The Global Debt/Financial Crisis, “Wall Street” Financing of “Main Street” and Rising Financial Risk
Carlos M Pelaez
The objective of this post is explaining the adverse trend of financial variables that threatens the recovery of the world economy. The regulatory shock is explained in terms of the fake dichotomy of the political discourse of (I) “Wall Street” financing of “Main Street”; four factors explaining financial turbulence in (II) the global/debt financial crisis; (III) rising financial risk; the economy not growing at rates that alleviate unemployment and underemployment of 26.9 million people as revealed by (IV) economic indicators; risk flight explaining (V) interest rates; and the final section providing some (VI) conclusions.
I “Wall Street” Financing of “Main Street.” The motivation for ongoing 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 political discourse emphasizes the dichotomy of the economy into separate compartments: a financial sector or “Wall Street” and a truly employment-creating productive sector or “Main Street” (http://www.whitehouse.gov/the-press-office/remarks-president-wall-street-reform ). In fact, analytically and in reality there is no dichotomy but rather one indivisible general economy. Regulatory shocks on banks and the financial sector, or “Wall Street,” have similar adverse effects on the general economy as the legislative restructurings of the business models, or “Main Street,” jeopardizing the creation of opportunities for 26.9 million people who are unemployed, working part-time because they cannot find any other occupation or who have given up search for a job. The complex interrelations of banking, finance and business models developed over decades. Legislative surgeries of business models in regulatory rush may make unviable individual parts and the whole, fracturing the job-creating function of the private sector. The truly constructive effort by government consists of regulation and an institutional framework that fosters the structures and functions of finance and the general economy (Pelaez and Pelaez, Government Intervention in Globalization, 1-12).
The approach of Functional Structural Finance (FSF) is proposed by Professors Robert Merton and Zvi Bodie (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 234-6, Financial Regulation after the Global Recession, 34-7). FSF considers six functions of the financial system. (1) Clearing and settlement systems are provided by the Fed wire and funds transfers by depository institutions such as banks with technology that enhances efficiency in the form of lower transactions costs that promote business. (2) Mobilization of savings agglutinates small funds of investors in financing large-scale projects through the distribution of small shares in corporate stock, allowing the public to benefit from capital appreciation increasing savings and retirement. (3) Transfer of resources across time and space allow households to invest in education and training for future jobs and business to create new opportunities of progress through research and development. Innovation and education have driven US prosperity. (4) Risk management identifies and measures risk in deriving the best opportunities. (5) Information in financial markets is required for business decisions. The collection of short and long exposures reveals the prices of equities and debt, signaling the opportunities in the economy while allowing hedge of risks. (6) The financial system or structure provides incentives for the reduction of information asymmetries. Modern banking theory considers the monitoring role of banks in evaluating information on the creditworthiness of borrowers to issue unmonitored deposits. Another function is transforming illiquid business projects into immediately liquid demand deposits (Douglas Diamond, Philip Dybvig and Raghuram Rajan cited in Pelaez and Pelaez, Regulation of Banks and Finance, 55-66).
The federal government chartered in 1970 the Federal Home Loan Mortgage Corporation, Freddie Mac, with the objective of guaranteeing mortgage-backed securities (MBS) that were created by bundling mortgages originated by thrift institutions (Pelaez and Pelaez, Financial Regulation after the Global Recession, 43). The household in “Main Street” identifies a suitable home and requests a loan from the local bank by mortgaging the home. The local bank obtains the funds from bundling many similar loans in maturity and credit risk into a MBS sold to investors through “Wall Street” that distributes the MBS to savings and retirement funds that obtain the money from various sources including family savings. Car loans, credit cards, student loans, home equity loans and most credit is processed through the bundling of loans into asset-backed securities (ABS) which are similarly sold to investors that ultimately obtain the money from savings. The financial system transforms illiquid bricks, land and construction labor in a home into instant liquidity in the form of a housing loan by mobilizing savings with a technological innovation that goes by the name of securitization or risk transfer used by banks in avoiding concentration of risks in their portfolio through the bundling of many loans into a security that is sold to final investors. The creation of liquidity can occur through sale and repurchase agreements (SRP) by which the temporary investor in the ABS finances it with cheaper short-term SRPs. The financial regulation bill emerging from Congressional reconciliation may frustrate innovation back to the Stone Age before certificates of deposits and commercial paper in which there were pure credit panics in less diversified and smaller banks. Between 1929 and 1933, 9440 commercial banks in the US or about 40 percent of close to 23,600 commercial banks were suspended. Britain, Canada and ten other countries with more concentrated banks experienced remarkable banking stability during the Great Depression (Pelaez and Pelaez, Regulation of Banks and Finance, 204). George Benston finds that only 10 of the 9440 failed banks were national banks and the others were more vulnerable unit banks or banks with only one or few branches (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 118). There were no problems in big banks per se in the credit crisis after 2007 but instead in mortgage banks and investment banks affected by the nonprime mortgages. The amputation of lines of business of banks by the finance bill may cause individual bank failures by disrupting viable business models and a more unstable or even unviable financial system with risk concentrated on pure lending.
Securitization or risk transfer worked smoothly over the past half century without a major crisis. The identification of the causes of the credit/dollar crisis and global recession after 2007 requires clear thought instead of distortions of the actual working of the financial system. The problem was in the form of excessive leverage or debt, low liquidity and unsound decisions on credit risk. The crisis consisted of the flooding of securitization with subprime and liar or Alt-A mortgages. Government policy caused the crisis (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 combination of the fed funds rate of nearly zero in 2003-4 with the lowering of mortgage rates by suspending the auction of 30-year Treasuries and the yearly housing subsidy of $221 billion encouraged excessive construction of houses under the illusion that prices would increase forever. The near zero interest rates penalized liquidity, encouraging cheaper short-term borrowing. Unsound home-buying credit was encouraged by the illusion of permanently increasing house prices and the purchase or guarantee of $1.6 trillion nonprime mortgages by Fannie Mae and Freddie Mac that caused generalized lowering of lending standards. The failure of more than 200 regional and community banks spreading throughout the country has an evident cause in the concession of excessive credit when interest rates were extremely low by Fed money creation and real estate prices were perceived to have a floor guaranteed by government policy (http://professional.wsj.com/article/SB10001424052748703957604575272333920494398.html?mod=wsjproe_hps_LEFTWhatsNews ). Section III below provides the data on the collapse of the stock market on May 25 led by bank stocks that was partly arrested when a leader in Congress had the wisdom to inform the public of the softening of bank swap-desk spinoffs in the reconciliation of the financial regulation bill.
II The Global Debt/Financial Crisis. Financial markets are under renewed stress. There are four causes of this stress that may determine the trend of financial variables that could be masked by daily oscillations. First, there are recurring fears about tightening monetary policy in China that could depress commodity futures prices and interregional trade among countries in Asia, which is an important source of growth in the region and the world economy. These fears alternate with optimism causing oscillation of Asia Pacific stocks. The Dow Jones Asia/Pacific Total Stock Market Index declined by 11.7 percent from a recent peak on Apr 15 to the close of market on May 28 and the Shanghai SE Composite declined by 16.1 percent in the same period (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_intl_dtabnk&symb=DWAP&page=intl ). Second, the sovereign risk crisis in Europe also has intermittent episodes of fear and optimism that add to stock market volatility. The STOXX Europe 50 stock index fell by 11.9 percent from the recent peak on Apr 15 to the close of market on May 28 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_intl_dtabnk&symb=ST:SX5P&page=intl ). Third, US budget deficits in excess of 10 percent of GDP, government debt in the unsustainable path toward 100 percent of GDP and the Fed balance sheet of $2.4 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ) may prove to be the strongest shock to the world economy. The Dow Jones Industrial Average declined by 9.5 percent from the recent peak on Apr 26 to the close of market on May 28 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_uss_dtabnk&symb=DJIA ). Fourth, the regulatory shock of financial institutions analyzed in the preceding section can exacerbate financial turbulence with likely adverse effects on growth and employment worldwide. The NYSE Financial Index declined by 15.5 percent from the recent peak on Apr 15 to the close of market on May 28 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_uss_dtabnk&symb=NYKID ).
III Rising Financial Risk. There are increasing perceptions of financial risk and in particular of counterparty credit risk in transactions among financial institutions. The Dow Jones Industrial Average suffered the deepest decline in the month of May since 1940 when FDR was president: 871.98 points or 7.92 percent (http://professional.wsj.com/article/SB10001424052748703957604575272930884830398.html?mod=wsjproe_hps_LEFTWhatsNews ). The drop was characterized by wide daily oscillations. The decline of the DJIA in an individual bad day such as 1.2 percent on May 28 is partly explained by events such as news of the downgrade of the credit rating of Spain by Fitch Ratings from AAA to AA+ (http://professional.wsj.com/article/SB10001424052748704596504575272641759918662.html?mod=wsjproe_hps_LEFTWhatsNews ). The DJIA dropped 292 points during the first 10 minutes of trading on May 25 because of concerns with rising LIBOR costs of banks amid higher risk perceptions of counterparty transactions and incidents in Korea but recovered to lose only 22.82 points in the day or -0.23 percent. The Nikkei average declined 3.1 percent, Hong Kong’s Hang Seng dropped 3.5 percent, the London FTSE fell 2.5 percent and the Paris CAC 40 lost 2.9 percent, copper futures declined 3.3 percent and crude-oil futures lost 2.1 percent. Copper declined 9 percent in the year to May 25 and oil 13 percent (http://professional.wsj.com/article/SB10001424052748704026204575266010587315860.html?mod=wsjproe_hps_TopLeftWhatsNews ). A contributing factor of the recovery of the market was the announcement by the Chairman of the House Financial Services Committee that the provision forcing banks to spinoff swap desks would be modified (http://professional.wsj.com/article/SB10001424052748704026204575266300665355526.html?mod=wsjproe_hps_LEFTWhatsNews ). Financial regulation legislation is affecting adversely financial markets and the recovery of the economy and jobs. The rise of the DJIA in a good day such as the gain of 2.9 percent on May 27 is explained by events such as the announcement by China that it would continue to position European securities (http://professional.wsj.com/article/SB10001424052748704269204575270003727602386.html ). The VIX implied volatility index declined in the week to 31 at the close of market on May 28 but is still above the long-term average of 20 (http://www.ft.com/cms/s/0/60dd1a72-6a9e-11df-b282-00144feab49a.html ). Indicators of risk perceptions in financial markets remained slightly lower on May 28 relative to a day earlier (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aOQ0XERiNFqw ). The dollar interbank loan rate LIBOR for three months was fixed at 0.536 percent compared with 0.538 a day earlier after doubling from levels before the current turbulence. The dollar LIBOR rate is significantly below the stratospheric peak of 4.81875 percent in 2008; the increase is substantial from 0.25 percent in Mar; there are increasing costs of $360 trillion instruments indexed to LIBOR; and higher bank borrowing costs are reflecting the $2.8 trillion debt of European banks to highly-indebted countries in Europe under sovereign risk stress (http://professional.wsj.com/article/SB10001424052748704792104575264883867618368.html?mod=wsjproe_hps_TopMiddleNews ). There was also a marginal decline of the LIBOR-OIS spread from 30.7 basis points (bps) to 30.6 bps, measuring the differential risk between interbank lending for three-months at the LIBOR rate and lending overnight at the fed funds rate. The LIBOR-OIS spread was only 9 bps on average in the first three months of 2010. The dollar swaps of the Fed with other central banks could have played a role in alleviating pressure on dollar rates. While it is true that the LIBOR-OIS spread is well below 364 bps after the Lehman Bros event in Sep 2008, counterparty risk perceptions have increased because of the global debt crisis and bank exposures to highly-indebted countries. The swap spread, or difference between the two-year swap rate and the yield of the corresponding Treasury note, increased by 11.96 bps on May 25, reaching 64.21 bps and then retreating to 49.56 in New York but still well above the year’s low of 9.63 bps (http://www.bloomberg.com/apps/news?pid=20601087&sid=a187sGWkbQtE&pos=5 ).
IV Economic indicators. The economy continues to expand led by manufacturing. There are doubts about the strength of the recovery in housing and growth may not be sufficient to provide relief to the 26.9 million persons in job stress. Existing home sales increased 7.6 percent in Apr and 22.8 percent relative to a year earlier (http://www.realtor.org/press_room/news_releases/2010/05/ehs_april ). New home sales in Apr 2010 were at a seasonally adjusted annual rate of 504,000, rising 14.8 percent relative to the Mar rate of 439,000 and 47.8 percent higher than 341,000 in Apr 2009 (http://www.census.gov/const/newressales.pdf ) but 63.3 percent below the rate of 1,374,000 in Jun 2005 (http://www.census.gov/const/newressales_200506.pdf ). The jump in Apr was motivated by the expiration of the tax credit for buying new homes. The Case-Shiller index is showing some weakness in house prices, with a decline of the National Home Price Index by 3.2 percent in the first quarter even if remaining above the level a year earlier (http://www.standardandpoors.com/spf/docs/case-shiller/CSHomePrice_Release_052506.pdf ). New orders of durable goods grew by 16.8 percent in the first four months of 2010 relative to the same period in 2009, by 14.3 percent excluding transportation and by 16.9 percent excluding defense (http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf ). GDP was revised to 3.0 percent for the first quarter from the preliminary estimate of 3.2 percent (http://www.bea.gov/newsreleases/national/gdp/2010/pdf/gdp1q10_2nd.pdf ). The annual seasonally adjusted quarterly percentage rates during this recovery of 2.2 in IIIQ09, 5.6 in IVQ09 and 3.0 in IQ10 have been quite inferior to those during the recovery of the similar recession in the 1980s of 5.1 in IQ83, 9.3 in IIQ83, 8.1 in IIIQ83, 8.5 in IVQ83, 7.1 in IQ84 and above 3 percent in the following quarters (http://www.bea.gov/national/nipaweb/TablePrint.asp?FirstYear=1983&LastYear=1984&Freq=Qtr&SelectedTable=2&ViewSeries=NO&Java=no&MaxValue=9.3&MaxChars=5&Request3Place=N&3Place=N&FromView=YES&Legal=&Land= ). Personal income increased 0.4 percent in Apr but personal consumption expenditures (PCE) were flat while the PCE price index, which is used by the Fed, increased by less than 0.1 percent (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm ). The Chicago ISM business barometer seasonally adjusted index declined from 63.8 in Apr to 59.7 in May, which is still well above the expansion tradeoff of 50 for the eighth consecutive month (https://www.ism-chicago.org/chapters/ism-ismchicago/files/ISM-C%20May%202010.pdf ). Initial jobless claims in the week ending on May 22 fell 14,000 to the seasonally-adjusted level of 460,000 from the revised 474,000 in the earlier week (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
V. Interest Rates. The yield curve of Treasuries, much as those of other major countries, continues to have a flat segment of nearly zero percent and a rising slope above two years. The 10-year Treasury yield declined to 3.30 percent on May 28 from 3.21 percent a week ago and 3.67 percent a month ago (http://markets.ft.com/markets/bonds.asp ). The decline in yields is caused by flight out of risk in other financial assets and currencies. The German 10-year bond traded at 2.68 percent on May 28 for a negative spread of 62 points relative to the 10-year Treasury. The relative attractiveness of Treasuries may change with the worsening trend of the ratio of government debt to GDP.
VI Conclusions. Fears of decline of China’s economic growth, repercussions in financial markets and economies of the sovereign risk crisis in Europe, the worsening fiscal situation of the US and the financial regulation shock drive adverse trends in financial risk. The increase in the debt to GDP ratio of the US together with the eventual unwinding of the bloated balance sheet of the Fed anchor the economy at low rates of growth. Job creation will be insufficient to provide relief to the 26.9 million people in job stress. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
Sunday, May 30, 2010
Sunday, May 23, 2010
The Political Discourse of a Wall Street/Main Street Dichotomy, the Senate Finance Bill, Financial Turbulence and the Global Debt/Financial Crisis
The Political Discourse of a Wall Street/Main Street Dichotomy, the Senate Finance Bill, Financial Turbulence and the Global Debt/Financial Crisis
Carlos M Pelaez
A prevailing wisdom in political discourse postulates that government policy can impose costs and regulatory constraints on banks and financial systems, or “Wall Street,” proposing legislation which would promote progress in the only important productive sector, or “Main Street.” The error in this approach is that the financial system, production, investment and government are equally important parts in different ways of the stability and prosperity of an indivisible whole or general economy. Legislative shocks on any of the sectors can disrupt the general economy and social wellbeing. Overhaul legislation focuses on restructuring business models by alleged superior wellbeing in the long term on the basis of this fake distinction of Wall and Main streets while ignoring the critical needed reform of government. There is high risk that overregulation of the financial sector may further complicate the ongoing crisis of unsustainable government budget deficits and debt that may erase in another global downturn the alleged prosperity claimed for restructurings. The sections below consider the true causes of the credit crisis and global recession of 2007-2009 by analysis of the indivisible (I) general economy, the instability and prosperity constraints added by (II) the Senate finance bill, the closer interrelation of (III) financial turbulence and the global debt/financial crisis, (IV) economic indicators and brief (V) conclusions.
I The General Economy. The conventional dichotomy of a financial sector or Wall Street and a productive sector or Main Street acting in conflict of interest is used to propose regulation: “Today the economy is growing. In fact, we’ve seen the fastest turnaround in growth in nearly three decades. Until this progress is felt not just on Wall Street but on Main Street we cannot be satisfied”(http://www.whitehouse.gov/the-press-office/remarks-president-wall-street-reform ). The noted economist Joseph Schumpeter postulated that the social process is an indivisible whole and that the economist abstracts economic principles for purposes of simplifying analysis (cited in Pelaez and Pelaez, Government Intervention in Globalization, 1-12, 131). The “economy” is in itself an abstract conceptualization in economics but it is also an indivisible process. Financial markets are considered in isolation to apply conventional tools of partial equilibrium or analyzed within general economy models. Economists are fully aware that all these markets interact in multiple ways into an aggregate called the economy. Thus, there is only a general economy and not separate compartments called “Wall Street” and “Main Street.” There is high risk in this dichotomy that punishing “Wall Street” can be accomplished without risking another even worst recession. Two competing explanations of the origins of the credit/dollar crisis and global recession illustrate this point and help to demystify the fake Wall Street and Main Street dichotomy.
First, official prudential and systemic regulation (OPSR) postulates that the credit crisis originated in inadequate regulation and excessive risk taking by financial entities. The system of originate to distribute of mortgages relaxed credit evaluation with resulting trillions of dollars of subprime mortgages bundled in mortgage-backed securities (MBS) sold to investors. Regulation failed to create and enforce standards of mortgage origination and securitization. Financial entities were reckless in risk management with excessive leverage, low liquidity, short-term financing in sales and repurchase agreements (SRP) or repos and complex financial products such as collateralized mortgage obligations (CDO) and credit default swaps (CDS). Reckless risk management was encouraged by remuneration of finance professionals mostly in cash without relation to “long-term” performance. While Main Street worked without excessive risks and low remuneration, Wall Street allegedly engaged in casino-style capitalism to appropriate cash windfalls. Eventually, Main Street paid for the excesses of Wall Street in the form of bailouts with taxpayer funds, economic contraction and loss of employment.
Second, the alternative view does not consider the fake Wall Street and Main Street dichotomy but actual interrelations in an indivisible general economy of sectors that only exist for purposes of abstract analysis. A stream of theory considers the relations of the financial sector and the rest of the economy by analysis of balance sheets. Consider a primary shock in the form of higher inventories than required in the productive sector. The reduction in inventories would be attained by reducing production that would require lower hours worked or even layoffs. Balance sheets of producers, wholesale distributors, retailers and families of workers would be weakened. The weakening of balance sheets of borrowers would weaken the balance sheets of banks and other financial entities by erosion of the credit quality of loan portfolios. Lending would be curtailed, reducing the ability of families and business to bridge their situation to the future by means of borrowing. The indivisible general economy could enter in recession.
The credit/dollar crisis and global recession can be explained by means of the balance sheet approach (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 Fed lowered the fed funds rate to 1 percent in Jun 2003 and kept it at that level, with a forward guidance that it would not be changed indefinitely, until Jun 2004 when it began to increase it by 25 basis points (bps) during 17 consecutive meetings of the Federal Open Market Committee (FOMC) until it reached 5.25 per cent in Jun 2006. Prior to that Treasury eliminated the 30-year Treasury between 2001 and 2005 to encourage purchases of mortgages to lower their rates in order to stimulate the economy perceived to be in a jobless recovery. The long-term policy of affordable housing resulted in a yearly subsidy of $221 billion per year. Fannie Mae and Freddie Mac operated with leverage of 70:1, faking their balance sheets to obtain higher remuneration of executives, effectively lobbying against their oversight supervisor and purchasing or guaranteeing $1.6 trillion of nonprime mortgages. In the first period of near-zero interest rates and housing subsidies the government created the artificial impression that housing prices would increase forever, which was equivalent to making everybody feel richer. For the borrower there was an opportunity of living in a house beyond the borrower’s income levels because of lower monthly payments caused by near zero interest rates with the minor downside risk of selling the house at a small profit in the future and repaying the mortgage. For the lender the only perceived risk was to sell the house after foreclosure to recover principal and interest owed and perhaps even some profit. The adjustable-rate mortgage (ARM) converted the borrower into something similar to a financial entity: the borrower took a 15-year loan on a house perceived as appreciating in price forever and financed the mortgage at short-term rates close to near-zero percent fed funds; the financial entity acquired a 10-year Treasury appreciating in price and financed it with near zero percent SRPs or repos. Borrowers and financial entities were induced by Fed policy to position houses and bonds, respectively, with near zero percent short-term interest rates. At the time of the policy before the recession policymakers and regulators deliberately induced borrowers and bankers to buy houses and position bonds. The complaint of policymakers and regulators with hindsight after the recession is that borrowers and bankers should have been omniscient and know that they were induced into a fatal error. The easy credit policy of the Fed encouraged both “Main Street” and “Wall Street” into taking high risks with borrowed liquidity at very low interest costs. Homeowners were caught in increasing monthly payments with declining house prices when the Fed increased the fed funds rate from 1 percent to 5.25 percent. The financial innovations in MBS and CDOs worked without problems in the past but collapsed in value because they were not intended to function with underlying nonprime mortgages. Fannie and Freddie purchased or guaranteed the subprime and liar mortgages with credit ultimately paid by the United States taxpayer. The deterioration of family balance sheets with the increase in monthly mortgage payments and loss of credit because of late payments resulted in erosion in the quality of loan portfolios of banks. Weakening balance sheets of banks and financial entities resulted in contraction of credit that affected balance sheets of producers. The end result was a rare global recession that would not have occurred if there had not been flooding of cheap liquidity and guarantees of liar mortgages. Neither “Wall Street” nor “Main Street” created this crisis. The government through low interest rate policy, housing policy, Fannie and Freddie created the crisis. Government is indispensable in modern societies and an essential part of the general economy (Pelaez and Pelaez, Government Intervention in Globalization, 1-12) but created the excessive leverage, low liquidity and false perception of increasing wealth that eventually caused the recession and 26.9 million people in job stress.
II The Senate Finance Bill. The objective of policy is not to punish the government or the financial system but to improve their functioning in inducing prosperity of the general economy. The Senate Finance Bill (http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_bills&docid=f:s3217as.txt.pdf http://banking.senate.gov/public/_files/FinancialReformSummaryAsFiled.pdf http://blogs.wsj.com/dispatch/2010/05/20/major-provisions-in-senate-financial-overhaul-bill/ ) is not the product of rigorous analysis of regulation that improves policy with individual provisions that are consistent in overall objectives. There are at least six categories of adverse consequences of this rush to regulation. (1) Credit volume and interest rates. The creation of a politicized consumer protection agency will reduce credit volumes and increase interest rates with rules similar in effects to the Credit CARD Act of May 22, 2009 ((http://www.whitehouse.gov/the_press_office/Fact-Sheet-Reforms-to-Protect-American-Credit-Card-Holders ). Nearly all credit in the US is raised by securitization of loans into bonds that are rated for credit by rating agencies. One of the low points in recent legislation is the amendment creating a Credit Rating Agency Board at the Securities and Exchange Commission (SEC) that would allocate thousands of bonds to rating companies (http://professional.wsj.com/article/TPMRKWC00020100517e65h003ea.html ). This board has an impossible technical task, reproducing at high cost the staff and knowledge of rating companies and even then would slow or even impede securitization, reducing credit and increasing interest rates. (2) Bank capital. Excessive regulation increases transaction costs of banks, reducing profits that constrain the banks’ ability to raise equity capital needed for Basel Tier 1 capital requirements. The Senate approved by unanimous vote (http://professional.wsj.com/article/SB10001424052748703691804575254433629763888.html?mod=wsjproe_hps_MIDDLESecondNews ) an amendment prohibiting the use of trust-preferred securities (TPS) that the Board of Governors of the Federal Reserve System had authorized bank holding companies to use as Tier 1 capital in Oct 1996 (Pelaez and Pelaez, Regulation of Banks and Finance, 68-9). This amendment is another of the low points in legislation within the same bill because it forces banks to raise more expensive capital without any gains in stability. The proposed change in reconciliation is to apply the amendment only to large banks, which would magnify the reduction of loans required for the general economy to recover and create jobs, distorting the optimum banking structure in the US. Imposing more costly capital for no sound reason prevents the US from negotiating international bank capital requirements. (3) Innovation and risk management. The bill frustrates innovation and risk management techniques by virtually eliminating the over-the-counter derivatives market, replacing it with inflexible trading in public exchanges. The objective is to prohibit what cannot be understood, which is similar to banning air transportation because the passengers do not understand aviation technology. If this law had existed decades ago there would not have been commercial paper, high-yield bonds and funding for credit cards, mortgages, auto loans and nearly all credit that financed the US at cheaper costs, promoting the prosperity of the general economy. The Senate Finance Bill is an act of prohibiting progress for all. (4) Bank and financial system instability. Frustration of innovative risk management techniques will create more unstable financial institutions, depending on pure lending. The financial stability oversight council will not have sound theory and measurements, amputating lines of business of banks, making whatever survives more unstable. The over financial system could become more unstable because of the combination of various banks subject to riskier activities caused by concentration on lending without risk-reducing diversification of activities. Congress is legislating systemic risk. The council could provoke a costly crisis by making banks and the financial system unstable after arbitrarily breaking up financial entities. Banks could not transfer fully risk by securitization of loans and mortgages becoming more vulnerable to credit risk by the requirement of holding part of the loans in their balance sheets. (5) Too politically important to liquidate. The bill sanctions a new doctrine of perpetuating with unlimited taxpayer funds zombie financial entities that are politically useful, beginning with Fannie and Freddie that contributed critically to the crisis and were saved from bankruptcy with taxpayers funds that will never be repaid. Fannie, Freddie and other similar politically important entities will be resuscitated with taxpayer funds, creating new risks in the future. The bill also prevents market exit of companies through M&As, forcing liquidations of the not politically important to liquidate that could have been restructured in private arrangements. (6) International competitiveness. The Senate Finance Bill makes US international banks uncompetitive and by anticipating global regulation allows other jurisdictions to adapt their statues to encourage the migration overseas of the US financial industry, which is a key component of the indivisible general economy.
III Financial Turbulence and the Global Debt Financial Crisis. Financial turbulence continues because of the fears of the growing global debt crisis that is being exacerbated by the overall financial system through both the cross-border and domestic exposures of banks. There were sharp percentage declines of equity indexes from highs in Apr to the closing of markets on May 21: Global Dow -15.2, Dax Germany -7.9, Shanghai Composite China -18.4 and S&P 500
-10.6 (http://online.wsj.com/mdc/public/page/mdc_international.html?mod=topnav_2_3002 ). The announcement by Germany of bans on naked short sales of equities and bonds caused an event of global financial market fright that was exacerbated by the procyclical Senate Finance Bill (http://www.ft.com/cms/s/0/d3fa8864-6436-11df-8618-00144feab49a.html ). Bloomberg informs that the fixing of LIBOR, to which $350 trillion of financial assets such as mortgages and student loans are indexed, increased for the ninth consecutive day to 0.497, which is the highest level since Jul 24 while the LIBOR/OIS spread rose to 26.7 basis points (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aAIJD5G5GME4 ). The LIBOR/OIS spread is three times higher than a month ago (http://www.ft.com/cms/s/0/857a3a1c-651d-11df-b648-00144feab49a.html ).VIX, the index of implied volatility of S&P options at the CBOE (http://www.cboe.com/micro/vix/introduction.aspx ), rose in intraday trading to 48.20, the highest level since Mar 9, 2009 and just below 48.46 after the Sep 11, 2001 attack (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a8qdvLtcM1oc ). VIX was at 15.23 six weeks ago, which was a three-year low (http://www.ft.com/cms/s/0/857a3a1c-651d-11df-b648-00144feab49a.html ).The most threatening fiscal situation could be that of the United States as revealed by the President’s budget (http://www.whitehouse.gov/omb/budget/fy2011/assets/hist.pdf ). The highest deficit as percent of GDP since World War II occurred in 1983, -6, but no past budget is comparable to the estimated deficits as percent of GDP of -9.9 in 2009, -10.6 in 2010 and -8.3 in 2011. The deficits are staggering in trillions of current dollars: -1.4 in 2009, -1.6 in 2010 and -1.3 in 2011. Estimated outlays or expenditures increase in current dollars by 28.5 percent from 2008 to 2011 while revenues increase 1.7 percent after declining by 14.2 percent between 2008 and 2010. As percent of GDP the estimated expenditures are the highest since 24.8 in 1946: 24.7 in 2009, 25.4 in 2010 and 25.1 in 2011. The federal debt held by the public as percent of GDP peaked at 108.7 in 1946, declining to 52.0 in 1956 and never exceeding 50 until the current estimates: 53.0 in 2009, 63.6 in 2011, 70.8 in 2012 and above 70 during the remainder of the decade but likely surpassing 100. David Ranson measures a ceiling of the ratio of government revenues to GDP of 20 percent calculated since 1929 (http://professional.wsj.com/article/SB30001424052748704608104575217870728420184.html ). Federal government expenditure has risen above 25 percent of GDP. Tax increases will not increase above 20 percent according to past experience. Increases in taxes such as the federal value added tax and the energy tax will slow economic growth, reducing tax revenue. US government debt may reach 100 percent of GDP faster than in forecasts that always underestimate the realized debt. The US is moving toward a government debt event consisting of expenditure reduction, tax increases and implicit default in dollar devaluation. Financial assets will increasingly incorporate in current prices the global debt event. The crowding out effect is defined as follows: “Economists have long agreed that, if the supply of goods and services is fixed and resources fully employed, the government can claim more of the economy’s output only by depriving the private sector of its use” (Benjamin M. Friedman, Brookings Papers on Economic Activity, 3 (1978), 596). With the economy moving toward full employment, historically high budget deficits at the economy’s limit of taxation will add to the federal debt replacing private economic activity with government economic activity likely flattening the expansion path of the economy. The rise of interest rates will be magnified by the unwinding of the Fed’s portfolio of $1.99 trillion of long-term securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). The economic cost of the restructurings is in terms of economic activity or percentage points of GDP and jobs that could be created by the private sector but that will be foregone because of the restructurings.
IV Economic Indicators. There is continuing recovery in manufacturing in the US with some doubts about employment and housing. The Empire State Manufacturing Survey by the New York Fed registers a tenth consecutive monthly improvement of conditions in manufacturing in May (http://www.ny.frb.org/survey/empire/empiresurvey_overview.html ). The Philadelphia Fed’s diffusion index of current activity increased for the fourth consecutive month in May and has been positive for the ninth consecutive month (http://www.phil.frb.org/research-and-data/regional-economy/business-outlook-survey/2010/bos0510.cfm ). Manufacturing was facing difficulties before the recession and recovered earlier and stronger. Housing starts increased in Apr to the seasonally annualized rate of 672,000, which is 5.8 percent higher relative to Mar and 40.9 percent above the Apr 2009 rate of 477,000. Housing permits in Apr declined to 606,000, which is 11.5 percent below Mar but 15.9 percent above 523,000 in Apr 2009 (http://www.census.gov/const/newresconst.pdf ). In Jan 2006, housing starts in the US were at an annual rate of 2265 thousand (http://www.census.gov/const/newresconst_200701.pdf ). Housing starts declined by 70.3 percent from Jan 2006 to Apr 2010. The increase in housing starts in Apr was part of a rush to receive the expiring tax credit and the decline in permits may signal decline in starts ahead. Price indexes are fluctuating with energy prices but without immediate threats of inflation. The producer price index declined 0.1 percent in Apr after increasing 0.7 percent in March and decreasing 0.6 percent in Feb. Prices for finished goods increased by 5.5 percent in the 12 months ending in Apr 2010 (http://www.bls.gov/news.release/pdf/ppi.pdf ). The consumer price index declined by 0.1 percent in Apr and increased by 2.2 percent over the past 12 months (http://www.bls.gov/news.release/pdf/ppi.pdf ). Initial jobless claims in the week ending May 15 increased by 25,000 to 471,000 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
V Interest Rates. Funds abandoning risk exposures partly flowed to Treasuries. The Treasury yield curve continued its downward shift with the 10 year declining to 3.24 percent from 3.44 percent a week earlier and 3.82 percent a month earlier (http://markets.ft.com/markets/bonds.asp ). This decline in yields of Treasuries will be reversed as the continuing increase in government debt and the unwinding of the Fed’s balance sheet become incorporated in measuring the rate/price risk of US debt. There was similar flow of funds into German bonds because of the lower deficit of Germany with the 10-year yield at 2.67 percent corresponding to a negative spread of 57 bps relative to the 10-year Treasury.
VI Conclusions. The combined crowding out effects on capital markets of the historically high budget deficits, government debt and unwinding of the Fed’s $1.99 trillion balance sheet will flatten the expansion path of the economy. Legislative restructurings of business models may hinder growth of the overall economy and job creation. There is no alleviation for the drama of the 26.9 million persons in job stress who have lost their priority in the agenda. Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
Carlos M Pelaez
A prevailing wisdom in political discourse postulates that government policy can impose costs and regulatory constraints on banks and financial systems, or “Wall Street,” proposing legislation which would promote progress in the only important productive sector, or “Main Street.” The error in this approach is that the financial system, production, investment and government are equally important parts in different ways of the stability and prosperity of an indivisible whole or general economy. Legislative shocks on any of the sectors can disrupt the general economy and social wellbeing. Overhaul legislation focuses on restructuring business models by alleged superior wellbeing in the long term on the basis of this fake distinction of Wall and Main streets while ignoring the critical needed reform of government. There is high risk that overregulation of the financial sector may further complicate the ongoing crisis of unsustainable government budget deficits and debt that may erase in another global downturn the alleged prosperity claimed for restructurings. The sections below consider the true causes of the credit crisis and global recession of 2007-2009 by analysis of the indivisible (I) general economy, the instability and prosperity constraints added by (II) the Senate finance bill, the closer interrelation of (III) financial turbulence and the global debt/financial crisis, (IV) economic indicators and brief (V) conclusions.
I The General Economy. The conventional dichotomy of a financial sector or Wall Street and a productive sector or Main Street acting in conflict of interest is used to propose regulation: “Today the economy is growing. In fact, we’ve seen the fastest turnaround in growth in nearly three decades. Until this progress is felt not just on Wall Street but on Main Street we cannot be satisfied”(http://www.whitehouse.gov/the-press-office/remarks-president-wall-street-reform ). The noted economist Joseph Schumpeter postulated that the social process is an indivisible whole and that the economist abstracts economic principles for purposes of simplifying analysis (cited in Pelaez and Pelaez, Government Intervention in Globalization, 1-12, 131). The “economy” is in itself an abstract conceptualization in economics but it is also an indivisible process. Financial markets are considered in isolation to apply conventional tools of partial equilibrium or analyzed within general economy models. Economists are fully aware that all these markets interact in multiple ways into an aggregate called the economy. Thus, there is only a general economy and not separate compartments called “Wall Street” and “Main Street.” There is high risk in this dichotomy that punishing “Wall Street” can be accomplished without risking another even worst recession. Two competing explanations of the origins of the credit/dollar crisis and global recession illustrate this point and help to demystify the fake Wall Street and Main Street dichotomy.
First, official prudential and systemic regulation (OPSR) postulates that the credit crisis originated in inadequate regulation and excessive risk taking by financial entities. The system of originate to distribute of mortgages relaxed credit evaluation with resulting trillions of dollars of subprime mortgages bundled in mortgage-backed securities (MBS) sold to investors. Regulation failed to create and enforce standards of mortgage origination and securitization. Financial entities were reckless in risk management with excessive leverage, low liquidity, short-term financing in sales and repurchase agreements (SRP) or repos and complex financial products such as collateralized mortgage obligations (CDO) and credit default swaps (CDS). Reckless risk management was encouraged by remuneration of finance professionals mostly in cash without relation to “long-term” performance. While Main Street worked without excessive risks and low remuneration, Wall Street allegedly engaged in casino-style capitalism to appropriate cash windfalls. Eventually, Main Street paid for the excesses of Wall Street in the form of bailouts with taxpayer funds, economic contraction and loss of employment.
Second, the alternative view does not consider the fake Wall Street and Main Street dichotomy but actual interrelations in an indivisible general economy of sectors that only exist for purposes of abstract analysis. A stream of theory considers the relations of the financial sector and the rest of the economy by analysis of balance sheets. Consider a primary shock in the form of higher inventories than required in the productive sector. The reduction in inventories would be attained by reducing production that would require lower hours worked or even layoffs. Balance sheets of producers, wholesale distributors, retailers and families of workers would be weakened. The weakening of balance sheets of borrowers would weaken the balance sheets of banks and other financial entities by erosion of the credit quality of loan portfolios. Lending would be curtailed, reducing the ability of families and business to bridge their situation to the future by means of borrowing. The indivisible general economy could enter in recession.
The credit/dollar crisis and global recession can be explained by means of the balance sheet approach (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 Fed lowered the fed funds rate to 1 percent in Jun 2003 and kept it at that level, with a forward guidance that it would not be changed indefinitely, until Jun 2004 when it began to increase it by 25 basis points (bps) during 17 consecutive meetings of the Federal Open Market Committee (FOMC) until it reached 5.25 per cent in Jun 2006. Prior to that Treasury eliminated the 30-year Treasury between 2001 and 2005 to encourage purchases of mortgages to lower their rates in order to stimulate the economy perceived to be in a jobless recovery. The long-term policy of affordable housing resulted in a yearly subsidy of $221 billion per year. Fannie Mae and Freddie Mac operated with leverage of 70:1, faking their balance sheets to obtain higher remuneration of executives, effectively lobbying against their oversight supervisor and purchasing or guaranteeing $1.6 trillion of nonprime mortgages. In the first period of near-zero interest rates and housing subsidies the government created the artificial impression that housing prices would increase forever, which was equivalent to making everybody feel richer. For the borrower there was an opportunity of living in a house beyond the borrower’s income levels because of lower monthly payments caused by near zero interest rates with the minor downside risk of selling the house at a small profit in the future and repaying the mortgage. For the lender the only perceived risk was to sell the house after foreclosure to recover principal and interest owed and perhaps even some profit. The adjustable-rate mortgage (ARM) converted the borrower into something similar to a financial entity: the borrower took a 15-year loan on a house perceived as appreciating in price forever and financed the mortgage at short-term rates close to near-zero percent fed funds; the financial entity acquired a 10-year Treasury appreciating in price and financed it with near zero percent SRPs or repos. Borrowers and financial entities were induced by Fed policy to position houses and bonds, respectively, with near zero percent short-term interest rates. At the time of the policy before the recession policymakers and regulators deliberately induced borrowers and bankers to buy houses and position bonds. The complaint of policymakers and regulators with hindsight after the recession is that borrowers and bankers should have been omniscient and know that they were induced into a fatal error. The easy credit policy of the Fed encouraged both “Main Street” and “Wall Street” into taking high risks with borrowed liquidity at very low interest costs. Homeowners were caught in increasing monthly payments with declining house prices when the Fed increased the fed funds rate from 1 percent to 5.25 percent. The financial innovations in MBS and CDOs worked without problems in the past but collapsed in value because they were not intended to function with underlying nonprime mortgages. Fannie and Freddie purchased or guaranteed the subprime and liar mortgages with credit ultimately paid by the United States taxpayer. The deterioration of family balance sheets with the increase in monthly mortgage payments and loss of credit because of late payments resulted in erosion in the quality of loan portfolios of banks. Weakening balance sheets of banks and financial entities resulted in contraction of credit that affected balance sheets of producers. The end result was a rare global recession that would not have occurred if there had not been flooding of cheap liquidity and guarantees of liar mortgages. Neither “Wall Street” nor “Main Street” created this crisis. The government through low interest rate policy, housing policy, Fannie and Freddie created the crisis. Government is indispensable in modern societies and an essential part of the general economy (Pelaez and Pelaez, Government Intervention in Globalization, 1-12) but created the excessive leverage, low liquidity and false perception of increasing wealth that eventually caused the recession and 26.9 million people in job stress.
II The Senate Finance Bill. The objective of policy is not to punish the government or the financial system but to improve their functioning in inducing prosperity of the general economy. The Senate Finance Bill (http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_bills&docid=f:s3217as.txt.pdf http://banking.senate.gov/public/_files/FinancialReformSummaryAsFiled.pdf http://blogs.wsj.com/dispatch/2010/05/20/major-provisions-in-senate-financial-overhaul-bill/ ) is not the product of rigorous analysis of regulation that improves policy with individual provisions that are consistent in overall objectives. There are at least six categories of adverse consequences of this rush to regulation. (1) Credit volume and interest rates. The creation of a politicized consumer protection agency will reduce credit volumes and increase interest rates with rules similar in effects to the Credit CARD Act of May 22, 2009 ((http://www.whitehouse.gov/the_press_office/Fact-Sheet-Reforms-to-Protect-American-Credit-Card-Holders ). Nearly all credit in the US is raised by securitization of loans into bonds that are rated for credit by rating agencies. One of the low points in recent legislation is the amendment creating a Credit Rating Agency Board at the Securities and Exchange Commission (SEC) that would allocate thousands of bonds to rating companies (http://professional.wsj.com/article/TPMRKWC00020100517e65h003ea.html ). This board has an impossible technical task, reproducing at high cost the staff and knowledge of rating companies and even then would slow or even impede securitization, reducing credit and increasing interest rates. (2) Bank capital. Excessive regulation increases transaction costs of banks, reducing profits that constrain the banks’ ability to raise equity capital needed for Basel Tier 1 capital requirements. The Senate approved by unanimous vote (http://professional.wsj.com/article/SB10001424052748703691804575254433629763888.html?mod=wsjproe_hps_MIDDLESecondNews ) an amendment prohibiting the use of trust-preferred securities (TPS) that the Board of Governors of the Federal Reserve System had authorized bank holding companies to use as Tier 1 capital in Oct 1996 (Pelaez and Pelaez, Regulation of Banks and Finance, 68-9). This amendment is another of the low points in legislation within the same bill because it forces banks to raise more expensive capital without any gains in stability. The proposed change in reconciliation is to apply the amendment only to large banks, which would magnify the reduction of loans required for the general economy to recover and create jobs, distorting the optimum banking structure in the US. Imposing more costly capital for no sound reason prevents the US from negotiating international bank capital requirements. (3) Innovation and risk management. The bill frustrates innovation and risk management techniques by virtually eliminating the over-the-counter derivatives market, replacing it with inflexible trading in public exchanges. The objective is to prohibit what cannot be understood, which is similar to banning air transportation because the passengers do not understand aviation technology. If this law had existed decades ago there would not have been commercial paper, high-yield bonds and funding for credit cards, mortgages, auto loans and nearly all credit that financed the US at cheaper costs, promoting the prosperity of the general economy. The Senate Finance Bill is an act of prohibiting progress for all. (4) Bank and financial system instability. Frustration of innovative risk management techniques will create more unstable financial institutions, depending on pure lending. The financial stability oversight council will not have sound theory and measurements, amputating lines of business of banks, making whatever survives more unstable. The over financial system could become more unstable because of the combination of various banks subject to riskier activities caused by concentration on lending without risk-reducing diversification of activities. Congress is legislating systemic risk. The council could provoke a costly crisis by making banks and the financial system unstable after arbitrarily breaking up financial entities. Banks could not transfer fully risk by securitization of loans and mortgages becoming more vulnerable to credit risk by the requirement of holding part of the loans in their balance sheets. (5) Too politically important to liquidate. The bill sanctions a new doctrine of perpetuating with unlimited taxpayer funds zombie financial entities that are politically useful, beginning with Fannie and Freddie that contributed critically to the crisis and were saved from bankruptcy with taxpayers funds that will never be repaid. Fannie, Freddie and other similar politically important entities will be resuscitated with taxpayer funds, creating new risks in the future. The bill also prevents market exit of companies through M&As, forcing liquidations of the not politically important to liquidate that could have been restructured in private arrangements. (6) International competitiveness. The Senate Finance Bill makes US international banks uncompetitive and by anticipating global regulation allows other jurisdictions to adapt their statues to encourage the migration overseas of the US financial industry, which is a key component of the indivisible general economy.
III Financial Turbulence and the Global Debt Financial Crisis. Financial turbulence continues because of the fears of the growing global debt crisis that is being exacerbated by the overall financial system through both the cross-border and domestic exposures of banks. There were sharp percentage declines of equity indexes from highs in Apr to the closing of markets on May 21: Global Dow -15.2, Dax Germany -7.9, Shanghai Composite China -18.4 and S&P 500
-10.6 (http://online.wsj.com/mdc/public/page/mdc_international.html?mod=topnav_2_3002 ). The announcement by Germany of bans on naked short sales of equities and bonds caused an event of global financial market fright that was exacerbated by the procyclical Senate Finance Bill (http://www.ft.com/cms/s/0/d3fa8864-6436-11df-8618-00144feab49a.html ). Bloomberg informs that the fixing of LIBOR, to which $350 trillion of financial assets such as mortgages and student loans are indexed, increased for the ninth consecutive day to 0.497, which is the highest level since Jul 24 while the LIBOR/OIS spread rose to 26.7 basis points (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aAIJD5G5GME4 ). The LIBOR/OIS spread is three times higher than a month ago (http://www.ft.com/cms/s/0/857a3a1c-651d-11df-b648-00144feab49a.html ).VIX, the index of implied volatility of S&P options at the CBOE (http://www.cboe.com/micro/vix/introduction.aspx ), rose in intraday trading to 48.20, the highest level since Mar 9, 2009 and just below 48.46 after the Sep 11, 2001 attack (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a8qdvLtcM1oc ). VIX was at 15.23 six weeks ago, which was a three-year low (http://www.ft.com/cms/s/0/857a3a1c-651d-11df-b648-00144feab49a.html ).The most threatening fiscal situation could be that of the United States as revealed by the President’s budget (http://www.whitehouse.gov/omb/budget/fy2011/assets/hist.pdf ). The highest deficit as percent of GDP since World War II occurred in 1983, -6, but no past budget is comparable to the estimated deficits as percent of GDP of -9.9 in 2009, -10.6 in 2010 and -8.3 in 2011. The deficits are staggering in trillions of current dollars: -1.4 in 2009, -1.6 in 2010 and -1.3 in 2011. Estimated outlays or expenditures increase in current dollars by 28.5 percent from 2008 to 2011 while revenues increase 1.7 percent after declining by 14.2 percent between 2008 and 2010. As percent of GDP the estimated expenditures are the highest since 24.8 in 1946: 24.7 in 2009, 25.4 in 2010 and 25.1 in 2011. The federal debt held by the public as percent of GDP peaked at 108.7 in 1946, declining to 52.0 in 1956 and never exceeding 50 until the current estimates: 53.0 in 2009, 63.6 in 2011, 70.8 in 2012 and above 70 during the remainder of the decade but likely surpassing 100. David Ranson measures a ceiling of the ratio of government revenues to GDP of 20 percent calculated since 1929 (http://professional.wsj.com/article/SB30001424052748704608104575217870728420184.html ). Federal government expenditure has risen above 25 percent of GDP. Tax increases will not increase above 20 percent according to past experience. Increases in taxes such as the federal value added tax and the energy tax will slow economic growth, reducing tax revenue. US government debt may reach 100 percent of GDP faster than in forecasts that always underestimate the realized debt. The US is moving toward a government debt event consisting of expenditure reduction, tax increases and implicit default in dollar devaluation. Financial assets will increasingly incorporate in current prices the global debt event. The crowding out effect is defined as follows: “Economists have long agreed that, if the supply of goods and services is fixed and resources fully employed, the government can claim more of the economy’s output only by depriving the private sector of its use” (Benjamin M. Friedman, Brookings Papers on Economic Activity, 3 (1978), 596). With the economy moving toward full employment, historically high budget deficits at the economy’s limit of taxation will add to the federal debt replacing private economic activity with government economic activity likely flattening the expansion path of the economy. The rise of interest rates will be magnified by the unwinding of the Fed’s portfolio of $1.99 trillion of long-term securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). The economic cost of the restructurings is in terms of economic activity or percentage points of GDP and jobs that could be created by the private sector but that will be foregone because of the restructurings.
IV Economic Indicators. There is continuing recovery in manufacturing in the US with some doubts about employment and housing. The Empire State Manufacturing Survey by the New York Fed registers a tenth consecutive monthly improvement of conditions in manufacturing in May (http://www.ny.frb.org/survey/empire/empiresurvey_overview.html ). The Philadelphia Fed’s diffusion index of current activity increased for the fourth consecutive month in May and has been positive for the ninth consecutive month (http://www.phil.frb.org/research-and-data/regional-economy/business-outlook-survey/2010/bos0510.cfm ). Manufacturing was facing difficulties before the recession and recovered earlier and stronger. Housing starts increased in Apr to the seasonally annualized rate of 672,000, which is 5.8 percent higher relative to Mar and 40.9 percent above the Apr 2009 rate of 477,000. Housing permits in Apr declined to 606,000, which is 11.5 percent below Mar but 15.9 percent above 523,000 in Apr 2009 (http://www.census.gov/const/newresconst.pdf ). In Jan 2006, housing starts in the US were at an annual rate of 2265 thousand (http://www.census.gov/const/newresconst_200701.pdf ). Housing starts declined by 70.3 percent from Jan 2006 to Apr 2010. The increase in housing starts in Apr was part of a rush to receive the expiring tax credit and the decline in permits may signal decline in starts ahead. Price indexes are fluctuating with energy prices but without immediate threats of inflation. The producer price index declined 0.1 percent in Apr after increasing 0.7 percent in March and decreasing 0.6 percent in Feb. Prices for finished goods increased by 5.5 percent in the 12 months ending in Apr 2010 (http://www.bls.gov/news.release/pdf/ppi.pdf ). The consumer price index declined by 0.1 percent in Apr and increased by 2.2 percent over the past 12 months (http://www.bls.gov/news.release/pdf/ppi.pdf ). Initial jobless claims in the week ending May 15 increased by 25,000 to 471,000 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
V Interest Rates. Funds abandoning risk exposures partly flowed to Treasuries. The Treasury yield curve continued its downward shift with the 10 year declining to 3.24 percent from 3.44 percent a week earlier and 3.82 percent a month earlier (http://markets.ft.com/markets/bonds.asp ). This decline in yields of Treasuries will be reversed as the continuing increase in government debt and the unwinding of the Fed’s balance sheet become incorporated in measuring the rate/price risk of US debt. There was similar flow of funds into German bonds because of the lower deficit of Germany with the 10-year yield at 2.67 percent corresponding to a negative spread of 57 bps relative to the 10-year Treasury.
VI Conclusions. The combined crowding out effects on capital markets of the historically high budget deficits, government debt and unwinding of the Fed’s $1.99 trillion balance sheet will flatten the expansion path of the economy. Legislative restructurings of business models may hinder growth of the overall economy and job creation. There is no alleviation for the drama of the 26.9 million persons in job stress who have lost their priority in the agenda. Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
Sunday, May 16, 2010
Financial Market Turbulence, the Economy and the Global Debt and Financial Crisis
Financial Market Turbulence, the Economy and the Global Debt and Financial Crisis
Carlos M Pelaez
The world economy and financial markets have moved into a different environment in which improving general economy indicators contrast with significant turbulence in financial markets. The explanation for the decoupling between the growing general economy and higher financial risk is related to events in China, the sovereign risk affecting the euro zone, the US fiscal imbalance and shock waves of regulation in the US and worldwide. The sections below consider (I) financial market turbulence, (II) China and commodities, (III) European sovereign debt and the euro, (IV) United States fiscal imbalance, (V) bank and financial regulation, (VI) the general economy, (VII) interest rates and brief (VIII) conclusions.
I Financial Market Turbulence. Economic turbulence is manifesting in the form of sharp oscillations of key financial variables. The euro US dollar rate depreciated from the closing rate of $1.513/euro (EUR0.6609/USD) on Nov 25, 2009 to the closing rate of $1.236/euro (EUR0.8096/USD) on May 14, 2010 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_curr_dtabnk&symb=CUR_EURUSD&sQuote=1 ), equivalent to a depreciation of the euro of 22.5 percent (0.8096/0.6609 – 1). There are five important effects among many of the depreciation of the euro. (1) European exports may gain competitiveness in world markets, which is important for example to Germany, a leading global exporter, but the reverse may be true for American exports. (2) Direct investment in Europe becomes relatively cheaper than investment in the US; dividend and earnings remittances from Europe to the US decline in dollar value. (3) The most critical effect is the typical perception of an increase in regional risk because the depreciating euro may reflect higher financial and economic risks. (4) The US dollar strengthens temporarily as a reserve currency for holdings by foreign countries because of its higher purchasing power in Europe. (5) Euro denominated assets and liabilities decline in dollar value. If euro-denominated assets are less than liabilities, the net international investment position (NIIP) of the US improves because the decline in assets is less than in liabilities. If euro-denominated assets are higher than liabilities the NIIP of the US deteriorates because the decline in assets exceeds that of liabilities (Pelaez and Pelaez, The Global Recession Risk, 200-2).
The Global Dow index declined from 2087.12 on Apr 15 to 1852.23 on May 14 or by 11.3 percent (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_intl_dtabnk&symb=GDOW&page=intl ). The DJIA of the US declined from 11,205.03 on May 26 to 10,620.16 on May 14 or by 5.2 percent (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_uss_dtabnk&symb=DJIA ). The Shanghai SE Composite declined from 3164.96 on Apr 15 to 2626.63 on May 14 or by 17 percent (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_intl_dtabnk&symb=CN:SHCOMP&page=intl ). The DAX (TR) of Germany declined from 6332.1 on Apr 24 to 5715.1 on May 7 or by 9.7 percent, recovering to 6056.7 on May 14 but still lower by 4.3 percent relative to Apr 24 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_intl_dtabnk&symb=DX:1876534&page=intl ). Wide fluctuations of shares of companies affect savings and retirement funds and may also influence investment decisions by the companies. It is difficult to relate stock market behavior to the general economy and even to other financial variables. The credit/dollar crisis and global recession of 2008-2009 was accompanied by sharp declines of stock market values.
Three key indicators of financial risk analyzed by Bloomberg have been reflecting higher risk perceptions of financial counterparty credit risk (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aQGk_KOnqwGY ). (1) The 3-month LIBOR rose to 0.445 percent on May 14, constituting the highest level since Aug 12. (2) The dollar LIBOR OIS spread, measuring reluctance to lending by banks, increased to 22.5 basis points (bps) to the highest level since Aug 19. On Oct 10, 2008, the LIBOR-OIS spread stood at 364 bps while it had been 11 bps on average during ten years before Aug 2007. (3) The swap spread, defined as the difference between the two-year swap rate and the Treasury note of comparable maturity, widened by 4.19 bps, or 13.5 percent, reaching 35,13 bps, much higher than 9.63 bps on Mar 24 prior to the turbulence. The widening of the spread and the rise of LIBOR reflect expectations of increasing credit risk.
II China and Commodities. There are three conventional arguments on the role of China on the world economy and financial turbulence. (1) China’s fast growth requires raw materials such as iron ore, copper and oil, maintaining high demand and prices for these industrial commodities. There are fears in market commentary of a possible “forced landing” or milder orderly deceleration of China because the overheated economy and appreciation of property values would motivate more measures of control of credit by the country’s monetary authorities. However, these fears have been common over many years without an adverse GDP event that actually occurred in much earlier history in 1989-90 (Pelaez and Pelaez, The Global Recession Risk, 56-80). It is difficult to explain the fluctuations in commodity prices with fundamentals such as those that would be used in partial equilibrium demand and supply models. The Jun crude light oil contract of NYMEX closed at $72.05/barrel on May 14 (http://online.wsj.com/mdc/public/page/mdc_commodities.html?mod=mdc_topnav_2_3000 ) after pressing toward $88/barrel in April for a decline of about 18 percent. The decline could be attributed to lower growth perspectives for China and the world economy and to changes in stocks. An alternative explanation is by appeal to the carry trade promoted by the zero or near zero policy interest rates of major central banks that could also explain the rise toward $149/barrel in 2008. The carry trade consists of a short position in the low yielding currency, such as short US dollar long euro, simultaneously with a long position in commodity futures such as oil (Pelaez and Pelaez, Globalization and the State, Vol. II, 203-4, Government Intervention in Globalization, 70-4). The depreciation of the euro could have caused significant losses in the short dollar/euro leg of the carry trade, causing the unwinding of the long commodities futures leg with offsetting short positions, thus forcing a decline in prices of industrial commodities. It is quite difficult to separate these two and other probable factors of the fluctuation of commodity prices but the appeal to China’s growth as the only factor may not be complete. (2) A more appealing argument is based on Asian interregional trade in which China plays a key role. The deceleration of the economy of China could cause lowering interregional trade, creating adverse growth expectations in other Asian economies with possible fluctuations of exchange rates and stock market valuations. (3) China allowed revaluation of about 21 percent of the renminbi between 2005 and 2008 and then fixed it again to the dollar. There are expectations that revaluation could occur again with possible adverse effects on China’s exports and fluctuation of Asian currencies. The revaluation of the renminbi between 2005 and 2008 was not a panacea for domestic industrial production in countries importing Chinese goods or disaster for the economy of China and more revaluation likely to be subdued may not have significant effects.
III European Sovereign Debt and the Euro. The European rescue effort of highly-indebted, high-fiscal imbalance member countries of the euro zone can be analyzed in terms of the same principles that motivated the creation of central banks. Walter Bagehot proposed the principle which bears his name that central banks should lend through the discount window to solvent but temporarily illiquid banks by discounting their high-quality paper at a punitive rate that would discourage “moral hazard” or borrowing to take reckless risks with subsequent long tradition of central banking theory and practice (Pelaez and Pelaez, International Financial Architecture, 175-8, 194, Financial Regulation after the Global Recession, 69-90, Regulation of Banks and Finance, 99-116). The International Monetary Fund (IMF) manages a safety net for its member countries, initially designed for solvent but temporarily illiquid members but that eventually included countries in need of rescheduling of unsustainable foreign debts. The dual objective of the safety net is to soften the impact of adjustment on the member countries while avoiding adverse effects on the rest of the world economy. The joint European Union (EU), IMF and European Central Bank (ECB) plan consists of an unusual structure for international debt management but that is reminiscent of the structured investment vehicles (SIV) or “conduits” of the credit crisis in 2007-2009. The assistance to the highly indebted countries consists of EUR442 billion from governments in the euro zone, EUR60 billion from an EU emergency fund and EUR250 billion from the IMF for a total close to the magic number of one trillion dollars (http://professional.wsj.com/article/SB10001424052748703674704575234371941567524.html?mg=reno-wsj ). The EUR440 billion are not in the form of immediately disbursable cash. The euro zone government would create an off-balance sheet special purpose vehicle (SPV) that would borrow with the guarantee of the AAA-rated sovereigns of the euro zone to lend to indebted countries. Banks in the US and Europe created off-balance sheet SIVs which issued commercial paper that was rated AAA because of letters of guarantee from the AAA-rated bank creating the SIV. The AAA-rated commercial paper was financed in term sale and repurchase agreements (SRP) with the proceeds used to acquire portfolios of also AAA-rated collateralized debt obligations (CDO). Following the default of the nonprime mortgages in mortgage-backed securities in tranches of the CDOs or in other instruments referenced to nonprime mortgages the SIVs encountered difficulties in refinancing the SRPs of maturing commercial paper. Banks had to provide the liquidity guarantees and eventually write down the assets in the SIVs (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9). The public is distracted from the root causes of the crisis, which were the government-created nonprime mortgages resulting from Fed-imposed near zero interest rates in 2003-2004, housing subsidies of $221 billion per year and purchase or guarantee of $1.6 nonprime mortgages by Fannie and Freddie. It is difficult to evaluate the success of the rescue program that will depend significantly on whether the highly-indebted countries with high fiscal imbalances can design and implement credible programs of fiscal adjustment that are not frustrated because of the adverse effects on the population. It is an uphill battle because of the late and weaker economic recovery: euro zone growth was 0.2 percent in IQ10 after 0 percent in IVQ09 and 0.4 percent in IIIQ09 and is negative or weaker in highly-indebted countries (http://epp.eurostat.ec.europa.eu/tgm/refreshTableAction.do?tab=table&plugin=1&pcode=teina011&language=en ). Adjustment with a weak or declining general economy may be quite difficult. Some economists argue that debt rescheduling would be more appropriate because of nearly impossible service of government debts. Rescheduling is not an easy solution. The dual objective of the rescue was to prevent an impact on the banks in the larger economies of the euro zone that have debt exposures to the highly-indebted countries and also to prevent what Paul Volcker has called the risk of “disintegration” of the euro (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aASZ4SCDL3uQ ). The continuing decline of the value of the euro in dollars suggests that the rescue plan may be facing an issue of credibility. In addition, financial risk indicators analyzed by Bloomberg such as LIBOR, the LIBOR/OIS spread and the swap spread suggest that financial risk perceptions are rising. The decline of the yields of government bonds of the highly-indebted countries would suggest the opposite. This may be partly the result of the ECB’s new policy of quantitative easing by which purchases of EUR20 billion of sovereign debt of highly-indebted countries may have caused the decline of their spreads relative to German bonds of equivalent maturity (http://www.ft.com/cms/s/0/7fd69a8a-5eb3-11df-af86-00144feab49a.html#). Analysts estimate that purchases of debt of affected countries by the ECB would have to rise to ERU300 to EUR600 billion but it is quite difficult to measure such numbers relative to success in calming markets permanently. The capitulation of the ECB to the policy of quantitative easing may be considered as a breach of its independence and loss of its credibility as a central bank during a tough emergency while the Fed bloats its balance sheet with dollar swaps with central banks (http://www.federalreserve.gov/newsevents/press/monetary/20100511a.htm ) that may have been ineffective in the credit crisis of 2007-2009 (John Taylor http://www.ft.com/cms/s/0/eedbe85c-5d2a-11df-8373-00144feab49a.html ).
IV United States Fiscal Imbalance. The shock to the highly-indebted countries in the euro zone is actually only part of a tough adjustment of fiscal imbalance facing the advanced economies. 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. Adverse expectations caused by the failure of the US to engage in credible fiscal consolidation may bring to the present in the form of financial turbulence a fiscal debacle that is actually only a few years ahead.
V Bank and Financial Regulation. There is an ambitious global financial regulation agenda that is being anticipated in the US Senate and is coinciding with regulatory probes on banks and financial institutions. The Senate bank regulation bill is proposed on the basis of the allegation that if it had been enacted before 2007 it would have prevented the credit crisis and global recession of 2007-2009. There is no technical knowledge to support this allegation. The effects of individual regulatory changes throughout several thousand pages of legislation cannot be analyzed properly and much less the overall effects of the legislation, which changes capriciously with each amendment. Even if the Senate bill were originally consistent in providing stability with growth of financial services, which it was not, the amendments could make the whole toxic. One of the most important determinants of the credit crisis and global recession was the guarantee or purchase of $1.6 trillion nonprime mortgages by Fannie Mae and Freddie Mac (Edward Pinto testimony cited in Pelaez and Pelaez, Regulation of Banks and Finance, 219-20, Financial Regulation after the Global Recession, 156) and the two companies operating with reckless leverage of 70:1, lobbying successfully against their regulatory oversight and faking profits in their balance sheets. A Senate bill proposed as an end of bailouts and the “too big to fail” actually perpetuates the “too politically important to liquidate” with Fannie and Freddie now endowed with an open-ended or limitless financing agreement by Treasury with taxpayer funds. The Senate voted down an amendment to consider Fannie and Freddie in its bill (http://professional.wsj.com/article/SB10001424052748704250104575238641146885632.html?mod=wsjproe_hps_TopMoreNews ). However, an amendment passed comfortably to create an unfeasible and chaotic agency to allocate specific companies to providing ratings of thousands of issues of securities (http://professional.wsj.com/article/SB10001424052748704635204575242472908973624.html?mod=wsjproe_hps_LEFTWhatsNews ). The combination of the noise from the financial regulation bill with a web of federal and New York State probes of large financial institutions contributed to the pressure on stocks of financial companies (http://www.ft.com/cms/s/0/cf8c7828-5f81-11df-a670-00144feab49a.html ). The regulatory effort of the US Congress is a clear case of procyclical regulation, accentuating instead of alleviating stress in financial markets, probably strangling needed financing of the overall economy or “Main Street” as typically referred in political statements.
VI The General Economy. The general economy continues to recover in manufacturing and now also consumption. Sales of merchant wholesalers increased by 2.4 percent in Mar relative to Feb and 15.8 percent relative to March 2009; inventories of merchant wholesalers increased by 0.4 percent in Mar relative to Feb but declined by 5.3 percent relative to Mar 2009 (http://www2.census.gov/wholesale/pdf/mwts/currentwhl.pdf ). US imports of goods and services of $188.3 billion in Mar exceeded exports of goods and services of $147.9 billion for a trade deficit of $40.4 billion, slightly higher than $39.4 billion in Feb (http://online.wsj.com/mdc/public/page/2_3063-economicCalendar.html?mod=topnav_2_3000 ). The US trade deficit is oscillating with the prices of imported petroleum but the revaluation of the dollar may still be a factor in restraining export growth. US Retail sales increased by 0.4 percent in Apr relative to Mar; the increase relative to Apr 2009 was 8.8 percent. US Sales in Feb through Apr 2010 were higher by 7.3 percent relative to the same period a year earlier (http://www.census.gov/retail/marts/www/marts_current.pdf ). Manufacturing output was higher by 1.0 percent in Apr over Mar and 6.0 percent relative to a year earlier. Manufacturing activity is increasing across many sectors. Capacity utilization was higher by 0.8 percentage point, reaching 7.08 percent, which is 8.4 percentage points below the average in 1972-2009 but higher by 5.7 percentage points relative to the trough in 2009 (http://www.federalreserve.gov/releases/g17/Current/default.htm ). Initial jobless claims for the week ending May 8 were lower by 4000 from the upwardly revised 448.000 in the prior week. Seasonally adjusted insured unemployment in the week ending May 1 was 4.627 million, increasing by 12,000 from the previous week’s level of 4.616 million (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
VII Interest Rates. The flight out of risk into Treasuries caused a downward shift of the US yield curve. The yield of the 10-year Treasury declined to 3.46 percent on May 14 from 3.84 percent a month earlier but was higher than 3.42 percent a week earlier (http://markets.ft.com/markets/bonds.asp ). The 10-year German government bond traded at 2.85 percent for a negative spread relative to the 10-year Treasury of 60 basis points (bps). France’s 10-year government bond traded at 3.11 percent for a negative spread of 34 bps. Although there are unresolved problems in the euro zone, the yields of government bonds of France and Germany are trading at lower levels than those of the US. Once the risks among sovereigns are evened, US Treasury yields may rise again. The bid rate of 3.43 percent and ask rate of 3.46 percent of the 10-year interest rate swap traded close to the 10-year Treasury yield of 3.42 percent (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=ICAP-140510 ).
VIII Conclusions. The doubts on China’s growth, the sovereign debt crisis raising clouds on the euro, the fiscal imbalance of the United States and the web of probes on banks coinciding with the threat of financial disintermediation resulting from the bank and financial regulatory exercise in Congress are exacerbating world financial turbulence. Higher taxation and increasing interest rates threaten the recovery of the general economy and employment in the short term while the agenda continues its focus on restructuring for the long term. The 26.9 million persons in job stress who are willing and available to work are being neglected. Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
Carlos M Pelaez
The world economy and financial markets have moved into a different environment in which improving general economy indicators contrast with significant turbulence in financial markets. The explanation for the decoupling between the growing general economy and higher financial risk is related to events in China, the sovereign risk affecting the euro zone, the US fiscal imbalance and shock waves of regulation in the US and worldwide. The sections below consider (I) financial market turbulence, (II) China and commodities, (III) European sovereign debt and the euro, (IV) United States fiscal imbalance, (V) bank and financial regulation, (VI) the general economy, (VII) interest rates and brief (VIII) conclusions.
I Financial Market Turbulence. Economic turbulence is manifesting in the form of sharp oscillations of key financial variables. The euro US dollar rate depreciated from the closing rate of $1.513/euro (EUR0.6609/USD) on Nov 25, 2009 to the closing rate of $1.236/euro (EUR0.8096/USD) on May 14, 2010 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_curr_dtabnk&symb=CUR_EURUSD&sQuote=1 ), equivalent to a depreciation of the euro of 22.5 percent (0.8096/0.6609 – 1). There are five important effects among many of the depreciation of the euro. (1) European exports may gain competitiveness in world markets, which is important for example to Germany, a leading global exporter, but the reverse may be true for American exports. (2) Direct investment in Europe becomes relatively cheaper than investment in the US; dividend and earnings remittances from Europe to the US decline in dollar value. (3) The most critical effect is the typical perception of an increase in regional risk because the depreciating euro may reflect higher financial and economic risks. (4) The US dollar strengthens temporarily as a reserve currency for holdings by foreign countries because of its higher purchasing power in Europe. (5) Euro denominated assets and liabilities decline in dollar value. If euro-denominated assets are less than liabilities, the net international investment position (NIIP) of the US improves because the decline in assets is less than in liabilities. If euro-denominated assets are higher than liabilities the NIIP of the US deteriorates because the decline in assets exceeds that of liabilities (Pelaez and Pelaez, The Global Recession Risk, 200-2).
The Global Dow index declined from 2087.12 on Apr 15 to 1852.23 on May 14 or by 11.3 percent (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_intl_dtabnk&symb=GDOW&page=intl ). The DJIA of the US declined from 11,205.03 on May 26 to 10,620.16 on May 14 or by 5.2 percent (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_uss_dtabnk&symb=DJIA ). The Shanghai SE Composite declined from 3164.96 on Apr 15 to 2626.63 on May 14 or by 17 percent (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_intl_dtabnk&symb=CN:SHCOMP&page=intl ). The DAX (TR) of Germany declined from 6332.1 on Apr 24 to 5715.1 on May 7 or by 9.7 percent, recovering to 6056.7 on May 14 but still lower by 4.3 percent relative to Apr 24 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_intl_dtabnk&symb=DX:1876534&page=intl ). Wide fluctuations of shares of companies affect savings and retirement funds and may also influence investment decisions by the companies. It is difficult to relate stock market behavior to the general economy and even to other financial variables. The credit/dollar crisis and global recession of 2008-2009 was accompanied by sharp declines of stock market values.
Three key indicators of financial risk analyzed by Bloomberg have been reflecting higher risk perceptions of financial counterparty credit risk (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aQGk_KOnqwGY ). (1) The 3-month LIBOR rose to 0.445 percent on May 14, constituting the highest level since Aug 12. (2) The dollar LIBOR OIS spread, measuring reluctance to lending by banks, increased to 22.5 basis points (bps) to the highest level since Aug 19. On Oct 10, 2008, the LIBOR-OIS spread stood at 364 bps while it had been 11 bps on average during ten years before Aug 2007. (3) The swap spread, defined as the difference between the two-year swap rate and the Treasury note of comparable maturity, widened by 4.19 bps, or 13.5 percent, reaching 35,13 bps, much higher than 9.63 bps on Mar 24 prior to the turbulence. The widening of the spread and the rise of LIBOR reflect expectations of increasing credit risk.
II China and Commodities. There are three conventional arguments on the role of China on the world economy and financial turbulence. (1) China’s fast growth requires raw materials such as iron ore, copper and oil, maintaining high demand and prices for these industrial commodities. There are fears in market commentary of a possible “forced landing” or milder orderly deceleration of China because the overheated economy and appreciation of property values would motivate more measures of control of credit by the country’s monetary authorities. However, these fears have been common over many years without an adverse GDP event that actually occurred in much earlier history in 1989-90 (Pelaez and Pelaez, The Global Recession Risk, 56-80). It is difficult to explain the fluctuations in commodity prices with fundamentals such as those that would be used in partial equilibrium demand and supply models. The Jun crude light oil contract of NYMEX closed at $72.05/barrel on May 14 (http://online.wsj.com/mdc/public/page/mdc_commodities.html?mod=mdc_topnav_2_3000 ) after pressing toward $88/barrel in April for a decline of about 18 percent. The decline could be attributed to lower growth perspectives for China and the world economy and to changes in stocks. An alternative explanation is by appeal to the carry trade promoted by the zero or near zero policy interest rates of major central banks that could also explain the rise toward $149/barrel in 2008. The carry trade consists of a short position in the low yielding currency, such as short US dollar long euro, simultaneously with a long position in commodity futures such as oil (Pelaez and Pelaez, Globalization and the State, Vol. II, 203-4, Government Intervention in Globalization, 70-4). The depreciation of the euro could have caused significant losses in the short dollar/euro leg of the carry trade, causing the unwinding of the long commodities futures leg with offsetting short positions, thus forcing a decline in prices of industrial commodities. It is quite difficult to separate these two and other probable factors of the fluctuation of commodity prices but the appeal to China’s growth as the only factor may not be complete. (2) A more appealing argument is based on Asian interregional trade in which China plays a key role. The deceleration of the economy of China could cause lowering interregional trade, creating adverse growth expectations in other Asian economies with possible fluctuations of exchange rates and stock market valuations. (3) China allowed revaluation of about 21 percent of the renminbi between 2005 and 2008 and then fixed it again to the dollar. There are expectations that revaluation could occur again with possible adverse effects on China’s exports and fluctuation of Asian currencies. The revaluation of the renminbi between 2005 and 2008 was not a panacea for domestic industrial production in countries importing Chinese goods or disaster for the economy of China and more revaluation likely to be subdued may not have significant effects.
III European Sovereign Debt and the Euro. The European rescue effort of highly-indebted, high-fiscal imbalance member countries of the euro zone can be analyzed in terms of the same principles that motivated the creation of central banks. Walter Bagehot proposed the principle which bears his name that central banks should lend through the discount window to solvent but temporarily illiquid banks by discounting their high-quality paper at a punitive rate that would discourage “moral hazard” or borrowing to take reckless risks with subsequent long tradition of central banking theory and practice (Pelaez and Pelaez, International Financial Architecture, 175-8, 194, Financial Regulation after the Global Recession, 69-90, Regulation of Banks and Finance, 99-116). The International Monetary Fund (IMF) manages a safety net for its member countries, initially designed for solvent but temporarily illiquid members but that eventually included countries in need of rescheduling of unsustainable foreign debts. The dual objective of the safety net is to soften the impact of adjustment on the member countries while avoiding adverse effects on the rest of the world economy. The joint European Union (EU), IMF and European Central Bank (ECB) plan consists of an unusual structure for international debt management but that is reminiscent of the structured investment vehicles (SIV) or “conduits” of the credit crisis in 2007-2009. The assistance to the highly indebted countries consists of EUR442 billion from governments in the euro zone, EUR60 billion from an EU emergency fund and EUR250 billion from the IMF for a total close to the magic number of one trillion dollars (http://professional.wsj.com/article/SB10001424052748703674704575234371941567524.html?mg=reno-wsj ). The EUR440 billion are not in the form of immediately disbursable cash. The euro zone government would create an off-balance sheet special purpose vehicle (SPV) that would borrow with the guarantee of the AAA-rated sovereigns of the euro zone to lend to indebted countries. Banks in the US and Europe created off-balance sheet SIVs which issued commercial paper that was rated AAA because of letters of guarantee from the AAA-rated bank creating the SIV. The AAA-rated commercial paper was financed in term sale and repurchase agreements (SRP) with the proceeds used to acquire portfolios of also AAA-rated collateralized debt obligations (CDO). Following the default of the nonprime mortgages in mortgage-backed securities in tranches of the CDOs or in other instruments referenced to nonprime mortgages the SIVs encountered difficulties in refinancing the SRPs of maturing commercial paper. Banks had to provide the liquidity guarantees and eventually write down the assets in the SIVs (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9). The public is distracted from the root causes of the crisis, which were the government-created nonprime mortgages resulting from Fed-imposed near zero interest rates in 2003-2004, housing subsidies of $221 billion per year and purchase or guarantee of $1.6 nonprime mortgages by Fannie and Freddie. It is difficult to evaluate the success of the rescue program that will depend significantly on whether the highly-indebted countries with high fiscal imbalances can design and implement credible programs of fiscal adjustment that are not frustrated because of the adverse effects on the population. It is an uphill battle because of the late and weaker economic recovery: euro zone growth was 0.2 percent in IQ10 after 0 percent in IVQ09 and 0.4 percent in IIIQ09 and is negative or weaker in highly-indebted countries (http://epp.eurostat.ec.europa.eu/tgm/refreshTableAction.do?tab=table&plugin=1&pcode=teina011&language=en ). Adjustment with a weak or declining general economy may be quite difficult. Some economists argue that debt rescheduling would be more appropriate because of nearly impossible service of government debts. Rescheduling is not an easy solution. The dual objective of the rescue was to prevent an impact on the banks in the larger economies of the euro zone that have debt exposures to the highly-indebted countries and also to prevent what Paul Volcker has called the risk of “disintegration” of the euro (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aASZ4SCDL3uQ ). The continuing decline of the value of the euro in dollars suggests that the rescue plan may be facing an issue of credibility. In addition, financial risk indicators analyzed by Bloomberg such as LIBOR, the LIBOR/OIS spread and the swap spread suggest that financial risk perceptions are rising. The decline of the yields of government bonds of the highly-indebted countries would suggest the opposite. This may be partly the result of the ECB’s new policy of quantitative easing by which purchases of EUR20 billion of sovereign debt of highly-indebted countries may have caused the decline of their spreads relative to German bonds of equivalent maturity (http://www.ft.com/cms/s/0/7fd69a8a-5eb3-11df-af86-00144feab49a.html#). Analysts estimate that purchases of debt of affected countries by the ECB would have to rise to ERU300 to EUR600 billion but it is quite difficult to measure such numbers relative to success in calming markets permanently. The capitulation of the ECB to the policy of quantitative easing may be considered as a breach of its independence and loss of its credibility as a central bank during a tough emergency while the Fed bloats its balance sheet with dollar swaps with central banks (http://www.federalreserve.gov/newsevents/press/monetary/20100511a.htm ) that may have been ineffective in the credit crisis of 2007-2009 (John Taylor http://www.ft.com/cms/s/0/eedbe85c-5d2a-11df-8373-00144feab49a.html ).
IV United States Fiscal Imbalance. The shock to the highly-indebted countries in the euro zone is actually only part of a tough adjustment of fiscal imbalance facing the advanced economies. 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. Adverse expectations caused by the failure of the US to engage in credible fiscal consolidation may bring to the present in the form of financial turbulence a fiscal debacle that is actually only a few years ahead.
V Bank and Financial Regulation. There is an ambitious global financial regulation agenda that is being anticipated in the US Senate and is coinciding with regulatory probes on banks and financial institutions. The Senate bank regulation bill is proposed on the basis of the allegation that if it had been enacted before 2007 it would have prevented the credit crisis and global recession of 2007-2009. There is no technical knowledge to support this allegation. The effects of individual regulatory changes throughout several thousand pages of legislation cannot be analyzed properly and much less the overall effects of the legislation, which changes capriciously with each amendment. Even if the Senate bill were originally consistent in providing stability with growth of financial services, which it was not, the amendments could make the whole toxic. One of the most important determinants of the credit crisis and global recession was the guarantee or purchase of $1.6 trillion nonprime mortgages by Fannie Mae and Freddie Mac (Edward Pinto testimony cited in Pelaez and Pelaez, Regulation of Banks and Finance, 219-20, Financial Regulation after the Global Recession, 156) and the two companies operating with reckless leverage of 70:1, lobbying successfully against their regulatory oversight and faking profits in their balance sheets. A Senate bill proposed as an end of bailouts and the “too big to fail” actually perpetuates the “too politically important to liquidate” with Fannie and Freddie now endowed with an open-ended or limitless financing agreement by Treasury with taxpayer funds. The Senate voted down an amendment to consider Fannie and Freddie in its bill (http://professional.wsj.com/article/SB10001424052748704250104575238641146885632.html?mod=wsjproe_hps_TopMoreNews ). However, an amendment passed comfortably to create an unfeasible and chaotic agency to allocate specific companies to providing ratings of thousands of issues of securities (http://professional.wsj.com/article/SB10001424052748704635204575242472908973624.html?mod=wsjproe_hps_LEFTWhatsNews ). The combination of the noise from the financial regulation bill with a web of federal and New York State probes of large financial institutions contributed to the pressure on stocks of financial companies (http://www.ft.com/cms/s/0/cf8c7828-5f81-11df-a670-00144feab49a.html ). The regulatory effort of the US Congress is a clear case of procyclical regulation, accentuating instead of alleviating stress in financial markets, probably strangling needed financing of the overall economy or “Main Street” as typically referred in political statements.
VI The General Economy. The general economy continues to recover in manufacturing and now also consumption. Sales of merchant wholesalers increased by 2.4 percent in Mar relative to Feb and 15.8 percent relative to March 2009; inventories of merchant wholesalers increased by 0.4 percent in Mar relative to Feb but declined by 5.3 percent relative to Mar 2009 (http://www2.census.gov/wholesale/pdf/mwts/currentwhl.pdf ). US imports of goods and services of $188.3 billion in Mar exceeded exports of goods and services of $147.9 billion for a trade deficit of $40.4 billion, slightly higher than $39.4 billion in Feb (http://online.wsj.com/mdc/public/page/2_3063-economicCalendar.html?mod=topnav_2_3000 ). The US trade deficit is oscillating with the prices of imported petroleum but the revaluation of the dollar may still be a factor in restraining export growth. US Retail sales increased by 0.4 percent in Apr relative to Mar; the increase relative to Apr 2009 was 8.8 percent. US Sales in Feb through Apr 2010 were higher by 7.3 percent relative to the same period a year earlier (http://www.census.gov/retail/marts/www/marts_current.pdf ). Manufacturing output was higher by 1.0 percent in Apr over Mar and 6.0 percent relative to a year earlier. Manufacturing activity is increasing across many sectors. Capacity utilization was higher by 0.8 percentage point, reaching 7.08 percent, which is 8.4 percentage points below the average in 1972-2009 but higher by 5.7 percentage points relative to the trough in 2009 (http://www.federalreserve.gov/releases/g17/Current/default.htm ). Initial jobless claims for the week ending May 8 were lower by 4000 from the upwardly revised 448.000 in the prior week. Seasonally adjusted insured unemployment in the week ending May 1 was 4.627 million, increasing by 12,000 from the previous week’s level of 4.616 million (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
VII Interest Rates. The flight out of risk into Treasuries caused a downward shift of the US yield curve. The yield of the 10-year Treasury declined to 3.46 percent on May 14 from 3.84 percent a month earlier but was higher than 3.42 percent a week earlier (http://markets.ft.com/markets/bonds.asp ). The 10-year German government bond traded at 2.85 percent for a negative spread relative to the 10-year Treasury of 60 basis points (bps). France’s 10-year government bond traded at 3.11 percent for a negative spread of 34 bps. Although there are unresolved problems in the euro zone, the yields of government bonds of France and Germany are trading at lower levels than those of the US. Once the risks among sovereigns are evened, US Treasury yields may rise again. The bid rate of 3.43 percent and ask rate of 3.46 percent of the 10-year interest rate swap traded close to the 10-year Treasury yield of 3.42 percent (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=ICAP-140510 ).
VIII Conclusions. The doubts on China’s growth, the sovereign debt crisis raising clouds on the euro, the fiscal imbalance of the United States and the web of probes on banks coinciding with the threat of financial disintermediation resulting from the bank and financial regulatory exercise in Congress are exacerbating world financial turbulence. Higher taxation and increasing interest rates threaten the recovery of the general economy and employment in the short term while the agenda continues its focus on restructuring for the long term. The 26.9 million persons in job stress who are willing and available to work are being neglected. Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
Sunday, May 9, 2010
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
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
Sunday, May 2, 2010
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
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
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