Cicero on Government Finances

June 30, 2009

So what have we learned in 2,064 years ?

“The budget should be balanced, the Treasury should be refilled, public debt should be reduced, the arrogance of officialdom should be tempered and controlled, and the assistance to foreign lands should be curtailed lest Rome become bankrupt. People must again learn to work, instead of living on public assistance.”

Cicero – 55 BC

This quote sent by my old friend Nob Hovde………

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A Link to Some Excellent Charts

June 25, 2009

Paul Swartz, an international economics analyst at the Council on Foreign Relations, has compiled an excellent series of charts comparing the current economic contraction with the average of previous recessions.  It is worth your while to take a look at:  http://www.cfr.org/content/publications/attachments/2009OutlookFinal_Long.pdf


If Stability Sows the Seeds of Its Own Destruction, What Seeds Does Instabilty Sow?

June 24, 2009

“Confidence grows like a coconut tree and drops like a coconut”(attributed to an economist in India)

It took 50 years to build confidence in the economy and financial system to what Malcolm Gladwell calls a tipping point. That tipping point was reached where investors believed in the prudence of 80% or higher equity ratios, consumers thought the value of their home would rise inexorably, financial firms believed that leverage of 30-to-1 was safe, banks thought they had found the secret of safely lending to subprime borrowers through securitization, and the invention of credit default swaps enabled the buying and selling of credit disconnected from any direct investment in the securities of the borrower. It was when we were tipped into the final orgiastic debt explosion leading to the worst financial/economic crisis of our age.

During those 50 years we:

  • successfully overcame recessions without putting huge dents in incomes and wealth
  • gained victory in a major battle with inflation (1973-1983)
  • were victorious in the Cold War
  • experienced peaceful and successful transitions following assassinations and presidential disgraces
  • made immense progress toward the integration of minorities
  • saw accelerated technological progress
  • raised our environmental consciousness
  • had persistent erosion of unionization and labor disruptions
  • benefited from a worldwide move toward privatization and democratic capitalism
  • enjoyed unimpeded trade and capital flows
  • watched and enjoyed accelerated economic progress in the less developed world
  • saw taxes on capital cut to the lowest level sine the ‘20’s
  • had minimal governmental intrusion a decline of regulatory actions
  • seemingly have prevented major recurrence of terrorist acts
  • had historically unprecedented economic stability
  • had a persistent, even if not consistent, bull market

To be sure, there were some frightening crises, stumbles, hiccoughs, and fevers along the way.  As they occurred it was easy and even rational to regard them as very serious and as having lasting consequences.  But they were contained by a combination of basic strengths in the structure of the economy and policy measures, particularly monetary policy. And the lasting consequences always turned out to have been overestimated.

Retrospectively, we can see that as we overcame each crisis/problem the economic and financial confidence of the participants went up another notch. Yes, there was one very major interruption in the 1970’s as inflation took a vicious turn that required painful medicine.  But by and large, it was a fantastic period for economic stability and progress, with the result of a growing willingness to assume risk and take on debt.

Then came our “Minsky Moment”.  By now most readers have heard of Hyman Minsky, an economist who died in 1996. He has become fashionably revered as a prophet who predicted that crises like the current one would be the inevitable result of long periods of stability. You should and can read more about Minsky in a New Yorker article that appeared in February of 2008, or in Wikipedia

Minsky, in saying that stability leads to instability, saw the financial system as an important promulgator of business cycles.  A fundamental characteristic of our economy,” Minsky wrote in 1974, “is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles.”

Often, Minsky’s ideas are linked to the shorter term, that is, just the business cycle.  But his basic idea can also relate to the longer term over which stability becomes such a trusted piece of the economic fabric that it leads to excesses of a more secular variety, particularly the accumulation of debt, such as we saw created in the 20 years through 2007.

Today it is commonly heard that the damage to wealth and incomes resulting from the financial crisis and the recession is so severe that we will see a lasting impact on economic behavior. Frequently, I have said this myself. But after considering this retrospective on how confidence was built, I have realized there is another possible outcome.  I am not ready to say it is the most likely outcome, but we should be aware of it.

It came to me on a recent day when I asked myself this question: if stability sows the seeds of its own destruction and creates instability, what seeds does instability sow?

We know we are currently in the midst of significant reform efforts with the worthy objective of preventing another financial crisis.  We don’t know all the specifics yet but these few generalities are clear:

  • there will be government oversight of systemic financial risk
  • we’ll see financial leverage limits and stricter capital requirements for financial firms
  • “too big to fail” may be an intolerable idea for the long-run, implying more and smaller financial institutions
  • exotic, non-standardized derivatives, with counterparty risk, are likely to be replaced by standardized contracts, traded anonymously on a central market
  • compensation schemes will be limited in their incentives to assume risk
  • there will be more transparency requirements for the “shadow banks”, mainly hedge funds

This almost certainly is not a complete list. But, I ask you, with such reforms in place, will you have more or less trust in the integrity of financial markets?  My own answer is “more”, even “lots more”.  Of course, I am ignoring other influences including economic fundamentals and their effects on volatility and valuations, but I conclude that reform can be, of itself, a very positive force.

How about economic fundamentals? Once consumers have reduced their leverage, and after housing prices have stopped declining, don’t we then have a more trustworthy economy, free of excesses?  It’s a question of when, not if these things happen, and we may, indeed, see more unpleasant developments between then and now.  But eventually, consumers will return as a growth force.  And when they do, they will be far healthier than when we entered the current mess.

Two of the more depressed markets, autos and housing, are now at levels below their “natural” demand levels.  Auto scrappage rates have declined in recent years as auto quality/durability has improved, but scrappage is still in the area of 11-12 million units on average, compared with current demand of only 9-10 million. Current housing starts of under a 500,000 annual rate compare with family formation of 1.5-1.6 million units.  So once we work through the excess supply plaguing today’s market, housing will have the fundamentals necessary to return to health.

One of the disequilibria that has been worrisome, and which was a result of the consumer-led, trade-deficit-causing boom in the U.S., was the amassing of immense dollar assets by our trading partners, especially China. But this too may look better in the coming years as China puts more emphasis on domestic consumption and less on export growth as a growth engine. The Chinese may well be less adamant about maintaining an undervalued currency and thus enable more balanced growth in tandem with their trading partners.

I have been pleasantly surprised at how well corporate profits have performed so far, in the midst of what was probably the sharpest part of the contraction.  It seems that there was a high degree of anticipation on the part of managements, as well as very fast reaction time in reducing expenses. Productivity, which usually declines as volume contracts, has actually risen through the first quarter. When volume begins to return to the marketplace the leverage to profits is likely to be substantial

If we emerge from this recession, adjustment, contraction, whatever you call it, with no further large disasters, will investors look at the outcome as a confidence-building success?  Might it be considered as evidence that we can overcome even a near-death experience and thereby induce a return of risk-taking? Might we not have generated proof that we have the policy know-how to prevent a cumulative decline?  Farfetched perhaps, but not impossible.

My point is not that recent problems are behind us. It’s much too early to say that. And I am not naive about difficulties we will have withdrawing monetary and fiscal stimuli. But I hear considerable despair about what may follow, so I think it’s valuable to ask what positive things might result from the pain we’ve been enduring.


China’s 2009 Growth Estimate Raised

June 18, 2009

Given the importance of the Chinese economy to world economic growth, it is encouraging to see growth estimates raised.  This has just happened with the World Bank’s estimate, which had been at 6.5% since March and has been hiked to 7.2%.

The macro economist for the Bank’s China office, Louis Kuijs, has a blog that might interest you.  The most recent posting concerns how China has been able to maintain a relatively high growth rate (the highest of any major economy) despite a sharp decline in exports, which had been driving the economy in recent years.

The key seems to have been their stimulus efforts, led by government led investment.  But is the higher growth sustainable for the next couple years in the absence of higher growth rates for the rest of the world?

You may read the blog at:

http://eapblog.worldbank.org/content/how-can-china-keep-on-growing-while-its-exports-are-shrinking


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June 17, 2009

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Interest Rates, Federal Deficits, and Inflationary Potential

June 15, 2009

If a credible plan to  reduce significantly the ongoing Federal deficits is not put in place, we face the risk of escalating inflationary expectations and a real fight between the Fed and the administration and congress. That would be a terrible development. It could seriously jeopardize the Fed’s independence. Note that never in economic history has hyperinflation occurred in a country that had a truly independent central bank.

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In recent weeks we have seen a somewhat unexpected and significant rise in yields of U.S. Treasury bonds.  The ten-year maturity has climbed persistently since early March, and is now just under 4%.  The low was reached in early January at 2.038%.  The yield on the two-year Treasury bottomed in December at 0.65%, and has now risen to 1.33%.

Two year vs.ten year treasury

Much of the commentary I see and read about this blames investor expectations of large demands for future Treasury financing. In March, the Congressional Budget Office projected a deficit, using the president’s budget, of $1.85 trillion, or 13.1% of GDP. To be sure, that’s a factor in causing rates to rise, but not the primary one.

The primary cause, in my opinion, is a welcome increase in investor confidence that is finally directing funds toward riskier securities. Stated another way, fears of a financial Armageddon, which gave rise to a massive flight to safety, have subsided. In fact,   although mortgage rates have been pushed higher, the yield spreads between Treasuries and corporate bonds have actually narrowed. That’s all to the good.

We also must note that despite the rise in Treasury yields, they are still at extremely low levels are not a serious threat to economic recovery.

But, lurking in the background and prepared to pounce on the markets at the least excuse is the threat of inflation, arising from both a set of profligate fiscal conditions and a fear that the Fed will be unable or politically unwilling to withdraw record monetary stimulus on a timely basis.

Over the 59 years spanning my career I have often listened to others expressing serious concern about Federal deficits, government financing “crowding out” private demand for capital, and general fears about government spending and deficits creating chronic inflation.

I have always been relatively dismissive of these concerns, believing first and foremost in the effectiveness of our independent central bank, particularly in containing inflation. Only once have I been disappointed and wrong. That was in the 1970’s when Arthur Burns, then Chairman of the Fed, decided not to risk counteracting the OPEC cartel’s push to raise oil prices, and monetarily validated the cost-push inflationary conditions that existed at that time.

Today, however, I am concerned, very concerned, about the ultimate inflationary result of a potent combination of monetary expansion and lack of a credible plan to bring huge Federal deficits under control. I am not worried about the short term, because for now, both fiscal stimulation and monetary expansion seem fully warranted.

So, I find myself to be a member of a growing group of economists and investors who might be labeled the “third year worry warts”.  We see no inflationary pressures for at least three years during which aggregate demand seems assured of being uncomfortably below both our labor capacity and physical capacity to produce.

The problem with these three-year worries is that they may not remain just inflationary worries. They could rapidly morph into inflation expectations, and expectations shape economic behavior. Rising inflationary expectations discourage lending and encourage borrowing, encourage spending and discourage saving, and rising inflationary expectations tend to increase interest rates and disrupt financial and currency markets.  Left alone, rising inflationary expectations can be self-fulfilling.

I have no doubts that the Fed has the tools necessary to reverse policy when the time comes to do so.  I have no doubt that they will see the need to tighten at an appropriate time. However, it is possible, even likely, that the Fed may find itself wanting to tighten, but because unemployment is likely to stay uncomfortably high well into a recovery, and because the Treasury’s financing needs will remain huge, it will be politically difficult to do so.  I can see it now: irate congressmen tongue lashing the Fed’s chairman for raising the cost of carrying the national debt and being unsympathetic to the jobless millions.  The Fed, always sensitive to threats to its independence, might have to back off. In my judgment, that possibility is the single biggest inflationary threat. The best defense against this would be the bond market itself.  Investors, seeing the inflationary implications of what was happening, would undoubtedly withhold supply of funds from the marketplace and push interest rates up considerably. Economic recovery would be threatened and financial markets badly harmed.

There are some who quite rationally fear that the sheer size of the needed Treasury financing, along with some unwillingness of our trading partners to continue building their dollar holdings, will force the Fed to monetize, i.e., buy for its own account, part of the increase in Federal debt. These fears were irrationally exacerbated by the Fed’s recent purchase of longer maturity Treasuries. It should be noted that despite the label of “quantitative easing” that was attached to that action, it makes no difference to the quantitative change in the monetary base whether the Fed buys long bonds or Treasury bills.  Anything the Fed buys, even furniture for its offices, increases the monetary base. It can, however, make a difference to the shape of the yield curve, and that’s what the Fed was trying to accomplish.

Bringing the deficits under control will be extremely difficult.  In the short term it simply will not happen because of the need for fiscal stimulus.  Longer term we face not only the usual political headwinds, but also the gigantic increases that will occur in the costs of Medicare and whatever additional healthcare programs might be legislated, and increasing Social Security payouts that will occur with the retirements of the baby boomers. (the oldest of whom are 64 this year)

According to my economist/econometrician/friend, Larry Chimerine, the Bush tax cuts, even after adjusting for the added tax revenues from additional economic growth they created, have created a structural imbalance of $200 billion plus per year, without even accounting for the increased interest costs. The Medicare drug program was enacted without any dedicated revenue source.  It’s costing $100 billion per year. And we’re spending $165 billion a year on two wars on top of an ongoing increase in defense spending where primarily older weapons systems and military aircraft are being replaced by newer, more modern equipment and aircraft.  Just these three together, the Bush tax cuts, the Medicare drug program, and increased defense spending have widened the budget deficit, every year going forward, by over $500 billion.

Additionally, coincident with the economic contraction that has reduced tax revenues dramatically, we’ve enacted the stimulus package, and the bailout packages, which when added together total a staggering $1.7 trillion.

Ten years from now, the number of Medicare recipients will be 30% higher than it is today, while the overall population will grow just 13%. The number of Social Security recipients will grow by about 25%.  Even without the recession and the stimulus programs we would be looking at budget deficits, on an annual basis going forward, of something like $800 or $900 billion per year.

President Obama has spoken forcefully in favor of deficit reduction. But we need much more than words. The administration’s budgetary projections of declining deficits (down to 4.2% of GDP by 2012) are based on clearly overly optimistic assumptions on economic growth. The numbers are simply not credible.

Currently, the president has the strong level of popularity necessary to play a forceful role in formulating a credible plan for deficit reduction. Let’s hope he doesn’t squander it. In particular, we need Congress to show some backbone.  It’s very difficult to trust that it will do so.

The next three years present a very narrow and treacherous pathway.  On one side are the necessary but politically difficult decisions to reduce entitlements and increase tax revenues to reduce future deficits, and on the other side is a potential inflationary chasm.


The Passing of a Great Mind

June 15, 2009

It was with great sadness that I read of Peter L. Bernsein’s death on June 5, 2009. I have known Peter since the 1960’s and 1970’s when he and I appeared together on several programs/panels sponsored by The Conference Board, Annual Analysts’ Societies conventions or the glitzy conferences put on by Institutional Investor magazine.

I have read almost all of his books, and have been a subscriber to his biweekly letter since it was first published. Occasionally I would talk to Peter by phone when I disagreed with him. He usually convinced me that he was right.

There is nobody in the profession whom I have quoted more. He was smart, incisive, provacative, and a really nice guy. I will miss him.