February 2009 Archives

From an email I just sent to several friends:

Ok, folks, it's time for another of my patented long-term predictions.

Let's say that Obama gets even a small part of what he promised in the
SOTU. We're talking about massive distortions in incentives and even in
basic industrial efficiency. This guy wants to roll back the industrial
revolution, which would be the net effect of making energy vastly more
expensive and tripling taxes on driving.

My prediction is that the public sector will soak up a far higher
proportion of national production. I've never joined in the chorus of
"the Democrats want to make the US look like Europe circa 1980." But now
I think that's an entirely reasonable expectation. This year's federal
spending will be 26% of GDP, up sharply from the 20 to 22 percent that
we've had every year for decades. As soon as we get it up to 45 or 50
percent, we're in France territory.

And the reduction of free-market choices and incentives just about
everywhere will create the inefficiency that could get us there.
Americans voted to give the government the power to set our economic
priorities, and there's no unscrambling that egg. What they're getting
as part of the bargain is a way of spending that has structural
disincentives to reduce costs. That's why I'm thinking a 45% federal
share of the economy isn't an unreasonable endpoint.

What will the effect be on the private sector? That's the interesting part.

From Holman Jenkins at the WSJ. Trenchant and succinct, with interesting stuff at the end.

None. No one paid any attention. The substance of the speech was "Look at meeeeeeeeeee! I'm BEAUTIFUL!" (Darn, what show is that from? Candide? Now it's going to bug me all morning.)

Bonds this morning are virtually unchanged. Stocks will struggle, but sentiment is slowly turning positive. What flashed through my mind yesterday morning was "400 point rally." We got 230 of that yesterday, so if my spider-sense is still accurate, we've got a few more to go.

As I've said before, there could be the basis of a rally if corporate earnings aren't worse than expected. People have been pricing stocks as if they're all going out of business.

The essential challenge for America is to simultaneously achieve two things that, in conventional ideology, are incompatible. These are to fulfill society's promise of affordable necessities and comfortable retirement for all, and also to preserve America's culture of freedom and economic opportunity, where anyone can get rich.

To speak of these priorities in these terms is to see how facially incompatible they are. That's simply because ideologues of the right or the left will consider one of the two priorities to be the only one which matters, and the other one will take care of itself.

The mistake that people on the right make is that markets, left fully free, will automatically take care of everyone's material needs, and that government's most valuable contribution will be to get out of the way. On the left, people assume that social justice is a simple matter of redistributing wealth from those who earned it to those who deserve it, and there's more than enough wealth to go around.

So it's perhaps novel to speak of achieving both of these priorities together, given that so many people are so firmly committed to one at the expense of the other. But we stand at a moment in history when it's critical to hold both opposing ideas firmly in mind, to see how they interact, and to see how we can indeed achieve both.

The government is floating the idea of taking up to a 40% share in the common equity of Citigroup, which is about as close as you come to admitting the bank is insolvent.

How are the markets reacting? Government coupon-debt is sharply lower on the news. It's being taken as a positive, reducing the need to hold Treasury paper as a safe haven. Stock markets will climb on the open.

Here's a canary in the coal mine: Canada's CPI has fallen four months in a row, which hasn't happened since the early Thirties. Our CPI is under pressure (it's being held up by slightly higher gasoline prices, as supply ratchets down to meet lower demand), but producer and wholesale prices so far are holding steady. That news is mixed and unconclusive.

We're used to thinking of "green energy" as a solution to the problem of energy independence, and to the problem of global warming (which, since the earth isn't demonstrably warming, now goes by other names, like "climate change").

Energy independence has been urgent because the high cost of fossil fuels results in a massive transfer of wealth from consumers to producers.

But today, fossil fuel prices are extremely low. And the bien pensant assume that by his very presence in the White House, Barack Obama will bring world peace. Thus, energy independence as a driver for green energy is attenuated.

Global warming, on the other hand, has attained to the status of a religion, with benefits that are taken as moral absolutes, and not subject to comparisons of relative utility. We're told that we should substitute wind and solar power for oil, gas and nuclear not because it makes economic sense (it doesn't), but because it's the right thing to do.

Fair enough. This debate ended when Americans elected their current leadership, for whom there's no question that we should proceed to green energy.

But a quite different line of thought has come to the fore: the idea that green energy, in and of itself, can be a driver for economic growth. This idea is at work when you hear people calling not for green energy, but rather for a green economy.

Yet anyone who can do simple arithmetic knows this is economic nonsense.

There's a remarkable story being reported in the New York Times. It's remarkable in itself, and also because as far as I can tell, it's only being reported in the Times.

It's a proposal by the Treasury for a radical way of restarting private participation in credit markets. I'm only going to give you the barest outlines of this with minimal analysis, because I can't be sure the Treasury really means it.

For many months now, "securitizations" have come to a near-standstill. That's the much-maligned process through which whole mortgages get "sliced and diced" into mortgage-backed securities and sold to the world's investors.

Through a different but analogous process, other kinds of consumer loans are also securitized: car loans, credit cards, and student loans. (The goal is always to give an investor a piece of paper with a credit rating, a semi-annual coupon payment, and a maturity date. Mortgage analytics and risk management are more complicated, but beyond that, the process is the same.)

Securitization matters because banks can't provide credit now that most of them are so far undercapitalized. Securitization is an alternate process through which investor funds are channeled into the consumer credit markets.

I'm trying to interpret all the stories floating around about foreign investors starting to demand that US agency paper be converted to an explicit full-faith-and-credit guarantee.

Between Fannie and Freddie, we're talking about $5 trillion in assets. Since the nationalization of the GSEs in September, their periodic debt auctions haven't gone all that badly, all things considered. The spread between agency paper and Treasuries is now in the 70-basis point range across parts of the curve. Far more than what it was pre-crisis, but far tighter than a few months ago.

And yet, foreigners are noting US officials' pointedly stopping short of calling the Federal guarantee of agency debt "explicit." (FHFA Administrator James Lockhart calls the guarantee an "effective" one.)

That's turning out not to be good enough for seriously risk-averse foreign investors, who appear to have shifted at least $100 billion from agencies to straight Treasury paper in the second half of 2008.

In effect, what they're trying to do is to exit their exposure to US housing finance, and change it to exposure to the US dollar itself. In a way, this converts credit risk to market risk.

But is it really that simple?

It's too early to figure out what Obama actually proposed yesterday, by way of mortgage reforms. It's not even right to call it a proposal, since we're not getting full details for another couple of weeks. It seems like Obama is trying to lead by press release.

There are two aspects to the "plan" that are intended to generate headlines: it will supposedly make mortgage payments "more affordable" for a total of 9 million people; and it will seek to drive everyone's mortgage payment to 31% of their monthly pre-tax income, or less.

Let's quickly dispose of the Fannie Mae/Freddie Mac aspect of the press release. There is a provision of $200 billion to be supplied to the GSEs, for purposes of covering losses in their mortgage portfolios. This would actually be an expansion of the $100 billion that was already provided when the GSEs were nationalized back in September. They haven't yet come near to consuming the $100 billion, so this is less than it appears to be. Still, it's a nice headline.

It's the $75 billion in direct aid to distressed homeowners that's more of interest. So far there are no details on how this will work. Obviously, the taxpayers will be transferring $75 billion to someone. But to whom, exactly?

It seems to me that Obama would like you to think that he's planning to put more money in your pocket. But judging from the uniformly-enthusiastic reactions of banking-industry executives and spokesmen, I think the money trail leads to them rather than to you.

Ok, so the Teacher And Firefighter Job-Preservation Act of 2009 is now law. Last week, President Obama told us that starting today, the stimulus would immediately speed saving succor to the US economy, using metaphors that suggested the stanching of an open wound. Are you feeling stimulated?

A more true metaphor is that the stimulus will be like a fart in a windstorm. Why? Three reasons: A) It's small relative to the size of the problem; B) It won't be spent all at once; and C) It's programmatic rather than broad-based. The real practical effect of the stimulus bill will be to enable 50 state governors to raise taxes less than they would have been forced to.

Why didn't Congress take the direct approach and simply enact a payroll-tax cut, which would have ultimately had the same effect, but much more immediate and more salutary? Well, I think the answer to that is more political than economic so I'll leave it to others.

And coming up fast in the rear-view mirror are the Detroit automakers, who as I've relentlessly predicted since December, will soon ask Washington for tens of billions of dollars more. Unless the autoworkers union agrees to far deeper cuts (not likely), the taxpayers will be supporting GM and perhaps Ford Motor, more or less permanently.

But we need to look ahead to the continuing banking crisis. Here we have to make hard choices between who lives and who dies.

Since the beginning of the economic crisis Paul Krugman has been the loudest advocate for a down-the-line, damn-the-torpedoes Keynesian approach. He continues to press this point in his latest op-ed column at the New York Times, which I would link except that it requires a registration.

Krugman knows his economics (and if you forget about that, his Nobel Memorial Prize will remind you). He's been writing cogently and presciently since nearly the beginning of the financial crisis (which long predates the economic one) about the clear and present danger of falling into a deflationary spiral.

Paul Krugman knows how mathematical models work as well as anyone. His problem is that he has a much more pedestrian understanding of how people work. This problem typifies the whole Obama Administration, which pays close attention to Krugman at his perch in Princeton, and professes to revere data rather than ideology.

In his latest column, Krugman cites an analysis by the Congressional Budget Office to the effect that over the next three years, the US economy will underperform its capacity by $2.9 trillion. (Of course, no color on the methodology or the approach of the study, but he's writing an op-ed piece, not an academic paper.) Let's take that large number on faith. It works out to about 7 percent of GDP.

This is the starting point from which Krugman goes on to call for government stimulus spending of about an equal size. Let's deconstruct the thinking a bit.

Something very important has been missing from the debate about fiscal stimulus. There are two really good reasons to oppose the Obama stimulus bill.

First, it's got be to just about the most hasty and poorly thought-out piece of legislation ever to come out of the US Congress. (Isn't it ironic that it also happens to be the biggest expansion of government spending ever?) This bill is so full of waste, earmarks and pork-barrel spending that Obama will have to use all his charm and deception to blow it past the American people.

Second, and this is what you hear from a lot of Congressional Republicans, the bill expands the Federal deficit tremendously.

It's being suggested by many sharp observers that global investors (like the Chinese) will be unwilling to fund this stimulus package, and will demand much higher interest rates on US debt.

Not quite. This deficit will be a lot easier to fund than many people think. It's what comes later on that we have to worry about.

Barack Obama has been very consistent about several elements of his storyline. It has three basic parts: First, the financial system just needs a little confidence. Second, the economy just needs a huge dose of spending on left-wing priorities. Third, and key to the point here, tax cuts don't work.

Obama always frames the point about taxes in a political context, something like: "the last eight years have proven that tax cuts are bad for the economy." So by taking him at his word, I'm at risk of misreading statements that may be meant only to shift blame for the difficult economy onto the Republicans. But here goes, anyway.

The great and abiding fear of Obama and his advisers, is a deflationary spiral, in which wages and prices fall, and people who owe money find it harder and harder to get by. (Debt-service generally consists of periodic payments of fixed size, so if the real value of the payments increases as overall prices fall, then debtors start defaulting more.)

And history suggests when you get a deflationary spiral, you can't get out of it, and it sticks around for years. What history? The Great Depression, and the "lost decade" in Japan. (Shockingly, Obama even mentioned the lost decade in his press conference the other night. Aren't Presidents supposed to avoid talking about worst-case scenarios?)

Unfortunately, there are several big problems with Obama's approach. First, he really doesn't know what he wants to do about the problem, other than spend nearly a trillion borrowed dollars to increase funding for a vast array of government programs, many of which are priorities of the political left wing.

Second, the President is profoundly misreading the mood of the country. The other night on national television, he repeated almost literally the conventional wisdom that the economy suffers when people save more money. (Confusingly, he also warned us that the era of debt-financed consumption and investment is over.)

I just noticed this news story. This is very important. Large employers are now starting to impose large and widespread cuts in wages and salaries.

This is a classic sign of a deflationary spiral, and it's going to be deeply frightening to a lot of people. Especially people in the Administration.

Why? Because sustained deflation is exactly what Obama is talking about when he says that we face the potential for an economic decline that we can't recover from. But there are good reasons to be encouraged by this news.

Yesterday was a very important turning point in the ongoing twin crises, in the banking/financial system, and in the overall economy.

Expectations were riding very high that Treasury Secretary Geithner would pull a rabbit out of a hat, in a speech billed as an announcement of bold, new plans to stabilize the banks. Obama himself, the night before in his press conference, assured us in the manner of a glib salesman that Geithner's speech would be most impressive.

You can see how impressive from a chart of the stock market. After a steady opening, stocks fell like a rock, almost from the moment Geithner opened his mouth. They never recovered, finishing the day down more than four percent. The sickening fall (led naturally by financial shares) was matched by a very strong rally in bonds. The large new issue of three-year Treasury notes was notably successful. The safe-haven bid for US government debt is back.

The Treasury Secretary really had nothing much to say. The bottom line is that the financial crisis is extremely challenging, and there aren't any good answers. Geithner wants to avoid nationalizing America's large banks (recognizing fully that the government doesn't know anything about running banks). He wants to attract private capital bank into them, and he wants to avoid asking Congress for another TARP program of perhaps a trillion dollars or more.

As I explained to you yesterday, the banks are undercapitalized from the losses they've taken on mortgage-based assets, and the losses still have a long way to go. Insolvent banks can't lend money, and the sheer scale of the losses they've suffered means that there may not be enough private capital in the world to bring them back. Full nationalization is probably the only choice.

This is a response I just made to a private email, that I thought was worth posting here. Everyone understands why inflation is bad. But I'm very often asked what's so bad about deflation ("wouldn't I be happy if bread cost five cents a loaf, like in 1933?")

No. No, you wouldn't. Because where inflation destroys savings, deflation destroys society.

I'm going to just whisper this because it's not yet clear how far we're going with it. But the thing about deflationary times is that they produce social change, which is sometimes radical change.

Deflationary worlds always produce fewer goods and services (consumables and tradables) than is possible. (The economists would say that the economy is performing below its capacity.) If deflation gets bad enough, the aggregate production of goods and services can fall below what is needed to sustain ordinary survival and basic health for all members of the population. Over time, populations respond to this by getting smaller. In the near term, they can respond by confiscating stores of wealth that are held in private hands.

The latter can happen in hard ways (the French Revolution), semi-hard ways (the New Deal and trade unionism), or soft ways (whatever is going to happen in America over the next five years). The point is that there is stored wealth in private hands, at all times. The social friction arises because privately-held wealth is withheld in times of deflation. People who control wealth are in a position to weather the storm, but people without wealth aren't. If things get bad enough, people without wealth can be relied on to rebel.

Wealth isn't money, which has no reality to begin with. Wealth is assets that can produce goods, like farms, quarries, factories, and the softer assets (such as business relationships) that are needed to produce services. Over time, deflation causes wealth to become socialized. That's where we're going,but no one yet knows how far.

Yesterday was his boss's turn. Today it's Tim Geithner's.

There are two crises going on, a financial one and an economic one. Yesterday, Obama went to Indiana (a red state that he flipped and needs to suck up to, so they'll keep going blue), and then to national television, to talk about the economic situation. His message was that the only way to make the economy better is to spend a lot of borrowed money, right now, and it almost doesn't matter what we spend it on.

The economic crisis is actually rather easy for the President to deal with, on the terms in which he has framed it. He's not actually interested in returning the US economy to stable, sustainable growth, while repairing the global macro-imbalances which are part of what caused the crisis.

All the President wants to do is to "create or save" 4 million jobs. He already has a disingenuous economic report in hand, published on January 9, which presents a spreadsheet version of an economics-101 case that $800 billion or so in government spending produces 1.5 times that much additional GDP, which by Okun's law will create or save 4 million jobs. QED.

Whatever happens in the economy, even a return to Great Depression-level unemployment rates, Obama will always be able to say that the situation would have been 4 million jobs worse than it is. His job is all done, except for the PR.

Geithner's job is just beginning. He has to stabilize the financial system. Success for him is being defined as a return to reasonably-normal levels of private credit formation. He's going to announce today that he really has no clue how to make that happen.

In a nutshell, Geithner's problem is that America's biggest banks aren't actually dead, they're just on life support. That constrains his options. Let me explain.

I'm always trying to find just the right-sized nutshell to put things into. You want to capture the essential dimensions of the debate without oversimplifying, but without writing a novel either.

 

We have a recession because consumption and investment have fallen sharply (axiomatic).

 

Concurrently (or perhaps causatively), we've seen a precipitous fall in the level of indebtedness by individuals and private businesses (the "credit crunch").

 

The government is stepping into the breach, with far higher deficit spending. Some of this is automatic, as tax collections fall with the decline in private income, and some will be an intentional fiscal stimulus.

 

Now the world's investors still have a large appetite for assets. They've executed a gargantuan substitution, amounting to many trillions of dollars, from risk-bearing assets to relatively risk-free (and more dollar-based) assets. That's for sure, although it's not sure whether this is a cause or an effect of the overall economic weakness.

The 10-year T-note is riding a hair under 3% tonight and may crash through that key level. 3% is psychologically important, although charts suggest that there is no significant buying support until the note falls considerably farther, perhaps to 3.10% or thereabouts. That's a very long drop, and may imply a return to retail mortgage rates above 5%.

The 30-year T-bond is at 3.68%. Very soon we'll be taking about a new issue, the 7-year note, which is interesting because heavy issuance at that maturity (should it materialize) suggests that the Treasury is planning to finance mortgage-backed securities, possibly the toxic ones everyone keeps talking about.

People are getting very concerned about these high rates. Of course they're a sign of deflation, but it's very important to be correct about the source of the weakness. Everyone has a theory, and not everyone is right.

Well, it's official. The President of the United States wants us to be very afraid of an economic crisis we might not recover from. Afraid enough, in fact, to support the passage of the biggest chunk of new government spending in history.

I'll forgive you for suspecting that Obama is blowing smoke up your nether regions. After all, no one has more to lose than he does from the poor economic conditions. At least if we enact a massive stimulus bill and things don't get any better, he'll tell you (without proof) that things would have been even worse otherwise.

But we've had recessions and economic slowdowns before. Lots of them. What makes this one so big and special that the President himself is warning that he might be unable to fix it?

The economic crisis is rooted in a financial crisis that began in 2007, which metastasized into a banking crisis in 2008. The immediate source of the crises is the collapse of the housing bubble.

For a lot of reasons, not just the few that you keep hearing about, the value of housing became inflated beyond all reason, not just in the US, but also in Britain, Ireland, Spain, and a few other places. When that unsustainable bubble started collapsing sometime in 2006, all the people who had lent money to homeowners for mortgages, began to suffer.

When the value of houses declines, it gets increasingly difficult for homeowners to keep paying their mortgages. Some of them will miss payments, and a small number will default altogether. If you've lent your money to the homeowner so she can take out a mortgage, you're now holding an asset that (because of the higher default risk) is far less valuable than it was when you made the loan.

See this news story.

The Federal Reserve is about to start up a $200 billion program to directly support credit markets for auto loans and other kinds of consumer credit. This of course is unprecedented, as I've said, and we'll see what happens.

The automakers, for their part, are repeating one of the two ways to interpret the current low-demand environment: they're out there saying that people aren't buying cars because they can't get credit.

What if it turns out that people aren't buying cars because they'd rather save their money instead? That's the other interpretation, and it's the one I'm voting for.

I live in New York City. I talk to a lot of businesspeople, investors, and Wall Streeters. I don't talk to all that many ordinary people.

But I enjoy being interviewed on live radio in other parts of the country. And when I do that, I get the chance to hear what local callers think about the economy, and more importantly, what they want.

They want to save a lot more money. This answer comes up automatically, without qualification, and without exception when you talk to ordinary folks.

When did this desire to save materialize? It was pretty sudden. If you look at official statistics (both the Commerce Department and the St. Louis Fed publish relevant ones), the personal saving rate suddenly ticked up to between 2 and 3 percent about four months ago. Remember, it had been running nearly zero before the financial crisis started. We had one month when personal savings jumped over 5%.

Curious? Sure enough, it was May 2008. That's when the tax rebate checks went out.

I won't try to explain the sudden desire on the part of consumers to start saving, after decades of dissaving, although that's certainly an interesting question. Sometimes the pendulum just has to swing the other way. If you try to associate the shift with some contemporaneous event (like an acute financial crisis, or the gasoline-price spike), you risk mistaking cause for effect.

Obama has been walking back his rhetoric on trade protectionism. Specifically, the "Buy American" clause in the fiscal stimulus bill now under debate in the Senate.

Think about it. We're getting ready to borrow trillions of dollars that our children will need to repay some day. We're going to give it to the governors of the fifty states, to spend on teacher salaries, Medicare and Medicaid, condoms, candy and bubble gum, new paint and computers for government buildings, a vast array of left-wing spending priorities, and a small number of roads and bridges.

Doesn't it make sense to keep as much of that money here, and keep it from leaking out to other countries?

Well, the $650 million that Nancy Pelosi wanted to spend on condoms would just have to leak away. Condoms are made in China. But what about the steel and other building materials for the roads and bridges? Doesn't it make sense to reserve as much as that spending as possible for American companies?

Ask your average person on the street, or certain Democratic Senators, and the answer would be some hyper-vigorous form of YES.

Responding to the political scandal du jour, executive pay and outrageous Wall Street bonuses, Obama will announce today that anyone who works for a bailed-out company can't make any more than $500,000 in cash compensation.

As always, there's far less here than meets the eye. And as always, there will be unintended consequences.

According to the reporting on the issue, Obama isn't going to make this retroactive. So it doesn't apply to companies that have already been bailed out, like AIG and Citigroup (which have each received over $100 billion in taxpayer support) or Fannie Mae and Freddie Mac. Or even GM and Chrysler LLC, the original poster children for taking the corporate jet to ask for handouts.

But this is less than it seems, because companies are still free to issue any amount of restricted stock to their executives. It will just be subordinated to any claim that the taxpayers may have on the assets of the affected companies.

And given that the whole ad hoc bailout policy has called for taking as small a claim as possible on the assets of the affected companies, the whole thing seems like a lot of PR to me.

Global stock markets are soft across the board as we swing into the first trading day of February. At first glance, this appears to be responsive to the constant drumbeat of terrible economic news, as economies and trade shrink in unison.

The action in the bond markets appears to be somewhat healthier. For several weeks, the theme underneath the surface noise in corporate debt markets has been gradual stabilization. Things are far from normal, but they're inching along in the right direction. Spreads between corporate debt and government debt have been compressing, and the tone shows that risk tolerance is making a comeback in some sectors.

The government debt market is where the real action is. The yield curve has been neurotically steepening and flattening as participants weigh the broadly offsetting influences on prices for governments: the steadily worsening economic news tends to support prices, and the gargantuan amounts of new issuance push the other way.

I think the friction and noise being generated as markets absorb new supply is the surface phenomenon, and the continuing strong demand for risk-free debt is the deep structure.

In case you hadn't noticed, most of the world's business reporting this week is bylined out of Davos. This is the one week out of the year when all the reporters follow all the bigshots to Switzerland to drink hot chocolate and solve the world's problems.

Over the last few years, Davos has talked about how George Bush would destroy the world in a blaze of gamma rays. This year, the talk is about how Barack Obama will bury the world under an avalanche of trade protectionism.

This is a fascinating theme on several levels. You'd think the world's finance ministers and political leaders would be blaming us for all the overvalued mortgage assets we sold them until the bubble burst. They certainly do blame us for that, and they certainly blame us for the financial cleverness they all tried to emulate until a few months ago.

A global financial crisis featuring badly disordered capital and credit markets is easy enough for the world's political leaders to snipe at us about. But when this one abruptly morphed into a global economic crisis, featuring a collapse of trade, output and employment, it got a lot harder for them to be smug.

That's because our economic problems have turned into a prospective disaster for the rest of the world. Remember the beginning of the financial crisis, a year and a half ago, when everyone with respectable opinions was saying that the world had "decoupled," meaning that our problems wouldn't affect any other country?

Wrong. The global economy turns out to be more dependent on the American economy than ever before. And that's become glaringly obvious because of the one thing that's distinctively missing in the current downturn: consumer demand.

The global economy depends on demand from America like a rich teenager depends on the coupon payments from her trust fund.