Double Dip or Muddle Through?

Double dip or muddle through? An increasing number of forecasters are calling for the former, but we’re now starting to lean towards the latter. The risk of a soft patch or even a period of negative growth has certainly been elevated over the last few months, but may now be receding. As is so often the case, public policymakers are still the actors on the margin, and ”muddle through” falls well short of galloping growth. But given the alternative,  it should feel just as welcome, and should offer some meaningful opportunities for investment and speculation.

Our take on the positive evidence:

• There are increasingly dovish fiscal signals coming from the Obama administration, including his stand (pdf) against premature fiscal consolidation at the G20 meeting this past weekend, and the resignation of OMB chief Peter Orszag, who like his old colleague William Gale at Brookings, is known to embody a hawkish approach to fiscal policy (as we’ve pointed out elsewhere, that approach may have been well suited to the Clinton era, but could prove toxic under current conditions). As one FT blogger put it, ”Barack Obama’s decision to sack General Stanley McChrystal this week drowned out news of the resignation of Peter Orszag, his star budget director, and the first of his cabinet members to step down. But the departure of Mr Orszag, who decided to resign partly in frustration over the absence of a tough plan to address America’s mounting national debt, may well come to be seen in retrospect as equally significant.” Not too long ago we penned the phrase “Thank God for Christina Romer,” which still holds true. A recent op-ed by her lieutenant Jared Bernstein indicates how additional stimulus measures will be sold to Congress, taxpayers, and the rest of the world. From the sounds of it, the days of shock and awe are over, but it’s still a better direction than concerted fiscal austerity. If we’re wrong, the U.K. should outperform the U.S. over the next several years.
• Voices of fiscal sanity — most notably Martin Wolf, in our view —  seem to be gaining some traction in the press. Even Forbes made space for an interview with Bob Lenzner, who argues (correctly we think) that Japan is the relevant example for policymakers and investors. And the recent America Speaks conference, which had started looking to us like little more than a Peterson Foundation trojan horse (their accompanying PR blitz became obvious when I awoke to our local NPR editor fawning over David Walker’s IQ!), attracted a fair amount of criticism and reportedly produced some surprising results.
• Though still playing its cards close to the chest, the ECB now appears to be supporting sovereign eurozone debt in a sustainable way. As Warren Mosler recently inferred, the ECB is managing the tensions between national finance ministers and eurozone industry on the one hand, and “money interests” on the other. Mosler has also keenly observed that if the ECB does in fact fully backstop eurozone government debt, this could be rather bullish for European equities, given that they appear to have priced in some degree of sovereign default(s). The wild cards at this point appear to be the length of the ECB’s commitment, what happens at the end of the stated commitment period, and what it does regarding sterilization.  Especially interesting to us is that the countries with the most upside in the coming decade are those on the periphery, including the notorious ‘PIIGS’.
• Real time indicators such as rail car loadings and trucking activity are still sending positive signals, and imply that Q2 GDP in the U.S. could surprise to the upside.
• Though the credit crisis (like periodic downgrades of Japan’s debt) has plainly revealed that we must take credit rating agencies actions with a large pile of salt, credit rating trends have turned positive for the first time since 2007. In addition, other than still stubborn yields on (and risk aversion to) European sovereigns’ debt, credit market indicators have calmed down notably since May and early June. And although we continue to expect the Treasury yield curve to flatten, its current slope still argues strongly against an imminent recession.

And the negative:

• A proprietary Hussman indicator is reportedly set to signal recession. Because it’s proprietary, we don’t know what factors it includes that might push back on a lower ISM reading. If it accurately signals recession, then we might indeed be heading into a period of negative growth, or at least a notable soft patch.
• Housing stinks of late, and it’s possible that the growth rate of rail car loadings and trucking will soon start to roll over; initial claims for unemployment insurance are still consistent with elevated single digit unemployment (i.e., muddle thru territory).
• Bond markets are still signalling growing deflation expectations and/or rising risk aversion. Self fulfilling expectations are possible, if bearish outlooks reach a tipping point that intensifies the demand for savings beyond what the public sectors of the world are currently willing to accomodate.
• There’s a widespread belief that the recent recovery is self sustaining and not due primarily to fiscal stimulus. This point of view ignores the essential meaning of fiscal multipliers, and on this point, we agree wholeheartedly with John Hussman, who recently wrote: ”Wall Street seems to have no concept at all that every bit of growth we’ve observed over the past year can be traced to government deficit spending, with zero private sector expansion when those deficits are factored out…In effect, Wall Street’s is seeing “legs” where the economy is in fact walking on nothing but crutches…If we fail to recognize that the “good news” reported over the past year is due not to a recovery in intrinsic economic activity, but instead to massive government intervention, we risk being blindsided as those synthetic effects gradually erode.” 
• There’s also a growing movement, primarily on the right, to cut public spending in order to boost growth. Proponents are citing the work of Harvard economist Alberto Alesina. However, as capable a scholar as Alesina is, there are two glaring problems with applying his  research findings to today’s world. First, it’s based on data from OECD countries over the period of the mid-1970s to the early 2000s. This period happens to coincide with the global financial and trade reintegration that followed World War II, and with the rise of the baby boomer generation in most developed nations (note that Japan is roughly ten years ahead on the demographic composition curve — its 1989 was our 1999). Second, it contains only instances where a single country or at most a handful of countries embarked on fiscal consolidation. Today, fiscal austerity is being pushed on public sectors in a majority of the world’s economies. The clear takeaway is that Alesina et al’s findings cannot be blindly applied to today; our current situation is far more reminiscent of Japan 1989-2009, and the world in the 1930s.
• A strong Republican showing in the November midterm elections could cause economic policymakers to commit the error outlined in the last two bullet points – a concerted withdrawal of fiscal support in the belief that the private sector recovery is self sustaining. If that happens, we would expect the Fed to ride to the rescue via quantitative easing and other unconventional measures. Unfortunately, that will make valuation and private sector investment more challenging at the margin. As we’ve pointed out previously, well designed (as opposed to politically expedient) fiscal stimulus can actually make room for the Fed to normalize monetary policy.
• Who will replace Orszag at OMB? Laura D’Andrea Tyson an interesting choice. Those suffering from blind political allegiance to the right won’t care for her (to the left should love her), but we think that her philosophical orientation is appropriate to prevailing conditions, as long as she doesn’t become a soak the rich crusader.
• State and local fiscal consolidation in the US continues apace. In fact, it has largely offset the direct contributions of the federal government to GDP in recent quarters. This is an area where Congress should be able to find some common ground on spending. The risk, as always is agency related. Obviously, not all public spending is created equal. Waste must be avoided and fraud must be punished severely. We continue to believe that the sanest way for the federal government to “spend” would be to enact a long term payroll tax holiday and an employer of last resort program. Tax code improvements would be wonderful as well. We can all dream…
• Imminent fiscal tightening in Europe, the U.K., and Japan could have negative spillover effects on financial markets and the global economy.
• Dislocations in non EMU countries of Europe could cause problems, especially given exposures within the eurozone banking system. Obviously the IMF would be on call, but how might that impact European bank capital, and how might the EMU and ECB respond, if at all?
• Low interest rates and, where applicable, continuing fiscal stimulus in developed nations will continue to create problems for faster growing economies. Watch things like food price inflation. This is tough for central banks and treasuries of emerging economies to manage, but they should be better equipped to do so than they were in the 1970s and 80s. This dynamic will also continue to have a push-pull effect on commodity prices.
• Along with the bullish behavior of Treasuries, equity market ”technicals” look scary — lots of dreaded “head and shoulders” patterns, and the possibility of a negative 50-day 200-day cross in the S&P 500:

Lining up the positive against the negative:

• We have pretty clear evidence that fiscal austerity in the U.S. is no longer imminent, which is a bullish development for the U.S. economy, employment, and asset prices. But that could change after midterm elections, and fiscal austerity continues to unfold at the state and local level and is imminent in other developed nations. If voices of fiscal sanity like Wolf’s continue to gain prominence, this should help. If the ‘cut spending now’ crowd carries the day, a double dip would become a virtual guarantee.  
• The ECB appears to be capably backstopping eurozone sovereign paper after all, though renewed stresses in the eurozone periphery and core, and/or in non-EMU Europe, could cause trouble. Most intriguing is that many European equities are priced for sovereign default. If that outcome isn’t realized, or is credibly postponed for a few years, then Mosler’s European equity call could be a good one.
• Real time indicators suggest that 2Q10 GDP in the U.S. could print well, but Hussman reports that his proprietary indicator is precipitously close to signalling recession.
• The Treasury yield curve is not signalling recession, but researchers have noted that yield curves have had little explanatory power in Japan since the BOJ faced the zero bound. Given how emphatic we are regarding the relevance of Japan’s experience and the direction of long term U.S. rates, that certainly gives us pause.
• Technical indicators give little comfort. However, an interesting idea among some analysts is to place more value on the KBW Bank Index (^BKX) than the S&P 500. That makes some sense, given that financial systems are at the heart of concerns over defaults and double dips. And that index paints a less dreary picture than the S&P 500. Though it’s still a challenging one, it looks more like a muddle through than a breakdown at this point:

Clearly, there are plenty of powerful cross currents at work for investors to mind. Our current investment stance:

• Cash offers no yield, but is the best hedge against deflation. It’s also important in volatile markets to keep dry powder on hand.
• We continue to expect yield curve flattening in the U.S. While the ten year may be a bit overbought for now, longer term Treasuries are still attractive, potentially offering a real “risk free” yield of three to four percent.
• We have taken off short gold positions, as (1) despite yesterday’s breakdown, the bubble trend still appears to be intact, and (2) both fiscal dovishness in the U.S. and the perceived risk of renewed central bank intervention (QE) should be supportive. We are considering long positions in far out of the money put options on GLD (conspiratorial rumors regarding the ETF’s actual physical holdings add an interesting wrinkle). Pair traders might also consider “retrieval” trades like short gold, long silver, although a double dip and/or deflation pose a risk to such strategies, especially if gold continues to be the primary hedge against QE and/or fiscal expansion.
• If our muddle-through-the-soft-patch thesis is correct, selective opportunitites in US cyclicals might be appropriate. Additional fiscal stimulus could conceivably be favorable to industrial services companies, for example. Thermadyne (THMD) continues to be a major holding in our Opportunistic Portfolio, although recent steel data causes some concern. Pike Electric (PIKE) is also a significant holding, but their clients’ expenditures have been frustrated by head fakes and uncertainty over government policies, including fiscal stimulus. Again, the cross currents are challenging. If we start to question our call against a double dip, we would hold or possibly pare back on these and/or other industrials and cyclicals. Also among cyclicals, it seems that Mr. Market has forgotten how far removed technology stocks now are from their 1999-2000 bubble. We continue to see some interesting values among small cap tech stocks.
• Splicing together the insights of Warren Mosler and Ajay Kapur, we are intrigued by eurozone equities, especially in PIIGS countries and parts of eastern and central Europe, including Russia. Market Vectors Poland ETF (PLND) is a core holding in our Opportunistic Portfolio, though we are cognizant of the heavy bank weighting of the index and the ETF, and the resulting risks to the upside and downside. We’ll develop this European equity theme in the days and weeks ahead, but with appropriate caution, given the continuing opacity around the ECB’s current intentions (as well as the looming ascendance of an even more hawkish successor to Trichet).
• Given how the fiscal outlooks have aligned globally, we’re not quite as bullish on the USD as we were early in the year, and now expect forex markets to muddle through for a bit as well. That said, it will be interesting to watch the British Pound and possibly the Euro as austerity measures begin to bite. If markets believe that central banks will stand firm, those currencies could strengthen. But if it looks like central banks will accomodate the anticipated side effects of austerity with lower rates or unconventional easing, then they’d be more likely to fall against the USD in our view. 
• The Japanese Yen provides a much more interesting case, and we’ve taken notice of its recent strengthening. Keep in mind that Japan is in the midst of a favorable turn in demographic composition, and at the end of a long period of private sector balance sheet repair, and both should be supportive of growth. That could pose a risk to the decades long role of the Yen as a funding or ‘carry trade’ currency. As in the 2008 crisis, renewed strength in the Yen could cause global dislocation. Thus, an ETF like CurrencyShares Japanese Yen Trust (FXY) might not be a bad hedge against riskier positions, including gold (though investors should always be aware of the consequences of their actions, even in hedging — a concerted move into Yen, which seems to be unfolding as I write, could help precipitate renewed market dislocation). And if higher growth and even inflation gradually take hold in Japan, as we expect, then the ’black widow’ trade of shorting Japanese government bonds might finally work. Of course, the deficit phobes will then rant and rave about how they were right all along, even as long rates continue to fall in other developed nations with rising debt to GDP levels; but we believe that the balance sheet and demographic recession explanations are a much better fit for the data.

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. At the time of writing, clients of the firm owned TLT, THMD, PIKE, PLND, FXY, EWJ, JSC, and/or FXY. The firm is long THMD. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

URLs:

http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/7857595/RBS-tells-clients-to-prepare-for-monster-money-printing-by-the-Federal-Reserve.html

http://www.whitehouse.gov/sites/default/files/rss_viewer/president_obama_letter_to_g-20_061610.pdf

http://www.ft.com/cms/s/0/8c4ade5c-80b9-11df-be5a-00144feabdc0.html

http://symmetrycapital.net/index.php/blog/2010/05/oecds-double-barrel/

http://www.ft.com/cms/s/0/b697d314-82e8-11df-8b15-00144feabdc0.html

http://www.ft.com/comment/columnists/martinwolf

http://www.forbes.com/2010/02/26/treasury-note-deflation-markets-streettalk-malpass.html

http://seminal.firedoglake.com/diary/55985

http://baltimorechronicle.com/2010/042810Ridgeway.shtml

http://tpmcafe.talkingpointsmemo.com/2010/06/27/in_deficit_town_meetings_people_reject_america_spe/?ref=mp

http://moslereconomics.com/2010/06/25/eu-daily-the-eu-is-on-a-financially-sustainable-path/

http://moslereconomics.com/2010/06/26/warning-massive-euro-zone-equity-rally-alert/

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

http://railfax.transmatch.com/ 

http://ceridianindex.com/news/release/pci-strikes-optimistic-note-for-us-economy-with-31-percent-gain-in-may/

http://www.bloomberg.com/news/2010-06-28/u-s-bond-upgrades-top-downgrades-for-first-time-since-07-credit-markets.html

http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/7857595/RBS-tells-clients-to-prepare-for-monster-money-printing-by-the-Federal-Reserve.html

http://www.ft.com/cms/s/0/8c4ade5c-80b9-11df-be5a-00144feabdc0.html

http://www.hussmanfunds.com/wmc/wmc100628.htm

http://seekingalpha.com/article/212145-john-hussman-recession-warning

http://globaleconomicanalysis.blogspot.com/2010/06/europe-slams-obamas-stimulus-plan.html

http://www.economics.harvard.edu/faculty/alesina/recently_published_alesina

http://blogs.ft.com/money-supply/2010/06/22/life-after-orszag/

http://www.bloomberg.com/news/2010-06-16/san-diego-may-use-bankruptcy-in-benefits-rollback-commentary-by-joe-mysak.html

http://www.econbrowser.com/archives/2009/04/the_yield_curve_6.html

http://www.minyanville.com/businessmarkets/articles/yahoo-tech-ticker-todd-harrison-eye/6/17/2010/id/28802

http://blogs.ft.com/money-supply/2010/06/22/life-after-orszag/

Hop Suisse! And why Spain will be OK…

Tough days for Spain — besides coming under pressure in credit markets, their ‘La Furia Roja’, a favored World Cup contestant, just suffered a shocking 1-0 defeat at the hands of Switzerland (we couldn’t help but notice that the Swiss goal looked like a typical Philadelphia Flyers goal, rough and ugly with bodies flying). ESPN reported a disturbing statistic about the number of teams that have won a World Cup after losing their first match, and it’s also been reported on SI:  “No team has ever won the World Cup after losing the opening match.” Not good news for the defending 2008 European Cup champs.

However, as long as its pending austerity measures don’t go so far as to create an old time Red Fury, Spain should be OK in the years ahead. As Ajay Kapur has pointed out, their demographic composition is shifting in a direction that looks very favorable to productivity, growth, savings, and investment.

URLs:

http://www.vanityfair.com/online/fairplay/2010/06/spain-la-furia-roja-the-red-fury.html

http://sportsillustrated.cnn.com/2010/soccer/world-cup-2010/writers/richard_deitsch/06/16/3thoughts.spain.swiss/index.html

http://www.thenagain.info/WebChron/EastEurope/OctRev.html

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

Markets continue to test our bearishness

Following on its rally of last week, the S&P 500 closed above its 200 day moving average yesterday for the first time since May 19th, continuing to put our bearish outlook to the test, at least in the short term:

While this can sometimes be considered a bullish sign, we’re still extremely cautious, for several reasons.

First, the underlying risks — primarily sovereign debt and interbank funding in the eurozone — have changed only marginally. It still looks as though the ECB’s interventions will only be temporary, and the core eurozone nations are still, for the most part, embracing concerted fiscal consolidation. Spain, which sports a much larger economy and national debt than Greece, is now the country on the margin, and is reportedly having a tough go of it, both in private and public sector credit markets. If and when asset values contract sufficiently, leverage in the continental banking system will transmit interbank shocks to the rest of the world.

Second, yesterday’s rally, though impressive in terms of percentage gain, was supported by rather low volume.

Finally, in the run up to the bear market leg of 2008-2009, the S&P 500 popped above its 200 day MA several times until early December 2007, when it was off to the races for the bears (and the pattern then, as now, was moves higher on lower volume, moves lower on higher volume):

Could we see another decline as vicious as the last? It’s certainly possible, but as we continue to point out, it’s within the power of policymakers, especially in Europe, to lessen or even prevent much of the damage. Unfortunately, they still don’t seem intent on doing that, their banks still appear to be highly levered, and that spells an eventual crisis in interbank funding markets and the global payments system. If that scenario unfolds, most asset values will be in for a rough ride, as they were in 2008 and 2009.

Like most snobby “fundamentalists”, we tend to reflexively distance ourselves from “technical” analysis, or the dissection of chart patterns. However, this is one of those periods when “getting technical” is helpful (or at least feels that way). We’re going to be watching stock markets’ shorter term moving averages in the days and weeks ahead to see what kind of clues they give about sentiment. For example, as long as the S&P 500’s 50 day MA can remain above its 200 day MA, its value should remain relatively stable, and we could even see some pretty nice gains into the fourth quarter (the right words, tones, and actions from policymakers could make that happen, we think). However, if the 50 day breaks down, we will become even more defensive, and where appropriate, help clients speculate more heavily on downside risk and/or update their ”shopping lists”.

In the latter case, we wouldn’t be surprised to see an eight handle on the S&P 500 again, at least for a quarter or two, and we’d only be somewhat surprised (and rather motivated to buy) if we saw a seven handle again. Investors should keep in mind that stock markets in Japan, whose demographic profile we follow by roughly a decade, was range bound for almost a full decade (1992-2000) until eventually moving lower.

On a related note, plenty of pundits and analysts (and even some inflation phobic policy makers) will continue to brow beat anyone who buys or holds U.S. Treasury securities at current levels, as interest rates surely “must” rise. We wouldn’t be so sure. If Japan’s experience is any guide — and there are compelling reasons to see it as such – longer dated Treasuries still have plenty of potential upside. In fact, 2010 marks the first time since 2001-02 that we’ve liked nominal Treasuries more than inflation indexed Treasuries as a long term asset. The only foreseeable development that would lead us to change our tune is another fiscal stimulus package of at least the size of ARRA. But if the mood of electorates around the world is any indication, and if the political forecasting models are accurate, then the GOP could score well in November, which would mean mean tighter federal purse strings, all else equal.

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. At the time of writing, neither the firm nor its principals own any securities mentioned, or any securities issued by entities mentioned. Some clients of the firm are long TLT and/or U.S. Treasury securities. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

URLs:

http://www.ft.com/cms/s/0/ebdbfc9a-78dd-11df-a312-00144feabdc0.html

http://symmetrycapital.net/index.php/blog/2010/06/is-bailout-and-stimulate-really-busted/

http://symmetrycapital.net/index.php/blog/2010/06/a-picture-of-the-great-moderation/

http://symmetrycapital.net/index.php/blog/2010/05/japan-not-greece-black-widow-ii/

http://symmetrycapital.net/index.php/blog/2010/06/a-must-see-chart/

USD strength and foreign credit growth

Back in January, we came across an interesting inverse correlation between the trade weighted USD exchange rate and the level of foreign financial commercial paper outstanding. Here’s the image we posted at the time, in which we wondered whether our strong USD call, if it were to prove accurate, would be associated with a contraction in commercial credit in the global economy:

 Sure enough, it has been, and visually, the relationship appears to be holding up:

From the lo0ks of it, foreign exchange stability would be good for the long term health of global credit markets. But that is currently a secondary objective (at best) of fiscal and monetary policy makers.

And while the decline looks eerily like the one that occurred in the midst of the recent recession, the year over year percentage change in foreign commercial paper does not look too dire — at least at this point:

URLs:

http://symmetrycapital.net/index.php/blog/2010/01/dollar-strength-foreign-credit/

Will current accounts be a wrench in EMU austerity plans?

New IMF research finds that current account deficits of “Southern Euro Area” (SEA) economies are likely “to remain high in the medium run.” This could spell trouble for the SEA economies in which it proves true, as it means that the entirety of austerity adjustments will by borne within those countries.

The IMF’s prescription? Tax hikes and spending cuts, of course:

Fiscal consolidation seems particularly appropriate if public saving is too low or monetary policy too lax, which may well have been the case for SEA countries. While SEA countries consolidated their fiscal position to enter the euro area, these efforts were not sustained to offset the strong declines in private saving and private investment booms that followed, leading to big current account deficits…Fiscal consolidation will remain crucial going forward, to reverse the extensive use of fiscal stimuli and automatic stabilizers during the crisis, to lower the public debt and reduce domestic demand pressure.

 

At least part of the fiscal recommendation makes sense:

Fiscal policy should also reduce or eliminate policies that may previously have been distorting private saving and investment decisions (e.g.33 Fiscal policy should also reduce or eliminate policies mortgage interest relief, favorable tax treatment of debt).

Other policy objectives recommended by the authors include structural reforms aimed at raising productivity, ‘internal devaluation’ via lower wage rates, and sounder financial regulation. Some good suggestions, some not so good, and all of them at least several years late.

Although the IMF study takes demographics into account in the form of population growth and current and future “old-age dependency” ratios, we’ll point again to an interesting wrinkle that few if any are paying attention to — shifts in demographic composition look positive in the SEA and a few other continental economies, but neutral to negative in core EMU countries. So there’s still a (seemingly outlandish) possibility that Greece, Portugal, and Spain will not only survive austerity measures, but actually end up in a notably stronger fiscal and/or economic position than Germany by the end of this decade.

URLs:

http://www.imf.org/external/pubs/cat/longres.cfm?sk=23940.0

http://symmetrycapital.net/index.php/blog/2010/05/europes-absolute-general-mobilization/

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

Is ‘Bailout and Stimulate’ really busted?

In a recent post, Eric Sprott argues that the ‘bailout and stimulate’ model of economic policy has been a spectacular bust in the U.S., Europe, and the banking sector.  We agree with the idea that bailout resources have been inequitably distributed in the U.S. and that rescue measures have been poorly designed in Europe.  However, our position is based on a very different view of the system dynamics at work.

Here’s Sprott’s underlying thesis, which we essentially agree with:

“Bailout and Stimulate” has been the rallying call for governments and central banks since the beginning of this financial crisis – and it has certainly had its impact over the last two years, but not the type of impact we need to propel real, sustainable growth.

He then offers some evidence in support, which we’ve critiqued below.

U.S. DEFICITS & GDP

For the U.S., he uses the following table to argue that “dimes” of incremental GDP are being “bought” for “dollars” of new public sector debt. First, we would point out that for any investment, a dime on a dollar (or 10%) is not a bad annual return.  Sprott mistakenly treats stimulus as analogous to a business expense. Properly done, it is an investment expense of the public sector. An up-front cash flow deficit is the definition of an investment, after all. 

And even by Sprott’s seemingly pessimistic analysis, a net impact of $215.6 B in marginal GDP on a net deficit of $2,481 B in deficit outlays produces a return of over 8% — about where we would expect it to be, given some estimates of fiscal multipliers under pessimistic conditions and low nominal interest rates. That’s nothing to sneeze at, and we’re almost certain that it has resulted in a more optimal economic outcome than would have occurred without it.

To get a better sense of the effects of ARRA and other 2009 measures, we might assume that their effects on GDP occurred with a lag, e.g., in 4Q09 and 1Q10.  Comparing the change in GDP in Q1 2010 ($37 B) plus Q109 ($53 B) to the 2009 cash flow deficit figure of $1,471 B, we get a two quarter return of 6%.  Admittedly, we’re assuming that the fiscal stimulus of 2009 (and the financial system support measures starting in 2008) enabled the private sector activity that constituted most of 4Q09 and 1Q10 GDP, so it’s crude and a bit aggressive. 

Using a more conservative calculation of $90B of GDP on $2,481 B in deficit stimulus since 2008 gives us an estimate of 3.6% over two quarters. Even using the more stringent $3T figure mentioned in Sprott’s article, from TARP’s inspector general, still gives us 3% over two quarters — and that’s with less than half of committed ARRA funds spent.  

If we extend that 3% figure over four quarters, we get an annual return of around 6%. Given that the Treasury currently pays a market rate of just over 3% per annum on its ten year debt securities, even straight debt financing looks like a no-brainer.

Again, this is admittedly crude arithmetic, but no more crude that that used by Sprott to trash the effects of stimulus.

COSTS OF vs RETURNS ON JOB CREATION

Sprott also points to estimates of the net return on job creation via stimulus measures. The Obama Administration estimated that each job resulting from stimulus measures would cost $92,000 and result in a $105,000 increase of GDP.  In other words, the estimated “multiplier effect” of stimulus was 105/92 = 1.14, or 14% on each dollar spent by the government.

Sprott then points to an empirical estimate for the actual cost of each new job created under ARRA as $117,933. If true, and if the Administration’s estimate of a $105,000 increase in GDP is accurate, then the resulting multiplier is 105/118 = .89, meaning that for every dollar spent, only eighty nine cents are recovered. Robert Barro shouldn’t start penning his Nobel acceptance speech yet though, as there are several problems with this analysis.

First and most obvious, Sprott has substituted for one Administration estimate (cost per job = $92K) without reassessing the other (marginal GDP per job = $105K).

Second, the figures for ARRA related job creation are as conservative as you can get. From the study cited by Sprott:

It is difficult to determine the number of jobs created from ARRA tax credits or higher levels of consumer spending from extended unemployment benefits. Jobs created or saved by direct contracts, grants and loans have been recorded each quarter, but the process has required a high level of judgment by those reporting on “jobs created or saved.” In the fourth quarter of 2009, the reporting guidelines were changed to emphasize jobs directly funded by the Recovery Act. Employment figures are now linked to hours worked in positions funded by the Act.

…this includes only the jobs associated with contracts, grants and loan spending, about one-third of the total stimulus program. Jobs created by tax credits or consumer spending due to COBRA or extended unemployment benefits are not included in this tally.

Third and most important, the study provides an unweighted average of each state’s cost per job. To a U.S. taxpayer, this is an utterly meaningless figure, unless each state received exactly 2% (1/50) of ARRA funds released. If you take the total ARRA dollars expended ($57.2 B) and divide it by the conservative number of jobs created (583,821), you get an average cost per job of $98,153 — only 7% above the Administration’s original estimates, and probably overstated given the conservative job counting method being used.

As we noted above, the Administration’s use of a 1.14 multiplier is probably conservative given the underlying economic conditions against which fiscal stimulus is being carried out, as some studies would put the figure closer to two under current conditions, and as high as three or even four under the worst of conditions (conditions which remain on the table, as long as policymakers around the world continue to agree with Sprott’s implicit view that the time for fiscal austerity is now at hand).

Of course, a multiplier of 1.14 is not reflected in the crude GDP numbers discussed above, which would need to be decomposed to get a better handle on the kind of multipliers that are actually at work.

The bottom line is that job costs appear to be in line with the Administration’s initial estimates, and that fiscal multipliers are positive, with returns well above the federal government’s cost of credit. In other words, there is absolutely nothing in Sprott’s data indicating that stimulus is somehow “busted” — quite the opposite, in fact.

We do like the last part of Sprott’s take on federal spending:

Rather than maximize spending, why not maximize actual employment by finding a way to produce a job for less than $92,000? Surely some of the fifteen million unemployed workers in the US would appreciate some help in that area.

As we’ve noted elsewhere, an ‘employment buffer stock’ or employer of last resort program, akin to the Civilian Conservation Corps under the New Deal, remains one of the most interesting and underexamined policy options for the federal government. It has also been touted in various forms by liberal, conservative, and heterodox (pdf) economists, and might go a long way towards easing some of the populist anger being felt towards large and powerful sectors of the economy that have enjoyed federal government largesse, in what has been, thus far, the Democrats’ version of “trickle down economics”.

EUROPE & LEVERAGE

Sprott then turns his sights onto Europe, first on the recent “bailout” fund:

In a show of force designed to impress the world markets, the European Union pieced together an unprecedented loan fund worth almost €1 trillion. The fund’s capital was made available to rescue euro zone countries in financial trouble. The European Central Bank announced it was ready to buy euro zone government and private bonds “to ensure depth and liquidity.” The US Federal Reserve, the Bank of Canada, the Bank of England, the European Central Bank and the Swiss National Bank announced that temporary US dollar swap facilities would be opened to provide liquidity. Never have so many organizations coordinated and contributed so much to a single bailout effort!

So what was the ultimate effect of this shock and awe campaign? After enjoying a short-lived obligatory rally, the market for stocks, bonds, and the euro (in terms of USD) traded lower by the end of the week.

He’s correct that the plan has had little if any positive impact, but overlooks the reasons. The key factor is the ECB’s stated intention to sterilize all interventions under the plan (as well as their meager and declining rate of purchases). This means that there will in fact be no actual relief provided to debtor countries, and thus no backstopping of troubled sovereign debt prices in anything beyond the short run. Markets seem to understand this and are reacting accordingly.

As we’ve previously observed, the knee jerk reaction to this argument is that monetization = inflation. But when a debt spiral deflation is in effect, it’s a long road between ‘disdeflation‘ and outright inflation. The real “shock and awe” of the eurozone plan is how shockingly incomplete its underlying assumptions are, and how awful its design and execution have been to date.

Sprott then fingers leverage in the banking system as the ultimate culprit, which we absolutely agree with, and his estimates of German bank leverage are far higher than the ones we recently sketched on the back of the envelope for the European banking system as a whole. His figures are IFRS based and thus more conservative than U.S. GAAP ratios, and one could argue that they are overstated to some degree. Nonetheless, their implication is clear: it will take only very small losses on highly levered banks’ assets to cause systemic insolvency and a payments system and counter party crash of the kind that we now believe is headed our way:

The German banks are not alone. Most large banks around the globe are operating with too much leverage. The governments can keep the “Bailout and Stimulate” game going, but it won’t amount to much in the long term unless the leverage issue is wrung out of the banking system. Until that happens, bailing out the banks is akin to pouring money down a bottomless pit.

That’s well said, and we do agree with the idea that concerted fiscal expansion must be accompanied by the implementation of sensible limits on global financial system leverage. There are simply no good reasons to allow high financial leverage — it serves the transient interests of financial executives, trading desks, and speculators at the (sometimes drastic) expense of everyone else. 

WHOSE MONEY? 

As with his take on fiscal stimulus, Sprott leaves a lot to be desired when he discusses the monetary aspects of government policy. He concludes with this gem (which to be fair, is how most people think about the subject):

The key point to remember with bailouts and stimulus is that it’s ultimately your money that the government is spending – and your children’s money.

The implication here is that the (non-bank) private sector produces money, which couldn’t be more wrong.  The private sector can only produce real goods and services, not money.  Of those goods and services, government will demand some amount as a consumer, and some amount in taxes.  Thus, money is simply an IOU — or non-interest bearing debt – created by the public sector, for which it agrees to extinguish private sector tax liabilities (it’s important to note that in the eurozone, this nexus between monetary and fiscal policies is largely absent — in the U.S., it’s as if there were a Federal Reserve, state and local governments, and no Treasury). 

To the extent that the availability of those IOUs exceeds (falls short of) demand, they are inflationary (deflationary).  In both cases, future economic outcomes are suboptimal.  In our current situation, where tax receipts and incomes are coming up short, deflationary signs abound in everything but gold, and governments around the world are preparing to compete intensely with the private sector for those IOUs with fiscal austerity measures, it’s inconceivable to us to think that flows of money — the non-interest bearing debt of the public sector — are not going to be in drastically short supply.

In this type of situation, with monetary policymakers constrained by the zero bound on interest rates, the fiscal lever becomes the clear and obvious choice for effective economic policy. Thus, concerted fiscal expansion, involving direct creation of money if necessary, is absolutely required if we are to avoid ten more years of muddling through or worse.

The bottom line is that against a backdrop of zero-bound monetary policy, well designed and executed fiscal expansion will leave us and our children better off, while fiscal retrenchment will leave us all worse off. Even Ben Bernanke* implied this in his Senate testimony yesterday, saying, despite his usual warnings about structural deficits, that “Right now is not the time to radically reduce our spending, or raise our taxes, because the economy is still in recovery mode and needs that support.”

Is “Bailout and Stimulate” really busted? We don’t think so. If anything, we need more of it, but we need to do it better — more intelligently, more openly, and more equitably.

*On a side note, we’re a bit concerned about the outlook for Bernanke’s tenure at the Fed, given his stated belief yesterday that the European sovereign crisis is likely to be “contained”. We just don’t see how another global payments system crisis can be avoided under the current policy measures being undertaken in Europe, and that’s an event that will have powerful impacts on the U.S. and global economies, and on global financial markets and asset prices. If he errs on this like he did with subprime mortgages, that’ll be two strikes against him — and it’s not clear whether Fed chiefs are entitled to three.

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. 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. Some clients of the firm are long FXP, GLL, TLT, and/or TWM. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

URLs:

http://seekingalpha.com/article/208687-a-busted-bailout-and-stimulate-formula

http://symmetrycapital.net/index.php/blog/2010/06/hussman-large-band-aids/

http://www.businessweek.com/news/2010-06-08/euro-area-fund-is-created-to-combat-debt-crisis-update3-.html

http://knowledge.wpcarey.asu.edu/article.cfm?articleid=1857

http://www.businessweek.com/news/2010-06-08/euro-area-fund-is-created-to-combat-debt-crisis-update3-.html

http://ideas.repec.org/p/wpa/wuwpma/9802006.html

http://www.amazon.com/gp/product/0674026942?ie=UTF8&tag=symmetrycapit-20&linkCode=as2&camp=1789&creative=390957&creativeASIN=0674026942

http://www.cfeps.org/pubs/wp-pdf/WP17-Wray.pdf

http://symmetrycapital.net/index.php/blog/2010/05/disdeflation/

http://symmetrycapital.net/index.php/blog/2010/06/disdeflation-revisited/

http://symmetrycapital.net/index.php/blog/2010/06/dissecting-headline-risk/

http://www.independent.co.uk/news/business/news/us-budget-deficit-is-not-sustainable-bernanke-warns-1996093.html

Dissecting “headline risk”

Financial pundits have been recycling a favorite meme from 2007-2008 – that despondent markets are responding to negative “headline risk” rather than positive fundamentals.  As in 2008, that’s an assertion that investors accept at their peril.  Here’s why:

First and foremost, with the sovereign debt crisis in Europe, we are not dealing with routine difficulties that can be worked out with minimal fallout to the global economy.  As with the failure of Lehman and AIG, these events will eventually, if unchecked, threaten to cause another sudden stop in the global payments system.  Trade and commerce will grind to a halt, however momentarily, as they did in late 2008.

Second, the shaky state of Europe’s sovereign dominos has some important similarities to the U.S. subprime crisis, the one that so many pundits and policymakers predicted would be “contained.”  Investors need to understand that financial assets (loans, debt, credit obligations) are created with leverage.  At a leverage ratio of ten-to-one, a lender can create $10 worth of loans from $1 worth of capital.   While that should make for more efficient use of (and higher returns on) capital, it also amplifies risk dramatically.

For example, if you have $1 and loan it to someone, the most you can lose is $1 if the loan goes bad; in other words, if 100% of your loans go bad, your worst case capital position is $0.

However, if you make $10 worth of loans, and just 10% of them ($1 worth) go bad, then your capital position is $0 and you’re insolvent.  If 50% of them ($5) go bad, then your capital position is negative, $1 – $5 = -$4.  To figure out how much of a loss will wipe out your capital, simply invert the leverage ratio. For example, if it’s 10, then 1/10 = 10%, meaning that a 10% loss on your loan portfolio will wipe out your capital.

The banks of continential Europe, just like bank holding companies in the U.S., have had a dangerous love affair with leverage over the past two decades.  They reached unprecedented levels by 2007-2008; by some measures they were as high as 50 or even 70 for some individual banks, and perhaps 70 for broker-dealers as a whole.  At 50-to-1, it takes only a 2% loss to wipe out your capital (1/50 = .02).  Since the first wave of the crisis (Bear-Lehman-AIG), it looks as though leverage ratios have retreated to around twenty or so, meaning that a 5% loss on assets is enough to wipe out banks’ capital.

Losses on Greek debt are over 5%, so if they were carried at something like 20:1 leverage, they’ve already wiped out an amount equal to their face value.

To try to get a back-of-the-envelope handle on how much damage the eurozone crisis could do, let’s start with just the external sovereign debt of the PIIGS economies.  The total is estimated at 3.9T euros, which is about 3.7% of global financial wealth, if we go by U.N. statistics (pdf).   We could assume that that debt is carried at leverage ratios of 20, but that might be a bit aggressive as it ignores unlevered holders like pension funds and individuals, so let’s assume it’s closer to 15.  That means that a 10% markdown on 3.9T in assets, or a 390B euro loss, would result in (390B)(15) = 5.85T euros in losses, or almost $7T at current exchange rates.  That’s equivalent to amost 50% of the EU’s 2009 GDP, and 11% of world GDP.

The following table shows various loss scenarios for different levels of leverage and losses, using 3.7% as the weight of PIIGS external sovereign debt to world financial assets:

We’ve highlighted the 15th row as a reasonable estimate for leverage.  We’ve also highlighted the columns showing losses of 25%, 50%, and 75% on PIIGS debt.  75% may seem extreme, but S&P has pegged 70% as the likely loss in a default (TOH Reggie Middleton, who’s been rather prescient on the eurozone’s troubles).  We’ve also highlighted in orange the outcomes that would “wipe out” global financial wealth – they appear to be outside the realm of possibilities, at least for now.

The resulting losses, assuming 3.7% is a reasonable estimate of the total weight of external PIIGS sovereign debt in global financial assets, are 14%, 28%, and 42%.  These ignore internal and private sector debt of PIIGS economies,  other contagion or knock on effects, and the debt of other European issuers (for example, some Swiss banks are believed to be in dire straits due to their exposure to central and eastern European public debt).  In other words, these are the best case “ring fence” outcomes.

We can also safely assume that the effects would fall disproportionately on riskier assets like equities, so the actual decline in stock markets is likely to be higher than these figures, offset by gains in sovereign debt of other countries (U.S., Germany, France, U.K., etc) and — of course — cold hard cash.

The Vanguard Total World Stock Index ETF (VT) is 17% below its 52 week high.  If we could assume that the total losses on PIIGS debt would be no more than 3%, that underlying leverage is no more than 15, and that their economies and tax revenues were set to expand, then it would make sense to start wading back into risky assets.  However, given the policy and operating stance of the ECB, and imminent fiscal contraction across the continent and the British Isles, there is almost zero likelihood that either condition one or three even comes close to reality.

Instead, we appear to be back to the future of 2008, when pundits and analysts mused that investors were reacting to “headline risk” and ignoring strong fundamentals.  If only it were so…

Until world leaders change their tune on fiscal and monetary policy, we are headed once again for serious carnage.  Thus, we view the rally earlier in the week was a technical bounce, rather than a buying opportunity.  Accordingly, we are positioning clients much more defensively and, where appropriate, helping them speculate on the downside.

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. Some clients of SCM are long FXP, GLL, TLT, and TWM. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

URLs:

http://www.wider.unu.edu/publications/working-papers/discussion-papers/2008/en_GB/dp2008-03/_files/78918010772127840/default/dp2008-03.pdf

http://preview.bloomberg.com/news/2010-04-27/greece-bondholders-may-lose-up-to-265-billion-as-s-p-sees-30-recovery.html

http://boombustblog.com/reggie-middleton/2010/04/27/how-greece-killed-its-own-banks/

http://www.businessweek.com/news/2010-06-07/bear-options-at-record-as-wien-says-stocks-to-rally-update2-.html

Martin Wolf warns on fiscal austerity

Martin Wolf has wisely paid attention to economist Adam Posen, and reached the conclusion (accompanied by some pretty good eye candy) that fiscal austerity might be premature, and thus lead to even worse outcomes than the current fiscal situations of most governments (emphasis added):

A consensus is forming that policymakers should tighten fiscal policy, sharply, in countries with large fiscal deficits. Yet what makes these policymakers sure that business and consumers will spend in response to austerity? What if they find that it tips economies into recession, or even deflation?

…As Adam Posen, outside member of the Bank of England’s monetary policy committee, pointed out in a recent speech, fiscal contraction, along with persistent banking problems and insufficiently loose monetary policy, generated the negative shock in 1997 that entrenched deflation in Japan.* Many economic historians argue that the US made a similar mistake in 1937.

How, I wonder, will the world look back on what is now being planned? Germany’s commitment to greater fiscal austerity across the eurozone is powerful, if hardly surprising. Judged by the UK prime minister’s speech on Monday, the UK is on the same path. Happily, the US has not joined the consensus – as yet.

…despite the heroic efforts of central banks, growth of broad monetary aggregates is subdued, mainly because the transmission mechanism is impaired: over the latest 12-month period, US and eurozone M2 grew just 1.6 per cent. Monetarists should be quite relaxed about the risks of inflation. They should be concerned, instead, that central banks are failing to give the private sector the liquidity it wants.

Against this background, what would a big tightening of fiscal policy deliver? In the absence of effective monetary policy offsets, one would expect aggregate demand to weaken, possibly sharply. Some economists do believe in “Ricardian equivalence” – the notion that private spending would automatically offset fiscal tightening. But, as Mr Posen argues of Japan, “there is no good evidence … of strong Ricardian offsets to fiscal policy.” In developed countries today, fiscal deficits are surely a consequence of post-crisis private retrenchment, not the other way round.

…Critics could argue that these arguments downplay the risks of a “sudden stop” in financial markets. But risks arise on both sides. When Japan – or Canada or Sweden – tightened in the 1990s, a buoyant world economy could absorb excess domestic supply. There is no world economy big enough to offset renewed contraction in Europe and the US. Concerted fiscal tightening could, in current circumstances, fail: larger cyclical deficits, as economies weaken, could offset attempts at structural fiscal tightening…

Premature fiscal tightening is, warns experience, as big a danger as delayed tightening would be. There are no certainties here. The world economy – or at least that of the advanced countries – remains disturbingly fragile. Only those who believe the economy is a morality play, in which those they deem wicked should suffer punishment, would enjoy that painful result.

Wolf has a pretty wide audience, so this column might offer a half glimmer of hope on the policy front (despite his prevarication on what we think are almost dead certainties).  It’s only a half glimmer because, while he lays out a case against fiscal tightening, he does not say anything about the value of greater fiscal expansion.

URLs:

http://www.ft.com/cms/s/0/6bc012d6-733c-11df-ae73-00144feabdc0.html

Hussman on large band aids

In a new piece posted by John Hussman yesterday, he makes some excellent points regarding the essence of debt deflation, and the horrendous degree of agency risk that’s been at work in private sector bailouts to date.

On debt deflation, he argues that nominal restructuring (adjusting the principal value and interest payments due on existing credit obligations) is the only way to mitigate debt deflation and its negative effects (emphasis added):

…from our perspective, the essential difficulty of the market here is not Greece, it is not the Euro, it is not Hungary, and it is really not even the slow pace of job growth in the latest report. The fundamental problem is that we have not, as a global economy, accepted the word “restructuring” into our dialogue. Instead, we have allowed our policy makers to borrow and print extraordinarily large band-aids to temporarily cover an open wound that will not heal until we close the gap. That gap is the difference between the face value of debt securities and the actual cash flows available to service them. The way to close the gap is to restructure the debt. This will require those who made the bad loans to accept the associated losses. By failing to do that, we have failed to address the essential problem faced by the world, which is that we have created more debt than we are able to service.

Hussman’s restructuring is related, in an inverse way, to the direct and indirect fiscal expansion we’ve been advocating.  Our proposal is focused on “flows”, while his is focused on the nominal “stock” of outstanding debt, or said another way, ours would seek to support nominal incomes (and thus the cash flows required to service debt) while his would focus on lowering the required cash flows on debt service.  Our idea is aimed more at preventing deflation, while Hussman’s proposal could have deflationary effects, at least in the short to intermediate term, while offering a more direct and orderly alternative to the immense backlog of filed and yet-to-be-filed bankruptcies.  

One serious impediment to his suggested approach is that financial institutions simply aren’t willing to take those haircuts.  They’ve leaned heavily on public sector support since the financial crisis erupted, while stalling on measures like MHA that are intended to put some of those haircuts into effect — even though the federal government has promised to eat part of the resulting losses. 

Meanwhile, the few haircuts that are taken are being dictated in a piecemeal fashion by bankruptcy judges.  Perhaps this will start to change in the months ahead, i.e., private sector actors (banks) will start doing the right thing; private sector fundamentalists have always said that they would, after all! To be fair, some creditors are reportedly offering balance liquidation plans and things like unsecured debt — but they’re doing so with the help of direct and indirect subsidies from the Fed and the Treasury, and typically without reductions in principal. 

Hussman captures this political agency risk and asymmetry well:

…when our policy makers insist on defending reckless lenders with public resources, we have to recognize that this is not free money. When the government issues a paper liability for real value, that real value gets directed to the recipient at the expense of countless other activities. Even seemingly costless interventions can be redistributions of wealth. For example, the strategy of dropping short-term interest rates to nearly zero as a way of increasing the interest spread earned by banks has the direct effect of impoverishing savers, very often elderly people who rely on lower risk investments for capital preservation. With regard to Fannie Mae and Freddie Mac, either the Treasury securities issued in order to cover their losses will crowd out other private investment, or the eventual inflationary effects of printing money to do so will act as an implicit tax on people with fixed incomes…

A dollar spent by the government is always a dollar taken from somebody and diverted from some other activity. The only question is whether the dollar spent is more productive, or satisfies a more desperate human need, than the alternative activity would. If not, the spending is hostile to economic growth and public welfare. There is no free lunch. At best, what people call “stimulus” can only occur if the dollars spent by government are more productive than they would have been if they were allocated privately. I cannot imagine how allocating public funds to the same reckless stewards of capital that made the bad loans in the first place can possibly be a productive use of capital.

While we have some quibbles with Hussman’s assumptions regarding printing money and “crowding out”, we wholeheartedly agree with his assessment of the disturbing political aspects of the public support given to date.  Beyond the Treasury’s backstopping of part or all of loans that should never have been made, consider the following:  the Fed lowers interest rates to levels that allow member banks to bid for new dollars at a very low nominal cost of ~0.25%; the banks buy Treasury or Treasury backed debt at, say, 3.25%; and the banks earn a risk free (for the time being at least) spread of 300 basis points! Great work if you can get it…

Assuming that the yield curve continues to flatten at low nominal rates as we expect, that subsidy will eventually shrink. But until then, it’s a big fat subsidy for the very entities that led us into this mess.  And while it’s being supported by this and other public subsidies, the industry has also been forcefully collecting on delinquent obligations. 

Perhaps the most disturbing political aspect is that households and the rest of the private sector don’t have the same kind of lifelines available to them as banks do.  To see the effects, one need only compare unemployment or welfare benefits and persistent unemployment to the perfect batting averages and ridiculously juicy profits earned by major investment banks’ trading desks in the first quarter of this year.

For households and individuals to ”survive” (literally for some of them) they need reasonably steady incomes, i.e., cash flows.  But when the private sector is retrenching — driven not only by balance sheet carnage and pyschology, but also by powerful factors like negative trends in demographic ratios — then incomes can only be supported via concerted fiscal expansion by the public sector.  And yet policymakers around the world are promising to do the exact opposite, with the G20 ministers ging their “exquisite foolishness” an hallelujah chorus over the weekend.

Many skeptics (Hussman included, we expect) react reflexively to that proposition as meaning that government is going to compete more intensively with the private sector for resources like labor and financial capital, while running up a larger deficit.  While that can happen under certain conditions, it’s (1) not likely today and (2) not what we’re proposing.  First, the slack overhanging the real economy for the foreseeable future precludes rampant inflation — the Cassandras are just flat wrong on that count.  And second, the federal government has the capacity to utilize idle resources, including labor, via the direct creation of new money — yes, the dreaded “printing press.”  Skeptics should realize that this is already occurring in a decidedly non-inflationary manner.  All our proposal would do is transfer the money creation process now underway from the control of the banking sector to the unemployed.  It’s certainly a more just and democratic approach than the current one.

Another more democratic approach is Warren Mosler’s payroll tax holiday, which has still received little if any attention from policymakers, even though it too would do far more for households than the status quo.  Skeptics will reflexively attempt to discredit such a proposal by referring to Ricardian Equivalence, sub-unity fiscal multipliers and the like.  But that’s because, personal values and biases aside, too few of them have bothered to critically examine the assumptions underlying the prevailing dogma. 

For the foreseeable future, that dogma will lead in the direction of fiscal austerity and ineffective, zero bound monetary policy.  And logically, as we’ve been noting of late, there is simply no reason for gold to be climbing in this environment, much less alongside the USD and US Treasuries.  But like other bubbles, there’s still a real probability that it traces an irrational parabola much higher before it finally crashes back to earth.  However, unlike more recent bubbles, and even the 1920s, the global financial system is in a decidedly deflationary posture today, which makes us wonder if there’s enough dry powder to push gold substantially higher.  As we noted recently, we’re watching the technicals.  If gold pushes through its current resistance, we’ll close out long GLL positions and replace them with long out of-the-money put options on GLD. 

TOH to Ed Harrison for the Hussman piece.  Ed put forth an interesting idea on why electorates seem to be pushing for fiscal austerity, despite the obvious damage it will create (emphasis added):

For the US, it is this understanding – that stimulus has merely been used to maintain a malinvested status quo ante – that is causing people to turn to austerity in disgust…

The Obama Administration has effectively demonstrated that special interests are too entrenched to trust the government to apply effective stimulus. They gifted the financial services industry billions and are still bailing them out via Fannie and Freddie. Afterwards, they went on the Healthcare boondoggle which is rightfully seen as a giveaway to the healthcare insurance companies resulting from secret closed door agreements with the Obama Administration.

They have discredited stimulus as a policy tool. And even deficit spending via tax cuts is now seen as irresponsible because of their efforts. Americans are willing to go with fiscal austerity if only to stop this predatory transfer of wealth.

Interesting take, and there might be something to it. But we doubt that public sector fiscal austerity will do anything to curb moral hazard in the financial sector, especially given the difficulties politicians and regulators are having in limiting systemic financial risk.  Instead, we think austerity is likely to cause further economic dislocation and thus cause current problems to intensify.  To the extent that this causes the payment system to freeze up again, the public sector will supply yet more support to the banking system, without symmetrical support to the household and other business sectors. Should that happen, the political upheaval could be significant. 

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. Some clients of SCM are long GLL and TLT. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

URLs:

http://www.hussmanfunds.com/wmc/wmc100607.htm

http://symmetrycapital.net/index.php/blog/2010/06/a-must-see-chart/

http://symmetrycapital.net/index.php/blog/2010/06/a-picture-of-the-great-moderation/

http://symmetrycapital.net/index.php/blog/2009/11/19046mauldin-on-japan/

http://symmetrycapital.net/index.php/blog/2010/06/austerity-as-intellectual-fashion-trend/

http://moslereconomics.com/2008/09/29/time-for-a-payroll-tax-holiday/

http://seekingalpha.com/article/209026-the-shape-of-market-bubbles

http://seekingalpha.com/article/208905-hussman-on-bailouts-of-poor-stewards-of-capital

A picture of the ‘Great Moderation’

A plot of the yearly change in the ratio between the 45-54 year old and 20-29 year old cohorts in the U.S.: