Thursday, August 25, 2011

Today's links

1--What Should We Have Known About Fiscal Stimulus?, Paul Krugman, New York Times

Excerpt: I’ve noticed a number of people arguing that the original Obama stimulus was underpowered because at the time nobody realized how deep a hole the economy was in. And it’s true that revised GDP numbers have shown that the 2007-2009 recession was even deeper than we thought. But the basic line of thought here is wrong: there was plenty of information in January 2009 indicating that the economy needed a lot more help than it was about to get.

First, even in January 2009 the CBO was forecasting an “output gap” — a shortfall of the economy’s actual production over what it could and should be producing — of more than $2 trillion over 2009-2010. That told you right there that an $800 billion stimulus, much of it consisting of tax cuts of dubious effectiveness, was likely to fall short.

There were also good reasons to believe that the slump would be prolonged, that the economy would need help over a protracted period. After all, the two previous recessions had been followed by long periods of jobless recovery, and there was every reason to expect a repeat. Moreover, we had international evidence showing that the aftermath of financial crises is a long period of high unemployment.

The point is that even in January 2009 it should have been obvious that the economy probably needed a really major push. Maybe that wasn’t possible politically; but it’s clear that there was a complacency in the White House that remains very hard to understand.

2--Home Prices Decline 5.9% in Second Quarter, Bloomberg

Excerpt: Home prices in the U.S. fell 5.9 percent in the second quarter from a year earlier, the biggest decline since 2009, as foreclosures added to the inventory of properties for sale.

Prices dropped 0.6 percent from the prior three months, the Federal Housing Finance Agency said today in a report from Washington. In June, prices retreated 4.3 percent from a year earlier, while increasing 0.9 percent from the previous month.

Foreclosures are boosting the supply of properties on the market and undercutting the confidence of homebuyers, sapping demand even as mortgage rates tumble to the lowest in more than half a century. The U.S. inventory of homes for sale averaged 3.7 million during the second quarter, the highest since the third quarter of 2010, data from the National Association of Realtors show. The mortgages on 6.5 million U.S. homes had late payments or were in foreclosure in June, according to Lender Processing Services Inc. in Jacksonville, Florida.

“Foreclosures water down home prices because banks want to get rid of properties as fast as they can,” said Patrick Newport, an economist at IHS Global Insight in Lexington, Massachusetts. “The key number driving foreclosures is the unemployment rate, and we saw that worsen in the second quarter.”

3--CBO: No Recession, But Growth So Slow Jobless Rate To Top 8% Until 2014, David Wessel, Wall Street Journal

Excerpt: The Congressional Budget Office, in its midyear update of its budget and economic forecast, says it “expects that the recovery will continue,” meaning it doesn’t foresee a recession, but it says that slow growth will keep GDP well below the economy’s potential for several years. On the basis of economic data available through early July – which means it doesn’t reflect more recent gloomy date – CBO projects that inflation-adjusted GDP will increase by only 2.3% this year and by 2.7% next year.

Under current law, it says, federal tax and spending policies will impose substantial restraint on the economy in 2013, so CBO projects that economic growth will slow that year before picking up later to average 3.6% per year from 2013 through 2016. The U.S. economy won’t be operating at potential – meaning that labor and capital are fully employed – until 2017, CBO projects.

That means a lousy job market for years to come. CBO expects the unemployment rate to fall from today’s 9.1 to 8.5 percent in the fourth quarter of 2012—and then to remain above 8% until 2014. “Weakness in the demand for goods and services is the principal restraint on hiring, but structural impediments in the labor market—such as a mismatch between the requirements of existing job openings and the characteristics of job seekers (including their skills and geographic location)—appear to be hindering hiring as well,” CBO said.

Although inflation increased in the first half of 2011, spurred largely by a sharp rise in oil prices, CBO projects that it will diminish in the second half of the year and then stay below 2.0% over the next several years.

4--The household-debt crisis, Washington Post

Excerpt: That means that in this crisis, indebted households can’t spend, which means businesses can’t spend, which means that unless government steps into the breach in a massive way or until households work through their debt burden, we can’t recover. In the 1982 recession, households could spend, and so when the Federal Reserve lowered interest rates and made spending attractive, we accelerated out of the recession.

The utility of calling this downturn a “household-debt crisis” is it tells you where to put your focus: you either need to make consumers better able to pay their debts, which you can do through conventional stimulus policy like tax cuts and jobs programs, or you need to make their debts smaller so they’re better able to pay them, which you can do by forgiving some of their debt through policies like cramdown or eroding the value of their debt by increasing inflation. I’ve heard various economist make various smart points about why we should prefer one approach or the other, and it also happens to be the case that the two policies support each other and so we don’t actually need to choose between them.

All of these solutions, of course, have drawbacks: if you put the government deeper into debt in order to help households now, you increase the risk of a public-debt crisis later. That’s why it’s wise to pair further short-term stimulus with a large amount of long-term deficit reduction. If you force banks to swallow losses or face inflation now, you need to worry about whether they’ll be able to keep lending at a pace that will support recovery over the next few years. But as we’re seeing, not doing enough isn’t a safe strategy, either.

5--MONEY MARKETS-Bank borrowing costs hit highest in a year, Reuters

Excerpt: Three-month dollar Libor reaches highest rate in a year...

The cost for banks to borrow short-term dollar funds from other banks rose to the highest level in a year on Wednesday as large U.S. money funds continued to pull back on making loans to Europe and as fears over bank counterparty risk increased.

London interbank offered rates for three-month dollars LIBOR increased to 0.31428 percent, the highest rate since last August and up from 0.31178 percent on Tuesday.

The rate has been steadily rising as investors have become increasingly reluctant to make dollar-based loans to European banks on longer than an overnight basis.

"Term funding markets have significantly less liquidity than they had, a lot of investors are getting very short. They don't want to take a lot of term risk," said Ira Jersey, interest rate strategist at Credit Suisse in New York.

U.S. money funds, which have traditionally been among the largest lenders of short-term dollar loans to European banks, have been reducing exposures to the region on concern over bank exposure to the debt of peripheral European nations....


The Libor panel continued to reflect tiering of banks, with European banks including Barclays (BARC.L), Credit Agricole (CAGR.PA), Credit Suisse (CSGN.VX), Royal Bank of Scotland (RBS.L), Societe Generale (SOGN.PA) and UBS (UBSN.VX) all reported having to pay slightly above the daily fixing.

6--QE2---The unintended consequences, FT.Alphaville

Excerpt: By 2010, the Fed became aware the US could be approaching a deflationary trap — where top line revenue for companies and individuals begins to decline, meaning the ability to pay off debt declines, extending the recession indefinitely. The weight of past debt simply keeps getting heavier.

Negative inflation thus had to be avoided at all costs.

But with traditional monetary clearly not working any more, how was the Fed to prevent the floor instituted by QE1 and Tarp from caving in?

At Jackson Hole, says Spellman, the Fed decided to do something quite extraordinary. Something they’d never done before — they put their hope in the shadow banking system to get the money into the spending stream instead of the banks.

After all, the reasoning was, inflation is a goods market phenomenon.

Rather than putting the money out to banks to loan, they would put it out to public capital markets in a bid to try to create an asset bubble. This they hoped would a) create a wealth effect and b) raise the price of public securities and reduce the rate for borrowers. In this way some business firms would be able raise capital cheaply enough in the public capital markets to cause them to pass on the money into the wider economy through energy and infrastructure spending.

A major economics 101 fail

But here’s where the story gets funny. Initially QE2 did exactly what it was intended to do. It inflated equities. Private institutions from which the Fed had purchased Treasuries began to put their money directly into the equity market. Stocks went up. Hurrah!

But there were also some unintended and potentially more serious consequences. Firstly, many institutions had no intention of getting riskier. They wanted to allocate the cash exactly the same way they had always done — in safety. Though, idealy, in better-yielding ‘safety’ securities.

According to Spellman, that saw QE2 money flow out in many curious ways. Among them, back into shadow banks and hedge funds, via overnight collateralised repo loans (unsecured lending is dead remember). The hedgies would use these loans to invest in high yielding instruments like junk bonds, emerging market securities (usually corporate) and even distressed peripheral debt. The “prudent” institutions were happy to do this, because it was only ever on a very short-term duration and they received a better return.

On top of all this, one of the most important factors in determining how money flowed was connected to a major monetary misunderstanding due to the way economics has been taught around the world for fifty-plus years.

Due to the quantity of money theory and the overuse of the term “money printing” in economics 101 coursebooks, Spellman says QE2 became synomyous with “money printing”, a fact which radically changed inflation expectations. This suited the Fed fine, since inflation expectations are important in a debt deflation. But arguably, the inflation expectations overshot entirely. (Spellman interestingly blames Bill Gross for fueling much of the inflation hysteria.)

When “prudent” investors, due to an inflationary view, decided to allocate QE2 cash into commodities and other emerging markets, further unintended consequences began to appear.

Unintended consequences

The first unintended consequence was the degree to which inflation was exported out of the United States and into emerging markets and commodities.

The second was the volatility this passed over into the foreign exchange markets — currency wars, capital control fears, and hot money inflows fears being the primary results.

The third was the degree to which all of the above posed a quandry for emerging market countries, torn between allowing currency appreciation and lower exports or domestic asset bubbles, which ultimately ran even more serious risks.

The fourth was the double-tiering of the US economy. Whatever policy route emerging countries took, Americans ultimately ended up paying more for imports whilst prices of domestically produced goods continued to fall.

Debt debacle effect

And that’s about where we were at when the debt debacle kicked off and QE2 finished. Which, as yet, has not been covered by Professor Spellman.

But FT Alphaville’s own interpretation is that this possibly changed everything. Above all it’s probably injected a short sharp shock of realisation into the market that high inflation expectations in an over-leveraged economy are highly unrealistic. The search for safety has now taken new and radical proportions, so much so that negative real inflation rates are once again the key concern of the Fed. But you can read more about that here. And here.

What are the options left now that QE3 is clearly not a viable option? We’ll discuss those in a follow-up post. But we ultimately we see debt deflation being prominently on Ben Bernanke’s mind at Jackson Hole more than anything else.

7--Fed's fantasy options, FT.Alphaville

Excerpt: ... Fed should start targeting nominal GDP – i.e. forget about inflation targeting altogether and start targeting nominal GDP via nominal incomes and something called NGDP futures. In Sumner’s own words:

It would be something like the classical gold standard, but with the dollar defined in terms of a specific NGDP futures contract, instead of a given weight of gold. The public, not policymakers in Washington, would determine the level of the money supply and interest rates most consistent with a stable economy.

Banks would fail, but the money supply would adjust so that expected future nominal spending continued to remain on target. Creative destruction could do what it’s supposed to do, with jobs lost in declining industries being offset by jobs gained in creative new enterprises.
More on how that works here....

...Of course, there’s also Paul Krugman’s argument that in a debt deflation trap, all conventional monetary tools become redundant and all central banks end up losing credibility. (Especially if the system is intrinsically insolvent.)

8--Gold falls 3% as investors cash in gains, Economic Times

Excerpt: Gold plunged in New York, heading for the biggest drop in 18 months, on speculation that financial markets may be stabilizing, eroding the appeal of the precious metal as a haven.

Bullion has tumbled more than 5 percent in two days, erasing gains in the past two weeks that sent the metal up as much as 16 percent since Aug. 5 to a record $1,917.90 an ounce yesterday. On Aug. 16, Wells Fargo & Co. said rising speculative demand from investors had pushed the market into a “bubble that is poised to burst.”

“This is liquidation from a crowded trade,” Adam Klopfenstein, a senior market strategist at MF Global Holdings Ltd. in Chicago, said in a telephone interview. “In the short run, there’s more optimism and that doesn’t bode well for gold. Investors have been using gold more as a fear barometer than a proxy for inflation.”

Gold futures for December delivery plunged $72.30, or 3.9 percent, to $1,789 an ounce at 12:11 p.m. on the Comex in New York. A close at that level would be the biggest loss since Feb. 4, 2010.

9--Manufacturing data suggest contraction, Credit Writedowns

Excerpt: The Richmond Fed manufacturing index fell to -10 in August from -1 in July. The new orders sub index fell to -11 from -5, shipments fell to -17 from -1 and the backlog of orders fell to -25 from -18 and has not grown since March.Inventories were unchanged at +17. Looking through the various regional indices, the New York index implies an ISM of around 49, the Richmond index 48, and the Philly index about 42 whilst last month’s ISM forward index of new orders minus inventories also implies an ISM of 42

10--Nomura: U.S. Economy Lost Jobs in August, Wall Street Journal

Excerpt: Kicking off what will likely be a series of downgrades to job forecasts in the coming week, Nomura’s U.S. economists said Wednesday they now expect nonfarm payrolls to show a decline of 5,000 in August – far off from their prior estimate of a 100,000 gain – due in part to the strike by Verizon Communications Inc. workers.

They project that private payrolls will show a gain of 5,000 (following July’s 154,000 increase), suggesting that public payrolls will post a decline of 10,000 jobs this month. The economists cite three reasons for their new forecast: 1) The sharp drop in the Philadelphia Fed’s August manufacturing survey “appears to signal a sudden decline in economic activity that we expect to be reflected in a slower pace of hiring.” 2) Growth in payroll tax receipts reported by the Treasury Department slowed from July. 3) The two-week strike by Verizon workers will reduce payrolls by about 45,000 for the period in which employers are surveyed. (They note that a similar strike in August 2000 led to a drop of 77,000 workers in the telecom industry that was reversed the following month when the strike ended.)

Even though layoffs didn’t rise in early August (at least as measured by jobless claims), the economists noted, “businesses likely shut the door on hiring as the economic outlook become even more ‘unusually uncertain’ amid fears of European contagion and stock market volatility. Surveys of business confidence have also pointed to stalled hiring intentions.”

That doesn’t necessarily mean August marks the start of a new recession, particularly because the end of the telecom strike should lead to some bounce back in September’s figures. The Nomura team says concluding a new recession began this month “would seem premature, although not altogether unwarranted.”

The Labor Department is scheduled to release its August employment report on Friday, Sept. 2.

11--WSJ: Europe Banks Lean More on Emergency Funding, Calculated Risk

Excerpt: Commercial banks boosted their reliance on the European Central Bank, borrowing €2.82 billion ($4.07 billion) from an emergency lending facility on Tuesday ... While the amount of borrowing is tiny ... the increase from €555 million a day earlier, nonetheless suggest that some lenders are struggling to borrow from traditional funding sources ... The ECB charges a punitive 2.25% interest rate to borrow from its facility.

12--Not Learning from the Past, Economist's View

Excerpt: The Frum Forum notes that many economists are now assigning a high probability to a double-dip, and adds:

If a double dip does come, it will be the inaction in the face of warnings that it was on the way which future generations will be most baffled by.

One quibble, calling it a policy of inaction is too kind. There has been action, but the wrong kind:

At this point the entire advanced world is doing exactly what basic macroeconomics says it shouldn’t be doing: slashing spending in the face of high unemployment, slow growth, and a liquidity trap. It’s a global 1937. And if the result is another recession, the witch-doctors will just demand more bleeding.

It's hard to believe we're doing this again.

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