US sees light at end of the tunnel

Financial Times | June 3 2009

By Krishna Guha and Sarah O’Connor

Is the US recession over? A handful of bullish economists are starting to claim that it is, or that it very soon will be

“The trough of the recession is imminent, if it has not already been passed,” said Neal Soss, chief economist at Credit Suisse.

“I have declared the recession (almost) officially over,” Marc Prado, market strategist at Cantor Fitzgerald, told clients this week. “The May data clearly has turned the corner.”

This is still very much a minority view. Most economists think the economy is stabilising but the low point has not yet been reached.

“It is not impossible. But it seems early to me, with payrolls still contracting at 500,000 plus as of May,” said Jan Hatzius, chief economist at Goldman Sachs.

Richard Berner, chief US economist at Morgan Stanley, agrees. “I think a few months later – perhaps September to October.”

The National Bureau of Economic Research business cycle dating committee, which decides when recessions begin and end, has not even begun discussing the end date and will probably not reach a verdict for 18 months or more.

But the fact that the end of the recession is being discussed at all is a sign of how far the debate has moved on. The “recession is over” camp highlights new claims for unemployment benefits and new orders for manufacturing goods.

Robert Gordon, professor at Northwestern University and a member of the NBER business cycle committee, recently published research that shows past recessions typically ended four to six weeks after new unemployment claims peaked.

The latest data, to the end of May 23, suggests new claims may have peaked at nearly 660,000 a week.

“My reasoning leads me to conclude that the ultimate NBER trough of the current business cycle is likely to occur in May or June 2009,” Mr Gordon said.

The ISM manufacturing survey for May rose to 42.8 – consistent with past recession troughs. The new orders index rose above 50 to 51.1 for the first time since December 2007, when this recession began.

“The 51.1 reading points to a big swing in industrial production over the next few months – from steep contraction to flat or even modest expansion,” Credit Suisse’s Mr Soss said.

The Conference Board consumer confidence survey jumped from 40 to 54.9 in May, while data suggest housing has bottomed in volume terms even if prices are still falling.

Nonetheless, most experts remain sceptical that the recession is already over. 

The NBER committee takes a broad overview of economic activity, emphasising gross domestic product but also looking at aspects such as monthly employment, personal income, manufacturing output and wholesale sales data.

Most forecasters think the economy will only start growing in the second half of the year. The ISM non-manufacturing survey showed that service sector activity only inched higher in May while new orders fell slightly. This is a reminder that while manufacturing may get a decent lift as the inventory cycle ends, the much larger service sector may not.

Even new unemployment claims remain higher than in the worst month of the last recession. Real disposable incomes have risen only because of stimulus tax breaks and higher benefit payments. Consumer spending, adjusted for inflation, fell in March and April.

Mr Frankel said he would be looking for a break in payrolls data to corroborate the notion that the economy was bottoming. 

Martin Feldstein, another Harvard professor and NBER cycle dating committee member, said “it is possible but unlikely” that the recession is already over.

“I think it is a more likely scenario that we are seeing the favourable effects of the fiscal stimulus,” he said. “That, for a while, will offset the general diminished trend we have seen over the past two quarters, but it is a one-shot thing.”

Most economists think a relapse is unlikely and that easing financial strains and ongoing ultra-low interest rates will support at least a muted recovery.

But if Mr Feldstein is right, there is a risk of a double-dip recession – or a renewed bout of weakness so close to the original one that it will ultimately be judged to have been part of the same recession.

Copyright The Financial Times Limited 2009

The three steps to financial reform

By George Soros

Financial Times | June 16 2009

The Obama administration is expected on Wednesday to propose a reorganisation of the way we regulate financial markets. I am not an advocate of too much regulation. Having gone too far in deregulating – which contributed to the current crisis – we must resist the temptation to go too far in the opposite direction. While markets are imperfect, regulators are even more so. Not only are they human, they are also bureaucratic and subject to political influences, therefore regulations should be kept to a minimum.

Three principles should guide reform. First, since markets are bubble-prone, regulators must accept responsibility for preventing bubbles from growing too big. Alan Greenspan, the former chairman of the Federal Reserve, and others have expressly refused that responsibility. If markets cannot recognise bubbles, they argued, neither can regulators. They were right and yet the authorities must accept the assignment, even knowing that they are bound to be wrong. They will, however, have the benefit of feedback from the markets so they can and must continually recalibrate to correct their mistakes.

Second, to control asset bubbles it is not enough to control the money supply; we must also control the availability of credit. This cannot be done with monetary tools alone – we must also use credit controls such as margin requirements and minimum capital requirements. Currently these tend to be fixed irrespective of the market’s mood. Part of the authorities’ job is to counteract these moods. Margin and minimum capital requirements should be adjusted to suit market conditions. Regulators should vary the loan-to-value ratio on commercial and residential mortgages for risk-weighting purposes to forestall real estate bubbles.

Third, we must reconceptualise the meaning of market risk. The efficient market hypothesis postulates that markets tend towards equilibrium and deviations occur in a random fashion; moreover, markets are supposed to function without any discontinuity in the sequence of prices. Under these conditions market risks can be equated with the risks affecting individual market participants. As long as they manage their risks properly, regulators ought to be happy.

But the efficient market hypothesis is unrealistic. Markets are subject to imbalances that individual participants may ignore if they think they can liquidate their positions. Regulators cannot ignore these imbalances. If too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or, worse, a collapse. In that case the authorities may have to come to the rescue. That means that there is systemic risk in the market in addition to the risks most market participants perceived prior to the crisis.

The securitisation of mortgages added a new dimension of systemic risk. Financial engineers claimed they were reducing risks through geographic diversification: in fact they were increasing them by creating an agency problem. The agents were more interested in maximising fee income than in protecting the interests of bondholders. That is the verity that was ignored by regulators and market participants alike.

To avert a repetition, the agents must have “skin in the game” but the 5 per cent proposed by the administration is more symbolic than substantive. I would consider 10 per cent as the minimum requirement. To allow for possible discontinuities in markets securities held by banks should carry a higher risk rating than they do under the Basel Accords. Banks should pay for the implicit guarantee they enjoy by using less leverage and accepting restrictions on how they invest depositors’ money; they should not be allowed to speculate for their own account with other people’s money.

It is probably impractical to separate investment banking from commercial banking as the US did with the Glass-Steagall Act of 1933. But there has to be an internal firewall that separates proprietary trading from commercial banking. Proprietary trading ought to be financed out of a bank’s own capital. If a bank is too big to fail, regulators must go even further to protect its capital from undue risk. They must regulate the compensation packages of proprietary traders so that risks and rewards are properly aligned. This may push proprietary trading out of banks into hedge funds. That is where it properly belongs. Hedge funds and other large investors must also be closely monitored to ensure that they do not build up dangerous imbalances.

Finally, I have strong views on the regulation of derivatives. The prevailing opinion is that they ought to be traded on regulated exchanges. That is not enough. The issuance and trading of derivatives ought to be as strictly regulated as stocks. Regulators ought to insist that derivatives be homogenous, standardised and transparent.

Custom-made derivatives only serve to improve the profit margin of the financial engineers designing them. In fact, some derivatives ought not to be traded at all. I have in mind credit default swaps. Consider the recent bankruptcy of AbitibiBowater and that of General Motors. In both cases, some bondholders owned CDS and stood to gain more by bankruptcy than by reorganisation. It is like buying life insurance on someone else’s life and owning a licence to kill him. CDS are instruments of destruction that ought to be outlawed.

The writer is chairman of Soros Fund Management and author of ‘The Crash of 2008’ (PublicAffairs 2009)

 Copyright The Financial Times Limited 2009

Nobel Winner Krugman Says Weakness May Persist for ‘Long Time’

By Shobhana Chandra

June 9 (Bloomberg) — Nobel Prize-winning economist Paul Krugman said damage from the U.S. recession may persist “for a very long time,” with no clear engine for renewed growth.

“I’m really quite scared that we could muddle along,” Krugman said in a lecture today at the London School of Economics and Political Science. “I really do see the possibility of a global version of the Japanese ‘lost decade’ without the prospect of an export-led recovery. This could be unpleasant for a very long time.”

U.S. stocks erased a decline yesterday after Krugman said the economy will probably emerge from the recession by September. Recent reports showing smaller declines in housing and manufacturing and fewer job losses have reinforced forecasts that the slump may end this year.

“The ‘oh-my-God-the-world-is-ending’” phase of the economic downturn is over, and financial markets are “stabilizing,” Krugman said today. Still, “the employment situation is continuing to look bad and will probably get worse,” he said.

Krugman said he has “no idea” what will power the U.S. out of recession. The U.S. fiscal stimulus package, while not “trivial,” isn’t large enough to fuel sustained growth. Also, with the global economy in the doldrums, the U.S. can’t rely on a revival from a surge in exports, he said.

Even the end of a recession “doesn’t mean the same thing as it did in the old days,” said Krugman, a Princeton University economist. Unemployment may remain high longer than after the end of prior economic contractions, he said.

The National Bureau of Economic Research, based in Cambridge, Massachusetts, is the official arbiter of U.S. recessions and expansions. Robert Hall, the head of the NBER’s business-cycle-dating committee, said last week that it’s “way too early” to say the contraction is over.

Economists clash on shifting sands

By Robert Skidelsky

Financial Times |Published: June 9 2009 18:52

History is replete with famous intellectual battles. In the natural sciences, these have usually led to decisive victories, with good science ousting bad. There are few Ptolemaic astronomers left, or believers in the phlogiston theory of combustion. In the social sciences, the situation is different. There have been famous battles galore, but no decisive victories. Indeed, it is characteristic of the social sciences that their battles are interminable, temporary defeats being followed by the regrouping of the defeated forces for a renewed assault.

That economics is not a natural science is clear from the inconclusive engagements that have punctuated its own history. A hundred years ago the classical theory reigned supreme. This “proved” that free markets were automatically self-adjusting to full employment. They were either continually at full employment or, if disturbed by an outside shock, rapidly returned to it. The only thing capable of wrecking the workings of the market’s invisible hand was the visible hand of government interference.

Then along came the Great Depression of 1929-32 and John Maynard Keynes. Keynes “proved” that markets had no automatic tendency to full employment. This failing of the invisible hand justified government policies to maintain full employment.

For 30 years or so Keynesianism ruled the roost of economics – and economic policy. Harvard was queen, Chicago was nowhere. But Chicago was merely licking its wounds. In the 1960s it counter-attacked. The new assault was led by Milton Friedman and followed up by a galaxy of clever young disciples. What they did was to reinstate classical theory. Their “proofs” that markets are instantaneously, or nearly instantaneously, self-adjusting to full employment were all the more impressive because now expressed in mathematics. Adaptive Expectations, Rational Expectations, Real Business Cycle Theory, Efficient Financial Market Theory – they all poured off the Chicago assembly line, their inventors awarded Nobel Prizes.

No policymaker understood the maths, but they got the message: markets were good, governments bad. The Keynesians were in retreat. Following Ronald Reagan and Margaret Thatcher, Keynesian full employment policies were abandoned and markets deregulated. Then along came the almost Great Depression of today and the battle is once more joined.

Haunters of the blogosphere will know that the main ground of the current engagement is about the effect of the “stimulus”. FT readers will have caught a faint whiff of the intensity of this battle in Niall Ferguson’s column of May 30, headed “A history lesson for economists in thrall to Keynes”. Prof Ferguson and Paul Krugman, the economist and New York Times columnist, had previously locked horns at a public symposium in New York on April 30. The historian had asserted that large fiscal deficits would push up long-term interest rates. This implied they would have a zero stimulatory effect: public spending would simply “crowd out” private spending. An enraged Mr Krugman responded on his blog that Keynes had proved that such crowding-out could occur only at full employment: if there were unemployed resources, fiscal deficits would not drive up interest rates without also expanding the economy. Prof Ferguson’s ignorant remarks only confirmed that “we’re living in a Dark Age of macroeconomics, in which hard-won know-ledge has simply been forgotten”.

However, this is not a debate between economists and historians. It is a battle within the economic profession – between the New Class-ical Economists and the New Keynesians. What is fascinating is that it is an almost exact rerun of the debate between Keynes and the British Treasury in 1929-30. The Treasury view was that bond-financed public spending was bound to diminish private spending by an equal amount. Keynes replied that if this were true it would apply to any new act of private spending. “In short, the fatalistic belief that there can never be more employment than there is is altogether baseless”.

Later the Treasury retreated to a more defensible position. The danger of extra government spending, it came to argue, lay not in the “physical” crowding out of resources but “psychological” crowding out. If doubts arose about the government’s solvency – a concern Prof Krugman has acknowledged – it might lead to capital flight, which would push up the cost of government borrowing.

Are we doomed to rehearse the same arguments time and again? In this particular debate, I am on Prof Krugman’s side, but I do not agree that Prof Ferguson’s position represents a retreat to a phlogiston state of economics. This is to take economics to be like a natural science, which Keynes never believed it was, because he thought its subject matter was much too variable over time.

Keynes’s view was that we need different economic models at different times. The beauty of his General Theory of Employment, Interest and Money was that it was general enough to accommodate a variety of models applicable to different conditions. Markets could behave in ways described by the classical and New Classical theories, but they need not. So it was important to take precautions against bad behaviour. Ultimately, the Keynesian revolution was a triumph not of good science over bad science, but of good judgment over bad judgment.

Lord Skidelsky’s ‘John Maynard Keynes: The Return of the Master’ will be published by Allen Lane in September

Fed Said to Retreat From Seeking Debt-Issuing Power

By Scott Lanman

June 9 (Bloomberg) — The Federal Reserve has backed off from seeking a new tool to forestall inflation, refraining from asking Congress for the power to issue its own debt, according to a person familiar with the matter.

Putting off the issue may avoid a political clash over whether the Fed should begin winding down its emergency lending programs while unemployment remains elevated. The central bank intends to rely instead on paying interest on banks’ reserve deposits to prevent a flood of cash into the economy.

After central bankers repeatedly said Fed bills would be a useful additional tool to mop up liquidity, Chairman Ben S. Bernanke omitted mention of the idea in congressional testimony last week. The person, who spoke on condition of anonymity, said the Fed hasn’t made a formal request to lawmakers.

“It’s important that we have all the tools in place” for the Fed to drain liquidity when it’s ready, House Financial Services Committee Chairman Barney Frank, a Massachusetts Democrat, said in an interview. Still, “it would be a mistake to start dealing with that before you know when, how, how much, et cetera.”

House Budget Committee Chairman John Spratt, a South Carolina Democrat, said in an interview after Bernanke testified to his panel June 3 that “if it was something that the Fed needed, he wasn’t pushing it with this committee.” Wisconsin Representative Paul Ryan, the panel’s ranking Republican, said “I do not like that idea at all.”

Granting Powers

Christopher Dodd, the Connecticut Democrat who chairs the Senate Banking Committee, has indicated he’s wary of granting the Fed additional regulatory powers. “The instances in which the Fed has failed to execute its existing authority are numerous,” Dodd said at a March 19 hearing.

In testimony before the budget committee, Bernanke suggested the Fed hasn’t abandoned the idea of issuing its own debt. Beyond the Fed’s current set of tools, Bernanke said “there are still other possibilities that we’re looking at and that perhaps we can discuss with Congress at some point,” without mentioning the authority to issue debt.

“We suspect the omission from Bernanke’s litany was not a slip of the tongue,” Joseph Abate, a money-market strategist at Barclays Capital in New York, said in a research note June 4.

Abate said in an interview that lawmakers may be reluctant to allow the Fed to issue debt that’s not subject to the Treasury limit and competes with other government securities. In addition, were Fed officials to ask Congress for debt-issuing powers, they would be “opening themselves up to political interference,” he said.

Fed Assets Double

The Fed has replenished and added liquidity in credit markets over the past year through lending programs and purchases of securities, more than doubling assets on its balance sheet to $2.1 trillion.

Gaining authority to issue its own debt would allow the Fed to reduce reserves in the banking system and push up interest rates without having to shrink the balance sheet, San Francisco Fed President Janet Yellen said March 25.

In his congressional testimony last week, Bernanke instead highlighted the Fed’s authority to pay interest on banks’ reserve deposits as a tool that bears “very importantly” on the central bank’s ability to tighten credit.

“We can raise interest rates, and then we can tighten policy,” Bernanke said in response to a question from Representative Rick Larsen, a Washington Democrat.

Lacking the power to issue its own debt separates the Fed from central banks in Japan, China, the U.K. and other countries that do have such authority.

‘Nice to Have’

New York Fed President William Dudley said last week that under such a program, Fed debt would probably be restricted to maturities of less than 30 days. “We’d like Congress to consider it,” Dudley said, according to a transcript of an interview with the Economist. “It’s nice to have — as opposed to critical.”

Yet seeking the power may lead to other legislation. The Senate in April passed a nonbinding resolution asking the Fed to identify borrowers, a move Bernanke has said would be “counterproductive” and result in “severe adverse consequences” for the economy. Another resolution called for an “evaluation of the appropriate number and the associated costs” of the Fed banks.

Bernanke gave Congress a similar opening last year when he sought, and received, immediate authority from Congress to pay banks interest on the reserves they kept at the Fed. The 27-word clause was part of the October law creating the $700 billion Troubled Asset Relief Program.

New Obligations

With that legislation, Congress placed several new obligations on the central bank. The Fed was required to devise a policy to ease terms on mortgages it had acquired, and to file reports with the legislature on emergency-lending programs and bailouts.

At the House Budget hearing, a lawmaker brought up the idea of making Fed district-bank presidents subject to Senate confirmation. Currently the presidents are nominated by the banks’ boards of directors and approved by the U.S.-appointed Fed governors in Washington.

Representative Marcy Kaptur, an Ohio Democrat, asked Bernanke during the hearing whether he supported the idea. “No,” the chairman replied.

“The last thing the Fed wants is for its independence of monetary policy to be challenged,” said David M. Jones, president of DMJ Advisors LLC in Denver and a former Fed economist. “It’s very unlikely this debt thing would be pursued.”

Is the US heading for a depression?

 

By Steve Schifferes Economics reporter, BBC News

 The sharp contraction of the US economy accelerated in the last three months of 2008, with official figures showing GDP shrinking at an annualised rate of 3.8%. With forecasters already predicting the worst US recession since World War II, how big a danger is there that the US economy will slip into a depression similar to the 1930s?

The latest figures paint a gloomy picture of the US economy. Consumer spending, which makes up two-thirds of the economy, fell for the second quarter in a row, by 3.5%. For all the talk of this being a consumer-led downturn, the credit crunch is hitting businesses even harder Paul Ashworth, Capital Economics US enters recession This drop was led by a 22% drop in spending on durable goods like automobiles and washing machines. The decline in motor vehicle production was so great that it alone contributed 2% to the fall in GDP.

Businesses hit

Businesses as well as consumers have been hit hard by the slowdown. Exports, which had helped boost GDP earlier in the year, fell sharply, by 19.7%, as foreign markets for US products were hit by their own recessions.

 US recession is a continuing disaster, President Obama says Investment fared even worse. Residential investment fell 23.6% as the glut of foreclosed properties reduced new home sales. Business investment was down 19.1%, led by a 27.8% drop in purchases of equipment and software. Business inventories of unsold goods mounted. If the inventory build up – which is likely to be temporary – is excluded, GDP fell at an annualised rate of 5.1%. “For all the talk of this being a consumer-led downturn, the credit crunch is hitting businesses even harder,” said Paul Ashworth of Capital Economics.

Consumers save

The economic uncertainty does seem to be changing consumer behaviour. People are saving more in preparation for the coming downturn. The personal savings rate rose to 2.9%, more than double the 1.2% rate in the previous quarter. Mr Ashworth predicts the savings rate will double again, to 5%. Consumers are being hit by a triple whammy: rising unemployment, which could rise from 7% to 10% of the workforce by the end of the year; restricted access to credit; and falling asset values. The fall in stock markets and house prices has reduced household wealth by 20%, from the middle of 2007. This alone has reduced consumption by around 1%, some economists estimate. It may make sense for consumers to save instead of spend, but in an economy as reliant on consumer spending as the US, this does add to recessionary pressures.

How long?

The key question in whether this will turn from a recession to a depression is how long the slowdown will last. FDR pledged a New Deal to combat the recession In the 1930s, output declined for four years, with GDP cut by half while unemployment soared to one-quarter of the workforce. Despite the New Deal, output did not recover to its 1929 level until World War II when there was a massive boost in government spending. At the moment, most economic forecasters are predicting that the US slowdown will last around two years, with the economy returning to weak growth by 2010. The National Bureau of Economic Research says the current economic slowdown actually began at the end of 2007 and is likely to be the longest post-war recession. The non-partisan Congressional Budget Office (CBO) estimates a drop in real GDP for 2009 of 2.2%, followed by a rise of 1.5% in 2010, while the IMF predicts a fall of 1.6% this year, following by a recovery of 1.6% in 2010. But economic forecasts have changed frequently in the past year. It is unclear what will happen after 2010, said the IMF’s chief economist Oliver Blanchard.

Government rescue?

The only thing currently boosting the US economy is Federal government spending, which rose 5.8% in the quarter. The government may have to help the millions who have lost their homes But even if Mr Obama gets rapid approval for his $800bn stimulus plan – which has passed the House of Representatives and is currently being considered by the Senate – it will take some time for the money to be felt in the economy. Only $170bn will be spent before 1 October 2009, representing just over 1% of US GDP, according to the Congressional Budget Office. The bulk of spending (including tax cuts) would occur in 2010 ($354bn) and 2011 ($174bn). Individual states may not be able to rapidly increase spending on infrastructure projects which make up a large part of the stimulus package. It is also unclear how many jobs will be created: President Obama aims to create 3.5 million new jobs, but others say the stimulus package could create between 1.2 and 3.6 million more jobs.

Financial squeeze

Big US banking groups may need a bigger bail-out. The other big uncertainty is whether the financial sector can be restored to health and at what cost. There is now $2.2 trillion of toxic bank debt worldwide, the IMF says, $500bn more than it estimated a few months ago. The collapse of financial markets in the autumn had a dramatic effect on consumer and business confidence. There are plenty of reasons why growth might be even less than forecast, the IMF’s Olivier Blanchard said, not least if banks have so many bad debts, they will further drag down the real economy. The Obama administration still has $350bn left of the $700bn bailout for banks approved in October last year. It may need to ask for more. If it gets the money it needs and if the money is spent promptly and wisely, the US might just escape with a relatively mild recession. But given the extraordinary events of the past six months, most economists are still hedging their bets.

Exploding debt threatens America

Financial Times: May 26 2009

By: John Taylor

Professor of economics at Stanford and a senior fellow at the Hoover Institution, is the author of Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis

Standard and Poor’s decision to downgrade its outlook for British sovereign debt from “stable” to “negative” should be a wake-up call for the US Congress and administration. Let us hope they wake up.

Under President Barack Obama’s budget plan, the federal debt is exploding. To be precise, it is rising – and will continue to rise – much faster than gross domestic product, a measure of America’s ability to service it. The federal debt was equivalent to 41 per cent of GDP at the end of 2008; the Congressional Budget Office projects it will increase to 82 per cent of GDP in 10 years. With no change in policy, it could hit 100 per cent of GDP in just another five years.

“A government debt burden of that [100 per cent] level, if sustained, would in Standard & Poor’s view be incompatible with a triple A rating,” as the risk rating agency stated last week.

I believe the risk posed by this debt is systemic and could do more damage to the economy than the recent financial crisis. To understand the size of the risk, take a look at the numbers that Standard and Poor’s considers. The deficit in 2019 is expected by the CBO to be $1,200bn (€859bn, £754bn). Income tax revenues are expected to be about $2,000bn that year, so a permanent 60 per cent across-the-board tax increase would be required to balance the budget. Clearly this will not and should not happen. So how else can debt service payments be brought down as a share of GDP?

Inflation will do it. But how much? To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices. That 100 per cent increase would make nominal GDP twice as high and thus cut the debt-to-GDP ratio in half, back to 41 from 82 per cent. A 100 per cent increase in the price level means about 10 per cent inflation for 10 years. But it would not be that smooth – probably more like the great inflation of the late 1960s and 1970s with boom followed by bust and recession every three or four years, and a successively higher inflation rate after each recession.

The fact that the Federal Reserve is now buying longer-term Treasuries in an effort to keep Treasury yields low adds credibility to this scary story, because it suggests that the debt will be monetised. That the Fed may have a difficult task reducing its own ballooning balance sheet to prevent inflation increases the risks considerably. And 100 per cent inflation would, of course, mean a 100 per cent depreciation of the dollar. Americans would have to pay $2.80 for a euro; the Japanese could buy a dollar for Y50; and gold would be $2,000 per ounce. This is not a forecast, because policy can change; rather it is an indication of how much systemic risk the government is now creating.

Why might Washington sleep through this wake-up call? You can already hear the excuses.

“We have an unprecedented financial crisis and we must run unprecedented deficits.” While there is debate about whether a large deficit today provides economic stimulus, there is no economic theory or evidence that shows that deficits in five or 10 years will help to get us out of this recession. Such thinking is irresponsible. If you believe deficits are good in bad times, then the responsible policy is to try to balance the budget in good times. The CBO projects that the economy will be back to delivering on its potential growth by 2014. A responsible budget would lay out proposals for balancing the budget by then rather than aim for trillion-dollar deficits.

“But we will cut the deficit in half.” CBO analysts project that the deficit will be the same in 2019 as the administration estimates for 2010, a zero per cent cut.

“We inherited this mess.” The debt was 41 per cent of GDP at the end of 1988, President Ronald Reagan’s last year in office, the same as at the end of 2008, President George W. Bush’s last year in office. If one thinks policies from Reagan to Bush were mistakes does it make any sense to double down on those mistakes, as with the 80 per cent debt-to-GDP level projected when Mr Obama leaves office?

The time for such excuses is over. They paint a picture of a government that is not working, one that creates risks rather than reduces them. Good government should be a nonpartisan issue. I have written that government actions and interventions in the past several years caused, prolonged and worsened the financial crisis. The problem is that policy is getting worse not better. Top government officials, including the heads of the US Treasury, the Fed, the Federal Deposit Insurance Corporation and the Securities and Exchange Commission are calling for the creation of a powerful systemic risk regulator to reign in systemic risk in the private sector. But their government is now the most serious source of systemic risk.

The good news is that it is not too late. There is time to wake up, to make a mid-course correction, to get back on track. Many blame the rating agencies for not telling us about systemic risks in the private sector that lead to this crisis. Let us not ignore them when they try to tell us about the risks in the government sector that will lead to the next one.

 

EDITOR’S CHOICE

S&P warns UK over high debt level – May-22

Chill wind blows for triple A nations – May-24

IN THE world that existed before the financial crisis, central bankers were triumphant. They had defeated inflation and tamed the business cycle. And they had developed a powerful intellectual consensus on how to do their job, summarised recently by David Blanchflower, a member of the Bank of England’s monetary policy committee, as “one tool, one target”. The tool was the short-term interest rate, the target was price stability. This minimalist formula fitted the laissez-faire temper of the times. A growing array of financial markets could price risk and allocate credit efficiently. Central bankers had merely to calibrate their interest-rate tools and all other markets would automatically adjust. Central banks still cared about financial stability and full employment, but could argue these were best served by stabilising prices—without, if you please, interference from politicians. The financial crisis has upended all that. The business cycle was supposedly subdued, yet the world is in the deepest recession since the 1930s. Deflation has become a more dangerous enemy than inflation; with interest rates in many countries at or close to zero, central banks have had to reach for other tools. More fundamentally, the collapse of stable relationships in financial markets has forced central banks to make judgments they once left to the private sector. From lenders of last resort, they became lenders of first resort when banks stopped trusting each other. They are, increasingly, arbiters of which types of borrowers get credit. With the reputation of market discipline in tatters, central bankers will get vast new supervisory powers. All this is dragging central banks back towards political turf from which they had been distancing themselves for years. Central bankers still believe that once the crisis has passed they will return to their pre-2007 roles as apolitical technocrats pulling a single lever and eyeing a single variable. It may be a vain hope. “When you question the basic premise which you have worked under for the last 15 to 20 years, which is that markets are rational and efficient, there is a case for a different approach to both monetary policy and regulation,” says Thomas Mayer, chief European economist of Deutsche Bank. Start with the most immediate question: what tools will central banks use to steer the economy in the near future? Before the crisis almost all leading central banks operated through the short-term (usually overnight) money-market rate. By itself, that rate mattered much less to economic activity than, say, those on 12-month corporate loans or 30-year mortgages. But the links between these and official rates were stable enough to allow the central banks to influence overall financial conditions and hence the entire economy. Those links came under strain before the crisis, as a global saving glut caused a decoupling of long- and short-term rates. During the crisis they disintegrated as lenders worried that loans could not be sold on or would not be repaid. Central banks responded by expanding their lending operations through a mixture of more types of credit and collateral, longer terms and more counterparties (see chart 1). The Federal Reserve began lending to investment banks. The European Central Bank (ECB) guaranteed unlimited funds for up to six months instead of one week. Some have gone much further. The Bank of Japan has bought equities and the Swiss National Bank has intervened in the currency markets. Even if the crisis is getting no worse, it is not over and most of the world is in recession. No central bank is about to withdraw any emergency measures. Some are contemplating new ones. Both the Bank of Canada and the ECB are considering outright purchases of government or corporate debt to boost the quantity of credit. Central bankers assume they will wind down these measures when the crisis ends. The Fed, for example, is required by law to end some when the need is no longer urgent. It charges a penalty for some programmes so that borrowers will return to private markets once these have healed. An exit strategy is necessary to “end up with a market-based economy that is more balanced and more resilient,” Donald Kohn, the Fed’s vice-chairman, has said. Mervyn King, governor of the Bank of England, has said the exit strategy will be dictated by the outlook for inflation and that central banks should not support markets that cannot survive on their own. In need of new targets But withdrawal may be harder than it sounds. A study last year by IMF staff asked, “What will ‘normal’ look like?” It argued: “There is no expectation that markets will return to their pre-crisis mode of operation soon, if ever. Market spreads taking account of credit and liquidity risk had arguably become too compressed pre-August 2007, and are now wider than they should be long-term. But it is not clear what the appropriate level should be.” After the Bank of Japan became the primary supplier of overnight funds to banks earlier this decade, the interbank market atrophied. It remains a fraction of its former size. European banks today are now heavily dependent on the Fed for dollars (supplied via swap lines with local central banks) and on the ECB for six-month euro funds. A tepid recovery will make central banks reluctant to withdraw support from critical markets, especially if business or politicians protest. In 1942 the Fed agreed to hold down long-term interest rates to help the Treasury finance the war; it did not extract itself from the commitment until 1951. When the time comes to sell its large holdings of mortgage debt, it may face resistance from America’s housing lobby. Central banks may not just have to rethink their tools. They may also have to rethink their goals. Governments and central banks had come to agree that they should focus only on achieving low and stable inflation. The Fed by law must emphasise employment and inflation equally, but in practice it, too, targets inflation. This consensus was forged in central banks’ research departments and universities, and its adoption paralleled a rise by academics to the top ranks of central banks: among the leading lights are not only Ben Bernanke, chairman of the Fed, and Mr King but also Lucas Papademos, vice-president of the ECB, and Lars Svensson, a deputy governor of Sweden’s Riksbank. Macroeconomics in general has come under fire for depending too much on assumptions of efficient markets and its inability to incorporate the spasms of emotion that create economic manias and panics. “As a monetary policymaker I have found the ‘cutting edge’ of current macroeconomic research totally inadequate in helping to resolve the problems we currently face,” said Mr Blanchflower, a labour economist, in a speech he gave on March 24th. The exclusive focus on low and stable inflation is being questioned for the same reason. The recession began against a backdrop of price stability—as did America’s Depression and Japan’s lost decade. “Inflation targeting alone will not suffice,” Mr Blanchflower said. “This approach failed to prevent the build-up of imbalances that presaged the crisis and was insufficient in dealing with failing banks and financial-market stress as the crisis developed. There is now a consensus that new tools are required to regulate the financial sector and prevent such crises in the future.” Mr Bernanke and his predecessor, Alan Greenspan, argued before the crisis that bubbles are hard to identify before they burst. Pricking them is even harder without wrecking the economy. Central banks should act only if bubbles threaten price stability; otherwise, they should wait and clean up after they burst. The shallow recession that followed the tech-stock boom of the late 1990s seemed to vindicate them. Recent experience does not help their argument. William White, who retired last year as chief economist of the Bank for International Settlements, argues that because central banks were focused on price stability in the medium term, they allowed bubbles to form. The bursting of these raises the risk of deflation in the long run. Inflation in many countries will be negative this year mainly because of cheaper fuel. But even in 2010, when that effect is fading, inflation will stay below the 2% most central banks define as price stability. In its latest forecast, published on April 22nd, the IMF says prices will fall in America, Japan and Switzerland (see chart 2). To be sure, many central banks are more sanguine, noting that inflation expectations are, in the jargon, well-anchored. Many in the market fear that once the crisis passes central banks will be too slow to raise rates and wind down their credit programmes, unleashing inflation. But persistently falling prices would constrain central banks’ ability to boost growth, because they would be unable to push interest rates below inflation—ie, make them negative in real terms. Using the Taylor rule, a popular rule of thumb, economists at Deutsche Bank suggest that given today’s degree of economic slack and inflation rates, short-term rates should be negative in America, Britain and the euro area. Instead, they are at or near zero (see chart 3). Were deflation to deepen, real interest rates would rise, further hampering economic activity. Eric Rosengren, president of the Federal Reserve Bank of Boston, noted recently that the Fed has hit, or all but hit, the zero limit twice this decade. That is more often than earlier simulations had indicated—and it suggests higher inflation targets should be considered. Another proposal is that central banks aim at a path for the price level rather than the inflation rate. Suppose that this path rose by 2% each year. Then after deflation of 1% in year one, the central bank would aim for inflation of more than 2% in later years (inflation of 5% in year two, say) to bring prices back up to the target. Greg Mankiw, a Harvard University economist, goes further, suggesting that inflation simply be given lower priority. “There are worse things than inflation,” he says. “We have them today.” Altering or abandoning inflation targets would make a big dent in the credibility that central banks took decades to establish and is therefore highly unlikely. And although benign neglect of bubbles no longer appears an option, central bankers are not ready to advocate pre-emptive popping, because the problem of identifying them early enough remains unsolved. Better, they argue, to use regulation to identify and defuse dangerous accumulations of risk in the financial system. The term for this is “macroprudential” supervision. Last year Mr Bernanke laid out how this would differ from the normal supervision of individual banks. He said a single firm may have an acceptable exposure to a particular type of risk that would be unacceptable if replicated across many firms. Similarly, a supervisor might press a particular bank to lend less during a slump whereas a “macroprudential supervisor would recognise that, for the system as a whole,” that could make matters worse. The embrace of macroprudential supervision represents a reversal of another pre-2007 trend—for central banks to shed supervisory duties and concentrate on monetary policy. Academics argued that supervision was a distraction from the pursuit of price stability and created potential conflicts: a central bank might run an inflationary policy to cushion a failing banking system, or prop up an insolvent bank to cushion the economy. Central banks in Australia and Britain gave up some or all of their supervisory roles. The ECB was created with none. The run on Northern Rock, a British bank, and problems at state-owned German banks were blamed in part on inadequate involvement by the central bank in supervision. This year the Bank of England received a more formal role in overseeing banks. A commission headed by Jacques de Larosière, a former head of both the Bank of France and the IMF, has recommended that the ECB chair a new European Systemic Risk Council made up of its member central banks and supervisors, but that it remain out of firm-specific supervision. The Fed until recently was the leading candidate to fill the American Treasury’s proposed job of “systemic risk regulator”, empowered to examine any corner of the financial system and act against emerging risks. Yet macroprudential supervision smacks of a fad that will not live up to its billing. It faces the same difficulty as conventional monetary policy does in spotting and popping bubbles. Moreover, there has been no correlation between a central bank’s supervisory responsibilities and its ability to prevent or deal with the crisis. The Fed is America’s most powerful and best informed financial regulator but the trouble began under its nose. Neither Australia’s central bank nor Canada’s has any supervisory duties, yet the financial systems of both countries have been virtually unscathed. This record has less to do with who supervises the financial system than with local laws and behaviour. Subprime mortgages peaked at about 1% of the total in Australia and 2.5% in Canada, compared with more than 14% in the United States. Illustration by Derek BaconNew combatants in the political arena Rightly or wrongly, central banks will emerge from the crisis with a bigger role in the markets and in supervision. This will challenge another element of the pre-2007 consensus: that central banks be as far removed from politics as possible. Formal independence insulated the central bank from politicians’ desire to play fast and loose with inflation. And part of the appeal of “one tool, one target” was that it made monetary policy explicitly a technical rather than political affair. The divide between central banking and politics looks much less clean today. Unconventional policies often require a central bank to make loans that may not be repaid in full. Because taxpayers will bear any losses, finance ministries need some say. Credit allocation and tighter regulation make some firms winners and others losers, and so require more public accountability. With interest rates at zero, the Fed and the Bank of England are buying government debt to boost the quantity of credit and the money supply. But governments could come to rely on such purchases to finance budget deficits. The potential for political conflict extends abroad too. Having cut its rates to zero, the Swiss National Bank has bought foreign currency to drive down the Swiss franc. Some labelled this competitive devaluation. Managing such conflicts is a delicate job. The Fed and the Treasury attempted to assuage concerns by releasing a joint statement affirming the Fed’s sole responsibility for price stability. Mr King broke a longstanding silence on fiscal policy to warn the British government against adding to a fast-growing national debt. Such tensions are unlikely seriously to dent the institutional protections built around central banks in recent decades. Last year Japanese opposition parties blocked the appointments of two candidates to head the Bank of Japan on the ground they were insufficiently independent of the government. There are exceptions: Iceland’s government amended the law so that it could fire David Oddsson, the head of its central bank. But Mr Oddsson had presided, first as prime minister and then as central-bank governor, over the policies that led to the country’s crisis. Central bankers’ jobs matter even more than they did before 2007. At the same time, they have been drawing more criticism and political scrutiny. Public disapproval ratings have risen notably for Mr Bernanke, the Bank of England and the ECB. They are having to defend their policies to the public as well as to the markets. Mr Bernanke agreed to a profile by “60 Minutes”, a news programme, in which he strolled down the streets of his hometown. Mr King sat for an interview with the BBC to explain quantitative easing. The six members of the ECB’s executive board gave 200 interviews last year. After the Riksbank slashed its interest-rate target to 0.5% on April 21st, its governor, Stefan Ingves, took questions from the public in an online chat session. Asked what he liked most about his job, the former economics professor said that what he used to study in theory he now gets to put into practice. He added: “It’s fun to go to work every day.” You may wonder how many of his peers would agree with him.

Depression Dynamic Ensues as Markets Revisit 1930s

By Rich Miller

March 9 (Bloomberg) — The U.S. economy’s vital signs may not confirm a diagnosis of depression. The symptoms increasingly point to one.

As in the Great Depression, world trade is collapsing, wealth is evaporating and the banking system is broken. Deflation is a growing threat as companies slash production, pay and prices. And leaders worldwide are having difficulty making headway in halting the self-perpetuating decline.

“We are tracking 1929-1930,” says Barry Eichengreen, a professor of economics and political science at the University of California, Berkeley.

The result: This contraction may leave a lasting imprint on the economy and society, just as the Depression did. In the wake of the devastation of the 1930s, Americans swore off stocks, husbanded their own resources and looked to the government for help. Now, another generation might draw some of the same lessons from the deepest economic collapse of their lifetime.

“This is going to scar the collective psyche,” says Mark Zandi, chief economist at Moody’s Economy.com in West Chester, Pennsylvania. “People will become much more conservative in borrowing, lending and investing.”

There’s no official definition of what qualifies as a depression. In the 1930s, the unemployment rate rose to 25 percent and the economy shrank by more than a quarter.

Not ‘Great’

No economist forecasts a return to the breadlines and shantytowns of that era. “Though the current recession is unquestionably severe, it pales in comparison with what our parents and grandparents experienced in the 1930s,” White House chief economist Christina Romer said in a speech today in Washington.

Still, the economy is getting closer to some of the metrics academics cite as constituting a depression, if not a “great” one.

Economist Robert Barro defines a depression as a 10 percent fall in per-capita gross domestic product and consumption. The Harvard University professor sees roughly a 30 percent chance of that occurring now.

Billionaire Warren Buffett said today the economy “has fallen off a cliff” and is unlikely to turn around soon. The Berkshire Hathaway Inc. Chief Executive Officer also said, in an interview with the CNBC television network, that efforts to stimulate recovery may lead to inflation higher than the 1970s.

The economy contracted at a 6.2 percent annual rate in the last quarter of 2008 and will shrink at a 7 percent rate in the first three months of 2009, projects Jan Hatzius, chief U.S. economist at Goldman Sachs Group Inc. in New York.

Defining Depression

Bradford DeLong, a former Treasury official who is now a professor at Berkeley, says a depression is a two-year period with unemployment at 10 percent or above. He says that’s possible, though not likely. The jobless rate rose to 8.1 percent in February, a 25-year high.

Some industries are already in a depression, led by housing, where the decline accelerated in recent months as the credit crisis intensified. During the last four years, residential investment is down by 37 percent. That compares with an 80 percent drop in spending on home building from 1929 to 1932.

“The past five months have been among the most difficult in U.S. economic history,” Robert Toll, chief executive of Horsham, Pennsylvania-based Toll Brothers Inc., said Feb. 11, after the largest U.S. luxury homebuilder reported a 51 percent sales drop.

In the auto industry, U.S. sales have fallen 55 percent from their July 2005 peak. Production of cars and trucks plunged in January to an annual rate of 3.9 million, the lowest since the Federal Reserve began keeping records in 1967, and 67 percent below the January 2005 level.

GM’s Survival

Things are so bad that auditors have questioned the ability of General Motors Corp., the biggest U.S. automaker, to continue as a going concern.

U.S. motor vehicle output slumped 75 percent from 1929 to 1932, according to statistics in the book “American Automobile Workers 1900-1933,” by Joyce Shaw Peterson.

“We are in an automotive depression,” said Efraim Levy, an equity analyst for Standard & Poor’s in New York.

The financial-services industry has also been decimated. Since the crisis began in the middle of 2007, institutions worldwide have racked up $1.2 trillion in credit losses and writedowns. Announced job cuts have topped 280,000.

“You’ve had a major disruption of the financial system, just like the 1930s,” says Mark Gertler, a New York University professor who collaborated on research about the Depression with Fed Chairman Ben S. Bernanke. In the 30s, more than 10,000 banks went bust.

Hoarding Capital

That disruption is making it hard for Bernanke and his fellow policy makers to get much traction in their efforts to stop the economic decline. Strapped with losses, banks are hoarding capital rather than lending.

This type of breakdown happens only two or three times a century and can lead to a “downward vortex” in which weaknesses in the economy and the financial industry feed on each other and are difficult to break, Lawrence Summers, director of the White House’s National Economic Council, said Feb. 26. “It’s the kind of vicious cycle Franklin Roosevelt talked about,” he told a forum in Arlington, Virginia.

Particularly worrying, says Stanford University professor Robert Hall, is the collapse of the jobs market. Over the past four months, payrolls have plunged 2.6 million.

Summers has also voiced concern about a return of deflation, which wreaked havoc on the economy during the Great Depression. As wages fell back then, workers had a harder time paying their debts, aggravating the banking industry’s woes.

Pay Cuts

In an echo of those troubles, GM, FedEx Corp. and casino company Wynn Resorts Ltd. are among businesses slashing pay for more than 100,000 workers as they cut costs to counter declining demand.

There are other echoes. Since hitting a peak in October 2007, the Dow Jones Industrial Average has fallen 54 percent. Over a similar length of time — from 1929 to 1931 — the average fell 55 percent. It ultimately dropped 89 percent from its 1929 high before beginning to recover in mid-1932.

Combined with collapsing house prices, the free-fall in the stock market will destroy $23 trillion worth of U.S. wealth, reckons Lawrence Lindsey, a former senior White House official who now heads his own consulting company in Arlington, Virginia.

Like the Great Depression, the current economic decline is global. The International Monetary Fund says this will be the first time since World War II that the U.S. and other industrial nations will suffer a simultaneous decline in their economies.

Trade Contracts

Worldwide trade is falling fast as the credit crunch curbs financing for exporters and importers. The volume of merchandise trade plunged at an annual rate of 22 percent in the fourth quarter from the third, according to the CPB Netherlands Bureau for Economic Policy Analysis. The peak-to-trough decline from 1929 to 1932 was 35 percent, as countries slapped big tariffs on imports.

“We’re in a depression, and we need policy makers to make the right decisions to ensure that it does not become great,” says Kevin H. O’Rourke, a professor at Trinity College in Dublin, who has studied the trade issue.

Government officials, especially in the U.S., are moving more rapidly to tackle the turmoil than their counterparts did during the early years of the Great Depression. Bernanke has cut the benchmark interest rate to as low as zero, while President Barack Obama won congressional approval of a $787 billion stimulus package.

Massachusetts Institute of Technology professor Peter Temin says the trouble is that the economy seems to be collapsing faster than policy makers are reacting. “They’ve only done enough to cushion the downturn,” says Temin, author of the book “Lessons from the Great Depression.”

Prolonged Slump

That leaves the U.S. — and the rest of the world economy — in danger of being mired in an extended period of little or no growth, much like that which afflicted Japan during the 1990s. Eichengreen says such an outcome would be equivalent to a depression.

Whatever it’s called, the economy’s continuing deterioration will likely leave enduring marks. U.S. households are already rebuilding savings in response to the crisis. The savings rate rose to 5 percent in January, the highest in almost 14 years.

“They’re buying what they need, and they’re being very smart about how they spend their money,” Myron Ullman, chief executive officer of Plano, Texas-based J.C. Penney Co., said on Feb. 20, after the third largest U.S. department-store chain forecast its first quarterly loss in almost five years.

In a Feb. 27 memo, “The Return of the Frugal Consumer,” Goldman Sachs economist Andrew Tilton projected a savings rate exceeding 8 percent by the end of 2010.

Americans may also turn more conservative about where they keep their money. Merrill Lynch & Co. says U.S. bonds owned by individuals likely will account for 2 percent of households’ financial assets by 2013, up from 0.2 percent now.

“We’re in the midst of a massive economic and financial crisis,” former Fed Chairman Paul Volcker said at a Columbia University conference on Feb. 20. “We’re going to hear reverberations about this for a long time

U.S. Stocks Are Cheap But Can They Get Cheaper?

 

Mar 06: The deep slide in U.S. stocks to 12-year lows along with lowered economic expectations has sapped investor sentiment and led many on Wall St to wonder how low equity markets can go. U.S. stocks are now down from their all-time peaks in Oct 2007 by more than 55%, eclipsed only by an almost 80% plunge after the crash of 1929. About $11.1tl in market wealth as measured by the DJ Wilshire 5000, which encompasses most U.S. public companies, has been wiped out during the plunge. Many investors now believe that stocks will take longer to recover than previously expected, a shift from the optimism at the end of 2008 when many thought the worst had passed (Reuters)

Mar 03: Rogers–>U.S. stocks may rally because of the enormous amount of money the government is pumping into the U.S. economy, but it’s not going to last. I don’t think the bottom is here, maybe ‘a’ bottom, but not ‘the’ bottom. The economy is going to get worse. You can’t have a good stock market without a good economy (Reuters)

Mar 03: Doll–>We have broken down and therefore the repair process to create a bottom and to create a foundation sort of has to start over again. It doesn’t mean we have to erase all the work that the markets have done to build a base and repair from the Nov 2008 lows. It just means it does have to go on for longer (Reuters)

Draughn (Jan): Earnings projections for S&P 500 are $42.26 for 2009. That makes the forward P/E 22. That doesn’t look like value at all, when the historical average is closer to 15

MS: Equity valuations are not cheap enough to compensate investors for earnings risk. The Graham-Dodd P/E (based on trailing inflation-adjusted 10-year earnings) is now marginally below its long-term average as of Dec 15. An alternative measure, based on the long-term profit share of GDP, remains above average

• CLSA (via Bloomberg): According to Tobin’s q, S&P 500 is too expensive relative to the cost of replacing assets. S&P may plunge another 55% to trough at 400 by 2014
  Merrill Lynch: Fed model suggests equities are undervalued. Valuations are well below long-term averages

PIMCO: Stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future

GS (not online): Low global real yields are likely to remain in place, supporting equities. US equity market looks inexpensive on a forward P/E basis – S&P 500 trading at 12.9x forward earnings, below 20-year average of 15.6x. Current valuations imply only 1% earnings growth per year over next 5 years, below 10-year historical average of 18% implied earnings growth for the S&P 500. Market undervaluing future earnings growth

JPMorgan (not online): Average PE multiple of 12x reached at the end of previous bear markets is well below current 16.2x but historical average may be depressed by “abnormally low” P/Es in 1970s due to inventory overstatement, depreciation understatement

See Stock Valuation Caveats for common problems in valuation