He likes it! Hey Nicky!

At the moment, Mr. Market looks pretty satisfied with the EMU’s surprisingly large rescue plan – European stock bourses are up over 5%, France’s CAC40 over 8%, while U.S. equity futures are up over 4%.  Vienna’s ATX and the Madrid General, with their home countries also heavily exposed to troubled sovereign debt (Spain doubly so), are up over 9% and 12% respectively:

Of course, following a week when indices were down 7 to 11%, these kinds of gains still leave markets roughly 3% shy of last week’s highs.

It’s not clear how much of this consists of short covering, and how much reflects renewed belief in fundamentals.  European officials still sound as if they are strongly committed to austerity — perhaps the sizeable rescue package reflects nothing more than a desire to spread the pain to bearish traders as well?

And globally, a handful of analysts have noted that many cyclical asset prices have optimistically decoupled from leading indicators such as Chinese property markets (see this rather cautious piece by former uber bull Ajay Kapur, for example: http://www.miraeasset.com/ourmarket/outlookView.do?board_id=1350&group_id=1&pageNo=1).

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. Symmetry Capital Management, LLC is an Amazon.com associate, and earns a commission on sales generated through links from our website. At the time of writing, the firm, its principals, and its clients did not own any securities mentioned, or any securities issued by entities mentioned.

“An absolute general mobilization” in Euroland

Wow…the EU may, may, have finally put together a mammoth, TARP sized plan to prevent or at least mitigate a 2008-style meltdown on the continent. As described in an article by Ambrose Evans-Pritchard of The Telegraph (UK):

“It is an absolute general mobilization: we have decided to give the eurozone a veritable economic government,” said French president Nicolas Sarkozy, once again basking as Europe’s action man. “Today we have an attack on the whole of the eurozone. This is a systemic crisis: the response must be systemic. When the markets open on Monday morning we will be ready to defend the euro.”

Great caution is in order. German Chancellor Angela Merkel has so far said little. The descriptions of the deal agreed by EU leaders in the early hours of Saturday are coming from the French bloc and EU bureaucrats. How many times during the Greek saga of the last four months have we heard claims from Brussels that turned out to be a distortion of what Germany had actually agreed, causing each relief rally to falter within days? They had better get it right this time.

Perhaps it shouldn’t be surprising that the French bloc is pushing such a description, given their relative exposure to Greece and their immense exposure to Italy:

Image by Bill Marsh/The New York Times

Evans-Pritchard continues, noting what a seminal event this is for the EMU and the euro:

…if the early reports are near true, the accord profoundly alters the character of the European Union…The creation of an EU rescue mechanism with powers to issue bonds with Europe’s AAA rating to help eurozone states in trouble — apparently €60bn, with a separate facility that may be able to lever up to €600bn — is to go far beyond the Lisbon Treaty. This new agency is an EU Treasury in all but name, managing an EU fiscal union where liabilities become shared. A European state is being created before our eyes.No EMU country will be allowed to default, whatever the moral hazard. Mrs Merkel seems to have bowed to extreme pressure as contagion spread to Portugal, Ireland, and — the two clinchers — Spain and Italy. “We have a serious situation, not just in one country but in several,” she said.

The euro’s founding fathers have for now won their strategic bet that monetary union would one day force EU states to create the machinery needed to make it work, or put another way that Germany would go along rather than squander its half-century investment in Europe’s power-war [sic] order.

According to Evans-Pritchard, a key problem with the present accord, beyond German inflation phobia, is that its key components still include severe austerity measures:

The answer to this — if the objective is to save EMU — is for Germany to boost its growth and tolerate higher `relative’ inflation. This would allow the South to close the gap without tipping into a 1930s Fisherite death spiral. Yet Europe will have none of it. The weekend deal demands yet more belt-tightening from the South. Portugal is to shelve its public works projects. Spain has pledged further cuts. As for Germany, it is preparing fiscal tightening to comply with the new balanced budget amendment in its Grundgesetz.

In other words, while Germany may have surrendered significant ground on the matter of closer fiscal integration, it has apparently not given up on its demands for severe austerity measures in other EMU nations. Note that even Sarkozy’s quote closes with the somewhat cryptic statement that “on Monday morning we will be ready to defend the euro.” Does that mean that a stronger euro will be pursued by policymakers, or that stabilization measures will be taken that, in the long run, should ensure the euro’s continued existence? The former would only exacerbate the sense of crisis and panic, so it’s tempting to assume that Sarkozy and other European leaders are committed to the second. However, Evans-Pritchard closes with two disconcerting historical references that should give pause:

While each component makes sense in its own narrow terms, the EU policy as a whole is madness for a currency union. Stephen Lewis from Monument Securities says Europe’s leaders have forgotten the lesson of the “Gold Bloc” in the second phase of the Great Depression, when a reactionary and over-proud Continent ground itself into slump by clinging to deflationary totemism long after the circumstances had rendered this policy suicidal. We all know how it ended.

We should see a good deal of dislocation (relocation?) and continuing volatility in markets tomorrow, with credit markets being key ones to watch. If European leaders can manage to soften the austerity demands, quell their inflation paranoia, and execute on a meaningful stabilization program, then things should settle down in reasonably short order.  If they can’t, then keep your seat belts fastened.

Another critical issue is whether the backstop provided by a new facility is large enough relative to the debt levels at the center of the crisis. According to data in a recent Spiegel article, it might be, all told. In 2012, there’s E370B of debt maturing in the PIIGS nations, E328B in 2011, and 276B in 2012. And something that has been completely overlooked in this crisis is that, according to Ajay Kapur’s research, most of the PIIGS countries are on the cusp of favorable turns in demographic composition, at least as it relates to financial sector performance. That certainly adds an interesting wrinkle to the story.

TOH to Zero Hedge for links to the Telegraph and Spiegel articles.

UPDATE 5/9/2010 — The ECB has announced that its bond market operations will be sterilized, which means it intends to offset the creation of new euros resulting from its planned bond market purchases. The net effect is to undo any actual debt monetization. This indicates to us that current plans to ‘protect the euro’ are indeed likely to have a deflationary bias. It will be interesting to see how forex markets react — do they think it can be done (stronger euro), or will they bet on inevitable ECB easing (weaker euro)?  This does nothing to undermine Stephen Lewis’ warning above about “deflationary totemism”.  

URLs:

http://www.telegraph.co.uk/finance/financetopics/financialcrisis/7702335/Europe-prepares-nuclear-response-to-save-monetary-union.html

http://learning.blogs.nytimes.com/2010/05/04/its-all-greek-to-me-understanding-the-debt-crisis-in-europe/

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

http://www.businessweek.com/news/2010-05-09/ecb-intervenes-in-bond-market-as-part-of-eu-debt-crisis-plan.html 

A brief “Now what?!?”

Equity markets and indices are down over 2% today on worries about what most pundits refer to as the “Greek bailout,” which took its (supposedly) final shape over the weekend, with details to follow from the IMF and other parties. The terms, as currently laid out, are brutal, a fact reflected by the intense street protests in Greece and the government’s loss of union support. The theories and practices underlying them are highly questionable and pitifully anachronistic as well, which make it all the more frustrating.   

There’s no doubt that Greece has made some mistakes, that the lack of accurate fiscal disclosures by its previous government was extremely unethical, and that labor market reforms may be in order. But there are humane ways to approach and work through the entire imbroglio. Unfortunately, neither the IMF nor major eurozone countries seem to be giving that much thought. And as Marshall Auerback has pointed out, Germany’s longstanding inflation paranoia has it behaving as if it’s 1921 all over again; when to us, reality appears to be much closer to the deflationary late 1920s and 1930s.   

We referred to the Greek plan as pitifully anachronistic because it embodies what we might call gold standard era thinking, when the supply of new money was a function of mining output and demand for gold ownership in the private sector. At the turn of the 20th century, economist Knut Wicksell pointed out the need for a “rational monetary system“, while highlighting intellectual obstacles to it:   

It is no exaggeration to say that even to-day many of the most distinguished economists lack any real, logically worked out theory of money, a circumstance which has not, of course, been particularly conducive to the success of modern discussions in this field.   

Wicksell’s sentiments are still relevant today, and (in our view) have been powerfully echoed and expanded upon by proponents of neo-chartalism, also known as Modern Monetary Theory. Bill Mitchell, an occasionally acerbic but ever prolific member of the MMT club, recently posted the following diagram on his website:   

The essential point of the diagram is to illuminate that, under a fiat currency system, the government (whether through its treasury or via a quasi-public central bank) is the sole provider of money. And one of the resulting takeaways of this fact is that under certain conditions, fiscal austerity in the public sector will impose significant costs on the private sector. In turn, that will tend to raise the value of money, all else equal, which is the essence of deflation. And as Wicksell pointed out over a hundred years ago, deflation, like inflation, comes at a cost (emphasis added):   

…when a rise or fall occurs in the money prices of all, or of most, commodities…[a]djustment can no longer proceed through changes in demand or through a movement of factors of production from one branch of production to another. Its progress is much slower, being accomplished under continual difficulties, and it is never complete; so that a residue, either temporary or permanent, of social maladjustment is always left over.   

By linking the inflation boogeyman to public sector debt levels, prevailing economic theory sometimes leads to poor policy prescriptions and outcomes, as we are now seeing in Greece. It also fails utterly to explain the experience of Japan over the last two decades, and it looks set to fail in both the Eurozone and the U.S. in the coming decade.  So far, our contrarian calls for a strengthening USD and a dovish view of long term U.S. Treasury yields has lent support to this thesis.   

As with our recent “What Happened?!?” piece, we also think it’s important to tie the Greek “rescue” package to the current U.S. policy outlook. Today, speaking to the Business Council, President Obama once again invoked our “unsustainable fiscal deficit” and argued for immediate reimplementation of PAYGO. Looked at in terms of Mitchell’s diagram above, that implies that at best, the federal government is unlikely to add to the supply of vertical money.  It’s also important to realize that a concept like PAYGO essentially restricts the vertical money supply function to the central bank. And yet, according to recent testimony from Fed Chairman Bernanke, the Fed is targeting roughly a 50% contraction in its balance sheet, which also implies a contraction in narrow or vertical money supply (though rising velocity could give the Fed some room to work with).  Similarly, it was over tightening in both the fiscal and monetary spheres that led to the 1937 recession after several years of economic recovery.

The upshot of all this is that leaders in the public sectors of both the U.S. and the Eurozone are clearly signalling their intentions to “crowd out” private sector saving and, potentially, income. And unfortunately, electoratal majorities in key countries seem to support this direction. Normally, we expect electoral outcomes to approach optimal, but in this particular case, we suspect that the historic lack of economic and financial education might steer us wrong. Then again, voters with incomes might be making some rational inferences about deficits, austerity, and taxes. If so, the burden of adjustment could rest even more heavily on the on the un- and under- employed (believe it or not, that’s something that a handful of policy pundits have advocated, and that at least one senator briefly pursued).   

Either way, deflation will be the inescapable result of excessive restriction or contraction in vertical money.  We’re currently getting slight whiffs of it from credit markets and price indices (although the latter are still positive); cooling measures in China are also likely to help it along. As noted in our “What Happened?!?” piece, we don’t expect it to manifest in an economic downturn until 2012 or 2013, but it could show up in market prices before that. We’ll be watching commodity markets closely, as a broad decline in those prices would provide an especially powerful confirming signal.  Stay tuned…   

URLs:   

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

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

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

http://en.wikipedia.org/wiki/File:GDP_depression.svg   

http://mises.org/books/interestprices.pdf   

http://bilbo.economicoutlook.net/blog/?p=7864  

http://www.econlib.org/library/Essays/wcksInt1.html   

http://symmetrycapital.net/index.php/blog/2010/04/a-brief-what-happened/ 

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.

A brief “What happened?!”

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

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

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

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

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

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

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

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

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

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

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

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

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. Symmetry Capital Management, LLC is an Amazon.com associate, and earns a commission on sales generated through links from our website. At the time of writing, some of the firm’s clients own shares of Alpha Bank (ALBKY), National Bank of Greece (NBG), and Currencyshares Euro Trust (FXE). One of the firm’s principals owns shares of Goldman Sachs (GS). The firm, its clients, and its principals do not hold any positions in Lehman Brothers, AIG, or the debt of any sovereign issuers mentioned.

URLs:

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

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

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

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

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

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

Poor auctions signifying…what exactly?

A good deal is being made of subpar Treasury auctions this past week and whether they signify a turning point in the market’s appetite for U.S. government debt. It’s certainly possible, but we suspect that there’s a more nuanced and global explanation.

First off, a 10 year Treasury yielding almost 4% annually does not look like a bad deal given the intermediate growth outlook in the U.S., despite what so many other pundits are saying (unless you believe that we’re on the verge of persistent domestic inflation, i.e., a widespread USD surplus…anyone?).

Second, if Treasury auction participants came to market with only cash and held no other assets, then the prevailing theory would be harder to refute. However, the most important participants in treasury auctions are the New York Fed’s primary dealer banks, which are divisions of BNP, Bank of America, Barclays, Cantor, Citigroup, Credit Suisse, Daiwa, Deutsche Bank, Goldman Sachs, HSBC, Jefferies, JP Morgan, Mizuho, Morgan Stanley, Nomura, RBC, RBS, and UBS. These bank divisions and their parents already own large amounts of financial assets. Thus, they also need to manage risk when making purchase commitments. And one of the biggest risks of the past week was whether the Eurozone could agree on an assistance plan for Greece.

The following members of the Fed’s primary dealer banks are also primary dealers for Greek debt: Barclay’s, BNP, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan, Merill Lynch (assumedly this is Bank of America), Morgan Stanley, Nomura, RBS, and UBS. This provides just a glimpse of the overall mosaic, as dealers also act as agents or conduits for public, and not just principals. However, it’s an important one, and it’s reported (and reasonable to assume) that several of them do own large slugs of Greek government debt.

Thus, given the uncertainty surrounding management of Greece’s funding crisis, and how it spiked again this past week as Germany dug in its heels, it’s quite possible that some of the usual buyers of U.S. Treasury debt are simply distracted and/or increasingly risk averse (even using low central bank interest rates to finance the purchase of protective credit default swaps, which probably offered more comfort in the immediate environment than new Treasuries).

 Consider, for example, that French and German banks are believed to be exposed to $119B of Greek debt. Assuming sane leverage ratios of 10x (a dangerous assumption to make), the potential financial loss is equivalent to a significant percentage of the two countries’ annual GDP of $6T (e.g., a 15% decline in the value of Greek bond holdings, if unhedged, would equal roughly 3% of combined French and German GDP).

As tempting as the U.S.-Treasury-on-the-brink hypothesis is for the public debt Cassandras, we think ours does a better job of incorporating the sharp strengthening of the USD over the past week, and market behavior since yet another agreement began to take shape.

Combined with the fact that speculative credit markets are looking awfully frothy, some other strange market signs, and the likelihood of federal fiscal consolidation in 2011, we think you have a recipe for an eventual rally in Treasuries. It reminds us a little bit of the post 9/11 Treasury market selloff. Caveat venditor?

IMPORTANT DISCLOSURES: The author does not own shares of any companies mentioned. Clients of the firm own shares of ALBKY, SHY, TLT, MFG, and NBG. A principal of the firm owns shares of C, GS, and MS. 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.newyorkfed.org/markets/pridealers_current.html

http://www.bankofgreece.gr/Pages/en/Markets/HDAT/DispItem.aspx?Item_ID=3220&List_ID=1af869f3-57fb-4de6-b9ae-bdfd83c66c95

http://www.businessinsider.com/germany-will-have-to-become-greeces-abu-dhabi-since-way-too-many-foreigners-hold-greek-debt-2010-1

http://dealbook.blogs.nytimes.com/2010/02/25/banks-bet-greece-defaults-on-debt-they-helped-hide/

http://online.wsj.com/article/SB10001424052748703798904575069712153415820.html

http://www.bloomberg.com/apps/cbuilder?ticker1=DXY%3AIND

http://www.businessweek.com/news/2010-03-27/bunds-fall-greek-bonds-rise-after-eu-leaders-agree-aid-plan.html

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aJZgGddV4mIY

http://ftalphaville.ft.com/blog/2010/03/24/185091/new-negative-territory/

IMF: Political Lobbying ~ Financial Risk

A new IMF analysis tests the common sense assertion that some mortgage lenders engaged in heavy political lobbying in the years prior to the financial crisis, and that the political results helped to precipitate the financial crisis (emphasis added):

On December 31, 2007, the Wall Street Journal reported that Ameriquest Mortgage and Countrywide Financial, two of the largest mortgage lenders in the nation, spent respectively $20.5 million and $8.7 million in political donations, campaign contributions, and lobbying activities from 2002 through 2006. The sought outcome, according to the article, was the defeat of anti-predatory lending legislation. In other words, timely regulatory response that could have mitigated reckless lending practices and the consequent rise in delinquencies and foreclosures was shut down by some mortgage lenders. Such anecdotal evidence suggests that the political influence of the financial industry contributed to the 2007 mortgage crisis, which, in the fall of 2008, generalized in the worst bout of financial instability since the Great Depression.

The researchers’ findings lend strong empirical support to the common sense:

Using detailed information on lobbying and mortgage lending activities, we find that lenders lobbying more on issues related to mortgage lending (i) had higher loan-to-income ratios, (ii) securitized more intensively, and (iii) had faster growing portfolios. Ex-post, delinquency rates are higher in areas where lobbyist’ lending grew faster and they experienced negative abnormal stock returns during key crisis events…These results show that lobbying lenders engage[d] in riskier lending.

URLs:

http://www.imf.org/external/pubs/ft/wp/2009/wp09287.pdf

Recent Articles on Federal Debt and Budget Deficits

Some reading material on the issue of federal debt and budget deficits, which we’ve been working over pretty heavily in recent weeks (apparently we’ve staked out a decidedly contrarian position). Brief commentaries included (some articles may require subscription and/or registration):

Randall Forsyth of Barron’s, “A Foolish View of America’s Debt”, 11/18/2009 – Forsyth points to recent Treasury data showing that foreign purchases of Treasuries continue apace, and to research that questions how sustainable this buying is. We would argue that when the private sector is diligently saving, the public sector should be busy “dissaving”, i.e., fostering productive investment and engaging in sound counter cyclical expenditures. In a global financial economy, the ability of domestic savers to fund overseas investments poses some risk to Treasury’s cost of capital. But to the extent that foreign savers are willing to finance our public deficits, we should take advantage (though one worry is that some or much of the buying might have to do with exchange rate management by foreign authorities, which is likely to have inflationary consequences globally, and could be a more volatile source of funding than ‘real’ savings).

A mostly spot on critique of the fiscal stimulus debate from the FT, 11/12/2009 – The author calls both Dems and the GOP to task, and points out that progressive Dems need to admit that policy uncertainty undermines productive private sector activity. Unfortunately, the author falls prey to the questionable orthodoxy that we somehow know the upper limit of public debt, and thus will require “fiscal consolidation” in the mid term. These assertions need better theory and (especially) better data. As we pointed out in our recent Idle Speculator piece, an honest empirical economist will admit that the data set on modern, developed financial economies is rather limited.

The FT’s Samuel Brittan, “Simple truths about the economy”, 11/13/2009 – An important counter point to the prevailing orthodoxynoted above, Brittan argues that ”The hole in the world economy can only be filled by deficit spending by the stronger western governments.”

“Are the US and UK heading towards debt crises?”, FinanceAsia.com, 10/15/2009 – A short paper that lends some current and historical empirical support to Samuel Brittan’s assertion that western governments should be running sufficiently large budget deficits. The argument that debt-to-GDP should not exceed some magical threshold is based on a lot of conjecture (IMF, are you listening?). 

President Obama will be holding a “jobs forum” in December - The federal government has done well with counter cyclical stabilizers, and an OK job trying to clean up the mortgage mess; but it’s come up far too short on stimulating productive investment, both in public projects and in private sector initiatives. The President and his party are in a tough spot.

President Obama states in an interview that ”it’s important to recognize that if the nation keeps adding to deficit spending through tax cuts or more stimulus spending, at some point people could lose confidence in the U.S. economy and that could ‘lead to a double-dip recession.’” Err, Mr. President, judging by (the admittedly limited) historical data, the surest recipe for a double dip recession is premature fiscal and/or monetary tightening (see the U.S. 1936-37 and Japan over the past two decades). In other words, if the President and his party fall prey to budget hawkishness, both a double dip and a loss of political power are likely to result. Obama did say that he is weighing tax breaks that would incentivize private sector hiring, but judging by their policy actions to date on that front, and the current makeup of Congress, the resulting policies and their economic impact are likely to be piecemeal. And, of course, temporary, like a “sunset”.

“Tax Amnesty Reaps Billions for Treasury”, FT, 11/17/2009 – Sometimes risk taking in the domain of taxes can produce positive results, as we’ve remarked before. In today’s economic climate, the deficit hawks and redistributionists should reconsider their approaches. A less distorting tax code, and a lower marginal tax burden, might not blow up the Treasury’s credit rating if coupled with productive public investments and a sound and reasonably certain regulatory outlook. Such measures are likely to be subsumed to continuing legislative efforts on health care and financial reform, which is unfortunate. Putting the economic horse ahead of those carts might have meant an earlier downturn in  unemployment, and more political capital for getting them done. Instead, we won’t see unemployment turn down until mid-2010 at the earliest; and that could prove a bigger risk for Democrats in midterm elections than budget deficits.

“Geithner: Recovery not enough without reforms,” Reuters, 11/19/2009 – Geithner testified to Congress that “the regulatory regime that failed so terribly leading up to the financial crisis is precisely the regulatory regime we have today.” Congress and the Administration’s legislative onslaught isn’t helping matters. There’s a lot on policymakers’ plate. In the meantime, the prevailing dynamic in the global financial system is the same one that has made financial crises such frequent visitors since the 1970s and 80s.

URLs:

http://online.barrons.com/article/SB125846371623352037.html

http://www.ft.com/cms/s/0/0c521d8c-cfbb-11de-a36d-00144feabdc0.html

http://symmetrycapital.net/idlespeculation/20091109.pdf

http://www.ft.com/cms/s/0/66e41076-cfc4-11de-a36d-00144feabdc0.html

http://www.ft.com/cms/s/0/0570e674-cf98-11de-b876-00144feabdc0,s01=1.html

http://www.financeasia.com/print.aspx?CIID=158204

http://news.yahoo.com/s/ap/20091118/ap_on_re_as/as_obama_economy

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

http://www.ft.com/cms/s/0/12465b26-d390-11de-9607-00144feabdc0.html

http://www.reuters.com/article/ousivMolt/idUSTRE5AI2Z820091119

IMF Models Its Own Uncertain Future

A new study by IMF researchers supports speculation that we offered back in January:

Is this merely a cyclical downswing, driven in part by global liquidity and economic activity? Or is this a dinosaur institution being forced to contemplate its fate? We tend to think it’s the latter…

From the IMF study:

…two approaches to modeling the use of IMF resources in order to gauge whether the recent decline in credit outstanding is a temporary or a permanent phenomenon…yield the same conclusion: the use of IMF resources is likely to decline sharply. Specifically, credit outstanding is projected to decline from an average of SDR 50 billion over 2000-05 to SDR 8 billion over 2006-10.

That’s an 84% drop between two five year periods, equating roughly to a 30% annual rate of decline. And where we offered caveats and hedges to our assessment, the IMF researchers are much more pessimistic:

Alternative scenarios assuming a weaker economic performance or a less benign global environment do not alter these results.

We’ll stick with our more intuitive hedged argument for the time being, that if central banks overshoot significantly in the future, the IMF might see its balance sheet expand as it is invited to help clean up the wreckage. The probability of chronic overshoot appears to be very low, however.

The full paper is available here: http://www.imf.org/external/pubs/ft/wp/2007/wp0770.pdf

Whither the IMF?

A robust global economy isn’t good for everyone. Take the IMF, for example. Early repayments by certain debtor countries, downwardly revised estimates of the need for its services this year, and competition from the private market are taking a huge bite out of projected 2007 income. The tenor of the report seems to treat this as a challenge to year ahead revenues, but there’s some rather large-writ handwriting on the wall, we think. An institution born out of a long string of political disasters and resultant economic crises is bound to suffer as the global political economy has gradually returned to sounder footing. Is this merely a cyclical downswing, driven in part by global liquidity and economic activity? Or is this a dinosaur institution being forced to contemplate its fate?

We tend to think it’s the latter, but we’ll throw on a hedge, and toss in a caveat. Our hedge is that if large central banks push real interest rates to an extreme, the IMF’s services will be back in demand (though we’re not sure that their charter will allow them to bail out over leveraged U.S. consumers and homeowners…). The caveat we’ll offer is supported by basic supply and demand, and by more interesting areas such as institutional economics and power relationships: the IMF is likely to remain the lender of last resort to the most extreme basket case countries, i.e., those that have screwed up their public policies – and domestic economies – royally. There aren’t a whole lot of these countries in the world, but those that fit the description will be forced to pay a relatively hefty fee for the IMF’s services, especially if we assume that private sector alternatives will be unwilling to step into these more extreme situations.

You can peruse the full report here: http://www.imf.org/external/NP/pp/eng/2006/120706.pdf