The Erroneously Diagnosed, Inopportune, Destabilizing and Job-Destroying Dodd-Frank Bill
Carlos M Pelaez
The purpose of this post is to critically analyze the Dodd-Frank bill that is moving toward approval in Congress. Section I considers the erroneous diagnosis of the financial crisis; II analyzes the inopportune timing during a period of financial turbulence, sovereign debt risks linked to bank stress and the unsustainable government debt of the US; the destabilizing effects of the bill are considered in III and the job destruction effects in IV; V concludes.
I Erroneous Diagnosis of the Financial Crisis. The main objective of the Dodd-Frank bill is to curb by regulation the alleged causes of the credit/dollar crisis and global recession by making “Wall Street accountable.” The bill is based on the erroneous interpretation that speculative practices by financial institutions caused excessive risks, low liquidity, short-term financing, high leverage and unsound credit decisions that resulted in a meltdown of financial markets. Besides some lax regulation, such as inadequate standards on mortgage origination, the Dodd-Frank bill implicitly assumes that the government had a perfect role in rescuing financial markets, or “Wall Street,” and prompting the recovery of the production and investment side of the economy, or “Main Street.” The fact is that there are not such things as Wall Street or financial sector and Main Street or factories but rather one indivisible general economy that was devastated by a set of government policies. The combined effect of these policies was equivalent to writing a put option on house prices, that is, the owners of houses were led to believe that government policies guaranteed a floor of the houses at the price equivalent to the principal in mortgages. The government would use a set of policies to prevent house prices from declining below the level at which mortgages were contracted. There was a set of four government policies that interacted with each other in creating excessive risk, low liquidity, short-term financing, high leverage and unsound credit (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).
First, the Federal Open Market Committee (FOMC) lowered the rate for lending reserves among banks, or fed funds rate, to 1 percent and held it at that level between Jun 2003 and Jun 2004, with the forward guidance of keeping it near zero percent until necessary to prevent deflation and recover the economy. Fed interest rate policy encouraged high risks in search of higher returns and penalized liquidity that was rewarded at near zero interest rates. The low short-term interest rate also encouraged adjustable rate mortgages (ARMS) and teaser mortgages without principal payment that lowered monthly payments well below those of fixed-rate mortgages charging much higher interest rates. The low short-term interest rate of near zero also eroded evaluation of creditworthiness of mortgage borrowers because if the Fed maintained interest rates at near zero percent house prices would increase forever as more people with lower incomes would afford to buy houses with ARMS and teaser payments. In this state of permanently near zero interest rates and house prices increasing forever, the only risk to the borrower was to live in a better house for a few years and then sell it for a profit that could be used as down payment for another and better house. The lenders believed that there was no risk in lending without verification of income, assets and jobs in NINJA mortgages based on “no income, no job and no assets.” There were also “piggyback mortgages” in which a second loan provided the funds for the mortgage down payment. There was even a “Mariachi mortgage” in which the only proof of business income was a photograph of the debtor dressed in the Mariachi costume used in a part-time job. The low interest rate policy spread throughout consumer goods such as buying a vacation home in more temperate climate, a luxury third car, home theaters and so on. The Fed encouraged the population not to save or be cautious about risks, including families and financial institutions. The Fed then increased the fed funds rate from 1 percent in Jun 2004 to 5.25 percent in Jun 2006, eroding the illusion of a floor on house prices that precipitated the real estate debacle. Sales of new single-family houses declined by 32.7 percent in May 2010 relative to Apr 2010, reaching an annual rate of 300,000 (http://www.census.gov/const/newressales.pdf ). Sales of new single family houses in July 2005 stood at 1,410,000 (http://www.census.gov/const/newressales_200507.pdf ). The decline in sales of new one family houses from Jul 2005 to May 2009 is 78.7 percent as the illusion of the government-supported floor on house prices collapsed. The interest rate and housing policies of the government have caused a tragedy of millions of families suffering foreclosure or owing underwater mortgages with prices under contractual principal and interest.
Second, Treasury suspended the auctions of 30-year Treasury bonds from 2001 to 2005. The objective of the Fed supported or suggested policy was to lower mortgage rates. Insurance companies and pensions funds have long-term obligations that are matched or hedged with long-term Treasuries. The disappearance of new 30-year Treasuries caused the purchase of mortgages of equivalent maturities that increased their prices, which is the same as lowering their yields. Refinancing of mortgages at lower rates provided households significant monthly reductions in payments that were more important as a source of extra cash in some cases than the tax rebates. The policy also contributed to the increases in prices, sales and construction of houses. Price increases were so rapid that many families obtained home-equity loans used sometimes in making the payments on the houses or consuming other goods. The increase in prices of houses created the perception of an increase in wealth that motivated less cautious evaluation of risks and higher consumption.
Third, the US has maintained a yearly subsidy of housing of $221.1 billion consisting of: “$37.9 billion in government outlays for low-income housing assistance, $156.5 billion in federal tax expenditures for housing and $26.7 billion in credit subsidies, including the GSEs [Fannie Mae and Freddie Mac] and the VA [Veterans Administration]” (Dwight Jaffee and John Quigley, cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 44). The policy of affordable housing encouraged sales, construction and increases of house prices.
Fourth, Fannie Mae and Freddie Mac expanded aggressively as part of the policy of affordable housing. The portfolio of retained and guaranteed mortgages of Fannie and Freddie rose from $740 billion in 1990 to $5,243 billion in the third quarter of 2008, which was equivalent to 43.5 percent of total mortgages in the US of $12,057 billion (Pelaez and Pelaez, Financial Regulation after the Global Recession, 45). Fannie and Freddie are authorized by Congress with a charter that requires their support for guaranteeing the secondary market for residential mortgages, assisting in financing mortgages for families with low and moderate income with concern for underserved areas. In Congressional testimony, the former chief credit officer of Fannie stated that Fannie and Freddie operated with a leverage ratio of 75:1 and purchased or guaranteed $1.6 trillion in nonprime loans and securities that will account for the default of one in every six home mortgages in foreclosure (Edward Pinto, cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 47, Regulation of Banks and Finance, 219-20). The government controlled Fannie and Freddie to create the illusion of affordable houses for everybody and ever increasing prices. The population and lenders were induced into buying and financing homes under the illusion there would not be any risks, that is, that government policy would maintain a floor of house prices at the level of contracted mortgages.
II Inopportune Timing. The timing of regulation may be perceived as opportune because of the November election but it is highly inopportune because of economic and financial uncertainty. Financial turbulence is manifested in downward trends of stocks, commodities and the euro with daily capricious oscillations. The percentage decline of major stock markets from Apr 15 to Jun 25 was: Dow Global -15, Dow Asia Pacific -9.6, Shanghai Composite -19.3 and STOXX Europe 50 -11.5. The percentage decline of US indexes from Apr 26 to Jun 25 was: DJIA -9.5, S&P 500 -11.5 and NYSE Financial -14.9. The dollar appreciated 22.3 percent relative to the euro from Nov 25, 2009 to Jun 25. The DJ UBS commodity index lost 11.2 percent from Jan 6 to Jun 25 (http://online.wsj.com/mdc/public/page/mdc_us_stocks.html?mod=topnav_2_3012 ). Financial turbulence is caused by four factors of risk perceptions in financial markets. First, a potential slowdown of the Chinese economy could cause downward pressure on commodity prices and contraction of interregional trade that could slow the Asian economy. Second, the sovereign debt crisis in Europe could paralyze financial markets through the increase in counterparty credit risk perceptions. Third, the eventual major risk factor in the world economy could be the unsustainable path of the government debt of the US resulting from record peacetime budget deficits. Fourth, the Dodd-Frank bill and continuing attacks on banks could slow credit required for rapid recovery and job creation.
III Destabilizing Effects. The Senate-House conference reached agreement on the Dodd-Frank Bill (http://banking.senate.gov/public/index.cfm?FuseAction=Issues.View&Issue_id=380e9256-0461-ff42-937a-cf820569c52e http://banking.senate.gov/public/index.cfm?FuseAction=Newsroom.PressReleases&ContentRecord_id=6eb3db3b-a672-fc05-17a2-35abd1c333c9 http://professional.wsj.com/article/SB10001424052748703615104575328430427126018.html?mod=wsjproe_hps_LEADNewsCollection The summary of the Senate-approved version reveals the intent of the legislation: “Restoring American Financial Stability. Create a sound economic foundation to grow jobs, protect consumers, rein in Wall Street, end too big to fail, prevent another financial crisis” (http://banking.senate.gov/public/_files/ChairmansMarkofHR4173forConference.pdf ). The 1974 pages of the conference base-bill do not accomplish those objectives. The primary objective is to “prevent another financial crisis.” There is no rigorous theory of financial crisis that was used to analyze regulation, supposedly known only by the architects of the Dodd-Frank bill, which can prevent financial crises. The individual provisions of the bill could be destabilizing and even more so when acting simultaneously. Regulation commonly results in effects that are entirely different than those intended by legislation. The Dodd-Frank bill is not the product of protracted reasoning and consultation but of a process of give and take compared in the press to “sausage making.” Even if the initial provisions were sound, they would become unsound after the negotiation. There are at least seven evident sources of financial instability that are added by the Dodd-Frank bill, which could be jointly a major source of financial instability. (1) Amputation and resolution of companies. The regulators can take over and break financial firms without using taxpayer funds. However, Treasury would provide upfront funds for the workout that would be recovered by fees on financial institutions with more than $50 billion in assets. There is no hard knowledge by regulators or actually anybody as to what are the business lines of financial companies that contribute to financial instability. Companies that are viable as a whole may become unviable after capricious amputations of business lines. The financial system may be viable as a whole but may become unstable after surgeries of companies by regulators. The upfront Treasury contribution is with taxpayer funds but in practice will rescue those firms “too politically important to fail,” as it is the ongoing case with Fannie and Freddie that may result in a trillion-dollar bailout fully paid with taxpayer funds because both companies are now part of the budget of the US. (2) Financial Stability Council. If there had been knowledge about anticipating and controlling the crisis, the Board of Governors of the Federal Reserve Bank would have known that knowledge and required policy tools to prevent or resolve the crisis. The ten-member new agency has politicized an unknown grand concept without definition, theory and reality labeled as “systemic risk.” The new council has superimposed on the Fed a new central bank board with less knowledge and experience under ultimate control by Congress and the executive. The council will erode the Fed’s independence, interfering with best-practice central banking.
(3) Volcker Rule. Proprietary trading, hedge funds and private equity were not part of the credit/dollar crisis and global recession or of prior crises. This rule does not contribute to financial stability, constituting merely a transfer of business from some financial institutions to others under the pretence of protecting taxpayers from bailouts caused by careless risks of banks. The alleged risks would fall outside regulation. The bill weakens banks by concentrating their business on lending, foregoing diversification into other sources of income that cushioned their balance sheets during the crisis. (4) Derivatives and swaps desks spin-off. The problem was not derivatives and swaps that served to price and transfer financial risk but the clogging of financial markets with mortgage-backed securities and derivatives indexed or based on cash flows of mortgage loans that were not sound. There were few if any direct problems with derivatives that were not linked to mortgages. If financial innovations were restricted to those understood by everybody, there would be a return to the stone age of banking, much the same as there would not be any air travel unless everybody understood how a jet plane functions. (5) Trust-preferred securities. There have been no problems with trust-preferred securities that are now banned as part of capital for no understandable reason. Banks calculate economic capital that includes regulatory capital and their own extra capital cushion to weather crises and engage in acquisitions according to their business models. Without specialized knowledge and wide consultation, the Dodd-Frank bill has anticipated the Basel III capital agreement that is likely to be finalized this year and prudently implemented after banks have fully adjusted to the crisis. (6) Securitization. The objective of securitization is to transfer risk from individual bank balance sheets to many investors. The requirement that banks keep 5 percent of the transfer of risk by securitization, allegedly committing them to quality in asset-backed securities, will weaken balance sheets, interfering with overall bank risk management. (7) Hedge funds. The compulsory registration of hedge funds may reveal transactions that are required in price discovery in temporarily stressed markets. There is no evidence that hedge funds had any role in the crisis.
IV Job Destruction. There are sources of inefficiency and job destruction in the Dodd-Frank bill. (1) Exporting the financial industry. The Dodd-Frank bill is hailed as “we are poised to pass the toughest financial reform since the ones we created in the aftermath of the Great Depression” (http://www.whitehouse.gov/the-press-office/remarks-president-wall-street-reform-1 ) The new financial regulatory framework is likely to cause an exodus of the financial industry to other jurisdictions, exporting jobs when 26 million are unemployed or can only find part-time jobs. The Banking Act of 1933 (12 U.S.C. § 371a) prohibited payment of interest on demand deposits and imposed limits on interest rates paid on time deposits issued by commercial banks implemented by Regulation Q (12 C.F.R. 217) (Peláez and Peláez, Financial Regulation after the Global Recession, 57). This depression rush to regulation was motivated by the erroneous belief that banks provided high-rate risky loans to pay high competitive market interest rates on deposits, which allegedly caused banking panics in the 1930s. An added motivation was the allocation of savings to housing by maintaining low interest rate ceilings benefitting savings banks and savings and loan associations that complained of unfair competition from higher deposit rates of commercial banks. Milton Friedman analyzed in 1970 that the rise of inflation above Regulation Q interest rate ceilings caused halving of issuance of certificates of deposit (CD), which was the banking innovation created to finance rising loan volumes. Banks accounted higher-rate CDs in their European offices as “due from head office” while the head office changed the liability to “due to foreign branches” instead of “due on CDs.” Friedman predicted the future as revealing as his forecast of 1970’s stagflation: “the banks have been forced into costly structural readjustments, the European banking system has been given an unnecessary competitive advantage, and London has been artificially strengthened as a financial center at the expense of New York.” (Journal of Money, Credit and Banking 2 (Feb 1, 1970), 26-7, cited by Pelaez and Pelaez, Financial Regulation after the Global Recession, 58). The Dodd-Frank bill is anticipating global regulation with tighter US regulation. Other jurisdictions will adjust their regulation to attract the exodus of US banks and financial institutions. Jobs and the financial industry will migrate to those jurisdictions, leaving behind a backward banking system concentrated on lending that has proved to be riskier than trading. (2) Jobless recovery. US GDP increased at the annual seasonally-adjusted percentage rate of 2.2 in QIII09, 5.6 in QIV09 and 2.7 in QI10 (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. High rates of economic growth require dynamic financing by banks and other financial institutions. The Dodd-Frank bill creates a plethora of transactions and funding costs that will restrict credit and increase interest rates. Transaction costs of regulation can be quite high because of the need to seek advice, hire specialized compliance staff, redesign and implement new lines of business while phasing out older ones, revamp systems and risk management and so on. (3) Interest rates. The cost of credit to consumers and business will be higher with the Dodd-Frank bill than otherwise. There are new fees for a $19 billion fund supposedly to pay for regulation reform and an increase in insured deposits to $250,000. Bank capital will become costlier because of the new requirements. The elimination of lines of business will make banks less profitable. The concentration on lending will require higher provisions for loan losses. The combined effect will be banks and financial institutions that have higher costs of doing business. The new costs will be wholly or partially passed on to consumers and business in the form of higher cost of lower volume of credit. (4) Credit volume. The proposed solution is to politicize consumer credit by creating an agency inside the Fed led by an independent director appointed by the President and confirmed by the Senate. The result is likely to be higher interest rates and lower volumes of available credit as shown by the CARD (Credit Card Accountability, Responsibility and Disclosure) Act of May 2009 and subsequently by lower growth and employment creation. Investors will withdraw funds from stocks of financial institutions engaged in consumer credit, reducing banks’ equity capital required for lending. The consumer will be harmed instead of protected.
V Conclusion. The Dodd-Frank bill is the wrong legislation at the wrong time. The analysis of the credit/dollar crisis supporting this bill is erroneous, camouflaging the true origins in government policies of near zero interest rates and subsidies to housing. The bill is being approved at the time when the economic recovery is just beginning at a slower pace than after earlier deep recessions with 26 million people without jobs or working part-time because they cannot find another occupation. The new regulatory framework incorporates seven sources of instability in the financial system that jointly may well cause another financial crisis. It also sanctions a new “too politically important to fail,” creating the first one with the trillion-dollar bailout of Fannie and Freddie with taxpayer funds. The costs and prohibitions of banking and finance will cause the exporting of the financial sector to other jurisdictions. The lower volume of finance at higher interest rates and the unsustainable government debt will prevent recovery of the economy and full employment. The progress of the US has been through technological innovations. The bill restricts progress with hurdles on financing innovation. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
Sunday, June 27, 2010
Sunday, June 20, 2010
Financial Stress, Financial Regulation and In the Medium Run, We Are All Bankrupt
Financial Stress, Financial Regulation and In the Medium Run, We Are All Bankrupt
Carlos M. Pelaez
The objective of this post is to analyze continuing stress in financial variables. Section I documents financial stress and its causes; bank stress tests are considered in II; financial regulation is analyzed in III; the postponement of fiscal adjustment to the medium run, when we are all bankrupt, is considered in IV; economic indicators are documented in V and interest rates in VI; and VII concludes.
I Financial Stress. World financial markets continue showing signs of stress. (1). Stocks. The major stock indexes have declined from the recent peak in April but most gained during the week ending on Jun 18. The Global Dow declined from the recent peak on Apr 15 by 12.6 percent but gained 3.3 percent in the week (http://online.wsj.com/mdc/public/page/mdc_international.html?mod=topnav_2_3002 ). The DJ Asia Pacific TSM declined by 9.4 percent from the recent peak on Apr 15 but gained 3.3 percent in the week. The Shanghai Composite declined by 20.6 percent from the recent peak on Apr 15 and also declined by 2.2 percent in the week. US stock indexes are still below the recent peak on Apr 26, the DJIA by 6.7 percent and the S&P 500 by 8.2 percent, but both gained in the week, the DJIA by 2.3 percent and the S&P 500 by 2.4 percent. The NYSE Financial index fell by 15.8 percent from the recent peak and by 3.2 percent in the week. (2). Currencies. The strength of the euro has been a barometer of economic and financial conditions in Europe. The dollar appreciated by 22.1 percent from Nov 25, 2009, to Jun 18 but depreciated by 2.3 percent since Jun 11. (3). Commodities. The DJ UBS commodity index declined by 11.4 percent from Jan 6 but gained 2.7 percent in the week. Crude oil traded at $77.35/barrel on Jun 18, recovering from the recent low below $69/barrel but copper traded at 291.75 cents/pound below 300 cents/pound. (4). Financial Risk. Libor has remained unchanged at 0.539 after jumping to a level twice higher than before the euro crisis. The dollar LIBOR-OIS spread, which measures the willingness of banks to lend, has remained at 31.94 basis points (bps) after jumping from 9 bps in the first three months of the year but still substantially lower than 364 bps in Sep 2008 (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aqE6cujZAPAA ). LIBOR is critically important because it is the reference index of about $360 trillion of financial assets worldwide (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aI9wAS.ZMFLU ).
The recovery of financial variables on Jun 15 was quite strong (http://professional.wsj.com/article/SB10001424052748704009804575308241077366122.html?mod=wsjproe_hps_LEFTWhatsNews ). All US stock indexes had strong gains: 2.1 percent for the DJIA, 2.4 percent for the S&P 500 and 2.8 percent for the Nasdaq Composite. Oil futures approached $77/barrel. The successful placement of debt by Spain and Belgium strengthened the euro above $1.23/EUR. Global financial stress originates in the incidence and interrelation of four sources of vulnerabilities. First, China’s GDP has been growing since 1979 at rates at least above 6 percent and in many years at 10 percent or higher (Pelaez and Pelaez, The Global Recession Risk, 80). Tighter monetary policy to control rising property values could reduce the rate of growth of China that would lower demand for industrial commodities, causing decline in their prices. There may be more merit in explaining the surge of commodity prices in the carry trade of shorting the dollar and buying commodity futures that has been induced by the zero interest rate on fed funds (Pelaez and Pelaez, Globalization and the State, Vol. II, 203-4, Government Intervention in Globalization, 70-4). The rise of oil to $149/barrel in 2008 during a major world crisis can only be explained by carry trade positions; the decline to less than $60/barrel can only be explained by the unwinding of those positions. Fear of regulatory shocks on oil futures moved substantial part of the carry trade to gold. The zero interest rate distorts financial and economic decisions on risks and rewards. Another important effect of the decline of China’s growth would be in the form of deceleration of other Asia Pacific economies because of the importance of interregional trade. The rise of US equities markets on Jun 15 and the strengthening euro caused the increase in Asian equities when markets opened because of the hopes that US growth would provide demand for Asia’s exports. There were sharp increases in equities of exporters and the equity indexes increased by 1.8 percent in Japan, 0.9 percent in South Korea, 1.2 percent in Australia and 1 percent in Indonesia and Singapore (http://professional.wsj.com/article/SB10001424052748704009804575309503381564996.html?mod=wsjproe_hps_LEFTWhatsNews ). Manufacturing and world trade have been leading the world economy out of the recession with trade among Europe, the US and Asia being of critical importance. It is not likely that revaluation of the renminbi will have major repercussions in the economies of China, Europe and the US because there were not many effects from the prior 20 percent revaluation. However, the announcement by China on Saturday of abandoning the peg of its currency to the dollar may contribute to at least temporary stability in currency and financial markets (http://www.ft.com/cms/s/0/ac0ca08e-7ba7-11df-aa88-00144feabdc0.html http://www.pbc.gov.cn/english/detail.asp?col=6400&id=1488 ). It may also help to avoid an adverse trade confrontation among nations. Second, the recovery of financial markets during the week also proved again the key importance of recovery of Europe from the sovereign risk issues as well as the strengthening of the European banking system. Third, the most threatening event is still dormant in the form of unsustainable US budget deficits and government debt. Fourth, global financial regulation, especially in the US, is adding to stress in bank equities at the wrong time.
II Bank Stress Tests. The European Central Bank (ECB) provided EUR85.6 billion to Spanish banks, or twice the level during the Lehman Bros demise in Sep 2008, representing 16.5 percent of ECB’s net lending to the euro zone (http://www.ft.com/cms/s/0/8eb0eeda-78de-11df-a312-00144feabdc0.html ). The Financial Times quotes estimates of the Royal Bank of Scotland of foreign-held liabilities of Spain reaching $1.8 trillion, which is equivalent to 142 percent of the country’s GDP, and EUR770 billion in the form of liabilities of Spanish banks (http://www.ft.com/cms/s/0/a4bfc6ec-79a6-11df-85be-00144feabdc0.html ). European banks had record deposits of EUR364.6 billion or $369 billion deposited at the European Central Bank (ECB), earning the low 0.25 percent rate of the deposit facility (http://www.ft.com/cms/s/0/1f922206-73ea-11df-87f5-00144feabdc0.html ). Deposits of banks at the ECB in the eight years before the demise of Lehman Bros averaged about EUR277 million (http://www.bloomberg.com/apps/news?pid=20601109&sid=aHl8DzEheXq8&pos=15 ). Banks are funding with short-term ECB loans and interbank funding for one month. The 96 bidders of 7-day loans at the ECB borrowed EUR122 billion at the rate of 1 percent on Jun 8, which is about triple that of the euro interbank offered rate of 0.37 percent (Ibid). The ECB announced on May 31 that write downs of European banks in 2011 will reach EUR195 billion in addition to EUR440 billion already taken for a total of $762 billion (Ibid). The initial sovereign risk issues in Europe have evolved into concerns about the strength of the banking system. The leaders of the European Union announced on Jun 18 that 26 banks will publish stress tests in July in an effort to recover confidence in banks and financial markets in general (http://www.ft.com/cms/s/0/32b9658c-7afd-11df-8935-00144feabdc0,dwp_uuid=79cadde4-5c1b-11df-95f9-00144feab49a.html ). Stress tests are part of an arsenal of tools used by financial institutions in processes of risk management (Pelaez and Pelaez, Globalization and the State, Vol. I, 78-100, Government Intervention in Globalization, 63-4, International Financial Architecture, 112-6). Financial markets were still fractured before Mar 2009. The US engaged in stress tests of major banks and subsequent public disclosure (Pelaez and Pelaez, Financial Regulation after the Global Recession, 164, 170, Regulation of Banks and Finance, 226, 231). Criticism of banks on alleged lack of understanding of complex products by most everybody is unwarranted. Most travelers do not have knowledge of how jet planes function but benefit from rapid transportation worldwide. Accidents occur because of the limitations of human knowledge. The problems with structured products originated in policies that effectively replicated the cash flows of writing by the government of a put option on house prices that could eventually not be honored (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). A jet plane requires high-grade fuel much the same as structured products cannot function properly with referenced unsound mortgages created by policy exuberance in the form of financing of everything at near zero interest rates of fed funds and purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie and Freddie. The partial costs to taxpayers of bailing out Fannie and Freddie are now estimated to be at least $160 billion but could reach as much as $1 trillion, without any provision in financial regulation laws (http://www.bloomberg.com/apps/news?pid=20601109&sid=an_hcY9YaJas&pos=10 ). Financial institutions have been performing stress tests or the use of multiple technical methods in calculating potential effects on values of exposures resulting from exceptional but still possible events. Stress tests attempt to measure what would happen to banks’ viability in case of wide swings of risk factors. The critical issue in the European bank stress-test exercises is whether the banks are sufficiently capitalized to take a hit on their capital originating in wide swings in variables that affect their risk exposures. At the extreme, stress tests can prove that almost any bank can disappear with wild shocks of financial variables even with Tier 1 capital above that proposed in Basel III, while stress testing with benign shocks of variables may not be convincing. Banks conduct regular stress tests that they share with regulators and the likely direction of the new stress tests is probably already known now instead of by the disclosure date in July. The outcome of the exercise is highly dependent on how financial stress evolves in the next months because under higher confidence weak results of stress tests could be dismissed by market participants.
III Financial Regulation. Crises are not opportunities for financial regulation. The Glass-Steagall Act of 1933 was proposed on the basis of alleged conflicts of interest of commercial banks in the form of unloading their bad loans by placing unsound securities with investors that have been disproved by well-established facts (see work by Randall Kroszner and Raghuram Rajan and vast literature cited in Pelaez and Pelaez, Globalization and the State Vol. I, 48, Government Intervention in Globalization, 45 Financial Regulation after the Global Recession, 91-101 and Regulation of Banks and Finance, 121-9). The current rush to regulation is similar to that in the 1930s that has been demystified by more careful technical work. The merging process of the inopportune House and Senate financial bills still struggles with issues that had nothing to do with the causes of the credit/dollar crisis and global recession or with any other alleged benefit of stability and efficiency in finance. The spinoff of swap derivatives desks of banks will be very costly to banks (http://professional.wsj.com/article/SB10001424052748703685404575307042349354142.html?mod=wsjproe_hps_LEFTWhatsNews ), increasing risks that could not be hedged with adverse instability effects, exporting the financial industry to other jurisdictions and harming the general public. Amputations of bank activities that have never posed risk, such as in the Volcker Rule, may unsettle currently viable institutions that could become unviable after regulatory surgery. The entire system may become crisis-prone by concentration of activities in credit instead of diversification that helps to soften cyclical impacts. US banks will become uncompetitive and unable to finance the international operations of US firms and large domestic projects required for growth of the American economy. Bulk financing of factories is required to create jobs that provide income for building of homes and financing investment in education. A more politicized Fed will be the result of subjecting to politics the 12 regional Federal Reserve Banks that have been independent for 97 years (http://professional.wsj.com/article/SB10001424052748704575304575297130299281828.html ). Government-owned and controlled banks have been more unstable and inefficient (Pelaez and Pelaez, Regulation of Banks and Finance, 227-9). The UK regulatory reform, while ambitious, is being more pragmatic than in the US, proceeding with careful review that will allow banks to recover before actual implementation of new regulation (http://professional.wsj.com/article/SB10001424052748704198004575310451098811086.html?mod=wsjproe_hps_LEFTWhatsNews ). US regulation will sharply increase bank costs, squeezing profits and capital. The general effect will be lower volume of financing and higher interest costs. Banks will find themselves in the difficult position of raising fees in the effort to avoid higher hits on their operations (http://professional.wsj.com/article/SB20001424052748703513604575311093932315142.html ). The message of the US to the G20 consists of: “stronger oversight of derivatives markets, more transparency and disclosure and more effective framework for winding down large global firms” (http://www.whitehouse.gov/sites/default/files/rss_viewer/president_obama_letter_to_g-20_061610.pdf ). The House and Senate bills have arbitrary provisions that jeopardize functions of financial institutions and markets with unknown but likely adverse effects of the entire bill, which defies technical analysis and experience. Financial regulation may restrict growth and recovery by contracting credit and increasing borrowing costs.
IV In the Medium Run, We Are All Bankrupt. The message of the US to the G20 identifies the top priority “to safeguard and strengthen the recovery,” calling for “unity of purpose to provide the policy support necessary to keep economic growth strong” (http://www.whitehouse.gov/sites/default/files/rss_viewer/president_obama_letter_to_g-20_061610.pdf ), which can be interpreted as “continued stimulus” or higher expenditures (http://www.businessweek.com/news/2010-06-18/obama-tells-g-20-to-strengthen-economic-recovery-update4-.html ). At the same time, the US message pleads for commitment “to fiscal adjustment” to stabilize “debt-to-GDP ratios at appropriate levels over the medium term” (http://www.whitehouse.gov/sites/default/files/rss_viewer/president_obama_letter_to_g-20_061610.pdf ). The famous phrase of John Maynard Keynes “in the long-run, we are all dead” in the Tract on Monetary Reform means to Keynesians that we live in the short run (http://www.econlib.org/library/Enc/KeynesianEconomics.html ). The current agenda is geared to alleged benefits of restructuring the economy toward the very long run. The delay of the control of the budget deficit and debt to the “medium term” may have the meaning of a new phrase: “in the medium run, we are all bankrupt.” The International Monetary Fund (IMF) projects the general government gross debt of the US at 92.6 percent in 2010, rising to 109.7 percent in 2015 and the general government net debt at 66.2 percent in 2010, rising to 85.5 percent in 2015. In 2008, the government gross debt was 70.6 percent of GDP and the government net debt was 47.2 percent of GDP (http://www.imf.org/external/pubs/ft/weo/2010/01/weodata/weorept.aspx?sy=2008&ey=2015&scsm=1&ssd=1&sort=country&ds=.&br=1&c=156%2C158%2C132%2C112%2C134%2C111%2C136&s=NGDP%2CGGXWDN_NGDP%2CGGXWDG_NGDP%2CNGDP_FY&grp=0&a=&pr1.x=59&pr1.y=15 ). The risk of a US debt stress event is that markets may discount to present value or current prices of financial assets the future consequences on risk, production and output of an unsustainable government debt.
V Economic Indicators. Manufacturing continues to lead the recovery of the US economy and inflation is subdued while housing and employment remain doubtful. The Empire State Manufacturing Survey of the New York Federal Reserve Bank finds improving conditions in Jun for the eleventh consecutive month (http://www.newyorkfed.org/survey/empire/empiresurvey_overview.html ). The Philadelphia Fed Business Outlook Survey finds that manufacturing is expanding in Jun but at slower rhythm than in May; manufacturing executives continue to expect growth in business in the next six months (http://www.phil.frb.org/research-and-data/regional-economy/business-outlook-survey/2010/bos0610.cfm ). The index of industrial production of the Fed finds an increase of industrial production in May of 1.2 percent after an increase in Apr of 0.7 percent; manufacturing increased 0.9 percent in May, standing higher than a year ago by 7.9 percent. Capacity utilization for total industry increased by one percentage point to 74.7 percent, which is higher by 6.2 percentage points than a year earlier but is still 5.9 percentage points below the average for 1972-2009 (http://www.federalreserve.gov/releases/g17/Current/default.htm ). The producer price index for finished goods fell 0.3 percent in May and is higher by 5.3 percent in the 12 months ending in May (http://www.federalreserve.gov/releases/g17/Current/default.htm ). The consumer price index fell 0.2 percent in May and increased by 2.0 percent in the 12 months ending in May (http://www.bls.gov/news.release/pdf/cpi.pdf ). The US current account deficit rose from a revised $100.9 billion in the fourth quarter of 2009 to $109.0 billion in the first quarter of 2010. The deficit was the third consecutive quarterly increase since the second quarter of 2009 when the deficit was $84.4 billion, which was the lowest since the third quarter of 1999 (http://www.bea.gov/newsreleases/international/transactions/transnewsrelease.htm ). Simple extrapolation of the deficit for the year of $436 billion is equivalent to about 3 percent of the CBO estimate of 2010 GDP of $14,706 billion (http://www.cbo.gov/ftpdocs/108xx/doc10871/01-26-Outlook.pdf ), which is significantly lower than predictions of two-digit current account deficits as percent of GDP before the credit crisis (Pelaez and Pelaez, The Global Recession Risk, 20-55). Housing recovery may be slow and prolonged. In Jan 2006, housing starts in the US were at an annual rate of 2265 thousand (http://www.census.gov/const/newresconst_200701.pdf ). In May 2010, housing starts were at an annual rate of 574 thousand, higher by 4.4 percent over a year earlier but 74.7 percent below the level in Jan 2006 (http://www.census.gov/const/newresconst_201002.pdf ). New unemployment insurance claims rose by 12 thousand in the week ending on Jun 12, reaching 472 thousand relative to 460 thousand in the prior week (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
VI Interest Rates. The use of Treasuries as intermediate safe haven for risk positions has resulted in the decrease of the yield of the 10-year Treasury from 3.986 percent on Apr 5 to 3.145 percent on Jun 7, 3.239 percent on Jun 11 and 3.225 per cent on Jun 18 (http://online.wsj.com/mdc/public/page/mdc_bonds.html?mod=mdc_topnav_2_3000 ). The yield curve is now almost undistinguishable over the past month with the 10-year Treasury almost equal at 2.23 percent from the level a week ago at 3.22 percent and 3.25 percent a month ago (http://markets.ft.com/markets/bonds.asp ). The German 10-year government bond traded on Friday at 2.73 percent for a negative spread of 50 bps relative to the comparable Treasury.
VII Conclusion. There are significant uncertainties in Asia, Europe and the United States that cause stress of financial variables. The regulatory shock in the US constitutes a threat to financial stability, economic recovery and employment creation. The unsustainable government debt of the US may translate into a new phrase that “in the medium run, we are all bankrupt.” (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
Carlos M. Pelaez
The objective of this post is to analyze continuing stress in financial variables. Section I documents financial stress and its causes; bank stress tests are considered in II; financial regulation is analyzed in III; the postponement of fiscal adjustment to the medium run, when we are all bankrupt, is considered in IV; economic indicators are documented in V and interest rates in VI; and VII concludes.
I Financial Stress. World financial markets continue showing signs of stress. (1). Stocks. The major stock indexes have declined from the recent peak in April but most gained during the week ending on Jun 18. The Global Dow declined from the recent peak on Apr 15 by 12.6 percent but gained 3.3 percent in the week (http://online.wsj.com/mdc/public/page/mdc_international.html?mod=topnav_2_3002 ). The DJ Asia Pacific TSM declined by 9.4 percent from the recent peak on Apr 15 but gained 3.3 percent in the week. The Shanghai Composite declined by 20.6 percent from the recent peak on Apr 15 and also declined by 2.2 percent in the week. US stock indexes are still below the recent peak on Apr 26, the DJIA by 6.7 percent and the S&P 500 by 8.2 percent, but both gained in the week, the DJIA by 2.3 percent and the S&P 500 by 2.4 percent. The NYSE Financial index fell by 15.8 percent from the recent peak and by 3.2 percent in the week. (2). Currencies. The strength of the euro has been a barometer of economic and financial conditions in Europe. The dollar appreciated by 22.1 percent from Nov 25, 2009, to Jun 18 but depreciated by 2.3 percent since Jun 11. (3). Commodities. The DJ UBS commodity index declined by 11.4 percent from Jan 6 but gained 2.7 percent in the week. Crude oil traded at $77.35/barrel on Jun 18, recovering from the recent low below $69/barrel but copper traded at 291.75 cents/pound below 300 cents/pound. (4). Financial Risk. Libor has remained unchanged at 0.539 after jumping to a level twice higher than before the euro crisis. The dollar LIBOR-OIS spread, which measures the willingness of banks to lend, has remained at 31.94 basis points (bps) after jumping from 9 bps in the first three months of the year but still substantially lower than 364 bps in Sep 2008 (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aqE6cujZAPAA ). LIBOR is critically important because it is the reference index of about $360 trillion of financial assets worldwide (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aI9wAS.ZMFLU ).
The recovery of financial variables on Jun 15 was quite strong (http://professional.wsj.com/article/SB10001424052748704009804575308241077366122.html?mod=wsjproe_hps_LEFTWhatsNews ). All US stock indexes had strong gains: 2.1 percent for the DJIA, 2.4 percent for the S&P 500 and 2.8 percent for the Nasdaq Composite. Oil futures approached $77/barrel. The successful placement of debt by Spain and Belgium strengthened the euro above $1.23/EUR. Global financial stress originates in the incidence and interrelation of four sources of vulnerabilities. First, China’s GDP has been growing since 1979 at rates at least above 6 percent and in many years at 10 percent or higher (Pelaez and Pelaez, The Global Recession Risk, 80). Tighter monetary policy to control rising property values could reduce the rate of growth of China that would lower demand for industrial commodities, causing decline in their prices. There may be more merit in explaining the surge of commodity prices in the carry trade of shorting the dollar and buying commodity futures that has been induced by the zero interest rate on fed funds (Pelaez and Pelaez, Globalization and the State, Vol. II, 203-4, Government Intervention in Globalization, 70-4). The rise of oil to $149/barrel in 2008 during a major world crisis can only be explained by carry trade positions; the decline to less than $60/barrel can only be explained by the unwinding of those positions. Fear of regulatory shocks on oil futures moved substantial part of the carry trade to gold. The zero interest rate distorts financial and economic decisions on risks and rewards. Another important effect of the decline of China’s growth would be in the form of deceleration of other Asia Pacific economies because of the importance of interregional trade. The rise of US equities markets on Jun 15 and the strengthening euro caused the increase in Asian equities when markets opened because of the hopes that US growth would provide demand for Asia’s exports. There were sharp increases in equities of exporters and the equity indexes increased by 1.8 percent in Japan, 0.9 percent in South Korea, 1.2 percent in Australia and 1 percent in Indonesia and Singapore (http://professional.wsj.com/article/SB10001424052748704009804575309503381564996.html?mod=wsjproe_hps_LEFTWhatsNews ). Manufacturing and world trade have been leading the world economy out of the recession with trade among Europe, the US and Asia being of critical importance. It is not likely that revaluation of the renminbi will have major repercussions in the economies of China, Europe and the US because there were not many effects from the prior 20 percent revaluation. However, the announcement by China on Saturday of abandoning the peg of its currency to the dollar may contribute to at least temporary stability in currency and financial markets (http://www.ft.com/cms/s/0/ac0ca08e-7ba7-11df-aa88-00144feabdc0.html http://www.pbc.gov.cn/english/detail.asp?col=6400&id=1488 ). It may also help to avoid an adverse trade confrontation among nations. Second, the recovery of financial markets during the week also proved again the key importance of recovery of Europe from the sovereign risk issues as well as the strengthening of the European banking system. Third, the most threatening event is still dormant in the form of unsustainable US budget deficits and government debt. Fourth, global financial regulation, especially in the US, is adding to stress in bank equities at the wrong time.
II Bank Stress Tests. The European Central Bank (ECB) provided EUR85.6 billion to Spanish banks, or twice the level during the Lehman Bros demise in Sep 2008, representing 16.5 percent of ECB’s net lending to the euro zone (http://www.ft.com/cms/s/0/8eb0eeda-78de-11df-a312-00144feabdc0.html ). The Financial Times quotes estimates of the Royal Bank of Scotland of foreign-held liabilities of Spain reaching $1.8 trillion, which is equivalent to 142 percent of the country’s GDP, and EUR770 billion in the form of liabilities of Spanish banks (http://www.ft.com/cms/s/0/a4bfc6ec-79a6-11df-85be-00144feabdc0.html ). European banks had record deposits of EUR364.6 billion or $369 billion deposited at the European Central Bank (ECB), earning the low 0.25 percent rate of the deposit facility (http://www.ft.com/cms/s/0/1f922206-73ea-11df-87f5-00144feabdc0.html ). Deposits of banks at the ECB in the eight years before the demise of Lehman Bros averaged about EUR277 million (http://www.bloomberg.com/apps/news?pid=20601109&sid=aHl8DzEheXq8&pos=15 ). Banks are funding with short-term ECB loans and interbank funding for one month. The 96 bidders of 7-day loans at the ECB borrowed EUR122 billion at the rate of 1 percent on Jun 8, which is about triple that of the euro interbank offered rate of 0.37 percent (Ibid). The ECB announced on May 31 that write downs of European banks in 2011 will reach EUR195 billion in addition to EUR440 billion already taken for a total of $762 billion (Ibid). The initial sovereign risk issues in Europe have evolved into concerns about the strength of the banking system. The leaders of the European Union announced on Jun 18 that 26 banks will publish stress tests in July in an effort to recover confidence in banks and financial markets in general (http://www.ft.com/cms/s/0/32b9658c-7afd-11df-8935-00144feabdc0,dwp_uuid=79cadde4-5c1b-11df-95f9-00144feab49a.html ). Stress tests are part of an arsenal of tools used by financial institutions in processes of risk management (Pelaez and Pelaez, Globalization and the State, Vol. I, 78-100, Government Intervention in Globalization, 63-4, International Financial Architecture, 112-6). Financial markets were still fractured before Mar 2009. The US engaged in stress tests of major banks and subsequent public disclosure (Pelaez and Pelaez, Financial Regulation after the Global Recession, 164, 170, Regulation of Banks and Finance, 226, 231). Criticism of banks on alleged lack of understanding of complex products by most everybody is unwarranted. Most travelers do not have knowledge of how jet planes function but benefit from rapid transportation worldwide. Accidents occur because of the limitations of human knowledge. The problems with structured products originated in policies that effectively replicated the cash flows of writing by the government of a put option on house prices that could eventually not be honored (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). A jet plane requires high-grade fuel much the same as structured products cannot function properly with referenced unsound mortgages created by policy exuberance in the form of financing of everything at near zero interest rates of fed funds and purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie and Freddie. The partial costs to taxpayers of bailing out Fannie and Freddie are now estimated to be at least $160 billion but could reach as much as $1 trillion, without any provision in financial regulation laws (http://www.bloomberg.com/apps/news?pid=20601109&sid=an_hcY9YaJas&pos=10 ). Financial institutions have been performing stress tests or the use of multiple technical methods in calculating potential effects on values of exposures resulting from exceptional but still possible events. Stress tests attempt to measure what would happen to banks’ viability in case of wide swings of risk factors. The critical issue in the European bank stress-test exercises is whether the banks are sufficiently capitalized to take a hit on their capital originating in wide swings in variables that affect their risk exposures. At the extreme, stress tests can prove that almost any bank can disappear with wild shocks of financial variables even with Tier 1 capital above that proposed in Basel III, while stress testing with benign shocks of variables may not be convincing. Banks conduct regular stress tests that they share with regulators and the likely direction of the new stress tests is probably already known now instead of by the disclosure date in July. The outcome of the exercise is highly dependent on how financial stress evolves in the next months because under higher confidence weak results of stress tests could be dismissed by market participants.
III Financial Regulation. Crises are not opportunities for financial regulation. The Glass-Steagall Act of 1933 was proposed on the basis of alleged conflicts of interest of commercial banks in the form of unloading their bad loans by placing unsound securities with investors that have been disproved by well-established facts (see work by Randall Kroszner and Raghuram Rajan and vast literature cited in Pelaez and Pelaez, Globalization and the State Vol. I, 48, Government Intervention in Globalization, 45 Financial Regulation after the Global Recession, 91-101 and Regulation of Banks and Finance, 121-9). The current rush to regulation is similar to that in the 1930s that has been demystified by more careful technical work. The merging process of the inopportune House and Senate financial bills still struggles with issues that had nothing to do with the causes of the credit/dollar crisis and global recession or with any other alleged benefit of stability and efficiency in finance. The spinoff of swap derivatives desks of banks will be very costly to banks (http://professional.wsj.com/article/SB10001424052748703685404575307042349354142.html?mod=wsjproe_hps_LEFTWhatsNews ), increasing risks that could not be hedged with adverse instability effects, exporting the financial industry to other jurisdictions and harming the general public. Amputations of bank activities that have never posed risk, such as in the Volcker Rule, may unsettle currently viable institutions that could become unviable after regulatory surgery. The entire system may become crisis-prone by concentration of activities in credit instead of diversification that helps to soften cyclical impacts. US banks will become uncompetitive and unable to finance the international operations of US firms and large domestic projects required for growth of the American economy. Bulk financing of factories is required to create jobs that provide income for building of homes and financing investment in education. A more politicized Fed will be the result of subjecting to politics the 12 regional Federal Reserve Banks that have been independent for 97 years (http://professional.wsj.com/article/SB10001424052748704575304575297130299281828.html ). Government-owned and controlled banks have been more unstable and inefficient (Pelaez and Pelaez, Regulation of Banks and Finance, 227-9). The UK regulatory reform, while ambitious, is being more pragmatic than in the US, proceeding with careful review that will allow banks to recover before actual implementation of new regulation (http://professional.wsj.com/article/SB10001424052748704198004575310451098811086.html?mod=wsjproe_hps_LEFTWhatsNews ). US regulation will sharply increase bank costs, squeezing profits and capital. The general effect will be lower volume of financing and higher interest costs. Banks will find themselves in the difficult position of raising fees in the effort to avoid higher hits on their operations (http://professional.wsj.com/article/SB20001424052748703513604575311093932315142.html ). The message of the US to the G20 consists of: “stronger oversight of derivatives markets, more transparency and disclosure and more effective framework for winding down large global firms” (http://www.whitehouse.gov/sites/default/files/rss_viewer/president_obama_letter_to_g-20_061610.pdf ). The House and Senate bills have arbitrary provisions that jeopardize functions of financial institutions and markets with unknown but likely adverse effects of the entire bill, which defies technical analysis and experience. Financial regulation may restrict growth and recovery by contracting credit and increasing borrowing costs.
IV In the Medium Run, We Are All Bankrupt. The message of the US to the G20 identifies the top priority “to safeguard and strengthen the recovery,” calling for “unity of purpose to provide the policy support necessary to keep economic growth strong” (http://www.whitehouse.gov/sites/default/files/rss_viewer/president_obama_letter_to_g-20_061610.pdf ), which can be interpreted as “continued stimulus” or higher expenditures (http://www.businessweek.com/news/2010-06-18/obama-tells-g-20-to-strengthen-economic-recovery-update4-.html ). At the same time, the US message pleads for commitment “to fiscal adjustment” to stabilize “debt-to-GDP ratios at appropriate levels over the medium term” (http://www.whitehouse.gov/sites/default/files/rss_viewer/president_obama_letter_to_g-20_061610.pdf ). The famous phrase of John Maynard Keynes “in the long-run, we are all dead” in the Tract on Monetary Reform means to Keynesians that we live in the short run (http://www.econlib.org/library/Enc/KeynesianEconomics.html ). The current agenda is geared to alleged benefits of restructuring the economy toward the very long run. The delay of the control of the budget deficit and debt to the “medium term” may have the meaning of a new phrase: “in the medium run, we are all bankrupt.” The International Monetary Fund (IMF) projects the general government gross debt of the US at 92.6 percent in 2010, rising to 109.7 percent in 2015 and the general government net debt at 66.2 percent in 2010, rising to 85.5 percent in 2015. In 2008, the government gross debt was 70.6 percent of GDP and the government net debt was 47.2 percent of GDP (http://www.imf.org/external/pubs/ft/weo/2010/01/weodata/weorept.aspx?sy=2008&ey=2015&scsm=1&ssd=1&sort=country&ds=.&br=1&c=156%2C158%2C132%2C112%2C134%2C111%2C136&s=NGDP%2CGGXWDN_NGDP%2CGGXWDG_NGDP%2CNGDP_FY&grp=0&a=&pr1.x=59&pr1.y=15 ). The risk of a US debt stress event is that markets may discount to present value or current prices of financial assets the future consequences on risk, production and output of an unsustainable government debt.
V Economic Indicators. Manufacturing continues to lead the recovery of the US economy and inflation is subdued while housing and employment remain doubtful. The Empire State Manufacturing Survey of the New York Federal Reserve Bank finds improving conditions in Jun for the eleventh consecutive month (http://www.newyorkfed.org/survey/empire/empiresurvey_overview.html ). The Philadelphia Fed Business Outlook Survey finds that manufacturing is expanding in Jun but at slower rhythm than in May; manufacturing executives continue to expect growth in business in the next six months (http://www.phil.frb.org/research-and-data/regional-economy/business-outlook-survey/2010/bos0610.cfm ). The index of industrial production of the Fed finds an increase of industrial production in May of 1.2 percent after an increase in Apr of 0.7 percent; manufacturing increased 0.9 percent in May, standing higher than a year ago by 7.9 percent. Capacity utilization for total industry increased by one percentage point to 74.7 percent, which is higher by 6.2 percentage points than a year earlier but is still 5.9 percentage points below the average for 1972-2009 (http://www.federalreserve.gov/releases/g17/Current/default.htm ). The producer price index for finished goods fell 0.3 percent in May and is higher by 5.3 percent in the 12 months ending in May (http://www.federalreserve.gov/releases/g17/Current/default.htm ). The consumer price index fell 0.2 percent in May and increased by 2.0 percent in the 12 months ending in May (http://www.bls.gov/news.release/pdf/cpi.pdf ). The US current account deficit rose from a revised $100.9 billion in the fourth quarter of 2009 to $109.0 billion in the first quarter of 2010. The deficit was the third consecutive quarterly increase since the second quarter of 2009 when the deficit was $84.4 billion, which was the lowest since the third quarter of 1999 (http://www.bea.gov/newsreleases/international/transactions/transnewsrelease.htm ). Simple extrapolation of the deficit for the year of $436 billion is equivalent to about 3 percent of the CBO estimate of 2010 GDP of $14,706 billion (http://www.cbo.gov/ftpdocs/108xx/doc10871/01-26-Outlook.pdf ), which is significantly lower than predictions of two-digit current account deficits as percent of GDP before the credit crisis (Pelaez and Pelaez, The Global Recession Risk, 20-55). Housing recovery may be slow and prolonged. In Jan 2006, housing starts in the US were at an annual rate of 2265 thousand (http://www.census.gov/const/newresconst_200701.pdf ). In May 2010, housing starts were at an annual rate of 574 thousand, higher by 4.4 percent over a year earlier but 74.7 percent below the level in Jan 2006 (http://www.census.gov/const/newresconst_201002.pdf ). New unemployment insurance claims rose by 12 thousand in the week ending on Jun 12, reaching 472 thousand relative to 460 thousand in the prior week (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
VI Interest Rates. The use of Treasuries as intermediate safe haven for risk positions has resulted in the decrease of the yield of the 10-year Treasury from 3.986 percent on Apr 5 to 3.145 percent on Jun 7, 3.239 percent on Jun 11 and 3.225 per cent on Jun 18 (http://online.wsj.com/mdc/public/page/mdc_bonds.html?mod=mdc_topnav_2_3000 ). The yield curve is now almost undistinguishable over the past month with the 10-year Treasury almost equal at 2.23 percent from the level a week ago at 3.22 percent and 3.25 percent a month ago (http://markets.ft.com/markets/bonds.asp ). The German 10-year government bond traded on Friday at 2.73 percent for a negative spread of 50 bps relative to the comparable Treasury.
VII Conclusion. There are significant uncertainties in Asia, Europe and the United States that cause stress of financial variables. The regulatory shock in the US constitutes a threat to financial stability, economic recovery and employment creation. The unsustainable government debt of the US may translate into a new phrase that “in the medium run, we are all bankrupt.” (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
Sunday, June 13, 2010
Financial Turbulence and the Global Debt/Financial Crisis
Financial Turbulence and the Global Debt/Financial Crisis
Carlos M Pelaez
This post provides an analysis of financial turbulence and its consequences for recovery and employment in terms of four vulnerabilities: China’s growth and commodities, sovereign risk issues, US budget deficits and debt and financial regulation. Section I documents financial turbulence; the factors of financial turbulence are analyzed in section II; economic indicators are analyzed in section III and interest rates in section IV; section V concludes.
I Financial Turbulence. There is financial turbulence in the trend of stocks from recent highs and in sharp intraday fluctuations. Similar turbulence is manifested in foreign exchange rates, prices of commodities futures, fixed income markets and indicators of financial risk. These financial variables are discussed in turn. 1. Stocks. The Dow Jones Industrial Average (DJIA) fell to 6547.05 on Mar 9, 2009 after reaching 14,164.53 on Oct 9, 2007, for a decline of 53.8 percent. The DJIA has recovered to 10,211.07 at the close of market on Jun 11, for an increase of 56 percent (http://online.wsj.com/mdc/public/page/marketsdata.html?refresh=on ). However, the DJIA fell from a recent high of 11,205.03 on Apr 26 to the close of market on Jun 11 or by 8.9 percent. On Monday Jun 7, the DJIA dropped 115.48 points to a seven-month low of 9816.49, for a decline of 1.2 percent, mostly at the end of trading, and of 12.4 percent relative to the recent high on Apr 26 (http://professional.wsj.com/article/SB20001424052748703303904575292171374533404.html ). On Jun 10, the DJIA jumped 273.28 point for an increase of 2.8 percent. This financial turbulence in stock markets is explained by the conjecture of apparent indecision of market players in finding direction or trends of major financial variables. It is also evident in other major stock markets in the form of declines from recent highs to the close of market on Jun 11: -12.3 in the DJ Asia-Pacific TSM from Apr 15, -18.8 percent in the Shanghai Composite from Apr 15,
-10.7 percent in the STOXX Europe 50 from Apr 15 and -15.7 in the NYSE Financial from Apr 15. 2. FX Rates. The dollar has appreciated relative to the euro by 25 percent from the high on Nov 11, 2009 to Jun 11 and by 26.9 percent relative to the turmoil of Jun 7 (http://online.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3051 ). Currencies also fluctuate sharply during individual market days. 3 Commodities. Prices of industrial commodities such as crude oil and copper have fluctuated sharply. The flight out of risk was accompanied on Jun 7 by an increase of 1.9 percent in gold prices for Jun delivery. There was sharp rise of gold prices by 2 percent in less than an hour. The DJ UBS Commodity Futures Index fell by 13.8 percent from Jan 6 to Jun 11 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_cmd_dtabnk&symb=DJUBS ). 4. Bonds. The 10-year Treasury has declined from a recent high of 3.986 percent on Apr 5 to a low of 3.145 on Jun 7, closing at 3.239 percent on Jun 11 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_bnd_dtabnk&symb=UST10Y&page=bond ). The decline in yields is explained by market analysts as the flight into Treasuries for temporary safe haven from risk exposures. 5. Financial Risk. European banks had record deposits of EUR364.6 billion or $440 billion deposited at the European Central Bank (ECB), earning the low 0.25 percent rate of the deposit facility (http://www.ft.com/cms/s/0/1f922206-73ea-11df-87f5-00144feabdc0.html ). US banks increased their reserves deposited at the Fed during the credit crisis and global recession because of the difficulty of assessing lending risk and higher perceptions of risk in transactions with financial counterparties (Pelaez and Pelaez, Financial Regulation after the Global Recession, 158-60, Regulation of Banks and Finance, 225-6). Bloomberg analyzes the indicators of financial risk (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a3JnMp3QMK_8 ). The 3-month LIBOR rate remained around 0.54 percent in the week of Jun 7 after more than doubling this year because of the sovereign risk issues. Markets calmed toward the last days of the week. The dollar-LIBOR OIS spread, which measures risk in transactions with financial counterparties stabilized at 32.5 basis points (bps), much higher than around 9 bps in the first quarter of 2010 but still significantly lower than 364 bps in Sep 2008.
II Factors of Financial Turbulence. The analytical explanation of financial turbulence requires a general equilibrium model of the world economy with specifications for financial markets. A more available option is an analytical narrative in terms of four vulnerabilities that recur in the financial media and in commentary by market participants. These four factors, (1) China’s growth, (2) sovereign risk issues, (3) US government deficits and debt and (4) financial regulation, are discussed in turn. 1. China’s Growth and Commodities. China has been growing at very high relative rates of growth of GDP and GDP per capita since 1991 after a slowdown in 1989-1990 (National Bureau of Statistics of China cited in Pelaez and Pelaez, The Global Recession Risk, 80). Recent data and analysis find that the economy continues to grow but with some concerns about property values and inflation (http://professional.wsj.com/article/SB10001424052748704575304575297462164585550.html?mod=wsjproe_hps_LEFTWhatsNews ). Accelerating world trade is shown by growth of merchandise exports of China by 48.5 percent in May relative to a year earlier. Manufacturing output grew by 16.5 percent in May relative to a year earlier. However, consumer price inflation is rising above 3 percent per year. The major source of concern is in the growth of construction starts by 72.4 per year in May relative to last year together with 44.1 percent in acquisition of land by developers. The decline of Chinese stocks and of industrial commodities such as crude oil and copper from recent highs is attributed to concerns that more restrictive monetary policy may be used by the authorities to prevent adverse events in property markets. Interregional trade in Asia is extremely important for growth. There are concerns that a slowing Chinese economy could impact Asian growth and the rest of the world economy. Investors’ perspectives and risk decisions change with new releases of data and information on the Chinese economy and related markets.
(2) Sovereign Risks. Government revenues decline during recessions because income contraction causes declines of tax receipts and expenditures rise in efforts to maintain economic activity. The euro zone is composed of countries with diverse performance in exports and in fiscal balances. Export economies are moving forward with high growth of manufacturing and lower fiscal imbalances. Economies with fiscal imbalances are experiencing difficulties with credit ratings and refinancing because of high debt/GDP ratios. The European Union is implementing a major bailout program for countries experiencing debt stress. Moreover, banks in the countries with lower debt/GDP ratios and fiscal imbalances have significant exposures to entities in countries with debt stress. As with all similar programs, evaluations of the potential success in resolving the sovereign risk issues fluctuate. The euro and financial markets worldwide are affected by the perceptions of resolution of the sovereign risk issues.
(3) United States Budget Imbalance. The fiscal imbalance and movement of the US debt in an unsustainable path may prove the most important factor of vulnerability of the world’s financial markets and global economy because of the size of the US economy and financial markets. McKinsey and Company and the Committee on Capital Markets Regulation analyze the dimensions of the US financial services industry in 2005 (cited in Pelaez and Pelaez, Globalization and the State, Vol. II, 169-72, Government Intervention in Globalization, 160-3). The financial services industry represented 8.1 percent of US GDP, providing 6 million jobs or about 5 percent of total private sector employment in 2005. The financial stock of the US, consisting of equities, bonds, loans and deposits, was $51 trillion followed by $35 trillion in the euro zone and $20 trillion in Japan. The US global share in investment banking was 42 percent. The International Monetary Fund (IMF) projects the general government gross debt of the US at 92.6 percent in 2010, rising to 109.7 percent in 2015 and the general government net debt at 66.2 percent in 2010, rising to 85.5 percent in 2015. In 2008, the government gross debt was 70.6 percent of GDP and the government net debt was 47.2 percent of GDP (http://www.imf.org/external/pubs/ft/weo/2010/01/weodata/weorept.aspx?sy=2008&ey=2015&scsm=1&ssd=1&sort=country&ds=.&br=1&c=156%2C158%2C132%2C112%2C134%2C111%2C136&s=NGDP%2CGGXWDN_NGDP%2CGGXWDG_NGDP%2CNGDP_FY&grp=0&a=&pr1.x=59&pr1.y=15 ). The risk of a US debt stress event is that markets may discount to present value or current prices of financial assets the future consequences on risk, production and output of an unsustainable government debt. In testimony on Jun 9 to the Committee on the Budget of the US House of Representatives, Chairman Bernanke reiterated his perceptive analysis and advice of the US fiscal situation: “Achieving long-term fiscal sustainability will be difficult. But unless we as a nation make 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/testimony/bernanke20100609a.htm ). If the US continues on an unsustainable debt path, financial asset prices and rates will begin to reflect the combination of a forced solution of fiscal imbalances by higher taxes and interest rates, sharp government expenditure reduction and disguised default in the form of dollar depreciation.
(4) Financial Regulation. Regulatory legislation and the general economy continue crossing each other in opposite railroad tracks without noticing each other as trains in London fog. The acts approved by the House and the Senate are quite complex (http://s.wsj.net/public/resources/documents/st_finregcompare0610_20100607.html ). It is difficult to technically justify the individual provisions. The end product of “reconciling” both laws will not improve functioning of financial markets, increasing interest rates and reducing loan volumes. The final law would not have prevented the credit/dollar crisis because it is based on an interpretation that solely blames private financial institutions when government policy was more important in creating the crisis. Near zero interest rates by the Fed and lower mortgage rates by suspending auctions of 30-year Treasuries combined with a housing subsidy of $221 billion per year and purchase or acquisition of $1.6 trillion of nonprime mortgages by Fannie Mae and Freddie Mac to create a housing surplus, eventual collapse of housing prices causing underwater mortgages, excessive risks and low liquidity by banks and households and unsound credit that caused the collapse of finance and the general economy (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 Institute of International Finance (IIF) calculates that the implementation of global financial regulation would cumulatively reduce US GDP by 2.6 percent in 2011-2015 and employment by 4.6 million. The euro zone GDP would be lower by 4.3 percent and employment by 4.7 million and Japan’s GDP would be lower by 3.1 percent and employment by 0.5 million (http://www.iif.com/ ). A law growing from 1500 pages has inexplicable provisions such as mandating the Fed to determine rates of 0.75 to 1.25 percent charged by banks on debit cards to vendors of transactions sold to bank customers (http://professional.wsj.com/article/SB10001424052748704256604575295072627703504.html?mod=wsjproe_hps_LEFTWhatsNews ). The concern of banks is that technological costs would be excluded by the wording of the bill such that in the future bank customers would have to return to stone-age times when they withdraw cash from their bank accounts to pay for transactions after the demise of the debit card and/or its technological inferiority. A more likely occurrence is higher bank costs, resulting in lower credit volumes at higher interest rates. There are no explanations of how such controls of debit cards by the Fed would have prevented the credit crisis and improve markets or why credit cards and not only debit cards are singled out by the law.
III Economic Indicators. There are encouraging signs of economic recovery but labor markets may still be under stress. The report by the Fed on the Flow of Funds Accounts of the United States provides encouraging information that household net worth, or value of assets less value of liabilities, increased by $1.1 trillion to reach $54.6 trillion in the first quarter of 2010 (http://www.federalreserve.gov/releases/z1/Current/z1.pdf ). Household debt fell for the seventh consecutive quarter at the annual rate of 2.5 percent. State and local government debt increased at the 4.25 percent annual rate while federal government debt rose at the annual rate of 18.5 percent, which was much higher than 12.6 percent in the earlier quarter but lower than annual rates ranging from 20.6 percent to 28.2 percent in the first three quarters of 2009. Another encouraging sign in similarity with other economies is that US exports of goods and services increased by 19.9 percent from Apr 2009 to Apr 2010 and imports by 23.9 percent, that is, trade is growing at very high rates, suggesting growth in the world economy (http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf ). The trade deficit in Apr was $40.3 billion, or exports of $148.8 billion less imports of $189.1 billion, slightly higher than $40.0 billion in Mar. The trade deficit is deteriorating from the lower levels during the recession, causing again concerns about joint trade and fiscal imbalances. Sales of merchant wholesalers grew by 0.7 percent in Apr relative to Mar and by 16.3 percent from a year earlier (http://www2.census.gov/wholesale/pdf/mwts/currentwhl.pdf ). Combined sales and shipments of manufacturers in Apr grew by 0.6 percent relative to Mar and by 13.1 percent relative to Apr 2009 (http://www.census.gov/mtis/www/data/pdf/mtis_current.pdf ). Revenue of the US information sector in the first quarter of 2010 grew by 1.1 percent over the prior quarter and 2.3 percent relative to the first quarter of 2009. Revenue of US professional, scientific and technical services increased by 3.1 percent in the first quarter relative to the prior quarter and by 3.4 percent relative to the first quarter of 2009 (http://www2.census.gov/services/qss/qss-current.pdf ). Advanced estimates of US retail and food services for May fell by 1.2 percent from the prior month but were higher by 6.9 percent relative to May 2009. However, sales in the Mar to May 2010 period were higher by 8.1 percent relative to the same period in 2009 (http://www.census.gov/retail/marts/www/marts_current.pdf ). New initial claims of unemployment insurance fell by 3000 in the week ending Jun 5 to 456K relative to the revised 459K in the prior week (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
IV Interest Rates. The flight out of risk exposures continued to drive the downward shift of the US yield curve. The 10-year Treasury was 3.23 percent on Jun 11 almost identical to 3.21 percent a week earlier but 22 bps below 3.55 percent a month earlier (http://markets.ft.com/markets/bonds.asp ). A similar force is apparent in the sharp decline of the yield of the 10-year German government bond to 2.57 percent, trading at a negative spread of 66 bps relative to the US 10-year Treasury yield at 3.21 percent.
V Conclusions. Trade information of individual countries suggests rapid growth of world trade and economic activity. Financial market turbulence is casting shadows of a global debt and financial crisis. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
Carlos M Pelaez
This post provides an analysis of financial turbulence and its consequences for recovery and employment in terms of four vulnerabilities: China’s growth and commodities, sovereign risk issues, US budget deficits and debt and financial regulation. Section I documents financial turbulence; the factors of financial turbulence are analyzed in section II; economic indicators are analyzed in section III and interest rates in section IV; section V concludes.
I Financial Turbulence. There is financial turbulence in the trend of stocks from recent highs and in sharp intraday fluctuations. Similar turbulence is manifested in foreign exchange rates, prices of commodities futures, fixed income markets and indicators of financial risk. These financial variables are discussed in turn. 1. Stocks. The Dow Jones Industrial Average (DJIA) fell to 6547.05 on Mar 9, 2009 after reaching 14,164.53 on Oct 9, 2007, for a decline of 53.8 percent. The DJIA has recovered to 10,211.07 at the close of market on Jun 11, for an increase of 56 percent (http://online.wsj.com/mdc/public/page/marketsdata.html?refresh=on ). However, the DJIA fell from a recent high of 11,205.03 on Apr 26 to the close of market on Jun 11 or by 8.9 percent. On Monday Jun 7, the DJIA dropped 115.48 points to a seven-month low of 9816.49, for a decline of 1.2 percent, mostly at the end of trading, and of 12.4 percent relative to the recent high on Apr 26 (http://professional.wsj.com/article/SB20001424052748703303904575292171374533404.html ). On Jun 10, the DJIA jumped 273.28 point for an increase of 2.8 percent. This financial turbulence in stock markets is explained by the conjecture of apparent indecision of market players in finding direction or trends of major financial variables. It is also evident in other major stock markets in the form of declines from recent highs to the close of market on Jun 11: -12.3 in the DJ Asia-Pacific TSM from Apr 15, -18.8 percent in the Shanghai Composite from Apr 15,
-10.7 percent in the STOXX Europe 50 from Apr 15 and -15.7 in the NYSE Financial from Apr 15. 2. FX Rates. The dollar has appreciated relative to the euro by 25 percent from the high on Nov 11, 2009 to Jun 11 and by 26.9 percent relative to the turmoil of Jun 7 (http://online.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3051 ). Currencies also fluctuate sharply during individual market days. 3 Commodities. Prices of industrial commodities such as crude oil and copper have fluctuated sharply. The flight out of risk was accompanied on Jun 7 by an increase of 1.9 percent in gold prices for Jun delivery. There was sharp rise of gold prices by 2 percent in less than an hour. The DJ UBS Commodity Futures Index fell by 13.8 percent from Jan 6 to Jun 11 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_cmd_dtabnk&symb=DJUBS ). 4. Bonds. The 10-year Treasury has declined from a recent high of 3.986 percent on Apr 5 to a low of 3.145 on Jun 7, closing at 3.239 percent on Jun 11 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_bnd_dtabnk&symb=UST10Y&page=bond ). The decline in yields is explained by market analysts as the flight into Treasuries for temporary safe haven from risk exposures. 5. Financial Risk. European banks had record deposits of EUR364.6 billion or $440 billion deposited at the European Central Bank (ECB), earning the low 0.25 percent rate of the deposit facility (http://www.ft.com/cms/s/0/1f922206-73ea-11df-87f5-00144feabdc0.html ). US banks increased their reserves deposited at the Fed during the credit crisis and global recession because of the difficulty of assessing lending risk and higher perceptions of risk in transactions with financial counterparties (Pelaez and Pelaez, Financial Regulation after the Global Recession, 158-60, Regulation of Banks and Finance, 225-6). Bloomberg analyzes the indicators of financial risk (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a3JnMp3QMK_8 ). The 3-month LIBOR rate remained around 0.54 percent in the week of Jun 7 after more than doubling this year because of the sovereign risk issues. Markets calmed toward the last days of the week. The dollar-LIBOR OIS spread, which measures risk in transactions with financial counterparties stabilized at 32.5 basis points (bps), much higher than around 9 bps in the first quarter of 2010 but still significantly lower than 364 bps in Sep 2008.
II Factors of Financial Turbulence. The analytical explanation of financial turbulence requires a general equilibrium model of the world economy with specifications for financial markets. A more available option is an analytical narrative in terms of four vulnerabilities that recur in the financial media and in commentary by market participants. These four factors, (1) China’s growth, (2) sovereign risk issues, (3) US government deficits and debt and (4) financial regulation, are discussed in turn. 1. China’s Growth and Commodities. China has been growing at very high relative rates of growth of GDP and GDP per capita since 1991 after a slowdown in 1989-1990 (National Bureau of Statistics of China cited in Pelaez and Pelaez, The Global Recession Risk, 80). Recent data and analysis find that the economy continues to grow but with some concerns about property values and inflation (http://professional.wsj.com/article/SB10001424052748704575304575297462164585550.html?mod=wsjproe_hps_LEFTWhatsNews ). Accelerating world trade is shown by growth of merchandise exports of China by 48.5 percent in May relative to a year earlier. Manufacturing output grew by 16.5 percent in May relative to a year earlier. However, consumer price inflation is rising above 3 percent per year. The major source of concern is in the growth of construction starts by 72.4 per year in May relative to last year together with 44.1 percent in acquisition of land by developers. The decline of Chinese stocks and of industrial commodities such as crude oil and copper from recent highs is attributed to concerns that more restrictive monetary policy may be used by the authorities to prevent adverse events in property markets. Interregional trade in Asia is extremely important for growth. There are concerns that a slowing Chinese economy could impact Asian growth and the rest of the world economy. Investors’ perspectives and risk decisions change with new releases of data and information on the Chinese economy and related markets.
(2) Sovereign Risks. Government revenues decline during recessions because income contraction causes declines of tax receipts and expenditures rise in efforts to maintain economic activity. The euro zone is composed of countries with diverse performance in exports and in fiscal balances. Export economies are moving forward with high growth of manufacturing and lower fiscal imbalances. Economies with fiscal imbalances are experiencing difficulties with credit ratings and refinancing because of high debt/GDP ratios. The European Union is implementing a major bailout program for countries experiencing debt stress. Moreover, banks in the countries with lower debt/GDP ratios and fiscal imbalances have significant exposures to entities in countries with debt stress. As with all similar programs, evaluations of the potential success in resolving the sovereign risk issues fluctuate. The euro and financial markets worldwide are affected by the perceptions of resolution of the sovereign risk issues.
(3) United States Budget Imbalance. The fiscal imbalance and movement of the US debt in an unsustainable path may prove the most important factor of vulnerability of the world’s financial markets and global economy because of the size of the US economy and financial markets. McKinsey and Company and the Committee on Capital Markets Regulation analyze the dimensions of the US financial services industry in 2005 (cited in Pelaez and Pelaez, Globalization and the State, Vol. II, 169-72, Government Intervention in Globalization, 160-3). The financial services industry represented 8.1 percent of US GDP, providing 6 million jobs or about 5 percent of total private sector employment in 2005. The financial stock of the US, consisting of equities, bonds, loans and deposits, was $51 trillion followed by $35 trillion in the euro zone and $20 trillion in Japan. The US global share in investment banking was 42 percent. The International Monetary Fund (IMF) projects the general government gross debt of the US at 92.6 percent in 2010, rising to 109.7 percent in 2015 and the general government net debt at 66.2 percent in 2010, rising to 85.5 percent in 2015. In 2008, the government gross debt was 70.6 percent of GDP and the government net debt was 47.2 percent of GDP (http://www.imf.org/external/pubs/ft/weo/2010/01/weodata/weorept.aspx?sy=2008&ey=2015&scsm=1&ssd=1&sort=country&ds=.&br=1&c=156%2C158%2C132%2C112%2C134%2C111%2C136&s=NGDP%2CGGXWDN_NGDP%2CGGXWDG_NGDP%2CNGDP_FY&grp=0&a=&pr1.x=59&pr1.y=15 ). The risk of a US debt stress event is that markets may discount to present value or current prices of financial assets the future consequences on risk, production and output of an unsustainable government debt. In testimony on Jun 9 to the Committee on the Budget of the US House of Representatives, Chairman Bernanke reiterated his perceptive analysis and advice of the US fiscal situation: “Achieving long-term fiscal sustainability will be difficult. But unless we as a nation make 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/testimony/bernanke20100609a.htm ). If the US continues on an unsustainable debt path, financial asset prices and rates will begin to reflect the combination of a forced solution of fiscal imbalances by higher taxes and interest rates, sharp government expenditure reduction and disguised default in the form of dollar depreciation.
(4) Financial Regulation. Regulatory legislation and the general economy continue crossing each other in opposite railroad tracks without noticing each other as trains in London fog. The acts approved by the House and the Senate are quite complex (http://s.wsj.net/public/resources/documents/st_finregcompare0610_20100607.html ). It is difficult to technically justify the individual provisions. The end product of “reconciling” both laws will not improve functioning of financial markets, increasing interest rates and reducing loan volumes. The final law would not have prevented the credit/dollar crisis because it is based on an interpretation that solely blames private financial institutions when government policy was more important in creating the crisis. Near zero interest rates by the Fed and lower mortgage rates by suspending auctions of 30-year Treasuries combined with a housing subsidy of $221 billion per year and purchase or acquisition of $1.6 trillion of nonprime mortgages by Fannie Mae and Freddie Mac to create a housing surplus, eventual collapse of housing prices causing underwater mortgages, excessive risks and low liquidity by banks and households and unsound credit that caused the collapse of finance and the general economy (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 Institute of International Finance (IIF) calculates that the implementation of global financial regulation would cumulatively reduce US GDP by 2.6 percent in 2011-2015 and employment by 4.6 million. The euro zone GDP would be lower by 4.3 percent and employment by 4.7 million and Japan’s GDP would be lower by 3.1 percent and employment by 0.5 million (http://www.iif.com/ ). A law growing from 1500 pages has inexplicable provisions such as mandating the Fed to determine rates of 0.75 to 1.25 percent charged by banks on debit cards to vendors of transactions sold to bank customers (http://professional.wsj.com/article/SB10001424052748704256604575295072627703504.html?mod=wsjproe_hps_LEFTWhatsNews ). The concern of banks is that technological costs would be excluded by the wording of the bill such that in the future bank customers would have to return to stone-age times when they withdraw cash from their bank accounts to pay for transactions after the demise of the debit card and/or its technological inferiority. A more likely occurrence is higher bank costs, resulting in lower credit volumes at higher interest rates. There are no explanations of how such controls of debit cards by the Fed would have prevented the credit crisis and improve markets or why credit cards and not only debit cards are singled out by the law.
III Economic Indicators. There are encouraging signs of economic recovery but labor markets may still be under stress. The report by the Fed on the Flow of Funds Accounts of the United States provides encouraging information that household net worth, or value of assets less value of liabilities, increased by $1.1 trillion to reach $54.6 trillion in the first quarter of 2010 (http://www.federalreserve.gov/releases/z1/Current/z1.pdf ). Household debt fell for the seventh consecutive quarter at the annual rate of 2.5 percent. State and local government debt increased at the 4.25 percent annual rate while federal government debt rose at the annual rate of 18.5 percent, which was much higher than 12.6 percent in the earlier quarter but lower than annual rates ranging from 20.6 percent to 28.2 percent in the first three quarters of 2009. Another encouraging sign in similarity with other economies is that US exports of goods and services increased by 19.9 percent from Apr 2009 to Apr 2010 and imports by 23.9 percent, that is, trade is growing at very high rates, suggesting growth in the world economy (http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf ). The trade deficit in Apr was $40.3 billion, or exports of $148.8 billion less imports of $189.1 billion, slightly higher than $40.0 billion in Mar. The trade deficit is deteriorating from the lower levels during the recession, causing again concerns about joint trade and fiscal imbalances. Sales of merchant wholesalers grew by 0.7 percent in Apr relative to Mar and by 16.3 percent from a year earlier (http://www2.census.gov/wholesale/pdf/mwts/currentwhl.pdf ). Combined sales and shipments of manufacturers in Apr grew by 0.6 percent relative to Mar and by 13.1 percent relative to Apr 2009 (http://www.census.gov/mtis/www/data/pdf/mtis_current.pdf ). Revenue of the US information sector in the first quarter of 2010 grew by 1.1 percent over the prior quarter and 2.3 percent relative to the first quarter of 2009. Revenue of US professional, scientific and technical services increased by 3.1 percent in the first quarter relative to the prior quarter and by 3.4 percent relative to the first quarter of 2009 (http://www2.census.gov/services/qss/qss-current.pdf ). Advanced estimates of US retail and food services for May fell by 1.2 percent from the prior month but were higher by 6.9 percent relative to May 2009. However, sales in the Mar to May 2010 period were higher by 8.1 percent relative to the same period in 2009 (http://www.census.gov/retail/marts/www/marts_current.pdf ). New initial claims of unemployment insurance fell by 3000 in the week ending Jun 5 to 456K relative to the revised 459K in the prior week (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
IV Interest Rates. The flight out of risk exposures continued to drive the downward shift of the US yield curve. The 10-year Treasury was 3.23 percent on Jun 11 almost identical to 3.21 percent a week earlier but 22 bps below 3.55 percent a month earlier (http://markets.ft.com/markets/bonds.asp ). A similar force is apparent in the sharp decline of the yield of the 10-year German government bond to 2.57 percent, trading at a negative spread of 66 bps relative to the US 10-year Treasury yield at 3.21 percent.
V Conclusions. Trade information of individual countries suggests rapid growth of world trade and economic activity. Financial market turbulence is casting shadows of a global debt and financial crisis. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
Sunday, June 6, 2010
The Biggest Bailout in History, Exporting the US Financial Industry and the 26 Million in Job Stress
The Biggest Bailout in History, Exporting the US Financial Industry and the 26 Million in Job Stress
Carlos M Pelaez
In memoriam Ed Mendez
The subject of section I is the biggest bailout in history, which will be the bailout by taxpayers of the growing US government debt that surpassed $13 trillion in the unsustainable road to 100 percent of GDP. Section II analyzes how US legislation is forcing the overseas exodus of the US financial industry. There are 26 million persons in job stress in the analysis of the employment report in section III. The short-term economic indicators analyzed in section IV continue to show strength in manufacturing but weakness in real estate. Section V concludes. This post is in memory of our good friend Ed Mendez.
I The Biggest Bailout in History. The “number of the week” is that the total national debt of the US exceeded $13 trillion (http://blogs.wsj.com/economics/2010/06/05/number-of-the-week-us-debt-nears-key-threshold/ ). The International Monetary Fund (IMF) projects the general government gross debt of the US at 92.6 percent in 2010, rising to 109.7 percent in 2015 and the general government net debt at 66.2 percent in 2010, rising to 85.5 percent in 2015. In 2008, the government gross debt was 70.6 percent of GDP and the government net debt was 47.2 percent of GDP (http://www.imf.org/external/pubs/ft/weo/2010/01/weodata/weorept.aspx?sy=2008&ey=2015&scsm=1&ssd=1&sort=country&ds=.&br=1&c=156%2C158%2C132%2C112%2C134%2C111%2C136&s=NGDP%2CGGXWDN_NGDP%2CGGXWDG_NGDP%2CNGDP_FY&grp=0&a=&pr1.x=59&pr1.y=15 ). The unsustainable path of the government debt of the US could be the single most important risk factor of the world economy, shadowing debts in other regions. At some point financial assets such as bonds will reflect the deteriorating fiscal situation of the US in prices that incorporate higher interest rates. The biggest bailout in history is by taxpayers who will pay the bailout of their government with a combination of higher taxes and interest rates, lower income growth and job creation and a depreciating dollar. A point of explosion may occur because slower growth restricts tax revenue and the ceiling of the capacity to increase taxes as percent of economic activity or GDP may force aggressive expenditure reductions. A current poll by Gallup finds that 40 percent of the interviewed consider the federal government debt as an extremely serious perceived threat to US future wellbeing, 39 percent consider it as very serious and 20 percent as not very serious or not a threat at all (http://www.gallup.com/poll/139385/Federal-Debt-Terrorism-Considered-Top-Threats.aspx ). The finance ministers and central bank governors of the G20 meeting in Busan state in the Communiqué of Jun 5 that: “those countries with serious fiscal challenges need to accelerate the pace of consolidation” (http://www.g20.utoronto.ca/2010/g20finance100605.html ). The 10-year Treasury closed at 3.30 percent on Jun 4, lower than 3.30 percent a week earlier and 3.39 percent a month earlier in an aberrant yield curve with a segment of near zero percent and then rising for maturities longer than two years (http://markets.ft.com/markets/bonds.asp ). The equally aberrant Fed balance sheet of $2.3 trillion dollars (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ) constitutes an additional threat on interest rates that can restrict the recovery and job creation. The combined government debt and Fed balance sheet are implicitly based on the view that fast economic recovery for some unknown reason may absorb with tax collections and higher interest rates the debt and the disposal of the securities in the Fed balance sheet. The expectation of higher taxes and interest rates may frustrate economic recovery, preventing the full taxation of the deficit that will expand with rising interest rates.
II Exporting the US Financial Industry. Financial turbulence continues to plague world financial markets and the economy. There have been sharp declines in stock market indexes from recent peaks: -11.6 percent in the Dow Jones Asia/Pacific Total Stock Market Index from Apr 15 to Jun 4; -19.3 percent in the Shanghai SE Composite from Apr 15 to Jun 4; -12.4 percent in the STOXX Europe 50 from Apr 15 to Jun 4; -11.7 percent in the Dow Jones Industrial Average from Apr 26 to Jun 4; and -18.7 percent in the NYSE Financial Index from Apr 15 to Jun 4 (http://online.wsj.com/mdc/public/page/mdc_us_stocks.html?mod=topnav_2_3051 ). The indicators of financial risk reported by Bloomberg continue at high levels (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aMBjAK8Mf.xg ). Three-month dollar LIBOR was fixed at 0.53656, remaining at the highest weekly level since Jul. The LIBOR-OIS spread inferred from contracts traded in forward markets is 49.15 basis points (bps) for Sept and 52.69 bps for Dec compared with 31.3 bps on Jun 4. The swap rate, or difference between the two-year swap rate and the comparable Treasury note yield, rose 5.3 bps to 48 bps. The European Central Bank informed that banks in the euro zone could experience $239 billion write-downs because of the sovereign risk deterioration in Europe. (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aMBjAK8Mf.xg ). Risk perceptions in transactions among financial counterparties are at very high levels.
There are two divergent financial regulation movements. First, most of the world’s banks will be subject to new capital rules under a Basel III agreement that may be finalized by the end of this year (for soft law and the Basel accords see Pelaez and Pelaez, International Financial Architecture, 239-300, Globalization and the State Vol. II, 114-48, Government Intervention in Globalization, 145-50, Financial Regulation after the Global Recession, 54-6, Regulation of Banks and Finance, 69-70). The initial intention for implementation of Basel III was at the end of 2012 in order to allow sufficient time for recovery of the world economy and financial markets. The negotiating countries are considering postponing implementation after 2012 (http://professional.wsj.com/article/SB10001424052748704183204575287930895807598.html?mod=wsjproe_hps_LEFTWhatsNews ). Second, the US is moving toward rushed reconciliation of the Senate and House financial regulation bills for final approval and signing by the President before Jul 4. Timing instead of substance has priority. The new financial regulatory framework is likely to cause an exodus of the financial industry to other jurisdictions. The Banking Act of 1933 (12 U.S.C. § 371a) prohibited payment of interest on demand deposits and imposed limits on interest rates paid on time deposits issued by commercial banks implemented by Regulation Q (12 C.F.R. 217) (Peláez and Peláez, Financial Regulation after the Global Recession, 57). This depression rush to regulation was motivated by the erroneous belief that banks provided high-rate risky loans to pay high competitive market interest rates on deposits, which allegedly caused banking panics in the 1930s. An added motivation was the allocation of savings to housing by maintaining low interest rate ceilings benefitting savings banks and savings and loan associations that complained of unfair competition from higher deposit rates of commercial banks. Milton Friedman analyzed in 1970 that the rise of inflation above Regulation Q interest rate ceilings caused halving of issuance of certificates of deposit (CD), which was the banking innovation created to finance rising loan volumes. Banks accounted higher-rate CDs in their European offices as “due from head office” while the head office changed the liability to “due to foreign branches” instead of “due on CDs.” Friedman predicted the future as revealing as his forecast of 1970’s stagflation: “the banks have been forced into costly structural readjustments, the European banking system has been given an unnecessary competitive advantage, and London has been artificially strengthened as a financial center at the expense of New York.” (Journal of Money, Credit and Banking 2 (Feb 1, 1970), 26-7, cited by Pelaez and Pelaez, Financial Regulation after the Global Recession, 58). People of modest means with lower income and wealth having no alternatives other than bankbook accounts received rates on their savings below those that would prevail in freer markets. Regulation transferred income from poorer depositors to endow banks with market power. The financial system was forced into costly readjustments while highly-paid financial jobs and economic activity were exported to foreign countries. The interest rate is the main compass of allocating savings and capital in a market economy but it was distorted by ill-conceived Great Depression regulation that is still emulated currently. The new financial regulation bill will also harm the most people of modest means.
In a remarkable anticipation of a key driver of the credit crisis in 2005, Professor Raghuram G. Rajan warned of the risks of illiquidity in financial transactions with an incentive for such illiquidity in the search for yields in an environment of low interest rates after a period of high rates (http://www.kc.frb.org/publicat/sympos/2005/PDF/Rajan2005.pdf cited in Pelaez and Pelaez, Regulation of Banks and Finance, 219). In a revealing article in the Financial Times on Jun 3, Professor Rajan analyzes the actual causes of the credit crisis and global recession (http://www.ft.com/cms/s/0/1182490e-6ea7-11df-ad16-00144feabdc0.html ), with important lessons in his successful must-read book on Fault Lines (http://www.amazon.com/Raghuram-Rajan/e/B0039XA4X8/ref=sr_tc_2_0?qid=1275829501&sr=1-2-ent ). Financial transactions play an important social role in allocating resources. Short-selling by traders of the equity of a company may deprive it from resources. If short-selling traders value correctly, resources would not be wasted in projects with negative present value of future cash flows; if short-selling traders value incorrectly, compensatory long positions by other traders will punish their error with losses and channel the resources to projects with positive net present value. A key function of financial markets is pricing risk. The search for the causes of the credit crisis is on why there were excessive rewards to unsound decisions with excessive risk, or how risk was mispriced. The interpretation of Professor Rajan is that a “tsunami” of money allocated by Congressional action to promote low-income housing together with an inflow of foreign capital into the US eroded the discipline in home loans or adequate calculus of risk and liquidity. The decision by the Fed to maintain low interest rates in fear of deflation and the jobless recovery camouflaged the costs of an illiquid balance sheet. Another equivalent form of viewing this interpretation is that the Fed and the housing subsidy were equivalent to the government writing a put option or floor on housing prices (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 government created the illusion that house prices would increase forever above the floor of abnormally-high prices at which mortgages had been contracted. Millions of homeowners with underwater mortgages, or home prices in a nearly impossible imagined sale that are below mortgage principal and interest, were doomed by government housing and interest rate policies. The regulators and legislators who created the crisis are reshaping financial regulation that resembling the Banking Act of 1933 will export the financial industry of the US to other jurisdictions and also this time raise interest rates by increasing the cost of financial intermediation required for growth and job creation.
III The 26 Million Persons in Job Stress. The employment report for May released on Jun 4 together with news of the concern over the debt of Hungary caused significant stress in financial markets worldwide. The Dow Jones Industrial Average (DJIA) fell 323.31 points equivalent to -3.2 percent, closing at 9931.97, which is down by 4.8 percent in 2010 (http://professional.wsj.com/article/SB10001424052748704764404575286093848380232.html?mod=wsjproe_hps_LEFTWhatsNews ). The DAX index of Germany declined about 2 percent and the CAC 40 of France fell 2.9 percent. The NASDAQ Composite index declined 3.6 percent and the S&P 500 fell 3.4 percent. The Dow Jones US Total Market Index, capturing the market value of almost all publicly-traded companies in the US, lost $480 billion of market value in just one day, or half a trillion dollars in more commonly-used dimensions in these times. The euro closed at $1.1966 for a week’s decline against the dollar of 2.5 percent. Copper futures prices fell 4.3 percent and crude-oil futures dropped 4.2 percent. The employment report raised doubts on the recovery of employment that would be required for growth of the general economy. A common argument is that personal consumption expenditures account for 71 percent of GDP (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=5&FirstYear=2009&LastYear=2010&Freq=Qtr ) and could be restricted by the weight of 26 million people in job stress and perceptions by many of those employed that their jobs may be at risk.
The focus of concern is that the increase in nonfarm payrolls by 431K in May, where K stands for thousand, consisted almost entirely of the addition of 411K temporary government workers for Census 2010. The increase in private sector employment was only 41K (http://www.bls.gov/news.release/pdf/empsit.pdf ). The revised increase in private nonfarm jobs for Apr was an increase by 218K, following an increase by 158K in Mar and 62K in Feb. The breakdown of job creation in the private sector in May illustrates the nature of the recovery that is confirmed by other short-term indicators considered in the next section IV. The bright hope of employment has been in the goods producing sector, which added 57K in Mar and 62K in Apr but only 4K in May. Manufacturing in the US, as elsewhere in the world, is leading the recovery with job creation of 19K in Mar, 40K in Apr and 29K in May, originating mostly in durable goods production. Construction added 27K jobs in Mar and 15K in Apr but destroyed 35K in May presumably because of the end of the tax credit of up to $8000 for the first-time purchase of a home. The surplus of houses created by the government subsidy directly or through interest rates near zero percent bloated construction followed by contraction after the collapse of house prices beginning in 2006. Many people are forced into difficult transfer to other occupations because the same jobs are seldom recovered in recessions. The private service-providing sector added 101K jobs in Mar and 156K in Apr but only 37K in May. Upward trends were reversed in all subsectors of services with the exception of temporary help services that have been adding an average of 29.9K jobs per month, including 31.0K in May. Retail trade destroyed 6.6K jobs in May perhaps because of the early Easter and financial activities destroyed 12K. Government added 50K in Mar, 72K in Apr and 390K in May mostly driven by temporary hiring for Census 2010. Short-term economic indicators fluctuate widely such that the May number could still be reversed in future months.
The household survey data continue to raise concerns about the employment situation of the US. (1) The unemployment rate declined from 9.9 percent in Apr to 9.7 percent in May, which is the same as in the first three months of 2010, but mainly because people dropped out from the labor force by ceasing to seek employment in the belief that none was available for them. The US labor forced declined by 322K from Apr into May. The number of unemployed is 15.0 million compared with 15.3 million in Apr largely because of the decrease in the labor force of 322K. (2) The percentage of unemployed persons that have been jobless for 27 weeks or more was about unchanged at 6.8 million, which is equivalent to 46.0 percent of unemployed persons and more or less the same as in Apr. The chances of finding employment after six months of unemployment diminish because of eroding marketable skills. (3) There were 8.809 million persons in May in involuntary part-time jobs because their work hours had been cut or because they could not find a full-time job. The number employed involuntarily in part-time jobs declined by 343K from 9.152 million in Apr. (4) The number of persons marginally attached to the labor force reached 2.2 million in May; these are persons not in the labor force, wanting and available for work and looking for a job in the prior 12 months but not in the past four weeks. The number of discouraged workers remained more or less stable at 1 million. (5) The unemployed of 15.0 million, the marginally attached to the labor force of 2.2 million and the 8.8 million in involuntary part-time jobs add to 26.0 million under job stress in May. The difference of 900K with the 26.9 million in job stress in April is explained by the decline of 300K in the unemployed mostly because they were dropped from the labor force after desisting from seeking a job, and declines in the marginally attached to the labor force and involuntarily employed part time. Job stress in the US economy continues to be extremely high.
US GDP increased at the annual seasonally-adjusted percentage rate of 2.2 in QIII09, 5.6 in QIV09 and 3.0 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. The agenda has focused on legislative restructurings of business models for alleged long-term structural gains. A jobs agenda should induce private-sector economic activity by allowing the optimum choice of business models. Legislative restructuring in a tough recession may be politically opportune but highly inopportune for recovery and job creation. The uncertainty of the next restructuring or the implementation of already enacted restructurings may create the expectation of job stress throughout the entire labor force. Jobs lost as a consequence of restructurings force a nearly impossible transfer to other occupations.
IV Economic Indicators. Both the industry and services reports of the Institute for Supply Management (ISM) continue to show accelerating economic recovery. The purchasing managers’ index (PMI) of manufacturing was 59.7 in May relative to 60.4 in Apr. Indexes above 50 indicate expansion. The PMI for economic activity in manufacturing has been showing growth of the sector during 10 consecutive months and of the overall economy during 13 consecutive months (http://www.ism.ws/ISMReport/MfgROB.cfm ). The non-manufacturing PMI (NM/PMI) remained at 55.4 in May and the index for business activity and production rose to 61.1 in May relative to 60.3 in Apr. The non-manufacturing sector has been growing during five consecutive months (http://www.ism.ws/ISMReport/NonMfgROB.cfm ). Sales of US autos grew for the seventh consecutive month. Sales of cars and light trucks rose in May by 19 percent to 1.1 million vehicles. The annualized rate of sales was 11.68 million in May, which was higher than 11.2 million in Apr and significantly above 9.86 million a year ago. All producers originating in the US or abroad had significant increases in sales, ranging from 17 percent to 33 percent (http://professional.wsj.com/article/SB10001424052748703561604575282473282622364.html?mg=reno-wsj ). Construction spending rose by 2.7 percent in Apr 2010 but was still below Apr 2009 by 10.5 percent (http://www.census.gov/const/C30/release.pdf ). New orders of manufactured goods in Apr rose by 1.2 percent, growing in 12 of the past 13 months and by a revised 1.7 percent in Mar (http://www.census.gov/manufacturing/m3/prel/pdf/s-i-o.pdf ). The pending home sales index of the National Association of Realtors (NAR) rose by 6.0 percent on the basis of contracts signed in Apr and is above the level in Apr 2009 by 22.4 percent (http://www.realtor.org/press_room/news_releases/2010/06/pending_surge ). Early data suggest that house sales fell significantly in May, perhaps by as much as 25 to 30 percent because of the expiration of the tax credit for first-time home buyers (http://www.realtor.org/press_room/news_releases/2010/06/pending_surge ). In the first four months of 2010, construction spending was below the same period in 2009 by 13.2 percent (http://www.census.gov/const/C30/release.pdf ). New claims for unemployment insurance fell from a revised level in the prior week of 463K to 453K for the week ending on May 29 but still remain at a high level (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
V Conclusions. The G20 finance ministers and central bank governors elevate fiscal consolidation to a key priority of global cooperation. Financial regulation in Basel III may be finalized this year but its implementation may be delayed beyond 2012 because of the turmoil in financial markets and the incipient economic recovery. The agenda of the US continues with legislative restructurings, ignoring the plight of 26 million people and moving divergently from calls for fiscal consolidation and delays in shocking the financial system with regulation. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
Carlos M Pelaez
In memoriam Ed Mendez
The subject of section I is the biggest bailout in history, which will be the bailout by taxpayers of the growing US government debt that surpassed $13 trillion in the unsustainable road to 100 percent of GDP. Section II analyzes how US legislation is forcing the overseas exodus of the US financial industry. There are 26 million persons in job stress in the analysis of the employment report in section III. The short-term economic indicators analyzed in section IV continue to show strength in manufacturing but weakness in real estate. Section V concludes. This post is in memory of our good friend Ed Mendez.
I The Biggest Bailout in History. The “number of the week” is that the total national debt of the US exceeded $13 trillion (http://blogs.wsj.com/economics/2010/06/05/number-of-the-week-us-debt-nears-key-threshold/ ). The International Monetary Fund (IMF) projects the general government gross debt of the US at 92.6 percent in 2010, rising to 109.7 percent in 2015 and the general government net debt at 66.2 percent in 2010, rising to 85.5 percent in 2015. In 2008, the government gross debt was 70.6 percent of GDP and the government net debt was 47.2 percent of GDP (http://www.imf.org/external/pubs/ft/weo/2010/01/weodata/weorept.aspx?sy=2008&ey=2015&scsm=1&ssd=1&sort=country&ds=.&br=1&c=156%2C158%2C132%2C112%2C134%2C111%2C136&s=NGDP%2CGGXWDN_NGDP%2CGGXWDG_NGDP%2CNGDP_FY&grp=0&a=&pr1.x=59&pr1.y=15 ). The unsustainable path of the government debt of the US could be the single most important risk factor of the world economy, shadowing debts in other regions. At some point financial assets such as bonds will reflect the deteriorating fiscal situation of the US in prices that incorporate higher interest rates. The biggest bailout in history is by taxpayers who will pay the bailout of their government with a combination of higher taxes and interest rates, lower income growth and job creation and a depreciating dollar. A point of explosion may occur because slower growth restricts tax revenue and the ceiling of the capacity to increase taxes as percent of economic activity or GDP may force aggressive expenditure reductions. A current poll by Gallup finds that 40 percent of the interviewed consider the federal government debt as an extremely serious perceived threat to US future wellbeing, 39 percent consider it as very serious and 20 percent as not very serious or not a threat at all (http://www.gallup.com/poll/139385/Federal-Debt-Terrorism-Considered-Top-Threats.aspx ). The finance ministers and central bank governors of the G20 meeting in Busan state in the Communiqué of Jun 5 that: “those countries with serious fiscal challenges need to accelerate the pace of consolidation” (http://www.g20.utoronto.ca/2010/g20finance100605.html ). The 10-year Treasury closed at 3.30 percent on Jun 4, lower than 3.30 percent a week earlier and 3.39 percent a month earlier in an aberrant yield curve with a segment of near zero percent and then rising for maturities longer than two years (http://markets.ft.com/markets/bonds.asp ). The equally aberrant Fed balance sheet of $2.3 trillion dollars (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ) constitutes an additional threat on interest rates that can restrict the recovery and job creation. The combined government debt and Fed balance sheet are implicitly based on the view that fast economic recovery for some unknown reason may absorb with tax collections and higher interest rates the debt and the disposal of the securities in the Fed balance sheet. The expectation of higher taxes and interest rates may frustrate economic recovery, preventing the full taxation of the deficit that will expand with rising interest rates.
II Exporting the US Financial Industry. Financial turbulence continues to plague world financial markets and the economy. There have been sharp declines in stock market indexes from recent peaks: -11.6 percent in the Dow Jones Asia/Pacific Total Stock Market Index from Apr 15 to Jun 4; -19.3 percent in the Shanghai SE Composite from Apr 15 to Jun 4; -12.4 percent in the STOXX Europe 50 from Apr 15 to Jun 4; -11.7 percent in the Dow Jones Industrial Average from Apr 26 to Jun 4; and -18.7 percent in the NYSE Financial Index from Apr 15 to Jun 4 (http://online.wsj.com/mdc/public/page/mdc_us_stocks.html?mod=topnav_2_3051 ). The indicators of financial risk reported by Bloomberg continue at high levels (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aMBjAK8Mf.xg ). Three-month dollar LIBOR was fixed at 0.53656, remaining at the highest weekly level since Jul. The LIBOR-OIS spread inferred from contracts traded in forward markets is 49.15 basis points (bps) for Sept and 52.69 bps for Dec compared with 31.3 bps on Jun 4. The swap rate, or difference between the two-year swap rate and the comparable Treasury note yield, rose 5.3 bps to 48 bps. The European Central Bank informed that banks in the euro zone could experience $239 billion write-downs because of the sovereign risk deterioration in Europe. (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aMBjAK8Mf.xg ). Risk perceptions in transactions among financial counterparties are at very high levels.
There are two divergent financial regulation movements. First, most of the world’s banks will be subject to new capital rules under a Basel III agreement that may be finalized by the end of this year (for soft law and the Basel accords see Pelaez and Pelaez, International Financial Architecture, 239-300, Globalization and the State Vol. II, 114-48, Government Intervention in Globalization, 145-50, Financial Regulation after the Global Recession, 54-6, Regulation of Banks and Finance, 69-70). The initial intention for implementation of Basel III was at the end of 2012 in order to allow sufficient time for recovery of the world economy and financial markets. The negotiating countries are considering postponing implementation after 2012 (http://professional.wsj.com/article/SB10001424052748704183204575287930895807598.html?mod=wsjproe_hps_LEFTWhatsNews ). Second, the US is moving toward rushed reconciliation of the Senate and House financial regulation bills for final approval and signing by the President before Jul 4. Timing instead of substance has priority. The new financial regulatory framework is likely to cause an exodus of the financial industry to other jurisdictions. The Banking Act of 1933 (12 U.S.C. § 371a) prohibited payment of interest on demand deposits and imposed limits on interest rates paid on time deposits issued by commercial banks implemented by Regulation Q (12 C.F.R. 217) (Peláez and Peláez, Financial Regulation after the Global Recession, 57). This depression rush to regulation was motivated by the erroneous belief that banks provided high-rate risky loans to pay high competitive market interest rates on deposits, which allegedly caused banking panics in the 1930s. An added motivation was the allocation of savings to housing by maintaining low interest rate ceilings benefitting savings banks and savings and loan associations that complained of unfair competition from higher deposit rates of commercial banks. Milton Friedman analyzed in 1970 that the rise of inflation above Regulation Q interest rate ceilings caused halving of issuance of certificates of deposit (CD), which was the banking innovation created to finance rising loan volumes. Banks accounted higher-rate CDs in their European offices as “due from head office” while the head office changed the liability to “due to foreign branches” instead of “due on CDs.” Friedman predicted the future as revealing as his forecast of 1970’s stagflation: “the banks have been forced into costly structural readjustments, the European banking system has been given an unnecessary competitive advantage, and London has been artificially strengthened as a financial center at the expense of New York.” (Journal of Money, Credit and Banking 2 (Feb 1, 1970), 26-7, cited by Pelaez and Pelaez, Financial Regulation after the Global Recession, 58). People of modest means with lower income and wealth having no alternatives other than bankbook accounts received rates on their savings below those that would prevail in freer markets. Regulation transferred income from poorer depositors to endow banks with market power. The financial system was forced into costly readjustments while highly-paid financial jobs and economic activity were exported to foreign countries. The interest rate is the main compass of allocating savings and capital in a market economy but it was distorted by ill-conceived Great Depression regulation that is still emulated currently. The new financial regulation bill will also harm the most people of modest means.
In a remarkable anticipation of a key driver of the credit crisis in 2005, Professor Raghuram G. Rajan warned of the risks of illiquidity in financial transactions with an incentive for such illiquidity in the search for yields in an environment of low interest rates after a period of high rates (http://www.kc.frb.org/publicat/sympos/2005/PDF/Rajan2005.pdf cited in Pelaez and Pelaez, Regulation of Banks and Finance, 219). In a revealing article in the Financial Times on Jun 3, Professor Rajan analyzes the actual causes of the credit crisis and global recession (http://www.ft.com/cms/s/0/1182490e-6ea7-11df-ad16-00144feabdc0.html ), with important lessons in his successful must-read book on Fault Lines (http://www.amazon.com/Raghuram-Rajan/e/B0039XA4X8/ref=sr_tc_2_0?qid=1275829501&sr=1-2-ent ). Financial transactions play an important social role in allocating resources. Short-selling by traders of the equity of a company may deprive it from resources. If short-selling traders value correctly, resources would not be wasted in projects with negative present value of future cash flows; if short-selling traders value incorrectly, compensatory long positions by other traders will punish their error with losses and channel the resources to projects with positive net present value. A key function of financial markets is pricing risk. The search for the causes of the credit crisis is on why there were excessive rewards to unsound decisions with excessive risk, or how risk was mispriced. The interpretation of Professor Rajan is that a “tsunami” of money allocated by Congressional action to promote low-income housing together with an inflow of foreign capital into the US eroded the discipline in home loans or adequate calculus of risk and liquidity. The decision by the Fed to maintain low interest rates in fear of deflation and the jobless recovery camouflaged the costs of an illiquid balance sheet. Another equivalent form of viewing this interpretation is that the Fed and the housing subsidy were equivalent to the government writing a put option or floor on housing prices (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 government created the illusion that house prices would increase forever above the floor of abnormally-high prices at which mortgages had been contracted. Millions of homeowners with underwater mortgages, or home prices in a nearly impossible imagined sale that are below mortgage principal and interest, were doomed by government housing and interest rate policies. The regulators and legislators who created the crisis are reshaping financial regulation that resembling the Banking Act of 1933 will export the financial industry of the US to other jurisdictions and also this time raise interest rates by increasing the cost of financial intermediation required for growth and job creation.
III The 26 Million Persons in Job Stress. The employment report for May released on Jun 4 together with news of the concern over the debt of Hungary caused significant stress in financial markets worldwide. The Dow Jones Industrial Average (DJIA) fell 323.31 points equivalent to -3.2 percent, closing at 9931.97, which is down by 4.8 percent in 2010 (http://professional.wsj.com/article/SB10001424052748704764404575286093848380232.html?mod=wsjproe_hps_LEFTWhatsNews ). The DAX index of Germany declined about 2 percent and the CAC 40 of France fell 2.9 percent. The NASDAQ Composite index declined 3.6 percent and the S&P 500 fell 3.4 percent. The Dow Jones US Total Market Index, capturing the market value of almost all publicly-traded companies in the US, lost $480 billion of market value in just one day, or half a trillion dollars in more commonly-used dimensions in these times. The euro closed at $1.1966 for a week’s decline against the dollar of 2.5 percent. Copper futures prices fell 4.3 percent and crude-oil futures dropped 4.2 percent. The employment report raised doubts on the recovery of employment that would be required for growth of the general economy. A common argument is that personal consumption expenditures account for 71 percent of GDP (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=5&FirstYear=2009&LastYear=2010&Freq=Qtr ) and could be restricted by the weight of 26 million people in job stress and perceptions by many of those employed that their jobs may be at risk.
The focus of concern is that the increase in nonfarm payrolls by 431K in May, where K stands for thousand, consisted almost entirely of the addition of 411K temporary government workers for Census 2010. The increase in private sector employment was only 41K (http://www.bls.gov/news.release/pdf/empsit.pdf ). The revised increase in private nonfarm jobs for Apr was an increase by 218K, following an increase by 158K in Mar and 62K in Feb. The breakdown of job creation in the private sector in May illustrates the nature of the recovery that is confirmed by other short-term indicators considered in the next section IV. The bright hope of employment has been in the goods producing sector, which added 57K in Mar and 62K in Apr but only 4K in May. Manufacturing in the US, as elsewhere in the world, is leading the recovery with job creation of 19K in Mar, 40K in Apr and 29K in May, originating mostly in durable goods production. Construction added 27K jobs in Mar and 15K in Apr but destroyed 35K in May presumably because of the end of the tax credit of up to $8000 for the first-time purchase of a home. The surplus of houses created by the government subsidy directly or through interest rates near zero percent bloated construction followed by contraction after the collapse of house prices beginning in 2006. Many people are forced into difficult transfer to other occupations because the same jobs are seldom recovered in recessions. The private service-providing sector added 101K jobs in Mar and 156K in Apr but only 37K in May. Upward trends were reversed in all subsectors of services with the exception of temporary help services that have been adding an average of 29.9K jobs per month, including 31.0K in May. Retail trade destroyed 6.6K jobs in May perhaps because of the early Easter and financial activities destroyed 12K. Government added 50K in Mar, 72K in Apr and 390K in May mostly driven by temporary hiring for Census 2010. Short-term economic indicators fluctuate widely such that the May number could still be reversed in future months.
The household survey data continue to raise concerns about the employment situation of the US. (1) The unemployment rate declined from 9.9 percent in Apr to 9.7 percent in May, which is the same as in the first three months of 2010, but mainly because people dropped out from the labor force by ceasing to seek employment in the belief that none was available for them. The US labor forced declined by 322K from Apr into May. The number of unemployed is 15.0 million compared with 15.3 million in Apr largely because of the decrease in the labor force of 322K. (2) The percentage of unemployed persons that have been jobless for 27 weeks or more was about unchanged at 6.8 million, which is equivalent to 46.0 percent of unemployed persons and more or less the same as in Apr. The chances of finding employment after six months of unemployment diminish because of eroding marketable skills. (3) There were 8.809 million persons in May in involuntary part-time jobs because their work hours had been cut or because they could not find a full-time job. The number employed involuntarily in part-time jobs declined by 343K from 9.152 million in Apr. (4) The number of persons marginally attached to the labor force reached 2.2 million in May; these are persons not in the labor force, wanting and available for work and looking for a job in the prior 12 months but not in the past four weeks. The number of discouraged workers remained more or less stable at 1 million. (5) The unemployed of 15.0 million, the marginally attached to the labor force of 2.2 million and the 8.8 million in involuntary part-time jobs add to 26.0 million under job stress in May. The difference of 900K with the 26.9 million in job stress in April is explained by the decline of 300K in the unemployed mostly because they were dropped from the labor force after desisting from seeking a job, and declines in the marginally attached to the labor force and involuntarily employed part time. Job stress in the US economy continues to be extremely high.
US GDP increased at the annual seasonally-adjusted percentage rate of 2.2 in QIII09, 5.6 in QIV09 and 3.0 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. The agenda has focused on legislative restructurings of business models for alleged long-term structural gains. A jobs agenda should induce private-sector economic activity by allowing the optimum choice of business models. Legislative restructuring in a tough recession may be politically opportune but highly inopportune for recovery and job creation. The uncertainty of the next restructuring or the implementation of already enacted restructurings may create the expectation of job stress throughout the entire labor force. Jobs lost as a consequence of restructurings force a nearly impossible transfer to other occupations.
IV Economic Indicators. Both the industry and services reports of the Institute for Supply Management (ISM) continue to show accelerating economic recovery. The purchasing managers’ index (PMI) of manufacturing was 59.7 in May relative to 60.4 in Apr. Indexes above 50 indicate expansion. The PMI for economic activity in manufacturing has been showing growth of the sector during 10 consecutive months and of the overall economy during 13 consecutive months (http://www.ism.ws/ISMReport/MfgROB.cfm ). The non-manufacturing PMI (NM/PMI) remained at 55.4 in May and the index for business activity and production rose to 61.1 in May relative to 60.3 in Apr. The non-manufacturing sector has been growing during five consecutive months (http://www.ism.ws/ISMReport/NonMfgROB.cfm ). Sales of US autos grew for the seventh consecutive month. Sales of cars and light trucks rose in May by 19 percent to 1.1 million vehicles. The annualized rate of sales was 11.68 million in May, which was higher than 11.2 million in Apr and significantly above 9.86 million a year ago. All producers originating in the US or abroad had significant increases in sales, ranging from 17 percent to 33 percent (http://professional.wsj.com/article/SB10001424052748703561604575282473282622364.html?mg=reno-wsj ). Construction spending rose by 2.7 percent in Apr 2010 but was still below Apr 2009 by 10.5 percent (http://www.census.gov/const/C30/release.pdf ). New orders of manufactured goods in Apr rose by 1.2 percent, growing in 12 of the past 13 months and by a revised 1.7 percent in Mar (http://www.census.gov/manufacturing/m3/prel/pdf/s-i-o.pdf ). The pending home sales index of the National Association of Realtors (NAR) rose by 6.0 percent on the basis of contracts signed in Apr and is above the level in Apr 2009 by 22.4 percent (http://www.realtor.org/press_room/news_releases/2010/06/pending_surge ). Early data suggest that house sales fell significantly in May, perhaps by as much as 25 to 30 percent because of the expiration of the tax credit for first-time home buyers (http://www.realtor.org/press_room/news_releases/2010/06/pending_surge ). In the first four months of 2010, construction spending was below the same period in 2009 by 13.2 percent (http://www.census.gov/const/C30/release.pdf ). New claims for unemployment insurance fell from a revised level in the prior week of 463K to 453K for the week ending on May 29 but still remain at a high level (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
V Conclusions. The G20 finance ministers and central bank governors elevate fiscal consolidation to a key priority of global cooperation. Financial regulation in Basel III may be finalized this year but its implementation may be delayed beyond 2012 because of the turmoil in financial markets and the incipient economic recovery. The agenda of the US continues with legislative restructurings, ignoring the plight of 26 million people and moving divergently from calls for fiscal consolidation and delays in shocking the financial system with regulation. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
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