Historic days lie ahead, and not because the occupant of the Oval Office will soon be of an atypical color.

The United States, throughout its early history, has been the only major trading nation to carefully avoid extensive government involvement in economics and finance. We went for more than 100 years without even a central bank (meaning, an official lender of last resort). And when the need for the Federal Reserve finally became undeniable in the wake of the Panic of 1907, its architects conceived it in secret meetings, and with a quasi-private structure, because they knew even then that Congress would never go for another attempt to establish a “Bank of the United States.”

During the New Deal, the role of the Federal Reserve was expanded to include regulatory control over the US banking system. In 1951, the Fed finally established its full independence from the US Treasury (in the sense that they could refuse to monetize issues of public debt), and entered the modern period of its history.

But in keeping with the American tradition of relatively light control over financial matters, the Fed’s objectives have always been primarily to maintain confidence in the value of the dollar, and to ensure the integrity of the interbank payments system.

They have long held a balance sheet consisting almost entirely of risk-free US Treasury securities. At times, like any lender of last resort, they have made funds available to their correspondent banks, but generally for the shortest possible terms, at relatively high “penalty” interest rates, and requiring collateral of the very highest quality.

In short, the Fed has never been a risk-taking entity. To take risk (and, equivalently, to intermediate credit) has always been the function of the private sector.

Until 2008.

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It’s the season for debating the effects of a historic increase in government spending on the economy.

The proposal on the table from Obama, is to increase government spending by about $775 billion over the next two years. About $300 billion of this would come as tax cuts of various kinds, and the rest as handouts to state and local governments and pork-barrel spending.

Why are we doing all this? Well, to make the economy better, of course. But precisely what does it mean to “make the economy better”?

I told you yesterday that, although the global economy and the global financial system face deep, systemic imbalances that have nothing whatsoever to do with the business cycle, the perception by policymakers and ordinary people is very different. The common view is that our biggest problem is an economic recession. And even more specifically, an increase in unemployment that results from reductions in industrial output, or GDP.

As I said, the whole situation is being oversimplified as a need to change two widely-reported statistics. The objective of the largest proposed increase in government spending for decades is not to do anything long-term positive for the the economy. Rather, it’s to increase reported GDP and to reduce reported unemployment.

So in this context, let’s try to understand the claims that are being made by advocates of increased spending. (I’ll leave for another time the issues of increased national indebtedness, misallocated resources, and increased government control over the economy, since the neo-Keynesians have already told us that we should sweep those effects under the carpet for now.)

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Sen. Dianne Feinstein made the innocent-sounding but in fact wholly-remarkable statement that the choice of Leon Panetta for DCI is unsatisfactory because the role should be filled by a person with enough experience to understand what the CIA actually does.

Wouldn’t it be equally remarkable to suggest that the American people should have elected a President with enough experience to understand what the government actually does?

We shouldn’t be surprised that a man like Obama would pick a man like Panetta for a critically-important job that he isn’t qualified to do.

Everyone’s attention has temporarily shifted away from the automaker bailout, to consideration of a vast Keynesian stimulus program, with some side-distractions relating to the personnel of the US Senate.

Don’t worry about the automaker situation: it’ll be back on the front-burner next month as both GM and Chrysler LLC will have burned through last month’s bailout money and will be back for more. A lot more.

Instead, let’s take a closer look at the New New Deal, which was hurriedly pulled out of a hat immediately after the Presidential election as Barack Obama’s answer to the musical question: “Omigosh, the economy is falling apart! WHAT ARE WE GOING TO DO???”

Exactly what is the New New Deal? More importantly, exactly what problems does it purport to solve? Not the ones you think.

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You know already that Congress scuttled Plan A of the automaker bailout. The outlines of Plan B are now becoming clear. Per President Bush’s announcement last Friday (and subsequent publication of “term sheets” by the Treasury) the Administration will extend about $17 billion in grants (euphemistically called “loans”) to General Motors and Chrysler.

The terms and conditions of this capital infusion will be identical in most respects to what Senate Republicans rejected on December 11. It’s anticipated that the deal will close on December 29, which is not a day too soon for General Motors.

Now of course Ron Gettelfinger, the leader of the United Auto Workers, got himself quoted far and wide this weekend. He said that his union is being “singled out” to take the pain in the coming inevitable restructuring of the auto industry.

If you’ve been around business or finance people, you know what “restructuring” means. In this context, it’s a euphemism for “fire a lot of people and get a lot smaller.”

You may think Gettelfinger is just being disingenuous. He’s not. In reality, he’s positioning himself for the epic political battle that will come early in 2009.

Let me tell you what to expect.

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You’ve heard the headlines. This morning at 9:00am ET, President Bush announced that the Treasury Department, acting without authorization from Congress, will execute several key provisions of the bailout legislation that was defeated by Senate Republicans on December 11.

Let me tell what we know and what we don’t know at this point.

There are no printed statements yet at the White House or the Treasury web sites, so all we have are the President’s words.

As I’ve explained several times here, the only source of funds available for General Motors and Chrysler LLC are what’s left of the first $350 billion of the Treasury’s TARP fund. There evidently was $13 billion and change left in that tranche.

That $13 billion will be made available immediately to GM and Chrysler in the form of a note, covered by warrants. The President hinted that another $4 billion will be made available “in February.” I suppose Mr. Bush is assuming that Congress will quickly approve the second tranche of the TARP fund, even though Congressional leaders in both parties have said in recent days that they may not release the second tranche at all.

So now we’re at $17 billion plus in taxpayer funds for GM and Chrysler. Ford Motor isn’t asking for anything at this time.

The terms of this announcement parallel the failed bailout legislation, which after all was negotiated by the White House and Congressional Democrats.

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The Federal Reserve’s tool of choice for setting and communicating its broad monetary policy has been the level of the “Fed Funds rate.” You’ve heard many times that the Fed raises or lowers interest rates to cool down or heat up the economy.

“Fed funds” is the nickname for the reserve balances that banks are required to hold on account with the Fed itself. Banks can and do lend this money to each other on an overnight basis, and the “Fed funds rate” is the interest rate at which they do this.

Accordingly, the Fed funds rate is the most basic component of the cost of providing credit to the economy. It’s like the price of iron ore to a steelmaker. If you can manipulate the cost of credit, you can indirectly affect the rate at which the economy grows, because (in normal times anyway) people make business investments with borrowed money.

The Fed funds rate is set by a free market, but the Fed manipulates the rate by actively participating in that market each morning.

That’s the short explanation of what’s going on when news reports tell you that “the Fed lowered interest rates by half a percentage point today!” or whatever. A lower cost of credit theoretically makes borrowing cheaper, and it also decreases the relative attractiveness of holding money in the form of bank deposits rather than higher-yielding investments. That’s supposed to give economic growth a boost.

In a post-Keynesian world, it’s also the government’s most important tool for macroeconomic management. When we have recessions, the Fed typically counteracts them by reducing the Fed funds rate.

Why am I telling you all this? For one thing, the Fed’s Open Market Committee (which sets the Fed funds rate) is having their regularly-scheduled meeting in Washington. They’ll be announcing their policy statement around 2:15pm ET, as usual.

For another thing, it’s not all that clear what they can say today.

And that’s because interest rates are already effectively zero now. If you want to stimulate the economy, how can you reduce the cost of credit, if you can’t reduce its price?

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You’ve already heard the headline: the UAW-bailout and electric-car legislation that was misnamed as a rescue plan for Detroit’s Big Three, has gone down to defeat on a cloture vote in the Senate last night.

The problem with this bill was that it attempted to solve the wrong problem.

We know that the Big Three automakers need to restructure in fundamental ways, to adjust to the reality of a significantly smaller and different North American market for vehicles in the coming years.

We also know that General Motors is suffering a cash crunch for reasons not entirely of their making, that threaten the company’s survival past the end of this year.

(Ford Motor’s situation is bad but they’re not in imminent danger of collapse. Chrysler’s owners, the private equity firm Cerberus Capital Management, have billions of dollars to spare, but they saw a chance to get taxpayers to give them money instead.)

GM needs an immediate cash bridge, to get them into position to execute something like a bankruptcy, even if it isn’t called that, and start cutting costs. Including labor costs.

Instead, what did the draft legislation, defeated last night, propose to do? Remember, it was negotiated between Congressional Democrats and the Bush Administration.

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And we have more expert coverage of the grand special-interest giveaway that is the automaker-bailout legislation currently being negotiated between the White House and Congressional Democrats.

The bailout contemplates a numerically-unspecified amount of public money to be donated to certain eligible automakers. You’re “eligible” if you filed a straw-man recovery plan in Congress on December 2. That means you’re either GM, Ford Motor, or Chrysler LLC.

And as I wrote earlier today, there is also a special handout of $500 million which seems tailored for a venture-funded electric-car startup named Tesla Motors, in Menlo Park, California.

I’ve already told you an awful lot about General Motors. Now I want to concentrate on Chrysler and Tesla.

Both of these companies are private, so we have no audited, public financial information to judge them by.

Chrysler has requested a grant of $7 billion in public money, to ensure its survival beyond the beginning of 2009. (I won’t call this a loan, because that would imply an expectation that we’ll get our money back. We won’t, certainly not if this pig of a bailout passes.)

All right, so let’s take Chrysler at their word. If they need that much money to survive, they’re in some pretty bad shape, right? Let’s assume so.

Who owns Chrysler LLC? Well, they’re 80% owned by Cerberus Capital Management LP, the private equity fund that bought Chrysler away from Daimler AG.

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We still don’t have a deal in Washington to bail out America’s financially-depleted Big Four automakers (three in Detroit, and a fourth, Tesla Motors, in Silicon Valley).

But the outlines of a deal are being hammered out between Congressional Democrats and the outgoing Bush Administration, while House and Senate Republicans are stuck outside the room, looking in and pressing their noses to the windows.

If we’re to judge from the “shell” legislation that leaked out on Monday, Congress is cooking up a very bad, an historically bad piece of legislation.

But that rather makes sense, if you look at the priorities of the people making the deal. The Democrats are intent on safeguarding the United Auto Workers, while forcing the Big Three to stop making SUVs and start making electric cars.

And the Bush people want only to make sure that General Motors doesn’t declare bankruptcy while they’re still in office.

The result is a cowardly, business-as-usual bailout that will guarantee the ultimate demise of the Big Three, while wasting an open-ended amount of taxpayer money in the process.

Republicans should oppose the bailout, assuming it emerges in substantially the same form that we saw on Monday. In fact, anyone who wants to see a strong, healthy domestic auto industry should oppose it. And if you care about not wasting public money, your hair should be catching fire now.

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Have you ever heard of Republic Windows And Doors? Unless you live on the North Side of Chicago, you probably haven’t. But they’re at the heart of what is becoming a textbook case in government overreach and willingness to interfere in private business dealings. And no less than the Man of Destiny himself, Barack Obama, has waded into this swamp, with both feet.

Republic is a family-owned business that has been operating since 1965, and had 700 employees as recently as two years ago. On Friday, they closed their doors forever.

Republic is a small-business victim of the “credit crunch” I’ve been telling you about here for sixteen months now. Their business of making new and replacement windows fell off sharply, along with the collapse of the residential construction industry. This is a sad story, which sadly will be repeated many, many times across America in the months and years ahead.

Republic did their banking with Bank of America, which pulled a line of credit from the company late last week, forcing them to close down. That’s what happens in a credit crunch. Now there isn’t enough public information to give you a full picture on the negotiations and other dealings that led to this point, and the company’s website has vanished behind a firewall.

The bottom line is that Republic’s business has largely evaporated. That’s not their fault, nor is it BoA’s fault, but it does mean that it makes no sense whatsoever for the company to continue drawing on credit lines, and it means that it makes no sense for BoA or anyone else to continue extending the credit. You simply do not lend money when it’s not likely you’ll be repaid. If you were a shareholder of BoA, that’s the very last thing you’d want them to do. Banking isn’t charity.

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As I write on Monday morning, the news reports have it that a short-term bailout of General Motors and Chrysler will emerge and be voted on sometime this week. What are the parameters and objectives of the immediate actions that will probably be taken?

The key objective is to prevent an out-of-cash situation at General Motors, and possibly at Chrysler. If nothing is done, it’s more likely than not that GM will enter a process of forced liquidation by the end of this year, mere days from now.

But because this is an emergency situation, there’s been no time to fully debate the issue, and to deal with the fact that no one has bothered to try to convince the American people that their tax dollars should be used to reward a couple of badly-failed businesses.

That heavy lifting indeed will get done. But not in the current Congress and Administration. The can is going to get kicked down the road into January.

And as you’ll see, this outcome is entirely to the liking of the United Auto Workers and their leader, Ron Gettelfinger.

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The news has been full of big economic stories this past week. And as often happens, some very important things got lost in the noise background. I told you about one of them
here.

Very interesting doings are afoot in China. You may have caught the handful of stories which quoted key figures in the Chinese investment world, to say that the United States needs to be “nicer” to the countries that lend us money.

Since that’s a none-too-veiled reference to the big role that China takes in funding our fiscal and current-account deficits, it’s worth looking closer at what’s going on.

China is showing signs of a shift in their policy regarding exports. In a speech last weekend, Premier Hu Jintao said that the government can and will act to increase exports.

And then on Monday, the People’s Bank of China dramatically reversed its course on the dollar/renminbi exchange rate, allowing the Chinese currency to fall sharply, a move which continued over several days.

Now this is noteworthy for a lot of reasons, but let’s start with the obvious ones: China’s share of global manufacturing is now as high as it’s ever been, and it’s still rising. Even though the global economy is slowing sharply in every country, including China.

The only way for China to continue increasing export volume in an economic slowdown, is for them to increase their already-large share of a shrinking pie. They’re trying to counteract the economic slowdown (which has hit them as hard as everyone else) by exporting their way out of trouble.

And what’s the most effective way to pursue such an overtly mercantilist policy? By devaluing their currency.

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As I’ve been telling you for nearly a month, General Motors is going to be out of cash by the end of this year, mere days from now.

If that happens, they won’t be able to write checks to their employees, suppliers, dealers, or bondholders. They’ll have opened a path that leads to a forced liquidation of their business.

What part of “out of cash” don’t you understand? Well, if you’ve ever run a business through a tough time and had trouble meeting a payroll (as I have), there’s no starker reality in the world. It burns in your gut like molten lead. You’ll never forget the feeling, and you’ll go to great lengths never to be in that position again.

But if you’ve never run anything in your life (like quite a few members of Congress, and like our historic, world-changing President-elect), then “out of cash” probably doesn’t have much practical meaning for you at all.

So yesterday and today, Congress is again listening to testimony from the CEOs of the Detroit Big Three and from the leadership of the UAW. The case for the automakers is: “We need your help on an emergency basis because there’s no one else that can do it. And we’ll take it on whatever terms we can get.”

But polling shows that the American people, still simmering with anger over the bailout of the financial industry and facing deep fears about their personal finances, are in no mood to spend their tax dollars on a lifeline to General Motors and Chrysler LLC, the automakers in imminent danger of collapse.

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This week, Congress returns to the question of what to do with the domestic auto industry, Detroit’s humbled Big Three. And the options range from awful to unthinkable.

Yesterday we got a reading of auto sales in November. The story was extremely bad. Continuing the trend from October, sales were down anywhere from a third to a half, across all the manufacturers who sell in North America.

Put simply, the US consumer, whose purchases comprise over 70% of GDP, has gone on strike. In the case of the automotive sector, opinion is split over the exact reason. It could be mostly because finance for new-car purchases has become far harder to get, as the credit crisis continues in full force.

Or, much more ominously, it could be because US consumers have simply decided to step down their purchasing levels, for whatever reason. Possibilities include: uncertainty about their jobs, desire to increase personal savings, concern about their ability to afford necessities, or a lack of confidence about the economy in general.

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I think we’re all getting a quite vivid sense that President-elect Obama’s way of handling tough situations is to set his jaw, furrow his brow, stare purposefully forward, say reassuring things, but on no account to make any clear statements of intent, or to actually do anything.

At least one of the consequences of this extremely risk-averse approach to leadership, is that financial markets are completely in the dark about what they can expect from the new government.

And when financial markets don’t know what to expect, they always err on the side of excessive caution. Hence the great difficulty they’ve been having in finding a bottom to bounce off from.

The stock and bond markets appear to be discounting an economic future that is little short of catastrophic. Since total catastrophe is one of the least likely outcomes, it stands to reason that markets are currently underpriced.

But that’s not to say they can’t very easily become a lot more underpriced!

Obama could sweep away a lot of this uncertainty and unreasoning fear with no more than a ten-minute news conference.

He could stand up, with the towering Paul Volcker, the sour-pussed Larry Summers and the sardonic-looking Tim Geithner standing behind him, and say the following:

“Ladies and gentlemen, I’ve consulted at length with my economic team. We’re acutely aware that our economy is facing great uncertainty. We understand that our system is a capitalistic one. We intend to do whatever it takes to get business and capital working again, for the sake of every consumer and working person in America.

That is all. Thank you.”

If Obama were to give this speech, you’d see explosive market rallies, and everyone would heave a big sigh of relief.

So how about it, Mr. President-elect?

-Francis Cianfrocca

The 30-year T bond is priced to yield 3.34% this morning. The 10-year note is at 2.83%. These are extraordinary numbers, and they’re still falling fast. Three-and-six month bills are already at or near zero. This is powerful and continuing evidence that markets are uncertain and fleeing from risk.

The midcurve and long-end are multi-trillion dollar asset classes that have increased in value by something like a third, in just the last few weeks. If you thought supertankers couldn’t turn on a dime, you haven’t been watching the bond market.

One is also tempted to say this is evidence that markets are expecting extreme economic weakness ahead.

But there are so many dislocations in the bond market and trading is so illiquid, that it would be a stretch to say this is signaling anything but total uncertainty. By “dislocation,” I mean that there is an abundance of relationships among assets that make no economic sense. (The continuing negative 30-year swap spread is just one example.)

A textbook world would arbitrage the dislocations away almost immediately. Yet they persist and in some cases are growing.

But what is the real price of money in a time of deflation? A zero-yield six-month Treasury bill, combined with October’s 1% decline in CPI, implies a real interest rate of something like 5 or 6%: that’s exceptionally high, and a very good reason not to engage in economic activity.

Then there is the pricing of TIPS. These are Treasury securities that adjust their principal amount every year according to the Consumer Price Index. So in theory, they represent the real cost of risk-free money at any given point on the yield curve. And the difference between TIPS yields and Treasury yields predicts future inflation.

As far as I can tell, the current TIPS spread appears to be predicting that we’ll have deflation of more than one percent each year for at least the next five years. Make of that what you will.

As I said, extreme uncertainty. And uncertainty breeds risk-aversion, which breeds economic weakness.

Update: At 10am ET, the 30-year bond is up almost two and 26/32, to yield 3.30%. The 10-year note is yielding 2.81%. As I said, extraordinary.

-Francis Cianfrocca

It seems to me that focus has shifted away from China’s economic and financial doings during the acute financial crisis that began last September.

The story in China for most of this year and last year has been extremely high inflation (particularly in prices for staple foods), and vigorous measures by the country’s banking and monetary authorities to reduce the formation of credit.

Up till late 2007, they also had a wicked bubble in their domestic stock markets (Shanghai and Shenzen, where non-Chinese may not trade), which they popped quite successfully. Be glad you weren’t invested in those markets.

In recent months, they’ve been walking back most of those policies, as economic growth has slowed sharply. Last year’s growth was 12.6%, led largely by exports and capital investment. (Three years ago, China had a true economic boom, led by domestic demand-growth, which had mostly petered out by last year.)

But next year, growth will probably run anywhere from 7.5% to 9%, according to estimates from the World Bank and other sources that are not the Chinese government. The raging inflation of the past year is also mostly gone.

As a result, the government is taking aggressive steps to pump growth back up, notably by pulling back policies intended to reduce bank lending. But it’s not clear to me that they can do this in the most healthy and sustainable way (by stimulating domestic demand).

Instead, they’re reaching for the tried-and-true: export growth.

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This is just a brief note to make you all aware that it’s being a very remarkable week in the Land of Fixed-Income and Monetary Policy.

I’ll post much more on this topic as soon as I can, but the Federal Reserve has qualitatively changed the nature of their response to the financial crisis. As of this week, they’ve embarked on what is called “quantitative easing” of monetary policy.

To oversimplify somewhat, they’ve transitioned from trying to effect policy by manipulating the price of credit, to directly creating credit themselves. This is by way of the flurry of new facilities they announced yesterday.

You can see for yourself one of the immediate consequences: yesterday morning, retail mortgage rates dropped almost 90 basis points. In most parts of the country, you can get a 30-year fixed rate mortgage for about 5.30%. It remains to be seen whether this will lure buyers back into the housing market, but it’s a hopeful sign.

Elsewhere, the Treasury has gone into overdrive, creating vast new supplies of the most desired asset class in the world, namely full-faith-and-credit US Treasury paper.

We’re going to see the yield curve flatten considerably in the near term. The Fed funds rate (which is currently targeted at 1%) is actually near zero. This limits the ability of short-dated paper (like T-bills) to increase in value.

Meantime, there is a lot of new supply hitting the 3-year sector of the curve. Treasury is now issuing new 3-year notes every month, and the new banks on Wall St. (which used to be investment banks) are issuing 3-year notes with an FDIC guarantee. That’s going to push up yields at this maturity.

And then there’s the Fed, which is out there buying up long-dated securities like Fannie/Freddie debt and mortgage-backed securities, and securitizations of consumer debt (student loans, credit cards, car loans). This will take sone supply out of the long end of the market and keep yields low.

More later.

-Francis Cianfrocca

Last week was Citigroup’s turn. Citi is one of the world’s best-known banking brands, and was once America’s largest bank by market capitalization.

Last week, investors knocked 60% off the value of Citi’s stock, in a nerve-rattling selloff that was too reminiscent of Bear Stearns and Lehman Brothers for comfort.

Citigroup is too large to fail. It has about 200 million accounts in more than 100 countries. Its balance sheet has $2 trillion in assets. They also have more than $1 trillion in off-balance sheet assets. (The latter are of great concern because they’re not subject to the same reserve and capital requirements as the normal stuff.)

Here’s the term sheet that appeared on the FDIC’s web site in the wee hours this morning. Usually the authorities try to get things like this done by 7pm Eastern time on Sunday nights. But tonight they had a bit more wiggle room because markets in Tokyo are closed for a holiday.

Market reaction as I write (around 6am ET) is mildly positive. The US Treasury yield curve is flatter overall with higher yields in the belly.

The Treasury and the FDIC have essentially agreed to guarantee the value of certain assets of Citigroup, in a manner that shares a few features with prior bailouts, like the “Maiden Lane” structure engineered by the New York Fed for Bear Stearns, and the Treasury’s conservatorship of Fannie Mae/Freddie Mac.

Let’s see if I can explain this really simply.

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