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