Swapping Places

In my youth, a swap was a way for the big kids to cheat the little kids out of their favorite marbles. When I first got into banking, it was a way for big banks to “help” the smaller banks manage their risk.

Not that much has changed.

Eventually, the money-center banks made markets swapping currencies, credit risk, and most everything else. If you can measure it, you can swap it. The bigger the market, the better for the market-makers. By charging a spread between bid and offer, the dealers make money on the deal-flow, just like a casino.

Only, in securities markets things like fiduciary duty and professional standards apply. Dealers can’t willingly help someone mask his true financial condition. Pleading “everyone does it” is no excuse, as your grandmother could tell you. Just because a transaction is legal and can generate a 7% margin doesn’t make it right.

Swaps have generated financial interconnections that have benefitted the global economy on average, but at the price of increased volatility. They need to be transparent, and they need better regulation.

Otherwise, they’re just more marbles for playground bullies.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Down to Earth

So what will happen to the deficit?

Some people are worried that with all that debt out there, the government will try to inflate it away. After all, if inflation raises the general price level, then all debts are devalued. That’s what happened in the late ‘60s and ‘70s.

Only, a lot has changed since then. Government benefits are now indexed to inflation. Tax rates are indexed to inflation. Most debt is short-term, and the interest on that debt would accrue more debt. And a lot of debt is now inflation-adjusted.

So accelerating inflation wouldn’t really help. We’d be in the same pickle we’re in now, only more so. And default isn’t an option. A country can default, but only if it doesn’t plan on borrowing again for decade or two.

There are really only two solutions. From 1947 through 1960, the top marginal tax rates were more than 90%. The post-war economy soared and the combination of tax-receipts and economic growth helped shrink the debt from 120% of the economy to 35%. But post-war growth is out, and I don’t think we’re going back to FDR’s taxes. The other solution? Cut discretionary spending: raise the retirement age, means-test Medicare, fold Federal pensions into Social Security.

But no one gets elected with a down-to-earth fiscal policy like tax hikes and spending cuts. So they pray for growth. But at least we know that inflation is no solution at all.

Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!

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direct: 603-252-6509
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Banks, Bonuses, and Bernanke

Welcome to the Political Fed. Do you like it?

On Thursday last week the Fed raised the discount rate on bank borrowings by .25%. They also removed some of the extraordinary measures that they’ve had in place since the winter of 2008. According to its web-site, the Fed thinks that the financial crisis is winding down.

It’s natural to ask why. Why did the Fed turn and raise the discount rate just after voting last month to keep interest rates low “for a considerable period?” One answer is inflation. Most governors think there is upside risk to inflation. But why now? This has to do with the banks.

We’ve just come through bonus season and it wasn’t pretty. The Fed’s low interest rates allow the banks to earn big bucks by just buying bonds. As long as they keep rates near zero, Bernanke and Co. could be accused of coddling the banks. And he was just about testify before Congress. In order to maintain his credibility as a regulator, Bernanke needs to distance himself from the Goldman and JP Morgan crowd. The rate hike was one way to do this.

By raising the penalty rate, the Fed signaled to Congress that that they’re the banks’ referee, not their cheering section. But when politics drives the Fed, I wonder who’s next.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Why Not Here?

Will the US become a Greek Tragedy?

After all, both countries have significant fiscal deficits, are just recovering from severe recessions, and have large foreign bondholders. Moreover, until recently, both have been in denial about the severity of their deficits.

The fear is that exploding debt funded by foreign investors will make us dependent upon them for our economic growth. If the Chinese threaten to sell our bonds, they might force us into a fiscal austerity program—perhaps funded by lower defense spending—akin to the one that the IMF might impose on Greece.

Such speculation ignores important differences. The US debt level isn’t as high as many people fear. Much of our “debt” is held internally by Social Security. Also, until recently deficits have actually been falling. For the past 30 years, real economic growth has averaged 3%. Deficits have averaged 2.5%. So the debt, as a percentage of the economy, has been getting smaller.

Also, the government is a much smaller part of the economy here than most people realize. Government spending makes up about 28% of GDP. By contrast, the Greek public sector is 40% of their economy. So it’s harder to cut spending there without pushing Greece into another recession. Finally, tax-avoidance and black-market activity aren’t national sports over here like they are in Greece. Corruption takes a massive toll on the economy.

Speculation that the Greek crisis will jump the Atlantic to the US is silly. The US isn’t Greece. Anyone claiming otherwise is either ignorant or unreliable.

Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!

Follow me on Twitter @GlobalMarketUpd

direct: 603-252-6509
reception: 603-224-1350

www.chartertrust.com • www.moneybasicsradio.com • www.globalmarketupdate.net