A brief “What happened?!”

It was a tough day in major equity indices yesterday, with the S&P 500 down over 2%.

We don’t think it had much to do with the Senate’s lengthy grilling of Goldman Sachs executives. Rather, it was mostly about the continuing sovereign crisis in Europe, especially Greece and Portgual. We think it might also have been helped along by President Obama’s remarks on deficit reduction earlier in the day, though that’s a much more controversial assertion. 

On top of Germany’s continuing hard line on support for Greece, S & P substantially lowered its ratings yesterday on the sovereign debt of Greece and Portgugal. Such actions lower the price that buyers are willing to pay for their debt in the market place. The resulting price adjustments are often exacerbated by rules governing institutional portfolio holdings and bank capital, as multiple large sellers head for the exits simultaneously. Momentum driven speculators might play a role as well. 

In turn, lower bond prices mean higher bond yields. For example, if a bond with a $100 face value pays an annual coupon of $5, its stated yield is 5%. But if the best price the bond can fetch is $50, then the yield rises to 10%, or $5 divided by $50. The yield to maturity on such a bond is even higher, since the holder eventually receives the $100 face value at maturity. 

This is trouble for Greece because a large slug of its sovereign debt matures this year, meaning that it will have to pay an exorbitantly high price (in terms of interest rates) on its new debt. If those rates are high enough that default or insolvency become inescapable, then current bond holders may not be able to recover the full face value of the bonds they own. There’s been a good deal of talk about debt restructuring, which is basically a process aimed at helping a debtor avoid a worst case outcome while containing the total damage done to creditors.

Importantly, the price adjustments did not just hit Greek and Portuguese debt, but also that of Ireland, Italy, and Spain. It’s more than a little ironic that dithering by the same governments that want banks and nations to shore up their balance sheets is having the exact opposite effect. And if that dithering continues long enough for full blown contagion effects to take hold, then the threat of the euro payments system locking up will become too large to ignore. That’s the very thing that the USD payments system faced in the wake of Lehman’s collapse and AIG’s near collapse in 2008, and which U.S. policymakers took such drastic measures to avert. Could Greece prove to be the eurozone’s Lehman, or at least its Bear Stearns? [Update 4/28/10 - We just noticed that Marshall Auerback asked a similar question on April 12th]

Ironically, Germany’s Angela Merkel has claimed that the primary motive for her country’s intransigence is to preserve the eurozone. And yet the current EMU is essentially what they’ve anted up in the high stakes game they are playing with Greece and other eurozone governments.

While we’re not huge fans of the credit rating agencies, especially given their track records during the mortgage crisis and during the twenty year bull market in Japanese government bonds, yesterday’s announcement might actually have some value when all is said and done, as long as the markets’ severe reactions act as a wake up call to European leaders. The news flow today seems to support that thesis, though only time will tell.

Meanwhile, President Obama’s remarks reminded us that the threat of premature fiscal tightening in the U.S. is still in play. We think that his call to cast a critical eye upon all federal expenditures and carefully address longer term structural deficits is absolutely appropriate (just as we think it’s fair for the German electorate to raise similar questions about Greece). However, we’re concerned that he might be a victim of the same budget surplus fetishism that has gripped many Democrats since the 1990s.

For example, he repeated, as erroneously as ever, that the federal government’s budget is like that of any family. But in fact, the federal government’s budget is more properly thought of as a complement to family and private sector budgets in the U.S. For example, if the private sector desires to increase it savings, the public sector should run larger deficits, all else equal. And if the public sector does not fully accomodate this desire, one likely result is higher private sector leverage (debt). We’re careful to point out that this dynamic is complicated by global effects — but it should still sound familiar to anyone who was awake during the past decade or two.

Amazingly, the same budget fetishists who continue to decry ”crowding out” effects in borrowing ignore those same effects when it comes to saving. 

Until the President and policymakers demonstrate a better grasp of this, our call for long term USD strengthening remains on the table. And if stringent fiscal reforms are accompanied by a Fed tightening cycle, watch out. This isn’t likely to unfold until 2012-2013 (late 2011 at the earliest). However, it’s important to point out that underlying demographic cycles have the potential to make things all the worse, perhaps along the lines of a 1937 redux.  

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, some of the firm’s clients own shares of Alpha Bank (ALBKY), National Bank of Greece (NBG), and Currencyshares Euro Trust (FXE). One of the firm’s principals owns shares of Goldman Sachs (GS). The firm, its clients, and its principals do not hold any positions in Lehman Brothers, AIG, or the debt of any sovereign issuers mentioned.

URLs:

http://preview.bloomberg.com/news/2010-04-27/greece-s-junk-contagion-pressures-eu-to-broaden-bailout-after-market-rout.html

http://www.newdeal20.org/2010/04/12/the-piigs-problem-maginot-line-economics-9697/

http://seekingalpha.com/article/200708-greece-will-have-the-last-laugh

http://www.newdeal20.org/2010/03/30/greece-and-the-eurozone-angie-aint-it-time-to-say-goodbye-9235/

http://www.cnbc.com/id/15840232?video=1478940638&play=1

http://www.whitehouse.gov/omb/blog/10/04/27/Laying-the-Path-to-Fiscal-Responsibility/

Good column by Ron Rhoades

 Good column by Ron Rhoades on RIABiz.com, in which he predicts what types of financial reforms might come out of Congress in the current session. He echoes some concerns we’ve raised (emphasis added):

There are many parts of the overall financial services reform legislation that are incremental improvements over what we have today, and which should be supported. I hope the upcoming amendments will address “too big to fail” and reduce the perverse compensation incentives which tend to drive improper risk-taking activities.

I am deeply troubled, however, by the lack of oversight of all credit default swaps and other forms of derivatives. There are likely to remain many gaps in regulation which can continue to be exploited.

Additionally, much of the bill appears to fragment, rather than to consolidate, banking regulation. Regulation needs to be robust – to paraphrase James Madison, if securities industry participants were all angels, regulation would not be needed. But regulation also needs to be efficient. Our country cannot afford inefficient regulation of the same functional areas through duplicative, often over-lapping agencies.

This point, on disclosure as panacea, was particularly interesting, and lends some support to our call (and others’) for bringing basic financial education (legal might be a good idea too) into primary education:

The fundamental problem is that the SEC continues to emphasize disclosure above all else. While I support better disclosures of compensation practices and conflicts of interest, we must be realistic in what disclosure can accomplish. Disclosures are usually ineffective, as research into behavioral biases has demonstrated.

Today the financial world is far more complex for consumers than it was in 1940. Hence, disclosures utterly fail to overcome the huge “knowledge gap” between financial advisors and their clients.

The full column is available here: http://www.riabiz.com/a/748005?subscribed=true

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

Paul Ryan’s floor speech

As most of the country knows, the House of Representatives passed its latest version of healthcare reform yesterday, and emotions are running high on all sides as a result. Rep. Paul Ryan, a Republican from Wisconsin whom we sincerely admire, seemed to best embody his party’s core philosophical objections to the bill. Unfortunately, too many of the GOP’s arguments are stubbornly anachronistic and overly narrow. They don’t fully reflect the realities of healthcare, and they conveniently overlook the fact that we have had ‘socialized’ medicine in this country for quite some time – since Medicare and Medicaid became laws, and since the tax code and other regulations began to favor group insurance plans.

Our intent isn’t to cheer or take shots at either side. Instead, it’s to raise the level of discourse, something that neither party nor the press has done very well. With an issue as complicated and important as this one, political maturity is a must, and truth telling from leadership is absolutely vital.  Unfortunately, Ryan’s speech was riddled with shallow thinking and empty slogans. Perhaps that suited its purpose, but it does little to move the debate or the electorate in constructive directions.

At 1:45 of the video:  “Our founders got it right, when they wrote in the Declaration of Independence that our rights come from nature and nature’s God, not from government.”

For tens, perhaps hundreds of thousands of years, and in almost every part of the world, invoking divinity is how the powerful have justified their position (they still do in some parts of the world). So Jefferson may simply have been speaking the English monarchy’s language when he wrote that in the DOI.

More seriously, in today’s world, rational people ought to be able to agree that political rights are absolutely defined and managed by governments. The classical liberal principle of doing no harm to others is a great starting point, but the philosophical or religious beliefs that inform one’s political philosophy are not in and of themselves “rights”.

In fact, in a society of diverse religious and philosophical views, it’s absolutely vital that a government does just that.

1:57 “Should we now subscribe to an ideology where government creates rights, is solely responsible for delivering these artificial rights, and then systematically rations these rights?”

Government does indeed create rights. It defined and allocated them in the Constitution without any mention of God as a source. And it has amended and reallocated them many times since. Calling them “artificial”, as in man made, is no more meaningful than the typical PETA slogan, or the idea that human creations, good and bad, are somehow ‘unnatural’.

And political institutions absolutely ration individual rights. They always have, all the way back to our hunting and gathering days, so it’s an idea that we really ought to be used to by now. The challenge is to hold governments accountable for doing it in a way that approaches some social optimum. That’s what the Constitution has done rather well over two centuries, and it’s something that modern political institutions have tended to become more adept at over time.

2:09 “Do we believe that the goal of government is to promote equal opportunity for all Americans to make the most of their lives? Or do we now believe that government’s role is to equalize the results of people’s lives?”

Long ago, the federal government enacted some stupid ideas on how to finance health care coverage. For generations, those ideas have benefitted employees of large corporations, unions, and public sector employees. They have been subsidized, either through higher premiums, greater personal risk, or less health care, by the self-employed and entrepreneurs (which may be why politicians always try to kiss their rear ends), as well as those who do not qualify for private insurance coverage, Medicare, or Medicaid. From the get go, these ideas have promoted INEQUALITY.

Healthcare reform is aimed, in part, at finally addressing this situation, a situation that has stood in stark contrast to the principle of equal opportunity. Over the years, the GOP has developed some good ideas on this issue, but in session after session, they utterly failed to do anything about it. They punted repeatedly until the situation got bad enough that the Dems were finally able to run the ball down their throat. Tua culpa, GOP.

Furthermore, this legislation can’t be said to seek equal outcomes, and Ryan surely most know that. It does seek to extend the social safety net, i.e., to redefine the acceptable minimum outcome in personal health care coverage. It also seeks to impose responsibility, in that everyone must chip in in some way. Personally, I don’t care for that kind of thing, and I know I’m not alone in that. Compulsory anything tends to rub Americans the wrong way.

Unfortunately, as long as there is Medicaid, and as long as health care costs of the uninsured are borne socially (via welfare or higher costs for others), it doesn’t make any sense to avoid a minimum level of buy in. It’s similar to having to carry liability coverage on your automobile, except that we are all physical bodies, and thus all have to participate.

If that really rubs you the wrong way, you have a few options:

• Start working on the technology that will provide the bodily equivalent of mass transit and other alternative modes of transport.
• Work to repeal Medicaid (why not Medicare while you’re at it?).
• Move.

2:24 “The philosophy advanced on this floor by this majority today is so paternalistic, and so arrogant. It’s condescending. And it tramples upon the principles that have made America so exceptional.”

Both parties have been guilty of arrogant, condescending paternalism throughout their history. I’m not sure what makes this bill so special. And if we look at the trajectory of American greatness, it’s hard to say that it’s based solely on founding principles (though they’ve certainly made it possible, along with plenty of luck).

Did the U.S. become more exceptional or less after the Progressive movement, the New Deal, and the Great Society? My point is not to sing the usual lefty praises for those episodes, but to point out that they do not seem to have undermined American exceptionalism at all.

3:18 “As we march towards this tipping point of dependency, we are also accelerating toward a debt crisis, a debt crisis that is the result of politicians of the past making promises we simply cannot afford to keep. Deja vu all over again…It’s unconscionable what we are leaving the next generation.”

First I’ll note my love for Yogi Berra quotes. Then I’ll reiterate that there is no U.S. debt crisis.

We do have entitlement and dependency issues to face as a society. But the federal budget is unlike any other budget in our country. It’s not like personal, household, business, or state and local government budgets. In the world, the only budgets that operate in a truly similar fashion are Japan’s and the United Kingdom’s (and in a far more constrained fashion, the European Monetary Union’s). Japan is about ten years ahead of us on the demographic curve, and its net public debt has reached levels that all the deficit hawks in the U.S. now shudder about. What happened? Nothing – no debt crisis, no threat of default, no crowding out. Nothing but a handful of downgrades from the credit rating agencies, and trading floors littered with the bodies of almost two decades worth of misguided hedge fund managers.

And the worst debt to GDP projections, even if we overlook the uncertainty involved in forecasting a decade or more, don’t reach any kind of level that justifies the prevailing deficit anxieties — not for a large modern economy with monopoly power over issuance of the currency used to pay interest on and retire its debts. Until people no longer want to accept dollars (and it’s easy enough for anyone to test out that hypothesis), the government can create more of them. In other words, unlike the rest of us, the only budget constraint faced by the federal government is the socially acceptable level of inflation.

Finally, without proper context, the ‘debt on the backs of our grandchildren’ meme is so much claptrap. If more debt now means better economic outcomes overall, then we are imposing severe opportunity costs on future generations if we do not run larger deficits.

That said, it may be true that health care reform does not represent a social investment with positive ROI. It may also be true that simply rectifying distortions and making the system fairer could have been accomplished with far less than what this bill contains. The electorate has a little over seven months to reflect on it before rendering its judgement in November, and as we’ve noted here and here, this issue deserves a lot more philosophical honesty than it’s been getting. It’s difficult, complicated stuff, with no right or wrong answers – only some as-yet-unknown social optimum, which our sometimes messy political processes are helping us grope our way towards.

URLs:

http://www.youtube.com/watch?v=lwk1aHU-pms

http://www.newdeal20.org/2010/02/10/the-federal-budget-is-not-like-a-household-budget-heres-why-8230/

http://654advisors.com/index.php/blog/2009/07/should-health-care-be-a-right/

http://654advisors.com/index.php/blog/2009/07/ryan-what-does-it-look-like-in-september/

How do you spell W-I-M-P-Y?

First Congressional jobs bill of 2010 has cleared the Senate:

Senate Democrats Wednesday delivered the first of several promised election-year jobs bills, passing a measure blending tax breaks for companies that hire unemployed workers with highway funding eagerly sought by the states.

The bipartisan 70-28 vote to pass the bill sends it to the House, where many Democrats say it is too puny…

We tend to agree with the House Dems. Among the bill’s measures:

Democrats promise additional measures to create jobs, promising help for small businesses having trouble getting loans, aid for cash-strapped state governments, and subsidies for people who make their homes more energy efficient…

The bill contains two major provisions. First, it would exempt businesses hiring the unemployed from the 6.2 percent Social Security payroll tax through December and give them an additional $1,000 credit if new workers stay on the job a full year. The Social Security trust funds would be reimbursed for the lost revenue.

Second, it would extend highway and mass transit programs through the end of the year and pump $20 billion into them in time for the spring construction season. The money would make up for lower-than-expected gasoline tax revenues…

And the reason it is so wimpy:

But budget deficits are a worry, and future measures are going to be more difficult to pass — especially since a top Senate Democrat has blocked unused authority from the Wall Street bailout program from being used to “pay for” jobs initiatives…

Sen. Judd Gregg of New Hampshire, top Republican on the Senate Budget Committee, blasted the measure for increasing the budget deficit to fund highway and transit programs. He said the measure made a joke of Democratic promises to adhere to “pay-as-you-go” budget rules requiring new spending programs to not increase the deficit.

“I don’t think you get people back to work in this nation by loading more and more debt onto the next generation,” Gregg said.

Sen. Gregg seems like a good man, but he just doesn’t get the underlying economics (unless he believes that the private sector is in robust shape and capable of standing on its own, which means he’s looking at different data than we are). And as we continue to point out, if he and other budget hawks are wrong about the underlying economics, then they are actually going to leave “the next generation” in even worse shape than they would be with more concerted stimulus.

Mark Zandi is cited as estimating that the Senate bill will create roughly 250,000 jobs. That number is unlikely to even make a perceptible dent in structural unemployment. By our back of the envelope calculations, the Senate bill will add about half a percentage point to GDP under the most optimistic assumptions.

We’ll close by calling again on correspondent J. Wellington Wimpy:

“You will gladly pay me today for a job that might be created tomorrow.”

URLs:

http://news.yahoo.com/s/ap/20100224/ap_on_bi_ge/us_congress_jobs

http://654advisors.com/index.php/blog/2010/02/the-hawks-are-circulating/

The hawks are circ(u)l(at)ing

Two interesting and somewhat discouraging trial balloons have been floated by the Senate recently:

Schumer-Hatch payroll tax break

First, in a NYT op-ed, Sens. Schumer and Hatch propose a payroll tax credit for employers who hire someone who’s been out of work for 60 days or more. This is intended to be a much simpler approach than the disastrous jobs tax credit of the 1970s:

…any private-sector employer that hires a worker who had been unemployed for at least 60 days will not have to pay its 6.2 percent Social Security payroll tax on that employee for the duration of 2010. The Social Security trust fund will then be made whole with spending cuts elsewhere in the budget between now and 2015. That’s it. Simple to understand, and easy to explain.

Simplicity is a reasonable objective, but as described, the proposal is NOT going to stimulate a return to full employment, because it’s fiscally hawkish, i.e., it aims for budget neutrality. Thus, the net economic effect is likely to be somewhere around nil, give or take.

It also gives no payroll tax break to the newly hired employees! That is NOT likely to play well to a frustrated electorate. Warren Mosler’s version of a payroll tax holiday would be fairer and much bolder. As he framed it at a recent Tea Party get together:

I believe that the surest engine for full economic recovery is a full payroll tax holiday. Payroll taxes take away over 15% of everyone’s paycheck, from the very first dollar earned. This is big money- about $1 trillion per year. Half comes from the employee and half from the employer. A payroll tax holiday does not give anyone anything. What it does is stop taking away $1 trillion a year from working people struggling to make their payments and stay in their homes, and businesses struggling to survive. A full payroll tax holiday means a husband and wife earning $50,000 a year each will see their combined take home pay go up by over $650 a month, so they can make their mortgage payments and their car payments and maybe even do a little shopping.

In their op-ed, the Senators also claimed:

Our two-pronged approach would be a far more efficient use of taxpayer dollars than other proposals under discussion, all of which could cost many times more with very little guaranteed improvement in unemployment. [emphasis added]

Taking care to use taxpayer dollars efficiently is a wonderful thing when resources are fully employed and there are sufficient dollars in circulation. But in the prevailing environment, it’s far too hawkish. As some have noted, the key factor that will incentivize hiring is for businesses to see signs of improving demand; tax breaks like this one are unlikely to have more than a marginal effect. And as long as Congress is stingy about deficits and about where taxpayer dollars come from, it could merely reallocate existing resources, rather than raise overall employment.

The entire idea brings to mind the old Hefty Bag jingo: WIMPY WIMPY WIMPY!!!

Senate jobs bill

Second, Senate Democrats have been circulating a comprehensive jobs bill that includes the Schumer-Hatch proposal. Positive features include extension of unemployment benefits and subsidies. More questionable are the extensions of various expired tax provisions through the end of 2010. Like financing federal expenditures with existing “taxpayer dollars”, sunset provisions will tend to offset any stimulative effects of ‘stimulus’.

From the proposed measures in the bill, it looks like members of Congress, especially Senators, believe that their reelection prospects hinge on budget and debt hawkishness. That might well be true, given that our educational system has done a lousy job teaching economics for generations. If that’s their angle, then they’re as bad as their policy ideas: WIMPY WIMPY WIMPY!!!

It’s estimated that the bill would create 80,000 to 180,000 new jobs in the coming year. We would need 180,000 or so per month to meaningfully reduce unemployment. Taking secondary effects into account, the typical employment multiplier falls in a range of roughly 2 to 4. That means that the overall impact on employment would range from 160,000 to 1.44 million new jobs in 2010. This would make less than an 18% dent in the number of jobs lost in this recession! [We've assumed that multiplier effects are not accounted for in that number; if they are, the package is even more pathetic.]

Admittedly, we’re leaving out private sector employment and the related multipliers, and 1.44 million new jobs would still be a good thing. But the glaring problem is that policymakers seem to believe that the real economy is in the kind of shape it’s been in since the mid-1980s, and that it will do just fine with the federal government contributing a net 20% or so to economic activity. We strongly disagree, and would point out that policymakers in Japan made the same error over their two lost decades. Policymakers need to dramatically raise expectations in the private economy, whether it’s through spending, tax cuts, or a combination of both. Wimpy proposals are not going to get it done.  

If the Senate bill is as good as we get, then our strong dollar call remains in place, and incumbents could face some rough sledding in November. The Obama administration is reportedly trying to work some better features into the bill, but most of them have an undeniable fiscal wimpiness to them, and thus won’t do much to alleviate the stubborn shortage of dollars, income, and employment in the real economy.

As J. Wellington Wimpy might say, “You will gladly pay me today for a job created tomorrow.”

Update 2/14/2010 – Perhaps this description of neo-Keynesian economics explains the cruelty of Hatch-Schumer:  “Tax cuts can deepen a recession if the short-term nominal interest rate is zero, according to a standard New Keynesian business cycle model. An example of a contractionary tax cut is a reduction in taxes on wages. This tax cut deepens a recession because it increases deflationary pressures.”  Good grief. The honorable gentlemen should note that this is just economic theory, which is far from settled (and that economists are probably not a good source of reelection advice). 

URLs:

http://www.nytimes.com/2010/01/26/opinion/26hatch.html?scp=2&sq=orrin%20hatch&st=cse

http://moslereconomics.com/2010/02/04/dallas-address/

http://www.webcpa.com/news/Senate-Democrats-Jobs-Bill-Includes-Tax-Breaks-53257-1.html

http://news.yahoo.com/s/ap/20100210/ap_on_bi_ge/us_what_jobs_11

http://www.newyorkfed.org/research/staff_reports/sr402.pdf

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.

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.

I’ll see your PAYGO and raise you a double dip

A key objective raised by President Obama in his state of the union address was to address the ‘fiscal hole’ of the federal government. His rationale was that “like any cash strapped family, we will work within a budget to invest in what we need and sacrifice what we don’t.” he asked Congress to reinstate PAYGO, which reportedly helped the federal government “record surpluses in the 1990s,” and advocated investing in people “without leaving them a mountain of debt.” He closed on this point by saying that it’s just common sense.

Culturally, these ideas resonate with Americans. And for a business or household, budget constraints are a matter of common sense (even though we don’t always adhere to them). But there is no budget constraint on a government that can create money, i.e., non-interest bearing debt, out of thin air. The only meaningful constraint to the level of non-interest bearing debt is inflation, which occurs when a government creates more money than the economy requires, causing its non-interest bearing debt to lose value against most goods and services. Thus, while it may score some political points (thanks to our primary educational system’s lack of a financial and economic curriculum?), it’s absurd for the president to embrace the common sense that households and businesses use in setting budgets. The federal government faces an entirely different kind of budget constraint.

Instead, given the government’s power to create money, common sense would hold that the amount of money supplied to the economy should be equal to the amount of money required by the economy (please note, this simplification is not an attempt to resurrect the policy prescriptions of old school monetarism). Thus, the proper approach to budgets at the federal level is to ask whether there is currently a surfeit or deficit of USDs in our economy. Given the number of private financial commitments that were entered into in the past decade, and dramatic declines in economic activity, it’s difficult to argue that there’s currently a surfeit of dollars. And if recent political rhetoric is any indication, dollars are likely to become scarcer in the years ahead (it would be ironic if, instead of inflation, deflation became the motivating force behind a move away from the USD as global reserve currency).

The president did set forth some positive ideas, such as a zero capital gains tax on small business investment, capital investment incentives for companies of all sizes, and infrastructure investment. Assuming these are financed at least in part by new money creation, they would help to prevent a renewed liquidity crunch. But to the extent that they are “offset” by cuts or freezes elsewhere in the name of closing fiscal gaps and filling in budget holes, or by higher taxes on other activities, the net short term effect on the economy will be nil or worse. And like Japan, we’ll be in for our second lost decade out of two. As we’ve pointed out, leaving future generations without a “mountain of debt” sometimes means leaving them with equivalent (or greater) opportunity costs. We should strive to avoid both of those outcomes. To do so, we have to rethink the cultural common sense that debt is always and everywhere to be avoided.

From an investing standpoint, if vigorous policy actions follow the path being laid out by the rhetoric and “common sense” emanating from so many quarters, then the USD will continue to strengthen, the real economy will stagnate or weaken further, and nominal asset values will fall for all but the highest grade government paper. In that scenario, we would be lucky to tread water and leave only 16% of the country underemployed.

Mr. President, I’ll see your PAYGO and raise you a double dip recession.

RELATED READING (file under confirmation bias): 

We’re well aware that our current view of things puts us shoulder to shoulder with some members of the “loony left”, but the macroeconomics of this stuff are fairly straightforward. Our lonely wing nut sojourn continues, placing us in lockstep with one Mr. Paul Krugman: http://krugman.blogs.nytimes.com/2010/01/26/obama-liquidates-himself/.

The Fed is seeking an exit strategy from its liquidity programs and low interest rate policy. The impact of that exit can be either muted or amplified by Congressional actions. If Congress becomes hawkish, there is no reason for the Fed to do so. If they both begin tightening, it’s hello 1937: http://www.bloomberg.com/apps/news?pid=20601015&sid=aXeUAV7_bz_o

An excellent idea from Warren Mosler — a full payroll tax holiday — that has yet to fall on the radar of federal policymakers: http://moslereconomics.com/2010/01/28/tea-party-plan-for-dems-cut-to-the-front-with-tax-cuts/. Here’s how Mosler describes the cause of poor economic policymaking: “…so-called economic experts have confused themselves and their political masters with contrived explanations for the way the economy works, and their limited vision has limited the range of policy choice. The result has been a monumental economic and social disaster caused by an obvious shortage of aggregate demand. The spending power needed to make mortgage payments, car payments, and do a bit of shopping- all of which would fix the economy and end the financial crisis- just isn’t there.”

Marshall Auerback writes that “Any kind of spending cuts in the middle of the worst recession since the Great Depression is insane.  What we are beginning to see is the return of Herbert Hoover and the ‘liquidationists.’” http://www.newdeal20.org/?p=7731

Ed Harrison posts an email exchange with Auerback, in which the latter wrote: “What the US government is now in danger of repeating is taking its economy down the fast track to a double-dip recession.  With investment still flat, consumers trying to increase their saving ratio and net exports making a negative contribution to growth – the President and his advisors evidently believe the persistently high unemployment is something the private sector has to deal with.”  http://www.creditwritedowns.com/2010/01/what-president-obama-can-do-to-improve-the-economy.html. As we’ve noted elsewhere, the demographic research of folks like John Geanakoplos, Diane Macunovich, and Ajay Kapur implies that for the next decade, the U.S. private sector is not going to behave as the baby boomer decades have conditioned us to expect. Hence the case for a more activist — and just as importantly, ‘self-financing’ – public sector. ‘Self financing’ today means the Federal Reserve creating the dollars that enable primary dealer banks to absorb Treasury offerings at auction via direct bids.  For that process to continue, the federal government must continue to issue debt, rather than shoveling dirt on the people and institutions that are still near the bottom of our deep ’fiscal hole’.

Jonathan Zasloff writes (TOH Krugman) that “At some point someone must make an argument for government.” http://www.samefacts.com/2010/01/politics-and-leadership/obamas-self-inflicted-lobotomy-proceeds-apace/  Why are Democrats today so afraid to make that argument? Like the health care debacle, could the lessons learned in the Clinton years be ill suited to today? As for the GOP, our take is that by harping on government in all its forms (besides those forms that help favored firms and industries collect their share of rents from the rest of us, of course), Republicans leave the door open to the development of increasingly socialist policies. In fact, if our take on the state of the private sector in the coming decade is accurate, they will practically mandate it.

State unemployment insurance tracker at Pro Publica (TOH Credit Writedowns) shows how critical federal government support currently is for many states: http://projects.propublica.org/unemployment/

George Soros thinks that premature budget tightening could be bearish for gold prices: http://www.telegraph.co.uk/finance/financetopics/davos/7085504/Davos-2010-George-Soros-warns-gold-is-now-the-ultimate-bubble.html. Reminiscent of Jon Nadler’s argument last fall against gold: http://654advisors.com/index.php/blog/2009/11/a-gold-bears-comments/

Finally, in what might be a mirror image of our loney wing nut position, Bill Gross seems to be exhibiting a profound case of anti-Keynesianism: http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2010/February+2010+Gross+Ring+of+Fire.htm