The 26 Million Persons in Job Stress, Financial Regulation, the Tax on Everything and Rising Interest Rates

There are 26 million persons in job distress: 15 million people unemployed (of which 6.5 million for 26 weeks or more), 9.5 million employed part-time because they cannot find full-time jobs and 2 million marginally attached to the labor force because they do not believe they will find jobs (http://www.bls.gov/news.release/pdf/empsit.pdf ). The priority of the national agenda is jobs as soon as possible or in the short run in which we live that the economist John Maynard Keynes dramatically emphasized with the phrase “In the long run, we are all dead.” The policy agenda is busy with restructuring everything for what is alleged to be a better long run. This comment considers below various views of the causes of the credit/dollar crisis and global recessions and their corresponding policy proposals for financial regulation, new releases of economic indicators, interest rates, government budget deficits and debt and the probable frustration by rising taxes and interest rates of rapid economic growth that can create the needed jobs. The agenda has perilously shifted from the macroeconomic policies required for growth and job creation to the important but currently irrelevant microeconomic policies that allegedly could improve efficiency in the long run when many will be unemployed and in default because of the huge cumulative debt resulting from rushed restructuring policies.
I Views on the Credit Crisis and Financial Regulation. The Government View of the origin of the credit crisis and global recession is explained in the Pittsburgh G20 statement on Sep 24-25, 2009, by an “era of irresponsibility” in the form of excesses in risks and leverage in banks (http://www.g20.utoronto.ca/2009/2009communique0925.html ). The proposed solution is strengthening the “international financial regulatory system.” There is an ambitious international agenda of financial regulation centered on the Basel institutions (Pelaez and Pelaez, Financial Regulation after the Global Recession, 171-5, Regulation of Banks and Finance, 229-36). This technical process of international cooperation should be completed instead of being anticipated by individual national legislative initiatives.
The Legislative View in the US postulates that the credit crisis originated in excessive risk taking by finance professionals who generated short-term profits to appropriate “irresponsible” compensation in bonuses and stock options. One of the major proposals is the creation of a Consumer Financial Protection Bureau as a new independent agency. The need for change here according to the Financial Stability Act of the Senate Banking Committee is that “the economic crisis was driven by an across-the-board failure to protect consumers” (http://banking.senate.gov/public/_files/FinancialReformSummary231510FINAL.pdf ). The new consumer protection agency may repeat CARD, the Credit Card Accountability, Responsibility and Disclosure Act signed on May 22, 2009. (http://www.whitehouse.gov/the_press_office/Fact-Sheet-Reforms-to-Protect-American-Credit-Card-Holders ). CARD went into effect on Feb 22, 2010, allowing nine months during which issuers engaged in lowering credit limits and raising interest rates for most cardholders but especially those with lower credit scores. Another proposal is creating a Financial Stability Oversight Council. The need for this new agency according to the Financial Stability Act is “identifying, monitoring and addressing systemic risks posed by large, complex financial firms as well as products and activities that spread risk across firms.” Bailouts would be financed from a fund created with fees from banks instead of taxpayer contributions. The $50 billion of that fund would not have bailed out Fannie and Freddie but the government in the new bailout activity could induce growth of larger firms that could become the future Fannie and Freddie (Peter Wallison and David Skeel in (http://professional.wsj.com/article/SB20001424052702303493904575167571831270694.html ). Breaking banks because they could be too big would make US banks uncompetitive internationally and without the capacity of financing overseas operations of US corporations. The bill is job destroying while also eroding financial competitiveness. Yet another proposal consists of the Volcker Rule prohibiting proprietary trading, hedge funds and private equity funds in banks. None of these activities was the source of problems during the credit crisis. The Volcker Rule weakens financial intermediation without promoting stability.
The Fed View argues that regulatory deficiencies did not timely identify exposures with excessive risk and low liquidity in the origination of mortgages bundled in securities that were subsequently sold and financed with short-term funds (http://www.federalreserve.gov/newsevents/speech/20100407a.htm ). There were subsequent problems in financial institutions with large, complex assets and interconnected with other entities, thus creating systemic risk. An important sound proposal in this view is maintaining the regulatory and supervisory functions of the Federal Reserve System. The Fed is endowed with unrivaled expertise and talent without the more politicized environment because of its policy independence and sober tradition.
According to an Alternative View, the credit/dollar crisis and global recession originated in four almost contemporaneous policies that stimulated excessive construction and high real estate prices, highly-leveraged risky financial exposures, unsound credit and low liquidity: (1) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities (MBS) equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between Jun 2003 and Jun 2004 with the implicit intention in the “forward guidance” of maintaining low rates indefinitely if required in avoiding “destructive deflation”; (3) the housing subsidy of $221 billion per year; and (4) the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac (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 combined stimuli mispriced risk, causing excessively risky and highly-leveraged exposures as the public attempted to obtain higher returns on savings. The increase of the fed funds rate by 25 basis points per meeting of the FOMC from Jun 2004 to Jun 2006 raised the fed funds rate from 1 percent to 5.25 percent around the time that house prices peaked. The response of the Fed to the credit/dollar crisis was the reduction of the fed funds rate from 5.25 in Sep 2007 to 0 – ¼ percent in Dec 2008 without any subsequent change. The Fed faces an even more difficult challenge in the current environment than in 2004 because the Fed balance sheet increased by 115.7 percent from $855.1 billion in February 2008 to $1844.9 billion in February 2009 (Pelaez and Pelaez, Regulation of Banks and Finance, 225-6, Financial Regulation after the Global Recession, 158-9). The proposal resulting from this view is to allow the completion of the regulatory proposals by the Basel institutions for implementation after economic and job recovery while permitting the Fed to steer monetary policy away from the stimulus.
II Economic Indicators. The nonmanufacturing index of the Institute for Supply Management (ISM) rose by 2.4 percentage points from 53 in Feb to 55.4 in Mar, suggesting growth in the services sector for the third consecutive month (http://www.ism.ws/ISMReport/NonMfgROB.cfm ). The National Association of Realtors announced an increase of 8.2 percent of pending home sales for Feb and 17.3 percent relative to a year earlier (http://www.realtor.org/press_room/news_releases/2010/04/phs_gain ). The Fed announced that consumer credit declined by $11.5 billion from $2459.4 billion in Jan to $2447.9 billion in Feb. Revolving credit declined by $9.5 billion and nonrevolving credit by $2.0 billion (http://www.federalreserve.gov/releases/g19/Current/ ). The annual rate of decline of consumer credit was 5.5 percent with revolving credit declining at the annual rate of 13 percent and nonrevolving credit declining at the rate of 1.5 percent. Revolving credit by credit card issuers had been experiencing sharp increases in interest rates and reductions in credit limits in anticipation of CARD, which went into effect with a nine month lag on Feb 22, 2010 (http://www.whitehouse.gov/the_press_office/Fact-Sheet-Reforms-to-Protect-American-Credit-Card-Holders ). Initial claims of unemployment insurance for the week ending on Apr 3 grew by 18,000, reaching 460,000 relative to the revised 442,000 a week earlier. The increase in the 4-week moving average was 2250, reaching 460,250 relative to the revised 448,000 a week earlier. The number of persons claiming benefits in state programs was 5.0 million, decreasing by 168,431 from a week earlier and much lower than 6.5 million a year earlier (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). Sales of merchant wholesalers increased by 0.8 percent in Feb relative to the earlier month and by 9.8 percent relative to a year earlier. Sales of durable goods grew by 6.5 percent relative to a year earlier and sales of motor vehicles and parts by 2.4 percent relative to a month earlier (http://www2.census.gov/wholesale/pdf/mwts/currentwhl.pdf ).
III Interest Rates. The Fed released on Apr 6 the minutes of the meeting of the Federal Open Market Committee (FOMC) held on Mar 16 (http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20100316.pdf ). The view in the FOMC meeting was of a strengthening economy proceeding at a “moderate pace.” There were significant gains in retail sales, business spending on equipment and software and expanding exports of goods. Labor markets were beginning to stabilize but housing and construction stalled. The view of the FOMC is of continuing subdued inflation. With one exception, FOMC members concurred that low levels of utilization of resources, subdued inflation and stable inflation expectations warranted the maintenance of low fed funds rates for an extended period. The FOMC did not take decisions on the exit strategy for the portfolio of long-term securities.
Strong demand in auctions for 10- and 30-year Treasuries (http://www.ft.com/cms/s/0/7a45a880-427b-11df-8c60-00144feabdc0.html ), probably because of doubts on sovereign risks, caused a slight downward shift in the yield curve on Apr 9 from a week earlier but continuing upward shift relative to a month earlier. The 10-year yield declined by 6 basis points (bps) to 3.88 percent from 3.94 percent a week earlier but increased by 18 bps from 3.72 percent a month earlier (http://markets.ft.com/markets/bonds.asp ). G7 countries with lower budget deficits have negative spreads relative to the 10-year Treasury: 3.65 - 3.88 or -24 bps for Canada and 3.17 – 3.88 or -71 bps for Germany (http://markets.ft.com/markets/bonds.asp ). On Apr 2, the 10-year interest rate swap was 3.87 percent while the 10-year constant-maturity Treasury was 3.89 percent for negative spread of -2 bps (http://www.federalreserve.gov/releases/h15/data.htm ).
IV Government Deficits, Debt and Taxes. The Congressional Budget Office (CBO) calculates record fiscal deficits from the President’s budget proposal of $1.5 trillion in 2010, or 10.3 percent of GDP, and $1.3 trillion in 2011, or 8.9 percent of GDP after $1.4 trillion or 9.9 percent of GDP in 2009 (http://www.cbo.gov/ftpdocs/112xx/doc11231/frontmatter.shtml ). Debt held by the public would rise from $7.3 trillion or 53 percent of GDP in 2009 to $20.3 trillion or 90 percent of GDP in 2020. Net interest would quadruple from 1.4 percent of GDP in 2010 to 4.1 percent in 2020. The First Managing Director of the International Monetary Fund (IMF), John Lipsky, revealed the projection that average government debt of advanced countries will increase from 75 percent of GDP at year-end 2007 to 110 percent of GDP at year-end 2014. The IMF expects that with the exception of Canada and Germany all G7 countries including the US will have debt/GDP ratios above 100 percent by 2014 (http://www.imf.org/external/np/speeches/2010/032110.htm ). The Fed holds a portfolio of $1.94 trillion of long-term securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ) that will cause increases in long-term interest rates when it is sold to the public even using appropriate tools in an optimum exit strategy. Issuance of debt to pay for continuing high government deficits and refinancing of maturing debt together with the sale of the Fed’s portfolio will cause upward pressure on long-term interest rates with likely adverse effects on the rate of economic growth and employment. The will to restore fiscal balance by elected officials is replaced by profligacy during election processes in alternate years.
The CEO of one of the largest banks that navigated through the credit crisis without a single quarter of loss states: “If we rewrite the rules for banks out of anger or populism, we’ll end up with the wrong solutions and put barriers in the way of future economic growth. Good policy and financial reform must be based on facts and analysis and need to be comprehensive, coordinated, consistent and relevant” (Jamie Dimon in http://files.shareholder.com/downloads/ONE/889418027x0x362440/1ce6e503-25c6-4b7b-8c2e-8cb1df167411/2009AR_Letter_to_shareholders.pdf ). Regulation should control reckless conduct without frustrating required financing of risk taking and innovation that Schumpeter identified as the driver of US economic growth (Pelaez and Pelaez, Government Intervention in Globalization, 46, Globalization and the State Vol. I, 50). Schumpeter also discovered a key role of banks in financing innovation and growth (Beck, Levine and Loayza and Rondo Cameron cited in Pelaez and Pelaez, Regulation of Banks and Finance, 41). The sober approach is that of Functional Structural Finance (FSF) developed by Robert C. Merton and Zvi Bodie, which is ideology-free because the financial functions can be provided by the private-sector, government and family institutions ((Pelaez and Pelaez, Regulation of Banks and Finance, 234-6, Financial Regulation after the Global Recession, 34-7). FSF posits that spirals of financial innovation, including structured products, academic landmarks such as Black-Scholes-Merton option pricing and risk-management techniques as by RiskMetrics®, improve the functions of finance required for economic growth. Excessive regulation can distort risk/returns decisions, preventing efficient financial functions, flattening the expansion path of the economy and preventing full employment.
Chairman Bernanke warned that “unless we as a nation demonstrate a strong commitment to fiscal responsibility, in the longer run we will have neither financial stability nor healthy economic growth” (http://www.federalreserve.gov/newsevents/speech/20100407a.htm ). Government expenditures have risen to a peacetime high of 25 percent of GDP. Instead of parsimony in government expenditure, proposals begin to surface for a national value added tax (VAT) and taxes on energy (http://professional.wsj.com/article/SB30001424052702303720604575170320672253834.html ). The expansion path of the economy will be flattened by taxes on everything to sanction a higher share of the government in economic activity. Taxes tend to create their own expenditure and may not fill the budget hole. Carmen Reinhart and Kenneth Rogoff conducted monumental research for their magnum opus This Time is Different, finding that credit crises are followed by even more damaging debt crises (http://www.ft.com/cms/s/0/f22a3704-4248-11df-9ac4-00144feabdc0.html http://www.amazon.com/This-Time-Different-Centuries-Financial/dp/0691142165/ref=ntt_at_ep_dpi_1 ). The combination of budget deficits of 10 percent of GDP and debt/GDP ratio on the road to 100 percent with taxation of everything pursuing government expenditure, rising interest rates and regulatory shocks will convert the long run in a succession of short runs of weak economic conditions and high unemployment. American companies and banks will not be of global best class and optimum size, being burdened by high costs and regulation and lower productivity will maintain lower relative wages. That long run will also be highly inefficient with lower paying jobs. There is still time to focus on an effective agenda for real prosperity. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)