Tuesday, July 13, 2010

Shared Sacrifice

Edward Hopper, Railroad Sunset, 1929.

A Prolonged Economic Slump

With the recently renewed concern that the economy is faltering, a number of writers have been hazarding guesses at how the debt crisis may eventually resolve itself in the context of an economic downturn. Especially interesting are the recent writings of David Rosenberg, Bill Gross, Niall Ferguson, and Edward Chancellor, which contain a number of common threads on this topic.

These threads combine to make a scenario that differs from some of the more extreme forecasts, in that it does not necessarily sound like a complete disaster for the US -- no deflationary spiral, out-of-control inflation, or currency crash. Just a prolonged economic slump driven by austerity and the rebuilding of balance sheets.

Fiscal Prudence Means Shared Sacrifice

David Rosenberg, Chief Economist at Gluskin Sheff, makes the argument for a prolonged economic slump in a recent Globe and Mail opinion piece.  According to Rosenberg, fiscal prudence is taking over at the individual and government levels. Without credit or spending to fire the economy, it will limp along with some degree until balance sheets are sufficiently repaired to bring growth again. This will take time. He bases this scenario on the assumption that the US population is sufficiently shocked from the debt crisis to change its economic behavior permanently:

"It is reasonable to assume that the economic behavior of the population in general, and the baby boom cohort in particular, is on the precipice of a dramatic change, as Main Street has enough understanding of the situation to start to take action to get its balance sheet in order."

He assumes that the economy does not fall apart in a deflationary collapse, allowing debts eventually to be paid off enough that economic growth can begin again -- although it may take some time:

"Most likely, what happens next is that the credit collapse proceeds on the back of a severe form of the “savings paradox,” resulting in a prolonged economic slump. The good news is that it will ultimately lead to a balance sheet rebuilding process, both at the household and government level, that can sustain the next secular economic expansion."

That doesn't sound too bad, because he says that the US will avoid total catastrophe, like debt default, currency collapse, or hyperinflation. However, working down debt will require fiscal austerity by everyone in society, which will not be a pleasant experience for the participants:

"In the meantime, an enormous amount of shared sacrifice will be required." (My emphasis.)

Individuals can rebuild their balance sheets by sacrificing consumption if they have incomes.  A problem is that employment will continue to suffer as government will be unable to substitute for private spending:

"Initially, we can expect to see less government, fewer entitlements and higher taxes. ... Less government will require balanced budgets and this will contribute to continued stress in the job market, at least for a while."

Not only consumption, but entitlements will be cut back:

"Currently, the seeds are being sown for a radical restructuring of entitlements. ... Across the nation, sweeping changes are taking place as pension trustees and legislatures push for higher monthly contributions to pension plans, a later retirement age and lower annual cost-of-living adjustments for current and retired workers."

Cutting back entitlements will force much of the population to cut back spending and save:

"Out of necessity, the boomer population will be pursuing a strategy of working longer, saving more and reducing their debt obligations in order to secure a comfortable retirement lifestyle, while at the same time the public sector moves in the very same direction toward fiscal probity."

This of course guarantees the the downturn is prolonged.  One has to wonder how boomers can work longer and save for retirement if there are no jobs for them. One also has to wonder how the unemployed, the disabled, and the elderly are going to survive if entitlements are cut to the bone. The payoff for all that suffering could well be that it buys enough economic and financial stability for the US to dig itself out of the hole:

"... what we could well be in for is a prolonged period of price stability or modest deflation. It is reasonable to assume that a resumption of strong GDP and earnings growth in the future and a resumption of inflation and appropriate inflation investment strategies will have to await the end of the rebuilding phase as it pertains to the household and government balance sheets."

Harry Sternberg, Builders, 1935-36.
The Lenders of Last Resort Are Out of Money

The latest monthly commentary latest monthly commentary by PIMCO's Bill Gross supports important parts of Rosenberg's scenario. Part of PIMCO's New Normal is the notion that the advanced world has run out of funding sources with which to restart economic growth. If not even sovereigns can lend, economies will remain subdued and there will be "low total returns on investment portfolios" until debts are paid down.

"Consumption when brought forward must be financed, and that financing is a two-way bargain between borrower and creditor. When debt levels become too high, lenders balk and even lenders of last resort – the sovereigns, the central banks, the supranational agencies – approach limits beyond which private enterprise’s productivity itself is threatened."

Shared Sacrifice Includes Default on Unfunded Liabilities

Harvard history professor Niall Ferguson also sees the US as avoiding an inflationary outcome, but he foresees problems with the deleveraging process. In fact, he does not see how the US can work off its debt without some kind of default.

The problem, he says, is that extreme debtors have rarely been able to grow their way out of debt in the past, and the conditions that allowed the rare historical case (like Britain after the Napoleonic wars) just don't pertain now. (We aren't the beneficiaries of a new industrial revolution.) This leaves inflation or default.

"Right now there is no sign of inflation. We have monetary contraction at an alarming rate, and zero inflation in terms of core CPI, so the option of inflating this debt away doesn't seem to be there right now. What you are left with is therefore default."

This could but doesn't necessarily have to include outright default to bondholders. Ferguson doesn't mention it, but we will later discuss a point of view saying that US outright default on its debt is very unlikely, given the past situations where this has occurred. Ferguson suggests this kind of default:

"And I think it is a fair bet that US will default at least on the unfunded liabilities of Social Security and Medicare at some point in the foreseeable future."

So we have another voice suggesting that the solution will include the dismantling of social programs. This would be part of the American people's if there is a prolonged slump.

No Default, but Bond Yields Are at Risk

GMO analyst Edward Chancellor has written a very interesting paper on the dynamics of extreme sovereign debt loads, which also contains a very interesting comparison to the current debt cycle. Given the historical preconditions for default, Chancellor concludes that the "US is not on the verge of a default." The US has carried high debt loads in the past and not defaulted outright, and it has the advantage that its debts are denominated in its own currency (although a lot of debt is foreign-owned). He agrees with the other forecasts in this respect, although not in others.

Chancellor thinks that "inflation is more likely than default in the US" because "public finance is a ponzi scheme." This makes the current environment of low government bond yields a very risky one for the bonds of the advanced economies:

"Under only one condition - that the world follows Japan's experience of prolonged deflation - do they offer any chance of a reasonable return. But this is not the only possible future. For other outcomes, long-dated government bonds offer a limited upside with a potentially uncapped downside. As investors, such asymmetric pay-off profiles don't appeal to us."

Despite this admirable risk aversion, Chancellor is self-contradicting in one respect. First, he says that US debt can be paid off only if interest rates remain low. Then he says that inflation is the likely outcome, and that bond prices will suffer then. He glosses over the implications for servicing the interest and rolling over maturing US sovereign debt (and private debt) if rates rise. Perhaps this contradiction is an honest reflection of the impossibility of forecasting, but the contradiction also masks the ugliness and unpredictable instability of debt servicing under rising yields.

Such uncertainties reflect real risks in future outcomes. Even if we end up in a deflationary economic slump, there is no guarantee that it will provide a smooth ride with price stability or mild deflation all the way to recovery.

Thomas Hart Benton, Mine Strike.

How the Sacrifice Will Be "Shared"

The "shared sacrifice" is really a "soft default" on entitlements, which are seen by the financial elite as mere promises of hippie liberal governments. However, so-called entitlements are in fact the foundation of life planning for a good part of the US citizenry. Such promises include essential components of a retirement plan, including program like Social Security and Medicare, which many people have already paid for during their working lives.  If people have paid for Social Security and Medicare during their entire working lives, and planned their retirements based on these payments, they don't look at those programs as "soft" entitlements. In fact, they deferred consumption in order to pay for these insurance programs, and they planned the course of their lives around them.

Rosenberg says that boomers will work longer, in order to save for retirement. How are they to do this when there are no jobs? They are hardly likely to work longer when they have no jobs in the first place. They will just languish in poverty and illness until sinking away to an early death. That is the "shared burden" that Rosenberg is really writing about.

Not everything will be sacrificed. You can be sure that zero-interest money will continue to flow to banks, who will use that money to engage in more speculation and provide bonuses to their most "productive" parasites.

Sacrificeing to Pay Down the Debt

There are many ways of achieving "soft default" on the programs that the common people have worked so long for. In the case of Medicare and Social Security, the government can raise age limits, reduce inflation indexing, phase in benefits over longer periods, index to individual net worth, or other tricks.

At the local level, education, public safety, and other basic services are already being sacrificed in order to avoid raising taxes. State governments have already started cutting back on essential social and health services such as meals for shut-ins, family crisis centers, and higher education. There are many more elements of civilized life that the elites will find a way to cut.

Don't forget tax policy. The elites will be sure that unearned income (economic rent) is taxed at lower rates than earned income. If taxes on earned income are raised, what do they care? If you complain, you are just opposing the wonderful capitalist system that rewards risk taking. Never mind if you invest your life and effort in training and labor, and then end up supporting the rich with your taxes.

This is only one, alternative scenario, but perhaps it is what the elites of the developed nations are hoping for. It is easy to believe that their cries for "austerity" are really calls for "soft default" in the form of fewer entitlements. After all, the financial elites managed to default on the losses that the banks suffered in the wake of the mortgage crisis due to their greed and incompetence. The taxpayers shouldered that burden. Why stop there?

The "prolonged deflationary slump" has a lot going for it as a plausible scenario for the future of the US, but it assumes that the US taxpayer can pay down much of the private and public debt loads.  Unless the US frees itself of the financially-driven bubble economy grows and restores a foundation for real, organic growth with employment and income growth, the slump may turn into something worse.

Monday, July 5, 2010

Changing Treasuries for CDS

Natori Shunsen:  Nakamura Utaemon as Hanako in Musume Dojoji.  In this kabuki dance-drama Hanako changes costumes several times, including instantaneous onstage costume changes matching the character's movements.  Just before the change, an onstage assistant removes basting strings holding together layers of costume.

As you probably know, PIMCO's Bill Gross has in recent months given changing and contradictory views on the attractiveness of US Treasury securities. Late last year, he wrote that US debt was to be avoided because of rising debt levels and declining ability to service the debt load. In contrast, in the past few weeks news stories indicated that PIMCO had changed course and increased holdings of US Treasuries as being more credit-worthy and offering less interest rate risk than the sovereign bonds of the more developed European nations.

These stories did not explain the time horizon of this shift in PIMCO's allocations -- whether it reflected some fundamental shift in the attractiveness of US debt, or rather a reflection of the relative attractiveness of the US in reaction to the sovereign debt crises on the periphery of the European Union. PIMCO clarified an important part of this issue in a recent commentary published on its website.

It turns out that PIMCO is insuring the sovereign debt of G-7 nations rather than buying their bonds outright. PIMCO does this by writing credit default swaps on the sovereign debt of these nations, by which PIMCO collects premium payments from the counterparties and promises to indemnify them should they suffer default by the issuers.

This means that PIMCO is not exposed to the interest rate risk on G-7 bonds, but it is betting that the G-7 nations will not default on their sovereign debt.

This seems a neat way of separating interest rate risk from default risk.

This also implies that PIMCO is serious when it predicts that increasing debt loads will lead to higher interest rates on the bonds of the developed nations. This also implies that PIMCO is serious in believing that the risk of default is very low among the G-7 nations.

This still leaves room for a lot of market upsetting conditions to come, including ballooning debt and falling bond prices, and for personally unpleasant conditions, such as higher taxes and reductions in government services due to fiscal austerity.