Business Conditions, Sentiment, the USD and Gold

File under confirmation bias:

The Philly Fed’s Business Conditions Index is still hanging tough after its most recent update, though it’s still slightly negative relative to historical data.

A point of interest we came across on the Philly Fed’s site is its regional July Business Outlook survey (pdf). The apparent downturn in sentiment in early 2010 appears to coincide with our “strong dollar” call in January 2010, which was based heavily on increasing verbal hawkishness (pdf) from the Obama administration on fiscal matters:

The timing could very well be coincidental, but we think sentiment and fiscal expectations are related at some level, which may be supported by some other interesting features in that graph, from a “sectoral balances” point of view.*  

One is that business sentiment was most buoyant at the time of President Bush and the GOP’s major fiscal easings in 2001 and 2003 (blue circle); the other is the steady downward trend in  sentiment as the Clinton administration’s and Dole-Gingrich GOP’s widely revered budget surpluses were materializing (green line):

Again, this is purely circumstantial evidence, and would require much more analysis to see if anything academic can be made of it. But it does fit nicely with the theoretical frameworks we’re relying on to guide clients through these “interesting times”.

It might also be reassuring that the USD has taken a slight break from its strengthening trend (the red line below is the inverted trade weighted USD index inverted, and the blue line is foreign commercial paper, a measure of foreign credit and business activity in the private sector).

While it’s not at a level that augurs an imminent return to the headiness of 2007 and early 2008, some stability at current levels would be a welcome sign for the world’s credit, goods, and services markets:

There’s also an interesting new bit of evidence that supports our Nov-Jan warnings of a strengthening USD and weakening gold prices. From the FT:

…more than 10 [banks] based in Europe…swapped gold with the Bank for International Settlements in a series of unusual deals that caused confusion in the gold market and left traders scratching their heads…

The Financial Times has learnt that the swaps, which were initiated by the BIS, came as the so-called “central banks’ bank” sought to obtain a return on its huge US dollar-denominated holdings. The BIS asked the commercial banks to pledge a gold swap as guarantee for the dollar deposits they were taking from the Basel-based institution…

Some analysts speculated that the swap deals were a surreptitious bail-out of the European banking system ahead of last week’s publication of stress tests…

…two central bank officials said some of the commercial banks…needed the US dollar funding and were keen to act as a counterparty with the BIS. The gold swaps began in December and surged in January, when the Greek debt crisis erupted and European commercial banks were facing funding problems…

In other words, large banks on the continent were more than willing to swap gold for USDs with the BIS when facing credit strains and stress tests. This is something to keep in mind among all the gold bug chatter — unbacked paper or “fiat” money can become dear, even relative to precious metals. Witness gold’s long term decline against the Yen as Japan’s balance sheet recession and negative turn in age structure unfolded:

 The wrench, as we always try to point out, is the USD’s global reserve status. More dovish monetary policy in the U.S. (which can only be accomplished via renewed “quantitative easing” and its distorting impacts) could very well stoke renewed inflationary pressures abroad, with feedback effects on certain components of U.S. price levels. In fact, the deep decline in Yen per gold ounce might have been driven in part by the absence of Yen carry trade mechanisms. Once those mechanisms were in place and more widely available (circa late 1990s or early 200s?), Yen-gold was freed to the upside.

The fact that the USD is the traditional carry trade currency is a reminder that USD-gold could still have plenty of room to run, and that uncertainty is why we are not placing any bets on gold prices, either to the upside or the downside. But to the extent that any rally is driven by Ponzi-style leverage — which is still quite possible due to the anemic and slow moving nature of some of the reform measures in Dodd-Frank – gold will, like residential real estate before it, eventually come crashing back down to more normal levels.

It may even be near “normal” levels now. The caveat we’re trying to put forth is that if fiscal, trade, or monetary policymakers err on the hawkish side in the next five to ten years, then USDs will be in scarcer supply, and all else equal, that would mean lower prices generally — even for gold.

One last note — preliminary second quarter GDP came in light at 2.4%. This is a steep fall from recent quarters, and it too lends some support to our argument (and others’) that federal stimulus played a significant role in driving and/or supporting private sector activity in 2H09 and early 2010.  That’s why we think that any concerted move towards fiscal tightening in the quarters ahead — whether through tax cut expirations (we’re talking to you, Democrats) or spending cuts (ahem-ahem-ahem, GOP) — will substantially raise the probability of a second recession.

* We note that the New School’s History of Economic Thought (HET) website has yet to publish anything on the recently deceased Wynne Godley, who helped to articulate the intersectoral balances approach. As with age structure, underappreciation implies to us that Godley’s balances framework can be put to an investor’s advantage. 

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. 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. You should consult with your personal financial advisor before engaging in any investment activity. Any mention of investable companies and/or securities is incidental and for illustrative purposes only.

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

Stiglitz: The Dangers of Deficit Reduction

A timely column from Nobel economist Joe Stiglitz (emphasis added):

A wave of fiscal austerity is rushing over Europe and America…But despite protests by the yesterday’s proponents of deregulation, who would like the government to remain passive, most economists believe that government spending has made a difference, helping to avert another Great Depression.

…even deficit hawks acknowledge that we should be focusing not on today’s deficit, but on the long-term national debt. Spending, especially on investments in education, technology, and infrastructure, can actually lead to lower long-term deficits. Banks’ short-sightedness helped create the crisis; we cannot let government short-sightedness – prodded by the financial sector – prolong it.

Faster growth and returns on public investment yield higher tax revenues, and a 5 to 6% return is more than enough to offset temporary increases in the national debt. A social cost-benefit analysis (taking into account impacts other than on the budget) makes such expenditures, even when debt-financed, even more attractive.

In those last two paragraphs, Stiglitz is pointing out that if the returns on public spending are greater than the cost of financing them, then the future debt level will actually be lower. The government’s current cost of financing is simply the yield on Treasury debt. As of Friday, the ten year Treasury note yields 3.7%, while thirty year Treasury bonds yield about 4.6%. If publicly financed investments can be expected to return more than those figures, then undertaking them — and adding to current deficits and debt levels — is a no-brainer.

And as long as the yields on the securities of private sector issuers aren’t abnormally higher than those on Treasuries, the argument that the federal government is going to ‘crowd out’ the private sector is without merit.

Of course, it’s debatable (1) whether public expenditures are likely to produce returns of that magnitude and (2) whether future Congresses, Administrations, and Treasury Departments will manage the federal balance sheet appropriately. Unfortunately, no one’s openly debating these points. Instead, we’re treated to pithy but nonstop dogma from both sides, and a peculiar obfuscation by those in the middle, which in all cases overlook the basic financial calculus that Stiglitz reminds us of in his column.

Most importantly for debt and deficit hawks and those who fear higher taxes (those whom econo-nerds would refer to as ‘Ricardian equivalence’ subscribers), when the financial calculus is positive, then the debt service associated with marginal federal spending can be financed organically, via higher growth, rather than through higher taxes.

In short, people on all sides of the deficit issue should be able to agree, at least on financial and economic grounds, that investments yielding more than their cost of financing, when they do not crowd out private sector borrowing or resource demand, should absolutely be carried out.

—

Unfortunately, Stiglitz overlooks his own argument when he writes the following, which make us wonder if he doubts his 5 to 6% return figures, or if he’s just offering a gratuitous slap at the financial sector (emphasis added):

As the global economy returns to growth, governments should, of course, have plans on the drawing board to raise taxes and cut expenditures…

Continuing with his love of taxes:

The financial sector has imposed huge externalities on the rest of society. America’s financial industry polluted the world with toxic mortgages, and, in line with the well established “polluter pays” principle, taxes should be imposed on it. Besides, well-designed taxes on the financial sector might help alleviate problems caused by excessive leverage and banks that are too big to fail. Taxes on speculative activity might encourage banks to focus greater attention on performing their key societal role of providing credit.

As we’ve pointed out elsewhere, the domestic financial sector is going to shrink even without  punitive measures, as demographic composition shifts away from the saving and investing age groups. Well-designed regulation might be a better approach than taxes to constraining financial sector activities to socially beneficial ones (we admit that a ‘Tobin tax’ can be the most efficient approach to regulation under certain conditions, but aren’t convinced that it’s optimal for the financial sector).

And it would be profoundly unjust for the federal government, which so strongly encouraged and underwrote the expansion of mortgage financing (Stiglitz’ “pollution”), to retroactively punish the financial sector, its employees, and its current and future clients for simply following the government’s orders.

Stiglitz also takes a step back from his underlying thesis with this sentence:

Over the longer term, most economists agree that governments, especially in advanced industrial countries with aging populations, should be concerned about the sustainability of their policies.

From a technical standpoint, this isn’t as iron clad as so many of us reflexively believe. First, we have no idea whether an aging population is bound to be a drag on an economy, whether it depends on particular conditions, or anything else. There simply isn’t much historical data available to test such a proposition. Second, if we assume that it is a significant drag, then policies that are seen as unsustainable under “normal” conditions might very well be the most sustainable under those novel conditions. This could include expanded deficit spending and public debt, and/or expansion of money supply.

[To be fair, Stiglitz is almost certainly referring to entitlement spending obligations in that passage, which might be a bird of a different feather. We're just using it as an opportunity to critique some of the conventional wisdom around demographics.]

—

Despite Sitglitz’ inability to break out of his New Keynesian box, or part ways with his passion for higher taxes, we agree wholeheartedly with his essential argument:

…even with large deficits, economic growth in the US and Europe is anemic, and forecasts of private-sector growth suggest that in the absence of continued government support, there is risk of continued stagnation – of growth too weak to return unemployment to normal levels anytime soon.

The risks are asymmetric: if these forecasts are wrong, and there is a more robust recovery, then, of course, expenditures can be cut back and/or taxes increased. But if these forecasts are right, then a premature “exit” from deficit spending risks pushing the economy back into recession. This is one of the lessons we should have learned from America’s experience in the Great Depression; it is also one of the lessons to emerge from Japan’s experience in the late 1990’s.

…we must be wary of deficit fetishism…high-return public investments that more than pay for themselves can actually improve the well-being of future generations, and it would be doubly foolish to burden them with debts from unproductive spending and then cut back on productive investments.

These are questions for a later day – at least in many countries, prospects of a robust recovery are, at best, a year or two away. For now, the economics is clear: reducing government spending is a risk not worth taking. 

URLs:

http://www.project-syndicate.org/commentary/stiglitz123/English

http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml

How do you spell W-I-M-P-Y?

First Congressional jobs bill of 2010 has cleared the Senate:

Senate Democrats Wednesday delivered the first of several promised election-year jobs bills, passing a measure blending tax breaks for companies that hire unemployed workers with highway funding eagerly sought by the states.

The bipartisan 70-28 vote to pass the bill sends it to the House, where many Democrats say it is too puny…

We tend to agree with the House Dems. Among the bill’s measures:

Democrats promise additional measures to create jobs, promising help for small businesses having trouble getting loans, aid for cash-strapped state governments, and subsidies for people who make their homes more energy efficient…

The bill contains two major provisions. First, it would exempt businesses hiring the unemployed from the 6.2 percent Social Security payroll tax through December and give them an additional $1,000 credit if new workers stay on the job a full year. The Social Security trust funds would be reimbursed for the lost revenue.

Second, it would extend highway and mass transit programs through the end of the year and pump $20 billion into them in time for the spring construction season. The money would make up for lower-than-expected gasoline tax revenues…

And the reason it is so wimpy:

But budget deficits are a worry, and future measures are going to be more difficult to pass — especially since a top Senate Democrat has blocked unused authority from the Wall Street bailout program from being used to “pay for” jobs initiatives…

Sen. Judd Gregg of New Hampshire, top Republican on the Senate Budget Committee, blasted the measure for increasing the budget deficit to fund highway and transit programs. He said the measure made a joke of Democratic promises to adhere to “pay-as-you-go” budget rules requiring new spending programs to not increase the deficit.

“I don’t think you get people back to work in this nation by loading more and more debt onto the next generation,” Gregg said.

Sen. Gregg seems like a good man, but he just doesn’t get the underlying economics (unless he believes that the private sector is in robust shape and capable of standing on its own, which means he’s looking at different data than we are). And as we continue to point out, if he and other budget hawks are wrong about the underlying economics, then they are actually going to leave “the next generation” in even worse shape than they would be with more concerted stimulus.

Mark Zandi is cited as estimating that the Senate bill will create roughly 250,000 jobs. That number is unlikely to even make a perceptible dent in structural unemployment. By our back of the envelope calculations, the Senate bill will add about half a percentage point to GDP under the most optimistic assumptions.

We’ll close by calling again on correspondent J. Wellington Wimpy:

“You will gladly pay me today for a job that might be created tomorrow.”

URLs:

http://news.yahoo.com/s/ap/20100224/ap_on_bi_ge/us_congress_jobs

http://symmetrycapital.net/index.php/blog/2010/02/the-hawks-are-circulating/

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:

Miller & Chevalier Tax Policy Forecast

Miller & Chevalier’s 2010 tax policy forecast survey is out (TOH WebCPA), and it starts with this rather gloomy preface:

Although Congress and the Administration continue to focus their attention on health care reform and the continuing economic downturn, the business community can expect that there will be a significant focus on tax policy issues in 2010, including the potential for the consideration and enactment of proposals that increase the corporate tax burden.

According to survey respondents:

An increase in the U.S. taxation of international operations (74 percent), increased taxes on capital gains, dividends and interest (67 percent) and codification of the economic substance doctrine (61 percent) are named as the leading tax revenue sources to be tapped to fund Congressional initiatives in 2010.

We sure hope they’re wrong. As we’ve noted elsewhere, if the federal government makes a concerted effort to finance its spending from current and short term revenues, then economic outcomes are sure to disappoint. In the wake of a financial crisis, money is in relatively short supply (high demand), and the last thing the public sector should be doing is competing for savings.

URLs:

http://www.webcpa.com/news/Execs-Concerned-about-US-International-Tax-Policy-53296-1.html

http://tinyurl.com/miller-chevalier-2010

Obama Budget & 4Q09 GDP

We were feeling a little smug about Friday morning’s GDP print, given our argument in 2H09 that growth prospects were probably being under estimated. At 5.7%, it wasn’t quite the six handle that we thought we might see, but barring any significant downward revisions, it was closer than most expected, and nominal GDP did indeed have a six handle.

Interestingly, headline government spending added little to the quarter’s numbers, so there will be an interesting debate over how much of a role ‘fiscal demand’ is playing, but we’re cautious about that for a few reasons. First, the slower pace at which private inventories were liquidated was a large contributor to GDP, but sustainable private sector growth and employment are unlikely as long as inventory building remains anemic.  Second, federal spending was down due to a lower defense spend, while non-defense spending was up 8% versus 7% in 3Q09, so it’s hard to argue there was no fiscal component. Third, it ignores the possibility of lag effects between public sector spending or deficits and subsequent private sector activity. And if we’re right that fiscal expenditures are still playing a role, the GDP data could imply a very healthy multiplier, a possibility sketched out in this recent academic paper.

This leads us to the Obama budget released today, which will be a real tooth gnashing, garment rending piece of work to many. But it looks pretty good to us at first glance (see the criteria on page six of this Idle Speculator), far better than recent rhetoric led us to expect. The deficit is forecast to be a record $1.56T in 2010 and to remain above $1T in 2011, and it’s beginning to appear that Obama is “triangulating” on fiscal austerity measures, or at least on the time frame over which deficit reduction will occur (though it’s not clear how PAYGO fits into this).

The President’s budget will be tough for some to swallow, but as we’ve pointed out elsewhere, the belief that government is always and everywhere the problem, or that it cannot contribute to real economic growth, is based on a massive underlying assumption: that the private sector is always and everywhere able to grow. It’s not hard to reduce that position to an absurd one, e.g., if a natural or biological calamity were to severely impact private sector potential, a government with a monopoly over money creation could pick up some or perhaps all of the slack.

Reality is far more complicated of course, but since demographic ratios came to our attention, it seems patently clear that private sector potential can vary wildly over multi decade periods, especially in economies where a steep fall in childhood mortality occurred at some point in history. Japan is the most recent example of a two decade downswing in potential output, and its policymakers mistakenly approached the problem as a cyclical rather than a secular one. The U.S. and other western nations are roughly ten years behind Japan in demographic terms, so there’s still roughly a decade of slow, no, or even negative growth ahead of us, barring an active public sector (note: “active” can include tax cuts). As we wrote last November:

We’re familiar with the major [economic] catechisms; we’re just not sure that the evidence supports any one of them over another. Structural economic conditions can and do change — age structure is just one example of how this can come about — and different conditions may call for different approaches.

There are several economic measures that, when viewed over the last two decades, support our assessment that demographics are playing a powerful role in the performance of the U.S. economy (and by extension, these measures tend to undermine arguments against Republican budget profligacy in the 2000s). For example:

The year over year decline in state and local income tax revenue has never been so precipitous, and it has become far more volatile since demographic ratios first turned negative in the late 1990s;

The trend in real private inventories has also been declining since the late 1990s; and 

Equipment and software investment has been in a similar downtrend since the late 1990s.

Admittedly, we’re just eyeballing graphs here and speculating on whether they correspond well to more robust empirical analyses. But we’re fairly confident in our speculation, and this has led us to accept that we are in a Keynesian moment, or more accurately, two Keynesian decades with a Minskian moment in the middle. In such an environment, where private sector expectations are pessimistic, the optimal response is for the public sector to pick up the slack in consumption, investment, and intermediation, within the constraints set by inflation expectations (granted, inflation is a messier issue in a world where the USD is the global reserve currency, and based on a first cut view of today’s budget, we believe our tradable goods inflation thesis is back in play).

The Obama budget appears to pick up a healthy measure of private sector slack, and should thus be favorable overall for employment, asset prices, and economic output. The inflation issue will be far more slippery: on the one hand, a well designed federal budget gives the Fed more room to tighten, as private sector expectations improve; on the other, fiscal direction is uncertain, especially beyond 2011, and prone to shocks, so central banks will have to be rather nimble (more nimble than they were in 2003-05 and 2008) to avoid taking an overly easy or tight approach to policy.

Obama’s proposed tax increases on high income households will cause some resentment, but it’s hard to see how the income disparity pendulum could keep swinging on its current arc. The administration might also believe that higher tax rates on higher incomes will be supportive of state and municipal debt financing. We’d feel better about it if there were an accompanying reinvention of the corporate tax code, as we believe that would have some positive second and third order effects on lower and middle class incomes; first order effects could be achieved by instituting a payroll tax holiday as Warren Mosler has suggested.

Unfortunately, we place a zero probability on corporate tax reform happening any time soon (the budget calls for increasing taxes on certain sectors of the economy), and a near zero probability on a long payroll tax holiday. Despite that, the President’s budget does brighten the economic outlook a bit for 2H2010 and 2011, and the possiblity of a double dip might have been pushed back to 2012 or 2013 (which clearly calls the semantics of ”double dip” into question).

URLs:

http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm

http://faculty.wcas.northwestern.edu/~yona/research/Multiplier-version12.pdf 

http://www.whitehouse.gov/omb/blog/10/02/01/Introducing-the-2011-Budget/

http://symmetrycapital.net/idlespeculation/20100112.pdf

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

http://research.stlouisfed.org/fred2/graph/?chart_type=line&s[1][id]=ASLPITAX&s[1][transformation]=pc1

http://research.stlouisfed.org/fred2/graph/?s[1][id]=CBIC1

http://research.stlouisfed.org/fred2/graph/?chart_type=line&s[1][id]=NRIPDC96&s[1][transformation]=pc1

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

http://moslereconomics.com/2010/01/28/tea-party-plan-for-dems-cut-to-the-front-with-tax-cuts/

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.

I’ll see your PAYGO and raise you a double dip

A key objective raised by President Obama in his state of the union address was to address the ‘fiscal hole’ of the federal government. His rationale was that “like any cash strapped family, we will work within a budget to invest in what we need and sacrifice what we don’t.” he asked Congress to reinstate PAYGO, which reportedly helped the federal government “record surpluses in the 1990s,” and advocated investing in people “without leaving them a mountain of debt.” He closed on this point by saying that it’s just common sense.

Culturally, these ideas resonate with Americans. And for a business or household, budget constraints are a matter of common sense (even though we don’t always adhere to them). But there is no budget constraint on a government that can create money, i.e., non-interest bearing debt, out of thin air. The only meaningful constraint to the level of non-interest bearing debt is inflation, which occurs when a government creates more money than the economy requires, causing its non-interest bearing debt to lose value against most goods and services. Thus, while it may score some political points (thanks to our primary educational system’s lack of a financial and economic curriculum?), it’s absurd for the president to embrace the common sense that households and businesses use in setting budgets. The federal government faces an entirely different kind of budget constraint.

Instead, given the government’s power to create money, common sense would hold that the amount of money supplied to the economy should be equal to the amount of money required by the economy (please note, this simplification is not an attempt to resurrect the policy prescriptions of old school monetarism). Thus, the proper approach to budgets at the federal level is to ask whether there is currently a surfeit or deficit of USDs in our economy. Given the number of private financial commitments that were entered into in the past decade, and dramatic declines in economic activity, it’s difficult to argue that there’s currently a surfeit of dollars. And if recent political rhetoric is any indication, dollars are likely to become scarcer in the years ahead (it would be ironic if, instead of inflation, deflation became the motivating force behind a move away from the USD as global reserve currency).

The president did set forth some positive ideas, such as a zero capital gains tax on small business investment, capital investment incentives for companies of all sizes, and infrastructure investment. Assuming these are financed at least in part by new money creation, they would help to prevent a renewed liquidity crunch. But to the extent that they are “offset” by cuts or freezes elsewhere in the name of closing fiscal gaps and filling in budget holes, or by higher taxes on other activities, the net short term effect on the economy will be nil or worse. And like Japan, we’ll be in for our second lost decade out of two. As we’ve pointed out, leaving future generations without a “mountain of debt” sometimes means leaving them with equivalent (or greater) opportunity costs. We should strive to avoid both of those outcomes. To do so, we have to rethink the cultural common sense that debt is always and everywhere to be avoided.

From an investing standpoint, if vigorous policy actions follow the path being laid out by the rhetoric and “common sense” emanating from so many quarters, then the USD will continue to strengthen, the real economy will stagnate or weaken further, and nominal asset values will fall for all but the highest grade government paper. In that scenario, we would be lucky to tread water and leave only 16% of the country underemployed.

Mr. President, I’ll see your PAYGO and raise you a double dip recession.

RELATED READING (file under confirmation bias): 

We’re well aware that our current view of things puts us shoulder to shoulder with some members of the “loony left”, but the macroeconomics of this stuff are fairly straightforward. Our lonely wing nut sojourn continues, placing us in lockstep with one Mr. Paul Krugman: http://krugman.blogs.nytimes.com/2010/01/26/obama-liquidates-himself/.

The Fed is seeking an exit strategy from its liquidity programs and low interest rate policy. The impact of that exit can be either muted or amplified by Congressional actions. If Congress becomes hawkish, there is no reason for the Fed to do so. If they both begin tightening, it’s hello 1937: http://www.bloomberg.com/apps/news?pid=20601015&sid=aXeUAV7_bz_o

An excellent idea from Warren Mosler — a full payroll tax holiday — that has yet to fall on the radar of federal policymakers: http://moslereconomics.com/2010/01/28/tea-party-plan-for-dems-cut-to-the-front-with-tax-cuts/. Here’s how Mosler describes the cause of poor economic policymaking: “…so-called economic experts have confused themselves and their political masters with contrived explanations for the way the economy works, and their limited vision has limited the range of policy choice. The result has been a monumental economic and social disaster caused by an obvious shortage of aggregate demand. The spending power needed to make mortgage payments, car payments, and do a bit of shopping- all of which would fix the economy and end the financial crisis- just isn’t there.”

Marshall Auerback writes that “Any kind of spending cuts in the middle of the worst recession since the Great Depression is insane.  What we are beginning to see is the return of Herbert Hoover and the ‘liquidationists.’” http://www.newdeal20.org/?p=7731

Ed Harrison posts an email exchange with Auerback, in which the latter wrote: “What the US government is now in danger of repeating is taking its economy down the fast track to a double-dip recession.  With investment still flat, consumers trying to increase their saving ratio and net exports making a negative contribution to growth – the President and his advisors evidently believe the persistently high unemployment is something the private sector has to deal with.”  http://www.creditwritedowns.com/2010/01/what-president-obama-can-do-to-improve-the-economy.html. As we’ve noted elsewhere, the demographic research of folks like John Geanakoplos, Diane Macunovich, and Ajay Kapur implies that for the next decade, the U.S. private sector is not going to behave as the baby boomer decades have conditioned us to expect. Hence the case for a more activist — and just as importantly, ’self-financing’ – public sector. ‘Self financing’ today means the Federal Reserve creating the dollars that enable primary dealer banks to absorb Treasury offerings at auction via direct bids.  For that process to continue, the federal government must continue to issue debt, rather than shoveling dirt on the people and institutions that are still near the bottom of our deep ’fiscal hole’.

Jonathan Zasloff writes (TOH Krugman) that “At some point someone must make an argument for government.” http://www.samefacts.com/2010/01/politics-and-leadership/obamas-self-inflicted-lobotomy-proceeds-apace/  Why are Democrats today so afraid to make that argument? Like the health care debacle, could the lessons learned in the Clinton years be ill suited to today? As for the GOP, our take is that by harping on government in all its forms (besides those forms that help favored firms and industries collect their share of rents from the rest of us, of course), Republicans leave the door open to the development of increasingly socialist policies. In fact, if our take on the state of the private sector in the coming decade is accurate, they will practically mandate it.

State unemployment insurance tracker at Pro Publica (TOH Credit Writedowns) shows how critical federal government support currently is for many states: http://projects.propublica.org/unemployment/

George Soros thinks that premature budget tightening could be bearish for gold prices: http://www.telegraph.co.uk/finance/financetopics/davos/7085504/Davos-2010-George-Soros-warns-gold-is-now-the-ultimate-bubble.html. Reminiscent of Jon Nadler’s argument last fall against gold: http://symmetrycapital.net/index.php/blog/2009/11/a-gold-bears-comments/

Finally, in what might be a mirror image of our loney wing nut position, Bill Gross seems to be exhibiting a profound case of anti-Keynesianism: http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2010/February+2010+Gross+Ring+of+Fire.htm

Bookstaber: ‘Controlled Burn’

Rick Bookstaber put forth an interesting argument about easing debt burdens on the public and private sectors through “controlled burn” inflation. If creditors aren’t willing to take large enough haircuts, that’s pretty much what you have to do to get aggregate credit burdens to a more manageable or desirable level.

There are a lot of misperceptions around this issue. FDR allegedly devalued the dollar c. 1934 by repegging it to gold at $35, instead of the $20 that prevailed before WWI. But if you look at the historical data, the USD was powerfully deflationary in the years leading up that action. And at best, the repegging only stemmed the rate of deflation. It did not create any inflation at all. In fact, the more closely we look at the data, the more closely aligned we become with folks who argue that the New Deal didn’t go far enough.  Paul Krugman’s warning in 2008 is looking fairly prescient:

…Barack Obama should learn from F.D.R.’s failures as well as from his achievements: the truth is that the New Deal wasn’t as successful in the short run as it was in the long run. And the reason for F.D.R.’s limited short-run success, which almost undid his whole program, was the fact that his economic policies were too cautious.

[I would add that other FDR actions were too bullheaded and hasty, errors that Obama also risks repeating.]

During the recent crisis and recession, plenty of pundits argued that USD devaluation would be the order of the day. We saw some risk of that, but not as much as those who pointed repeatedly to the Federal Reserve’s unprecedented balance sheet expansion of 2008-2009, or the federal government’s enlarged deficits. That’s because those factors are meaningless if the private sector is not taken into account (i.e., the effects of monetary policy and public and private sector borrowing are not independent). If there’s intensive deleveraging and a rising desire for saving in the private sector, then expansive actions by the central bank and federal government are merely going to absorb some slack. Ony if they absorb more slack than exists will there be any risk of inflation.

Unfortunately, of late, the messages coming out of almost all political quarters is that the slack in the real economy is going to increase — and that means higher deflationary risk, and conversely to Bookstaber’s argument, rising real credit burdens. That, in turn, will lead to credit after shocks and rising unemployment. Granted, to the extent that people’s nominal income stays the same, real incomes rise in a deflationary environment, so this would be good news for pensioners, savers, and highly valued employees. But we shouldn’t overlook the real opportunity costs that deflation implies.

We see a threat of increasing slack because there’s a rising chorus of fiscal hawkishness all around us. Today, Rep. Chris Van Hollen, chairman of the Democratic caucus, told a CNBC interviewer that the government ”need[s] to get every penny back” from TARP. Yesterday, Republican Rep. Jeb Hensarling said that the election of Scott Brown was a sign that voters cared about debt and deficits (to be fair, he did mention lowering capital gains and payroll taxes, but debt and deficits seemed to be on the top of his mind). Today, a CNBC commentator referred to “your [taxpayers'] money” leading into a report on pending transportation spending. Policymakers are treading the line between semi-sensibility and madness.

First, Congress and the Administration should look forward. That requires changing the regulatory framework in a way that will prevent excessive systemic fragility in the future, and that’s the direction that Obama laid out in his remarks yesterday, with Paul Volcker, who imposed a massive deflationary contraction as Fed chairman in the early 1980s,  smiling in the background. But all else equal, this will lower overall credit capacity, and demanding full repayment of TARP will will make it worse. In order to avoid a double dip, the federal government has to act as the borrower of last resort, i.e., run larger deficits. To us, that’s the real problem with the path being laid out by Obama and Democratic leaders — taking with one hand, and not giving with the other, means economic contraction, all else equal.

Second, debt and deficit hawkishness could not be more untimely. We should pay serious attention to where and how public expenditures are directed, but we need to be honest about the need for significant deficit financed expenditures. Looking at underlying demographic structure, we probably shouldn’t concern ourselves with lowering the federal debt until the end of this coming decade.

Finally, the dollar is ”our money” in the sense that we use it to pay our tax liabilities to a government that has monopoly power to create it. Better yet, it creates it out of thin air (yes, if that power is abused or misused, it can lead to inflation, even hyperinflation, but the risk of such an outcome right now is very, very low). If fiscal policy does indeed swing in a more hawkish direction, then there’s going to be a surfeit of monetary units. And the more we taxpayers or our elected representatives grab for ”our money”, the worse it’s going to get. This ‘chartalist’ view is also somewhat complicated by the fact that our money creation process is controlled by the quasi-public Federal Reserve system. That means that the federal government can only issue interest bearing debt to finance its deficits. It sells those securities to primary dealer banks at auction. And the primary dealers rely on the Federal Reserve system to create the monetary units (the non-interest bearing debt of the U.S. government) that are used to purchase its interest bearing debt.

Keeping those last three sentences in mind, consider that:

• The President intends to tighten the tax and regulatory collars on the banks
• Fed Chairman Bernanke’s confirmation by the Senate is now in serious doubt
• Government spending and investment are especially critical in this recession (see here and here)
• Policymakers are clearly signalling that they’re going to get serious about “fiscal responsibility” 

The clear implication is that USDs are more likely to increase in value. So while Rick Bookstaber is right about the ability of inflation to lower existing debt burdens, it looks to us like we’re headed in the opposite direction, at least for now. The consequences will be discouraging to just about everybody.

URLs:

http://rick.bookstaber.com/2010/01/controlled-burn-inflation.html

http://www.aei.org/article/26390

http://www.nytimes.com/2008/11/10/opinion/10krugman.html

http://research.stlouisfed.com/recession/gdpdata.html

http://research.stlouisfed.com/recession/indicators.html

Dollar Strength & Foreign Credit

We came across an interesting piece on the relationship between the USD and commercial credit activity outside the U.S., as shown in the chart below. The implication, based on a quick and dirty visual analysis, is that if USD strengthening continues (the red line, which is plotted inversely), then foreign commercial paper (the blue line) is likely to contract. In other words, a dearer dollar could spell trouble for foreign economies, and that would have negative implications for economic activity, commodities, and risky assets abroad, all else equal.

This piece of evidence, combined with our strong dollar call yesterday, raises some fascinating possibilities. A rush to the USD was not on many strategists’ radar in 2009, or even to this point in 2010. Judging by markets’ performance today and yesterday, we could be seeing a significant break from those views. Then again, we might just be seeing the first notable stock market correction since last year; a USD squeeze might also be a short lived phenomenon.

We see too many moving parts to make a firm call either way. The markets continue to face the spectre of tightening federal purse strings and a ‘less easy’ Federal Reserve in 2010, and as of this week, they are now sitting in the middle of the open conflict that has broken out between the administration and the financial industry.  

We also see complexities in that battle that make it hard to come down on either side. We offered criticism of Obama’s initial remarks on the financial assets tax, though we later qualified it, and some of his remarks today were spot on. And while government policies and institutions certainly set up incentives to greed and stupidity, the actions embodying greed and stupidity (and the massive trading of rents that did little or nothing — arguably less – for economic welfare) were taken by individuals and organizations in the financial industry. And yet the overall tone of hawkishness from policymakers has negative implications for everyone, regardless of what street they make a living on.

There’s also a little noted irony in the apparent desire of some Democrats to constrain the size and activities of the financial sector. If Ajay Kapur’s research is on the mark, the sector is going to be shrinking in the years ahead regardless of regulatory changes, due to the shrinking ratio of middle aged adults.  A more interesting thing to speculate on, given the continuing centrality of the USD in the global economy, is how well those faster growing regions of the world will cope with tigher global liquidity. 

[UPDATE 1/21/2010 - In a CNBC interview moments ago, House Financial Services Commitee chairman Barney Frank put a far kinder and gentler spin on the recent presidential bluster, saying that a regulatory regime shift would have to be drawn out over several years and do a minimal amount of harm. This appears to have calmed frayed nerves in the market, and is a nifty scoop for Burnett and Cramer. Cramer's inferring that Paul Volcker (a man with a history of bull-in-a-china-shop approaches to policy) has the President's ear, while Frank comes down with the more nuanced regulatory views of Fed and Treasury, which could make for some political drama in the year ahead. It could even be a high stakes game of good cop, bad cop -- time will tell.]

http://shadowcapitalism.com/2010/01/20/the-implications-of-a-dollar-squeeze-on-foreign-banks-credit-access/

http://www.miraeasset.com/data/download.jsp?file_path=upload&file_name=MiraeAsset_TheGlobalInvestigator_20090812.pdf

http://www.cnbc.com/id/15840232?video=1340630859

http://www.cnbc.com/id/34979114/site/14081545