This Time It's (Not) Different

Greg Mankiw had this posting from the FT this morning - definitely worth a read. Here's an excerpt:

Why we should expect low growth amid debt

By Carmen Reinhart and Kenneth Rogoff

Published: January 27 2010 20:17 | Last updated: January 27 2010 20:17

As government debt levels explode in the aftermath of the financial crisis, there is  growing uncertainty about how quickly to exit from today’s extraordinary fiscal stimulus. Our research on the long history of financial crises suggests that choices are not easy, no matter how much one wants to believe the present illusion of normalcy in markets. Unless this time is different – which so far has not been the case – yesterday’s financial crisis could easily morph into tomorrow’s government debt crisis.

In previous cycles, international banking crises have often led to a wave of sovereign defaults a few years later. The dynamic is hardly surprising, since public debt soars after a financial crisis, rising by an average of over 80 per cent within three years. Public debt burdens soar owing to bail-outs, fiscal stimulus and the collapse in tax revenues. Not every banking crisis ends in default, but whenever there is a huge international wave of crises as we have just seen, some governments choose this route.

While the exact mechanism is not certain, we presume that at some point, interest rate premia react to unchecked deficits, forcing governments to tighten fiscal policy. Higher taxes have an especially deleterious effect on growth. We suspect that growth also slows as governments turn to financial repression to place debts at sub-market interest rates.

Another big unknown is the future path of world real interest rates, which have been trending downwards for many years. The lower these rates are, the higher the debt levels countries can sustain without facing market discipline. One common mistake is for governments to “play the yield curve” – as debts soar, shifting to cheaper short-term debt to economise on interest costs. Unfortunately, a government with massive short-term debts to roll over is ill-positioned to adjust if rates spike or market confidence fades.

Given these risks of higher government debt, how quickly should governments exit from fiscal stimulus? This is not an easy task, especially given weak employment, which is again quite characteristic of the post-second world war financial crises suffered by the Nordic countries, Japan, Spain and many emerging markets. Given the likelihood of continued weak consumption growth in the US and Europe, rapid withdrawal of stimulus could easily tilt the economy back into recession. Yet, the sooner politicians reconcile themselves to accepting adjustment, the lower the risks of truly paralysing debt problems down the road. Although most governments still enjoy strong access to financial markets at very low interest rates, market discipline can come without warning. Countries that have not laid the groundwork for adjustment will regret it.

Markets are already adjusting to the financial regulation that must follow in the wake of unprecedented taxpayer largesse. Soon they will also wake up to the fiscal tsunami that is following. Governments who have convinced themselves that they have done things so much better than their predecessors had better wake up first. This time is not different.

Ms Reinhart is professor of economics, University of Maryland, and Mr Rogoff is professor of economics, Harvard University. They are co-authors of ‘This Time is Different: Eight Centuries of Financial Folly’ (Princeton)

http://www.ft.com/cms/s/0/f4630910-0b7a-11df-8232-00144feabdc0.html

Sweet Sixteen for The Mighty Fed

I have been a big fan of Roger Federer for years aka The Mighty Fed.

Congratulations, Rog, for winning the Australian Open - your 16th major title!

International Diversification

My colleague Bob Quinn has been pushing me to rethink my current skepticism on international investing.

It's not that I don't understand the arguments: more than half of the world's stock market capitalization is outside the US; growth rates may be better outside of this country; foreign markets may offer welcome diversification to domestic stocks, etc.

The problem I'm having is that I have been convinced of the virtues of international investments several times during my career. In fact, I wrote a long paper in graduate school back in 1981 (!) about the virtues of international investing.

But then, when I go ahead and commit capital, the results are often not as appealing as they should be. Moreover, the correlation between foreign markets and the US is often quite high (with the exception of Japan), so the diversification argument has often not carried the day.

But I am once again thinking I should be pushing for more international stocks, especially in the emerging markets. I'm not all the way there yet, but I'm doing alot of work on the subject.

There was a good column in this morning's Wall Street Journal about international stocks written by Jason Zweig, who's a pretty savvy journalist. Here's the link:

http://online.wsj.com/article/SB10001424052748704343104575033103904554046.html?mod=WSJ_hp_editorsPicks

Annuities

In the "old days" - that is, a generation ago - workers at many companies enjoyed the security of knowing that when they retired that would have a pension for the rest of their lives.

Even if the monthly pension payments were modest, there was a certain comfort in knowing that one could live out the retirement years with financial security.

Now, of course, the fate of your retirement largely rests on what happens in your 401(k), IRA, etc. Put another way: it's up to you, and the markets, as to how financially secure your "golden years" will be.

The only product on the market that compares to a pension plan is an annuity. Unfortunately, annuities have a poor reputation among consumers, often with good reason. High fees, unintelligible legal language, poor sales practices - you name it - a product that should resonate with investors and savers alike has all of the appeal of a root canal for many people.

This may change, especially in light of the poor stock market performance for the last decade. In addition, as this post from today's New York Times notes, the administration seems to be making a not-so-subtle push for Americans to rethink their current mindset about annuities, and reconsider them as part of their overall financial planning.

Here's the link to the article by Ron Lieber:

http://www.nytimes.com/2010/01/30/your-money/annuities/30money.html?ref=business

Good Description of Economic Environment from Larry Summers

From today's Wall Street Journal:

• January 30, 2010, 8:13 AM ET

Summers: ‘Statistical Recovery and Human Recession’

Key Obama economic adviser Larry Summers coined a telling way to look at the current American economic state of play. He said the U.S. is experiencing a “statistical recovery and a human recession.”

It is a phrase that should resonate through much of the industrial world, where high and long-standing unemployment is increasingly becoming a huge domestic political issue.

Speaking on a panel at the annual meeting of the World Economic Forum in Davos, Summers said one in five American men aged 25 to 54 are unemployed. He said given a “reasonable recovery,” that rate could improve to one in seven or one in eight. That still contrasts with a 95% employment rate for that group in the mid-1960s.

He said the U.S. can gain from increased global integration, but if it is to be politically sustainable it “has to work for people.” That means job creation in the U.S. is a crucial issue.

Credit Crisis Unfolding in Europe

Much of the attention in the global credit markets over the past week has been on Greece. As you probably saw, Germany announced earlier this week its strong feeling that it would not be in favor of aiding other members of the euro community, which was widely interpreted to mean Greece.

However, Greece is not the only country in Europe that are facing problems. Spain and Portugal have also been mentioned as countries that are facing serious credit crunches.

Here's a post from Rolfe Winkler of Reuters with some details:

Spanish canary in the European coal mine

Jan 29, 2010 14:04 EST

The quote of the day comes from Marc Chandler, currency strategist at Brown Brothers Harriman, who graciously offered to let me reprint a note he sent today.

While Greece gets much of the news, Chandler argues that it’s in Spain where the policy dilemma is “most stark.”

Today Spain reported that its unemployment rate in Q4 rose to 18.8% from 17.9% in Q3. The consensus was for a rise toward 18.5%. The unemployment rate has doubled in the past two years. As seems to be typical in Europe, the unemployment [rate] is especially pronounced for young people. In Spain it’s 40%…

Cyclical forces and the €8 billion public works program pushed Spain’s deficit to around 11.2% of GDP last year according to the EC. This is almost as large as Greece’s. One key difference between the two in this context is that Spain’s debt to GDP is considerably lower than Greece, giving it perhaps greater chance to stabilize the debt/GDP ratios before they become ruinous.

In the face of such sobering news on the labor market today, Spain officials have felt compelled to indicate that they are considering increasing their efforts to cut the budget deficit quicker. The government is contemplating proposals that will cut another €50 billion or 5% of GDP by 2013.

This illustrates the dilemma policy makers face. The economy does not warrant an end to fiscal support yet. The IMF has argued this. The EC has argued this. But the dramatic market response to Greece has been a siren call, seemingly forcing policy makers–not just in Spain, but Portugal earlier this week and Poland earlier today too–to mitigate the wrath of the bond vigilantes.

By appeasing the vigilantes, officials risk aggravating the economic downturn, which offsets some of the fiscal austerity and spurs social tensions. [But] if the vigilantes’ concerns are not addressed in a satisfactory fashion, capital will strike, at least partially, and interest rates will rise…also exacerbating the economic downturn.

Many developed economies have borrowed so much, they can borrow no more. While borrowers love to hate their lender, they need him desperately if they’ve levered up their lifestyle past the point their income can support.

The Power of "Disconforming Ideas" - Good Read from the Harvard Business Review

Brooksley Born and the Power of an Opposing Idea

8:49 AM Friday January 29, 2010
by Whitney Johnson

"If she just would have gotten to know us...maybe it would have gone a different way" said Arthur Levitt, former chairman of the SEC, in an excellent 2009 Frontline episode titled The Warning. The 'she' Levitt refers to is Brooksley Born, former Chair of the Commodity and Futures Trading Commission (CFTC), who waged an unsuccessful campaign to regulate the multitrillion dollar derivatives market, whose crash helped trigger the recent financial collapse.

Ms. Born, the first female president of the Law Review at Stanford, the first female to finish at the top of the class, and an expert in commodities and futures, was brought in by the Clinton Administration to run the (CFTC), a little known regulatory backwater. Soon after assuming the reins, she became aware of the over-the-counter (OTC) derivatives market, a rapidly expanding and opaque market, which she attempted to regulate. According to Frontline, "Her attempts to regulate derivatives ran into fierce resistance from then-Fed Chairman Alan Greenspan, then-Treasury Secretary Robert Rubin and then-Deputy Treasury Secretary Larry Summers, who prevailed upon Congress to stop Born and limit future regulation." Put more directly by NY Times reporter Timothy O'Brien, "they...shut her up and shut her down."

Ms. Born's distinctness (training as a commodities and futures lawyer, her perch at the CFTC, likely her woman-ness) was her value proposition; it was also her demise. To be fair to Greenspan et al, their resistance was not surprising. According to psychologists Hillel Einhorn and Robin Hogarth, "we [as human beings] are prone to search only for confirming evidence, and ignore disconfirming evidence." In the case of Ms. Born, it was the 90s, the markets were doing well, the country was prospering; it's easy to see why the powerful troika rejected her disconfirming views. Throw in the fact that the disconcerting evidence was coming from a 'disconfirming' person, as Levitt intimates, and they were even more likely to disregard the data. Ms. Born quotes Michael Greenberg, the Director of the CFTC under her, as saying "They say you weren't a team player, but I never saw them issue you a uniform."

We like ideas and people that fit into our worldview, but there is tremendous value in finding room for those that don't. According to Paul Carlile and Clayton Christensen, in The Cycles of Theory-Building in Management Research, "It is only when an anomaly is identified — an outcome for which a theory can't account that an opportunity to improve theory occurs."

So what can we do when we're faced with such anomalies?

Be aware of our tendency to reject 'disconfirming evidence'. As an equity analyst, I continually dealt with disconfirming data. One instance, in particular, I had made a carefully considered, albeit unpopular call, in downgrading media conglomerate Televisa (NYSE: TV). The risk, however, was that I would become anchored to my view, embracing data points that supported the sell, rejecting those that argued for a buy. In this case, I didn't. Rejecting disconfirming evidence is often behind the tendency to hang on to winners (or losers) too long.

Recognize signals of positive/negative bias. When friends and associates suggested to Janna Taylor that she start her own tutoring business in Manhattan, she became defensive, with remarks such as "There's no way I can do it." Perhaps when we become defensive, it's a signal that we've uncovered an important anomaly. Ms. Taylor's Mindfull Tutors is now thriving. Certainly it's easier to hear disconfirming evidence from people we know and trust.

Encourage the anomalies. When our employees provide feedback that a product isn't working, do we encourage this feedback, or shut it down? Will the Senate (on both sides of the aisle) welcome the opportunity to better articulate their views on healthcare with the election of Senator Scott Brown, or simply embrace him because he's one of 'us' (whoever 'us' is), or shut him down, because he's not?

Whether running a business, government, or our lives, when we encounter disconfirming ideas or people, perhaps they'll just be an annoyance which we can flick away. If we find ourselves more than annoyed — defensive, even dismissive — and we're smart, we'll stay with the people and the ideas that we find so disturbing, analyze the anomaly, and wonder at this disconfirming evidence. So the next time you get that 'one of these things is not like the other' urge to shut someone or something down, why not instead sit down with them and listen.

Whitney Johnson is a founding partner of Rose Park Advisors, Clayton M. Christensen's investment firm. Previously, she was a double-ranked Institutional Investor analyst at Merrill Lynch covering both telecom and media in the emerging markets.

Social Media

This report from emarketer.com caught my eye. There's lots of statistics that you can read for yourself, but I was surprised at the overwhelming popularity of Facebook - even among the World War II generation. I was also interested at the fairly low (13%) of so-called Generation Y that used LinkedIn - I would have thought they would be using it for job searches.

Baby Boomers Get Connected with Social Media

JANUARY 28, 2010

Living longer and richer lives, they go online to stay in touch

Baby boomers have always been good communicators, as evidenced by their presence at sit-ins, protests, demonstrations and “happenings” in the 1960s. So it was inevitable that boomers would check out social media sites.

“Creating and renewing personal connections online is the biggest draw for these boomers,” said Lisa E. Phillips, eMarketer senior analyst and author of the new report, “Boomers and Social Media.” “About 47% of online boomers maintain a profile on at least one social network, according to several sources. Their contacts include family, friends and co-workers of all ages.”

Burst Media reported that 47.5% of online boomer respondents had a social network profile in June 2009. In September of that year, Deloitte found 46% of boomer respondents said they maintained a social network profile—an important difference from simply creating one and forgetting about it.

Boomers’ social network presence has grown steadily since Deloitte’s 2007 survey, when only 30% said they maintained a profile on a social network. In that period, millennials’ use of social profiles remained fairly steady—and heavily penetrated—at 71% in 2007 and 77% in 2009.

Facebook is the favorite social network for boomers, as both comScore and Anderson Analytics data show.

“Boomers expect that technology will help them live longer and better lives and keep them connected to family, friends, co-workers and, eventually, healthcare providers,” said Ms. Phillips. “To fulfill these expectations, boomers are turning to social media, where they keep up their offline social connections and make new ones. Online marketing messages that help them build on their connections—and foster other online relationships—will get their interest.”

Free Tickets to the U.S. Open!

I came across this in the New York Magazine website. The way I see it, even if you can't win a single point against Federer or Nadal in the first round, you still get a chance to get into the grounds at Flushing Meadows and watch some great tennis!

Now all I have to do is become a better tennis player....

How You — Yes, You — Can Play in the U.S. Open

This could be you.

If you've ever thought to yourself, "Hey, that could be me out there getting smoked by Roger Federer or Serena Williams in the first round of the U.S. Open," this is your big chance. The USTA will introduce the U.S. Open National Playoffs this year, in which anyone 14 and over (well, anyone 14 and over who's an active member of the USTA and forks over a $125 entry fee) can play for a shot at a wild-card berth in the U.S. Open qualifying tournament, at which they can play for a spot in the main draw of the U.S. Open. See, easy.

The USTA will stage sixteen open-to-anyone sectional tournaments around the country this spring, with the winners of each advancing to a championship round. (The New York matches take place April 20 through April 26 at Flushing Meadows. Each tournament is limited to 256 players; registration for New York opens March 1.) Basically, it's like American Idol for tennis players, only instead of worldwide fame and a huge record contract, the winner gets an audition to maybe become one of Kelly Clarkson's backup singers.

And yes, this sucks for the man and woman who would have otherwise been the last person to qualify for their respective qualifying tournaments, but there's something undeniably cool about the idea that some random person could go on a hot streak and make it all the way to Flushing Meadows. (This, by the way, is the same concept that makes low-level NCAA conference basketball tournaments so much fun.) To hammer home the idea that literally anyone with a pulse can enter this tournament, the press release announcing the playoffs mentions that Bode Miller (the skier who, to be fair, has a tennis background) will be competing in one of the tournaments. So even if you don't go all the way, there's always the chance you'd get to beat Bode Miller at something, which is fun in its own right.

Read more: How You — Yes, You — Can Play in the U.S. Open -- The Sports Section http://nymag.com/daily/sports/2010/01/how_you_yes_you_can_play_in_th.html#ixzz0dvtb7rMR

"Not Liberal or Conservative, Just Incoherent"

Greg Ip (who used to cover the Fed for the Wall Street Journal) has this excellent note out today in The Economist about the political problems surrounding government policy. Here's an excerpt from his piece:

IN ITS updated global forecast released this morning, the IMF warns against “premature and incoherent exit” from government support for the economy. “Incoherent” nicely describes the policy debate in Washington. Partisans have aimed their poison at the Federal Reserve and at the government's fiscal policy choices but what, exactly, do they want? The logical implications of their complaints are contradictory at best and dangerous at worst.

Start with the Fed. On the right, they’re angry about quantitative easing which they say is monetising deficits. On the left, they’re angry about lax regulation of banks. Both are furious at bail-outs of banks and AIG, and both think the Fed created a bubble with its low interest rates. So the Fed, presumably, should shrink its balance sheet, end its asset purchases and liquidity programmes, order banks to raise underwriting standards and raise rates to nip the next bubble in the bud. And this is going to bring unemployment down?

For the entire story:

http://www.economist.com/blogs/freeexchange/2010/01/working_draft

Jeremy Grantham of GMO on the Stock Market

This morning's Wall Street Journal carried a short article summarizing the most recent outlook letter from Jeremy Grantham. I have long been a fan of Mr. Grantham - his work is usually supported by fairly rigorous analysis of the data.

(By the way, as you can tell from my previous post today, I believe the term "bubble" has become one of the most overused terms in the markets. I would suggest that markets may be overpriced in the short run, but a market that is still 30% lower than it was in October 2007 is probably not in a "bubble")

A Bear Reawakens After a Bullish Run

GMO's Grantham Warns of a Stock Bubble

By JONATHAN BURTON

Jeremy Grantham, the investment guru who correctly predicted the 2009 market rally, now warns that a new bubble is forming.

Stocks are likely to move higher in coming months, but prices are expensive, and long-term investors should be mindful of a volatile mix that Federal Reserve policy and government actions are causing, according to Mr. Grantham, the frequently bearish chief investment strategist at Boston-based institutional money manager GMO.

Reuters

GMO's chief investment strategist, Jeremy Grantham, has returned to his bearish bent, saying easy money is inflating stocks.

"Once again, the Fed is playing with fire," Mr. Grantham wrote in his latest quarterly letter to institutional clients.

The Fed's policy of low interest rates and easy money has boosted the economy but has stimulated Wall Street and stocks even more, Mr. Grantham says.

That is why, much to his dismay, he sees another large speculative wave forming.

"I was counting on the Fed and the Administration to begin to get the point that low rates held too long promote asset bubbles, which are extremely dangerous to the economy and the financial system," he writes.

"Now, however, the penny is dropping," he says, "and I realize the Fed is unwittingly willing to risk a third speculative phase, which is supremely dangerous this time because its arsenal now is almost empty."

At the same time, Mr. Grantham says, higher prices suggest a stock market that is increasingly stable and confident, encouraging investors to buy first and ask questions later, if at all.

The upside, at least in the short term, is that speculation will drive the stock market for the next several months, he believes. Accordingly, he says GMO's strategy will be to "very slowly" trim equity positions and to "swallow our distaste for parking the rest in unattractive fixed-income."

This next leg up will be unlike 2009's rally, when low-quality and riskier stocks fared best, Mr. Grantham says.

He expects a broader advance, "in which high-quality stocks should hold their own or even outperform."

But it will be a false rally, he finds. The Standard & Poor's 500-stock index is worth "850 or so; thus any advance from here will make it once again seriously overpriced." The S&P 500 closed Tuesday at 1092.17.

Mr. Grantham is frequently bearish, so it was uncharacteristic in March 2009 when he urged investors to buy stocks. His timing, at the bottom of the market, was correct, just as it was in late 2007, when he warned that stocks were precariously perched.

Going forward, Mr. Grantham predicts a "multiyear headwind" on the markets, during which investors will see "below-average profit margins" and price/earnings ratios in a period more akin to the bumpy 1970s than the bumper 1990s.

Over what Mr. Grantham calls the next "seven lean years," GMO forecasts large-cap U.S. stocks to deliver a real return (after inflation) of 1.3% annualized, while small-caps provide a 0.5% return.

The outlook is better for high-quality U.S. stocks, which have an expected yearly return of 6.8%.

"For the longer term, the outperformance of high quality U.S. blue chips compared with the rest of U.S. stocks is … nearly certain," Mr. Grantham says.

International stocks also fare reasonably well in GMO's model, up about 4.7% annualized over the seven-year period, while emerging markets come in with a 3.9% annualized gain.

"Going into this next decade, we start with the U.S. overpriced," Mr. Grantham cautions, "so do not be conned into believing that every bad decade is followed by a good one."

Bubbles, Bubbles - Everywhere there are Bubbles

Ever since the late 1990's - when technology stocks were vastly overpriced (remember when Cisco was going to be the first company worth $1 trillion?) - analysts and commentators have become very quick to say a particular market or asset is in a vastly overpriced "bubble".

Occasionally these bubble comments are right (e.g. Las Vegas real estate in the middle of the last decade) but I often think they are missing the point. To me, a true asset price bubble is one which is a longer term phenomena where prices are vastly higher than the economic worth of a particular security or property.

Robert Shiller of Yale (he of Irrational Exuberance fame) gave a talk in Davos yesterday where he identified the characteristics of a bubble (reprinted from the New York Times blog):

http://dealbook.blogs.nytimes.com/2010/01/27/schillers-list-how-to-diagnose-the-next-bubble/

Beware Telecom Stocks

For accounts looking for income, high dividend paying stocks like Verizon (current yield 6.2%) and AT&T (current yield 6.6%) might seem attractive. However, I am very cautious about the telecom sector - I don't believe the dividends are sustainable longer term, as the business fundamentals remain terrible.

Background: Ten years ago, in 2000, I attended a technology conference here in Boston. One of the featured speakers was John Chambers, CEO of Cisco.

The one key takeaway from John's talk was this statement: "Voice will be free".

In other words, the world was moving towards an internet-based communication system in which consumers and businesses would eventually pay nothing for telecommunications.

Since John's talk, the big telecom stocks have been terrible performers, underperforming the S&P 500 by 2300 basis points. I don't believe the next few years will be any different.

Investing in stocks where the price of the services they provide is continually heading lower, but the costs of providing those services keeps going higher, is probably not a mix that will lead to long term business success.

On top of this, the major telecom companies have huge legacy obligations (pension and health care).

I could go on, but here's an excerpt from a news story today about layoffs at Verizon from Dow Jones (I've highlighted the key parts):

JANUARY 26, 2010, 1:05 P.M. ET

Verizon Swings To 4Q Loss On Layoff Charges

  By Roger Cheng
Of DOW JONES NEWSWIRES

NEW YORK (Dow Jones)--Verizon Communications Inc. (VZ) swung to a fourth-quarter loss as a result of heavy charges, and announced another round of layoffs as executives cast a downbeat note on the economic recovery.

While the New York telecommunications giant's wireless arm remained resilient in the face of lower consumer spending, its legacy wireline segment wasn't so fortunate. Verizon said there haven't been any indications of a pickup in spending on the business side, while the number of new FiOS customers disappointed Wall Street.

"The economy won't help us as much as we thought," said Chairman and Chief Executive Ivan Seidenberg, adding that he doesn't see a significant improvement until the end of the year. As a result, the company plans to shed another 13,000 jobs in 2010, roughly the same amount cut in each of the past two years. The latest represents 11.1% of its total work force of 117,000.

Verizon shares fell 2% to $30.06.

The company reported a loss of $653 million, or 23 cents a share, compared with a year-earlier profit of $1.23 billion, or 43 cents. Excluding one-time items, among them the costs from cutting some 8,000 jobs, earnings fell to 54 cents a share.

Revenue jumped 9.9% to $27.09 billion. Both profits and revenue disappointed analysts, who were already bracing for weaker results.

Verizon Wireless' decision to move into the prepaid arena through a reseller deal, as well as the recent price cut on its unlimited voice plan - which prompted AT&T to follow suit -underscored the pricing pressure the industry faces for voice service.

Verizon Wireless - which is jointly owned by Verizon and Vodafone Group PLC (VOD) - saw revenue rise 22.5% to $15.73 billion as a result of a higher reliance on smartphones with data services.

Wireline revenue, however, continued to drag on Verizon, falling 3.9% to $11.5 billion.

"Today's results were eye-opening, if only because of the magnitude of the divergence," said Craig Moffett, an analyst at Sanford C. Bernstein & Co. "Wireline results were at least as weak as wireless was strong."

The company has pegged its growth on its FiOS services, which include a faster Internet connection and television. In the quarter, it added 153,000 customers to both FiOS Internet and FiOS TV services, driving a 12.6% increase in its average revenue per user. FiOS TV growth, however, was down 50% from a year ago, and results were considered a disappointment.

What's Really Important in Your Life?

Interesting column from last Sunday's New York Times.

Op-Ed Columnist

What Could You Live Without?

By NICHOLAS D. KRISTOF

Published: January 24, 2010

http://www.nytimes.com/2010/01/24/opinion/24kristof.html

12 Traps With Roth IRA Conversions

12 Traps With Roth IRA Conversions

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The Bank Problem in a Single Chart

This chart appeared this morning in the Financial Times. It comes from Deutsche Bank strategist Jim Reid.

I will attach the complete link to the site below, but I think the chart and article discuss an important point. Until the late 1990's, the growth in banking profits largely mirrored the economy. This seems logical.

However, once derivatives and leverage combined to allow the financial sector to make huge profits, finance became an important driver of earnings for the economy (in 2007, for example, almost 40% of the profits of the S&P 500 came from the financial sector). However, all of this came crashing down in 2008, as we are all painfully aware.

But here's the problem: notice the spike in financial profits that occurred last year as a result of government intervention. Once again, the financial sector appears to be making profits that are disproportionate to the overall economy. This is probably one of the main issues that President Obama (spurred by Paul Volcker) is trying to address.

However, as we saw in the past decade, sometimes regulations can lead to unexpected consequences, and not all of them are favorable.

Here's the link:

http://ftalphaville.ft.com/blog/2010/01/25/133331/the-bank-problem-in-a-single-chart/

Bearish Comments from Morgan Stanley

Here's Morgan Stanley's take, courtesy of the blog Clusterstock:

Morgan Stanley: Sell Into Strength, The Tightening Has Begun

What's amazing is how the start of the tightening cycle seems to have completely caught investors by surprise.

Two weeks ago it was hardly an issue. Now it's here.

Morgan Stanley analyst Teun Draisma:

Sell into strength, as authorities have switched from "all out stimulus" to "let's start some stimulus withdrawal". Tightening measures are coming in thick and fast around the world. We always thought that the start of tightening was not the first Fed rate hike, but could be many other things including higher taxes, less spending, more regulation, Chinese/Asian tightening, or Fed language change. Recent initiatives include Obama's banking initiatives, and several Asian tightening measures. In the next few months this theme is set to intensify, and we expect positive payrolls, a Fed language change, and the start of QE withdrawal. This willingness of authorities to move away from crisis mode is an important change and means that the tightening phase in the broad sense of the word has now started. Thus, indeed, 2010 is shaping up to be like 1994 and 2004, as we expected.

The start of tightening is hardly ever the end of the growth cycle, and normally the accompanying dip needs to be bought, but it typically is a serious double-digit dip lasting 2 quarters or more. The sector rotation has of course already started in October-2009 and is set to continue. As a result we move 2% from equities to bonds in our asset allocation, going to +5% cash, -2% UW equities, -3% UW bonds. We think short-term strength is quite possible, and we have not quite gotten anoutright sell signal on our MTIs either, but the 6 month risk-reward of being long is worsening, and we recommend to sell into strength. Our 12 month MSCI Europe target of 1030 implies 6% downside.

The PGA Tour Without Tiger Woods

Interesting story in this morning's Wall Street Journal about what the absence of Tiger means to the Tour. What happens when he returns? - is it the economy, or is it Tiger?

I think that LPGA is in even more financial difficulties. It's tough to justify sponsoring a golf tournament when business continues to struggle.

Here's the link:

http://online.wsj.com/article/SB10001424052748703699204575017550261245506.html?mod=WSJ_hps_MIDDLESixthNews

Was the President reacting to last week's election results?

One of my favorite bloggers - Professor Greg Mankiw from Harvard - had a piece yesterday about President Obama's proposed regulations on the banks. He quoted an Obama insider who insisted that the timing of the announcements was purely coincidental, and not a reaction to the loss of the Senate seat in Massachusetts.

I hope he's right, but I am doubtful. The Obama team, I think, is incredibly well-disciplined, and almost always "stays on message". They must have anticipated how the financial markets would have reacted - Larry Summers, after all, was a consultant for a hedge fund before he moved back to government - but simply decided that they were not going to worry about it.

That said, if I am wrong and the timing was just unlucky, financial stocks could represent an opportunity in here.

Here's the link to the blog:

http://gregmankiw.blogspot.com/

Market Thoughts

I'm getting ready for an investment committee meeting on Monday, so it gave me a chance to try to synthesize our thoughts about the economy and markets.

Here's a copy of some of my notes:

Meeting Notes – 1/25/10

Overall:

Market is at an inflection point. Government catalysts for strong rally since March 2009 will be missing in 2010. Private sector needs to perk up.

Items to Watch:

1. Washington

· Odds against significant health changes. Negative for health care stocks, which had rallied since last November in anticipation of changes.

· “Glass Steagall Lite” removes financial sector tailwind;

· Confirmation of Bernanke for another term as Fed chairman in doubt;

· Taxes almost certainly have to rise for all.

· Defense spending will probably decline mid-2010

2. China
• Chinese economy growing rapidly again Stimulus package passed by the Chinese govt. had an immediate (positive) effect on economy;
• Still, some questions on sustainability of recovery, especially if trading partners remain sluggish;
• “War of words” on internet, climate policy, etc., doesn’t help. Also illustrates a more confident Chinese govt. that is less concerned about US opinion

3. Capital Markets

· Huge demand for lower quality credits – credit fears gone. Investors bidding lower quality assets aggressively – spreads nearly back to where they were in early 2008;

· Yield curve is at its steepest level in at least 25 years. The good news: Investors can’t stay in 0% cash forever. More good news: steep yield is usually a harbinger of strong economy.

· Higher yields and more future inflation pressures are widely anticipated. But is all of the “bad news” in the bond prices?

4. Earning expectations

· Consensus earnings expectations for S&P 500 +24% for 2010 and +21% for 2011. Groups with most expected earnings upside: energy/commodities (+47% in 2010) and technology (+26%). Lowest expectations in consumer staples (+7%) and telcom/utilities (+7%).

· While numbers may look aggressive initially, they are all coming off low bases in 2009. Overall S&P earnings not expected to get back to 2007 levels until 2011.

· On negative side, earning estimates are usually too high at the end of recessions. Also, analyst margin expectations are very high – near historic peak. Is this realistic?

5. Economy

· Unemployment a huge problem – actual figures in high teens if you include “discouraged” workers. Business reluctant to make new hires in uncertain economic environment. Final health care costs also not clear;

· Inflation simply not a problem – too much capacity. Unit growth volumes are rising, but pricing keeps falling

Investment Implications - Stocks

Overall Market

• Probably due for a correction but, if economy improves and short term interest rates remain low, market should finish year higher;
• Low quality, high beta stocks did best last year. Historically high quality outperforms over longer periods of time. Also, higher quality stocks are just statistically cheaper;
• Earning expectations are achievable, but are “upside surprises” possible?
• Large cap, dividend-paying stocks look cheap. Small cap stocks that offer M&A potential (i.e. large cash positions) might interesting as well.

Bearish Thoughts from Merrill Lynch

Alot of the Washington activity this week may work its way into the stock market - and not necessarily in a good way. Here's a post from the blog Clusterstock :

Worrisome Political Development: Bernanke Confirmation Unclear

Earlier this week, I published an interview with Warren Buffett. He indicated that if Mr. Bernanke is not reappointed as Fed chairman, he would be a seller of stocks.

I agree. I think that Bernanke did a masterful job of pulling the financial system from the brink. The recovery in the economy and the financial system is still fragile, and could easily be derailed by ill-informed decisions.

http://online.wsj.com/article/SB10001424052748704423204575017580583607908.html?mod=dist_smartbrief

Good Summary of "Glass Steagall Lite" - President Obama's Bank Regulation Proposals

From The Economist:

http://www.economist.com/opinion/displayStory.cfm?story_id=15374543&source=features_box1

Financial stocks got killed yesterday after the President spoke. As the article notes, it is not clear whether the regulations would have prevented the financial meltdown of 2008. However, clearly the President hopes to tap into the public's anger over Wall Street's resurgence.

Computer Passwords

I don't know about you, but I get very frustrated with passwords for the various sites that I like to visit. At home I have at least two pages of various passwords that I have used over the years, even to buy movie tickets on line (why do I have to have a password to buy a movie ticket??).

Today's papers carry a story about passwords, and how too many of us use easily hacked passwords. According to the report, here is a list of the most common passwords:

1. 123456
2. 12345
3. 123456789
4. Password
5. iloveyou
6. princess
7. rockyou
8. 1234567
9. 12345678
10. abc123

Here's the link to the whole story: http://www.guardian.co.uk/technology/blog/2010/jan/21/password-analysis-weakness-rockyou

Implications of Senator Brown of Massachusetts for Stocks

Best Headline of the Day (from The Village Voice) :

Scott Brown Wins Mass. Race, Giving GOP 41-59 Majority in the Senate

It is too early to gauge all of the implications Republican Scott Brown's victory for the Senate seat. However, in my opinion, many of the near-term implications may be negative for the health care and utility sectors of the market.

Last fall, when it seemed likely that some form of national health care would pass, health care and drug stocks soared. The thinking seemed to be that Obamacare would lead to millions of people receiving health insurance, and thereby becoming more frequent users (this was the Massachusetts experience when our state required health insurance for all).

Now, assuming that any significant legislation will be either watered-down or delayed, some of the steam may go out of the health care group, with the possible exception of the managed care group.

The utility group may also be hit. The proposed "cap-and-trade" legislation that was targeted at reducing carbon emissions would actually have wound up to be a positive for utilities, who would have realized trading profits from the carbon grants (in Britain, utility companies minted money on the scheme when cap-and-trade was imposed several years ago). Now, however, it is unlikely that any significant carbon tax proposal will pass, given the opposition of the Republicans to the whole idea.

Less clear at this time are the implications for other sectors. For example, what happens to defense stocks (will the defense budget still be pared in 2011, once the planned Afghanistan pull-out starts?). And what about the banking and financial sector (will the Treasury secretary and Fed chairman have as much freedom to operate?)?

Finally, it will be interesting to see what happens with tax policy. The looming huge fiscal deficits are the legacy of decisions by both parties, and now the bill has come due. It's easy to campaign against raising taxes, but fiscal reality is not so simple.

Today's Comments from Warren Buffett

We've been having a spirited discussion this AM about the implications of the new Republican senator from Massachusetts - I'll post some preliminary thoughts later today.

In the meantime, I thought this AM's thoughts from Warren Buffett were interesting (courtesy of the blog "Clusterstock"):

"The Candidate" - Great Movie Starring Robert Redford

It's "special election" day here in Massachusetts, and either Scott Brown or Martha Coakley will be the next senator from our state. Neither has served in the US Congress before, so it will be a new experience for one of the two.

In any event, today's election brought to mind the last scene from this movie. Even though it was made almost 30 years ago, it still seems relevant.

Haitian Donations

Over the weekend I was talking to a friend about the incredible amounts of funds being raised to aid the victims of the earthquake in Haiti. Where, I asked, could all of this money be spent? All of us want to help (reading any of the news stories of the incredible suffering is heart-rending) and yet it appears that the problems now are not financial but logistical.

Here's an interesting read on the whole subject from journalist Felix Salomon:


Don’t give money to Haiti
Jan 15, 2010 16:30 EST
philanthropy

Between the Twitter campaigns and the telethons and the corporate donations and the record sums raised through text messages, you can be sure that an enormous amount of cash is going to end up being raised to help Haiti. This is not necessarily a good thing.

For one thing, right now there’s very little that can be done with the money. There are myriad bottlenecks and obstacles involved in getting help to the Haitians who need it, but lack of funds is not one of them. For the next few weeks, help will come largely from governments, who are also spending hundreds of millions of dollars and mobilizing thousands of soldiers to the cause. But with the UN alone seeking to raise $550 million, it’s going to be easy to say that all the money donated to date isn’t remotely enough.

The problem is that Haiti, if it wasn’t a failed state before the earthquake, is almost certainly a failed state now — and one of the lessons we’ve learned from trying to rebuild failed states elsewhere in the world is that throwing money at the issue is very likely to backfire.

What’s more, charities raising money for Haiti right now are going to have to earmark that money to be spent in Haiti and in Haiti only. For a Haiti-specific charity like Yele, that’s not an option. But as The Smoking Gun shows, Yele is not the soundest of charitable institutions: it has managed only one tax filing in its 12-year existence, and it has a suspicious habit of spending hundreds of thousands of dollars on paying either Wyclef Jean personally or paying companies where he’s a controlling shareholder, or paying his recording-studio expenses. If you want to be certain that your donation will be well spent, you might be a bit worried that, for instance, Yele is going to be receiving 20% of the proceeds of the telethon.

Meanwhile, none of the money from the telethon will go to the wholly admirable Medecins Sans Frontieres/Doctors Without Borders, which has already received enough money over the past three days to keep its Haiti mission running for the best part of the next decade. MSF is behaving as ethically as it can, and has determined that the vast majority of the spike in donations that it’s received in the past few days was intended to be spent in Haiti. It will therefore earmark that money for Haiti, and try to spend it there over the coming years, even as other missions, elsewhere in the world, are still in desperate need of resources. Do give money to MSF, then, but if you do, make sure that your donation is unrestricted. The charity will do its very best in Haiti either way, but by allowing your money to be spent anywhere, you will help people in dire need all over the world, not just in Haiti. Here’s the message on MSF’s website:

We are incredibly grateful for the generous support from our donors for the emergency in Haiti.

MSF has been working in Haiti for 19 years, most recently operating three emergency hospitals in Port-au-Prince, and is mobilizing a large emergency response to this disaster. Our immediate response in the first hours following the disaster in Haiti was only possible because of private unrestricted donations from around the world received before the earthquake struck. We are currently reinforcing our teams on the ground in order to respond to the immediate medical needs and to assess the humanitarian needs that MSF will be addressing in the months ahead.

We are now asking our donors to give unrestricted funding, or to our Emergency Relief Fund. These types of funds ensure that our medical teams can react to the Haiti emergency and humanitarian crises all over the world, particularly neglected crises that remain outside the media spotlight.

The last time there was a disaster on this scale was the Asian tsunami, five years ago. And for all its best efforts, the Red Cross has still only spent 83% of its $3.21 billion tsunami budget — which means that it has over half a billion dollars left to spend. Not to put too fine a point on it, but that’s money which could be spent in Haiti, if it weren’t for the fact that it was earmarked.

It’s human nature to want to believe that in the wake of a major disaster, we can all do our bit to help just by giving generously. And if there’s a silver lining to these tragedies at all, it’s that they significantly increase the total amount of money donated to important charities by individuals around the world. But if a charity is worth supporting, then it’s worth supporting with unrestricted funds. Because the last thing anybody wants to see in a couple of years’ time is an unseemly tussle over what happened to today’s Haiti donations, even as other international tragedies receive much less public attention.

Update: Saundra Schimmelpfennig has a great list of what to do and what not to do when you’re making donations in the wake of a disaster; it includes, of course, that donations should be unrestricted. And the Philanthrocapitalists suggest that you “match fund what you have given to Haiti with a gift to someone suffering just as much, but less dramatically, elsewhere in the world”.

Update 2: Sophie Delaunay of MSF USA responds in the comments. And in case this blog entry isn’t clear, let me be explicit: DO give lots and lots of money to MSF’s Emergency Relief Fund. Give now, because the tragedy in Haiti is in the news and because you want to do something to help; MSF is there and is helping and is a great cause. And then continue to give in the future, because there are many other equally tragic situations elsewhere in the world, where MSF is doing just as great a job, but there isn’t the same degree of media coverage and there’s much less money flowing in. Earmarking your funds for Haiti in particular is not helpful. But that’s no reason to give nothing at all.

Contrary View: "We Don't Know When the Recovery is"

Most economists and market analysts insist that economic recovery is upon us, and that 2010 will be a stronger year for most countries. I largely agree with this opinion, yet I am concerned that in our desire for conditions to improve we are ignoring data that would indicate another (less hopeful) scenario.

For example, I was struck by both the results and the tone of JP Morgan's fourth quarter and full year results that were released last week. Jamie Dimon has consistently held one of the better views of the world since he took over at JPM, so it is worth listening to his views.

Here's the Reuters report of the Morgan numbers:

JPMorgan loan losses overshadow higher Q4 profit
Fri, Jan 15 2010
* Q4 EPS 74 cents; Street view 61 cents

* Loan loss reserves rise for mortgages, commercial loans

* Investment bank profit still drives results

* Record compensation for investment bank staff

* Shares down 2.1 pct in morning trading (Corrects third paragraph from bottom to name commission)

By Elinor Comlay

NEW YORK, Jan 15 (Reuters) - JPMorgan Chase & Co reported deep losses on mortgage and credit card loans in the fourth quarter, damping hopes that consumer credit is on the mend.

Strong investment banking results helped quarterly profit soar to $3.3 billion, topping Wall Street expectations. But analysts had been hoping for signs that the bank's credit costs were leveling off or even starting to fall, particularly for consumer loans.

"Consumer credit may be close to a bottom here, but it's not getting better, and people wanted JPMorgan to say it's getting better," said Ralph Cole, portfolio manager at Ferguson Wellman Capital Management, which owns JPMorgan shares.

Losses at the second largest U.S. bank were in line with typically cautious guidance the bank had given in recent months but its projections for 2010 were hardly any more sunny.

"We don't know when the recovery is," Chief Executive Jamie Dimon said on a conference call with investors.

JPMorgan is the first of the major banks to report fourth-quarter numbers and its results may bode ill for competitors.

The New York-based bank's overall quarterly profit amounted to 74 cents a share, beating analysts' average estimate of 61 cents, according to Thomson Reuters I/B/E/S. Year-earlier earnings were $702 million, or 6 cents a share.

Revenue, excluding the impact of assets that have been packaged into bonds and largely sold to investors, totaled $25.2 billion, falling short of analysts' average forecast of $26.8 billion.

Social Security/Medicare Conflict

From this morning's Wall Street Journal. Good illustration of how tricky this financial planning can be.

* JANUARY 14, 2010

Medicare Costs More—for Some



By KELLY GREENE and ANNE TERGESEN

Some Medicare beneficiaries are finding their 2010 premiums—which they thought would be frozen at 2009 levels—are actually jumping 15%.

The hike affects individuals who have heeded the advice of experts and waited to claim Social Security benefits until they reach full retirement age, as the federal government defines it.

The increase results from a little-noticed intersection between rules governing Medicare and Social Security, two of the country's largest entitlement programs.

Under the Social Security Act's "hold harmless" provision, Medicare can't pass along to Social Security recipients a premium hike that's higher than whatever they would receive through Social Security's annual cost-of-living adjustment, according to Mark Lassiter, a Social Security Administration spokesman in Washington, D.C

With no Social Security increase expected for 2010, Medicare can't charge beneficiaries who are also Social Security recipients any extra premium.

The Department of Health and Human Services sets the standard premium each year for Medicare Part B, which mainly helps pay for doctor visits and other outpatient treatment. Premium revenues are supposed to cover about 25% of the average cost of Medicare Part B services incurred by enrollees age 65 and older.

Of the 42.3 million Americans covered by Medicare Part B, some 73% also receive Social Security—meaning the remaining 27% of Medicare beneficiaries must make up the difference by paying higher premiums.

"The Part B premium increase is higher than it would otherwise be because the costs are spread across a smaller share of beneficiaries," according to a Kaiser Family Foundation report.

The affected beneficiaries include the 3% of Medicare Part B recipients who are celebrating their 65th birthday this year, along with the 2% who haven't started collecting Social Security yet mainly because they haven't reached their "full retirement age"—the age at which older adults can receive 100% of the Social Security benefit to which they are entitled. For people turning 65 in 2008 through 2019, full retirement age is 66.

Dave Weber, a 65-year-old part-time consultant from Scottsdale, Ariz., enrolled in Medicare last year but postponed Social Security in order to get a higher monthly check at some future point. Now, he feels he is being unfairly penalized for this decision.

While retirees collecting Social Security were spared, his Part B premium is rising to $110.50 a month from $96.40. "My annual income—from a small pension, investment income and some part-time consulting—is only enough to put me in the 28% federal tax bracket," Mr. Weber says. "It's not like I'm in a high income bracket."

Richard Braden, 66, was laid off in 2008 but delayed signing up for Social Security until his 66th birthday, in December 2009. "I was trying to do what was right for myself and my family and wait to get my full benefit," he says.

Mr. Braden wasn't on the Social Security rolls in November, as required to be covered by the "hold harmless" provision, and so he must pay the higher Part B monthly premium this year. "It really bothers me that I'm being penalized for waiting," says the Tomball, Texas, resident, whose family lives on savings and his wife's salary.

The inequity is expected to extend into 2011. With no Social Security cost-of-living adjustment anticipated for next year, Medicare has estimated that some Part B premiums could increase an additional 9% to at least $120.20 a month.

Assuming that Social Security payments increase in 2012, Part B premiums for everyone would reset at $111.50 (or more for higher-income enrollees).

Last year, HHS supported a bill that would have eliminated the higher premiums for Part B enrollees not covered under the "hold harmless" provision. The bill passed in the House but stalled in the Senate.

Such enrollees include both higher-income individuals who are subject to larger monthly premiums, and lower-income enrollees whose premiums are paid by Medicare and Medicaid, the state- and federal-funded health program for the poor.

Orlando Ortega, 74, was paying monthly Medicare Part B premiums of $250.50 a month for his wife and for himself (their modified adjusted gross income, including tax-exempt interest income, exceeds the $170,000 annual threshold after which married couples pay higher premiums).

With the additional increase, the Fullerton, Calif., couple will each see their monthly premium rise to $287.30 this year. "Those whose income exceeds the threshold are being penalized twice," says Mr. Ortega.

In the past, the "hold harmless" provision affected a much smaller portion of Social Security recipients because there was a cost-of-living adjustment. It was relatively low, and so the "hold harmless" provision applied to a smaller number of Medicare Part B enrollees, Mr. Lassiter says.

For example, someone getting $500 a month in Social Security in a year with a 1% cost-of-living adjustment—for an additional $5 a month—wouldn't have to pay more than $5 a month in additional Medicare Part B premiums if the cost were to increase.

This year "is the first time it has touched so many people," Mr. Lassiter says. As for those who are deferring their Social Security benefits, Mr. Lassiter says even though they are on the hook this year for an additional $169.20 in Medicare premium payments, they can still take comfort.

"They're increasing their benefits each year," he says. "I would imagine that trade-off is still advantageous to them."

Good Explanation of how Fed Policy May Not Be Inflationary

From Greg Mankiw in yesterday's NY Times. Dr. Mankiw also has a very useful blog: http://gregmankiw.blogspot.com/



January 17, 2010
Economic View
Bernanke and the Beast
By N. GREGORY MANKIW

IS galloping inflation around the corner? Without doubt, the United States is exhibiting some of the classic precursors to out-of-control inflation. But a deeper look suggests that the story is not so simple.

Let’s start with first principles. One basic lesson of economics is that prices rise when the government creates an excessive amount of money. In other words, inflation occurs when too much money is chasing too few goods.

A second lesson is that governments resort to rapid monetary growth because they face fiscal problems. When government spending exceeds tax collection, policy makers sometimes turn to their central banks, which essentially print money to cover the budget shortfall.

Those two lessons go a long way toward explaining history’s hyperinflations, like those experienced by Germany in the 1920s or by Zimbabwe recently. Is the United States about to go down this route?

To be sure, we have large budget deficits and ample money growth. The federal government’s budget deficit was $390 billion in the first quarter of fiscal 2010, or about 11 percent of gross domestic product. Such a large deficit was unimaginable just a few years ago.

The Federal Reserve has also been rapidly creating money. The monetary base — meaning currency plus bank reserves — is the money-supply measure that the Fed controls most directly. That figure has more than doubled over the last two years.

Yet, despite having the two classic ingredients for high inflation, the United States has experienced only benign price increases. Over the last year, the core Consumer Price Index, excluding food and energy, has risen by less than 2 percent. And long-term interest rates remain relatively low, suggesting that the bond market isn’t terribly worried about inflation. What gives?

Part of the answer is that while we have large budget deficits and rapid money growth, one isn’t causing the other. Ben S. Bernanke, the Fed chairman, has been printing money not to finance President Obama’s spending but to rescue the financial system and prop up a weak economy.

Moreover, banks have been happy to hold much of that new money as excess reserves. In normal times when the Fed expands the monetary base, banks lend that money, and other money-supply measures grow in parallel. But these are not normal times. With banks content holding idle cash, the broad measure called M2 (including currency and deposits in checking and savings accounts) has grown in the last two years at an annual rate of only 6 percent.

As the economy recovers, banks may start lending out some of their hoards of reserves. That could lead to faster growth in broader money-supply measures and, eventually, to substantial inflation. But the Fed has the tools it needs to prevent that outcome.

For one, it can sell the large portfolio of mortgage-backed securities and other assets it has accumulated over the last couple of years. When the private purchasers of those assets paid up, they would drain reserves from the banking system.

And as a result of legislative changes in October 2008, the Fed has a new tool: it can pay interest on reserves. With short-term interest rates currently near zero, this tool has been largely irrelevant. But as the economy recovers and interest rates rise, the Fed can increase the interest rate it pays banks to hold reserves as well. Higher interest on reserves would discourage bank lending and prevent the huge expansion in the monetary base from becoming inflationary.

But will Mr. Bernanke and his colleagues make enough use of these instruments when needed? Most likely they will, but there are still several reasons for doubt.

First, a little bit of inflation might not be so bad. Mr. Bernanke and company could decide that letting prices rise and thereby reducing the real cost of borrowing might help stimulate a moribund economy. The trick is getting enough inflation to help the economy recover without losing control of the process. Fine-tuning is hard to do.

Second, the Fed could easily overestimate the economy’s potential growth. In light of the large fiscal imbalance over which Mr. Obama is presiding, it’s a good bet he will end up raising taxes for most Americans in coming years. Higher tax rates mean reduced work incentives and lower potential output. If the Fed fails to account for this change, it could try to promote more growth than the economy can sustain, causing inflation to rise.

Finally, even if the Fed is committed to low inflation and recognizes the challenges ahead, politics could constrain its policy choices. Raising interest rates to deal with impending inflationary pressures is never popular, and after the recent financial crisis, Mr. Bernanke cannot draw on a boundless reservoir of good will. As the economy recovers, responding quickly and fully to inflation threats may prove hard in the face of public opposition.

Investors snapping up 30-year Treasury bonds paying less than 5 percent are betting that the Fed will keep these inflation risks in check. They are probably right. But because current monetary and fiscal policy is so far outside the bounds of historical norms, it’s hard for anyone to be sure. A decade from now, we may look back at today’s bond market as the irrational exuberance of this era.

N. Gregory Mankiw is a professor of economics at Harvard. He was an adviser to President George W. Bush.

More on Roth IRA Conversions

This letter - which appeared in today's Wall Street Journal - has a fairly detailed description of some of the issues involved with the new Roth IRA regulations.

Ready to Roth: How You Fund an IRA Conversion Through the 'Back Door'


By KELLY GREENE

My wife and I have been unable to contribute to Roth IRAs for the past several years due to the Roth IRA income limits. We have Roth IRAs from years that we were eligible, and we both have rolled over 401(k)s from previous employers to IRAs. I was planning to take advantage of the back door into the Roth IRA for people like ourselves. We were going to fund after-tax , traditional IRAs for 2009 and 2010 this month, and then immediately convert them to Roth IRAs, which we had hoped would be tax-free, since all of the money converted would be after-tax money. However, I read in a Wall Street Journal article that you can't convert only your nondeductible contributions. You have to calculate your "basis" and deduct that portion.

My follow-up question is: Are my rollover IRAs from previous 401(k) plans considered part of my total balance in IRAs? Or can I only count the traditional IRAs that I'm converting as my IRA balance?
—Swastik Lahiri, Plano, Texas

Individual retirement accounts funded with 401(k) assets count among your traditional IRA assets during a Roth IRA conversion.

The language is confusing, since many custodians refer to such accounts as rollover IRAs. But they are technically traditional IRAs. Any IRA labeled as a SEP, SIMPLE or contributory is included, as well.

As you point out, you could fund traditional IRAs for 2009 and 2010 anytime between now and April 15 (and you could fund a 2010 IRA contribution up through April 15, 2011). There are no income limits for making nondeductible IRA contributions. But there are income limits for making Roth IRA contributions: Individuals whose modified adjusted gross income for 2010 is $120,000 or more can't contribute. For couples who file joint tax returns, the cutoff is $177,000. (You can figure out your modified adjusted gross income using a work sheet on page 59 of Publication 590 at www.irs.gov.)

Here is where the "back-door" method comes into play: As of Jan. 1, the federal government has lifted the $100,000 household income limit (again, modified adjusted gross income) on converting traditional IRA assets to a Roth. Having that limit removed makes it possible for people with higher incomes to move assets from traditional IRAs to Roth IRAs. First, you would fund a traditional IRA and then you could convert those assets to a Roth.

But people, including our readers here, who have rollover IRAs from past employment will have to include those assets when they figure out how much tax they owe on such a conversion. You can convert all, or part of, your traditional IRA assets to a Roth, but you owe tax proportionately on the amount that wasn't taxed previously.

That is where the Internal Revenue Service's pro rata rule comes into play. Basically, you can't cherry-pick the assets you convert. Instead, the IRS says you must first take the balance in your IRA, or the combined balances of multiple IRAs, and then divide any nondeductible contributions by that balance. This gives you the percentage of any conversion that is tax-free.

Let's say your rollover IRA has a balance of $23,000, and the new IRAs you fund are worth $13,000, including $12,000 in nondeductible contributions. You would divide $12,000 by $36,000, to find that 33%, or one-third, of your conversion would be tax-free.

There is one possible way around the tax. If your current employer has a retirement plan, you may be able to roll the pretax assets from your rollover IRA into it, if the plan's rules allow such a move, leaving only your nondeductible contributions subject to the pro rata rule. Remember, the pro rata rule is tied, in large part, to the balance of all your IRAs (except for Roth and inherited IRAs). So, the smaller the proportion of tax-deferred assets and earnings in the accounts, the more money you can convert tax-free. And some company retirement plans do let participants roll assets from an IRA back into a 401(k). The key: Assets in a 401(k) or similar retirement plan aren't included in pro rata calculations.

Even if you work part-time as an independent contractor, it may be worth it to open an individual 401(k) for that side business, says Julie Schatz, a certified financial planner in Menlo Park, Calif. That way, you could roll some IRA assets into your own 401(k) to help limit the tax bite on a conversion.

Of course, some employer-sponsored 401(k)s may have fewer investment options than an IRA, and many people want to move as much money as possible into a Roth, where withdrawals eventually can be tax-free. (once you meet the holding requirements). So this is mainly a strategy to consider if you are facing a significant tax bill.

There is more information about Roth IRA conversions in IRS Publication 590 at www.irs.gov.