The Global Debt and Financial Crisis and the 26 Million Persons in Job Stress

The Global Debt and Financial Crisis and the 26 Million Persons in Job Stress
Carlos M. Pelaez

The purpose of this post is to analyze the worrisome combination of fiscal imbalances and government debt with stress in financial markets. The sections below consider in turn (I) the rising perception of financial risk, (II) the global debt and financial crisis, (III) the stress of 26.9 million unemployed or underemployed, (IV) the interest rate conundrum and (IV) conclusions.
I Financial Risk. The three major dimensions of increasing financial risk are considered below. First, financial risk is present in the decline of equity indexes. At the close of markets on May 7, major equity indexed registered percentage declines in 2010 of: Global Dow 8.1, Shanghai Composite 18.0, Hong Kong Hang Seng 8.9, Nikkei Japan Average 1.7, CAC 40 France 13.8, DAX Germany 4.1, FTSE 100 UK 5.4, Russia Titans 8.7 and Brazil BOVESPA 8.3 (http://online.wsj.com/mdc/public/page/2_3022-intlstkidx.html?mod=topnav_2_3000 ). The Dow Jones Industrial Average (DJIA) declined 6.9 percent in the week ending on Apr 7 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_h_dtabnk&symb=DJIA ) and the S&P 500 declined by 7.6 percent (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_uss_dtabnk&symb=SPX ).
Second, an important manifestation of the credit/dollar crisis and global recession of 2007-2009 was in the form of exploding perceptions of default risk in counterparty financial transactions. The nonprime mortgages behind mortgage-backed securities (MBS) and their derivatives eroded the confidence in financing among banks and other financial institutions because they were not fully certain of the soundness of their own balance sheets and of those of other banks and financial institutions (Pelaez and Pelaez, Financial Regulation after the Global Depression, 48-52, 157-66, Regulation of Banks and Finance, 59-60, 217-27). The paralysis of the sale and repurchase agreements (SRP) of asset-backed securities (ABS) caused fire sales of securities and collapse of their prices, resulting in major write downs of assets in balance sheets of banks and financial institutions. 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: (i) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of MBS equivalent to a reduction in mortgage rates; (ii) 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”; (iii) the housing subsidy of $221 billion per year; and (iv) the purchase or guarantee of $1.6 trillion of nonprime MBS 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 proposal of the Troubled Asset Relief Program (TARP) to Congress as required for either withdrawing “toxic” assets from bank balance sheets or risking another Great Depression further eroded confidence that deepened the financial crisis and global recession. The current environment is again characterized by the same quasi-zero interest rates, much more aggressive quantitative easing and a tough international bailout of at least one country to avoid domestic rescues of banks. The aggravating difference is increasing fiscal imbalances that may end in unsustainable government debt of 100 percent of GDP.
Third, the indicators of rising financial counterparty credit risk are raising concerns. The overnight index swap (OIS) consists of an agreement by which counterparties exchange at contractual maturity the notional value times the difference between accrued interest at the fixed rate such as the London interbank offered rate (LIBOR) and interest accrued by the geometric interest average of the reference index rate such as the fed funds rate. The OIS is one of many risk management tools, such as synthetic CDOs, required in risk transfer (Pelaez and Pelaez, International Financial Architecture, 134-54, Globalization and the State, Vol. I, 78-100, Government Intervention in Globalization, 57-64, 70-4). The flood of subprime mortgages originating in the government policy of housing subsidies undermined these instruments and the entire financial system. Blaming financial innovation and institutions for the credit/dollar crisis is similar to blaming the crash of modern aircraft on its technology instead of on the use of worthless government-subsidized fuel. Risk management innovations were never intended to be used with subprime mortgages purchased or guaranteed by the government-related entities Fannie Mae and Freddie Mac and originated with interest rates fixed at artificially levels in 2003-2004 just before their sustained increase in 2004-2006 to levels at which the mortgages were unviable. The agreement to receive the fixed rate in the OIS is equivalent to lending cash while paying the fixed rate is equivalent to borrowing cash (http://www.acisuisse.ch/docs/dokumente/OIS_Note_CSFB_Zurich.pdf ). The perception is that there is higher risk in lending to other banks at LIBOR than at the overnight fed funds rate. An increase in the spread of three-months LIBOR over the OIS referenced to the overnight fed funds rate is a measure of risk perceptions of interbank lending. The spread was typically below 10 basis points (bps) before the credit/dollar crisis but rose to several hundred bps during the crisis. The Financial Times (FT) registered a record sharp increase of the spread of EURIBOR to the OIS in the week of Apr 3 (http://www.ft.com/cms/s/0/0be6616e-586e-11df-9921-00144feab49a.html# ). Additional signs of stress were increasing spreads of credit-default swaps (CDS) for major European banks and the concentration of 90 percent of bank lending on overnight transactions. The FT quotes estimates by Barclays Capital that French and German financial institutions have exposure of $103 billion to Greek government debt (Ibid). While interbank lines are active, the three-month LIBOR rate increased to 0.42813 percent on Friday from 0.37359 on Thursday, reaching the highest level since Aug 2009 (http://professional.wsj.com/article/SB10001424052748703338004575230102280362776.html?mod=wsjproe_hps_LEFTWhatsNews ). More signs of stress of financial institutions are revealed by declines of their stock prices and increases in the yields required on their bonds (Ibid).
Fourth, the anticipation of financial regulation in the United States in detriment of global agreements that induce competitiveness of international banks and financial institutions is adding significantly to the uncertainty of financial markets. A positive development was the abandoning of the destabilizing audit of Fed monetary policy in a Senate amendment but there is uncertainty in the reconciliation with the House bill that has such an audit provision. The Senate bill will restrict credit volume, increase interest rates and generate a more unstable banking and financial system. It appears that the majority in the Senate will not favor the permanent solution to the biggest bailout of the credit/dollar crisis by perpetuating Fannie Mae and Freddie Mac. A bill continuing the open-ended bailout of Fannie and Freddie is a statute sanctioning the “too big and politically important to liquidate,” contradicting the stabilizing intention of the legislation and creating with the systemic risk oversight council a precedent for political bailouts. There will be selective bailouts of politically important entities.
II The Global Debt and Financial Crisis. Sovereign risk is becoming the equivalent of the subprime credit problem of the new government debt/financial crisis. The major vulnerability is a repetition of the sovereign risk event in more economies with larger dimensions. The current World Economic Outlook of the International Monetary Fund provides estimates of the fast increase of the government debt as percentage of GDP for advanced economies from 2008 to 2015: Canada 22.6 to 30.4, France 57.8 to 85.1, Germany 59.3 to 74.8, Italy 103.9 to 122.1, Japan 96.9 to 153.9, United Kingdom 45.5 to 83.9, United States 47.2 to 85.5 and Euro Area 59.5 to 84.9 (http://www.imf.org/external/pubs/ft/weo/2010/01/pdf/text.pdf ). The IMF states that “without more fully restoring the health of financial and household balance sheets, a worsening of public debt sustainability could be transmitted back to banking systems or across borders” (http://www.imf.org/external/pubs/ft/gfsr/2010/01/pdf/summary.pdf ). The term contagion may be misleading. Countries with more manageable fiscal situations may suffer less in a global debt/financial crisis. What appears impossible is escaping altogether the effects of such a crisis that originates in the United States and Europe. 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 Fed holds a portfolio of $1.98 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 that may fail operationally. 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 Medicare Board of Trustees calculates under its “budget perspective” present-value net deficits of $45.8 trillion in the next 75 years from Medicare and Old Age, Survivors and Disability Insurance (OASDI) or Social Security that are equivalent to 5.8 percent of the present value of the GDP in that period of $791 trillion (http://www.cms.gov/ReportsTrustFunds/downloads/tr2009.pdf ). The Medicare hospital insurance or Part A trust fund will be exhausted by 2017. The solution to the Medicare financial imbalance could require gradual or immediate increases in the payroll tax from the current 2.90 percent to 6.78 percent equivalent to an increase of the tax by 134 percent or reduction of expenditures by 53 percent. The OASDI Board of Trustees predicts that annual costs will be higher than income by 2016 and that the OASDI trust fund could be exhausted by 2037 (http://www.ssa.gov/OACT/TR/2009/tr09.pdf ). States face unfunded entitlement liabilities while experiencing substantial budget deficits.
III Job Stress. There are multiple positive developments in the employment report for Apr (http://www.bls.gov/news.release/pdf/empsit.pdf ). (1) The sample of nonfarm payroll employment registers an increase of 290,000 jobs in sharp contrast with a loss of 528,000 in Apr 2009. Moreover, the upwardly revised increase for Mar is 230,000 and for Feb 39,000. (2) The increase of private sector jobs in Apr is 231,000 following revised increases of 174,000 in Mar and 62,000 in Feb. (3) The net increase in government jobs is 59,000 after allowing for 66,000 temporary workers for Census 2010. (4) The job increases are spread throughout nearly all sectors of private employment with the exception of transportation and warehousing. (5) The increase in nonfarm payroll employment since December is 573,000 of which 483,000 in the private sector, occurring mostly in Apr and Mar. (6) The average workweek for all employees in private nonfarm payrolls increased from 34.0 hours in Mar to 34.1 hours in Apr. (7) The rate of participation of the civilian labor force increased by 0.3 percent to 65.2 percent with an increase in the labor force of 805,000. The reentrants of the labor force from the unemployed increased by 195,000. This could signal renewed confidence in the feasibility of finding jobs. The household survey data still raise concerns about the employment situation in the US. (1) The unemployment rate increased from 9.7 percent in the first three months to 9.9 percent in Apr. The number of unemployed is 15.3 million even with increased hopes of finding jobs. (2) The percentage of unemployed persons that have been jobless for 27 weeks or more increased to 45.9 percent. There is less hope for finding employment after prolonged unemployment. (3) There were 9.2 million persons in April in involuntary part-time jobs because their work hours had been cut or because they could not find a full-time job. (4) The number of persons marginally attached to the labor force reached 2.4 million in Apr compared with 2.1 million a year earlier; these are persons not in the labor, wanting and available for work and looking for a job in the prior 12 months but not in the past four weeks. (5) The unemployed of 15.3 million, the marginally attached to the labor force of 2.4 million and the 9.2 million in involuntary part-time jobs add to 26.9 million under job stress.
US GDP increased at the annual seasonally-adjusted percentage rate of 2.2 in QIII09, 5.6 in QIV09 and 3.2 in QIII10 (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&FirstYear=2009&LastYear=2010&Freq=Qtr ). These rates of growth may be insufficient to recover full employment. In the recession of the 1980s the quarterly annual percentage rate of growth of GDP was: -7.9 QII80, -0.7 QIII80, 7.6 QIV80, 8.6 QI81, -3.2 QII81, 4.9 QIII81, -4.9 QIV81, -6.4 QI82, 2.2 QII82, -1.5 QIII82 and 0.3 QIV82. During the recovery phase GDP grew at the quarterly annual percentage rate of: 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. Change in private inventories was a significant contributor to the rate of GDP growth in terms of percentage points only in a few quarters: 3.5 QII83, 3.1 QIV83 and 5.1 QI84. Growth was driven by personal consumption expenditures and fixed investment. 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 recovery of full employment depends on sustained high quarterly annual rates of growth of GDP originating in demand and fixed investment. Taxation and high interest rates may flatten dynamism from the private sector.
IV Economic Recovery. The data released in the week of May 3 are encouraging. The report of the Institute of Supply Management (ISM) registers the ninth consecutive monthly growth of manufacturing with the PMI index reaching 60.5 percent for the fastest growth since Jun 2004 (http://www.ism.ws/ISMReport/MfgROB.cfm ). The nonmanufacturing index of business activity of the ISM increased in Apr by 0.3 to reach 60.3 percent for the fifth consecutive month of growth (http://www.ism.ws/ISMReport/NonMfgROB.cfm ). Personal income increased by 0.3 percent in April and disposable income by 0.3 percent while personal consumption expenditures (PCE) increased by 0.6 percent or 2.9 percent relative to a year earlier (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm ). New orders for manufactured goods increased strongly in Mar by 1.3 percent after an increase in Feb also by 1.3 percent; new orders excluding transportation increased by 3.1 percent (http://www.census.gov/manufacturing/m3/prel/pdf/s-i-o.pdf ). Consumption, which represents more than 70 percent of the economy, is growing. The index of pending home sales of the National Association of Realtors (NAR) increased in Mar by 5.3 percent and 21.1 percent relative to a year earlier (http://www.census.gov/manufacturing/m3/prel/pdf/s-i-o.pdf ). The index is forward looking, leading the NAR to believe in a strong spring sales season. Construction spending increased in Mar by 0.2 percent above Feb but declined 12.3 percent relative to Mar 2009, showing a still depressed situation (http://www.census.gov/const/C30/release.pdf ).
VI Interest Rates. Sovereign risk deterioration in Europe, the decline in world stock markets and major reductions in risk exposures channeled funds into Treasuries, causing downward shifts of the US yield curve. On Apr 7, the yield of the 10-year Treasury stood at 3.42 percent, which was 25 basis points (bps) less than 3.67 percent a week earlier and 46 bps less than 3.88 percent a month earlier (http://markets.ft.com/markets/bonds.asp ). However, the 10-year government bond of Germany traded at a yield of 2.79 percent for a negative spread of 63 bps relative to the 10-year Treasury yield of 3.42 percent. The 10-year interest rate swap traded at 3.41 percent bid and 3.44 percent ask virtually the same at the 10-year Treasury yield of 3.42 percent (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=ICAP-070510 ). The yield differentials of sovereign bonds and private swap contracts relative to the yields of Treasuries will move substantially together with the budget deficits and debt/GDP ratio of the United States.
V Conclusion. The absorption of resources by the government sector from the private sector during the largest fiscal imbalance in the United States since World War II threatens future economic growth and the job creation by the private sector that can bring relief to the 26.9 million persons suffering job stress. Adverse expectations of unsustainable government debt in a few years may affect prices of financial assets today. The government debt crisis in the United States and other regions may affect the functioning of the financial system, employment and production and investment in the overall economy. Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10