Somerville, Massachusetts. Annie Fedele, doing crochet on underwear in dirty kitchen. Said she often works here and eats out in the back yard. The people are supposed to do the work only under certain restrictions, but when the inspector and the one who delivers the goods are not around, they do as they please.
Ilargi: I think we need to assume that some evil force laced Paul Krugman's drinks all those nights he spend in Stockholm bars celebrating his new-found stature as a fake Nobelist. It's the only credible explanation for all the blubber he's written since. Finally today, Willem Buiter takes him and his ilk to task for their loud and desperate calls for ever more public money to be pumped into every black hole they can find, or else woe, the world will perish. And in a sense they're right, but they ignore the fact that it's not their money, it's yours.
They're right because THEIR world will end, or at least the one they've grown to like. They're wrong because, as I said, it's not their money to spend (though that doesn't seem to register, neither with them or with you), and besides, no matter how elevated their desperation becomes, they're propagating theories and ideas that are singularly unproven. America's rich, in their attempts to save the cushy lives they have built for themselves, have nothing to offer but belief systems, religious services built on the Book of Keynes, which was deemed failed and outdated at least 40 years ago.
I sometimes think I'm the only one saying these things, but I do have at least one ally in Mike Shedlock. As I said a few days back, I don't think he knows what socialism is; he seems to think it's handing money to rich people. I think that is more like oligarchy. But he's got a lot of things right. Here's some Mish quotes from the past few days:
Something for nothingIlargi: Still, despite what Mish and myself may say, we are on a one way bridge to nowhere. And it's up to you to tell your elected officials that you don't want them to spend your money on religion-based experiments. And that is what they truly are, I hope you see that, there's no science or anything behind it, it's (make-) believe. If you don't tell them to cut it out, they'll continue, and all you have left will be gone along with what you already lost. No laughing matter. The rich people that you now allow to make decisions on where to spend your money, have faith (yeah, that notion again) that they will be fine if their multi-trillion dollar spending schemes fail. Whether that is true or not is irrelevant for you. What counts for you is the certainty that the plans must fail, and that you will emerge broke, broken and desolate.Keynes Discredited It is amazing that so much love exists for a man whose ideas have been thoroughly discredited on many occasions. Here is a little blurb from the American Journal of Economics and Sociology. The crisis policy devised by John Maynard (Lord) Keynes, which seemed to work well during World War II and in postwar reconstruction, met its nadir in 1975.
Contrary to Keynesian theory, formalized in the Phillips Curve argument that inflation and mass unemployment are mutual trade offs, double digit inflation and record unemployment made further deficit spending an impossible policy. In other words the stagflationary 70's killed (or rather I say should have killed), Keynesian theory given that the "impossible" happened (rising unemployment and rising inflation). Sadly, Keynesian ideology persisted right through another episode that should have thoroughly discredited the theories: Deflation in Japan.
State workers fight over cutbacksObama needs a lesson in economics. Everyone in his administration needs a lesson in economics. Everyone in the Bush administration needed a lesson in economics, as does and did every member in Congress. American dreams are not founded on unsound spending. And as far as states go, it appears they are going to get only $200 billion of the $1 trillion they want. That is not going to be enough to stop massive layoffs. As a side note, reflect on the fact that the word only is in front of $200 billion. That number at one time would have been shocking. Now $200 billion does not raise an eyebrow.
However, we still need to put that $850 billion package in perspective. Close to $8 trillion in wealth has been wiped out by this bear market and more is coming. Credit balances on the books of banks and corporations is extremely suspect, at best. Unemployment is likely headed to 9% if not 11% by the time the economy bottoms, and housing is unlikely to bottom for several more years. Consumers are retrenching and will stay retrenched. Boomers headed into retirement need to draw on savings as opposed to accumulate them. No matter how one slices this, it is damn hard to get hyperinflation or even a significant amount of inflation out of this mess. Credit is being destroyed faster than any proposed stimulus.
Fed's Yellen supports "experimental approaches" to prevent deflationSummary of Yellen's Proposal
1)Yellen wants to "pull out all the stops to ensure an extended period of stagnation does not occur"
2)Yellen wants to do this even though the "approaches are experimental, and there is a great deal of uncertainty concerning their likely effects.”
3)To top it off, Yellen admits that an extended period of stagnation will occur anyway: “Even with vigorous Fed action to restore credit flows, an extended period of economic weakness is likely.”
One Sentence Summary Yellen wants to pull out all the stops using experimental approaches to the fiscal crisis that she admits will not solve the crisis and might even be detrimental. [..] To further recap, Yellen proposes "novel interventions" of dubious merit, admitting they will not work, and wants a "timely" plan to end them. How about right now, before they do any more damage?
Meanwhile, the cries for more and more and still more spending grow louder by the day. Willem Buiter's take on the issue is ss simple as his article is long. He says the US can't afford the coming stimulus plans, because it's already been sucked too deep into the quicksand, and even if they can sell their debt, it will be at market prices, not any longer at the favorable rates a reserve currency can impose. And as Stoneleigh and I have pointed out a thousand times here, there's no such thing as “just printing money” in today’s world. The US will need to finance its debt through Treasuries or other sorts of bonds. Not only has it lost much of its financial shine as a nation, it will now have to compete with a fast and furious rise in bond issues from its own municipalities, states and corporations.
There will undoubtedly be a ton of good feeling surrounding Obama's ascent to the throne. Question is, how long will it last? The economic numbers so far this year are a mile and a half below awful. There is a substantial risk that a bank or some other kind of large corporation will fail soon. The cries for federal funds will stretch form here to infinity and beyond. And that threatens to overwhelm the new president as soon as he first enters the Oval Office, and through the rest of his term. Just throwing money around isn't going to change that. Economics is neither a science nor a religion, and no priest or vicar should handle your day's pay. Sadly, the people who truly understand that are few and far between.
Can the US economy afford a Keynesian stimulus?
Economic policy is based on a collection of half-truths. The nature of these half-truths changes occasionally. Economics as a scholarly discipline consists in the periodic rediscovery and refinement of old half-truths. Little progress has been made in the past century or so towards understanding how economic policy, rules, legislation and regulation influence economic fluctuations, financial stability, growth, poverty or inequality. We know that a few extreme approaches that have been tried yield lousy results - central planning, self-regulating financial markets - but we don’t know much that is constructive beyond that. The main uses of economics as a scholarly discipline are therefore negative or destructive - pointing out that certain things don’t make sense and won’t deliver the promised results. This blog post falls into that category.
Much bad policy advice derives from a misunderstanding of the short-run and long-run impacts of events and policies. Too often for comfort I hear variations on the following statements: “The long run is just a sequence of short runs, so if we make sure things always make sense in the short run, the long run will take care of itself.” This fallacy, which I shall, unfairly, label the Keynesian fallacy, compounds three errors. The first error is the leap from the correct assertion that a long interval of time is the sum of successive short intervals of time to the incorrect impact that the long-run impact of a policy or event is in any sense the sum of its short-run impacts. The second error is the failure to recognise that our models (formal or implicit) of how the economy works are inevitably incomplete. Parts of the transmission mechanism - positive or negative feedbacks and other causal links between actions today, future outcomes and anticipations today of future outcomes and future actions - that can safely be ignored when we consider the impact of a policy over a year or two can come back to haunt us with a vengeance over a three-year or longer horizon.
The third error is that, when economic agents, households, firms, portfolio managers and asset market prices are even in part forward-looking, the long run is now. More precisely, the long-run consequences of current policies can, through private sector expectations and through forward-looking asset prices influence consumption behaviour, employment and investment decisions and asset prices today. Matching the Keynesian fallacy is the view that just because a certain set of policies is not sustainable, in the sense that it cannot be maintained indefinitely, such policies should not be implemented even temporarily. I will call this the sustainability fallacy. It rests on the simple error that identifies a sustainable policy rule or programme, with a specific constant policy action. A sustainable, sensible or even optimal contingent policy programme, or contingent sequence of policy actions, will in general involve specific actions that will be undone, reversed or even neutralised by later contingent policy actions in the opposite direction. These specific actions may be eminently sensible, even from a long-run perspective, provided they are not maintained indefinitely and are, and are expected to be, reversed in due course, according to the rule, when the state of the economy has evolved or when a new unexpected contingency arises.
How does this apply to the macroeconomic stabilisation policy and the financial stability support policies being pursued in the US today? First, the fiscal policy actions pursued thus far by the Bush administration, but even more so the policy proposals leaked by Obama’s proto-administration are afflicted by the Keynesian fallacy on steroids. They appear to exist outside time, with neither the long-run consequences of the actions like to be implemented over the next couple of years, nor the history that brought the US to its current predicament, the initial conditions, being given any serious attention.
Even before the crisis erupted, around the middle of 2007, the US economy was in fundamental disequilibrium. The external primary deficit (the external current account deficit plus US net foreign investment income) was running at around five or six percent of GDP. The US was also a net external debtor. Its net external investment position (at fair value, or the statisticians best guess at it) was somewhere between minus 20 percent and minus 30 percent of annual GDP. The US economy managed to finance this debt and deficit position quite comfortably because it gave foreigners an atrocious rate of return on their investment in the US - a rate of return much lower, when expressed in a common currency, than the rate of return earned by US-resident investors abroad. Some of this lousy ex-post average return on foreign investment in the US was no doubt unexpected and one-off. If risk premia on foreign investment in the US and on US investment abroad were the same, the appearance of excess returns to US investment abroad relative to foreign investment in the US may simply have been an example of the “peso problem” - a “small-sample bias” in expected returns.
Assume expected returns are equal using the true distribution of returns. The true distribution may, however, have fat or long tails, with extreme negative values that occur infrequently (e.g. the collapse of a currency peg). The term ‘peso problem’ came from observations on realised returns on US dollar-denominated securities and Mexican peso-denominated securities during the 1970s. The forward premium on the Mexican peso relative to the US dollar was positive through 22 years of a pegged exchange rate, until August 1976, of eight Mexican pesos to the US dollar. On September 1, 1976, the peso devalued by 45 percent vis-à-vis the US dollar. The term peso problem was, according to Paul Krugman, invented by a bunch of MIT graduate students of the late Rudi Dornbusch. William S. Krasker published the first paper using the expression (”The ‘peso problem’ in testing the efficiency of forward exchange markets”, Journal of Monetary Economics, Volume 6, Issue 2, April 1980, pages 269-276), long before fat tails, black swans and related regurgitations of the same phenomenon became current. The attribution of the expression “peso problem” to Milton Friedman is almost certainly incorrect.
When the disaster scenario (a collapse of the currency peg) materialises, the roof caves in for peso investments. Before the collapse, statisticians, unlike market participants, don’t know the true distribution but base their calculation of the expected return on a sample during which the extreme event has not (yet) materialised. The result is that statisticians overestimate the expected return on the peso (there has been no depreciation of the peso during my sample, therefore the future expected depreciation rate is zero) and attribute the positive (risk-adjusted) rate of return differential on the peso to “alpha”. It is, of course, “false alpha”, as the September 1, 1976 collapse of the peso (repeated a number of times since then) made clear.
Some of the excess returns on US investment abroad relative to foreign investment in the US, may have been anticipated, and may have reflected a low or even a negative risk-premium on US investment. In that case, if risk-adjusted rates of return to foreign investment in the US and on US investment abroad are the same, we would expect that the so far unrealised risk will in due course materialise and blow a large hole in the US external asset position. Even with a very long enough sample, ex-post realised average rates of return on investing in the US will still be lower than ex-post realised rates of return on investment abroad, but the (ex-post) positive correlation between the return on foreign investment and consumption growth could be stronger for foreign investment in the US than for US investment abroad.
Some of the excess returns on US investment abroad relative to foreign investment in the US may have reflected true alpha, that is, true US alpha - excess risk-adjusted returns on investment in the US, permitting the US to offer lower financial pecuniary risk-adjusted rates of return, because, somehow, the US offered foreign investors unique liquidity, security and safety. Because of its unique position as the world’s largest economy, the world’s one remaining military and political superpower (since the demise of the Soviet Union in 1991) and the world’s joint-leading financial centre (with the City of London), the US could offer foreign investors lousy US returns on their investments in the US, without causing them to take their money and run. This is the “dark matter” explanation proposed by Hausmann and Sturzenegger for the “alpha” earned by the US on its (negative) net foreign investment position. If such was the case (a doubtful proposition at best, in my view), that time is definitely gone.
The past eight years of imperial overstretch, hubris and domestic and international abuse of power on the part of the Bush administration has left the US materially weakened financially, economically, politically and morally. Even the most hard-nosed, Guantanamo-bay-indifferent potential foreign investor in the US must recognise that its financial system has collapsed. Key wholesale markets are frozen; the internationally active part of its financial system has either been nationalised or underwritten and guaranteed by the Federal government in other ways. Most market-mediated financial intermediation has ground to a halt, and the Fed is desperately trying to replace private markets and financial institutions to intermediate between households and non-financial operations. The problem is not confined to commercial banks, investment banks and universal banks. It extends to insurance companies (AIG), Quangos (a British term meaning Quasi-Autonomous Government Organisations) like Fannie Mae and Freddie Mac, amorphous entities like GEC and GMac and many others.
The legal framework for the regulation of financial markets and institutions is a complete shambles. Even given the dismal state of the legal framework, the actual performance of key regulators like the Fed and the SEC has been appalling, with astonishing examples of incompetence and regulatory capture. There is no chance that a nation as reputationally scarred and maimed as the US is today could extract any true “alpha” from foreign investors for the next 25 years or so. So the US will have to start to pay a normal market price for the net resources it borrows from abroad. It will therefore have to start to generate primary surpluses, on average, for the indefinite future. A nation with credibility as regards its commitment to meeting its obligations could afford to delay the onset of the period of pain. It could borrow more from abroad today, because foreign creditors and investors are confident that, in due course, the country would be willing and able to generate the (correspondingly larger) future primary external surpluses required to service its external obligations.
I don’t believe the US has either the external credibility or the goodwill capital any longer to ask, Oliver Twist-like, for a little more leeway, a little more latitude. I believe that markets - both the private players and the large public players managing the foreign exchange reserves of the PRC, Hong Kong, Taiwan, Singapore, the Gulf states, Japan and other nations - will make this clear. There will, before long (my best guess is between two and five years from now) be a global dumping of US dollar assets, including US government assets. Old habits die hard. The US dollar and US Treasury bills and bonds are still viewed as a safe haven by many. But learning takes place. The notion that the US Federal government will be able to generate the primary surpluses required to service its debt without selling much of it to the Fed on a permanent basis, or that the nation as a whole will be able to generate the primary surpluses to service the negative net foreign investment position without the benefit of “dark matter” or “American alpha” is not credible. So two things will have to happen, on average and for the indefinite future, going forward. First, there will have to be some combination of higher taxes as a share of GDP or lower non-interest public spending as a share of GDP. Second, there will have to be a large increase in national saving relative to domestic capital formation.
As regards the required massive transfer of resources from the public to the private sector in the US, it has long been recognised by those who look at long-term prospects for taxes and public spending in the US, that a combined permanent increase in the tax share/reduction in the share of public spending in GDP of around ten percentage points would be required to fund existing Medicare and Medicaid commitments (and to a lesser extent Social Security commitments). In the past decade the US has legislated for its citizens (though Medicare, Medicaid and Social Security retirement) a West European-style welfare state. Obama’s proposals for universal health care will complete this process. The US has done so with a general government public expenditure share in GDP that is about 10 percentage points below the West European average (in the mid-thirties for the US, in the mid-forties in for Western Europe. Evolving demographics and entitlement will drive US welfare state expenditure towards the West-European levels, in the absence of political decisions in the US to limit coverage and entitlements.
This resource shift from the private to the public sector would only manifest itself gradually however, and no doubt, there will be changes in (whittling down of) these commitments before their full impact is felt. The US Federal government has taken on massive additional contingent liabilities through its bail out/underwriting of the US financial system (and possibly other bits of the US economic system that are too politically connected to fail). Together will the foreseeable increase in actual Federal government liabilities because of vastly increased future Federal deficits, this implies the need for a future private to public sector resource transfer that is most unlikely to be politically feasible without recourse to inflation. The only alternative is default on the Federal debt. There is little doubt, in my view, that the Federal authorities will choose the inflation and currency depreciation route over the default route. If I can figure this out, so can anyone in the US or abroad who follows recent economic developments. The dawning of the realisation will lead to the dumping of the assets.
Even if the US Federal government decides to go the inflation route for “paying off” public debt is would be too politically difficult to service through tax increases or spending cuts, it is unlikely that some, not insignificant, resource transfer from the private to the public sector will have to take place. And there we have the short run-long run conundrum. If the economy were at full employment and a high rate of capacity utilisation today, it would still require a permanent resource transfer from the private sector to the public sector, that is, higher taxes or lower public spending. But for cyclical purposes, lower taxes and higher public spending are indicated - provided the authorities have the credibility to commit themselves to future tax increases and/or spending cuts that would not just take care of the existing obligation, but also of the additional debt that would be incurred as a result of the Keynesian stimulus.
The latest gurgling about the magnitude of the Obama fiscal stimulus are certainly impressive: $775bn or so (around 5 per cent of GDP) over two years. This on top of a Federal deficit that even absent these stimuli could easily top $750bn. I now anticipate a Federal deficit of between $1.5 trillion and $2.0 trillion for 2009 and something slightly lower for 2010. With both the Fed and the Treasury exposed to trillions of private assets and institutions of doubtful quality and solvency, the stock of US Federal debt could easily increase by many more trillions of US dollars during the next couple of years. Those familiar with the post World War I and post-World War II public debt levels will not be impressed with even a doubling of the public (Federal) debt held by the public as share of GDP, from its current level of around 40 per cent of annual GDP (gross public debt, including debt held by other government agencies, like the Social Security Trust Fund, stands at around 70 per cent of GDP). Chart 1 is taken from Wikepedia. Following World War II public debt stood at more than 100 percent of annual GDP.
A simple (coarse?) indicator of “tax tolerance” - willingness to pay taxes or to make others pay taxes - is the highest marginal rate of personal income tax. For the US this is shown in Table 2 below. It is taken from the website of TruthAndPolitics.org.
That, however, was then. The debt was incurred to finance a temporary bulge in public spending motivated by a shared cause: defeating Japan and the Nazis. The current debt is the result of the irresponsibility, profligacy and incompetence of some. Achieving a political consensus to raise taxes or cut spending to restore US government solvency is going to test even the talents of that Great Communicator, Barack Obama. If you add to the Keynesian fiscal stimulus package Obama’s ambitions for increasing infrastructure investment to stimulate growth, to fund (not quite) universal healthcare and to stimulate alternative energy production and use, the incompatibility of US public spending ambitions and the political capacity to raise the necessary revenues is glaring. So the government would borrow. From whom? Not from the domestic private sector. They are saving rather little and are being discourage from saving what little they are saving by the fiscal stimulus package. So the US government will borrow abroad to finance its infrastructure, health ambitions and green agenda? Some day perhaps. But not during Obama’s presidency.
So will the Keynesian demand stimulus work? For a while (a couple of years, say) it may. When the consequences for the public debt of both the Keynesian stimulus and the realisation of the losses from the assets and commitments the Fed and the Treasury have taken onto their balance sheets become apparent, the demand stimulus will fade and may be reserved as precautionary behaviour takes over in the private sector. My recommendation is to go easy on the fiscal stimulus. The US government is ill-placed financially and fiscally, to engage in short-term fiscal heroics. All they can really do is pray for a stronger-than-expected revival of global demand, without any major stimulus from the US. Beggars can’t be choosers. The US has been able to get away with decades of private sector improvidence because of two unique and time-limited factors. The first is a sequence of capital gains on household assets (stocks and real estate) that provided a lovely substitute for saving to provide for retirement, old age and a rainy day. The second was the excess returns earned by the US on its net foreign investment (its ability to borrow at an unbelievably low rate of interest/rate of return) because of the unique position of the US as the ultimate source of liquidity and security.
Both rational drivers of a low US saving rate are gone. The US housing market and global stock markets have imploded. It will take years, even decades, to restore household financial wealth-income ratios to levels that don’t guarantee retirement in poverty for much of the US population. The rest of the world will also no longer lend to the US at a negative nominal (and real) interest rate, as it has done for years. So the US has to shift aggregate demand from domestic demand to external demand. And it has to shift production from non-tradables to tradables - exportable and import-competing goods and services. By how much? At full employment, probably at least six and more likely by around eight percent of GDP.
As regards shifting production towards tradables, this will not be easy. And policy is pushing in the wrong direction. The Bushbama administrations have decided to bail out the US car industry. That industry does not produce cars the rest of the world wants. If and when the global economy recovers and oil prices rise to $150 per barrel again, US consumers also won’t want the cars produced by Detroit. Sure, they can change. They could have changed in 1973, in 1980 and at any time since then. If they could change, they probably would have by now. Other US industries are more competitive internationally. But shifting resources towards tradables and away from non-tradables will require re-training and re-education as well as a significant depreciation of the US dollar’s real exchange rate - which amounts to a significant cut in real wages. Chart 3, which shows the US broad real effective exchange rate index, provided by the Fed, shows the behaviour of one measure of the real exchange rate since 1973.
In the past year, the effective real exchange rate of the US dollar has in fact strengthened rather than weakened, thus impeding the necessary external adjustment. With the short risk-free nominal interest rate effectively at the zero floor, conventional expansionary monetary policy cannot be used any longer to weaken the exchange rate. The effect of quantitative easing and qualitative easing on the exchange rate are ambiguous. If they succeed in stimulating spending by credit-constrained businesses and households, it could well strengthen the currency and weaken the trade balance. In the decades since I first lived in the US, the quality of secondary education and of vocational training appears to have worsened. Despite the excellence of some institutions, including the wide range and variety of community colleges that give a second chance to so many Americans, the educational system of the US increasingly resembles that of the UK: islands of excellence in a sea of mediocrity. This means that, to become competitive, if you cannot compete on quality and innovation, you will have to compete on price. A larger real exchange rate depreciation and cut in real consumer wages will be required to achieve a given shift of resources to the external sector.
With all the talk about investing in the future, improving infrastructure and creating a dynamic competitive economy, I don’t think the Obama administration will want to achieve the necessary shift of resources towards the rest of the world by reducing domestic investment. In fact, in the one area where domestic investment could and should be reduced (residential construction), there is bipartisan support for boosting investment in residential housing. That leaves an increase in national saving as the only way to achieve the required primary external surplus. The government is, however, planning to boost its spending and cut taxes. No increase in public saving therefore can be anticipated for many years to come. The private sector in the US is, at last, saving. We have gone from a declining growth rate of private consumption to a declining level of private consumption. But what do the policy authorities do? Rising household saving equals falling household consumption equals declining effective demand equals longer and deeper recession. Can’t have that. Here is a tax cut. If you can no longer borrow from your bank, we may guarantee your mortgage so you can borrow after all. Everything that is desirable from a short-run Keynesian aggregate demand perspective (assuming these measures are indeed effective) is a step in the wrong direction from the perspective of restoring external equilibrium and raising the US national saving rate.
One obvious response to this opposition between what is desirable now and what is necessary in the longer run is to say: let’s do now what is desirable now and let’s take care of what is necessary tomorrow. That might be viable if the US private sector and the US policy makers had the necessary credibility to head south when the destination is north, because they can commit themselves to a timely reversal. If the authorities go ahead with the short-run Keynesian stimulus without having convinced the global capital markets and domestic producers and consumers that there will be a timely reversal, the policies will not work. This failure of expansionary fiscal policy is not for Ricardian reasons (Mr. Jean-Claude Trichet gets this wrong all the time - the Ricardian model has as one of its key assumptions that the government always satisfies its intertemporal budget constraint, that is, the government when it cuts taxes or raises spending today, is believed to raise taxes or cut spending by the same amount, in present discounted value, in the future; the second key assumption is that postponing taxes, while keeping their present discounted value constant, does not stimulate consumer demand.
There either is no redistribution (from the young to the old, from those currently alive to the unborn and from those who are constrained by permanent income to those constrained by current income) or this redistribution does not have aggregate spending effects. Instead the failure of expansionary fiscal policy is because of the fear, uncertainty and higher risk premia caused by the higher risk of sovereign default caused by expansionary policy. If the government is believed to be fiscally continent (future taxes will be raised and/or future public spending will be cut by enough to safeguard the solvency of the state) but turns out not be so after all, the Keynesian fiscal policy will be effective in the short run (as long as the public believes in the fiscal virtue of the government) but will become highly contractionary once the truth dawns.
Given the bad fiscal position of the US Federal government and given the vulnerability of the external position of the US and its growing reliance on foreign funding, the scope for expansionary fiscal policy in the US is much more limited than president-elect Obama’s advisers appear to realise. Underneath the effective demand problem is a deep structural rot, especially in household sector and financial sector balance sheets. Keynesian cyclical policy options that would be open to more structurally sound economies should therefore not be tried on anything like the same scale by the US authorities.
Fighting Off Depression
“If we don’t act swiftly and boldly,” declared President-elect Barack Obama in his latest weekly address, “we could see a much deeper economic downturn that could lead to double-digit unemployment.” If you ask me, he was understating the case. The fact is that recent economic numbers have been terrifying, not just in the United States but around the world. Manufacturing, in particular, is plunging everywhere. Banks aren’t lending; businesses and consumers aren’t spending. Let’s not mince words: This looks an awful lot like the beginning of a second Great Depression. So will we “act swiftly and boldly” enough to stop that from happening? We’ll soon find out.
We weren’t supposed to find ourselves in this situation. For many years most economists believed that preventing another Great Depression would be easy. In 2003, Robert Lucas of the University of Chicago, in his presidential address to the American Economic Association, declared that the “central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades.” Milton Friedman, in particular, persuaded many economists that the Federal Reserve could have stopped the Depression in its tracks simply by providing banks with more liquidity, which would have prevented a sharp fall in the money supply. Ben Bernanke, the Federal Reserve chairman, famously apologized to Friedman on his institution’s behalf: “You’re right. We did it. We’re very sorry. But thanks to you, we won’t do it again.”
It turns out, however, that preventing depressions isn’t that easy after all. Under Mr. Bernanke’s leadership, the Fed has been supplying liquidity like an engine crew trying to put out a five-alarm fire, and the money supply has been rising rapidly. Yet credit remains scarce, and the economy is still in free fall. Friedman’s claim that monetary policy could have prevented the Great Depression was an attempt to refute the analysis of John Maynard Keynes, who argued that monetary policy is ineffective under depression conditions and that fiscal policy — large-scale deficit spending by the government — is needed to fight mass unemployment. The failure of monetary policy in the current crisis shows that Keynes had it right the first time. And Keynesian thinking lies behind Mr. Obama’s plans to rescue the economy.
But these plans may turn out to be a hard sell. News reports say that Democrats hope to pass an economic plan with broad bipartisan support. Good luck with that. In reality, the political posturing has already started, with Republican leaders setting up roadblocks to stimulus legislation while posing as the champions of careful Congressional deliberation — which is pretty rich considering their party’s behavior over the past eight years. More broadly, after decades of declaring that government is the problem, not the solution, not to mention reviling both Keynesian economics and the New Deal, most Republicans aren’t going to accept the need for a big-spending, F.D.R.-type solution to the economic crisis.
The biggest problem facing the Obama plan, however, is likely to be the demand of many politicians for proof that the benefits of the proposed public spending justify its costs — a burden of proof never imposed on proposals for tax cuts. This is a problem with which Keynes was familiar: giving money away, he pointed out, tends to be met with fewer objections than plans for public investment “which, because they are not wholly wasteful, tend to be judged on strict ‘business’ principles.” What gets lost in such discussions is the key argument for economic stimulus — namely, that under current conditions, a surge in public spending would employ Americans who would otherwise be unemployed and money that would otherwise be sitting idle, and put both to work producing something useful.
All of this leaves me concerned about the prospects for the Obama plan. I’m sure that Congress will pass a stimulus plan, but I worry that the plan may be delayed and/or downsized. And Mr. Obama is right: We really do need swift, bold action. Here’s my nightmare scenario: It takes Congress months to pass a stimulus plan, and the legislation that actually emerges is too cautious. As a result, the economy plunges for most of 2009, and when the plan finally starts to kick in, it’s only enough to slow the descent, not stop it. Meanwhile, deflation is setting in, while businesses and consumers start to base their spending plans on the expectation of a permanently depressed economy — well, you can see where this is going. So this is our moment of truth. Will we in fact do what’s necessary to prevent Great Depression II?
Engines of Recovery Flame Out as Economy Seeks Rescue From Obama, Bernanke
The engines that have lifted the U.S. economy out of every recession since World War II will be of little help this time around. Inventory rebuilding, household spending, home construction and payroll growth -- the forces that powered, to a greater or lesser extent, each recovery since 1945 -- may remain missing for much of 2009. A glut of unsold properties may keep housing depressed, while shriveled savings will discourage consumers. Companies may be reluctant to restock and rehire while their profits are squeezed. "There are no obvious drivers of growth from the private sector," says Jan Hatzius, chief U.S. economist at Goldman Sachs Group Inc. in New York.
The result: A recovery, whenever it comes, may be anemic and heavily dependent on low-cost lending by Federal Reserve Chairman Ben S. Bernanke and stepped-up spending by new President Barack Obama. Short-term interest rates might have to remain around zero throughout the year, while the federal budget deficit stays at or near record highs into 2010. "If we don’t act swiftly and boldly, we could see a much deeper economic downturn that could lead to double-digit unemployment," Obama said in his weekly radio address on Jan. 3. The jobless rate stood at 6.7 percent in November. UBS Securities LLC forecasts that gross domestic product will contract at a 3 percent annual pace this quarter after shrinking 4.5 percent in the final three months of 2008.
James O’Sullivan, senior economist at UBS in Stamford, Connecticut, says the economy is likely to stop eroding in the second quarter, thanks to an unprecedented "policy blitz" by the Fed and the Obama administration. The second-half recovery, though, will be weak, he says: growth of 1.5 percent in the third quarter and 2 percent in the fourth, as tight credit continues to pressure consumers and companies. That’s in contrast to past rebounds, where growth was boosted by a robust revival of private-sector demand. Inventory swings played a key role in the 16-month recession of 1973-75 and the recovery that followed. Companies slashed stocks in 1974 and 1975 as demand dropped, and then rebuilt them rapidly the following year. That raised 1976 GDP by 1.4 percentage points, the biggest such contribution in 21 years. Consumer spending and housing powered the economy out of recession in 1983, as pent-up demand sent purchases of cars and homes soaring. Payroll growth was also strong, with 1.1 million jobs created in September alone.
In 1992, housing again was a big help. Along with capital spending, residential construction spurred the biggest contribution to growth from investment since 1984. Homebuilding and consumer spending played a more modest role in the economy’s revival in 2002, but that’s because they never declined in the previous year’s recession, which was the mildest since World War II. All those factors may be missing in action this time around. With just-in-time inventory management, the downs -- and ups -- of the stockpiling cycle are more muted than before. Companies are quicker to pare stockpiles when demand wanes, limiting the buildup in unwanted products both at their own sites and those of their customers. For example, Corning, New York-based Corning Inc., the largest maker of glass for flat-panel televisions, said last month it will cut prices to clear out excess inventories.
The downside of this rapid response is that the economy won’t get as much of a pop from businesses restocking as demand recovers. "There is a lack of a big inventory cycle," O’Sullivan says. Companies may also be reluctant to ramp up production in the face of what many economists expect to be a slow increase in consumer demand. Allen Sinai, chief global economist at Decision Economics in New York, says households are in hunker-down mode after suffering $10 trillion in losses in wealth from sagging home prices and shrinking investments. "They know they have to save more; they have no choice," he says. The Conference Board’s index of consumer confidence fell in December to the lowest level on record as anxiety about job losses overcame the beneficial effects of a 60 percent decline in gasoline prices since July.
U.S. companies cut 533,000 jobs in November, the most in 34 years. Economists surveyed by Bloomberg News forecast that figures out on Jan. 9 will show a further 500,000 reduction in payrolls in December and an unemployment rate of 7 percent. Joblessness is likely to continue to rise throughout 2009 and perhaps into 2010. "We’ll probably have a good chance of seeing unemployment hit 9 or 10 percent," says Kenneth Rogoff, a former chief economist for the International Monetary Fund who’s now a professor at Harvard University. Consumers have also been shaken by the plunge in the value of homes, for many their biggest asset. Home prices in 20 major U.S. cities declined 18 percent in October from a year earlier, the biggest drop on record for the S&P/Case-Shiller index that goes back to 2001. The collapse in property values is damping expectations for an early rebound in the housing market. "We’re in the midst of a downward spiral and the momentum is building," Stuart Miller, chief executive officer of Miami-based Lennar Corp., which builds homes in 14 U.S. states, said on a Dec. 18 conference call.
A glut of unsold properties is prolonging the industry’s pain. The number of previously owned homes on the market at the end of November would take 11.2 months to sell at the current pace. That’s the highest inventory level in at least 10 years. "Housing starts and building permits are in free-fall," Nouriel Roubini, chairman of Roubini Global Economics and a professor at New York University, said in a Bloomberg Television interview on Dec. 23. "There’s no bottom." Hopes that exports would buoy the economy have been dashed by the spread of the U.S. recession overseas. Japan’s economy, the world’s second-largest after the U.S., probably shrank at an annual 12.1 percent pace last quarter, the sharpest drop since 1974, according to Kyohei Morita, chief Japan economist at Barclays Capital in Tokyo. That’s left it up to U.S. policy makers to try to pick up the slack.
The Fed cut the main U.S. interest rate to a target range between zero and 0.25 percent on Dec. 16 and pledged to do whatever is necessary to end the longest recession in a quarter century. The incoming Obama administration, meanwhile, is working on a two-year stimulus package worth as much as $850 billion in increased government spending and lower taxes. "The U.S. is in the midst of a long, deep and severe downturn," Sinai says. "When we do recover, the engine will be government spending, not home building or the consumer."
Auto Slump Has Deep Impact on Japan
As goes Toyota Motor, so goes Japan. In recent economic downturns, Japan's been able to lean on its auto industry to offset declines elsewhere. But a decade of success by the car makers -- particularly Toyota's challenge of General Motors' position as the world's biggest producer -- means that they've become Japan's largest export sector just in time for a protracted slump in global auto sales. While auto makers now account for only 0.8% of U.S. gross domestic product, they make up 3.2% of Japan's GDP, according to J.P. Morgan. And the country's reliance on indebted, car-loving Americans, in particular, has actually increased in recent years.
The export value of cars and auto parts has doubled in less than a decade and, in the fiscal year that ended last March, accounted for over a fifth of Japan's $940 billion in exports. The U.S. accounts for a third of sales at Toyota and half at Honda Motor. So the cuts in planned output and layoffs that are following poor sales at home and abroad, are already hitting hard -- in particular in the Japanese regional auto hub of Tokai. The area is home to about 12% of Japan's 128 million population, and managed to avoid the spike in unemployment elsewhere in the nation during both the Asian financial crisis and dot-com downturn -- thanks to continuing growth in auto exports.
That's surely little comfort to policy makers in the region now. Aichi prefecture, which is home to the bulk of Toyota's domestic plants is planning to start hiring staffers to do odd jobs -- like inspecting roads -- to offset employment cuts. Detroit's sister city, Toyota City, with 400,000 residents and 76,000 jobs connected to the auto business, meanwhile, expects next fiscal year's corporate tax revenue to plunge from about $490 million to one-tenth of that. So public-works spending is being slashed.
But the auto makers are probably just getting started with their cuts. The country's main eight car makers have already cut planned output by 2.2 million units and axed over 11,000 contract workers. Toyota alone accounts for almost half of the production cuts, which it announced in early November. The situation, of course, has worsened considerably since then.
Japan auto executives hope for US recovery
Japan auto executives gathered for an annual New Year's party Monday expressed hopes for a U.S. turnaround and a strengthening dollar to fix the faltering global market. Japan's export-dependent automakers have been battered by the slowdown in the U.S. set off by the financial crisis last year. The rising yen has also hurt the companies. The dollar, which had cost 113 yen a year ago, is trading at about 90 yen lately, a 13-year low. Despite the hard times, the annual event at a Tokyo hotel hosted by the Japan Automobile Manufacturers Association, which groups this nation's automakers, was packed with suited businessmen and other guests eager to start the new year by networking toward a recovery.
Takeo Fukui, president and chief executive of Japan's No. 2 automaker, Honda Motor Co., said he hoped the global economy had bottomed out. Tokyo-based Honda has its hopes on the hybrid Insight set to go on sale later this year, he said, but the main problems were the U.S. downturn and the weak dollar. "First of all, the U.S. market has to recover," he told reporters. "The yen is at an abnormally high level. The Japanese economy needs its export industries." Honda, which makes the Odyssey minivan and Accord sedan, has cut production to adjust to slowing demand, and slashed its profit forecast for the fiscal year ending in March to 185 billion yen ($2.0 billion), less than a third of its previous year's earnings. Japan's top automaker Toyota Motor Corp. isn't faring any better, toppling into its first operating loss in 70 years. Toyota, which makes the Prius gas-electric hybrid and Camry sedan, is forecasting a net profit of 50 billion yen ($555 million), down drastically from the 1.7 trillion yen earned the previous year.
"We tried to create a business that can withstand currency fluctuations, but the latest changes have been too much," said Toyota President Katsuaki Watanabe. Toyota's Honorary Chairman, Shoichiro Toyoda, a member of the company's founding family, stressed the importance of an American recovery. "We are all in trouble without an American recovery," he told The Associated Press. "The American economy has a big impact on the world." Nissan Motor Co., which is expecting a 160 billion yen ($1.6 billion) profit for the fiscal year through March 31, down 67 percent from the previous year, is also hoping for a U.S. recovery. In past years, the overall U.S. market has totaled about 16 million vehicles, peaking at 17 million in 2000. That has shrunk to 11 million vehicles, according to some estimates for last year.
Nissan Chief Operating Officer Toshiyuki Shiga said such low levels couldn't last forever because of the historic size of the U.S. auto market and the growing population there. "The recovery will get moving once financing problems settle down and American individual consumer sentiments start looking up," he said. Although Japanese automakers have been trying to expand in new markets -- such as China, Brazil and Russia -- those markets are still small. The Japanese market has been sluggish for years, but the stagnation has worsened since the U.S. crisis. Japan sales of new vehicles fell to 3.2 million vehicles last year, the lowest in 34 years, the Japan Automobile Dealers Association said Monday.
Obama Pledges 3 Million New Jobs, But How?
With the country mired in the worst economic crisis since the Great Depression and unemployment at its highest levels in 15 years, President-elect Barack Obama goes to Capitol Hill today to convince lawmakers to support an economic stimulus package, the "number one goal" of which is to create 3 million new American jobs. The scope of the jobs creation program is one of the largest since the Depression, when some 8 million jobs were created under the Work Projects Administration, and is an upward revision of two previous pledges Obama made since winning election to "create or preserve" 2.5 million to 3 million jobs. Obama's jobs plan is part and parcel of an ambitious stimulus proposal that includes middle-class tax relief, spending on schools, aid to states for infrastructure projects, green initiatives and modernizing the healthcare system that he estimates will cost between $675 billion and $775 billion.
The sheer size and expense of the project has many Republicans already criticizing what they have heard of the plan through the media, but even some of president-elect's supporters question whether it is plausible that so many new jobs can be created. "Time and again history has proven government-centered job creation doesn't work. Under [President] Carter in the late '70s people had all sorts of plans and ignored larger economic realities," former Speaker of the House Newt Gingrich told ABCNews.com. "In Japan they spent 13 years building an airport no one wants use. Under the Socialists the French tried over and over again to create jobs and it didn't work. We know what creates jobs and it isn't putting the Treasury Department at the center of American capitalism. We need an investment strategy that supports the private sector and small entrepreneurial businesses," he said.
Just before Thanksgiving, Obama pledged to "create or preserve" 2.5 million jobs, a figure he increased to 3 million less than a month later after receiving projections that indicated that without substantial action, up to 4 million jobs will be lost in 2009 and unemployment could rise to 9 percent or more. The unemployment rate in November 2008 -- the last month the federal government released statistics -- was 6.7 percent, the highest in 15 years. In his weekly radio address on Saturday, Obama called creating 3 million new jobs "the number one goal of my plan" and said 80 percent of them would be in the private sector. "There is a real difference between creating 3 million new jobs and creating or preserving 3 million jobs," Robert Reich, treasury secretary under Bill Clinton, told ABCNews.com. "The economy lost 1.9 million jobs in 2008, and if nothing is done we'll probably lose 2 million or more in 2009. The stimulus plan could conceivably prevent a lot of that from happening."
Speaking on Saturday, Obama did not give a timeframe in which the new jobs would be created, but in December he set a goal of creating or saving 3 million jobs in two years. "Creating and preserving jobs is a more realistic goal than just creating them and it depends on the timeframe. Something needs to be done to stop the erosion in 2009," said Reich who will testify about the unemployment rate Wednesday on Capitol Hill. In 2009, Reich said, a goal of creating or saving a total of 1.5 million jobs was reasonable, but employment rates were contingent more on stimulating the economy back to health than establishing jobs programs. "Realistically," he said, "instead of 2.5 million jobs lost in 2009, you lose 1.5 million, so that's 1 million there. If we create new jobs net half a million, that's a total of 1.5 million." During the presidential campaign -- before the scope of the unemployment crisis was known -- Obama pledged to invest $150 billion over 10 years to create some 5 million "new green jobs" in industries that will produce the next generation of alternative fuels, plug-in hybrid automobiles and a power grid.
An aide to the Obama transition told ABCNews.com that some of the 3 million jobs would come from those 5 million green jobs. "The 5 million green jobs [are] over a longer time horizon," the transition aide said. "So there's overlap -- some of the 3 million would be green jobs that count towards the 5 million green jobs. But they are certainly not additive." The green jobs promised during the campaign would harness "America's highly-skilled manufacturing workforce," according the campaign's Web site to create new biofuels and hybrid cars, jobs that would potentially require years of training and retooling before they could become a reality. Obama today is still talking about environmentally friendly jobs, but in industries that would require far less investment or training. Instead of jumping to overhaul the national power grid, the president-elect wants to first employ people to weatherize homes and public buildings to make them more energy efficient.
The bulk of the new jobs in the short run will not be in green industries or new technology the but in old-fashioned construction and repair projects -building roads, bridges and schools- reminiscent of the New Deal's WPA. Obama has said he wants to target projects deemed "shovel ready," and has insisted on a "use it or lose it" policy, warning states that they would lose the money if they didn't begin building promptly after receiving it, according to a transition aide. Obama has called plan "the largest new investment in national infrastructure since the creation of the federal highway system in the 1950s," but Republican lawmakers contend these projects could cost up to $1 trillion and were created by Obama and his team behind closed doors without their consultation.
"We need to find the right mix of tax relief and other measures to grow the economy," Senate Republican leader Mitch McConnell of Kentucky said in a statement last week. "This will require the consideration of alternative ideas, public Congressional hearings and transparency, not a rushed, partisan take-it-or-leave-it approach," he said. Today, Obama will reportedly meet House Speaker Nancy Pelosi of California and Senate Majority Leader Harry Reid of Nevada, both Democrats and then Republican leaders Sen. McConnell and Rep. John Boehner of Ohio.
Deflation is new Public Enemy No.1
Deflation, the steadily falling prices that are a byproduct of the virulent global recession and financial-market weakness, has emerged as a top danger for monetary policy markets in the U.S. and Europe, top central bankers made clear Sunday. In separate comments, Lucas Papademos, the number-two official at the European Central Bank, and Janet Yellen, president of the San Francisco Federal Reserve Bank, and one of the most influential officials at the Fed, said that they would quickly seek to contain the danger of deflation if it emerges in coming months.
Their remarks came at he American Economics Association convention. Yellen said the U.S. faces a clear risk of deflation: "The odds are high that over the next few years, inflation will decline below desirable levels." To keep falling prices from becoming entrenched, the Fed would have to make it clear to the financial markets that such an outcome is unacceptable. "I am optimistic that, by clearly communicating the Fed's commitment to low and stable inflation and by backing that commitment up with determined policy actions should the need arise, any deflationary pressures caused by the weak economy can be contained," Yellen said.
Papademos said the risk of deflation is a more distant threat to Europe. "We will do what is necessary, in terms of the timing and in terms of the size (of interest rate policy action) to ensure that price stability is preserved," Papademos told reporters. "Inflation will not be allowed to fall significantly below 2% for a protracted period of time, over the medium term, which we do not expect on the basis of our present analysis," he said. It was only this past summer that central bankers were focused on the risk of higher prices, or inflation. But the financial market collapse of mid-September radically changed the outlook. One effect of deflation is that consumers delay purchases in order to wait for better bargains. But a more pernicious threat, especially for the U.S., is that it would make household debt burdens heavier.
Japan has become ensnared in a deflation cycle that has cut the growth rate to a snail's pace. Prominent economists at the convention were not of one mind about whether an outbreak of deflation was likely. Some say the risk is remote. But many agree with Barry Eichengreen, a professor at the University of California at Berkeley, who called deflation "a very serious danger." Central bank officials are "scared, if not scared witless" about the specter of deflation, he said. The good news is that, because the Fed is so vigilant, the U.S. should be able to avert it, he said. Fed officials would use the new unconventional monetary policy measures to simply buy up "anything whose price shows signs of going down," he said. Eichengreen was less sanguine about Europe's chances of avoiding deflation. "There is more of a danger there," he said. The ECB is miles behind the Fed in cutting short-term interest rates and Europe does not have a unified fiscal policy authority, he noted.
Deflation: It's Starting to Get Silly
So, let me get this straight... After presiding over the inflation and bursting of the biggest financial bubble in the history of mankind, in the process blessing soaring home prices that far outstripped any reasonable expectation of borrowers to repay and praising the "financial innovation" of Wall Street for facilitating such, the smartest economists at the world's most important central banks are now concerned (actually, "scared witless" as you'll see below) that prices may fall.
Yes, "Deflation is the New Public Enemy Number 1". It says so right there in the MarketWatch headline in what is quickly becoming one of the silliest ongoing stories in the global economy - dimwitted economists are once again redirecting the discussion and a gullible public and financial media are going along... Deflation is the problem now. Never mind what led up to the current crisis. More of what got us into this mess is required to get us out. It seems "the drunk must be kept in Scotch a while longer".
Here she is, doe-eyed Janet Yellen, President of the Federal Reserve Bank of San Francisco to make the case for why all the stops must be pulled out - governments and central banks must borrow and print money as never before. Now that short-term interest rates are at zero, Ms. Yellen favors the expansion of the Federal Reserve's recent unconventional monetary policy measures where anything and everything is bought with newly created money. She also urged aggressive spending of newly borrowed money by the Obama administration. The menace is upon us again.
The scourge of "deflation" is here, where individuals see prices dropping like a rock and defer purchases, pulling the rug out from underneath a consumer-led economy, creating a vicious downward spiral, an economic black hole from which there is no escape. Never mind that people are scared witless because they fear for their job, their retirement accounts, their home, their children's future, and the Western way of life where overconsumption was the rule rather than the exception, something that, up until about a year ago, seemed like a birthright. Consumers are pulling back because they see prices falling - it's DEFLATION!! According to the MarketWatch report, central bankers are scared:
But many agree with Barry Eichengreen, a professor at the University of California at Berkeley, who called deflation "a very serious danger." Central bank officials are "scared, if not scared witless"about the specter of deflation, he said.
The good news is that, because the Fed is so vigilant, the U.S. should be able to avert it, he said. Fed officials would use the new unconventional monetary policy measures to simply buy up "anything whose price shows signs of going down," he said.
If only the Fed had been a so vigilant a few years ago.
U.S. Debt Expected To Soar This Year
With President-elect Barack Obama and congressional Democrats considering a massive spending package aimed at pulling the nation out of recession, the national debt is projected to jump by as much as $2 trillion this year, an unprecedented increase that could test the world's appetite for financing U.S. government spending. For now, investors are frantically stuffing money into the relative safety of the U.S. Treasury, which has come to serve as the world's mattress in troubled times. Interest rates on Treasury bills have plummeted to historic lows, with some short-term investors literally giving the government money for free. But about 40 percent of the debt held by private investors will mature in a year or less, according to Treasury officials. When those loans come due, the Treasury will have to borrow more money to repay them, even as it launches perhaps the most aggressive expansion of U.S. debt in modern history.
With the government planning to roll over its short-term loans into more stable, long-term securities, experts say investors are likely to demand a greater return on their money, saddling taxpayers with huge new interest payments for years to come. Some analysts also worry that foreign investors, the largest U.S. creditors, may prove unable to absorb the skyrocketing debt, undermining confidence in the United States as the bedrock of the global financial system. While the current market for Treasurys is booming, it's unclear whether demand for debt can be sustained, said Lou Crandall, chief economist at Wrightson ICAP, which analyzes Treasury financing trends. "There's a time bomb in there somewhere," Crandall said, "but we don't know exactly where on the calendar it's planted."
The government's hunger for cash began growing exponentially as the nation slipped into recession in the wake of a housing foreclosure crisis a year ago. Washington has since approved $168 billion in spending to stimulate economic activity, $700 billion to prevent the collapse of the U.S. financial system, and multibillion-dollar bailouts for a variety of financial institutions, including insurance giant American International Group and mortgage financiers Fannie Mae and Freddie Mac. Despite those actions, the economic outlook has continued to darken. Now, Obama and congressional Democrats are debating as much as $850 billion in new federal spending and tax cuts to create or preserve jobs and slow the grim, upward march of unemployment, which stood in November at 6.7 percent.
Congress is not planning to raise taxes or cut spending to cover the cost of those programs, because economists say doing so would further slow economic activity. That means the government has to borrow the money. Some of the borrowing was done during the fiscal year that ended in September, when the Treasury added nearly $720 billion to the national debt. But the big borrowing binge will come during the current fiscal year, when the cost of the bailouts plus another stimulus package combined with slowing tax revenues will force the government to increase the debt by as much as $2 trillion to finance its obligations, according to a Treasury survey of bond dealers and other market analysts.
As of yesterday, the debt stood at nearly $10.7 trillion, of which about $4.3 trillion is owed to other government institutions, such as the Social Security trust fund. Debt held by private investors totals nearly $6.4 trillion, or a little over 40 percent of gross domestic product. According to the most recent figures, foreign investors held about $3 trillion in U.S. debt at the end of October. China, which in October replaced Japan as the United States' largest creditor, has increased its holdings by 42 percent over the past year; Britain and the Caribbean banking countries more than doubled their holdings. Economists from across the political spectrum have endorsed the idea of going deeper into debt to combat what many call the most dangerous economic conditions since the Great Depression. The United States is in relatively good financial shape compared with other industrial nations, such as Japan, where the public debt equaled 182 percent of GDP in 2007, or Germany, where the debt was 65 percent of GDP, according to a forthcoming report by Scott Lilly, a senior fellow at the Center for American Progress.
Even a $2 trillion increase would push the U.S. debt to about 53 percent of the overall economy, "only a few percentage points above where it was in the early 1990s," Lilly writes, noting that plummeting interest rates show that "much of the world seems not only willing but anxious to invest in U.S. Treasurys, which are seen as the safest security that an investor can own in a risky world economy." Still, some analysts are concerned that the deepening global recession will force some of the largest U.S. creditors to divert cash to domestic needs, such as investing in their own banks and economies. Even if demand for U.S. debt keeps pace with supply, investors are likely to demand higher interest rates, these analysts said, driving up debt-service payments, which last year stood at $250 billion.
"When you accumulate this amount of debt that we're moving into, it's not a given that our foreign friends are going to continue on the path they've been on," said G. William Hoagland, a longtime Republican budget analyst who now serves as vice president for public policy at the health insurer Cigna. "There's going to come a time when we can't even pay the interest on the money we've borrowed. That's default." Others say those fears are overblown. The market for U.S. Treasurys is by far the largest and most liquid bond market in the world, and big institutional investors have few other places to safely invest large sums of reserve cash. Despite their growing domestic needs, "China and the oil countries are going to continue running large surpluses," said C. Fred Bergsten, director of the Peterson Institute for International Economics. "They certainly will be using money elsewhere, but I don't think that means they won't give it to us."
As for the specter of default, Steven Hess, lead U.S. analyst for Moody's Investors Service, said even a $2 trillion increase in borrowing would not greatly diminish the U.S. financial condition. "It's not alarmingly high by our AAA standards," he said. "So we don't think there's pressure on the rating yet." But that could change, Hess said. Nearly a year ago, Moody's raised an alarm about the skyrocketing costs of Social Security and Medicare as the baby-boom generation retires, saying the resulting budget deficits could endanger the U.S. bond rating. Even as the nation sinks deeper into debt to finance its own economic recovery, several analysts said it will be critical for Obama to begin to address the looming costs of the entitlement programs and signal that he has no intention of letting the debt spiral out of control. Failure to do so, Bergsten said, would "create dangers . . . in market psychology and continued confidence in the dollar."
Obama Eyes $300 Billion Tax Cut
President-elect Barack Obama and congressional Democrats are crafting a plan to offer about $300 billion of tax cuts to individuals and businesses, a move aimed at attracting Republican support for an economic-stimulus package and prodding companies to create jobs.
The size of the proposed tax cuts -- which would account for about 40% of a stimulus package that could reach $775 billion over two years -- is greater than many on both sides of the aisle in Congress had anticipated. It may make it easier to win over Republicans who have stressed that any initiative should rely more heavily on tax cuts rather than spending.
The Obama tax-cut proposals, if enacted, could pack more punch in two years than either of President George W. Bush's tax cuts did in their first two years. Mr. Bush's 10-year, $1.35 trillion tax cut of 2001, considered the largest in history, contained $174 billion of cuts during its first two full years, according to Congress's Joint Committee on Taxation. The second-largest tax cut -- the 10-year, $350 billion package engineered by Mr. Bush in 2003 -- contained $231 billion in 2004 and 2005. Republicans and business leaders hadn't seen specifics of the proposals Sunday night, but welcomed the idea of basing a bigger proportion of the stimulus plan on tax cuts. Their response suggests the legislation could attract relatively broad support, and it highlighted the Obama team's determination to win backing from varied interests. Some Republicans, including Senate Minority Leader Mitch McConnell (R., Ky.), have warned against a careless stimulus plan that enables unfettered spending.
The largest piece of tax relief in the new plan would involve cuts for people who pay income taxes or who claim the earned-income credit, a refund designed to lessen the impact of payroll taxes on low- and moderate-income workers. This component would serve as a down payment on the "Making Work Pay" proposal Mr. Obama outlined during his election campaign, giving a credit of $500 per individual or $1,000 per family. On the campaign trail, Mr. Obama said he would phase out a similar tax-credit proposal at around $200,000 per household, but aides said they haven't settled on an income cap for the latest proposal. This part of the plan is similar to a bipartisan initiative launched in early 2008, which sent out checks worth $131 billion.
Economists of all political stripes widely agree the checks sent out last spring were ineffective in stemming the economic slide, partly because many strapped consumers paid bills or saved the cash rather than spend it. But Obama aides wanted a provision that could get money into consumers' hands fast, and hope they will be persuaded to spend money this time if the credit is made a permanent feature of the tax code. As for the business tax package, a key provision would allow companies to write off huge losses incurred last year, as well as any losses from 2009, to retroactively reduce tax bills dating back five years. Obama aides note that businesses would have been able to claim most of the tax write-offs on future tax returns, and the proposal simply accelerates those write-offs to make them available in the current tax season, when a lack of available credit is leaving many companies short of cash.
A second provision would entice firms to plow that money back into new investment. The write-offs would be retroactive to expenditures made as of Jan. 1, 2009, to ensure that companies don't sit on their money until after Congress passes the measure. Another element would offer a one-year tax credit for companies that make new hires or forgo layoffs, which could be worth $40 billion to $50 billion. And the Obama plan also would allow small businesses to write off a broad range expenditures worth up to $250,000 in 2009 and 2010. Currently, the limit is $175,000.
William Gale, a tax-policy analyst at the Brookings Institution think tank in Washington, said the scale of the whole package is larger than expected. He called the business offerings a true surprise, since most attention has been focused on the spending side of the equation, especially the hundreds of billions of dollars being discussed for infrastructure and aid to state and local governments. "On the other hand, it was hard to figure out how they were going to spend all that money in intelligent ways, so it makes sense to do more on the tax side," Mr. Gale said. His biggest question about the latest proposal concerns the credits for hiring new workers or refraining from layoffs. Much of that money would likely go to companies that would have hired more people anyway, he said, adding that it is impossible to know what firms would have done without such a credit.
Business lobbyists are pushing hard for Congress to allow companies that haven't paid corporate income taxes to get a break, too. Start-up companies, alternative-energy firms and large corporations that have been swallowing losses for years -- such as automotive and steel companies and some airlines -- have already begun lobbying for such "refundability." They argue that a provision to claim losses on back taxes will have little effect on the economy if firms that need it most -- struggling companies that weren't obligated to pay any taxes -- can't benefit from a tax break. Mr. Obama, however, doesn't back payments to companies that haven't paid taxes, aides said. Instead, businesses that haven't been paying taxes would be able to get payments from tax credits they would have taken in 2008 and 2009 for incentives offered by Congress, such as the production tax credit offered to renewable-energy firms. These amounts would likely be relatively small.
"We're working with Congress to develop a tax-cut package based on a simple principle: What will have the biggest and most immediate impact on creating private-sector jobs and strengthening the middle class?" said transition-team spokeswoman Stephanie Cutter. "We're guided by what works, not by any ideology or special interests." As these details are being worked out, Mr. Obama and his family left Chicago during the weekend for Washington. He will be on Capitol Hill Monday, first to meet with House Speaker Nancy Pelosi (D., Calif.) and Senate Majority Leader Harry Reid (D., Nev.), then with the broader bipartisan leadership of Congress. The stimulus package will be front-and-center in those discussions. Democratic leaders and Obama aides acknowledge that congressional Democrats' initial goal of passing the recovery package before Mr. Obama's Jan. 20 inauguration is unrealistic. Now, they hope for passage before the Feb. 13 congressional recess.
Republicans are already criticizing parts of the stimulus package. Sen. McConnell, speaking Sunday on ABC's "This Week," questioned one of the biggest items, which would send as much as $200 billion to states largely to expand the federal share of Medicaid, the health program for the poor. He suggested structuring that aid as a loan, saying it would encourage states to "spend it more wisely." An array of business tax cuts could help overcome such GOP opposition, enabling the Democrats to present their plan as a balanced mix of tax cuts and spending. It also would likely encourage business interests to lobby hard for its enactment. Mr. Obama's team has spoken of wanting to attract significant Republican support, not simply picking up votes from a Republican moderate or two.
Obama aides have already enlisted business groups to rally behind spending for public-works projects. Norman R. Augustine, a former chairman and chief executive of Lockheed Martin Corp., will testify before the House Democrats' Steering and Policy Committee Wednesday in favor of an infusion of federal infrastructure spending. But the tax cuts may hold more sway with Republicans.
Fed Officials Endorse 'Big Stimulus' to Battle U.S. Recession
Federal Reserve officials, after taking the historic step of cutting the benchmark interest rate to as low as zero, are calling for greater government spending to help revive the U.S. economy. San Francisco Fed President Janet Yellen said yesterday at an economics conference in San Francisco that "it’s worth pulling out all the stops" with an economic recovery package. Charles Evans, president of the Chicago Fed, told the same gathering he believes a "big stimulus is appropriate." The remarks underscore the view of many economists that unprecedented fiscal measures are needed to combat the yearlong recession, and come ahead of meetings this week between President-elect Barack Obama and congressional leaders. They also reflect the failure of Fed efforts so far, including record rate cuts, emergency lending programs and backstops for debt markets, to halt the crisis.
Yellen, Evans and other officials at the conference didn’t specify their recommendations for the size of the stimulus. Obama is asking that tax cuts make up 40 percent of a package that may be worth as much as $775 billion, a Democratic aide said yesterday. Yellen said she favors a "diversified package of policies" that includes government spending. "Fiscal stimulus has got to be an important part of the package" implemented by the federal government, Frederic Mishkin, a former Fed governor, said yesterday at the conference in San Francisco. The "$500 billion-plus question" is, "can they get it right?" he said. The "financial shock" that caused the current crisis is "worse than the one that happened during the Great Depression," he said. Mishkin left the central bank in August and returned to his post as a professor of economics at Columbia University.
The stimulus that emerges from talks between Obama’s aides and Congress will be much larger than the $150 billion proposal from lawmakers in October, when Chairman Ben S. Bernanke endorsed the concept of such a program. He noted then that the impact of the $168 billion stimulus a year ago had waned. Obama, who has picked New York Fed President Timothy Geithner as his Treasury secretary, is honing a combination of tax cuts and spending on roads, bridges and other infrastructure to create or save 3 million jobs. Economists and a group of Democratic governors led by New Jersey’s Jon Corzine have called for a $1 trillion program. Obama takes office Jan. 20. "The current downturn is likely to be far longer and deeper than the ‘garden-variety’ recession," Yellen, who became chief of the San Francisco Fed in 2004, said in a speech. "If ever, in my professional career, there was a time for active, discretionary fiscal stimulus, it is now."
Yellen was an adviser to the last Democratic president, Bill Clinton, serving as chairman of his Council of Economic Advisers from 1997 to 1999 after a stint as a Fed governor in Washington. Last month, Fed policy makers reduced their target for the federal funds rate, or the rate banks charge one another for overnight loans, to as low as zero for the first time in an attempt to end the longest economic slump in a quarter-century. The central bank is also shifting its focus to the amount and type of debt it buys, with announcements of new lending programs or asset purchases serving as the principal signals of policy. Economic data released last week show U.S. consumer confidence sinking to the lowest level in at least 41 years and home prices in 20 major cities declining at the fastest rate on record. Another report showed that the decline in U.S. manufacturing deepened in December.
"The current downturn is likely to last much longer than previous ones," said Harvard University economics professor Martin Feldstein, former president of the National Bureau of Economic Research. "So, fiscal policy is likely to be useful." Still, such stimulus would increase the long-term burden on taxpayers, Evans said in his Jan. 3 speech. "Federal debt held by the public is 38 percent of GDP, states have large unfunded liabilities and growing numbers of retiring baby-boomers will further pressure the unfunded liabilities for Social Security and Medicare," Evans said. University of Chicago professor Raghuram Rajan, former chief economist at the International Monetary Fund, said in an interview at the conference that he’s "in the crowd that is a little more skeptical" about a federal effort to rejuvenate the economy, especially a proposal to provide federal funds to states.
"The U.S. is of course central to the world economy, and so getting the U.S. back on track I think is very important," Rajan said. "The real issue is cleaning up the financial sector," he said, adding he wants to see from the Obama administration a "clear plan" of how to handle "weak" companies. The outgoing Bush administration has thrown a lifeline to the troubled automobile industry, granting loans worth $13.4 billion to keep General Motors Corp. and Chrysler LLC from bankruptcy for now. The U.S. Treasury also threw the door open to taxpayer financing for a widening array of companies and industries last week, drafting broad guidelines on aid to the auto industry.
Treasury guidelines would let officials provide funds to any company they deem important to making or financing cars. That left room for the government to provide money from the $700 billion Troubled Asset Relief Program beyond loans already committed to GM, Chrysler and GMAC LLC. Mishkin said working as a Fed policy maker during the credit crisis is similar to serving in a wartime Pentagon. The central bank is "fighting a war," he said. Instead of deploying "tanks and guns," it’s "monetary policy, credit policy and liquidity policy."
Banks' 'Catatonic Fear' Means Consumers Don’t Get TARP Relief
As the new owner of $172.5 billion of preferred shares and warrants in 208 U.S. financial institutions, the Treasury Department hasn’t succeeded in thawing frozen credit markets, leaving taxpayers propping up an industry that won’t lend to them. While inter-bank lending rates have fallen since Congress approved the $700 billion Troubled Asset Relief Program on Oct. 3, most bank lending to consumers remains tight and interest rates high. The average credit-card rate was 14.33 percent on Dec. 16, according to IndexCreditCards.com in Cleveland, almost unchanged from 14.41 percent in October 2007. That’s prompted criticism from Alan S. Blinder, a professor of economics at Princeton University in New Jersey and a former Federal Reserve vice chairman, who says the government should take a more active role as a stakeholder in the nation’s banks.
"With the banks in a state of catatonic fear now, they’re just sitting on the capital," Blinder said in an interview. "I don’t fault the banks one bit, since this shows Wall Street they’re safer, but then this doesn’t get you much improvement. If you’re taking money from the public purse, we should get something in return, and we’re really not." Jeffrey Garten, a professor of international trade and finance at the Yale School of Management in New Haven, Connecticut, and a Commerce Department undersecretary during the Clinton administration, says banks should be forced to increase their lending or risk having taxpayer money taken away. "The government isn’t acting aggressively enough to demand a quid pro quo," Garten said. "The public good is the key to the private good in this case. It’s not the other way around."
Although the government has committed more than $8.5 trillion to energizing the economy, and the Fed cut a key lending rate almost to zero, banks haven’t made it easier to borrow. The Fed said consumer credit fell by $6.4 billion in August, the largest drop in 65 years, and then by $3.5 billion in October, the first time since 1992 that there were two months of declines in a year. In its most recent quarterly Senior Loan Officer Opinion Survey in October, the Fed reported that about 85 percent of U.S. banks said they had tightened standards on commercial and industrial loans to companies with more than $50 million in annual sales, up from 60 percent in July. Ninety-five percent said they increased the cost of those loans. About 70 percent said they made it more difficult to obtain prime mortgages, and almost 65 percent said they did the same for consumer loans.
While mortgage rates have declined, they haven’t fallen as fast as bank borrowing rates, meaning financial institutions are demanding more profit for every dollar they lend. Average rates on 30-year residential mortgages fell to 5.14 percent last month, according to data compiled by McLean, Virginia-based Freddie Mac. That’s down from 6.67 percent in June 2007, before the worst turmoil in the housing market. At the same time, the spread of mortgage rates over the 10-year Treasury bond yield rose to 2.958 percentage points from 1.567. The spread of rates on so-called jumbo mortgages, those of more than $729,750, is close to a record at 1.6 percentage points above the rate for smaller mortgages that conform to terms of ones Freddie Mac and Fannie Mae will purchase, according to financial data firm BanxQuote in White Plains, New York. A year ago the difference was 0.23 percentage points. High interest rates have angered consumers. The Fed has offered relief in the form of rule changes that allow banks to raise rates only on new credit cards and future purchases, not on existing balances. Banks will also have to give cardholders 45 days notice of changes in terms, up from 15 days. Those changes aren’t scheduled to take effect until July 2010.
"We own them now, and we should use that to make sure they stop ripping us off," said Gail Hillebrand, head of the financial-services campaign at Consumers Union, an advocacy group based in Yonkers, New York. "We shouldn’t allow banks to use the money to support things that hurt consumers and taxpayers. What we’re looking for is responsible behavior, not social benefits." Bank profits or returns on the government investments are secondary concerns, Hillebrand said. That view is opposed by free-market advocates such as Gary Becker, a professor of economics and sociology at the University of Chicago and a Nobel Prize winner, who says the primary aim of the government bailout should be a hasty withdrawal from investments that shouldn’t have been made in the first place. "If you believe in a private-enterprise system, you use competition to control the banks, not a stakeholding," Becker said. "It would be a grave mistake to use these private institutions for social goals."
Diane Casey-Landry, chief operating officer of the American Bankers Association, a trade group in Washington, said that bank profitability had to come ahead of any demand to ease lending. "Taxpayers should get a return on their investment," Casey-Landry said. "We have to go back to a time when we realize not everyone is entitled to get a loan. What is going to get us out of this recession is sound lending to people who are going to pay it back, not throwing money at people who can’t." When Congress passed the Emergency Economic Stabilization Act in October authorizing TARP, the funds were supposed to be used to acquire troubled mortgage-related assets from banks in order to ease credit. "The underlying weakness in our financial system today is the illiquid mortgage assets that have lost value as the housing correction has proceeded," Treasury Secretary Henry Paulson said on Sept. 19. "These illiquid assets are choking off the flow of credit that is so vitally important to our economy. When the financial system works as it should, money and capital flow to and from households and businesses to pay for home loans, school loans and investments that create jobs."
Two weeks after the legislation was passed, Paulson changed course and said it was more important to recapitalize the banks, allowing them to determine how best to deploy their capital. Since then, Treasury has allocated $250 billion to buy non- voting preferred shares of banks paying a 5 percent annual dividend, as well as warrants convertible into equity. The investments range from $25 billion each in JPMorgan Chase & Co., Citigroup Inc. and Wells Fargo & Co. in San Francisco to $1.6 million in Westminster, California-based Saigon National Bank. In addition, $40 billion has gone to New York-based American International Group Inc.; another $20 billion to Citigroup in New York, along with a $5 billion guarantee against possible losses; $20 billion to purchase consumer and small-business loans; and $13.4 billion to Detroit-based automakers General Motors Corp. and Chrysler LLC. Last week the government announced that $5 billion of TARP funds would be used to purchase preferred shares and warrants in GMAC LLC, the automaker’s financing arm, with Treasury separately lending another $1 billion to GM to support GMAC’s transition into a bank holding company.
With the exception of GMAC, which immediately began offering loans to GM customers with lower credit scores in order to halt the decline in auto sales, most financial institutions that received TARP funds have been reluctant to lend. "Right now there is no new lending, and without new lending it’s going to be difficult for the economy to recover," Roger Altman, founder and chief executive officer of boutique investment bank Evercore Partners Inc. and an assistant Treasury secretary in the Carter administration, said in a Dec. 29 interview with Bloomberg TV. A report released Dec. 2 by the Government Accountability Office in Washington questioned whether Treasury is policing the cascade of federal money closely enough. "Although Treasury has said that it expects the institutions to increase the flow of credit," the report said the department "has not yet determined whether it will impose reporting requirements on the participating financial institutions." David John, a senior fellow with the Heritage Foundation, a public policy and research group in Washington, said it was inappropriate for the government to demand policy changes from the banks and that doing so would be counterproductive because it would stifle innovation. Instead, he said banks should use the capital to recover stability and then be forced to return the taxpayer funds.
"Bureaucrats take no risks, they have no ideas," John said. "If this recoups a profit for the taxpayer, great, but a slight loss would be acceptable. I don’t see it as a long-term value to be an activist shareholder." There are no partisan lines separating those who favor a passive investment strategy and those who want the government to play a more active role. "I do not see the Treasury or the Fed as active investors in the banks, and it would be a mistake if they were," said Martin N. Baily, a chairman of the Council of Economic Advisers in the Clinton administration and now a senior fellow at the Washington-based Brookings Institution. "The goal is to stabilize the financial sector and to be mindful of the costs to taxpayers. Perhaps there will be positive returns on these investments, but not necessarily." Bruce Josten, executive vice president for governmental affairs at the U.S. Chamber of Commerce, a pro-business group, said taxpayers had a right to expect a loosening of credit by the banks, though the government "shouldn’t micromanage them."
"I don’t think there’s one good answer here," Josten said. "There’s no paint-by-the-numbers road map. It’s all improvised." For Garten, the unprecedented nature and scale of the problems means that policy makers and taxpayers will have to get used to a new way of thinking as long as the crisis lasts. "There’s a philosophical conflict in the American mind because we’re just not used to this level of intervention," Garten said. "That hang-up is not compatible with the depth of this crisis."
U.S. Retailers to Report Grim Results
When retailers report December sales on Thursday, the picture won't be pretty. Sales at stores open at least a year -- a key barometer of retail health -- are expected to show an average decline of 1.1%, according to analysts' estimates for 35 chains compiled by Thomson Reuters. The reports will likely confirm that the 2008 holiday season was the worst for retailers in decades. Excluding Wal-Mart Stores Inc., which has benefited from a consumer focus on buying necessities as the economy soured, the picture is even grimmer, with December sales falling an average of 6.3%, Thomson Reuters says. Some analysts expect an increase in the rate of gift returns, which could further crimp sales.
The December sales results would likely have been even worse if retailers hadn't slashed prices sharply before and after Christmas to lure shoppers. The discounts "will have turned what would have been a disastrous retail season into a dismal retail season," says Craig R. Johnson, president of Customer Growth Partners, a New Canaan, Conn., retail consulting and research firm. At Abercrombie & Fitch Co., a teen retailer that bucked the discounting trend, sales are expected to have plunged 20% last month, according to Thomson Reuters. That is worse than the expected decline of 14.6% for the teen-and-children's category overall and the 13% drop at American Eagle Outfitters Inc.
J.P. Morgan analyst Brian Tunick says children's retailers, in particular, suffered because "parents hesitated paying full price for things and finding them cheaper at Wal-Mart and Target." Among other apparel specialists, Gap Inc. is likely to report a 10.5% decline in sales, while women's-apparel retailer Chico's FAS Inc. will see sales fall 15%, according to Thomson Reuters. Among department stores, midmarket chains J.C. Penney Co. and Kohl's Corp. are expected to post declines of 12% and 5%, respectively, while the estimate for Macy's Inc. is a more modest decline of 2%. Chains that sell more-expensive goods are generally expected to do worse. At Nordstrom Inc., analysts expect sales to decline 16.5%. Saks Inc. is expected to post a decline of 11%.
Wal-Mart, meanwhile, is expected to continue to outperform its competitors, posting a 2.8% sales gain, according to Thomson Reuters. Wal-Mart has benefited from its focus on low prices and its selection of food and more brand names, particularly in electronics.Costco WholesaleCorp. and Target Corp. are expected to post sales declines of 3% and 7.3%, respectively, Thomson Reuters says.
Wall Street braces for 2009's first full week
Wall Street will open for trading Monday at a two-month high as investors have grown more optimistic that the worst of the market's rout might be over. But, analysts contend, the real test is still to come. There will be no shortage of economic data and potential corporate news as traders get back to work after the holidays. The real hope is that the market can build upon Friday's rally, when the Dow Jones industrial average snapped a four-week losing streak and closed above 9,000 for the first time since Nov. 5. The past month has shown that the negative sentiment about things like corporate earnings and still-sluggish credit markets have already been factored into the market. Analysts say the next few weeks will determine if investors are comfortable enough to return to the market -- with their fears of missing out on a rally outweighing concerns of a renewed downturn.
"There's now an estimated $8.9 trillion sitting on the sidelines in cash and money markets," said Stephen Leeb, president of New York-based Leeb Capital Management. "High cash levels and low stock prices historically go hand in hand. The current level as a percentage of the stock market's capitalization matches that at the market bottom in 1990." He said this huge amount of liquidity "has yet to include the massive amount of money that will be created as a result of the Federal Reserve's recent unprecedented actions to stimulate the economy and financial system." That also could help bolster markets in the coming months. Leeb and other analysts do not discount that the market may retreat and retest lows seen in November. The next few weeks will go a long way in assessing the market's resiliency, even in the face of abysmal economic news. Early futures prices pointed to a negative start to the week. Dow industrials futures dipped 22 points, or 0.25 percent, to 8,936. Broader indexes also slipped, with Standard & Poor's 500 index futures down 2.40 points, or 0.26 percent, to 923.00; while Nasdaq-100 futures shed 3.00, or 0.24 percent, to 1,250.00.
This week investors will be eyeing the Labor Department's December unemployment report, due out Friday. Employers are expected to have cut 475,000 jobs from their payrolls, according to analysts polled by Thomson Reuters. That would be below the 533,000 jobs in the previous month. Meanwhile, the unemployment rate is expected to have risen to 7 percent from 6.7 percent in November. The government will also release its weekly jobless claims report on Thursday, which is again expected to show another increase. Other reports on tap this week include November construction spending, auto sales reports, a survey on the services sector, November factory orders, and chain store sales. The Federal Reserve on Wednesday will release the minutes from its Dec. 15-16 policy-making meeting. At that meeting, the central bank lowered the federal funds rate to between zero percent and 0.25 percent, and indicated rates would remain at that level for foreseeable future. Also on Wednesday, the House Financial Services Committee meets to discuss how the next administration might make use of the remaining TARP funds. A House panel will also hold an economic recovery plan hearing with testimony from some of the nation's top economists.
The House Financial Services Committee on Monday will also hold a hearing on Bernard Madoff, the investor who lost potentially $50 billion in what is being called the biggest Ponzi scheme in U.S. history. In corporate news, technology stocks may also be in the spotlight with two major events planned -- Macworld and the Consumer Electronics Show. Apple Inc. will unveil some of its new products at Macworld in San Francisco on Monday and Tuesday, where investors will be looking for any signs into the health of Chief Executive Steve Jobs. He is not expected to attend the event. The Consumer Electronics Show will kick off in Las Vegas on Wednesday night. The trade show gives tech companies an opportunity to present new products, and that often can send their shares higher.
US will emerge as undisputed top dog in 2009
Interest rates near zero across the G10 bloc will prevent a replay of the Great Depression, but they will not pull us quickly out of the doldrums, writes Ambrose Evans-Pritchard. Central banks will do whatever it takes to combat debt deflation. Even Frankfurt will join the rush to print money, buying every form of debt from mortgages to corporate bonds. The Fed will follow the Bank of Japan in propping up stock markets. Puritans will grumble, but the surprise will be how it long takes for this stimulus to gain traction. We will learn the term "pushing on a string".
Western societies will feel the first shivers of raw fear as people twig that the authorities are not in control. Iceland's winter will set an awful example. Job losses will reach 1m a month in the US at the point of peak pain. Economists know this is a late-cycle effect – darkest before dawn – but the public will see it otherwise. This will be the phase that shakes society. The geopolitical landscape will look different. Cohesive states with a rule of law and old democracies – the Anglosphere, Holland, France, Scandies – will muddle through. They will start to enjoy a political premium in investor psychology, despite horrendous debts.
Obama's America will shine. The country will reemerge as undisputed top dog, the only one with real demographic, scientific, and strategic depth. As first into the crisis, it will be the first to hit bottom. Those expecting the dollar to collapse will have to wait. The damage to core Europe will take longer, but run deeper. Belgium will face a break-up scare. Markets will test highdebt states as they try to roll over bonds – €200bn (£191bn) for Italy and €40bn for Greece. Spain's corporate debts will turn bad. Germany's economy will contract by 3pc as exports collapse, and the delayed effects of the strong euro and tight money feed through. Angela Merkel's Left-Right coalition will be haunted by its failure to tackle the crisis earlier.
The neo-Marxist Linke party and the hard-Right will muscle in. The country will start to look ungovernable. This will at least divert attention from the Club Med mess, making a North-South split in the eurozone less likely. After sterling's sudden death, the euro will face slow death. The pair will refind their accustomed level. Authoritarian regimes will fare badly. Those that depend on perma-boom to hold power will fray. Repression will escalate in China as an inflammatory cocktail of migrant workers and jobless graduates vent their anger in riots. Massive fiscal spending will buy time. The Kremlin will not have that option. Oil at $40 (£28) a barrel will expose the insolvency of the Russian state, forcing spending cuts. Anti-Kremlin marches will evolve into a simmering rebellion, setting off pitched battles with police. Analysts will be shocked by the ferocity of the downturn across Asia, where the strategy of export-led growth will be called into question.
It will become clearer that Asia's boom has been a leveraged play on the West, and leverage works both ways. Some Pacific tigers will try to resist the denouement by holding down currencies. Such beggar-thy-neighbour policies will lead to tit for tat responses. The US and Europe will tire of holding the ring for free trade. The WTO will look ever more like the League of Nations. By late 2009, the massive monetary and fiscal stimulus will feed through. Angst will start to switch from deflation back to the risk of incipient inflation. Equities, oil, and gold will rally. Bonds will falter, and then crash. At that point it will become clear that reflation is just as dangerous as deflation in a world of debt. We will find that there is no way out. But that, perhaps, can wait until 2010.
Only Government Bonds Returned Profits to Investors Last Year
Investors could have made money last year simply by holding developed-market government bonds, but almost every other kind of liquid asset lost money. And even in the bond markets, fund managers' performances varied widely. U.S. government bonds rose 9% in 2008, according to the J.P. Morgan index of U.S. government bonds with a maturity of one to five years, with other indexes of U.S. government bonds showing similar returns. European government bonds also made a positive return for investors, with the J.P. Morgan EMU government-bond index up 2%.
European corporate bonds earned investors 3%, according to J.P. Morgan's index of euro-sterling corporate bonds with maturities of more than 10 years. But U.S. corporate bonds lost money for investors; the J.P. Morgan credit index of other corporates with a maturity of five to seven years dropped 13%, for example. Investments in equities fared badly last year, with the MSCI World index of all equities falling 42%. The falls in stock markets will have counted far more with investors than the returns on their other investments, because they accounted for a more significant portion of their total investments.
If passive investments in equity markets would have mostly lost money for investors, those investors that employed a stock picker would have had to choose their manager with care, or good fortune, if they were to make money. According to data provider Morningstar's analysis of funds available to retail investors, which serves as a proxy for the returns generated for institutional and rich, or high-net-worth, investors as well, the top three funds invested in dollar government bonds made returns of more than 50%, but the worst performer lost 7%. In emerging market equities, the top performing fund lost 4% while the worst performer lost 58%.
Investors dump $89 billion in U.S. securities in historic fire sale
The deep river of private money that helped knit together the global economy has abruptly dried up, new government figures show. As the global financial crisis grew more severe this summer, foreigners sold almost $90 billion of U.S. securities — the greatest quarterly fire sale by overseas investors since the government began keeping track in 1960. U.S. investors also are retrenching; they unloaded about $85 billion worth of foreign holdings in the quarter, says the Commerce Department's Bureau of Economic Analysis.
"We've had a global panic. Everyone is pulling their money home," says economist Adam Posen of the Peterson Institute in Washington, D.C. That's bad for economic growth in the U.S. because it threatens to starve capital-hungry companies and entrepreneurs. But it's especially serious for emerging-market countries that rely heavily on outside financing. Capital flows into countries such as South Korea, Turkey and Brazil were evaporating even before the mid-September Lehman Bros. bankruptcy made things worse.
The reversal of private capital flows signals an abrupt end to a nearly two-decades-long era of financial globalization, says economist Brad Setser of the Council on Foreign Relations. Private flows into and out of the U.S. for purchases of stocks, corporate bonds and federal agency bonds have dropped from around 18% of economic output to near zero "in a remarkably short period of time," Setser says. The past five quarters — roughly since the August 2007 onset of the financial crisis — private foreign investors have been net sellers of U.S. securities. The turnabout represents a dramatic change from the first half of 2007 when foreign purchases of U.S. securities other than Treasuries averaged about $250 billion per quarter.
The past two quarters also have seen an about-face in cross-border bank flows as institutional investors found lenders unwilling to extend credit. In the first quarter of 2008, foreigners deposited more than $79 billion with U.S. banks. That flow reversed in the second quarter, as foreigners withdrew a staggering $256 billion, and the outflow continued in the third quarter with an additional $147 billion. Likewise, banks in the U.S. brought home more than $151 billion in the quarter, as overseas institutions repaid loans. "Institutional investors, including banks, across the board are pulling their capital back home," says economist Eswar Prasad of the Brookings Institution. One bright spot: Foreign central banks continue to spend heavily on U.S. government securities, allowing the U.S. to finance the gap between what it produces and consumes.
Profit Slump Deepens Worldwide as Shrinking Orders Raise Bankruptcy Risk
Corporate earnings will continue to slump into the first half of 2009 amid the first simultaneous recessions in the U.S., Japan and Europe since World War II. Earnings at Standard & Poor’s 500 companies will probably fall in the first half, marking eight straight quarters of declines. In Europe and Asia, the outlook may be even worse as the recession curbs demand for retail goods and exports. "It’s going to be a miserable ride," said Bruce McCain, chief investment strategist at Cleveland-based Key Private Bank, which manages about $30 billion. Earnings probably won’t rebound until the end of 2009, he said. "The market recovers, then the economy recovers, then finally the earnings recover."
Companies are battling falling consumer demand and dwindling cash flows after banks tightened lending to cope with billions of dollars of real-estate losses. The U.S. Federal Reserve has cut interest rates to as low as zero percent, while governments worldwide have taken stakes in banks and companies to prevent a collapse of the global financial system. "We hit the peak in earnings in 2007, and in 2009 we’re going to see continued deterioration," said Diane Garnick, who helps oversee $500 billion as an investment strategist at Invesco Ltd. in New York. Analysts’ earnings estimates are "still way too optimistic." In the U.S., profit at Standard & Poor’s 500 companies will fall 11 percent in the first quarter, followed by a 6.2 percent drop in the following three months, according to data compiled by Bloomberg. Earnings should improve in the second half, driven by a rebounding financial industry, the data show.
While profits will rise 4.3 percent for the full year in the U.S., earnings in Europe are projected to decline for all of 2009 and analysts predict worsening reports out of Asia because the recession hasn’t fully hit there yet The energy industry will lead U.S. declines, with earnings estimated to drop 29 percent in 2009. Profit at Exxon Mobil Corp., Chevron Corp. and ConocoPhillips, the largest U.S. oil companies, will probably fall after the recession sapping fuel demand, spurring a 78 percent drop in crude-oil prices from July’s record. At Irving, Texas-based Exxon Mobil, the world’s biggest publicly traded company, earnings will probably tumble 39 percent to $28.2 billion, the first decline since 2002, according to a Bloomberg survey of analysts. "We expect industry earnings to be down sharply, especially in exploration and production," said Gene Pisasale, who helps manage $13 billion at PNC Capital Advisors in Baltimore.
Earnings at U.S. retailers will fall 20 percent this year, according to analysts’ estimates. The International Council of Shopping Centers in New York predicts 73,000 U.S. stores may shut in the first half of 2009 after what may have been the worst holiday-shopping season in 40 years. That’s after about 148,000 stores closed last year, the most since the 2001 recession, according to the trade group. "You’ll see department stores, specialty stores, discount stores, grocery stores, drugstores, major chains -- either multi- regionally or nationally -- go out," said Burt Flickinger, managing director of Strategic Resource Group, a retail-industry consulting firm in New York. AnnTaylor Stores Corp., Talbots Inc. and Sears Holdings Corp. are among chains shuttering underperforming locations as consumers tighten budgets. More than a dozen U.S. retailers filed for bankruptcy in 2008, including Circuit City Stores Inc., Linens ‘n Things Inc. and Sharper Image Corp. Wal-Mart Stores Inc., the largest retailer, may report a 6 percent profit increase this year by offering lower prices to consumers seeking bargains, according to estimates.
JPMorgan Chase & Co., Citigroup Inc., Bank of America Corp., Goldman Sachs Group Inc. and Morgan Stanley, the biggest U.S. banks, will probably post higher profits this year compared with 2008, when finance companies wrote down more than $720 billion of losses. "For the large financials, it’s going to be a very difficult year," said David Burg, a Purchase, New York-based analyst at Alpine Woods Capital Investors LLC, which manages about $6.5 billion, including JPMorgan shares. "The story for 2009 continues to be radical transformation -- companies fundamentally changing their business model." Goldman Sachs and Morgan Stanley, which were the two biggest U.S. securities firms before converting into banks, will suffer from a 15 percent decline in mergers and acquisitions and slowing underwriting fees, Kenneth Worthington, an analyst at JPMorgan in New York, said last month in a note.
U.S. automakers will show some improvements in 2009 after sales plummeted last year, forcing the government to lend $13.4 billion to General Motors Corp. and Chrysler LLC to keep them out of bankruptcy. GM’s loss may narrow to $12.8 billion from $19.6 billion last year, according to analysts’ estimates. Ford Motor Co. may report a loss of $6.38 billion, compared with $9.2 billion last year, the estimates show. Technology will be one of the best-performing sectors in the second half as customers start to increase budgets, said Pete Sorrentino, senior portfolio manager for Cincinnati-based Huntington Asset Management, which oversees $16.5 billion. Earnings at software and services companies may rise 8.1 percent in 2009, while profits at hardware makers may slip 6.7 percent, according to analysts’ estimates. Consumers may continue to curb spending in the first half, dragging down sales at Apple Inc., maker of the iPhone and Macintosh computers, David Bailey, an analyst at Goldman Sachs in New York, said last month. Google Inc., owner of the most popular search engine, will probably post a 14 percent increase in profit in 2009 as it clamps down on spending, according to the estimates.
Health care will be one bright spot, as sick people still need medical treatment, said Les Funtleyder, an analyst with Miller Tabak & Co. in New York. Profit at Standard & Poor’s 500 drug companies and medical equipment makers, such as Johnson & Johnson and Pfizer Inc., may increase 6.8 percent in 2009. "Health care tends to be recession-resistant," Funtleyder said. "Some people may use fewer drugs, so that’s obviously a bad thing, but it’s less cyclical than other industries." In Europe, profits at Dow Jones Stoxx 600 Index companies may fall less than 1 percent this year, compared with a 17 percent decline in 2008. Oil and gas companies face the heaviest declines, according to analysts’ estimates. "The biggest near-term risk is how tough it’s getting overseas," said McCain at Key Private Bank. "That’s the wild card." Earnings at European oil companies may drop 21 percent in 2009, compared with a 4.7 percent gain last year, according to estimates. Profit at Royal Dutch Shell Plc, Europe’s largest oil company, may drop 27 percent. The company postponed projects in Canada and Australia as demand for oil declined.
European retailers may post a 12 percent drop in earnings this year. Discounts of 70 percent or more during the holiday shopping season by U.K. stores hurt profit margins and may lead to a raft of bankruptcies, said Nick Hood at Begbies Traynor. Nokia Oyj, the largest mobile-phone maker, said last month the global handset market may contract this year for the first time since 2001. Earnings at Espoo, Finland-based Nokia could decline 14 percent in 2009, according to analysts’ estimates. Half of Asia will probably be in recession this year as a $700 billion drop in export earnings causes economies in Japan, Hong Kong, Singapore, South Korea and Taiwan to shrink, according to Macquarie Group Ltd. Japanese corporate earnings may extend their slump after the yen rose against all major currencies in 2008 and eroded the value of exports. Credit Suisse Group AG estimates earnings will be weakest in the first half at carmakers, machinery producers and technology companies. Japanese automakers are slashing output, jobs and profit forecasts as the global recession deters consumers from buying new cars and sport-utility vehicles. Toyota Motor Corp., Japan’s biggest automaker, last month predicted its first operating loss in 71 years for this fiscal year because of the slump and a stronger yen.
Vehicle demand from emerging markets, where automakers had counted on sales shoring up collapsing demand in the U.S., Europe and Japan, is also likely to decline as fallout from the credit crunch and economic slump spread, said Song Sang Hoon, a Seoul- based analyst at Kyobo Securities Co. "No one will be immune from this downturn. It’s time to see who’s losing least, not who’s winning more," he said. Among technology companies, Tokyo-based Sony Corp. will begin eliminating 16,000 jobs as the slump undermines sales of Bravia televisions and Cyber-shot digital cameras. Panasonic Corp. is projecting profit in the year ending March 31 will be 90 percent lower than previously anticipated.
Asian banks will grapple with falling earnings and rising defaults on loans this year as economies from China to Australia slow, prompting central banks to slash interest rates, said Tim Rocks, an Asian equities strategist at Macquarie in Hong Kong. Lenders in Japan, Australia, Singapore and South Korea raised money in the final quarter of 2008 after they escaped most of the initial writedowns and credit losses that forced U.S. and European rivals into government takeovers. "This quarter and the first quarter ‘09 are just going to be really ugly quarters," said Frederic Dickson, who helps manage about $19 billion at D.A. Davidson & Co. in Lake Oswego, Oregon. "It’s just going to take a long time to get confidence restored."
US consumers to Pare High-Tech Purchases
More than half of U.S. consumers plan to cut back on purchases of high-tech products this year, according to a survey that adds to clouds hanging over two big trade shows this week. The findings by Forrester Research, scheduled for release Monday, aren't surprising, given the litany of bad economic news since September. But the online survey of more than 5,000 American adults, conducted in November, provides some of the first specifics about spending choices that consumers are likely to make. The findings are particularly gloomy for newer categories of devices. Some 66% of respondents, for example, said they were less likely to purchase satellite radios this year because of the sour economy, while 62% said they are less likely to buy a portable Global Positioning System navigation device. Even smart phones, a hot category lately, aren't immune: 63% of respondents said they are less likely to buy one.
More established categories of products also fared poorly. Sixty-two percent of those surveyed said they are less likely to buy a new videogame console, Forrester said. As for personal computers, 45% of respondents said they have delayed plans to purchase new ones, though 40% said they hadn't changed their purchasing plans. Eighteen percent of respondents said they now plan to spend less money on a new system. Television sets fared a bit better, with 44% of respondents saying they haven't changed their plans to buy a new set. In all, 51% of respondents said they would spend less on technology this year, while 44% said they would spend the same. Only 5% said they would spend more. "It's pretty grim," said Paul Jackson, a principal analyst with Forrester.
The findings from the Cambridge, Mass., firm are the latest in a series of ominous portents preceding Macworld and the Consumer Electronics Show. The trade shows -- in San Francisco and Las Vegas, respectively -- are expected to draw hundreds of exhibitors this week despite the tough economic environment. While the downturn took hold too recently for companies to change plans for introducing products at the shows, many are sending fewer employees while laying plans for new tactics over the course of the year. Companies such as Forrester and consulting firm Accenture are offering a number of recommendations, including developing fewer, more highly differentiated products and tailoring them to market segments and regions that are relatively recession-resistant.
"There are still some geographies that are performing well," said Marty Cole, chief executive of Accenture's communications and high-tech operating group. "You can't paint it with a broad brush." Indeed, surveys point to a few signs of strength in the tech sector, particularly in services that consumers feel they can't do without. An Accenture survey found that only 3.7% of U.S. consumers are willing to stop using home Internet access, 8.7% are willing to give up mobile-phone service and just 9.6% are willing to stop using cable or satellite TV services. Those findings echoed those of the Forrester survey about consumers' commitment to mainstream technology services. But not many people plan to add new services: 58% of respondents said they don't have a digital video recorder service and don't plan to add one, while 69% said they wouldn't add a video rental service akin to that offered by Netflix Inc., Forrester said.
"Indications are when it comes time for renewals, people may reduce their service packages," Mr. Jackson said. "That is a long-term danger that may be more keenly felt later." Gadget makers and service providers can also take solace in signs that consumers will allocate more of their spending to home entertainment. Forrester said 52% of respondents expect to spend less on entertainment outside the home and 56% said they will spend less on eating out. About 58% said they will spend the same amount on entertainment in the home.
Europe’s ‘Detroit’ runs into rough terrain
The General Motors factory in Gliwice in Poland is one of the most efficient in the ailing company, but that has not protected it from the downswing in the car industry. The factory is reducing shifts from three to two this month, and is laying off contract workers. Tony Francavilla, the factory’s general manager, says that until late last year everything was going well, “until the floor fell out from under the market”. He adds that sales of the Zafira model, the factory’s main product, have fallen by about 30 per cent. It is a situation being repeated across central Europe, a region that had become Europe’s Detroit due to cheap but highly skilled labour, membership of the European Union and good transport links with the west. With small local markets that favour used cars over new, the vast majority of production is exported to western Europe, with a significant amount also bound for Russia. In 2007, the main car-producing countries of central Europe – Poland, Hungary, the Czech Republic, Romania and Slovakia – produced 2.8m cars and commercial vehicles, about 14 per cent of the EU total and about double their 2000 production.
But storm clouds are gathering. In Romania, the automaker Dacia, which is owned by France’s Renault, has stopped work four times over the previous quarter. Stoppages totalling almost three weeks in November were followed by a decision in mid-December to stop its production lines for a month. Work at the carmaker’s plant is due to resume on January 12. In Hungary, Audi has announced a month-long stoppage at its site in the western city of Gyor, although factory officials insisted this was the result of a seasonal drop in demand for its open-topped cars. Already, 160 employees have been axed. Gordon Bajnai, Hungary’s economics minister, has said that unemployment in the sector is sure to rise. Magyar Suzuki, the Hungarian affiliate of Japan’s Suzuki Motor, is axing 1,200 of 5,500 workers. Production for 2008 has been reduced from a planned 300,000 to 282,000, and further cuts to about 210,000 cars are planned for this year. In the Czech Republic, where cars are responsible for about 10 per cent of gross domestic product, carmakers and their suppliers are expected to axe more than 13,000 workers by mid-2009.
The most exposed country is Slovakia, which has the world’s highest per capita car production, at 106 cars per 1,000 inhabitants. Three big factories – Volkswagen, PSA Peugeot Citroën, and Korea’s Kia – have set up in the west of the country and car production amounts to a fifth of GDP. Volkswagen, with a factory near Bratislava, the capital, is in the riskiest position – making gas-guzzlers such as the Porsche Cayenne, the Audi Q7 and the Volkswagen Touareg. “A product mix that consists to a big extent of SUVs is obviously not a good one for this kind of crisis,” says Jan Toth, a Slovak economist. The makers of smaller cars are cautiously optimistic that they will be spared the worst of the forthcoming pain. “The crisis is affecting demand for small cars much less than for large ones,” says Jean Mouro, director of the PSA Peugeot Citroën factory in Trnava. Slovakia gets some added protection because of its cheaper labour costs. Mr Mouro says the company has cut production at its factories near Paris and Madrid while leaving production intact in Slovakia.
Although small carmakers are still relatively bullish, that sentiment may not survive long if the new car market continues to deteriorate. Enrico Pavoni, chief executive of Fiat’s Polish subsidiary, is increasing production and hiring more workers at Fiat’s factory in Tychy, in southern Poland, where the company makes high-selling budget cars such as the Panda and the Fiat 500. However, even he turns gloomy when he considers whether the downturn could last much beyond 2009. Sipping from a coffee cup decorated with a large US flag and the motto “God Bless America”, GM’s Mr Francavilla says his Polish workers still only cost about a third of their German counterparts, in spite of seeing multiple double-digit wage increases. Workers in Gliwice are setting up a production line for the Opel Astra which is being moved from Antwerp. However, there is concern that the region’s cost advantages may not be all that useful in retaining or even attracting new factories if west European countries prop up their own car industries, which would make it politically difficult for manufacturers to shift production eastwards.
ECB seeks wider policing role
The European Central Bank could be given significant extra powers as part of measures to boost eurozone bank supervision, its vice-president has proposed, in the clearest signal yet that the bank believes a re-think of regulation is urgently needed. Lucas Papademos said the ECB could take responsibility for policing large banks operating across borders in the 16-country eurozone, working in conjunction with national central banks. Although Europe avoided a bank collapse on the scale of Lehman Brothers of the US, European policymakers fear the existing fragmented structure, based on national institutions, leaves the region dangerously exposed. Proposals to strengthen the ECB’s role at the expense of domestic regulators would run into heavy opposition in national capitals. Some European Union policymakers would also prefer to keep eurozone bank regulation at arm’s length from the ECB’s responsibilities for setting interest rates and combating inflation.
But there are signs that Mr Papademos’s suggestions would command strong support in the ECB’s 22-strong governing council. In the European Union, some 45 large cross-border institutions account for 70 per cent of total bank assets. So far Jean-Claude Trichet, ECB president, has stopped short of suggesting explicitly that the powers of the Frankfurt-based institution should be enhanced. But last month he told the FT it was “clear that we can improve the present framework”. Mr Trichet referred then to suggestions by the European parliament “that the ECB would play a particular role in this domain for the co-ordination of surveillance for cross-border institutions – a little bit like in the US”. He also pointed to support from the private sector for an enhanced ECB role.
However, Mr Papademos, who has responsibility for financial stability, went significantly further in Wirtschaftswoche, the German business magazine. He argued that EU plans to strengthen co-operation between supervisors within the existing institutional framework could “work over the medium term, but it is not likely to be the best solution in the long run”. Mr Papademos argued that, in the eurozone, the ECB and national central banks, which comprise the so-called “eurosystem”, “could become the supervisory authority for cross-border banking groups. “I believe that we – the ECB and the eurosystem – would perform this task effectively.” Before Christmas, Athansios Orphanides, central bank governor of Cyprus, told the FT that the current economic situation “is a great opportunity for moving forward towards convergence in banking supervision and regulation in the European Union, which is important for averting similar crises in the future.”
Germany prepares new stimulus boost
The German government’s second fiscal stimulus could be far more ambitious than expected just a week ago, senior officials suggested on Monday as leaders of chancellor Angela Merkel’s coalition were meeting in Berlin to hammer out an agreement on the package. Volker Kauder, parliamentary leader of Ms Merkel’s Christian Democratic Union, said in a radio interview on Monday that the measures – a combination of infrastructure investments, tax cuts and targeted help for German industry – could be worth a total of up to €50bn ($68bn) for 2009 and 2010. “This would be bigger than we thought but we would still prefer to see €50bn in the first year, which would be about 2 per cent of gross domestic product,” said Dirk Schumacher, an economist at Goldman Sachs. The package would add to the fiscal boost enacted by the government last October, which added up to just over €12bn over two years. To this, the government adds another €20bn in growth-boosting measures decided before the outbreak of the financial crisis in September.
The two parties in Ms Merkel’s fractious coalition are still at odds as to the exact shape and range of the second package, however. Coalition insiders said an agreement was unlikely on Monday but would come at a second top-level coalition meeting scheduled for next Monday at the latest. In a last-minute concession to critics within her political camp, Ms Merkel dropped her opposition to limited tax cuts at a meeting on Sunday, ending a long-standing dispute with the Christian Social Union, the CDU’s sister party in Bavaria. The new CDU/CSU plan would include a 4 per cent rise in the yearly income not subjected to income tax, to €8,000 per person, as well as a cut in the lowest income tax rate bracket. The plan also proposes to cut mandatory health insurance contributions by 0.9 percentage points. The cut in health insurance contributions alone – which, unlike tax cuts, would benefit low-income households who do not pay taxes but are subject to social security insurance contributions – would be worth €10bn a year.
Like the Social Democratic Party (SPD), the junior partner in the coalition, the CDU/CSU envisage a vast programme of infrastructure investments in areas ranging from transport to energy, education and communication networks. However, the two camps in the coalition are still far apart on the issue of tax. The SPD, led by Frank-Walter Steinmeier, foreign minister and vice-chancellor, is pushing for a €40bn stimulus that would be partly financed through a €2bn increase in taxes for individuals who earn more than €125,000 a year. “What you need right now is to encourage consumption,” Mr Schumacher said. “So while it makes political sense for the SPD to talk about tax increases, economically, it is the last thing Germany needs.” “A good plan would have a balance of higher social transfers for low-income people; tax cuts also targeted mainly at low- and middle-income households; and infrastructure investments,” he said. “My concern is that we will get mainly infrastructure investments. These are good but they take time to percolate through the economy.”
China's demise much exaggerated
Widespread riots, economic collapse and the end of the Communist Party have all been predicted for 2009, but China is not on the ropes yet. "Buckle up for what's coming," says Goldman Sachs, for there's a storm brewing in the East. And the erstwhile investment bank is not alone in its gloom. Everyone from Hu Jintao, the Chinese president, to the traders on Shanghai's stock exchange has suddenly decided that the world's third-largest economy is set for a tumultuous 2009. The apparent turnaround in China's fortunes has been abrupt. In October, Chinese exports rose by 17.6pc compared with the year before, inflation was cooling, a £400bn "New Deal" stimulus package had been announced and all was well. One month later, however, after exports shrank for the first time in seven years, panic broke out. One after another, economists have cut their growth estimates. The current king of the bears is Royal Bank of Scotland, predicting just 5pc growth – one percentage point less than Goldman Sachs. The country's manufacturing base shrank in November, figures released just yesterday showed.
The Chinese government has also been notably unsettled. President Hu and Wen Jiabao, the prime minister, have both admitted that the financial crisis has had a "much deeper" effect on China than anticipated. Zhang Jing, the mandarin in charge of day-to-day economic and reform policy, said China had been derailed. The economic crisis, he said, posed a "serious challenge" and made it "difficult" for China to attain its targeted growth. Government think-tanks have secretly predicted that growth could be as low as 4pc – a catastrophe in a country that needs to create millions of new jobs. The Communist Party has pledged to create 9m jobs in China's cities next year. But many are questioning its optimism, and some experts predict that 25m people could be unemployed by the year's end. "The fact that the government is talking about social tension is an important signal," said Ben Simpendorfer, RBS's chief Asia economist. "The public security bureau is questioning fired workers to find out what they are up to."
Riots have already broken out across the export-led manufacturing belts in southern and eastern China. Factories are closing without paying workers, and local governments have been paying compensation to avoid any serious social tension. "So far, I don't think we are talking about systemic breakdown," said Mr Simpendorfer. "There's more likely to be sporadic patches of unrest." However, in a country the size of Europe, not all news is bad news. The factories in the Pearl and Yangtze river deltas may be closing, but in central and western China there is plenty of optimism for the year ahead. In Pudong, the skyscraper district of Shanghai, the office workers are calm and phlegmatic. Guo Han, a 31-year-old employee of an international bank, said Chinese employees had methods to deal with budget cuts. "They asked us to cut the money that we spend on our clients at Christmas – the dinners and gifts – by half. But no one really listens. We have our own ways around it. We simply pushed through the bills the month before," he said.
Elsewhere in the city, the mood is upbeat. Annie Ni, 27, whose company provides maids, said she felt the crisis "would not last long" and that the "future is promising". Frank Gong, chief Asia economist at Merrill Lynch, shares her view. He has predicted 8pc growth for 2009, on the basis that China is still largely a state-controlled country and the state has plenty of cash to throw at its problems. "The fiscal stimulus is real and it is massive," he said. "And it will be implemented much faster than similar plans in most other economies." JP Morgan has also predicted near 8pc growth, pointing out that the stimulus package will provide five percentage points of that sum. Beijing-based consultancy Dragonomics has gone for the same figure. "Lots of people are forecasting around 5pc growth, but we think that compared with previous downturns, households and banks are better placed. The banks have got rid of most of their bad debt, the households have plenty of savings and the corporations have cash piles," said Rosealea Yao, its chief economist.
China's transition to a market economy, says Mr Gong, is far from complete. Although Chinese exports and the influx of foreign companies have received a much attention, their actual contribution to the economy is far smaller than popularly imagined. Much more important are the vast state-owned companies which will swing into gear to implement the government's stimulus package. The total value of China's exports was about 36.5pc of GDP this year, but in net terms, exports account for only between 7pc and 10pc of the economy. "The idea that China is an export-led economy is probably the biggest and most pervasive myth of them all," said Jonathan Anderson at UBS. He said once the cost of importing materials to make China's toys, electronics, clothes and furniture has been stripped out, the value accrued to the economy is "by no means tiny, but still very moderate". Meanwhile, the government has pledged to support the faltering property market and create a new social security system. It has also promised universal healthcare for 90pc of the population, a vital measure to keep social unrest at bay.
Hedge fund tools may see revival in Asia
Global asset management firm Bank of New York Mellon sees the Asia-Pacific region leading the revival of hedge fund instruments, such as the so-called structured products, despite the stigma from the financial meltdown that started in the United States. "Over time, there will be a world-wide return to structured products. They have gotten a bad name with this crisis, for good reason. They are, however, an important investment vehicle for financial institutions," BNY Mellon chair for Asia Pacific Christopher Sturdy told the Inquirer. A structured product is a pre-packaged investment instrument based on derivatives, such as a single security, a basket of securities, options, indices, commodities, debt issuances, foreign currencies and to a lesser extent, swaps.
"Because Asia-Pacific hasn't been burned on that, it may well lead the rest of the world back into those products," said Sturdy. "Infrastructure development which is needed across Asia-Pacific depends on those products. You can't do it on straight bank lending or bond issuance," Sturdy said. He said the big challenge if structured products were to be revived would be to make sure that they were well-understood and properly rated. "The problem was the structures of these products got so complex, that people lost sight of what the underlying assets really were. The market was relying solely on rating agencies," Sturdy said. In the case of the US financial crisis, financial institutions incurred huge losses on structured products with subprime mortgage credit as underlying assets. Rising delinquency among US subprime borrowers, or those with poor credit records and little equity, created ripples across the globe.
BNY Mellon, which follows a "bank for banks" model, is a global player in asset management, issuer services and treasury services. It has more than $23 trillion in assets under custody and administration worldwide. It had earlier divested its retail banking interest. Amid the US financial meltdown, BNY Mellon has been tapped to service the US government's Troubled Asset Relief Program (TARP), which would take out toxic assets clogging the financial system. In the Philippines, BNY Mellon maintains a representative office.
Moody’s Economy.com sees a bleak year ahead
Strong and coordinated policy action is urgently needed to prevent the world economy from sliding into a deep and protracted recession, given the huge drop in private demand, said Moody’s Economy.com. "The year will be a bleak one, marked by rising unemployment and stressed financial markets. Global real GDP is estimated to grow on a market-value basis by about 2% in 2008 and may slow to 0.2% in 2009 because of sharply decelerating trade flows, plummeting private fixed investment spending, and near-dormant consumption spending.
"The weak state of the world economy gives rise to numerous downside risks, among them escalating protectionism and greater social unrest as the global slowdown consumes millions of jobs," said Moody’s Economy.com senior economist, Tu Packard. She said with absolutely no risk that private investment would be crowded out, there was no better time for massive public spending on programmes with high social returns that could increase the world economy’s growth potential. "Strong fiscal stimulus programmes and accommodative monetary policies should help the global economy gain traction in the second half of 2009, though a self-sustaining expansion is not expected to take hold until well into 2010," Packard said.
She said recessions in recent years tended to be brief and mild, but this time, the unparalleled magnitude and systemic cast of the financial crisis increased the likelihood of a longer, more severe and broader downturn, not just in the United States, but in other major developed countries. "Compared with previous downturns, this one is more tightly synchronised because of the global spread and depth of the financial shock. As a result, recession’s tentacles are now gripping Japan and most major European economies, including Germany, the UK, France, Italy, Spain and Ireland," she said. Packard said recognising the threat to the world economy and financial markets, policymakers in the major economic powers had taken extraordinary measures that would eventually cost trillions of dollars to try to contain the crisis.
She said the US recession had spread to nearly every industry, occupation, demographic group and region, with the latest indicators pointing to an estimated 4.5% decline in real GDP during the final quarter of 2008. "Employment in November fell by 533,000, the largest one-month drop since December 1974, hurting both service- and goods-producing industries and boosting the unemployment rate to 6.7%. "The most recent report on jobless benefit claims suggest that the decline in December nonfarm payrolls may exceed November’s decline, for a cumulative loss of 1.9 million jobs since the beginning of 2008," she said. Packard said falling asset prices from the third quarter of 2007 to the third quarter of 2008 slashed US household net worth by over US$7 trillion.
"That, combined with weak income growth and rising unemployment, will keep consumption spending sluggish in 2009. At the same time, recent data on new orders for manufactured durable goods indicate that capital spending is still weak and likely to contract further. "With private consumption and investment spending in an absolute swoon, massive public sector spending is the last hope to stimulate demand," she added. Packard said the British economy shrank by an annualised rate of 2.4% during the third quarter of 2008, the biggest quarterly contraction in 18 years, amid rapidly deterioriating labour market conditions. She said the unemployment rate had been climbing steeply, from 5.2% in May to 6% in October, while industrial output fell 1.8% month-on-month, while in recent months, industrial output in Germany, France and Spain also had been falling much more rapidly than European monetary authorities expected.
"Indeed, policymakers’ slow and overly cautious response to rapidly deteriorating conditions will delay Europe’s economic recovery, and a protracted downturn is expected," Packard added. She said the much-weakened world economy was worsening the recession in Japan more rapidly than expected. "As a result of falling external demand, especially the steep plunge in auto demand worldwide, the November seasonally adjusted index of industrial production fell by 8.1% from the prior month for a 16.2% y/y drop. Based on survey findings, a further monthly drop of 8% is officially projected for December. "Japanese motor vehicle and automotive equipment production has taken the biggest hit," she said. Packard said the other East Asian countries also had been badly hurt by falling external demand and the reduction in trade flows was compounded by the credit crunch, which disrupted trade finance in China and other Asian countries.
"Credit to private exporters dried up, banks refused to honour letters of credit, and shipments were held up. "China, South Korea, Taiwan, Hong Kong and Singapore have suffered sharply decelerating or contracting export growth, falling industrial output, and widespread layoffs. In China alone, an estimated 670,000 firms shut down in 2008, putting over 10 million people out of work," she said. Packard said China was the world’s second-largest exporter after the EU, and slowing exports from China were hurting shipping companies and ports. She said the Baltic Dry Index, a measure of shipping costs of commodities, was down 93% from its peak in May, suggesting that export volumes would stay depressed. "For many countries, China is now a major trading partner, and its declining import demand is being felt acutely across the region as well as around the globe.
"Exporters of commodities as well as capital goods are being hurt by China’s demand slump. Korea, Japan, Australia and all of Southeast Asia are reeling from the impact of falling Chinese demand for their exports," Packard said. She said commodity exporters faced a double whammy — demand from China is falling, and commodity prices have tumbled. "Countries with diversified exports, such as many in the Americas, will ride out this storm with relatively little damage. Others, highly dependent on a few commodities — like most of sub-Saharan Africa and oil producers in the Middle East face a grimmer outlook. "Capital goods account for one-half of Chinese imports from the US and euro zone, so China’s demand swoon is hurting capital good exporters in the US and Europe. The aerospace industry will feel the pain because the Chinese government is encouraging airlines — many are losing money — to cancel orders or postpone plane deliveries."
Packard said thus far, the economies of Latin America had shown extraordinary resilience in the face of the financial shock. "Latin American markets have suffered from contagion effects, but the region’s financial institutions have remained strong for two reasons: They have low exposure to risky assets, and they benefit from higher standards of regulation by governments well-schooled by the financial crises of the 1980s and 1990s. "The region is estimated to have grown by 4.6% in 2008, but the slump in global demand will cause it to slow to around 2.8% in 2009," she said.
Ukraine gas row complicates as Russia toughens position
Russia on Sunday raised the price of natural gas it asked Ukraine to pay, intensifying the gas dispute which has reduced supplies to several European countries. Russia's state-controlled gas company Gazprom said the company wanted 450 U.S. dollars per 1,000 cubic meters, 32 dollars more than its last offer. "Naftogaz urges Gazprom to stop technical manipulation of volumes and gas supply routes, synchronize the work of the gas distribution systems of Russia, Ukraine and Europe and resume talks," it added.
Poland, Hungary, Romania, Bulgaria and Turkey have reported drops in supplies after Russia's state gas monopoly Gazprom cut off supplies to Ukraine last Thursday because of delays in payment for gas supplied in November and December and a demand for more than half a billion dollars in late-payment fines. European countries currently pay about 500 U.S. dollars per 1,000 cubic meters, including transit costs, but the price is expected to decline significantly as the gas market begins to reflect the fall in world oil prices. Russia and Ukraine failed to reach compromise over a new price and gas transit fees for a 2009 contract.
The negotiations were hampered by strained ties between Russia and Ukraine due to the latter's bid to join NATO and its support for Georgia during its war with Russia in August. On Friday, Gazprom accused Ukraine of "stealing" gas in transit. Ukrainian officials denied the accusation, saying that Russia is not delivering the due quantities to European clients. Around a quarter of the gas used in the European Union -- more than 40 percent of the bloc's imports -- comes from Russia, and Ukraine sits on the main transit route for gas exports, accounting for 80 percent of the continent's gas supply from Russia. Both Russia and Ukraine have been soliciting support from EU nations.
European Commission spokesman Ferran Tarradellas said that the European Union had no plans to get involved in a dispute he described as a "bilateral problem." European Union ambassadors are scheduled to hold an emergency meeting in Brussels Monday, where the Czech Republic, which holds the 27-nation EU's presidency, will brief members about talks it had been holding with officials from Moscow and Kiev. In 2006, a dispute over gas prices between Kiev and Moscow sent jitters among European customers after Gazprom cut all gas supplies to Ukraine. Experts say that as EU states and Ukraine itself now have sufficient gas reserves, they are capable of coping with the lack of fresh Russian supplies.
Berlusconi Plan Saps Italian Pensions With Privatized Funds Bush Promoted
Italy did for retirement financing what President George W. Bush couldn’t do in the U.S.: It privatized part of its social security system. The timing couldn’t have been worse. The global market meltdown has created losses for those who agreed to shift their contributions from a government severance payment plan to private funds meant to yield higher returns. Anger is rising both at the state, which promoted the change, and money managers such as UniCredit SpA and Arca Previdenza, which stood to profit. Prime Minister Silvio Berlusconi’s administration is now considering ways to compensate as many as 1.2 million people who made the switch, giving up a fixed return for private plans linked to financial markets. It’s also letting people delay redemptions on retirement funds to avoid losses after Italy’s benchmark stock index fell 50 percent in 2008, destroying 300 billion euros ($423 billion) in wealth.
"The reform didn’t help anyone," said Gabriele Fava, who heads the Fava & Associati law firm in Milan and writes about labor law. "Not the government, which was hoping everyone would make the switch to take the strain off its coffers, nor the workers who have not resolved the problem of needing a supplement to their social security pensions." Italy’s experience shows how difficult it is to solve a problem facing governments from the U.S. to Europe to Japan as populations age and the old system of taxing workers to support retirees becomes unsustainable. Bush failed to persuade Congress to let workers put a portion of their Social Security taxes into privately invested accounts as voter opposition increased. For a quarter of a century, employers in Italy have paid about 7 percent of each worker’s annual salary into the severance system, called TFR. Workers received lump-sum payouts whether they retired, were fired or simply changed jobs.
Someone earning 80,000 euros a year would receive more than 200,000 euros in TFR after 35 years on the job and more than 60,000 euros after a decade of work. The fund pays a fixed return that aims to exceed inflation. The program was a tempting target for a government struggling to meet its pension obligations. Italy spends about 14 percent of gross domestic product on pensions, the most in the European Union. Spain spends 9 percent and the U.K. 7 percent. Italy has the EU’s lowest birthrate of 1.3 children per woman. By 2050, the country will have fewer than two working-age people for each person over 65, the lowest ratio in the EU, according to Eurostat, the bloc’s statistics agency. Previous governments adopted measures to lower pension payouts and force workers to retire later. Benefits will drop to as little as 30 percent of a worker’s final salary from about 75 percent now, creating an incentive for Italians to seek higher returns by moving severance funds into a complementary plan.
Gaetano Turchetta, a Rome office manager, made the irreversible move to a private plan after a union representative boasted of the potential for 20 percent annual returns. The 43- year-old father of three now says he would sign with "two hands and two feet" if he could switch back. "What do I want from the government?" he said. "Just not to become a burden on my kids." The TFR plan was meant to dent Italy’s risk-averse culture and lure more people to investment funds, said Biagio Masi, head of Banca Sella SpA’s insurance unit, who called the shift a "world-shattering change in mentality." Eight percent of Italians invested in stocks in 2008, half the level of 2002, according to an Oct. 30 report commissioned by Acri, the country’s savings bank association. About 80 percent favored keeping their savings in the bank and 25 percent have a private pension or life insurance, the report said.
Money managers such as UniCredit, Italy’s largest bank, and Arca Previdenza, the biggest pension fund manager, lobbied customers to make the change, seeing it as an opportunity to kick-start a moribund fund management industry. Funds under management in Italy have shrunk by a quarter in the past seven years, according to the Bank of Italy. The value of pension funds is equal to about 3 percent of GDP, compared with more than 90 percent in the U.S. Even with full-page newspaper ads, billboards and telephone hotlines spurring Italians to switch, only 1.2 million people, or 10 percent of the eligible private-sector workers, chose to give up the TFR for private plans before the June 2007 deadline, according to fund regulator Covip. Italian lawmakers approved the reform at the end of 2006. It was part of the 2007 budget proposed by former Prime Minister Romano Prodi’s government.
Italy’s benchmark stock index has fallen 53 percent since the switchover. Last year was the first time since 2003 that TFR outperformed private plans, with workers guaranteed a return of 2.8 percent in the 10 months through October, Rome-based Covip said. The average return for private, non-union pension plans ranged from a gain of 2.6 percent for fixed-income funds, to a decline of 24 percent for stock funds, according to Covip. The government is considering Covip’s proposal to compensate retirees for losses on private pensions incurred in the 12 months beginning Aug. 31, 2008. The watchdog has also proposed forcing funds to adopt more conservative investment strategies as clients near retirement. Turchetta said his father, a construction worker, got a TFR payout of about 40,000 euros when he retired two years ago. He fears that he’ll be lucky to make ends meet after watching his pension plan drop more than 20 percent. "Dad was assured a set amount, whereas I’m sitting here watching the market fall," he said. "It’s so sad."
Corporate Britain faces £110 billion debt time bomb
As the horror of recession descends this year, finance directors and the companies they shepherd face a terrifying race to defuse Britain's debt time bomb. For many companies which have survived the credit crisis the greater challenge lies ahead - the task of navigating through a record £ 110bn of debt that will have to be repaid in 2009. But the bomb was primed by the companies themselves as they drew down hundreds of billions of pounds of cheap debt over the last decade to help fuel growth. Now that world has come crashing down and the money drawn has become a ticking time-bomb with companies waking up to the stark reality that lenders are demanding their cash back. According to data compiled for The Sunday Telegraph by Dealogic, British businesses have £25bn of debt maturing in the form of corporate bonds this year as well as a staggering £85bn of loans.
The lack of funding available to companies was behind the Government's unprecedented £500bn bail-out of the British banking sector last October but the credit markets remain stubbornly frozen, raising fears that companies face annihilation if they are unable to refinance their debt. Boardrooms at even the bluest-of-blue-chip giants will be forced to focus their attention on refinancing the biggest ever annual maturity of debt owed to banks, bondholders and other lenders. Sam Dean, global co-head of equity capital markets at Deutsche Bank, says a lot of companies will need to make tough strategic decisions about how to cope with overburdened balance sheets. For some that will mean the difference between survival and extinction. There are very few sectors that won't face refinancing issues this year, says Mr Dean. "And, in this environment, as each company finds its own solution, the difference in outcomes will be extreme, with losers facing real difficulties - and some won't survive.''
Public companies in the UK have seen £645bn wiped off their stock market value in 2008 while their private equity backed rivals, under the burden of higher levels of leverage, face even greater challenges. John Cridland, deputy director general of the CBI, is under no illusions about the scale of the problem which he says could drive many companies to the wall. "When it comes to issues facing businesses, credit is top of the list,'' he says. "There is a significant amount of debt coming up for renewal in 2009. If banks are looking for a significant reduction in the amount of credit they make available or for sharply higher rates, companies are going to find it very tough.'' The threat to companies is the double whammy of recession biting into their profitability at the same time as their cost of funding - if they can get it at all - rising sharply.
The Bank of England's latest Quarterly Bulletin echoed the CBI's warning. The Bank said that though the availability of trade finance had fallen over recent months, demand had risen, further straining corporate cash flows just as large volumes of debt have to be repaid. Companies across all sectors are frantically trying to devise strategies to present to the debt market this year, but few are palatable. Deutsche Bank's Dean says: "A lot of firms will have to hammer out solutions quickly, whether by refinancing through debt markets, which is not as easy as it was, raising new capital through equity via rights issues or placings, or even raising cash through strategic sales.'' Simon Collins, who heads accountant KPMG's special situations division, says he has never seen conditions so difficult. His department was created last year to advise companies - even those with ostensibly healthy balance sheets - on renegotiating debt in a market which has almost entirely closed to new lending. "Redemptions and refinancing will be a fundamental issue for everyone,'' says Mr Collins. "Even for the very best companies it is difficult to refinance now. There is hope that some limited liquidity might return, but unfortunately the underlying difficulty has not gone away. All companies will be refinancing with penal rates.''
Among companies trying to renegotiate debt are retirement housing specialist McCarthy & Stone and motor dealer Pendragon, which last month secured a covenants waiver to give it breathing space to continue negotiations. KPMG also recently helped bookmaker William Hill arrange an innovative refinancing deal designed to lock existing lenders in place right until the end of the term of debt, when a pre-agreed refinancing will kick in. But Mr Collins says the demand for refinancing will come not only because facilities have naturally come to an end, but also thanks to the raft of covenant breaches that will create a second trigger for refinancing. All firms are susceptible to this risk, but it most acutely faces private equity businesses which are highly leveraged and have historically been more aggressive in raising debt levels In 2009 a large part of the debt maturing is in the form of corporate bonds. The feverish growth of the bond market in recent years helped fuel takeover activity and now, according to Dealogic, corporate bond redemptions are approaching historical highs. Among those companies with bonds due are government-backed Network Rail with $11.2bn (£7.8bn) of securities, while mobile giant Vodafone has $5.2bn, oil group BP $3.1bn, satellite broadcaster BSkyB $2bn and tobacco company BAT $1.9bn.
And while some companies may be in a position to repay, for many the maturity deadline is looming all too fast. According to Mr Collins, current negotiations are for bonds maturing after September this year, pay dates before then have already been attempted or refinanced - and if alternatives have not been found, it is almost certainly too late. Transport group Stagecoach, bookmaker Ladbrokes, broadcaster ITV and pubs chain JD Wetherspoon all have debt maturing and are under trading pressure. Paying off old borrowings with corporate bonds has drawbacks. To issue them at all, investors are demanding a track record and investment grade credit ratings and even then companies will be forced to pay higher interest rates. Corporates also face stiff competition from governments, who are issuing billions of pounds of bonds themselves to raise emergency funds. However, with investors having lost faith in stock markets there are some reassuring signs of life in the bond market. "The level of interest from retail investors in the bond markets is similar to that in the early 1990s,'' says Barry Donlon, a bond syndicate banker at UBS. "People are furious with the performance of the equities market and asking why they shouldn't buy BSkyB bonds paying 10pc interest instead.''
Retail investors are taking up some of the slack left by the collapse of large parts of the hedge fund industry but their buying power pales beside that formerly held by the financial whizz-kids. That, says Donlon, means buyers are calling the shots. "We are rebuilding the investor base but it is only to the extent that blue chip companies can access the debt markets, albeit at a far higher cost,'' he says. "For the weaker companies or those that are new to bond investors, the markets remain largely shut.'' The Bank of England's decision to cut interest rates to 2pc - from 5.5pc a year ago - has offered companies some respite, dramatically bringing down the base cost of borrowing, but banks remain reluctant to pass on the cuts and investors are demanding more generous terms. Blue chip names from BMW to BSkyB are among companies that have been forced to cough up. The UK pay-TV provider sold $600m of bonds in November on which it was forced to offer interest of 9.5pc. The last time the company sold dollar denominated debt, in February 2008, it paid a coupon of 6.1pc. "There are sectors where refinancing fears have been overplayed,'' claims Donlon. "BMW and Daimler came in and got deals done, albeit they had to pay up.''
For those companies which find themselves unable to find new borrowings and for whom the corporate bond market is closed there is the option of pushing out their own equity in return for cash. Department store group Debenhams is reportedly considering raising new cash in this way to tackle its debt. However, the risks remain potent in a highly volatile stock market - which necessitate deeply discounted rights issues or equity placings. Deutsche's Dean, who spent last year raising billions of pounds of capital for the banking sector, maintains that shareholders have both the will and the money to put their cash to work. "In 2009, institutional investors really want to have the option to be the first to put money behind the companies they own,'' he says. Firms that want the support of major shareholders will need to ensure they keep a close dialogue with them, says Dean, who believes some companies overlook involving investors in the right way.
"In many cases the market perception of particular companies is worse than reality and these companies would do well to spend more time meeting investors face-to-face. More than ever, investors want to have the chance to really understand management plans, to see the whites of their eyes, and particularly to be consulted in an appropriate way about strategic options.'' Last year, financial companies who tapped up investors for cash early enjoyed far more attractive terms than banks that arrived later to market, and Dean says the trend will repeat itself as industry turns to capital raising for funding. However, though liquidity is there, investors will be picky about which firms they back. Because of this, companies should take the opportunity to fortify their balance sheets early to win the lion's share of the finite cash available. Firms facing funding pressure could find the money has been mopped up by their rivals - who now sit on predatory war chests - even before they get out their begging bowls. Another option would be debt for equity swaps with lenders, but again existing investors could be wiped out and frustrated.
The prospective battle for indebted companies to raise new funds is therefore likely to lead to casualties. Debt defaults, or even the fear of money not being repaid, will provoke many banks to pull the plug and the retail sector's recent raft of administrations has already shown how nervous and trigger happy the banking sector has become. Even if banks take action early they face being forced to write off billions of pounds worth of debt, hammering their only recently rebuilt balance sheets and raising the terrifying spectre of a second banking crisis. Since pressure on banks will be brought to bear on companies, it is no surprise that those on the front line of the potential debt default battle are finding themselves under surveillance by still cash rich funds which smell a profit from the spoils of war.
One debt banker said he had been inundated with calls from hedge funds looking for tips on those companies expected to face the greatest difficulties refinancing their loans or bonds. "The big trade for hedge funds is betting on who is going to be shut out of the debt markets in 2009,'' he says. "Debt fears have driven the stock markets in much of 2008 and will play an even greater role this year. Leisure, property, construction, retail - they're all areas to watch.'' That means finance directors will be fighting on two fronts. Battling in the debt market to win breathing space for new funds, but also fighting a rearguard action against hostile moves from predators. Having primed the debt bomb they now face the threat that it is about to explode in their faces.
UK businesses 'focus on survival'
Businesses are starting the new year facing huge difficulty in getting credit to keep working as the economy falters, according to a survey published today. The latest quarterly survey of chief financial officers by consultants Deloitte shows that an overwhelming 99% say credit is difficult to obtain, up from 55% a year ago. The figures come in spite of the Bank of England's huge cuts in interest rates in the past three months to 2%, their lowest level for 58 years. The Bank is expected to make another cut this week to an all-time low of 1% or 1.5%.
Deloitte's survey also reveals that 95% of finance bosses said credit was expensive, up from 64% a year earlier. Deloitte partner and vice chairman Margaret Ewing said: "Faced with an unprecedented speed of economic downturn in recent months, a further deterioration in credit conditions and exceptional uncertainties, chief financial officers have become significantly more risk averse and many are simply focused on survival for their companies." The survey comes days after the Bank of England's latest credit conditions survey predicted a further reduction in lending to businesses and households during the first three months of this year.
More than half of those surveyed by Deloitte, 56%, planned to reduce debt during the coming year; 11% were intending to increase it. Deloitte economist Ian Stewart said: "Tighter credit conditions have brought about a dramatic shift in corporates' attitudes to debt. "A year ago the balance of opinion among CFOs was that the UK sector was under-geared. Today, the view is that corporates have too much debt." Nearly a quarter of CFOs expect to cut dividends to shareholders, to save cash. But firms also see opportunities. Three-quarters of those surveyed said they could seek to boost their market share and buy companies or other assets cheaply. More than a third, 38%, plan to profit from weaker labour markets by taking on more skilled staff, Deloitte said.
UK Construction faces a grim 2009 as industry shrinks at fastest pace in a decade
The construction sector is facing another year of misery in 2009 after the pace of decline accelerated at the fastest rate in 12 years in December, according to the latest survey published today. The housing industry continued to be worst hit but activity in the commercial and civil engineering sectors also fell at record rates. As a result the headline Construction Purchasing Managers' Index (PMI), which combines output and orders, fell to 29.3 in December from 31.8 in November - a new survey low and the sharpest monthly fall since the series began in April 1997. It was the 10th successive month that the index was below the 50 mark, where anything under 50 indicates a contraction and anything above an expansion.
Roy Ayliffe, a director at the Chartered Institute of Purchasing and Supply which produces the survey, said: "The New Year spirit was decidedly muted among UK constructors amid reports of ever toughening market conditions. Further falls in global demand resulted in the most severe retrenchment in the PMI's 11 year history."Amidst a climate of doom and gloom, firms were forced to axe more jobs in preparation for what is set to be another year of trouble and turmoil." Sharp falls in new orders prompted companies to slash costs, and job cuts remained considerable in December. "The construction purchasing managers' survey for December is simply awful, indicating that the sector ended 2008 very much on a low and is facing an extremely difficult 2009," said Howard Archer, chief economist at IHS Global Insight.
Ilargi: Unless the fall-out of the Gaza situation spreads across the Middle East, I don’t see much of any support for oil prices. The cash-starved members will need to sell what they can, and I don't see OPEC being able to stop them. Some of these countries are on the brink of insolvency. What terrible threats can Saudi Arabia utter that would have -some of- the other members go under while they could sell their surpluses at $20 or $30 a barrel? If Mid East volatility blows up, yes, of course, oil would rise. But if it doesn't, it's hard to call any bottom on prices. I see Russia as main factor as well. Its production went down in '08, as did prices. I haven't seen anyone add up the difference between what Putin expected on Jan 1 '08 and what he got on Jan 1 '09, but it must have been massive. You think he won't try to sell more? It's the archetypical race to the bottom. It'l bring peak oil back with a vengeance, through lack of exploration, but not inside the next 5-10 years. The collapse in demand has a long way to go yet. China shores up demand a little, but it is through filling reserves, not through direct usage.
Oil supported above $46 as OPEC cutbacks take hold
Evidence that OPEC cutbacks were taking hold helped support oil prices above $46 a barrel Monday, with crude also getting support from new unrest in oil-rich Nigeria. A dispute between Ukraine and Russia over gas imports and Israel's ground offensive in Gaza also kept tensions high, although analysts were split over how much the conflict in the Middle East is affecting markets. Light, sweet crude for February delivery rose 2 cents to $46.36 a barrel in electronic trading on the New York Mercantile Exchange by midday in Europe. The contract rose Friday $1.74 to settle at $46.34. Analysts at JBC Energy said in a research note that prices were supported by "increasing evidence that OPEC is adhering to its agreed production cuts and the announcement of the US government to add more oil into its strategic reserves." Prices were also buoyed by the "latest news from Nigeria that saboteurs had attacked and partly destroyed part of a pipeline," the analysts said.
Nigerian regional army chief Brig. Gen. Wuyep Rimtip said Saturday he did not know how severely the pipeline was damaged and suspected local youths rather than militants were responsible for the attack. Nigeria's major militant group, the Movement for the Emancipation of the Niger Delta, declared a cease-fire in September, but has warned that attacks could resume if it is provoked. In the oil-rich Middle East, tensions were high as thousands of Israeli troops backed by tanks and helicopter gunships surrounded Gaza's largest city and fought Hamas militants at close range Sunday, as the offensive moved from airstrikes to artillery shelling and ground fighting in a bid to stop rocket fire on southern Israel.
An Iranian Revolutionary Guard commander on Monday urged Islamic nations to use crude as a weapon to exert pressure on Western backers of Israel. Still, even Iran -- among the more radical OPEC members -- was unlikely to jeopardize its precious oil income, and with no oil producing nation directly involved, analysts were split over the market impact of the Gaza unrest. "With Israeli troops going into Gaza, that just heightens fears of the possibility of a wider Middle East conflict," said Ken Hasegawa, an energy analyst with broker Newedge in Tokyo. "Prices will likely continue to rise in the short term."
In Vienna, however, JBC Energy said that to all appearances the conflict "has not had much of an impact so far." Victor Shum, an energy analyst with Purvin & Gertz in Singapore, said prices "will depend on OPEC's compliance with their output cuts and the health of the global economy." Shum said he expects prices to average in the low $50s this year. Iran's state television said OPEC countries have decided to hold an extraordinary meeting on falling oil prices in Kuwait in February. The report on Monday quoted Iran's OPEC governor Mohammad Ali Khatibi as saying the organization planned to bring forward the regular meeting in March because the "trend of oil prices" calls for holding a meeting a month earlier. A dispute between Russia and Ukraine over natural gas payments also concerned traders Monday.
Russian gas monopoly Gazprom has cut off gas shipments to Ukraine since Thursday, and Ukraine has warned that European customers could see serious natural gas disruptions in about two weeks. Gazprom has continued to send gas to Europe, which relies on it for a quarter of its gas. But 80 percent of the gas Gazprom sends west passes through the same pipelines that supply Ukraine, and over the past four days the pressure in the pipelines has dropped. Some European countries -- including Bulgaria, the Czech Republic, Hungary, Poland and Romania -- have reported a decline in supplies. In other Nymex trading, gasoline futures rose nearly 4 cents to $1.15 a gallon. Heating oil gained close to 3 pennies to $1.48 a gallon while natural gas for February delivery was flat at $5.97 per 1,000 cubic feet. In London, February Brent crude rose $1.01 to $47.92 a barrel on the ICE Futures exchange.
US banks drawn into Bernard Madoff scandal amid fear of more victims
The role of America's federally regulated banks in the $50 billion Bernard Madoff investment scandal has come into question after it emerged that a number of victims of his alleged Ponzi scheme thought they had invested their money with an ordinary bank. Two law firms in Florida, which are gathering claims from Madoff victims, are both representing a couple who say that they believed that they had invested about $1 million (£688,000) with the Westport National Bank, a regulated savings bank in Connecticut, rather than with Mr Madoff.
The Florida case raises concern that a new wave of unwitting victims may emerge from Mr Madoff's investment scheme. The FBI and the Securities and Exchange Commission (SEC) are already investigating the role of certain hedge funds that provided Mr Madoff with new clients. The biggest of these is Fairfield Greenwich, a Connecticut hedge fund believed to have lost about half its assets, totalling $7.3 billion, to Mr Madoff's scheme. The Florida couple, whom lawyers declined to name, received a letter from the bank dated December 12, the day that Mr Madoff was charged with fraud, explaining: "You currently have a custodian agreement with Westport National Bank [...] you gave full discretionary authority to Bernard L Madoff Investment Securities."
According to Craig Stein, an attorney with Stein & Pinsky in Boca Raton, Florida, the couple had no inkling of their exposure to Mr Madoff and received annual statements from the bank that showed deductions for custodial and record-keeping fees that added up to 4 per cent a year, or $40,000 at the peak of their investment. Mr Stein said that his clients had been introduced, with other investors in Westport, by a "promoter". Westport National Bank insists that "the bank has not invested any of its own funds or the funds of its depositors with Madoff, and the bank has not advised any customer of anybody else to invest with Madoff". The implication is that the investment must have gone via another route, therefore.
The Office of the Comptroller of the Currency, America's banking regulator, refused to comment on whether it was questioning Westport or investigating whether US banks played a role in helping Mr Madoff to create what is described as the world's biggest fraud. The two Florida law firms have also claimed that those eligible to join his fund needed to be far less rich than first believed. When the scandal came to light almost a month ago, it was thought that new clients had to be prepared to invest at least $10 million in order to qualify for their money to be managed by Mr Madoff. However, according to Mr Stein and Adam Rabin, of McCabe Rabin, a law firm in West Palm Beach, Florida, investors were eligible with sums of about $100,000. Both attorneys also said that they had been approached by victims of modest means who had joined Mr Madoff's investment fund by pooling their savings.
Mr Madoff, 70, is alleged almost a month ago to have told his sons Mark and Andrew, who worked for him, that he was "finished" and that their investment firm was a giant Ponzi scheme. He has been charged with securities fraud and is under house arrest and is electronically tagged. A leading financial committee in the US Congress has said that it would like to call Bernard Madoff to testify at a public hearing over his $50billion failed investment scheme. The call came as David Kotz, inspector-general of the Securities and Exchange Commission, prepared to be questioned today by the House of Representatives Financial Services Committee about how the Wall Street regulator missed the biggest alleged fraud in history. The hearing will be shown live on American television and on the internet.
SEC Must ‘Defend Its Existence’ After Madoff Lapses
The U.S. Securities and Exchange Commission may come under fire from lawmakers today for failing to quash Bernard Madoff’s alleged $50 billion Ponzi scheme after an investor alerted the agency to the suspected fraud. The House Financial Services Committee is scheduled to hear from one of Madoff’s alleged victims, securities law experts and the SEC’s inspector general, David Kotz, who’s probing the agency’s handling of the matter. Harry Markopolos, the former money manager who says regulators didn’t act on his tips about Madoff, canceled his appearance. "The SEC will have to defend its existence," said Donald Langevoort, a former agency attorney who teaches securities law at Georgetown University in Washington.
The meeting is "a way of sending a message to the SEC of Congress’s anger and dismay that this happened, especially given all the things that have happened in the last six to eight months," such as the collapse of investment bank Lehman Brothers Holdings Inc., he said. Markopolos, 52, a former chief investment officer at Rampart Investment Management in Boston, is now a financial fraud investigator for institutional investors. Other witnesses include Stephen Harbeck, president of Securities Investor Protection Corp.; Allan Goldstein, a retiree who invested with Madoff; Leon Metzger, a former executive with hedge-fund firm Paloma Partners LLC; and Boston University law professor Tamar Frankel. Kotz is the only SEC employee set to testify. Markopolos withdrew, citing an illness, according to the office of Representative Barney Frank, the committee’s chairman. SEC spokesman John Nester declined to comment on the pending hearing.
Madoff’s firm was examined at least eight times in 16 years by regulators following up on e-mailed tips that described his business practices as "highly unusual," the Wall Street Journal reported earlier today. Madoff himself was interviewed at least twice by SEC officials, the newspaper said. The hearing, scheduled for 2 p.m. in Washington, will help guide Congressional leaders as they weigh a "substantial rewrite of the laws governing the U.S. financial markets," Representative Paul Kanjorski, a Pennsylvania Democrat who leads a subcommittee overseeing capital markets, said in a Dec. 31 statement. In a speech last month, President-elect Barack Obama said the Madoff scandal shows "how badly reform is needed." Whether the agency should be beefed up or dismantled will be a likely topic at meetings this year about the SEC’s future. "It would be a big mistake for the hearing to start focusing on throwing more money at the SEC, until the question has been answered about whether the agency is using the resources that it has adequately," said Jacob Frenkel, a former SEC attorney now at Shulman Rogers Gandal Pordy & Ecker in Rockville, Maryland.
Madoff, 70, was arrested Dec. 11 and charged at federal court in Manhattan with securities fraud after allegedly telling his sons his investment advisory business was a Ponzi scheme, in which early investors are paid with money from subsequent participants. Madoff is free on bail and hasn’t formally responded to the charges or entered a plea. Madoff’s clients included banks, hedge funds, charities, universities and wealthy individuals. They had about $37 billion with Bernard L. Madoff Investment Securities LLC, according to a Bloomberg News tally of disclosures and press reports. SEC Chairman Christopher Cox said Dec. 16 that he asked Kotz to review how the agency responded to tips about Madoff and to find ways to improve internal policies. The staff failed to act for almost a decade on "credible and specific" allegations and never recommended commissioners take action, Cox said. The SEC closed a Madoff probe in 2007 that Markopolos helped trigger.
The SEC’s investigators had a brush with Madoff in 1992 while suing two Florida accountants for allegedly selling $441 million in unregistered securities. The regulator, then headed by Republican Richard Breeden, said the accountants began raising money in 1962 and placing it with Madoff while promising investors returns of 13.5 percent to 20 percent, according to court documents obtained by Bloomberg. Auditors hired to unravel the case asked Madoff for copies of account statements, which he provided, the records show. He wasn’t accused of wrongdoing. Markopolos raised his concerns with an examiner in the SEC’s Boston office in 2000, saying that Madoff’s returns were too good to be true, and pressed the agency to scrutinize Madoff’s business until last year, the Wall Street Journal reported Dec. 18. In a 17-page memo from November 2005, three months after Cox became chairman, Markopolos laid out a list of "red flags," and claimed Madoff must either be trading ahead of client orders, a practice known as front-running, or, more likely, running the world’s largest Ponzi scheme.
SEC investigators in New York, where Madoff’s firm is based, focused on front-running, and after encountering obstacles didn’t finish verifying trades Madoff said were for advisory clients, a person with knowledge of the agency’s efforts said last month. His company’s trades were cleared through a single account at Depository Trust & Clearing Corp., making it difficult to distinguish transactions specifically for Madoff’s advisory business, the person said. Some transactions were completed through foreign brokerages, which meant the agency would have had to persuade other regulators to collect the data. Instead, SEC investigators closed the case in 2007 after Madoff agreed to register his investment advisory business.
The SEC was facing criticism before Madoff’s arrest. Last year’s collapse of investment banks Bear Stearns Cos. and Lehman Brothers tarnished the agency’s reputation as a market watchdog, and senators such as Connecticut Democrat Christopher Dodd and Iowa Republican Charles Grassley have questioned its vigilance in enforcing securities laws. Cox, a Republican appointed by President George W. Bush, has said he will leave office at the end of the Bush administration. Obama on Dec. 18 announced his choice of brokerage regulator Mary Schapiro to succeed Cox.