TOPICS IN POLITICAL ECONOMY

OUTLOOK FOR 2012

Believers in the business cycle should opt for modest optimism for the U.S. economy in 2012.

As I pointed a year ago, the average expansion phase of a business cycle since 1945 is 59 months. We are now just halfway - 30 months - along that path, and nearly all the key indicators remain favorable, although not buoyant.

The economy in 2011 grew at about 2%, less than my cheery forecast of 3.5%, but enough to silence the "double dip" recession fears of some. Signs of encouragement include:

• In the past 12 months, the number of unemployed has dropped by 1.3 million. Employment has being rising steadily, although is still down substantially from the cyclical peak.
• Industrial production is up 3.7% through November.  
• U.S.-assembled auto sales in December were 11% ahead of a year ago.

The private sector's weak spots continue to be employment in financial services (particularly investment banking and related activities) and residential construction,  whose sweetheart bubble burst in 2008.  Contrast the flat employment picture in these sectors with the overall economy, as charted below using BLS data.

TOTAL EMPLOYMENT, 2001-2011

 

EMPLOYMENT - CONSTRUCTION OF BUILDINGS, 2001-2011

 EMPLOYMENT - SECURITIES, COMMODITIES, INVESTMENTS

 2001-2011

As a long-time believer in the powerful dynamics of the business cycle, I would normally be comfortable in suggesting economic growth in the U.S. next year should be on the order of 3.5% or better.  This would be achieveable even with continuing sluggishness in single-family home building and important financial subsectors.

Consumer spending is clearly strengthening and capital spending budgets appear to be buoyant.  The latter is due partly to the spreading impact of gas and oil shale drilling, development, and pipeline activity on both suppliers and customers (e.g. utilities and chemical manufacturers in several regions of the country.

However, the outcomes of the European Euro-debt crisis and political gridlock in the U.S. over taking steps to avoid precipitating a similar situation on this side of the Atlantic are truly exceptionally bothersome uncertainties. 

The pessimist will side with Kenneth Rogoff, the leading historian of such events, who has written  recently about "the likely coming wave of sovereign defaults."  The optimist will concede that Greek bondholders will shortly take a bath, but that the resulting waves will be insufficient to overturn the boat.

Bottom line?  A growth rate of 3.5% for the U.S. in 2012 is my "most likely" possibility, but the downside odds are larger than usual. 

 

 

 

BEATING UP THE BANKS

As an economist and former banker, I think you have to start feeling sorry for senior management and shareholders of our largest banks.  After all, whatever their past sins, as a result of the recent Frank-Dodd legislation they are supposed to make their profits from low risk activities so they don't have to be bailed out by the government for high-risk debacles.

Hidden Fees? But today's supercharged political environment is creating a bizarre situation. When the major banks try to increase their prices for basic services, like checking accounts or debit cards (to make up for lost profits on activities now denied to them), they generate an avalanche of hot political rhetoric. This includes charges of "hidden fees" by President Obama, in referring to a widely publicized announcement by Bank of America that it was instituting a $5 a month fee for many debit card holders.

Aside from the President, the rhetoric tends to be from those Congressmen and "consumer advocates" who pushed into the financial reform legislation a section that put limits on the fees that bankers can charge merchants for debit card transactions. Of course, this part of the legislation had nothing to do with the subprime debacle, and everything to do with a long-standing complaint by retail merchants about bank card transaction fees. That is the way the Congressional sausage machine works.

Pay Now or Pay Later. So, consumers who paid for the convenience of bank card debit activity through higher prices when they shopped, will now pay for that convenience with higher fees on their cards. The only change is that the transaction cost of using cards will be more transparent. Do retail merchants really want customers to use dirty dollar bills?

A contributing factor to the banks' dilemma are today's extremely low interest rates (thank you, Ben Bernanke). This means that customer deposit balances cannot be invested by their bank at a significantly higher interest rate to help profit margins.

Loss of Clout.The large banks' political clout has seriously eroded over the past three years.  Even Fox News is now lumping Bank of America severance payments for recently-fired senior mangers with fuel for anti-bank Wall Street demonstrators. But while there is a reasonable argument for market-based constraints (e.g. higher capital requirements) to discourage the biggest banks from becoming too large, there is no credible economic argument to institute price controls on basic bank services.  

It would be most helpful if the President and more Congressmen, newspaper editorial writers and bloggers could understand basic economics when it comes to the cost of running the nation's payment system - and the implications of trying to set price controls on what it does.  If you want a healthy banking system, the last thing you want to do to is to start controlling prices for bank services.

WHY THE FED IS FLOUNDERING

“Most of the economic policies that support robust economic growth in the long run are outside the province of the central bank.”  Federal Reserve Chairman Ben Bernanke, August 26, 2011

 Here we go again. A majority of the high priests of monetary policy (e.g. members of the Federal Reserve's Open Market Committee) voted to institute "Operation Twist" at their most recent meeting.

This follows their efforts to stimulate growth and bring down unemployment by pumping $600 billion into the economy under the "QE2" program by purchasing U.S. Treasury securities. With little to show for that project, the Fed will now try to reduce long-term interest rates and increase slightly short-term rates by selling shorter term bonds and buying longer term ones.

If you want an insider's technical critique of this maneuver, read today's remarks by Dallas Federal Reserve Bank President Richard Fisher, who voted against Operation Twist. 

However, Fisher also makes several more important points. First, he suggests the Fed does not really know what it is doing. He does this by passing along a wry Norwegian aphorism:

Theory is when you understand everything, but nothing works.

Practice is when everything works, but nobody understands why.

[Here], theory and practice are united, so nothing works and nobody understands why.

Secondly, Fisher stressed that further monetary accommodation, of whatever form, "will represent nothing more than pushing on a string" until Congress and the Executive get their act together on spending, taxes and the deficit.

The Fed is floundering because it is trying to do too much.  In the process of doing so it has managed to simultaneously raise Congressional hopes about what it can do and stir up a hornet's nest of political critics.  Despite his message at the opening of this blog regarding the Fed's limited powers in the current situation, Chairman Bernanke still feels impelled to do "something."

A stronger Fed Chairman would put substantially more heat under the bottoms of Congressional leaders of both parties and the White House to dispel the vast amount of regulatory and fiscal policy uncertainty created by the politicians. That is Washington's real damper on the private sector's willingness to spend and invest.

REGULATION, POLITICS AND HOMEOWERSHIP

OK, John Q. Public, you asked for it:  "Stop those greedy bankers from making crazy loans and selling them to dumb investors."

Here's the federal government's response, published this week:  233 pages of proposed regulations and their rationale from the six different regulatory agencies in Washington who deal with the financial sector.

In a world with less government intervention and fewer bail outs, financial institutions wouldn't need another 233 pages of regulation - they would be more careful to begin with. But it's not a perfect world, so we are stuck with a decidedly second-best approach.

All that careful verbiage tries to do only two things: (1) Ensure that the bankers keep 5% of the credit risk in any loans they make and then sell to others ("securitization") and (2) Exempt "qualified" residential and commercial mortgages, auto loans, and similar financial assets from rule (1).

The QRM. The most prominent features of a "qualified" residential mortgage (QRM) are the requirement for a 20% down payment and no financing of closing costs. Just like in the good old days, before the "affordable housing," homebuilding and mortgage banking lobbies managed to weaken lending standards and help set us up for the "sub-prime" financial fiasco.

Of course, the bankrupt government-sponsored mortgage giants, Fannie Mae and Freddie Mac are exempt from the new rules over the near term, which dilutes their immediate impact substantially.

So, who's out in front protesting that the rules defining "qualified" mortgages are "too strict?"  The same old faces: the Mortgage Bankers Association, National Association of Realtors, the National Association of Homebuilders and the "affordable housing" lobby.

In some ways, it's an American tradition to support home ownership. It goes back to the Homestead Act of 1862, which helped entice settlers to move west of the Mississippi with the promise of free land if they farmed it.  About 1.6 million homesteads were granted. 

Stacking the Deck Against Renting.  But the West has been tamed and settled.  The case today for the federal government to encourage people to incur large amounts of debt to buy a house instead of renting is flimsy, unless you are working for the housing lobby.  Furthermore, homebuying subsidies will cost the federal budget roughly $200 billion this year  according to the government.  Of these, the deductibility of home mortgage interest is by far the largest, on the order of $630 billion over the next five years.

In short, the struggle over what is a "qualified" mortgage is about much more than trying to make our financial system safer.  It is also about powerful special interests trying to make life easier for themselves at the expense of all taxpayers.

FED POLICY AND PERSONALITIES: RECOMMENDED READING

If you want a short but excellent and level-headed analysis of current Federal Reserve policy, Ben Bernanke, the health of the financial system, and the economic outlook, go to economist John Mason's most recent post.

MONEY, MAGIC AND THE EURO

 Modern money is a wondrous thing. 

Nothing more than blips on some computer’s hard drive, it is created by a collective belief that the bank deposit, money market shares or similar asset can be exchanged for something more tangible – a loaf of bread, a haircut, a new car, a piece of machinery.

The Key:  Credible Value. When the credibility of the issuing authority  (a commercial bank, money market fund or government department) in maintaining the value of that deposit comes into question, the illusion fades. The money stock, adjusted for inflation, starts to disappear. Financial markets are disrupted.

The U.S. dollar and the euro  are now confronted with increasing doubts about their issuing authorities’ credibility. The initial warning sign is the sustained rise in the price of gold, from $800 to $1,400 an ounce over the past two years. This took place simultaneously with the financial crash of 2008-2009 and massive injections of central bank-created money and government-backed credit extensions in the U.S. and abroad.

More Doubts.  While those injections stabilized the financial system, a second wave of doubts, generated by an even more massive wave of prospective future budget deficits may be harder to dispel. 

At the moment, the focus is on European countries who have adopted the euro and whose near term fiscal outlook is unsettling:  Ireland, Portugal, Greece, and Spain. Efforts to bring budget deficits under control have been launched, but their eventual outcome is still in doubt, as demonstrated by continuing disruption in European bond markets. 

In addition, serious questions are being raised about the longevity of the euro.  How is it possible to have a credible common currency without credible budgetary controls on all its users?  The Germans have been asking this question ever since the euro was introduced more than ten years ago. The answer has always been, "we will just wing it.”

In the U.S. In the U.S. there are equal grounds for concern. True, President Obama’s deficit reduction commission voted 11-7 for a plan which would, in theory, “achieve nearly $4 trillion in deficit reduction through 2020” (but still show an annual deficit in that year of nearly $300 billion). 

Because the plan did not get 14 votes, there will be no vote in Congress on the package. At least the commission’s plan, a skillful exercise in the uniform distribution of dissatisfaction, was favored by a majority of members, and will remain a starting point in any substantive legislation to come.

But if the bulk of the recommendations prove too tough for the President and Congress to swallow, a very nasty U.S. bond market, with markedly higher rates, is a reasonable forecast.

Money and Magic.  Meanwhile, Ben Bernake of the Fed and Jean-Claude Trichet of the European Central Bank,  enveloped by the traditional aurora of central banker omnipotence, try to soothe troubled waters with calming words and massive purchases of government debt.  Simultaneously they plead (behind closed doors) with their political masters to bring budget deficits under control.

Thus, they continue to perform as high profile magicians  ("the real secret of the magician's art lies in fooling the mind rather than the eye”)  trying to maintain the normally helpful illusion of the value of money with well-chosen words for the public, but behaving as hard-nosed realists when off the stage.

Let us hope that they succeed. 

"TOO BIG TO FAIL" - PROGRESS

One of the very few positive accomplishments of the Dodd-Frank financial reform legislation was to create two market-based disincentives for banks to become too big.

The first measure was to increase capital requirements for the larger banks.  This is a work in progress.  The second, which this blog mentioned briefly in June, is an adjustment in the FDIC's deposit insurance regime.

Implementation Underway.  The implementation of this directive from Congress is now underway.  Banks with insured deposits pay an insurance premium to the Federal Deposit Insurance Corporation (FDIC). Up until now, the base for the assessment premium has been determined by the insured deposits that each bank holds, with some minor adjustments.  But compared to smaller institutions, large banks, especially those considered "too big to fail," use relatively more non-deposit sources of funding - Eurodollars, commercial paper, etc. to fuel their growth. 

According to the current schedule, starting next April 1 the new assessment base for insurance premiums will be "consolidated total assets" less "tangible equity."  In other words, the more assets you have, the higher your insurance premiums.  The FDIC estimates that under the new system, 80% of premiums will be paid by the larger banks, compared to 70% at present. Most of that increase will be paid by banks with over $100 billion in assets.

Leveling the Playing Field.  Insurance purists (and the big banks) will protest that the linkage between the insurance premium and what is being insured will be broken.  But to a large extent bailouts of large institutions have always protected their biggest depositors and other creditors from losses.  Eurodollar deposits have never been covered, but their holders have always been repaid.  No depositor at or lender to Continental Illinois lost money in 1984, nor did they at First Republic in Texas in 1988. (Some large depositors at Indymac Bank, which failed in 2008, suffered "haircuts" in their accounts as a result of a change in the law after First Republic's failure.) 

Plenty of uninsured depositors at smaller banks that fail, however, have suffered serious losses when FDIC insurance limits were exceeded. Thus the continuing belief in "too big to fail."  

The nice thing about this piece of legislation is that it discourages  regulated banks from growing too large simply by tweaking the cost of insurance; at the same time it levels the playing field a bit for smaller competitors. It won't prevent future financial crises, but it may well reduce their severity and introduce a bit more fairness in the deposit insurance system.

QUANTITATIVE EASING: ECONOMICS OR POLITICS?

 

What is one to make of the Federal Reserve's  decision to buy up to $600 billion of Treasury debt over the next few months? 

Virtuous Circle or Incipient Bubble?  Fed Chairman Ben Bernake's op-ed in today's Washington Post tells us that jobs aren't being created fast enough. He is concerned that very low inflation such as we are experiencing now "can morph into deflation." He would have us believe that helping to finance the Treasury's massive borrowing program will promote "easier financial conditions" which in turn will promote economic growth, e.g. make housing more affordable, promote higher stock prices, and encourage corporations to borrow for more investment. These developments will lead to "a virtuous circle which will further support economic expansion."

In short, Bernake's op-ed reads like he is promoting another financial bubble.  Too much household debt was a critical ingredient in making the most recent recession so severe.  Since when is the Federal Reserve in the business of openly promoting higher stock prices? There are plenty of astute observers nervous about potential inflationary pressures in the near term.

Atonement for Past Sins. In reality, the majority of Federal Reserve governors and bank presidents are trying to atone for contributing, in a major way, to the subprime debacle. Holding short-term rates too low for too long and deliberate indifference toward mortgage underwriting and credit rating agency practices were essential elements in the severity of the debacle. Now, having cut short-term interest rates down to nearly 0%, the Fed still feels pressure to Do Something! "Quantitative easing" is the result.

Ultimately, the Federal Reserve is a creature of Congress, so it behaves with a degree of deference towards Congressional demands, while at the same time lobbying individual Congressional Representatives and Senators to support or oppose policies impacting the Fed. While the final version of the Frank-Dodd financial reform legislation was stripped of some its most bothersome provisions affecting Federal Reserve system flexibility, some provisions (e.g. an audit of its emergency lending activity since 2007 and a change in the manner in which Reserve Bank presidents are elected) were passed into law.

Recall that Ben Bernake's re-appointment as Federal Reserve Chairman last January was not a pro-forma exercise.  For the Fed Chairman's confirmation, the final vote in favor was 70-30 - an unusually high number of "no's" for such an appointment.

Just Tell Them the Truth.  It would be nice if Bernake and other senior policymakers could tell the politicians and the public the truth:

Because of the nature and severity of the recession, the recovery in terms of jobs and economic growth will be slower than usual. The Fed has done just about all it can in the current situation without making major problems for the near-future.

Congress and the President have exacerbated the problem by creating vast amounts of uncertainty for households and business regarding:

(1) Tax rates for 2011. 

(2) The organization of the health-care sector.

(3) The future structure of much of the financial sector.

(4) Regulation and subsidies for the energy sector.

(5) How massive trillion dollar Federal deficits are going to be dealt with. 

But instead of plain talk we end up with "quantitative easing."

POLITICS AND THE FEDERAL RESERVE SYSTEM

Chattering about Federal Reserve actions and words these days is reaching the level of a massive, discordant community sing-along.

Perhaps a few words from someone who started his professional career as a clerk to a Federal Reserve governor might help listeners understand the themes.

A Creature of Congress.  The central political reality revolves around the fact that the Federal Reserve System (12 regional banks and the Board of Governors in Washington) is a creature of Congress, not the Constitution. 

When unemployment is relatively high, as at present, there is intense pressure from the Congress and, occasionally, from the White House, to print money and keep interest rates low. With the one interest rate the Fed controls directly already as low as it can get (the Federal funds target rate is 0%-1/4%), the focus is now on the Fed to print money by buying Treasury and government agency securities.

This pressure is felt most intensely by the Presidentially-nominated and Senatorially-confirmed seven Federal Reserve governors.

Life in the Pressure Cooker.  It is not just their mandated testimony and periodic water torture by numerous Congressional committees that subjects them to pressure.  It also comes from their daily interaction with visiting delegations of bankers, car dealers, farmers, and the like in dozens of phone calls, meetings, and evening receptions.  And, of course, the Secretary of the Treasury and the White House make their thoughts known through various informal channels. 

Five of the regional Federal Reserve Bank presidents serve with the seven Board members on the policy-making Open Market Committee (FOMC). Their relative independence from Congress and physical distance from Washington helps to explain why normally they are much less enthusiastic than Board members to keep interest rates low and print money freely. 

For example, Thomas Hoenig, the president of the Kansas City Fed was the lone dissenter in the FOMC's August 10 decision to keep interest rates at current levels indefinitely.  This was his fourth straight dissent, without any support from the Washington-based governors.

How the Fed Fights Back.  The Fed is not a passive Congressional punching bag.  It is tenacious in resisting attempts by Congress to dictate short-term policy or alter its governance structure.  Fed principals try to shape public opinion (and Congressional actions) while at the same time seeming to empathize with it, most visibly through speeches and testimony.

These messages, particularly from Fed Chairmen like Paul Volcker and Alan Greenspan, are frequently delphic in content to ensure that the central bank can seldom be demonstrably wrong (subprime oversight being an unusual slip-up). Stressing the uncertainties about how monetary policy works helps to project a priest-like role for Fed governors and the regional bank presidents. 

The most under-rated mechanism in the Fed's political tool kit is the members of each regional bank's board and advisory committees. Comprised of bankers, business representatives, academics and assorted community leaders, these individuals are a highly influential group.  And the Board in Washington treats them as such, and as an effective channel to reach the Congress - with the Fed's message. 

When financial reform legislation threatened, earlier this year, to reduce drastically the roles of the regional reserve banks, the Fed and its supporters fought back quietly but successfully, for the most part. 

Bailout Activity Consequences.  However, the Fed's series of massive bailout actions in 2008 has seriously weakened its ability to resist Congressional  (or Executive branch) pressure for future politically-driven interventions.  Precedents have been set, no matter how one reads restrictive language in the recently-passed financial reform legislation.  

In the meantime, the age-old tension between "easy money" advocates and "inflation hawks" remains.  For the layman, distinguishing between technical arguments and pure politics must be as confusing as ever. 

THE NEXT "TOO BIG TO FAIL" CHALLENGE

What event is most likely to characterize the next big financial upheaval?

A Run on the Treasury. My candidate is a "run" on the U.S. Treasury. Foreign holders of Treasury bonds and bills suddenly refuse to re-invest maturing securities in new issues or seek to sell existing holdings. As a result, bond prices fall (and yields soar), the U.S. dollar weakens, stock markets plunge and worriers about the sky-rocketing federal budget deficit say, "I told you so."

What might be the catalyst for the "run"?  The most likely candidate at this point is a default by a major state or local government on its financial obligations. But why would foreign holders of U.S. Treasury securities be bothered by this?

The short answer is, because Gerald Ford is no longer President. In 1975, when New York City effectively defaulted, Ford told the City to "drop dead" (as the New York Post headline put it) when the local politicians - and not a a few financial types -petitioned for federal aid. As a result, the City (and State of New York) was forced to take the initiative and put its house in order. It worked out a financing plan with its lenders and employee unions. At that point, with a credible plan in hand, much like a Chapter 11 bankruptcy, the federal government did step in and provide temporary financing for the City.

Why won't this model be followed in the future?  Because after you've bailed out Citibank, CIT, General Motors and AIG on short notice, Washington is unlikely to refuse to rescue California, Illinois and a host of other large sub-federal governments when they can't pay their bills or their lenders. It will make no difference whether or not they have credible restructuring plans.  

A Promise of Bailouts. If you want a reasonable basis for this prediction, consider what recently happened on Capitol Hill. On May 18th, the U.S. Senate rejected an amendment to the pending financial reform legislation which would have prohibited the use of any federal funds to bail out any state or local government which had defaulted on its financial obligations (or was at risk of doing so) in the absence of a natural disaster. The vote was 47 in favor (all Republicans plus 6 Democrats) and 50 against.

So, when the balloon goes up as California (or Illinois or . . . ) goes down, the fed's bailout window will be wide open, again, fueling even further the massive federal deficit - and spooking our foreign creditors. 

Unless there's another Jerry Ford out there.