Friday, November 06, 2009

The Rising Fiscal Cost of Unemployment

Paraphrasing the old frat house saying about the party only getting started when something breaks- a financial crisis only truly gets going when the bond market starts to crash.

Sometimes a picture really is worth 1000 words.

click for bigger graph

The graph above depicts the 12 month moving average of the Federal Fiscal Deficit (in blue, left axis) and Non-Farm Payrolls (in red, right axis) since 1981. As you can see unemployment is becoming increasingly expensive.

When I first glanced at the data I was quite surprised. I wondered if the problem was more a function of expenditures, particularly War and Financial Bail-Out costs. While these play a significant part, the graph below shows that Federal Tax Receipts (in blue, left axis) are increasingly sensitive to changes in employment.

click for bigger graph

I'll be a very interested observer of the US Bond market in the coming months (who knows, things could get exciting today) to see if the normal "weak economy equals strong bond market" relationship doesn't shift into a "weak economy equals lower tax receipts, higher deficits, more bond supply and thus weaker bond market" relationship.

Paraphrasing the old frat house saying about the party only getting started when something breaks- a financial crisis only truly gets going when the bond market starts to crash.  After all it isn't much of a crisis if your lenders are willing to lend to you at lower rates then before the crisis, is it?

Full Disclosure: No position in US Bonds (but I'm thinking about it)

Wednesday, November 04, 2009

Feds Forget Bread Crumbs, Have No Exit Strategy

Early in the morning came the woman, and took the children out of their beds. Their bit of bread was given to them, but it was still smaller than the time before. On the way into the forest Hansel crumbled his in his pocket, and often threw a morsel on the ground until little by little, he had thrown all the crumbs on the path. Hansel & Gretel

This afternoon (thanks to the good fellows at Zero Hedge) I found my way to the Minutes of the Meeting of the Treasury Borrowing Advisory Committee Of the Securities Industry and Financial Markets Association.

After debate on other issues, The Committee then turned to a presentation by one of its members on the likely form of the Federal Reserve's exit strategy and the implications for the Treasury's borrowing program resulting from that strategy.

The presenting member began by noting the importance of the exit strategy for financial markets and fiscal authorities...A critical issue will be the impact on the riskier asset classes as market interest rates move away from zero.

The presenting member then looked at the likely sequence of the Federal Reserve's exit strategy. The member acknowledged that the central bank must address the uncertainty and fragility of the economic recovery and the dependence of the housing market on low rates. It was suggested that the most likely sequence would be the draining of excess reserves from the banking system, the cessation of the mortgage-backed securities purchase program, and only then raising the Fed funds target rate.

There you have it, drain excess reserves, stop buying mortgage back securities and then raise Fed Funds.

Easy, right?

Not so fast.

Several members at this point asked why draining reserves before ending the MBS program made sense. The presenting member noted that the program was already set to expire, and other measures, such as a revival of the Supplementary Financing Program, could be utilized by the Federal Reserve at the same time.

The presenting member then addressed the options for draining reserves from the banking system. The problem of excess reserves could persist through the end of 2011 with up to one trillion in excess reserves remaining after liquidity facilities and on balance sheet securities have rolled off. One approach, raising the Fed funds rate to increase the opportunity costs of banks using their reserves, carries the attendant problems of increasing interest rates too soon in the economic recovery. A second option, taking in term deposits, lacks a clear mechanism for rate setting and bank use. Selling assets may run into difficulties if the public appetite for debt at that time is sated, especially considering the impact on the housing market and the major role the Federal Reserve currently plays in the market.

According to the presenting member, these less than optimal solutions leaves the Federal Reserve the option of reverse repurchase agreements (reverse repos) as the most likely option although the potential of the mechanism for draining reserves is unclear. If it is to undertake these reverse repos, the selection of counterparty is important. Depending on how the program is designed, whether it is made to work with dealers or money market funds or to pursue a TALF model with banks as agents, there will be different impacts on the scope of the program, the ease with which it can be set up, and the term of the contracts. In all cases, the program will compete with other short-term investments and put upward pressure on Treasury bill rates according to the presenting member. Moreover, draining excess reserves may dampen the demand for Treasury securities by banks given that banks are investing in securities – particularly Treasuries - in the absence of loan demand.

Several members noted the graph discussing net fixed income supply in 2009 and 2010, and how issuance will ramp up dramatically in 2010. Federal Reserve purchases have taken an enormous amount of supply out of the market this past year across fixed income markets, but next year, financial markets should expect even greater issuance with no support. Such an outcome could pressure rates.

"Pressure rates," now there's an understatement. 

It looks to me as if the Feds didn't consider an exit strategy before embarking on their journey into the liquidity swamp called Quantitative Easing. There seems to me to be no viable exit strategy that won't have severe implications for the real economy. Given that we will be having elections in 2010, and again in 2012, the odds of the liquidity swamp getting drained any time soon, which would surely sour the mood on incumbents seems quite small.
Tightening, I suspect, will be done by the markets, and, under that scenario, those excess reserve might come in handy. At least then the Feds will then have someone else to try to blame.
Alternatively, this meeting could be just a show to buy time before the US$ starts to really sink.
No wonder Mr. Buffett wants to get rid of his cash.

Tuesday, November 03, 2009

Whistling past the Depression

Ben Bernanke – for it was he, of course – has found himself in an even more privileged position to learn such lessons. As chairman of the Fed, his record already deserves more plaudits than those prematurely heaped upon his predecessor. How lucky for us that a Great Depression buff was running the Fed when a second Great Crash came along! For this time the contractionary forces have not been intensified, in the name of sound money. Instead, an active monetary policy has pursued a strategy of easing credit restraints on the real economy, and the threat of inflation has been rightly dismissed as a purely notional danger under present circumstances. FT

The Fed, according to a scan of the financial news, is currently debating the timing and method of an "exit strategy" from the zero-interest-rate-policy (ZIRP), which, according to the above view, saved the US from a repeat of the Depression. This may well prove to be true, and if so, would be, in my view, an example of the myopia inducing effects of unproved assumptions.

The assumption, in this case, is the belief that a good deal of the pain of the Great Depression could have been avoided by policies enacted after the Crash of '29.

This was Milton Freidman's assumption and, judging by Mr. Bernanke's academic work and recent speeches, his as well. Depressions, they think, can be "cured".  Most people have not studied the Great Depression but in many cases seem more than willing to whistle past the the idea of a Depression- uneasily perhaps, but unwilling to change course while, knowingly or not, willing to put their faith in conclusions similar to those in the opening paragraph.

Conclusions drawn from a study of any historic event will necessarily be colored by prejudice. Open minded people, without an axe to grind, might quickly lose those prejudices that seem inconsistent with the facts and theoretical bent, if any, while the less open minded, for whatever reason, will come away with their main prejudices confirmed.

Perhaps because I've studied the Depression without hopes of being an economist with a future at the Fed or of writing any policy-effecting book on the topic (I'm lucky to get 1000 page views on this site) but rather as a husband and father who merely wishes to muddle through without calamity, my read of that (and the preceding) period in US history is that there is no "cure". Perhaps in the event that Plato's Philosopher-Kings ran the world, Depressions might be avoided- although this would involve a system of political economy very different from ours- but never cured.

The reasoning behind this view is as follows. Depressions, in contrast to the more common financial or inventory overheated recessions, are caused by many years of what Austrian Economists call mal-investment- investment, and by consequence, education and employment patterns predicated on a view of the future radically inconsistent with the economic conditions that actually unfold.

Depressions are not, in my view, caused by the financial crises that tend to precede them.  Rather the financial crisis is the moment when the mal-investment is first revealed to the unsuspecting, usually without changing too many minds.

In the case of the Great Depression of the 30s, the view upon which mal-investments were based was that there would always be willing and able consumers to buy whatever the US manufacturing machine was capable of producing at a profit to their costs. In the event, US manufacturers discovered they had grossly over-estimated the willingness and ability of the world's consumers to buy their goods. Had the emergence of World War II not provided insatiable consumers, and provided a crisis-induced mental reboot of the population, if you will, I suspect the 40s would have been far grimmer in economic terms than it proved to be.

In our current situation, the mal-investment is, in a sense, reversed. Instead of believing that consumers are infinitely willing and capable of buying their goods, the US believes that suppliers are infinitely willing to accept US$s in exchange for goods, regardless of US official policy towards their currency. Instead of people trained to work in factories, and an infrastructure geared to manufacturing, people are trained to work in Dilbert style cubicles, and our infrastructure is geared for an endless supply of cheap oil.

In both cases, strong lobbies resist change. Manufacturers had their thumb on government for much of the 20th Century, only to find their position usurped by Finance, which it still retains. Long standing beliefs as to the virtues of such influence will be slow to change, as will the beliefs of many people who, in my view, are educating and training themselves for a world that won't manifest.

World War II, as earlier noted, provided a crisis that engendered a period when one could look at the world with fresh eyes. In the US families of farmers and laborers were able to dream of sending their children to college to become engineers, scientists, doctors and lawyers, or even to do this themselves.

I don't yet see such a catalysts for a mental reboot in the present period, although perhaps a US$ currency crisis might prove sufficient (and hopefully a war won't be necessary).

The thrust of my view is, to the extent I've correctly identified some of the causes of the Depression, the required mental changes in a good deal of the population, not to mention the manifestations thereof in education, training and investment will take years to unfold. If the US will no longer be able to set the terms of trade more or less unilaterally, we have a long way yet before our economy is ready to compete.  At a minimum the US population must accept that they will have to produce much more to enjoy the same standard of living, or deal with less.

In 2007, Fed Chairman Bernanke argued: Economic growth and prosperity are created primarily by what economists call "real" factors--the productivity of the workforce, the quantity and quality of the capital stock, the availability of land and natural resources, the state of technical knowledge, and the creativity and skills of entrepreneurs and managers. He then went on to highlight the crucial supporting role that financial factors play in the economy. I think he continues to place too much emphasis on the latter and not enough on the former in his views and the policies which emerge therefrom (on second thought he hasn't done a great job in getting finance to help the real sector either- leveraged bets on bond market capital appreciation doesn't seem like a cure for anything).

He, and many others may think they can whistle past a Depression as easily as they whistle past a graveyard, but in the case of a Depression, the Bogeyman is real.

Monday, November 02, 2009

Roubini Forgets the Riskiest Asset of All (the US$)

Since March there has been a massive rally in all sorts of risky assets – equities, oil, energy and commodity prices – a narrowing of high-yield and high-grade credit spreads, and an even bigger rally in emerging market asset classes (their stocks, bonds and currencies). At the same time, the dollar has weakened sharply , while government bond yields have gently increased but stayed low and stableNouriel Roubini

Mr. Roubini, whose views I usually find most enlightening, was one of the few prominent economists who forecast the financial crisis of 2008.  Recently, however, perhaps due to a 2005 forecast of an unraveling of Bretton Woods II and sharp decline in the US$ that didn't pan out (at least so far), Mr. Roubini, judging by the above argument, assumes that the US$ is "here to stay" at least in the medium term. 

I disagree (and think he and Mr. Setser should have stuck to their earlier views- sometimes such things take time).

In A Brief History of Time, Stephen Hawking relates the story below which is quite germane to a discussion of Mr. Roubini's view.
A well-known scientist (some say it was Bertrand Russell) once gave a public lecture on astronomy. He described how the earth orbits around the sun and how the sun, in turn, orbits around the center of a vast collection of stars called our galaxy. At the end of the lecture, a little old lady at the back of the room got up and said: "What you have told us is rubbish. The world is really a flat plate supported on the back of a giant tortoise." The scientist gave a superior smile before replying, "What is the tortoise standing on?" "You're very clever, young man, very clever", said the old lady. "But it's turtles all the way down!"

The question, on what belief(s) does your argument rest, gained increased importance ever since David Hume pulled the rug out from under those who assumed any "real-world" arguments were validly based on pure reason. Hume's argument, never refuted, at least to my knowledge, is that "always being followed by" is not the same as caused by. We might infer such, and certainly act on the view that what has happened in the past will happen again, but as we didn't make the rules of the universe, we don't really know. At best we can believe.

On what turtle does Mr. Roubini's view rest? It rests on the view that the US$ has intrinsic value. As he argues: First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts.

I ask, why can't the value of the US$ fall to zero? From the long view of History, the odds of a currency of virtually no intrinsic value declining to that value is high, which might explain Voltaire's quote on paper money.

Perhaps, however, Mr. Roubini was speaking of the medium term, and using the value of the Japanese Yen as a "turtle" to support his argument. Alas, the US is not Japan. Despite their fiscal woes, Japan runs a current account surplus- last month's surplus came in at $13B. The world is not awash in Yen, on the contrary, Japan is awash in US$s, as are quite a few other nations- China comes to mind.

When the Yen was the carry trade vehicle of choice, the risk, which manifested from time to time, was of a sharp rally due to the lack of Yen in international markets. If Japan ran a current account deficit this risk would be much diminished. I suspect if Japan was running a C/A deficit when it opted for a zero-interest-rate-policy (ZIRP) the Yen would have quickly lost a good deal of its value.

The US has both a C/A deficit and a ZIRP. While I agree with Mr. Roubini that the US ZIRP is inspiring the mother of all carry trades, which can inspire sharp corrections, that risk is, in my view, more than offset by the mother of all long positions in the riskiest "asset" of all, the US$. The ZIRP makes holding US$s a losing proposition, as Mr. Roubini notes.

The turtle on which Mr. Roubini's view stands is the notion that the US$ is an asset, when, in my view, it is a liability. By statute there is no fixed exchange rate between the US$ and anything other than US$ debts.  Each time an adjustment arises such that there is a shortage of US$s, the Fed rides in to "add liquidity" because they are more interested in keeping the big banks afloat than the currency. Until that changes, the mother of all carry trades will, despite the odd setback, continue to grow.