Between Scylla and Charybdis

A number of Wall Street investment banks are calling for a positive year in the US stock market, and many others are calling for a good first half of the year, followed by a weak second half, as the Fed cuts back on its easing. As suspect as Wall Street’s pronouncements may be (who would believe Goldman Sachs?), it must be admitted that the Fed’s accommodation is a very friendly environment for the markets, and a tighter stance would likely end the good times.

Although many commentators say that they are expecting a tighter Fed policy this year, when we look more closely, there is a variety of viewpoints about likelihood and timing. Let’s look at three opposed viewpoints : (1) a declining stock market due to Fed exit, which is the prevalent viewpoint, (2) a prolonged market advance because the Fed finds it impossible to exit, and (3) a new financial bubble in commodities (triggering another economic downturn) once it is understood that the Fed cannot exit.


A Fed Exit in 2010


Bill Gross of PIMCO is one of the most vocal and most visible proponents of the view that the Fed will cut back on quantitative easing this year. As described in his January 2010 commentary, Gross summarized his view this way:

If 2008 was the year of financial crisis and 2009 the year of healing via monetary and fiscal stimulus packages, then 2010 appears likely to be the year of “exit strategies,” during which investors should consider economic fundamentals and asset markets that will soon be priced in a world less dominated by the government sector.


If, in 2009, PIMCO recommended shaking hands with the government, we now ponder “which” government, and caution that the days of carefree check writing leading to debt issuance without limit or interest rate consequences may be numbered for all countries.


… 2010 will likely witness an attempted exit by the Fed at the end of March, and perhaps even the BOE later in the year.

The reason that 2009 was so dominated by the government sector was the extraordinary amount of fiscal and monetary stimulus, including:

… the global innovation known as “quantitative easing,” where central banks and fiscal agents bought Treasuries, Gilts, and Euroland corporate “covered” bonds approaching two trillion dollars … the Fed and the Bank of England (BOE) alone expanded their balance sheets (bought and guaranteed bonds) up to depressionary 1930s levels of nearly 20% of GDP.

The reason he believes that this stimulus must end in 2010 is that:

… the check writing is ultimately inflationary and central bankers don’t like to get saddled with collateral such as 30-year mortgages that reduce their maneuverability and represent potential maturity mismatches if interest rates go up.


Now, however, the Fed tells us that they’re “fed up,” or that they think the economy is strong enough for them to gracefully “exit,” or that they’re confident that private investors are capable of absorbing the balance.

Despite the Fed’s apparent plans, Gross thinks that the exit from quantitative easing will not be so graceful:

Our fiscal 2009 deficit totaled nearly 12% of GDP and required over $1.5 trillion of new debt to finance it. … foreign investors as a group bought only 20% of the total – perhaps $300 billion or so. The balance over the past 12 months was substantially purchased by the Federal Reserve. Of course they purchased more 30-year Agency mortgages than Treasuries, but PIMCO and others sold them those mortgages and bought – you guessed it – Treasuries with the proceeds.

Although Gross doesn’t say so explicitly, the implication is that, in the absence of further Fed purchases, the market for Agency mortgages will be, to say the least, weak. Also, given that PIMCO and other funds have already loaded up on Treasuries, the US may face problems selling the new Treasury issuance that will be coming to market in 2010. Higher interest rates on mortgage securities and Treasuries would discourage investors, businesses, and consumers, providing strong headwinds against stock and bond markets and the economy.Putting this all together, Gross is predicting a “double whammy” resulting from (1) heavy debt loads in the “spendthrift” nations and (2) the withdrawal of government support from the financial markets:

Gross doesn’t see the Fed exit strategy as the only problem. Like others, he feels that budget deficits already incurred will be a drag on both the economy and the Treasury securities market for years to come. Interestingly, he quantified the impact:

Various studies by the IMF, the Fed itself, and one in particular by Thomas Laubach, a former Fed economist, suggest that increases in budget deficits ultimately have interest rate consequences and that those countries with the highest current and projected deficits as a percentage of GDP will suffer the highest increases – perhaps as much as 25 basis points per 1% increase in projected deficits five years forward.



Using 2007 as a starting point and 2014 as a near-term destination, the IMF numbers show that the U.S., Japan, and U.K. will experience “structural” deficit increases of 4-5% of GDP over that period of time, whereas Germany will move in the other direction. Germany, in fact, has just passed a constitutional amendment mandating budget balance by 2016.

Putting this all together, Gross sees a "double whammy" of debt loads for many nations plus the end of easy fiscal and monetary policies:

If these trends persist, the simple conclusion is that interest rates will rise on a relative basis in the U.S., U.K., and Japan compared to Germany over the next several years and that the increase could approximate 100 basis points or more.

… the shifting of private investment dollars to more fiscally responsible government bond markets … in 2010 and beyond.


Additionally, if exit strategies proceed as planned, all U.S. and U.K. asset markets may suffer from the absence of the near $2 trillion of government checks written in 2009.

I recommend looking at Gross’s commentary for the chart comparing the deficits and debt levels of a number of large economies. It is fascinating that PIMCO is quantifying the impact of the US budget deficit in terms of bond pricing relative to more prudent countries.

Also, it is interesting to compare Gross’s statements to those of another PIMCO executive, Mohammed El Erian. In Fortune’s 2010 investment guide, El Erian expressed great doubts about the US economy’s ability to sustain any kind of recovery this year. That’s hardly the right environment for Fed tightening, but maybe PIMCO thinks that the Fed has run out of ammunition.  Credit rating agencies have warned that the US must cut back spending or else risk a downgrade.

 No Fed Exit in 2010

The RGE Monitor, Nouriel Roubini’s website recently published an article that argued against any tightening during 2010. The core of their prediction was:

But we expect carry trades to resume in 2010 as policy rates stay at or near zero in the major economies and inflation leads to further EM and commodity-country rate hikes …. We expect the Fed to stay on hold throughout 2010 ...

This is a complete turnabout for Roubini, since not long ago he was writing about the danger that accommodative monetary policies would fuel a continued carry trade on the US dollar and fuel dangerous bubbles in financial markets around the world.

Perhaps Roubini has a point about near zero rates. With unemployment running around 10%, will the Fed dare to tighten ahead of the November midterm elections? With fiscal stimulus running out in the second half of the year, monetary tightening may be out of the question.

In contrast to Roubini, Gross’s prediction is based on Fed and Administration expectations of a self-sustaining economy (do we believe that?) and the supposition that the Fed is being forced to clean up its own balance sheet.  Given the extent to which much of the world is dependent on the US economy, it hardly seems likely that anyone would encourage the Fed to tighten when the economy is at best fragile.  Thewarnings of Fitch et al. hardly matter compared to the stances taken by the central bankers of the world.

 No Fed Exit and a Commodities Bubble


In "Roubini v. Gross on Outlook for 2010", Yves at the Naked Capitalist blog points out that if Roubini is correct and the Fed does not tighten in 2010, the markets will create their own organic problems. The reasoning is that continued accommodation will encourage risk-seeking trades (carry trade in the US dollar) that will push money into “hot” assets. In this view, the most dangerous recipient of these flows is commodities. As we saw during the last oil bubble, rising commodity prices produce a drag on the economy – a drag that 2010’s fragile economy can hardly afford.

Warnings about rising commodity prices are already appearing in the press, such as this recent article this recent article  in the Wall Street Journal, and a growing global asset price bubble is depicted on the latest cover of The Economist.  There is some justification for these warnings, because the valuation of the US stock market is approaching historical highs on fundamental measures, and a number of emerging stock and real estate markets are looking overheated.  As we have seen during the past decade, inflating bubbles can persist for a quite some time before they burst.

Negative feedback from a slowing economy would eventually burst the bubble – but damage would already have been done to both the economy and financial markets.

The Fundamental Problems Remain

I don’t know which, if any, of these views will turn out to be correct, but the Fed is in a dilemma. Despite massive quantitative easing last year, the underlying problems weren’t solved, they were only postponed. We still have heavy public and private debt loads, banks holding impaired financial assets, and unaffordable home prices. Remove the lax monetary and fiscal policies and the financial markets will dry up, credit will tighten, and the economy will suffer. Continue the laxity and money will flow where it can find a return, into bubbles, not into the basic US economy.

Whether the Fed tightens or not in 2010, the financial markets and the economy are still caught between the Scylla of crushing debt and the Charybdis of unbridled speculation.

Merry Christmas

More Profits, Less Welfare

Lucienne Bloch, Land of Plenty, woodcut, ca 1935.  Lucienne Bloch was in the WPA and worked with muralist Diego Rivera in the 1930s.

While Congress is working on half-measures to reform the US system of health insurance, I ran across these news stories about how our health care and welfare systems are working.  We always hear myths about America's systems of health and welfare:  You can depend on health insurers to protect your health.  Anyone can get the medications that they need.  America wouldn't let children go hungry.  The reality is anything but.

Aetna Is Forcing 600,000-Plus to Lose Coverage in Effort to Raise Profits

In a third-quarter earnings conference call, officials at Aetna announced that the health insururer is planning to force up to 650,000 clients to drop their coverage next year in order to raise to meet profit expectations.  They predicted that the company would lose between 300,000 and 350,000 members next year from its national account as well as another 300,000 from smaller group accounts.  Aetna's third quarter earnings were up 26 percent year over year, but if they price more families out of insurance, they can do better.

Unburied Bodies Tell the Tale of Detroit -- A City in Despair

Things are bad in Detroit.  The murder rate is soaring. The school system is in receivership. The city treasury is $300 million short.  The city cannot reliably provide rubbish collection and other basic services. Thousands of houses are abandoned.  Entire shopping districts lie boarded up.  Auto manufacturing plants have been abandoned for years.

Can it get worse?  It just did.  People are dying from their poverty, and not even receiving burials.

In June, the $21,000 annual county budget to bury Detroit’s unclaimed bodies ran out. Many there cannot affort to bury their family members, and the city managed to provide burial in the past. Now that the city is in financial straits, the bodies are piling up in the morgue now.

What has alarmed medical examiners at the mortuary is that most of the dead died of natural causes. It is evidence, they believe, of people who could not afford medical insurance and medicines and whose families can now not afford to bury them.

Many people cannot afford health insurance ... and they are dying because of it.  Does anyone doubt that the US needs national health insurance for all the people?

The Safety Net Is Failing Needy Americans

Four organizations -- The Institute for Policy Studies, the Center for Community Change, Jobs With Justice, and Legal Momentum -- have released a study showing how the nation's social welfare system is failing millions of Americans during the Great Recession, just as the need is greatest.  Here are highlights from Battered by the Storm: How the Safety Net is Failing Americans and How to Fix It.

Temporary Assistance to Needy Families (TANF) is supposed to be our nation’s last line of defense against falling into the depths of poverty.

Yet this program is so deeply inadequate that by 2008, the number of needy children receiving TANF fell to only 22 percent. Under the pre-“welfare reform” system of Aid to Families with Dependent Children (AFDC) in 1995, 62 percent of poor children were benefiting. Eligibility criteria are set at sub-poverty levels in some states, making poor children ineligible, and barriers such as lack of childcare and lack of access to employment have further kept poor children from receiving desperately needed economic assistance that a system such as TANF should provide.

The food stamp program is doing better, because it has responded to growing need by reaching more households.  Sadly, the average monthly benefit per person is only about $100.  The report asks: "How can our children be happy, healthy, and adequately nourished on that?"

The reason for this human misery lies in the political trend of the past 30 years that has benefitted the wealthiest Americans while reducing wages and increasing poverty for the rest.  With the onset of the Great Recession, we are seeing more poverty and likelihood of reprecussions for years to come.

Henri Matisse, Icarus

Eight Centuries of Financial Crises

Thomas Hart Benton, The Departure of the Joads, 1940.  Oil painting commissioned by 20th Century Fox to advertise their film production of John Steinbeck's novel, The Grapes of Wrath.

As behavioral economists know well, humans suffer from biases that cause them to overweight the present and the recent past in their reasoning.  If one's biases have been based on a period of good economic times, it is not surprising that many will be unprepared and suffer greatly during a general crisis.  Those wanting to place the present financial crisis in a long-term historical context may wish to read a fascinating, recently-released study from the National Bureau of Economic Research -- This Time is Different: A Panoramic View of Eight Centuries of Financial Crises, by Carmen M. Reinhart of the University of Maryland and Kenneth S. Rogoff of Harvard University.  Quotes of some of the key findings, with my comments:

We find that serial default is a nearly universal phenomenon as countries struggle to transform themselves from emerging markets to advanced economies.

The current crisis is nothing unique, because disruptive financial crises have occurred from time to time over the centuries.  Maybe it is prudent to live one's life as if financial and economic disaster is a real possibility (like avoiding massive debts, saving money, etc.).

Major default episodes are typically spaced some years (or decades) apart, creating an illusion that “this time is different” among policymakers and investors.

People have limited memories and tend to treat the recent past as "normal".  Those living in good times will hardly be prepared for extreme adverse events, unless they consciously review the historical record.

We also confirm that crises frequently emanate from the financial centers with transmission through interest rate shocks and commodity price collapses.

In other words, the current crisis is highly typical.  Problems started in US and spread to the rest of the world.  Within the US, the crisis started in the financial centers, including the large mortgage brokers and investment banks, spread into markets for securitized mortgages and credit default swaps, and snowballed into problems for Main Street and the entire nation.  A lack of proper regulatory oversight permitted critical financial institutions to operate without consideration to risk management and precipitate a massive crisis.

Our data also documents other crises that often accompany default: including inflation, exchange rate crashes, banking crises, and currency debasements.

Just because US hasn't experienced inflation, exchange rate crashes, or currency debasements yet, we can't ignore these possibilities.  Conditions are still in place for the crisis to morph into new phenomena.  Debt is being transferred from the financial system to the balance sheet of the Fed.  Most private debt (home mortgages, commercial real estate, credit cards, etc.) has hardly been touched yet.  There is a distinct risk that more crises could come soon.

The authors looked in particular detail at the years 1800 to 2006, where the data are the most complete:

Aside from the current lull, one fact that jumps out from the figure are the long periods where a high percentage of all countries are in a state of default or restructuring.

Countries are connected financially, now as in the past.  We should be on the lookout for further breakdowns as the crisis spreads and strains build on weak points throughout the world.   East European countries have built huge debts with West European banks.  Will this be the next place to crack?

Serial default on external debt—that is, repeated sovereign default—is the norm throughout every region in the world, even including Asia and Europe.

Soverign default isn't just possible, it is common.  Countries like France and Spain have defaulted multiple times in the past.  In view of the problems faced by a number of governments around the world (not just the US), we should be prepared for more shocks to come to the financial system.

Our extensive new dataset also confirms the prevailing view among economists that global economic factors, including commodity prices and center country interest rates, play a major role in precipitating sovereign debt crises.

If you have been worrying about these kinds of risks, you weren't off the mark.  Despite worries about the long-term sustainability of the US debt, there are many other countries around the world where sovereign risks are greater and more immediate.  Whenever central banks raise short-term interest rates in anticipation of economic recovery, there will be countries and corporations that will be unable to withstand the shock.

Periods of high international capital mobility have repeatedly produced international banking crises, not only famously as they did in the 1990s, but historically.

Capital mobility is one of the hallmarks of the present era of globalization.  However, our world has undergone earlier eras of globalization, accompanied both by capital flows and episodes of financial crises.  In fact, the present era's flows of instantaneous information seem pale in their impact, compared to the flow of material goods loosed on the world by industrialization and the age of steam in the nineteenth century.   We are not unique, and we would do well to consider the lessons of past crises.

Yet, the government’s gain to unexpected inflation often derives at least as much from capital losses that are inflicted on holders of long-term government bonds.

The US response to the financial crisis seems to have done little but increase the risks of new bubbles.   Is anyone worried that the US might try to inflate its way out of its debt problems?  Is anyone worried about a bubble in US Treasuries?  Of course they are.

Watteau, The Embarcation for Cythera, 1717.  Cythera is one of the Ionian islands and in antiquity was site of a shrine to Aphrodite.  Watteau is playing on a popular notion viewing Cythera as a fictional place where the power of love eliminated petty conflicts and people could live harmoniously and engage in amorous pursuits.  This idea followed the humanist views of the age of reason, whereby human beings were seen as perfectable and capable of achieving greater happiness.  In the midst of this dreamy optimism, the lower classes lived desperate lives under the thumb of the aristocracy.  In the painting, the elegantly attired rich await their departure for Cythera.  After their departure from the dust bowl, the Joads faced desperation, disillusion, and rejection.

Caryatids

Porch of the Caryatids, the Erectheon, Athens (author's photo)

Architecturally, a caryatid is a female figure acting as a column to hold up a structure. In a more figurative sense, I can't help thinking how much these caryatids on the Acropolis remind me of the American people. Our special burden isn't architectural, of course. It is debt, public and personal.

For some of us the burden is immediate and acute. The fallout of the financial crisis has left many unemployed, buried in debt, and foreclosed or at risk of foreclosure. States and cities are going broke as their tax base has withered. The elderly who lived prudently and saved their money are being punished by a financial system that keeps savings interest rates low, but quickly loans funds to speculators.

As for the rest of America, those not being crushed by debt, most of us are probably not overly worried about debt. But that may be a mistake. Since the start of the 21st century, Federal government debt has been rising due to lax fiscal policy, tax breaks for the rich, subpar economic growth, funding endless wars, and many other reasons, political and economic. Most recently, bailouts of our reckless financial sector ballooned the Federal debt to previously unimaginable levels that should give us all pause for our futures. Meanwhile, a recession has reduced the tax base from which to pay for the ballooning national debt. Even as economic growth shifts overseas, policies to renew economic growth seem lacking.

Now that the national debt is ballooning, and the economic capacity to service the debt is declining, our creditors seem to be growing increasingly worried. If they come to believe that they won't be paid back anything close to 100 cents on the dollar, they may look elsewhere to invest. That dollar could tank, interest rates rise, and the resultant defaults send the economy into a deep depression.

Rodin transformed the architectural convention of the female form supporting weight in the Fallen Caryatid Carrying Her Stone. In her fatigue, the caryatid can no longer support her weight. As she is crushed under the stone, what is going through her head?

Those who have lost jobs, homes, or lifetime savings know what it is like to support a weight too heavy to endure. The rest of us should care, because we are all caryatids now.

Fallen Caryatid Carrying Her Stone, Auguste Rodin, Musee Rodin, Paris

No American Dream without Social Mobility

The American Dream

Income disparities in America have been growing for years as the very rich got richer and the rest of society stagnated economically. But the American Dream is till alive, isn't it? You can still advance based on your abilities and not your family background, can't you?

It's All Based on Social Mobility

We like to think of America as a land of opportunity, where anyone can succeed no matter how rich or poor he or she starts out in life. Unfortunately, America does not compare well to other advanced countries when it comes to the basic precondition for the American Dream, social mobility. There are many advanced countries where the social rank of a child's family means a lot less than it does in America for that child's educational achievement and chances of future economic advancement.

New Data from the OECD

Now comes a report from the Organization for Economic Cooperation and Development examining social mobility in the advanced economies. Orsetta Causa and Asa Johansson, the authors of Intergenerational Social Mobility, find that there are many advanced countries where the economic conditions of a child's family mean a lot less than they do in America for that child's future educational achievement and economic advancement in life.

What They Found

The influence of parental background on individual earnings varies widely across OECD countries, but low mobility across generations, as measured by a close link between parent’s and children’s earnings, is particularly pronounced in the United Kingdom, Italy, the United States and France. Mobility is higher in the Nordic countries, Australia and Canada.

The influence of parental socio-economic status on students’ achievement in secondary education is particularly strong in the United States, France and Belgium, while it is weaker in some Nordic countries, as well as Korea and Canada.

Inequalities in secondary cognitive skills are likely to translate into inequalities in post-secondary educational achievement and subsequent wage inequality in the labour market.

The Role of Social Policy

According to the report, any measure that reduces inequality will make it easier for individuals to break free of the constraints of their backgrounds. More progressive income taxation and higher short-term unemployment benefits were found to be helpful. Both were associated with a looser link between parental background and outcomes for children's cognitive skills and wages. If children are to succeed based on their own merits, they need equal access to the means of self-help.

Good for Economic Growth

Not only is social mobility fair, but it can be good for all of society. The report points out "the ability of an economy to continuously allocate human resources to their best use can have important effects on economic performance". The better the opportunity to succeed on your own merits, the better your skills will be employed in the economy. By understanding how economic growth and equal opportunity are mutually supporting, we can design policies to encourage both.

Worrying Trends in Income Inequality

With the gap between rich and poor growing so rapidly, it is no surprise ifthe American Dream is fading. A 2008 OECD report found that this trend is persistent and getting worse rapidly. (See Growing Unequal? Income Distribution and Poverty in OECD Countries, Country Note: United States.) The trend goes back to the 1970s, but since 2000, income inequality has increased rapidly.

Rich households in America have been leaving both middle and poorer income groups behind. This has happened in many countries, but nowhere has this trend been so stark as in the United States.

The distribution of earnings widened by 20% since the mid-1980s which is more than in most other OECD countries. This is the main reason for widening inequality in America.

As a result, the United States is the country with the highest inequality level and poverty rate in the OECD, with the exception of Mexico and Turkey. Just consider the data: "The average income of the richest 10% is US$93,000 US$ in purchasing power parities, the highest level in the OECD. However, the poorest 10% of the US citizens have an income of US$5,800 US$ per year – about 20% lower than the average for OECD countries."

We Need to Overhaul Social and Economic Policy

No one wants his or her children at a disadvantage in life merely because they lack the advantages available to the rich. However, as the 2008 OECD report notes: "Redistribution of income by government plays a relatively minor role in the United States." Unless we design policies to increase social mobility, we will continue to underuse our society's human resources and suffer sub-par growth. Meanwhile, other nations are growing quickly, and their people are reaping the benefits.

We aren't a third world country -- not yet -- but we can do better. After all, we still see outselves as a world leader, and maybe we can act like a leader. Social stratification is growing in America, and we must act to reverse the trend if we are to preserve the American Dream.