Wednesday, October 26, 2011

Today's links

1-Euro roundup, Wall Street Journal

Excerpt: With European Union leaders heading from one pivotal summit to another, intense negotiations are underway to hammer out details on a plan to stem the euro debt crisis, including a sweeping recapitalization of European banks, a bigger bailout fund and a substantial restructuring of Greece’s debt. EU and euro-zone leaders are meeting again on Wednesday to finalize a deal after laying out the foundations for a bank recapitalization plan and leveraging of the European Financial Stability Facility at meetings Sunday.

Pressure is mounting on euro-zone leaders to deliver a convincing plan before G-20 leaders meet Nov. 3-4. The situation is fluid due to the complex nature of negotiations, meaning timetables are still be susceptible to change. EU finance ministers are likely to meet ahead of the summit, while the German Parliament has also scheduled a critical debate for Wednesday to approve any changes to the EFSF’s role. There are now two options for the EFSF on the table, which could be combined. One is an insurance plan that foresees the fund’s setting aside a pool of money that could be used to offset part of any losses suffered by purchasers of the debt of weak countries, such as Italy. The other would be to create a special, separate fund, which would raise money from private investors and others, like sovereign-wealth funds, to buy debt of weak countries. The EFSF would also participate in the fund–but would suffer the first losses. The scale of write-downs on Greek debt as part of a second bailout agreement for the country are also still being finalized. The range of a write-down under discussion is between 40% and 60%, with Germany at the high end and France at the low.

2--European Banks Warn of Credit Drought, Bloomberg

Excerpt: European banks say they have to cut assets to help satisfy a government push to boost capital faster than planned to insulate them against the sovereign debt crisis. That may trigger a credit crunch for companies and consumers throughout the 17-nation euro zone, helping to push its economy into recession, say Citigroup Inc. and Deutsche Bank AG analysts.

Leaders meet today in Brussels to approve a plan to increase lenders’ capital by about 100 billion euros ($139 billion). Banks say they will more likely achieve the new requirements by shrinking rather than raising cash from shareholders, a scenario they want to avoid partly because their share prices have fallen 30 percent this year....

Banks are more important to the European economy than they are in the U.S., according Bank of America Corp. economist Laurence Boone. She calculates that loans to the private sector totaled 145 percent of gross domestic product in 2007, more than double that of the U.S., where companies rely more on stock and bond markets for capital.

James Ferguson, head of strategy at Arbuthnot Securities Ltd. in London, draws parallels between Europe’s current situation and the credit crunches suffered in recent decades by Japan, the U.S. and the U.K.

“History shows that bank recapitalizations provide the catalyst for the credit crunch,” he said in an Oct. 20 note. “Japan learned this in 1998, and the U.S. and the U.K. in 2008. Continental Europe’s lesson starts now.”

Banks across Europe have announced they will trim more than 775 billion euros from their balance sheets in the next two years to reduce short-term funding needs and achieve the 9 percent in regulatory capital required by the Basel Committee on Banking Supervision ahead of schedule, according to data compiled by Bloomberg. They may be required by policy makers today to meet this ratio by the end of June, two people with knowledge of the talks said....

Deutsche Bank CEO Josef Ackermann, 63, who said on Oct. 13 that banks may be forced to restrict lending “due to possible debt haircuts in the euro zone.”

Regulators say the risk of reduced lending is worth taking in light of a bigger concern about the banks’ ability to find short-term funding on the markets at a time when investors are questioning their sovereign debt holdings....

“The banks need to deleverage, but if they choose to deleverage by cutting assets not by raising equity then it will have negative consequences for the economy,” Simon Maughan, head of sales at MF Global Holdings Ltd. in London. “It’s much better to force a deleveraging through more equity even if that means it has to be forcibly injected in the banks.”

3--On political dysfunction in Europe, Naked Capitalism

Excerpt:...Fiscal consolidation is not expansionary. Moreover, it increases deficits due to the increase in spending on fiscal stabilisers and the decrease in tax receipts – that is unless the cuts are extremely large. There is zero chance that Greece will make its targets. I don’t expect Portugal, Italy, Ireland or Spain to meet their targets either, especially given the incipient double dip we are witnessing.

As the Germans are likely to see their fiscal trajectory deteriorate markedly in this environment due to the anaemic domestic demand and dependence on exports, their willingness to fund bailouts will evaporate. The political calculus may turn to topping up capital at underfunded German banks. Greece, at a minimum, will default. Indeed, without the ECB’s assistance Italy would default – that’s the real Armageddon scenario because no amount of recapitalisation would prevent a deep depression. Stark’s resignation increases the chances that just this will occur....

On the fourth topic of Germany having its fill of bailouts and moving to recapitalisation, that is definitely what is happening here. But Italy is the real problem for the Germans. Politically, there is no appetite to bail out the Italians. As I said above, “without the ECB’s assistance Italy would default – that’s the real Armageddon scenario because no amount of recapitalisation would prevent a deep depression.” The ECB is going to have to monetise Italian debt or a deep Depression is coming. There is no other choice. Silvio Berlusconi recognizes this and said as much yesterday. However, the ECB needs movement on the reform front first. The question is whether the reforms happen before the bank sector implodes and sovereign yields in Italy and Belgium spike. If they don’t, there will be contagion into the real economy and the recession in the euro zone will deepen.

Yes, I still think the euro zone is coming apart at the seams.

4--Chart of the Day: US Income Growth 1979-2007, Credit Writedowns

Excerpt: (Must see chart)

The CBO writes:

From 1979 to 2007, real (inflation-adjusted) average household income, measured after government transfers and federal taxes, grew by 62 percent. That growth was not equal across the income distribution: Income after government transfers and federal taxes (denoted as after-tax income) for households at the higher end of the income scale rose much more rapidly than income for households in the middle and at the lower end of the income scale.

In a study prepared at the request of the Chairman and former Ranking Member of the Senate Committee on Finance, CBO examines the trends in the distribution of household income between 1979 and 2007. (Those endpoints allow comparisons between periods of similar overall economic activity.)

After-Tax Income Grew More for the Highest-Income Households

CBO finds that between 1979 and 2007:

--For the 1 percent of the population with the highest income, average real after-tax household income grew by 275 percent (see figure below).
--For others in the 20 percent of the population with the highest income, average real after-tax household income grew by 65 percent.
--For the 60 percent of the population in the middle of the income scale, the growth in average real after-tax household income was just under 40 percent.
--For the 20 percent of the population with the lowest income, the growth in average real after-tax household income was about 18 percent.
[…]

Market Income Shifted Toward Higher-Income Households

The major reason for the growing unevenness in the distribution of after-tax income was an increase in the concentration of market income—income measured before government transfers and taxes—in favor of higher-income households. Specifically, over the 1979 to 2007 period, the highest income quintile’s share of market income increased from 50 percent to 60 percent (see figure below), while the share of market income for every other quintile declined. In fact, the distribution of market income became more unequal almost continuously between 1979 and 2007 except during the recessions in 1990–1991 and 2001.

5--It's consumer spending, stupid, New York Times

Excerpt: AS an economic historian who has been studying American capitalism for 35 years, I’m going to let you in on the best-kept secret of the last century: private investment — that is, using business profits to increase productivity and output — doesn’t actually drive economic growth. Consumer debt and government spending do. Private investment isn’t even necessary to promote growth.

Between 1900 and 2000, real gross domestic product per capita (the output of goods and services per person) grew more than 600 percent. Meanwhile, net business investment declined 70 percent as a share of G.D.P. What’s more, in 1900 almost all investment came from the private sector — from companies, not from government — whereas in 2000, most investment was either from government spending (out of tax revenues) or “residential investment,” which means consumer spending on housing, rather than business expenditure on plants, equipment and labor.

In other words, over the course of the last century, net business investment atrophied while G.D.P. per capita increased spectacularly. And the source of that growth? Increased consumer spending, coupled with and amplified by government outlays.

The architects of the Reagan revolution tried to reverse these trends as a cure for the stagflation of the 1970s, but couldn’t. In fact, private or business investment kept declining in the ’80s and after. Peter G. Peterson, a former commerce secretary, complained that real growth after 1982 — after President Ronald Reagan cut corporate tax rates — coincided with “by far the weakest net investment effort in our postwar history.”

President George W. Bush’s tax cuts had similar effects between 2001 and 2007: real growth in the absence of new investment. According to the Organization for Economic Cooperation and Development, retained corporate earnings that remain uninvested are now close to 8 percent of G.D.P., a staggering sum in view of the unemployment crisis we face.

So corporate profits do not drive economic growth — they’re just restless sums of surplus capital, ready to flood speculative markets at home and abroad. In the 1920s, they inflated the stock market bubble, and then caused the Great Crash. Since the Reagan revolution, these superfluous profits have fed corporate mergers and takeovers, driven the dot-com craze, financed the “shadow banking” system of hedge funds and securitized investment vehicles, fueled monetary meltdowns in every hemisphere and inflated the housing bubble.

Why, then, do so many Americans support cutting taxes on corporate profits while insisting that thrift is the cure for what ails the rest of us, as individuals and a nation? Why have the 99 percent looked to the 1 percent for leadership when it comes to our economic future?...

Consumer spending is not only the key to economic recovery in the short term; it’s also necessary for balanced growth in the long term. If our goal is to repair our damaged economy, we should bank on consumer culture — and that entails a redistribution of income away from profits toward wages, enabled by tax policy and enforced by government spending. (The increased trade deficit that might result should not deter us, since a large portion of manufactured imports come from American-owned multinational corporations that operate overseas.)

We don’t need the traders and the C.E.O.’s and the analysts — the 1 percent — to collect and manage our savings. Instead, we consumers need to save less and spend more in the name of a better future.

6--The Demand Doctor, John Cassidy, The New Yorker

Excerpt:...In “The General Theory,” Keynes took aim at this view of the world. His central insight was that the economy was driven not by prices but by what he called “effective demand”—the over-all level of demand for goods and services, whether cars or meals in fancy restaurants. If car manufacturers perceived that the demand for their products was lagging, they wouldn’t hire new workers, however low wages fell. If a restaurateur had vacant tables night after night, he would have no incentive to borrow money and open a new venture, even if his bank was offering him cheap loans. In such a situation, the economy could easily remain stuck in a rut, until some outside agency—the government was Keynes’s favored candidate—intervened and spurred spending. Only then would private businesses be emboldened to expand production and hire workers.

Nasar, in her capacious and absorbing book, makes the key point well:

What made the General Theory so radical was Keynes’s proof that it was possible for a free market economy to settle into states in which workers and machines remained idle for prolonged periods of time. . . . The only way to revive business confidence and get the private sector spending again was by cutting taxes and letting business and individuals keep more of their income so they could spend it. Or, better yet, having the government spend more money directly, since that would guarantee that 100 percent of it would be spent rather than saved. If the private sector couldn’t or wouldn’t spend, the government would have to do it. For Keynes, the government had to be prepared to act as the spender of last resort, just as the central bank acted as the lender of last resort....

In the course of his career, Keynes advocated tax cuts and interest-rate cuts, but he didn’t limit himself to those measures. During the nineteen-twenties, when the unemployment rate reached double figures, and British monetary policy was hamstrung by the gold standard, Keynes called for additional spending on public housing, roadworks, and other civic projects. “Let us be up and doing, using our idle resources to increase our wealth,” he wrote in 1928. “With men and plants unemployed, it is ridiculous to say that we cannot afford these new developments. It is precisely with these plants and these men that we shall afford them.”...

In the summer of 1931, the government made deep spending cuts, intending to restore confidence in government finances. Keynes warned that the effect would be to worsen the slump, throwing more people out of work. He said that budget deficits were a by-product of recessions, and that they served a useful purpose: “For Government borrowing of one kind or another is nature’s remedy, so to speak, for preventing business losses from being, in so severe a slump as the present one, so great as to bring production altogether to a standstill.”...

It is a complete mistake to believe that there is a dilemma between schemes for increasing employment and schemes for balancing the Budget,” Keynes wrote. “There is no possibility of balancing the Budget except by increasing the national income, which is much the same thing as increasing employment.”...

A wartime economy may present a special case, but a recent working paper published by the National Bureau of Economic Research looked at data going back to 1980 and found that government investments in infrastructure and civic projects had a multiplier of 1.8—pretty close to Keynes’s estimate.

So why didn’t the Obama Administration’s 2009 stimulus package usher in a true recovery? Keynes would have pointed out that, with households and firms intent on paying down debts and building up their savings in the aftermath of a credit binge, large-scale deficit spending is needed merely to prevent a recession from turning into a depression. With interest rates already close to zero, Keynes would have argued that the economy was stuck in a “liquidity trap,” greatly limiting the Federal Reserve’s scope for further action. He would also have noted that the stimulus was—especially compared with the devastation it meant to address—rather small: equivalent to less than two per cent of G.D.P. a year for three years. Even this overstates its magnitude, given that much of the increase in federal spending was offset by budget cuts at the state and local levels. In its totality, government spending didn’t increase much at all. Between 2007 and the first half of this year, it rose by about three per cent in real dollars...

The recent slowdown in the U.S. economy occurred just as Obama’s 2009 stimulus package was running dry. The U.K. economy provides an even more striking case study. As in this country, the authorities reacted to the 2008 financial crisis by cutting interest rates, boosting public expenditure, and allowing the budget deficit to rise sharply. In 2009 and in the first part of 2010, the economy began to recover. But since the middle of last year, when the Conservative-Liberal coalition announced substantial budget cuts to balance the budget, growth has virtually disappeared. “The reason the current strategy will fail was succinctly stated by John Maynard Keynes,” Robert Skidelsky and the economist Felix Martin wrote in the Financial Times recently. “Growth depends on aggregate demand. If you reduce aggregate demand, you reduce growth.”...

Yet Keynes was anything but a spendthrift. When deficits and debts reached historically high levels, he believed, it was necessary to spell out how they would be reduced in the long term. As Backhouse and Bateman observe in their timely and provocative reappraisal, Keynes never said that deficits don’t matter (the lesson that Dick Cheney reportedly drew from President Reagan). He believed not only that large-scale deficit spending should be confined to recessions, when business investment was unusually curtailed, but that it should be directed mainly toward long-term capital projects that eventually would pay for themselves. When some of his followers, by way of postwar planning, advocated using tax cuts and deficit spending to “fine-tune” the economy on an ongoing basis, Keynes struck a note of caution. “If serious unemployment does develop, deficit financing is absolutely certain to happen, and I should like to keep free to object hereafter to the more objectionable forms of it,” he wrote....

Even his great intellectual contribution—the notion that economies can remain in an “equilibrium” state with mass unemployment—defies easy explanation. How exactly does it come about? Not simply because, as textbooks often suggest, prices and wages get “stuck,” maybe as a result of union contracts. Keynes was convinced that, even if wages and prices are flexible, the economy could remain mired...

7--Examining Keynes’ Letters to Franklin Roosevelt, Rortybomb

Excerpt: Keynes also noted that getting the housing market straightened out is one of the best ways to handle the Depression. “Housing is by far the best aid to recovery because of the large and continuing scale of potential demand; because of the wide geographical distribution of this demand; and because the sources of its finance are largely independent of the Stock Exchanges.” Getting the housing market right is also an uphill battle for our recession and administration....

Since we are looking at Keynes’ letters to President Roosevelt, let’s look at his 1933 open letter to FDR, published in the New York Times. Among other recommendations, he advises the new administration to do two things on the domestic front (my bold):

If you were to ask me what I would suggest in concrete terms for the immediate future, I would reply thus… In the field of domestic policy, I put in the forefront, for the reasons given above, a large volume of Loan-expenditures under Government auspices. It is beyond my province to choose particular objects of expenditure. But preference should be given to those which can be made to mature quickly on a large scale, as for example the rehabilitation of the physical condition of the railroads… You can at least feel sure that the country will be better enriched by such projects than by the involuntary idleness of millions.

I put in the second place the maintenance of cheap and abundant credit and in particular the reduction of the long-term rates of interest. The turn of the tide in great Britain is largely attributable to the reduction in the long-term rate of interest which ensued on the success of the conversion of the War Loan. This was deliberately engineered by means of the open-market policy of the Bank of England. I see no reason why you should not reduce the rate of interest on your long-term Government Bonds to 2½ per cent or less with favourable repercussions on the whole bond market, if only the Federal Reserve System would replace its present holdings of short-dated Treasury issues by purchasing long-dated issues in exchange. Such a policy might become effective in the course of a few months, and I attach great importance to it.....

His first suggestion constitutes fiscal stimulus. But his second suggestion is urging the Federal Reserve to replace its short-term bonds with long-term bonds to bring down the rates on the long-term bonds — just like Operation Twist! Equally interesting, instead of naming an amount of Treasuries to buy, like $800 billion or $2 trillion, Keynes says to hit a specific rate. The Federal Reserve can either set a rate or an amount, and we’ve been doing QE through setting purchase amounts. Maybe this other way that he suggests, having QE set a target for long-term rates, is a better way of doing QE? He’s a pretty smart fellow.

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