Threats For 2011

Posted in Economics, Financial Markets, Politics and Policy at 9:55 pm

A number of bloggers are making their annual predictions on what’s in store for the economy in the coming year.  Since I consider trying to forecast GDP, unemployment, and other macro measures a year out to be a fool’s errand, I will instead focus on what I consider to be the biggest threats to the US economy in 2011.

  1. Oil Prices. Crude is now over $91/bbl.  That represents a 35% increase over where it stood early this past Summer.  Rising oil prices act as a brake on economic growth.  $100/bbl is an important psychological milestone, and if it goes much above that, we will certainly see an impact on auto sales, airline profits, and transportation industry profits, along with a general falloff in demand as disposable income is reduced.
  2. Real Estate Prices. Housing prices started falling again in July after appearing to stabilize.  It appears that the temporary stabilization was largely a result of the homebuyer tax credit, and its expiration means housing is resuming its slide.  This will mean more negative equity, more foreclosures, and more economic pain for almost everyone.
  3. Stimulus Wind Down. The growth rate of ARRA spending has already peaked.  Many programs are winding down.  There will almost certainly be many (misguided) calls for further austerity.  State budgets are being cut back to the point where basic services like snow removal (as the recent Northeast blizzard demonstrated) are becoming a challenge.  The 2% payroll tax cut and unemployment extension will provide some respite, but these are temporary measures.
  4. The European Debt Situation.  The crisis that is continually contained, until it isn’t.  It’s likely that we’ll continue to see flare ups followed by new emergency measures that bring about temporary calm repeated almost ad infinitum.  My fear is that, for whatever reason, there will eventually be a “European Lehman” that fails and the European authorities will be unwilling or unable to implement a rescue in time.
  5. Policy Paralysis. Politically, there isn’t going to be any further fiscal stimulus.  Conventional monetary policy is at its limit.  Unconventional monetary policy will face widespread opposition from both the left and the right.  We are thus vulnerable to any significant shocks that occur, whatever they may be.

Never forget the old boxing saying that it’s always the punch you didn’t see that knocks you out.


The Irish Bailout

Posted in Economics, Financial Markets, Politics and Policy at 7:11 pm

More or less what was expected.  €85 billion at 5.8% interest.  €10 billion in immediate cash to re-capitalize the banks, another €25 billion line of credit for the banks, and €50 billion to meet state budgetary needs.  Oddly, the Irish government must contribute €17.5 billion, mostly from the state pension system.

Most interestingly, a vague “permanent resolution mechanism” for restructuring debt was announced that will go into effect sometime in 2013, and that “may” require bondholders to take losses at that point.  That’s their long term solution to the contagion problem?  Wow.


Wait, what? Belgium?

Posted in Economics, Financial Markets, Politics and Policy at 10:58 pm

It seems that a number of blogs have picked up on Belgium as a likely candidate for the next domino to fall – either immediately before or immediately after Portugal.

Let’s look at the facts here:

  • Belgium’s budget deficit is under 5% of GDP, below the Eurozone average
  • Belgium has a savings rate of 11.5%
  • Belgium is currently running a current account surplus, and has been for some time
  • Belgian GDP is growing around 2% per year
  • Belgian 10 yr bonds are trading at roughly 1% above German Bunds, a mere fraction of the spreads at which other Eurozone countries’ bonds are trading

So what is the case for a Belgian default?

It seems to be:

  • Belgian national debt is around 100% of GDP, third overall in the Eurozone, behind Greece and Italy
  • Belgium has failed to form a new government for the past 6 months, with a split between parties representing the Dutch and French speaking areas
  • Concerns over Belgian banks, which in reality are no shakier than those of other Eurpoean countries not consider to be on the domino list, certainly far less shaky than those of Ireland

National debt as a % of GDP is not an indicator of short term instability.  It’s only real relevance is with regard to debt service levels, and given Belgium’s current account surplus, savings rate, and GDP growth, this is a non-issue in the short to medium term.  The danger represented by lack of a government is completely overblown, and if there were a crisis, I’m fairly confident they’d pull together a government in short order.  The banks, again, really are in no more of a fragile state than those in the rest of Europe.

If, in fact, a “crisis” does develop in Belgium, I think it warrants stepping back and re-examining what’s really happening in Europe and whether the current approach to rectifying the problem is appropriate.

And Spain?

Posted in Economics, General Musings, Politics and Policy at 7:12 pm

Assume you are a neutral observer, behind a sort of Rawlsian Veil of Ignorance, tasked with examining an unknown country’s economic situation and making policy recommendations.

The facts are: 20% unemployment rate, 0% GDP growth, inflation at just over 2%, and a budget deficit of 2.96% of GDP and down significantly from a year ago.

Would anyone in their right mind recommend further austerity, e.g., spending cuts and tax increases, given this set of facts?

Ireland, then and now

Posted in Economics, Financial Markets, General Musings, Politics and Policy at 6:17 pm

In 2007, Ireland ran a budget surplus of 0.051% of GDP.  That was the 5th straight annual budget surplus for Ireland.  In fact, from 1997-2007, Ireland ran an average 1.6% annual budget surplus.  Likewise, in 2007, Ireland’s total government debt was 25% of GDP.  This was not a country on the brink of a fiscal crisis.

Fast forward to the present.

Ireland is now running an annual budget deficit of around 32% of GDP and the national debt is 65.6% of GDP.

What happened?  Obviously the financial crisis led to a large falloff in tax revenue, along with an increase in countercyclical spending.  That’s not the main story, however.  What really happened is that Ireland experienced a banking crisis and the Irish government guaranteed its banks.  That is the prime driver behind the numbers and is the motivating factor behind the ongoing bailout talks.

Ireland is about to inflict an unconscionable amount of pain on its citizens through a combination of austerity programs while saddling them with an enormous amount of new debt in the form of the EU/IMF bailout.  Is this necessary?  This amounts to a naked transfer of wealth from ordinary Irish citizens to a handful of German, British, and French banks who are creditors of the failed Irish banks.  There’s no making the losses disappear, the only question is who realizes them.  It has been determined that the Irish government, and by extension, the citizens of Ireland, will realize the loss.  Why?  Why not the bondholders?


Thoughts on the “deficit crisis”

Posted in Economics, General Musings, Politics and Policy at 11:15 am

Post-WWII (1946-2009) Average Federal Gov’t Spending and Receipts as a % of GDP:

Receipts: 17.8%
Spending: 19.6%

2007 Numbers:

Receipts: 18.5%
Spending: 19.6%

2009 Numbers:

Receipts: 14.8%
Spending: 24.7%

There were no significant tax policy changes between 2007 and 2009.  Nor were there any major spending policy changes apart from those incurred due to the financial and economic crisis.

The long-term historical budget gap has averaged around 1.8-1.9% of GDP.  Immediately prior to the crisis, it was right around, if not slightly below, the long term average.

The current budget gap of around 10% of GDP is due almost entirely to the financial crisis which caused a falloff in GDP (and thus, tax receipts) and the need for temporary emergency spending.  Eventually, receipts will rise and spending will fall as a result of pickup in GDP and the winding down of temporary emergency programs even if we take no deliberate action.  Adopting austerity measures to try and prematurely bring down spending and increase receipts will likely have the opposite effect.

There has been no significant increase in the “structural deficit” over the past 3 years.  While the Bush tax cuts and the 2 wars we’re fighting have obviously played some role in our budgetary position, they’re not the major drivers.  Democrats who say otherwise are lying.  Likewise, Obama hasn’t done anything to increase the structural deficit either.  Republicans who say otherwise are lying.  The entire “deficit crisis” meme is nonsense.  Long term, we do need to get Medicare costs (and healthcare costs in general) under control; short term, the focus needs to be 100% on economic growth and jobs, even if that means bigger deficits.


Some further thoughts on QE2

Posted in Economics, Financial Markets, Politics and Policy at 7:54 am

I’ll focus here on what I call “compositional effects” – how the composition of an action (in this case QE) can be more important than the absolute level of the action.

Bernanke has used the metaphor of “dropping money from a helicopter” in past discussions of monetary policy.  The implication is that the Fed could always prevent a deflationary spiral through the use of their “printing press”.  Let’s look at compositional effects as they apply to the helicopter metaphor.  In this case, what matters is who receives the newly created money, or, to extend the metaphor, the location of the helicopter when the drop begins.  Consider for a moment that the banking system is currently sitting on around $1 Trillion in excess reserves and the helicopter drop will simply funnel an additional $75 billion or so per month to these same banks.  Bernanke has effectively positioned the helicopter over a volcano before starting the drop.  When the drop is done, we’ll likely have $1.6 Trillion in excess reserves with very little net change in the real economy.  Perhaps a smaller drop, with the helicopter instead positioned over Main Street would have been a wiser move.

Now let’s look at QE and inflation expectation through the lens of compositional effects.  Changes in inflation expectations have been put forward by numerous economists, including Paul Krugman, as the primary mechanism through which QE will stimulate the economy.  This makes sense if price level changes, or rather the expectation of future price level changes, are more or less homogenous throughout the economy.  What happens if they are not?  What happens if the primary effect of QE is to increase the prices of commodities (oil, food, metals, etc.) but not finished goods or labor?  This would result in a sort of reverse wealth effect for individuals (who could now consume less energy and food out of a constant income) and declining profitability for firms (who face rising input costs and constant output prices).  The net effect would be a decline in aggregate demand.  Compositional effects matter.


QE2 Is Here

Posted in Economics, Financial Markets, Politics and Policy at 2:28 pm

FOMC Press Release:


To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.

$600 billion in longer-term Treasuries at a rate of around $75 billion per month.  This is roughly in line with expectations (consensus was for $500 billion – $1 trillion, at a rate of around $100 billion per month), though it’s at the lower end of the range.  Also, there had been talk about the Fed potentially purchasing MBS and other assets in addition to or instead of Treasuries and that did not materialize.

I’ll post more later.


Is the focus on QE2 distracting the Fed?

Posted in Economics, Politics and Policy at 8:40 pm

This week we saw a number of releases from the Fed discussing potential upcoming QE2 measures.

The issue continues to be framed in the traditional context of how to best expand the Fed’s balance sheet (i.e., what assets to purchase) and whether the primary effect will be via lowered interest rates on long term debt or through the expansion of bank reserves.

This seems to me to be missing the point.  Interest rates are already at historical lows.  Does the Fed really think that driving rates on 30 year fixed mortgages down by another 30-40 basis points will provide that much of an INCREMENTAL boost to aggregate demand?  Do they think that adding another $100 billion (or less) in reserves to a system that already has approximately $1 Trillion in excess reserves will stimulate further bank lending?

The problem is that the financial system itself is still broken.  Banks are still carrying too many non-performing and barely performing assets at inflated prices on their balance sheets.  The private securitization market is virtually non-existent.  Meanwhile, the consumer is facing a nearly 10% unemployment rate, home prices that are still declining in many areas, and a crushing debt load.  This translates into businesses facing reduced demand for their goods and services, along with their own debt problems.  At some point, private sector debt (consumer, financial business, and non-financial business) has to fall further.  This implies that public debt will have to rise by an offsetting amount.  Yet austerity is the talk of the day.  You can’t have it both ways.  There are going to have to be large writedowns, which means more banks are going to fail, and at some point we’re going to have to address the problem at a systemic level, something we should have done in early 2009.  The alternative is a series of QE half measures, attempts at premature fiscal restraint that actually worsen the budget position, and the institutionalization of zombie banks.  In other words, a repeat of Japan’s lost decade….err….two decades….err….you get the point.

First Citi, Now AIG

Posted in Economics, Financial Markets, Politics and Policy at 8:38 pm

The Treasury seems to be in an awful rush to convert the preferred shares it acquired in these companies as part of the bailouts into common shares.  This entails giving up a sizable dividend, giving up their place in the hierarchy of creditors should there be future financial problems at the firms, and exposing themselves to additional market risk as the value of the common shares fluctuate.

There are a number of scenarios under which this could make sense.

If the Treasury intended to sell the shares all at once, the dividends and creditor standing would largely be irrelevant.  They also wouldn’t be exposed to market risk over time, although the selling of such a large block at once would certainly depress the price enough to significantly reduce the amount of money they’d receive.  In any case, the Treasury has signaled that they do not intend to take this route and will slowly dispose of their common shares over an extended period.

Another scenario where this approach would be desirable would be if the Treasury expected a period of strong economic growth leading to strong profit growth for these companies followed by a significant appreciation in share price.  It’s hard to see how that could realistically be their near to mid term forecast, however.

That leaves largely political motivations.  The administration wants to end the noise about “government takeovers” coming from the Right.  The American people in general find the idea of bailouts distasteful.  The firms in question want to improve their PR images.  So on and so forth.  There are risks here though.  Prematurely paying back the government and having the government prematurely extricate themselves will leave the firms more exposed should the financial storm reappear.  It would also make it politically difficult for the government to engineer additional policy measures should that happen.