Economy on a knife’s edge

The Philly Fed’s ADS Business Index gave us the old demon drop last week.  While the index had been negative since the start of Q2, the readings were fairly dovish, until last week’s updates.  The latest print shows that conditions in June and July were two to three times worse than originally thought (also that conditions were notably less ebullient in March, April and May).  As a result, the ”progressively more negative values” of the index are offering a much stronger indication of “progressively worse-than-average conditions”:

Excluding the 2008-2009 recession, the low of -0.79 in July was last seen in mid-2005 and during the 2001 recession:

A crude first pass at the data indicates that an ADS reading of -0.79 or lower has been associated with recessionary conditions 85% of the time.  Using more conservative and statistically meaningful approaches brings the recession probability below 50%, but that’s still too high for comfort, and is likely to rise in the weeks ahead — just one more piece in a disconcerting mosaic.

Other important pieces of the mosaic include:

The budget situation faced by state and local governments, which the FT recently took Congressional Democrats to task for:

Congress should pass the state aid bill next week, but more than that it needs to get a grip. Democrats are fearful of November, as they should be; Republicans are content to watch them squirm. Government is paralysed and the economy struggles.

The right fiscal policy for the US is ease sustained for the time being, followed by tightening through higher taxes and lower spending as conditions allow. It is a sad and even alarming fact that Washington’s political dysfunction now puts this straightforward advice in the realm of fantasy. Not just the US economy but the global economy too will have to bear the consequences.

Today’s FOMC statement, which indicated that the Federal Reserve intends to keep its balance sheet at around current levels, and to reinvest income into government securities in order to keep lending rates low:

To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature. 

And a continuing grind lower in long term Treasury yields that implies falling expectations for economic growth and/or inflation, perhaps even concerns about deflation.  The downtrend of yields in recent months looks a bit like the one that unfolded in 2H07, about six months prior to the start of the last recession:

However you slice the data, the economy appears to be walking on a knife’s edge, or at the very least approaching one.  And the key ingredients of the grout holding this pessimistic mosaic together are, in our view, negative demographic shifts and household balance sheet deleveraging, neither of which argue in favor of fiscal austerity as the right approach for policymakers. 

In fact, a small but potentially very significant piece of the mosaic is anecdotal claims about rising rates of expatriation by high U.S. income earners.  As Rueven Brenner has pointed out, immigration and emigration have historically played an important part in the rise and fall of nations and economies.  It’s too soon to make any meaningful assessments, but this is a risk that policymakers (and voters!) must stay attuned to.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy.

Moving the Policy Discussion Forward

Some interesting articles on the state and direction of economic policy:

David Frum challenges fellow conservatives to come up with compelling policy alternatives to Paul Krugman’s recommendations:

 …if Krugman’s direct government expenditure is not a very good policy answer, his dire economic warning remains a haunting policy question. What can we do to accelerate economic growth and job creation? For those of us on the free-market side of the debate, the question is even more haunting: What’s our countervailing idea? And if our countervailing idea is tax cuts, what is our reply to the obvious rebuttal that the Bush tax cuts have been in effect through the whole of this crisis, seemingly without effect?

Marshall Auerback outlines a bevy of progressive policies in response:

…Professor James K. Galbraith sets out some useful criteria for good stimulus:

1. Open-ended support for the current operations of state and local governments…

2. Comprehensive foreclosure relief…

3. Increased Social Security benefits…and a cut in the eligibility age of Medicare…

4. A payroll tax holiday to restore effectively the purchasing power of working families. By setting the payroll tax rate at zero (and letting the government write a check to the Social Security Trust Fund for the uncollected sums), tax relief can be delivered at large scale and with immediate effect…

…And finally deploy government spending in a way which REDUCES unemployment, rather than arises as a consequence of it. We therefore suggest a new approach: a Job Guarantee Program. The U.S. Government can proceed directly to zero unemployment by hiring all of the labor that cannot find private sector employment. Furthermore, by fixing the wage paid under this ELR program at a level that does not disrupt existing labor markets, i.e., a wage level close to the existing minimum wage, substantive price stability can be expected…As we have argued before, the Job Guarantee program should remain a permanent feature of our economy, in effect acting as a buffer stock to put a floor under unemployment, whilst maintaining price stability whereby government offers a fixed wage which does not “outbid” the private sector, but simply creates a stabilizing floor and thereby prevents deflation. [Many on the right might reflexively think of such a program as socialism run amok, but as we've pointed out more than once, an employer-of-last-resort program has been proposed on the right by Nobel economist Ned Phelps. The idea is definitely worth a closer bipartisan look.]

There are good ideas out there, but there is a distinct failure of political imagination and courage to implement them. With any hope Frum’s provocative article will spur a healthy discussion on the possible solutions, rather than a retreat to tired, discredited economic shibboleths.

But Brad DeLong gives little hope that Auerback’s retreat can be avoided:

…Congress is balking. Republican legislators from states with double-digit unemployment have put party above country. Blue Dog Democrats, who think that they can marginally improve their chance of gaining more terms in office if they publicly worry about the deficit to the exclusion of all else, have put self above country and party. And, significantly, the Obama Administration has never offered a grand bargain for tax increases and entitlement caps in the future in return for more spending now to restore full employment.

We’ll toss a few cents into the discussion in an attempt to show that we can and should overcome irrational deficit phobia (yes, there are sometimes rational reasons to fear government deficits), we’re likely to make little progress towards ensuring a strong and durable economic recovery, and ironically, we’re likely to end up in a worse public debt position. 

On Frum’s question, Randy Wray has pointed out (pdf) that an accelerating pace of federal government tax receipts followed the Bush tax cuts and recovery, and may have contributed to the intersectoral strains that eventually resulted in financial collapse (emphasis added):

Every recession since World War II was preceded by a government surplus or a declining deficit-to-GDP ratio, including the recession following the Clinton surpluses. Recovery from that recession resulted from renewed domestic private sector deficits, although growth was also fueled by government budget deficits that grew to 4 percent of GDP. However…the Bush recovery caused tax revenues to grow so fast that the budget deficit fell through 2007, setting up the conditions for yet another economic collapse…

In 2005, tax revenues were growing at an accelerated rate of 15 percent per year—far above the GDP growth rate (hence, reducing nongovernment sector income) and above the government spending growth rate (5 percent)…this fiscal tightening was followed by a downturn—which automatically slowed growth of tax revenue.

Thus, conservatives might not be painted into as severe a policy corner as Frum fears. But that’s true only if they can let go of their (newfound, circa 2006?) deficit phobia and escape the intellectual tyranny of Ricardian equivalence. We think that’s easily done, but there are two basic concepts that need to be framed out before the policy conversation can make any significant progress.

First, we need to frame our modern financial economy as Knut Wicksell did over 100 years ago. There are two ‘interest rates’ at work, one on the credit (financial) side, and one on the real (economy) side. The financial rate (in reality, there are many of them) is determined in large part by the cost of a marginal unit of money. The economic rate (in reality there are many of these too) is determined by the expected return on a marginal unit of investment.

When the financial rate is below the economic rate, the result is inflation (greater expected returns on investment lead to increased demand for credit, and money eventually becomes less valuable relative to real goods and services). When it’s above the economic rate, the result is deflation (negative expected net returns on investment lead to decreased demand for credit and increased demand for saving; money thus becomes more valuable relative to real goods and services).

Wicksell’s original thesis has been tweaked to acknowledge that inflation and deflation are unlikely to persist indefinitely. We also need to incorporate the idea of leverage. Low systemic leverage (the amount of credit relative to money) implies a higher cost of credit and lower inflationary pressures. When there’s a high degree of leverage, inflationary swings can be exaggerated, and can turn sharply and suddenly into deflation (Minsky’s “Ponzi finance” or Austrian’s “crack up boom”, of which 2008-2009 was a prime example).

Second, we need to get a better grasp of money — what it is, where it comes from, and how it works. 

Under any type of gold standard, gold is essentially money, and over the long run, gold’s real value is a function of its supply relative to all other goods, services, and assets (gold’s flexibility, durability, and steady long term accumulation rate give it its monetary properties). As long as money is defined as a fixed weight of gold, the value of money will closely track the value of gold. Thus, under a gold standard, the financial rate of interest is determined in large part by developments in the gold industry relative to the rest of the economy (as an aside, Ricardian equivalence might have some merit in that type of system).

However, in a fiat currency system like the U.S. has had (officially) since 1973, money is just money, which the government sector creates at minimal cost (currently the money creation process is controlled by the Federal Reserve through its interactions with member banks and primary dealers). Thus, the financial rate on fiat money is more easily attuned to the economic rate, thereby helping to mitigate the cycles of inflation and deflation that occurred regularly under classical gold (that was Wicksell’s stated intent when he first outlined his monetary theory). Granted, it’s taken policymakers and markets several decades to learn how to run such a system effectively, and there’s still plenty of room for improvement, but that’s to be expected with any large scale innovation.

A key takeaway is that the federal government creates the money used in private sector transactions, satisfaction of tax and other liabilities to the public sector, and demand for goods and services by the public sector. Thus, saving or spending desires of the private sector can only be accomodated by the federal government (leaving aside export income), while under a gold standard, they could only be accomodated (with some qualifications) by the available supply of gold. In other words, despite the widespread belief that they are subject to the same constraints, the federal government’s budget is nothing like households’ or businesses’ budgets, and in fact, in some key respects it is the inverse (just as under a gold standard, the gold industry would need to “dis-save” gold in order to satisfy the desire for saving in other sectors of the economy).

Today, if households, businesses, and state and local governments want to run a surplus, then the federal government must by definition (again ignoring exports) run a deficit. That’s not an ideological statement, it’s a simple operational fact, which is why (we think) it opens up a lot of common ground for policy.

So what role do federal government deficits play in our economy?

Depending on how they come about, they can raise the expected rate of economic return (by increasing aggregate demand), lower the financial rate (by increasing the supply of money), or both (by financing its demand for real goods and services with new money).

Conversely, a budget surplus (or a smaller deficit) can lower expected economic returns, and can also impact the financial rate (under our Wicksellian framework, if money becomes more scarce, then the prevailing nominal interest rate becomes tighter, all else equal).

In certain environments (e.g., Japan 1990′s thru 2000′s, U.S. 2000′s thru 2020), expanded deficits make sense, while in others (e.g., Japan 1970′s thru 1980′s, U.S. 1980′s thru 1990′s), smaller deficits or even surpluses might make sense – albeit with this caveat from Wray:

…the United States has also experienced six periods of depression that began in 1819, 1837, 1857, 1873, 1893, and 1929. Comparing these dates with the periods of budget surpluses, one finds that every significant reduction of the outstanding debt, with the exception of the Clinton surpluses, has been followed by a depression, and that every depression has been preceded by significant debt reduction. The Clinton surpluses were followed by the Bush recession that was ended by a speculative, private debt–fueled euphoria, and was followed in turn by our current economic collapse. The jury is still out on whether we might yet suffer another Great Depression. While we cannot rule out coincidences, seven periods of surplus followed by six and a half depressions (with some possibility for making it a perfect seven) should raise eyebrows…our less serious downturns in the postwar period have almost always been preceded by reductions of federal budget deficits. [Note that all six depressions occurred under a gold standard of some kind, so the direction of causation is open to question.]

Where are we today? U.S. demographic composition (pdf) implies a relatively pessimistic outlook for productivity, saving, and investment, possibly until the end of this decade. Large swaths of the private sector — notably households, but also some state and local governments – are in desperate need of repairing their balance sheets. Many corporations are flush with cash but apparently reluctant to invest it in human or physical capital. In other words, the demand for saving in the private sector remains high, and probably will for some time. 

What’s the proper response?

For households, some combination of fiscal support (e.g., extended payroll tax holiday, financed by money creation if need be) and financial relief (e.g., cleaning up the mortgage mess in as fair and transparent a way as possible, possibly with greater commitment from the federal government, as opposed to the private sector incentives and public-private partnerships experimented with to date) should help.

For state and local governments, direct budget assistance, again financed with new dollars if necessary (which is essentially how it’s now done, except that primary dealer and other banks get to hold Treasury paper for “financing” the federal deficit and earn the spread over the fed funds rate).

For the corporate sector, expanded public sector demand (e.g., maintenance and productivity enhancing infrastructure improvements, R&D into promising areas like energy and health care, etc) and perhaps most importantly, tax and regulatory assurances that will decrease the level of political uncertainty that businesses now face.

All of these would mean higher deficits in the short run, but if we’re right about the underlying state of the economy for the next decade, they will mean lower future debt and deficits than would otherwise occur (unless liquidationists and entitlement cutters were to win in drastic fashion, but in that improbable case the net costs would be much greater than any savings implied by a smaller federal debt).

It’s also important to point out to the Tea Party types that, as Jamie Galbraith and many other economists have noted, only a small percentage of the rise in federal deficit and debt to GDP ratios was driven by increased discretionary outlays by the Democrats. Almost all of the rise is simply a function of counter cyclical measures like unemployment insurance in the numerator and lower GDP in the denominator.

However it turns out, the federal government is not “broke” and never can be. The only true constraint on federal deficits is inflation, and there simply aren’t any signs of elevated inflation risk  today — although USD exchange rate depreciation is a meaningful risk, depending upon the relative movements of fiscal, trade, and monetary policies in different countries and regions. As Wray observes (emphasis added):

…there is no financial constraint on the ability of a sovereign nation to deficit spend. This doesn’t mean that there are no real resource constraints on government spending, but these constraints, not financial constraints, should be the real concern. If government spending pushes the economy beyond full capacity, then there is inflation. Inflation can also result before full employment if there are bottlenecks or if firms have monopoly pricing power. Government spending can also increase current account deficits, especially if the marginal propensity to import is high. This could affect exchange rates, which could generate pass-through inflation. [Viewed in this light, the Obama administration's export initiative might be a wise idea.]

The alternative would be to use fiscal austerity and try to keep the economy sufficiently depressed in order to eliminate the pressure on prices or exchange rates. While we believe that this would be a mistake—the economic losses due to operating below full employment are almost certainly much higher than the losses due to inflation or currency depreciation—it is an entirely separate matter from financial constraints or insolvency, which are problems sovereign governments do not face.

We openly admit that:

• While some of the measures we’ve outlined could be easily implemented, others are much easier said than done.
• All of them are subject to severe agency and other risks. But that’s true for most things in life, not just politics!
• Many of the distortions and perverse incentives that got us here still need to be corrected.
• Many voters may fear — perhaps justifiably, judging by some of the rhetoric on the left — that deficits do indeed imply higher future taxes and should thus be avoided.

We also admit that under certain conditions, fiscal austerity (via higher taxes and/or lower spending) may indeed be supportive of growth. But we do not think those conditions are in play today in most developed nations.

The bottom line is that no meaningful, bipartisan measures capable of supporting of economic growth at a reasonably healthy level can be crafted until we’ve moved beyond irrational deficit hysteria. And that requires a broader and deeper understanding of how modern money and financial economies work.

URLs:

http://theweek.com/bullpen/column/204603/the-krugman-question

http://www.newdeal20.org/2010/07/02/free-market-showdown-david-frum-poses-the-question-heres-the-answer-14105/

http://theweek.com/bullpen/column/204665/keynes-amp-co-have-lost-the-stimulus-argument

http://www.levyinstitute.org/pubs/ppb_111.pdf

http://en.wikipedia.org/wiki/Ricardian_equivalence

http://654advisors.com/index.php/blog/2006/12/committees-vs-markets/

http://654advisors.com/index.php/blog/2010/07/galbraith-blasts-the-deficit-commission/

“Money we don’t have”

Good NYT article on deficit hysteria, with an especially illustrative quote from Rep. Cooper (D, TN):

“We have to stop spending money we don’t have,” said Representative Jim Cooper, a Tennessee Democrat who voted against the bill. “I hope deficit reduction fever is catching.”

The U.S. is in the midst of a balance sheet recession, with demographic ratios shifting an an unfavorable economic direction for several more years.  Under those conditions, deficit reduction fever will lead directly to the dreaded Japanese Disease —  another decade of stagnation, underemployment, and opportunity costs, all of which will impose greater burdens on future generations than expanded federal deficits would.

And policymakers — not to mention most members of the electorate, including analysts and the media — continue to commit two fundamental errors regarding fiscal policy:

1. They believe that all deficit spending must be financed with interest bearing debt, thus competing with the private sector for scarce financial resources.  However, judging by current Treasury rates, there’s still plenty of room for expanded federal borrowing.  And there’s a symbiosis between federal deficits and repair of balance sheets in the financial sector, as evidenced by the perfect quarters turned in by several major investment banks recently.  Politically, that relationship is almost nauseating, as it’s doing very little to relieve distressed households — but it nevertheless makes apparent the  dynamic between public sector fiscal deficits and private sector balance sheet relief.
2. They also believe implicitly that the U.S. is on a gold or similar standard, where fiscal and monetary policies are constrained by the supply of some exogenous factor, and governments can thus literally “run out of money.”  Governments can’t run out of money, as it is ’created’ by nothing more than digital ledger entries.  In other words, government (today, via operations of the quasi-private Fed) is the sole creator and supplier of high powered money.  Thus, the only constraint on money creation is inflation and a loss of confidence in the currency, and at the moment, those forces are emphatically not in play.  This too is symptomatic of Japanese Disease.

The fears of incumbent politicians like Cooper are certainly understandable.  But they’re borne of either ignorance about how these things work, or self-preservation.  Either way, it smacks of lousy political leadership. 

And given that Republicans are likely to benefit in November, we’d expect the trend towards fiscal conservatism to intensify.  Even President Obama, in a speech yesterday, promised the following:

• A three year freeze on all non-discretionary federal spending beginning in 2011
• Expiration of tax cuts via sunset provisions
• Elimination of 120 federal programs
• Reinstatement of PAYGO
• Higher fees on banks that are expected to lower federal deficits by $90B over ten years

He promised all of this as a way to force the public sector to budget in the same way that families and businesses do.  Again, this is wrong, and is borne of either ignorance or pandering.  And as with Congress, it smacks of crummy political leadership either way. 

The administration’s jawboning is also reminiscent of budget austerity measures touted by the Carter administration in the 1970s in reaction to the “tax revolt” — austerity measures that contributed to its eventual demise, even though they may have been more appropriate to the conditions prevailing at the time (e.g., baby boomers entering adulthood, global trade and financial integration, etc).   Today, austerity is far less appropriate, but even more vigorously pursued.  That almost certainly spells trouble for Obama in 2012 – assuming the GOP can field a worthy candidate and avoid blowing all of its political capital in the intervening years. 

You also have to wonder, were he to experience a change of heart, whether there’s any credible way for him to backtrack from his neo-liberal rhetoric.  The DLC, Brookings, Peterson, and all the other usual suspects have painted the guy into one hell of a corner.

In the meantime, assuming that reality will align with rhetoric, the political climate continues to be favorable to the USD and Treasuries, and rather risky to gold.  A contrarian call? You bet.  But it’s based on what we think is a well-grounded and – just as importantly – non-ideological assessment of the facts. 

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a state registered investment adviser in the Commonwealth of Pennsylvania. The views expressed by the author are as of the publication date, and are subject to change based on market and other conditions. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy or a solicitation to sell any security, or to engage in any investment strategy. Investors should not use this information as a basis for any investment decisions without first consulting their own financial adviser. SCM is an Amazon.com associate, and earns a commission on sales generated through links from our website. Some clients of the firm are long GLL and/or long TLT.  At the time of writing, neither the firm nor its principals owned any securities mentioned. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

URLs:

http://www.nytimes.com/2010/05/29/us/politics/29deficit.html

http://www.japanreview.net/review_bsr.htm

http://www.miraeasset.com/ourmarket/outlookView.do?board_id=1125&group_id=1&pageNo=2

http://www.investmentnews.com/article/20100602/FREE/100609973

http://seekingalpha.com/article/208174-how-deficit-hawks-will-keep-cutting-spending-until-we-re-all-on-food-stamps

Poor auctions signifying…what exactly?

A good deal is being made of subpar Treasury auctions this past week and whether they signify a turning point in the market’s appetite for U.S. government debt. It’s certainly possible, but we suspect that there’s a more nuanced and global explanation.

First off, a 10 year Treasury yielding almost 4% annually does not look like a bad deal given the intermediate growth outlook in the U.S., despite what so many other pundits are saying (unless you believe that we’re on the verge of persistent domestic inflation, i.e., a widespread USD surplus…anyone?).

Second, if Treasury auction participants came to market with only cash and held no other assets, then the prevailing theory would be harder to refute. However, the most important participants in treasury auctions are the New York Fed’s primary dealer banks, which are divisions of BNP, Bank of America, Barclays, Cantor, Citigroup, Credit Suisse, Daiwa, Deutsche Bank, Goldman Sachs, HSBC, Jefferies, JP Morgan, Mizuho, Morgan Stanley, Nomura, RBC, RBS, and UBS. These bank divisions and their parents already own large amounts of financial assets. Thus, they also need to manage risk when making purchase commitments. And one of the biggest risks of the past week was whether the Eurozone could agree on an assistance plan for Greece.

The following members of the Fed’s primary dealer banks are also primary dealers for Greek debt: Barclay’s, BNP, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan, Merill Lynch (assumedly this is Bank of America), Morgan Stanley, Nomura, RBS, and UBS. This provides just a glimpse of the overall mosaic, as dealers also act as agents or conduits for public, and not just principals. However, it’s an important one, and it’s reported (and reasonable to assume) that several of them do own large slugs of Greek government debt.

Thus, given the uncertainty surrounding management of Greece’s funding crisis, and how it spiked again this past week as Germany dug in its heels, it’s quite possible that some of the usual buyers of U.S. Treasury debt are simply distracted and/or increasingly risk averse (even using low central bank interest rates to finance the purchase of protective credit default swaps, which probably offered more comfort in the immediate environment than new Treasuries).

 Consider, for example, that French and German banks are believed to be exposed to $119B of Greek debt. Assuming sane leverage ratios of 10x (a dangerous assumption to make), the potential financial loss is equivalent to a significant percentage of the two countries’ annual GDP of $6T (e.g., a 15% decline in the value of Greek bond holdings, if unhedged, would equal roughly 3% of combined French and German GDP).

As tempting as the U.S.-Treasury-on-the-brink hypothesis is for the public debt Cassandras, we think ours does a better job of incorporating the sharp strengthening of the USD over the past week, and market behavior since yet another agreement began to take shape.

Combined with the fact that speculative credit markets are looking awfully frothy, some other strange market signs, and the likelihood of federal fiscal consolidation in 2011, we think you have a recipe for an eventual rally in Treasuries. It reminds us a little bit of the post 9/11 Treasury market selloff. Caveat venditor?

IMPORTANT DISCLOSURES: The author does not own shares of any companies mentioned. Clients of the firm own shares of ALBKY, SHY, TLT, MFG, and NBG. A principal of the firm owns shares of C, GS, and MS. Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy.

URLs:

http://www.newyorkfed.org/markets/pridealers_current.html

http://www.bankofgreece.gr/Pages/en/Markets/HDAT/DispItem.aspx?Item_ID=3220&List_ID=1af869f3-57fb-4de6-b9ae-bdfd83c66c95

http://www.businessinsider.com/germany-will-have-to-become-greeces-abu-dhabi-since-way-too-many-foreigners-hold-greek-debt-2010-1

http://dealbook.blogs.nytimes.com/2010/02/25/banks-bet-greece-defaults-on-debt-they-helped-hide/

http://online.wsj.com/article/SB10001424052748703798904575069712153415820.html

http://www.bloomberg.com/apps/cbuilder?ticker1=DXY%3AIND

http://www.businessweek.com/news/2010-03-27/bunds-fall-greek-bonds-rise-after-eu-leaders-agree-aid-plan.html

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aJZgGddV4mIY

http://ftalphaville.ft.com/blog/2010/03/24/185091/new-negative-territory/

Crisis, regulation, vigilance & cynicism

A cynical take on Sen. Dodd’s financial regulatory reform bill by Matt Koppenheffer for Motley Fool:

We can probably point to plenty of regulatory failures in the lead-up to the financial crisis. But I hardly think that they’re regulatory failures stemming from lack of regulators. As Valukas noted in his report, regulators were swarming on Lehman well before its collapse…

It seems to me that the issue never was whether there were people trying to address the problem, but rather that they were trying to regulate on a fuzzy mandate of not letting something bad happen within the bounds of a very permissive system. For the same reason that we have speed limit signs posted in our residential neighborhoods, we need to give regulators a clearer, tougher set of standards that they can impose on financial companies.

First and foremost, those standards need to address the lunatic business model that Lehman Brothers — and, really, most of the big financial companies — was operating on at the time of its demise.

Specifically, Lehman was increasingly building up large, illiquid, proprietary investments while primarily financing itself through very short-term agreements. What it became was a massive, teetering Jenga game right smack in the middle of our financial system that could be toppled in the blink of an eye if it lost the confidence of major counterparties…

That last paragraph echoes a beautiful turn of phrase by Bill Bernstein in the most recent Financial Analysts Journal, in which he refers to ”leveraging so unstable that it could not survive the slightest of economic breezes, let alone a 100-year storm.”

Koppenheffer continues:

…the bill includes the Volcker Rule the way Cocoa Puffs include well-balanced nutrition. Little actually gets implemented in the text of the bill. Rather, specific regulations are supposed to come from a study on the rule’s potential impact. Not only is this likely to maximize the squishiness of the eventual rules, but it also gives lobbyists plenty of time to work their magic.

In the end, I don’t see the Fed folks as a bunch of incompetent bumblers. But when it comes to smothering the next Lehman, Fannie Mae…or AIG…I do think they’ll fail miserably because they’re being given a butter knife to regulate with when what they need is a buzzsaw.

A tangential riff: If we aren’t going to impose a hard, fast cap on leverage and other risky behaviors, then perhaps the power of network effects and private sector vigilance (vigilantism?) can help fill the gaps in our financial regulatory structure. For example, it seems reasonable to expect (OK, hope) that the next Harry Markopolos will be taken more seriously.

But when the issue is not fraud by a single market participant, but rather systemic levels of leverage and risk, then it seems unlikely that any kind of enforcement powers could be brought to bear if regulatory bodies haven’t purposefully enlisted private sector assistance beforehand. 

I suppose we’re a bit cynical too.  

URLs:

http://www.fool.com/investing/general/2010/03/24/why-the-fed-will-fail.aspx

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1553816

http://en.wikipedia.org/wiki/Internet_vigilantism

http://en.wikipedia.org/wiki/Harry_Markopolos

Mosler blowing minds (sort of)

Warren Mosler was given a brief spot on CNBC this morning to discuss his version of modern monetary theory, an idea that deserve a wider audience. The cognitive dissonance he induced among the host, a co-hosting economics reporter, and a successful hedge fund manager was pretty apparent. Warren lacks the charisma to make a quick sale, but as the co-host pointed out in the wrap up, it was a start.

Shovel-ready news bits

It’s another shovel ready snow day in the mid-Atlantic, with our second two footer in five days. Too bad we can’t ship the stuff to Vancouver efficiently. A couple of interesting things on the wires today:

The Fed’s exit strategy

Ben Bernanke outlined the Fed’s game plan for tightening monetary policy when the time is right. In our judgement he said the right things for the most part. The relatively new policy tool that is getting the most attention is the payment of interest on excess reserves that member banks have on deposit with the Fed (“IOER”).

Our initial take on IOER when it was legislated in 2008 was that it offered a way around the zero bound on the Fed’s interest rate target, but that was wrong. We overlooked that (1) the interest is not necessarily paid with new USDs, but could be paid out of cash flows earned on the voluminous assets that have been taken onto the Fed’s books and (2) the incentive effect of the interest payments is to “tie up” banks’ reserves outside of credit creation channels.

Fortunately, the Fed’s current interest rate is not competitive with spreads on public and private sector credit; instead, it appears to compete solely on the basis of risk, as banks don’t have to worry about mismatching assets and liabilities (borrowing short term and lending long term). But overall, it’s hard to see how those two effects of IOER support economic activity in the present. Apparently we’re not the only ones trying to get our heads around this.

ABC News poll

Headline numbers from a recent ABC News poll look bad for President Obama and Democrats, but there are some interesting things under the hood. First the headlines:

• Trust in Democrats’ ability to handle critical policy issues such as the economy and terrorism gave decline steadily since last year, with the overall gap versus Republicans falling from roughly 25% to 5%. 
• Obama’s approval ratings are below 50% on creating jobs, the economy, health care, and the deficit (his approval on terrorism is a very healthy 56%).

Some of the nuances that should be very relevant for political strategists include:

• While the margin has dropped considerably from 13%, 49% of independents lean towards Dems, 45% towards the GOP (p.5).
• While respondents viewed the loss of the Dems’ Senate super majority positively, 58% view the GOP as obstructionist, and 68% say that obstructionism should only be used infrequently (p.4).
• 48% describe themselves as “anti-incumbent”, below the 54% and 53% that preceded the “throw the bums out” elections of 1994 and 2006.

Health care reform is especially interesting; while most respondents view the present outcomes negatively:

• 80% support banning limits on pre-existing conditions.
• 56% support a personal health insurance mandate, including public assistance.
• 65% say the current approach is overly complicated, and 59% say it’s too expensive.
• 74% of those with private insurance trust their carrier to handle claims fairly, and more of these folks oppose the current reform packages.

One takeaway is that there’s plenty of room for strategic and tactical maneuvering by both parties in the quarters ahead.

Another, based on that last bullet point on health care, is that there appears to be a powerful asymmetry at work, one that I’m much more sympathetic to nowadays: people who have satisfactory health coverage are going to have a harder time empathizing with the challenges faced by those who don’t. That seems pretty rational, if not a little cut throat – if it ain’t broke for me, why should I have to pony up for your troubles?

My wife, who has worked in architecture for almost twenty years, was out of work for most of 2009. If not for the COBRA subsidy, we would have been in a much deeper financial hole, to the tune of about $600+ per month. When the subsidy was set to expire in December, we applied for coverage with the carrier we had through her prior employer, but were denied coverage for preexisting conditions, namely minor wear and tear to one of my knees and heightened anxiety in a person who had just lost her job and income. Huh??? 

And if you’ve ever tried to purchase a policy as an individual, you know how frustrating it is to try making comparisons between apples, oranges, cumquats, dragon fruit, and a bunch of others (let alone issues like financial strength and ratings). You also have to be a very savvy insurance consumer to detect the coverage gaps at work in different kinds of policies.

The family’s now fully insured thanks to good news on the employment front, but this is an issue that we have a whole new perspective on — one that’s firmly supportive of well designed health care reform.  

URLs:

http://news.yahoo.com/s/ap/20100210/ap_on_bi_ge/us_bernanke_exit_strategy

http://www.ny.frb.org/newsevents/speeches/2009/dud090729.html

http://www.newsneconomics.com/2008/12/why-exactly-does-fed-pay-interest-on.html

http://abcnews.go.com/images/PollingUnit/1102a22010Politics.pdf

Krugman vs CNBC

A couple of CNBC commentators ripped Paul Krugman for today’s op-ed on budget deficits, with Rick Santelli saying something about lining a bird cage. We aren’t defending Krugman against charges of self-contradiction or factual inaccuracies, but we are definitely siding with him on the economic substance of his argument (the lonely wingnut’s sojourn continues).

Prevailing rhetoric holds that the U.S. government is over extended, and that there’s precious little room for additional economic stimulus. That would be true if US dollars could only be obtained by taking them from people who have them, or by digging new ones out of the ground. In that case, servicing our debts — both private and public — would be quite burdensome. But the reality is that in a modern monetary system, monetary units are simply ledger entries. Whether carried in hand as a Treasury obligation, or held digitally in a bank account, all dollars are created out of thin air by the Federal Reserve in response to demands of the banking system.

The federal government does not have direct control of the Federal Reserve, so its control of money creation is only indirect (if Congress wished, it could wrest control of USD creation from the quasi-private Fed, a measure that a small number of radical but diverse members might like to see). But existing arrangements do not change the basic fact that the U.S. has the capacity to print the money (the non-interest bearing debt) used to service its public debt. That means that the only meaningful constraint on the level of our pubic debt is people’s willingness to accept the USD. And despite the sophomoric rhetoric on that point, people are still overwhelmingly willing to accept USDs.

The claim that Congress is “spending money that we don’t have” is even more egregious. To reiterate: if USDs could only be dug out of the ground, or pulled out of taxpayers’ pockets, then the argument might make some sense. But as long as we have the ability to create USDs out of thin air, then Congress has the ability to spend new USDs instead of existing ones.

The conservative argument against this type of Keynesian activism rests on a couple of key pillars, and under certain conditions, they’re valid: (1) as long as government constraints on the private sector are moderate, an economy will grow at or near full capacity; (2) public demand for capital will always tend to ‘crowd out’ private sector borrowing; and (3) public sector allocation of capital is inevitably distorted, which imposes long run economic costs. 

As long as those assumptions are valid, then Congressional thrift, beyond a basic level of social insurance and national defense spending, is a desirable objective. However:

(1) History doesn’t lend strong support to the idea that an unbridled private sector will always and everywhere produce positive growth; and if monetary policy is constrained by a zero bound (i.e., interest rates can’t go below zero), then whenever growth is below potential, fiscal stimulus is appropriate (and can be enacted in myriad ways that appeal to lefties or righties). This is especially true for long economic cycles, such as the Great Depression, Japan from 1989 until 2008 or so, and several developed western economies since roughly 1999. Judging by the available empirical research, demographic composition could be the main driver of these cycles (and if the effect is strong enough, it might deemphasize the importance of rationality vs behavioralism in theory and policy making).

(2) When private sector demand for capital is contracting, as can happen in a long down cycle, then public sector demand for capital (i.e., deficits and debt issuance) is beneficial, and should foster rather than crowd out private sector credit demand. However, under certain conditions, this will only work if money creation is supportive of public sector credit demand, i.e, if new money is created to finance the public sector debt (the conservative point of view tends to see this as banana republic monetary policy, but that isn’t always the case). Today, banks are taking advantage of a steep yield curve to borrow funds from the Federal Reserve (which creates new USDs) to purchase higher yielding Treasury debt, i.e., a significant amount of our public debt is being ‘monetized’. While that would be a bad thing in an inflationary environment, it’s a good thing when it offsets deflationary forces. Almost everyone who parrots the prevailing rhetoric is overlooking this dynamic.

(3) Public sector capital allocation is certainly prone to distortion in as much as it is not subjected to competition and the judgement of diverse agents. But asymmetries in the private sector can have powerfully negative effects too (financial crisis, anyone?). And while there’s room in our political system for new institutions designed to allocate public resources more optimally, the existing ones, such as voting, negotiation, and oversight, should do a good enough job in the meantime.

Krugman wrote that “there’s no reason to panic about budget prospects for the next few years, or even for the next decade,” and apparently this has some pundits and analysts pulling their hair out. But if prevailing demographic ratios are going to drive another decade of subpar economic outcomes…then he’s absolutely right!  

When the real economy is humming along, we can leave the creation and allocation of new USDs to the private sector, and rein in public deficits without doing too much harm. But when the state of the real economy is uncertain, as it certainly is now (pun intended), the refusal to finance public spending, investment, and intermediation via the creation of new dollars (within the constraints dictated by inflation objectives and expectations) is inherently deflationary and destructive. And that is what undermines the sophomoric notion that we are “leaving a mountain of debt to our grandchildren.” If the public sector is not active enough to offset destructive forces acting in the economy today, then our grandchildren will be worse off. Like most economic variables, public debt levels mean nothing in isolation. And we shouldn’t just look at it relative to current GDP. We must also look at it relative to opportunity cost, or looked at another way, to future GDP. There are actions that the public sector can take today to favorably impact GDP in the future, but they all require financing, including deficit spending. We should only be frightened of deficits when they are scarier than the opportunity costs imposed by government saving. Today, that is simply not the case.

So Krugman is right to be concerned about the policy outlook, which he has a rather pessimistic view of:

Washington now has its priorities all wrong: all the talk is about how to shave a few billion dollars off government spending, while there’s hardly any willingness to tackle mass unemployment. Policy is headed in the wrong direction — and millions of Americans will pay the price.

We’ve expressed similar concerns since 2H09, but it now looks to us as though the Obama administration is “triangulating” on deficits and the federal debt, with no intention to substantially withdraw fiscal stimulus in the government’s 2011 fiscal year (though again, we’re still trying to figure out how the president’s emphasis on PAYGO fits into this). If we’re right, then the readjustments underway in exchange rates, specifically the Euro and USD, are being driven by the Euro and sovereign debt concerns, rather than from the USD side. That means we should settle into a new exchange rate equilibrium in the coming weeks, at which point risky assets should start to recover. It’s going to be a bumpy ride, but we’ll get there.

URLs:

http://www.nytimes.com/2010/02/05/opinion/05krugman.html

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. Symmetry Capital Management, LLC is an Amazon.com associate, and earns a commission on sales generated through links from our website. At the time of writing, the firm, its principals, and its clients did not own any securities mentioned, or any securities issued by entities mentioned.

Global sell off and the EMU

Markets for risky assets — stocks, commodities — are down significantly around the world today. The selling is reportedly being caused by intensifying worries over government debt levels in Greece, Spain, Portugal, Italy, and Ireland (the so-called PIIGS), and the possibility of a sovereign debt crisis for one or more of them. The USD is up, continuing its months long rally.

The European Monetary Union is an interesting contrast to the U.S. It shares a common currency, the euro, which is analogous to the USD here. The governing agreements of the EMU require that each member state impose a certain level of fiscal discipline, i.e., government budget constraints. That’s the nominal policy, but imposing discipline on member countries has proven to be elusive. The important difference between the U.S. and the EMU is that our federal government sets both fiscal and (quasi-public) monetary policies at a national level, while in the EMU, monetary policy is set at the highest level, but fiscal policies are pursued by individual countries, and they can vary quite a bit, from German thrift to PIIGS’ profligacy (there also tend to be tighter constraints on state and local budget deficits in the U.S. than in some European countries). The result is that national governments in the EMU do not have the power to create the non-interest bearing debt (the euro) used to service their interest bearing debt. Technically, the U.S. doesn’t either, as the Fed is not a government agency, but it’s fair to say that Congress and the Administration wield far more power over the Federal Reserve than European governments do over the ECB. 

So when highly leveraged sovereigns in Europe run into trouble, like Portugal’s recent failed debt auction, there’s plenty of consternation and conflict among EMU members about the appropriate measures to take. That uncertainty may indeed be causing increased investor pessimism, and raising the probability that one or more of these countries defaults on its debt.

A CNBC commentator also pointed out that credit default swaps, the cause of AIG’s demise, could be playing a role. This market is still largely unregulated, unfortunately. If a CDS were nothing more than a betting contract between gamblers, they wouldn’t be a big deal. But the CDS market is huge. It has gone well beyond its primary purpose of hedging credit risk, instead allowing active and highly levered speculation on credit troubles, and the ‘notional’ value of contracts far exceeds the actual amount of debt outstanding. Many of the counter parties involved in the CDS market are intimately tied to the global payments system, so an implosion affects all of us. It’s for that reason that updated financial regulation is so critical, whether it’s to tax principal trading assets, limit the level of credit default insurance to the actual level of an issuer’s debt, limit or monitor systemic leverage, etc.

That segues into an important consideration regarding the potential economic impact of a sovereign debt crisis. Some analysts and commentators point out that the economies of the countries at risk are a small percentage of global or even European GDP. However, Lehman Brothers was also small relative to world or U.S. GDP. What’s important from a systemic standpoint is the number of financial commitments associated with the sovereign paper that is at risk of defaulting, i.e., the systemic fragility that could be exposed by such an outcome. The global financial system has deleveraged significantly since 2007, but from astronomical levels; a large loss on sovereign paper could still destroy a lot of capital in fairly short order. There’s also contagion risk — if more than one of these sovereigns were to default, the relative size of the problem would be larger.

Interestingly, we’re bullish on all but one of these countries in the longer term, so we’re looking for opportunity amid the crisis.  

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. Symmetry Capital Management, LLC is an Amazon.com associate, and earns a commission on sales generated through links from our website. At the time of writing, the firm, its principals, and its clients did not own any securities mentioned, or any securities issued by entities mentioned.

Obama Budget & 4Q09 GDP

We were feeling a little smug about Friday morning’s GDP print, given our argument in 2H09 that growth prospects were probably being under estimated. At 5.7%, it wasn’t quite the six handle that we thought we might see, but barring any significant downward revisions, it was closer than most expected, and nominal GDP did indeed have a six handle.

Interestingly, headline government spending added little to the quarter’s numbers, so there will be an interesting debate over how much of a role ‘fiscal demand’ is playing, but we’re cautious about that for a few reasons. First, the slower pace at which private inventories were liquidated was a large contributor to GDP, but sustainable private sector growth and employment are unlikely as long as inventory building remains anemic.  Second, federal spending was down due to a lower defense spend, while non-defense spending was up 8% versus 7% in 3Q09, so it’s hard to argue there was no fiscal component. Third, it ignores the possibility of lag effects between public sector spending or deficits and subsequent private sector activity. And if we’re right that fiscal expenditures are still playing a role, the GDP data could imply a very healthy multiplier, a possibility sketched out in this recent academic paper.

This leads us to the Obama budget released today, which will be a real tooth gnashing, garment rending piece of work to many. But it looks pretty good to us at first glance (see the criteria on page six of this Idle Speculator), far better than recent rhetoric led us to expect. The deficit is forecast to be a record $1.56T in 2010 and to remain above $1T in 2011, and it’s beginning to appear that Obama is “triangulating” on fiscal austerity measures, or at least on the time frame over which deficit reduction will occur (though it’s not clear how PAYGO fits into this).

The President’s budget will be tough for some to swallow, but as we’ve pointed out elsewhere, the belief that government is always and everywhere the problem, or that it cannot contribute to real economic growth, is based on a massive underlying assumption: that the private sector is always and everywhere able to grow. It’s not hard to reduce that position to an absurd one, e.g., if a natural or biological calamity were to severely impact private sector potential, a government with a monopoly over money creation could pick up some or perhaps all of the slack.

Reality is far more complicated of course, but since demographic ratios came to our attention, it seems patently clear that private sector potential can vary wildly over multi decade periods, especially in economies where a steep fall in childhood mortality occurred at some point in history. Japan is the most recent example of a two decade downswing in potential output, and its policymakers mistakenly approached the problem as a cyclical rather than a secular one. The U.S. and other western nations are roughly ten years behind Japan in demographic terms, so there’s still roughly a decade of slow, no, or even negative growth ahead of us, barring an active public sector (note: “active” can include tax cuts). As we wrote last November:

We’re familiar with the major [economic] catechisms; we’re just not sure that the evidence supports any one of them over another. Structural economic conditions can and do change — age structure is just one example of how this can come about — and different conditions may call for different approaches.

There are several economic measures that, when viewed over the last two decades, support our assessment that demographics are playing a powerful role in the performance of the U.S. economy (and by extension, these measures tend to undermine arguments against Republican budget profligacy in the 2000s). For example:

The year over year decline in state and local income tax revenue has never been so precipitous, and it has become far more volatile since demographic ratios first turned negative in the late 1990s;

The trend in real private inventories has also been declining since the late 1990s; and 

Equipment and software investment has been in a similar downtrend since the late 1990s.

Admittedly, we’re just eyeballing graphs here and speculating on whether they correspond well to more robust empirical analyses. But we’re fairly confident in our speculation, and this has led us to accept that we are in a Keynesian moment, or more accurately, two Keynesian decades with a Minskian moment in the middle. In such an environment, where private sector expectations are pessimistic, the optimal response is for the public sector to pick up the slack in consumption, investment, and intermediation, within the constraints set by inflation expectations (granted, inflation is a messier issue in a world where the USD is the global reserve currency, and based on a first cut view of today’s budget, we believe our tradable goods inflation thesis is back in play).

The Obama budget appears to pick up a healthy measure of private sector slack, and should thus be favorable overall for employment, asset prices, and economic output. The inflation issue will be far more slippery: on the one hand, a well designed federal budget gives the Fed more room to tighten, as private sector expectations improve; on the other, fiscal direction is uncertain, especially beyond 2011, and prone to shocks, so central banks will have to be rather nimble (more nimble than they were in 2003-05 and 2008) to avoid taking an overly easy or tight approach to policy.

Obama’s proposed tax increases on high income households will cause some resentment, but it’s hard to see how the income disparity pendulum could keep swinging on its current arc. The administration might also believe that higher tax rates on higher incomes will be supportive of state and municipal debt financing. We’d feel better about it if there were an accompanying reinvention of the corporate tax code, as we believe that would have some positive second and third order effects on lower and middle class incomes; first order effects could be achieved by instituting a payroll tax holiday as Warren Mosler has suggested.

Unfortunately, we place a zero probability on corporate tax reform happening any time soon (the budget calls for increasing taxes on certain sectors of the economy), and a near zero probability on a long payroll tax holiday. Despite that, the President’s budget does brighten the economic outlook a bit for 2H2010 and 2011, and the possiblity of a double dip might have been pushed back to 2012 or 2013 (which clearly calls the semantics of ”double dip” into question).

URLs:

http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm

http://faculty.wcas.northwestern.edu/~yona/research/Multiplier-version12.pdf 

http://www.whitehouse.gov/omb/blog/10/02/01/Introducing-the-2011-Budget/

http://654advisors.com/idlespeculation/20100112.pdf

http://654advisors.com/idlespeculation/20091109.pdf

http://research.stlouisfed.org/fred2/graph/?chart_type=line&s[1][id]=ASLPITAX&s[1][transformation]=pc1

http://research.stlouisfed.org/fred2/graph/?s[1][id]=CBIC1

http://research.stlouisfed.org/fred2/graph/?chart_type=line&s[1][id]=NRIPDC96&s[1][transformation]=pc1

http://en.wikipedia.org/wiki/Minsky_moment

http://moslereconomics.com/2010/01/28/tea-party-plan-for-dems-cut-to-the-front-with-tax-cuts/

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. Symmetry Capital Management, LLC is an Amazon.com associate, and earns a commission on sales generated through links from our website. At the time of writing, the firm, its principals, and its clients did not own any securities mentioned, or any securities issued by entities mentioned.