Yoga with Brad and Larry

In a timely and somewhat interesting paper, economists Brad DeLong and Larry Summers argue that fiscal policy has an important role to play when monetary policy is constrained by the zero bound on interest rates. From the abstract:

“This paper examines logic and evidence bearing on the efficacy of fiscal policy in severely depressed economies. In normal times central banks offset the effects of fiscal policy. This keeps the policy-relevant multiplier near zero. It leaves no space for expansionary fiscal policy as a stabilization policy tool. But when interest rates are constrained by the zero nominal lower bound, discretionary fiscal policy can be highly efficacious as a stabilization policy tool. Indeed, under what we defend as plausible assumptions of temporary expansionary fiscal policies may well reduce long-run debt-financing burdens. These conclusions derive from even modest assumptions about impact multiplier, hysteresis effects, the negative impact of expansionary fiscal policy on real interest rates, and from recognition of the impact of interest rates below growth rates on the evolution of debt-GDP ratios. While our analysis underscores the importance of governments pursuing sustainable long run fiscal policies, it suggests the need for considerable caution regarding the pace of fiscal consolidation in depressed economies where interest rates are constrained by a zero lower bound.”

Of course, it’s too large of a paradigm shift for them to admit, for example, that (1) fiscal and monetary approaches are largely interchangeable insofar as additions to and subtractions from the stock of net financial assets go, or (2) that Clinton-era Rubinomics “succeeded” thanks to ongoing and demographically supported credit expansion in the private sector (and was an utter disaster for U.S. dollar-dependent entities such as Argentina, Mexico, Russia, and Asian Flu countries).

Their paper extends earlier work done by sympathetic economists on fiscal policy in low interest-rate environments. While it offers the right policy prescription, it’s also an effort to preserve and protect some prevailing but defective macro models.

One particular point of interest is that DeLong and Summers cite MMT stalwart Randy Wray on page three, however briefly. Fortunately, fellow MMT economist Bill Mitchell posted a critique of the zero-bound or ‘liquidity trap’ argument just yesterday, concluding:

The reason the mainstream promoted monetary policy to the fore was because they were really advocating smaller government and more free market space. Hence they had to undermine the case for fiscal policy. In doing so, they have created three or more decades of persistent underutilisation of labour resources in most nations; virtually zero growth in per capita incomes in the poorest nations; and set the World up for the current crisis.

By continuing to see quantitative easing as the solution, the more progressive mainstream economists have also caused the current crisis to be extended.

Fiscal policy expansion is always indicated when there is a spending gap. It is a direct policy tool ($s enter the economy immediately) and can be calibrated and targetted with more certain time lags. Liquidity trap or not, fiscal policy is the best counter-stabilisation tool available to any government.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. SCM is not affiliated with or related to Symmetry Partners, LLC. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment. We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. All views and positions are subject to change without notice.

Like Diet & Exercise for Pneumonia

An important post at FT Alphaville from Izabella Kaminski regarding looming capital tightening at European banks this summer (bold passages are Kaminski quoting economist Richard Koo):

As a practical matter, the only way banks can satisfy the new capital requirements if raising capital is difficult is by reducing the denominator in the capital ratio: total assets. If all banks try to do that at the same time, the result will be a destructive credit crunch.

So, no new capital = need to sell-off assets = brand new credit crunch.

Hardly constructive.

And that, Koo says, is exactly what happened when stricter capital rules from the BIS were introduced in 1997 in Japan:

Although Japan’s bubble burst in 1990, it was not until October 1997 that the economy experienced a serious credit contraction. The decision by the Ministry of Finance’s Banking Bureau to unveil the details of new BIS-based capital rules on 1 October that year—a time when most Japanese banks were struggling under the weight of bad debts—triggered a destructive credit crunch. Discussions about the new BIS standards had been ongoing for a number of years, but it was the announcement of the specifics on new rules in October 1997, when the bubble’s collapse had left Japanese banks in an extremely weakened state, that prompted a major credit contraction.

It’s perhaps no coincidence then that the first mention of the [stricter capital rules for European banks] coincided with a marked deterioration of the crisis in the summer of 2011. Also, coincidentally, the moment when Italy became fully ensconced in the quagmire too.

It’s surprising in that context, says Koo, that no-one has yet called for a revision of the rule and/or government-led capital injections into the banking system ahead of the June 2012 deadline to discourage further asset sell-offs.

…not scrapping the [stricter capital rules], says Koo, could be the equivalent of telling a patient with pneumonia to do some exercise and to go on a diet.

While it’s possible that Europe can limp through the twin shoals of tighter capital requirements and the risk of private-sector haircuts on much greater swaths of troubled government debt, both of which will lead to renewed financial crisis and contagion, it seems just as possible that it will threaten to smash itself between the two.

As a result, we decided today to take off clients’ long positions in European equity funds for the time being, booking very small gains in the European Equity Fund (EEA) and the SPDR Euro STOXX 50 ETF (FEZ) since late January. While it may be premature, Europe still looks to us like a classic case of risk  outweighing potential reward.

Investors must also keep in mind that the European Central Bank’s Long-Term Refinancing Operation (LTRO) offered loans to eligible banks for no longer than three years. The LTRO, largely a life-support measure for bank and government balance sheets, will need to be extended, probably more than once, for European financial markets and economies to remain stable.

If the ECB issued sufficient net financial assets, and/or national governments were permitted to run large enough deficits, financial stability and economic growth would both be possible. But the current situation in Europe (as well as the United Kingdom) is eerily reminiscent of the lead-up to the Great Depression, when a nominal gold price target that was probably half of what is should have been—or said another way, a chronic and substantial shortage of net financial assets—forced national economies and their central banks into a game of musical chairs that eventually came unhinged.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. SCM is not affiliated with or related to Symmetry Partners, LLC. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment. We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. All views and positions are subject to change without notice. Both EEA and FEZ positions were liquidated today in the accounts of clients holding them. Neither the firm nor its principals currently own EEA or FEZ.

Near-Term Looking Rosy, Longer-Term Not So Clear

One of our firm’s recession models, based on the Philadelphia Federal Reserve’s State Leading Indices, is now putting a near-zero percent probability on a U.S. recession in the next six to 18 months given the January 2012 readings. This is a sharp turnaround from the recession warning triggered in August 2011:

Exhibit 1 – Symmetry Capital Recession Model

While that probability is sure to fluctuate in the months ahead, there are some interesting facets to the underlying data, and some caveats for the longer term outlook.

  • The current outlook for all 50 states is positive, an event that has only occurred in 11% of the monthly observations since January 1982.
  • At 2.29, the median state outlook is in the top quintile of monthly observations since 1982.
  • The median is higher than its last peak in the second half of 2003 and its prior high of late 1999 (Exhibit 2).
  • Historically, U.S. GDP has almost always been positive when the median outlook is at current levels.

Exhibit 2 – Median State Leading Index and U.S. GDP

This report continues a string of economic surprises that have unfolded since late 2011:

  • In late summer 2011, the U.S. Congress abandoned (however temporarily) its hellbent intent to welch on existing financial commitments, and U.S. budget deficits have remained high.
  • In the fourth quarter of 2011, The European Central Bank (ECB) forcefully (but quietly, given the Continent’s morbid fears of waking the ghosts of Weimar) committed to ring fencing the government debt of Italy and Spain for at least the next three years through its Long-Term Refinancing Operations (LTRO).
  • Japan’s economy and Asia-based supply chain linkages have recovered following the natural and nuclear disasters in Japan.

All in all, the immediate economic outlook looks fairly upbeat. There are some caveats though:

  • The post-2008 recovery (as well as the strongest GDP readings during President George W. Bush’s administration) have been accompanied by significant federal deficits. A resurgence of irrational deficit/debt phobias and policy prescriptions poses a significant risk to markets. Given that 2012 is an election year, perhaps Congress will take a more constructive (or at least less dramatic) approach to fiscal affairs than it did in 2011.
  • It’s speculative at this point, but given recent income improvements, the current tax season may take a bite out of those currently large net budget deficits, leading to an economic soft patch at around the same time that equity markets typically start their ’summer break.’
  • As economist Diane Macunovich has demonstrated, demographic shifts in the U.S. do not augur well for domestic GDP in the rest of this decade (see Exhibit 3). The proportion of young adults of household-formation age is set to begin dropping sharply. Thanks to the large current crop of ‘boomerangers,’ there may be significant pent-up demand for household formation that would be unleashed if employment and incomes continue to improve. But such a possibility remains highly dependent on a continuation of easy fiscal policy in our view, and is unlikely to completely offset the negative effects of a sharp contraction in this age group.
  • A widely under-appreciated risk (hat tip to Warren Mosler) is the threat of more private-sector haircuts for holders of troubled European government debt. However one might feel about the fairness of such an approach, it would impose a severe shock on the asset side of banks’  balance sheets, leading to a replay—and perhaps an intensification—of the global market turbulence and stress caused by Greece’s debt travails. If unmanaged, it has the potential to threaten the global payments system as badly as the collapse of Lehman Brothers and near-collapse of AIG did in 2008. That would completely undo the benefits realized thus far from the ECB’s LTRO, which already suffers from the extreme policy conservatism of the European Union.
  • It’s also important to realize that Europe is still wearing the fiscal straitjacket rather tightly, which limits the ultimate effectiveness of the ECB. As long as this continues, it will pose a risk to the EU economy. It’s important to note that the UK government is making similar mistakes, with similar effects.
  • China’s economic growth rate will continue to slow. The extent to which this impacts global financial markets and the world economy remains to be seen.
  • And of course, there are always the ‘unknown unknowns.’ Japan in 2011 and the attacks of September 11, 2001 are good examples.

Exhibit 3

Source: Diane Macunovich

Our Current Asset Class Views

In terms of investment assets, we think it’s worth weighing in on the recent back up in U.S. Treasury yields, given the loud told-ya-so’s from the Death-of-the-U.S.-dollar-and-American-way-of-life Cassandra Chorus. While we have defended long-term Treasury yields in the past, they are much less attractive (at least at this point in time, but if policymakers lead us the way of Japan, that would change) at sub-2% on the 10-year and circa 3% on the 30-year. Furthermore, the recent string of upside economic surprises strongly argues for higher yields. However, this is not the beginning of some fancifully imagined “end,” and we would be likely to add significantly to long bonds once again for the appropriate clients if 30-year yields were to re-approach the 4% level or higher.

In the current environment, non-sovereign corporate credit looks interesting to us, although spreads have come in dramatically since the second half of 2011, and a strengthening dollar could present a meaningful risk to riskier credits (high-yield to some extent, but externally denominated emerging-market debt especially). And as attractive as the world of preferred stocks has been since the last forceful hiccup in Europe, the risk of more private sector haircuts could cause renewed turmoil in that asset class due to intensifying concerns over banks’ balance sheets (financial companies are a significant proportion of preferred issuers). Such an event might present an opportunity judging by policymakers’ and regulators’ behaviors since 2008, but for current preferred holdings, attention to risk seems warranted.

Among equities, we continue to believe that Japan presents a rare opportunity. Although its overall population growth is nothing to write home about, its internal age structure should be in the years ahead (Exhibit 4). And after twenty bitterly disappointing years for Japanese equity investors, its stock markets are ridiculously cheap. One must always be attentive to exchange rate risks and the risks associated with exposure to a single country—the 2011 disasters are instructive in this regard—but the current risk-reward calculus makes Japan a no-brainer in our view.

Exhibit 4

Source: Diane Macunovich

This leads us to one prediction that I have total confidence in—if Japan’s economy improves as expected over the coming decade, the Japanese Government Bond zombie-vigilantes will shout victory from the rooftops as domestic interest rates rise in Japan. However, if they do so while ignoring an improving economy and equity markets and the fact that their predictions of inflationary collapse aren’t materializing, then they’re being completely disingenuous. Take their words with a grain-of-salt chaser, or better yet, ignore them.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. SCM is not affiliated with or related to Symmetry Partners, LLC. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment. We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. All views and positions are subject to change without notice. Neither the firm, its principals, or its clients (in accounts which SCM manages) own shares of Lehman Brothers, AIG, or any other issuer or specific security mentioned. Some clients of the firm own long-term U.S. Treasuries and/or Japanese equity investments.

A Disturbance in the Force

A Jerry-Maguire like shot emanated from Goldman Sachs yesterday. Greg Smith, an executive director and longtime employee of the firm, published a stinging resignation letter in the New York Times:

I believe I have worked here long enough to understand the trajectory of its culture, its people and its identity. And I can honestly say that the environment now is as toxic and destructive as I have ever seen it. To put the problem in the simplest terms, the interests of the client continue to be sidelined in the way the firm operates and thinks about making money.

The rest of the letter is heavy on drama, but also passion and emotion—Smith clearly cares about the firm and its direction. We can only assume that during his successful decade-plus stint at Goldman, he has put away a large enough financial cushion (and/or has a big enough book deal in the works!) to absorb both the resulting legal fees and the possibility that he just committed career seppuku.

Far more important to the rest of the galaxy was this eerily similar and closely timed resignation: http://www.thedailymash.co.uk/news/society/why-i-am-leaving-the-empire%252c-by-darth-vader-201203145007/

Neither the firm nor its clients (in accounts that the firm manages) presently hold or intend to hold positions related to Goldman Sachs.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. SCM is not affiliated with or related to Symmetry Partners, LLC. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment. We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. All views and positions are subject to change without notice.