Spain becomes the 4th EU country to get bailed out

Posted in Economics, Financial Markets, General Musings, Politics and Policy at 7:41 am

Yesterday, the EU agreed to provide Spain with a 100 billion Euro ($125 billion) rescue package.

The money will go into a fund called FROB (Fund for Orderly Bank Restructuring) modeled loosely after the US TARP prgram.  The Spanish government will be responsible for paying back the loan, but they are constrained in how they can use the money; essentially, it has to be used to recapitalize their banks.

It appears this will calm the markets, but for how long?

Why is “calming the markets” always the proximate (and often the ultimate) goal?  Spain has an overall unemployment rate over 24%, with unemployment levels hovering around 50% for the young.  GDP growth was negative in 2009 and 2010, barely positive in 2011, and now has gone negative again for the first half of 2012 with consensus estimates for all of 2012 coming in around -1.5%.  The housing market is in shambles after a boom and bust.  Where are the plans to address crisis-level unemployment and jump start economic growth?  Where are the plans to fix the housing market?

It’s interesting to note the similarities between Spain and Ireland, both of which pursued fiscally responsible policies prior to the financial crisis.  Spain ran budget surpluses in 2006, 2007, and 2008.  In 2009, Spain’s public debt was under 60% of GDP, well below the EU average.   Even now, after the crisis, it only stands at around 68% of GDP.  Like Ireland, Spain is not a tale of fiscal profligacy, it’s a story of a country that experienced the collapse of an asset price bubble followed by a banking crisis.  Awhile back, Paul Krugman noted that Rogoff and Reinhart got the correlation between public debt as a % of GDP and economic crisis correct, but they had the causation reversed.  An economic crisis causes public debt to skyrocket, not vice versa.  Spain is a perfect example.

Where do we go from here?   What will the political repercussions be, both in Spain and in the rest of the EU?  Will Ireland and others demand a renegotiation of their bailouts to remove or reduce the austerity measures attached to them?  What impact will this have on the Greek elections?  Will the contagion spread to Italy next?


From Occupation to……….

Posted in General Musings, Politics and Policy at 8:51 pm

The OWS protesters have gotten everyone’s attention now, and started a conversation (that probably should have taken place in late 2008 or early 2009, but better late than never); it’s now time to move from just occupation to an actual program for moving forward.

Some suggestions:

Get rid of all of the demands that aren’t related to the economy.  Issues like animal rights, gay marriage, and other social issues are creeping into the conversation.  They’re all fine issues that deserve a hearing of their own.  However, with regard to what is trying to be accomplished here, they’re a distraction.

Have both a short term agenda and a long term agenda.  We have a lot of short term problems right now.  Many are symptoms of longer term issues.  Both sets of issues have to be addressed, but sequence and priority is critical.

Keep the agenda points short and concise.  Limit the number of them.  Don’t get mired in the details.

Here’s a good starting point:

Short Term

  • Focus on jobs.  The government should make jobs a top priority until the unemployment rate falls below 5%.  Bring the full power of fiscal and monetary policy to bear, and if necessary, pursue direct works programs.
  • Focus on housing.  The housing market is fundamentally broken.  It needs to be fixed.  The economy will not recover until it’s fixed.  Doing nothing is not an option.
  • Focus on education.  The economy of the future demands a better educated workforce.  People shouldn’t have to become lifetime debt slaves to acquire a college degree and a secure future.

Long Term

  • Realign finance.  Financial institutions should exist to fund productive investment by matching savers/lenders with investors/borrowers.  The economy can’t function without a working financial system.  Unfortunately, it’s been turned into a casino where heads the big banks win and tails the taxpayers pick up the losses.
  • Develop an industrial policy.  Historically, this has meant a combination of trade restrictions like quotas/tariffs with subsidies to business.  That’s not what we need now.  What we need is a policy that takes into account the needs of all stakeholders – importers, exporters, labor, management, business owners both small and large.
  • Save the middle class.  This is what all of the short term and long term agenda points mentioned thus far lead up to.  A vibrant, growing, and upwardly mobile middle class is what has made America great.  For generations, people were inspired by the idea that their children would do better than them.  That idea is fading rapidly.  We need to change that.  It will take action – a large middle class is NOT something that just comes about naturally, it’s not a natural outgrowth of capitalism or any other ism; disabuse yourself of that false notion.

This is the sort of agenda that will resonate with the American people.  The statistics on the decline of the American middle class are indisputable.  When confronted with this, the 1% will have no choice but to remain silent or change the subject.  Keep pushing.


The question that needs to be asked at the next GOP debate

Posted in General Musings, Politics and Policy at 4:26 pm

“If you were president, and you received a call at 2AM stating that Greece has defaulted, the contagion has already begun to spread to several other European countries, and a number of large European banks are hours away from bankruptcy and about to trigger a repeat of the 2007-2009 financial crisis, what would you do?

“Before you answer, Mr. Candidate, understand the following.  In 2008, the US exported $325 billion in goods and services to Europe; in 2009, that figure dropped to $258 billion due largely to the financial crisis and recession.  That effect alone was enough to trim over a half a percentage point off of GDP growth, and Europe was not the center of that crisis.  In this case, we could likely expect the impact on US GDP to be an immediate multiple of that.  However, that’s not the biggest problem.  The biggest problem is that US Money Market funds have nearly $1 trillion in exposure to European banks.  Once again, the entire US financial system, and much of the world financial system, are roughly 24 hours away from complete collapse.”

“The Chairman of the Federal Reserve and the Secretary of the Treasury have been meeting all night and are prepared to brief you on the situation as well as lay out their plan for avoiding catastrophe.  It involves extending unlimited liquidity lines to the ECB and other central banks as well as massive capital injections into the largest domestic banks.  We have the chairmen of the SEC and CFTC along with the president of the NYSE on standby to dial in.”

The answers to this question should be quite illuminating for a number of different reasons.  They will immediately demonstrate which candidates have a grasp of economic policy issues and which do not.  This represents a crisis situation that demands a solution, and will demonstrate candidates’ capability to respond to an emergency.  It is a specific question that demands specific answers, rather than ideology, handwaving, and spinning of past accomplishments.


Quick thoughts on yesterday’s Fed action

Posted in Economics, Politics and Policy at 6:45 am

The Fed is clearly aiming to do the minimum amount it thinks necessary in an effort to extend the effectiveness of its available tools.  The other components of the expected action – a cut in the interest rate on excess reserves and a commitment to maintain the size of its balance sheet for an extended period are coming, just not yet.  So are additional asset purchases.  This is a mistake, and is reminiscent of Fed policy in 2007 – a quarter point cut here a half point cut there, until they woke up to the severity of what was happening around them.



Posted in General Musings, Politics and Policy at 7:01 am

Obama’s “pivot to jobs” was amazingly short – roughly one week in duration.  Apparently, we’ve now returned to deficit reduction as the primary focus, with the President unveiling his new millionaire’s tax proposal.  This is absurd.  Deficit reduction is not the most important issue facing the country right now.   In fact, it should be pretty close to the bottom of the list of priorities. When the economy has been growing at a rate >3% per year for at least two years AND unemployment is below 6% and, then we can focus on deficit reduction.   Although I have a hunch that once we reach that point, there won’t be much to talk about since most of the deficit “problem” will have resolved itself.  As of right now though, it’s a distraction, and anything we do to reduce the deficit will make the economy WORSE.


American Jobs Act

Posted in Economics, Politics and Policy at 8:14 am

The official release has a good breakdown and details, so no need to reproduce that here.



$447 Billion Total

$253 Billion in tax cuts/credits
$194 Billion in spending


Tax Cuts

- Extend last year’s payroll tax cut for another year and increase the cut from 2% to 3.1%.  $175 Billion
- Cut employers’ share of payroll taxes in half (from 6.2% to 3.1%) on the first $5 million in payroll (covers 98% of businesses).  Eliminate employers’ share of payroll taxes entirely for any new workers or raises for existing workers, up to $50 million per company.  $65 Billion
- Extend 100% expensing of new capital investment for businesses for one year.  $5 Billion.
- New tax credit of $5600 to $9600 for each veteran hired.
- New tax credit of $4000 for each long term unemployed person hired.

- Direct aid to states to prevent layoffs of teachers, police, and firefighters.  $35 Billion
- Modernizing public schools and community colleges.  $30 Billion
- Investment in roads, rails, and airports.  $50 Billion
- Infrastructure bank creation to attract private funds for additional investment.  $10 Billion
- Project Rebuild, putting people to work rehabilitating houses, businesses, and communities.  $15 Billion
- Expanding wireless broadband access to >98% of Americans.
- Reform and extension of unemployment insurance.  $49 Billion
- Worker training programs.  $5 Billion

There’s also a section on helping more Americans refinance at lower rates than are able to today.

My initial thoughts are it’s a decent plan.  Highly focused on capital improvements and front loaded.  Will have a positive impact, but is too small to reduce unemployment by more than about 1 percentage point over the next year and a half, and after that the stimulus effect peters out.  The obsession with “paying for” the plan almost immediately after it ends will hurt the economy at that point.  I don’t think a lot of politicians get the fact that stimulus is SUPPOSED TO increase the deficit, that’s how it works.  My biggest concern is that it will not survive Congress intact – House Republicans will insist on stripping out almost all of the spending and probably on scaling back some of the consumer (as opposed to business) tax cuts.


A simple solution to the housing market problem

Posted in Economics, Financial Markets, General Musings, Politics and Policy at 4:02 pm

Forced debt to equity conversions have been proposed as a solution to make insolvent banks solvent again.  The idea is that some portion of a bank’s outstanding debt is converted into equity in order to restore a positive net worth (assets – liabilities).  There’s no reason why this same approach could not be taken with private homeowners.

Let’s look at a simplified example:

Home purchaser takes out a $100k bank loan to buy a $100k house.
Assets = $100k, liabilities = $100k, net worth = $0.

House price drops to $80k.  Now:

Assets = $80k, liabilities = $100k, net worth = -$20.

Undertake the debt to equity conversion:

Loan reduced to house market value = $80k.
In exchange, bank gets $20k equity = ($20k/$80k) = 25% ownership stake in house.

The homeowner essentially gives up 25% of future increases in home value in order to not be underwater now.

At some point in the future, the house will be sold.  When that happens, one of the following scenarios will play out.

Scenario 1 – House sells for <$80k.  Bank gets fraction of its $80k loan back.  Bank gets nothing on its equity.  Homeowner gets nothing.

Scenario 2 – House sells for $80k.  Bank gets all of its $80k loan back.  Bank gets nothing on its equity.  Homeowner gets nothing.

Scenario 3 – House sells for >$80k.  Bank gets all of its $80k loan back.  Bank gets 25%*(Home price – $80k) on its equity.  Homeowner gets 75%*(Home price – $80k).

At a sale price of $160k, the bank recoups all of its initial loan ($80k modified loan + 25%*$80k = $100k).  The bank makes a net profit on any final sale price over $160k.

The homeowner will also receive an option to buy out the bank’s equity at any point in the future for 25% * (Market value – $80k) plus some pre-determined premium.

This program would be open to all homeowners, banks would have no say in the matter.  Obviously, homeowners who are not underwater would not have any reason to participate.

Is this solution perfect?  No.

Is it preferable to a taxpayer-funded mortgage forgiveness program whereby the government pays banks to forgive a portion of underwater loans?  Yes.

Is it preferable to doing nothing and having the debt overhang doom the economy to a decade or more of below-potential GDP and high unemployment?  Yes.

I’m well aware of the difficulties involved.  The loan writedowns would impair bank earnings for a period of time (though there would now be future upside).  The impact on mortgage services, MBS, CDOs, and the holders of MBS and CDOs would be messy.  There would be lawsuits.  Again, it must be measured against the alternatives and not some utopian fantasy world where all debts will be eventually paid in full and no losses have to be taken.

What I’ve laid out above is a simplified, stylistic version.  All sorts of modifications could be made to improve it.  The percentage of debt converted could be increased to provide additional monthly payment relief.  The equity structure could be modified to give the bank a bigger percentage claim on the first $20k in price appreciation.  Other terms of the loan could be modified.  The point here is just to lay out a set of guiding principles; the details can be hashed out later.


Fed Announcement

Posted in Economics, Financial Markets, Politics and Policy at 7:25 pm

The Fed announced at 2:15 that it would hold the Federal Funds rate near zero for 2 years.

More significant was what it did NOT announce:

  • It did not announce it would keep rolling over its bond portfolio for 2 years.
  • It did not announce it would change the composition of its bond portfolio to longer maturity bonds.
  • It did not announce it would cut the interest rate (0.25%) it pays on bank reserves.
  • It certainly did not announce QE3.

The immediate market reaction was predictably negative – market consensus was for more action by the Fed.

However, that reaction was short-lived, and the market soon took off like a rocket.  Very odd.


Greek exposure and derivatives exchanges

Posted in Economics, Financial Markets, Politics and Policy at 1:53 pm

There’s a considerable amount of debate regarding the exposure of US banks to Greek sovereign default via their CDS protection sales to European banks.  See:





Yet some policymakers and industry participants still aren’t convinced of the need to move CDS trading to exchanges and bring transparency to the market?  Seriously?  We really didn’t learn anything from the 2008-2009 crisis.

A Greek Debtor’s Prison

Posted in Economics, Financial Markets, Politics and Policy at 8:42 am

Some key stats:

  • Debt-To-GDP of around 150%
  • Budget Deficit >10% of GDP
  • Current account deficit >10% of GDP.
  • GDP growth for Q1 2011 -5.5%
  • 15.9% unemployment rate
  • 2-Yr hitting a high of 30% and the 10-Yr hitting a high of 18%

With average interest rates around 20%, and around a 150% Debt to GDP ratio, Greece needs a primary surplus (government budget net of interest) of 30% to service that debt.  Yet tax revenues are falling at an alarming clip because of the decline in GDP.

What Greece needs, in order:

1. Economic growth
2. Lower interest rates

Austerity programs (lower spending, higher taxes) lead to lower economic growth in the short to medium term, with very little impact on interest rates over that time period.

The bailouts increased the debt to GDP ratio, and any softening effect they had on market interest rates was highly temporary.

Unfortunately for Greece, an absence of bailout funding means an almost immediate default on existing debt.  I agree that this would be a highly destabilizing event for the entire Eurozone if not the world, BUT – the architects of the bailout have no credible explanation for how Greece is to sustain its debt service over the next 2-5 years apart from simply ASSUMING that austerity will somehow magically lead to both balanced budgets and robust economic growth, which is NONSENSE.

Meanwhile, EU/ECB/IMF leaders’ primary concern is how to get Greece’s creditors to rollover short term maturing debt in a manner that does not trigger a “credit event”.  The fact that they are talking in CDS terms speaks volumes.  This is silliness.

The Greek Parliament ought to outright REJECT the asuterity measures that European banks are attempting to impose on them.  Tell the EU/ECB/IMF that they want to honor their debts but that the only way to do so is through economic growth, and ask for a plan that will increase economic growth to a level that makes current debt service sustainable.  Make it clear that the only other option to the “growth plan” is immediate default, French and German banks be damned.

The more Greece tries to balance its budget by cutting spending and increasing taxes, the more the budget deficit will actually widen as the economy slows and tax receipts decline.  Austerity is not the solution, it is a big part of the problem.  Likewise, exchanging existing government debt for new government debt, while interest rates continue to rise, only makes future debt service more difficult.  Stop the madness.

There’s a reason why we abolished debtor’s prisons a long time ago.  They effectively make it impossible for the debtor to ever repay his debts, and thus are to the detriment of both debtor and creditor.  Yet, what the European authorities have done is essentially put Greece into a debtor’s prison named Austerity.  They should release Greece if they are to have any hopes of being paid anything back.