a few banks fail a few years ago would not have created the same fear of systemic risk as possible country defaults today. And at some point, losses must be realized instead of simply passed on to supposedly deeper pockets. Ain't hindsight great?

This Way to the Egress!

Last week, Bernanke tentatively laid out the next possible steps toward tightening monetary policy, which focus on controlling the rate the Fed pays banks for deposits. By raising this rate, the banking system will be encouraged to place more funds on deposit with the Fed, thereby taking them out of the system.

In addition, he repeated the current mantra that low fed funds rates will remain in place "for an extended period," suggesting such steps are in the distant future.

What lies in the near future is a possible increase in the Fed's discount rate, the rate at which weaker banks borrow directly from the Fed. Bernanke made it clear that raising this rate will be geared toward discouraging such borrowing and should not "lead to tighter financial conditions for households and businesses and should not be interpreted as signaling any change in the outlook for monetary policy."

It sounds like the Fed is not ready to grab the punch bowl, but it is beginning to eyeball it.

Key Developments

Wholesale inventories in December declined by 0.8 percent versus expectations of a 0.5 percent increase. Both durable and non-durable goods contributed to the decline, which could lead to a downward revision of fourth quarter's GDP figure.

Retail sales in January rose 0.5 percent after declining slightly in December. There has been a moderate, but consistent, rebound in retail sales since the height of the crisis in late 2008. Given the current stall in unemployment growth, continued momentum in retail sales throughout 2010 is possible barring another negative shock to the system.

The EU has announced plans to bail out Greece, but the details are few. They find themselves in a Catch-22 where non-action could drive investors away from riskier sovereigns in the region and a full bailout could encourage wild spending on those same nations.

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