TOPICS IN POLITICAL ECONOMY

THE ECONOMY: NOTES ON A PRETTY GOOD YEAR . . .

Considering the gloom, doom and uncertainty facing the U.S. economy at the beginning of 2009, one has to conclude that things turned out reasonably well. 

The recession appears to have ended in the third quarter (as we suggested a year ago), corporate profits turned out better than analysts expected and the stock market confounded most forecasters with 20% plus gains.  As we were expecting, the unemployment rate rose to 10% even as the economy began to pick up.

In short, the economy followed the traditional downside leg of a business cycle - with above-average amplitude in the swings of production and employment. We should be thankful that 2009's  2.5% drop in gross domestic product is modest compared to countries like the U.K. and Japan with drops of 4.5% and 5.4% respectively.

To Whose Credit? Should we give credit to anyone for turning the corner toward renewed growth? Probably not. Outside of thanking the Treasury Department and the Federal Reserve for stopping the run on the banking system, and averting an even deeper "bottom" to the cycle, we should be very cautious in handing out any kudos. 

While the income tax rebate checks of 2008 may have had a slight "bottom cushioning" effect, survey studies suggest only about one-third of the rebate money was spent, the rest being saved.  With only a little over one-quarter of the Obama Administration's $787 billion spent as of November, its impact to date has similarly been modest. Programs such as the "cash for clunkers" simply change the timing of consumer expenditures for the most part; by one estimate only 18% of the 690,000 cars sold under the program were truly "stimulated" purchases. "Clunkers" also had the perverse effect of destroying substantial wealth. (It mandated the destruction of seven hundred thousand automobile engines, many of which would normally have been recovered by scrap dealers for spare parts, refurbishing or export.) 

Business cycles have their own self-correcting features - inventories run down and eventually have to be replaced, returns to investing in new technology appear increasingly attractive, profits recover under the impact of cost-cutting, and lenders' appetites grow to make new loans instead of investing in Treasury bills with minimal returns. These have been the driving forces in the economy in the closing months of 2009, supplemented by some modest Federal stimulus spending.  

Looking Ahead. The biggest threats to a continuation of the recovery are the higher taxes, deficits, and rules/regulations likely to flow from Obama Administration legislation dealing with healthcare,  energy/climate change, and a major expansion of the financial regulatory regime.   To this list should be added the Administration's continued very public bad mouthing of bankers' compensation and lending practices. (We thought the primary lesson of the financial crisis was too much lending, not too little.)

Such factors are of more than usual importance in sustaining a decent recovery. Thanks to past excesses, home building is likely to be of little help, in contrast to its traditional leading role in an economic upturn. Similarly, debt-financed consumer spending is unlikely to be a recovery leader. Clearly, consumers have learned their lesson from the financial crisis of the past two years: "We borrowed too much."  Savings rates have rebounded dramatically; credit card balances are shrinking and prepaid or debit cards are very much in fashion.  According to the Federal Reserve, consumer credit has declined by $100 billion since the third quarter of 2008.

Exports have been and should continue to be a solid plus for the economy.  Even if the U.S. dollar were to strengthen somewhat, U.S. manufacturers, service providers, and agricultural and raw material producers should continue enjoy reasonably strong demand from abroad. Business investment in inventories should remain strong for the near-term, and capital spending shows signs of strengthening.  

However, it is business investment outlays that is most vulnerable to ill-conceived actions by Congress and the Administration. Such actions run the risk of dampening business confidence, increasing uncertainty and sabotaging the recovery. They will be coming in the middle of Federal Reserve efforts to withdraw substantial amounts of the credit it has extended the financial system over the past year and heightened concern about financing massive deficits.

Beware the Law. In short, the Law of Unintended Consequences could be very much in evidence over the next 12 months - with unpleasant results. Politicians and pundits: be careful what you wish for.   

"SYSTEMIC STABILITY" - THE CASE FOR HEDGE FUNDS

What prominent group of risk-taking financial intermediaries posed the least threat to the financial system over the past two years? 

Consider the much-maligned hedge funds.

Like many others, they lost billions for their investors over the past two years, as the above chart from a recent BNY-Mellon report shows.  However, no one shed a tear or a taxpayer bailout dollar for them.  Their "lockup" clauses prevented investors from withdrawing en masse during those scary weeks following Lehman Brothers bankruptcy - when the $3 trillion money market fund sector had to be bailed out by the Treasury Department. As 2009 drew to a close, they apparently are growing again, leaner and wiser.

It wasn't the largely unregulated hedge funds that had to be bailed out - in the U.S., it was the SEC-regulated investment banks and the Federal Reserve-regulated mega bank holding companies that were re-floated with taxpayer dollars and Fed credit. Overseas, all manner of over-leveraged banks were propped up by their central banks.

Why Hedge Funds Are Not a Threat. It wasn't the hedged funds who were leveraged up to the moon in 2008.  As Andrew Haldane (Executive Director for Financial Stability at the Bank of England) and Piergiorgio Alessandri point out in an important recent paper, "most hedge funds today operate with leverage less than a tenth that of the largest global banks."  In other words, hedge fund managers (and their bankers) remember the fate of LTCM, the highly-leveraged mega-hedge fund that blew up in 1998.

Further, as Haldane and Alessandri point out, large hedge funds typically have assets of less than $40 billion, compared to global banks with assets in excess of $3 trillion. About 1 in 20 hedge funds goes out of business in any given year - with little disruption (post LTCM) and no taxpayer expense.  As their chart below shows, the top five hedge funds now have roughly 8% of total fund assets, e.g. none are "too big to fail" (TBTF). The five largest global banks account for almost 30% of global bank assets. Few doubt that they have been deemed by their governments as TBTF.

Why Hedge Funds Are a Threat - To the Banks. The history of financial institutions is replete with examples of how regulatory restrictions stimulate innovation and new competitors.  So it is not surprising that, continuing a long-standing antipathy towards "disruptive" hedge funds, the European Commission appears determined to drag them into a vast regulatory thicket, starting with restrictions on managements' compensation. No doubt the Commission is listening to commercial banks' concerns that, with the likelihood of being forced to lower their leverage, increase their liquidity reserves, and pay top performers less, they will lose additional business and talent to unregulated hedge funds. 

The same fears appear to be at work in the sausage factory on Capitol Hill in Washington, DC, where pending financial reform legislation in both House and Senate attempt to drag the funds further into the regulatory web.  

Bottom Line. The "bottom line" for hedge funds from the Bank of England's Executive Director for Financial Stability should be carefully considered by all those involved in the policymaking process:  "it might be that the structure of this sector delivered greater systemic robustness than could be achieved through prudential regulation." 

In other words, maybe what is needed for "systemic stability" is less, not more regulation, and far less willingness to bail out the imprudent when the going gets tough.

CAN WE CONTROL THE FEDERAL DEFICIT?

An action event is in the offing: 

Congress will need to increase the debt ceiling limit before the end of the year.  When this legislation comes up, the budget hawks in the House and Senate will attempt to add legislation which would appoint a powerful commission to specify cuts in spending/tax increases to reduce the massive deficits in the offing from Medicare, Medicaid, and Social Security - not to speak of the massive unfunded outlays implicit in both House and Senate health care reform legislation.  (If you know of a better mechanism to deal with the issue, please let me know.)

Read how the major players in Washington are trying to deal with this issue in today's Wall Street Journal. Don't be surprised if Nancy Pelosi thinks this is a bad idea. 

Beat your drum and cross your fingers.

TWO BIG HOLES IN FINANCIAL REFORM LEGISLATION

Financial regulatory reform draft legislation is making its way through the Congressional sausage factory: 253 pages in the House version and 1,136 pages for the Senate's (Senators tend to be more wordy than Representatives).

But, despite their weight, there are two gaping holes in both versions: not a word dealing with the biggest bad actors in the mortgage market (Fanny Mae and Freddy Mac) or with the financial sector that posed the biggest threat to a nationwide financial panic - money market funds.

While there are plenty of issues to debate within the draft legislation, let's focus here on the two missing chapters.

Fanny and Freddy. According to the Washington Post, the federal government's seizure of these two government-sponsored housing agencies  has cost the taxpayers $121 billion.  And more dollars are likely to be needed to keep them afloat. And then there's the issue of the original federal housing agency, the FHA, which now looks like it, too, is going to need a multi-billion bailout.

If Congress and the Treasury can't confront the underlying problems arising from federal intervention in the residential mortgage market (making it too easy for high risk borrowers to get government-subsidized  credit), they clearly haven't addressed one of the principal factors in the credit crisis of the past two years. Of course, that would be a lot harder to do, politically, than beating up on bankers.

Money Market Funds. For some reason, outside of Paul Volcker's vigorous warnings and substantive proposals from The Group of 30, almost no one at the center of policymaking in Washington appears to be seriously concerned about the role poorly designed money market funds (MMFs) played in the credit crisis.

Promising to hold MMF share prices to $1.00, helped by SEC regulations permitting questionable accounting to maintain that price, and acquiescing in SEC mandates to use credit rating agency marks on all their holdings, the MMF sector literally "blew up" last September. That was when one of the oldest and biggest funds, The Reserve Fund, "broke the buck" thanks to its $785 million investment in Lehman Brothers highly-rated commercial paper. 

The money market fund sector has evolved into a trillion dollar "shadow" banking system - but it is regulated by an SEC that is subservient to the investment companies that sell and manage MMFs and is generally clueless about banking issues (and how to catch Barney Madoff). 

While the SEC has requested comments on various proposals dealing with possible MMF reforms, the likelihood of serious, fundamental changes is very dim without a legislative directive.

Bottom Line. It would be most constructive if some of the heavy hitters in the Washington sausage factory could add a little more substance to the financial regulatory reform package that is currently moving down the production line.

THE HEALTHCARE DEBATE: THE PUBLIC OPTION

Bob Samuelson, the sharpest economic columnist in the country (at the Washington Post, no less), has written an incisive and devastating analysis of the "public option" proposal in pending healthcare legislation. 

He calls it "an exercise in political avoidance: it pretends to control costs and improve access to quality care when it doesn't." 

If you are at all interested in how this major policy debate is going to be settled, read Bob's column - and send it around to others.

WHERE ARE THE TRUE REFORMERS?

The real problem in Washington, Holman Jenkins reminds us in a grim column in today's Wall Street Journal, is: 

. . . the giant riverboat gamble that Washington can save the economy by doing what comes naturally—spending money carelessly, creating massive new entitlements without funding them, dishing out cheap credit to politically favored sectors, telling business people where and how to invest.

Current healthcare legislation working its way through the Congressional sausage factory is described by Jenkins as "the equivalent of climbing aboard a train about to plunge into a canyon and deciding what it really needs is a bomb on board," thanks to the expansion of coverage paid for largely with flimsy assumptions about "cost savings."

Jenkin's wishes that Larry Summers and Ben Bernanke would step up and try "to steer Team Obama off its suicide mission."  

I would note that Council of Economic Advisers Chair Christina Romer recently observed, there is a "budgetary catastrophe looming for our children and grandchildren."  Was the White House listening?

There are plenty of good, robust proposals for real reform ready for implementation, Jenkins reminds us:

The hopper is hardly barren of ideas, like raising the retirement age, enacting the Breaux Commission's Medicare proposals, instituting a flat tax and eliminating the tax distortions that every serious economist knows contributed to the housing bubble and the health-care bubble.

 

Anybody listening?

 

 

PRESIDENT OBAMA AND THE COLA: PANDERER IN CHIEF

On October 5th, I commented - critically - on the legislation moving through Congress to award Social Security recipients a special $250 payment.  Due to a small projected decline in inflation for 2009, there will be no cost-of-living  (COLA) increase in Social Security monthly stipends for 2010.

Now President Obama has come out in favor of this $13-$14 billion post-Christmas present (financing unspecified by the White House), thus joining the pandering politicians in Congress at throwing money at what might be called "the grasping geezers." 

The original legislation which provided for COLAs said that upward adjustments in COLA would always be made (my social security check went up 5.8% this year), but if prices declined (as in 2009, for the first time since the COLA was instituted) downward adjustments were ruled out. Talk about a sweetheart deal.  But not sweet enough, apparently, especially for frequent voters. 

The White House says that seniors are among those "hardest hit by this recession."  In a class with automobile workers??  The  Presidential statement points to the decline in home values, but ignores the reality that, so long as seniors stay in their current residence, the fluctuation in home values has no impact on them - only their heirs. Yes, maybe their retirement savings accounts have fallen in value - but so have those of "juniors."  And juniors didn't get a 5.8% increase in Social Security stipends this year.

Now that the President has endorsed it, the $250 pandering payment is probably unstoppable in Congress, despite a growing sense that Federal spending is on a suicidal track. Only a resolute, far-sighted leader in the White House could have mustered the political courage to derail a craven, populist proposal.

But we don't have a lion in the White House; we have a free-spending fox. 

SOCIAL SECURITY COLAS: THE PANDERING POLITICIANS AT WORK

Here's a letter I have just sent one of my Senators.  The leaders of this classic example of the mob at work are Senator Sanders from Vermont and Congressman Pete DeFazio of Oregon.  The official title of the legislation is The Emergency Senior Citizens Relief Act (H.R. 3597 in the House, S. 1685 in the Senate). If you agree with the thoughts, send something similar to your Senators and Congressman - or, better yet, your newspaper.

Dear Senator Casey:

I understand you are a co-sponsor of legislation to provide a one-time payment of $250 to all Social Security recipients, since there will be no cost-of-living (COLA)  increase for them this year.  Your proposal would increase federal outlays by $14 billion.

I am one of those potential recipients. And I strongly oppose your proposal. The reason there is no COLA this year is because consumer prices have declined. When consumer prices increase, my Social Security check increases; but it doesn’t decrease if prices decline. That was the deal when Congress wrote COLA into the Social Security System in 1975.  A lot of working people would say that’s pretty good deal – if they’re still working.

You argue that medical costs keep going up.  But most Social Security recipients are on Medicare, which insulates them from the bulk of such cost increases.

My bus fare hasn’t gone up in years: I pay nothing, thanks to my senior pass.

You say you will make up the $14 billion in handouts by increasing Social Security taxes on the working rich.  Sounds very familiar: robbing Peter at work to pay Paul at home.

Seniors have been insulated from economic hardship more than any other age group during this economic recession.

Senator, stop pandering to us.

  Sincerely,

    James B. Burnham

THE PERILS OF MODELING: FINANCE AND CLIMATE

The 10-year plateau in global temperatures is beginning to draw considerable attention.

A recent New York Times article, "Momentum on Climate Pact is Elusive," documents the fears of global warming pessimists that the prospects for "action" are weakening in the face of hard data. Some pessimists are also warning that the relative stability in temperatures could prevail for another decade due to "cyclical shifts in the oceans" - but rest assured, their models promise us that the long-run outlook is decidedly grim. 

Modelers' Hubris. The faith that such forecasters have in their models would be touching if it were not so dangerous.  While the most reputable forecasters admit to the vast complexities and unknowns in modeling global climate patterns, that doesn't stop many of them - and their publicists, like Al Gore - from calling for massive economic dislocations designed to forestall modest possible increases in temperature.

You would think that such individuals would take a few lessons from the recent travails of chastened hedge fund managers and the  financial market modelers and quantitative analysts who fed them great ideas.  They, too, used massive computers and reams of data, along with sometimes plausible theories, to forecast future trends in stocks, bonds, options, and the like.  They even had the history of  multi-billion dollar collapse of hedge fund LTCM in 1998 to warn them of "long tails" in statistical distributions.

When it comes to climate modeling, while many of the data time series are longer than those of financial modelers, they are subject to much more "measurement error." The daily record of Interest rates and stock prices is a lot more certain and precise than global average temperatures in the 19th or 20th centuries.

Of even greater importance, consider the problems in measuring the amount of solar radiation that reaches the earth. While climate pessimists credit the sun spot cycle with a very modest impact on the earth's temperature, some reputable scientists argue that it has a major effect (see Scafetta and West, "Is Climate Sensitive to Solar Variability?" Physics Today, March 2008).

 According to NASA, we only have modestly accurate data on solar radiation since 1979, when the first satellite designed to take such measurements was launched.  Even now, while we can measure solar radiation to within a few watts (per square meter of earth surface area), the measurement error is greater than the natural fluctuation which takes place over an 11-year sun spot cycle.

Wait Til Next Year! A mini-test of sorts is now underway, since the current minimum in solar sun spot activity is the deepest in a century, according to NASA.  By itself, that would suggest less radiation is reaching the earth, and cooler times are ahead.

So, rather than rush to judgment with coercive "cap and trade" regimes and similar steps to reduce carbon emissions, let's simply asked the climate modelers to give us hard forecasts for the next five years, backed up with their own money via bets in Las Vegas (financed by home equity loans and hedge funds?). 

FINANCIAL MARKETS, THE G-20 AND UNINTENDED CONSEQUENCES

One year ago, following the collapse of Lehman Brothers, the $3.4 trillion money market fund industry essentially froze up when The Reserve Fund "broke the buck."  That was the real start of the financial crisis, as this blog has suggested in the past.

The best detailed description how this event caught the Fed and the Treasury Department off-guard is now the recent extensively researched article by Bloomberg reporters.

There is a lesson to learn (or relearn, if you have forgotten three hundred years of financial market history) from the article: in a complex financial world with many players, an unexpected, catalytic event can lead to a rush for liquidity which threatens to overwhelm not just all the players, but the customers and spectators as well.

The real danger now is that governments will over-react with poorly thought-out legislation and regulation that will create even greater problems down the road.

While some of the suggestions for reform are sensible (such as requiring larger banks to hold more capital), the list of "further steps" that the G-20 heads of state and ministers are supposed to consider in Pittsburgh later this month contains the potential for substantial amounts of mischief and unintended consequences, e.g. "global standards on pay structure" and "oversight for systemically important firms."  (The latter item has taken on concrete form in the proposed legislation to have the Federal Reserve designate "Tier I" firms, as discussed in my previous blog.)

At Least Lehman Brothers Was Allowed to Fail. Despite much talk of the "mistake" in letting Lehman Brothers fail, there are some astute observers (see Niall Ferguson in yesterday's Financial Times) who point to that event as a much-needed reminder that very large institutions can fail - and all managers, shareholders and creditors of other financial institutions should keep this always in mind.

Never permitting another Lehman-type bankruptcy is the worst possible policy goal of financial reform.  As Ferguson points out, "the real tragedy is that the failure of Lehman has left Wall Street's survivors both bigger in relative terms and more secure politically . . . if only we had learnt from Lehman that no bank should be 'too big to fail', we might still have a real capitalist system, instead of the state-guaranteed monstrosity that is the real legacy of last year's crisis."

Ferguson is a bit too gloomy, and no doubt the attempt to ensure "a level playing field" around the globe will slow down truly ill-advised initiatives. But never underestimate the ego of determined politicians to "do something."