Moving the Policy Discussion Forward

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

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

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

Marshall Auerback outlines a bevy of progressive policies in response:

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

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

2. Comprehensive foreclosure relief…

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What’s the proper response?

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

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

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

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

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

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

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

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

We openly admit that:

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

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

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

URLs:

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

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

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

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

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

http://symmetrycapital.net/index.php/blog/2006/12/committees-vs-markets/

http://symmetrycapital.net/index.php/blog/2010/07/galbraith-blasts-the-deficit-commission/

IRS (still) has control issues

One of the major challenges to running a modern organization is having effective accounting controls in place. In fact, for the foreseeable future, the most effective control systems could actually prove to be a source of durable competitive advantage (though technology, learning curves, imitation, and innovation should eventually erode it away).

Apparently this has been a challenge even for the IRS:

Internal accounting errors by the Internal Revenue Service reduced federal funding available for unemployment benefits by $63 million, according to a new report…

While the IRS has improved its reporting of expenses associated with administering the fund, it still lacks sufficient controls to ensure that costs are calculated accurately. TIGTA found that the IRS overstated its expenses by $63,368,413 over a five-year period. These excess funds were transferred to the General Fund for overall federal government operations instead of remaining in the Unemployment Trust Fund.

URLs:

http://www.webcpa.com/news/IRS-Shortchanged-Unemployment-Funds-53904-1.html

SEC’s Goldman bombshell

The SEC has filed a civil complaint against Goldman Sachs alleging fraud (yes, the f-word) for synthesizing an asset backed security related to residential mortgage loans in 2007. It was done for one of Goldman’s prize clients — John Paulson’s hedge fund, which returned billions of dollars to partners as the wave of mortgages security downgrades and defaults broke (and according to some authors, alerted Goldman to looming problems in mortgage markets) – so that he could take a large short position in (i.e., sell) U.S. mortgage securities.

The rub is that every short seller requires a buyer. And the SEC complaint alleges that Goldman’s and others’ disclosures to buyers were not above board.

There are many, many angles to this story — reputational risk, the firm’s culture and political capital, effects on pending financial regulation, implications for other investment banks and certain hedge funds — the list goes on. We think there are two quick takeaways worth thinking about:

First, the episode illuminates the dark side of financial innovation. There are actually grounds in financial theory for defending creation of this type of product. But it’s apparent that such innovations create serious agency risks for the parties involved. And the SEC is alleging that Goldman did not manage those risks effectively.

Second, we can use the event to cast a different light on the idea of “too big to fail.” At least in this case, the problem appears to have been that Goldman was too big to conduct itself ethically. We’ll leave it to readers to debate whether  “greedy” should be substituted for “big”. In the meantime, the market has been vomiting Goldman shares since the news broke.

URLs:

http://sec.gov/news/press/2010/2010-59.htm

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. At the time of this writing, neither the firm nor its clients own shares of stock or any securities issued by Goldman Sachs. One of the firm’s principals owns shares of Goldman Sachs common stock. 

Good column by Ron Rhoades

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

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

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

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

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

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

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

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

Days of reckoning for state pensions?

Northwestern professor Joshua Rauh has published a paper in which he estimates that (1) state pension funds will run out of money in an average of 10 to 20 years and (2) the current gap between state pension assets and liabilities is equivalent to 25% of outstanding federal debt.

Rauh points out that actuarial practices understate the gap, and that with 8% annual return on pension assets [optimistic in our view], annual contributions to pension funds would have to double over the next ten years to close the gap. That’s a heck of a tax increase and/or shift in social spending at the state level. And given the contractual nature of defined retirement benefits, the fact that they are not indexed to nominal asset values in any way, and the importance they are afforded in most state constitutions, it seems unlikely that any ground can be made up on the benefits side of the equation.

States potentially have the option of scrip’ting away part of the problem by issuing their own currency (a more permanent version of California’s IOUs). The problem there is that many pension beneficiaries may live outside of the state they worked for, and that such measures might run afoul of pension guarantees.

Thus, it seems inevitable that the federal government will become more deeply involved in this issue in coming years. And while a great deal has been made of a ‘Keynesian revival’ in economic policy over the past few years, the pension crisis, like demographic cycles, actually seems to call for a revival of Abba Lerner’s ‘functional finance’, and the neo-chartalist school in general.

Essentially, if tax related or other burdens associated with pension fund solvency would impose deflation and/or penalties on real output, then the sanest way to resolve the crisis would be to employ the federal government’s capacity to issue interest and non-interest bearing debt (Treasury bills/notes/bonds and U.S. dollars, respectively), as we did with the financial system.

While straightforward in theory and operation, functional finance could prove a bit messier in its outcomes, given that U.S. dollars are still the global reserve currency. As we’ve pointed our previously, goods subject to the Law of One Price, primarily commodities, could very well ”inflate” in price, even if core U.S. price indices are relatively tame. That combination can have a regressive impact on households, and asymmetric impacts by industry.

If mishandled, it would mean that we’re shifting some of the adjustment costs in state pension assets to people outside and inside our borders who had nothing to do with the problem, while others would benefit unduly. Messy stuff.

URLs:

http://kelloggfinance.wordpress.com/2010/03/22/the-day-of-reckoning-for-state-pension-plans/

http://www.kellogg.northwestern.edu/faculty/rauh/research/RauhASPSSUSC2010.pdf

http://www.sscommonsense.org/page04.html

http://www.cfeps.org/pubs/wp-pdf/WP10-Wray.pdf

http://www.ucm.es/info/ec/ecocri/cas/Febrero.pdf

Crisis, regulation, vigilance & cynicism

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

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

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

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

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

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

Koppenheffer continues:

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

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

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

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

I suppose we’re a bit cynical too.  

URLs:

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

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

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

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

Greece and Goldman

There’s been a good deal of news swirl about Goldman Sachs’ role in entering into swaps contracts with Greece in order to assist it in “hiding” some of its public debt as it prepared to enter the EMU.

Here’s a good primer from 2003 on these types of swaps, and an interesting thought piece on it from Ed Harrison.

URLs:

http://www.risk.net/risk-magazine/feature/1498135/revealed-goldman-sachs-mega-deal-greece

http://seekingalpha.com/article/190390-inside-the-mind-of-an-investment-banker-greece-goldman-and-derivatives

The Deficit Commission: Hubris or Pandering?

The President signed an executive order yesterday to establish a deficit reduction commission headed by Erskine Bowles and Alan Simpson. Bowles was instrumental in the Clinton administration’s budget negotiations of the late 1990s, while Simpson helped ensure passage of the tax hikes in 1990 that torpedoed the first President Bush’s reelection.

Why do we think the commission is a display of hubris? Because there’s nothing in its mission about better understanding the nature of the problem, i.e., whether enlarged deficits and public debt ever make sense over a longer period of time, and if so, whether those conditions exist today. Instead, it seeks to cram macroeconomic orthodoxy down our throats, presumably in order to fatten up the livers of U.S. taxpayers by the arbitrarily imposed year of 2015.  But we predict that even in five years the fiscal foie gras will still be pretty lean.  According to the Washington Examiner:  

Here are the kinds of steps the panel is likely to consider as it seeks to tackle deficits that never dip below $700 billion under Obama’s budget:

_Raise the retirement age for full Social Security benefits to more than 67 years old and have benefits grow at a less generous inflation rate. Expose more income to Social Security and Medicare payroll taxes.

_Require seniors to pay more Medicare costs out of their own pockets and curb payments to health care providers.

_Raise taxes on people making less than $200,000 a year, requiring Obama to break a signature campaign pledge.

“You’re going to have to do all of the above,” said [Sen. Kent] Conrad. “You’re going to have to do all of the things that people don’t want to do.”

The first one isn’t a terrible idea, though its second part might constitute an overall tax hike on anyone earning over ~$100K per year, depending on how it is accounted for in income taxes.

The second one, although it’s a pressing issue given demographic projections, would have harsh consequences on seniors, not only in terms of out of pocket costs, but also in the availability of Medicare providers; it also renders the economics of a medical education far more difficult (if not impossible) for those who would be willing to administer primarily to the poor and the elderly.

The third one, depending on how big a hike is involved and how far down the income ladder it extends, could have negative economic consequences and profound political implications.

The long term structural issues do present a fiscal challenge. However, policymakers may be getting too far ahead of the problem, and if they are, the consequences could actually worsen the longer term fiscal outlook. And yet the president has charged the commission with lowering public deficits, period, without any consideration of what it could mean to the economy, or whether there’s any truth to his arguments that the government could “run out of money,” or that it’s subject to the same kinds of budget constraints as a household or business.

Obviously, given our take on the role of the federal budget, we would be relieved if the commission turns out to be little more than election year pandering. And the fact that it aims for budget normalization rather than budget balance, and shoots for it in five years rather than one or two, is a good sign. But based on U.S. demographic composition, we think 2018 to 2020 would make far more sense.

If the commission produces hawkish recommendations that are pursued vigorously in the coming years,  our strong dollar call will become stronger yet, and our willingness to wager on a double dip or ‘recession within a depression’ type of event would increase (2012-2013 could be interesting, and not in a good way).

URLs:

Marshall the Moody’s Mauler

Marshall Auerback offered up a brutal dismantling of rating agencies’ negative outlooks on sovereign debt issuers like Japan, the U.K., and the U.S.

America’s Triple AAA credit rating could be at risk should its nascent economic revival not develop into a full-blown recovery, Moody’s Investor Service warned yesterday…

Sound familiar? The so-called “Big Three” ratings agencies have been making claims like this for years: in Japan, the UK and, now, the United States. It is worth recalling that these are the same organizations which, as recently as 2007, were conferring Triple AAA ratings on subprime mortgage paper…

Unlike Moody’s, we think it is absurd to say that the government is going to ‘run out of money’ as our President has repeated. It is not dependent on China or anyone else. There is no operational limit to how much government can spend, when it wants to spend. This includes making interest payments and Social Security and Medicare and Medicaid payments. It includes all government payments made in dollars to anyone.

And if Moody’s (or any other ratings agency) genuinely thinks that government debt is intrinsically evil and that surpluses should be the stated goal of US government policy (in order to safeguard America’s Triple AAA rating) then it must spell out the full consequences of this policy choice. The ratings agencies appear incapable or (at the very least) unwilling to explain the essential sectoral relationships that link the government, private and external sectors. They seem to think that you can have everything – a budget surplus and high private saving and debt reduction. You cannot as a matter of plain accounting logic unless you suddenly start net exporting in great volumes, (which has not happened to the US in its post W.W. II history), or if the domestic private sector is either choosing to deleverage or use leverage less than in the past, that means it will take large and increasing fiscal deficits, or small and decreasing trade deficits, or some combination of the two, in order to achieve trend real GDP growth paths. Otherwise, the result is stagnation or in the extreme, debt deflation. That will not do much to enhance America’s credit rating.

If there’s one thing that Auerback and his fellow neo-chartalists stand out on, it’s this: rating agencies, policymakers, economists, pundits, and many, many others think and speak about debt, deficits, and money as if the world still operated on some type of commodity standard. It does not. Smaller economies may be forced by circumstance to be on hard currency standards, at least operationally, and that is somewhat analogous to a commodity standard. But there is no compelling reason why any issuer of the world’s major currencies (ex-ECB ) should ever miss a debt payment. It’s preposterous.

And yet people actually buy protection against default on U.S. treasury debt via credit default swaps (CDS)! That’s a financial snake oil that comes with potentially significant economic costs. Here’s why:

• Holders of Treasury debt are giving away money to the counter parties selling CDS protection.*
• If it were possible for the U.S. government to default, what counter party could possibly cover its obligations? Diligence schmiligence?
• Leverage, insufficient regulation, and herding behavior have actually made the long CDS trade a winner at times over the past several years.
• That means a greater amount of capital becomes (mis)allocated to people who have done nothing to improve overall economic well-being.
• Those winners will suffer delusions of genius, which almost guarantees they’ll make bad decisions in the future.
• If those bad decisions are levered highly enough, their errors will have systemic implications.
• Add opportunity costs to the risk of systemic damage and the net long term social costs of such behavior are almost certainly negative.

* It might not seem like much — at 50 basis points it costs $50,000 to “insure” $10MM of Treasury debt — but if we assume, for example, that a pension fund is on the long side of the swap, it’s giving away the equivalent of one or two pensioners’ incomes. And while it might look like a good move as long as speculation in Treasury CDS continues to run, the real economic value is ZERO, for the reasons outlined by Auerback.

URLs:

http://www.newdeal20.org/?p=8162

http://www.reuters.com/article/idUSN0524400220100205?loomia_ow=t0:s0:a49:g43:r1:c1.000000:b30347234:z0

Volatility? Shocking!

The news flow this week has put equity markets into one of their periodic panics. It’s been almost a year since the last one, so in the long term, this might be healthy. Healthy or not, it’s peculiar how closely these shakeouts have coincided with the political calendar, and judging by available academic research, the market should be better prepared for air pockets like the current one. For example, according to a 1997 study by Lamb et al:

Almost the entire advance in the [stock] market since 1897 corresponds to the periods when Congress is in recess. This is an impressive result, given that Congress is in recess about half as long as in session. Furthermore, average daily returns when Congress is not meeting are almost thirteen times greater than when Congress is in session. Throughout the year, cumulative returns during recess are eight times that experienced while Congress is in session. [emphasis added]

Or this 2006 study by Michael Ferguson and H. Douglas Witte:

We find a strong link between Congressional activity and stock market returns that persists even after controlling for known daily return anomalies. Stock returns are lower and volatility is higher when Congress is in session. This “Congressional Effect” can be quite large—more than 90% of the capital gains over the life of the DJIA have come on days when Congress is out of session. The Effect varies systematically with the public’s opinion of Congress: returns are lower and volatility higher when a relatively unpopular Congress is active. Public opinion appears to play a fundamental role in market prices. This is consistent with a mood-based explanation that sees Congress as ‘depressing’ the average investor. Alternatively, our results can also be reconciled with rational explanations that view Congressional activity as a proxy for regulatory uncertainty or rent-seeking behavior. [emphasis added]

Federal policies have a powerful effect on asset prices, and risk aversion has been very low until this week. With Congress back in town, the President on the war path, and widespread gnashing of teeth and rending of garments over budget deficits and the federal debt, volatility had nowhere to go but up. Our advice? Don’t worry about it (too much). It would be great if our elected leaders inspired more confidence and certainty, but political noise happens — the current bout might even need to happen in order to get satisfactory regulatory reforms enacted. However, we have one of the best (if not the best) political systems for correcting political errors. 

The big question ahead of us is how closely we’ll skirt a 1937 outcome, which shouldn’t be a material risk until 2011-12. The Treasury yield curve will probably provide the best clues. If longer term yields come down considerably in 2010, watch out. 

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. 

URLs:

http://www.unf.edu/~rlamb/Docs/FinServRev.pdf

http://www.fma.org/Orlando/Papers/Congress_and_the_Stock_Market.pdf