Tuesday, January 31, 2012

Today's links

1--International Capital Flows, House Prices, and the Euro, Streetlight blog

Excerpt: ...This paper addresses the question of whether there is in fact a systematic relationship between capital flows into a country and house prices. Were the house price booms of the 2000s caused by international financial flows?

The answer provided by this paper is no, or at least not directly. When different possible macroeconomic explanations for changes in average national house prices are considered, it turns out that by far the most important factor is the ease of bank credit. In other words, rising house prices in the 2000s (as well as their subsequent fall) probably had much more to do with the willingness of banks to lend than any other factor. When banks are happy to lend money and they relax lending standards, house prices go up. When banks reverse course, house prices go down.

The importance of bank lending standards to the US housing bubble has been well documented and discussed, but this data suggests that the same may be true for a number of other countries as well. On the other hand, countries that did not experience a general relaxation in lending standards in the early 2000s did not experience house price booms. Once changing lending standards are taken into consideration, changes in international capital flows seem to have little additional explanatory power for house price changes.....(BUT)

. When a country seems to be headed for better economic times and risk tolerance grows, banks become generally more willing to lend. And that is where we come to the euro......consider the likelihood that the adoption of the euro by the peripheral European countries (e.g. Spain, Ireland, and Greece) created expectations for higher growth (and lower interest rates) in those countries, and helped persuade banks to become less risk averse. House prices start to rise and banks become more willing to lend. House prices rise more. Banks respond by relaxing credit standards further. And the bubble begins to inflate.

Surges in capital flows don’t directly create house price bubbles. But this paper does help us understand a mechanism by which the adoption of the euro could have indirectly caused house price booms: by changing expectations and altering the perception of risk in the eurozone periphery, a self-reinforcing cycle of easier credit was sparked in those countries. That’s not all there is to it, of course – other factors surely must have also caused changes in risk aversion and bank lending standards in the housing bubble countries – but it does seem to be a likely piece of the puzzle for the peripheral eurozone.

2--Monti's attack on labor, Bloomberg

Excerpt: The government has also started talks with unions and employers aimed at overhauling the country’s rigid labor laws, the last pillar of Monti’s plans to remake the 1.6 trillion-euro economy. Labor Minister Elsa Fornero said this week that she hopes to have an agreement within a month.

The new plan comes as many Italians are rejecting Monti’s calls for shared sacrifices now to spur future prosperity. A wildcat strike by truck drivers this week has clogged traffic on Italian highways, forcing Fiat SpA to halt car production and leaving some cities short of gasoline and food.

Public transport workers and some airport and airline staff are striking today, disrupting travel across Italy. The 24-hour strike wrecked havoc on transport on buses and trains while Rome’s two metro lines and local commuter trains were shut down, ATAC, the company that runs them, said in a statement on its website....

While Monti’s measures may have helped shore up investor confidence in Italian debt, the budget cuts and higher taxes are deepening the economic slump in a country where growth has lagged behind the euro-region average for more than a decade. The International Monetary Fund forecast on Jan. 24 that the economy will shrink 2.2 percent this year, compared with a 0.5 percent contraction for the euro area.

3--GDP report: Austerity is stifling the recovery, moneywatch

Excerpt: Investment has two components -- business investment and the construction of new houses. Businesses are waiting for the outlook to improve before increasing investment (Business investment will follow GDP growth, not lead, and the housing market is unlikely to give us the necessary spark.) Net exports are a possibility. They were featured in President Obama's State of the Union speech as part of the path to a better economy, but problems in Europe make an export boom unlikely anytime soon. Besides, not every country can be a net exporter. Other countries will not sit idle while we try to increase our share of exports to world markets, so that even if the world economy grows robustly gaining, market share will not be easy

GDP growth in Q4: Good, not great

That leaves government spending. However, these numbers are moving in the wrong direction, and that is unlikely to change given the emphasis on reducing the long-run budget problem. In fact, premature austerity -- cutting spending before the economy is ready for it -- is taking a toll on the recovery. The fall in government spending reduced fourth-quarter growth by 0.93 percent; if government spending had remained constant, GDP growth would have been 3.7 percent, rather than 2.8 percent.

This is the opposite of what the government should be doing to support the recovery. We need a temporary increase in government spending to increase demand and employment through, for example, building infrastructure. That would help to get us out of the deep hole we are in. Instead, the government seems to be trying to make it harder to escape.

4--(From the archives) Europe’s Lehman moment, Reuters

Excerpt: Europe is in the midst of its variant of the great debt crisis that hit the United States in 2008. Fears abound that if things go wrong, the continent will face its own “Lehman moment” – a recurrence of the sheer panic that hit American and world markets after the collapse of Lehman Brothers in October 2008. How did Europe arrive at this dire strait? What are its options? What is likely to happen?

Europe is retracing steps Americans took a couple of years ago. Between 2001 and 2007 the United States went on a consumption spree, and financed it by borrowing trillions of dollars from abroad. Some of the money went to cover a Federal fiscal deficit that developed after the Bush tax cuts of 2001 and 2003; much of it went to fund a boom in the country’s housing market. Eventually the boom became a bubble and the bubble burst; when it did, it brought down the nation’s major financial institutions – and very nearly the rest of the world economy. The United States is now left to pick up the pieces in the aftermath of its own debt crisis.

Europe’s debtors went through much the same kind of borrowing cycle. For a decade, a group of countries on the edge of the Euro zone borrowed massively from Northern European banks and investors. In Spain, Portugal, and Ireland, most of the borrowed money flooded into the overheated housing market....

But as in the United States, the boom was not sustainable. When the global financial crisis began in October 2008, the European debtors were largely frozen out of financial markets. As their economies spiralled downward, they faced grave difficulties in servicing their debts.

The problems of Europe’s debtors were not just worrisome for the debtors themselves. Most of their debts were owed to Northern European banks and investors, and the crisis threatened the very solvency of major European financial systems. This – not some abstract desire to extend a hand to the Greek and Portuguese people, or to save the euro – has been the principal reason for Europe’s ongoing debt bailout:

The rationale here was like that of bailing out a bank: a collapse of Greek or Portuguese finances could harm the rest of the euro-zone financial systems. If Bank of America was too big to fail, then so was Greece. And since a deepening of the financial crisis that drew in the entire euro zone would affect the entire global financial system, the International Monetary Fund was also drawn into the rescue….And because the Greek emergency triggered a crisis of confidence in other euro-zone countries whose failure could harm the region as a whole, the European Union was driven into a massive trillion-dollar package for other troubled European debtors. (page 188)...

Some or all of these debts will have to be restructured, the interest rates reduced and maturities extended. If not, there will be a wave of defaults whose reverberations will rival those of the Lehman failure.

For two years, Europe’s governments have been grappling with how to address this continuing debt crisis. But most of the public discussions have been highly misleading. In Northern Europe, and especially Germany, the tone has been one of outraged indignation. This high moral tone is misplaced. Certainly many Southern European banks and households, and the Greek government, borrowed irresponsibly; but German and other Northern European banks and investors lent just as irresponsibly. It’s not clear that there’s any real ethical distance between irresponsible borrowers and irresponsible lenders.

And most Northern Europeans also seem to believe that the bailouts have gone to lazy Southern Europeans. In fact, their purpose has been to shore up the fragile Northern European financial systems. German banks are among the weakest in Europe; some of them (especially the state-owned landesbanks) are effectively bankrupt. If they were forced to mark down their Southern European debt, they might well collapse in a heap, and the European financial system could grind to a halt. Just as in the United States, the real impact of the European bailout has been to shore up the continent’s banks – not to help the continent’s debtors. The recent downgrading of two of France’s most important banks, due to their holdings of Greek debt, reminds us of how exposed Northern Europe’s financial systems remain. And rumors of a recent IMF report that European banks are over $270 billion short of the capital they need to confront their current problems served to drive the point home....

Eventually Europe’s creditors and its debtors will have to admit that these debts will not be serviced as contracted, and the debts will be restructured. Pretending otherwise will only prolong the agony – not just for the debtor countries imposing austerity, but also for the financial systems that are now crippled by debts that nobody believes will be repaid. When major central banks, earlier this week, threw a lifeline to the European financial markets, they undoubtedly helped avoid what appeared to be an imminent panic. However, this initiative will only postpone the final reckoning with the region’s underlying financial weaknesses.

In Europe as in America, the real question is how the costs of this devastating debt crisis will be distributed. Who will pay – creditors or debtors? Taxpayers or government employees? Germans or Greeks?

5--De-Mythologizing Fiscal Consolidation, Econbrowser

Excerpt: The September 2010 WEO cross-country analysis of fiscal contraction effects was discussed in this post (And the absence of expansionary fiscal contraction in the UK here).

Fiscal contractions raise both short-term and long-term unemployment, as shown in Chart 3, but the impact is much greater on the latter. Long-term unemployment refers to spells of unemployment lasting more than six months. Moreover, within three years the rise in short-term unemployment due to fiscal consolidation comes to an end, but long-term unemployment remains higher even after five years.

So, in addition to contracting the economy, fiscal contractions exacerbate the already daunting challenges facing the long term unemployed (keeing in mind long term unemployment is not necessarily the same as structural unemployment). [1] [2]

What about how the burden of adjustment is allocated?

How does fiscal consolidation affect the distribution of income between wage-earners and others? The research shows the pain is not borne equally. Fiscal consolidation reduces the slice of the pie going to wage-earners. For every 1 percent of GDP of fiscal consolidation, inflation-adjusted wage income typically shrinks by 0.9 percent, while inflation-adjusted profit and rents fall by only 0.3 percent. Also, while the decline in wage income persists over time, the decline in profits and rents is short-lived

The foregoing suggests that the schedule of fiscal consolidation should be such that spending cuts and tax increases are implemented when the economy has recovered. The findings also imply that fiscal consolidation should be accompanied by measures to protect low wage earners and the long term unemployed.

Hence, our fiscal policy prescriptions in Lost Decades:

...with the economy growing only modestly as recovery began, too rapid a retrenchment in spending and an increase in taxes could very well be counterproductive, throwing the economy back into recession and further accumulation of debt. However, the politics of countercyclical fiscal policy can be perverse, as the Obama administration found. Recessions hit hardest at poor and working-class families, who would benefit most from stimulative fiscal policy. But attempts to undertake these policies face opposition from upperincome taxpayers who are less affected by the recession and more concerned about the impact on their future taxes. This opposition can impede an effective fiscal response to cyclical downturns. Whatever the difficulty with devising appropriate short-term fiscal policy, government finances over the next two decades need everyone’s focused attention. The big problems are Americans’ unwillingness to tax themselves, ever since the Bush tax cuts of 2001 and 2003, and the entitlement programs—Medicare, Medicaid, and Social Security—which are going to consume ever greater shares of the budget. ...

6--Lost decades, econbrowser

Excerpt: Half of the holdings of US Treasury securities and Treasury and Agency securities were held by China and Japan. While the Chinese and Japanese holdings were about the same size, China's had caught up quickly, over the preceding five years.

..The boom in the shadow financial system, as measured by asset backed commercial paper, started taking off in 2004, and peaked in 2007. The collapse in this market began over a year before the Lehman bankruptcy.


7--What Predicts a Credit Boom Bust?", econbroswser

Excerpt: From Chapter 1 of the IMF’s recent World Economic Outlook (Box 1.2), a set of findings by Jörg Decressin and Marco Terrones:

The econometric results confirm that net capital inflows, financial sector reform, and total factor productivity are good predictors of a credit boom. Net capital inflows appear to have an important predictive edge over the other two factors....

I think this is a particularly interesting set of findings; credit boom/busts are closely associated with financial crises. As an international finance economist, my view had been that net capital inflows were particularly dangerous for the United States in that they resulted in increasing net indebtedness to foreigners that would eventually lead to foreigners dumping dollar denominated assets (see Chinn (Council on Foreign Relations, 2005)). A competing view was that the net capital inflows signaled financial excess (of course, the two are not mutually exclusive -- both forces could be in effect, but with different strength). The findings reported here are more consistent with the second view. (There is of course yet another view, that all that borrowing was justified by the high productivity and entrepreneurial energies unleashed by the tax cuts of 2001 and 2003); ‘nuff said of that.) ...

Several policy implications flow from these findings:

... Given the high costs of credit boom-bust cycles, policymakers should closely monitor the joint behavior of capital inflows and domestic lending. 6 There is also evidence that financial sector reforms are predictors of credit boom-busts. Policymakers must ensure that financial liberalization programs are designed to strengthen financial stability frameworks. Last, there is evidence that large productivity gains increase the risk of a credit boom, particularly in advanced economies, driven perhaps by exuberant optimism in new sectors. Thus, even during particularly good periods for the economy, policymakers must be on the lookout for emerging threats to financial stability stemming from credit booms.

I think this warning should be kept in mind when three years after the largest financial crisis in history, we see attempts to gut effective regulation of the U.S. financial system. From Moneyline.com:

Republicans will are likely to up attacks on the Dodd-Frank legislation that increases regulation on the financial sector as campaign season heats up, the New York Times reports.

Dodd-Frank aims to curb abusive lending practices, stop high-risk bets on complex derivative securities and protect consumers from financial fraud, among other goals.

Many of the bill's provisions haven't gone into effect, which will give Republicans new material to point out how President Barack Obama's efforts to increase regulation will continue to hamper economic recovery.

"It created such uncertainty that the bankers, instead of making loans, pulled back," says Republican presidential hopeful Mitt Romney, speaking at a South Carolina rally over Labor Day weekend where he again called for the law’s repeal, the New York Times reports.

8---Lost Decades: The Making of America's Debt Crisis and the Long Recovery, econbrowser

Excerpt: From the preface to Lost Decades, published today (9/19) by W.W. Norton:

The United States ... lost the first decade of the twenty-first century to an ill-conceived boom and a subsequent bust. It is in danger of losing another decade to an incomplete recovery and economic stagnation.

In order to not lose the decade to come, the United States will have to bring order to financial disarray, gain control of a burgeoning burden of debt, and re-create the conditions for sound economic growth and social progress. None of this will be easy. The tasks are made more difficult by the fact, which we have learned to our alarm, that all too many policymakers and observers cling to the failed notions that got the country into such trouble in the first place. If Americans do not learn from this painful episode, and from others like it, they will condemn the nation to another lost decade.. (p. xvi)....

For us, we find key blame in a toxic and synergistic mixture of ample foreign savings, a profligate fiscal policy (EGTRRA, JGTRRA, Iraq, Medicare Part D), a debt-biased tax code, and most importantly regulatory disarmament.

Government policies enabled, catalyzed, and fueled America’s crisis. The Bush administration’s tax cuts and spending splurge drove the federal budget from surplus to deficit, beginning the most recent cycle of foreign borrowing boom and bust. The Federal Reserve’s excessively loose monetary policy encouraged households to take advantage of very low real interest rates to embark on a debt-financed consumption spree, with much of the debt borrowed from abroad. Neither the government nor the households that did the borrowing used enough of the borrowed funds to increase the nation’s productive capacity and its ability to eventually service the debt without sacrifice. Lawmakers disarmed financial regulators, who in turn used few of the weapons left in their arsenals, allowing financial institutions to develop new instruments that were largely untested and wholly unsupervised. Financial institutions worked madly to increase their profits in a low-interest-rate environment by taking on ever riskier assets, insisting that they had mastered risks they barely understood.

Any one of these policies might have gotten the United States into serious trouble. Together they created a financial perfect storm, driving the American economy to the brink of financial collapse and dragging much of the rest of the world with it. (pp. 201-02)...

clearly, regulatory disarmament/nonenforcement and "criminal activity" were important. Office of Thrift Supervision under the Bush Administration "helped out" IndyMac [2] [3], and how deregulatory zeal [4] [5] metastatized over into criminal activities on the part of regulators and the regulated.

Fiscal profligacy is important because it pushed the economy more into a boom exactly at a time when not needed (i.e., near full-employment), and the tax cuts made people feel like they had more discretionary income than justified, thereby adding extra fuel to the asset boom....

Finally, tax policy clearly provided incentives to borrow and leverage. In particular, I have been thinking about the tax deductibility on second homes, a provision dating back to 1997 [6] [7] [8]. (Mortgage deductibility on a second home never made sense to me, let alone on a first home); see Capital Games and Gains, who highlighted this provision, citing a NYT article). I suspect that on its own, this provision wouldn't had a big impact, but in combination with the other forces and distortions, it might have.

Typically, for ordinary phenomena, I would think of these factors adding up in a linear fashion, so that each of the impulses would sum to the total effect. But I think it's worthwhile to think about lax monetary policy, deregulatory zeal and criminal activity/regulatory disarmament, and tax cuts and tax policy changes, all combining to lead to the "bubble" (in a nontechnical sense) or episode of Akerlof-Romer "looting", and subsequent collapse we’ve witnessed.

Consider one example of a pernicious synergy: the 2001 and 2003 tax cuts were aimed at higher income households, while the second home mortgage deductibility benefited mostly higher income households [9]; with regulatory oversight absent, and low interest rates, the stage was set.

So, despite the outward trappings that seemingly differentiated the last crisis from previous ones, we can interpret the recent episode as yet another capital flow cycle: We borrowed from overseas, not only because of ample supplies of capital, but because government profligacy and the distortions in the purportedly "deep and liquid" (but actually under-regulated) financial markets....

Second, turning to the longer horizon, we see equally daunting obstacles to preventing a replay of financial crisis. If one believes that highly leveraged and unregulated financial institutions and households were important, then one want to implement tighter standards and higher capital requirements. However, some have argued for a "just say no" approach to further bailouts. We believe that that approach will work as well in financial regulation as it did in drug policy, and really just covers for the naked self-interest. (See how finance was powerful enough to force Republicans to delete all references to Wall Street in the Financial Crisis Inquiry Commission report. [11]) As we note:

None of the changes necessary to avoid a repeat of this disaster will be easy. At every turn there are major political obstacles. Financial interests resist regulations that shift the burden of risky behavior back onto them and off of taxpayers. Beneficiaries of government programs fight against attempts to curb their benefits. Taxpayers refuse to pay the taxes needed to pay for the programs they want. Partisan politicians block reasoned discussion, suggesting absurd pseudo-solutions instead of realistic alternatives. Ideologues and political opportunists encourage Americans to cling to the childish things that have served them so poorly in the past: a mindless belief that markets are perfect, that tax cuts solve every ill, that borrowing is to be encouraged. Despite the great trouble these policies have caused, their attractions continue to be touted and spouted by unprincipled pundits. (p. 221)

Hence, the challenge of avoiding a second lost decade is still a very real one.

9--Austerity Is Not The Correct Medicine---Greek Tragedy should not set fiscal agenda for rest of world, Richard Koo, Nomura via zero hedge

Excerpt: I think it a miracle if Europe does not experience a full-blown credit contraction.

EU’s response has aggravated crisis

This 9% rule effectively prescribes the size of European banks’ balance sheets. This means banks will not be able to increase lending no matter how much liquidity the ECB supplies, effectively rendering any monetary accommodation by the ECB powerless to stimulate the economy.

The EBA’s 9% rule may help in preventing the next crisis, but it will do nothing to resolve the current one—in fact, it will make it much worse...

Apart from the problems in Europe, economic activity is decelerating in China and India, where policymakers are working to rein in inflation. Some areas of China are facing a deflation—not yet a collapse—of the real estate bubble leading to balance sheet recession-like conditions.

Economic conditions in Japan and the US are relatively stable by comparison. But the governments of both countries are moving towards fiscal consolidation at a time when the private sector is trying to clean up its own balance sheet. If the private and public sectors attempt to deleverage simultaneously at a time of zero interest rates, the risk is that the economy will fall into a deflationary spiral....

New eurozone capital rules will lead directly to credit contraction

The new international capital requirements proposed by the BIS, known as Basel III, call on banks to raise their core capital ratios to 7% by 2019. The EBA, meanwhile, has demanded another 2% on top of that while insisting that banks comply by June 2012, offering no logical basis for its position. Nor has the ongoing credit crunch in the eurozone prompted any discussion of a government recapitalization of the banking system.

Even a 7% target would have been hard for banks to meet, which is why they were given until 2019 to comply. The EBA’s demand that banks raise core capital ratios to 9% by June 2012 in the midst of a systemic crisis seems spectacularly ill-advised. I think it a miracle if Europe does not experience a full-blown credit contraction....

In Europe, however, I find few people—including the authorities—understand what a balance sheet recession is. The vast majority are unaware that such a thing even exists, and to some extent that is why the crisis continues to worsen. Since the ongoing balance sheet recession and sovereign downgrades are a first for eurozone investors, their confusion, like that of their predecessors in Japan, is understandable.

But I think it is just a matter of time before eurozone investors come to understand this concept and learn to ignore the views of rating agencies operating in ignorance of economic realities.

Monday, January 30, 2012

Today's links

1--The ECB is Plugging Holes, Economonitor

Excerpt: Today the ECB released its monthly data on monetary developments in the Euro area (EA), as measured by M3 and its components. The market usually focuses on the marketable assets portion of M3, M3-M2, as a representation of funding access – here’s an FT Alphaville post highlighting as much. In December 2011, M3-M2 declined 0.2% over the year, its first annual decline since early 2010. What’s going on here? The ECB’s plugging holes.

There’s an evolution in marketable debt that is telling a very interesting story regarding bank funding through December 2011. As each private funding market shuts down, the ECB compensates by relaxing its lending facilities and collateral rules, effectively shoring up bank liquidity.

Look at the chart below: it maps out the dynamics of the components of marketable instruments in the EA, M3-M2, in levels of seasonally adjusted billion €. See Table 1 of the release, or download the data here. Since September 2011, the level of repo lending dropped 21%, or – €107 billion. Not coincidentally, the ECB started to introduce longer-term refinancing operations starting with the 1-yr in LTRO October. Holdings of debt instruments <2 years increased €40 billion, as banks use the securities for collateral under the ECB’s lending operations....

It’s pretty clear what the ECB is doing: plugging up the bank funding holes left exposed by private capital markets. What’s next?

2--The Role of Austerity, NY Times

Excerpt: The chart here offers one of the better recent snapshots of the American economy that you will find.

The blue line shows the rate at which the government — federal, state and local — has been growing or shrinking. The red line shows the same for the private sector. (Chart) The brief version of the story is that the government, which helped mitigate the recession, has been a significant drag on growth for more than a year now.

In 2007, both the private sector and government were growing. The government continued growing through 2008 and most of 2009, with the exception of one quarter when military spending fell. The private sector, though, began to shrink in 2008 and by late 2008, as the financial crisis took hold, it was shrinking rapidly.

3--FHA serious delinquency rate inches up while originations decline, Housingwire

Excerpt: The serious delinquency rate for Federal Housing Administration mortgages reached 9.6% in December, the highest level in more than two years, the Department of Housing and Urban Development said.

More than 711,000 FHA-insured loans were seriously delinquent, up 18.9% from one year earlier, according to the HUD report. It's also a 3.2% increase from the month before. The delinquency rate has been steadily increasing since passing 8.2% last summer.

Meanwhile, originations are down. In December, the FHA insured 93,700 mortgages, a nearly 30% decline from the 133,000 insured in December 2010.

4--Why Europe’s crisis can’t be averted, Feklix Salmon, Reuters

Excerpt: Politically, we still seem to be very far away from a fiscal solution to Europe’s problems, and the baseline scenario has to be that we’re not going to get one — ever. The result is likely to be a series of countries exiting the euro, and/or the “East Germanification” of much of Europe’s periphery: flows of money and human capital away from countries like Greece and Portugal, and towards the more prosperous countries with healthy economies and substantial trade surpluses. Essentially, those countries would become holiday resorts for the north, with all the real economic activity being concentrated in more prosperous nations. If you’re a smart young Spaniard, it’s much more attractive to seek your fortune in the UK than it is to take your chances in a deflating country with a stratospheric youth-unemployment rate.

Certainly there seems to be no belief at all, even among the well-intentioned technocrats at Davos, that coordinated international action will or should solve this particular crisis. And the inevitable conclusion is that the crisis is not going to be averted: it’s only going to get worse. It’s a very scary prospect — but one which it’s very important for global elites to come to terms with. And that’s exactly what they’re doing in Davos this week.

5--4Q GDP; Getting it right, CEPR

Excerpt: There are always a number of random factors that will affect measured GDP in any given quarter. Often they average out so that the measured GDP is pretty much in line with what we may view as the underlying rate of growth. Sometimes they don't average out so that the headline number might be notably better or worse than the economy's underlying growth rate. This is the situation for the last two quarters.

The most obvious wildcard in GDP numbers is inventory changes. These are erratic. Sometimes they reflect conscious decisions of firms to build-up or run-down inventories. Sometimes firms accumulate inventories because they didn't sell as much as expected. Sometimes it is just the timing of when items get counted in stock.

Whatever the cause, inventory fluctuations often have a very large impact on GDP growth. And, this impact is often reversed in the following quarter. (The impact on growth is the change in the change. If inventories grow by $50 billion in both the third and fourth quarters then inventories add zero to growth. The $50 billion growth in inventories only boosts growth in the fourth quarter if we added less than $50 billion in the third quarter.)

This is worth noting because more than the entire difference between the third quarter growth rate and the fourth quarter growth rate can be explained by the movement in inventories. Inventories subtracted 1.35 percentage points from growth in the third quarter, when they rose at just a $5.5 billion annual rate. They added 1.95 percentage points to growth in the fourth quarter when they rose at a strong $63.6 billion annual rate.

Needless to say, this speedup in the rate of inventory accumulation will not continue. In future quarters inventories are likely to grow at a somewhat slower pace. In the absence of this inventory growth we would have been looking at 0.9 percent growth rate in the fourth quarter....

The long and short is that there was likely little change in the underlying rate of growth from the third quarter to the fourth quarter. The winding down of the stimulus, coupled with the negative impact from the Japan earthquake brought growth to a near halt in the first half of the year.

Now that the stimulus has almost fully unwound we are back on a growth path of around 2.5 percent -- pretty much the economy's trend rate of growth. This means that we are making up little or none of the ground loss during the recession. That is a really bad story.

6-- Permanent Zero and Personal Interest Income, credit writedowns

Excerpt: If you are an American retiree or near-retiree, you’re not happy these days. Five years ago, you were getting a decent return on your fixed income investments. But since then, the Fed has trashed the fixed income market by reducing interest rates to zero percent for "an extended period". The thinking is that this will get people to take on more credit. But the reality is that a lot of people are stuffed to the gills with existing credit and are not creditworthy. The Fed is pushing on a string.

Meanwhile, it is sucking money out of the economy. Ross Perot would tell you that giant sucking sound is the fed reaching into your pocket and giving your interest income to the Treasury by buying up government debt and keeping interest rates at zero. (chart shows personal interest income dropped more than $400 bil in 2011)

Prediction: The next recession will see significant deleveraging and financial distress. The Fed will then move to purchasing municipal bonds, stocks and real assets for fear of a deflationary spiral.

P.S. – If you’re close to retirement, you are going to have to postpone that retirement for "an extended period".

7--MONEY MARKETS-Shrug off Greek talks setback as cash buffer anchors rates, Reuters

Excerpt: Strong demand for short-term debt from the euro zone's lower-rated countries also continued, with Spanish borrowing costs for 3- and 6-month Treasury bills falling sharply, supported by cash-flush domestic banks.


Despite being awash with cash after the injection of nearly half a trillion euros in 3-year loans in December, there was no easing in banks' appetite for central bank funds.

Banks took up 130.3 billion euros at the ECB's weekly tender, up from 126 billion euros last week and the same level of demand as before looser ECB reserve rules kicked in last month, freeing up more bank funds.

Focus is now on how much of the 44 billion euros in 3-month loans maturing on Wednesday they will roll over, with a lower uptake likely to signal that banks are sticking to very short-term funding to keep collateral free for the ECB's next injection of 3-year loans on Feb. 29.

8--The Real Money Goes under the Mattress, TrimTabs

Excerpt: Checking and Savings Accounts Get More Than Eight Times More Money Than Stock and Bond Mutual Funds and Exchange-Traded Funds in First Eleven Months of 2011.

The Federal Reserve is doing almost everything in its power to entice investors to speculate in overpriced asset markets. Yet investors are generally refusing to embrace speculation. The real money these days is going under the mattress.

In the first 11 months of 2011, investors poured a stunning $889 billion into checking and savings accounts. This inflow is more than eight times higher than the $109 billion that flowed into stock and bond mutual funds and exchange-traded funds.

Inflows into checking and savings accounts peaked at $208 billion in July 2011 and $207 billion in August 2011 as the Standard & Poor’s downgrade of the U.S. credit rating and the Eurozone debt crisis rattled markets. Yet inflows into checking and savings accounts outstripped inflows into stock and bond mutual funds and ETFs in every single month of 2011, including in tax season.

Most portfolio managers desperately want to believe that the economy will improve this year so they can pocket bigger bonus checks for 2012 than they will for 2011. But our real-time indicators suggest the economy is still sluggish. Wages and salaries, which we track each day in real time, are falling slightly sequentially, mostly because Wall Street players are getting smaller bonuses. Meanwhile, postings on online job boards are rising only slightly sequentially.

Given the economy’s weakness and the constant interventions in markets by central bankers and politicians, it’s no wonder investors are hunkering down in bank accounts. As long as most investors keep stuffing most of their money under the mattress, the economy is unlikely to get off to the races anytime soon.

9--Obama administration bolsters homeowner lifeline, Reuters

Excerpt: "DeMarco said he is willing to reconsider principal reduction for mortgages backed by Fannie and Freddie, if, in his words, 'a source of funds outside the enterprises emerge to cover some portion of the costs associated with reducing principal,'" Senator Jack Reed, a member of the Senate Banking, Housing & Urban Affairs Committee, said in a statement.

"The administration has now made those funds available," Reed, a Rhode Island Democrat, said. "I expect FHFA to promptly reconsider their analysis and help more Americans avoid foreclosures."...

The Obama administration, in an election-year bid to help distressed homeowners, on Friday expanded its main foreclosure prevention program, and pushed for Fannie Mae and Freddie Mac to forgive mortgage debt.

The administration said it would extend the life of the Home Affordable Mortgage Program by a year through 2013 and widen it to reach more heavily indebted homeowners.

It also said it would provide incentives to encourage Fannie Mae and Freddie Mac, the government-controlled mortgage finance providers, to write down loans, an idea which their regulator has worried would unnecessarily add to the cost of taxpayer bailouts for the two firms.

The regulator, the Federal Housing Finance Agency, withheld final judgment on the proposal, saying it would study it further.

Fannie Mae and Freddie Mac own or guarantee about half of all U.S. home loans, and their participation in principal reduction under HAMP could greatly expand the reach of the $29.9 billion program

Nearly 11 million Americans are underwater on their mortgages - meaning they owe more than their homes are worth. With some key electoral swing states among the hardest hit by the housing crisis, the sector's health could become an important factor in November's elections....

When the administration launched the program in 2009, it expected as many as 4 million loans would be modified. So far, only about 900,000 households have permanently won new loan terms.

As of the end of last year, only about $3 billion had been spent of the $29 billion set aside for HAMP.


As part of its effort to reach more Americans, both the Treasury Department and the Department of Housing and Urban Development said they would seek to aid homeowners pinched by other types of debt, including credit cards and medical bills.

In addition, the administration said it was tripling the incentives paid to investors when they reduce loan balances. Investors who rent out properties would also be able to access mortgage aid under the revamped program.

10--(From the archives) Americans buy record numbers of guns for Christmas, Telegraph

Excerpt: Americans bought record numbers of guns last month amid an apparent surge in popularity for weapons as Christmas presents.

According to the FBI, over 1.5 million background checks on customers were requested by gun dealers to the National Instant Criminal Background Check System in December. Nearly 500,000 of those were in the six days before Christmas.

It was the highest number ever in a single month, surpassing the previous record set in November.

On Dec 23 alone there were 102,222 background checks, making it the second busiest single day for buying guns in history.

The actual number of guns bought may have been even higher if individual customers took home more than one each.

Explanations for America's surge in gun buying include that it is a response to the stalled economy with people fearing crime waves. Another theory is that buyers are rushing to gun shops because they believe tighter firearms laws will be introduced in the future.

Friday, January 27, 2012

Weekend links

1--The Fed will Keep Rates at "Exceptionally Low Levels" Through Late 2014, economist's view

Excerpt: The Press Release describing the decisions of the Fed's monetary policy committee decisions was released this morning, and it is very similar to the press release from its last meeting in mid December with one notable exception. The Fed announced a commitment to "maintain a highly accommodative stance for monetary policy" by keeping the federal funds rate at "exceptionally low levels" at least through late 2014. The previous policy was to keep rates low through "at least through mid-201," so this extends the commitment by a year and a half and represents an easing of policy... from the latest release:

Press Release, January 25, 2012 , Federal Reserve Board: Information received since the Federal Open Market Committee met in December suggests that the economy has been expanding moderately, notwithstanding some slowing in global growth. While indicators point to some further improvement in overall labor market conditions, the unemployment rate remains elevated. Household spending has continued to advance, but growth in business fixed investment has slowed, and the housing sector remains depressed. Inflation has been subdued in recent months, and longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects economic growth over coming quarters to be modest and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that over coming quarters, inflation will run at levels at or below those consistent with the Committee's dual mandate.

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

2--What drives surges in capital flows?, VOX EU

Excerpt: In the immediate aftermath of the global financial crisis, there was a rapid surge in net capital flows to emerging market economies. The subsequent decline in recent months has been even more rapid. Looking at data on 56 capital surges between 1980 and 2009, this column examines the causes of the mercurial movement of capital flows across countries and outlines the implications for policy.

After collapsing during the 2008 global financial crisis, capital flows to emerging market economies surged in late 2009 and 2010, raising both macroeconomic challenges and financial-stability concerns. Several commentators have argued that country-specific determinants – or ‘pull’ factors – in emerging markets were the dominant factor in accounting for the post-crisis surge (eg Fratzscher 2011). By the second half of 2011, however, amid a worsening global economic outlook, capital flows receded rapidly, eliminating much of the cumulated currency gains, and leaving emerging markets grappling with sharply depreciating currencies in their wake. While such volatility is nothing new – historically, flows have been episodic (Figure 1) – it rekindles questions about the nature of capital flows to emerging markets....

Our analysis also shows that inflow surges to emerging markets are mainly liability-driven – only one third of the net flow surges correspond to changes in residents’ foreign assets. The factors driving the two types of surges turn out to be quite similar: global factors matter for both, with lower US interest rates (or greater risk appetite) encouraging both foreigners to invest more in emerging markets, and domestic residents to invest less abroad. Yet some differences are discernible. Foreign investors are equally attuned to local conditions (the external financing need, real economic growth, capital-account openness, and institutional quality) as domestic investors, but tend to be more sensitive to changes in the real US interest rate and global market volatility, and are also more subject to regional contagion than domestic investors.

Policy implications

These findings hold important policy implications.

Inasmuch as surges reflect exogenous supply-side factors that could reverse abruptly, or are driven by contagion rather than by fundamentals:
•There is a stronger case for imposing capital controls (provided macro policy prerequisites have been met, Ostry et al 2011) on inflow surges that may cause economic or financial disruption.

•Greater policy coordination between capital source and recipient countries may also be called for.

If the aggregate volume of capital flows to emerging markets is largely determined by supply-side factors, but the allocation of flows across countries depends on local factors (including capital-account openness):

There may also be a need for coordination among recipient countries to ensure that they do not pursue beggar-thy-neighbour policies in an effort to deflect unwanted surges to each other.

Further, while the drivers of asset- and liability-driven surges may be largely similar, policy responses may need to be adjusted to the type of surge, for example:

•Prudential measures might be more important for dealing with financial-stability risks caused by asset-driven surges,

•Capital controls on inflows may be an additional option for liability-driven surges.

Disclaimer: The views expressed herein are those of the authors, and should not be attributed to the IMF, its Executive Board, or its management.

3--Dow Rises to Highest Level Since May 2008, Bloomberg

Excerpt: U.S. stocks advanced, sending the Dow Jones Industrial Average toward the highest level since May 2008, after earnings at companies including Caterpillar Inc., 3M Co. (MMM) and Time Warner (TWC) Cable Inc. exceeded analysts’ estimates....

The Standard & Poor’s 500 Index advanced 0.3 percent to 1,329.49 at 10:13 a.m. New York time, rising a second day. The Dow increased 65.84 points, or 0.5 percent, to 12,819.09 today.

“The backdrop that is coming forth is a nightmare for those who are way underinvested in U.S. equities,” Jeffrey Saut, chief investment strategist at Raymond James & Associates in St. Petersburg, Florida, said in a telephone interview. His firm manages $300 billion. “Earnings continue to come in better than expected, our economy is improving and the Fed stands ready to do whatever is necessary. In addition, it looks like the ‘euro-quake’ situation appears, at least in the short term, to be on the back burner. And the list goes on and on.”

4--Bernanke Makes Case for More Bond Buying, Bloomberg

Excerpt: Ben S. Bernanke laid the groundwork for a third round of large-scale asset purchases should unemployment remain higher than the Federal Reserve would like while inflation falls below a newly-established target.
The Federal Open Market Committee “recognizes the hardships imposed by high and persistent unemployment in an underperforming economy, and it is prepared to provide further monetary accommodation,” Bernanke said yesterday at a press conference in Washington....

The U.S. central bank’s “two main tools” to boost growth are asset purchases and communications, and bond buying is “an option that is certainly on the table,” Bernanke said. “The unemployment level is elevated and the inflation outlook is subdued.”

Policy makers yesterday set a long-term goal of 2 percent inflation, and forecast that price increases would fall short of that target this year and next. The personal consumption expenditures price index (SPX) climbed 2.5 percent for the 12 months ending in November.

5--UK: Into Recession, econbrowser

Excerpt: So much for expansionary fiscal contraction in the UK. Not that that’s a surprise.

The UK Office of National Statistics has just released preliminary estimates for real GDP growth in 2011Q4. The 0.8% contraction (q/q SAAR) was large than consensus [1], and in fact larger than the 0.6% decline forecasted by Deutsche Bank on 1/18. Figure 1 illustrates the fact that a year and a half after the election of a coalition government bent on a path of austerity, the UK economy is likely to be entering a new recession (not that growth was so great even before the dip)....

In my view, this is pretty much the nail in the coffin that an expansionary fiscal contraction will occur, even in a relatively small, open economy with a flexible exchange rate (see JEC/Republicans for an exposition, and this post for a critique).

Simon Wren-Lewis at Mainly Macro provides additional commentary, which I think advocates of austerity in the US would do well to heed:

The first estimate of UK growth in the last quarter of 2011 was negative. As these updated NIESR charts show, no other UK recovery has stalled in this way. Of course very little is ever certain, but we can be pretty sure that growth would have been significantly better if the current government had not imposed severe additional austerity measures beginning in 2010. (This is the counterfactual that matters, and just looking at GDP components can be a misleading way at getting at this for reasons I discussed here.) Of course growth might have been better too if the Euro crisis had not happened, but this government had no control over the Euro crisis, while it does decide fiscal policy.

I do not have anything very new to say about this, in part because many people predicted growth would be harmed before the policy was introduced. (See, for example, this letter from 80 economists published during the 2010 election campaign.) What was the reason for this major macroeconomic policy error? For some I think it was a political calculation that it would be advantageous to get as much of the cuts out of the way early, well before the next general election. However I think others in the coalition were genuinely spooked by events in Greece and elsewhere.

Unfortunately the key difference between economies in the Eurozone and those with their own central bank was not appreciated. Today the claim that if these additional austerity measures had not been introduced UK interest rates on debt would have suffered the same fate as many Eurozone countries looks pretty implausible. In Denmark we even have an example of a country that has recently undertaken stimulus measures, and where interest rates have continued to fall in line with other countries outside the Eurozone (see David Blanchflower here).

So I believe we must add 2010 to a list of major macroeconomic policy errors made in the UK since the war. Like the failed monetarist experiment in the early 1980s, it is the result of a government adopting a policy which relied on a mistaken macroeconomic analysis that was not supported by the majority of academic opinion. And like that earlier failure, it will leave unemployment significantly higher than it need to have been for many years.

6--Why Home Prices Have Much Further To Fall, advisors perspectives

Excerpt: There has been a deluge of articles recently about the upticks in the housing data. The consensus is that these data points are surely indicating, finally, a bottom in the depressing decline of real estate. Let me acknowledge that I do not dispute the improvement in the data regarding home starts, permits, pending sales, etc. However, let's be clear that all of these data points are still mired at very depressed levels. So, while optimism is certainly always a welcome thing, for the average American, the world is quite different....

Over the last 30 years, a big driver of home prices has been the unabated decline of interest rates. When declining interest rates were combined with lax lending standards, home prices soared off the chart. No money down, ultra-low interest rates and easy qualification gave individuals the ability to buy much more home for their money. The demand for home ownership, promulgated by the Fed, the finance and real-estate industry, drove prices far beyond rational levels. Easy credit terms combined with a plethora of psychological encouragement, from home flipping and house decorating television to direct advertisement of the "dream of homeownership", enticed families to bite off way more than they could ever hope to chew...

The decline in home prices so far has largely been due to the initial process of the real estate bust and the deleveraging of the American household balance sheet. According to recent data, as much as 2/3rds of the sales completed so far have been distressed in some form or fashion. However, the real potential for declines in price will come when interest rates began to rise.

At some point in the future interest rates will begin to rise back towards the long term median of 8.9%. From the current 4% rate, that is a substantial rise. However, before you guffaw the idea entirely, let me just remind you that 30-year interest rates were almost 7% in mid-2006. Therefore a rise to the long term median is not entirely out of the question - the only debate will be the timing and the trigger of the event....

With this in mind, let's review how home buyers are affected. If we assume a stagnant purchase price of $125,000, as interest rates rise from 4% to 8% by 2024 (no particular reason for the date - in 2034 the effect is the same), the cost of the monthly payment for that same priced house rises from $600 a month to more than $900 a month - a 33% increase. However, this is not just a solitary effect. ALL home prices are affected at the margin by those willing and able to buy and those that have "For Sale" signs in their front yard. Therefore, if the average American family living on $55,000 a year sees their monthly mortgage payment rise by 33%, this is a VERY big issue.

Let's look at this another way. Assume an average American family of four (Ward, June, Wally and The Beaver) are looking for the traditional home with the white picket fence. Since they are the average American family, their median family income is approximately $55,000. After taxes, expenses, etc., they realize they can afford roughly a $600 monthly mortgage payment. They contact their realtor and begin shopping for their slice of the "American Dream."

At a 4% interest rate they can afford to purchase a $125,000 home. However, as rates rise, that purchasing power quickly diminishes. At 5% they are looking for $111,000 home. As rates rise to 6% it is a $100,000 property, and at 7%, just back to 2006 levels mind you, their $600 monthly payment will only purchase a $90,000 shack. See what I mean about interest rates?...

This is why the Fed has been so adamant to suppress interest rates at very low levels and have injected trillions of dollars to achieve that goal. They understand the ramifications of rising interest rates, not only on home prices, but also on the $3 Trillion in debt they are currently carrying on their balance sheet.

There are basically two possible outcomes from here. First, Ben Bernanke and his gang artificially suppress interest rates for a very long period of time creating the "Japan Syndrome" in the US, which leads to rolling recessions and a general economic malaise. Or, secondly, interest rates rise back towards more normalized levels as the economy begins a real and lasting recovery. I am really hoping for the later. In either case there is a negative and sustained impact to housing going forward. The excesses that were created over the last 20 years will have to be absorbed into the system, allowing prices to return to a more normalized and sustainable level.

None of this means that home construction, sales, etc. can't stabilize at these lower levels even as prices revert to their long term median price. However, stabilization and a recovery, such as the media is currently hoping for, are two vastly different things. We are very early in the entire deleveraging process, and until the excesses are removed from the system, the real housing bottom may be more elusive than anyone expects.

7--The British Economy Is Now Doing Worse than it Did in the Great Depression, Grasping Reality

Excerpt: Yep. This many months after the start of the Great Depression, the British economy was rapidly converging back to its pre-depression level of production under Chancellor of the Exchequer Neville Chamberlain's policy of using stimulative policies to restore the price level to its pre-Great Depression trajectory.

By contrast, the Cameron-Osborne policies of expansion-through-austerity have produced a flatline for real GDP, and the odds are high that British real GDP is headed down again.

In less than a year, if current forecasts come true, the Cameron-Osborne Depression will not be the worst depression in Britain since the Great Depression, but the worst depression in Britain… probably ever.
That is quite an accomplishment.

As Phillip Inman of the Guardian puts it:

the UK's plan for recovery from the financial crisis was based on a full-throttle recovery in 2012... consumer confidence, business investment and general spending would converge to send the economy on a trajectory of above-average growth... the lack of investment will perplex ministers. They have done what the right-wing economists told them to do and moved out of the way – the theory being that public sector spending and investment was ‘crowding out’ the private sector...

It did not work: “Spain is showing the way with its austerity-driven recession. Where the weak tread, we [in Britain] look keen to follow...”
That expansionary austerity is not working in Britain should give all of its advocates great pause, and lead to a great rethinking. Britain is a highly open economy with a flexible exchange rate. Britain has some room for further monetary ease. There is no risk or default premium baked into British interest rates to indicate that fear of future political-economic chaos down the road is discouraging investment. There was an argument--I’m not saying that it was true, but there was an argument--that the Blair-Brown governments had overshot Britain’s long-term sustainable government-spending share of GDP (in contrast to those countries that had reduced their debt-to-GDP levels in the 2000s, where there was no such argument, and in contrast to the United States where the problem was not spending overshoot but taxation undershoot under the Bush administration) and that spending cutbacks were advisable in the long run.

Yet with a ten-year nominal interest rate in Britain of 2.098% per year, if low long-term Treasury interest rates were the key to recovery, Britain would be in a boom. If there was ever a place where expansionary austerity would work well--where private investment and exports would stand up as government purchases stood down--if its advocates’ view of the world was reality rather than fantasy, it would be Britain today.
But it is not working.

And the lesson is general.

If it is not working in Britain, how well can it possibly work elsewhere in countries that are less open, that don’t have the exchange-rate channel to boost exports, that don’t have the degree of long-term confidence that investors and businesses have in Britain?...

Policy makers elsewhere in the world take note: starving yourself is no road to health, and pushing unemployment higher now is no road to market confidence.

8--Big questions about Obama’s mass-refinancing plan, Washington Post

Excerpt: The ongoing housing crisis is among the biggest reasons that our economy is still in a funk, and on Tuesday, President Obama laid out a new plan to help resolve it. He wants Congress to pass a bill that would allow “every responsible homeowner” to refinance at lower interest rates, estimating that it would save every participant about $3,000 a year on their mortgage. Obama would pay for his mass-refinancing plan by levying a new fee on big financial institutions. But economists on both left and right have raised large questions about the plan.

The biggest concern is how much risk taxpayers would be taking on through this approach to mass refinancing. A White House official, speaking on the condition on anonymity, indicated that the plan would be fairly broad in scope: It would not only include mortgages that the government already holds through Fannie Mae and Freddie Mac, but also to holders of loans backed by the private sector as well.

That approach could potentially help a large number of homeowners and prevent more foreclosures. But there also is the risk that we would be “transferring massive amounts of bad debt from the current holders to the government,” says Dean Baker, co-director of the left-leaning Center for Economic Policy Research. “If the government is going to guarantee refinancing in this way, then we are giving much more money to banks and investors than to homeowners,” he argues.

Columbia University’s Glenn Hubbard, an economic policy adviser to the Romney campaign, echoed some of Baker’s concerns. Hubbard has proposed a mass refinancing plan that would be restricted to mortgages held by Government-Sponsored Enterprises, and he thinks Obama’s plan to extend it beyond such mortgages would be placing taxpayers at greater risk. “In the case of GSEs, the government already had the risk. Here the administration is needlessly taking on new risk because it can’t or won’t manage the GSEs and FHFA,” Hubbard said in an e-mail. “As I understand the plan, the President took a good idea and turned it into a bad one.”

9--State of the Union Preview: Housing and Fairness Don’t Connect, CNBC

Excerpt: Let’s start with that principal forgiveness. Some Democrats have been hounding the regulator of Fannie Mae and Freddie Mac (the FHFA and its leader Ed DeMarco) to initiate a program to reduce the value of mortgages where the mortgage is larger than the value of the home, i.e. “underwater”. The idea is that this will keep those borrowers from defaulting on these mortgages.

DeMarco is against this, so Democrats, or at least Rep. Elijah Cummings, the ranking Democrat on the House Oversight Committee, went so far as to request proof of Demarco’s contention that such a program would do more harm than good. This after the Federal Reserve officials, in a recent “White Paper,” suggested, “some actions that cause greater losses to be sustained by the [GSE’s] in the near term might be in the interest of taxpayers to pursue if those actions result in a quicker and more vigorous economic recovery.”

The losses to Fannie and Freddie, according to DeMarco, would be somewhere around $100 billion, if they were to write down principal on all 3 million underwater mortgages backed by the two. That money, DeMarco noted in a letter back to the Congressman, would come from taxpayers, who have already footed a $150 billion bill from Fannie and Freddie.

Then there’s that pesky refi plan that’s been floating around for a few years now. The idea is that Fannie and Freddie would refinance about 14 million of their own borrowers to 4 percent or less, as long as the borrowers are current on their loans. This would supposedly juice the economy with household savings of about $36 billion a year. Administration officials have already told me they are not considering such a program as it is too expensive in too many ways. And then there’s that fairness issue again, as in why should the government fund refinances for borrowers with Fannie and Freddie loans but not for the other half of American borrowers who don’t have Fannie and Freddie loans?...

The one potential housing fix that does seem fair is the REO to rental program being hashed out among federal regulators and the FHFA. This would be for Fannie, Freddie and the FHA to sell their REO’s (foreclosed properties they now own) in bulk to investors. There would likely be some tax incentives offered, but this is the fastest way to get rid of distress in the housing market, thereby stabilizing overall home prices. It would also put more rental inventory on the market, as demand has been high, pushing up rents higher. The trouble is this isn’t particularly politically popular, as it runs contrary to the American Dream of home ownership, not to mention it helps investors, who are largely blamed for the housing mess in the first place. And there’s that pesky fairness thing again.

10--President Obama Proposes Mortgage Refinances for 'Responsible Borrowers', CNBC
Excerpt: "I'm sending this Congress a plan that gives every responsible homeowner the chance to save about $3,000 a year on their mortgage, by refinancing at historically low interest rates. No more red tape. No more runaround from the banks," the President announced in his State of the Union address.

Unlike previous efforts in the refinance space, including a recently revamped and expanded government program for borrowers who owe more on their mortgages than their homes are currently worth, this plan would not be limited to those with loans backed by Fannie Mae and Freddie Mac, according to senior administration officials. The two mortgage giants own or guarantee about half of the nation's mortgages. It would be open to all borrowers current on their loans.

The Obama administration is offering precious few details, promising more in the coming weeks, but several sources say the plan is to ask Congress to allow the government mortgage insurer, the Federal Housing Administration (FHA), to back refinances of underwater mortgages. No estimates were given as to how many borrowers such a plan could potentially help, only that this would be a voluntary, borrower-initiated plan, and not a blanket refinance of all borrowers....

The idea is to remove the barriers and "frictions" that have kept many borrowers out of refinancing to historically low rates. Some of those include high levels of negative equity, loan level price adjustments, loan origination dates, put-backs on loans that default, and borrower qualifications.

Then there is the very basic problem of politics. Whatever the details of the plan are, Republicans, despite the fact that they have been calling for more refinances, are unlikely to hand President Obama a popular victory on the eve of a presidential election. They may also oppose anything that makes Fannie Mae and Freddie Mac bigger, when the two are allegedly winding down.

11--(A really brilliant bit of reasoning) Philip Pilkington: Is QE/ZIRP Killing Demand?, naked capitalism

Excerpt: Warren Mosler recently ran a very succinct account of why the Fed/Bank of England’s easy monetary policies – that is, the combination of Quantitative Easing and their Zero Interest Rate Programs – might actually be killing demand in the economy.

Mosler’s argument runs something like this: when interest rates hit the floor they suck interest income payments that might flow to rentiers and savers. And no, we’re not just talking about Johnny Moneybags refusing to buy his daughter a new Prada handbag (which, say what you will, creates job opportunities). We’re also talking about regular savers and, as the Fed recently noted, pension funds seeing their income fall – not to mention certain industries, like insurance, finding their profits lowered (and hence their premiums raised?).
Mosler sums it up well:

Lowering rates in general in the first instance merely shifts interest income from ‘savers’ to borrowers. And with the federal government a net payer of interest to the economy, lowering rates reduces interest income for the economy.

He then goes on to make the point that we’d have to see borrowers spending more than savers to see any real stimulative effect on the real economy. But alas, such is probably not the case.

The only way a rate cut could add to aggregate demand would be if, in aggregate, the propensities to consume of borrowers was higher than savers. But fed studies have shown the propensities are about the same, and, again, so does the actual empirical evidence of the last several years. And further detail on this interest income channel shows that while income for savers dropped by nearly the full amount of the rate cuts, costs for borrowers haven’t fallen that much, with the difference going to net interest margins of lenders. And with lenders having a near zero propensity to consume from interest income, versus savers who have a much higher propensity to consume, this particular aspect of the institutional structure has caused rate reductions to be a contractionary and deflationary bias.

In her seminal book The Accumulation of Capital – truly a forgotten classic of 20th century economics, right up there with Keynes’ General Theory – Joan Robinson trashes out the implications of falling interest rates. Of the investor she writes:

If he has been successful in the guessing game (on the advice of his broker or backing of his own fancy) and made [investments] which have risen in price so that his capital has appreciated, he has to debate with his conscience whether he has a right to realise the appreciation and spend it, and his decision turns very much upon whether he may expect similar gains in the future, so that they are properly to be regarded as a continuing income.

The point that Robinson is making is that investors have a peculiar morality – she calls it a ‘peasant morality’ – which leads them to separate in their own mind their capital and their income. Investors tend to prefer to spend based on income – that is: dividends, interest etc. – and preserve their capital intact. It’s a bit like the drug dealer’s street wisdom: “Never get high on your own supply”. Spending out of capital – even if this capital has accumulated in the short-to-medium run – is seen by the investor as being somehow immoral. And for this reason investors tend not to dip into their outstanding capital lest their net worth fall as a result.

Robinson then goes on to make a point that would certainly resonate with bond traders today who are, due in large part to the Fed and the Bank of England’s easy monetary policies, seeing value increase and yields (which are essentially interest income) fall.

If the value of [the investor’s] holdings has risen, not because of his personal skill as [an investor], but because of a general fall in the level of interest rates which is expected to be permanent, he is faced with a different problem. For the time being his receipts are unchanged and the value of his [investments] has risen, but, unless all his holdings are in very long-dated bonds, or in shares in whose future capacity to pay dividends the market has great confidence, he will later have to replace money at a lower return, so that his prospect of future income has fallen.
Robinson’s point is that in the investor’s mind his income has fallen. And such a fall in income leads him to retract consumption spending. This leads, as Mosler points out, to a dampening of effective demand in the economy.

It also, I should think, affects investor psychology in that a lack of future income leads them to see the future as being all the more bleak. Their prospect of future income having fallen, this could well lead to a far greater propensity to hoard. It could also make investors more edgy as they try to preserve their capital in what has come to seem like a very uncertain environment. This could lead them to seek out what they think to be safe investments – such as gold and other commodities – thereby inflating bubbles that further exacerbate consumer spending power.

Monetary policy is a slippery beast indeed. But it has become the mantra of the day. For many central bankers, whom I have no doubt go to bed at night dreaming that their governments would initiate stimulus programs, it is all they have. That said, they should really take a look at the facts and not assume simple causal relations that may hold good (to some extent) some of the time, but by no means hold good all of the time.

Yet, the internet commentariat continue to call for more ‘innovative’ monetary policy. A good recent example of this is Clare Jones over at the FT:

What’s clear already though is that, unless the Fed opts to give more quantitative easing — or something more radical — a try, there’s little else it can do to lower the cost of borrowing.

Analysts need to drop their preconceptions. There are very few hard and fast causal relations in capitalist or any other economies. These economies are constantly changing and as they toss this way and that causal relations alter and break down. To try to come up with simple rules to understand the workings of an economy is to excuse oneself for giving up on actually thinking things through.

In truth, negative real interest rates – which, I believe, is what Jones is alluding to – even if they could be implemented (which I don’t believe they can), would be rather dangerous in the current environment. They would likely lead to more hoarding behaviour as investors became ever more nervous about the future. Its expansionary fiscal policy we need. Strong-armed expansionary fiscal policy. There is no alternative.

Thursday, January 26, 2012

Today's links

1--How Larry Summers' memo hobbled Obama's stimulus plan, The Guardian

Excerpt: The Obama administration's economic blueprint was fatally flawed: it led to a weak stimulus and premature deficit reduction...

Those still wondering why the Obama administration surrendered so quickly on the drive for stimulus and joined the deficit reduction crusade, got the smoking gun in an article by the New Yorker's Washington correspondent Ryan Lizza. Lizza revealed a 57-page memo drafted by Larry Summers, the head of the National Economic Council, in the December of 2008, the month before President Obama was inaugurated.

The memo was striking for two reasons. First, it again showed the economic projections that the administration was looking at when it drafted its stimulus package. These projections proved to be hugely overly optimistic.
They showed that even without stimulus, job loss would peak at around 5 million in the 4th quarter of 2009. They projected that the economy would then begin to add jobs at a fairly rapid pace, regaining all the lost jobs by the end of 2011. In this non-stimulus baseline scenario, the unemployment rate never rose above 9.0%, which it would hit in the winter of 2010.

In reality, the economy had already lost almost 7 million jobs by May of 2009, the month when the first stimulus dollars were going out the door. The job loss didn't stop until February of 2010, at a point where the economy had lost 8.5m jobs. Even with the benefit of the stimulus, the economy is still down by more than 6m jobs from its pre-recession level.
The unemployment rate had already hit 9.4% when the stimulus first started to be felt in May of 2009. It eventually peaked at 10.0% in October of 2009.

In short, the economy was clearly in much worse shape than was implied by the projections that the Obama administration used in crafting its stimulus. In fairness to the Obama administration, these projections were in keeping with the consensus among economists at the time.

2--Perverse Austerity, The Economist

Excerpt: THE International Monetary Fund sharply lowered its global economic outlook today and warned that an intensified euro crisis could tip the world back into recession. Its latest forecast is for the world to grow 3.3% this year and the advanced countries 1.2%, sharply lower than it saw just four months ago. Those numbers, it warns, are predicated on a comprehensive solution to Europe’s crisis.

More interesting, and disturbing, are some findings in the IMF's accompanying Fiscal Monitor. Last year was one for fiscal hawks to celebrate as fiscal consolidation proceeded apace. Throughout the advanced economies, budget deficits fell by about 1% of GDP. Only a little of that was due to the cyclical economic improvement. Most was structural, i.e. through discretionary spending cuts or tax increases. That should continue this year, led by America where, even if the payroll tax cut is extended, the structural deficit will decline by 1.4 percentage points.

In the euro zone, Germany, France, Spain and Italy all managed to reduce their structural budget deficits, the latter three thanks to austerity. All are expected to reduce those deficits further this year. But this is not the good news it seems. Austerity, the IMF has found, could be making Europe’s crisis worse, rather than better....

Got that? Cut the deficit too aggressively, and the negative impact on growth and the rise in the cost of debt service from higher spreads could result in a higher, not lower, debt-to-GDP ratio.

It is not clear if the IMF thinks that has actually happened, and it recommends caution in interpreting these results. The analysis examined behavior across countries rather than across time, and thus the results may reflect circumstances unique to 2011.

Still, the findings are sobering and explain the IMF's advice that countries that have not been cut off from the markets must avoid further discretionary austerity. “Decreasing debt is a marathon, not a sprint,” observed Olivier Blanchard, the fund’s chief economist. “Going too fast will kill growth.”

3--Keynes on Austerity and Extremism, NY Times

Excerpt: Does this sound familiar?

Central bankers who are so concerned about the threat to their currency that they demand that austerity be imposed upon angry citizens. Political leaders who, facing a deep recession that has led to large-scale unemployment, insist that the only route to recovery is to cut public spending, pay off national debt and impose higher taxes.

How about this? Economists, doubting the wisdom of bankers and lawmakers, argue that the best way to avoid a decade of lost jobs and economic stagnation is to borrow and spend to promote economic growth. They are ignored in favor of a creed that deems government intervention damaging to business confidence and the self-restoring effects of the market....
Keynes proposed a revolutionary way of reviving a flagging economy. He argued that the Bank of England should keep interest rates low so businesses could borrow cheaply, and that taxation should be sharply cut to promote spending. He also advocated putting the unemployed — at the time, 11.4 percent of the labor force — to work building roads and housing projects

To the faint hearts afraid that such measures would run up crippling government debt, Keynes said there would be time enough to pay down the borrowing when the economy was booming again. There was no need to worry about the long term, he famously wrote, for ‘‘in the long term we are all dead.’’

4--First Act of Greek Default Proceedings Drawing to a Close, credit writedowns

Excerpt: Global stock markets are up about 10% since the beginning of the year, volatility has collapsed, US economic data continue to defy even the mild slowdown proponents and the ECB seems to have backstopped the European banking system.

Yes, my dear reader. This is how quickly you move away from the apocalyptic abyss and back to normal. My base case is that we are close to excess complacency in equity markets and a sell off is overdue, but it is exactly also under these circumstances (where smart money start to hedge) that the market may deliver one final run up to get everyone and the postman in before hosing everyone.

In the short term, one of the only remaining stumbling block in the form of the ongoing default proceedings in Greece seem to be no match for the ongoing positive animal spirit of the equity market. Only a week ago, we got news that talks in Greece had stalled, but most recently we have been reassured that talks are back on track.

5---The hangover, The Economist

Excerpt: America is recovering from the debt bust faster than European countries. Why?

ALMOST half a decade after the onset of the rich world’s credit bust, depressing evidence of its after-effects is visible in everything from feeble output figures to swollen jobless rolls. But for a truly grim picture, read a new report on deleveraging by the McKinsey Global Institute. It points out that in many rich countries the process of debt reduction hasn’t even started. America has begun to pare its debt burden, although the drop is small compared with the build-up in 2000-08 (see chart). But many European countries are more, not less, in hock than they were in 2008. There the hangover could last another decade or more.

These transatlantic differences stem from the trajectory of private debt. Government borrowing soared everywhere after 2008 as government deficits ballooned. But in America the swelling of the public balance-sheet has mirrored a shrinking of private ones. Every category of private debt—financial, corporate and household—has fallen as a share of GDP since 2008. The financial sector’s debt is now at its 2000 level. Corporate indebtedness, never very high, has shrunk. So, more importantly, has household debt. America’s ratio of household debt to income is down by 15 percentage points from its peak in 2008, after rising by over 30 percentage points in the eight preceding years. McKinsey reckons America’s households are between a third and halfway through their debt-reduction process. They think the household-debt hangover could end by mid-2013.

In Europe private debt has fallen much less and in some cases even risen. In Britain the financial sector’s debts have grown since 2008. In Spain corporate debt, far higher as a share of GDP than in most rich countries, has barely budged. But the biggest difference is among households. Even countries which saw the biggest surges in household debt during the bubble era, such as Britain and Spain, have scarcely seen a dent since 2008. McKinsey’s analysts reckon it will take British households up to a decade to work off their debt burdens.

It’s not that American households have been more frugal or disciplined. Household debt has fallen largely thanks to defaults, particularly on mortgages. America had a bigger housing bust; in some states non-recourse lending rules make default easier (people can walk away from home loans without fear of losing other assets). Some two-thirds of America’s $600 billion decline in household debt is due to defaults. With another $250 billion of mortgages in the process of foreclosure, further reduction is likely.

Europe’s post-bubble economies, in contrast, have seen smaller drops in house prices, lower mortgage costs thanks to variable interest-rate mortgages, and gentler treatment from banks. The Bank of England suggests that around 12% of British mortgages receive some kind of forbearance. Fewer people are turfed out of their homes, but the millstone of debt weighs for longer.

America’s private-sector debt reduction has also taken place against the backdrop of loose fiscal policy. Although state and local governments have been cutting back, the federal government has (at least until now) put off most fiscal tightening. In Europe, however, the sovereign-debt crisis means governments have been forced, or chosen, to undertake swingeing budget cuts long before the private sector’s deleveraging is done.

Note the Nordics

That stands in stark contrast to most successful bouts of debt reduction. The McKinsey report pores over two episodes that it considers most relevant for today: the experiences of Sweden and Finland following their banking busts in the early 1990s. Debt reduction took place in two stages. In stage one, the private sector reduces its debts; the economy is weak and public debt soars. In stage two, growth recovers and the longer-term process of reducing government debt begins. In both these cases growth was buoyed by booming exports, a boon that seems unlikely this time. But it is telling that Sweden did not begin its budget-cutting until the economy had recovered; and that when Finland tried an early bout of austerity, this worsened its recession.

The McKinsey analysts carefully avoid suggesting this means Europe’s austerity is misguided. Circumstances today are different, they argue: European governments began with higher debt and deficits, leaving them with less room for manoeuvre. But the message is clear: America is closer to Sweden’s successful template than Europe is. Debt reduction is very difficult without economic growth, and the scale of Europe’s austerity makes it hard to see where that growth will come from.

That’s all the more true because Europe’s governments have been remarkably timid, compared with the Nordics, in exploiting another avenue to growth—structural reform. The report underscores just how dramatically Sweden and Finland overhauled their economies in the wake of their debt crises. Banks were nationalised and restructured; whole sectors, such as retailing, were deregulated. Thanks to a slew of efficiency-enhancing reforms, productivity soared and investment boomed.

Nothing so bold has been attempted this time. America has not managed much in the way of growth-enhancing structural reforms and has a long to-do list, from improving worker training to reining in health-care costs. But it is in Europe where the potential gains from structural reforms are greatest and where the policy focus has nonetheless been overwhelmingly on austerity.

That may change. With much of the euro zone in recession, structural reforms are getting higher billing. Spain’s new government began with an extra dollop of austerity; it now wants to accelerate the freeing of its rigid labour rules. Italy’s prime minister, Mario Monti, first raised taxes and cut spending; now he is about to take on the unions. Angela Merkel, the German chancellor, is saying that Europe’s leaders need to focus on growth. But a shift in the policy mix will not stop many European countries’ debt burdens from spiralling yet higher. Depressing, indeed.

6--Bernanke near inflation target prize, but jobs a concern, Reuters

Excerpt: The Federal Reserve could take the historic step this week of announcing an explicit target for inflation, a move that would fulfill a multi-year quest of the central bank's chairman, Ben Bernanke.

An inflation target would be the capstone of Bernanke's crusade to improve the Fed's communications, an initiative aimed at making the central bank more effective at controlling growth and inflation. It would, at long last, bring the Fed into line with a policy framework used by most other major central banks.

Bernanke has made clearer communications a hallmark of his leadership, and bit by bit, he has worked to cast light on what for years had been purposefully opaque and secretive deliberations.

He has even given the campaign a personal stamp, contrasting his plainspoken and unaffected persona with that of his predecessor, Alan Greenspan, whose ruminations were notoriously oblique and who was associated with an aloof cadre of policy mandarins....

By announcing a target, the Fed could smooth the path to another round of bond buying should the recovery falter.

"It's a good idea whose time has come," said Marvin Goodfriend, a professor at the Tepper School of Business at Carnegie Mellon University in Pittsburgh and a former senior Fed policy adviser

7--Obama's SOTU, Nomi Prins

Excerpt: Big banks. The largest firms continue to grow their asset bases and fee extrapolation strategies from their captive customer base (If you’re say, a JPM Chase customer, it costs you $5 to extract your own money from a Bank of America ATM – both banks get a cut). It was Obama that re-confirmed Fed Chairman Ben Bernanke for another fourteen years (and yes, a bi-partisan Congress agreed), and who still keeps Treasury Secretary, Tim Geithner around. Both men were gung-ho about the merger mania that dotted Wall Street in the fall of 2008 and making the ‘too-big-to-fail” banks bigger, as they now are.

5) Small banks. President Obama didn’t address the smaller bank closings occurring because the big banks got disproportionate subsides;, 389 smaller banks (with $297 billion in assets) failed from 2009 to 2011. Like during the early years of the Great Depression, this means less choice for individuals, less loans for local businesses, and consolidation of influence and market share for the big banks – which comprise Obama’s largest bundling base.

6) Borrowers. Despite a few tepid programs to help homeowners, the sheer number of foreclosures is higher today than it was in 2008. There were a record number of foreclosure filings: 2.9 million in 2010 and 2.7 million in 2011. These are predicted to rise in 2012 amidst default surges and more lender notices than in 2011.

Why? Because Obama’s program (that was supposed to help 5 million borrowers, and helped half a million) had to be approved by the banks. Banks don’t like citizen aid programs, even if they screwed citizens to begin with by fueling a $14 trillion toxic asset pyramid repackaging risky (for people), high interest-bearing (for them). Obama said, “The banks will repay a deficit of trust”? What?! When?! Where?!

Banks hoarding. Obama neglected to mention the $1.6 trillion that banks are stashing at the Fed in the form of excess (and interest-bearing) reserves, which do nothing for the Main Street economy. Meanwhile, small business loans are at a 12-year low, having shrunk continuously since 2008.

10) Obama conveyed that we dodged a bullet by getting the banking system under control. He didn’t note the rising risk in the banking system: the largest four US banks (JPM Chase, Citibank, Bank of America and Goldman Sachs) control nearly 95% of the US derivatives market, which has grown by 20% since just last year, to $235 trillion. JPM Chase holds 11% of the world’s derivative exposure, Citibank, Bank of America, and Goldman comprise about 7% each. Goldman has 537 times as many (from 440 times last year) derivatives as assets and it’s still considered a bank holding company (as per Bernanke) that gets federal backing.

8--Some Americans preparing for ‘civilization’s collapse’, Reuters

Excerpt: When Patty Tegeler looks out the window of her home overlooking the Appalachian Mountains in southwestern Virginia, she sees trouble on the horizon.

“In an instant, anything can happen,” she told Reuters. “And I firmly believe that you have to be prepared.”

Tegeler is among a growing subculture of Americans who refer to themselves informally as “preppers.” Some are driven by a fear of imminent societal collapse, others are worried about terrorism, and many have a vague concern that an escalating series of natural disasters is leading to some type of environmental cataclysm.

They are following in the footsteps of hippies in the 1960s who set up communes to separate themselves from what they saw as a materialistic society, and the survivalists in the 1990s who were hoping to escape the dictates of what they perceived as an increasingly secular and oppressive government.

Preppers, though are, worried about no government.

Tegeler, 57, has turned her home in rural Virginia into a “survival center,” complete with a large generator, portable heaters, water tanks, and a two-year supply of freeze-dried food that her sister recently gave her as a birthday present. She says that in case of emergency, she could survive indefinitely in her home. And she thinks that emergency could come soon.

“I think this economy is about to fall apart,” she said.

A wide range of vendors market products to preppers, mainly online. They sell everything from water tanks to guns to survival skills.

9--Banks Hoarding ECB Cash to Double Company Defaults: Euro Credit, Bloomberg

Excerpt: Corporate defaults may almost double in Europe as companies struggle to refinance debt and banks hoard cash borrowed from the European Central Bank or use it to buy government bonds.

Europe’s default rate may soar to 8.4 percent or more, from 4.8 percent at the end of 2011 as the recession bites and company financing dries up, according to Standard & Poor’s. Petroplus Holdings AG (PPHN) became the latest victim of the tough stance banks are adopting when the region’s biggest independent oil refiner said this week it will file for insolvency after losing access to $2.1 billion of credit lines.

“It’s very challenging for anyone to raise money from lenders right now,” said Andrew Cleland-Bogle, a Frankfurt- based director at corporate finance specialist DC Advisory Partners. “Combine that with increased bank capital requirements and you can see that although banks are getting money they’re very selective when it comes to lending it. 2012 is going to be a very, very tough year.” ...

Banks are using the 489 billion euros they borrowed at 1 percent from the ECB under its three-year longer-term refinancing operation to scoop up government bonds yielding more than 2.5 percentage points extra instead of lending the money to companies.

Italian Yields
Italian bonds due in three years, the maturity of the ECB loans, now yield 4.37 percent, down from 7.36 percent at the end of November. The country’s 10-year bonds have declined to 6.11 percent from 7.02 percent. Spanish three-year notes now yield 3.04 percent, down from 5.51 percent in November, while yields on 10-year bonds have fallen to 5.29 percent from 6.23 percent.