Federal Deficits….Where Will the Money Come From? (posted 11/4/09)

A dozen or so years ago I heard Pete Peterson, former Secretary of Commerce and Senior Chairman of Blackstone Group, expound on the low savings, high balance of payments deficits, and frightening outlook for the fiscal affairs of the United States. He went on to found the Peter G. Peterson Foundation with $1 billion of the proceeds of his interest in Blackstone.  The Foundation has the mission of raising the awareness of the necessity of fiscal responsibility.

At the time Peterson struck me as an alarmist.  But no more.

Over the 15 years leading up to the current economic/financial problems, our high consumption economy, combined with a significantly undervalued Chinese currency and high oil prices, caused an immense explosion of foreign-owned U.S dollar assets…….negative saving here, by both consumers and government, and high savings abroad.  Our deficits were financed in significant part by foreigners, notably China.

The long-term hope during this period was that we would see a reduced level of military spending, lower oil imports, and enough upward adjustment in the Chinese currency to start bringing things back into balance.

But China has made only token moves to revalue their currency, we have not made any meaningful progress in reducing oil imports, due primarily to price increases, and our federal deficits have exploded upward as the economy and financial system ran into serious trouble. So even as consumer savings began to rise, dissaving by government has increased rapidly. Remember that it’s aggregate savings that interest us, that is, savings of both the private and government sectors.

You’ve probably seen the numbers. Looking forward, federal deficits seem out of control.  When realistc assumptions about economic growth are plugged into the calculations, the annual and cumulative deficits are truly staggering.  And when Medicare and Social Security obligations are added, the numbers look impossible to manage. Something will have to give…..

 

 Where does the money come from to finance these deficits? Will they have to be monetized, with treacherous implications for inflation? If so, to what extent?

These are very key questions.  As to monetization, one is tempted to say that unless the Federal Reserve’s independence is compromised, it won’t happen.  But there are several congressional camels trying to get their noses under the tent here.  As now structured, I believe the Fed could avoid significant monetizing as long as the economy is growing and unemployment is not a serious problem. If the economy is not growing satisfactorily, and unemployment is uncomfortably high, some monetization might actually be desirable, but in any event the political pressures on the Fed to keep rates low would be immense.

Above all, beware of threats to the independence of the Fed. As I have pointed out in earlier Musings, hyperinflation has never occurred in a country with an independent central bank. Or saying it differently, as Niall Ferguson did in his recent book, The Ascent of Money, inflation is always a monetary phenomenon, but hyperinflation is always a political decision.

As to funding Medicare and Social Security entitlements, at this point in time I must say the problem looks almost too big to solve. Social Security and Medicare have promised $43 trillion more in benefits to senior and disabled workers than the programs will be able to pay.  And that’s before any changes that might be wrought by the new healthcare legislation. The 2008 annual report of the trustees of the Social Security and Medicare trust funds concludes that both programs will require progressively larger transfers from general revenues to maintain projected levels of spending.

Medicare is the greater challenge. It seems very unlikely that our legislators will raise premiums sufficiently to cover the rising costs.  If not, then benefits must be significantly reduced (also unlikely) or tax revenues must be increased.  The latter looks like a shoo-in. One reputable estimate is that if financed by payroll tax, the Medicare tax would have to double to 5.7% by 2020 and triple to over 9% by 2030

Social Security will have positive cash inflow in until 2017 when it goes negative.  But starting next year, 2010, the $80 billion or so of surplus Social Security annual cash inflow that has been borrowed  by congress and used for other purposes begins to shrink and will have to be found elsewhere., thus further aggravating the task of finding financing for the federal deficit. By 2020 today’s $80 billion surplus will become a $75 billion shortfall.  The shift of $155 billion will have to come from either general revenue or from a big jump in the payroll tax.

Meanwhile, back to the projected total deficit where we revert to talking about trillions of dollars instead of mere billions.  No matter how you slice it, the federal government must find $12 to $15 trillion in cash over the next 10 years.  From where?  How?

If, for a variety of reasons, including lower net exports to the U.S., fear of a weak dollar, fear of U.S. inflation, and reluctance to add to already large dollar holdings, foreigners do not buy large hunks of dollar assets, including new federal debt, the money must come from either domestic savings or new money creation.

If domestic private savings are to be the primary source of funding, significantly higher interest rates will be required to attract those savings (which would also help to keep foreigners from abandoning us).  If higher interest rates are deemed undesirable as a matter of economic policy, then higher taxes seem to be the only answer.  But, of course, both high interest rates and higher taxes stunt economic growth, so we are looking at a vicious circle.

Hmmmmmm……  higher interest rates, higher taxes, higher domestic private savings…………not exactly a formula for a high growth economy is it? Is there a way out? 

The ideal, of course, would be to have a high growth, low inflation, high savings economy, with a favorable trade balance and strong dollar.  I don’t think that is a reasonable probability.  Do you?

A Sense of Unease as the Cycle Begins a Laborious Turn (posted 10/24/09)

 

Most economists now seems fairly confident that an economic recovery of global dimensions is taking place.  Indeed, much of the domestic data we follow has stopped declining and there are many series which have turned up at least slightly. The most notable exceptions are employment, which continues to decline, commercial real estate, and state and local government expenditures. As we are told by the optimists, employment is a lagging indicator, but as it continues to deteriorate it can be a heavy burden for any recovery to carry.

 The effects of cost cutting on operating leverage are showing up in better-then-expected earnings for dozens of major companies, lending credence to expectations of a quick return to past peak earnings when volume growth resumes. The question is when and how does volume growth begin.

 Mind you, there is still plenty of room for recovery just to get back to where we were in real GDP, industrial production, and profits.  At its worst, industrial production registered a 14.7% year-to-year decline, the steepest of the Post-War period.  It has now recovered a very slight 2.5% from its low point.  Capacity utilization, having dropped to the lowest point since the data started to be recorded, has risen only slightly off the bottom.

 States and municipalities (which employ more people than manufacturing) are in agony over declining revenues and increased demands for services. It’s only because of federal stimulus money going to the rescue that major disruptions in services have been avoided.  Higher taxes seem out of the question politically, but look as if they ultimately cannot be postponed.

 As we look for a slow recovery for the U.S. economy we must keep reminding ourselves that it’s a global economy we live in, and generally speaking it’s the developing part of the globe that is the best growth engine at the moment.

 Financial markets have become increasingly sure about a global recovery and its effects on corporate profits. But as I watch the optimism grow, and even as I accept the turn of the cycle, I have an unease, a sense that all is not right.

 I certainly share that view that with consumers deleveraging at a considerable speed, with unemployment still rising, bank credit still contracting, and capacity utilization very low, the recovery will lack vigor. But that’s not the reason for my unease.

The financial world has not been reformed.  Far from it.  The “too big to fail” firms have only become bigger as a result of governments’ moves to save them. Bernanke and the president himself have asked for an end to “too big to fail”. Just how we do that is quite unclear.  I am becoming convinced that any reform legislation should require that these financial giants be broken up into smaller pieces to restore the kind of healthy competition that any industry should have. If that’s not going to happen, then we need very strong oversight and regulation of the survivors. We can’t let them return to playing the same games that finally sent them to the taxpayer trough.

 When I read a Wall Street Journal headline that investment banks expect to pay record bonuses, I get mad.  Has nothing changed?  These firms are remarkably politically insensitive to flaunt their record profits in the faces of taxpayers and the body politic, seemingly thumbing their noses at the rest of us, including the millions who are unemployed because of the excesses created by these very same firms? Goldman Sachs may have paid back all the taxpayer money, but they might not even exist had not the federal government injected sufficient cash into AIG to allow that company to make good on its portfolio of credit default swaps.

 So far I see nothing in the way of seriously proposed reforms that is likely to produce real change in behavior. Naked short selling continues, and bear raids on a company’s stock, which brought many firms to their knees last year, are still possible. The uptick rule, which we lived with for more than 70 years should be reinstated. (This rule required any short sale to be executed only on a price uptick from the previous sale.)

 Global financial markets need a watchdog to oversee systemic risk, to identify it early and then prevent it from developing.  The IMF would seem to be a likely candidate, but we’re a long way from any program with real teeth. The capital structures of financial firms must be firmly regulated. Leverage and asset quality need strong oversight.

As a starter, we need a domestic overseer of systemic risk, but we seem to be mired in a turf battle that is slowing progress on this to a crawl.  The longer we tarry past last winter’s point of maximum stress the less likely we will see an effective agency put in place.

 In an earlier Musing I asked this question: If prolonged periods of stability sow seeds of their own destruction, what kind of seeds do periods of instability create?

 Over the past 60 years the U.S. has experienced 10 recessions.  As we navigated these periods successfully, that is, without ultra severe consequences or systemic collapse, business and financial markets became increasingly confident that depressions were both structurally unlikely and preventable by appropriate fiscal and monetary policy.  We also saw in the early 1980’s that monetary policy could successfully be used to kill inflation.  Each time an economic problem was overcome, confidence rose another notch, culminating in willingness on the part of financial institutions, businesses, investors and consumers to assume greater and greater risks.  Financial leverage at all levels finally exploded upward.

 So the answer to my question is that past periods of instability, as they were overcome, sewed the seeds of higher confidence in stability!

 Now, in this crisis we have seen government actions in dimensions far greater than anything in the past.  I wrote here last December that I thought the Federal Reserve had taken the possibility of a depression off the table. I think that has been proved correct. But what price are we paying? 

 The immense increase in federal debt gets the most attention. To be sure, the fiscal realities facing the OECD economies are daunting.  The future almost assuredly must include some combination of substantially higher taxes, higher interest rates, higher levels of private saving, and curbs on government spending on entitlements. A potent list of growth dampeners, to be sure.

 But additionally, have we created a dangerous faith in our ability to prevent depressions?  Does the fact that we have avoided a depression cause confidence to rise again?  Are we going right back to the same games that got us in this mess?                                                                                                     

 Looking at the remarkable comeback of the stock market one might think so. And given the spineless moves toward re-regulation and prevention of systemic excesses one has a legitimate right to worry.

Low Quality Recovery; Job Losses Continue

 

As I have previously written, the so-called reccovery may be statistically a fact, but it is what I have termed very low quality.  It is the result of an end to the major negative contributors to GDP, but not actual improvement. Headwinds are still strong, and investors should be very cautious after the dramatic improvement in stock prices.

The monthly jobs report, issued last Friday, was disheartening.  Below I have quoted the analysis of the report by Dave Rosenberg, former chief economis t of Merrill Lynch, now with the Toronto-based firm of Gluskin Sheff.

“Nonfarm payrolls in the U.S. slid 263,000 in September, but the details were even more sombre. The Household Survey showed a massive 785,000 plunge in September, and employment on this score has now slid by 1.2 million in the past two months. Sustainability is the key and there can be no durable recovery without net job creation and organic wage growth, which were both lacking in Friday’s report. In fact, the combination of the workweek edging back down to retest the all-time low of 33.0 hours and the near-stagnation in hourly wages dragged the proxy for personal income down 0.2% Month-over-Month (in nominal terms) and the Year-over-Year trend is getting perilously close to deflation terrain, at +0.7% from +0.8% in August and +1.2% in July.

Civilian employment is down 4.3% Year-over-Year and that too is a record in the post-WWII era; remember, the Household survey leads the cycle and typically bottoms and peaks before the Payroll survey does. This survey showed a 785,000 plunge in employment in September, and never before has a recession ended with civilian employment declining this much (on average, it goes down around 70,000 or almost negligible the month the recession ends).

In the last three months, the Household survey shows that civilian employment has plunged 1.33 million. At the time of the end of the 2001 recession, the three-month rally was -3,000 – we hadn’t even entered the jobless recovery at that point. There has never been a time, ever, when a recession ended during a span when the economy lost 1.33 million jobs. So all the calls that the recession is over may have been a tad premature. If the jobs data are correct, and the recession is in fact not over, this entire 60% rally is at risk of unravelling.

There were absolutely no redeeming features in the data. The private nonfarm diffusion index sank to 31.9 in September from 34.9 in August (the manufacturing diffusion index fell to 22.9 from 28.3 in August) which means that for every company adding to their staff loads, more than two are cutting back. The labour force contracted by 571,000 and has plunged now by 1.1 million since May. That again is a sign of the labour market seizing up, which is very disturbing when you consider all the government efforts to stem the tide last quarter – from housing subsidies, to cash-for-clunkers, to mortgage modifications.

The fact that initial jobless claims have peaked and rolled over – modestly by historical standards – tells only half the story which is firings. It is so painfully obvious from the data what is lacking most, is new hiring, especially in the small business sector which accounts for half of the job creation in the United States. The average duration of unemployment rose to 26.2 weeks – a half year! – from 24.9 weeks in August; the median spiked to 17.3 weeks from 15.4. It is so difficult now to find a job that a record 36% of the ranks of those unemployed have been searching with futility now for at least six months. In “normal” recessions since 1950, this ratio peaked at just over 20%. It is nearly double that today. In number terms, we are talking about 5.4 million Americans who have been out of work – but looking – for at least six months. This is troubling.

The U6 measure of the unemployment rate, which is the most inclusive definition of the labour force and takes into account the fact that we have a record 9 million people working part-time because they have been pushed off full-time payrolls, hit a new high of 17.0% in September from 16.8% in August. The gap between this rate and the ‘official’ rate of 9.8% is at a record of seven percentage points. The historical norm is closer to four percentage points and so the concept of mean reversion – Bob Farrell’s first market rule to remember – suggests that the unemployment rate is going to be setting new highs for the post-WWII era before too long (the prior high was 10.8% in November-December of 1982). So the chances that we see a 13% peak unemployment rate this cycle is far from a ludicrous proposition at this point; and just in time for the mid-term elections.

The index of aggregate hours worked, which combines hours worked with the number of bodies at work, seemed to be carving out a bottom in July and August; however, it was a false bottom because this critical ingredient into GDP fell 0.5% in September, to stand at its lowest level in six years. For Q3, aggregate hours worked actually contracted at a 3.0% annual rate, so basically, what is keeping the economy afloat is continued strong productivity gains. But productivity growth alone cannot possibly lead the economy into a sustainable recovery — labour input at some point is going to have to kick in. For Q3, aggregate hours worked actually contracted at a 3% annual rate so basically, what is keeping the economy afloat, is continued strong productivity gains. But productivity growth alone cannot possibly lead the economy into a sustainable recovery; labour input at some point is going to have to kick in.

Take note that the Bureau of Labor Statistics (BLS) also announced a preliminary estimate regarding the benchmark revisions that get published every February and they suggest an additional 824,000 jobs were lost in the year to March 2009, which would put the cumulative decline at over 8.0 million (versus 7.2 million currently, which, even in percent terms – down 5.2%, is the worst in 64 years).

Many of these jobs are never coming back, either. The share of the unemployed who are not on layoff is at record 54.3% as of September. In prior recessions, this ratio would barely pierce the 40% mark. In number terms, we are talking about 8.5 million Americans who have lost their job due to permanent shutdowns, a figure that is double what you typically see at the peak of the recession. “

Anatomy of the Decline and an Early Look at the Recovery

I have found it instructive to look back for a moment and analyze the anatomy of the economic decline. From the 4Q of 2007, when the recession officially began, through the 2Q of 2009, real GDP declined 3.5%. Here are the contributors to that fall; that is, here are the actual percentage points of GDP decline caused by each sector:

Personal Consumption………………………………….-1.2%

Investment in Non-Residential Structures……-0.6

Investment in Equipment and Software………..-1.8

 Residential Construction………………………………-1.0

Inventory Liquidation……………………………………-1.2

Lower Exports of Goods and Services……… …….-1.6

                              Total Negatives…………………………..-7.4%

The positive offsets have been few:

Reduced Imports…………………………………………….3.2%

Government Expenditures……………………………..0.6

Statistical Residual………………………………………….0.1

                                    Total Positives………………………..3.9%

                            NET DECLINE………………………………3.5%

This table understates the negative contribution from residential construction because it had already suffered a hefty decline by 4Q 2007. But otherwise it shows a clear picture of what has happened.

Because one hears often about the positive contribution from exports in this recession, some may be surprised to see lower exports as an important negative force. That’s because the positive contribution has been from NET exports, which has been a negative for GDP for some years as our imports soared and surpassed our exports. (Net Exports effectively became Net Imports, but the National Income compilations left the Net Exports title unchanged). What has happened in this recession is that imports have declined much more than our exports, thus reducing the negative size of NET exports.

This is worth considerable emphasis. Reduced imports have acted like a powerful shock absorber, offsetting over 40% of the recessionary forces! This was not only the result of lower consumption of finished, imported goods. A significant part of the import growth in the decade preceding the recession was the result of domestic firms outsourcing production to foreign producers. When domestic demand contracted, therefore, the outsourced production (imports) was affected disproportionately.

Looking at what happened is of some help in judging what will happen now. It is not clear that the reduction of imports relative to exports will continue. Most recent trade figures indicate otherwise, although the dollar weakness of the past few weeks is not yet reflected therein.

The most immediate help to economic activity is coming from an end of inventory liquidation. As liquidation turns to modest accumulation, GDP could benefit by as much as 2%.

Residential construction seems to have finally stabilized, even if at a very low level. Mere stabilization can add a full percentage point to GDP growth.

Signs of stabilization have also been appearing elsewhere, notably in investment in equipment and software. No large positive yet, but stabilization will help the GDP numbers. Meanwhile the effects of government stimulus are accumulating and will be a solid positive for some quarters ahead.

John Mauldin has called it a “statistical recovery”. By that he means a recovery which looks good on paper in terms of magnitude but doesn’t really feel like a recovery. I prefer to call it a “low quality recovery”. For rather than being a broadly-based increase in aggregate demand it is quite narrow, being heavily weighted toward stabilization where there has been negative growth, plus a turn from inventory liquidation to modest inventory accumulation, and dependency upon government stimulus.

Headwinds are still very powerful: commercial construction continues to fall, state and local governments are reducing spending as tax receipts plummet, and high unemployment and underemployment make any meaningful growth of personal consumption unlikely for some time ahead.

Programs like Cash for Clunkers have come and are now gone, giving the auto industry a big shot of adrenalin but leaving consumers $10 billion deeper in debt than they would have been otherwise and the auto industry without an encore. (although, on the positive side, it’s worth noting that total consumer credit outstanding contracted at a very rapid rate in July)

The slight recovery in housing has been dependent upon large price reductions, sales of foreclosures and the aggressive FHA mortgage lending program, which has pushed that agency’s share of market from 8% to 23%. (the price? FHA’s delinquency rate has soared to 8% from 5.5% a year ago) Amazing what can happen when you ask for only 3.5% down.

Yet, as indicated above, despite the negatives, GDP growth will be nicely positive this quarter and probably next quarter. (Early this year I predicted in this blog that GDP would stabilize and /or turn up by the 3rd quarter. That prediction was made almost completely based on the huge monetary expansion we experienced during last fall and the early winter months, and on my bias toward monetarism.)

But what then? I still do not see the makings of a broad growth in aggregate demand for several years, as financial leverage at all levels continues to be reduced and as employment growth lags. And yet……..it looks as if we have survived, and have prevented a depression and extended deflationary period. The price we have paid is not yet clear. To be sure, the growth of the national debt will be a constraining force on economic policy. Any politically neutral viewer of the future almost surely sees higher taxes at all levels as a necessity. And then there are the questions about the Fed’s ability to withdraw monetary stimulus in a timely way and return to more normal levels of interest rates. So far, inflationary expectations have been well contained, but we are close to the line which, if crossed as demand levels return to more normal levels, would be devilish to control

Business Ahead of the Curve, But…Have Job Losses Become a Leading Indicator

I received the following email from a well-known, astute businssman and friend.  I have chosen to protect his anonymity.

I thought that both his major point and my reply might be of interest.  It won’t take much of an upturn in volume to produce some stunning profits.

Is it possible that job losses, normally a lagging indicator, are sufficiently severe to have transformed them into leading indicators, at least in the short run?

*********************************

Paul-

I enjoy your “musings”. I wonder if your recent comment about the weak employment situation could not also be seen in a different light.

My reading is that consumption is down “somewhat’…2.2% or so.

Business has pulled back strongly as seen by the unemployment figures and domestic investment which is down by 15% plus housing by 50%.

Wages as well as Disposable Income have held up despite employment.

This says to me that business is out ahead of the problem which may be good.

What do you think?

Regards,  J——

*********************************************

Dear J—-,

You are certainly correct.  Business has been ahead of the curve in cutting employment and so far profits have behaved better than I would have expected, given the magnitude of the contraction.  The productivity numbers also indicate this.  When volume recovers the earnings results could be stunning.

My concern has been that employment has been falling so fast that, at least in the near term, its usual “lagging indicator” status might not hold, becoming more of a leading or at least a coincident indicator.  I think that has been more or less the case until now.  What I am anxious to see are signs that job losses are slowing.  The May numbers seemed to indicate that but the June report gave no such evidence.  One possibly hopeful sign is that last week’s initial unemployment claims declined, and now are down over 90,000 from the peak.  Initial claims ran over 600,000 for 22 consecutive weeks!  However, now we have simply returned to the January level, which we thought was horrendous at the time. July’s employment change may look better than June…but it’s still likely to be bad, only less so.

In the meantime, consumption is being supported by significantly lower taxes and unemployment benefits, and penalized by higher fuel prices (after benefiting greatly from lower fuel prices in the 1st quarter).  Disposable Income has held up pretty well, but I don’t foresee any real improvement for quite a while.

Inventories have been reduced big time, and any initial improvement in GDP will be largely the result of and heavily affected by what happens to inventories.  If inventory liquidation were simply to cease, GDP would jump by 2%.

Hope your summer weather has been better than ours.  New Hampshire’s  June was the second cloudiest  of the past 100, exceeded only by 1903!

Best Regards,   Paul