Post Office, Washington. Flag Day
Ilargi: On this fine holiday, a bunch of numbers to sober you up. Let's stay with real estate. The New York Post reports that $1.4 trillion in commercial real estate debt runs the risk of failing to be re-financed in the next 4 years. But is you think that’s bad, it's just the start. The losses on CRE in that period will be many times that, making re-financing a non-issue.
The New York Times runs a piece on residential real estate developments. Not looking good. Even so, first something that struck me. Here's a quote from the NYT piece:
In the first two months of the year alone, another 313,000 mortgages landed in foreclosure or became delinquent at least 90 days, according to First American CoreLogic.
Followed by this from CBC.ca on May 13:
RealtyTrac, a California-based company that markets real estate, said that banks and other authorities slapped foreclosure actions on more than 340,000 properties in [April]."This would mean foreclosure numbers doubled in April vs Jan/Feb. That would seem steep, even if moratoriums ended, What I suspect is that First American CoreLogic's data are on the conservative side. Something to keep in mind when reading the following:
From November to February, the number of prime mortgages that were delinquent at least 90 days, were in foreclosure or had deteriorated to the point that the lender took possession of the home (REO) increased more than 473,000, exceeding 1.5 million, according to a New York Times analysis of data provided by First American CoreLogic, a real estate research group. Those loans totaled more than $224 billion. During the same period, subprime mortgages in those three categories increased by fewer than 14,000, reaching 1.65 million. The number of similarly troubled Alt-A loans — those given to people with slightly tainted credit — rose 159,000, to 836,000.
So from November to February, default filings on prime mortgages rose some 50%, covering a total of $224 billion in loans.
Over all, more than four million loans worth $717 billion were in the three distressed categories in February (the RealtyTrac website states 1.9 million foreclosures at the end of April), a jump of more than 60 percent in dollar terms compared with a year earlier. Under a program announced in February by the Obama administration, the government is to spend $75 billion on incentives for mortgage servicing companies that reduce payments for troubled homeowners. The Treasury Department says the program will spare as many as four million homeowners from foreclosure. But three months after the program was announced, a Treasury spokeswoman, Jenni Engebretsen, estimated the number of loans that have been modified at "more than 10,000 but fewer than 55,000."
The Obama anti-foreclosure measures are painful failures, that much is clear. A 1.4% success rate in 3 months is dismal and abysmal. Moreover, I estimate that lenders (read: the 4 big US banks) will lose upwards of $300 billion just on the $717 billion that are listed in the 3 distressed categories AT PRESENT. And it doesn't stop there. There's much more to come, numbers are going up fast, and the Option-ARM and Alt-A resets haven't even started for real. There is one factor that drives the issue more than any other as it is going forward:
Last year, foreclosures expanded sharply as the economy shed an average of 256,000 jobs each month. Since then, the job market has deteriorated further, with an average of 665,000 jobs vanishing each month. Each foreclosure costs lenders $50,000, according to data cited in a 2006 study by the Federal Reserve Bank of Chicago, so an additional two million foreclosures could mean $100 billion in lender losses.
I have to admit, I don't know what the Chicago Fed incorporates in that number, but it can't possibly be ALL losses. More likely, it’s merely the transaction and litigation costs. And that still leaves a dark horse the New York Times doesn't mention: securities portfolio's based on the mortgages involved, and don’t let's get into wider derivatives. Suffice it to say that potential losses per foreclosure are many times more than $50.000. Still, to get back to that one major driving factor, here's the NYT again:
Economy.com expects that 60 percent of the mortgage defaults this year will be set off primarily by unemployment, up from 29 percent last year.
Note: this doesn't mean the factors setting off defaults have improved, just that defaults caused by unemployment have risen enormously, along with job losses.
To sum it up: close to 2 million foreclosures are done. 4 million more mortgages are in "distress", half of which are very likely to be foreclosed on sometime in the next year. And there's still no way on earth the foreclosures can be handled faster than new ones come in. The US loses over 600.000 jobs a month, and talking about green shoots may stall a further increase a few months, but no more than that. If I may repeat an old piece of information: if the US automotive industry cuts production in half, that will 2.5-3 million jobs. At present, the industry runs at 42% of capacity.
And that is with heavy government subsidies of the lending industry, especially GMAC. Take that away, and car sales drop to not to the 10 million Obama talked about this weekend, but more likely below 5 million. And of course, as I keep on saying, the mortgage industry I started this off with would be equally disabled without your money paying for your neighbors' home. Yes, that's right, you're paying for his car too. The chances he'll default on either or both of those loans are higher now than when you started reading this. Are you sure you feel that's a good way to spend your remaining dough?
I’m right, you know, home prices will fall 80% or more peak to trough. if only because you can hardly even afford to pay for your own home and car, let alone you neighbors as well. You don't feel it that way yet because you pay for his in an indirect way. But you do pay.
Job Losses Push Safer Mortgages to Foreclosure
As job losses rise, growing numbers of American homeowners with once solid credit are falling behind on their mortgages, amplifying a wave of foreclosures. In the latest phase of the nation’s real estate disaster, the locus of trouble has shifted from subprime loans — those extended to home buyers with troubled credit — to the far more numerous prime loans issued to those with decent financial histories. With many economists anticipating that the unemployment rate will rise into the double digits from its current 8.9 percent, foreclosures are expected to accelerate.
That could exacerbate bank losses, adding pressure to the financial system and the broader economy. "We’re about to have a big problem," said Morris A. Davis, a real estate expert at the University of Wisconsin. "Foreclosures were bad last year? It’s going to get worse." Economists refer to the current surge of foreclosures as the third wave, distinct from the initial spike when speculators gave up property because of plunging real estate prices, and the secondary shock, when borrowers’ introductory interest rates expired and were reset higher.
"We’re right in the middle of this third wave, and it’s intensifying," said Mark Zandi, chief economist at Moody’s Economy.com. "That loss of jobs and loss of overtime hours and being forced from a full-time to part-time job is resulting in defaults. They’re coast to coast." Those sliding into foreclosure today are more likely to be modest borrowers whose loans fit their income than the consumers of exotically lenient mortgages that formerly typified the crisis. Economy.com expects that 60 percent of the mortgage defaults this year will be set off primarily by unemployment, up from 29 percent last year.
Robert and Kay Richards live in the center of this trend. In 2006, they took a 30-year, fixed-rate mortgage — a prime loan — borrowing $172,000 to buy a prefabricated house. They erected the building on land they owned in the northern Minnesota town of Babbitt, clearing the terrain of pine trees with their own hands. Mr. Richards worked as a truck driver, hauling timber from a nearby mill. His wife oversaw the books. Together, they brought in about $70,000 a year — enough to make their monthly mortgage payments of $1,300 while raising their two boys, now 11 and 16.
But their truck driving business collapsed last year when the mill closed. Mr. Richards has since worked occasional stints for local trucking companies. His wife has failed to find clerical work. "Every month that goes by, you get a little further behind," Mr. Richards said. Last June, they missed their first payment, and they have since slipped $10,000 into arrears. They are trying to persuade their bank to cut their payments ahead of a foreclosure sale.
From November to February, the number of prime mortgages that were delinquent at least 90 days, were in foreclosure or had deteriorated to the point that the lender took possession of the home increased more than 473,000, exceeding 1.5 million, according to a New York Times analysis of data provided by First American CoreLogic, a real estate research group. Those loans totaled more than $224 billion. During the same period, subprime mortgages in those three categories increased by fewer than 14,000, reaching 1.65 million. The number of similarly troubled Alt-A loans — those given to people with slightly tainted credit — rose 159,000, to 836,000.
Over all, more than four million loans worth $717 billion were in the three distressed categories in February, a jump of more than 60 percent in dollar terms compared with a year earlier. Under a program announced in February by the Obama administration, the government is to spend $75 billion on incentives for mortgage servicing companies that reduce payments for troubled homeowners. The Treasury Department says the program will spare as many as four million homeowners from foreclosure. But three months after the program was announced, a Treasury spokeswoman, Jenni Engebretsen, estimated the number of loans that have been modified at "more than 10,000 but fewer than 55,000."
In the first two months of the year alone, another 313,000 mortgages landed in foreclosure or became delinquent at least 90 days, according to First American CoreLogic. "I don’t think there’s any chance of government measures making more than a small dent," said Alan Ruskin, chief international strategist at RBS Greenwich Capital. Last year, foreclosures expanded sharply as the economy shed an average of 256,000 jobs each month. Since then, the job market has deteriorated further, with an average of 665,000 jobs vanishing each month. Each foreclosure costs lenders $50,000, according to data cited in a 2006 study by the Federal Reserve Bank of Chicago, so an additional two million foreclosures could mean $100 billion in lender losses.
The government’s recent stress tests of banks concluded that the nation’s 19 largest could be forced to write off as much as a fresh $600 billion by the end of 2010, bringing their total losses to $1 trillion. The Federal Reserve concluded that these banks needed to raise another $75 billion. Many economists pronounce that assessment reasonable, while cautioning that it could become inadequate if foreclosures continue to accelerate. "The margin for error is not that big," said Brian Bethune, chief United States financial economist for HIS Global Insight. "It’s kind of like, ‘Let’s keep our fingers crossed that we’ve seen the worst.’ "
Among prime borrowers, foreclosure rates have been growing fastest in states with particularly high unemployment. In California, for example, the unemployment rate rose to 11.2 percent from 6.4 percent for the year that ended in March, while the foreclosure rate for prime mortgages nearly tripled, reaching 1.81 percent. Even states seemingly removed from the real estate bubble are seeing foreclosures accelerate as the recession grinds on. In Minnesota, three of every five people seeking foreclosure counseling now have a prime loan, according to the nonprofit Minnesota Home Ownership Center.
In Woodbury, Minn., Rick and Christine Sellman are struggling to persuade their bank to reduce their $2,200 monthly mortgage on their five-bedroom home. Mr. Sellman, a construction worker, found some work putting in asphalt driveways last summer, but he is now receiving unemployment. Ms. Sellman’s scrapbooking businesses shut down last summer. Since then, they have slipped $19,000 behind on their mortgage. "We were always up on our house payments," Ms. Sellman said. "You work so hard to keep what you have, and because of circumstances beyond our control now, there’s nothing we can do about it."
S&P’s warning to Britain marks the next stage of this global crisis
"This is the next stage of the global crisis." Simon Johnson, former chief economist of the International Monetary Fund (IMF), is hardly renowned for hyperbole, so his description of the events of the past week, including Standard & Poor's warning over Britain's creditworthiness, is difficult to ignore. Thought we were on the long road to recovery; that economies and financial systems were now back in rude health; that interest rate cuts and quantitative easing were likely to push us out of recession and generate another boom? Not so fast.
When the ministers and central bankers from the world's richest nations met last month in Washington there was little room for back-slapping. Sure, they had seen their economies through the worst of the financial crisis. Most banks had been rescued from full-scale implosion. Governments had taken drastic measures to shore up their capital and ensure their survival. But the mountain of debt that had poisoned the financial system had not disappeared overnight. Instead, it has been shifted from the private sector onto the public sector balance sheet. Britain has taken on hundreds of billions of pounds of bank debt and stands behind potentially trillions of dollars of contingent liabilities.
If the first stage of the crisis was the financial implosion and the second the economic crunch, the third stage – the one heralded by Johnson – is where governments start to topple under the weight of this debt. If 2008 was a year of private sector bankruptcies, 2009 and 2010, it goes, will be the years of government insolvency. That, at least, is the horror story. It was one underlined by S&P's decision to change the outlook on Britain's debt from "stable" to "negative". While the UK still clings on to its prized AAA rating, it now stands a very real chance of losing it within two years – 37pc if past experience is any guide. Questionable as are the credentials of the agencies following the financial crisis, the significance should not be underestimated – particularly not in the case of the UK. A cut in S&P's ratings would reflect a considered opinion that this country may default for the first time in its history.
If Japan's experience in 2001 is anything to go by, it would also trigger an instant exodus of cash from foreign investors, since many of their reserve managers are obliged to invest the vast bulk of their cash in AAA-rated currencies. And all of this is before one even factors in the humiliation such an experience would be likely to inflict on the Government – whatever hue it is by then. But in spite of all this potential fire and brimstone, the reaction from financial markets in the wake of the S&P announcement was hardly dramatic. Gilt prices dipped sharply, but recovered their poise after a few hours. The FTSE 100 fell, but recovered the following day. After dropping precipitously straight after the announcement, the pound bounced back sharply. As the week ended it was knocking on $1.59 – the highest level since last November and hardly a currency in the midst of an obvious crisis.
Moreover, according to Simon Derrick of Bank of New York Mellon, who monitors the actual flow of cash streaming in and out of the economy, there was little evidence from activity on Thursday and Friday to suggest that the S&P decision had suddenly swung investors away from the UK. "Flows into sterling-denominated fixed income have certainly flattened out over the past month," he said. "There is a caution about buying anything sterling-denominated. It's early days, but it hasn't deteriorated much further since Thursday. And the pound still compares very well against dollar and euro-denominated debt. It seems to me that investors aren't looking at the UK in any more negative a light than the US or eurozone."
Indeed, so far as markets were concerned, a couple of disastrous headlines for the Government – the S&P decision and the IMF's verdict on the management of the economy the previous day – were no more a concern than the latest nasty set of economic output or employment data from the Office for National Statistics. Still, capital markets are unpredictable. As emerging markets – which have suffered sudden crises as international investors abandoned ship – know to their cost, creditors can turn on a sixpence. It is a cause for real concern in Whitehall, where officials and politicians are under little delusion about how reliant Britain is on support from the capital markets.
The Government is set to run a major deficit for the next five years at least, as it borrows deep to avoid the recession intensifying and satisfy its spending pledges. Unless the Government can borrow this cash, it will be forced to raise taxes and cut spending at an eye-watering rate. Foreign investors hold around a third of UK debt – most of it in the short-term gilt market. Unlike Japan, which had a massive saving glut when it lost its AAA-rating, the UK is directly vulnerable if their central banks and sovereign wealth funds turn a cold shoulder on sterling. Says one money market insider from a major investment bank: "We were called in by a major foreign central bank only the other week. They were asking probing questions about the stability of British debt and the long-term stability of the UK economy. They are genuinely worried."
But in reality the provenance of the cash is less important than the sheer level of revulsion towards the economy. In the 1970s, when the UK faced its last funding crisis and had to be rescued by the IMF, it was the exodus not of foreign investors but of domestic creditors, who relocated their cash to Switzerland and elsewhere, that caused the real problems. As things stand, the UK is the first of the major G7 economies to have been put on watch during this crisis (Japan is already AA). Were it the only country under real threat of downgrade, it would be easy to make baleful predictions about the impact. However, the economic crisis has touched every nation. The UK is likely to be joined by other countries as the full scale of the downturn becomes apparent and more financial skeletons are pulled from the sub-prime closet.
Indeed, the day after the S&P announcement more attention was on the US, which, according to Bill Gross of bond giant Pimco, is just as likely to lose its AAA rating in the coming years. Indeed, the S&P decision seems in fact to have moved the US Treasury yield even more than it did Britain's gilt yield. Neither is it inconceivable that if the recession remains truly global and intensifies rather than mellows in the coming year, we could find ourselves in a world where there are no AAA-rated sovereigns. According to Julian Jessop of Capital Economics: "If conditions deteriorated to the extent that the US were downgraded, many other countries would presumably be in just as big a mess and any hit on the dollar might be at least partially offset by safe haven buying. Sterling could not rely on the same support. But overall, we suspect that the blow to national pride from a rating downgrade would be much greater than the additional harm caused to the financial markets."
So while we may suspect this is how the next stage of the financial crisis will look, it is harder to grasp which countries, or for that matter which businesses or investments, will benefit and which will suffer. Central banks are likely to invest some of their cash in commodities such as gold and oil; tangible assets will become more desirable – perhaps housing may enjoy another boost. For Governments, survival is based on relative rather than absolute strengths. Countries that provide the most feasible and sensible fiscal plans are likely to thrive as they garner investment and support, while those that churn public money while failing to mend their financial systems are the most likely to suffer.
And it is this final point which is perhaps the silver lining for the UK. The S&P announcement this week represented something of an ultimatum. The statement warned that unless the party that wins the election shows clear and convincing signs of putting the fiscal books back in order, a downgrade will surely follow. Neither Gordon Brown nor David Cameron will like it, but this could be the final stick that beats back their first Budget into order. It means they will be forced either to slash spending or raise taxes in as soon as a year. No one will much enjoy this but if it helps preserve Britain's ratings, and thus ensures the UK can keep financing itself, it will be a pain worth suffering. For in the final stage of this crisis, those countries that recover and start to flourish will be those that face up soonest to the new period of fiscal austerity that must last for the next decade.
Mounting sadness behind the happy headlines
One of the driving forces in economics, according to Robert Shiller of Yale, is the story we tell ourselves. We create happy versions of life in the boom times and sad ones in the bust. It might be said the story is the product of events. But the process is circular. Events drive the story, the story drives our behaviour and our behaviour drives events. Franklin Roosevelt grasped the point when he told the American people in 1933 that the only thing they had to fear was fear itself. So what is the story today? On the face of it, a happy one. Equity markets are flying – most of the time, anyway. Investors are hurling billions of new money at the banks, including the most moribund ones. The world’s fund managers, according to the latest Merrill Lynch survey, are positively bubbling.
Their expectations for global growth and corporate earnings are at a five-year high, having been in the pits at Christmas. That mood is shared by the general public, in the US at any rate. Consider the University of Michigan’s survey of consumer sentiment, which asks people how they see things going over the next five years. The reading hit a low last summer – though not as low as in the two oil shocks of 1973 and 1979, or even the recession of 1990. Since then it has rebounded very nearly to its long-run average. That is striking on two counts. First, at the risk of seeming cynical, there is no reason to suppose the general public’s instincts are less trustworthy here than those of investment professionals. Second, it is the mood and therefore the behaviour of the general public that matters above all.
As Prof Shiller put it in a lecture at the London School of Economics last week, the central question now is whether we just got our confidence back. If so, logic suggests our problems should disappear. Prof Shiller is not sure about that, nor am I. It strikes me the feel-good story could be modified by events, in the usual circular way. Equally important, there are other less cheerful stories running alongside it. On the first point, it is instructive that the US popular mood should have started to revive as long ago as July. For it was not until September that most of the really big stuff happened: the collapse of Lehman Brothers, AIG and Washington Mutual. On the other hand, it was already clear by July that the US government was going to bail out Fannie Mae and Freddie Mac. So it seems the public had already judged – correctly, on the showing so far – that the government would go to any lengths to shore up the system.
But there are other things which, though foreseeable in principle, could turn out unexpectedly grievous in practice. It seems clear that unemployment will worsen from here, the only question being by how much. As to house prices, further evidence produced by Prof Shiller – an expert on the subject – reminds us of how far we are in unknown territory. The fall to date is without precedent. But so was the previous rise. In 1990, US house prices were in real terms roughly where they had been a century earlier. Then they almost doubled to the peak. The picture in the UK is uncannily similar. Prof Shiller shows a chart comparing house prices in London and Los Angeles in the boom and bust. They are almost identical, with the grim proviso that UK prices have yet to fall nearly as far. That said, let us turn to some of the other stories around. A central part of Prof Shiller’s thesis, as set out in his recent book Animal Spirits, is that people’s mood and behaviour is affected by certain constants, of which we may focus on two: fairness and corruption.
The issue of fairness, particularly in respect of chief executive pay, is scarcely new. But it is when things go wrong that perceived unfairness makes people angry, and thus has consequences. Two examples. First, in the US, the Securities and Exchange Commission has finally proposed that investors should be allowed to nominate directors. The chief investment officer of Calpers, a leading US institution, commented: "The credit debacle represents a massive failure of oversight." Second, Shell has had its directors’ pay package voted down. The oil company had missed targets that would have triggered bonuses, but proposed to pay them anyway. Add to this the furore over abuse of the expenses system by UK Members of Parliament, and we get the impression of a much angrier and unhappier story than the headlines might suggest. Conceivably, we are past the worst. But it does not quite feel like it.
Why US Debt Rating Poses Such a Big Worry to Investors
Even if a downgrade in US credit is not imminent, the underlying conditions that raised such fears are worrying investors about what the future holds. The move Thursday by Standard & Poor's to cut Britain's credit outlook has raised fears that the US may be next. Should that happen, the news likely wouldn't be good for stocks, while the dollar and Treasury prices would dip and gold probably would benefit as an investment of last resort. While a number of experts, including Moody's, largely dismissed such concerns at least for the short term, market experts were leery of what could happen down the road should the country continue to pursue its current debt policies.
"We are heading down a virtually irreversible road where the overall financial picture of the US is going to look very bad," said Peter Tanous, president and director of Lynx Investment Advisory in Washington, D.C. "Is this something to worry about or dismiss? Clearly, it's something to worry about," says Tanous. "In normal times nobody cares, because we're good for it. This time is different because the numbers are getting scary." The sheer magnitude of the numbers being bandied about is causing some investor fear. "All of this translates into hell of a big financial mess that will indeed affect US credit," Tanous said. "I've been in the business for 40 years and I've never used the world trillion before until recently. Unfortunately, it's trillions of dollars we don't have."
Boatloads of US debt in the hands of foreign governments and the myriad problems that can cause, primarily in the form of higher interest rates down the road, are causing the most concerns. As the US continues to issue Treasury notes, there is concern that China and other large debt holders will demand higher yield, sending interest rates up for borrowers and further hampering a real estate recovery. "At some point the market is going to extract a penalty because you're essentially putting the US government credit on the line in so many areas at such a great cost," said Mike Larson, analyst at Weiss Research in Jupiter, Fla. "You're seeing the ramifications of such short-sighted thinking."
Larson has been warning of a Treasury bubble popping since late 2008 and said the most recent conditions are further signal that US government debt prices are on a precipitous track lower, and yields will move higher. Prices and yields move in opposite directions. China has been relied on to buy debt, but a New York Times report Thursday indicated the nation is becoming more selective in buying Treasurys and is moving towards the lower end of the yield curve, a possibly ominous sign for the long-term state of US financial health. Continuing prospects for government bailouts also are raising concern.
"You have to really start asking yourself whether the cure is worse than the disease," Larson said. "The real danger is this trend accelerates and gets out of control. It's a risk that everybody's sort of keeping in the back of their minds, that we start to see more manifestations of the flat-out repudiation of US assets." Beyond that, there is concern about what the debt will mean to the government's budget and how those bills will be paid by future generations. For investors, the end result is caution that springs from an uncertain world where economic weakness pervades and government budgets crumple under their own weight.
"It's going to make funding more expensive. It almost becomes a death spiral, which might be a little overdramatic, but it presents some problems," says Uri Landesman, head of global growth strategies at ING Investment Management in New York. "They way they're running things now certainly is not geared towards keeping a respectable credit rating." Fears of what will happen to the US credit rating came to the forefront Thursday after Pimco co-CEO Bill Gross said the nation was in danger of going the same route as the UK and losing its credit rating. Pimco runs the world's largest bond fund and Gross has been an influential voice in the shaping of monetary policy here and abroad.
Speaking on CNBC earlier Friday, Gross' counterpart, Mohamed El-Erian, said investors were satisfied that the government had stemmed credit and liquidity problems in the short term but were worried about long-range ramifications. "All of us have to worry about unintended consequences of policy action as well as the intended consequences," El-Erian said. "Every sector is having this tug of war between what it has been doing, what it ought to be doing and what people expect it to be doing." The fragility of investor confidence went on full display Thursday after Gross' comments, when equities, Treasurys and the dollar all sold off while gold went upward.
"When the market starts to disbelieve something, the selling can turn violent," Art Cashin, director of floor operations at UBS, told CNBC. Yet the markets turned around a bit Friday, edging higher as investors sought out positions ahead of the extended Memorial Day weekend. Indeed, investors if nothing else, have been resilient since the rally off the March lows, and even talk of the US losing its vaunted credit rating wasn't enough to spoil the holiday optimism. "The market will go down the day of the week that any of these countries are downgraded," Landesman said. "I don't think this fear is going to prevent a market rally if the economy continues to recover and people think the worst is behind us. It will be a glitch in the road."
Why Are Long-Term Rates Going Up? Because Lenders Think We're Screwed?
The whole world is deflating, but long-term interest rates are moving up. See the chart for the 10-yr Treasury:
10 Year Treasury Rates The world is deleveraging. Debt is being drawn down. Securitization of various types of debt has seriously slowed. Banks are cutting back on lending. Home prices are dropping all over the world. Commercial real estate is rolling over, and banks all over the world are exposed. "Recession turns malls into ghost towns" is the headline in today'sWall Street Journal. Personal savings are rising and retail sales are flat to down. Unemployment is rising. All this should be massively deflationary. Interest rates should be falling or at least not rising. But a funny thing is happening. In the past two months, the yield on the ten-year bond has risen by 1%. It has moved 0.38% or almost "4 big handles" in just two weeks. Look at the chart. What is happening?
Why? Tim Geithner thinks it's because traders are recognizing that the economy's beginning to recover. That's one happy theory. And it's possible (fingers crossed). But here are two less-happy theories:
First, long-term rates are going up because traders are getting nervous about future inflation. This is sensible. Given all the money the world is printing, it is quite likely that we're eventually going to have severe inflation, which will destroy the value of savings and bonds. The question is when that will start. (Japan has been able to postpone it for 15 years and counting).
Second, long-term rates are going up because traders are realizing that the world's big economies will need to issue trillions of dollars of new debt to pay for all their deficit spending...and there's just not enough dumb money in the world. Put differently, where is all this money going to come from?
John Mauldin ran some numbers on this over the weekend. The US is in trouble. Japan's in trouble. Germany's in trouble. The UK's in trouble. Spain is in trouble. European banks are in trouble. All of the aforementioned countries, including the US, will be running deficits of over 10% a year, likely for several years to try to stave off economic collapse. The US deficit alone will eat $1.8 trillion next year, forcing the US to issue $1.8 trillion of new debt. When you go out a few years and add in the other countries, the amount of new money required gets very big very fast. And, again, the big question is...where is that money going to come from?Here's John Mauldin:The world is going to have to fund multiple trillions in debt over the next several years. Pick a number. I think $5 trillion sounds about right. $3 trillion is in the cards for the US alone, if current projections are right. The US trade deficit is now down to under $350 billion a year. The Fed can monetize a trillion [buy debt directly from the Treasury, thus printing new money]. Maybe... US savings are going to go up, but where is the incentive to buy ten-year debt at 3.5%? Four-year debt under 2% doesn't do much for your savings growth. Even with monetization and the Chinese buying our debt with the dollars we send them, that still leaves the bond market about $1.5 trillion short, give or take $100 billion...I think the bond market is looking at the mountain of debt that will have to be somehow sold and wondering where such a colossal sum will come from. Where do you find $10 trillion in the next ten years for US debt? And that is just for US government debt. $5 trillion for new global debt in the next two years? In a deleveraged world? How much will the other countries need? What about money needed for businesses and mortgages and credit cards and so on? If you add $10 trillion to the current $11.3 trillion (including Social Security trust funds, etc.), that totals $21 trillion in 2019. Let's be generous and suggest that interest rates will only be an average of 5%. That would be an interest-rate expense of over $1 trillion. That is 25% of projected revenues and 20% of expected expenses. And that assumes you have nominal growth of over 4% for the next ten years. If growth is less, tax revenues will be less.
Put another way: Interest rates may be going up because the bond market is concluding that the world's biggest borrowers are becoming lousy credits. The only way you can induce lenders to lend to lousy credits (subprime borrowers, for example) is to charge sky-high interest rates with lots of onerous terms. So what may be happening in the bond market is that the "teaser rate" of the past few years is resetting to a usurious rate that will make it fantastically expensive to borrow the money we need.
(This is what some bond market vigilantes have been predicting for years, by the way. They've just been wrong for so long that everyone has stopped listening to them. Maybe now they'll be right). The Obama administration (and the governments of the other big countries mentioned above) is betting that it can turn the economy around in time to start paying off the mortgage before the teaser rate resets. Here's hoping the bet works out.
US bonds sale faces market resistance
The US Treasury is facing an ordeal by fire this week as it tries to sell $100bn (£62bn) of bonds to a deeply sceptical market amid growing fears of a sovereign bond crisis in the Anglo-Saxon world. The interest yield on 10-year US Treasuries – the benchmark price of long-term credit for the global system – jumped 33 basis points last week to 3.45pc week on contagion effects after Standard & Poor's issued a warning on Britain's "AAA" credit rating. The yield has risen over 90 basis points since March when the US Federal Reserve first announced its controversial plan to buy Treasury bonds directly, a move designed to force down the borrowing costs and help stabilise the housing market.
The yield-spike may be nearing the point where it threatens to short-circuit economic recovery. While lower spreads on mortgage rates have kept a lid on home loan costs so far, mortgage rates have nevertheless crept back up to 5pc. The Obama administration needs to raise $2 trillion this year to cover the fiscal stimulus plan and the bank bail-outs. It has to fund $900bn by September. "The dynamic is just getting overwhelming," said RBC Capital Markets. The US Treasury is selling $40bn of two-year notes on Tuesday, $35bn of five-year bonds on Wednesday, and $25bn of seven-year debt on Thursday. While the US has not yet suffered the indignity of a failed auction – unlike Britain and Germany – traders are watching closely to see what share is being purchased by US government itself in pure "monetisation" of the deficit.
Don Kohn, the Fed's vice-chair, said over the weekend that Fed actions would add $1 trillion of stimulus to the US economy over time and had already prevented "fire sales" of assets. "The preliminary evidence suggest that our programme has worked," he said. The US is not alone in facing a deficit crisis. Governments worldwide have to raise some $6 trillion in debt this year, with huge demands in Japan and Europe. Kyle Bass from the US fund Hayman Advisors said the markets were choking on debt. "There isn't enough capital in the world to buy the new sovereign issuance required to finance the giant fiscal deficits that countries are so intent on running. There is simply not enough money out there," he said. "If the US loses control of long rates, they will not be able to arrest asset price declines. If they print too much money, they will debase the dollar and cause stagflation.
"The bottom line is that there is no global 'get out of jail free' card for anyone", he said. The US is acutely vulnerable because it relies heavily on foreign goodwill. China and Japan alone hold 23pc of America's $6,369bn federal debt. Suspicions that Washington is trying to engineer a stealth default by letting the dollar slide could cause patience to snap, even if Asian exporters would themselves suffer if they harmed their chief market. The dollar has fallen 11pc against a basket of currencies since early March. Mutterings of a "dollar crisis" may now constrain the Fed as it tries to shore up the bond market. It has so far bought $116bn of Treasuries as part of its "credit easing" blitz, out of a $300bn pool.
When the Fed first said it was going to buy Treasuries in March the 10-year yield to dropped instantly from 3pc to near 2.5pc, but shock effect has since worn off. Any effort to step up purchases might backfire in the current jittery mood. In the late 1940s the Fed was able to cap the 10-year yield at around 2pc, but that was a different world. The US commanded half global GDP and had a colossal trade surplus. The Fed could carry out its experiment without worrying about foreign dissent. Fed chair Ben Bernanke has long argued that central banks can bring down long-term borrowing rates by purchasing bonds "at essentially no cost". His frequent writings rarely ask whether foreigner investors – from a different cultural universe – will tolerate such conduct.
Mr Bernanke is betting that under a floating currency regime there is no risk of repeating the disaster of October 1931, when the Fed had to raise rates twice to stem foreign gold withdrawals, with catastrophic consequences. This assumption may be tested. It is not clear where the capital will come from to cover global bond issues. Asian central banks and Mid-East oil exporters have cut back on their purchases of US and European bonds as reserve accumulation slows. Russia has slashed its holding by a third to support growth at home. Even Japan's state pension fund has become a net seller of bonds for the first time this year the country's population ages.
Japan's public debt will reach 200pc of GDP next year. Warnings by the Japan's DPJ opposition party that, if elected this autumn, it would not purchase any more US debt unless issued in yen, is a sign that the political mood in Asia is turning hostile to US policy. There is no evidence yet that foreigners are in the process of dumping US Treasuries. Brad Setser from the US Council on Foreign Relations said global central banks added $60bn to their US holdings in the first three weeks of May. This is bitter-sweet for Washington. It suggests that private buyers are pulling out, leaving foreign powers as buyer-of-last resort. We just have to hope that G20 creditors agree to put a clothes peg on their nose and keep buying Western debt until the crisis passes, for the sake of the world.
Debt Destroys Solvency
Every loan officer knows the story begins with debt and income. Debt and income define the financial health of a borrower. Is it any different for a country? If yes, then what do you use to determine the financial health of a country?
One method I suggest is a shaman. Mine uses a divining rod. He stands himself inside a circle of cow chips, and keeps a rabbit’s foot, resting on top of his head, but hidden under a baseball cap. And then he sees everything. I wish I could tell you what his chant is, but his guidance is proprietary.
When the shaman won’t work with me, I go back to basics. Debt and income for a borrower’s home or a country’s economy are perfectly synonymous factors: They are the decisive fact defining financial health or sickness.
A mortgage lender wants the borrower’s monthly payments, after taking on the new debt, to equal no more than 36% of income. Less is better. More sometimes works. So how do you determine a country’s income? That’s very simple. Substitute gross domestic product (GDP) for income. Then review the chart immediately below.
If, after reviewing the chart, you aren’t crying now, then you don’t know what you have just seen. What does the chart say? It predicts we have unpayable debt equal to $21 trillion. Where all the lines go up in the chart, assume they all have to come back down again. If we write off $21 trillion, the job gets done.
If you play your cards right, it’s enough money to buy every residential property in the United States. And after you buy all those homes you can put a serious killer deck on each and every one of your new property investments. And then, as a closing present, you easily pay for every family in the United States to travel all around the world for 80 days – at least. Tell them to eat and drink whatever they want. If you like to buy wars, wait it out six or 12 months, and buy the property then. You can do it all. It’s crazy what you can do with $21 trillion. Know what I mean?
Before signing off, I should mention a gaping hole in the preceding argument. I have assumed that 1980 was a year of sanity for debt. And I have assumed 2008 was the denouement of decades of debt insanity. Nobody, to my knowledge, has published a detailed report defining the correct ratio of debt-to-GDP/income for a country. I have seen a few mentions here and there, and a few graphs, but nothing convincing or serious.
And if nobody has done that work, what does it mean? It quite simply means that we are all dumb and we don’t know what we are talking about. Now that I’ve said it, doesn’t that sound like the world we all know? I’ve been there anyway.
We can and should confirm that economics is a dismal science. And the herd, including you and me, really should think about going back to school. That’s it for now. Enjoy the bull market. Isn’t it fun to be confident again? Enjoy your holiday weekend. And, if you don’t mind, please pass the Cool Aid. I’ll take a pitcher if you don’t mind? I love that stuff.
We cannot inflate our way out of this crisis
by Wolfgang Münchau
"The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists."
Ernest Hemingway, "Notes on the Next War: A Serious Topical Letter" , 1935
What I hear more and more, both from bankers and from economists, is that the only way to end our financial crisis is through inflation. Their argument is that high inflation would reduce the real level of debt, allowing indebted households and banks to deleverage faster and with less pain. To achieve the desired increase in inflation, the US Federal Reserve should either announce an inflation target or simply keep interest rates at zero when the recovery begins. That way, real interest rates would become strongly negative. The advocates of such a strategy are not marginal and cranky academics. They include some of the most influential US economists.
Four immediate questions arise from these considerations. Can it be done? Can it be undone? Can it be done at a reasonable economic cost? Last, should it be done? Of course, it can be done, but only for as long as the commitment to higher inflation is credible. Inflation is not some lightbulb that a central bank can switch on and off. It works through expectations. If the Fed were to impose a long-term inflation target of, say, 6 per cent, then I am sure it would achieve that target eventually. People and markets might not find the new target credible at first but if the central bank were consistent, expectations would eventually adjust. In the end, workers would demand wage increases of at least 6 per cent each year and companies would strive to raise their prices by that amount.
If, however, a central bank were to pre-announce that it was targeting 6 per cent inflation in 2010 and 2011, and 2 per cent thereafter, the plan would probably not succeed. We know that monetary policy affects inflation with long and variable lags. Such a degree of fine-tuning does not work in practice. My own guess is that one would have to make a much longer-term commitment to a higher rate of inflation for such a policy shift to be credible. I suspect that the greater the distance between the new rate and the current rate, the longer the commitment would have to be.
Could it be reversed, once it had been achieved? Again, the answer is yes; again, the commitment would have to be credible. But herein lies precisely the problem. If the central bank were honest from the start and pre-announced that it would eventually reverse its policy, it might never reach its goal of higher inflation in the first place. If the central bank were dishonest, it might achieve the goal. But it would lose credibility the moment it decided to reverse. So any new credibility would have to be earned through new policy action. This might imply nominal interest rates significantly above 6 per cent for an uncomfortably long period.
What would happen then? I can think of two scenarios. The best outcome would be a simple double-dip recession. A two-year period of moderately high inflation might reduce the real value of debt by some 10 per cent. But there is also a downside. The benefit would be reduced, or possibly eliminated, by higher interest rates payable on loans, higher default rates and a further increase in bad debts. I would be very surprised if the balance of those factors were positive. In any case, this is not the most likely scenario. A policy to raise inflation could, if successful, trigger serious problems in the bond markets. Inflation is a transfer of wealth from creditors to debtors – essentially from China to the US. A rise in US inflation could easily lead to a pull-out of global investors from US bond markets. This would almost certainly trigger a crash in the dollar's real effective exchange rate, which in turn would add further inflationary pressure.
Under such a scenario, it might not be easy to keep inflation close to a hypothetical 6 per cent target. The result could be a vicious circle in which an overshooting inflation rate puts further pressure on the bond markets and the exchange rate. The outcome would be even worse than in the previous example. The central bank would eventually have to raise nominal rates aggressively to bring back stability. It would end up with the very opposite of what the advocates of a high inflation policy hope for. Real interest rates would not be significantly negative, but extremely positive.
Should this be done? A credible inflation target of 2 or 3 per cent, maintained over a credibly long period of time, is useful. But I doubt that a 6 per cent inflation target could be simultaneously credible and sustainable. Tempting as it may be, it is a beggar-thy-neighbour policy unless replicated elsewhere and would come to be regarded as such by many countries in the world. It would produce a whole new group of losers, both inside and outside the US, with all its undesirable political, social, economic and financial implications. It would also fuel the already rampant discussions about the inevitable death of fiat money. Stimulating inflation is another dirty, quick-fix strategy, like so many of the bank rescue packages currently in operation. As Hemingway said, it would feel good for a time. But it would solve no problems and create new ones.
Don't Monetize the Debt
From his perch high atop the palatial Dallas Federal Reserve Bank, overlooking what he calls "the most modern, efficient city in America," Richard Fisher says he is always on the lookout for rising prices. But that's not what's worrying the bank's president right now. His bigger concern these days would seem to be what he calls "the perception of risk" that has been created by the Fed's purchases of Treasury bonds, mortgage-backed securities and Fannie Mae paper. Mr. Fisher acknowledges that events in the financial markets last year required some unusual Fed action in the commercial lending market. But he says the longer-term debt, particularly the Treasurys, is making investors nervous. The looming challenge, he says, is to reassure markets that the Fed is not going to be "the handmaiden" to fiscal profligacy.
"I think the trick here is to assist the functioning of the private markets without signaling in any way, shape or form that the Federal Reserve will be party to monetizing fiscal largess, deficits or the stimulus program." The very fact that a Fed regional bank president has to raise this issue is not very comforting. It conjures up images of Argentina. And as Mr. Fisher explains, he's not the only one worrying about it. He has just returned from a trip to China, where "senior officials of the Chinese government grill[ed] me about whether or not we are going to monetize the actions of our legislature." He adds, "I must have been asked about that a hundred times in China." A native of Los Angeles who grew up in Mexico, Mr. Fisher was educated at Harvard, Oxford and Stanford. He spent his earliest days in government at Jimmy Carter's Treasury. He says that taught him a life-long lesson about inflation.
It was "inflation that destroyed that presidency," he says. He adds that he learned a lot from then Fed Chairman Paul Volcker, who had to "break [inflation's] back." Mr. Fisher has led the Dallas Fed since 2005 and has developed a reputation as the Federal Open Market Committee's (FOMC) lead inflation worrywart. In September he told a New York audience that "rates held too low, for too long during the previous Fed regime were an accomplice to [the] reckless behavior" that brought about the economic troubles we are now living through. He also warned that the Treasury's $700 billion plan to buy toxic assets from financial institutions would be "one more straw on the back of the frightfully encumbered camel that is the federal government ledger."
In a speech at the Kennedy School of Government in February, he wrung his hands about "the very deep hole [our political leaders] have dug in incurring unfunded liabilities of retirement and health-care obligations" that "we at the Dallas Fed believe total over $99 trillion." In March, he is believed to have vociferously objected in closed-door FOMC meetings to the proposal to buy U.S. Treasury bonds. So with long-term Treasury yields moving up sharply despite Fed intentions to bring down mortgage rates, I've flown to Dallas to see what he's thinking now. Regarding what caused the credit bubble, he repeats his assertion about the Fed's role: "It is human instinct when rates are low and the yield curve is flat to reach for greater risk and enhanced yield and returns." (Later, he adds that this is not to cast aspersions on former Fed Chairman Alan Greenspan and reminds me that these decisions are made by the FOMC.)
"The second thing is that the regulators didn't do their job, including the Federal Reserve." To this he adds what he calls unusual circumstances, including "the fruits and tailwinds of globalization, billions of people added to the labor supply, new factories and productivity coming from places it had never come from before." And finally, he says, there was the 'mathematization' of risk." Institutions were "building risk models" and relying heavily on "quant jocks" when "in the end there can be no substitute for good judgment." What about another group of alleged culprits: the government-anointed rating agencies? Mr. Fisher doesn't mince words. "I served on corporate boards. The way rating agencies worked is that they were paid by the people they rated. I saw that from the inside." He says he also saw this "inherent conflict of interest" as a fund manager.
"I never paid attention to the rating agencies. If you relied on them you got . . . you know," he says, sparing me the gory details. "You did your own analysis. What is clear is that rating agencies always change something after it is obvious to everyone else. That's why we never relied on them." That's a bit disconcerting since the Fed still uses these same agencies in managing its own portfolio. I wonder whether the same bubble-producing Fed errors aren't being repeated now as Washington scrambles to avoid a sustained economic downturn. He surprises me by siding with the deflation hawks. "I don't think that's the risk right now." Why? One factor influencing his view is the Dallas Fed's "trim mean calculation," which looks at price changes of more than 180 items and excludes the extremes. Dallas researchers have found that "the price increases are less and less. Ex-energy, ex-food, ex-tobacco you've got some mild deflation here and no inflation in the [broader] headline index."
Mr. Fisher says he also has a group of about 50 CEOs around the U.S. and the world that he calls on, all off the record, before almost every FOMC meeting. "I don't impart any information, I just listen carefully to what they are seeing through their own eyes. And that gives me a sense of what's happening on the ground, you might say on Main Street as opposed to Wall Street." It's good to know that a guy so obsessed with price stability doesn't see inflation on the horizon. But inflation and bubble trouble almost always get going before they are recognized. Moreover, the Fed has to pay attention to the 1978 Full Employment and Balanced Growth Act -- a.k.a. Humphrey-Hawkins -- and employment is a lagging indicator of economic activity. This could create a Fed bias in favor of inflating. So I push him again.
"I want to make sure that your readers understand that I don't know a single person on the FOMC who is rooting for inflation or who is tolerant of inflation." The committee knows very well, he assures me, that "you cannot have sustainable employment growth without price stability. And by price stability I mean that we cannot tolerate deflation or the ravages of inflation." Mr. Fisher defends the Fed's actions that were designed to "stabilize the financial system as it literally fell apart and prevent the economy from imploding." Yet he admits that there is unfinished work. Policy makers have to be "always mindful that whatever you put in, you are going to have to take out at some point. And also be mindful that there are these perceptions [about the possibility of monetizing the debt], which is why I have been sensitive about the issue of purchasing Treasurys."
He returns to events on his recent trip to Asia, which besides China included stops in Japan, Hong Kong, Singapore and Korea. "I wasn't asked once about mortgage-backed securities. But I was asked at every single meeting about our purchase of Treasurys. That seemed to be the principal preoccupation of those that were invested with their surpluses mostly in the United States. That seems to be the issue people are most worried about." As I listen I am reminded that it's not just the Asians who have expressed concern. In his Kennedy School speech, Mr. Fisher himself fretted about the U.S. fiscal picture. He acknowledges that he has raised the issue "ad nauseam" and doesn't apologize. "Throughout history," he says, "what the political class has done is they have turned to the central bank to print their way out of an unfunded liability. We can't let that happen. That's when you open the floodgates. So I hope and I pray that our political leaders will just have to take this bull by the horns at some point. You can't run away from it."
Voices like Mr. Fisher's can be a problem for the politicians, which may be why recently there have been rumblings in Washington about revoking the automatic FOMC membership that comes with being a regional bank president. Does Mr. Fisher have any thoughts about that? This is nothing new, he points out, briefly reviewing the history of the political struggle over monetary policy in the U.S. "The reason why the banks were put in the mix by [President Woodrow] Wilson in 1913, the reason it was structured the way it was structured, was so that you could offset the political power of Washington and the money center in New York with the regional banks. They represented Main Street. "Now we have this great populist fervor and the banks are arguing for Main Street, largely. I have heard these arguments before and studied the history. I am not losing a lot of sleep over it," he says with a defiant Texas twang that I had not previously detected. "I don't think that it'd be the best signal to send to the market right now that you want to totally politicize the process."
Speaking of which, Texas bankers don't have much good to say about the Troubled Asset Relief Program (TARP), according to Mr. Fisher. "Its been complicated by the politics because you have a special investigator, special prosecutor, and all I can tell you is that in my district here most of the people who wanted in on the TARP no longer want in on the TARP." At heart, Mr. Fisher says he is an advocate for letting markets clear on their own. "You know that I am a big believer in Schumpeter's creative destruction," he says referring to the term coined by the late Austrian economist. "The destructive part is always painful, politically messy, it hurts like hell but you hopefully will allow the adjustments to be made so that the creative part can take place." Texas went through that process in the 1980s, he says, and came back stronger.
This is doubtless why, with Washington taking on a larger role in the American economy every day, the worries linger. On the wall behind his desk is a 1907 gouache painting by Antonio De Simone of the American steam sailing vessel Varuna plowing through stormy seas. Just like most everything else on the walls, bookshelves and table tops around his office -- and even the dollar-sign cuff links he wears to work -- it represents something. He says that he has had this painting behind his desk for the past 30 years as a reminder of the importance of purpose and duty in rough seas. "The ship," he explains, "has to maintain its integrity." What is more, "no mathematical model can steer you through the kind of seas in that picture there. In the end someone has the wheel." He adds: "On monetary policy it's the Federal Reserve."
China warns Federal Reserve over 'printing money'
China has warned a top member of the US Federal Reserve that it is increasingly disturbed by the Fed's direct purchase of US Treasury bonds. Richard Fisher, president of the Dallas Federal Reserve Bank, said: "Senior officials of the Chinese government grilled me about whether or not we are going to monetise the actions of our legislature." "I must have been asked about that a hundred times in China. I was asked at every single meeting about our purchases of Treasuries. That seemed to be the principal preoccupation of those that were invested with their surpluses mostly in the United States," he told the Wall Street Journal.
His recent trip to the Far East appears to have been a stark reminder that Asia's "Confucian" culture of right action does not look kindly on the insouciant policy of printing money by Anglo-Saxons. Mr Fisher, the Fed's leading hawk, was a fierce opponent of the original decision to buy Treasury debt, fearing that it would lead to a blurring of the line between fiscal and monetary policy – and could all too easily degenerate into Argentine-style financing of uncontrolled spending. However, he agreed that the Fed was forced to take emergency action after the financial system "literally fell apart". Nor, he added was there much risk of inflation taking off yet. The Dallas Fed uses a "trim mean" method based on 180 prices that excludes extreme moves and is widely admired for accuracy.
"You've got some mild deflation here," he said. The Oxford-educated Mr Fisher, an outspoken free-marketer and believer in the Schumpeterian process of "creative destruction", has been running a fervent campaign to alert Americans to the "very big hole" in unfunded pension and health-care liabilities built up by a careless political class over the years. "We at the Dallas Fed believe the total is over $99 trillion," he said in February. "This situation is of your own creation. When you berate your representatives or senators or presidents for the mess we are in, you are really berating yourself. You elect them," he said. His warning comes amid growing fears that America could lose its AAA sovereign rating.
China stuck in ‘dollar trap’
China’s official foreign exchange manager is still buying record amounts of US government bonds, in spite of Beijing’s increasingly vocal fear of a dollar collapse, according to officials and analysts. Senior Chinese officials, including Wen Jiabao, the premier, have repeatedly signalled concern that US policies could lead to a collapse in the dollar and global inflation. But Chinese and western officials in Beijing said China was caught in a "dollar trap" and has little choice but to keep pouring the bulk of its growing reserves into the US Treasury, which remains the only market big enough and liquid enough to support its huge purchases.
In March alone, China’s direct holdings of US Treasury securities rose $23.7bn to reach a new record of $768bn, according to preliminary US data, allowing China to retain its title as the biggest creditor of the US government. "Because of the sheer size of its reserves Safe [China’s State Administration of Foreign Exchange] will immediately disrupt any other market it tries to shift into in a big way and could also collapse the value of its existing reserves if it sold too many dollars," said a western official, who spoke on condition of anonymity. The composition of China’s reserves is a state secret but dollar assets are estimated to comprise as much as 70 per cent of the $1,953bn total and China owns nearly a quarter of the US debt held by foreigners, according to US Treasury data.
The collapse of Fannie Mae and Freddie Mac, the US mortgage financiers, last summer prompted Safe to adjust its strategy and start buying far more short-term US government securities, instead of longer-maturity bonds and notes. This approach is widespread in the market because of expectations that the US will have to raise interest rates in the medium term to deal with rising inflation, as a result of all the money that it is printing. But Safe has not fundamentally changed its strategy of allocating the bulk of its burgeoning foreign exchange reserves to US Treasury securities, a western adviser familiar with Safe thinking told the Financial Times.
He said Safe traders were "very negative" on sterling because of expectations of renewed weakness of the UK currency but Safe was neutral on the euro and bullish on the Australian dollar. The pound ended last week at its strongest since December, shrugging off a warning over the UK’s soaring public debt from Standard & Poor’s, a rating agency. The US dollar fell to its lowest level of the year against major currencies last week. Treasury yields spiked to six-month highs as investors focused on the willingness of creditors to fund a deficit that was expected to be about 13 per cent of gross domestic product this year.
China’s determination to keep buying US government debt is helping Washington fund its soaring budget deficit and there is no indication that Beijing will shy away from continued purchases, the Obama administration’s budget chief told a congressional sub-committee last week. As its reserves soared in recent years, Safe began trying to diversify away from the dollar, It has been adding to its gold stocks and taking small equity stakes in publicly listed companies all over the world.
Over the long term, Beijing hopes to reduce the size of its enormous reserves and cut exposure to US Treasury bonds by encouraging state-owned enterprises to use foreign exchange to acquire competitors abroad. Chinese outbound foreign direct investment nearly doubled from 2007 to $52.2bn last year. Beijing announced a plan last week to ease restrictions on domestic companies to make it easier to buy and borrow foreign exchange for offshore investment.
The Weimar Hyperinflation: Time to get out the wheelbarrows?
by Ellen Brown
"It was horrible. Horrible! Like lightning it struck. No one was prepared. The shelves in the grocery stores were empty.You could buy nothing with your paper money."
– Harvard University law professor Friedrich Kessler on on the Weimar Republic hyperinflation (1993 interview)
Some worried commentators are predicting a massive hyperinflation of the sort suffered by Weimar Germany in 1923, when a wheelbarrow full of paper money could barely buy a loaf of bread. An April 29 editorial in the San Francisco Examiner warned: "With an unprecedented deficit that's approaching $2 trillion, [the President's 2010] budget proposal is a surefire prescription for hyperinflation. So every senator and representative who votes for this monster $3.6 trillion budget will be endorsing a spending spree that could very well turn America into the next Weimar Republic."1
In an investment newsletter called Money Morning on April 9, Martin Hutchinson pointed to disturbing parallels between current government monetary policy and Weimar Germany's, when 50% of government spending was being funded by seigniorage – merely printing money.2 However, there is something puzzling in his data. He indicates that the British government is already funding more of its budget by seigniorage than Weimar Germany did at the height of its massive hyperinflation; yet the pound is still holding its own, under circumstances said to have caused the complete destruction of the German mark. Something else must have been responsible for the mark's collapse besides mere money-printing to meet the government's budget, but what? And are we threatened by the same risk today? Let's take a closer look at the data.
In his well-researched article, Hutchinson notes that Weimar Germany had been suffering from inflation ever since World War I; but it was in the two year period between 1921 and 1923 that the true "Weimar hyperinflation" occurred. By the time it had ended in November 1923, the mark was worth only one-trillionth of what it had been worth back in 1914. Hutchinson goes on: "The current policy mix reflects those of Germany during the period between 1919 and 1923. The Weimar government was unwilling to raise taxes to fund post-war reconstruction and war-reparations payments, and so it ran large budget deficits. It kept interest rates far below inflation, expanding money supply rapidly and raising 50% of government spending through seigniorage (printing money and living off the profits from issuing it). . . .
"The really chilling parallel is that the United States, Britain and Japan have now taken to funding their budget deficits through seigniorage. In the United States, the Fed is buying $300 billion worth of U.S. Treasury bonds (T-bonds) over a six-month period, a rate of $600 billion per annum, 15% of federal spending of $4 trillion. In Britain, the Bank of England (BOE) is buying 75 billion pounds of gilts [the British equivalent of U.S. Treasury bonds] over three months. That's 300 billion pounds per annum, 65% of British government spending of 454 billion pounds. Thus, while the United States is approaching Weimar German policy (50% of spending) quite rapidly, Britain has already overtaken it!"
And that is where the data gets confusing. If Britain is already meeting a larger percentage of its budget deficit by seigniorage than Germany did at the height of its hyperinflation, why is the pound now worth about as much on foreign exchange markets as it was nine years ago, under circumstances said to have driven the mark to a trillionth of its former value in the same period, and most of this in only two years? Meanwhile, the U.S. dollar has actually gotten stronger relative to other currencies since the policy was begun last year of massive "quantitative easing" (today's euphemism for seigniorage).3 Central banks rather than governments are now doing the printing, but the effect on the money supply should be the same as in the government money-printing schemes of old.
The government debt bought by the central banks is never actually paid off but is just rolled over from year to year; and once the new money is in the money supply, it stays there, diluting the value of the currency. So why haven't our currencies already collapsed to a trillionth of their former value, as happened in Weimar Germany? Indeed, if it were a simple question of supply and demand, a government would have to print a trillion times its earlier money supply to drop its currency by a factor of a trillion; and even the German government isn't charged with having done that. Something else must have been going on in the Weimar Republic, but what?
Light is thrown on this mystery by the later writings of Hjalmar Schacht, the currency commissioner for the Weimar Republic. The facts are explored at length in The Lost Science of Money by Stephen Zarlenga, who writes that in Schacht's 1967 book The Magic of Money, he "let the cat out of the bag, writing in German, with some truly remarkable admissions that shatter the 'accepted wisdom' the financial community has promulgated on the German hyperinflation." What actually drove the wartime inflation into hyperinflation, said Schacht, was speculation by foreign investors, who would bet on the mark's decreasing value by selling it short.
Short selling is a technique used by investors to try to profit from an asset's falling price. It involves borrowing the asset and selling it, with the understanding that the asset must later be bought back and returned to the original owner. The speculator is gambling that the price will have dropped in the meantime and he can pocket the difference. Short selling of the German mark was made possible because private banks made massive amounts of currency available for borrowing, marks that were created on demand and lent to investors, returning a profitable interest to the banks. At first, the speculation was fed by the Reichsbank (the German central bank), which had recently been privatized. But when the Reichsbank could no longer keep up with the voracious demand for marks, other private banks were allowed to create them out of nothing and lend them at interest as well.4
If Schacht is to be believed, not only did the government not cause the hyperinflation but it was the government that got the situation under control. The Reichsbank was put under strict regulation, and prompt corrective measures were taken to eliminate foreign speculation by eliminating easy access to loans of bank-created money. More interesting is a little-known sequel to this tale. What allowed Germany to get back on its feet in the 1930s was the very thing today's commentators are blaming for bringing it down in the 1920s – money issued by seigniorage by the government. Economist Henry C. K. Liu calls this form of financing "sovereign credit." He writes of Germany's remarkable transformation:
"The Nazis came to power in Germany in 1933, at a time when its economy was in total collapse, with ruinous war-reparation obligations and zero prospects for foreign investment or credit. Yet through an independent monetary policy of sovereign credit and a full-employment public-works program, the Third Reich was able to turn a bankrupt Germany, stripped of overseas colonies it could exploit, into the strongest economy in Europe within four years, even before armament spending began."5
While Hitler clearly deserves the opprobrium heaped on him for his later atrocities, he was enormously popular with his own people, at least for a time. This was evidently because he rescued Germany from the throes of a worldwide depression – and he did it through a plan of public works paid for with currency generated by the government itself. Projects were first earmarked for funding, including flood control, repair of public buildings and private residences, and construction of new buildings, roads, bridges, canals, and port facilities. The projected cost of the various programs was fixed at one billion units of the national currency. One billion non-inflationary bills of exchange called Labor Treasury Certificates were then issued against this cost.
Millions of people were put to work on these projects, and the workers were paid with the Treasury Certificates. The workers then spent the certificates on goods and services, creating more jobs for more people. These certificates were not actually debt-free but were issued as bonds, and the government paid interest on them to the bearers. But the certificates circulated as money and were renewable indefinitely, making them a de facto currency; and they avoided the need to borrow from international lenders or to pay off international debts.6 The Treasury Certificates did not trade on foreign currency markets, so they were beyond the reach of the currency speculators. They could not be sold short because there was no one to sell them to, so they retained their value.
Within two years, Germany's unemployment problem had been solved and the country was back on its feet. It had a solid, stable currency, and no inflation, at a time when millions of people in the United States and other Western countries were still out of work and living on welfare. Germany even managed to restore foreign trade, although it was denied foreign credit and was faced with an economic boycott abroad. It did this by using a barter system: equipment and commodities were exchanged directly with other countries, circumventing the international banks. This system of direct exchange occurred without debt and without trade deficits. Although Germany's economic experiment was short-lived, it left some lasting monuments to its success, including the famous Autobahn, the world's first extensive superhighway.7
Germany's scheme for escaping its crippling debt and reinvigorating a moribund economy was clever, but it was not actually original with the Germans. The notion that a government could fund itself by printing and delivering paper receipts for goods and services received was first devised by the American colonists. Benjamin Franklin credited the remarkable growth and abundance in the colonies, at a time when English workers were suffering the impoverished conditions of the Industrial Revolution, to the colonists' unique system of government-issued money. In the nineteenth century, Senator Henry Clay called this the "American system," distinguishing it from the "British system" of privately-issued paper banknotes. After the American Revolution, the American system was replaced in the U.S. with banker-created money; but government-issued money was revived during the Civil War, when Abraham Lincoln funded his government with U.S. Notes or "Greenbacks" issued by the Treasury.
The dramatic difference in the results of Germany's two money-printing experiments was a direct result of the uses to which the money was put. Price inflation results when "demand" (money) increases more than "supply" (goods and services), driving prices up; and in the experiment of the 1930s, new money was created for the purpose of funding productivity, so supply and demand increased together and prices remained stable. Hitler said, "For every mark issued, we required the equivalent of a mark's worth of work done, or goods produced." In the hyperinflationary disaster of 1923, on the other hand, money was printed merely to pay off speculators, causing demand to shoot up while supply remained fixed. The result was not just inflation but hyperinflation, since the speculation went wild, triggering rampant tulip-bubble-style mania and panic.
This was also true in Zimbabwe, a dramatic contemporary example of runaway inflation. The crisis dated back to 2001, when Zimbabwe defaulted on its loans and the IMF refused to make the usual accommodations, including refinancing and loan forgiveness. Apparently, the IMF's intention was to punish the country for political policies of which it disapproved, including land reform measures that involved reclaiming the lands of wealthy landowners. Zimbabwe's credit was ruined and it could not get loans elsewhere, so the government resorted to issuing its own national currency and using the money to buy U.S. dollars on the foreign-exchange market. These dollars were then used to pay the IMF and regain the country's credit rating.8
According to a statement by the Zimbabwe central bank, the hyperinflation was caused by speculators who manipulated the foreign-exchange market, charging exorbitant rates for U.S. dollars, causing a drastic devaluation of the Zimbabwe currency. The government's real mistake, however, may have been in playing the IMF's game at all. Rather than using its national currency to buy foreign fiat money to pay foreign lenders, it could have followed the lead of Abraham Lincoln and the American colonists and issued its own currency to pay for the production of goods and services for its own people. Inflation would then have been avoided, because supply would have kept up with demand; and the currency would have served the local economy rather than being siphoned off by speculators.
Is the United States, then, out of the hyperinflationary woods with its "quantitative easing" scheme? Maybe, maybe not. To the extent that the newly-created money will be used for real economic development and growth, funding by seigniorage is not likely to inflate prices, because supply and demand will rise together. Using quantitative easing to fund infrastructure and other productive projects, as in President Obama's stimulus package, could invigorate the economy as promised, producing the sort of abundance reported by Benjamin Franklin in America's flourishing early years.
There is, however, something else going on today that is disturbingly similar to what triggered the 1923 hyperinflation. As in Weimar Germany, money creation in the U.S. is now being undertaken by a privately-owned central bank, the Federal Reserve; and it is largely being done to settle speculative bets on the books of private banks, without producing anything of value to the economy. As gold investor James Sinclair warned nearly two years ago: "[T]he real problem is a trembling $20 trillion mountain of over the counter credit and default derivatives. Think deeply about the Weimar Republic case study because every day it looks more and more like a repeat in cause and effect . . . ."9
The $12.9 billion in bailout funds funneled through AIG to pay Goldman Sachs for its highly speculative credit default swaps is just one egregious example.10 To the extent that the money generated by "quantitative easing" is being sucked into the black hole of paying off these speculative derivative bets, we could indeed be on the Weimar road and there is real cause for alarm. We have been led to believe that we must prop up a zombie Wall Street banking behemoth because without it we would have no credit system, but that is not true. There is another viable alternative, and it may prove to be our only viable alternative. We can beat Wall Street at its own game, by forming publicly-owned banks that issue the full faith and credit of the United States not for private speculative profit but as a public service, for the benefit of the United States and its people.11
Inflation from Money Creation Isn't a Problem
A commonly expressed concern regarding the Federal Reserve's recent policy actions is by increasing money supply the Federal Reserve is stoking the fires of inflation once the recovery starts. This statement could be true in a limited set of circumstances. However, the far more probable scenario is the increased money supply will not lead to increased inflation. Let's look at the reasons why.
Before we move further there are two relevant points. The first is some of he information contained in this article is based on a booklet originally issued by the Chicago Federal Reserve titled, "Modern Money Mechanics." While it is no longer available from the Chicago Fed it is available by searching the Internet for the title "Modern Money Mechanics." Secondly, this article is a joint effort with a friend who -- for professional reasons -- must remain anonymous (various links refer to his pseudonymous work elsewhere).
First, let's look at the data of money supply to see what is actually happening. Here is a chart from the St. Louis Federal Reserve of M2:
This is in logarithmic scale with a circle around the last few years of activity. Notice how the recent money creation registers an increase, but not one of monumental proportions; it is hardly out of line with other increases that occurred over the last 30 years.
Secondly, let's take a look at the rate of change in the money supply:
This is the year over year rate of change in M2. Notice how the US experienced a higher year over year rate of change at the end of the early 1980s double dip recession and during the last recession. In other words, the current rate of growth in the money supply is hardly out of line with historical experience.
Finally there is the broadest measure of money supply M3. Unfortunately the government no longer maintains this monetary aggregate. However, Shadow Stats does. Here is their chart:
Notice how the rate of change has been decreasing since the beginning of 2008. Also notice that according to this chart, M1 has been increasing. However, remember that M2 and M3 each include M1 in their calculations. So the increase in M1 -- which is essentially physical currency -- is already factored into the M2 and M3 charts. The fact that M1 has been increasing indicates the Federal Reserve has been doing everything it can to get physical currency into the economy in order for people to spend it.
But just because the Federal Reserve is printing money does not mean we are spending it. The rate at which consumers spend their money is called velocity, which is "A term used to describe the rate at which money is exchanged from one transaction to another." Here is a chart of US monetary velocity:
The circle is around the latest time period. Notice how velocity -- the rate at which money goes through the economy -- has dropped at a sharp rate. This indicates that despite the increase in M1 (physical currency) people are spending it at a slower rate.
Let's tie this information into the official inflation rate. Here is a chart of velocity and CPI.
Above is a chart of velocity and CPI. Notice there are three periods. The first occurs from the end of 1959 to roughly the beginning of the 1990s. During this period velocity and inflation were highly correlated -- an increase in velocity meant an increase in inflation and a decrease in velocity meant a decrease in inflation. However, that relationship stopped for roughly 10 years from 1993 to 2003. The reason for this "decoupling" was the Internet/technology boom during that period. It allowed an increase in velocity to not have any impact on CPI. However, starting again in 2003 we see an a return to that correlation where an increase in velocity leads to an increase in inflation. That means that as velocity drops we are more likely to have a decrease in overall CPI -- which is demonstrated by the current chart.
Keep in mind the most fundamental definition of inflation: Too much money chasing too few goods. Now consider that the collective household balance sheet of America has shrunk over the last six quarters by some $13 trillion dollars, and will almost certainly decline further when the next Fed Flow of Funds report is released in a few weeks. (It is in this context -- the massive shrinkage of the American balance sheet -- that the Fed's money creation should be considered.) Keep in mind too the massive deleveraging that began last year and that will likely continue for some time to come. The San Francisco Fed highlighted this trend in a recent report. Ongoing changes in spending habits and attitudes toward credit itself are going to be secular -- not cyclical -- in nature.
These are deflationary, not inflationary, changes (particularly in view of the fact that the U.S. consumer has been roughly 70 percent of GDP). There have been myriad stories written about the new "thrift" and "frugality" of the American consumer, and this change will be measured in years, not months or even quarters (this report foretold our Frugal Future). Hence these quotes from the most recent FOMC minutes:
"Most participants expected inflation to remain subdued over the next few years, and they saw some risk that elevated unemployment and low capacity utilization could cause inflation to remain persistently below the rates that they judged as most consistent with sustainable economic growth and price stability." And this: "All [participants] anticipated that unemployment, though declining in coming years, would remain well above its longer-run sustainable rate at the end of 2011; most indicated they expected the economy to take five or six years to converge to a longer-run path characterized by a sustainable rate of output growth and by rates of unemployment and inflation consistent with the Federal Reserve's dual objectives, but several said full convergence would take longer."
Let's sum up so far. While M2 has increased in total and on a year over year basis, the increase is in line with historical experience. We saw a sharper increase in M2 at the end of the early 1980s and early 2000s recession. Finally, the direct relationship between and increase or decrease in velocity and inflation has returned along with a massive drop-off in velocity. This means we've seen a big drop-off in inflation.
Now, onto the issue of money creation. There has been a constant refrain that the Fed is printing money like there's no tomorrow. What these statements forget is they are temporary. Here's why. The Federal Reserve has essentially propped up most debt markets through their programs like the Commercial Paper Funding Facility, and the Term Asset Backed Securities Loan Facility along with several other programs. Through these facilities the Federal Reserve is essentially propping up several markets that were frozen because of the credit crisis. For those of you who are interested, the Wall Street Journal looks at the Fed's balance sheet every week.
These facilities create money. Here's how it works. When the Federal Reserve purchases a security it credits the seller's account. This increases the seller's reserves -- reserves against which he can now make loans and increase the money supply. However, let's remember an incredibly important -- and easily forgotten -- point. These Fed facilities are temporary; they will end one day. They started because of the Credit Crisis. As the credit crisis eases The Fed will start to sell these securities back to credit market participants As the do so they will "mop up" the excess reserves in the system. "Mopping up" means when Fed sells the securities to market participants the market participants will have to pay for the securities. That means the market participants will have to decrease their reserves, thereby lowering the amount of money they have available for loans, thereby shrinking the money supply. While it is true the Fed has never had to mop up as much liquidity as we have right now, that does not mean they can't do it. It simply means it will be a bigger job.
So to wrap up we have the following points.
- Absolute M2 is increasing but in line with current experience.
- The year over year percentage change increase in M2 is lower than the previous two recessions.
- M3 -- a larger monetary measure than M2 -- has actually decreased.
- Velocity is way down, indicating that the rate at which people spend money is decreasing at a fast rate.
- While the Fed has increased the monetary supply, they will mop up the excess liquidity as they wind down their programs -- all of which are temporary.
Simply put, monetary based inflation isn't a problem right now.
No New Lease On Trillions In Debt
A trillion-dollar storm is gathering over the commercial real estate landscape that's threatening to add further pain to an already bruised US economy. At the center of the worries is some $3.5 trillion in debt backed by everything from strip malls to offices and apartments across the nation -- the lion's share of which is badly underwater because this recession followed a five-year commercial property boom fueled by easy money and loose underwriting standards. Now the owners of the less-than-full malls, apartment complexes and office buildings are succumbing to the worst economic collapse since the Great Depression -- because they can't refinance the debt.
The commercial debt securitization market is dead. "Because there is no securitization the system cannot process the wave of maturities coming due," said Scott Latham, commercial property broker at Cushman & Wakefield. "This is arguably the most important fact we're going to be dealing with. If there's no mortgage market that can feed the machine you're just not going to have deals," he said. "It's going to be years before we recover and even when that happens we're going to discover that we're in a new paradigm," Latham added. About $1.4 trillion in real estate debt is set to mature over the next four years, with some $204 billion coming due this year alone.
Most of that debt won't be able to be refinanced or restructured because lending standards have tightened and commercial real estate values have cratered since last year, according to Deutsche Bank analyst Richard Parkus. The debt behind the commercial real estate boom, commercial mortgage-backed securities, or CMBS, entails pooling together commercial mortgages in apartment buildings, shopping malls or trophy offices in different locations, packaging them into bonds and selling them to investors. CMBS issuance reached its peak with $230 billion transactions completed in 2007. Last year, as the market was dying, a relatively anemic $12 billion in activity was seen, according to industry newsletter Commercial Mortgage Alert.
The last time the markets saw a tsunami like this one was in the late 1980s during the savings and loan crisis, when builders overwhelmed the markets with commercial supply that went vacant for years. However, this commercial real estate crisis, fueled primarily by developers and property investors getting easy access to relatively cheap loans, may be even worse than what's come before. That's especially the case since Average Joes and Janes are by extension huge landlords via pensions, endowments and mutual funds -- which have big commercial property exposure over the past few years. Broadly speaking, commercial real estate values are off by as much as 40 or 50 percent by some estimates.
C&W's Latham also points out that some loan agreements with bank lenders stipulate that properties have to be rented at a certain dollar amount or run into technical default. "Many of these loans don't live long enough [to refinance]," Parkus told The Post. The research analyst plans on submitting a more comprehensive commercial real estate report as a follow-up to his popular report next week that's even grimmer than his original. According to C&W, Manhattan vacancies jumped 20 percent in the first quarter from three months earlier, with Midtown seeing a 24 percent vacancy rate. "There's going to be a lot of pain," Anton commented. Here is how the commercial real estate crunch is affecting three companies:
Broadway Partners Take the case of Scott Lawlor, who is struggling to keep a $14 billion assemblage of the nation's choicest properties he owns via real estate fund Broadway Partners from falling into the hands of his lenders -- or worse, having to file for bankruptcy. Recently, a consortium of lenders foreclosed on Lawlor's John Hancock Tower -- a trophy Boston office building. The $660 million the building fetched at auctioned when sold by Lawlor's creditors represented half the amount Lawlor's fund paid for it in 2006. It serves as a haunting experience for the son of a Queens cab driver who in rapid-fire fashion in less than five years grew his firm from a few small office buildings in Philadelphia and New York into a billion-dollar empire spanning the nation. He did it on the back of leverage.
As it stands, Lawlor is fighting to restructure much of the debt he borrowed to fund his buying spree in the hopes of weathering the real estate storm. Sources told The Post that the Broadway CEO is currently in talks to recast a block of offices acquired from real estate fund Beacon Capital Partners and financed by the defunct Lehman Brothers. Privately, Lawlor has told peers that he believes that he may lose one or two more properties to foreclosure but expects to maintain the bulk of his multi-million square foot office portfolio. A spokesman for Broadway declined comment.
Tishman Speyer Sources tell The Post that the sprawling 80-acre Stuyvesant Town-Peter Cooper Village apartment complex that Tishman Speyer acquired with its partners three years ago for $5.4 billion may end up in lenders' hands after cash reserves for the residential complex run dry. And that's not the only asset on which the company is feeling the pinch. Tishman bought for about $21 billion on leverage the real estate investment trust Archstone-Smith at the height of the market.
Tishman's Archstone purchase loaded the REIT up with massive debts, and lenders are believed to have been forced to place about $1 billion more into the company in order to keep it afloat. Tishman officials have argued that they're not taking as big a hit on its investments as one might believe because it never put that much equity at risk. Tishman put about $250 million into its investment in Stuy-Town and about $112 million in Archstone, sources said. A spokesman for Tishman declined to comment.
General Growth Properties So far the biggest commercial real estate blow up has been that of REIT General Growth Properties Trust, the second-biggest owner of shopping malls throughout the US. It filed for bankruptcy protection last month. Like many of the commercial real estate investors, GGP ballooned in size by using leverage to scoop up a raft of malls in the early-2000s as choice, rarely sold mall jewels that hit the market.
GGP used billions in CMBS debt to fund its acQuisitions, but as retailers got slammed and the economy spiraled into recession so it couldn't keep up with its payments. In fact, GGP's collapse into bankruptcy is testing the bounds of the laws that govern which debtholders get what when companies fall into Chapter 11. As a holding company, GGP has filed for bankRuptcy, but it has many so-called special purpose entities that represent the individual malls it owns under the GGP umbrella. Debtholders of those CMBS bonds had always thought that in a bankruptcy their ownership would be insulated from getting whacked -- but now they're not so sure.
So far instances like GGP, Tishman and Broadway have been treated as one-offs but there are already signs that a wave of such problem property situations is waiting in the wings. In total, more than 4,500 properties are on the brink of default, representing some $95 billion in assets in the US, according to Real Capital Analytics. At this point, it's hard to determine how the commercial real estate problem will resolve itself but it's expected that banks may suffer losses of $200 billion with regional banks being slammed the worst.
World economy stabilizing: Krugman
The world economy has avoided "utter catastrophe" and industrialized countries could register growth this year, Nobel Prize-winning economist Paul Krugman said on Monday. "I will not be surprised to see world trade stabilize, world industrial production stabilize and start to grow two months from now," Krugman told a seminar. "I would not be surprised to see flat to positive GDP growth in the United States, and maybe even in Europe, in the second half of the year." The Princeton professor and New York Times columnist has said he fears a decade-long slump like that experienced by Japan in the 1990s.
He has criticized the U.S. administration's bailout plan to persuade investors to help rid banks of up to $1 trillion in toxic assets as amounting to subsidized purchases of bad assets. Speaking in UAE, the world's third-largest oil exporter, Krugman said Japan's solution of export-led growth would not work because the downturn has been global. "In some sense we may be past the worst but there is a big difference between stabilizing and actually making up the lost ground," he said. "We have averted utter catastrophe, but how do we get real recovery? "We can't all export our way to recovery. There's no other planet to trade with. So the road Japan took is not available to us all," Krugman said.
Global recovery could come about through more investment by major corporations, the emergence of a major technological innovation to match the IT revolution of the 1990s or government moves on climate change. "Legislation that will establish a capping grade system for greenhouse gases' emissions is moving forward," he said, referring to the U.S. Congress. "When the Europeans probably follow suit, and the Japanese, and negotiations begin with developing countries to work them into the system, that will provide enormous incentive for businesses to start investing and prepare for the new regime on emissions... But that's a hope, that's not a certainty."
German minister says Opel bids fall short
All three bids for General Motors Corp.'s Opel unit have shortcomings and a bankruptcy filing might still be a better option, Germany's economy minister was quoted as saying Sunday. The three bids filed last Wednesday by potential investors came from Italy's Fiat SpA, a consortium of Canadian auto parts maker Magna International Inc. and Russia's Sberbank, and U.S. buyout firm Ripplewood Holdings LLC. "We now have three offers for an Opel takeover, but that doesn't mean that one of them will automatically come to fruition," Economy Minister Karl-Theodor zu Guttenberg was quoted as telling the Bild am Sonntag newspaper.
"We must first have a high degree of certainty that the significant tax money we will have to provide is not lost," he added, Bild am Sonntag reported. "From my point of view, none of the three offers so far provides this certainty in a sufficient way." "If these deficits were to remain, an orderly insolvency would clearly be the better solution -- it also could open opportunities for the future of Opel," Guttenberg was quoted as saying. U.S. parent GM faces a June 1 deadline to restructure or file for bankruptcy. Berlin is keen to ensure the future of Ruesselsheim, Germany-based Adam Opel GmbH. Opel employs some 25,000 people in Germany, nearly half GM Europe's total work force.
German officials say it is up to GM to choose Opel's investor, while Berlin will decide whether and how to lend state support to the selected bidder. Foreign Minister Frank-Walter Steinmeier said it was "good that there is now a real bidding competition." Steinmeier, the center-left challenger to conservative Chancellor Angela Merkel in September's elections, also took a swipe at the comments by Guttenberg, a conservative. "I advise everybody finally to stop the talk about an Opel insolvency," he said. "We should focus all our energy on saving as many jobs as possible at Opel instead of raising new specters."
Several German politicians have indicated that they favor Magna's bid, though the governor of one of the states with Opel plants opposes it. Guttenberg has named no favorite. Fiat's plan, which foresees wrapping Opel and British sister brand Vauxhall into a global car-making powerhouse along with Chrysler LLC, has raised fears in Germany of large job cuts. However, Fiat CEO Sergio Marchionne was quoted as telling Bild am Sonntag that "in the worst case, a maximum of 2,000 jobs in Germany would be affected" by the planned integration.
Moral Hazard and the Meltdown
An appropriate government response to the bursting of the housing bubble requires a full understanding of what went wrong and why. Many commercial banks, investment banks, savings and loans, mortgage originators, subprime borrowers, and insurance giant AIG obviously placed heavy bets on continued housing-price appreciation. They gambled; the losses have been huge and widespread. Why did so many players place these large, risky bets? A simple yet significant part of the answer is that the potential gains and losses were asymmetric. If housing prices continued to climb, or at least not fall, the participants could achieve large profits. If housing prices failed to appreciate, or even fell, the losses would be largely borne by others, including taxpayers. "Heads" and the bettors would win -- "tails" and others would lose.
On the supply side, de facto -- and now de jure -- government guarantees of Fannie Mae and Freddie Mac debt lowered their financing costs and thus amplified mortgage-credit expansion and housing-price appreciation. Bank deposit insurance and implicit guarantees of bank obligations encouraged risky mortgage lending and investment, especially given strong pressure from Congress for more subprime lending. The shift to corporate ownership of investment banks, with limited liability, encouraged them to take greater risk in relation to capital, especially given expanded competition with investment-bank affiliates of bank holding companies that followed the Gramm-Leach-Bliley Act in 1999. Moreover, the Security and Exchange Commission's adoption in 2004 of "consolidated supervision" of the largest investment banks allowed them to increase leverage substantially, in significant part by taking on more subprime-mortgage exposure.
Meanwhile, AIG facilitated investment in mortgage securitization by domestic and foreign banks and investment banks by selling cheap protection against default risk. Subprime mortgage originators were often new entrants that had little reputational capital at risk, and didn't have to hold the mortgages. On the demand side, many subprime borrowers acquired properties with little or no money down. They faced relatively little loss if housing prices fell and they defaulted. Many people took cheap mortgages on investment property to speculate on housing-price increases. Others took cheap second mortgages to fund current consumption. The Federal Reserve played a key role in making these bets attractive to borrowers, lenders and investors. It kept interest rates at historically low levels until it was too late to prevent the eventual implosion.
This deliberate policy and public statements by then Fed Chairman Alan Greenspan fueled demand for credit and housing and encouraged lenders to relax mortgage-lending criteria. Given what we know about the bubble's causes, the main objectives of legislative and regulatory responses should be to encourage market discipline as a means to promote prudence, safety and soundness in banking and securities. We should avoid extending explicit or implicit "too big to fail" policies beyond banking. Unfortunately, the most conspicuous proposals on Capitol Hill -- the creation of a "systemic risk" regulator and expanded federal authority over financially distressed insurers and other nonbank institutions -- could easily undermine both objectives by protecting even more institutions, investors and consumers from the downside of their actions.
Held hostage by the health system
The Senate Finance Committee's hearings on health reform earlier this month did not include testimony from any advocate for single-payer insurance. Physicians for a National Health Program, which represents 16,000 doctors, asked the committee to invite me to testify, but it chose not to. If I had been invited, this is what I would have said:
The reason our health system is in such trouble is that it is set up to generate profits, not to provide care. We rely on hundreds of investor-owned insurance companies that profit by refusing coverage to high-risk patients and limiting services to others. They also cream off about 20 percent of the premiums for profits and overhead. In addition, we provide much of our medical care in investor-owned health facilities that profit by providing too many services for the well-insured and too few for those who cannot pay. Most physicians are paid fee-for-service, which gives them a similar incentive, particularly specialists who receive very high fees for performing expensive tests and procedures.
Nonprofits behave much like for-profits, because they must compete with them. In sum, healthcare is directed toward maximizing income, not maximizing health. In economic terms, it's a highly successful industry, but it's a massive drain on the rest of the economy. The reform proposals advocated by President Obama are meant to increase coverage for the uninsured. That is certainly a worthwhile goal, but the problem is that they leave the present profit-driven and highly inflationary system essentially unchanged, and simply pour more money into it - an unsustainable situation.
That is what is happening in Massachusetts, where we have nearly universal health insurance, but costs are growing so rapidly that its long-term prospects are poor without cutting benefits and greatly increasing co-payments. Initiatives such as electronic records, case management, preventive care, and comparative effectiveness studies may improve care, but the Congressional Budget Office and most health economists agree that they are unlikely to save much money. Promises by for-profit insurers and providers to mend their ways voluntarily are not credible.
Nearly every other advanced country has a largely nonprofit national health system that provides universal and comprehensive care. Expenditures are on average about half as much per person, and health outcomes are generally much better. Moreover, these countries offer more basic services, not fewer. They have on average more doctors and nurses, more hospital beds, longer hospital stays, and there are more doctor visits. But they don't do nearly as many tests and procedures, because there is little financial incentive to do so.
It is often argued that the first order of business should be to expand coverage, and then worry about costs later. But it is essential to deal with both together to stop the drain on the rest of the economy and the further fraying of healthcare. The only way to provide universal and comprehensive coverage and control costs is to adopt a nonprofit single-payer system. Medicare is a single-payer system, with low overhead costs, but it uses the same profit-oriented providers as the private system and also preferentially rewards specialists for tests and procedures. Consequently, its costs are rising almost as rapidly as those in the private sector. Representative John Conyers introduced an excellent bill that calls for extending Medicare to everyone in a nonprofit delivery system. That could be done gradually, by lowering the Medicare age a decade at a time.
A single-payer system is ignored by lawmakers because of the influence of the health industry lobbies. They raise the specter of rationing and long waits for care. There are indeed waits for some elective procedures in some countries with national health systems, such as the United Kingdom. But that's because they spend far less on healthcare than we do. For them, the problem is not the system; it's inadequate funding. For us, it's not the funding; it's the system. We spend more than enough. I urge you to consider a nonprofit single-payer system. The economic interests of the health industry should not be permitted to hold the rest of the economy hostage and threaten the health and well-being of the public.
Calculate your losses
Ilargi: Harvard economics professor Greg Mankiv keeps on digging that hole of his. As long as people like him have any say, forget about any sort of recovery.
That Freshman Course Won’t Be Quite the Same
My day job is teaching introductory economics to about 700 Harvard undergraduates a year. Lately, when people hear that, they often ask how the economic crisis is changing what’s offered in a freshman course. They’re usually disappointed with my first answer: not as much as you might think. Events have been changing so quickly that we teachers are having trouble keeping up. Syllabuses are often planned months in advance, and textbooks are revised only every few years.
But there is another, more fundamental reason: Despite the enormity of recent events, the principles of economics are largely unchanged. Students still need to learn about the gains from trade, supply and demand, the efficiency properties of market outcomes, and so on. These topics will remain the bread-and-butter of introductory courses. Nonetheless, the teaching of basic economics will need to change in some subtle ways in response to recent events. Here are four:
THE ROLE OF FINANCIAL INSTITUTIONS Students have always learned that the purpose of the financial system is to direct the resources of savers, who have extra funds they are willing to lend, to investors, who have projects that need financing. The economy’s financial institutions — banks and insurance companies, for example — are mentioned as part of that system. But after a brief introduction in the classroom, they quickly fade into the background and are examined in detail only in more advanced courses.
The current crisis, however, has found these financial institutions at the center of the action. They will need to become more prominent in the classroom as well. Financial institutions are like the stagehands who work behind the scenes at the theater. If they are there doing their jobs well, the audience can easily forget their presence. But if they fail to show up for work one day, their absence is very apparent, because the show can’t go on. The process of financial intermediation is similarly most noteworthy when it fails.
THE EFFECTS OF LEVERAGE Not long ago, I was explaining to a freshman that the economic crisis arose because some financial institutions had, in effect, invested in housing by holding mortgage-backed securities. When housing prices fell by about 20 percent nationwide, these institutions found themselves nearly insolvent. But the student then asked an important question: "If housing prices have fallen only 20 percent, why did the banks lose almost 100 percent of their money?" The answer was leverage, the use of borrowed money to amplify gains and, in this case, losses. Economists have yet to figure out what combination of mass delusion and perverse incentives led banks to undertake so much leverage. But there is no doubt that its effects have played a central role in the crisis and will need a more prominent place in the economics curriculum.
THE LIMITS OF MONETARY POLICY The textbook answer to recessions is simple: When the economy suffers from high unemployment and reduced capacity utilization, the central bank can cut interest rates and stimulate the demand for goods and services. When businesses see higher demand, they hire more workers to meet it. Only rarely in the past did students ask what would happen if the central bank cut interest rates all the way to zero and it still wasn’t enough to get the economy going again. That is no surprise; after all, interest rates near zero weren’t something that they, or even their parents, had ever experienced.
But now, with the Federal Reserve’s target interest rate at zero to 0.25 percent, that question is much more pressing. The Fed is acting with the conviction that it has other tools to put the economy back on track. These include buying a much broader range of financial assets than it typically includes in its portfolio. Students will need to know about these other tools of monetary policy — and will also need to know that economists are far from certain how well these tools work.
THE CHALLENGE OF FORECASTING It is fair to say that this crisis caught most economists flat-footed. In the eyes of some people, this forecasting failure is an indictment of the profession. But that is the wrong interpretation. In one way, the current downturn is typical: Most economic slumps take us by surprise. Fluctuations in economic activity are largely unpredictable. Yet this is no reason for embarrassment. Medical experts cannot forecast the emergence of diseases like swine flu and they can’t even be certain what paths the diseases will then take. Some things are just hard to predict. Likewise, students should understand that a good course in economics will not equip them with a crystal ball. Instead, it will allow them to assess the risks and to be ready for surprises.
Sorry Greg, This Crisis Was Completely Predictable and Predicted
Gregory Mankiw uses his NYT column today to give us an explicit "who could have known?" about the economy crisis. He tells readers that: "fluctuations in economic activity are largely unpredictable." No, this crisis was completely predictable. The problem was that the leading lights in the economics profession completely missed the boat and are now using their platforms to tell the public that it wasn't their fault. The basic story was and is the housing bubble. How could they miss an $8 trillion housing bubble? What were they smoking?
We have a hundred year long trend, from 1895 to 1995, when nationwide house prices just track the overall rate of inflation. Suddenly in the mid-90s, coinciding with the stock bubble, house prices begin to hugely outpace inflation. The run up in prices cannot be explained by any obvious shifts in the fundamentals of supply and demand. Furthermore there is no remotely corresponding increase in real rents. And, the vacancy rate for housing rises to record levels.
If economists could not see this bubble, then they should look for another line of work. Sorry, this fluctuation was entirely predictable. The people whose job responsibilities including recognizing a dangerous bubble like this one just blew it completely. It speaks volumes about the nature of the U.S. economy that almost all of those people still have their jobs, unlike the tens of millions of other workers who lost their jobs or can only work part-time because of the incompetence of the economists.
Credit rating downgrade could threaten UK car industry rescue plan
The Government's £2.3bn rescue deal for the ailing automotive industry will be in jeopardy if Britain loses its prized AAA credit rating. Lord Mandelson, the Business Secretary, has pledged to underwrite loans for investment in green technology as vehicle makers suffer amid a dramatic fall in sales and available credit. A total of £1.3bn of the guarantees are for European Investment Bank loans, but these will be worthless if the UK's credit rating is downgraded. The EIB refuses to lend more than £200m unless the receiver, or a guarantor, has a AAA credit rating, and therefore the ailing car manufacturers could potentially be unable to access the loans.
The chances of a downgrade are the most serious since ratings began in 1978 after the leading credit rating agency Standard & Poor's (S&P) cut its medium-term outlook from stable to negative. S&P claimed public debt could reach 100pc of gross domestic product. A downgrade, especially in the short term, is considered unlikely but the potential impact on the Automotive Assistance Programme highlights the serious implications on the real economy. Jaguar Land Rover (JLR) has already been awarded a loan of €366m (£332m) while Nissan has been given €400m, half for the UK, by the EIB. They would be stripped of their most likely backer and have to find another AAA institution to guarentee the loan.
JLR employs 15,000 staff across the UK and the EIB loan is vital if the company is to secure the future of many of those jobs. Negotiations between Tata Motors, the Indian owner of the upmarket car maker, and the Government have been tense and already lasted months. The Government would not comment specifically on JLR, but a Treasury spokesperson downplayed the chances of a downgrade. "Standard and Poor's have reaffirmed the UK's AAA rating on the basis of our 'wealthy, diversified economy; high degree of fiscal and monetary flexibility' and 'relatively flexible product and labour markets'," he said.
What If Arnold Had Seized the Moment?
While politicians debate whether this week's rejection of various spending initiatives in California marks the beginning of an antitax insurgency, I can't help but wonder what might have been had Arnold Schwarzenegger immediately pushed for reform upon taking office in 2003. The Arnold of the state's recall election was the Barack Obama of the 2008 presidential election. He was a man of wealth and privilege, restyled as a populist outsider and overhyped by a fawning media, who came into office with a window of opportunity to achieve most anything his heart desired. For Mr. Schwarzenegger, that window remained open for about a year.
Sacramento Democrats recognized that taking on the celebrity governor was a fight they would lose. But Mr. Schwarzenegger failed to seize the opportunity. He needed to make entrenched lawmakers an offer: Either work with him on budget and government reform so everyone can have a nice bipartisan bill-signing, or expect a knock-out fight at the polls over a set of ballot initiatives. Had he done so, he might have gotten some of the good ideas that the state needs -- such as setting up a serious rainy-day fund and creating an honest spending cap -- enacted into law. Would the Democrats who control California's legislature have rolled over that easily? We'll never know, but the threat of taking the issue to the voters is how the governor got workers' compensation reform through the legislature within six months of taking office.
Mr. Schwarzenegger did offer a plan to revamp state government during his honeymoon phase in 2004. But his approach -- the "California Performance Review," or CPR -- was a metaphor for his political failure. It involved a 275-member task force that produced a 2,500-page proposal. That report, which offered upwards of $32 billion in savings, never caught anyone's fancy. It was dead on arrival because it was too complicated for voters to rally behind and legislators didn't want to see it enacted. Five years later, Mr. Schwarzenegger is back with a second, less ambitious version that one aide has said might produce "hundreds of millions" in savings.
Instead of reform, the man who promised to "blow up the boxes" of government nearly six years ago embarked on a crusade to save the planet in an attempt to win re-election in 2006. If Arnold's political obituary were to be written today its narrative would turn on environmental issues, such as solar roof panels, hydrogen cars and curbing emissions. Missing would be the issues that got him elected in the first place -- tax cuts, fiscal discipline and restoring dignity to Sacramento. The governor didn't blow up the boxes. He just affixed "recycle" labels to them. This is not to berate Mr. Schwarzenegger for evolving as a public servant. But the nagging question about the governor involves his core convictions and stick-to-it-iveness.
Last year was supposed to be, according to a declaration from the governor, "the year of education." Before that, we were in the "the year of heath reform." In 2005, his theme was "the year of reform." None of these slogans translated into tangible changes -- 2005 culminated in a special election in which all four of the governor's proposals (curbing teacher tenure, reining in union dues, capping spending, and redrawing political districts) failed spectacularly. They failed because of a $100 million war chest compiled by Democratic-friendly unions and months of guerilla campaign tactics at Arnold's expense -- the sort of thing that would have been politically difficult in the honeymoon months of early 2004.
The bottom line for the Age of Arnold is this: Catchy sloganeering has given the state's more pressing problems the look and feel of coming attractions. (Imagine the movie trailer, "Health Reform 2007: This Time, It's Personal.") And the constant showdowns at the ballot box (seven special and general elections since 2002) have voters asking what exactly it is that lawmakers do in Sacramento? In theory, all of this plays to Mr. Schwarzenegger's strengths as a cinematic action hero and a skilled marketer. Only on Tuesday the public wasn't buying what he was selling. Maybe Californians do hate higher taxes. Or maybe they're not in a mood to follow a governor and legislature whose combined approval rating is below 50%. Or maybe this week's no-confidence vote offers a lesson on leadership and principles for Mr. Schwarzenegger.
Politicians who play to the middle by championing triangulation or "postpartisan" tactics have trouble finding core constituencies. And it was core voters who turned out on Tuesday. Liberals came out because they were worried about spending cuts. Conservatives turned out because they were enraged by the thought of higher taxes. Core voters look for core beliefs. Where is Mr. Schwarzenegger's core? Is he the free-market, antitax candidate of the recall? The right-of-center union buster of the 2005 special election? The humbled, bipartisan eco-warrior of the 2006 re-election campaign? The tax-and-spend-and-cut Sacramento insider?
Rather than spend Election Day in California, Mr. Schwarzenegger attended a public event at the White House. There was a time when any visit by him to the nation's capital would have sparked a flurry of stories about the need for Republicans to adopt his winning ways and amend the U.S. Constitution to allow him to seek the presidency. Today, Republicans running for governor in California go out of their way to point out where they differ with Mr. Schwarzenegger. Maybe Mr. Schwarzenegger will be able to mount another political comeback. In the meantime, he must wish life could imitate art, and like the Terminator he too could go back in time.
The Crisis Isn't California's Alone
It's been a tough week for the Terminator everywhere but the box office. On May 19, California voters solidly rejected a series of ballot initiatives that would have provided Governor Arnold Schwarzenegger with short-term fixes to help patch the state's $21 billion budget deficit. Then, while in Washington, Schwarzenegger got the cold shoulder from Treasury Secretary Timothy Geithner and legislative leaders when he asked the federal government to help guarantee some of the state's future borrowings. Back in California on May 21, Schwarzenegger said he'd gotten the message and was asking his budget team to go back to the cutting board. "The people want Sacramento to live within its means," he said.
It's a message politicians across the country have to come to grips with. According to the nonprofit Center on Budget & Policy Priorities, some 47 states face budget gaps in the 2010 and 2011 fiscal years. (Hats off to you Montana, Wyoming, and North Dakota.) The collective shortfall is a staggering $350 billion. Congress offered some relief with $140 billion in state funding packed into the $787 billion stimulus bill passed in Februrary. California is set to receive $8 billion of that. But the appetite in Washington to work out additional funding for the true basket cases like California is nil. "They all got something in the stimulus bill," says Brian Riedel, a senior policy analyst at the Heritage Foundation. "No other state has requested a special bailout."
That leaves states turning to a mixed bag of revenue hikes and expense cuts. Governors have announced furloughs of state workers, layoffs, fee hikes, and across-the-board spending cuts. Sixteen states are enacting tax hikes and 17 others are considering doing so. "The size of the gap puts everything on the table," says Arturo Perez, a fiscal analyst at the National Conference of State Legislators. The California state legislature will now have to consider many more cuts. They'll range from relatively smaller items—a $4 million-a-year poison-control hotline that gets 900 calls a day—to sweeping cuts in health-care spending that will reduce coverage for 2 million poor state residents. "These are folks who may go to the emergency room, but they'll face the bills afterward," says Anthony Wright, executive director of advocacy group Health Access California. "If you're trying to lift yourself out of poverty, that won't help you."
California legislators had already passed $16 billion in spending cuts and $12 billion in fee hikes to tackle the current fiscal year's budget. Schwarzenegger says his own office has been reduced by 27 positions, to 147 people, and remaining staffers are taking a 9% pay cut. State legislators, though, say the governor's decision this week to stop pursuing short-term borrowings came as a surprise to them. Noreen Evans, a Democrat who chairs the budget committee in the State Assembly, says she was against borrowing more money to begin with. She thinks the fix lies in a number of spending cuts and tax increases—everything from putting a sales tax on tickets to sporting events to the $750 million a year that could be gained from taxing oil production in the state. "We should think about taxing oil producers before we cut health care coverage to 200,000 children," she says.
Some see California's fiscal crisis as an opportunity to address structural problems with the state's government. California is one of only three states that requires its legislature to pass laws by a two-thirds vote rather than by a simple majority. That leaves it subject to recurring stalemates and compromises with the Republican minority. "If the legislature can pass a majority rule, it can more easily cut spending and raise taxes," says Rick Jacobs, whose Courage Campaign is pushing to eliminate the two-thirds rule. "Right now it is not responsible to the people of California," he says. "It's hamstrung."
Louis H. Schimmel Jr., who directs the municipal finance staff at the Mackinac Center for Public Policy in Michigan, says the crisis gives citizens everywhere an opportunity to reassess the role of government. "We need to take a new look at everything and decide how much government we want," he says. Schimmel was called by the state of Michigan twice in the past two decades to oversee runaway deficits for the cities of Hamtramck and Ecorse. "I went in with the understanding I would not raise taxes or figure out how to get more money," he said. "I was just going to cut."
Early retirement claims increase dramatically
Instead of seeing older workers staying on the job longer as the economy has worsened, the Social Security system is reporting a major surge in early retirement claims that could have implications for the financial security of millions of baby boomers. Since the current federal fiscal year began Oct. 1, claims have been running 25% ahead of last year, compared with the 15% increase that had been projected as the post-World War II generation reaches eligibility for early retirement, according to Stephen C. Goss, chief actuary for the Social Security Administration. Many of the additional retirements are probably laid-off workers who are claiming Social Security early, despite reduced benefits, because they are under immediate financial pressure, Goss and other analysts believe.
The numbers upend expectations that older Americans who sustained financial losses in the recession would work longer to rebuild their nest eggs. In a December poll sponsored by CareerBuilder, 60% of workers older than 60 said they planned to postpone retirement. Goss said it remained unclear whether the uptick in retirements would accelerate or abate in the months ahead. But another wave of older workers may opt for early retirement when they exhaust unemployment benefits late this year or early in 2010, he noted. The ramifications of the trend are profound for the new retirees, their families, the government and other social institutions that may be called upon to help support them.
On top of savings ravaged by the stock market decline and the loss of home equity, many retirees now must make do with Social Security benefits reduced by as much as 25% if they retire at age 62 instead of 66. "When the recession ends and the economy bounces back, there may be a band of people for whom things will never be the same again. They'll still be paying the price for 10, 20, 30 years down the road," said Cristina Martin Firvida, director of economic security for AARP, the nation's largest membership organization for people 50 and older. For Herman Hilton, 66, of Jacksonville, Fla., a lean 6-foot-2 electrician with a bushy gray beard, the decision to lay down his pliers and screwdriver was born of frustration.
For at least the last 10 years, as he wired new buildings, he was looking toward retiring as soon as he hit 66 and qualified for full benefits. And last fall, like millions of other older workers, Hilton put his "golden years" plan on hold when his 401(k) lost more than a third of its value. Then last month, his life took another unwelcome turn: Hilton's foreman pulled him aside to tell him that he was being laid off. For several weeks, Hilton collected unemployment insurance. But he soon decided to call it quits and file for Social Security. "I can live on what I have," Hilton said. "But it's not what I planned on. I won't have the comfort factor of as much of a safety cushion."
That cushion is important. As Americans live longer, the elderly are increasingly at risk of outlasting their financial assets. That's a serious problem for them and their families, who are often called upon to provide assistance. Because benefits are reduced for people who retire early, the surge in retirements should not have any long-term effect on the solvency of the Social Security system, although it will probably add to the near-term budget deficits confronting the Obama administration, Social Security's Goss said. The full consequences of retirement decisions made in hard times will become apparent when people who retired early begin to exhaust their savings.
"As they get into their 70s and 80s, it will be increasingly inadequate," said Alicia H. Munnell, director of the Center for Retirement Research at Boston College. The most severe effect will probably fall on the unemployed widows of workers who retire early, Munnell said. Survivors' benefits also take a deeper cut when people retire early -- reduced as much as 30% for retirement at 62. Because women tend to live longer than men, that leaves them more vulnerable to running out of money as expenses for assisted living and other costs rise in advanced old age. Significant numbers of workers have long chosen to retire early. In 2007, the most recent year for which statistics are available, 42% of men and 48% of women began collecting Social Security retirement benefits at age 62, the first year of eligibility.
The current recession, the worst since the Depression, is striking when older workers are by historical standards unusually vulnerable. Though older workers in previous recessions were less likely than their younger counterparts to be laid off, that advantage has eroded in recent years, said Munnell, who analyzed more than two decades of Labor Department data on layoffs. Fewer workers are now protected by union contracts that require newer employees to be laid off first. And older workers now typically have less of a seniority advantage in a workforce that more frequently switches jobs. Once they lose their jobs, older workers have a harder time finding new ones. On average, it takes laid-off workers 55 and older nearly a month longer than their younger counterparts to find new employment, and the gulf has been growing recently, according to the U.S. Bureau of Labor Statistics.
Goss said it was theoretically possible that people who claimed retirement benefits during the recession would resume working once the economy improves. Yet experience suggests that retired workers are unlikely to return to work in large numbers, particularly not to full-time jobs that would allow them to make up their earnings losses while they were out of the workforce, said Paul N. Van de Water, a former senior policy official at the Social Security Administration and now a senior fellow at the Center on Budget and Policy Priorities, a Washington think tank. "It's partly a question of intent," Van de Water said. "It's partly a question of your skills not being kept up to date."
Africa 'giving away' land as rich countries push for food security
African countries are giving away vast tracts of farmland to other countries and investors almost for free, with the only benefits consisting of vague promises of jobs and infrastructure, according to a report published today. "Most of the land deals documented by this study involved no or minimal land fees," it says. Although the deals promise jobs and infrastructure development, it warns that "these commitments tend to lack teeth" on the contracts.
"Land grab or development opportunity?" is written jointly by two United Nations bodies - the Food and Agriculture Organisation and the International Fund for Agricultural Development - and the International Institute for Environment and Development, a London-based think-tank. It is the first major study of the "farmland grab" trend, in which rich countries such as Saudi Arabia or South Korea invest in overseas land to boost their food security . The investors plan to export most of the crops back to feed their own populations.
The trend gained notoriety after an attempt by South Korea's Daewoo Logistics to secure a big chunk of land in Madagascar, which contributed to the collapse of the African country's government. Some critics, including Jacques Diouf, head of the FAO, warn against "neo-colonialism" but others say the investments can boost economic growth in Africa. The report, seen by the Financial Times, concludes that "virtually all the [farmland] contracts" were "strikingly short and simple compared to the economic reality of the transaction". Key concerns such as "strengthening the mechanisms to monitor or enforce compliance with investor commitments" on jobs or infrastructure, "maximising government revenues", or "balancing food security concerns . . . are dealt with by vague provisions if at all", it says.
The report, which studied cases in Ethiopia , Ghana, Mali, Madagascar and Sudan, uncovered farmland investment in the past five years totalling about 2.5m hectares (6.2m acres) - equal to about half the arable land of the UK. Other estimates, including one from Peter Brabeck, chairman of Nestlé, put total farmland investments in Africa, Latin America and Asia above 15m hectares, about half the size of Italy. Also raised in the report was the risk that poor people will lose access to farmland and water.
A Failure of Capitalism: Reply to Alan Greenspan
by Richard A. Posner
I have received an email from Alan Greenspan in which he expresses regret at what he describes as my "rather thin analysis of the source of the current financial crisis." He states that his "view is different," and by way of explanation prints excerpts of three pieces written by him. The first is from remarks, entitled "Risk and Uncertainty in Monetary Policy," that he made at a meeting of the American Economics Association in January of 2004, while he was still chairman of the Federal Reserve and the housing bubble was expanding. The second is from an article that he published in the Financial Times on April 6, 2008, called "A Response to My Critics." The third is from an op-ed that he published in the Wall Street Journal on March 11 of this year, entitled "The Fed Didn't Cause the Housing Bubble." Above are the links to the three pieces, and I suggest you read them before reading my reply, which follows.
The first piece is a narrative of the Federal Reserve's monetary policy between 1979 and 2004. Greenspan explains that the Fed during this period, under Paul Volcker's chairmanship and then Greenspan's, raised and lowered the federal funds rate (the rate at which banks borrow from each other overnight) in order to achieve so far as possible full employment with minimal inflation. He notes the dot-com stock market bubble of the late 1990s and explains that the Fed did not try to puncture it by raising interest rates, fearing that to do so would cause "a substantial economic contraction and possible financial destabilization." But the article does not explain why he thought those consequences would have ensued. He notes that after the bubble burst and a recession ensued in 2001, the Fed reduced the federal funds rate; by June 2003 it was at 1 percent, "the lowest level in 45 years."
He thought this could be done without risk of inflation (the usual consequence of extremely low interest rates) because "both inflation and inflation expectations were low and stable." In fact, as I have explained in my book and in previous blog entries, the low interest rates had caused asset-price inflation--the housing and stock market bubbles, both well under way when Greenspan wrote the article in 2004.The rest of the article is devoted to generalities about monetary policy. There is no mention of a housing bubble. And rather than "trying to contain a putative bubble by drastic actions with largely unpredictable consequences," he contended that the Fed should "focus on policies 'to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.'" The quotation appears to be from earlier testimony by him before Congress.
Greenspan's second article, published in April of last year, remarks that similar housing bubbles emerged in more than two dozen countries, including the United States, between 2001 and 2006. He attributes these housing bubbles not to monetary policy (namely the low federal funds rate) but a "dramatic fall in real long term interest rates." He therefore refused to acknowledge that the Fed should have started pushing up interest rates before 2004, adding that "regulators confronting real time uncertainty have rarely, if ever, been able to achieve the level of future clarity required to act preemptively." He said that tighter regulation would have made no difference. He attributed the entire subprime debacle to "misjudgments of the investment community," thought the situation was stabilizing, and repeated the view expressed in his 2004 article that the Federal Reserve should not try to prick bubbles.
Greenspan's third article, published just this last March, is, as one would expect, more defensive in tone; for by then, as he acknowledges, disaster had struck. He argues in the article that the cause of the housing bubble and the ensuing near collapse of the international banking system was in no measure due to the Federal Reserve's having under his chairmanship pushed the federal funds rate way down and kept it there for years, but instead was the result of the adoption by developing countries such as China of an export-oriented trade policy, as a result of which these countries accumulated huge dollar surpluses which they then lent in the United States, driving down interest rates. This must be so, he argues, because the housing bubble was caused by long-term interest rates--mortgage interest rates are long term--and the federal funds rate is a short-term rate; and while short-term rates and long-term rates used to move in tandem, this relation was, he argues, shattered, beginning in 2002, by the flood of foreign capital into the United States.
I do not find this analysis persuasive. The federal funds rate, being the rate at which banks borrow reserves (cash) from each other, has a strong influence on long-term interest rates. The lower the cost at which a bank acquires capital to lend, the lower will be the rates at which it lends, whether long term or short term, because competition will compress the spread between the bank's cost (its interest expense) and its revenue (such as interest on the loans it makes). At the beginning of 2000, when the federal funds rate was 5.45 percent, the interest rate for the standard 30-year fixed-monthly-payment mortgage rate was 8.21 percent. By the end of 2003, the federal funds rate was below 1 percent (and was negative in real terms, because there was inflation), and the mortgage interest rate had fallen to 5.88 percent.
The Fed then gradually raised the federal funds rate, to 5.26 percent in July 2007, and the mortgage interest rate rose also, to 6.7 percent, a smaller but still significant increase; and the bubble burst. Furthermore, given the popularity of adjustable-rate mortgages--which Greenspan encouraged--short-term interest rates had a direct effect on the cost of mortgages during this period. Greenspan's analysis implies that the Federal Reserve lost control of long-term interest rates because of foreign capital and therefore could not have lanced the housing bubble even if it had wanted to, which is hard to square with the fact that the bubble did burst when the mortgage interest rate rose. (Though there was a lag, as I explained in a blog entry of May 19, because of the self-sustaining tendency of a bubble.)
And it is plain from the earlier statements to which Greenspan has directed us that he neither was aware that there was a housing bubble nor would have lanced it had he realized it, since it was and appears to still be his position that bubbles should be allowed to expand and burst, and then the Federal Reserve will wake up, step in, and clean up the debris ("mitigate the fallout when it occurs")--which we have discovered it cannot do.
Ilargi: Hard to decide which is worse: Obama's refusal to close Guantanamo or his refusal to end the equally morally depraved practices at credit card lenders. There is no excuse for torture in a civilized nation, and there's no excuse for 15-20%+ interest rates when the Fed rate is 0.25%. And that's all that needs to be said.
New Rules for College Credit Cards
The credit-card bill signed into law by President Obama addresses some, but not all, of the industry's most controversial campus practices. The landmark credit-card legislation that President Barack Obama signed into law on May 22 offers a bevy of protections for card holders. It outlaws some of the industry's most contentious billing practices. Card companies, for instance, will no longer be able to raise interest rates on card holders' existing balances until the borrower is 60 days behind in payments. And it forces the companies to give customers ample notice—45 days—before jacking up rates. The bill also addresses some of the worst abuses of credit-card use on campuses.
Without a co-signer, full-time college students under 21 will be confined to what amounts to credit-card training wheels, with credit restricted to 20% of a student's income. The presence of a co-signer protects college students from sudden rate increases; under the new law, a student's co-signer has to approve any such hikes. But the sweeping law, which takes effect in nine months, doesn't address every college credit-card controversy. Most notably it does little to address affinity-card contracts, which encourage colleges and universities to sell students' contact information to credit-card companies. These often confidential contracts bond hundreds of schools across the country with credit-card companies eager to sign up undergraduates. In some cases the school's financial reward increases handsomely when students frequently swipe their cards.
Students at the University of Michigan, for example, probably aren't aware that their e-mail addresses and contact information are worth a whopping $25.5 million. That's how much Bank of America (BAC) is paying the Michigan Alumni Assn. over an 11-year affinity-card contract to market school-branded plastic to students, alums, and sports fans. The Michigan Alumni Assn., which forged the deal, gets 0.5% of total purchases racked up on the school-branded cards. And the University of Michigan is hardly alone in inking a contract that rewards it for turning over students' personal information—precious leads in the hunt for new customers. Such financial alliances, in which participating schools have an incentive to encourage credit-card use, raise questions about the role colleges should play in the credit-card debate.
Should schools be entering into these agreements, encouraging students to amass often high-cost debt at a time when tuition costs have ballooned and growing numbers of students struggle to make ends meet? Roughly half of the nation's college students carry at least four cards in their wallets, shouldering an average of $3,173 in debt, according to Sallie Mae (SLM), the student lender that monitors college-debt levels. College students aren't just swiping their cards to pick up pizza tabs or buy school-spirited sweatshirts. They are increasingly using them for such big-ticket items as college tuition. Just five years ago, 24% of students charged a portion of tuition to a credit card—a number that has grown to about 30%, according to Sallie Mae.
At the bill-signing ceremony, President Obama emphasized that the new law was aimed at upholding basic standards of fairness and accountability. He said that credit cards can be a valuable tool for consumers while he decried unfair billing practices that can transform credit cards from a "lifeline" to an "anchor." The bill is the first significant piece of legislation passed to rein in the credit-card industry in the past decade. Under the law, banks won't be able to raise rates on outstanding balances until a card holder is 60 days late with a payment. Even if consumers pay late and become subject to a rate increase, there's an escape hatch: If they pay on time for the next six months, the card company must immediately restore the lower rate. The bill also eliminates fees for paying balances online. More flexibility is built into the law as well. Credit-card companies now have to apply payments to that part of a consumer's debts that carries the highest interest rates.
Ilargi: If people who have all the necessary data and means at their disposal are so bad at predicting developments, they need to be sent away. That goes for Canada, and that goes for the US and Britain (and many others). There is after all no reason to expect (the key word here) that their predictions will be more accurate this time around.
Canada deficit will be much larger than expected
The Canadian federal deficit this year will be "substantially more" than the C$33.7 billion ($30.1 billion) that was forecast in the January budget, Finance Minister Jim Flaherty said on Monday. Flaherty blamed the economic slowdown, lower tax revenues, and higher payments to the unemployed. Many economists and opposition figures had complained the government's forecasts were hopelessly optimistic. "The deficit will be substantially more than was anticipated in the January budget and I will report in detail on that in June," Flaherty told reporters. He did not give more specific details.
Markets shrugged off the news and the Canadian dollar was barely affected. In January, the government unveiled a two-year C$40 billion stimulus program designed to kick-start the economy. It forecast a total C$83.1 billion deficit over five years starting in the current fiscal year. Last week, the IMF predicted the deficit would total C$120 billion over the same five years. "We fully expected capitulation of this sort at the federal level," said Eric Lascelles, chief economics and rates strategist at TD Securities. "At the time they were reasonable (forecasts), but fairly quickly it became clear that the economy was turning down more sharply than those initial estimates," he told Reuters.
Flaherty said the larger deficit would not change the size of Ottawa's stimulus package and would not affect government plans return to surplus in the 2013-14 financial year. "These are extraordinary times requiring extraordinary measures. We will do what we have to do to protect the Canadian economy and to cushion the impact on Canadians of this recession," he said after a day of talks with his counterparts from Canada's 10 provinces. "I think what we need to do now is get through the storm, which continues ... There are some encouraging signs in the economy but this is still a serious recession that we're in."
The Canadian dollar weakened slightly from around C$1.1225, or 89.09 U.S. cents, ahead of the news to around C$1.1250, or 88.88 U.S. cents. "It's a little bit disappointing, but it's not altogether surprising. It's a bit of a moving target," said Steve Butler, director of foreign exchange trading at Scotia Capital. "There's been so much optimism coming into the market lately that even if we see the deficit maybe come in slightly higher, as Mr. Flaherty is indicating, than we originally hoped for it's not too much of a shocker at this point," he said.
Latvia Races to Cut Deficit to Keep to Its Bailout Deal
Many countries in the world have felt the sting of the economic crisis, but few can match Latvia for sheer pain. A harrowing contraction in the economy is reordering expectations for the future as the country’s leaders grapple with a credit-fueled boom turned to bust. Two brothers, Matiss and Oskars Barkoviskis, see it every day as they make their rounds here in their borrowed Mazda pickup truck. In the three months since they founded a charity for feeding the poor, they have discovered a strong and growing demand for their services. In just that time, the number of families they visit each week has nearly doubled, with new ones answering ads in Riga’s free newspaper every day. They started by delivering groceries down the dirt roads outside Riga and into decrepit, Soviet-era high-rise apartment buildings.
But now they find themselves helping out families who live in apparently comfortable surroundings, but who can no longer afford to feed themselves. "Before we started this project, I never thought people could live like this," said Matiss Barkoviskis, 20. "There is a sadness that I did not expect." It is not hard to grasp what stands behind the sour mood in Latvia. Forced into the arms of the International Monetary Fund, the Latvian government is now slashing its budget and the wages of state employees in a bid to rebalance a society that had run badly out of whack. Austerity is rippling down the social hierarchy, as the affluent cancel vacations, middle-class people fret about social descent, and Dickensian scenes of destitution multiply.
In Riga, the capital, abandoned construction sites, vast lots of repossessed cars and a new, utterly empty shopping mall testify to the misery. But the government’s tough medicine for the crisis, stiffer than Black Balsam, the syrupy herbal liqueur that is the country’s national drink, has defined the times. Latvia is racing to halve an enormous government budget deficit, now estimated at 12 percent of gross domestic product, even as its economy is expected to contract by 16.5 percent this year. That is a condition of the $10 billion bailout by the I.M.F. that the European Union, of which Latvia is a member, also supported. Prime Minister Valdis Dombrovskis, acutely aware that the previous government fell after Riga was shaken by riots in January, must now convince wary lawmakers that the country’s choices have narrowed to bad and worse.
"There is a growing awareness of what the problems are, but also what the alternatives are," Mr. Dombrovskis said in an interview. "The alternative is not receiving international financing." The alternative, in other words, is default. In better times, the global financial system would barely flinch at the idea of Latvian insolvency. But the other Baltic countries, Estonia and Lithuania, as well as Romania and Bulgaria and even Western stalwarts like Ireland all gorged on cheap credit and are all groaning under a heavy debt load. The last thing they want to see is a default, which could reignite a crisis that appears to be easing.
"Latvia is a reminder that there are other countries struggling with huge imbalances, though nobody has turned out as bad as Latvia," said Lars Christensen, chief analyst at Danske Bank in Copenhagen, who has long warned of a convulsion in the region. "Some come pretty close." In the heady days after it gained membership in the European Union in 2004, Latvia pegged its currency, the lat, to the euro in anticipation of eventually adopting the European currency. Its economy blossomed and Riga, blessed with its abundance of stunning Art Nouveau architecture, emerged as a kind of capital of the Baltics. Euro-denominated lending exploded, to the point where 85 percent of household debt was held in euros. But that seemed immaterial at the time, since the euro would soon replace the lat as the country’s currency, or so it was thought.
The lat is still with Latvia, however, and so is a colossal problem of how to devalue the currency — the usual adjustment mechanism in a financial crisis — without creating a crushing debt burden. Rather than let the currency decline, the government has chosen what it calls an "internal devaluation," in which wages are forced downward to restore the economy’s equilibrium. In December, the previous government reduced wages by at least 15 percent for most civil servants, and Mr. Dombrovskis is promising more. The government’s procurement budget was cut by a quarter, while the value-added tax increased to 21 percent from 18 percent. Exceptions for books and hotels fell away; excise duties on alcohol and gasoline rose.
The experience is weakening the bonds that Latvians feel for their state. Though proud of their heritage in language and culture, many now speak openly of emigration, and fading memories of citizens standing together with leaders to throw off Soviet domination 19 years ago only accentuate the alienation. "Independence or bondage is an easy question to answer," said Krisjanis Karins, a former Latvian economy minister. "This time it is not so cut and dried." Girts, a lanky 40-year-old doctor’s assistant, works three jobs in three hospitals for a monthly salary of $1,350 and spends half his income servicing a euro-denominated mortgage on his apartment.
The mood at Latvia’s state-run hospitals, he said, is now one of foreboding, as employees gripe that managers did not share in the pain of a 20 percent wage cut in January — one that covered all government workers — and will dodge another later this year. "I have very little faith left in the Latvian state," said Girts, who asked that his surname be withheld for fear of retribution by supervisors. "I don’t know how much longer this can go on." For Latvia’s poor, the mood falls somewhere between bewilderment and frustration, as families struggle to comprehend why their world has come apart. It did not make them rich, but Latvia’s boom over the past few years reached Aija Voitov and her husband, Juris, who live in a two-room shack heated by a crude metal stove down a dirt road outside Riga.
Though Mr. Voitov switched jobs from time to time, work was plentiful, and Mrs. Voitov had only to walk over to the nearby main road to find work at a big supermarket. Three months ago, Mr. Voitov lost his job at a food processing factory where he had earned $735 a month, a tiny enough sum. Since then, as the family scrapes by on state assistance, Mrs. Voitov confesses little comprehension of exactly what went wrong, only that in the past, things were better. "It was normal, it was good," Mrs. Voitov said. "There was plenty of work."