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

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

The purpose of this post is to analyze the worrisome combination of fiscal imbalances and government debt with stress in financial markets. The sections below consider in turn (I) the rising perception of financial risk, (II) the global debt and financial crisis, (III) the stress of 26.9 million unemployed or underemployed, (IV) the interest rate conundrum and (IV) conclusions.
I Financial Risk. The three major dimensions of increasing financial risk are considered below. First, financial risk is present in the decline of equity indexes. At the close of markets on May 7, major equity indexed registered percentage declines in 2010 of: Global Dow 8.1, Shanghai Composite 18.0, Hong Kong Hang Seng 8.9, Nikkei Japan Average 1.7, CAC 40 France 13.8, DAX Germany 4.1, FTSE 100 UK 5.4, Russia Titans 8.7 and Brazil BOVESPA 8.3 (http://online.wsj.com/mdc/public/page/2_3022-intlstkidx.html?mod=topnav_2_3000 ). The Dow Jones Industrial Average (DJIA) declined 6.9 percent in the week ending on Apr 7 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_h_dtabnk&symb=DJIA ) and the S&P 500 declined by 7.6 percent (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_uss_dtabnk&symb=SPX ).
Second, an important manifestation of the credit/dollar crisis and global recession of 2007-2009 was in the form of exploding perceptions of default risk in counterparty financial transactions. The nonprime mortgages behind mortgage-backed securities (MBS) and their derivatives eroded the confidence in financing among banks and other financial institutions because they were not fully certain of the soundness of their own balance sheets and of those of other banks and financial institutions (Pelaez and Pelaez, Financial Regulation after the Global Depression, 48-52, 157-66, Regulation of Banks and Finance, 59-60, 217-27). The paralysis of the sale and repurchase agreements (SRP) of asset-backed securities (ABS) caused fire sales of securities and collapse of their prices, resulting in major write downs of assets in balance sheets of banks and financial institutions. The credit/dollar crisis and global recession originated in four almost contemporaneous policies that stimulated excessive construction and high real estate prices, highly-leveraged risky financial exposures, unsound credit and low liquidity: (i) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of MBS equivalent to a reduction in mortgage rates; (ii) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between Jun 2003 and Jun 2004 with the implicit intention in the “forward guidance” of maintaining low rates indefinitely if required in avoiding “destructive deflation”; (iii) the housing subsidy of $221 billion per year; and (iv) the purchase or guarantee of $1.6 trillion of nonprime MBS by Fannie Mae and Freddie Mac (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). The combined stimuli mispriced risk, causing excessively risky and highly-leveraged exposures as the public attempted to obtain higher returns on savings. The proposal of the Troubled Asset Relief Program (TARP) to Congress as required for either withdrawing “toxic” assets from bank balance sheets or risking another Great Depression further eroded confidence that deepened the financial crisis and global recession. The current environment is again characterized by the same quasi-zero interest rates, much more aggressive quantitative easing and a tough international bailout of at least one country to avoid domestic rescues of banks. The aggravating difference is increasing fiscal imbalances that may end in unsustainable government debt of 100 percent of GDP.
Third, the indicators of rising financial counterparty credit risk are raising concerns. The overnight index swap (OIS) consists of an agreement by which counterparties exchange at contractual maturity the notional value times the difference between accrued interest at the fixed rate such as the London interbank offered rate (LIBOR) and interest accrued by the geometric interest average of the reference index rate such as the fed funds rate. The OIS is one of many risk management tools, such as synthetic CDOs, required in risk transfer (Pelaez and Pelaez, International Financial Architecture, 134-54, Globalization and the State, Vol. I, 78-100, Government Intervention in Globalization, 57-64, 70-4). The flood of subprime mortgages originating in the government policy of housing subsidies undermined these instruments and the entire financial system. Blaming financial innovation and institutions for the credit/dollar crisis is similar to blaming the crash of modern aircraft on its technology instead of on the use of worthless government-subsidized fuel. Risk management innovations were never intended to be used with subprime mortgages purchased or guaranteed by the government-related entities Fannie Mae and Freddie Mac and originated with interest rates fixed at artificially levels in 2003-2004 just before their sustained increase in 2004-2006 to levels at which the mortgages were unviable. The agreement to receive the fixed rate in the OIS is equivalent to lending cash while paying the fixed rate is equivalent to borrowing cash (http://www.acisuisse.ch/docs/dokumente/OIS_Note_CSFB_Zurich.pdf ). The perception is that there is higher risk in lending to other banks at LIBOR than at the overnight fed funds rate. An increase in the spread of three-months LIBOR over the OIS referenced to the overnight fed funds rate is a measure of risk perceptions of interbank lending. The spread was typically below 10 basis points (bps) before the credit/dollar crisis but rose to several hundred bps during the crisis. The Financial Times (FT) registered a record sharp increase of the spread of EURIBOR to the OIS in the week of Apr 3 (http://www.ft.com/cms/s/0/0be6616e-586e-11df-9921-00144feab49a.html# ). Additional signs of stress were increasing spreads of credit-default swaps (CDS) for major European banks and the concentration of 90 percent of bank lending on overnight transactions. The FT quotes estimates by Barclays Capital that French and German financial institutions have exposure of $103 billion to Greek government debt (Ibid). While interbank lines are active, the three-month LIBOR rate increased to 0.42813 percent on Friday from 0.37359 on Thursday, reaching the highest level since Aug 2009 (http://professional.wsj.com/article/SB10001424052748703338004575230102280362776.html?mod=wsjproe_hps_LEFTWhatsNews ). More signs of stress of financial institutions are revealed by declines of their stock prices and increases in the yields required on their bonds (Ibid).
Fourth, the anticipation of financial regulation in the United States in detriment of global agreements that induce competitiveness of international banks and financial institutions is adding significantly to the uncertainty of financial markets. A positive development was the abandoning of the destabilizing audit of Fed monetary policy in a Senate amendment but there is uncertainty in the reconciliation with the House bill that has such an audit provision. The Senate bill will restrict credit volume, increase interest rates and generate a more unstable banking and financial system. It appears that the majority in the Senate will not favor the permanent solution to the biggest bailout of the credit/dollar crisis by perpetuating Fannie Mae and Freddie Mac. A bill continuing the open-ended bailout of Fannie and Freddie is a statute sanctioning the “too big and politically important to liquidate,” contradicting the stabilizing intention of the legislation and creating with the systemic risk oversight council a precedent for political bailouts. There will be selective bailouts of politically important entities.
II The Global Debt and Financial Crisis. Sovereign risk is becoming the equivalent of the subprime credit problem of the new government debt/financial crisis. The major vulnerability is a repetition of the sovereign risk event in more economies with larger dimensions. The current World Economic Outlook of the International Monetary Fund provides estimates of the fast increase of the government debt as percentage of GDP for advanced economies from 2008 to 2015: Canada 22.6 to 30.4, France 57.8 to 85.1, Germany 59.3 to 74.8, Italy 103.9 to 122.1, Japan 96.9 to 153.9, United Kingdom 45.5 to 83.9, United States 47.2 to 85.5 and Euro Area 59.5 to 84.9 (http://www.imf.org/external/pubs/ft/weo/2010/01/pdf/text.pdf ). The IMF states that “without more fully restoring the health of financial and household balance sheets, a worsening of public debt sustainability could be transmitted back to banking systems or across borders” (http://www.imf.org/external/pubs/ft/gfsr/2010/01/pdf/summary.pdf ). The term contagion may be misleading. Countries with more manageable fiscal situations may suffer less in a global debt/financial crisis. What appears impossible is escaping altogether the effects of such a crisis that originates in the United States and Europe. The Congressional Budget Office (CBO) calculates record fiscal deficits from the President’s budget proposal of $1.5 trillion in 2010, or 10.3 percent of GDP, and $1.3 trillion in 2011, or 8.9 percent of GDP after $1.4 trillion or 9.9 percent of GDP in 2009 (http://www.cbo.gov/ftpdocs/112xx/doc11231/frontmatter.shtml ). Debt held by the public would rise from $7.3 trillion or 53 percent of GDP in 2009 to $20.3 trillion or 90 percent of GDP in 2020. Net interest would quadruple from 1.4 percent of GDP in 2010 to 4.1 percent in 2020. The Fed holds a portfolio of $1.98 trillion of long-term securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ) that will cause increases in long-term interest rates when it is sold to the public even using appropriate tools in an optimum exit strategy that may fail operationally. Issuance of debt to pay for continuing high government deficits and refinancing of maturing debt together with the sale of the Fed’s portfolio will cause upward pressure on long-term interest rates with likely adverse effects on the rate of economic growth and employment. The Medicare Board of Trustees calculates under its “budget perspective” present-value net deficits of $45.8 trillion in the next 75 years from Medicare and Old Age, Survivors and Disability Insurance (OASDI) or Social Security that are equivalent to 5.8 percent of the present value of the GDP in that period of $791 trillion (http://www.cms.gov/ReportsTrustFunds/downloads/tr2009.pdf ). The Medicare hospital insurance or Part A trust fund will be exhausted by 2017. The solution to the Medicare financial imbalance could require gradual or immediate increases in the payroll tax from the current 2.90 percent to 6.78 percent equivalent to an increase of the tax by 134 percent or reduction of expenditures by 53 percent. The OASDI Board of Trustees predicts that annual costs will be higher than income by 2016 and that the OASDI trust fund could be exhausted by 2037 (http://www.ssa.gov/OACT/TR/2009/tr09.pdf ). States face unfunded entitlement liabilities while experiencing substantial budget deficits.
III Job Stress. There are multiple positive developments in the employment report for Apr (http://www.bls.gov/news.release/pdf/empsit.pdf ). (1) The sample of nonfarm payroll employment registers an increase of 290,000 jobs in sharp contrast with a loss of 528,000 in Apr 2009. Moreover, the upwardly revised increase for Mar is 230,000 and for Feb 39,000. (2) The increase of private sector jobs in Apr is 231,000 following revised increases of 174,000 in Mar and 62,000 in Feb. (3) The net increase in government jobs is 59,000 after allowing for 66,000 temporary workers for Census 2010. (4) The job increases are spread throughout nearly all sectors of private employment with the exception of transportation and warehousing. (5) The increase in nonfarm payroll employment since December is 573,000 of which 483,000 in the private sector, occurring mostly in Apr and Mar. (6) The average workweek for all employees in private nonfarm payrolls increased from 34.0 hours in Mar to 34.1 hours in Apr. (7) The rate of participation of the civilian labor force increased by 0.3 percent to 65.2 percent with an increase in the labor force of 805,000. The reentrants of the labor force from the unemployed increased by 195,000. This could signal renewed confidence in the feasibility of finding jobs. The household survey data still raise concerns about the employment situation in the US. (1) The unemployment rate increased from 9.7 percent in the first three months to 9.9 percent in Apr. The number of unemployed is 15.3 million even with increased hopes of finding jobs. (2) The percentage of unemployed persons that have been jobless for 27 weeks or more increased to 45.9 percent. There is less hope for finding employment after prolonged unemployment. (3) There were 9.2 million persons in April in involuntary part-time jobs because their work hours had been cut or because they could not find a full-time job. (4) The number of persons marginally attached to the labor force reached 2.4 million in Apr compared with 2.1 million a year earlier; these are persons not in the labor, wanting and available for work and looking for a job in the prior 12 months but not in the past four weeks. (5) The unemployed of 15.3 million, the marginally attached to the labor force of 2.4 million and the 9.2 million in involuntary part-time jobs add to 26.9 million under job stress.
US GDP increased at the annual seasonally-adjusted percentage rate of 2.2 in QIII09, 5.6 in QIV09 and 3.2 in QIII10 (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&FirstYear=2009&LastYear=2010&Freq=Qtr ). These rates of growth may be insufficient to recover full employment. In the recession of the 1980s the quarterly annual percentage rate of growth of GDP was: -7.9 QII80, -0.7 QIII80, 7.6 QIV80, 8.6 QI81, -3.2 QII81, 4.9 QIII81, -4.9 QIV81, -6.4 QI82, 2.2 QII82, -1.5 QIII82 and 0.3 QIV82. During the recovery phase GDP grew at the quarterly annual percentage rate of: 5.1 QI83, 9.3 QII83, 8.1 QIII83, 8.5 QIV83, 8.0 QI84, 7.1 QII84 and thereafter at rates in excess of 3 percent. Change in private inventories was a significant contributor to the rate of GDP growth in terms of percentage points only in a few quarters: 3.5 QII83, 3.1 QIV83 and 5.1 QI84. Growth was driven by personal consumption expenditures and fixed investment. The rate of unemployment increased from 6.3 percent in January 1980 to a peak of 10.8 percent in December 1982, declining at year end to: 8.3 percent in 1983, 7.3 percent in 1984 and 7.0 percent in 1985 (http://data.bls.gov/PDQ/servlet/SurveyOutputServlet ). The recovery of full employment depends on sustained high quarterly annual rates of growth of GDP originating in demand and fixed investment. Taxation and high interest rates may flatten dynamism from the private sector.
IV Economic Recovery. The data released in the week of May 3 are encouraging. The report of the Institute of Supply Management (ISM) registers the ninth consecutive monthly growth of manufacturing with the PMI index reaching 60.5 percent for the fastest growth since Jun 2004 (http://www.ism.ws/ISMReport/MfgROB.cfm ). The nonmanufacturing index of business activity of the ISM increased in Apr by 0.3 to reach 60.3 percent for the fifth consecutive month of growth (http://www.ism.ws/ISMReport/NonMfgROB.cfm ). Personal income increased by 0.3 percent in April and disposable income by 0.3 percent while personal consumption expenditures (PCE) increased by 0.6 percent or 2.9 percent relative to a year earlier (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm ). New orders for manufactured goods increased strongly in Mar by 1.3 percent after an increase in Feb also by 1.3 percent; new orders excluding transportation increased by 3.1 percent (http://www.census.gov/manufacturing/m3/prel/pdf/s-i-o.pdf ). Consumption, which represents more than 70 percent of the economy, is growing. The index of pending home sales of the National Association of Realtors (NAR) increased in Mar by 5.3 percent and 21.1 percent relative to a year earlier (http://www.census.gov/manufacturing/m3/prel/pdf/s-i-o.pdf ). The index is forward looking, leading the NAR to believe in a strong spring sales season. Construction spending increased in Mar by 0.2 percent above Feb but declined 12.3 percent relative to Mar 2009, showing a still depressed situation (http://www.census.gov/const/C30/release.pdf ).
VI Interest Rates. Sovereign risk deterioration in Europe, the decline in world stock markets and major reductions in risk exposures channeled funds into Treasuries, causing downward shifts of the US yield curve. On Apr 7, the yield of the 10-year Treasury stood at 3.42 percent, which was 25 basis points (bps) less than 3.67 percent a week earlier and 46 bps less than 3.88 percent a month earlier (http://markets.ft.com/markets/bonds.asp ). However, the 10-year government bond of Germany traded at a yield of 2.79 percent for a negative spread of 63 bps relative to the 10-year Treasury yield of 3.42 percent. The 10-year interest rate swap traded at 3.41 percent bid and 3.44 percent ask virtually the same at the 10-year Treasury yield of 3.42 percent (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=ICAP-070510 ). The yield differentials of sovereign bonds and private swap contracts relative to the yields of Treasuries will move substantially together with the budget deficits and debt/GDP ratio of the United States.
V Conclusion. The absorption of resources by the government sector from the private sector during the largest fiscal imbalance in the United States since World War II threatens future economic growth and the job creation by the private sector that can bring relief to the 26.9 million persons suffering job stress. Adverse expectations of unsustainable government debt in a few years may affect prices of financial assets today. The government debt crisis in the United States and other regions may affect the functioning of the financial system, employment and production and investment in the overall economy. Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10

The Global Debt and Financial Crisis Risk

The Global Debt and Financial Crisis Risk
Carlos M Pelaez

The most critical vulnerability of the world economy is the risk of the combination of a global debt event with another financial crisis. The objective of this comment is to analyze this risk by considering below the major aspects of the (I) global government debt and bank crisis, the contribution to the shock by (II) the Senate bank regulation risk of financial crisis, the analysis of (III) economic recovery and (IV) conclusions.
I Global Government Debt and Bank Crisis. There is an explosion of sovereign risk mixed with bank exposures across frontiers that may dominate all events in the world economy. The current World Economic Outlook of the International Monetary Fund provides estimates of the fast increase of the government debt as percentage of GDP for advanced economies from 2008 to 2015: Canada 22.6 to 30.4, France 57.8 to 85.1, Germany 59.3 to 74.8, Italy 103.9 to 122.1, Japan 96.9 to 153.9, United Kingdom 45.5 to 83.9, United States 47.2 to 85.5 and Euro Area 59.5 to 84.9 (http://www.imf.org/external/pubs/ft/weo/2010/01/pdf/text.pdf ). The IMF states that “without more fully restoring the health of financial and household balance sheets, a worsening of public debt sustainability could be transmitted back to banking systems or across borders” (http://www.imf.org/external/pubs/ft/gfsr/2010/01/pdf/summary.pdf ). The IMF has had significant experience in resolving the interaction of debt crises with the delicate web of interbank credit lines. Banks with exposure of interbank credit lines to other banks in the debt crisis country do not renew short-term credit and short country risk to diminish their exposures in avoiding hits to shareholder wealth (Pelaez and Pelaez, International Financial Architecture, 186). The Fed has issued guidance on the management of interbank financial liabilities (http://www.federalreserve.gov/newsevents/press/bcreg/20100430a.htm ). There are available currency, interest and credit default derivatives to buy protection or insurance against default of credit to the government, entities or individuals in the country with unsustainable debt (Pelaez and Pelaez, International Financial Architecture, 134-54, Globalization and the State, Vol. I, 78-99, Government Intervention in Globalization, 57-63, 70-4). The mechanisms of risk management to diminish exposures to subprime mortgages were similar. In both cases the original cause was also similar: excessive budget deficits in the country with unsustainable debt and excessive mortgages with lax credit standards in the US originating in a long period of low interest rates with 1 percent fed funds rates in 2003-2004, artificial lowering of mortgage rates by elimination of auctions of 30-year Treasuries, housing subsidy of $221 billion per year and purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie Mae and Freddie Mac (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). In both cases, defensive risk management in the form of buying insurance against loss of net worth is erroneously alleged as a cause: (i) “speculative attacks” against a nation by shorting its debt and currency when even the nationals exit the currency to save their net worth; and (ii) sophisticated short derivative transactions by banks, financial institutions and even personal wealth portfolios to reduce heavy losses in exposures to mortgages. Banks in the larger economies in Europe have exposures to the countries with economies of smaller dimension but significant combined aggregate size that could be hurt in country debt defaults (http://professional.wsj.com/article/SB10001424052748704423504575212323413641634.html?mg=reno-wsj ). The European Central Bank (ECB) is finding a different balance sheet risk. Loans to indebted countries that could be collateralized with the debt of those countries could lose value in default events, causing losses to the portfolio of the ECB (http://professional.wsj.com/article/SB10001424052748703832204575210334213031028.html?mg=reno-wsj ). A central bank could be in risk similar to that of a collateralized debt obligation (CDO) referenced to nonprime debt, formerly AAA-rated debt in the case of the central bank and formerly AAA-rated mortgages in the case of mortgages. Evidently, credit ratings and credit decisions are not characterized by perfect foresight. The flaw of attributing the crisis to banks is also evident here: who could have thought that AAA-rated sovereign debt securities would default? Low interest rates, Fannie and Freddie created the illusion of permanently rising real estate prices such that even nonprime loans could be saved by selling foreclosed property without a loss.
The issue of global imbalances was considered in academic literature and in research by the IMF as joint occurrence of domestic fiscal deficits together with external or current account deficits. An important aspect of the theoretical and empirical analysis of global imbalances is the difficulty posed by the aging population in mature economies in Europe and Japan in the adjustment of fiscal deficits and government debts while increasing productivity to remain competitive (Pelaez and Pelaez, The Global Recession Risk, 109-11, 135-44). Depending on the assumptions, the US is more or less years away within the current decade of government debt around 100 percent of GDP. The problem of entitlements is also critical in the US. The Medicare Board of Trustees calculates under its “budget perspective” present-value net deficits of $45.8 trillion in the next 75 years from Medicare and Old Age, Survivors and Disability Insurance (OASDI) or Social Security that are equivalent to 5.8 percent of the present value of the GDP in that period of $791 trillion (http://www.cms.gov/ReportsTrustFunds/downloads/tr2009.pdf ). The Medicare hospital insurance or Part A trust fund will be exhausted by 2017. The solution to the Medicare financial imbalance could require gradual or immediate increases in the payroll tax from the current 2.90 percent to 6.78 percent equivalent to an increase of the tax by 134 percent or reduction of expenditures by 53 percent. The OASDI Board of Trustees predicts that annual costs will be higher than income by 2016 and that the OASDI trust fund could be exhausted by 2037 (http://www.ssa.gov/OACT/TR/2009/tr09.pdf ). States face unfunded entitlement liabilities while experiencing substantial budget deficits. Chairman Bernanke summarizes the risks: “Increasing levels of government debt relative to the size of the economy can lead to higher interest rates, which inhibit capital formation and productivity growth, and might even put the current economic recovery at risk. Moreover, other things being equal, increased federal debt implies higher taxes in the future to cover the associated interest costs—higher taxes that may create disincentives to work, save, hire, and invest” (http://www.federalreserve.gov/newsevents/speech/bernanke20100427a.htm ). The most important fiscal imbalance and debt sustainability issues that can jeopardize the immediate future are bypassed in the effort to restructure the economy. Successive unfavorable short-term adversities may reverse any of the alleged long-term benefits of the restructuring legislation.
II Bank Regulation. There are two major issues relating to the Senate Financial Stability Act (SFSA) being debated in Congress to regulate banks: the allegation that the SFSA would have prevented the credit/dollar crisis and global recession and the risk that the SFSA may create another financial crisis. First, Origins of the Credit/Dollar Crisis. The credit/dollar crisis did not originate in insufficient bank and financial regulation but rather in monetary policy that is a form of regulation. Thus, the credit/dollar crisis and global recession would have been avoided by different government policies instead of simply by draconian controls of banks and financial institutions as proposed by the SFSA. The official conventional story is that monetary policy was perfect but that greed, irresponsibility and “unfettered” free markets caused the debacle. The release of the Federal Open Market Committee (FOMC) transcript of May 4, 2004, is being analyzed in terms of the reasons behind the decision to increase interest rates by 25 basis points (bps) in 17 consecutive FOMC meetings from 1 percent in Jun 2004 to 5.25 percent in Jun 2006. The argument is that the 25 bps increments during a prolonged period actually encouraged the creation of excess credit in the economy such as the boom in mortgages that fueled house prices (http://professional.wsj.com/article/SB10001424052748703871904575216242106011222.html?mod=wsjproe_hps_LEFTWhatsNews ). Members present at the FOMC meeting on Dec 14, 2004, expressed the view that the low interest rates by the Fed had encouraged mortgages at low rates that fueled house prices (http://www.bloomberg.com/apps/news?pid=20601087&sid=asN.6J4RCnOo&pos=3 ) The transcripts of the May 4, 2004, meeting reveal that the motivation for the small doses of 25 bps increases over a prolonged two-year period originated in reflections by then Chairman Greenspan of an earlier episode: “When I say ‘move,’ I mean by 25 basis points. I mention that partly because of the experience of February 1994. Those of you who were here then may remember that there was a groundswell opinion within the Committee in favor of moving rates up not 25, but 50 basis points. And I went berserk for the first time and, I hope, the last time at an FOMC meeting, on the ground that, whatever we did, the markets were going to respond fairly exceptionally, which in fact they did. So, on the basis of that particular history, I would say that we should not move more than 25 basis points in June” (http://www.federalreserve.gov/monetarypolicy/files/FOMC20040504meeting.pdf ). Stress tests of banks use parameters of the bond market crash in 1994, which started in the US by the tightening of the fed funds rate from 3.00 percent in Feb 1994 to 6.0 percent in Dec 1994 (Pelaez and Pelaez, International Financial Architecture, 114-5, The Global Recession Risk, 206-7). The yield of the US 30-year Treasury bond increased by 150 basis points, causing declines in bond prices because increases of yields of 100 basis points caused declines of prices of 13 percent, which were magnified by typical leverage of 10:1. There was an increase in 30-year mortgage rates of 200 basis points that caused the loss of most of the value in funds of asset-backed securities. Europe was lagging the business cycle in the US and bond strategies consisted of long positions in higher-yielding markets that eventually also turned sour. Traders with long leveraged fixed-income and derivatives exposures waited for decoupling of European bond prices that continued declining during 1994. The correlation of bond yields of the US, European Union and Japan was only 0.18 and that of equities 0.40. Available statistical models failed to capture the much higher fed-tightening event correlation of fixed income and equities used in subsequent stress tests much the same as changes in correlations and effectiveness of hedge ratios caused by flight out of risk during the Long Term Capital Management (LTCM) event in 1998, converting LTCM’s hedged position into a short naked option (Philippe Jorion cited in Pelaez and Pelaez, The Global Recession Risk, 12-3). The Mexican crisis of 1994 was significantly influenced by the flight from risk and duration caused by the doubling of the policy rate by the Fed in 11 months, causing shocks in Argentina and Brazil. The 1994 episode resembles the increase of the fed funds rate from 1 percent to 5.25 percent from Jun 2004 to Jun 2006 that had strong effects on the credit quality of mortgages. The strength of labor and financial markets and the real economy were not major factors of fed policy. In the increase of rates in 1994 the Fed was concerned with inflation originating in commodity price increases that failed to spread to general prices. In the increase after Jun 2004 the Fed was escaping the 1 percent interest rate and forward guidance after deflation also failed to materialize, which was an important determinant of the credit/dollar crisis and global recession (Pelaez and Pelaez, The Global Recession Risk, 207, 221-5, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). The fed has been managing monetary policy with aggressive changes in interest rates based on the view of the economy and financial markets six months ahead. There may not be sufficient knowledge about central bank policy for controlling the effects of these wide swings in monetary policies (Pelaez and Pelaez, Regulation of Banks and Finance, 108-112, Financial Regulation after the Global Recession, 74, 84-6, International Financial Architecture, 230-7). In the meeting of May 4, 2004, the Fed was beginning to realize the excessive credit stimulus that it had created by lowering the fed funds rate to 1 percent for one entire year from Jun 2003 to Jun 2004, issuing a guidance that rates would remain as low as required and commenting in speeches that low rates were required to avoid catastrophic deflation as it had occurred in Japan and during the Great Depression (http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm cited in Pelaez and Pelaez, The Global Recession Risk, 93). There is no scientific/painless exit from the Fed balance sheet portfolio of $1.98 trillion of long-term securities as of Apr 28 (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ) and the 0-1/4 percent fed funds rate. The combination of unwinding the portfolio of $1.98 trillion and raising the fed funds rate may not be orderly even with new instruments (http://www.federalreserve.gov/newsevents/press/monetary/20100430a.htm ) especially in a troubled global debt and financial environment. What are the painless or optimum timing, dose and speed of fed funds rate increases?
Second, Senate Bank Regulation Risks of Financial Crisis. The SFSA regulation of banks can cause another stressful environment for banks in two general forms that could trigger another financial crisis. (1) The SFSA restricts diversification of banks into different lines of activities, concentrating transactions in credit. Less diversified banks are more vulnerable because certain revenues, such as trading currently, compensate for write downs, such as the tail of loan losses from the credit crisis. The SFSA creates a consumer protection agency that will drive investors away from the stocks of banks engaged in consumer credit subject to arbitrary regulatory sanctions and restriction of profits. The consumer will also experience lower credit volumes at higher interest rates as with the CARD (Credit Card Accountability and Responsibility Act) of May 2009. The Volcker Rule would deprive banks of revenues from trading and managing hedge funds and private equity funds that have never posed problems in earlier crisis, again concentrating transactions in riskier lending. The derivatives provisions of the SFSA would cause the spinning of swap desks of banks. An important result of the SFSA will be the migration overseas of these banks activities and the resulting weakening of the competitiveness of US banks relative to foreign banks that will hurt trade and global operations of US companies. (2) Much the same as what is revealed in the transcripts of FOMC meetings will happen with the systemic risk oversight council: lack of knowledge on what to do with regulatory powers. Banks that are viable in their present form may not be viable when dismembered of lines of business. The financial system may suffer crisis stress when the dismembering or even closing of one bank affects other banks that are large, medium or small and even the entire financial system. Amputations of business lines of key players in the financial system without precise science may well trigger the “systemic” crisis that the SFSA intends to prevent. Turmoil in financial markets and bank stocks in the preceding week created unpleasant memories of declines of stock prices of large financial institutions toward zero.
III Economic Recovery. US GDP increased for a third consecutive quarter at a seasonally annualized percentage rate of: IQ10 3.2, IVQ09 5.6 and IIIQ09 2.2 (http://www.bea.gov/newsreleases/national/gdp/2010/pdf/gdp1q10_adv.pdf ). GDP declined by 2.4 per cent in 2009 after increasing by 0.4 percent in 2008 and 2.1 percent in 2008. The credit/dollar crisis and global recession after 2007 is typically exaggerated as the “worst” financial and economic crisis since the Great Depression of the 1930s. Comprehensive review of the vast literature on the Great Depression reveals a contraction of output and employment that was immeasurably stronger than the world contraction in 2008-2009 (Pelaez and Pelaez, Regulation of Banks and Finance, 197-217). The decline in real or price adjusted GDP in 1930-1933 accumulated to 26.7 percent and 45.5 percent in current dollars or without adjusting by price changes (Pelaez and Pelaez, Financial Regulation after the Global Recession, 151). There was significant improvement in the driver of growth in IQ10 relative to IVQ09 revealed by the contribution in percentage points (pp) to the growth rate: personal consumption expenditures 2.55 pp in IQ10 versus only 1.16 pp in IVQ09, services 1.15 pp in IQ10 versus 0.49 pp in IVQ09and change in private inventories only 1.57 pp in IQ10 versus 3.79 pp in IVQ09. Net exports of goods and services contributed -0.61 pp in IQ10 versus 0.27 pp in IVQ09 and government -0.37 in IQ10 pp versus -0.26 in IVQ09. Demand instead of inventory reduction was the driver of GDP growth. The growth of GDP from the same quarter a year before of 2.5 percent in IQ10 was much higher than 0.1 percent in IVQ09, and the highest change since 1.6 percent in IIQ08. Personal consumption expenditures increased by 1.8 percent in IQ10 relative to a year earlier and gross private domestic investment by 7.7 percent for the first increase since IIIQ06. The percentage decline of gross private domestic investment exceeded 25 percent in the first three quarters of 2009 relative to the same quarter a year earlier. The Chicago purchasing managers’ business barometer increased for the seventh consecutive month by 5 points, reaching 63.8, which is the highest reading since Apr 2005 (https://www.ism-chicago.org/chapters/ism-ismchicago/files/ISM-C%20April%202010.pdf ). Seasonally adjusted initial-claims of unemployment insurance for the week ending Apr 24 decreased by 11,000 to 448,000 from the revised 459,000 in the previous week. Insured unemployment was 4.654 million in the week ending Apr 17, declining by 18,000 from the prior week’s 4.663 million (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
The failure to address the budget deficit and debt except probably by national value added and energy taxes to be considered after November could prevent the growth impulse required for alleviation of the plight of 26 million people in job stress. 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, and 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 ).
IV Conclusion. The recovery of full employment depends on sustained high quarterly annual rates of growth of GDP originating in demand and fixed investment. However, those rates may be restricted by taxation and higher interest rates. Exploding budget deficits and government debt may lead to higher taxation and interest rates that will stall economic recovery and relief to 26 million people suffering job stress. Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10

Too Politically Important to Liquidate, Job Loss in Financial Regulation Wars, Government Debt Burden and the 26 Million in Job Stress

Too Politically Important to Liquidate, Job Loss in Financial Regulation Wars, Government Debt Burden and the 26 Million in Job Stress
Carlos M Pelaez

The objective of this post is to analyze the Senate Financial Stability Act (SFSA) in a national and international perspective. The sections below consider (I) the SFSA, (II) international regulatory arbitrage, (III) government debt and interest rates, (IV) economic indicators and (IV) brief conclusions.
I The Financial Stability Act. The objective of the proposed Senate financial regulation is “to promote the stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail,’ to protect consumers from abusive financial services practices and for other purposes” (http://banking.senate.gov/public/_files/TheRestoringAmericanFinancialStabilityActof2010AYO10732_xml0.pdf http://banking.senate.gov/public/_files/FinancialReformSummaryAsFiled.pdf ). There are seven major issues and corresponding regulatory measures in the SFSA that are critically discussed in turn.
(1) The Procrustean bed of the causes of the credit/dollar crisis and global recession. The objective of the SFSA is to rein in banks and related financial institutions that allegedly created the crisis by irresponsible conduct. Irresponsibility of banks and the financial system allegedly manifested in excessive leverage, low liquidity, financing long-term instruments with short-dated funds in a “shadow banking system,” lax credit standards in origination of mortgages and generation of short-term profits in order to capture millions of dollars in immediate cash remuneration. The SFSA departs from an erroneous interpretation of the origins, propagation and duration of the credit crisis by entirely ignoring the causal and interactive policy impulses. The credit/dollar crisis and global recession originated in four almost contemporaneous policies that stimulated excessive construction and high real estate prices, highly-leveraged risky financial exposures, unsound credit and low liquidity: (i) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities (MBS) equivalent to a reduction in mortgage rates; (ii) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between Jun 2003 and Jun 2004 with the implicit intention in the “forward guidance” of maintaining low rates indefinitely if required in avoiding “destructive deflation”; (iii) the housing subsidy of $221 billion per year; and (iv) the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). The combined stimuli mispriced risk, causing excessively risky and highly-leveraged exposures as the public attempted to obtain higher returns on savings. The increase of the fed funds rate by 25 basis points per meeting of the FOMC from Jun 2004 to Jun 2006 raised the fed funds rate from 1 percent to 5.25 percent around the time that house prices peaked. The response of the Fed to the credit/dollar crisis was the reduction of the fed funds rate from 5.25 percent in Sep 2007 to 0 – ¼ percent in Dec 2008 without any subsequent change, inducing wide swings in world financial variables through distortions such as the carry trade of short positions in the dollar and long positions in emerging market stocks and commodities. The return of confidence after Mar 2009 reversed the carry trade, causing another opposite round of oscillation of financial variables. The inevitable adjustment of the fed funds rate creates now an environment of expected market stress similar to that during the increase from 1 percent to 5.25 percent in 2004-2006. The SFSA assumes perfect knowledge in legislation and regulation while in reality there are deficient forecasts of financial variables and the economy required for policy and inadequate knowledge about their interrelation. Most policy is a shot in the dark. The SFSA has passed the analysis of the crisis through a Procrustean bed to justify regulation already decided before any analytical considerations.
(2) Rush to regulation. The SFSA is proposed in a threatening tone of urgency that if it is not implemented the world may experience another devastating financial crisis. The rush to regulation contrasts with the lack of convincing technical analysis of the adequacy of the provisions to solve alleged individual vulnerabilities. There is no rigorous analysis of how the set of measures would work together in preventing financial crises. There is the more audacious contention that if the SFSA had been implemented there would not have been a credit crisis. This is a counterfactual (Pelaez and Pelaez, Globalization and the State, Vol. I, 125) or what would have occurred after 2006 if there had been careful implementation of the SFSA. The exercise would require data including the implementation of the SFSA before the credit crisis while only data without the SFSA are available. The future may reserve an actual adverse set of data of weaker economic growth because of lack of financing of innovation and financial crises after implementation of the SFSA. Past regulatory reforms have claimed that the system would be free of crises, such as the trust in central banking because of a long period of growth with low inflation known as the “great moderation” (Kenneth Rogoff cited in Pelaez and Pelaez, Regulation of Banks and Finance, 221, Globalization and the State, Vol. II, 195) only to awake to the surprise of an even deeper and adverse financial event. Prudence in analysis and choice of measures is not characteristic of the SFSA that resembles the CARD (Credit Card Accountability, Responsibility and Disclosure) Act of May 2009 (http://www.whitehouse.gov/the_press_office/Fact-Sheet-Reforms-to-Protect-American-Credit-Card-Holders ) that reduced credit limits and increased interest rates for almost everybody before its implementation in Feb 2010 with evident harms to consumers and the overall economy.
(3) Liquidation mechanism. The SFSA provides new authority to Treasury for the liquidation of banks and other institutions engaged in financial activities that pose a risk of bailouts with taxpayer funds in an alleged end of the “too big to fail.” An initial mechanism consists of a fund of $50 billion or $150 billion or more in other superfund proposals created with fees collected from banks to be used in “orderly” liquidation of big firms. The Congressional Budget Office (CBO) estimates that “the operations of Fannie Mae and Freddie Mac added $291 billion to CBO’s August 2009 baseline estimate of the federal deficit for fiscal year 2009 and $99 billion to the total deficit projected for the 2010-2019 period (http://www.cbo.gov/ftpdocs/108xx/doc10878/01-13-FannieFreddie.pdf ). Treasury eliminated the $400 billion ceiling of support of Fannie and Freddie, which “may tell the real story about the cost to taxpayers” (http://professional.wsj.com/article/SB10001424052748704671904575193910683111250.html ). Treasury entered into an agreement in Dec 2009 with Fannie and Freddie to provide “funds, as needed, to correct any net worth deficits for calendar quarters in 2010 through 2012” (http://www.fanniemae.com/kb/index?page=home&c=investors ). There will not be “funerals” for “the too politically important to liquidate” will enjoy existence with the wasteful use of taxpayers’ money. The liquidation mandate opens the opportunity for government ownership of financial institutions. Government ownership and control of banks over the world has been disastrous (Pelaez and Pelaez, Regulation of Banks and Finance, 227) and the Swedish bank workout was successful with an agreement by the major political parties of not nationalizing the banks (Financial Regulation after the Global Recession, 170-1).
(4) Systemic risk council. The SFSA provides for an oversight council that “will monitor systemic risk and make recommendations to the Federal Reserve for increasingly strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity, with significant requirements on companies that pose risks to the financial system” (http://banking.senate.gov/public/_files/FinancialReformSummaryAsFiled.pdf ). The task of this council is dismembering big financial entities because of fears that they will fail, causing failures of other entities. There is no operational theory of systemic risk. A motivation for the council is that companies engage in complex financial transactions that they do not even understand. If this were true, how can the council understand the transactions and their effects through the financial system? A bank may be viable under the current structure but could become unviable if limited or dismembered by such a council. Much the same is true of the financial system as a whole such that the council poses the risk of triggering by its actions adverse effects throughout the entire financial system. In its dismembering role, the council may frustrate financial innovations that are required for financing technological change in the overall economy that has been the driver of United States economic growth, prosperity and job creation. In short, the council may frustrate progress and also create its own adverse financial events.
(5) Transparency and accountability for exotic instruments. The system of securitization of credit and risk management with derivatives functioned without problems until monetary and housing policy induced a flood of nonprime mortgages. There were few if any problems with non-mortgage backed securities and derivatives. The transfer of derivatives transactions to formal exchanges with standard contracts will prevent clients in “Main Street” as well as in “Wall Street” financial institutions from obtaining risk management products that are tailored to their needs in size, notional value and term. It would also eliminate sources of profit diversification to banks, concentrating risk on credit. The derivatives transactions will migrate to other jurisdictions, weakening the international competitiveness of US banks.
(6) Consumer protection. The effects of consumer protection can be predicted from the CARD Act: lower volumes of lending at higher rates. Politicizing consumer credit will scare investor capital away from banks engaged in consumer credit. Lower Tier 1 capital will force contraction of consumer lending volumes.
(7) Executive compensation and corporate governance. The SFSA is preventing financial institutions from hiring the talent at market rates of remuneration that is required for successful management. There is here again the Procrustean bed by cherry picking a few cases to cloud the knowledge provided by the vast majority of cases. A few believed in 2007 in widespread mortgage default and protected their net worth with defensive positions but the intent of the legislature is to penalize their success. In fact, those defensive or short positions were beneficial because the sooner real estate prices inflated by housing and interest rate policies declined to a trough the faster and stronger the recovery. Efforts to prevent real estate prices to reach rebound levels prolong the adjustment and raise its costs (Pelaez and Pelaez, Globalization and the State, Vol. II, 210-3, Government Intervention in Globalization, 182-4). The flight of talent and financial institutions overseas will erode the quality and competitiveness of US financial institutions.
II International Regulatory Arbitrage. The communiqué of the G20 meeting of finance ministers and central bank governors on Apr 23 informs the commitment to complete financial regulation rules by end-2010. It states that: “these rules will be phased in as financial conditions improve and economic recovery is assured, with the aim of implementation by end-2012” (http://www.g20.utoronto.ca/2010/g20finance100423.pdf ). Key member countries in the International Monetary and Financial Committee of the IMF (IMFC) (see Pelaez and Pelaez, International Financial Architecture, 96-100, Globalization and the States, Vol. II, 114-25) favor a regulatory environment “helping to promote a level playing field” (http://www.imf.org/external/np/sec/pr/2010/pr10166.htm ). The SFSA is jumping ahead of the world, allowing other jurisdictions to arbitrage regulation so as to attract the financial industry away from the United States. Financial institutions and their customers will be forced by the SFSA to incur heavy costs of regulation, known as transaction costs, and even outright prohibition of lines of business that had nothing to do with the financial crisis. The loss of competitiveness by financial institutions will drive them to other jurisdictions, causing direct losses of jobs. The higher cost and lower volume of credit will reduce innovation, growth and job creation.
III Government Debt and Interest Rates. The current World Economic Outlook of the International Monetary Fund provides estimates of the fast increase of the government debt as percentage of GDP for advanced economies from 2008 to 2015: Canada 22.6 to 30.4, France 57.8 to 85.1, Germany 59.3 to 74.8, Italy 103.9 to 122.1, Japan 96.9 to 153.9, United Kingdom 45.5 to 83.9, United States 47.2 to 85.5 and Euro Area 59.5 to 84.9 (http://www.imf.org/external/pubs/ft/weo/2010/01/pdf/text.pdf ). The IMF states that “without more fully restoring the health of financial and household balance sheets, a worsening of public debt sustainability could be transmitted back to banking systems or across borders” (http://www.imf.org/external/pubs/ft/gfsr/2010/01/pdf/summary.pdf ). The recovery of the world economy will be constrained by taxation and increases in interest rates resulting from the fiscal imbalance in countries that account for more than one half of the generation of world economic activity. Sovereign debt events in certain countries in Europe are causing oscillations in yields of Treasuries. The yield curve on Apr 23 shows an increase in the yield of the 10-year Treasury to 3.82 percent from 3.77 percent in the prior week (http://markets.ft.com/markets/bonds.asp ). The 10-year sovereign bond of Canada traded at a negative spread of 12 basis points (bps) relative to the 10-year Treasury (3.70 versus 3.82) and the 10-year German sovereign bond at a negative spread of 75 bps (3.06 versus 3.82). The ask rate of the 10-year swap traded at 3.81 percent or 1 basis point less than the yield of 3.82 percent of the 10-year Treasury (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=ICAP-230410 ). United States government debt could trade at a risk premium unless there is a credible deficit and debt control effort that does not rely exclusively on taxes such as the balloon trial of a stealth value added tax (VAT) and new taxes on energy.
IV Economic Indicators. Housing could be reaching a bottom, industry leads the recovery, inflation is subdued and recovery of employment will take time. Two reports find improving conditions in housing. First, existing home sales reported by the National Association of Realtors increased by 6.8 percent in Mar, reaching the seasonally adjusted annual rate of 5.35 million units relative to 5.01 million in Feb and higher by 16.1 percent relative to 4.61 million in Mar 2009. The inventory of existing homes available for sale increased by 1.5 percent in Mar to 3.58 million, which is equivalent to 8 months of supply and 21.7 percent below the record of 4.58 million in Jul 2008 (http://www.realtor.org/press_room/news_releases/2010/04/ehs_favorable ). Second, sales of new single-family houses increased by 26.9 percent in Mar from a 411,000 seasonally-adjusted rate relative to the revised Feb level of 324,000; Mar sales are 23.8 percent higher than 332,000 in Mar 2009 (http://www.census.gov/const/newressales.pdf ). Sales in these reports were likely influenced by the rush in capturing the home-purchase stimulus before expiration on Apr 30. The producer price index increased by 6.0 percent in the 12 months ended in Mar 2010. However, the increase in prices for consumer foods of 2.4 percent caused 70 percent of the increase in the index of finished goods. Prices of finished goods increased 0.7 percent but prices excluding food and energy increased by only 0.1 percent (http://www.bls.gov/news.release/pdf/ppi.pdf ). New orders of manufactured durable goods decreased in Mar by 1.3 percent but increased by 2.8 percent excluding transportation. New orders increased by 11.9 percent in the 12 months ending in Mar 2010 and excluding transportation by 13.8 percent (http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf ). Initial claims for unemployment insurance in the week ending on Apr 17 were 456,000, decreasing by 24,000 relative to 480,000 in the prior week. Seasonally-adjusted insured unemployment in the week ending on Apr 10 was 4.644 million, declining by 40,000 from the prior week’s 4.686 million (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
V Conclusion. The SFSA will destroy jobs because of higher costs of business resulting from new regulation that will increase interest rates and reduce credit volume. By anticipating regulation ahead the rest of the world, the US will export its financial industry and jobs to other jurisdictions with more competent and prudent regulation. Another adverse financial event in the US precipitated by regulatory attacks on banks will spread throughout the world. Economic recovery will be limited by the rise in taxes and interest rates resulting from fiscal profligacy in the form of government debt catapulting toward 100 percent of GDP. There is still time to modify the agenda to ensure future progress and job creation that will rescue the 26 million persons in the United States in job stress. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 ).

Too Big To Liquidate, Destroying Jobs by Regulation, the 26 Million Persons in Job Stress and the Global Debt Crisis

Too Big To Liquidate, Destroying Jobs by Regulation, the 26 Million Persons in Job Stress and the Global Debt Crisis
Carlos M Pelaez

The motivation for financial regulation consists of four major objectives: (1) preventing speculators from taking risky positions in expectation of bailouts with taxpayer funds; (2) creating the tools required in preventing another crisis; (3) holding Wall Street accountable and protecting consumers; and (4) providing transparency and oversight of derivatives to avoid risks that can undermine the economy (http://www.whitehouse.gov/blog/2010/04/16/every-member-congress-going-have-make-a-decision ). The objective of this post is to analyze the adequacy of the Senate proposal for a Financial Stability Act in attaining the four goals that motivate financial regulation. The first section below provides (I) analysis and an example of the role of transaction costs and the following three sections consider the proposed legislation of (II) consumer protection, (III) systemic risk oversight council and (IV) derivatives regulation by appeal to their potential effects on transactions costs, employment and stability. The analysis evaluates the effectiveness in attaining the four goals of the financial overhaul effort. The remainder considers (V) current economic conditions, (VI) interest rates, the fiscal situation and brief (VII) conclusions.
I Transaction Costs. Neoclassical or mainstream economics analyzes an abstract firm managed by entrepreneurs incurring costs of production such as labor, capital and natural resources and occasionally transportation costs. In his 1937 magnum opus that only received the Nobel Prize in 1991 (http://nobelprize.org/nobel_prizes/economics/laureates/1991/coase-autobio.html ) the British economist Ronald H. Coase explored a more complex “coordinator” in corporations making decisions on “transaction costs” that can be defined as all costs other than those incurred in production and transportation (Pelaez and Pelaez, Globalization and the State, Vol. I, 137-43, Government Intervention in Globalization, 81-4). John Wallis and Douglas North estimate that the transaction sector in the US economy is equivalent to about one half of GDP (cited in Pelaez and Pelaez, Government Intervention in Globalization, 82, 191). Higher additional transaction costs that will be created by the proposed financial regulation in Congress increase costs of business, preventing investment, production and job creation.
Trade finance provides an example of transaction costs from actual banking experience (Pelaez and Pelaez, Globalization and the State, Vol. I, 140). In short, trade finance converts a future commitment of a US company to sell manufactured goods at a future date, say in 90 days, to a foreign buyer into bank credit received today by the American company with which to pay for costs of hiring labor and initiating production of goods for future delivery, or in 90 days. Consider a small manufacturing business in the US seeking buyers for its products. There are myriad transaction costs in developing the export business that can create jobs: (1) acquiring knowledge in foreign markets to find buyers and product prices; (2) spending in financial planning in calculating if the price in foreign markets is more attractive than selling in the US; (3) negotiating contracts with foreign buyers among many potential clients; (4) developing or outsourcing staff with language and cultural skills; (5) spending on specialized attorneys in various jurisdictions or through large law firms with foreign relations; (6) negotiating trade finance with a domestic international bank or a corresponding bank of foreign banks to receive immediately the proceeds of future sales required to hire employees, buy inputs and pay all production expenses; (7) supervising compliance of the contract by the foreign client; (8) spending by the bank in evaluating credit perhaps using costly infrastructure of relationship banking that increases the costs to the client; (9) vigilance by the exporter that the foreign buyer will comply with the agreement; and (10) arranging with the bank tailor-made derivatives contracts for delivery of a future foreign exchange rate that prevents changes in prices to the foreign buyer in his/her currency at the time of closing the sale. The Senate Financial Stability Act is job destroying by increasing transaction costs through this chain and similar ones that inhibit business and job creation. The large international bank required by US small and large companies for business abroad will be dismembered arbitrarily and surviving business and jobs will be transferred to foreign jurisdictions with more appropriate regulation. The required derivatives contract will be provided by a bank in a foreign jurisdiction, destroying jobs in domestic banks. Instead of parsimony in government expenditure, trial balloons by insiders propose a national value added tax (VAT) and taxes on energy or stealth taxes that would exacerbate adverse effects of higher transaction costs by taxing almost everything, eroding competitiveness and destroying jobs (http://professional.wsj.com/article/SB30001424052702303720604575170320672253834.html ). The tax is stealth because consumers will see a higher price but no tax breakdown. The poor with higher consumption as percentage of income will pay more dearly for those taxes.
II Consumer Financial Protection Bureau. The need for change here according to the Financial Stability Act is because “the economic crisis was driven by an across-the-board failure to protect consumers” (http://banking.senate.gov/public/_files/FinancialReformSummary231510FINAL.pdf ). The proposed solution is to politicize consumer credit by creating an agency “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 caused by the CARD (Credit Card Accountability, Responsibility and Disclosure) Act of May 2009 (http://www.whitehouse.gov/the_press_office/Fact-Sheet-Reforms-to-Protect-American-Credit-Card-Holders) and subsequently by lower growth and employment creation. Investors will not purchase stocks of financial institutions engaged in consumer credit, reducing banks’ equity capital required for lending. Consumers of credit will pay in higher interest rates and lower credit limits for the increased transaction costs to banks that remain in the business of consumer lending resulting from a new costly and politicized consumer protection agency.
III Financial Stability Oversight Council. The need for this new agency according to the Financial Stability Act is “identifying, monitoring and addressing systemic risks posed by large, complex financial firms as well as products and activities that spread risk across firms.” Alan H. Meltzer reminds that this council will be controlled by Treasury, which has been behind all past bailouts (http://www.house.gov/apps/list/hearing/financialsvcs_dem/meltzer.pdf ). Treasury has a political conflict of interest. The proposal of this council is not operational. If large, complex and “interconnected” financial institutions pose systemic risk, the regulator without theory, measurement and experience will trigger that risk worldwide by attempts to dismember these institutions. The regulatory agency would become a laboratory of detonating systemic risk with the public in the role of the controlled patients exposed to the toxin of the ill-devised experiment. Of course, there are no controlled experiments especially of these dimensions in economics. It would be like “detonate the big banks and run for cover.” How does the council dispose of trillions of dollars of assets without causing a major upheaval in world financial markets and another global recession? Viable institutions may become unviable after dismembering with the government taking over permanently the remainder of the worthless corpus. The $50 billion of the proposed bailout fund or the $150 billion alternative would not have been enough for the hundreds of billions of dollars of the bailouts of Fannie and Freddie but the new bailout activity or “business as usual” of the government could induce growth of larger firms that could become the future Fannie and Freddie (Peter Wallison and David Skeel in http://professional.wsj.com/article/SB20001424052702303493904575167571831270694.html ). There is the danger in the new liquidation authority, with or without bailout fund, that a troubled bank could become state-controlled or the banking equivalent of Fannie and Freddie by replacing “too big to fail” with the more political “too big to liquidate.” Government ownership and control of banks over the world has been disastrous (Pelaez and Pelaez, Regulation of Banks and Finance, 227) and the Swedish bank workout was successful with an agreement by the major political parties of not nationalizing the banks (Financial Regulation after the Global Recession, 170-1).
IV Derivatives. The stringent derivative rules simply increase transaction costs and rapidly export the financial industry to other jurisdictions, resulting in the loss of jobs and business. US banks would not be able to compete with large international banks, which are the ones prevailing in foreign jurisdictions. The large number of smaller banks in the US is a relic of past regulation (Pelaez and Pelaez, Regulation of Banks and Finance, 72-7, 82-99, 203-5, Financial Regulation after the Global Recession, 20-1, 56-61, 63-8). Problems occurred only with derivatives written on cash flows of underlying nonprime mortgages. Starts of privately-owned housing in Mar stood at the seasonally-adjusted rate of 626,000, 1.6 percent above the revised Feb estimate of 616,000 and 20 percent above 521,000 in Mar 2009 (http://www.census.gov/const/newresconst_201003.pdf ) but well below by 71 percent of rates around 2.2 million at the turn of 2005 into 2006 (http://www.census.gov/const/newresconst_200601.pdf ). It is difficult to find physical rates of declines such as these ones in historical data, which illustrate that the housing subsidy by interest rates, housing policy and Fannie and Freddie is the main culprit of the credit/dollar crisis and global recession. A combination of near-zero interest rates, housing subsidy of $221 billion per year and purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie and Freddie created a flood of nonprime mortgages that eroded the credit quality of segments of financial assets and their derivatives ((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). There was a credit/dollar crisis, and not a financial crisis, resulting from nonprime credit in mortgages induced by housing and interest rate policy stimuli. Job levels lost in construction and real estate may not be recovered, forcing millions of workers into tough adjustments in different occupations.
V Economy. Net long-term purchases of US securities by foreigners totaled $47.1 billion in Feb with domestic securities purchased by foreigners of $51.4 billion and foreign securities purchased by US residents of $4.2 billion (http://www.ustreas.gov/press/releases/tg642.htm ). Total foreign holdings of Treasuries were $3750 billion of which the two largest were $877 billion or 23 percent by China and $768 billion or 20 percent by Japan for combined concentration of 43 percent in those two countries (http://www.treas.gov/tic/mfh.txt ). Exports of goods and services of $143.3 billion less imports of goods and services of $182.9 billion in Feb resulted in a trade deficit of $39.7 billion, which is higher than $37.0 billion in Jan (http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf ). While the deficit in trade in goods was $51.3 billion, the surplus in services was $11.6 billion. The US is a net exporter of services with high-paid domestic-created jobs in contrast with the critical literature blaming loss of jobs by “offshoring” or contracting services abroad (See Gregory Mankiw and literature cited in Pelaez and Pelaez, Globalization and the State, Vol. I, 192-7, Government Intervention in Globalization, 101). The trade deficit of goods and services jumped by $13.2 billion relative to that of Feb 2009, raising concern that global trade imbalances (Pelaez and Pelaez, The Global Recession Risk, Globalization and the State, Vol. II 180-94, Government Intervention in Globalization, 167-70) may recur in the recovery phase. Imports increased by $31.1 billion or 20.5 percent while exports increased by $17.9 billion or 14.3 percent. The increase in imports of goods from Feb 2009 to Feb 2010 in industrial supplies and material, automotive vehicles, capital goods and others confirms the recovery of the economy. Retail and food services sales increased in Mar by 1.6 percent relative to Feb and by 7.6 percent relative to Mar 2009. Sales in Jan-Mar 2010 increased by 5.5 percent relative to Jan-Mar 2009 (http://www.census.gov/retail/marts/www/marts_current.pdf ). The inventory/sales ratio declined to 1.27 in Jan 2010 much lower than 1.46 in Feb 2009 and close to 1.25 in 2005 well below the 2001 recession level of 1.45 (http://www.census.gov/mtis/www/data/pdf/mtis_current.pdf ). The Empire State Manufacturing Survey of the FRBNY increased by 9 points to 31.9 showing rapid pace of improving conditions for New York State manufacturers (http://www.ny.frb.org/survey/empire/Empire2010/empiresurvey_20100415.html ). The index of current activity of the Philadelphia FRB survey increased from 18.9 in Mar to 20.2 in Apr for the third consecutive monthly increase and positive reading in eight consecutive months (http://www.phil.frb.org/research-and-data/regional-economy/business-outlook-survey/2010/bos0410.pdf ). The index of industrial production of the Fed estimates an increase of 0.1 percent in Mar and an annual rate of increase of 7.8 percent in the first quarter of 2010. Capacity utilization in industry increased in Mar to 73.2 percent from 73.0 percent in Feb, which is still significantly below the average capacity utilization of 80.6 percent in 1972-2009 and the 1994-5 high of 84.9 percent (http://www.federalreserve.gov/releases/g17/Current/g17.pdf ). The consumer price index (CPI) increased by 0.1 percent in Mar and by 2.3 percent in the prior 12 months (http://www.bls.gov/news.release/pdf/cpi.pdf ). Initial jobless claims seasonally adjusted were 484,000 in the week ending Apr 10, increasing by 24,000 from the revised 460,000 for the previous week. Seasonally adjusted insured unemployment in the week ending Apr 3 was 4.639 million, increasing by 73,000 from the prior week’s 4.566 million (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). The Easter holiday week may mask numbers that could be lower. The Beige Book of the FRS finds that “overall economic activity increased somewhat since the last report” in all FRS districts except St. Louis (http://www.federalreserve.gov/fomc/beigebook/2010/20100414/default.htm ).
VI Interest Rates. On Apr 17, the yield curve of Treasuries was: 6-months 0.23 percent, 2-years 0.96 percent, 5-years 2.47 percent and 10-years 3.77 percent (http://markets.ft.com/markets/bonds.asp ). The yield curves for governments of Japan and the Euro Area were similarly shaped, horizontal for the short segment near the “zero bound” and sharply increasing in slope for the long segment. The turbulence with sovereign risks combined with the selloff in equities because of fears of China and US financials lowered the yields of Treasuries causing unloading of risk by investors in pursuit of safety. The 10-year yield spreads of Germany relative to Treasuries was -69 basis points (bps) (3.08 less 3.77) and -9 bps for Canada (3.68 less 3.77) (http://markets.ft.com/markets/bonds.asp ). The ask rate for the 10-year interest rate swap was 3.76 percent, 1 basis point less than the 3.77 percent yield of the 10-year Treasury and the ask rate of the 30-year interest rate swap was 4.49 percent or -22 bps less than the 4.67 percent yield of the 30-year Treasury (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=ICAP-160410 ). Yields of Treasuries are probably beginning to reflect the sharply deteriorating fiscal situation of the US. The First Managing Director of the International Monetary Fund (IMF), John Lipsky, revealed the projection that average government debt of advanced countries will increase from 75 percent of GDP at year-end 2007 to 110 percent of GDP at year-end 2014. The IMF expects that with the exception of Canada and Germany all G7 countries including the US will have debt/GDP ratios above 100 percent by 2014 (http://www.imf.org/external/np/speeches/2010/032110.htm ). The Fed holds a portfolio of $1.98 trillion of long-term securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ) that will cause increases in long-term interest rates when it is sold to the public even using appropriate tools in an optimum exit strategy. Issuance of debt to pay for continuing high government deficits and refinancing of maturing debt together with the sale of the Fed’s portfolio will cause upward pressure on long-term interest rates with likely adverse effects on the rate of economic growth and employment. Chairman Bernanke considers a baseline scenario of the Congressional Budget Office under which the debt/GDP ratio would “be greater than 70 percent at the end of fiscal 2012” and probably continue rising. Under alternative assumptions “the deficit at the end of 2020 would be 9 percent of GDP and the federal debt would balloon to more than 100 percent of GDP. Addressing the country’s fiscal problems will require difficult choices, but postponing them will only make them more difficult” (http://www.federalreserve.gov/newsevents/testimony/bernanke20100414a.htm ). Economic recovery and job creation will be restrained by higher taxes and interest rates for everything and everybody.
VII Conclusion. Government is perhaps the most important institution in modern democracies. Balancing government intervention with private decisions is one of the most difficult intellectual endeavors with many approaches or models but no unified theory (Pelaez and Pelaez, Government Intervention in Globalization, 1-11, 75-88, Globalization and the State, Vol. I, 110-56, Regulation of Banks and Finance, 5-29, Financial Regulation after the Global Recession, 4-44). Each case must be considered on net probable benefits relative to costs. The Financial Stability Act will increase transaction costs inhibiting business activity and job creation. There is risk of financial instability in a risk oversight council lacking credible theory, information, forecasts and policy but with excessive powers in arbitrarily dismembering banks. Arbitrary restrictions on banks by new layers of regulatory agencies not only will increase the cost of credit and reduce its volume but will also cause flight of equity capital that could generate another financial crisis by collapse of bank stocks toward zero. Part of the US financial sector and jobs will be exported to other jurisdictions that are wiser in regulation. The first major country implementing financial regulation is precisely the one exporting its financial sector to other jurisdictions. The approach of a world level playing field in banking by the Basel institutions is superior to regulatory wars. The financial overhaul is inopportune in that it may accentuate the deterioration of the credit quality of the debt of the United States government and of banks and other financial institutions. Economic recovery will flatten without hope for the 26 million people locked in prolonged job stress largely because of misguided interest rate and housing policies. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)

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

There are 26 million persons in job distress: 15 million people unemployed (of which 6.5 million for 26 weeks or more), 9.5 million employed part-time because they cannot find full-time jobs and 2 million marginally attached to the labor force because they do not believe they will find jobs (http://www.bls.gov/news.release/pdf/empsit.pdf ). The priority of the national agenda is jobs as soon as possible or in the short run in which we live that the economist John Maynard Keynes dramatically emphasized with the phrase “In the long run, we are all dead.” The policy agenda is busy with restructuring everything for what is alleged to be a better long run. This comment considers below various views of the causes of the credit/dollar crisis and global recessions and their corresponding policy proposals for financial regulation, new releases of economic indicators, interest rates, government budget deficits and debt and the probable frustration by rising taxes and interest rates of rapid economic growth that can create the needed jobs. The agenda has perilously shifted from the macroeconomic policies required for growth and job creation to the important but currently irrelevant microeconomic policies that allegedly could improve efficiency in the long run when many will be unemployed and in default because of the huge cumulative debt resulting from rushed restructuring policies.
I Views on the Credit Crisis and Financial Regulation. The Government View of the origin of the credit crisis and global recession is explained in the Pittsburgh G20 statement on Sep 24-25, 2009, by an “era of irresponsibility” in the form of excesses in risks and leverage in banks (http://www.g20.utoronto.ca/2009/2009communique0925.html ). The proposed solution is strengthening the “international financial regulatory system.” There is an ambitious international agenda of financial regulation centered on the Basel institutions (Pelaez and Pelaez, Financial Regulation after the Global Recession, 171-5, Regulation of Banks and Finance, 229-36). This technical process of international cooperation should be completed instead of being anticipated by individual national legislative initiatives.
The Legislative View in the US postulates that the credit crisis originated in excessive risk taking by finance professionals who generated short-term profits to appropriate “irresponsible” compensation in bonuses and stock options. One of the major proposals is the creation of a Consumer Financial Protection Bureau as a new independent agency. The need for change here according to the Financial Stability Act of the Senate Banking Committee is that “the economic crisis was driven by an across-the-board failure to protect consumers” (http://banking.senate.gov/public/_files/FinancialReformSummary231510FINAL.pdf ). The new consumer protection agency may repeat CARD, the Credit Card Accountability, Responsibility and Disclosure Act signed on May 22, 2009. (http://www.whitehouse.gov/the_press_office/Fact-Sheet-Reforms-to-Protect-American-Credit-Card-Holders ). CARD went into effect on Feb 22, 2010, allowing nine months during which issuers engaged in lowering credit limits and raising interest rates for most cardholders but especially those with lower credit scores. Another proposal is creating a Financial Stability Oversight Council. The need for this new agency according to the Financial Stability Act is “identifying, monitoring and addressing systemic risks posed by large, complex financial firms as well as products and activities that spread risk across firms.” Bailouts would be financed from a fund created with fees from banks instead of taxpayer contributions. The $50 billion of that fund would not have bailed out Fannie and Freddie but the government in the new bailout activity could induce growth of larger firms that could become the future Fannie and Freddie (Peter Wallison and David Skeel in (http://professional.wsj.com/article/SB20001424052702303493904575167571831270694.html ). Breaking banks because they could be too big would make US banks uncompetitive internationally and without the capacity of financing overseas operations of US corporations. The bill is job destroying while also eroding financial competitiveness. Yet another proposal consists of the Volcker Rule prohibiting proprietary trading, hedge funds and private equity funds in banks. None of these activities was the source of problems during the credit crisis. The Volcker Rule weakens financial intermediation without promoting stability.
The Fed View argues that regulatory deficiencies did not timely identify exposures with excessive risk and low liquidity in the origination of mortgages bundled in securities that were subsequently sold and financed with short-term funds (http://www.federalreserve.gov/newsevents/speech/20100407a.htm ). There were subsequent problems in financial institutions with large, complex assets and interconnected with other entities, thus creating systemic risk. An important sound proposal in this view is maintaining the regulatory and supervisory functions of the Federal Reserve System. The Fed is endowed with unrivaled expertise and talent without the more politicized environment because of its policy independence and sober tradition.
According to an Alternative View, the credit/dollar crisis and global recession originated in four almost contemporaneous policies that stimulated excessive construction and high real estate prices, highly-leveraged risky financial exposures, unsound credit and low liquidity: (1) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities (MBS) equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between Jun 2003 and Jun 2004 with the implicit intention in the “forward guidance” of maintaining low rates indefinitely if required in avoiding “destructive deflation”; (3) the housing subsidy of $221 billion per year; and (4) the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). The combined stimuli mispriced risk, causing excessively risky and highly-leveraged exposures as the public attempted to obtain higher returns on savings. The increase of the fed funds rate by 25 basis points per meeting of the FOMC from Jun 2004 to Jun 2006 raised the fed funds rate from 1 percent to 5.25 percent around the time that house prices peaked. The response of the Fed to the credit/dollar crisis was the reduction of the fed funds rate from 5.25 in Sep 2007 to 0 – ¼ percent in Dec 2008 without any subsequent change. The Fed faces an even more difficult challenge in the current environment than in 2004 because the Fed balance sheet increased by 115.7 percent from $855.1 billion in February 2008 to $1844.9 billion in February 2009 (Pelaez and Pelaez, Regulation of Banks and Finance, 225-6, Financial Regulation after the Global Recession, 158-9). The proposal resulting from this view is to allow the completion of the regulatory proposals by the Basel institutions for implementation after economic and job recovery while permitting the Fed to steer monetary policy away from the stimulus.
II Economic Indicators. The nonmanufacturing index of the Institute for Supply Management (ISM) rose by 2.4 percentage points from 53 in Feb to 55.4 in Mar, suggesting growth in the services sector for the third consecutive month (http://www.ism.ws/ISMReport/NonMfgROB.cfm ). The National Association of Realtors announced an increase of 8.2 percent of pending home sales for Feb and 17.3 percent relative to a year earlier (http://www.realtor.org/press_room/news_releases/2010/04/phs_gain ). The Fed announced that consumer credit declined by $11.5 billion from $2459.4 billion in Jan to $2447.9 billion in Feb. Revolving credit declined by $9.5 billion and nonrevolving credit by $2.0 billion (http://www.federalreserve.gov/releases/g19/Current/ ). The annual rate of decline of consumer credit was 5.5 percent with revolving credit declining at the annual rate of 13 percent and nonrevolving credit declining at the rate of 1.5 percent. Revolving credit by credit card issuers had been experiencing sharp increases in interest rates and reductions in credit limits in anticipation of CARD, which went into effect with a nine month lag on Feb 22, 2010 (http://www.whitehouse.gov/the_press_office/Fact-Sheet-Reforms-to-Protect-American-Credit-Card-Holders ). Initial claims of unemployment insurance for the week ending on Apr 3 grew by 18,000, reaching 460,000 relative to the revised 442,000 a week earlier. The increase in the 4-week moving average was 2250, reaching 460,250 relative to the revised 448,000 a week earlier. The number of persons claiming benefits in state programs was 5.0 million, decreasing by 168,431 from a week earlier and much lower than 6.5 million a year earlier (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). Sales of merchant wholesalers increased by 0.8 percent in Feb relative to the earlier month and by 9.8 percent relative to a year earlier. Sales of durable goods grew by 6.5 percent relative to a year earlier and sales of motor vehicles and parts by 2.4 percent relative to a month earlier (http://www2.census.gov/wholesale/pdf/mwts/currentwhl.pdf ).
III Interest Rates. The Fed released on Apr 6 the minutes of the meeting of the Federal Open Market Committee (FOMC) held on Mar 16 (http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20100316.pdf ). The view in the FOMC meeting was of a strengthening economy proceeding at a “moderate pace.” There were significant gains in retail sales, business spending on equipment and software and expanding exports of goods. Labor markets were beginning to stabilize but housing and construction stalled. The view of the FOMC is of continuing subdued inflation. With one exception, FOMC members concurred that low levels of utilization of resources, subdued inflation and stable inflation expectations warranted the maintenance of low fed funds rates for an extended period. The FOMC did not take decisions on the exit strategy for the portfolio of long-term securities.
Strong demand in auctions for 10- and 30-year Treasuries (http://www.ft.com/cms/s/0/7a45a880-427b-11df-8c60-00144feabdc0.html ), probably because of doubts on sovereign risks, caused a slight downward shift in the yield curve on Apr 9 from a week earlier but continuing upward shift relative to a month earlier. The 10-year yield declined by 6 basis points (bps) to 3.88 percent from 3.94 percent a week earlier but increased by 18 bps from 3.72 percent a month earlier (http://markets.ft.com/markets/bonds.asp ). G7 countries with lower budget deficits have negative spreads relative to the 10-year Treasury: 3.65 - 3.88 or -24 bps for Canada and 3.17 – 3.88 or -71 bps for Germany (http://markets.ft.com/markets/bonds.asp ). On Apr 2, the 10-year interest rate swap was 3.87 percent while the 10-year constant-maturity Treasury was 3.89 percent for negative spread of -2 bps (http://www.federalreserve.gov/releases/h15/data.htm ).
IV Government Deficits, Debt and Taxes. The Congressional Budget Office (CBO) calculates record fiscal deficits from the President’s budget proposal of $1.5 trillion in 2010, or 10.3 percent of GDP, and $1.3 trillion in 2011, or 8.9 percent of GDP after $1.4 trillion or 9.9 percent of GDP in 2009 (http://www.cbo.gov/ftpdocs/112xx/doc11231/frontmatter.shtml ). Debt held by the public would rise from $7.3 trillion or 53 percent of GDP in 2009 to $20.3 trillion or 90 percent of GDP in 2020. Net interest would quadruple from 1.4 percent of GDP in 2010 to 4.1 percent in 2020. The First Managing Director of the International Monetary Fund (IMF), John Lipsky, revealed the projection that average government debt of advanced countries will increase from 75 percent of GDP at year-end 2007 to 110 percent of GDP at year-end 2014. The IMF expects that with the exception of Canada and Germany all G7 countries including the US will have debt/GDP ratios above 100 percent by 2014 (http://www.imf.org/external/np/speeches/2010/032110.htm ). The Fed holds a portfolio of $1.94 trillion of long-term securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ) that will cause increases in long-term interest rates when it is sold to the public even using appropriate tools in an optimum exit strategy. Issuance of debt to pay for continuing high government deficits and refinancing of maturing debt together with the sale of the Fed’s portfolio will cause upward pressure on long-term interest rates with likely adverse effects on the rate of economic growth and employment. The will to restore fiscal balance by elected officials is replaced by profligacy during election processes in alternate years.
The CEO of one of the largest banks that navigated through the credit crisis without a single quarter of loss states: “If we rewrite the rules for banks out of anger or populism, we’ll end up with the wrong solutions and put barriers in the way of future economic growth. Good policy and financial reform must be based on facts and analysis and need to be comprehensive, coordinated, consistent and relevant” (Jamie Dimon in http://files.shareholder.com/downloads/ONE/889418027x0x362440/1ce6e503-25c6-4b7b-8c2e-8cb1df167411/2009AR_Letter_to_shareholders.pdf ). Regulation should control reckless conduct without frustrating required financing of risk taking and innovation that Schumpeter identified as the driver of US economic growth (Pelaez and Pelaez, Government Intervention in Globalization, 46, Globalization and the State Vol. I, 50). Schumpeter also discovered a key role of banks in financing innovation and growth (Beck, Levine and Loayza and Rondo Cameron cited in Pelaez and Pelaez, Regulation of Banks and Finance, 41). The sober approach is that of Functional Structural Finance (FSF) developed by Robert C. Merton and Zvi Bodie, which is ideology-free because the financial functions can be provided by the private-sector, government and family institutions ((Pelaez and Pelaez, Regulation of Banks and Finance, 234-6, Financial Regulation after the Global Recession, 34-7). FSF posits that spirals of financial innovation, including structured products, academic landmarks such as Black-Scholes-Merton option pricing and risk-management techniques as by RiskMetrics®, improve the functions of finance required for economic growth. Excessive regulation can distort risk/returns decisions, preventing efficient financial functions, flattening the expansion path of the economy and preventing full employment.
Chairman Bernanke warned that “unless we as a nation demonstrate a strong commitment to fiscal responsibility, in the longer run we will have neither financial stability nor healthy economic growth” (http://www.federalreserve.gov/newsevents/speech/20100407a.htm ). Government expenditures have risen to a peacetime high of 25 percent of GDP. Instead of parsimony in government expenditure, proposals begin to surface for a national value added tax (VAT) and taxes on energy (http://professional.wsj.com/article/SB30001424052702303720604575170320672253834.html ). The expansion path of the economy will be flattened by taxes on everything to sanction a higher share of the government in economic activity. Taxes tend to create their own expenditure and may not fill the budget hole. Carmen Reinhart and Kenneth Rogoff conducted monumental research for their magnum opus This Time is Different, finding that credit crises are followed by even more damaging debt crises (http://www.ft.com/cms/s/0/f22a3704-4248-11df-9ac4-00144feabdc0.html http://www.amazon.com/This-Time-Different-Centuries-Financial/dp/0691142165/ref=ntt_at_ep_dpi_1 ). The combination of budget deficits of 10 percent of GDP and debt/GDP ratio on the road to 100 percent with taxation of everything pursuing government expenditure, rising interest rates and regulatory shocks will convert the long run in a succession of short runs of weak economic conditions and high unemployment. American companies and banks will not be of global best class and optimum size, being burdened by high costs and regulation and lower productivity will maintain lower relative wages. That long run will also be highly inefficient with lower paying jobs. There is still time to focus on an effective agenda for real prosperity. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)

Twenty Six Million Persons in Job Distress, the Nascent Economic Recovery, the Debt, Taxes and Rising Interest Rates

Twenty Six Million Persons in Job Distress, the Nascent Economic Recovery, the Debt, Taxes and Rising Interest Rates
Carlos M Pelaez

The economic indicators released in the week ending on Apr 2 continue to verify the “nascent economic recovery” announced by Chairman Bernanke (http://www.federalreserve.gov/newsevents/testimony/bernanke20100224a.htm ). The indicators confirm that manufacturing is the worldwide driver of the recovery. Construction continues to show significant weakness. However, there are 26 million persons in job distress: 15 million people unemployed (of which 6.5 million for 26 weeks or more), 9.5 million employed part-time because they cannot find full-time jobs and 2 million marginally attached to the labor force because they do not believe they will find jobs. The priority of the national agenda is jobs as soon as possible or in the short run in which we live. The increase in nonfarm payrolls by 162,000 and revisions totaling 62,000 more jobs in Jan and Feb are good news and likely showing the initial reversal toward a trend of job creation but still only make a dent in relief for the 26 million under job distress. A rise in long-term interest rates and indications of at least temporarily higher yields for Treasuries than yields for similar bonds in other countries and yields for private interest rate swaps may signal that the growth of the federal debt toward 100 percent of GDP could constrain future economic growth and job creation by increasing taxes and interest rates. This post considers in turn below short-term economic indicators, interest rates, the rising government debt and some brief conclusions.
Short-term economic indicators. The week around the turn of the month is full of releases of indicators of the economy. (1) Personal income. The BEA of the Department of Commerce released the estimates for Feb of personal income, personal consumption expenditures (PCE), savings and the PCE price index (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm ). Real personal income did not change in Feb after an increase of 0.1 percent in Jan but it increased by 2.0 percent in Feb relative to a year earlier following an increase of 1.2 percent in Jan over a year earlier. Personal income does not show yet strong growth. PCEs are important because they represent about 70 percent of GDP, increasing by 0.3 percent in Feb on a monthly basis but by 3.4 percent relative to a year earlier. The PCE price index did not change in Feb. The Fed uses the PCE as inflation indicator, meaning that interest rates targets could remain low on the basis of inflation. (2) S&P Case Shiller Price Index. This index estimates home prices in two indices of 10 US cities and 20 US cities (http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff--p-us---- ). The Jan 10-city index remained unchanged relative to a year earlier while the 20-city index declined by 0.75 percent. There has been steady improvement toward erasing sharp year-on-year negative changes in house prices. Some cities still show deep decline of prices relative to a year earlier such as -17.4 percent in Las Vegas but there are price increases such as 9 percent in San Francisco and 4.1 percent in Dallas. (3) Consumer Confidence Index (CCI). The Conference Board released the CCI on Mar 30 (http://www.conference-board.org/economics/ConsumerConfidence.cfm ). The CCI rebounded in Mar to 52.5 from the depressed level of 46.4 in Feb. The expectations index increased to 70.2 in Mar from 69.2 in Feb. Consumption appears to be on an uptrend. (4) Manufacturers new orders. Manufacturing is the locomotive pulling the US and the world economy from recession. The US Census Bureau released on Mar 31 manufacturing orders and shipments for Feb (http://www.census.gov/manufacturing/m3/prel/pdf/s-i-o.pdf ). Manufacturers’ new orders have increased with healthy month-to-month seasonally adjusted percentage changes and only two declines in the past year: -1.7 Mar09, 0.7 Apr09, 1.2 May09, 0.7 Jun09, 1.8Jul09, -0.8Aug09, 1.8 Sep09, 0.8Oct09, 1.0 Nov09, 1.5 Dec09, 2.5 Jan10 and 0.6 Feb10 (http://www.census.gov/briefrm/esbr/www/esbr022.html ). (5) Construction spending. The US Census Bureau released the Feb construction report on Apr 1 (http://www.census.gov/const/C30/release.pdf ). The data still show weakness. The estimate for the annual seasonally-adjusted construction spending in Feb is $846.2 billion, 1.3 percent below the Jan revised estimate of $857.8 billion and 12.8 percent below the Feb 2009 estimate of $970.4 billion. In the first two months of 2010, construction spending is estimated at $116.2 billion, 14.4 percent below $135.7 billion in the same period in 2009. Construction spending in Feb 2007 stood at an annual rate of $1185 billion such that the annual rate of $846.2 billion in Feb 2010 is below that of three years ago by 28.6 percent. (5) ISM report on business. On Apr 1, the Institute for Supply Management released its report on business for Mar 2010 (http://www.ism.ws/ISMReport/MfgROB.cfm ). The manufacturing part of the ISM mirrors recessions. The index began to decline after Sep 2008 and to recover after Mar 2009. The recession was largely concentrated within those seven months. Index readings above 50 correspond to expansion and below 50 to contraction. A purchasing managers’ index (PMI) over 42 percent sustained over time signals expansion of the entire economy. The PMI shows growth over 11 consecutive months, suggesting that the overall economy has been expanding. The annualized PMI in Jan-Mar 2010 suggests growth of GDP of 5.9 percent. There were jumps in the PMIs for key countries worldwide in points from Feb into Mar: US 3.1, China 3.1, Euro Zone 2.4 and UK 0.7 (http://online.wsj.com/article/SB10001424052702303960604575157701739806306.html ). The world economy is recovering with manufacturing driving growth.
(6) Employment report. The most important release was the employment report for Mar by the BLS of the Department of Labor on Apr 2 (http://www.bls.gov/news.release/pdf/empsit.pdf ). There are two components in the employment report: nonfarm payrolls increased by 162,000 in Mar and the unemployment rate remained at 9.7 percent. This recession has been characterized by significant loss of employment, especially concentrated in the period of Aug 2008 to Jul 2009. The number of unemployed persons in Mar was 15 million. The jobless rate is particularly high for teenagers 26.1 percent, blacks 16.5 percent and Hispanics 12.6 percent but is also quite high for adult men 10.0 percent, adult women 8 percent and Asians 7.5 percent. The most shocking datum is that the long-term unemployed, who have been jobless for 27 weeks and over, increased by 414,000 in Mar, reaching 6.5 million, representing 44.1 percent of unemployed persons. The number of persons working part time for economic reasons, or involuntary part-time workers, increased to 9.1 million in Mar. These persons work part time because they had been cut back or because they could not find a full-time job. The number of people “marginally attached to the labor force” was about 2.3 million in Mar, higher than 2.1 million a year earlier. These persons are not counted in the labor force because they had not searched for work in the four weeks before the employment survey but wanted and were available for work, having searched for a job at one point in the prior 12 months. Marginally attached workers include 1.0 million discouraged workers in Mar, an increase of 309,000 from a year earlier, consisting of persons who are not searching for a job because they do not believe one would be available for them. The remaining 1.3 million of the marginally attached consisted of persons who had not searched for work in the four weeks before the survey because of school attendance or family responsibilities. Table B1 of the employment report provides the breakdown of the 162,000 new jobs in the survey of nonfarm payrolls of which 123,000 were in the private sector and 39,000 in government. The total number of people unemployed or underemployed is 24 million: 15 million unemployed plus 9 million employed part time because of economic reasons. The civilian labor force in Mar 2010 stood at 154 million. The 24 million persons unemployed or underemployed represent 15.6 percent of the labor force. There are another 2 million marginally attached to the labor force for total of 26 million persons in job distress.
Interest rates. A key event in financial markets is the rise in yields in the long-segment of the yield curve. On Apr 2, the 10-year Treasury closed at the yield of 3.94 percent, 9 basis points (bps) above the yield of 3.85 percent a week earlier and 32 bps above the yield one month earlier (http://markets.ft.com/markets/bonds.asp?ftauth=1270340644886 ). The 30-year Treasury yield closed at 4.80 percent, 5 bps above 4.75 percent a week earlier and 22 bps above 4.58 percent a month earlier. Actually, the yield curve of Treasuries has been shifting upward in the past month for all maturities such as from 2.27 percent to 2.66 percent for the 5-year and from 0.81 percent to 1.10 percent for the 2-year.
Another important development is the negative spread of Treasuries relative to debt of other countries. The 10-year Treasury traded on Apr 2 at 3.94 percent for a negative spread of 86 bps relative to the German bond that traded at 3.08 percent and also a negative spread of 39 bps relative to the Canadian bond that traded at 3.55 percent. Treasury debt sales in the week of April 5 total $82 billion (http://www.ft.com/cms/s/0/0002d4a4-3e7e-11df-a706-00144feabdc0.html ) of which $21 billion of 10-year notes on Apr 7, $13 billion of 30-year notes on Apr 8 and $40 billion of 3-year notes on Apr 6 (http://www.treasurydirect.gov/instit/annceresult/press/preanre/2010/2010.htm ).
On Mar 26, the 10-year interest rate swap was 3.73 percent while the 10-year constant-maturity Treasury was 3.79 percent (http://www.federalreserve.gov/releases/h15/data.htm ). On Mar 30, the 10-year swap rate traded at 3.82 percent for a negative spread of 5 bps below the 10-year yield of 3.87, which had not occurred before Mar, 2010 at least since 1995 (http://www.ft.com/cms/s/0/4f3f237c-3c46-11df-b316-00144feabdc0.html ).
There have been divergent trends of yields in Treasury and corporate debt markets. On Apr 1, the 52-week percentage change of Barclays Capital indexes for Treasuries were -11.74 percent for long-term price return and -7.28 for percent long-term total return in contrast with 30.13 percent for long-term corporate. The Merrill Lynch triple-C-rated (CCC) index 52-week change was 121.66 percent (http://online.wsj.com/mdc/public/page/2_3022-bondbnchmrk.html?mod=topnav_2_3000 ). The Merrill Lynch triple-C-rated (CCC) yield is trading at 11.703 percent while the high in 52 weeks was 36.725 percent and the low 11.508 percent (http://online.wsj.com/mdc/public/page/2_3022-bondbnchmrk.html?mod=topnav_2_3000 ). The return of risk appetite and the fears of the growing debt have channeled funds into corporate bonds, decreasing the spreads relative to Treasuries. Arbitrage strategies short Treasuries and go long other instruments to capture the shrinking or reversing spreads.
Government debt and interest rates. The yield curve continues to be J-shaped with percentage annual yields of: 0.17 3-months, 1.10 2-years, 2.66 5-years, 3.94 10-years and 4.80 30-years (http://markets.ft.com/markets/bonds.asp?ftauth=1270387583761 ). There are two threats of jumps and twists of this abnormal yield curve. First, the Fed holds a portfolio of $709 billion of Treasury notes and bonds, $1069 billion of mortgage-backed securities and $169 billion of federal agency securities for total of $1.9 trillion with excess reserve balances of $1051 billion and $125 billion in the Treasury supplementary financing account in the road to $200 billion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). The Fed has terminated its purchases of long-term securities under the policy of quantitative easing. Second, budget deficits are proposed by the Executive at $1.5 trillion in 2010, or 10.3 percent of GDP, and $1.3 trillion in 2011, or 8.9 percent of GDP (http://cboblog.cbo.gov/?p=482 ). The budget proposal of the Executive would increase the federal debt from $7.5 trillion at the end of 2009, or 54 percent of GDP, to $20.3 trillion at the end of 2020, or 90 percent of GDP. Sharp increases in long-term interest rates caused by unwinding the Fed’s portfolio of securities, financing budget deficits and refinancing maturing debt threaten the expansion path of the economy and recovery of full employment. The rising government debt is a two-edge sword, cutting on the side of increasing interest rates as well as on the side of increasing taxes. Efforts resolving the immediate employment situation are far more opportune than regulatory exercises with delayed implementation.
According to Alan Blinder, “Keynesians believe that what is true about the short run cannot necessarily be inferred from what must happen in the long run, and we live in the short run. They often quote Keynes’s famous statement, ‘In the long run, we are all dead,’ to make the point” (http://www.econlib.org/library/Enc/KeynesianEconomics.html ). The policy agenda, Keynesian or otherwise, should turn toward the critically relevant issues in the short run in which we live: the government debt, taxes, interest rates and relief for the 26 million people suffering job distress. Prosperity in the long run will be attained with repetition of successful short runs. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)