Like the recent east coast earthquake, the Budget Control Act of 2011 left Washington shaken and completely confused, the epicenter being the Department of Defense.

While some are saying that the super committee will be able to reach a deal and cut the additional $1.5 trillion (half from defense), others are not so confident there will be any agreement, resulting in automatic caps for the next nine years.  Either way, defense spending will make or break a super committee budget deal.

Truthfully, Congress has a better chance of willfully trimming the budget at the super committee stage because they have more tools to orchestrate a reduction. Even if they deadlock, they’ll push through artificial savings mechanisms, anything to merit a Mission Accomplished banner. Medicare doc fixes are an example of such “solutions”. Though Congress’s intention was to curb Medicare spending, they came up with an unworkable formula that has now resulted in temporary increases and extensions of existing physician reimbursement rates, all in an attempt to circumvent a long-term solution. Applying this to what Congress may do with defense spending, a successful deal may be nothing more than a tacit convention of today’s culture on Capitol Hill, do anything to avoid Armageddon. And some do consider the trigger provision of the bill to be deadly. Secretary of Defense Leon Panetta even called it the “doomsday mechanism.”

Under sequestration, or the trigger, defense cuts are still a variable certainty. We simply do not know how bad it is. It all boils down to the language of the bill. Here’s why:

1.The bill does not organize any of its spending requirements against any baseline.

2.Positive numbers (discretionary spending caps) without context forces you to make arbitrary assumptions.

3.No analyst can come up with a number that is reasonable/unreasonable.

The question on everyone’s mind: What on earth do we base these numbers against?

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Dr. Peter Diamond has once again found himself in the cross-hairs of Sen. Richard Shelby of Alabama, the highest ranking Republican serving on the Senate Banking Committee.  A Nobel laureate and MIT professor, Diamond has been nominated three times for the vacant seat on the influential Federal Reserve Board, twice having been blocked by Republicans at the committee stage for approval to the full Senate.

At the nomination hearing this past Tuesday, Sen. Shelby provided a critical analysis of Diamond’s economic philosophy.

“In short, Dr. Diamond is an old-fashioned, big government Keynesian. Many of us believe that this is not the economic philosophy the Fed should be embracing at this point in our economic history. Our economy is already suffering from excessive government debt and misguided regulation.  Our financial regulators should be trying to take steps to strengthen our markets, rather than replace them with new layers of government.”

Shelby noted Diamond’s support of the President’s $800 billion stimulus package and his call for additional fiscal stimulus.  He also referenced a paper written by Diamond and former CBO Director Peter Orszag that argued for higher taxes.   “The policy preferences of Fed nominees matter,” Shelby observed.

Sen. Pat Toomey of Pennsylvania, a former bond trader and veteran of the financial services community, is no fan of the Fed’s monetary policy, which he feels is over accommodating.  He raised some serious concerns about the likelihood of rising inflation and the result that would have on the Fed’s forthcoming exit strategy from its monetary policy.

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It’s official.  The New York Stock Exchange has been sold to, in one CNBC anchor’s words, ‘a bunch of foreigners’.    The iconic trading floor of the NYSE was tense this morning as CNBC’s Mark Haines’ grilled CEO Duncan Niederauer on the just announced merger of Deutsche Börse and the NYSE, a deal resulting in the creation of the world’s largest share- and derivatives-trading platform.

According to the Wall Street Journal,

Under the terms of the deal, Deutsche Börse shareholders will own 60% of the newly merged company, with NYSE shareholders controlling 40%. Each Deutsche Börse share will be exchanged for one share of the new company’s stock, while each share of NYSE Euronext will be swapped for 0.47 share of the new company stock.

The announcement was not a surprise, as talks surrounding a possible merger have been floating around for years, further indicating global consolidation of the exchange industry.  Those in support of the deal have recognized the NYSE’s strategy to increase its scale of trading by merging with the Frankfurt based exchange.  In today’s global environment, Niederauer argues:

‘It isn’t a sale, we’re trading from strength…It gives us opportunities to create our own destiny going forward… If you think about it, what I’ve said for two years is exchanges should be competing across the value chain.’

Let’s be clear– this is a German acquisition of a US company.  The Board of Directors is split up 60/40 with respect to ownership, which equates to 10/7 seats respectively.    That puts Deutsche Börse shareholders at a majority. Something of interest: Niederauer overtly ignores Haines’ inquiry on who initiated dialogue.

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Yesterday at the National Press Club, Fed Chairman Ben Bernanke delivered a lengthy sermon justifying his grand strategy for the US economic recovery.  In his discourse, the Chairman made it abundantly clear that, in his view, it was unfair to label Fed monetary policy as the cause of global increases in commodities prices, an issue some market pundits have speculated as of late.

Attacks on the Fed have been quite peculiar–some have even gone so far as to suggest US monetary policy played a role in the government collapse of Egypt.   Three decades of oppression would seem a more likely explanation.  But Bernanke’s statement was also peculiar:

It’s entirely unfair to attribute excess demand issues in emerging markets to US monetary policy.

“Entirely unfair?”  One would expect the Chairman to say to his critics that it is ‘entirely inaccurate’ or ‘misleading’.  But it does not seem entirely unfair to, at a minimum, examine a linkage between record high commodity prices and the Fed’s controversial, and highly unconventional, monetary policy.  This early in the game, it simply cannot be ruled out as a contributing factor.  Then again, that is the very problem- it’s too early in the game.

To provide a sensible explanation for his critics, Bernanke puts in plain words how the role of supply and demand accounts for price increases:

On the inflation front, we have recently seen significant increases in some highly visible prices, notably for gasoline. Indeed, prices of many commodities have risen lately, largely as a result of the very strong demand from fast-growing emerging market economies, coupled, in some cases, with constraints on supply.

During the question and answer period, Bernanke was keener on separating the Fed’s liability:

There’s a lot going on there …When you talk about food prices… you talk about supply and demand …The fed monetary policy is aimed at the US economy….We are using policy to address stability in the United States.

Let us use the crisis in Egypt as a way of applying his methodology.  While under political turmoil, Egypt is also the world’s largest importer of wheat.   Yesterday wheat prices surged on the Minneapolis Grain Exchange to levels past $10 a bushel, as demand in Egypt is likely to increase partly based on the following speculation: political disorder will interrupt routine commercial activity, thus more wheat will be needed to supply Egyptian natives.

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We are navigating through truly uncharted political and economic territory.  Members of the financial cognoscenti have freshly alluded to the notion of the ‘government bubble’ as the next blow to the world economic order.

Since 2008 we have seen the housing, financial, and insurance markets hit on a global level, one after the other.  At one point, they all burst because they were unsustainable.  You don’t have to be a politico to know that the sovereign debt crisis is real.  Just look around.  As European countries (Portugal, Ireland, Italy, Greece, Spain, and Belgium) reshuffle hundreds of billions of dollars to lighten rising government deficit and debt levels, Republican appropriators here at home futilely attempt to get our books in order.  Ladies and gentleman, something is afoot.

The recent crisis in Egypt has only intensified discussion on the stability of the world economic order. No one knows what’s going to happen.  In an ideal situation, a peaceful transition of power will re-stabilize what has triggered a sell-off in equity markets and posed more geo-political uncertainty in the region as energy commodities are poised for gains based on fear.  And the bad news just keeps pouring in.

According to Reuters,

Adding to Cairo’s financial woes, ratings agency Moody’s downgraded the country’s debt rating on concern the Mubarak regime may spend more to placate protesters.

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The news is in.  Even you can open an account at the Bank of China in New York or Los Angeles.  But you have to hurry, trading will be limited.

What does this bank account entail?  According to the Wall Street Journal,

The Bank of China here in the U.S. has started allowing American customers to open an account and to invest up to $4,000 per day—and a total of $20,000 a year—in Chinese yuan, or renminbi. Until now, you had few options to hold money in yuan, which is a “closed” currency managed, and protected, by Beijing.

To try to understand what’s at play here, let us determine who gains what.  For the Chinese, some might see this move as a clear indication that they want more US dollars.  After all, China is a developing economy, and with that comes expenses.  These expenses to a large degree are outside goods and services with companies that settle their contracts in dollars.  This would be a very shortsighted intuition.

The Big Picture: China is beginning to internationalize the yuan in an attempt to turn it into a new formidable world currency. Opening Chinese banks to American customers is one small step for the yuan, one giant step for China.

How should the average investor look at this move?

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This week the world discovered that Goldman Sachs and Russian investor Digital Sky Technologies are planning to invest $500 million in Facebook, a deal which values the company at $50 billion.

As a part of the deal, Goldman also plans to raise $1.5 billion by peddling $2 million stakes in Facebook among its most wealthy clients.  With all the recent Chinese internet IPOs (DangDang, Youku) it’s no surprise that major US players want to get bullish on untapped American internet companies (Facebook, Twitter, Groupon, LivingSocial).  There’s an angle.  In order to circumvent the financial disclosure requirements set by the SEC that would force Facebook to go public, Goldman has come up with a ‘special purpose vehicle’ according to Business Insider:

The best thing about the vehicle: It will bypass SEC requirements that firms with over 499 investors have to disclose their financial results to the public, since the vehicle will be managed by Goldman, which, despite pooling the funds of thousands of investors, is deemed to be a single investor.

Bravo, Mark Zuckerberg and Goldman Sachs.  Zuckerberg has raised a serious amount of capital through a backroom deal, effectively bypassing the scrutiny of an initial public offering and listing on the New York Stock Exchange.  This is what we call a loophole.  What does this loophole mean for the future?  Well for one, we can almost be certain that the SEC will continue to overcomplicate the process of companies going public.  More laws, more regulation.

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Evidently, at least one member of Congress thinks that $500,000 of your tax dollars is appropriate to construct a fish passage barrier for salmon in Alaska.  Although the Republican conference in both the House and Senate has sworn off earmarks, it seems that some in the Senate need one last feast at the trough of pork barrel spending before 2011.

The Senate is considering a catch all spending bill for the year, called the Omnibus Spending Bill that funds the federal government until September 30, 2011.  This bill is almost 2,000 pages long and is loaded with at least $8 billion in earmarks.

Senator John McCain (R-Arizona) said on the Senate floor yesterday:

At 12:15 p.m. this afternoon, my office received a copy of the omnibus appropriations bill. It is 1,924 pages long and contains the funding for all 12 of the annual appropriations bills for a grand total of over $1.1 Trillion. It is important to note that the 1,924 pages is only the legislative language and does not include the thousands of pages of report language which contain the details of the billions of dollars in earmarks and, I’m sure, countless policy riders.

Senators Tom Coburn (R-Oklahoma) and Jim DeMint (R-South Carolina) have pledged to force the Senate to read the bill.

The AP reports that “Earmarks feast on pork one last time before diet.”

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The municipal bond market is having a tough time today largely in part of looming rumors concerning the expiration of the Build America Bond or ‘BAB’ program.  After all, this program was omitted from Obama’s tax deal with Republicans.

As a part of Obama’s Recovery and Reinvestment Act, BABs allow state and local governments to issue debt to fund basic infrastructure projects at a 35 percent discount on the bond’s interest costs, handing that bill to the federal government.

CNBC reports that the BAB program accounts for nearly 26 percent of today’s municipal bond market- with October being reported as the biggest month for the program, as issuers increasingly position themselves to reap the benefits of the program which is set to expire on the 1^st of January next year.

What will happen when municipal bond issuers are not able to borrow more cheaply?  Well, heaven forbid, they would be forced to pay market rates for debt.  If they can’t afford these rates, then they’ll have to cut spending and re-gear their budgets to enter the credit market.  The 2010 election results at the state level may indeed have changed things.   With a sweeping conservative, Republican wave in state and local governments this past election (the GOP took over a dozen state legislatures), it is almost certain that such cuts will now be possible.

According to Blackrock’s December 2010 Municipal Bond Market Report entitled State of the States and Local Governments, “[State and local governments] have accelerated spending cuts to reduce operating deficits.”  This incoming class at the state and local government level will only advance cost cutting and budget balancing.   They are being mandated to do so by their constituents.  Such a mandate may be just what will protect the American taxpayer from another Obama bailout.  Congressman Frank Wolf (R-VA) has most recently called for an audit on the $5.2 billion Dulles Rail project, which is already looking like it’s over budget.  Such oversight is exactly the attitude we can expect from the incoming class of elected officials at the state and local level.

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