When you’ve been on the edge of having a convulsion for months, you could be excused for clutching at anything to convince yourself at least temporarily that you’ve turned the corner. Today, this is looking like a fair characterization of last week’s big relief rally at the euro “rescue” plan that was “agreed” in Brussels.

Markets are trading significantly lower this morning, and much is being made of something that I mentioned briefly on Coffee and Markets the other day: right after the accord, Italy’s government went into the bond market to sell an issue of three-year notes, and had to pay 4.93%, well above what they had paid for the same maturity just a few weeks ago. The dogs aren’t eating the dog food.

It seems clear that we’ve averted a serious financial crisis/panic/crash for at least a few months. That much was accomplished. But on further inspection, the plans have deep flaws both from a financial/economic and a political point of view.

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If you were watching capital markets closely yesterday, you saw a phenomenon that has rarely been seen before. I certainly never have. And it was linked to the Federal Reserve’s policy statement, released about 2:15pm Eastern time.

This was an extraordinary statement, containing several rarely-seen features. The first one, of course, was the commitment by the Fed to keep policy interest rates at or near zero until the middle of 2013. Never before to my knowledge has the Fed put a specific schedule on its interest-rate guidance. The expectation by market participants has been that the Fed would start raising rates as soon as economic conditions (notably unemployment) improved, and they could argue over the timing. Yesterday, that changed.

Any interest rate is the risk-adjusted sum of a series of shorter-term interest rates. When the Fed says that policy rates will be zero for the upcoming 24 months, they’re effectively telling the market that the interest rate on the two-year Treasury note is also zero.

That had an instant effect on the capital markets. It jacked the whole front-end of the yield curve down by nearly 30 basis points. The two-year note briefly traded at a record low yield of about 16.5 basis points. The 10-year note, which had been yielding about 2.30% at 2.15pm, suddenly zoomed upward in price, its yield plunging to an all-time low just above 2.03%.

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So this year’s fiscal-policy code word is “balanced approach.” This means nothing more or less than higher taxes on high earners, business income, and capital gains.

Congressman Eric Cantor remarked at one point in the debt-ceiling debate that the Democrats (including Obama) were totally stuck on the idea of raising taxes. But Cantor stressed that they never presented an economic rationale for higher taxes. It was all about class warfare, pure and simple.

Class warfare is like catnip to progressives. The problem with class warfare is that it doesn’t give us growth and jobs. At least a few of the Democrats recognize that growth is a mandatory part of a fiscal-reform strategy (higher taxes and spending/entitlement cuts are the other two).

Remember the Bush tax-cut debate last year? Then, Democrats readily admitted the numbers: the Bush tax cuts on high earners were worth an estimated $700 billion in revenues over ten years, while the same cuts on everyone else were worth about $2.8 trillion.

You can raise taxes on high earners, but you don’t solve any economic problem that way. There just aren’t enough rich people to buy candy and bubble gum for everyone else. Plus, you kill job growth by wiping out their incentives to take on economic risk.

So it’s plain and obvious that the ONLY motivation that Obama and the Democrats have for their “balanced approach” is class envy. Economics has nothing to do with it.

Let’s challenge the Democrats on this one. If they’re so committed to the idea that we need higher taxes, then let them propose a broad-based, regressive increase: either a VAT, or a large payroll-tax rate increase (which Reagan also did).

Just do it, Democrats. You want higher taxes? Then propose higher taxes that really will reduce deficits while minimizing the effect on job creation. Otherwise, shut up.

Jean-Claude Trichet, the outgoing governor of the European Central Bank, just announced that the ECB will engage in purchases of euro-denominated bonds issued by Spain and Italy. This long-resisted move is intended to stem the latest flareup of the sovereign-debt heartburn that is a far greater threat to financial-market stability than the US debt downgrade. If the ECB manage to sustain this, it probably will work, for a while at least.

If you’re an investor in Italian or Spanish (or French) debt, your goals are pretty simple: you just want to enjoy the benefits of higher interest rates, while being assured by someone more credible than Spain or Italy that you’ll get your money back. Can’t blame people for wanting a free lunch, especially if Uncle Trichet is scared enough to offer it to them.

There are two enormous problems with Trichet’s announcement:

1) It represents a complete abandonment of the ECB’s iron pledges not to pull national governments out of the fire; and

2) We’re talking about far more debt than the ECB can possibly buy without creating a lot of inflation. They simply don’t have the resources to sterilize it all. And if they stop short, the move won’t have the market impact they’re looking for.

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This isn’t Monday-morning quarterbacking. For one thing, it’s not football season yet. For another, the game wasn’t played on Sunday afternoon. It’s been going on for weeks, with twists and turns more reminiscent of comic opera than football.

Even so, today’s media game has been all about deciding who got the better deal. Many of the partisans think they came up short, and are looking to blame their guys. In the media (which sees any legislation as an achievement, no matter how hollow, cynical, or ultimately ineffectual), many are scoring this as a win for both sides. (That’s to say, all of the parties will be able to go back to their respective bases with something to brag about.)

Around the middle of last week, I lost track of the specific content of the deals, which was in constant flux. And the media lost track of it too! The only reporting, it seemed, was about who was up (Boehner, Reid, Obama) and who was down at any point in time. That tells you all you need to know about how cynical and empty this whole process has been.

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Currency markets are open in the Far East as I write this, and the dollar is a little weaker. No interest rates or commodity prices yet, but I’ll update you if anything exciting materializes.

I must say that I found it weird to hear John Boehner and others talking about making a deal before the trading week starts. (And if you’re a long-time RedState reader, you know I’m the guy who was watching the market opens every Sunday evening with my heart in my mouth during the 2008 crisis.)

There’s nothing to suggest that a legislative failure today or over the next week would significantly disrupt markets. I think there’s considerably more risk in the other direction. Markets have sold off risk-bearing assets and lowered interest rates in response to the uncertainty, but as soon as there is a deal, I expect markets to recover robustly.

When I say “as soon as there is a deal,” I mean that the monkeys in Washington will stop howling and throwing feces at each other long enough to ink a three-month debt-ceiling extension with no other commitments beyond a promise to keep howling and throwing feces at each other.

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Ok, let’s look at both the politics and the economics of this issue.

The underlying politics is as follows: the American people are sick and tired of deficit spending. The pundits are completely wrong when they downplay this issue, because deficits are FAR worse now than they ever have been in peacetime (10+% of GDP). And they got far worse at almost the exact moment Obama was elected president.

The practical politics looks like this: Congressional Republicans chose the otherwise-routine moment of a debt-ceiling increase to draw a line in the sand and press the deficit-reduction argument, on behalf of the American people. But by linking two things that don’t really belong together (the political objective of deficit-reduction with the technical objective of funding the government), Republicans have backed themselves into a corner. Their position is strong on the merits but extremely weak in practical terms.

And the practical weakness of the Republican position arises from the economics of the issue. There’s been a lot of argumentation of this point, most of it pure garbage spouted by people (including economists) who know little or nothing about capital-market dynamics or practical finance. I happen to know something about both, and I’m going to tell you the truth about the matter.

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Noted briefly: the BLS report on June employment conditions was sharply disappointing. Non-farm payrolls rose by only 18,000 jobs. This is far below the +200,000 jobs we were seeing monthly earlier this year. It undershot the expectations of private economists, some of whom were expecting at least +50,000. And it varies from the considerably more-optimistic ADP report issued earlier this week.

The June number has been widely anticipated because the May number was such a stinker. If these reports are accurate, it looks like the US economy suddenly slammed on the brakes and stopped creating many jobs, late this past spring. Many people believed that the May number was an outlier, and the June number would correct it on the upside.

Instead, the June report looks like a repeat of May. Nearly every sector is continuing trend. Mining, leisure/hospitality, and business services all created jobs, but not in excess of earlier trends. Manufacturing, which had been strong earlier in the year due to the auto industry, has stopped growing. All levels of government are losing jobs rapidly.

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While you were watching imported Chinese fireworks yesterday, the Europeans were shooting off some home-grown ones.
The euro has been trading down for most of the last 24 hours, as S&P and Fitch announced that they would consider the French-led rollover plan for Greek debt a “selective” default.
What’s really going on is that a negotiation is taking place over what should be the credit rating of Greece as an issuer, and of its particular debt issues. (Wouldn’t it be nice if you could negotiate with ratings agencies over your credit rating, next time you have to borrow money?)
Greece has to “roll over” its existing debt (meaning, reissue it as it matures) without getting slaughtered on the interest rate or even failing to find lenders at all. And of course, they’re running a budget deficit that’s in the high single digits (ours is even higher, at about 11%), so they need to keep issuing brand new debt on top of the rolls.

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Watching the Europeans go through their gyrations over Greece, it’s striking that so little of the commentary focuses on the true issue that is at stake for policymakers: the financial health of the holders of current Greek debt. Stay with me on this, because I’ll show you how it impacts current policy in the US.

There is something afoot called the “Vienna alternative” under which holders of euro-denominated debt issued by Greece would voluntarily agree to roll over their holdings on terms that are materially less favorable to them, either in terms of maturity, interest rate, collateral covenants, or whatever.

What is this “alternative” an alternative to? There are (at least) two other ways this could go. One is an involuntary restructuring of debt terms, initiated by the Greek government without agreement from its creditors. That’s also known as a default. Various ratings agencies are now in the process of heatedly debating whether the voluntary version should also be considered a default.

The other way this can go is for a broader and permanent version of what happened last year: the supranational monetary authorities (primarily the ECB and the IMF) would make a money-good offer to buy out Greek debt at a certain price, most probably higher than current market, implying a significantly lower interest rate.

This is the full-bailout strategy. If the IMF is a major player, it could be carried out using capital imported from the non-euro zone. The latter outcome would be a big winner among French and German politicians.

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Peter A. Diamond, a professor of economics at MIT, has just published a hissy fit in the NY Times titled “When a Nobel Prize isn’t enough.” I won’t link the piece because of the Times’s paywall, so I’ll just tell you what he says.

Diamond wants to be a governor of the Federal Reserve. Barack Obama wants the same thing, having nominated Diamond three times now. He had only a small amount of support from Senate Republicans, mostly from Michael Bennett and Judd Gregg. After being dissed by Richard Shelby, Diamond is now withdrawing is candidacy. (There are currently two open Fed governorships.)

Peter Diamond thinks he should be on the Fed’s board of governors because he won the Nobel Memorial Prize in economics last year, for his work in fundamental market dynamics, particularly in labor markets. He’s not going to get the job, and he thinks the reason why is that Republicans are too stoo-pid to be impressed by his Nobel Prize. In the New York Times, he says quite straightforwardly that you’d think a Nobel Prize would be  qualification enough for him to have the job, but that Senate Republicans insist on questioning his candidacy.

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My observations on the tax-cut deal:

I don’t have a problem with extending the UI benefits. As I’ve said elsewhere, I think there are a few million people out there, mostly middle-aged, who will never see another job at their old rate of pay, and this is because the economy is changing, not because of recession. We’re going to eventually end up with permanent income supports for these people, so get used to it.

I do have a problem with the payroll tax cut: not big enough and not long enough. This cut will feed maybe $85bn or so into the economy next year (by the back of my envelope), but if we eliminate the payroll tax altogether (and both sides of it too), the hit could be more like $700bn. Now that’s stimulus I can believe in.

“But Francis, you hypocrite, you were against the $800bn porkulus last year.” Yes, but this is an altogether different stimulus. Last year’s was fed to Democratic state and local politicians, who passed it on to their union supporters. A full payroll tax holiday would go to ordinary people all over the country. And ordinary people are the ones I want to see empowered, not politicians.

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Yesterday afternoon, Ireland finalized terms of a bailout valued at 85 billion euros, from the ECB, the IMF, a government pension fund, and several European states. (Details here.) So far, the bailout is NOT having a calming effect on Europe’s capital markets.

Credit spreads on so-called “peripheral” European sovereigns are blowing out this morning, and government bonds of Portugal and Spain are falling sharply. Italy managed to tap the credit markets earlier today, but the interest rate was high and the subscription level was disappointing.

This can’t keep up. If investors continue to dial up the interest rates they charge Europe’s governments, there’s little chance of a sustained recovery. And that makes European states even less credit-worthy.

The Germans are in good shape. Switzerland and the Scandinavian states are in decent shape. The UK is on the fence. Everyone else, possibly including even the French, could be looking into the barrel of a gun.

I’ve been asked to give some basic perspective on what the Fed’s “quantitative easing” actually is. Since writing this piece, I’ve become more convinced that I was on the right track.

So far, three different QE models have been observed in the wild: the Japanese (2001-06), the British (2008-09), and Bernanke I (2008-10). We’re about to see Bernanke II. All of them are forms of monetary accommodation (“easy money”), exactly as lowering short-term interest rates is.

The specific objectives and techniques vary, and these depend somewhat on the “style” of the monetary authority. For example, the Brits and Euros tend to target monetary aggregates like M2 and M3, while the Fed likes to look at consumer-inflation measures like CPI.

They call it “quantitative” easing because the mechanism involves increasing the quantity of money flowing through the economy. This isn’t the same as increasing the amount of reserves in the banking system (which is what you might do if you were concerned about impaired liquidity). We did the latter in huge amounts in 2008, and it did nothing to improve the overall economy. I’m referring to this distinction when I talk about “bank money” as opposed to “economy money.”

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It’s been clear enough to everyone with eyes that the most visible effect of the Fed’s QE2 program would be to inflate the stock market, and possibly (because of the weaker dollar) commodities too.

A view is starting to emerge that this is what Bernanke actually had in mind. Creating a huge amount of new "bank money" obviously did nothing to stimulate the creation of "economy money," and I suspect this came as something of a surprise to Bernanke.

So the idea with QE2 is to actually create "economy money" by bidding up midcurve Treasury paper well past its current value. (If that reminds you of what Fannie and Freddie do with mortgages, give yourself a gold star.)

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If you’re a Republican partisan, tonight was a very, very good night. If you’re an ordinary person trying to suss out the business and financial outlook, tonight was basically a non-event.

Nothing that happened on Election Day 2010 was a surprise. The results basically match what non-political junkies been expecting for months.

We’re going to get no fundamental change in the overall approach to policy. (Democrats will not interpret the results as a repudiation of what they want to do). But we’re also going to get a House leadership that will curb the worst excesses of liberal partisans running amok. In a word, stasis.

What that means for the outlook is: no short-term tax or regulatory relief, and no relief from the medium-term entitlement crisis.

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Pretty much everything Yves Smith says in this New York Times op-ed piece is true, although she elides a lot of details, probably to fit in the available space. (It’s not for lack of knowledge. She’s totally up on this situation and has been from nearly the beginning.) She doesn’t really tie all the threads together, though.

Mechanically, the problem is that many people who have initiated foreclosure proceedings don’t have a clear paperwork trail documenting their ownership of the mortgage note, and thus their standing to foreclose.

Lots of people (particularly on our side of the political aisle) say that this is all just a paperwork snafu, even if longstanding rules haven’t been followed and certain law firms seem to have made a systematic business out of forging documents for large banks.

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Paul Krugman is on again today about the disappearing middle class, and how the Bush tax cuts are and always have been a huge, unfair giveaway to “the rich,” whoever they are. Because I happen to remember that the Bush tax cuts actually were an across-the-board cut in marginal rates, together with strong reductions in taxes on capital, I wondered how Krugman gets from there to considering them unfair.

Well, of course it’s because high-income people pay more taxes than lower-income people. A LOT more taxes. So any change in marginal rates necessarily affects them more, whether you raise rates or cut them. Clearly enough, Krugman doesn’t have a problem with low tax rates. He has a problem with the fact that some people earn a lot of money.

That got me wondering why we have so much income inequality in the first place. I don’t think there’s one simple answer to that question, but a lot of it comes down to the amount of risk you take.

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