Geithnernomics and form H.4.1

Washington's examination of Treasury Secretary Timothy Geithner focused mostly on his apparent inability to put form 1099 income in the right box on a tax return.

But in terms of what taxpayers care about -- a restoration of economic confidence and growth -- it may be more important for both Mr. Geithner and the Congress to pay attention to a seemingly obscure, but multi-trillion dollar, entry in the Federal Reserve's weekly H.4.1 release.

There, in table 1A and associate footnotes, the central bank reports "foreign official holdings" of various securities, as follows:

That's the argument of economic historian and forecaster John Mueller, who along with investor and intellectual Lewis Lehrman, and colleagues at the consulting firm of LBMC, LLC, believe that it is changes in this line of the Fed's balance sheet that is the driving force behind most booms and bust in the U.S. and global economy.

Dollar Basics

A quick glance at changes in the Lehrman-Mueller World Dollar Base, and (especially in this decade) its composition, suggests that this seemingly esoteric footnote may indeed be a golden key to understanding what is going on in today's global deflation.

"In early 2000," Mueller notes, "foreign official holdings of Federal Agency Securities" -- largely, Freddie Mae and Freddie Mack securities tied to mortgages -- "was $83.5 billion." Over the ensuing decade, this rose to a peak of $1 trillion -- "$980 billion, to be exact" -- in August, 2008. That's an eight-year surge of more than 1,000 percent.

Mix in a lot of lobbying from both Democrats and Republicans at the time, and the result was the great housing bubble. (See also "Housing Bubble, RIP," Bottom Line, August 5, 2005.)

But officials were too busy bragging about increased home ownership rates -- a major theme of both Barney Frank's harangues of policy officials at the time, and the Republican Convention of 2004 -- to take proper caution. And their focus on only the domestic variables of money supply led them to overlook the vast monetary expansion going on.

Well into 2004, the Fed remained principally concerned about deflation, and from most of 2005 to 2007, saw a balance of risks -- rather than the huge spike in oil and gold prices foreseen by LBMC.

Unlike Mueller, these officials were not taking a look at table 1A, footnotes 1 and 2, of Fed release H.4.1. What's a couple trillion dollars among central bank friends?

Bursting the bubble

Enter 2006-2008, and a belated Fed effort to softly ease the air out of the balloon to produce a soft landing. Housing turned down first. In fact, the housing stocks, which tend to anticipate much later changes in actual housing prices, peaked in the third quarter of 2005, and slumped for virtually three years. Highly-leveraged mortgage-backed securities suffered an unprecedented plunge in the second half of 2007, another warning sign of what was to come.

Unfortunately, in the maddening way that monetary policy and foreign central bank holdings work, these changes did not reflect quickly in the commodity markets, which continued to surge from the delayed impact of more than five years of hyperexpansive monetary policy. They were felt more quickly in housing where the bubble-burst, visible since summer 2005, was finally feeding into actual home prices.

Meanwhile foreign central banks, with those trillion dollars in "federal agency securities" had shifted onto a kind of housing standard. Their assets, like those of a typical U.S. consumer, had shifted in large amounts away from Treasuries, and into a sort of global derivative on U.S. mortgages. The world's currency, the dollar, and the global banking system, were on a kind of "housing standard," analogous to the gold standard of the prosperous 18th and 19th Centuries.

As the housing crisis deepened into August, the resulting downturn proved hard to contain. Foreign central banks, watching the collapse of the housing market, sold off more than $170 billion in mortgage-related federal agency securities over the ensuing 16 months, a 17 percent decline.

The reliance of foreign-bank balance sheets on mortgage-based debt, of course, is only implicit, not official. In some ways, however, this makes its impact all the more powerful. Officials seem only vaguely aware of the impacts of these massive shifts in bank balances; the issue didn't even come up at confirmation hearings for Geithner, nor for Fed Chairman Ben Bernanke.

The Bottom Line: Investment strategy

So, now what?

The current conundrum for investors is well illustrated by the fact that in recent months, the Fed has been trying to do the right thing -- and yet, because of its focus purely on the partial-equilibrium case of U.S. domestic liabilities, doesn't know how to do it.

The ratio of foreign and domestic components of the World Dollar Base, Mueller says, reflects not only the supply of, but also demand for, high-powered dollars, for which the supply is falling while demand rises -- "at rates," Mueller says, "not seen since the 1930s." As the Fed attempts to lean against this by buying up toxic debt and other federal agency securities, it is selling Treasuries to the aforementioned foreign central banks -- who have little appetite for large cash balances, given the reduced transactional needs in a slowing global economy.

The result of this policy mix, "paradoxically, is actually deflationary in the short term," say 12 months, though it will be inflationary in the longer term, coming home to roost in say 2011-2012.

"As long as the Fed and Treasury do not understand the facts revealed by their own balance sheets," Mueller suggests, "the Obama Administration will have the same vulnerability as George W. Bush's administration. It's likely that the crude oil price will fall below optimistic current market expectations for 2009 and 2010." Over that period, "Obama's popularity, at least based on economics, could remain stratospheric" -- about as high as for George W. Bush after 9/11, when gasoline prices were lower than they are now. It also bodes well for Democrats in the 2010 elections.

As the inflationary impact of recent Fed easing begins to be felt, however, energy and consumer prices should surge starting in 2011. If the Fed responds by liquidating a substantial share of the recently created bank reserves, the oil price will spike further, as housing prices did at the start of the Fed's attempt to tighten over 2004-2006.

This would bring Obama's popularity, depending on other factors of course, back down to as low as 50 percent or 40 percent -- a parallel, in some ways, to the presidencies of Jimmy Carter and George Herbert Walker Bush.

Bottom Line: Housing inventories have been in decline for several months, and the rally in housing stocks, almost a year old now, should continue. Even though the real economy may be a couple of quarters from an upturn, the new monetary surge should be felt relatively quickly in equities prices and real estate markets, with most commodities off the table into 2010, if Mueller is right.

In the kingdom of the blind, the one-eyed man is king. But where officials at the Fed and Treasury aren't able to even use the one eye they have, they may as well be blind, and we can expect more stumbling into booms and busts in the years to come.

(Gregory Fossedal managed investments for the Emerging Markets Group from 1998 to 2005, and has been a UPI commentator since 2002. He was manager of the Emerging Markets Group at LBMC from 1992 to 1997. Fossedal is the author of numerous books on financial and political history, including "Direct Democracy in Switzerland," "Our Finest Hour," and "The Democratic Imperative.")

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