Lieutenant 'Mike' Hunter, Army test pilot assigned to Douglas Aircraft Company, Long Beach, California
Ilargi: Last Friday, I named my daily post "Never deny beating your wife", referring to a column that day at Bloomberg from Caroline Baum, who was talking about Ben Bernanke's testimony before the House Oversight Committee regarding his role in the BofA-Merrill Lynch takeover.
The line is straight out of PR and media training 101: how to avoid digging yourself into a hole when asked questions phrased in particular ways. Or, alternatively, how to dig a hole for someone you ask a question. Note: the actual question is slightly different and more devious: "When did you stop beating your wife?" or "Do you still beat your wife". The training is aimed at recognizing the pitfalls before you start denying and painting yourself into a corner you don't want to be in. Baum writes:
Bernanke could have used a presentation-skills coach, not to mention a make-up artist. He looked tired, which is understandable for someone running on little sleep and maximum stress. He was uncomfortable with the subject matter, preferring the arcana of output gaps and inflation expectations to fending off accusations of improper conduct on the part of the Fed. Several times under pressure, he fell back on “I don’t recollect” or “I don’t recall” the details of a particular conversation or e-mail.
The Fed chief was asked repeatedly whether he threatened to fire Ken Lewis and his board; whether he instructed former Treasury Secretary Henry Paulson to convey that threat; whether he promised a specific amount of government money if the deal were consummated; and whether he had knowingly withheld information on the merger from other regulatory agencies. And he repeatedly answered in the negative. In so doing, he violated what my colleague calls the First Rule of PR: Never deny beating your wife. Never say, “I’m not a crook.” When you do, you lose.
Bernanke lost on defense. Not that his offense was anything to write home about, considering he can run circles around lawmakers, many of whom look as if they are reading their staff- prepared opening statements for the first time. He dodged questions about whether Lewis and Paulson were lying when they claimed he was the bearer of threats. As far as the audience is concerned, a dodge is as bad as negative denial (see First Rule of PR above).
This principle works in more ways than one. People who've done the PR 101 course, and more, can for instance use it to say things by not saying them. That is what White House Senior Adviser David Axelrod did this morning on ABC's "This Week With George Stephanopoulos", and I wouldn't want to bet George wasn't in on it:
AXELROD: [..] you know, we take the long view on this. Look, when the president signed the stimulus package -- the economic recovery package, he said it's going to take a while for this to work, and we're going to go through some rough times, and unemployment is going to go up, and we've got to work -- we have to work our way through this. So... [..] ... none of this -- none of this is surprising[..].
STEPHANOPOULOS: The money is not going out as fast as you had hoped, is it?
AXELROD: Well, I think the money -- we would like the money to go out faster in some instances, but a lot has been accomplished, and that should not be diminished. There are 4,000 or 5,000 road projects going on in this country right now that would not have gone on. There are energy projects going on in this country right now, and homes being retrofitted to be energy efficient that would not have happened. There are policemen and firefighters and teachers who are still on the job today because of that package. So I think it's done an awful lot of good.
The fact is that we're in the teeth of one of the worst recessions that we've had since the Great Depression, perhaps the worst, and we're going to have to work our way through that. And I think the American people understand that at some level, and that -- and so we're not sitting there -- the numbers we're worried about are not poll numbers. It's how many people can we get back to work, how do we get this economy moving again in the long run, and mostly how do we build a solid foundation so we're not in this bubble-and-burst kind of economy that we've seen over the last decade that leaves both our country and our families and businesses in jeopardy.
STEPHANOPOULOS: Some economists look at that, including Paul Krugman, [..] he says you're looking at 9, 10 percent unemployment coming in September. That's going to necessitate a second stimulus package. Is that still on the table for the president right now? And what would that mean for your other plans on energy and health care?
AXELROD: Well, first of all, I don't want to prejudge that at all. You know, as you said earlier, there's still -- most of the stimulus money, the economic recovery money is yet to be spent. Let's see what impact that has. I'm not going to make any judgment as to whether we need more. We have confidence that the things we're doing are going to help, but we've said repeatedly, it's going to take time, and it will take time. It took years to get into the mess we're in. It's not going to take months to get out of it.
There are plans being prepared, if they're not already fixed, for a second stimulus plan, By not denying, he admits it. It may not look that way at first sight, but it's there. Stephanopoulos quotes Krugman (and more economists) as saying that a 9-10% unemployment rate in September will necessitate a second stimulus package. Axelrod has no denial, he doesn't even try, silently implying that Krugman is correct. He simply says: "I don't want to prejudge that at all."
The position the White House is in is precarious. People need to be prepared for a deteriorating economy, and therefore for that next stimulus package. But the speed at which the first stimulus is being spent is ridiculously slow. We've seen this past week that US incomes are up because stimulus money is going into benefits, but that does nothing for the number one goal: creating jobs. And the White House's best guess at the number of jobs created so far, out of 3 million plus promised 5-6 months ago, is 150.000, a number, to make it even better, that's strongly disputed by all sides of the spectrum because there exists no proof whatsoever.
So while the first stimulus plan is in a shambles, and the economy is fast sinking, as is evident from unemployment and real estate stats, the government needs to prepare the nation for more taxpayer funded spending. Obama and Tim Geithner can't touch that topic with a ten foot pole, not for quite a while. So they send out the support troops, in today's case Axelrod and Christina Romer. They can't get the finances and economics right, but they have one hell of a PR and spin team. Don't underestimate the degree to which this administration is run by that team. You go with your strengths.
From where I'm sitting, though, it all rings increasingly hollow. New unemployment numbers are due later this week. It's high time for some real answers. You can't fool all of the people all of the time.
U.S.'s debtor status worsens dramatically
In the midst of the longest, and probably deepest, postwar recession last year, the U.S. investment position with the rest of the world sharply deteriorated. At the end of 2008, America's net international investment position was minus $3.47 trillion, the Commerce Department reported Friday. That represents the difference between the value of U.S. assets owned by foreigners ($23.36 trillion) and the value of foreign assets owned by Americans ($19.89 trillion).
At the end of 2007, the U.S. net international investment position was minus $2.14 trillion. Thus, America's net indebtedness with the rest of the world increased by $1.33 trillion, or 62 percent, during 2008. It was by far the biggest annual increase in data that go back to 1976. Foreigners now hold nearly 50 percent of the federal government's publicly held debt. If foreign investors significantly reduce their purchase of future U.S. Treasury debt securities, without even dumping their current holdings, U.S. interest rates could soar and the dollar could collapse, analysts fear.
At minus $3.47 trillion, America's net debtor status with foreigners represents nearly 25 percent of U.S. gross domestic product, the highest level in history. "Three decades of massive [trade] deficits have converted the United States from the world's banker - able to 'pay any price and bear any burden in the cause of freedom' - to the world's largest debtor, utterly dependent on China and other foreign interests," said Charles McMillion, chief economist of Washington-based MBG Information Services.
Essentially, America's net international investment position is driven by what the United States borrows from the rest of the world to finance its ongoing trade deficit, said Brad Setser, a fellow for geoeconomics at the Council on Foreign Relations. Over the 2003-07 period, however, foreign equity markets outperformed the U.S. stock market, and the dollar steadily depreciated. These two factors reduced the annual deterioration in America's investment position that otherwise would have been dictated by massive U.S. trade deficits during this period.
"Both of those factors reversed themselves last year," Mr. Setser said. The dollar appreciated, and foreign stock markets suffered bigger declines than America's. As a result, America's net debtor status worsened significantly more during 2008 than its nearly $700 billion trade deficit would have dictated, Mr. Setser explained. Over the years, America's status as a creditor or debtor has changed enormously.
In the early 1980s, America's net international investment position averaged $350 billion, or 11 percent of GDP, making the United States the world's largest creditor. Today, it is the world's largest debtor - by far. As recently as 1996, America's net debtor status was minus $456 billion. Since 1996, it has increased by more than $3 trillion, or 660 percent, as America's 12-year cumulative trade deficit soared by $5.7 trillion.
Foreign governments have taken notice - in particular, China, which now holds more U.S. Treasury debt than any other country. In the 12 months through April, China's portfolio of Treasury debt securities has soared by more than a quarter of a trillion dollars to nearly $800 billion. In its annual financial stability report issued on Friday, China's central bank once again declared there were serious problems with the global monetary system's reliance on a single dominant currency - the dollar.
An estimated 65 percent to 70 percent of China's $2 trillion in foreign exchange reserves, the world's largest stockpile, is held in dollar-denominated assets. The People's Bank of China also warned the United States on Friday about its very expansionary monetary and fiscal policies. "We are so deeply in debt and this money is so liquid that it hamstrings our monetary, fiscal and trade policies," Mr. McMillion said. "We've really mortgaged our financial future."
The Debt Tsunami
The CBO's latest warning on the long-term deficit is scarier than ever
The Congressional Budget Office has a tough job: to provide America's lawmakers with a reality check on their tax and spending plans. Not surprisingly, the CBO's projections are not always received cheerfully. Both President Obama and leading congressional Democrats were less than thrilled when the CBO estimated that the costs of universal health coverage would be much higher than advertised.
To be sure, projecting the cost of legislation involves making assumptions and constructing models that may or may not prove accurate 10 years down the road. Nonetheless, the CBO, with its tradition of scholarly independence, is the best available arbiter, and Congress must heed its numbers -- like them or not. Now comes the CBO with yet more news of the sort that neither Capitol Hill nor the White House is likely to welcome: its freshly released report on the federal government's long-term financial situation.
To put it bluntly, the fiscal policy of the United States is unsustainable. Debt is growing faster than gross domestic product. Under the CBO's most realistic scenario, the publicly held debt of the U.S. government will reach 82 percent of GDP by 2019 -- roughly double what it was in 2008. By 2026, spiraling interest payments would push the debt above its all-time peak (set just after World War II) of 113 percent of GDP. It would reach 200 percent of GDP in 2038.
This huge mass of debt, which would stifle economic growth and reduce the American standard of living, can be avoided only through spending cuts, tax increases or some combination of the two. And the longer government waits to get its financial house in order, the more it will cost to do so, the CBO says. The CBO's new long-term forecast is considerably more pessimistic than the one it issued 18 months ago, mostly because of the recession, which has driven the budget deficit above 12 percent of GDP.
But the report makes clear that the recent economic downturn did not cause the government's predicament and that the situation will not necessarily improve once the economy does. The principal cause of long-term fiscal distress is the aging of the U.S. population, coupled with rising health-care costs -- which, together, will drive spending on Medicare, Medicaid and Social Security to new heights.
Unchecked, federal spending on Medicare and Medicaid combined will grow from almost 5 percent of GDP today to almost 10 percent by 2035 -- and to more than 17 percent of GDP by 2080. Like his predecessors, Mr. Obama is aware of this issue. Like them, he has promised a plan to deal with it. And like them, he has not come up with anything credible yet. It's time for that to change.
Obama adviser not ready to back a second stimulus
A senior White House adviser said Sunday the economic stimulus has not yet "broken the back of the recession" but set aside calls for a second massive spending bill. Republicans, meanwhile, called spending under way a failure. White House adviser David Axelrod urged patience for President Barack Obama's $787 billion economic stimulus package in the face of sliding poll numbers.
Former Massachusetts Gov. Mitt Romney, a past and potentially future presidential candidate, said the spending was ill-designed and served only to expand the size of government. Republicans have seized on the public's growing unease over government debt and spending to challenge the popular president. Sensing their own vulnerabilities, Obama's top advisers have ramped up their defense of spending that is incomplete and going slower than many had hoped.
"You know, we take the long view on this. Look, when the president signed the stimulus package - the economic recovery package - he said it's going to take a while for this to work," Axelrod said. "And we're going to go through some rough times, and unemployment is going to go up, and ... we have to work our way through this."
Some economists and business leaders have called for a second spending bill designed to help guide the economy through a downturn that has left millions without jobs. Axelrod said it's too early to know if more spending would be needed or if the administration would seek more money from Congress.
"Most of the stimulus money - the economic recovery money - is yet to be spent. Let's see what impact that has," Axelrod said. "I'm not going to make any judgment as to whether we need more. We have confidence that the things we're doing are going to help, but we've said repeatedly, it's going to take time, and it will take time. It took years to get into the mess we're in. It's not going to take months to get out of it."
Republicans, though, aren't waiting. "I don't think the stimulus that was passed is going to be much help," Romney said. "The stimulus that was passed was, unfortunately, focused more on government and creating employment inside government than it was creating jobs in the private sector." Another Republican, Sen. Lindsey Graham, R-S.C., said Obama and his Democratic allies rammed through the spending bill without Republican support or significant input.
"He missed a chance to have a bipartisan stimulus package that would have created more jobs and helped people who'd lost their jobs," Graham said. "I hope they'll rethink it." In the meantime, the current spending isn't doing enough, they said. "For the millions of extra people who are going to be unemployed, it has not been successful," Romney said. "It has failed in delivering the stimulus that was needed at the time it was needed."
Axelrod acknowledged the economic challenges and unemployment inching close to 10 percent nationally. "Well, there's no doubt that ... we have not broken the back of the recession," he said. "No one's happy with that number." Axelrod appeared on ABC's "This Week" and NBC's "Meet the Press." Graham and Romney appeared on ABC.
Axelrod waffles on Obama no-middle-class-tax-hike vow
The White House seems to be retreating from President Barack Obama’s campaign promise that he would not raise taxes on families making less than $250,000. Under persistent questioning from ABC’s George Stephanopoulos Sunday, Obama senior adviser David Axelrod declined to restate the vow and left open the possibility that the president might sign health care reform legislation that taxes high-cost, employer-provided insurance plans which some middle-class families currently receive tax free.
“The president had said in the past that he doesn't believe taxing health care benefits at any level is necessarily the best way to go here. He still believes that, but there are a number of formulations and we'll wait and see,” Axelrod said on ABC’s “This Week.” “The important thing at this point is to keep the process moving, to keep people at the table, to the keep the discussions going. We've gotten a long way down the road and we want to finish that journey.”
When Stephanopoulos asked why Obama hadn’t drawn a “line in the sand” over his tax pledge, Axelrod suggested that kind of ultimatum is at odds with the president’s effort to being a new tone to politics. “One of the problems we've had in this town is that people draw lines in the sand and they stop talking to each other. And you don't get anything done. That's not the way the president approaches this,” the White House adviser said.
Romer upbeat on US economy
The US economy will feel a substantial boost from the Obama administration’s emergency spending package over the next few months, says Christina Romer, a senior White House official, who has warned against tightening monetary and fiscal policy before recovery is well established. Ms Romer, chairman of the US president’s council of econ?omic advisers, told the Financial Times in an interview she was “more optimistic” that the economy was close to stabilisation.
But while hopeful that America could yet experience a V-shaped recovery, she said it was much too soon to begin tightening policy: “We do not want to repeat the mistake Japan made in the 1990s, when the moment things started to improve they tightened policy.” Meanwhile, David Axelrod, a senior White House adviser, told NBC Television on Sunday the administration would be open to further stimulus if needed. “Let’s see in the fall where we are, but right now we believe what we have done is adequate to the task. If more is needed, we’ll have that discussion.”
Ms Romer’s comments come as opposition Republicans step up their attacks on the $787bn fiscal stimulus, pointing out that it has not prevented unemployment from hitting a quarter-century high of 9.4 per cent. Ms Romer said stimulus spending was “going to ramp up strongly through the summer and the fall”. “We always knew we were not going to get all that much fiscal impact during the first five to six months. The big impact starts to hit from about now onwards,” she said.
Ms Romer said that stimulus money was being disbursed at almost exactly the rate forecast by the Office of Management and Budget. “It should make a material contribution to growth in the third quarter.” But she acknowledged that cutbacks by states facing budget crises would push in the opposite direction. Ms Romer said the latest economic data were encouraging, following a weaker patch a month ago. “I am more optimistic that we are getting close to the bottom,” she said.
The CEA chairman, who has forecast a sharper rebound in 2010 than most economists, said she had lowered her estimates for growth this year “and also for next year, a bit” since the start of the year. She said the consensus forecast that unemployment would continue to rise for the rest of this year and peak early next year was probably accurate. But she added: “I still hold out hope it will be a V-shaped recovery. It might not be the most likely scenario but it is not as unlikely as many people think. “We are going to get some serious oomph from the stimulus, there is the inventory cycle and I believe there is some pent-up demand by consumers.”
Even so, Ms Romer warned against tightening monetary and fiscal stimulus prematurely. She said the authorities should continue to work on their exit plans but not implement them until the economy came back strongly.
“It is important to think about it now but policymakers should not start acting until we are really recovering well and are approaching full employment.” Ms Romer, an expert on monetary policy, said she thought the risk of inflation was “very low”. “With unemployment and unused capacity high, it is not as if inflation is going to creep up on us. We will have a long period of time to figure out what to do.”
Who Owns the Banks, Round Two?
Bank nationalization will soon be back on the agenda unless the economy picks up.
The stress tests came and went, but haven't settled the argument over whether anything short of seizing the biggest banks amounts to recapitulating Japan's experience with zombie banks. That argument remains relevant -- because bank nationalization will soon be back on the agenda unless the economy picks up. It would be good to get the parallel straight.
Japan's problem wasn't so much zombie banks as zombie borrowers, kept alive with new infusions of money because the political class, speaking for Japanese society, wanted to delay and minimize foreclosures, layoffs and asset fire sales to preserve "harmony." An even more important, but unsung, factor in Japan's so-called lost decade was a relentless series of tax hikes.
Letting U.S. banks slide on their capital ratios is not the same as making "zombie banks." Somebody somewhere has to hold bad loans until they're resolved, either because borrowers make repayment or are forced into liquidation. There's no question that the Obama administration has opted for an unspoken policy of regulatory forbearance with respect to various too-big-to-fail banks. But those banks have no natural reason (aside from political pressure) to keep zombie borrowers alive if it would be financially advantageous to foreclose.
For all that, the Obama stress tests have served a confidence-building purpose -- confidence in Washington, not the banks. It dispensed with the idea that the problem of how to unwind Washington's massive commitment to the financial sector could somehow be solved at the expense of bank shareholders. That idea was always a distraction -- there was not enough market capitalization in the entire banking sector to make a fig's difference, especially while the prospect of nationalization hung over it.
In climbing down, the Fed and the Obama administration did indeed credit future earnings of the banks with solving a big part of their capital problem. Call it fudge: This is a bet on growth, the only decent solution out there, because neither nationalization nor capital raising by banks can get the Federal Reserve off the hook of inflating away the banking system's massive additional losses on consumer, business and housing loans if growth doesn't come back.
As usual, however, there is no coherence in the administration's approach. Even while it counts on surging bank profits, it attacks the banking system's credit card profits, its mortgage profits, its senior-secured lending profits, etc. This is no way to avoid the rightly frightful prospect of having to add Citigroup and Bank of America to the portfolio of companies Washington is running badly.
Meanwhile, Team Obama is periodically tempted by the pro-nationalizers' claim that giving the big banks time to heal can only stifle recovery by retarding their return to lending. The critics underestimate two things: The dynamism of our financial sector, with plenty of healthy banks, start-ups and foreign investors likely to step into any lending gap if real opportunities for profitable loans present themselves (a difference vs. Japan, whose financial system was relatively closed).
They also underestimate the degree to which the problem is demand for loans rather than supply. It's good to recall the puzzlement of the early Clinton administration over the "jobless recovery" that prevailed after it took office in 1993. The mystery wasn't the mystery the administration liked to pretend: Business refused to hire or expand out of fear of Bill Clinton's then-pending health-care reforms.
Mr. Obama's own initiatives on climate, labor, taxes and health care are the biggest threat to growth -- thus to the success or disaster of the Fed's giant liquidity bet, failure of which could still send us Argentina's way (as the Fed itself no doubt is discussing in its closed meetings today and yesterday). Here, a happy happenstance for the nation is that our president is an object of craving utterly independent of the policies he pursues. Mr. Obama, therefore, has an unlikely degree of freedom to throw overboard his agenda and go for growth without fear of his public abandoning him.
From the start, he has seemed uniquely detached and noncommittal about his own policy positions, as if he was entertaining them only to see if they might be useful to him. Let's not underestimate this advantage over lesser politicians, who get trapped by their rhetoric. Let's also hope Mr. Obama takes advantage, becoming the "growth" president and saving the big initiatives for his second term. Otherwise, with the AIG disaster before him, he may be remembered as the president who nonetheless blundered into similar disasters trying to manage Citibank et al.
Banks earnings buoyed by record fund-raising
Buoyant capital markets activity underpinned US banks’ second-quarter earnings, with a boom in equity and debt issuance helping offset continued losses on toxic assets, bankers and analysts said. With two days to go before the end of the quarter and a fortnight before banks begin reporting results, executives said the strong performance in trading and underwriting in the first quarter was exceeded in the three months to June.
The completion of the US government’s stress tests set off a flurry of activity on Wall Street, with financial institutions reaping large fees for helping rivals raise equity to plug capital shortfalls and repay federal aid. Banks and other financial groups raised $89bn in equity via 92 deals in the second quarter, the highest number of deals on record and the highest dollar volume for a year.
US groups’ second-quarter equity issuance of $259bn was more than three times the $71.3bn raised in the first quarter, according to Dealogic . A rebound in high-yield bond activity and unusually high margins in fixed income trading also contributed to what one Wall Street executive called a “perfect storm for investment banking businesses”. “The second quarter has been exceptional,” said one head of capital markets at a US bank. “It’s good to be back and pricing deals.”
Bankers at a rival institution said the second quarter was shaping up as the best ever for their companies’ capital markets businesses. The boom in securities’ markets has benefited banks such as Goldman Sachs and Morgan Stanley, whose business models had been called into question at the turmoil’s height due to fears over their ability to fund themselves without retail deposits.
“Goldman Sachs is having a very good quarter. Investors should be pleased with what they see,” wrote Richard Bove, analyst at Rochdale Securities. He added that Morgan Stanley was also gaining ground because the “operating improvement is likely to get stronger”. Most banks will suffer writedowns on toxic assets, with analysts predicting a worsening in the performance of commercial mortgage-backed securities. Some banks are also expected to record large accounting losses on the treatment of their debt.
Small Banks Not Shying From TARP
Enterprise Bank has one office, three shareholders and $4 million in fresh capital from the U.S. government's Troubled Asset Relief Program. "That's not a bailout. That's being patriotic," said Chuck Leyh, president and chief executive of the Allison Park, Pa., bank's parent company, Enterprise Financial Services Group. Enterprise Bank, which has $180 million in assets and turned a first-quarter profit of $85,000, plans to funnel the money it got from the Treasury Department on June 12 into loans to fledgling businesses in western Pennsylvania.
In contrast to Wall Street firms like J.P. Morgan Chase & Co., Goldman Sachs Group Inc. and American Express Co. that returned $68.25 billion in one day this month to escape TARP and all the strings that were attached, a steady stream of small banks still is lining up for government money. Since May 31, 20 small banks have received a total of $164.1 million in taxpayer-funded capital, according to the Treasury's latest available figures.
Half of those banks got the money in the same week that 10 big financial institutions gave theirs back. Analysts see no end in sight to the trend. The recession and borrowers are squeezing most of the 8,200 federally insured commercial banks and savings institutions in the U.S., so even a dollop of TARP funds could make a difference. Some banks are turning to the government to fill a void left by investors who are leery about pouring money into the sector, despite the rebound by bank stocks since early March.
Meanwhile, the rules and stigma of TARP that turned some executives such as J.P. Morgan Chairman and CEO James Dimon against the program are irrelevant to small institutions. Their employees usually don't fly on corporate jets or collect hefty bonuses that trigger outrage from taxpayers, customers and Congress. And curbs on dividend payments are a modest price to pay for greater assurance that the banks can plow ahead with their core mission to gather local deposits, lend them nearby and support local charities, some recent TARP recipients said.
Still, unflattering headlines and television talking heads that have jabbed at TARP since it was launched last October made some small-bank executives wary about lining up for government money. Berkshire Bancorp Inc., a five-branch, five-year-old bank in Wyomissing, Pa., with $133 million in assets, raised $3 million from private investors in 2007. Executives were looking for more capital to fuel the bank's growth, deciding to take $2.9 million from TARP on June 12 rather than spend time and money on a capital-raising program that might flop. Bank officials debated the pros and cons, bracing for tough questions from customers and investors.
"We spent a lot of time with more than 400 shareholders, explaining to them what the plan was and our reasoning behind it," said Norman Heilenman, Berkshire's chairman and chief executive. "There have been a lot of questions, but we haven't had negative reaction." Without the $15 million River Valley Bancorporation Inc. got two weeks ago, the Wausau, Wis., bank would have been forced to rein in lending. "One of the only other options is to borrow from large banks and, frankly, they're not in the market to do that," said Steve Anderson, president and CEO of River Valley, with $925 million in assets and 18 branches in Michigan and Wisconsin.
Last year, River Valley sold a corporate plane that ferried executives between branches that are about four hours from each other by car. Smaller TARP recipients have a leg up on big banks that tapped the rescue program. Because small institutions often are closely held, they typically haven't publicly announced getting TARP. Treasury officials publish a spreadsheet that includes a running list of all TARP recipients.
In April, Mark Hanna, president and CEO of Virginia Co. Bank, announced at the Newport News, Va., bank's shareholder meeting that the four-year-old, two-branch bank was approved for $4.7 million in TARP funds. The initial reaction from some investors was negative, but they warmed up after being told that preferred shares issued to the government wouldn't dilute their holdings, he said. "We haven't received a single customer complaint or comment, but they may not know," Mr. Hanna said.
Overall, 633 U.S. banks have received a total of $199.57 billion in TARP money, according to the Treasury. Of the 32 banks to repay a combined $70.12 billion to the government so far, about 20 are small institutions. Separately, the Treasury on Friday issued details on the procedures that banks must follow if they want to repurchase warrants that the government received as part of the capital infusions. The 10 big banks that repaid TARP funds earlier this month are wrestling with that issue and must submit their assessment about the value of the warrants by the end of next week.
Governor's last stand: his way or IOUs
Gov. Arnold Schwarzenegger, seeking to conquer what could be the last budget crisis of his tenure, is engaged in a high-stakes negotiating strategy with lawmakers that could force him to preside over a meltdown of state government. As legislators have scrambled to stop the state from postponing payment of its bills and issuing IOUs starting next week, the governor has vowed to veto any measure that fails to close the state's entire $24-billion deficit.
In doing so, Schwarzenegger has sent the message that he would rather allow the state to begin shutting down than let lawmakers push its troubles off for months by closing only part of the shortfall. The latter prospect could swallow up the rest of his governorship. "Whatever needs to be done," Schwarzenegger told reporters outside his Capitol office Friday when asked why he would be willing to delay payments to needy Californians. "I know that there is a history in this building of always being late with the budget, to drag it out and to kick that can down the alley. . . . I don't think we have this luxury this time."
The governor readily admits that he sees the crisis as a chance to make big changes to government -- to "reform the system," he said Friday -- with proposals he has struggled to advance in the past. Among them: reorganizing state bureaucracy, eliminating patronage boards and curbing fraud in social services that Democrats have traditionally protected. The governor also would like to move past the budget crisis to reach a deal on California's water problems that has so far eluded him.
By agreeing to a partial budget solution such as one the Assembly approved Thursday, the governor would lose leverage to accomplish many of those things. Without the pressure of imminent insolvency, Democrats might be less likely to agree to his demands. But if his strategy fails, he could be blamed for unnecessarily subjecting state residents to misery.
"I don't believe the governor wants his legacy to be that he had the opportunity to avoid IOUs for Californians and that he failed to take it because he wanted to play a game of chicken," Senate President Pro Tem Darrell Steinberg (D-Sacramento) said last week. California Controller John Chiang has announced that on Thursday he will begin issuing IOUs on the scale of $3 billion a month, delaying payments to college students, welfare recipients, the elderly, the blind and the disabled. The state is on track to run out of cash by the end of July.
The governor has pushed lawmakers to move with urgency, but he has also made clear that his two priorities are ensuring that the state will not raise taxes, as it did in February, and that it closes the whole deficit in one shot. The Assembly approved measures totaling $5 billion Thursday that would have cut education funding and deferred some expenses, extending the timeline before the state would run out of money. But the Senate rejected the proposal before it reached the governor's desk, so he did not have to exercise a veto, as he had promised to do.
Even if he had, said Bruce Cain, professor of political science at UC Berkeley, the time is ripe for Schwarzenegger to take a gamble: The governor has no obvious designs on future office that might require him to be cautious, and voters who rejected tax hikes in May's election appear to support his approach. In any case, Cain said, most Californians will see those to be hurt by IOUs as vendors and "overpaid state employees," not themselves.
"The reality of what these cuts he is pushing for will mean hasn't hit home with the public yet," Cain said. "They see him standing up to unions and trying to cut all the waste and fraud. . . . Until the middle class bleeds in a way they care about, Arnold has the upper hand." In this final year before he becomes a lame duck, the governor has attempted to use the budget standoff to burnish the kind of legacy he originally sought, as a populist change agent who promised to control California's finances, "blow up the boxes" of Sacramento's bureaucracy and attack the Capitol's sacred cows.
"We must use this crisis as an opportunity to make government more efficient, which is a much better option than raising your taxes," Schwarzenegger said in a radio address this weekend. In past years, his plans ran into opposition organized largely by well-funded labor groups and Democrats, who say his proposals are really meant to strangle government. Now he is newly armed with negotiating power over Democratic lawmakers desperate to preserve state programs.
Back on the governor's demand list is a plan to cut the pensions received by state workers, which unions have stymied before but which he thinks may gain traction with a cash-strapped public. Schwarzenegger also views this as an ideal time to once again target growth and fraud in the state's multibillion-dollar in-home healthcare program, which employs 300,000 unionized workers.
His agenda includes anti-fraud efforts and tougher enrollment requirements for the state's food stamp programs, efforts that advocates for the poor say are designed to discourage people from participating. In his radio address, he said the state and counties could get by with a "fraction" of the 27,000 workers now handling eligibility for Medi-Cal and food stamps by using Web-based enrollment.
Schwarzenegger has revived plans to allow local school districts to contract out for services like school bus transportation and lawn maintenance, a proposal favored by the GOP but despised by school employee unions. Gary Jacobson, a professor of political science at UC San Diego, said Schwarzenegger has put himself at risk of antagonizing the public by holding out for some of these ideas while forcing deep cuts and forswearing new taxes that could alleviate some of the pain.
"When it hits people how much damage this budget has done, they are going to say, 'So what that he got some of these things through? Look at what he has done to us in the meantime. State parks are closed. Classrooms are huge. People are being thrown out of the hospital. Medical clinics are shutting down,' " Jacobson said. "When all this hits," he added, "it is going to be hard to imagine people will look on him favorably because he got some of the structural reforms he wanted."
Personal bankruptcies surge in Southern California
Going legally broke has made a big comeback -- especially in the Los Angeles area -- despite a mid-decade revision to the U.S. Bankruptcy Code intended to curb filings. The number of Southern Californians seeking bankruptcy protection nearly doubled in 2008 from 2007 in the U.S. Bankruptcy Court's seven-county California Central District, by far the biggest increase in the nation. Bankruptcy is still booming. Personal filings from January through April, the most recent month available, rose 75% in the Central District compared with the year-earlier period.
Bankruptcy experts attribute the growth mainly to the mortgage meltdown, which hit the region's adventuresome borrowers particularly hard. Add soaring credit card debt and medical expenses, and people who never thought they'd see a bankruptcy courtroom are lining up with petitions in hand. "California has been one of the biggest climbers in the filing rate in the last few years," said Robert Lawless, a law professor at the University of Illinois and contributor to the Consumer Bankruptcy Project, which examined how the 2005 bankruptcy overhaul affected filers. "I attribute a lot of that to the foreclosure problem."
The scene plays out weekdays in the downtown Los Angeles bankruptcy filing office. In 2006 and 2007, with bankruptcy filings in the doldrums, official statistics indicate this room was less than bustling. But on a recent morning, nearly 20 people were waiting in the hallway before the doors opened, many looking for a way out of their mortgage troubles. Kim Smock raced in to ask a clerk: "Do you think I can make an 11:30 sale?"
It was 10:45 a.m. and Smock had only 45 minutes to stop the foreclosure sale of his home. In short order, Gerri Colwark arrived for a similar reason -- the bank was ready to sell her father's foreclosed home that morning. A bankruptcy filing stops a foreclosure sale, at least temporarily, even if the paperwork is stamped only a minute before the sale is to take place. "I rushed over here," she said, a bit out of breath.
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 was designed to keep people who had the ability to pay debts from enjoying the benefits of bankruptcy. At the heart of the changes is a complex "means test" to analyze a person's ability to pay debts before being allowed to seek Chapter 7 bankruptcy protection, which along with Chapter 13 are the types most often used by individuals. "Too many people have abused the bankruptcy laws," President George W. Bush said as he signed the measure into law. "They've walked away from debts even when they had the ability to repay them."
But Lawless, citing studies, said the revisions mainly confused legitimate filers and led to higher attorney fees. "The effect was that people are arriving in Bankruptcy Court in worse financial shape," he said. U.S. Bankruptcy Court Judge Maureen Tighe, based in the Woodland Hills division, said the more complex rules ultimately stopped few bankruptcies. "The changes just made it more expensive for people to file," she said.
The 2005 revamp immediately cooled the bankruptcy frenzy. In 2004, about 60,300 people sought Chapter 7 or 13 bankruptcy in the district, which covers Los Angeles, Orange, Riverside, San Bernardino, Ventura, Santa Barbara and San Luis Obispo counties. In 2006, the first full year under the new rules, about 17,600 people filed, down 71% from two years earlier. Nationwide, filings fell less dramatically, 61%, to 612,000 in 2006 from 1.6 million in 2004.
Before long, filing rates were rising again as more and more people were resorting to bankruptcy. Last year, about 65,000 Southern Californians filed, sailing past the 2004 level. The typical consumer bankruptcy filer isn't a scofflaw, Harvard University law professor Elizabeth Warren said. "They have decent educations and they once had good jobs," said Warren, whose public profile has soared recently as chairwoman of the congressional panel monitoring the Treasury Department's distribution of bailout money through the Troubled Asset Relief Program.
"Nearly all of them are shocked that play-by-the-rules people like themselves have ended up in bankruptcy," Warren said. The reason most turn to bankruptcy strikes close to home. "It's real estate," said Encino bankruptcy attorney David S. Hagen, who conducts free seminars for homeowners organized by the nonprofit Neighborhood Legal Services. "People got sold a bill of goods on some kind of nontraditional mortgage and thought they could change it when the worth of their house went up. But the worth went down and the payments went up," he said. "They start to live off of their credit cards."
By the time Norris Daniels of Sherman Oaks made it to the self-help desk staffed by Neighborhood Legal Services at the Woodland Hills Bankruptcy Court division, he had racked up $47,000 in credit card debt. His house troubles consisted mostly of storm damage repairs that spiraled out of control. The house eventually sold, but then came a divorce and support for his mother when she was ill. According to a recent study by Harvard researchers, doctor and hospital bills plus other costs because of illness contribute to about 60% of bankruptcies. "I was a person with a good credit score -- 750 -- when I bought my house," said Daniels, 42, a salesman at a Beverly Hills clothing store. "I'm a regular guy."
An attorney wanted to charge Daniels about $3,000, which he couldn't afford on top of the $299 court filing fee. So, like approximately 25% of local Chapter 7 filers, he'll represent himself. (Those who file for Chapter 13 bankruptcy usually need a lawyer's help.) The complications of the 2005 revisions caused attorney fees to increase to about $1,200 and higher for a Chapter 7 filing. Before that, lawyers charged about $800, Tighe said. Lawless estimated that attorney fees had risen about 50% nationwide.
Chanese Cole, a medical administrative assistant, was one of the people sitting quietly at the downtown Los Angeles filing room, waiting for her turn to be called. "I can't afford a lawyer," Cole said. Instead, she paid $200 to a bankruptcy petition preparer -- a job title for which no certification or license is needed -- to help her fill out the paperwork. She had a $23,000 judgment against her because of an auto accident more than 10 years ago. If Cole did nothing, her wages would be garnisheed for a long time to come. "I never thought I would experience something like this," she said. "It's kind of nerve shattering."
A Chapter 7 bankruptcy normally doesn't reduce secured debt, such as a mortgage. So, even though it stops foreclosure proceedings, that's only temporary; many who file end up losing their homes. Other debts a bankruptcy usually can't wipe out include alimony, child support and student loans. And the person filing probably won't obtain credit for a long time. A bankruptcy stays on a credit report for 10 years. That doesn't matter to Daniels. He wants a fresh start. "There was no way I was ever going to be able to pay off $47,000," he said.
If his filing is successful, Daniels said he'd like to go to a low-cost college to get an MBA. "I'm going to reinvent myself," he said. "And stay away from credit cards."
Hyper-Deflation on the Streets of Paris
by Bill Bonner
Scarcely a block from our office in Paris is a monetary phenomenon that has escaped the financial press. In one of the highest-cost economies in the world, you can buy a woman’s shirt for 2 euros. A dress? Four euros. A man’s jacket can be had for the price of a cup of coffee. The shop is tended by Chinese merchants…apparently dodging France’s employment laws by only hiring family members. The merchandise, too, dodges high rents by squatting the sidewalk, under improvised blue awnings.
How come such cheap duds in such a dear city? The latest figures show negative consumer price inflation in 14 countries. In Ireland prices are collapsing at a 4.7% rate. In the United States, they are falling at 1.3% annually – their biggest drop in 59 years. In Britain, consumer price inflation is still positive…but falling. But clothing on the Boulevard de la Villette seems to have been thrown out of an airplane. It is not in deflation; it is in hyper-deflation.
What could cause it? A guess: excess capacity, inspired by excesses of credit, consumption and claptrap during the Bubble Epoque. Spurred by what seemed like insatiable demand from the United States and Britain, Asians built superfluous factories…Greeks bought superfluous ships…and Americans built superfluous malls. Now, the feet are in the other shoes – the cheap ones. The action of the bubble years produces an equal and opposite reaction: excess supply bedevils the market. Unable to sell superfluous brand name clothing, the rag trade strips off the alligators and polo sticks and dumps clothes on discount racks.
Last week, we warned about the extremely destabilizing effects of hyperinflation. One day middle class men are saving money for their daughters’ dowries. The next, they are putting knives between their teeth and swimming across the Rhine. Today, we deny hyperinflation thrice before the cock crows…and then deny we denied it.
First, Professor Alan Blinder in The New York Times: “the clear and present danger, both now and for the next year or two, is not inflation but deflation.”
Second, BusinessWeek elaborates: “…the inflationary effects of the new money are being fully offset, or more than offset, by the far-reaching and long-lasting impact of household debt repayments. Whether it’s voluntary frugality or under the coercion of creditors, Americans have abruptly switched from living beyond their means to saving more and working down the debts they incurred during the bubble years.”
Third, as Ambrose Evans Pritchard puts it in the Telegraph: “the Fed’s efforts to boost the money supply are barely keeping pace with the deflation shock. Stimulus is not gaining traction. The credit system is broken.”
Professor Blinder explains why: “In normal times, banks don’t want excess reserves, which yield them no profit. So they quickly lend out any idle funds they receive. Under such conditions, Fed expansions of bank reserves lead to expansions of credit and the money supply and, if there is too much of that, to higher inflation. In abnormal times like these, however, providing frightened banks with the reserves they demand will fuel neither money nor credit growth – and is therefore not inflationary.”
Reserves are what nobody wanted in the bubble years; now we live in a world of squirrels. Bankers add to their reserves; so do individuals and businesses. Americans saved an average of 7% of disposable income since the ’30s. In the 2002-2007 bubble, that rate fell to zero. Now, it’s back to nearly 5% and rising. Thrift is making a comeback. People are changing their own automobile oil. They are cutting their own hair and planting their own gardens.
When consumers cease consuming, producers cease producing. And shippers have nothing to ship. World trade has collapsed by more than it did at this stage of the Great Depression. And at 65% of capacity, there are more idle factories in America than at any time since they stopped making tanks and airplanes after WWII. Business earnings are falling, with no pricing power in sight. In this respect, this downturn is much more deflationary than Japan’s recession of the ’90s. When Japan went into a slump, the rest of the world continued to grow. Japan could continue to manufacture and export products – at a profit. Still, with so much excess capacity, producer prices in Japan fell in nine of 10 years in the ’90s.
And now the denial: These commentators are right; deflation is the immediate problem. Our guess is that it will be deeper and more vexing than even they believe. The feds’ money machine is broken. They can add reserves. But they can’t turn the reserves into price inflation at the consumer level. Result: deflation…maybe hyper-deflation. But far from eliminating the danger of hyperinflation, falling prices practically guarantees it. In other words, it’s not inflation we worry about; it’s the lack of it. Unable to stimulate inflation in the usual way, the feds are forced to resort to extraordinary measures.
Only central banks with their backs against the wall – like Germany in the ’20s…Argentina in the ’80s…and Zimbabwe in the ’00s…would dare to risk hyperinflation. But if its efforts to produce mild inflation don’t work, the United States will eventually be in the same desperate position.
The only bonus you'll get this summer is the sun
One of the cleverest ideas developed by the Japanese business world is the distribution of semiannual "bonuses" to employees. Usually, a bonus is tied to a company's good fortune or an employee's performance. Japanese workers have always deemed them to be part of their salaries and tend to plan their finances accordingly. Employees and employers look at bonuses differently: The former see them as an entitlement, while the latter use them as a safety valve.
With the onset of the recession, Japanese companies have exercised their option to reduce or even cancel bonuses, and for the past month the media has been buzzing with a new term — June crisis — to describe the situation of workers who may not be able to meet mortgage payments as a result. June and December are bonus months, and 45 percent of Japanese people with housing loans have contracts that require them to pay larger amounts in these months than they do in other months, in some cases as much as five times.
Publications and TV news shows have been filled with human-interest stories about people suddenly faced with the possibility of losing their homes. The Asahi Shimbun tells of a 40-year-old housewife whose husband did not receive a bonus this month and apparently won't receive one in December either. Even worse, his salary has been cut by 20 percent. They have 20 years left on their 35-year mortgage. They pay only ¥80,000 a month toward the loan, but during each bonus month they pay ¥400,000. With one child in university and another in junior high school, they have saved very little. "When we took out our mortgage," the woman says, "it was unthinkable that my husband's bonus would be zero."
According to the Ministry of Internal Affairs and Communications, homeowners now spend an average of 20.5 percent of their disposable income on housing loans, the highest portion ever. Meanwhile, the Japan Business Federation has reported that total bonus payments this June is 19 percent less than the total for last year, the greatest year-on-year drop since they started compiling statistics in 1959.
In the past, company labor unions would protest to employers when bonuses were cut, calling bonuses "life expenses," but recently they have taken management's side and agreed that bonuses should be tied to company performance. But the roots of the June crisis go deeper. Housing has always been the government's main means of economic stimulation. During the 1990s, when the economy was stagnant, housing was pretty much the only sector keeping the economy going thanks to the Flat 35 scheme, which allowed home buyers to take out loans with only 10 percent down payments instead of the usual 20 percent.
The government's new stimulus measures eliminate down payments altogether for Flat 35. These loans are guaranteed by a government entity called the Japan Housing Finance Agency. A person who wouldn't normally be able to buy a home can more easily buy one, and as we have seen with the subprime loan fiasco in the United States, lowering the bar for home ownership can have disastrous consequences. People who bought homes in the '90s under the Flat 35 scheme with "relaxed" (yutori) interest rates are the ones most affected by the June crisis.
NHK illustrated this tendency on the program "Yudoki Network" with the story of a former taxi driver who received a notice from JHFA saying that since he was delinquent for six months he would have to pay the balance of his loan — more than ¥24 million for a ¥36 million condo he bought in 1998 — or the condo would be auctioned off. The man's situation is worse than it sounds, because if his condo is repossessed, he still has to pay off his loan.
Japanese mortgages are recourse loans, meaning the borrower is still liable even after foreclosure. Depending on the state, most banks in America offer nonrecourse loans, which are secured by collateral, usually the property itself. Once they foreclose, the borrower's debts are gone. If you default on a nonrecourse loan, you're messed up three times: you lose your home, you lose all the money you sunk into it, and you still have debt. Wait, make that four times — your credit rating is garbage.
The taxi driver opted to sell his condo before it went on the block (where it would probably sell for about 80 percent of its market value), but the realtor he hired said she could get, at most, ¥25 million for it. With all the fees involved, he'd still end up ¥3 million in the hole. Fuji TV's "Sakiyomi" profiled an unemployed sushi chef facing foreclosure who still owes ¥9 million on his three-bedroom Chiba Prefecture house. All the realtors he's talked to say his property is worth about ¥5 million but the only offer he's gotten is ¥2.5 million.
His family has already left him and he's contemplated suicide. These cases are accompanied by advice from financial planners that boils down to refinancing the loan so that monthly payments are reduced. But that means extending the loan period and, as a result, paying more money in the end for a home that will likely be worth nothing, which they rarely mention. Recourse loans are directly related to Japan's infamous "scrap-and-build" housing policy. Banks can't be expected to lend money for houses that start losing value the moment construction is completed if those houses are used as collateral.
There are more than 6 million vacant houses in Japan. Most will never be sold, because they're pieces of crap that were never meant to outlast their 35-year mortgages. Condominiums are no better. On average, Tokyo "mansions" built in 1990, when land values peaked, were selling for half their original prices by 2004. Interviewed on NHK Radio, economist Akiko Hagiwara said that people who realistically can't afford homes have been suckered into buying them in order to prop up the economy. People in this income bracket are also typically the first to get laid off or have their bonuses cut. "They're victims of the government," she said.
GM to Take On Future Product-Liability Claims
General Motors Corp., under pressure from state attorneys general, has agreed to assume legal responsibility for injuries drivers suffer from vehicle defects after the auto maker emerges from bankruptcy protection. The concession means consumers who are injured in car accidents after GM emerges from Chapter 11 protection will be able to bring product-liability claims against the new government-owned auto maker.
Under GM's original bankruptcy plan, the auto maker planned to leave such liabilities behind after selling its "good" assets to a "New GM" owned by the government. That meant future GM car-accident victims who believed faulty manufacturing caused their injuries would be unable to sue the New GM. Instead, they would have been treated as unsecured creditors, fighting over the remains of GM's old bankruptcy estate.
GM's move to take responsibility for future product-liability claims, outlined in a court filing late Friday evening, represents a partial victory for more than a dozen state attorneys general and several consumer advocacy groups. They had objected to GM's original plan to shed these liabilities, arguing it robbed future car-accident victims of their legal rights because they would have no way of knowing they might be entitled to claims.
GM advisors, members of President Barack Obama's auto task force and the attorneys general engaged in talks over the past several days aimed at addressing concerns over product-liability claims, among other issues. The talks heated up on Friday ahead of GM's Tuesday court date, when it will ask a judge to approve the auto maker's plan to create a new GM by selling its desirable assets to the government.
An administration official told The Wall Street Journal recently that the government had become concerned about murky legal precedent surrounding the issue of future product-liability claims. The official said case law was "unclear and ambiguous on the issue of future product-liability claims" making it sensible "for both sides to settle."
In court papers, GM maintained it was not legally-required to take on the claims, saying "federal-preemption" meant the bankruptcy code overrode state laws governing the rights of car-accident victims to sue the new GM. It also noted that Chrysler Group LLC, which recently emerged from bankruptcy in a deal with Fiat SpA, would not be responsible for such claims after a bankruptcy judge dismissed objections to its plan.
But the auto maker said it agreed to take on future product-liability claims "to alleviate certain concerns that have been raised on behalf of consumers." The auto maker said it would "expressly assume all products liability claims arising from accidents or other discrete incidents arising from the operation of GM vehicles occurring subsequent to [the emergence of New GM], regardless of when the product was purchased."
Car-accident victims with pending lawsuits and those who had won damages against GM before it filed for bankruptcy would still be unable to bring claims against the new GM. They would remain with other unsecured creditors making claims against the "old GM." As GM's old estate winds down, those victims are likely to recover little or nothing. An ad hoc committee representing GM car-accident victims who have sued the auto maker says there are more than 300 people with personal injury claims exceeding $1.25 billion.
A committee representing GM and Chrysler car-accident victims called GM's move "a positive development for public safety and we commend New GM and the auto task force for acknowledging the loophole in the bankruptcy plan and for beginning to address it." The committee said new GM should take on claims from victims already hurt from defective GM vehicles.
It also said Chrysler should take responsibility for future claims, as well as those with pending lawsuits and successful cases brought against Chrysler before it filed for bankruptcy. The committee said Chrysler's unwillingness to take on future claims as GM has represented "an unacceptable double standard."
When Is It Cheaper to Ditch a Home Than Pay?
Foreclosures aren’t only due to homeowners facing a cash crunch. One out of four defaults on mortgage loans is “strategic,” a new study says, due to a mortgage’s value exceeding the value of a house even if the homeowner can afford to pay. Strategic default is most likely when home values have fallen by more than 15%, according to the study by authors of the Financial Trust Index, a joint project of the University of Chicago’s Booth School of Business and Northwestern University’s Kellogg School of Management.
The researchers found that homeowners start to default once their negative equity passes 10% of the home’s value. After that, they “walk away massively” after decreases of 15%. About 17% of households would default — even if they could pay the mortgage — when the equity shortfall hits 50% of the house’s value, they found. “Housing policy under the current administration has focused on reducing households’ cash flow problems in response to the housing crisis, but no one has addressed the negative equity issue as part of public policy regarding housing,” Sapienza said.
The research is based on homeowner surveys, which also considered moral and social factors involved. People who said it was immoral to default were 77% less likely to declare their intention to do so, the authors write, while those who know someone who defaulted were 82% more likely to say they would default themselves.
“Our research showed there is a multiplication effect, where the social pressure not to default is weakened when homeowners live in areas of high frequency of foreclosures or know others who defaulted strategically,” Zingales said. “The predisposition to default increases with the number of foreclosures in the same ZIP code.” Among the other findings:
- People under 35 years and over 65 said were less likely to say it was morally wrong to default, compared to middle-aged respondents.
- People with a higher education and African-Americans are less likely to think it’s morally wrong to default, while respondents with higher incomes were more likely to think it’s morally wrong.
- Republicans and Democrats showed little difference in moral views of strategic default, while independents were less likely to say defaulting is immoral.
- People who supported government intervention to help homeowners were 12 percentage points less likely to say strategic default is immoral, the authors found.
How can we tell incompetent from unlucky government?
“The economy, stupid.” An internal reminder for Bill Clinton’s presidential election team eventually became one of the most famous slogans in politics. The first President Bush was duly kicked out by the voters in the teeth of a recession, and Clinton became the 42nd president of the United States. That is a common story. While there are exceptions, voters tend not to re-elect governments that have trashed the economy.
Barack Obama’s electoral fortunes were clearly boosted by the collapse of the US economy – it is easy to forget that, before Lehman Brothers folded, John McCain had been ahead in the polls. After Northern Rock failed, Gordon Brown hesitated and then decided against calling an early election with the economy looking ropey. Unfortunately for him, it has been looking ropier ever since, along with his approval ratings. But is this really fair? Gordon Brown’s first line of defence is that we are facing a world economic recession, so it’s not his fault. The opposition likes to point out the corollary: in that case, the good times weren’t his doing either.
There’s truth in both claims. Most domestic recessions have an international component. Japan and Germany are certainly in that situation now, having contracted faster than a cowboy’s lasso. Robert Mugabe must take responsibility for Zimbabwe’s economic disintegration, but it is hard to blame Taro Aso for the fact that Japan’s economy shrank 4 per cent in the first quarter of this year. The question is, can the voters tell the difference between an incompetent government and an unlucky one?
Andrew Leigh, an economist at Australian National University, thinks not. In a recent article in the Oxford Bulletin of Economics and Statistics, he looks at 268 elections held across the world between 1978 and 1999. He estimates how much of a country’s economic performance is due to booms in the world economy and how much is due to competent government – and whether the voters can tell the difference.
Both matter, but as far as the voters are concerned, it is better to be a lucky government than a skilful one. For instance, a one-percentage point increase in world economic growth above the norm is associated with a hefty rise in the chance that incumbents will be re-elected – from the typical chance of 57 per cent to a more than decent 64 per cent. A stellar domestic performance, outpacing world growth by one percentage point, contributes less than half as much to the chances of being re-elected, raising them from 57 to 60 per cent.
Why are voters so wretchedly ungrateful? The common-sense answer is that it is not easy to distinguish a lucky government from a skilful one. In addition – and this point is less obvious – an individual voter has little incentive to do so. We all know that elections are almost never decided by a single vote, and so each voter would be right to conclude that her vote is highly unlikely to make a difference. We vote for many reasons – a sense of duty, a desire to participate, and so on – but nobody votes under the illusion that it’s all down to him.
And if the result does not depend on any particular one of us, trying to disentangle luck from skill by ploughing through the latest reports from the International Monetary Fund is likely to remain a minority hobby. One other thing: Andrew Leigh finds some slight evidence that countries with high newspaper circulation have voters better able to distinguish luck from skill. Radio does not help, and television makes things worse. One more reason to switch off your set and pick up the Financial Times.
Benefit payouts will exceed income tax revenue
The state will pay out more in social security benefits than it raises from workers in income tax this year, The Daily Telegraph can disclose. The stark evidence of the growing imbalance between what the Government raises and what it spends is likely to intensify the political row over the public finances and may strengthen calls for cuts in spending. Treasury figures show that welfare payments will exceed income tax receipts by almost £25 billion. Normally, income tax receipts comfortably cover the benefits bill.
In 2008/09, gross income tax receipts were £152.5 billion. In the same year, social security benefits cost the Exchequer £150.1 billion. In 2009/10, the Treasury is expecting to take in £140.5 billion in gross income tax receipts. Social security benefits are projected to be £164.7 billion. The disparity between tax revenue and welfare costs was identified by Andrew Brough, a fund manager at Schroder Investment Management, who suggested that the amount of money spent on social protection could soon exceed that raised from both income tax and national insurance.
According to an official Treasury forecast, benefits will cost £170.9 billion in 2010/11. That is equal to what the Government will spend on the NHS, schools and universities combined. This year will be the first in a decade that benefits cost more than workers pay in income tax. And the last time the threshold was crossed, in 1999/00, benefits exceeded revenues by only a small margin. Then, income tax raised £95.7 billion and benefits cost £97.2.
As well as spending more on welfare, the Government is facing rising bills for the interest on the growing national debt, which is set to hit £1.4 trillion in five years. The Government is already spending more money paying the interest on its debts than it raises from one of its most unpopular taxes, fuel duty imposed on motorists. This year, motorists will pay £26.6 billion in fuel duty. At the same time, the Government will pay out £27.2 billion debt interest to the investors who hold Treasury bonds.
Debt interest payments are growing rapidly. Grant Thornton, an accountancy firm has estimated that by 2013, debt interest will cost £58 billion, exceeding Government spending on education in England and almost as much as the Treasury raises from VAT. The rising cost of welfare payments and debt interest represent a political embarrassment for Gordon Brown, who has described such spending as the "costs of failure."
Delivering his 2000 Budget speech, Mr Brown made clear that money spent on debt and welfare was money lost to the public services. He said: "Our promise was to reduce the costs of failure - the bills for unemployment and debt interest - in order to reallocate money to the key public services." The state of the public finances is set to dominate the next general election campaign. Mr Brown has repeatedly attempted to frame the election as a choice between "Tory cuts" and "Labour investment". The Tories counter that spending restraint is inevitable because of Labour's borrowing.
Mr Brown's argument was undermined this week when Mervyn King, the Bank of England governor, warned that whoever wins the next election will have no choice but to cut spending and raise taxes in order to reduce the "extraordinary" deficit Labour has run up. Mr Brough warned that unless the public finances are quickly brought back into balance, the international investors will turn their backs on Britain, threatening a national financial catastrophe.
He said: "If the parties aren't honest with the people then the markets will be. If you have any doubts then ask the people of Iceland what it is like when the markets lose faith." The soaring benefits bill will increase the political pressure for sweeping reform of the welfare system. A Daily Telegraph/YouGov poll this week showed that 40 per cent of voters believe that the welfare system should bear the brunt of any spending cuts that are required to balance the Government's books.
Senior Conservatives have hinted that a Tory government would impose welfare cuts including ending rules that allow even some middle-income households to receive state handouts. Some 130,000 households with a total income over £50,000 are currently eligible for tax credits of about £10 a week. George Osborne, the shadow chancellor, said: "Gordon Brown used to talk about the costs of social failure. Now those costs are soaring and he has no plans to deal with them. The welfare agenda has been well and truly blocked by this government and it will take a Conservative government to get it moving."
The Treasury blamed the worsening state of the public finances on "the global financial crisis and recession". A spokesman defended higher welfare payments, saying: "The operation of automatic stabilisers in the social security system will help support the economy through the downturn. The Government is committed to sustainable public finances and has announced plans to halve the deficit over 4 years."
Spain launches $138 billion bank rescue fund
Spain on Friday approved a 99 billion euro ($137.9 billion) bank restructuring fund to spur mergers and prevent solvency problems at smaller banks damaging confidence in large, publicly-traded institutions. Faced with spiraling bad debts after the collapse of a real estate boom, Spain's Socialist government issued a decree to create the Fund for Ordered Bank Restructuring (FROB), firing the starting gun on an expected wave of bank tie ups and interventions.
"This is a really positive move, they're taking the bull by the horns and converting systemic risk into selective risk," said Citi strategist Jose Luis Martinez, who saw the fund restructuring the sector over years rather than months. The government said it expected some banks to face solvency risks in the next months after bad loans quadrupled in the past year.
"We are trying to avoid problems at any institution," said Deputy Prime Minister Maria Teresa de la Vega in a press conference to announce the long-awaited fund. The law will now go to parliament, but as its contents have already been negotiated with the main conservative opposition party, it should be approved without much trouble.
Spain's tightly regulated banks emerged largely unscathed from the first phase of the global crisis that sparked bailouts across northern Europe and the United States. But, the Bank of Spain launched its first intervention of the crisis in March and other small and medium-sized banks are expected to suffer losses in 2010 as they dig into capital to cover soaring defaults in recession set to last until 2011.
"Their combined problems could generate possible systemic risk that justifies extra instruments and use of public funds," according to the decree text. Moody's on June 15 cut the credit ratings of 25 Spanish banks, with a third of them seeing their rating drop to D- or lower, meaning they potentially require some outside support such as government aid. Among those cut were three of Spain's ten largest savings banks: Caixa Catalunya, CAM and Bancaja.
The rescue fund will start with capital of 9 billion euros, three-quarters of which coming from public funds and the rest from a private deposit insurance agency. It will eventually have power to borrow up to 10 times that amount, although neither the government nor analysts expect that to be necessary. Wrangling between the government and political parties over the power of the Bank of Spain in the fund has delayed the project for months, with regional governments trying to retain veto powers over savings bank mergers.
If all restructuring attempts fail, the final decree gives the central bank rights to take control of a savings bank and override veto powers of local politicians. Once the Bank of Spain takes the reins, it will hold five of the struggling institution's eight board seats and work under the direction of the central bank's deputy governor.
"This is a good moment to start an ordered restructuring of our country's financial system," said Economy Minister Elena Salgado, warning some smaller banks would face problems if the global crisis dragged on but saying none requires urgent aid. Bank of Spain Governor Miguel Angel Fernandez Ordonez says large banks, such as Santander and BBVA, remain healthy but small and medium-sized institutions could require support.
He hopes some will disappear, just as they did in the 1980s when a slew of interventions nearly halved the number of savings banks. "It's not our intention that everyone survives. The banks that survive must be competitive and can't get unfair support, they can't be on a life support system," he told a congressional commission this week.
Banks which voluntarily apply for funds will be granted up to five years to repay debt. PriceWaterhouseCoopers expects the Spanish financial system to need between 25 billion euros and 70 billion euros in recapitalization, and suggests banks shrink their size by 12,000 branches or 35,000 employees.
Spain's downturn hits foreign workers
With its soaring roof and light-filled spaces, Madrid's Barajas airport is a sign of the good times Spain has enjoyed. But spend some time in the departure lounge and you can see the signs of the economic downturn. There is raw emotion at the departure gates. Airlines say 25,000 Latin Americans have bought one-way tickets home.
I met Pilar, from Ecuador, just after she had waved farewell to her sister. "A lot of my friends and relatives have gone back," she says. "It's better to be in Ecuador with your loved ones and enough to eat, than here without work."
In the past decade, five million foreign workers have arrived in Spain - making up 10% of the population. But with unemployment reaching almost 17%, immigrants are now among the first to lose their jobs. The Spanish government is encouraging them to go back home by offering jobless Latin Americans money in exchange for a promise not to return to Spain for at least three years. It may sound attractive, but Pilar says not many are interested. "There's too much bureaucracy. They want to be able to return," she explains.
Spain's authorities confirm that only around 4,000 Latin Americans have taken up the offer. But now a similar plan is being considered for more than 70,000 unemployed Romanians. For the first time, an EU country is actively trying to persuade EU citizens from other member-states to leave. I took a train to Alcala de Henares, a medieval city not far from Madrid. It is the birthplace of the writer Cervantes, and is also famous for its cathedral and other historic buildings.
But there is another reason the name of the city is widely known in Spain. One in 10 people here are from Romania. Alcala has the biggest Romanian community in Spain, complete with several shops, bars and transport businesses. In the window of a grocery, the Romanian and Spanish flags are proudly on display, next to a poster advertising the recent European election - in which several Romanians ran on the lists of mainstream Spanish parties.
Inside, the shelves are stacked with Romanian produce, including typical cheese made from sheep's milk, and spicy salami. Every transaction is conducted in Romanian. At the Hispanic-Romanian centre round the corner, the Spanish language class is well attended, and the students have no plans to go back to Romania. "Not in the near future," one woman says. "There's a crisis in Romania too. If we get jobs there, we'll go back, but as it is, we won't." Several people nod their heads vigorously in agreement.
One of the main reasons Romanians were keen to join the EU in 2007 was freedom of movement. Under EU rules, workers from member countries can travel freely across the continent in search of jobs. It is estimated that more than two million Romanians have travelled to Spain and Italy, whose languages are - like Romanian - rooted in Latin.
But some are starting to head back. Didi Subtirel, a broad-shouldered man in a flowery shirt, told me he could not find work in construction any more, and had problems paying his rent. He came to Spain six years ago after losing his job as a metalworker in central Romania. He saved enough money to build a house in his hometown in Romania, and bring over two of his four sons.
But now Didi is desperate to go back to his wife - and bitterly regrets coming to Spain. "It was the biggest mistake I have made in my life," he says. "The most stupid decision possible. If I manage to get some work, I think I'll be home in Romania by Christmas, so I can slaughter the pig and look after my family. That's my hope, God willing."
Spain's tide of migrants may be reversing, but it is a trickle rather than a flood. In a bar next to a church where an Eastern Orthodox mass is held every Sunday, Gheorghe Gainar, the president of the local Romanian cultural association in Alcala, said many were embarrassed to speak about going back because they thought of it as an admission of failure.
But familiar faces are disappearing. "We don't see them any more," Mr Gainar explains. "After mass on Sunday, we usually come to this bar, so we notice if somebody's missing. When I ask where they are, people say they had to leave because they had no more work." But Mr Gainar is dismissive about the Spanish scheme to offer Romanians money to return.
"What Spain is trying to do is to take Romanian unemployed out of the Spanish statistics and move them over to the Romanian statistics. "But the Spanish unemployment benefits are higher than a Romanian salary, so it's better for them to stay here in Spain than go home to Romania." At the Spanish ministry for labour and immigration, the director general, Javier Orduna, is considering various options, including financial contributions from the EU and Romania.
He agrees that unless they are offered help, Romanians simply will not go back. But he denies that the planned return scheme is just an attempt to massage the figures. "Of course the crisis affects all of Europe, Romania too," he says. "But the Romanian unemployment rate is only 5.5%, while in Spain it's nearly 17%. "We're not trying to shift the statistics so that Spain's employment rate looks better or to get rid of anyone, we're just trying to reorganise the labour market."
No-one knows how many Romanians have gone home. Some who did leave are now back in Spain, or return every three months to collect unemployment benefits. In Alcala, more seem to be planning to stay than to leave. And, in a Europe without borders, there is little the Spanish government can do to send them packing.
More Doom than Boom
Dr. Marc Faber, the Thailand-based editor and publisher of The Gloom Boom & Doom Report, favors stocks only as the least of all evils.
Q: How high can the market go before, if I read your work correctly, America falls apart and takes everything down with it?
A: I'm not sure that the risk/reward now is particularly favorable. The inflationary school of thought says the Federal Reserve has no other option but to print money, and that will lift asset prices. The Standard & Poor’s 500 could get to 1,000 or 1,100 or depending on how much money they print, possibly even higher than that.
Between March and today, the S&P is up 40%, and in an environment of zero interest rates, that's a huge gain. Many of the resource stocks we were recommending in November and December have tripled. So, maybe we have for two or three months now a reversal in expectations, where people suddenly realize that maybe the economy doesn't recover a lot and that deflationary pressures are still there. But if the S&P was to come down to 800 or 750, the Fed would probably increase its money printing activity. So, I kind of doubt that we'll see new lows.
Q. You've warned that US risks Zimbabwe-style hyperinflation and then more recently said US inflation could reach 10% to 20% in five to ten years. Isn't there a big gap between those outcomes?
A. We have the worst recession since the Second World War and actually the prices of necessities are still rising, including food and energy. So, one day within the next ten years, when the economy slowly recovers and when further dollar weakness occurs, inflationary pressures will increase. And once you have inflation increasing, it's not easy to stop it unless you implement tight monetary conditions, which would imply very high real interest rates. And I don't think that Mr. Bernanke or the US government have any intention whatsoever of having positive real interest rates. Combine easy monetary policies with large fiscal deficits, and the likelihood of much higher inflation is there. Once we go to 10% inflation, 20% becomes quite likely and once we go to 20%, we can easily go into hyperinflation.
Q. If the largest economy in the world is at risk of hyperinflation, shouldn't people be selling everything and hoarding gold and silver?
A. For sure, gold is better than cash. But the devious thing about inflation, if we define it as money and credit growth, is that it touches different asset prices at different times with different intensity. And so, you can have for one year a huge increase in the price of gold and then the next year you could have a huge increase in the price of real estate and the next you could have an increase in silver or agricultural commodities, and the next year in wages or stock prices. You just don't know exactly which one will do the best. It's a very tricky environment, and it favors large speculators and the people who are close to the government. It shifts wealth from the middle class and workers to rich people, as has happened over the last 25 years.
Q. You've been bullish on Asia and in particular on Asian banks and Asian real estate, and yet the attitude of Asian central bankers doesn't seem to be materially different from that of the Fed. How does it feel to be invested in assets that are appreciating based on the same Keynesian policies?
A. I don't like Fed policy and I don't like the policy of the Bank of Thailand. But I have to live with it. I'm an investor, and so rather than holding cash in a Thai bank at zero interest rates, I'm investing in equities. But it is not because I have great conviction that anything is healthy. I'm investing in equities because I think that the whole world is basically [in trouble.] The worse the conditions will be, the more they will print money. I can buy in Thailand a basket of equities that will give me a dividend yield, after tax, of 5% to 6%. So at least I'm paid to wait. I would buy Asia on a correction.
Q. Why is Europe so out of favor with international investors?
A. In 2008, the most cyclical economies got hit the hardest. And so, because of the cyclicality, Europe and Japan fell out of favor. Whoever bets on the economic recovery should bet on the most cyclical industries and the most cyclical countries. That would be Japan, southeast Asia, resource producers, and obviously Europe, because they have a high dependence on exports, particularly Germany.
Q. But you don't sound terribly committed to that proposition in the short run.
A. When the market [perceives] that we've fixed the bottom in economic activity and it's growing again, then they can push up stock prices as they have done after March. But it doesn't mean that the global economy will revisit the peak of prosperity we had in 2006-07. That may be a long way away. But you can have a big bounce within the context of a bear market. So, I think that the markets still have a chance to go up, especially given the money-printing attitude not only of the Fed but of all central banks.
Q. You've lampooned President Obama as "the Great Obutu" and called him a commissar, and you've been critical of the Fed's leadership as well. Would it be fair to say you're contemptuous of American policies and American leadership at the moment?
A. I think that's a fair comment. I'm disgusted by the kind of crony capitalism that has emerged in the United States where the doors of the Federal Reserve, of the US Treasury, of the Wall Street establishment are all open to each other. The economic policy of the US since 1982 has been to stimulate consumption. But you can't create prosperity from consumption—you need savings and capital spending.
The End Of The Recession?
I walked into the office yesterday evening and there was someone on CNBC talking about how the 50-day moving average of the S&P 500 rising above the 200-day moving average was telling us the market was getting ready to rise and the recovery had started. I listened to his babbling for another 2-3 minutes and couldn't take it anymore (and no, it was not my friend Larry Kudlow, who is a lot more balanced than whoever was on.)
We keep getting told that the market is telling us "something," usually that the recession is going to end. For some reason, people keep repeating the bromide that the market looks out about 6 months. To that I politely say, rubbish.
Riddle me this, Batman. Did the market see the recession in October of 2007? We were already in recession and the S&P 500 (see below) was making new highs! Where was the market prescience? Did it see the 25%+ drop in January of this year? And I could go back and cite scores of examples where the market "missed" the future turning points over the past ten decades.
What about the shibboleth that the market turns up 6 months before the end of a recession? Sometimes that is true. But does it mean anything? The same people who said it meant something last December and January are saying it means something now. But now it's June and the recovery is not here, so maybe the market wasn't telling us something in January after all.
Gentle reader, there will be a recovery. We will talk about what kind in a few pages, if we have the time. And it is (statistically speaking) likely that the markets will have turned up before the actual recovery. But does that mean anything today?
Go back to the chart above. Notice that in 2003, when the market finally turned up, we were already well out of recession. And the market had a very quick 12% or so drop while we were in recovery, while later we went on to a 90% run-up! Was the drop telling us anything, or do we explain it away?
"In the short run," St. Graham said, "the market is a voting machine. In the long run it is a weighing machine." The voting is based on current sentiment, but what the market weighs in the long run is earnings. The market tries to forecast future income streams. And it gets it wrong as often as it gets it right.
Let's look at this yet another way. This is an important concept, and it should be a component of your economic BS detector. The CNBC host talked in breathless terms about the importance of the 50-day average moving above the 200-day average. It means nothing until it means something, and we won't know what that something is for some time.
Earlier this week (Monday, I think) the 50-day average moved BELOW the 200-day average. The analysts at Bespoke Investment Group noted:
"Going back to 1928, this is the 25th time that the S&P 500 has declined through both of these levels on the same day. On page two we have provided a table showing each of these occurrences as well as the index's returns going forward. Based on those prior instances, the S&P 500's returns going forward have been notably negative. While the S&P 500 has averaged positive returns over the next week, average returns have been negative over the next month, three months, and six months." (emphasis mine)
But 33% of the time, the markets were up six months later, often by quite a bit. And sometimes down quite a bit, but on average only slightly. Which means that as a forward-looking indicator it is interesting but not anything I would put my money (or client money) on!
(I saw some reports that differed, selecting fewer such data points and suggesting that market returns were up after such an event. Logically, that can't be. Let's be generous and just assume sloppy research.)
Before major market moves down, the 50-day average will always move below the 200 average. And the reverse is also true. It is not a sign. It is just what statistically MUST happen. And sometimes they reverse themselves, and sometimes they don't. We have no way on God's green earth of knowing whether the two moves (both up and down) this week will be bullish or bearish six months from now, based simply on the moving averages crossing. You can make the data say anything you want, but you are still just guessing.
Sidebar note: Trend Following 101. I spend a lot of time analyzing trend-following money managers of one kind or another. Basically, they look at data and try to spot trends and then invest in them. A trader who is right 70% of the time is amazing and very rare. 50% is more like it for successful traders. But they have sharp risk controls that cut their losing trades and let their winning trades "ride." Being right 50% of the time can be profitable over time. (Being right 50% of the time is harder than it looks!)
But in the media you get these "analysts" who talk a good game, acting as if a 50-70% probability is something meaningful. "The market has turned. The recession is over." And they say that when we have the first balance-sheet recession in 70 years, yet they want to compare garden-variety recessions to what we have now. Again, we can only know which of the moves (above and below the 200-day moving average) will be the real "indicator" in six months. It is only an indicator today to the extent that we can drive our cars forward looking in the rear-view mirror.
The New Normal Is Still In Our Future
Now let's take that principle a little further. Last week I detailed how air, trucking, and rail shipping is down 20% year-over-year. Global trade is down about 30% in the major exporting countries (see below).
World trade shrinks : Chart 1: Year-over-year change in total exports from 15 major exporting countries (1991-02/2009) / Chart 2: Year-over-year change in exports from 15 major exporters between February 2008 and February 2009 (size of circles reflects volume of exports in 2008)
End of the world? Do we just keep falling? No. At some point, six months or a year from now, the year-over-year comparisons become easier. If you are at 100 and fall to 80, then a year later you are at 88 and voila! you have a 10% increase! And the perma-bulls will be talking it up. The fact that you are still down 12% from the peak is ignored.
The point is that we have fallen quite a bit in a lot of major categories. There is really only so much you can fall. And then when you reach that new lower level of the New Normal, you begin to rise. At some point, we will be on the path to "recovery." That does not mean that we will be back to the halcyon days of mid-2007 within a year. It just means that we have stopped falling and now have to adjust to the levels of the New Normal.
The Hidden Problem Within Unemployment Data
This is going to be most evident and painful in the unemployment numbers. Last month saw the number of unemployed rise by 345,000. What was not in the headline data was that 217,000 of those jobs were estimated from the "birth-death" ratio. The US economy creates new businesses that do not get counted in the data, so the BLS estimates what that number is, using previous data patterns. When the economy turns, it overestimates new jobs in recessions and underestimates them in recoveries. No conspiracy, it is just the best methodology we currently have.
But does anyone really think 200,000 jobs were created last month? The real number of lost jobs is worse than the headline. And next month the birth-death number will likely be over 200,000 again. Add another 100,000 or so to the headline number to get closer to reality,
Again, analysts talked about a turnaround because job losses were "just" 345,000. That is a higher number than any month in the 2001-02 recession, and larger than the month after 9/11. That is a green shoot? Yes, we will see the monthly unemployment numbers fall, but they are falling from historic highs. And based on some research by the San Francisco Federal Reserve, it is likely that we will see still higher unemployment that will persist for a while longer.
Let me quote and summarize through the research at http://www.frbsf.org/publications/economics/letter/2009/el2009-18.html. (It is not long, and worth reading.)
"Our analysis generally supports projections that labor market weakness will persist, but our findings offer a basis for even greater pessimism about the outlook for the labor market. Specifically, we suggest that the relatively low level of temporary layoffs and high level of involuntary part-time workers make a jobless recovery similar to the one experienced in 1992 a plausible scenario."
Essentially, there are always workers moving into and out of employment. What they note is that the patterns seem to be changing. In the '70s and '80s, job losses were quick and deep, but the recovery was also quick. In the last two recessions, job recovery was noticeably slower, giving rise to the term "jobless recovery." It was the lack of hiring, and not firing, that was responsible for the slow employment recovery. MY thought is that before 1990 many of the job losses in recessions were from manufacturing. Businesses were quick to lay off and quick to rehire. We now have fewer manufacturing jobs, so the rehiring process has been much slower in recent recessions.
"The long and gradual return to pre-recession unemployment levels implied by the Blue Chip consensus forecast is consistent with a labor market recovery that is slightly weaker than that experienced in 1983 and slightly stronger than that experienced in 1992. However, should labor market conditions instead proceed along the path taken in the 1992 recovery, the unemployment rate could peak close to 11% in mid-2010 and remain above 9% through the end of 2011."
That is not in any Congressional budget forecast. Want to run an election campaign at 10% unemployment levels?
"... What does all this mean for the course of the labor market? We combine data on involuntary part-time workers with the standard unemployment rate to arrive at an alternative measure of labor underutilization. We plot this measure in Figure 3, which shows that the labor market has considerably more slack than the official unemployment rate indicates. The figure extends this labor underutilization measure using the Blue Chip consensus forecast for the unemployment rate as a benchmark and then adding a share of involuntary part-time workers based on the proportion of workers in that category to the unemployed during the current recession. This projection indicates that the level of labor market slack would be higher by the end of 2009 than experienced at any other time in the post-World War II period, implying a longer and slower recovery path for the unemployment rate. This suggests that, more than in previous recessions, when the economy rebounds, employers will tap into their existing workforces rather than hire new workers. This could substantially slow the recovery of the outflow rate and put upward pressure on future unemployment rates." (emphasis mine)
Was Income Really Up?
Now, let's turn our attention to today's headline. Income is surprisingly up. That has to be a green shoot, right? Well, not if you look at the underlying data.
Personal income from wages and salaries was down $12 billion in May. So how did income go up? A large increase in "government social benefits" and a decline in personal taxes accounted for all the gain, and then some. The increase was the effect from the recent stimulus package, which is (for now) temporary, and not the result of a recovering economy. Hardly green shoots. It is just borrowed money from another (government) source. In principle, it is not much different than home equity withdrawal, except that taxpayers are on the hook.
And those government subsidies are going to increase. Look at the graph below. What it shows is that the average duration of unemployment is at a 60-year high, and rising. It is now at 22.5 weeks. Unemployment benefits stop at 39 weeks, temporarily up from 26 weeks. More and more people each week are thrown into very dire circumstances when they fail to find jobs and lose the benefits. Care to wager whether, when Congress comes back from vacation, the time people are allowed to be on unemployment will be increased?
And speaking of the increase in government payments to individuals, what did they do with them? In aggregate, what is happening to this stimulus? The data came out today, and I must admit I was surprised. I have been writing for years that American consumers would start to save in this recession, but I (and nearly every credible observer I read) thought that we would see a more gradual rate of increase in the savings rate. The increase in savings has been nothing short of remarkable. (See graph below.)
From a negative 3% in late 2005 (the result of massive borrowing, primarily mortgage equity withdrawal and credit cards), we have risen to a positive 6.9%. That is the highest rate since 1993. The savings rate was less than 1% last August. And totals savings (on an annualized basis) was $608 billion in April, rising to $768 billion in May. That is a 30% month-over-month increase! Maybe the American consumer has found a new religion!
But, there is more than just a new savings fervor at work. Spending rose more than disposable income, so without that increased level of government transfer payments, it is unlikely that savings would have risen as much. Before we get too giddy about savings going through the roof, we need to wait a few months to see if this was the result of new savings religion or government transfer payments (stimulus), which will soon wind down
That being said, given the sharp increase in savings, it's no wonder shipping is down 20% and global trade in the exporting economies by 30%. No wonder retail sales are down, except for Wal-Mart and other lower-price venues.
Final thought for today. The Congressional Budget Office released another report this week, saying that the current deficit levels are unsustainable. They suggest that either taxes must increase by $440 billion or spending must be cut by a like amount, or some combination. If you assume some of the new health-care and other programs are enacted, the number comes closer to $700 billion.
This is not a Congress that wants to cut other parts of the budget by $700 billion. Raising taxes by $700 billion (over 4% of GDP) will dip us back into recession. Not raising taxes will result in debt that cannot be funded at anywhere close to today's rates. A recent IMF study is very sobering about the worldwide problem of growing country debt. Finding a trillion dollars in the market every year, when every other country is also trying to raise debt is simply not going to happen. It will destroy the dollar. There are few good choices in front of us, and fewer still good choices that are likely.
OK. One final suggestion for your weekend reading. Atul Gawande, writing in The New Yorker, weaves a very sobering picture of the problem of reining in health-care costs. He contrasts two Texas border cities with similar demographics, yet one spends twice as much on health care. One town has doctors who order every possible test and the other doesn't. There is no real difference in outcomes. And then compare it to other areas, and the problem facing any health-care policy becomes all too evident. Reportedly, Obama has had everyone read this, and you should too. It provides a very different angle on the problem. Click here
A Global Recovery for a Global Recession
by Joseph Stiglitz
This is not only the worst global economic downturn of the post-World War II era; it is the first serious global downturn of the modern era of globalization. America's financial markets failed to do what they should have done--manage risk and allocate capital well--and these failures have had a major impact all over the world. Globalization, too, did not work the way it was supposed to. It helped spread the consequences of the failures of US financial markets around the world.
September 11, 2001, taught us that with globalization not only do good things travel more easily across borders; bad things do too. September 15, 2008, has reinforced that lesson. A global downturn requires a global response. But so far our responses--to stimulate and regulate the global economy--have largely been framed at the national level and often take insufficient account of the effect on others. The result is that there is less coordination than there should be, as well as a smaller and less well-designed stimulus than is optimal.
A poorly designed and insufficient stimulus means that the downturn will last longer, the recovery will be slower and there will be more innocent victims. Among these victims are the many developing countries--including those that have had far better regulatory and macroeconomic policies than the United States and some European countries. In the United States a financial crisis transformed itself into an economic crisis; in many developing countries the economic downturn is creating a financial crisis.
The world has two choices: either we move to a better global regulatory system, or we lose some of the important benefits that have resulted from globalization. But continuing the status quo management of globalization is no longer tenable; too many countries have had to pay too high a price. The G-20's response to the global economic crisis, crafted at meetings in November in Washington and in April in London, was a beginning--but just a beginning. It did not do enough to address the short-term problems nor did it put in place the long-term restructuring necessary to prevent another crisis.
A United Nations meeting in late June hopes to continue the global discussion begun at earlier G-20 meetings and to extend this discussion to what went wrong in the first place so that we can do a better job of preventing another crisis. The global politics of this meeting are complex. Many of the 173 countries that are not members of the G-20 argue that decisions affecting the lives of their citizens should not be made by a self-selected club that lacks political legitimacy.
Some members of the G-20--including new members brought into the discussion for the first time as the G-8 expanded to the G-20--like things the way they are; they like being in the inner circle and argue that enlarging it will only complicate matters. Many from the advanced industrial countries would like to avoid overly harsh criticism of their banks, which played a pivotal role in the crisis, or of the international economic institutions that not only failed to prevent the crisis but pushed the deregulatory policies that contributed so much to it and its rapid spread around the world. Indeed, the G-20's response to the crisis in developing countries relied centrally on the IMF.
I chair the UN Commission of Experts, which was given the task by the General Assembly of preparing an interim report before the June meeting. This report will, I hope, have some influence on the discussions. It is too soon to tell whether it will, or if anything concrete will come from the meeting. The international community should realize, however, that much more needs to be done than has so far been undertaken by the G-20.
Our preliminary report lists ten policies that need to be implemented immediately. These include strong stimulus efforts from developed countries, providing additional funding for developing countries, creating more policy space for developing countries, avoiding protectionism, opening advanced countries' markets to the least developed countries' exports and improving coordination of global economic policies. In addition, the commission recommends ten deeper reforms to the global financial system on which work needs to begin.
The United States may have the resources to bail out its banks and stimulate its economy, but developing countries do not. Developing countries have been important engines for economic growth in recent years, and it is hard to see a robust global recovery in which they do not play an important role. There is a consensus that all countries should provide strong stimulus packages, but many of the poorer developing countries don't have the resources to do so. Many in the developed world are worried about the debt burdens resulting from stimulus packages, but for those still scarred by debt crises, taking on additional debt may involve an unacceptable burden. Assistance has to be provided in grants, not just loans.
In the past, the IMF provided assistance accompanied by "conditions." In many cases it demanded that countries raise interest rates to high (sometimes very, very high) levels and reduce deficits by cutting expenditures and/or raising taxes--just the opposite of US and European policies. This led to a weakening of national economies, when the point of IMF assistance was to strengthen them. Although those providing assistance want to be sure their money is used well, these kinds of conditions are counterproductive and make many developing countries reluctant to accept help. A condition imposed on international institutions that provide assistance to developing countries should be that they not engage in such "conditionality."
To help fund the large amount of assistance required, developed countries should set aside 1 percent of their stimulus package to help developing countries. The funds have to be distributed through a variety of channels, including regional institutions and possibly a newly created credit facility whose governance better reflects new potential donors (Asian and Middle East countries) and recipients.
The G-20 did make significant efforts to expand the IMF's lending capacity--partly, some suspect, because of the role the IMF may play in rescuing Eastern Europe rather than because of its desire to help the least developed countries. One clever way of doing so was a new issue of IMF money (to the tune of $250 billion) called "special drawing rights," a positive move, but too little of it will wind up in the hands of the poorest countries.
Although the G-20 made grand statements at its November meeting about avoiding protectionism, the World Bank notes that since then seventeen members have undertaken protectionist measures. Developing countries have to be protected from protectionism and its consequences, especially when it discriminates against them. The United States, for example, included a "buy American" provision in its stimulus bill, but many advanced industrial countries are exempt from this provision due to a WTO government procurement agreement. This means that America, in effect, discriminates against poor countries.
We know that subsidies distort free and fair trade as much as tariffs, but subsidies are even worse than tariffs, because developing countries can ill afford them. The massive bailouts and guarantees provided by the United States and other wealthy countries give their firms an unfair competitive advantage. It is one thing for firms from poor countries to compete against well-capitalized US firms; it is another to compete against Washington. Such subsidies, bailouts and guarantees are understandable, but the adverse impacts on developing countries must be recognized, and we must find some way of compensating them to offset this unfair advantage.
International cooperation is also required if we are to devise an effective regulatory regime. There is international agreement on ten issues.
- First, the crisis was caused by excesses of deregulation and deficiencies in the enforcement of existing regulations.
- Second, self-regulation will not suffice.
- Third, regulation is required because failures in a large financial institution or the financial system more generally can have "externalities," adverse effects on workers, homeowners, taxpayers and others worldwide.
- Fourth, more than transparency is required--even full disclosure of the complex derivatives and other financial products might not have allowed for an adequate risk assessment.
- Fifth, perverse incentives that encouraged excessive risk-taking and shortsighted behavior contributed to bad banking practices.
- Sixth, deficiencies in corporate governance contributed to flawed incentive structures.
- Seventh, so too did the fact that many banks had grown "too big to fail"--which meant that if they gambled and won, they walked away with the gains, but if they lost, taxpayers picked up the losses.
- Eighth, unless regulation is comprehensive there can be a "race to the bottom," with countries with lax regulation competing to attract financial services.
- Ninth, if that race happens, countries will have to take action to protect their economies--they cannot allow bad practices elsewhere to harm their citizens.
- And tenth, regulation has to be comprehensive across financial institutions. As we have seen, if we regulate the banking system but not the shadow banking system, business will migrate to where it is less well regulated and less transparent.
Despite this broad consensus, the G-20 said little or nothing about some key issues: what to do with banks that have grown not only too big to fail but (according to the Obama administration) too big to be financially restructured? The G-20 failed to ask the hard questions: if these big banks' shareholders and bondholders are insulated from the risk of default, how can there be market discipline? What will replace that discipline?
The G-20 has talked about the rapid return of "private capital," but what does this bode if private capital returns without market discipline? There was also talk of continuing to allow over-the-counter derivatives-trading with no transparency. But without transparency of each trade--to assess the nature of the counterparty risk--how can there be market discipline? The G-20 did take long-overdue action on nontransparent offshore banking centers.
The large amount of banking in these centers is not a result of these countries' comparative advantage in providing banking services. It is because they avoid and evade taxes and regulations. But these problems, while important, played little if any role in the current crisis. Why was so much effort spent on these extraneous issues rather than on those more directly related to the crisis?
From the perspective of the developing countries, though, not enough was done about bank secrecy in offshore as well as onshore centers. Developing nations are often criticized for corruption, but secret bank accounts wherever they may be facilitate corruption, providing safe haven for stolen funds. Developing countries want this money returned and want access to information that will allow them to detect secret accounts.
Financial and capital market liberalization--as well as banking deregulation--contributed to the crisis and to the spread of the crisis from the United States to developing countries. Advanced industrial nations are reluctant to admit that these policies, which they pushed so hard on developing countries, are part of the problem. No wonder, then, that the G-20 did not argue for a reconsideration of these longstanding policies.
The global economic crisis highlights the deficiencies of existing international institutions. As I noted, the IMF and the Financial Stability Forum--created in the aftermath of the last global financial crisis, in 1997-98--did not prevent the crisis. In some cases they pushed policies that are now recognized as root causes. Although some of the proposals are moves in the right direction, others (such as changing the name of the Financial Stability Forum to the Financial Stability Board) are unlikely to have much effect, and as a package they are unlikely to suffice.
If we are to make our global economic system work better, we have to have better systems of global economic governance. It is important to move from ad hoc arrangements to more inclusive and representative institutional frameworks. We need a global economic coordinating council within the UN, not only to coordinate economic policies (e.g., the size of the stimulus and regulatory structures) but also to identify and rectify gaps in the global economic institutional structure.
For instance, this crisis will almost surely be marked by some sovereign debt defaults. Despite extensive discussions at the time of Argentina's 2001 default, there was no progress in creating a sovereign debt-restructuring mechanism. The IMF--dominated by the creditor countries--cannot play a central role in designing such a mechanism (any more than we in the United States should turn to our banks to design a good bankruptcy law).
One of the alleged reasons for not "playing by the rules" and forcing troubled international banks to go through financial restructuring (instead, bailing them out) was that it would give rise to huge cross-border complications. Citibank, for example, operates worldwide, and depositors in many countries are not insured. What responsibility do US taxpayers have to depositors abroad if Citibank fails? They didn't pay deposit insurance; there is no contract committing us to pick up the pieces.
Yet some claim it would do irreparable harm to America's image if we took no responsibility. Iceland's banking problems illustrate the potential seriousness of these cross-border problems. Its citizens' standard of living may be impaired for decades because of the bankruptcies of its banks and the Icelandic government's decision to assume some responsibility for these failures. And yet, again, nothing is being done to address these problems.
Most important, the UN commission calls attention to the need for reform in the dollar-based global reserve system; it advocates the creation of a global reserve system. Not only is the current system fraying; it contributes to an insufficiency of global aggregate demand and to global instability. Every year developing countries set aside hundreds of billions of dollars to protect themselves against the costs of such instability, made so evident by the East Asia crisis.
The commission has argued persuasively that this problem must be addressed if we are to have a robust global recovery. Recent statements from the BRIC nations (Brazil, Russia, India and China), expressing their concerns about the dollar reserve system, have added immediacy to the commission's recommendation. This is an old idea--Keynes argued strongly for the creation of a global reserve currency more than sixty years ago--whose time has come.
Those who would like us to go back to the world as it was before the crisis will find some of the questions being asked at the UN summit uncomfortable. They would be happier with a few harsh words for the offshore islands, a few cosmetic reforms to banking regulation, a few lectures about hedge funds (which, like offshore banking centers, were not at the center of this crisis), a new name and a couple of new members for the Financial Stability Forum--and then for us to move on. Many developing countries will be less content to accept these "reforms" as going to the heart of the matter.
As developed countries struggle to ensure a quick recovery, they need to think of the effects of their actions on developing countries. It is time to begin the restructuring of our global economic and financial system in ways that ensure that the fruits of prosperity are more widely shared and that the system is more stable. This task will not be accomplished overnight. But it is a task that must be begun, now.
This Week With George Stephanopoulos: David Axelrod
STEPHANOPOULOS: Hello, again.
Congress has gone home for their July 4th break and they had better rest up, it's shaping up to be the busiest summer in a generation: health care, energy, the Supreme Court, and the economy. And for the debate on where things stand right now, we're going to begin this morning with the president's senior adviser, David Axelrod.
AXELROD: Thanks, George. Good to be here.
STEPHANOPOULOS: Let's begin with that vote Friday night in the House, this vote on climate change legislation, very close, 219 to 212. Democrats say it's a major step forward for energy independence, to create green jobs, to control global warming.
But you know the Republicans are saying it's going to cost Americans jobs, going to send jobs overseas. And most important, they say it is a huge tax. And on that they have some backup from one of the president's supporters, Warren Buffett.
Take a look.
(BEGIN VIDEO CLIP)
WARREN BUFFETT, CEO, BERKSHIRE HATHAWAY: I think if you get into the way it was written, it's a huge tax and there's no sense calling it anything else. I mean, it is a tax. So it -- and it's a fairly regressive tax.
(END VIDEO CLIP)
STEPHANOPOULOS: How do you answer that? Republicans say this is the defining vote of 2008. They're going to use that in the 2010 elections.
AXELROD: Well, you know, it's interesting. We're trying to solve a problem that has languished for a decade, the problem of energy that has bedeviled us for a long time. And they're talking about how they can use it as an issue inaction as somehow a strategy. And that's not a strategy.
As for the tax issue, you know, I have a high regard for Warren Buffett, and the president does as well. I think the Congressional Budget Office addressed this issue, and their conclusion was the way the bill was written, the impact on the average American will be negligible over time.
And I think it was written for...
STEPHANOPOULOS: About $150 a year.
AXELROD: ... that reason. In 2020, and for lower income people, it actually will be a net gain because they'll get some help with their energy bill. So I think this is a phony issue.
And the real issue is, what is the Republican strategy for creating jobs? This bill actually, they call it a job killer, it will create millions of green jobs, the jobs of the future. We've lost millions of jobs in the recession that began last year and continues.
What is their strategy for that? What is their strategy for reducing our dependence on foreign oil? And how are we going to deal with this issue of carbon pollution that threatens people's health and the planet?
STEPHANOPOULOS: As you know, you're also facing some resistance from Democrats though in the Senate on this bill as well, senators like Claire McCaskill saying they're going to need some major changes.
And I've been trying to get into the issue of legislative strategy a little bit. The president is also pushing very hard on health care reform. He said he wants the Senate to act on this energy bill as well.
Does he want them to take it up right away or wait until after they finish considering health care in the fall?
AXELROD: Well, I think this energy bill will probably be dealt with in the Senate in the fall.
STEPHANOPOULOS: So after health care.
AXELROD: Health care I think will be the first thing on the agenda. Both the Senate and the House are well down the road on that.
But, George, understand that both of these issues, energy and health care, have languished for a long time. And the president believes that we have to deal with these issues in order to build a stronger foundation for our economy in the future.
And so he is taking the long view about how we get our economy moving, not just in the short term, but the long term. And he is asking Congress to join with him in this effort.
STEPHANOPOULOS: ... with that, especially on health care, excuse me, is figuring out where the revenues are going to come from. And, you know, a lot of talk about taxes in the House and the Senate as well.
And I want to show our viewers something the president said during the campaign back in September.
(BEGIN VIDEO CLIP)
OBAMA: I can make a firm pledge: Under my plan, no family making less than $250,000 a year will see any form of tax increase, not your income tax, not your payroll tax, not your capital gains taxes, not any of your taxes.
(END VIDEO CLIP)
STEPHANOPOULOS: Not any of your taxes, a firm pledge. Does that mean the president will veto any health care bill that includes a tax increase on people earning less than $250,000 a year?
AXELROD: Well, first of all, George, let's make a few points. The president has said whatever is done has to not add to the deficit. So that's one of the prerequisites for this bill. We've got issue with our budget. Everybody is aware that we don't want to add to our deficit.
So this is going to have to be paid for. Two-thirds of the expenses -- two-thirds of the expense of it under the president's plan and proposal would be done by transferring money within the health care system from Medicare on wasteful spending, giveaways to insurance and drug companies, and so on.
And so we're talking about the final third. He has proposed a plan that would be in keeping with the promise that he made, to cap deductions for the wealthiest Americans on their taxes.
He still believes that's the way to go. And he has made a strong case to the House and the Senate on it.
STEPHANOPOULOS: But he also said this week he was open to compromise on this. And as you know, the Senate is looking especially at this issue of capping the deductions for health care that employers and employees now get. That would get -- would be a tax increase for many families earning under $250,000.
But the president said he was open to it. So that means that the tax pledge he made back in September is no longer operative?
AXELROD: Well, George, first of all, there are a lot of different formulations of that plan. The president had said in the past that he doesn't believe taxing health care benefits at any level is necessarily the best way to go here. He still believes that.
But there are a number of formulations and we'll wait and see. The important thing at this point is to keep the process moving, to keep people at the table, to the keep the discussions going.
We've gotten a long way down the road and we want to finish that journey.
STEPHANOPOULOS: But if you're open to tax increases for people under $250,000, that means that the pledge he made last September in Dover is no longer operative. AXELROD: George, I think the president has made clear the way he feels this should be funded. And certainly is consistent with what he said during...
STEPHANOPOULOS: But he's not drawing a line in the sand.
AXELROD: ... the campaign.
STEPHANOPOULOS: He said that.
AXELROD: Well, you know what? The -- one of the problems we've had in this town is that people draw lines in the sand and they stop talking to each other. And you don't get anything done. That's not the way the president approaches us.
He is very cognizant of protecting people -- middle class people, hard-working people who are trying to get along in a very difficult economy. And he will continue to represent them in these talks.
But they're also dealing with punishing health care costs, and that's something that we have to deal with
STEPHANOPOULOS: One of the Republicans who is both drawing lines in the sand and still talking is our next guest, Charles Grassley of Iowa. And he has made it very, very clear what he believes has to be in a plan.
One of the things he said is, absolutely no public health insurance plan in the bill. The president has said he has made a very strong case for that this week. And Senator Grassley has also said that we're probably going to have to have some taxation of benefits.
And I guess what I'm trying to get at, is that a price that the president is willing to pay? I know you're saying that the president has laid out his preferences, but what price is he willing to pay to get Republican votes, to get a bipartisan bill?
AXELROD: Well, George, first of all, the bill will be bipartisan by definition. Just this week the Senate Health Committee, Senator Dodd has done a spectacular job in moving this along. And the Senate Health Committee accepted 82 Republican amendments.
Republican ideas are going to be included in this package. We hope it will come with Republican votes as well. But the important thing is that we solve this problem. That we begin to move...
STEPHANOPOULOS: So that's the new...
AXELROD: ... forward on health care reform.
STEPHANOPOULOS: And the chief of staff, Rahm Emanuel, has made the same point you just made. That seems to be the new White House definition of bipartisanship. It's a bipartisan bill if there are some ideas that have been advocated by Republicans, even if Republicans don't vote for the bill in the end.
Senator Grassley says, no way. It is not bipartisanship either if you include just the Republican ideas but not Republican votes, or even if you simply get six or seven Republican votes, he says that's not true, durable bipartisanship. That's not the road he's going to go down.
AXELROD: Look, I don't think we should get consumed by process at a time when health care costs are increasing at -- you know, they've doubled in decade. Out-of-pocket costs for people on health care up 32 percent, punishing families, businesses, banks, you know, ultimately will bring the federal budget down (ph).
We have to act. We can't afford to get ensnared in these kind of Washington discussions. We've got to deal with the issue that the American people are confronting.
STEPHANOPOULOS: And the American people are also confronting the issue of the economy. That is their number one issue. And some of your critics say the president has gone off-course a little bit, has lost his focus on the economy.
We had a new Washington -- ABC/Washington Post poll this week that had some fairly revealing numbers. Number one, it showed on the stimulus package, the support for people who felt the stimulus package was helping the economy: 59 percent in April, down a little bit to 52 percent. Now whether the country is going in the right direction hit 50 percent in April, had been skyrocketing since the election, but for the first time started to slip back.
How concerned are you by this? And how much are you worried about the fact that people don't believe that the president's plans -- are starting lose faith that the president's plans are actually helping the economy?
AXELROD: George, we lived through several years in which we were confronted with poll numbers that said we were 30 points behind in the race for the presidency. I confront a lot of doomsday questions from people less smart than you in this town.
And, you know, we take the long view on this. Look, when the president signed the stimulus package -- the economic recovery package, he said it's going to take a while for this to work, and we're going to go through some rough times, and unemployment is going to go up, and we've got to work -- we have to work our way through this. So...
STEPHANOPOULOS: But the money is not getting out as fast as you hoped, is it?
AXELROD: ... none of this -- none of this is surprising. What?
STEPHANOPOULOS: The money is not going out as fast as you had hoped, is it?
AXELROD: Well, I think the money -- we would like the money to go out faster in some instances, but a lot has been accomplished, and that should not be diminished. There are 4,000 or 5,000 road projects going on in this country right now that would not have gone on. There are energy projects going on in this country right now, and homes being retrofitted to be energy efficient that would not have happened. There are policemen and firefighters and teachers who are still on the job today because of that package.
So I think it's done an awful lot of good. The fact is that we're in the teeth of one of the worst recessions that we've had since the Great Depression, perhaps the worst, and we're going to have to work our way through that. And I think the American people understand that at some level, and that -- and so we're not sitting there -- the numbers we're worried about are not poll numbers. It's how many people can we get back to work, how do we get this economy moving again in the long run, and mostly how do we build a solid foundation so we're not in this bubble-and-burst kind of economy that we've seen over the last decade that leaves both our country and our families and businesses in jeopardy.
STEPHANOPOULOS: Some economists look at that, including Paul Krugman, who's going to be on this show later in the program, he says you're looking at 9, 10 percent unemployment coming in September. That's going to necessitate a second stimulus package. Is that still on the table for the president right now? And what would that mean for your other plans on energy and health care?
AXELROD: Well, first of all, I don't want to prejudge that at all. You know, as you said earlier, there's still -- most of the stimulus money, the economic recovery money is yet to be spent. Let's see what impact that has. I'm not going to make any judgment as to whether we need more. We have confidence that the things we're doing are going to help, but we've said repeatedly, it's going to take time, and it will take time. It took years to get into the mess we're in. It's not going to take months to get out of it.
STEPHANOPOULOS: Let me turn to the crisis in Iran. The crackdown appears to be working for now. The streets have gone quiet. A huge security presence in the streets. Mir-Hossein Mousavi, the chief opposition leader, has not called for new protests. And President Ahmadinejad is striking back at President Obama and the comments that President Obama made on Friday. He has said -- he's calling on the United State to stop meddling, and then he's gone on and said, "without a doubt, Iran's new government will have a more decisive and firmer approach toward the West. This time, the Iranian nation's reply will be harsh and more decisive to make the West regret its meddlesome stance."
It does appear that the prospects for engagement are diminishing, that Iran is taking a harder line.
AXELROD: Well, first of all, you know, let's be clear that we didn't meddle in the election in Iran. The dispute in Iran is between the leadership in Iran and their own people, and plainly, Mr. Ahmadinejad thinks that by -- by fingering the United States, that he can create a political diversion. So I'm not going to entertain his bloviations that are politically motivated.
STEPHANOPOULOS: Well, (inaudible) entertaining them.
AXELROD: It's just an opportunity to say "bloviate."
AXELROD: No, I'm not -- the point is this. We are going to continue to work through the P5, through the multilateral group of nations that are engaging Iran, and they have to make a decision, George, whether they want to further isolate themselves in every way from the community of nations, or whether they are going to embrace that. And understand that whatever Mr. Ahmadinejad says, everyone understands that in Iran, he is not the person who makes decisions on foreign policy, on defense policy. So this is political theater.
STEPHANOPOULOS: But the invitation is still open. If the Iranians want to come to Paris and sit down with the United States and the Europeans on the nuclear program, that invitation is still open.
AXELROD: Well, yes. And understand, you say it's an invitation. It is not a reward. We are not looking to reward Iran. We are looking to -- the nations of the P5, the five-plus-one, they want to sit down and talk to the Iranians and offer them two paths. And one brings them back into the community of nations, and the other has some very stark consequences.
STEPHANOPOULOS: Final question. I was talking to an ambassador from the region this week, who said now, if you sit down with the Iranians after everything we've seen in the last couple of weeks, you're going to be crushing the hopes of the young people in Iran and across the region, who listened hard to the president's Cairo speech and thought he was striking out in a new direction.
AXELROD: I think the president's sense of solicitude with those young people has been very, very clear, and we're very mindful of that. We are also mindful of the fact that the nuclear weapons in Iran and the nuclearization of that whole region is a threat to that country, all countries in the region, and the world. And we have to address that. We can't let that lie.
STEPHANOPOULOS: David Axelrod, thanks very much.
AXELROD: Good to be with you.
The Science of Economic Bubbles and Busts
The worst economic crisis since the Great Depression has prompted a reassessment of how financial markets work and how people make decisions about money
It has all the makings of a classic B movie scene. A gunman puts a pistol to the victim’s forehead, and the screen fades to black before a loud bang is heard. A forensic specialist who traces the bullet’s trajectory would see it traversing the brain’s prefrontal cortex—a central site for processing decisions. The few survivors of usually fatal injuries to this brain region should not be surprised to find their personalities dramatically altered. In one of the most cited case histories in all of neurology, Phineas Gage, a 19th-century railroad worker, had his prefrontal cortex penetrated by an iron rod; he lived to tell the tale but could no longer make sensible decisions. Cocaine addicts may actually self-inflict similar damage. The resulting dysfunction may cause even abstaining addicts to crave the drug any time, say, the thudding bass of a techno tune reminds them of when they were stoned.
Even people who do not use illicit drugs or get shot in the head have to contend with the reality that some of the decisions cooked up by the brain’s frontal lobes may lead them astray. A specific site within the prefrontal cortex, the ventromedial prefrontal cortex (VMPFC) is, in fact, among the suspects in the colossal global economic implosion that has recently rocked the globe.
The VMPFC turns out to be a central location for what economists call “money illusion.” The illusion occurs when people ignore obvious information about the distorting effects of inflation on a purchase and, in an irrational leap, decide that the thing is worth much more than it really is. Money illusion may convince prospective buyers that a house is always a great investment because of the misbegotten perception that prices inexorably rise. Robert J. Shiller, a professor of economics at Yale University, contends that the faulty logic of money illusion contributed to the housing bubble: “Since people are likely to remember the price they paid for their house from many years ago but remember few other prices from then, they have the mistaken impression that home prices have gone up more than other prices, giving a mistakenly exaggerated impression of the investment potential of houses.”
Economists have fought for decades about whether money illusion and, more generally, the influence of irrationality on economic transactions are themselves illusory. Milton Friedman, the renowned monetary theorist, postulated that consumers and employers remain undeluded and, as rational beings, take inflation into account when making purchases or paying wages. In other words, they are good judges of the real value of a good.
But the ideas of behavioral economists, who study the role of psychology in making economic decisions, are gaining increasing attention today, as scientists of many stripes struggle to understand why the world economy fell so hard and fast.
And their ideas are bolstered by the brain scientists who make inside-the-skull snapshots of the VMPFC and other brain areas. Notably, an experiment reported in March in the Proceedings of the National Academy of Sciences USA by researchers at the University of Bonn in Germany and the California Institute of Technology demonstrated that some of the brain’s decision-making circuitry showed signs of money illusion on images from a brain scanner. A part of the VMPFC lit up in subjects who encountered a larger amount of money, even if the relative buying power of that sum had not changed, because prices had increased as well.
The illumination of a spot behind the forehead responsible for a misconception about money marks just one example of the increasing sophistication of a line of research that has already revealed brain centers involved with the more primal investor motivations of fear (the amyg?dala) and greed (the nucleus accumbens, perhaps, not surprisingly, a locus of sexual desire as well). A high-tech fusing of neuroimaging with behavioral psychology and economics has begun to provide clues to how individuals, and, aggregated on a larger scale, whole economies may run off track. Together these disciplines attempt to discover why an economic system, built with nominal safeguards against collapse, can experience near-catastrophic breakdowns. Some of this research is already being adopted as a guide to action by the Obama administration as it tries to stabilize banks and the housing sector.
The Rationality Illusion
The behavioral ideas now garnering increased attention take exception to some central ideas of modern economic theory, including the view that each buyer and seller constitute an exemplar of Homo economicus, a purely rational being motivated by self-interest. “Under all conditions, man in classical economics is an automaton capable of objective reasoning,” writes financial historian Peter Bernstein.
Another central tenet of the rationalist credo is the efficient-market hypothesis, which holds that all past and current information about a good is reflected in its price—the market reaches an equilibrium point between buyers and sellers at just the “right” price. The only thing that can upset this balance between supply and demand is an outside shock, such as unanticipated price setting by an oil cartel. In this way, the dynamics of the financial system remain in balance. Classical theory dictates that the internal dynamics of the market cannot lead to a feedback cycle in which one price increase begets another, creating a bubble and a later reversal of the cycle that fosters a crippling destabilization of the economy.
A strict interpretation of the efficient-market hypothesis would imply that the risks of a bubble bursting would be reflected in existing market prices—the price of homes and of the risky (subprime) mortgages that were packaged into what are now dubbed “toxic securities.” But if that were so and markets were so efficient, how could prices fall so precipitously? Astonishment about the failure of conventional theory was even expressed by former chair of the Federal Reserve Board Alan Greenspan. A persistent cheerleader for the notion of efficient markets, he told a congressional committee in October 2008: “Those of us who looked to the self-interest of lending institutions to protect shareholder’s equity, myself especially, are in a state of shocked disbelief.”
The behavioral economists who are trying to pinpoint the psychological factors that lead to bubbles and severe market disequilibrium are the intellectual heirs of psychologists Amos Tversky and Daniel Kahneman, who began studies in the 1970s that challenged the notion of financial actors as rational robots. Kahneman won the Nobel Prize in Economics in 2002 for this work; Tversky would have assuredly won as well if he were still alive. Their pioneering work addressed money illusion and other psychological foibles, such as our tendency to feel sadder about losing, say, $1,000 than feeling happy about gaining that same amount.
A unifying theme of behavioral economics is the often irrational psychological impulses that underlie financial bubbles and the severe downturns that follow. Shiller, a leader in the field, cites “animal spirits”—a phrase originally used by economist John Maynard Keynes—as an explanation. The business cycle, the normal ebbs and peaks of economic activity, depends on a basic sense of trust for both business and consumers to engage one another every day in routine economic dealings. The basis for trust, however, is not always built on rational assessments. Animal spirits—the gut feeling that, yes, this is the time to buy a house or that sleeper stock—drive people to overconfidence and rash decision making during a boom. These feelings can quickly transmute into panic as anxiety rises and the market heads in the other direction. Emotion-driven decision making complements cognitive biases—money illusion’s failure to account for inflation, for instance—that lead to poor investment logic.
The importance of both emotion and cognitive biases in explaining the global crisis can be witnessed throughout the concatenation of events that, over the past 10 years, left the financial system teetering. Animal spirits propelled Internet stocks to indefensible heights during the dot-com boom and drove their values earthward just a few years later. They were present again when reckless lenders took advantage of low-interest rates to proffer adjustable-rate mortgages on risky, subprime borrowers. A phenomenon like money illusion prevailed: the borrowers of these mortgages failed to calculate what would happen if interest rates rose, which is exactly what happened during the middle of the decade, causing massive numbers of foreclosures and defaults. Securitized mortgages, debt from hundreds to thousands of homeowners packaged by banks into securities and then sold to others, lost most of their value. Banks witnessed their lending capital decline. Credit, the lifeblood of capitalism, vanished, bringing on a global crisis.
Rules of Thumb
Behavioral economics and the related subdiscipline of behavioral finance, which pertains more directly to investment, have also begun to illuminate in more detail how psychological quirks about money can help explain the recent crisis. Money illusion is only one example of irrational thought processes examined by economists. Heuristics, or rules of thumb that we need to react quickly in a crisis, are perhaps a legacy that lingers from our Paleolithic ancestors. Measured reasoning was not an option when facing down a wooly mammoth. When we are not staring down a wild animal, heuristics can sometimes result in cognitive biases.
Behavioral economists have identified a number of biases, some with direct relevance to bubble economics. In confirmation bias, people overweight information that confirms their viewpoint. Witness the massive run-up in housing prices as people assumed that rising home prices would be a sure bet. The herding behavior that resulted caused massive numbers of people to share this belief. Availability bias, which can prompt decisions based on the most recent information, is one reason that some newspaper editors shunned using the word “crash” in the fall of 2008 in an unsuccessful attempt to avoid a flat panic.
Hindsight bias, the feeling that something was known all along, can be witnessed postcrash: investors, homeowners and economists acknowledged that the signs of a bubble were obvious, despite having actively contributed to the rise in home prices.
Neuroeconomics, a close relation of behavioral economics, trains a functional magnetic resonance imaging device or another form of brain imaging on the question of whether these idiosyncratic biases are figments of an academician’s imagination or actually operate in the human mind. Imaging has already confirmed money illusion. But investigators are exploring other questions as well; for instance, does talking about money or looking at it or merely thinking about it activate reward and regret centers inside the skull?
In March at the annual meeting of the Cognitive Neuroscience Society in San Francisco, Julie L. Hall, a graduate student of Richard Gonzalez at the University of Michigan at Ann Arbor, presented research showing that our willingness to take risks with money changes in response to even subtle emotional cues, again undercutting the myth of the steely, cold investor. In the experiment, 24 participants—12 men and 12 women—viewed photographs of happy, angry and neutral faces. After exposure to happy faces, the study’s “investors” had more activation in the nucleus accumbens, a reward center, and consistently invested in more risky stocks rather than embracing the relative safety of bonds.
“Happy faces” were a constant presence during the real estate boom earlier in this decade. The smiling visage and happy talk of Carleton H. Sheets, the late-night real estate infomercial pitchman, promised fortunes to those who lacked cash, credit or previous experience in owning or selling real estate. Lately, Sheets’s pitch now highlights “Real Profit$ in Foreclosures.” Behavioral economics has gone beyond just trying to provide explanations for why investors behave as they do. It actually supplies a framework for investing and policy making to help people avoid succumbing to emotion-based or ill-conceived investments.
The arrival of the Obama administration marks a growing acceptance of the discipline. A group of leading behavioral scientists provided guidance on ways to motivate voters and campaign contributors during the presidential campaign. Cass Sunstein, a constitutional scholar who wrote the well-regarded book Nudge, which President Barack Obama has reportedly read, was appointed head of the Office of Information and Regulatory Affairs, which reviews federal regulations. Other officials who are either behavioral economists or aficionados of the discipline are now populating the White House.
Sunstein and his Nudge co-author Richard Thaler, the latter one of the founders of behavioral economics, came up with the term “libertarian paternalism” to describe how a government regulation can nudge people away from an inclination toward poor decision making. It relies on a heuristic called anchoring—a suggestion of how to begin thinking about something in the hope that thought carries over into behavior. People, for example, might be prodded into saving more for retirement if they were enrolled automatically in a pension plan from the outset, rather than merely being given an option to sign up. “Employees are enrolled if they do nothing, but they can opt out,” Thaler remarks. “This assures that absentmindedness does not produce poverty when old.” This idea was reflected in the Obama administration’s plans to automatically enroll people in a retirement plan in their workplace.
Decision making can be more complex than simply responding to a gentle push down a given path. In those circumstances, a “choice architecture” is needed to help someone decide among various options. In buying a house, for instance, purchasers need clearer information about money illusion and the like. “When all mortgages were of the 30-year, fixed-rate variety, choosing the best one was simple—just pick the lowest interest rate,” Thaler says. “Now with variable rates, teaser rates, balloon payments, prepayment penalties, and so forth, choosing the best mortgages requires a Ph.D. in finance.” A choice architecture would require that lenders “map” options clearly for borrowers, reducing an imposing stack of paperwork when buying a house into two neat columns, one that lists the various fees, the other that notes interest payments. Captured in a digital format, for instance, these two spreadsheet columns could be uploaded and compared with offerings from other lenders.
Along similar lines, Yale’s Shiller outlines an intricate strategy designed to avoid the excesses of bubble economics by educating against errors in “economic thinking.” Shiller suggests adopting new units of measurement akin to the unidad de fomento (UF) put in place by the Chilean government in 1967 and also embraced by other Latin American governments. The UF is a safeguard against money illusion, allowing a buyer or seller to know whether a price has increased in real terms or is just an inflationary mirage. It represents the price of a market basket of goods and is so commonly used that Chileans often quote prices in these units. “Chile has been the most effectively inflation-indexed country in the world,” Shiller says. “House prices, mortgages, some rentals, alimony payments, and executive incentive options are often expressed in these inflation units.”
Shiller also remains an ardent advocate of new financial technology that could serve as antibubble weapons. Regulators are now scrutinizing the sophisticated financial instruments that were supposed to protect against default on the mortgage-backed securities that fueled the housing boom. Shiller, however, argues that derivatives (a class of financial instruments that is meant to shield against risk but whose misuse for speculation contributed to the credit crisis) can help guarantee that there are enough buyers and sellers in housing markets. Derivatives are financial contracts “derived” from an underlying asset, such as a stock, a financial index or even a mortgage.
Despite the potential for abuse, Shiller perceives derivatives as prudent “hedges” against dire economic scenarios. In the housing market, homeowners and lenders might use these financial instruments to insure against falling prices, thereby providing sufficient liquidity to keep sales moving.
Can Biology Save Us?
Ultimately, a solution to the current crisis will have to be informed by new ways of thinking about how investors act. One particularly creative approach would correct deficiencies in existing economic theory by melding the old with the new. Andrew Lo, a professor of finance at the Massachusetts Institute of Technology and an official at a hedge fund, has devised a theory that gives equilibrium economics and the efficient-market hypothesis their due while also acknowledging that classic theory does not reflect the way markets work in all circumstances. It attempts a grand synthesis that combines evo?utionary theory with both classical and behavioral economics.
Lo’s approach, in other words, builds on the idea that incorporating Darwinian natural selection into simulations of economic behavior can help yield useful insights into how markets operate and provide more accurate predictions than usual of how financial actors—both individuals and institutions—will behave. Similar ideas have occurred to economists before. Economist Thorstein Veblen proposed that economics should be an evolutionary science as early as 1898; even earlier Thomas Robert Malthus had a profound influence on Darwin himself with his musings on a “struggle for existence.”
Just as natural selection postulates that certain organisms are best able to survive in a particular ecological niche, the adaptive-market hypothesis considers different market players from banks to mutual funds as “species” that are competing for financial success. And it assumes that these players at times use the seat-of-the-pants heuristics described by behavioral economics when investing (“competing”) and that they sometimes adopt irrational strategies, such as taking bigger risks during a losing streak.
“Economists suffer from a deep psychological disorder that I call ‘physics envy,’ ” Lo says. “We wish that 99 percent of economic behavior could be captured by three simple laws of nature. In fact, economists have 99 laws that capture 3 percent of behavior. Economics is a uniquely human endeavor and, as such, should be understood in the broader context of competition, mutation and natural selection—in other words, evolution.”
Having an evolutionary model to consult may let investors adapt as the risk profiles of different investment strategies shift. But the most important benefit of Lo’s simulations may be an ability to detect when the economy is not in a stable equilibrium, a finding that would warn regulators and investors that a bubble is inflating or else about to explode.
An adaptive-market model can incorporate information about how prices in the market are changing—analogous to how people are adapting to a particular ecological niche. It can go on to deduce whether prices on one day are influencing prices on the next, an indication that investors are engaged in “herding,” as described by behavioral economists, a sign that a bubble may be imminent. As a result of this type of modeling, regulations could also “adapt” as markets shift and thus counter the type of “systemic” risks for which conventional risk models leave the markets unprotected.
Lo has advocated the establishment of a Capital Markets Safety Board, similar to the institution that investigates airline accidents, to collect data about past and future risks that could threaten the larger financial system, which could serve as a critical foundation for adaptive-market modeling. As brain science unravels the roots of investors’ underlying behaviors, it may well find new evidence that the conception of Homo economicus is fundamentally flawed. The rational investor should not care whether she has $10 million and then loses $8 million or, alternatively, whether she has nothing and ends up with $2 million. In either case, the end result is the same.
But behavioral economics experiments routinely show that despite similar outcomes, people (and other primates) hate a loss more than they desire a gain, an evolutionary hand-me-down that encourages organisms to preserve food supplies or to weigh a situation carefully before risking encounters with predators.
One group that does not value perceived losses differently than gains are individuals with autism, a disorder characterized by problems with social interaction. When tested, autistics often demonstrate strict logic when balancing gains and losses, but this seeming rationality may itself denote abnormal behavior. “Adhering to logical, rational principles of ideal economic choice may be biologically unnatural,” says Colin F. Camerer, a professor of behavioral economics at Caltech. Better insight into human psychology gleaned by neuroscientists holds the promise of changing forever our fundamental assumptions about the way entire economies function—and our understanding of the motivations of the individual participants therein, who buy homes or stocks and who have trouble judging whether a dollar is worth as much today as it was yesterday.