U.K.’s Austerity Plan

The only way this can work is if the U.K.’s recent budget deficits were large enough to offset the deflationary impact (a massive trade surplus would help too, but don’t expect the export powers of China, Germany and Japan to cooperate, or even the U.S.):

Britain outlined the sharpest cuts to public spending since World War II on Wednesday — slashing benefits and cutting public sector jobs with an austerity plan aimed at clearing record debts that swelled during the global financial crisis.After the country spent billions bailing out indebted banks, and suffered a squeeze on tax revenue and an increase in welfare bills, Treasury chief George Osborne has staked the coalition government’s future on tough economic remedies.

Mr. Osborne confirmed there would be $128 billion in spending cuts through 2015, which he claims are necessary along with some tax increases to wipe out a spending deficit of $172 billion.

As many as half a million public sector jobs will be lost, about $28.5 billion axed from welfare payments and the pension age raised to 66 by 2020, earlier than previously planned.

Even Queen Elizabeth II will take a hit, asked to trim the budget the government provides for her staff by 14 percent.

On that last point, is it fair to say that when the House of Windsor accepted a more limited governance role over citizens of the United Kingdom, the deal it struck simply annuitized the wealth and power it had amassed?  Americans get upset over public sector pensions.  Imagine if we also had to support a family that historic good fortune had smiled upon.  Probably a non-starter for us Yanks (fuull disclosure: Go Phils!).

“It is a hard road, but it leads to a better future,” Mr. Osborne said, preparing the public for hardship as he seeks a balanced budget within four years.

Deluded and dangerous.  As we continue to point out, austerity has real costs that can offset or even swamp the perceived benefits of deficit and debt reduction.  That’s the essence of Abba Lerner’s ‘functional finance’ — if it makes sense to slash deficits, in terms of better economic and social outcomes, then by all means do it.  But don’t do it just because the numbers seem big, or because the idea of governments doing anything is unappealing.

Mr. Osborne stood on the floor of the House of Commons for more than an hour and dismantled program after program built during the Labor government’s 13-year reign, saying Britain must pay “the bills from a decade of debt.”

If those programs serve no social purpose, they should be dismantled.  But if they are simply dismantled in order to pay “bills from a decade of debt,” that’s stupidity of the highest order.  If folks in the Exchequer’s office really think this way nowadays, then the U.K. could be in for a world of hurt. 

As ordinary Britons lose out, Mr. Osborne confirmed that a temporary levy on bank balance sheets will be made permanent to “extract the maximum sustainable taxes from the banking system.”

Nice sentiment, but as Warren Mosler recently pointed out regarding the FDIC’s proposed restoration plan, all this will lead to is higher costs for borrowers, without higher interest rates for savers. 

Spending on health, education and overseas aid will be maintained at current levels or increased, while many major transport and climate change projects will go ahead…

Mr. Osborne confirmed the policing budget will fall by 4 percent a year — part of an overall 23 percent cut to the Home Office’s resource spending. The Association of Chief Police Officers said Britain would have fewer police as a result.

This was surely cheered by the criminals and thugs who were paying attention. It actually will create greater opportunities for ’underground ventures’. And if the cuts have the expected effect on economic variables like unemployment and incomes — it’s not certain that they will of course, but if they do — then the eventual ”savings” from law enforcement cuts will be anything but, as the ’unbudgeted’ social costs that arise will have to be addressed in other ways.  We’re in favor of an appropriate level of public sector dissaving as well as cooperative civic action. But if either of them come about in this way, it implies that significant opportunity costs have been incurred. And those costs truly are ignored by austerity proponents.

In one of the most significant proposals, Mr. Osborne said the state pension age for men and women will rise to 66 by 2020, four years early. It will alter retirement plans for 5 million people, but save $7.8 billion a year once it comes into effect.

A minimum retirement age of 66 that begins in ten years seems far from draconian. But to claim that it will “save” anything has to be qualified.  Every dollar of dissaving by a sovereign government is offset by a dollar of saving in the private sector.  So for the government to “save”, as Osborne is so intent to see happen, the U.K.’s private sector will have to dissave by a commensurate amount, adjusted for trade flows.  This has to be one of the least controversial aspects of “Keynesianism”, but it seems like very, very few people in positions of power and influence have any clue about it.

Atwater: Zero Sum Economy

Market Watch carried a very interesting article by Peter Atwater of Minyanville. I don’t agree with everything he says (objections noted below), but the vision he articulates looks like a compelling one to us, well grounded in the realities of the day:

As I look at the economic landscape, there are winners and losers everywhere…

But note that because overall growth in the U.S. is so slow, there’s no collective victory. And as a consequence, I expect many behaviors to change.

How?

First, focused industry trade groups will become much more influential than broad over-arching organizations…

Second, increasingly both Congress and the judiciary branch of the federal government will be called upon to play referee between the winners and losers…But rather than the marketplace driving these outcomes, elected officials and judges will be called upon to weigh in, and I suspect that not all outcomes will necessarily be as “populist” as many currently believe.

Further, in this kind of environment, business decisions will have not only economic consequences, but enormous political implications as well. And with the U.S. government an active shareholder/guarantor of some of our largest financial institutions, not to mention automakers, this may create unanticipated consequences…

Third, the potential for price competition/margin compression is huge, particularly in places where the government may be a major buyer. Remember, it’s a zero-sum game for Washington, too. For example, I can easily foresee Congress demanding “rebates” when food stamps are used… And with many corporations limited on how much further they can cut headcount, the only place to turn for expense savings is input costs and operating budgets. In a zero-sum economy, when it comes to spending, less is the new flat.

I also think that the zero-sum economy could create an “every man for himself” environment among historically oligopolistic industries, particularly where there may be a particularly vulnerable enterprise…

And needless to say, all of this is highly deflationary…

Fourth, and related, the Robin Hood economy, which I discussed last year, isn’t dead, but just being taken to a new extreme…I fully expect that whether directly or indirectly, developed nations globally will seek to translate higher corporate earnings into higher taxes.

I’d argue with the first sentence of that paragraph. A Robin Hood economy? The data all show that we’ve been living in a Sherriff of Nottingham economy for some time, whether we look at income disparity or a heavier-than-necessary tax burden imposed by the federal government (or worse, federal budget surpluses).  And as Warren Mosler has pointed out, when you have rising unemployment against a rising stock market and corporate profits, that implies a massive transfer of wealth upward.

Fifth, I wouldn’t underestimate the social upheaval as extended high unemployment rates transform the zero-sum economy from a short-term event into an era. It’s one thing to lose for a little while. It’s another thing altogether to see those losses become permanent…

Certainly agree with this.  Real social costs and opportunity costs — which have a far more negative impact on future generations’ well being than the federal debt – are not being discounted sufficiently.

Finally, and really as a function of all of the above, I’d offer that the zero-sum economy will force organizations from small business through to the federal government to make very difficult choices which will, ironically, only further accentuate the divisions between the winners and losers. And in this regard, I’d pay particularly close attention to the mortgage space, as it remains largely unresolved how that sector’s increasing losses will be “resyndicated” among homeowners, bondholders, [GSEs], underwriters, originators — not to mention home equity lenders, credit card companies, and even U.S. retailers.

And I see similar “resyndication” efforts necessary in both the municipal and sovereign debt space as well.

If by “sovereign” he means a sovereign issuer of the money (non-interest bearing debt) used to service interest bearing debt, then “resyndication” won’t be necessary, even though it is for the private sector and non-sovereign public sector (U.S. cities and states, eurozone members).

Today, folks like Cramer see the zero-sum economy as a viable investment strategy. I’d offer that whatever gains there are, they’re likely to be fleeting at best…

The Foreclosure Fiasco

Shaun Donovan, Obama’s HUD Secretary, has said that there is no “structural issue” with the mortgage foreclosure process. From Market Watch:

He said there’s no evidence yet of “structural” issues with the Mortgage Electronic Registration System, an electronic registry of home loans that critics have charged with violating property record-keeping laws. Banks that package loans into bonds called mortgage-backed securities often rely on MERS to track owners of mortgages as the securities change hands.

There are plenty of interesting takes on this issue (see below), which we have been following since late 2009.  It seems apparent from Donovan’s comments that the Obama administration doesn’t see the foreclosure issue as something to campaign on.  It’s an interesting political gamble either way.  Standing up to lenders’ foreclosure agents might rally parts of the Dems’ base.  While the “let the market work” counter argument wouldn’t normally sway voters from either side, the fact that We the Taxpayer still own stakes in some of the banks at the center of the crisis might be causing Dems to fear that a foreclosure freeze would hand the GOP another club to beat them over the head with as the campaign season wraps up (though one can also argue that siding with “put back plaintiffs” could recover taxpayer funds too). 

For those who haven’t been following recent developments, here are some key aspects:

The one that has been apparent for the longest is whether or not MERS, which is essentially just a database for securitized mortgages, has standing to foreclose, and whether a clear chain of title can be established to a property where the lender used MERS to track the securitized mortgage on it.  Industry proponents tend to argue that chain of title has conventionally been documented after the fact as necessary to foreclose.  But that’s been put to the test with all of the litigation arising out of the foreclosure mess, and a slew of recent court decisions have put the lending industry on the defensive.

Recent discoveries have documented the existence of “robo-signers”, employees who sign many thousands of affidavits saying they are familiar with the details of each mortgage foreclosure when obviously they couldn’t be.  There have also been clearer (though far fewer) occurrences of outright fraud by foreclosure agents (some of which industry proponents still defend as business as usual practices), as well as instances of baseless foreclosures (people who are not delinquent on their mortgage losing their home).  When you consider the fact that most foreclosed properties are sold to someone, the utter FUBARness of the situation becomes apparent.

A more recent aspect is the potential “put backs” of certain mortgage securities to the investment banks and/or originators, which we wrote about last week.  The recent suit filed by several large money managers, which is mentioned in the HUD article, is based on this aspect of the mortgage fiasco.  It’s interesting to note that investment banks are now reserving for “put back” losses, while most of them felt it was an immaterial risk just six months or so ago.

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More mortgage related reading…hat tips are due, but unfortunately, I forgot to note them. Most are via Warren Mosler’s blog post linked below.

Tax Credit + Tax Credit Expiration + Record Foreclosures + Documentation Issues + Probes + Renewed Foreclosure Spike (?) = Home Price Uncertainty and Volatility

http://www.ibtimes.com/articles/71820/20101014/u-s-foreclosure-repossessions-record-september-housing-bubble-foreclosure-filings.htm

Plaintiffs, including fifty state attorney generals, have been pushing back on foreclosures, while judges are seeking to tighten up the legal proceedings:

http://www.bizjournals.com/jacksonville/stories/2010/10/11/daily38.html?ana=yfcpc

http://www.nypost.com/p/news/business/hear_ye_hear_ye_EVyzIEMklFWu9GSwn3oaSN

An interesting debate between contributors to Calculated Risk and Naked Capitalism: 

http://www.calculatedriskblog.com/2010/10/why-did-mortgage-servicers-use-robo.html

http://www.nakedcapitalism.com/2010/10/guest-post-so-why-did-the-mortgage-servicers-use-robo-signers.html

Warren Mosler’s take — this wave of the crisis lends support to his belief that “The financial sector is a lot more trouble than it’s worth”:

http://www.nakedcapitalism.com/2010/10/guest-post-so-why-did-the-mortgage-servicers-use-robo-signers.html

The world of private equity is involved, via investments in some of the ‘foreclosure mill’ firms. I can understand why this might have looked like an attractive investment idea. But as one of the subjects of the article notes, private equity investors will tend to push hard for lower cost, higher margin (and/or turnover) production, which has obvious social costs and consequences as a foreclosure tsunami unfolds. And what happens if the investments were levered up, and the mill operations are shut down as a result of current probes and litigation? It’s not just the executives and clients of that private equity shop that suffer then — all of us get to share the pain. And that’s the main problem with innovation in the financial sector. Leverage means that the costs are absorbed by society, i.e., people who had nothing to do with the risk taking. Definitely a call for private equity clients to stay on top of what their managers are doing:  http://www.nytimes.com/2010/10/21/business/21equity.html?_r=1

The MMT folks weigh in — Randy Wray, Bill Black, Marshall Auerback:

http://www.benzinga.com/comment/reply/524394

http://www.benzinga.com/life/politics/10/10/517948/if-not-now-when

http://www.newdeal20.org/2010/10/15/foreclosure-fraud-we-need-to-fix-the-banks-again-23421/

Swans, Mind Games, and Curve Balls

Excellent piece by James Montier on the mortgage crisis, with a short primer on behavioral finance:

… it is wholly wrong to characterize what happened to the US economy and markets as a black swan. To do so is, in fact, an abdication of responsibility. If these extraordinary events were totally unpredictable, then there would have been nothing we could have done to prevent them.

The events of 2003–2008 were not black swans at all. They were “predictable surprises.” The term was first coined by Michael Watkins and Max Bazerman. A predictable surprise also has three characteristics: (1) At least some people are aware of the problem; (2) The problem intensifies over time, and (3) Eventually the problem explodes into a crisis, much to the “shock” of decision-makers. As Bazerman says: “The nature of predictable surprises [is that] while uncertainty surrounds the details of the impending disaster, there is little uncertainty that a large disaster awaits.” 

What evidence do I have that the current mess was a predictable surprise? The New York Times ran a fascinating article in mid-December 2007. This noted that, seven years earlier, Edward Gramlich, a governor of the Federal Reserve, had warned that a fast-growing new breed of lenders was luring many households into risky mortgages they couldn’t afford. The article also cited the Herculean efforts of Sheila C. Bair, a senior Treasury official, to persuade sub-prime lenders to adopt a code of practice and to let external monitors verify whether they were complying with these standards…

So the big question is this: What prevented us from reacting to the predictable surprise? I can think of five major psychological hurdles that hampered us in this regard.

Montier goes on to list five innate hurdles identified by behavioralists:

1. Over optimism
2. Illusion of control
3. Self serving bias – reacting to and interpreting information in ways that support what we already believe
4. Myopia or “hyperbolic discounting”
5. Inattentional blindness

The article covers these innate human behaviors in a quick and easily comprehensible fashion — highly recommended. In fact, learning to identify and manage these innate hurdles in ourselves can help us to become not only better investors, but better family members, co-workers, citizens, and voters.

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Here’s a fascinating item related to “innate hurdles” — scientists argue that the “break” that we perceive in a pitcher’s curve ball, and the “rise” in a fastball, are illusions.

“What?!?” the baseball junkie might ask.  Yep. Check it out.

If you’re familiar with our Links page, you may have noticed our link to the BrainConnection.com library. We’re utterly fascinated by the biological reality (and puzzles) of human perception. It’s not nearly as uniform and objective as we like to think, nor is the physical world as distinct and external as we tend to believe. And that raises a lot of questions, some of them even more uncomfortable (but still fascinating!) as the curve ball question is for many baseball fans:

Batters throughout Major League Baseball may be struggling with an optical illusion when they try to hit a curveball.

Scientists suggest in new research that curveballs don’t actually break near home plate — it just appears that way as a hitter switches modes of seeing.

The break, which appears to be a sudden change from the ball’s curved path, may come from the way the human eye shifts between central and peripheral vision, according to the research, released yesterday by the journal PLoS One. The scientists explained the “rise” in a fastball the same way.

The work is the first to explain the break and rise as illusions, according to the authors. Previous explanations include the idea that the hitter underestimates a ball’s speed, said Zhong-Lin Lu, a neuroscientist at the University of Southern California in Los Angeles.

“The brain is tricked,” Lu said in a telephone interview.

He and his group used a flash animation of a descending circle with a moving shadow that mimicked spin. When five observers stared directly at the circle, it fell straight, and when they focused their vision on something else, the ball appeared to move to the side of the screen. That’s because the brain couldn’t process both the spin and the vertical motion, Lu said.

The researchers used the observers’ reports to figure out the size of the break. If the eye is off the curveball by about 10 degrees, the size of the break is about a foot, Lu said.

A fastball “rises” for the same reason, even though in reality, the ball is dropping, he said.

The researchers aren’t saying that a curve ball doesn’t curve (“Magnus force” is what physicists use to explain the arcing trajectory of a pitch). They are simply pointing out that some of the perceived movement in a curve ball (and all or most of the perceived rise in a fastball) are optical illusions.

So the traditional interpretation that curve balls had a sharp break, or that fast balls rose, were largely illusory; definitely an example of self-serving bias and inattentional blindness. Meanwhile, hitters who learned not to be fooled by their innate biological hurdles should have performed well relative to their ability.

Likewise, awarerness of biases and beliefs, and attentively seeking novel information that can challenge or refine those beliefs, can serve investors well.

“Positively Evil”

Felix Salmon has written a good piece on the behavior of the investment banks that bought, securitized, and sold mortgages in the years leading up to the crisis (emphasis added, bold only):

…[Investment banks] tested only a small portion of the loans in [a] pool [of mortgages]. So [they] knew that if there were a bunch of bad loans [discovered by testing], there were bound to be even more bad loans among the loans that…had not [been] tested. And those loans it couldn’t put back to the originator, because [they] didn’t know exactly which loans they were.

If there had been any common sense in the investment banks, that would have been the end of the deal. But there wasn’t. Rather than simply telling the originator that its loan pool wasn’t good enough, the investment banks would instead renegotiate the amount of money they were paying for the pool.

This is where things get positively evil. The investment banks didn’t mind buying up loans they knew were bad, because they considered themselves to be in the moving business rather than the storage business. They weren’t going to hold on to the loans: they were just going to package them up and sell them on to some buy-side sucker.

In fact, the banks had an incentive to buy loans they knew were bad. Because when the loans proved to be bad, the banks could go back to the originator and get a discount on the amount of money they were paying for the pool. And the less money they paid for the pool, the more profit they could make when they turned it into mortgage bonds and sold it off to investors.

Now here’s the scandal: the investors were never informed of the results of [the] test[s]. The investment banks were perfectly happy to ask for a discount on the loans when they found out how badly-underwritten the loan pool was. But they didn’t pass that discount on to investors, who were kept in the dark about that fact.

Disconcerting stuff, though judging by a recent Bloomberg poll, it wouldn’t surprise most Americans:

Wall Street financial firms and the mortgage industry get the most blame for the country’s economic weakness. More than three-quarters of the 1,000 Americans polled say the former has hurt the economy, while more than 80 percent fault the latter.

On a related note, Warren Mosler made the following observations in a recent presentation (pdf):

There is no public purpose served by allowing:

• Banks to sell their loans
• Sales of credit default risk when loans are based on credit analysis
• Banks to engage in any secondary market activity
• Proprietary trading

Mosler also observed that ”Banking should be a lot more limited than even restoring Glass-Steagall implies,” and that “The number of regulators needed increases geometrically with expanded bank activities.” He also ably dissected TARP and the shortcomings in federal stimulus measures. As he cleverly puts it on his website, “The financial sector is more trouble than it’s worth.”

And indeed, some empirical studies support the argument that the financial sector has been a mammoth rent sucking machine for decades. But good luck doing anything about it. Its immense profitability and resulting political clout have made it a powerful lobby, which is reflected in many parts of the recent Dodd-Frank legislation, as well as the deregulatory push of recent decades. And the fact is, the activities that Mosler listed have made some people incredibly wealthy, and there are simply too many more who want their shot at the million or billion dollar carrot, social consequences be damned. In fact, few if any of them even have a clue that their activities are socially harmful or neutral at best. Nothing quiets one’s conscience like visions of philanthropy, I suppose.

But despite the opaque complexities of the industry, people are on to it, as the Bloomberg poll shows. And the threat of pitch forks, however distant, might be at work in some recent industry actions, like the shutting down of proprietary trading desks and (tangentially) FINRA’s proposal to allow investors to select an all-public panel of arbitrators. Time will tell.

Luskin: Twin Doomsday Clocks

A timely op-ed in the WSJ by Don Luskin (hat tip to David Rosenberg) in which he points to the twin threats of higher taxes and higher tariffs: 

Thankfully, we’re not repeating all the mistakes of 1937. But Congress and the Obama administration are flirting dangerously with one of them by failing to extend the expiring low tax rates for all Americans. What’s worse, we’re close to repeating the mother of all policy errors, the one made not in 1937 but in 1930—the one that started the Great Depression. We’re on track to resurrect the 1930 Smoot-Hawley Tariff Act… 

Both issues—extending today’s low tax rates, and protectionism against China—are animated by the coming election. Once that has passed, presumably cooler heads on both sides of the aisle will prevail, and these twin threats to our fragile economic recovery will fade away. 

But sometimes such things can take on lives of their own. And sometimes in the heat of politics cooler heads do not prevail. If that happens now with issues as critical as these, then the economy and the stock market will be doomed to repeat the tragedies of the 1930s. 

His overlay of the 2009 DJIA on the 1936 DJAI is a must see:

Keep in mind that in the 1936-37 period, both monetary and fiscal policy were tightening at the same time. Of course, bad fiscal policy can cause monetary policy to tighten by default. And full expiration of the Bush tax cuts — as Luskin speculates could happen — would certainly do that. 

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In a related story on Bloomberg, President Obama’s public meeting with his Economic Recovery Advisory Board yesterday, which was supposed to focus on education, ’veered into an off-script tax-cut debate’. Interesting stuff. Kudos to the President for tolerating this kind of dissension and diversion, as the appropriateness of his desired policy direction is suspect, and because it takes some courage to face fire like this. Kudos to his advisors who spoke openly as well.

Obama turned for support to former Clinton economic advisor Laura D’Andrea Tyson, who actually said some OK things, such as offsetting higher rates on high income earners with additional federal spending. Philosophically, it’s fine to be opposed to that kind of tradeoff. But economically, it’s critically important that any expiring tax cut NOT be used for deficit reduction at this point. When private sector demand recovers, and inflation risks arise, then deficit reduction will be worth looking at.

Reuters: WashPost-ABC poll results

Reuters reports on the most recent Wash Post-ABC polling of likely midterm voters that Democrats may have closed the gap a bit in recent weeks. Last month’s survey came in at 54% GOP to 40% Dems, while this one came in at 49% to 43%. The sample margin of error is 3.5% though, so this improvement could be spurious, and so could the finding that “forty-one percent of respondents said they trusted Democrats to do a better job of coping with the main problems the United States faces over the next few years, while 39 percent favored the Republicans.”

As we’ve been pointing out for awhile, as long as the primary political philosophies of the two parties are ”soak the rich” and “starve the beast”, neither one will be all that great for the economy. [We should probably qualify those; "soak the rich who can't afford a high priced team of lawyers and accountants" and "starve the beast except for the part that resides in the Pentagon" have nice rings to them.]  

The greatest risk we face is rising deficit phobia, and it’s still not easy to tell which party would push hardest on austerity measures, generalizations aside.

The most telling parts of the survey?

Fifteen percent said they did not trust either party to do the job…

Voter dissatisfaction with lawmakers in Washington remained high, with Congress getting a 23 percent approval rating in the poll. Congressional Democrats have a disapproval rating of 61 percent, while 67 percent disapprove of Republicans.

If the findings are valid regarding “coping with the main problems” and relative disapproval ratings, then Dems might not be in for quite the drubbing thet appeared to face earlier in the year. Whether that’s good or bad is entirely up in the air at this point.

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The photo accompanying the Reuters story (from the House GOP’s Pledge to America session, I believe) is interesting, as everyone is “dressed down”. President Obama has been doing the same thing in recent stump speeches. Does the fact that there are (presumably) well paid staffers and consultants in the world offering such advice annoy anyone else???