Jobless Recovery, Policy Asset Put, Fiscal/Monetary Stimulus and Debt Crisis Fear
Carlos M Pelaez

The recession of 2001 was “shallow” with relatively low annual percentage rates of GDP contraction in only two quarters: -1.3 QI01, 2.6 QII01, -1.1 QIII01 and 1.4 QIV01. Economists, such as Paul Krugman, argue that recent recessions have been characterized by “jobless recovery” (http://krugman.blogs.nytimes.com/2008/01/22/deep-maybe-long-probably/ ). The peak of nonfarm payroll employment of 133,371,000 in November 2000 was only attained again with 134,058,000 in May 2005 and the annual average of 2000, 131,785,000, was only surpassed in 2006, 136,086,000 (http://data.bls.gov/PDQ/servlet/SurveyOutputServlet ). The unemployment rate as percent of the labor force was 4.0 in 2000, increasing steadily to 4.7 in 2001, 5.8 in 2002, peaking at 6.0 in 2003 and declining to 4.6 in 2006 (http://www.bls.gov/web/cpseea1.pdf ). The preliminary number of nonfarm payrolls in 2009 is 130,912,000 and the average yearly rate of unemployment 9.3 percent. The most important current issue of economic policy is creating incentives in attaining rapid quarterly annual rates of economic growth similar to those in the upswing of the 1980s: 5.1 QI83, 9.3 QII83, 8.1 QIII83, 8.5 QIV83, 8.0 QI84, 7.1 QII84 and thereafter at rates in excess of 3 percent. The rate of unemployment increased from 6.3 percent in January 1980 to a peak of 10.8 percent in December 1982, declining at year end to 8.3 percent in 1983, 7.3 percent in 1984 and 7.0 percent in 1985 (http://data.bls.gov/PDQ/servlet/SurveyOutputServlet ). The civilian labor force of the US was 153 million in January 2010 of which 14.8 million were unemployed equivalent to an unemployment rate of 9.7 percent and 8.3 million worked part-time because of economic conditions or could not find another job (http://www.bls.gov/news.release/pdf/empsit.pdf ). The data reveal a tough national event. Commonly considered policy options are (1) inducing high rates of growth by creating incentives for private sector job creation without significant expenditures or tax decreases; (2) increasing public expenditures in stimulus programs or reducing taxes selectively to increase aggregate demand for goods and services; and (3) a combination of (1) and (2). This writing provides background on the origin of the credit/dollar crisis and the fiscal/monetary stimulus followed by analysis of the current policy options in the light of current conditions in the world economy.
First, policy asset put. The credit/dollar crisis and global recession is officially attributed to an era of “irresponsibility” by finance professionals taking excessive risks to generate abnormal profits with which to receive billions of dollars in cash bonuses and other compensation. There is a competing interpretation. The financial system of securitization converts illiquid assets into immediate liquidity as in the banking theory of Douglas Diamond and Raghuram Rajan (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 37-44, 51-60, Financial Regulation after the Global Recession, 22-6, 30-42; see Globalization and the State Vol. II, 73-81, Government Intervention in Globalization, 128-31). A major part of credit is processed by securitization. Consider an example of mortgages that is valid for almost all credit such as credit cards, automobile loans, consumer loans and so on. The acquiring home owner receives cash to buy the home from an originating bank in exchange for a mortgage with the house as collateral and a loan agreement. Mortgages of similar credit rating and other characteristics are bundled into a security called mortgage-backed security (MBS) in which principal and interest are paid from the original mortgages. The MBS is acquired by investors and financed in short-term sale and repurchase agreements (SRP) in which the investor in the MBS or financed counterparty sells the MBS to a financing counterparty with an agreement to repurchase it at a contracted price plus interest for settlement at a specified short-term future date. The SRP converts the underlying illiquid home in the MBS into immediately available cash that can be construed as the funds that financed the purchase of the home. Securitization had worked for decades without a major crisis. The system was fractured when the financing counterparty decided not to renew the SRP in fear of defaulting mortgages underlying the MBS or asked for a deep discount in the contracted price in order to avoid losses if the financed counterparty did not repurchase the MBS because its market price collapsed. The financing counterparty would incur a loss equal to the difference between the depressed price received from selling the MBS used as collateral in the SRP and the value of the principal and interest defaulted by the financed counterparty. Some MBS were pooled in credit derivatives such as collateralized debt obligations (CDO) that were financed by issue of commercial paper of the structured investment vehicle (SIV), often related to banks, which was unable to roll over the SRPs of commercial paper because of defaults in mortgages underlying the CDOs (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9). The critical event triggering the credit crisis was the default of mortgages in securitized instruments and derivatives.
The primary cause of the credit/dollar crisis and global recession was the fracturing of counterparty financing in SRPs of asset-backed securities and their derivatives. The most important function of finance professionals is protecting capital without which their institution disappears. Many finance professionals held most of their wealth in stock of the company where they worked. Many homeowners purchased their homes without premeditating or risking default and foreclosure that could ruin their lives. There is a more compelling alternative interpretation that the crisis was primarily caused by near zero interest rates, lowering of mortgage rates by interruption of the issue of 30-year Treasury bonds, housing subsidy of $221 billion per year and the purchase or guarantee of $1.6 trillion of nonprime MBS by Fannie Mae and Freddie Mac with leverage of 75:1 (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). The target of the fed funds at 1 percent with forward guidance that it would be maintained low as long as required created an equivalent of a put option or floor on the prices of financial and real assets. The low interest rate policy was designed to prevent deflation and its adverse consequences, causing the unintended expectation that house prices and financial assets would increase indefinitely but never dropping below a price floor. There was upside potential without downside risk. Wealth, which includes financial and real assets and human capital, would also increase but never decline below a floor. Monetary policy encouraged high risk and leverage in the pursuit of higher returns to avoid near zero remuneration by interest rates that penalized holding liquid balances. The mirage was broken when the Fed raised targets on fed fund rates from 1 percent in June 2004 to 5.25 percent in June 2006 (http://www.federalreserve.gov/fomc/fundsrate.htm ). The increase in interest rates caused increases in monthly payments of adjustable rate mortgages (ARMS) that pushed many borrowers toward default. The increasing use of ARMS was based on the belief that rates would remain low forever. The collapse of house prices caused default of mortgages underlying the MBS financed in SRPs and other structured products. Counterparty financing risk perceptions catapulted, contracting the volume of SRP financing that paralyzed credit transactions throughout all segments of the financial system.
Second, monetary/fiscal stimulus. Research by Bloomberg finds that the US government and the Fed “spent, lent or committed $12.8 trillion” by March 2009 which was about the entire economic activity or GDP in 2008 (www.bloomberg.com cited in Pelaez and Pelaez, Regulation of Banks and Finance, 224). The amount disbursed or lent by March 2009 was about $4.2 trillion. The Fed used about 11 credit facilities during the crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession, Table 6.3, 160-1). The Fed also engaged in the policy of “quantitative easing” (Pelaez and Pelaez, Regulation of Banks and Finance, 224, see The Global Recession Risk, 83-107). As of the last statement on February 3, 2010, the Fed held $1.8 trillion of securities, consisting of $708 billion of Treasury notes and bonds, $164 billion of Federal agency securities and $970 billion of MBS (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). The retained portfolio of MBS by Fannie and Freddie was $1.6 trillion as of the third quarter of 2009 (http://www.fhfa.gov/Default.aspx?Page=70 ). The eventual sale of these portfolios of the Fed, Fannie and Freddie could exert significant pressure on interest rates. Since December 16, 2008, the target rate of fed funds has been 0-0.25 percent (http://www.federalreserve.gov/fomc/fundsrate.htm ). The zero target of the fed funds rate has played a significant role in the carry trade. The carry trade consists of shorting the currency of the country with low interest rates to take long positions in the currency of the country with high interest rates. These are high risk uncovered positions that can cause losses if the dollar appreciates and/or if commodity prices and stock markets lose value (Pelaez and Pelaez, Globalization and the State Vol. II, 203-4, Government Intervention in Globalization, 70-4). The carry trade has evolved into shorting the dollar and going long in commodity futures and emerging market stocks. The dollar depreciated to $1.59/euro by 7/14/08 with the DJ-UBS commodity index reaching 237.08 on 7/03/08 (http://online.wsj.com/mdc/public/page/mdc_commodities.html?mod=mdc_topnav_2_3000 ). The flight to the dollar because of the global recession caused dollar appreciation to $1.261/euro on 3/09/09 and decline of the DJ-UBS commodity index to 104.83. Renewed risk appetite resulted in $1.50/euro on 11/30/09 with the DJ-UBS commodity index at 136.49. The ongoing sovereign debt crisis resulted in appreciation to $1.368/euro on 2/05/10 and decline of the DJ-UBS commodity index to 126.558. The carry trade has been more cautious because of the threat of an increase in interest rates in the US that would appreciate the dollar, causing a loss in the short dollar leg.
Third, debt crisis fear. A few facts illustrate the deteriorating fiscal situation of the US. The largest recorded deficits of the US as percent of GDP occurred during World War II: -14.2 in 1942, -30.3 in 1943, -22.7 in 1944 and -25 in 1945. The deficit as percent of GDP declined to -7.2 in 1946 and turned into surplus of 1.7 percent in 1947 (http://www.whitehouse.gov/omb/budget/fy2011/assets/hist.pdf ). The highest deficit as percent of GDP since World War II occurred in 1983, -6, but no past budget is comparable to the estimated deficits as percent of GDP of -9.9 in 2009, -10.6 in 2010 and -8.3 in 2011. The deficits are staggering in trillions of current dollars: -1.4 in 2009, -1.6 in 2010 and -1.3 in 2011. Estimated outlays or expenditures increase in current dollars by 28.5 percent from 2008 to 2011 while revenues increase 1.7 percent after declining by 14.2 percent between 2008 and 2010. As percent of GDP the estimated expenditures are the highest since 24.8 in 1946: 24.7 in 2009, 25.4 in 2010 and 25.1 in 2011. The federal debt held by the public as percent of GDP peaked at 108.7 in 1946, declining to 52.0 in 1956 and never exceeding 50 until the current estimates: 53.0 in 2009, 63.6 in 2011, 70.8 in 2012 and above 70 during the remainder of the decade. In an essay presented at the meetings of the American Economic Association in 2004, Robert Rubin, Peter Orszag and Allen Sinai argued that the US federal budget was moving along an unsustainable path, accumulating over $5 trillion between 2004 and 2013 with the federal debt rising above 50 percent for the first time since the 1950s when the country was still paying for World War II. The deficit was rising toward the future time of collective retirement of the baby boom generation when multiple entitlements will sharply increase government expenditures (http://www.brookings.edu/~/media/Files/rc/papers/2004/0105budgetdeficit_orszag/20040105.pdf ). The federal debt held by the public is now moving toward an estimated 77.2 percent of GDP in 2020 (http://www.whitehouse.gov/omb/budget/fy2011/assets/budget.pdf ). Long-term projections are subject to significant error and actions could occur before the debt touches 100 percent of GDP.
Interest rate increases and higher taxes are inevitable in the next few years, restricting the rate of economic growth and the capacity of the private sector to create jobs. Further stimulus could deteriorate the fiscal situation. Sovereign debt fears that spooked financial markets last week, reversing carry trades with a flight to dollar assets, are less likely to cause similar events with US federal debt. The major problem with US debt is the trillions of dollars that must be financed because of the deficits or refinanced because of maturing debt. Excessive existing weight of Treasury securities in portfolios together with trillions of dollars of new debt issuance may trigger a premium on interest rates of Treasury securities. Managing the federal debt may become more difficult if markets anticipate rising rates that could cause capital losses. The Congressional Budget Office (CBO) defines an “unsustainable federal budget” as federal debt increasing at a much faster rate than the economy as a whole (http://www.cbo.gov/ftpdocs/102xx/doc10297/SummaryforWeb_LTBO.pdf ). Agendas of regulation, prodigal budgets and targeted taxation of segments of business and income brackets may be inferior to stimulating attitudes that foster confidence in business plans inducing job creation. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)