The Rise of the Era of Uncertainty
Carlos M Pelaez
“All human planning and execution involve uncertainty, and a rational social order can be realized only if all persons have a rational attitude toward risk and chance,” Frank H. Knight (The ethics of competition. Quarterly Journal of Economics 37 (4, Aug 1923), 565).
The objective of this post is to relate uncertainty as widely perceived today to the frustration of investment by business and individuals and the weakening hiring decisions by small and large business. (I) relates the work of Frank Knight and the era of uncertainty, (II) provides the information on financial turbulence and (II) and (IV) evaluate economic indicators and interest rates. (V) concludes.
I Frank Knight and The Era of Uncertainty. The economist Frank H. Knight considered in his 1921 classic opus Risk, Uncertainty, and Profit three different types of probability (http://www.econlib.org/library/Knight/knRUP6.html#Pt.III,Ch.VII ). First, a priori probability is explained by the example of tossing the perfect die that will show a given number one-sixth of the time (see William Feller, An introduction to probability theory and its applications. Wiley, 1968, 7-25). Second, there is the work of actuarial science in insurance in which past information is used to calculate the fair premium. The present value of the actuarially fair premium is equal to the expected costs of the benefits to be received from the plan, or costs weighted by probability of occurrence, if the load, or administrative costs, is assumed to be zero. Knight finds that the distinguishing characteristic of this type is that “it rests on an empirical classification of instances” (Ibid). Third, there is what Knight calls “estimates,” for which “there is no valid basis of any kind for classifying instances” and constitute an “uncertainty” (Ibid). Knight argues that “an uncertainty which can by any method be reduced to an objective, quantitatively determined probability, can be reduced to complete certainty by grouping cases.” The process of Value at Risk (VaR), measuring the maximum loss in a target horizon for a desired level of confidence, could fit into this category (Pelaez and Pelaez, International Financial Architecture, 106-12). For example, JP Morgan Chase reports a decline of the investment bank trading VaR from $170 million in 2Q09 to $72 million in 2Q10, measuring the highest loss per day 99 per cent of the time from the trading transactions of the investment bank (http://files.shareholder.com/downloads/ONE/889418027x0x387171/79855d7d-cc5f-4a91-87ed-8ca848266fd8/2Q10_ERF_Supplement_7-14-10_FINAL.pdf ). An important concept used by Knight is that change causes uncertainty.
The method used by business in reducing uncertainty is capital budgeting in investment decisions. As Knight argues in his classic work, the entrepreneur receives the difference between the selling price and cost. An entrepreneur deciding on a project would construct the “estimates” mentioned by Knight. The method is similar to the cost/benefit analysis of economics (Pelaez and Pelaez, Financial Regulation after the Global Recession, 22, Regulation of Banks and Finance, 27-32, Government Intervention in Globalization, 52-6, 87, Globalization and the State, Vol. I, 119-25) and applied in the economics of climate change (Pelaez and Pelaez, Globalization and the State, Vol. II, 59-63). The entrepreneur projects forward to the horizon or year of maturity of the investment the cash flows to be received, or revenue, and the cash flows to be paid, or costs. For each year, the projections would show net revenue, or revenue less cost. The future net revenues have to be converted into dollars of today by discounting them by another estimate of the rate of interest. The sum of the discounted net revenues is the present value of the project. The entrepreneur chooses projects with positive present value.
Consider the development of pharmaceuticals. Industry data reported to the Federal Drug Administration (FDA) find that 5 of 5000 compounds entering preclinical testing actually move on to clinical testing and only 1 of the 5 is finally found satisfactory for sales to the public (http://www.fda.gov/Drugs/ResourcesForYou/Consumers/ucm143455.htm ). The estimate of expenditure costs per approved new drug is $403 million but rises to $802 million when discounting sales backwards and capitalizing costs forward over the gestation period. The time cost of investment is about 50 percent of the cost (Joseph DiMasi, Ronald Hansen and Henry Grabowski, The price of innovation: new estimates of drug development costs. Journal of Health Economics 22 (2)). The capital budgeting of a pharmaceutical requires the estimation of the revenue that it will bring, which depends on the capacity of the pharmaceutical company to anticipate a host of uncertain future decisions by patients, providers, institutions, health insurance and regulation. The costs require estimates of the transition probabilities and costs of moving the compound from the synthesis to animal testing, New Drug Application at the FDA, human testing in three clinical phases of the FDA process and the costs of approval and final marketing. The development of drugs is characterized by risk because of thousands of compounds only one reaches the pharmacy counters as the compound moves through this prolonged and costly process to final approval and marketing. The conversion of costs to current time when the decision is made requires a continuum of investments over time. The costs to be incurred are brought to current time by an appropriate discount rate. The pharmaceutical company would require estimation of the sales of the new product in the “in patent” period less the costs to calculate if it could remunerate the investment at the rate of return required by investors. The process absorbing two decades more or less is similar to the third category of probabilities that Knight calls “estimates.” In his subsequent work on The Ethics of Competition, Knight adds that “a rational social order can be realized through individual action only if all persons have a rational attitude toward risk and chance” (The ethics of competition. Quarterly Journal of Economics 37 (4, Aug 1923), 565). Harold Demsetz provides the check by government of the rational risk attitudes that can encourage prosperity by “the design of institutional arrangements that provide incentives to encourage experimentation (including the development of new products, new knowledge, new reputations, and new ways of organizing activities) without overly insulating these experiments from the ultimate test of survival” (Information and efficiency: another viewpoint. Journal of Law and Economics 12 (1, Apr 1969), 20). The essence of the argument is that both government and markets may fail, requiring adequate balance of their institutional roles (Pelaez and Pelaez, Government Intervention in Globalization, 1-12, 80-6, Globalization and the State, Vol. I, 133-43, Financial Regulation after the Global Recession, 11-5, Regulation of Banks and Finance, 33-5). An adequate role of government can create incentives to innovation that result in prosperity while an asphyxiating role of government imposed by drastic changes in one year can frustrate innovation, causing lower living standards, unemployment and underemployment.
The entrepreneur has to finance the project in the capital markets for debt and equity, a process that shows the equivocal political discourse of a dichotomy of “Wall Street” and “Main Street” when in fact there is only one and indivisible general economy. A misleading characterization of the credit/dollar crisis is that financial institutions took careless risks on products that nobody understands. The fact is that financial institutions face the same uncertainty as other types of business and used methods to reduce them to “certainty,” similar to those considered by Frank Knight that are used by business and individuals in making investment and hiring decisions. A high school student considering a medical career faces an even more complex decision of at least a million dollars of costs incurred or in foregone income over the next fifteen years that may be more uncertain in terms of returns than those of a pharmaceutical company pondering on a new drug or actually almost any business large or small. Banks and other financial institutions use models of risk management to estimate their exposures to risks and to protect the market value or capital of their institutions. The models did not fail (Christopher C. Finger cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 131, 176, 193, Regulation of Banks and Finance, 236). What failed was the illusion of a floor on house prices and real estate wealth created by government policy of a near zero interest rate on the Fed funds rate in 2003-4, the reduction of mortgage rates by suspension of the auctions of 30-year Treasuries in 2001-5, the housing subsidy of $221 billion per year and the purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie and Freddie (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). These combined actions clogged the securitization of credit with mortgage-based securities and their derivatives referenced to nonprime mortgages that brought down world finance, causing the global recession. Investors would evaluate the project of the drug manufacturer that could be financed by multiple alternatives such as bank loans, corporate bonds, and placement of equity and so on. There would then be a calculation by lenders and investors of the discounted net cash flows. The entrepreneur would receive the funds and begin hiring and spending on the project. Breaking the functions of the final system and its own process of innovation by the Dodd-Frank bill will prevent the calculation of the cost of investment, retarding the overall economy, frustrating technological progress and undermining future prosperity and employment. The criticism that financial products and risk management are not understandable to users such as borrowers of car loans with funds from securitized credit is as ridiculous as requiring airplane travelers to hold a PhD in physics.
Chairman Bernanke states in the Fed’s Monetary Policy Report to the Congress that “of course, even as the Federal Reserve continues prudent planning for the ultimate withdrawal of extraordinary monetary policy accommodation, we also recognize that the economic outlook remains unusually uncertain” (http://www.federalreserve.gov/newsevents/testimony/bernanke20100721a.pdf page 7). The economy is in the world of doubts about the future that Frank Knight analyzed in his 1921 magnum opus on Risk, Uncertainty, and Profit. Business and individual cannot calculate risks and rewards of decisions that generate economic growth and hiring. The critical concept in the work of Frank Knight is that uncertainty is caused by “change.” Uncertainty means that it is almost impossible to calculate with some confidence the future net cash flows of investments or the appropriate rate of discount to use in measuring net present value. The uncertainty frustrates the calculations of entrepreneurs for investment and hiring and the vital investment in education and training by people of all ages. There is just too much change at the inopportune time when confidence is required to generate sufficient economic growth that will alleviate the plight of 27 million people unemployed or forced to work part time because no other opportunity is available. The Dodd-Frank bill of financial regulation creates lethal uncertainty by reduced availability of credit and the likely higher interest rate to be paid for whatever credit is available. Legislative restructurings of large segments of economic activity and other draconian regulation cloud the calculations of net present value of investments and business decisions. The government forecast for the deficit of 2011 has been increased from $1.27 trillion estimated in February to $1.4 trillion, or 9.2 percent of GDP, released on Friday with upward revisions for the next three years (http://professional.wsj.com/article/SB10001424052748703294904575385481462433508.html?mod=wsjproe_hps_LEFTWhatsNews ). The Fed balance sheet is bloated at $2.3 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1c ). The largest government deficits in a peace period and the eventual unwinding of the portfolio of long-term securities of the Fed create the uncertainty of large increases in taxes and rising interest rates.
The US economy is decelerating with lowering forecasts for second-quarter GDP. There are doubts if the growth of the US economy will be sufficient to absorb 27 million people currently in job stress composed of: 14.6 million unemployed (of whom long-term unemployed of 6.8 million or 45.5 percent who have been unemployed more than 27 weeks), 8.6 million working part-time because they could not find a better job, 2.6 million marginally attached to the labor force (who wanted and were available for work and had searched for work in the prior 12 months) and 1.2 million discouraged workers (who believe there is no job for them or had not searched for work in the prior four weeks) (http://www.bls.gov/news.release/pdf/empsit.pdf ).
The President of the European Central Bank, Jean-Claude Trichet, has called for global fiscal consolidation (http://www.ft.com/cms/s/0/1b3ae97e-95c6-11df-b5ad-00144feab49a.html ). There is no dispute on the need for fiscal consolidation but rather on the timing. Trichet finds that in the four years after 2007 government debt will grow by 20 percentage points in the euro area, 35 percentage points in the US and 45 percentage points in Japan. The three elements of Trichet’s argument are: (1) fiscal consolidation with appropriate restructuring policies promote stable growth; (2) consolidation is required to prevent loss of confidence from debts perceived as growing nonlinearly; and (3) consolidation is needed to recover fiscal strength that may be used in future crises.
Lawrence Summers, chief economic adviser to the President and Director of the White House National Economic Council, argues that the US follows the correct policy of supporting economic recovery in the short term while pursuing fiscal consolidation in the medium and long term because of likely general agreement by economists on three propositions (http://www.ft.com/cms/s/0/966e25b8-9295-11df-9142-00144feab49a.html ). First, in normal economic times, increasing budget deficits may not have an impact on output and employment, affecting only the composition instead of the level of aggregate economic activity. Second, in an economy with idle capacity and a near zero interest rate that cannot be reduced further, fiscal policy may have substantial impact on output and employment. Third, anticipations of fiscal consolidation in the medium and long term will maintain confidence in an adequate environment for investment and job creation. The time may have arrived to strengthen the anticipations of fiscal consolidation to avoid adverse investor expectations such as those that occurred during the Asian crisis of 1997-1998, requiring a “credible plan” for crisis resolution (Lawrence Summers Richard T. Ely Lecture, AER 2000, cited in Pelaez and Pelaez, Globalization and the State, Vol. II, 106). The “fundamentals” of the US are deteriorating because of lack of a credible plan for fiscal consolidation.
Michael J. Boskin, Professor at Stanford and fellow at the Hoover Institution, warned in 2008 that permanently expanding government with taxes is not sound policy in hard times (http://professional.wsj.com/article/SB10001424052748703724104575378751776758256.html ). Future higher taxes to finance the current deficits will deteriorate the economy and are widely anticipated. The legislative restructurings, bailouts, regulation and mandates are forcing non-business decisions on the economy that is anticipating the uncertainty of decisions and rules by the new laws and regulations. The combined environment has created the uncertainty analyzed by Frank Knight that prevents investment and hiring.
II Financial Turbulence. Equity markets improved substantially but experienced significant turbulence in the current week and continue to trade much lower than their recent peaks (http://online.wsj.com/mdc/page/marketsdata.html ). Financial variables are available with high frequency, daily with market trading, while data on the overall economy become available with a lag of weeks or months. The percentage performance of major US indices to Jul 23 was: DJIA -7.0 from the recent peak on Apr 26 and 3.2 in the week; S&P 500 -9.4 from the recent peak on Apr 23 and 3.6 in the week; and NYSE Financial -13.4 since Apr 15 and 3.9 in the week. The percentage performance of major world stock markets from Apr 15 to Jul 23 was: Dow Global -11.9 and 2.8 in the week; Dow Asia Pacific TSM -8.3 and 1.0 in the week; Shanghai -18.7 and 6.1 in the week; and STOXX Europe 50 -8.8 and 2.8 in the week. The euro moved sideways, trading at $1.2930/EUR on Jul 23. The dollar has gained 17.2 percent relative to the euro since the recent trough on Nov 25, 2009, and gained 0.3 percent in the week. The DJ UBS commodity index fell 10.4 percent since the recent peak on Jan 6 and gained 1.8 percent in the week. The 10-Treasury traded at 3.000 percent on Jul 23 as funds flowed back into risk positions. Earnings of corporations have been strong, in particular with growing revenue and enhanced prospects for Caterpillar and UPS that reflect higher economic activity. Favorable news was that only seven of 91 banks in Europe had Basel Tier 1 capital ratio of less than 6 percent after stressing their balance sheets with a scenario of weak economy and sovereign risks (http://professional.wsj.com/article/SB10001424052748703294904575384940544522582.html?mod=wsjproe_hps_LEFTWhatsNews http://online.wsj.com/public/resources/documents/cebs-Summaryreport-20100725.pdf ). These tests will be scrutinized during the week.
III. Economic Indicators. Housing starts in Jun were at a seasonally-adjusted annual rate of 454,000, which is below the May estimate by 0.7 percent and 5.8 percent below the Jun 2009 rate of 583,000 (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 ). The decline from Jan 2006 to Jun 2010 is by 80 percent, a contraction of physical data that is very difficult to find in recorded history. This disaster is impossible to explain by lack of financial regulation but it can be explained by government policy of near-zero interest rates, subsidies to housing and the mismanagement of Fannie and Freddie. Building permits increased by 2.1 percent from May into Jun but were below 2.3 percent relative to Jun 2009. Existing home sales dropped 5.1 percent from May into Jun but remain 9.8 percent higher than in Jun 2009 (http://www.realtor.org/press_room/news_releases/2010/07/ehs_june_above ). Initial claims for unemployment insurance increased by 37,000 in the week ending Jul 17 from the prior week, reaching 464,000 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
IV Interest Rates. There was a slight upward shift in the US yield curve as funds flowed back from the safe haven of Treasuries and highly-rated fixed income into risk exposures. The 10-year Treasury increased to 3.00 percent from 2.94 percent a week ago but declined from 3.11 percent a month ago. The 10-year German bond traded at 2.75 percent, tightening its spread to -0.25 basis points relative to the 10-year Treasury (http://markets.ft.com/markets/bonds.asp?ftauth=1280055941689 ).
V Conclusion. There is promise of further review of regulatory measures (http://professional.wsj.com/article/SB10001424052748703467304575383490332411012.html ). A policy shift in the form of concrete measures could encourage decisions on investment and hiring by business and investment on education and training by people of all ages that could reduce the uncertainty in the economy, promoting prosperity. Increasing uncertainty will worsen the plight of the 27 million unemployed or underemployed. A strong positive confidence shock will reignite the economy, creating far more jobs than another construction project with negative present value and eventual financing of that waste by taxpayers. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
Thursday, July 29, 2010
Sunday, July 25, 2010
The Rise of the Era of Uncertainty
The Rise of the Era of Uncertainty
Carlos M Pelaez
“All human planning and execution involve uncertainty, and a rational social order can be realized only if all persons have a rational attitude toward risk and chance,” Frank H. Knight (The ethics of competition. Quarterly Journal of Economics 37 (4, Aug 1923), 565).
The objective of this post is to relate uncertainty as widely perceived today to the frustration of investment by business and individuals and the weakening hiring decisions by small and large business. (I) relates the work of Frank Knight and the era of uncertainty, (II) provides the information on financial turbulence and (II) and (IV) evaluate economic indicators and interest rates. (V) concludes.
I Frank Knight and The Era of Uncertainty. The economist Frank H. Knight considered in his 1921 classic opus Risk, Uncertainty, and Profit three different types of probability (http://www.econlib.org/library/Knight/knRUP6.html#Pt.III,Ch.VII ). First, a priori probability is explained by the example of tossing the perfect die that will show a given number one-sixth of the time (see William Feller, An introduction to probability theory and its applications. Wiley, 1968, 7-25). Second, there is the work of actuarial science in insurance in which past information is used to calculate the fair premium. The present value of the actuarially fair premium is equal to the expected costs of the benefits to be received from the plan, or costs weighted by probability of occurrence, if the load, or administrative costs, is assumed to be zero. Knight finds that the distinguishing characteristic of this type is that “it rests on an empirical classification of instances” (Ibid). Third, there is what Knight calls “estimates,” for which “there is no valid basis of any kind for classifying instances” and constitute an “uncertainty” (Ibid). Knight argues that “an uncertainty which can by any method be reduced to an objective, quantitatively determined probability, can be reduced to complete certainty by grouping cases.” The process of Value at Risk (VaR), measuring the maximum loss in a target horizon for a desired level of confidence, could fit into this category (Pelaez and Pelaez, International Financial Architecture, 106-12). For example, JP Morgan Chase reports a decline of the investment bank trading VaR from $170 million in 2Q09 to $72 million in 2Q10, measuring the highest loss per day 99 per cent of the time from the trading transactions of the investment bank (http://files.shareholder.com/downloads/ONE/889418027x0x387171/79855d7d-cc5f-4a91-87ed-8ca848266fd8/2Q10_ERF_Supplement_7-14-10_FINAL.pdf ). An important concept used by Knight is that change causes uncertainty.
The method used by business in reducing uncertainty is capital budgeting in investment decisions. As Knight argues in his classic work, the entrepreneur receives the difference between the selling price and cost. An entrepreneur deciding on a project would construct the “estimates” mentioned by Knight. The method is similar to the cost/benefit analysis of economics (Pelaez and Pelaez, Financial Regulation after the Global Recession, 22, Regulation of Banks and Finance, 27-32, Government Intervention in Globalization, 52-6, 87, Globalization and the State, Vol. I, 119-25) and applied in the economics of climate change (Pelaez and Pelaez, Globalization and the State, Vol. II, 59-63). The entrepreneur projects forward to the horizon or year of maturity of the investment the cash flows to be received, or revenue, and the cash flows to be paid, or costs. For each year, the projections would show net revenue, or revenue less cost. The future net revenues have to be converted into dollars of today by discounting them by another estimate of the rate of interest. The sum of the discounted net revenues is the present value of the project. The entrepreneur chooses projects with positive present value.
Consider the development of pharmaceuticals. Industry data reported to the Federal Drug Administration (FDA) find that 5 of 5000 compounds entering preclinical testing actually move on to clinical testing and only 1 of the 5 is finally found satisfactory for sales to the public (http://www.fda.gov/Drugs/ResourcesForYou/Consumers/ucm143455.htm ). The estimate of expenditure costs per approved new drug is $403 million but rises to $802 million when discounting sales backwards and capitalizing costs forward over the gestation period. The time cost of investment is about 50 percent of the cost (Joseph DiMasi, Ronald Hansen and Henry Grabowski, The price of innovation: new estimates of drug development costs. Journal of Health Economics 22 (2)). The capital budgeting of a pharmaceutical requires the estimation of the revenue that it will bring, which depends on the capacity of the pharmaceutical company to anticipate a host of uncertain future decisions by patients, providers, institutions, health insurance and regulation. The costs require estimates of the transition probabilities and costs of moving the compound from the synthesis to animal testing, New Drug Application at the FDA, human testing in three clinical phases of the FDA process and the costs of approval and final marketing. The development of drugs is characterized by risk because of thousands of compounds only one reaches the pharmacy counters as the compound moves through this prolonged and costly process to final approval and marketing. The conversion of costs to current time when the decision is made requires a continuum of investments over time. The costs to be incurred are brought to current time by an appropriate discount rate. The pharmaceutical company would require estimation of the sales of the new product in the “in patent” period less the costs to calculate if it could remunerate the investment at the rate of return required by investors. The process absorbing two decades more or less is similar to the third category of probabilities that Knight calls “estimates.” In his subsequent work on The Ethics of Competition, Knight adds that “a rational social order can be realized through individual action only if all persons have a rational attitude toward risk and chance” (The ethics of competition. Quarterly Journal of Economics 37 (4, Aug 1923), 565). Harold Demsetz provides the check by government of the rational risk attitudes that can encourage prosperity by “the design of institutional arrangements that provide incentives to encourage experimentation (including the development of new products, new knowledge, new reputations, and new ways of organizing activities) without overly insulating these experiments from the ultimate test of survival” (Information and efficiency: another viewpoint. Journal of Law and Economics 12 (1, Apr 1969), 20). The essence of the argument is that both government and markets may fail, requiring adequate balance of their institutional roles (Pelaez and Pelaez, Government Intervention in Globalization, 1-12, 80-6, Globalization and the State, Vol. I, 133-43, Financial Regulation after the Global Recession, 11-5, Regulation of Banks and Finance, 33-5). An adequate role of government can create incentives to innovation that result in prosperity while an asphyxiating role of government imposed by drastic changes in one year can frustrate innovation, causing lower living standards, unemployment and underemployment.
The entrepreneur has to finance the project in the capital markets for debt and equity, a process that shows the equivocal political discourse of a dichotomy of “Wall Street” and “Main Street” when in fact there is only one and indivisible general economy. A misleading characterization of the credit/dollar crisis is that financial institutions took careless risks on products that nobody understands. The fact is that financial institutions face the same uncertainty as other types of business and used methods to reduce them to “certainty,” similar to those considered by Frank Knight that are used by business and individuals in making investment and hiring decisions. A high school student considering a medical career faces an even more complex decision of at least a million dollars of costs incurred or in foregone income over the next fifteen years that may be more uncertain in terms of returns than those of a pharmaceutical company pondering on a new drug or actually almost any business large or small. Banks and other financial institutions use models of risk management to estimate their exposures to risks and to protect the market value or capital of their institutions. The models did not fail (Christopher C. Finger cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 131, 176, 193, Regulation of Banks and Finance, 236). What failed was the illusion of a floor on house prices and real estate wealth created by government policy of a near zero interest rate on the Fed funds rate in 2003-4, the reduction of mortgage rates by suspension of the auctions of 30-year Treasuries in 2001-5, the housing subsidy of $221 billion per year and the purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie and Freddie (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). These combined actions clogged the securitization of credit with mortgage-based securities and their derivatives referenced to nonprime mortgages that brought down world finance, causing the global recession. Investors would evaluate the project of the drug manufacturer that could be financed by multiple alternatives such as bank loans, corporate bonds, and placement of equity and so on. There would then be a calculation by lenders and investors of the discounted net cash flows. The entrepreneur would receive the funds and begin hiring and spending on the project. Breaking the functions of the final system and its own process of innovation by the Dodd-Frank bill will prevent the calculation of the cost of investment, retarding the overall economy, frustrating technological progress and undermining future prosperity and employment. The criticism that financial products and risk management are not understandable to users such as borrowers of car loans with funds from securitized credit is as ridiculous as requiring airplane travelers to hold a PhD in physics.
Chairman Bernanke states in the Fed’s Monetary Policy Report to the Congress that “of course, even as the Federal Reserve continues prudent planning for the ultimate withdrawal of extraordinary monetary policy accommodation, we also recognize that the economic outlook remains unusually uncertain” (http://www.federalreserve.gov/newsevents/testimony/bernanke20100721a.pdf page 7). The economy is in the world of doubts about the future that Frank Knight analyzed in his 1921 magnum opus on Risk, Uncertainty, and Profit. Business and individual cannot calculate risks and rewards of decisions that generate economic growth and hiring. The critical concept in the work of Frank Knight is that uncertainty is caused by “change.” Uncertainty means that it is almost impossible to calculate with some confidence the future net cash flows of investments or the appropriate rate of discount to use in measuring net present value. The uncertainty frustrates the calculations of entrepreneurs for investment and hiring and the vital investment in education and training by people of all ages. There is just too much change at the inopportune time when confidence is required to generate sufficient economic growth that will alleviate the plight of 27 million people unemployed or forced to work part time because no other opportunity is available. The Dodd-Frank bill of financial regulation creates lethal uncertainty by reduced availability of credit and the likely higher interest rate to be paid for whatever credit is available. Legislative restructurings of large segments of economic activity and other draconian regulation cloud the calculations of net present value of investments and business decisions. The government forecast for the deficit of 2011 has been increased from $1.27 trillion estimated in February to $1.4 trillion, or 9.2 percent of GDP, released on Friday with upward revisions for the next three years (http://professional.wsj.com/article/SB10001424052748703294904575385481462433508.html?mod=wsjproe_hps_LEFTWhatsNews ). The Fed balance sheet is bloated at $2.3 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1c ). The largest government deficits in a peace period and the eventual unwinding of the portfolio of long-term securities of the Fed create the uncertainty of large increases in taxes and rising interest rates.
The US economy is decelerating with lowering forecasts for second-quarter GDP. There are doubts if the growth of the US economy will be sufficient to absorb 27 million people currently in job stress composed of: 14.6 million unemployed (of whom long-term unemployed of 6.8 million or 45.5 percent who have been unemployed more than 27 weeks), 8.6 million working part-time because they could not find a better job, 2.6 million marginally attached to the labor force (who wanted and were available for work and had searched for work in the prior 12 months) and 1.2 million discouraged workers (who believe there is no job for them or had not searched for work in the prior four weeks) (http://www.bls.gov/news.release/pdf/empsit.pdf ).
The President of the European Central Bank, Jean-Claude Trichet, has called for global fiscal consolidation (http://www.ft.com/cms/s/0/1b3ae97e-95c6-11df-b5ad-00144feab49a.html ). There is no dispute on the need for fiscal consolidation but rather on the timing. Trichet finds that in the four years after 2007 government debt will grow by 20 percentage points in the euro area, 35 percentage points in the US and 45 percentage points in Japan. The three elements of Trichet’s argument are: (1) fiscal consolidation with appropriate restructuring policies promote stable growth; (2) consolidation is required to prevent loss of confidence from debts perceived as growing nonlinearly; and (3) consolidation is needed to recover fiscal strength that may be used in future crises.
Lawrence Summers, chief economic adviser to the President and Director of the White House National Economic Council, argues that the US follows the correct policy of supporting economic recovery in the short term while pursuing fiscal consolidation in the medium and long term because of likely general agreement by economists on three propositions (http://www.ft.com/cms/s/0/966e25b8-9295-11df-9142-00144feab49a.html ). First, in normal economic times, increasing budget deficits may not have an impact on output and employment, affecting only the composition instead of the level of aggregate economic activity. Second, in an economy with idle capacity and a near zero interest rate that cannot be reduced further, fiscal policy may have substantial impact on output and employment. Third, anticipations of fiscal consolidation in the medium and long term will maintain confidence in an adequate environment for investment and job creation. The time may have arrived to strengthen the anticipations of fiscal consolidation to avoid adverse investor expectations such as those that occurred during the Asian crisis of 1997-1998, requiring a “credible plan” for crisis resolution (Lawrence Summers Richard T. Ely Lecture, AER 2000, cited in Pelaez and Pelaez, Globalization and the State, Vol. II, 106). The “fundamentals” of the US are deteriorating because of lack of a credible plan for fiscal consolidation.
Michael J. Boskin, Professor at Stanford and fellow at the Hoover Institution, warned in 2008 that permanently expanding government with taxes is not sound policy in hard times (http://professional.wsj.com/article/SB10001424052748703724104575378751776758256.html ). Future higher taxes to finance the current deficits will deteriorate the economy and are widely anticipated. The legislative restructurings, bailouts, regulation and mandates are forcing non-business decisions on the economy that is anticipating the uncertainty of decisions and rules by the new laws and regulations. The combined environment has created the uncertainty analyzed by Frank Knight that prevents investment and hiring.
II Financial Turbulence. Equity markets improved substantially but experienced significant turbulence in the current week and continue to trade much lower than their recent peaks (http://online.wsj.com/mdc/page/marketsdata.html ). Financial variables are available with high frequency, daily with market trading, while data on the overall economy become available with a lag of weeks or months. The percentage performance of major US indices to Jul 23 was: DJIA -7.0 from the recent peak on Apr 26 and 3.2 in the week; S&P 500 -9.4 from the recent peak on Apr 23 and 3.6 in the week; and NYSE Financial -13.4 since Apr 15 and 3.9 in the week. The percentage performance of major world stock markets from Apr 15 to Jul 23 was: Dow Global -11.9 and 2.8 in the week; Dow Asia Pacific TSM -8.3 and 1.0 in the week; Shanghai -18.7 and 6.1 in the week; and STOXX Europe 50 -8.8 and 2.8 in the week. The euro moved sideways, trading at $1.2930/EUR on Jul 23. The dollar has gained 17.2 percent relative to the euro since the recent trough on Nov 25, 2009, and gained 0.3 percent in the week. The DJ UBS commodity index fell 10.4 percent since the recent peak on Jan 6 and gained 1.8 percent in the week. The 10-Treasury traded at 3.000 percent on Jul 23 as funds flowed back into risk positions. Earnings of corporations have been strong, in particular with growing revenue and enhanced prospects for Caterpillar and UPS that reflect higher economic activity. Favorable news was that only seven of 91 banks in Europe had Basel Tier 1 capital ratio of less than 6 percent after stressing their balance sheets with a scenario of weak economy and sovereign risks (http://professional.wsj.com/article/SB10001424052748703294904575384940544522582.html?mod=wsjproe_hps_LEFTWhatsNews http://online.wsj.com/public/resources/documents/cebs-Summaryreport-20100725.pdf ). These tests will be scrutinized during the week.
III. Economic Indicators. Housing starts in Jun were at a seasonally-adjusted annual rate of 454,000, which is below the May estimate by 0.7 percent and 5.8 percent below the Jun 2009 rate of 583,000 (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 ). The decline from Jan 2006 to Jun 2010 is by 80 percent, a contraction of physical data that is very difficult to find in recorded history. This disaster is impossible to explain by lack of financial regulation but it can be explained by government policy of near-zero interest rates, subsidies to housing and the mismanagement of Fannie and Freddie. Building permits increased by 2.1 percent from May into Jun but were below 2.3 percent relative to Jun 2009. Existing home sales dropped 5.1 percent from May into Jun but remain 9.8 percent higher than in Jun 2009 (http://www.realtor.org/press_room/news_releases/2010/07/ehs_june_above ). Initial claims for unemployment insurance increased by 37,000 in the week ending Jul 17 from the prior week, reaching 464,000 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
IV Interest Rates. There was a slight upward shift in the US yield curve as funds flowed back from the safe haven of Treasuries and highly-rated fixed income into risk exposures. The 10-year Treasury increased to 3.00 percent from 2.94 percent a week ago but declined from 3.11 percent a month ago. The 10-year German bond traded at 2.75 percent, tightening its spread to -0.25 basis points relative to the 10-year Treasury (http://markets.ft.com/markets/bonds.asp?ftauth=1280055941689 ).
V Conclusion. There is promise of further review of regulatory measures (http://professional.wsj.com/article/SB10001424052748703467304575383490332411012.html ). A policy shift in the form of concrete measures could encourage decisions on investment and hiring by business and investment on education and training by people of all ages that could reduce the uncertainty in the economy, promoting prosperity. Increasing uncertainty will worsen the plight of the 27 million unemployed or underemployed. A strong positive confidence shock will reignite the economy, creating far more jobs than another construction project with negative present value and eventual financing of that waste by taxpayers. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
Carlos M Pelaez
“All human planning and execution involve uncertainty, and a rational social order can be realized only if all persons have a rational attitude toward risk and chance,” Frank H. Knight (The ethics of competition. Quarterly Journal of Economics 37 (4, Aug 1923), 565).
The objective of this post is to relate uncertainty as widely perceived today to the frustration of investment by business and individuals and the weakening hiring decisions by small and large business. (I) relates the work of Frank Knight and the era of uncertainty, (II) provides the information on financial turbulence and (II) and (IV) evaluate economic indicators and interest rates. (V) concludes.
I Frank Knight and The Era of Uncertainty. The economist Frank H. Knight considered in his 1921 classic opus Risk, Uncertainty, and Profit three different types of probability (http://www.econlib.org/library/Knight/knRUP6.html#Pt.III,Ch.VII ). First, a priori probability is explained by the example of tossing the perfect die that will show a given number one-sixth of the time (see William Feller, An introduction to probability theory and its applications. Wiley, 1968, 7-25). Second, there is the work of actuarial science in insurance in which past information is used to calculate the fair premium. The present value of the actuarially fair premium is equal to the expected costs of the benefits to be received from the plan, or costs weighted by probability of occurrence, if the load, or administrative costs, is assumed to be zero. Knight finds that the distinguishing characteristic of this type is that “it rests on an empirical classification of instances” (Ibid). Third, there is what Knight calls “estimates,” for which “there is no valid basis of any kind for classifying instances” and constitute an “uncertainty” (Ibid). Knight argues that “an uncertainty which can by any method be reduced to an objective, quantitatively determined probability, can be reduced to complete certainty by grouping cases.” The process of Value at Risk (VaR), measuring the maximum loss in a target horizon for a desired level of confidence, could fit into this category (Pelaez and Pelaez, International Financial Architecture, 106-12). For example, JP Morgan Chase reports a decline of the investment bank trading VaR from $170 million in 2Q09 to $72 million in 2Q10, measuring the highest loss per day 99 per cent of the time from the trading transactions of the investment bank (http://files.shareholder.com/downloads/ONE/889418027x0x387171/79855d7d-cc5f-4a91-87ed-8ca848266fd8/2Q10_ERF_Supplement_7-14-10_FINAL.pdf ). An important concept used by Knight is that change causes uncertainty.
The method used by business in reducing uncertainty is capital budgeting in investment decisions. As Knight argues in his classic work, the entrepreneur receives the difference between the selling price and cost. An entrepreneur deciding on a project would construct the “estimates” mentioned by Knight. The method is similar to the cost/benefit analysis of economics (Pelaez and Pelaez, Financial Regulation after the Global Recession, 22, Regulation of Banks and Finance, 27-32, Government Intervention in Globalization, 52-6, 87, Globalization and the State, Vol. I, 119-25) and applied in the economics of climate change (Pelaez and Pelaez, Globalization and the State, Vol. II, 59-63). The entrepreneur projects forward to the horizon or year of maturity of the investment the cash flows to be received, or revenue, and the cash flows to be paid, or costs. For each year, the projections would show net revenue, or revenue less cost. The future net revenues have to be converted into dollars of today by discounting them by another estimate of the rate of interest. The sum of the discounted net revenues is the present value of the project. The entrepreneur chooses projects with positive present value.
Consider the development of pharmaceuticals. Industry data reported to the Federal Drug Administration (FDA) find that 5 of 5000 compounds entering preclinical testing actually move on to clinical testing and only 1 of the 5 is finally found satisfactory for sales to the public (http://www.fda.gov/Drugs/ResourcesForYou/Consumers/ucm143455.htm ). The estimate of expenditure costs per approved new drug is $403 million but rises to $802 million when discounting sales backwards and capitalizing costs forward over the gestation period. The time cost of investment is about 50 percent of the cost (Joseph DiMasi, Ronald Hansen and Henry Grabowski, The price of innovation: new estimates of drug development costs. Journal of Health Economics 22 (2)). The capital budgeting of a pharmaceutical requires the estimation of the revenue that it will bring, which depends on the capacity of the pharmaceutical company to anticipate a host of uncertain future decisions by patients, providers, institutions, health insurance and regulation. The costs require estimates of the transition probabilities and costs of moving the compound from the synthesis to animal testing, New Drug Application at the FDA, human testing in three clinical phases of the FDA process and the costs of approval and final marketing. The development of drugs is characterized by risk because of thousands of compounds only one reaches the pharmacy counters as the compound moves through this prolonged and costly process to final approval and marketing. The conversion of costs to current time when the decision is made requires a continuum of investments over time. The costs to be incurred are brought to current time by an appropriate discount rate. The pharmaceutical company would require estimation of the sales of the new product in the “in patent” period less the costs to calculate if it could remunerate the investment at the rate of return required by investors. The process absorbing two decades more or less is similar to the third category of probabilities that Knight calls “estimates.” In his subsequent work on The Ethics of Competition, Knight adds that “a rational social order can be realized through individual action only if all persons have a rational attitude toward risk and chance” (The ethics of competition. Quarterly Journal of Economics 37 (4, Aug 1923), 565). Harold Demsetz provides the check by government of the rational risk attitudes that can encourage prosperity by “the design of institutional arrangements that provide incentives to encourage experimentation (including the development of new products, new knowledge, new reputations, and new ways of organizing activities) without overly insulating these experiments from the ultimate test of survival” (Information and efficiency: another viewpoint. Journal of Law and Economics 12 (1, Apr 1969), 20). The essence of the argument is that both government and markets may fail, requiring adequate balance of their institutional roles (Pelaez and Pelaez, Government Intervention in Globalization, 1-12, 80-6, Globalization and the State, Vol. I, 133-43, Financial Regulation after the Global Recession, 11-5, Regulation of Banks and Finance, 33-5). An adequate role of government can create incentives to innovation that result in prosperity while an asphyxiating role of government imposed by drastic changes in one year can frustrate innovation, causing lower living standards, unemployment and underemployment.
The entrepreneur has to finance the project in the capital markets for debt and equity, a process that shows the equivocal political discourse of a dichotomy of “Wall Street” and “Main Street” when in fact there is only one and indivisible general economy. A misleading characterization of the credit/dollar crisis is that financial institutions took careless risks on products that nobody understands. The fact is that financial institutions face the same uncertainty as other types of business and used methods to reduce them to “certainty,” similar to those considered by Frank Knight that are used by business and individuals in making investment and hiring decisions. A high school student considering a medical career faces an even more complex decision of at least a million dollars of costs incurred or in foregone income over the next fifteen years that may be more uncertain in terms of returns than those of a pharmaceutical company pondering on a new drug or actually almost any business large or small. Banks and other financial institutions use models of risk management to estimate their exposures to risks and to protect the market value or capital of their institutions. The models did not fail (Christopher C. Finger cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 131, 176, 193, Regulation of Banks and Finance, 236). What failed was the illusion of a floor on house prices and real estate wealth created by government policy of a near zero interest rate on the Fed funds rate in 2003-4, the reduction of mortgage rates by suspension of the auctions of 30-year Treasuries in 2001-5, the housing subsidy of $221 billion per year and the purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie and Freddie (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). These combined actions clogged the securitization of credit with mortgage-based securities and their derivatives referenced to nonprime mortgages that brought down world finance, causing the global recession. Investors would evaluate the project of the drug manufacturer that could be financed by multiple alternatives such as bank loans, corporate bonds, and placement of equity and so on. There would then be a calculation by lenders and investors of the discounted net cash flows. The entrepreneur would receive the funds and begin hiring and spending on the project. Breaking the functions of the final system and its own process of innovation by the Dodd-Frank bill will prevent the calculation of the cost of investment, retarding the overall economy, frustrating technological progress and undermining future prosperity and employment. The criticism that financial products and risk management are not understandable to users such as borrowers of car loans with funds from securitized credit is as ridiculous as requiring airplane travelers to hold a PhD in physics.
Chairman Bernanke states in the Fed’s Monetary Policy Report to the Congress that “of course, even as the Federal Reserve continues prudent planning for the ultimate withdrawal of extraordinary monetary policy accommodation, we also recognize that the economic outlook remains unusually uncertain” (http://www.federalreserve.gov/newsevents/testimony/bernanke20100721a.pdf page 7). The economy is in the world of doubts about the future that Frank Knight analyzed in his 1921 magnum opus on Risk, Uncertainty, and Profit. Business and individual cannot calculate risks and rewards of decisions that generate economic growth and hiring. The critical concept in the work of Frank Knight is that uncertainty is caused by “change.” Uncertainty means that it is almost impossible to calculate with some confidence the future net cash flows of investments or the appropriate rate of discount to use in measuring net present value. The uncertainty frustrates the calculations of entrepreneurs for investment and hiring and the vital investment in education and training by people of all ages. There is just too much change at the inopportune time when confidence is required to generate sufficient economic growth that will alleviate the plight of 27 million people unemployed or forced to work part time because no other opportunity is available. The Dodd-Frank bill of financial regulation creates lethal uncertainty by reduced availability of credit and the likely higher interest rate to be paid for whatever credit is available. Legislative restructurings of large segments of economic activity and other draconian regulation cloud the calculations of net present value of investments and business decisions. The government forecast for the deficit of 2011 has been increased from $1.27 trillion estimated in February to $1.4 trillion, or 9.2 percent of GDP, released on Friday with upward revisions for the next three years (http://professional.wsj.com/article/SB10001424052748703294904575385481462433508.html?mod=wsjproe_hps_LEFTWhatsNews ). The Fed balance sheet is bloated at $2.3 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1c ). The largest government deficits in a peace period and the eventual unwinding of the portfolio of long-term securities of the Fed create the uncertainty of large increases in taxes and rising interest rates.
The US economy is decelerating with lowering forecasts for second-quarter GDP. There are doubts if the growth of the US economy will be sufficient to absorb 27 million people currently in job stress composed of: 14.6 million unemployed (of whom long-term unemployed of 6.8 million or 45.5 percent who have been unemployed more than 27 weeks), 8.6 million working part-time because they could not find a better job, 2.6 million marginally attached to the labor force (who wanted and were available for work and had searched for work in the prior 12 months) and 1.2 million discouraged workers (who believe there is no job for them or had not searched for work in the prior four weeks) (http://www.bls.gov/news.release/pdf/empsit.pdf ).
The President of the European Central Bank, Jean-Claude Trichet, has called for global fiscal consolidation (http://www.ft.com/cms/s/0/1b3ae97e-95c6-11df-b5ad-00144feab49a.html ). There is no dispute on the need for fiscal consolidation but rather on the timing. Trichet finds that in the four years after 2007 government debt will grow by 20 percentage points in the euro area, 35 percentage points in the US and 45 percentage points in Japan. The three elements of Trichet’s argument are: (1) fiscal consolidation with appropriate restructuring policies promote stable growth; (2) consolidation is required to prevent loss of confidence from debts perceived as growing nonlinearly; and (3) consolidation is needed to recover fiscal strength that may be used in future crises.
Lawrence Summers, chief economic adviser to the President and Director of the White House National Economic Council, argues that the US follows the correct policy of supporting economic recovery in the short term while pursuing fiscal consolidation in the medium and long term because of likely general agreement by economists on three propositions (http://www.ft.com/cms/s/0/966e25b8-9295-11df-9142-00144feab49a.html ). First, in normal economic times, increasing budget deficits may not have an impact on output and employment, affecting only the composition instead of the level of aggregate economic activity. Second, in an economy with idle capacity and a near zero interest rate that cannot be reduced further, fiscal policy may have substantial impact on output and employment. Third, anticipations of fiscal consolidation in the medium and long term will maintain confidence in an adequate environment for investment and job creation. The time may have arrived to strengthen the anticipations of fiscal consolidation to avoid adverse investor expectations such as those that occurred during the Asian crisis of 1997-1998, requiring a “credible plan” for crisis resolution (Lawrence Summers Richard T. Ely Lecture, AER 2000, cited in Pelaez and Pelaez, Globalization and the State, Vol. II, 106). The “fundamentals” of the US are deteriorating because of lack of a credible plan for fiscal consolidation.
Michael J. Boskin, Professor at Stanford and fellow at the Hoover Institution, warned in 2008 that permanently expanding government with taxes is not sound policy in hard times (http://professional.wsj.com/article/SB10001424052748703724104575378751776758256.html ). Future higher taxes to finance the current deficits will deteriorate the economy and are widely anticipated. The legislative restructurings, bailouts, regulation and mandates are forcing non-business decisions on the economy that is anticipating the uncertainty of decisions and rules by the new laws and regulations. The combined environment has created the uncertainty analyzed by Frank Knight that prevents investment and hiring.
II Financial Turbulence. Equity markets improved substantially but experienced significant turbulence in the current week and continue to trade much lower than their recent peaks (http://online.wsj.com/mdc/page/marketsdata.html ). Financial variables are available with high frequency, daily with market trading, while data on the overall economy become available with a lag of weeks or months. The percentage performance of major US indices to Jul 23 was: DJIA -7.0 from the recent peak on Apr 26 and 3.2 in the week; S&P 500 -9.4 from the recent peak on Apr 23 and 3.6 in the week; and NYSE Financial -13.4 since Apr 15 and 3.9 in the week. The percentage performance of major world stock markets from Apr 15 to Jul 23 was: Dow Global -11.9 and 2.8 in the week; Dow Asia Pacific TSM -8.3 and 1.0 in the week; Shanghai -18.7 and 6.1 in the week; and STOXX Europe 50 -8.8 and 2.8 in the week. The euro moved sideways, trading at $1.2930/EUR on Jul 23. The dollar has gained 17.2 percent relative to the euro since the recent trough on Nov 25, 2009, and gained 0.3 percent in the week. The DJ UBS commodity index fell 10.4 percent since the recent peak on Jan 6 and gained 1.8 percent in the week. The 10-Treasury traded at 3.000 percent on Jul 23 as funds flowed back into risk positions. Earnings of corporations have been strong, in particular with growing revenue and enhanced prospects for Caterpillar and UPS that reflect higher economic activity. Favorable news was that only seven of 91 banks in Europe had Basel Tier 1 capital ratio of less than 6 percent after stressing their balance sheets with a scenario of weak economy and sovereign risks (http://professional.wsj.com/article/SB10001424052748703294904575384940544522582.html?mod=wsjproe_hps_LEFTWhatsNews http://online.wsj.com/public/resources/documents/cebs-Summaryreport-20100725.pdf ). These tests will be scrutinized during the week.
III. Economic Indicators. Housing starts in Jun were at a seasonally-adjusted annual rate of 454,000, which is below the May estimate by 0.7 percent and 5.8 percent below the Jun 2009 rate of 583,000 (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 ). The decline from Jan 2006 to Jun 2010 is by 80 percent, a contraction of physical data that is very difficult to find in recorded history. This disaster is impossible to explain by lack of financial regulation but it can be explained by government policy of near-zero interest rates, subsidies to housing and the mismanagement of Fannie and Freddie. Building permits increased by 2.1 percent from May into Jun but were below 2.3 percent relative to Jun 2009. Existing home sales dropped 5.1 percent from May into Jun but remain 9.8 percent higher than in Jun 2009 (http://www.realtor.org/press_room/news_releases/2010/07/ehs_june_above ). Initial claims for unemployment insurance increased by 37,000 in the week ending Jul 17 from the prior week, reaching 464,000 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
IV Interest Rates. There was a slight upward shift in the US yield curve as funds flowed back from the safe haven of Treasuries and highly-rated fixed income into risk exposures. The 10-year Treasury increased to 3.00 percent from 2.94 percent a week ago but declined from 3.11 percent a month ago. The 10-year German bond traded at 2.75 percent, tightening its spread to -0.25 basis points relative to the 10-year Treasury (http://markets.ft.com/markets/bonds.asp?ftauth=1280055941689 ).
V Conclusion. There is promise of further review of regulatory measures (http://professional.wsj.com/article/SB10001424052748703467304575383490332411012.html ). A policy shift in the form of concrete measures could encourage decisions on investment and hiring by business and investment on education and training by people of all ages that could reduce the uncertainty in the economy, promoting prosperity. Increasing uncertainty will worsen the plight of the 27 million unemployed or underemployed. A strong positive confidence shock will reignite the economy, creating far more jobs than another construction project with negative present value and eventual financing of that waste by taxpayers. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
Sunday, July 18, 2010
The Causes and Consequences of Slower Growth and Job Creation
The Causes and Consequences of Slower Growth and Job Creation
Carlos M. Pelaez
The economic growth of the US is underperforming past cyclical expansions from sharp recessions with resulting 27 million people in job stress. The objective of this post is relating the consequences of further apparent slowing of the US economy and job creation to its causes of failures of economic policy in the form of unsuccessful fiscal stimulus and legislative and regulatory restructurings that have undermined confidence. Declining confidence is further slowing decisions on investment, hiring and consumption. Policy shift by concrete actions instead of rhetoric is required to reignite the US economy and its private-sector engine of job creation. Continuing financial turbulence is analyzed in (I) and explained in (II) by concerns on Chinese growth and European sovereign risks and banks. The insufficiency of current growth in the US to recover employment is covered in (III). The remaining factors of erosion of confidence in the US are covered by analysis of the failures of economic policy in (IV) and regulatory and legislative restructurings in (V). Economic indicators are discussed in (VI) and interest rates in (VII). The concluding remarks are in (VIII).
I Financial Turbulence. Equity markets had improved substantially in the earlier week but experienced significant turbulence in the current week and continue to trade much lower than their recent peaks (http://online.wsj.com/mdc/page/marketsdata.html ). Financial variables are available with high frequency, daily with market trading, while data on the overall economy become available with a lag of weeks or months. The percentage performance of major US indices was: DJIA -9.9 from the recent peak on Apr 26 to Jul 16 and -1.0 in the week; S&P 500 -12.5 from the recent peak on Apr 23 and -1.2 in the week; and NYSE Financial -16.6 since Apr 15 and -2.8 in the week. The percentage performance of major world stock markets from Apr 15 to Jul 9 was: Dow Global -14.2 and -0.4 in the week; Dow Asia Pacific TSM -9.1 and 0.1 in the week; Shanghai -23.4 and -1.9 in the week; and STOXX Europe 50 -11.3 and -1.0 in the week. The euro strengthened, trading at $1.2930/EUR on Jul 16. The dollar has gained 16.9 percent relative to the euro since the recent trough on Nov 25, 2009, but lost 2.3 percent in the week. The DJ UBS commodity index fell 12.0 percent since the recent peak on Jan 6 and gained 0.5 percent in the week.
The beginning of reports of second quarter corporate earnings on Monday was awaited with optimism by investors. Earnings reports are backward looking information while investment in financial variables is forward looking and observed with high frequency data. The weighing in investment decisions of the probable impact of some deceleration of growth relative to strong earnings reports may have strong influence on financial turbulence. The financial markets of the US were hit on Friday Jul 16 by the combination of weak indicators of industry and sales released during the week and what the market viewed as disappointing corporate earnings. The DJIA dropped 261.41 points, equivalent to a decline of 2.5 percent, courting again at 10,097.90 the barrier of 10,000. All components of the DJIA dropped. The broader market S&P 500 lost 3.1 percent and the Nasdaq Composite fell 2.9 percent. Shares of large financial institutions dropped sharply. The Wall street Journal depicted the markets as hit by fading optimism (http://professional.wsj.com/article/SB10001424052748704913304575370584279739608.html?mod=wsjproe_hps_LEFTWhatsNews ). The yield of the 10-year Treasury dropped to 2.927 percent as risk exposures were abandoned in favor of the temporary safe haven of Treasuries and other highly-rated fixed income securities.
II Confidence Shocks. Two of four global factors of risk in the world economy that affect confidence in financial markets are considered in this section and the other two, failures of economics policy in (IV) and regulatory and legislative restructuring in (V) after analysis of US growth and employment in (III). First, there are recurring doubts on growth of the economy of China that could cause lower commodity prices and weaker interregional trade in Asia with adverse effects on regional and global growth. Doubts on China’s growth resurfaced again (http://www.ft.com/cms/s/0/6bf81ecc-8fb8-11df-8df0-00144feab49a.html http://professional.wsj.com/article/SB10001424052748703609004575354501318242096.html?mod=wsjproe_hps_TopLeftWhatsNews ). The growth model of China is based on developing internal infrastructure with bank credit and a more efficient export sector adding final touches to semifinished imports that are exported as final goods to the rest of the world (Pelaez and Pelaez, The Global Recession Risk, 56-80). The strategy was crafted to absorb labor from the less productive agricultural sector and provide jobs for rapid population growth via infrastructure projects while simultaneously irradiating higher productivity in the export sector to the rest of the economy. The strategy encounters paucity of sound projects in infrastructure with positive present value and slower growth in a flatter expansion path of the world economy. Growth remains vigorous but the doubts persist as to the redesigning of the new Chinese strategy. Second, the sovereign credit risk of several European countries is interrelated with exposures of banks to heavily indebted countries. The Committee of European Banking Supervisors advised stress tests for 91 banks that account for 65 percent of the European Union banking sector (http://www.c-ebs.org/CMSPages/GetFile.aspx?nodeguid=357173cf-0b06-4831-abcd-4ea90c64a960 ). The enlarged list includes segments of the banking industry that are considered weak (http://www.ft.com/cms/s/0/c6f4545e-8e81-11df-964e-00144feab49a.html ). Stress tests are part of an arsenal of tools used by financial institutions in processes of risk management (Pelaez and Pelaez, Globalization and the State, Vol. I, 78-100, Government Intervention in Globalization, 63-4, International Financial Architecture, 112-6). Financial markets were still fractured before Mar 2009. The US engaged in stress tests of major banks and subsequent public disclosure (Pelaez and Pelaez, Financial Regulation after the Global Recession, 164, 170, Regulation of Banks and Finance, 226, 231). Stress tests are useful but it is not feasible to solve ex post unsound exposures with risk management techniques that should have been used with sound judgment ex ante.
III. US Growth and Employment. There are doubts if the growth of the US economy will be sufficient to absorb 27 million people currently in job stress composed of: 14.6 million unemployed (of whom long-term unemployed of 6.8 million or 45.5 percent who have been unemployed more than 27 weeks), 8.6 million working part-time because they could not find a better job, 2.6 million marginally attached to the labor force (who wanted and were available for work and had searched for work in the prior 12 months) and 1.2 million discouraged workers (who believe there is no job for them or had not searched for work in the prior four weeks) (http://www.bls.gov/news.release/pdf/empsit.pdf ). During the recovery phase of similar recession in the early 1980s, 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. 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 ). US GDP increased at the annual seasonally-adjusted percentage rate of 2.2 in QIII09, 5.6 in QIV09 and 2.7 in QI10 (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&FirstYear=2009&LastYear=2010&Freq=Qtr ). These rates of growth may be insufficient to recover full employment.
IV Failures of Economic Policy. There are doubts about the effectiveness of economic policy in the US. In May, US exports were $152.3 billion and imports $194.5 billion for a trade deficit of goods and services of $42.3 billion. Exports of goods and services grew by $26.4 billion, or 21.0 percent, from May 2009 to May 2010 while imports increased by $43.8 billion or 29.1 percent (http://www.bea.gov/newsreleases/international/trade/tradnewsrelease.htm ). The Bureau of Economic Analysis (BEA) of the Department of Commerce has revised the trade data for 2009. Total US exports of goods and services in Jan-Dec 2009 were $1570 billion, declining by 14.6 percent from $1839 billion in 2008 and imports in Jan-Dec 2009 were $1945 billion, declining by 23.4 percent from $2538 billion in 2008 (http://www.bea.gov/newsreleases/international/trade/2010/pdf/trad1310.pdf ). The growth in exports in 2010 relative to 2009 is not the result of export promotion by public policy, which is only an intention of creating two million jobs (http://www.whitehouse.gov/the-press-office/president-obama-details-administration-efforts-support-two-million-new-jobs-promoti ), but rather part of similarly high rates of growth in other countries resulting from comparisons with very low levels in 2009. The American Recovery and Reinvestment Act of 2009 (ARRA) consisted of fiscal stimulus of around $800 “that would raise employment relative to what it would be in the absence of stimulus by 3 to 4 million by the end of 2010” (http://news.uchicago.edu/files/newsrelease_20090227.pdf ). The calculations were based on the multipliers of a Keynesian model. The application of this model to the trade balance of the US requires considering income-creating multipliers of exports but also opposite effects from income-destroying multipliers of imports much the same as ARRA-created taxes will have negative income-destroying multipliers. Counterfactual claims consist of empirical issues that are quite difficult to measure such as “what would have been otherwise.” These counterfactuals abound in economics but are almost impossible to prove rigorously (Pelaez and Pelaez, Globalization and the State, Vol. I, 17, 124-5). In this case, proving that the stimulus “saved” millions of jobs requires detailed data on the US economy with and without the stimulus while data are only observed with the stimulus and it is very difficult to separate the effects of alternative hypotheses. Persistent high unemployment raises doubts on the effects of the fiscal stimulus.
V Regulatory and Legislative Restructuring. The failed fiscal stimulus combines with legislative restructurings of key economic activities and widespread and profound regulatory shocks, raising transaction costs that deteriorate consumer and business confidence, in turn paralyzing investment decisions and hiring. The experience of the Great Depression has been misinterpreted and applied to the current recession. In 1929-33, the US economy experienced a decline of employment by 25 percent and of output by 26.7 percent. In 1939, in a truly lost decade, both employment and output were substantially below their levels in 1929, resulting from erroneous policies of the Roosevelt administration in promoting higher prices by support of monopolies and higher wages by support of unions (Harold Cole and Lee Ohanian cited in Pelaez and Pelaez, Regulation of Banks and Finance, 215-7). Amity Shlaes published a must-read book on The Forgotten Man: A New History of the Great Depression, analyzing why the Great Depression lasted until World War II (http://www.amazon.com/Forgotten-Man-History-Great-Depression/dp/0060936428/ref=ntt_at_ep_dpi_1 ). Shlaes has revealingly related the current lack of business confidence that may flatten the path of recovery of the economy to a similar adverse confidence shock by the Roosevelt administration (http://professional.wsj.com/article/SB10001424052748703636404575353431153327248.html ). Confidence doubts creep into the sober acts of the Federal Open Market Committee (FOMC) meeting in Jun: “a number of participants expressed the view that, over the next several years, both employment and inflation would likely be below levels they consider to be consistent with their dual mandate” (http://www.federalreserve.gov/newsevents/press/monetary/fomcminutes20100623.pdf 8). The confidence shock is being magnified by the Dodd-Frank bill (http://professional.wsj.com/article/SB10001424052748703615104575328430427126018.html ), which will sharply increase all the costs of consuming and doing business in the US. Transaction costs consist of costs other than those incurred in production and transportation: negotiation, legal counsel, litigation, enforcement of judgments and many others that are equivalent to almost one-half of GDP (Pelaez and Pelaez, Globalization and the State, Vol. I, 137-8, Government Intervention in Globalization, 81-3). Twenty six pages of flow charts are required simply to illustrate the timeline of the Dodd-Frank bill that will result in 243 rules by ten regulators over a period of at least six months and perhaps 18 months or more (http://professional.wsj.com/article/SB10001424052748704288204575363162664835780.html?mod=wsjproe_hps_MIDDLESecondNews ). Markets resigned to the fact that the shock of financial regulation is over with approval of the Dodd-Frank bill but it is just beginning. An indicative measure of the huge magnitude of transactions costs is that one of the largest banks in the US is assigning one hundred teams solely to examine the legislation (http://professional.wsj.com/article/SB10001424052748704682604575369030061839958.html ). Another large bank estimates that the restrictions on debit-card fees paid by merchants for client transactions may cause a charge on earnings of $10 billion (http://noir.bloomberg.com/apps/news?pid=20601087&sid=a7T01FWuMWtQ&pos=4 ). The capricious regulation of derivatives is likely to create higher costs and uncertainty in agricultural business (http://professional.wsj.com/article/SB10001424052748704258604575361182317501188.html?mod=wsjproe_hps_TopLeftWhatsNews ). The consumer protection agency will asphyxiate consumer credit, increasing rates and lowering limits. The Dodd-Frank bill creates new fees on banks (http://professional.wsj.com/article/SB10001424052748704746804575367290289483772.html?mod=wsjproe_hps_LEFTWhatsNews ) that will likely be passed on as higher rates to borrowers. The regulators crafting the new worldwide Basel rules on bank capital are prudently softening them and postponing their implementation because of concerns of another credit crunch as banks are still recovering from bad loans and write downs (http://professional.wsj.com/article/SB10001424052748704746804575367193230588972.html?mod=wsjproe_hps_TopMiddleNews ). US regulators closed six additional banks in three states on Jul 16, bringing the total for the year to 96 closed banks, doubling the rate of bank closings from 140 banks in 2009 (http://professional.wsj.com/article/SB10001424052748704746804575367193230588972.html?mod=wsjproe_hps_TopMiddleNews ). The timing of the Dodd-Frank bill is highly inopportune because it will add to bank difficulties when credit growth is required to finance the recovery of the economy. The draconian regulation of the Dodd-Frank bill and the hundreds of rules by ten regulators will crush the competitive advantage of US banks in world markets. Financial regulation is exporting the financial industry to other more favorable jurisdictions as it happened with the Bank Act of 1933 (12 U.S.C. § 371a) and Regulation Q (12 C.F.R. 217) prohibiting payment of interest on demand deposits and imposing limits on interest paid on time deposits issued by commercial banks that caused the exodus of US banking to London and other overseas financial centers (Pelaez and Pelaez, Financial Regulation after the Global Recession, 57-8). The individual measures of the Dodd-Frank bill will increase the cost of credit, lowering the volume of loans. The combined measures of the Dodd-Frank bill will make the US financial system more prone to crises and highly restrictive in financing growth and employment creation.
VI Economic Indicators. Recent data are showing weakness in all sectors of the economy, including manufacturing and sales that were leading the recovery. While the Empire State Manufacturing Survey of the New York Fed registered improving conditions for manufacturers in New York in Jul, the rhythm of growth of business activity declined “substantially,” with the index falling from 19.6 in Jun to 5.1 in Jul and falling a cumulative 27 points from the peak of 31.9 in Apr (http://www.ny.frb.org/survey/empire/empiresurvey_overviewexpand.html ). The Business Outlook Survey of the Philadelphia Fed finds that while manufacturing executives expect growing business over the next six months, optimism has declined. The region’s manufacturing activity is expanding in Jul but it has slowed in the past two months (http://www.phil.frb.org/research-and-data/regional-economy/business-outlook-survey/2010/bos0710.pdf ). Manufacturing output dropped 0.4 percent in Jun, following three months of increases around 1 percent. Total industrial production grew 0.1 percent in Jun after increasing by 1.3 percent in May. The rate of capacity utilization for total industry was unchanged at 74.1 percent in Jun, which is below last year’s rate by 5.9 percent points and 6.5 percentage points below the average from 1972 to 2009 (http://www.federalreserve.gov/releases/g17/Current/default.htm ). The advance estimate of US retail and food services sales for Jun measures a decline of 0.5 percent from the previous month but an increase of 4.8 percent relative to Jun 2009; the Apr to May estimate was revised to a decline of 1.2 percent (http://www.census.gov/retail/marts/www/marts_current.pdf ). The combined value of distributive sales and shipments by manufacturers in May fell by 0.9 percent relative to Apr but increased by 11.8 percent from May 2009. Manufacturers and trade inventories rose by 0.1 percent in May relative to April but fell by 1.5 percent relative to May 2009 (http://www.census.gov/mtis/www/data/pdf/mtis_current.pdf ). Initial unemployment insurance claims for the week ending Jul 10 fell by 29,000 to 429,000 relative to the revised 458,000 for the week earlier (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). The delay this year of manufacturing retooling does not permit accurate reading of initial unemployment insurance claims. The producer price index fell by 0.5 percent in Jun relative to May but increased by 2.8 percent in the past 12 months (http://www.bls.gov/news.release/ppi.nr0.htm ). The consumer price index fell by 0.1 percent in Jun relative to May, increasing by 1.1 percent in the previous 12 months (http://www.bls.gov/news.release/pdf/cpi.pdf ).
VII Interest Rates. Faster expansion of the economy may be arrested by an unsustainable US debt galloping toward 100 percent of GDP with plans of financing it with tax increases as well as by the inevitable increases in interest rates of unwinding the Fed’s balance sheet (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ) and relaxing the zero interest rates on fed funds. Treasuries are still used as safe haven for temporarily unloading risk exposures during moments of stress such that the yield of the 10-year Treasury has declined to 2.93 percent on Jul 16 from 3.06 percent a week ago and 3.19 percent a month ago. The 10-year government bond of Germany traded at 2.61 percent on Jul 16 for a negative spread of 31 basis points relative to the comparable Treasury (http://markets.ft.com/markets/bonds.asp ). Relative European and US risks are changing with the dollar depreciating to 1.2930/euro.
VIII Conclusion. Growth in the US is insufficient to improve the plight of 27 million persons in job stress. It is still uncertain if the deceleration of economic growth in the US, and most other countries, is temporary and there is no certainty on the rate of growth in the expansion. There is certainty of not repeating the jump from a seasonally-adjusted annual rate of growth of GDP of -6.4 percent in the second quarter of 1982 to 9.3 percent in the second quarter of 1983 and a compound average of seasonally-adjusted annual rates of 7.7 percent measured with the six quarters from the first quarter of 1983 to the second quarter of 1984. The V-shaped recovery from deep recessions has been crushed by failures of economic policy. Fiscal policy appears to be crowding out private sector investment and job creation. Confidence shocks resulting from regulation and legislative restructurings have paralyzed US companies that are holding two trillion dollars of cash instead of investing and hiring. More ambitious measures to change most economic activities for an alleged better world decades ahead, when we all may be dead after national bankruptcy, should be replaced by a policy shift of recovering business and consumer confidence. That policy shift will prove more effective in promoting faster economic growth that will alleviate the actual job stress of 27 million people and of the rest of the population who will breathe in relief of the threat of potential job stress. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
Carlos M. Pelaez
The economic growth of the US is underperforming past cyclical expansions from sharp recessions with resulting 27 million people in job stress. The objective of this post is relating the consequences of further apparent slowing of the US economy and job creation to its causes of failures of economic policy in the form of unsuccessful fiscal stimulus and legislative and regulatory restructurings that have undermined confidence. Declining confidence is further slowing decisions on investment, hiring and consumption. Policy shift by concrete actions instead of rhetoric is required to reignite the US economy and its private-sector engine of job creation. Continuing financial turbulence is analyzed in (I) and explained in (II) by concerns on Chinese growth and European sovereign risks and banks. The insufficiency of current growth in the US to recover employment is covered in (III). The remaining factors of erosion of confidence in the US are covered by analysis of the failures of economic policy in (IV) and regulatory and legislative restructurings in (V). Economic indicators are discussed in (VI) and interest rates in (VII). The concluding remarks are in (VIII).
I Financial Turbulence. Equity markets had improved substantially in the earlier week but experienced significant turbulence in the current week and continue to trade much lower than their recent peaks (http://online.wsj.com/mdc/page/marketsdata.html ). Financial variables are available with high frequency, daily with market trading, while data on the overall economy become available with a lag of weeks or months. The percentage performance of major US indices was: DJIA -9.9 from the recent peak on Apr 26 to Jul 16 and -1.0 in the week; S&P 500 -12.5 from the recent peak on Apr 23 and -1.2 in the week; and NYSE Financial -16.6 since Apr 15 and -2.8 in the week. The percentage performance of major world stock markets from Apr 15 to Jul 9 was: Dow Global -14.2 and -0.4 in the week; Dow Asia Pacific TSM -9.1 and 0.1 in the week; Shanghai -23.4 and -1.9 in the week; and STOXX Europe 50 -11.3 and -1.0 in the week. The euro strengthened, trading at $1.2930/EUR on Jul 16. The dollar has gained 16.9 percent relative to the euro since the recent trough on Nov 25, 2009, but lost 2.3 percent in the week. The DJ UBS commodity index fell 12.0 percent since the recent peak on Jan 6 and gained 0.5 percent in the week.
The beginning of reports of second quarter corporate earnings on Monday was awaited with optimism by investors. Earnings reports are backward looking information while investment in financial variables is forward looking and observed with high frequency data. The weighing in investment decisions of the probable impact of some deceleration of growth relative to strong earnings reports may have strong influence on financial turbulence. The financial markets of the US were hit on Friday Jul 16 by the combination of weak indicators of industry and sales released during the week and what the market viewed as disappointing corporate earnings. The DJIA dropped 261.41 points, equivalent to a decline of 2.5 percent, courting again at 10,097.90 the barrier of 10,000. All components of the DJIA dropped. The broader market S&P 500 lost 3.1 percent and the Nasdaq Composite fell 2.9 percent. Shares of large financial institutions dropped sharply. The Wall street Journal depicted the markets as hit by fading optimism (http://professional.wsj.com/article/SB10001424052748704913304575370584279739608.html?mod=wsjproe_hps_LEFTWhatsNews ). The yield of the 10-year Treasury dropped to 2.927 percent as risk exposures were abandoned in favor of the temporary safe haven of Treasuries and other highly-rated fixed income securities.
II Confidence Shocks. Two of four global factors of risk in the world economy that affect confidence in financial markets are considered in this section and the other two, failures of economics policy in (IV) and regulatory and legislative restructuring in (V) after analysis of US growth and employment in (III). First, there are recurring doubts on growth of the economy of China that could cause lower commodity prices and weaker interregional trade in Asia with adverse effects on regional and global growth. Doubts on China’s growth resurfaced again (http://www.ft.com/cms/s/0/6bf81ecc-8fb8-11df-8df0-00144feab49a.html http://professional.wsj.com/article/SB10001424052748703609004575354501318242096.html?mod=wsjproe_hps_TopLeftWhatsNews ). The growth model of China is based on developing internal infrastructure with bank credit and a more efficient export sector adding final touches to semifinished imports that are exported as final goods to the rest of the world (Pelaez and Pelaez, The Global Recession Risk, 56-80). The strategy was crafted to absorb labor from the less productive agricultural sector and provide jobs for rapid population growth via infrastructure projects while simultaneously irradiating higher productivity in the export sector to the rest of the economy. The strategy encounters paucity of sound projects in infrastructure with positive present value and slower growth in a flatter expansion path of the world economy. Growth remains vigorous but the doubts persist as to the redesigning of the new Chinese strategy. Second, the sovereign credit risk of several European countries is interrelated with exposures of banks to heavily indebted countries. The Committee of European Banking Supervisors advised stress tests for 91 banks that account for 65 percent of the European Union banking sector (http://www.c-ebs.org/CMSPages/GetFile.aspx?nodeguid=357173cf-0b06-4831-abcd-4ea90c64a960 ). The enlarged list includes segments of the banking industry that are considered weak (http://www.ft.com/cms/s/0/c6f4545e-8e81-11df-964e-00144feab49a.html ). Stress tests are part of an arsenal of tools used by financial institutions in processes of risk management (Pelaez and Pelaez, Globalization and the State, Vol. I, 78-100, Government Intervention in Globalization, 63-4, International Financial Architecture, 112-6). Financial markets were still fractured before Mar 2009. The US engaged in stress tests of major banks and subsequent public disclosure (Pelaez and Pelaez, Financial Regulation after the Global Recession, 164, 170, Regulation of Banks and Finance, 226, 231). Stress tests are useful but it is not feasible to solve ex post unsound exposures with risk management techniques that should have been used with sound judgment ex ante.
III. US Growth and Employment. There are doubts if the growth of the US economy will be sufficient to absorb 27 million people currently in job stress composed of: 14.6 million unemployed (of whom long-term unemployed of 6.8 million or 45.5 percent who have been unemployed more than 27 weeks), 8.6 million working part-time because they could not find a better job, 2.6 million marginally attached to the labor force (who wanted and were available for work and had searched for work in the prior 12 months) and 1.2 million discouraged workers (who believe there is no job for them or had not searched for work in the prior four weeks) (http://www.bls.gov/news.release/pdf/empsit.pdf ). During the recovery phase of similar recession in the early 1980s, 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. 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 ). US GDP increased at the annual seasonally-adjusted percentage rate of 2.2 in QIII09, 5.6 in QIV09 and 2.7 in QI10 (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&FirstYear=2009&LastYear=2010&Freq=Qtr ). These rates of growth may be insufficient to recover full employment.
IV Failures of Economic Policy. There are doubts about the effectiveness of economic policy in the US. In May, US exports were $152.3 billion and imports $194.5 billion for a trade deficit of goods and services of $42.3 billion. Exports of goods and services grew by $26.4 billion, or 21.0 percent, from May 2009 to May 2010 while imports increased by $43.8 billion or 29.1 percent (http://www.bea.gov/newsreleases/international/trade/tradnewsrelease.htm ). The Bureau of Economic Analysis (BEA) of the Department of Commerce has revised the trade data for 2009. Total US exports of goods and services in Jan-Dec 2009 were $1570 billion, declining by 14.6 percent from $1839 billion in 2008 and imports in Jan-Dec 2009 were $1945 billion, declining by 23.4 percent from $2538 billion in 2008 (http://www.bea.gov/newsreleases/international/trade/2010/pdf/trad1310.pdf ). The growth in exports in 2010 relative to 2009 is not the result of export promotion by public policy, which is only an intention of creating two million jobs (http://www.whitehouse.gov/the-press-office/president-obama-details-administration-efforts-support-two-million-new-jobs-promoti ), but rather part of similarly high rates of growth in other countries resulting from comparisons with very low levels in 2009. The American Recovery and Reinvestment Act of 2009 (ARRA) consisted of fiscal stimulus of around $800 “that would raise employment relative to what it would be in the absence of stimulus by 3 to 4 million by the end of 2010” (http://news.uchicago.edu/files/newsrelease_20090227.pdf ). The calculations were based on the multipliers of a Keynesian model. The application of this model to the trade balance of the US requires considering income-creating multipliers of exports but also opposite effects from income-destroying multipliers of imports much the same as ARRA-created taxes will have negative income-destroying multipliers. Counterfactual claims consist of empirical issues that are quite difficult to measure such as “what would have been otherwise.” These counterfactuals abound in economics but are almost impossible to prove rigorously (Pelaez and Pelaez, Globalization and the State, Vol. I, 17, 124-5). In this case, proving that the stimulus “saved” millions of jobs requires detailed data on the US economy with and without the stimulus while data are only observed with the stimulus and it is very difficult to separate the effects of alternative hypotheses. Persistent high unemployment raises doubts on the effects of the fiscal stimulus.
V Regulatory and Legislative Restructuring. The failed fiscal stimulus combines with legislative restructurings of key economic activities and widespread and profound regulatory shocks, raising transaction costs that deteriorate consumer and business confidence, in turn paralyzing investment decisions and hiring. The experience of the Great Depression has been misinterpreted and applied to the current recession. In 1929-33, the US economy experienced a decline of employment by 25 percent and of output by 26.7 percent. In 1939, in a truly lost decade, both employment and output were substantially below their levels in 1929, resulting from erroneous policies of the Roosevelt administration in promoting higher prices by support of monopolies and higher wages by support of unions (Harold Cole and Lee Ohanian cited in Pelaez and Pelaez, Regulation of Banks and Finance, 215-7). Amity Shlaes published a must-read book on The Forgotten Man: A New History of the Great Depression, analyzing why the Great Depression lasted until World War II (http://www.amazon.com/Forgotten-Man-History-Great-Depression/dp/0060936428/ref=ntt_at_ep_dpi_1 ). Shlaes has revealingly related the current lack of business confidence that may flatten the path of recovery of the economy to a similar adverse confidence shock by the Roosevelt administration (http://professional.wsj.com/article/SB10001424052748703636404575353431153327248.html ). Confidence doubts creep into the sober acts of the Federal Open Market Committee (FOMC) meeting in Jun: “a number of participants expressed the view that, over the next several years, both employment and inflation would likely be below levels they consider to be consistent with their dual mandate” (http://www.federalreserve.gov/newsevents/press/monetary/fomcminutes20100623.pdf 8). The confidence shock is being magnified by the Dodd-Frank bill (http://professional.wsj.com/article/SB10001424052748703615104575328430427126018.html ), which will sharply increase all the costs of consuming and doing business in the US. Transaction costs consist of costs other than those incurred in production and transportation: negotiation, legal counsel, litigation, enforcement of judgments and many others that are equivalent to almost one-half of GDP (Pelaez and Pelaez, Globalization and the State, Vol. I, 137-8, Government Intervention in Globalization, 81-3). Twenty six pages of flow charts are required simply to illustrate the timeline of the Dodd-Frank bill that will result in 243 rules by ten regulators over a period of at least six months and perhaps 18 months or more (http://professional.wsj.com/article/SB10001424052748704288204575363162664835780.html?mod=wsjproe_hps_MIDDLESecondNews ). Markets resigned to the fact that the shock of financial regulation is over with approval of the Dodd-Frank bill but it is just beginning. An indicative measure of the huge magnitude of transactions costs is that one of the largest banks in the US is assigning one hundred teams solely to examine the legislation (http://professional.wsj.com/article/SB10001424052748704682604575369030061839958.html ). Another large bank estimates that the restrictions on debit-card fees paid by merchants for client transactions may cause a charge on earnings of $10 billion (http://noir.bloomberg.com/apps/news?pid=20601087&sid=a7T01FWuMWtQ&pos=4 ). The capricious regulation of derivatives is likely to create higher costs and uncertainty in agricultural business (http://professional.wsj.com/article/SB10001424052748704258604575361182317501188.html?mod=wsjproe_hps_TopLeftWhatsNews ). The consumer protection agency will asphyxiate consumer credit, increasing rates and lowering limits. The Dodd-Frank bill creates new fees on banks (http://professional.wsj.com/article/SB10001424052748704746804575367290289483772.html?mod=wsjproe_hps_LEFTWhatsNews ) that will likely be passed on as higher rates to borrowers. The regulators crafting the new worldwide Basel rules on bank capital are prudently softening them and postponing their implementation because of concerns of another credit crunch as banks are still recovering from bad loans and write downs (http://professional.wsj.com/article/SB10001424052748704746804575367193230588972.html?mod=wsjproe_hps_TopMiddleNews ). US regulators closed six additional banks in three states on Jul 16, bringing the total for the year to 96 closed banks, doubling the rate of bank closings from 140 banks in 2009 (http://professional.wsj.com/article/SB10001424052748704746804575367193230588972.html?mod=wsjproe_hps_TopMiddleNews ). The timing of the Dodd-Frank bill is highly inopportune because it will add to bank difficulties when credit growth is required to finance the recovery of the economy. The draconian regulation of the Dodd-Frank bill and the hundreds of rules by ten regulators will crush the competitive advantage of US banks in world markets. Financial regulation is exporting the financial industry to other more favorable jurisdictions as it happened with the Bank Act of 1933 (12 U.S.C. § 371a) and Regulation Q (12 C.F.R. 217) prohibiting payment of interest on demand deposits and imposing limits on interest paid on time deposits issued by commercial banks that caused the exodus of US banking to London and other overseas financial centers (Pelaez and Pelaez, Financial Regulation after the Global Recession, 57-8). The individual measures of the Dodd-Frank bill will increase the cost of credit, lowering the volume of loans. The combined measures of the Dodd-Frank bill will make the US financial system more prone to crises and highly restrictive in financing growth and employment creation.
VI Economic Indicators. Recent data are showing weakness in all sectors of the economy, including manufacturing and sales that were leading the recovery. While the Empire State Manufacturing Survey of the New York Fed registered improving conditions for manufacturers in New York in Jul, the rhythm of growth of business activity declined “substantially,” with the index falling from 19.6 in Jun to 5.1 in Jul and falling a cumulative 27 points from the peak of 31.9 in Apr (http://www.ny.frb.org/survey/empire/empiresurvey_overviewexpand.html ). The Business Outlook Survey of the Philadelphia Fed finds that while manufacturing executives expect growing business over the next six months, optimism has declined. The region’s manufacturing activity is expanding in Jul but it has slowed in the past two months (http://www.phil.frb.org/research-and-data/regional-economy/business-outlook-survey/2010/bos0710.pdf ). Manufacturing output dropped 0.4 percent in Jun, following three months of increases around 1 percent. Total industrial production grew 0.1 percent in Jun after increasing by 1.3 percent in May. The rate of capacity utilization for total industry was unchanged at 74.1 percent in Jun, which is below last year’s rate by 5.9 percent points and 6.5 percentage points below the average from 1972 to 2009 (http://www.federalreserve.gov/releases/g17/Current/default.htm ). The advance estimate of US retail and food services sales for Jun measures a decline of 0.5 percent from the previous month but an increase of 4.8 percent relative to Jun 2009; the Apr to May estimate was revised to a decline of 1.2 percent (http://www.census.gov/retail/marts/www/marts_current.pdf ). The combined value of distributive sales and shipments by manufacturers in May fell by 0.9 percent relative to Apr but increased by 11.8 percent from May 2009. Manufacturers and trade inventories rose by 0.1 percent in May relative to April but fell by 1.5 percent relative to May 2009 (http://www.census.gov/mtis/www/data/pdf/mtis_current.pdf ). Initial unemployment insurance claims for the week ending Jul 10 fell by 29,000 to 429,000 relative to the revised 458,000 for the week earlier (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). The delay this year of manufacturing retooling does not permit accurate reading of initial unemployment insurance claims. The producer price index fell by 0.5 percent in Jun relative to May but increased by 2.8 percent in the past 12 months (http://www.bls.gov/news.release/ppi.nr0.htm ). The consumer price index fell by 0.1 percent in Jun relative to May, increasing by 1.1 percent in the previous 12 months (http://www.bls.gov/news.release/pdf/cpi.pdf ).
VII Interest Rates. Faster expansion of the economy may be arrested by an unsustainable US debt galloping toward 100 percent of GDP with plans of financing it with tax increases as well as by the inevitable increases in interest rates of unwinding the Fed’s balance sheet (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ) and relaxing the zero interest rates on fed funds. Treasuries are still used as safe haven for temporarily unloading risk exposures during moments of stress such that the yield of the 10-year Treasury has declined to 2.93 percent on Jul 16 from 3.06 percent a week ago and 3.19 percent a month ago. The 10-year government bond of Germany traded at 2.61 percent on Jul 16 for a negative spread of 31 basis points relative to the comparable Treasury (http://markets.ft.com/markets/bonds.asp ). Relative European and US risks are changing with the dollar depreciating to 1.2930/euro.
VIII Conclusion. Growth in the US is insufficient to improve the plight of 27 million persons in job stress. It is still uncertain if the deceleration of economic growth in the US, and most other countries, is temporary and there is no certainty on the rate of growth in the expansion. There is certainty of not repeating the jump from a seasonally-adjusted annual rate of growth of GDP of -6.4 percent in the second quarter of 1982 to 9.3 percent in the second quarter of 1983 and a compound average of seasonally-adjusted annual rates of 7.7 percent measured with the six quarters from the first quarter of 1983 to the second quarter of 1984. The V-shaped recovery from deep recessions has been crushed by failures of economic policy. Fiscal policy appears to be crowding out private sector investment and job creation. Confidence shocks resulting from regulation and legislative restructurings have paralyzed US companies that are holding two trillion dollars of cash instead of investing and hiring. More ambitious measures to change most economic activities for an alleged better world decades ahead, when we all may be dead after national bankruptcy, should be replaced by a policy shift of recovering business and consumer confidence. That policy shift will prove more effective in promoting faster economic growth that will alleviate the actual job stress of 27 million people and of the rest of the population who will breathe in relief of the threat of potential job stress. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
Sunday, July 11, 2010
Slower Growth, Financial Turbulence, Persisting Job Stress of 27 Million and Failures of Economic Policy
Slower Growth, Financial Turbulence, Persisting Job Stress of 27 Million and Failures of Economic Policy
Carlos M. Pelaez
The objective of this post is to relate (I) slowing economic growth to (II) financial turbulence, (III) job stress and (IV) failures of economic policy. Economic indicators are analyzed in (V) and interest rates in (VI) while (VII) concludes.
I Economic Growth. The world economy is growing in 2010 and is likely to grow in 2011. However, growth is uneven among regions. The July update of the World Economic Outlook (WEO) of the IMF projects continuing growth of the world economy of 4.6 percent in 2010 and 4.3 percent in 2011 (http://www.imf.org/external/pubs/ft/weo/2010/update/02/index.htm#tbl1 ). The world economy lost 0.6 percent of output in 2009 after growing by 3.0 percent in 2008. The outlook for the “advanced economies” is less promising with growth of 2.6 percent in 2010 and 2.4 percent in 2011 after decline of 3.2 percent in 2009 and growth of only 0.5 percent in 2008. The growth impulse in the projections originates in emerging and developing economies that grow by 6.8 percent in 2010 and 6.4 percent in 2011 after growing by 2.5 percent in 2009 and 6.1 percent in 2008. The sharpest decline in output in 2009 was -7.9 percent in Russia and the best performance was growth in China by 9.1 percent. The growth prospects for the largest economies are not attractive: US 3.3 percent in 2010 and 2.9 percent in 2011, euro area 1.0 percent in 2009 and 1.3 percent in 2011 and Japan 2.4 percent in 2010 and 1.8 percent in 2011. The contraction of output was -2.4 percent in the US in 2009, -4.1 percent in the euro area in 2009 and Japan -1.2 percent in 2008 followed by -5.2 percent in 2009. Comparisons of the global recession with the Great Depression are seriously misleading. 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 with high unemployment until World War II (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). The magnitude of the recession of 2008-2009 should be increased by the decline of the rate of economic growth from trend, which would add about 3 percent of lost GDP to the US. The sum of actual contraction and growth below trend would result in GDP loss in the US of about 6 percent, which is substantial but minute, compared to the depth and length of the Great Depression. Another important calculation of the IMF WEO Apr 2010 update is the contraction of world trade: growth of only 2.8 percent in 2008, -12.9 percent in 2009 and recovery by 9.0 percent in 2010 and 6.3 percent in 2011. The IMF obtains its information through research and continuing consultations with its member countries, constituting an important global public good (Pelaez and Pelaez, International Financial Architecture, Government Intervention in Globalization, 145-50, Globalization and the State, Vol. I, 129-31, Globalization and the State, Vol. II, 46-8, 114-25).
II Financial Turbulence. An important projection of the IMF’s WEO of Apr 2010 is the increase in the net debt of the US from 47.2 percent in 2008 to 85.5 percent in 2015 and of the gross debt from 70.6 percent of GDP in 2008 to 109.7 percent of GDP in 2015 (http://www.imf.org/external/pubs/ft/weo/2010/01/pdf/text.pdf 169). The July WEO update depicts revealingly the current crossroad: “recent turbulence in financial markets—reflecting a drop in confidence about fiscal sustainability, policy responses, and future growth prospects—has cast a cloud over the outlook. Crucially, fiscal sustainability issues in advanced economies came to the fore during May.” High unemployment and weak household and financial balance sheets constrain private spending required for strong demand that would drive faster economic growth. The IMF WEO July update argues that financial turbulence can affect the overall economy through various channels such as reduction of credit by uncertainty on risk exposures of banks and higher funding costs. Private consumption and investment could be less dynamic because of declining consumer and business confidence. The IMF still finds that the recovery of the global economy will continue even with more financial turbulence.
Equity markets improved substantially in the past week but continue to be much lower than their recent peaks (http://online.wsj.com/mdc/page/marketsdata.html ). The percentage performance of major US indices was: DJIA -9.0 from the recent peak on Apr 26 to Jul 9 and 5.3 in the week; S&P 500 -11.4 from the recent peak on Apr 23 and 5.4 in the week; and NYSE Financial -14.2 since Apr 15 and 7.7 in the week. The percentage performance of major world stock markets from Apr 15 to Jul 9 was: Dow Global -14.0 and 5.4 in the week; Dow Asia Pacific TSM -9.2 and 3.7 in the week; Shanghai -21.9 and 3.7 percent in the week; and STOXX Europe 50 -10.4 and 5.8 in the week. The euro strengthened, trading at $1.2642/EUR on Jul 9. The dollar has gained 19.7 percent relative to the euro since the recent trough on Nov 25, 2009, but lost 0.6 percent in the week. The DJ UBS commodity index fell 12.5 percent since the recent peak on Jan 6 and gained 2.4 percent in the week. The beginning of reports of second quarter corporate earnings on Monday is awaited with optimism by investors. Earnings reports are backward looking information while investment in financial variables is forward looking. The weighing in investment decisions of the probable impact of some deceleration of growth relative to strong earnings reports may have strong influence on financial turbulence.
Indicators of financial risk continue to reflect financial turbulence. The 10-year Treasury traded at 3.057 percent on Jul 7 because of the use of Treasuries and high quality mortgage-based securities and corporate debt as safe haven from financial risk. Inflows into money market funds increased to $33.5 billion in the week of Jul 9, the largest inflows in 18 months since Jan 2009 when inflows were $37.7 billion (http://www.ft.com/cms/s/0/b0877070-8b84-11df-ab4d-00144feab49a.html ). Commercial real-estate loans are still a source of difficulties for US banks. The research firm Foresight Analytics is quoted by the Wall Street Journal as estimating $176 billion of troubled commercial real estate loans. Approximately two-thirds of commercial real-estate loans that mature until 2014 are underwater with property prices below loan values; the delinquency rate of commercial-property loans held by banks rose to 9.1 percent in the first quarter in contrast with 7 percent a year earlier and 1.5 percent in the first quarter of 2007 (http://professional.wsj.com/article/SB10001424052748704764404575286882690834088.html?mod=wsjproe_hps_LEFTWhatsNews ). The three-month euro interbank rate in London increased to 0.76 percent, which is the highest level in 10 months. The euro LIBOR-OIS spread increased to 19.3 basis points while the three-month dollar LIBOR fell slightly to 0.5277 percent (http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=ayFxN3BLEVeE ). There is still uncertainty as to what the stress tests of European banks will reveal. The success of US stress tests of banks was followed by a 36 percent increase in their stock prices. The S&P 500 financial index declined by 6 percent in 2010, much lower than the decline by 14 percent of Bloomberg’s index of Europe Banks and Financial Services. The 20 largest banks in Europe trade at a discount of 10 percent relative to book value but the 20 largest US banks trade at a premium of 10 percent (http://noir.bloomberg.com/apps/news?pid=20601109&sid=abl8IFKnuuaU&pos=10 ).
III Job Stress. The US economy is lagging others in job recovery. An analysis of 11 countries by the Wall Street Journal finds a positive association between strong job recovery and moderate debts and strong banking systems (http://professional.wsj.com/article/SB10001424052748704799604575357031890309998.html?mod=wsjproe_hps_LEFTWhatsNews ). Employment has increased by 4.5 percent in Brazil and 6.8 percent in Chile since Dec 2007. Interregional trade in commodities with Asian countries and relatively unharmed financial system has permitted Australia to increase employment by 3.7 percent. In contrast, the WSJ research finds that employment in the US had declined in Jun by 4.8 percent relative to Dec 2007. The US consumer is burdened by household debts of 122 percent of disposable income, which is still below the peak of 131 percent, but still at a level exerting pressure on further spending. Another important example is Japan with government debt above 200 percent of GDP and employment down 3.3 percent from Dec 2007. There were 27 million people in job stress in the US in Jun, composed of: 14.6 million unemployed (of whom long-term unemployed of 6.8 million or 45.5 percent who have been unemployed more than 27 weeks), 8.6 million working part-time because they could not find a better job, 2.6 million marginally attached to the labor force (who wanted and were available for work and had searched for work in the prior 12 months) and 1.2 million discouraged workers (who believe there is no job for them or had not searched for work in the prior four weeks) (http://www.bls.gov/news.release/pdf/empsit.pdf ). The combination of high household debt and weak financial system is the result of four economic policies that were the root cause of the credit/dollar crisis and global recession ((Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). First, the Fed lowered the fed funds rate to 1 percent in 2003 and left it at that level until 2004 with the forward guidance that it would maintain it at that level until required in fear of deflation that never existed (http://www.federalreserve.gov/boarddocs/SPEECHES/2002/20021121/ ). Households and other economic agents were induced to take high debts, consuming and financing almost everything with short-dated funds. There would never be risks again because the Fed assured a “great moderation,” or permanent prosperity with fewer, milder recessions and perennially low inflation. Fed policy distorted the calculation of risks, which were made by policy to look nonexistent, and rewards, which were illusorily made to look unbounded. The policy induced excessive leverage and risks in financing, discouraging liquidity while eroding soundness in credit evaluation. Adjustable rate mortgages (ARMS) looked attractive because the low short-dated interest rate would be maintained forever by Fed policy. The near zero interest rate caused the intended boom of the economy. The Fed then decided to increase the fed funds rate by 25 basis points (bps) at every one of 17 consecutive meetings of the Federal Open Market Committee (FOMC) from 1 percent in Jun 2004 to 5.25 percent in Jun 2006, eroding the illusion of a Fed-guaranteed floor on house prices that precipitated the real estate debacle. Second, the Fed has experimented with policies that can bring down long-term interest rates to the level of fed funds rates. Treasury suspended the auctions of 30-year Treasuries from 2001 to 2005 to boost investment and credit by lower yields on asset-backed securities or securitization of loans. High-quality mortgage-backed securities (MBS) began to be used in matching assets with long-term obligations such as pensions. The increase in demand for MBS caused an increase in their prices, which is equivalent to lowering their yields. The first wave of refinancing of mortgages injected more income in households than tax rebates because of lower monthly payments in house loans. New acquisitions of homes and home-equity loans further fueled the housing, consumption and debt boom. Third, the US has maintained a yearly housing subsidy of $221 billion per year, which has contributed significantly to a surplus of housing that eventually depressed prices. Fourth, Fannie Mae and Freddie Mac purchased or guaranteed $1.6 trillion of nonprime mortgages, giving the seal of government quality to unsound house loans (Edward Pinto, cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 47, Regulation of Banks and Finance, 219-20).
IV Failures of Economic Policy. The response of the government to the credit/dollar crisis was massive stimulus. Fiscal policy consisted of the $787 billion American Recovery and Reinvestment Act (ARRA) signed on Feb 17, 2009, as “an unprecedented effort to jumpstart our economy, save and create millions of jobs and put a down payment on addressing long-neglected challenges so that our country can thrive in the 21st century” (http://www.whitehouse.gov/recovery/about ). The government increased expenditures sharply to 25 percent of GDP while tax revenue declined from 18.5 percent of GDP in 2007 to 14.8 percent of GDP in 2009, remaining at nearly the same level in 2010 ((http://professional.wsj.com/article/SB10001424052748703426004575338991852947182.html ). Monetary policy consisted of a zero fed funds rate as of Dec 2008, multiple facilities of financing and the acquisition by the Fed of a portfolio of long-term Treasuries, agency debt and MBS to lower long-term rates that has resulted in a Fed balance sheet of $2.3 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 224-7). The Fed is in a policy corner of unwinding the balance sheet and increasing interest rates of relatively monumental proportions relative to the crossroad of Jun 2004 when it increased interest rates over a long period in small increments. The combination of the fiscal and monetary stimulus has created the expectation of taxation and increases in interest rates that may restrict investment and hiring. The new jobs strategy is export-led growth, creating two million jobs by doubling exports. The strategy is allegedly already on track by government data showing growth of exports of 17 percent in the first four months of 2010 relative to depressed levels in 2009 (http://professional.wsj.com/article/SB10001424052748703636404575352731258196298.html?mod=wsjproe_hps_MIDDLEForthNews ). US exports are merely following the recovery of world trade but not because of the US declared intention to revive trade agreements with South Korea, Colombia and Panama, which face difficult approval in Congress and may not boost exports as desired. The fact is that there is a current “hold” on optimism on the US economy (http://www.ft.com/cms/s/0/83c978de-8b8a-11df-ab4d-00144feab49a.html ). The threat of taxation and rising interest rates is combining with complex legislative restructurings for alleged long-term benefits and deeply intrusive, widespread regulatory shocks to discourage investment and job creation. The type of change and the threat of more inopportune change are asphyxiating private investment and job creation in the US economy. Government spending even financed by taxes such as not to create deficits, or tax to spend, “crowds out,” or reduces the private investment that would have occurred without the fiscal expansion of the government (Olivier Blanchard and Roberto Perotti, Quarterly Journal of Economics 117 (4), 1363). The replacement of job-creating private investment by fiscal government expansion and the discouragement of small and medium business investment by taxation, interest rates and other costs of doing business is a major cause of the job stress of 27 million people.
V Economic Indicators. The US economy continues to expand, perhaps with slight deceleration, but growth is insufficient to create required employment that would alleviate the job stress of 27 million people. The Institute of Supply Management (ISM) index of the non-manufacturing sector finds that economic activity rose in Jun for the sixth consecutive month but the index fell from 55.4 in May to 53.8 in Jun, showing a slightly lower rate of growth. The employment index fell to 49.7 percent, showing mild contraction or stability (http://www.ism.ws/ISMReport/NonMfgROB.cfm ). Consumer credit fell by $9.1 billion in May relative to Apr and is $107.5 billion below the level in 2007 or a decline of 4.3 percent. Revolving credit dropped by $7.4 billion in May relative to Apr and is $112.1 billion below the level in 2007 or a decline of 11.9 percent (http://www.federalreserve.gov/releases/g19/Current/ ). Consumers may not be demanding as much credit as before because of uncertainty about employment and the economy. Tighter consumer credit terms and higher rates have occurred already because of the CARD (Credit Card Accountability, Responsibility and Disclosure) Act of May 2009 and even worst conditions are likely under the consumer protection agency of the Dodd-Frank bill. Sales of merchant wholesalers fell 0.3 percent in May relative to April but were still higher by 15.1 percent relative to May 2009. While sales of durable goods grew by 0.5 percent in May relative to Apr, sales of nondurable goods fell by 1.0 percent. Inventories rose by 0.5 percent (http://www2.census.gov/wholesale/pdf/mwts/currentwhl.pdf ). Seasonally-adjusted initial claims for unemployment insurance fell by 21,000 to 454,000 in the week ending on Jul 3 relative to the prior week. The four-week moving average fell by 1250 to 466,000 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). Claims are still at a high level relative to around 350,000 in 2007.
VI Interest Rates. The US yield curve is stationary with the peculiar shape of a long segment close to zero percent, rising mildly to 0.63 percent for the 2-year Treasury and then rising more sharply with 1.84 percent for the 5-year Treasury, 3.06 percent for the 10 year and 4.04 percent for the 30 year. The 10-year Treasury yield rose to 3.06 percent from 2.98 percent a week ago and declined from 3.22 percent a month ago (http://markets.ft.com/markets/bonds.asp ). The unwinding of the $2.3 trillion Fed balance sheet with this yield curve and the federal debt in an unsustainable path may not be harmless to the overall economy. The 10-year German government bond traded at 2.64 percent on Jun 9 with a negative spread relative to the 10-year Treasury of 42 bps.
VII Conclusion. There is complex interrelation of slowing economic growth, financial turbulence, job stress and failures of economic policy. Policies stimulating investment in the private sector are more likely to generate new employment that will alleviate the job stress of 27 million people. Crises are inopportune events for advancing legislative restructurings and regulatory shocks shifting decisions from business to government because of crowding out of private investment and exacerbating uncertainty in business decisions and hiring. Policy is asphyxiating job creation. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
Carlos M. Pelaez
The objective of this post is to relate (I) slowing economic growth to (II) financial turbulence, (III) job stress and (IV) failures of economic policy. Economic indicators are analyzed in (V) and interest rates in (VI) while (VII) concludes.
I Economic Growth. The world economy is growing in 2010 and is likely to grow in 2011. However, growth is uneven among regions. The July update of the World Economic Outlook (WEO) of the IMF projects continuing growth of the world economy of 4.6 percent in 2010 and 4.3 percent in 2011 (http://www.imf.org/external/pubs/ft/weo/2010/update/02/index.htm#tbl1 ). The world economy lost 0.6 percent of output in 2009 after growing by 3.0 percent in 2008. The outlook for the “advanced economies” is less promising with growth of 2.6 percent in 2010 and 2.4 percent in 2011 after decline of 3.2 percent in 2009 and growth of only 0.5 percent in 2008. The growth impulse in the projections originates in emerging and developing economies that grow by 6.8 percent in 2010 and 6.4 percent in 2011 after growing by 2.5 percent in 2009 and 6.1 percent in 2008. The sharpest decline in output in 2009 was -7.9 percent in Russia and the best performance was growth in China by 9.1 percent. The growth prospects for the largest economies are not attractive: US 3.3 percent in 2010 and 2.9 percent in 2011, euro area 1.0 percent in 2009 and 1.3 percent in 2011 and Japan 2.4 percent in 2010 and 1.8 percent in 2011. The contraction of output was -2.4 percent in the US in 2009, -4.1 percent in the euro area in 2009 and Japan -1.2 percent in 2008 followed by -5.2 percent in 2009. Comparisons of the global recession with the Great Depression are seriously misleading. 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 with high unemployment until World War II (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). The magnitude of the recession of 2008-2009 should be increased by the decline of the rate of economic growth from trend, which would add about 3 percent of lost GDP to the US. The sum of actual contraction and growth below trend would result in GDP loss in the US of about 6 percent, which is substantial but minute, compared to the depth and length of the Great Depression. Another important calculation of the IMF WEO Apr 2010 update is the contraction of world trade: growth of only 2.8 percent in 2008, -12.9 percent in 2009 and recovery by 9.0 percent in 2010 and 6.3 percent in 2011. The IMF obtains its information through research and continuing consultations with its member countries, constituting an important global public good (Pelaez and Pelaez, International Financial Architecture, Government Intervention in Globalization, 145-50, Globalization and the State, Vol. I, 129-31, Globalization and the State, Vol. II, 46-8, 114-25).
II Financial Turbulence. An important projection of the IMF’s WEO of Apr 2010 is the increase in the net debt of the US from 47.2 percent in 2008 to 85.5 percent in 2015 and of the gross debt from 70.6 percent of GDP in 2008 to 109.7 percent of GDP in 2015 (http://www.imf.org/external/pubs/ft/weo/2010/01/pdf/text.pdf 169). The July WEO update depicts revealingly the current crossroad: “recent turbulence in financial markets—reflecting a drop in confidence about fiscal sustainability, policy responses, and future growth prospects—has cast a cloud over the outlook. Crucially, fiscal sustainability issues in advanced economies came to the fore during May.” High unemployment and weak household and financial balance sheets constrain private spending required for strong demand that would drive faster economic growth. The IMF WEO July update argues that financial turbulence can affect the overall economy through various channels such as reduction of credit by uncertainty on risk exposures of banks and higher funding costs. Private consumption and investment could be less dynamic because of declining consumer and business confidence. The IMF still finds that the recovery of the global economy will continue even with more financial turbulence.
Equity markets improved substantially in the past week but continue to be much lower than their recent peaks (http://online.wsj.com/mdc/page/marketsdata.html ). The percentage performance of major US indices was: DJIA -9.0 from the recent peak on Apr 26 to Jul 9 and 5.3 in the week; S&P 500 -11.4 from the recent peak on Apr 23 and 5.4 in the week; and NYSE Financial -14.2 since Apr 15 and 7.7 in the week. The percentage performance of major world stock markets from Apr 15 to Jul 9 was: Dow Global -14.0 and 5.4 in the week; Dow Asia Pacific TSM -9.2 and 3.7 in the week; Shanghai -21.9 and 3.7 percent in the week; and STOXX Europe 50 -10.4 and 5.8 in the week. The euro strengthened, trading at $1.2642/EUR on Jul 9. The dollar has gained 19.7 percent relative to the euro since the recent trough on Nov 25, 2009, but lost 0.6 percent in the week. The DJ UBS commodity index fell 12.5 percent since the recent peak on Jan 6 and gained 2.4 percent in the week. The beginning of reports of second quarter corporate earnings on Monday is awaited with optimism by investors. Earnings reports are backward looking information while investment in financial variables is forward looking. The weighing in investment decisions of the probable impact of some deceleration of growth relative to strong earnings reports may have strong influence on financial turbulence.
Indicators of financial risk continue to reflect financial turbulence. The 10-year Treasury traded at 3.057 percent on Jul 7 because of the use of Treasuries and high quality mortgage-based securities and corporate debt as safe haven from financial risk. Inflows into money market funds increased to $33.5 billion in the week of Jul 9, the largest inflows in 18 months since Jan 2009 when inflows were $37.7 billion (http://www.ft.com/cms/s/0/b0877070-8b84-11df-ab4d-00144feab49a.html ). Commercial real-estate loans are still a source of difficulties for US banks. The research firm Foresight Analytics is quoted by the Wall Street Journal as estimating $176 billion of troubled commercial real estate loans. Approximately two-thirds of commercial real-estate loans that mature until 2014 are underwater with property prices below loan values; the delinquency rate of commercial-property loans held by banks rose to 9.1 percent in the first quarter in contrast with 7 percent a year earlier and 1.5 percent in the first quarter of 2007 (http://professional.wsj.com/article/SB10001424052748704764404575286882690834088.html?mod=wsjproe_hps_LEFTWhatsNews ). The three-month euro interbank rate in London increased to 0.76 percent, which is the highest level in 10 months. The euro LIBOR-OIS spread increased to 19.3 basis points while the three-month dollar LIBOR fell slightly to 0.5277 percent (http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=ayFxN3BLEVeE ). There is still uncertainty as to what the stress tests of European banks will reveal. The success of US stress tests of banks was followed by a 36 percent increase in their stock prices. The S&P 500 financial index declined by 6 percent in 2010, much lower than the decline by 14 percent of Bloomberg’s index of Europe Banks and Financial Services. The 20 largest banks in Europe trade at a discount of 10 percent relative to book value but the 20 largest US banks trade at a premium of 10 percent (http://noir.bloomberg.com/apps/news?pid=20601109&sid=abl8IFKnuuaU&pos=10 ).
III Job Stress. The US economy is lagging others in job recovery. An analysis of 11 countries by the Wall Street Journal finds a positive association between strong job recovery and moderate debts and strong banking systems (http://professional.wsj.com/article/SB10001424052748704799604575357031890309998.html?mod=wsjproe_hps_LEFTWhatsNews ). Employment has increased by 4.5 percent in Brazil and 6.8 percent in Chile since Dec 2007. Interregional trade in commodities with Asian countries and relatively unharmed financial system has permitted Australia to increase employment by 3.7 percent. In contrast, the WSJ research finds that employment in the US had declined in Jun by 4.8 percent relative to Dec 2007. The US consumer is burdened by household debts of 122 percent of disposable income, which is still below the peak of 131 percent, but still at a level exerting pressure on further spending. Another important example is Japan with government debt above 200 percent of GDP and employment down 3.3 percent from Dec 2007. There were 27 million people in job stress in the US in Jun, composed of: 14.6 million unemployed (of whom long-term unemployed of 6.8 million or 45.5 percent who have been unemployed more than 27 weeks), 8.6 million working part-time because they could not find a better job, 2.6 million marginally attached to the labor force (who wanted and were available for work and had searched for work in the prior 12 months) and 1.2 million discouraged workers (who believe there is no job for them or had not searched for work in the prior four weeks) (http://www.bls.gov/news.release/pdf/empsit.pdf ). The combination of high household debt and weak financial system is the result of four economic policies that were the root cause of the credit/dollar crisis and global recession ((Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). First, the Fed lowered the fed funds rate to 1 percent in 2003 and left it at that level until 2004 with the forward guidance that it would maintain it at that level until required in fear of deflation that never existed (http://www.federalreserve.gov/boarddocs/SPEECHES/2002/20021121/ ). Households and other economic agents were induced to take high debts, consuming and financing almost everything with short-dated funds. There would never be risks again because the Fed assured a “great moderation,” or permanent prosperity with fewer, milder recessions and perennially low inflation. Fed policy distorted the calculation of risks, which were made by policy to look nonexistent, and rewards, which were illusorily made to look unbounded. The policy induced excessive leverage and risks in financing, discouraging liquidity while eroding soundness in credit evaluation. Adjustable rate mortgages (ARMS) looked attractive because the low short-dated interest rate would be maintained forever by Fed policy. The near zero interest rate caused the intended boom of the economy. The Fed then decided to increase the fed funds rate by 25 basis points (bps) at every one of 17 consecutive meetings of the Federal Open Market Committee (FOMC) from 1 percent in Jun 2004 to 5.25 percent in Jun 2006, eroding the illusion of a Fed-guaranteed floor on house prices that precipitated the real estate debacle. Second, the Fed has experimented with policies that can bring down long-term interest rates to the level of fed funds rates. Treasury suspended the auctions of 30-year Treasuries from 2001 to 2005 to boost investment and credit by lower yields on asset-backed securities or securitization of loans. High-quality mortgage-backed securities (MBS) began to be used in matching assets with long-term obligations such as pensions. The increase in demand for MBS caused an increase in their prices, which is equivalent to lowering their yields. The first wave of refinancing of mortgages injected more income in households than tax rebates because of lower monthly payments in house loans. New acquisitions of homes and home-equity loans further fueled the housing, consumption and debt boom. Third, the US has maintained a yearly housing subsidy of $221 billion per year, which has contributed significantly to a surplus of housing that eventually depressed prices. Fourth, Fannie Mae and Freddie Mac purchased or guaranteed $1.6 trillion of nonprime mortgages, giving the seal of government quality to unsound house loans (Edward Pinto, cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 47, Regulation of Banks and Finance, 219-20).
IV Failures of Economic Policy. The response of the government to the credit/dollar crisis was massive stimulus. Fiscal policy consisted of the $787 billion American Recovery and Reinvestment Act (ARRA) signed on Feb 17, 2009, as “an unprecedented effort to jumpstart our economy, save and create millions of jobs and put a down payment on addressing long-neglected challenges so that our country can thrive in the 21st century” (http://www.whitehouse.gov/recovery/about ). The government increased expenditures sharply to 25 percent of GDP while tax revenue declined from 18.5 percent of GDP in 2007 to 14.8 percent of GDP in 2009, remaining at nearly the same level in 2010 ((http://professional.wsj.com/article/SB10001424052748703426004575338991852947182.html ). Monetary policy consisted of a zero fed funds rate as of Dec 2008, multiple facilities of financing and the acquisition by the Fed of a portfolio of long-term Treasuries, agency debt and MBS to lower long-term rates that has resulted in a Fed balance sheet of $2.3 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 224-7). The Fed is in a policy corner of unwinding the balance sheet and increasing interest rates of relatively monumental proportions relative to the crossroad of Jun 2004 when it increased interest rates over a long period in small increments. The combination of the fiscal and monetary stimulus has created the expectation of taxation and increases in interest rates that may restrict investment and hiring. The new jobs strategy is export-led growth, creating two million jobs by doubling exports. The strategy is allegedly already on track by government data showing growth of exports of 17 percent in the first four months of 2010 relative to depressed levels in 2009 (http://professional.wsj.com/article/SB10001424052748703636404575352731258196298.html?mod=wsjproe_hps_MIDDLEForthNews ). US exports are merely following the recovery of world trade but not because of the US declared intention to revive trade agreements with South Korea, Colombia and Panama, which face difficult approval in Congress and may not boost exports as desired. The fact is that there is a current “hold” on optimism on the US economy (http://www.ft.com/cms/s/0/83c978de-8b8a-11df-ab4d-00144feab49a.html ). The threat of taxation and rising interest rates is combining with complex legislative restructurings for alleged long-term benefits and deeply intrusive, widespread regulatory shocks to discourage investment and job creation. The type of change and the threat of more inopportune change are asphyxiating private investment and job creation in the US economy. Government spending even financed by taxes such as not to create deficits, or tax to spend, “crowds out,” or reduces the private investment that would have occurred without the fiscal expansion of the government (Olivier Blanchard and Roberto Perotti, Quarterly Journal of Economics 117 (4), 1363). The replacement of job-creating private investment by fiscal government expansion and the discouragement of small and medium business investment by taxation, interest rates and other costs of doing business is a major cause of the job stress of 27 million people.
V Economic Indicators. The US economy continues to expand, perhaps with slight deceleration, but growth is insufficient to create required employment that would alleviate the job stress of 27 million people. The Institute of Supply Management (ISM) index of the non-manufacturing sector finds that economic activity rose in Jun for the sixth consecutive month but the index fell from 55.4 in May to 53.8 in Jun, showing a slightly lower rate of growth. The employment index fell to 49.7 percent, showing mild contraction or stability (http://www.ism.ws/ISMReport/NonMfgROB.cfm ). Consumer credit fell by $9.1 billion in May relative to Apr and is $107.5 billion below the level in 2007 or a decline of 4.3 percent. Revolving credit dropped by $7.4 billion in May relative to Apr and is $112.1 billion below the level in 2007 or a decline of 11.9 percent (http://www.federalreserve.gov/releases/g19/Current/ ). Consumers may not be demanding as much credit as before because of uncertainty about employment and the economy. Tighter consumer credit terms and higher rates have occurred already because of the CARD (Credit Card Accountability, Responsibility and Disclosure) Act of May 2009 and even worst conditions are likely under the consumer protection agency of the Dodd-Frank bill. Sales of merchant wholesalers fell 0.3 percent in May relative to April but were still higher by 15.1 percent relative to May 2009. While sales of durable goods grew by 0.5 percent in May relative to Apr, sales of nondurable goods fell by 1.0 percent. Inventories rose by 0.5 percent (http://www2.census.gov/wholesale/pdf/mwts/currentwhl.pdf ). Seasonally-adjusted initial claims for unemployment insurance fell by 21,000 to 454,000 in the week ending on Jul 3 relative to the prior week. The four-week moving average fell by 1250 to 466,000 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). Claims are still at a high level relative to around 350,000 in 2007.
VI Interest Rates. The US yield curve is stationary with the peculiar shape of a long segment close to zero percent, rising mildly to 0.63 percent for the 2-year Treasury and then rising more sharply with 1.84 percent for the 5-year Treasury, 3.06 percent for the 10 year and 4.04 percent for the 30 year. The 10-year Treasury yield rose to 3.06 percent from 2.98 percent a week ago and declined from 3.22 percent a month ago (http://markets.ft.com/markets/bonds.asp ). The unwinding of the $2.3 trillion Fed balance sheet with this yield curve and the federal debt in an unsustainable path may not be harmless to the overall economy. The 10-year German government bond traded at 2.64 percent on Jun 9 with a negative spread relative to the 10-year Treasury of 42 bps.
VII Conclusion. There is complex interrelation of slowing economic growth, financial turbulence, job stress and failures of economic policy. Policies stimulating investment in the private sector are more likely to generate new employment that will alleviate the job stress of 27 million people. Crises are inopportune events for advancing legislative restructurings and regulatory shocks shifting decisions from business to government because of crowding out of private investment and exacerbating uncertainty in business decisions and hiring. Policy is asphyxiating job creation. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
Sunday, July 4, 2010
The 27 Million Persons in Job Stress, Financial Regulation and Failures of Economic Policy
The 27 Million Persons in Job Stress, Financial Regulation and Failures of Economic Policy
Carlos M Pelaez
The objective of this post is to analyze the job stress in the US that is increasingly being related to failures of economic policy. Section I considers the 27 million persons in job stress; II analyzes the failures of economic policy and III financial regulation; financial turbulence is documented in IV, economic indicators in V and interest rates in VI; VII concludes.
I The 27 Million in Job Stress. Economic policy appears to be failing at least in the most important task, which is employment creation, requiring more effective policy strategy. The nonfarm payroll survey finds 125,000 job losses in Jun with a decline of temporary workers employed in the Census 2010 by 225,000 and an increase in private-sector payroll employment of 83,000 (http://www.bls.gov/news.release/pdf/empsit.pdf ). The unemployment rate of the household survey stood at 9.5 percent while the civilian labor force fell by 625,000 because people desisted from finding a job. Thus, the unemployment rate fell not because more people found jobs but as a result of 625,000 people dropping out of the labor force by interrupting their job searches. In the past two months more than one million persons dropped out of the labor force, stopping the search for jobs because of various factors such as the end of unemployment benefits that forces them to engage in job-searching, returning to school to bridge the difficult times and so on while the US population increased by 361,000 (http://blogs.wsj.com/economics/2010/07/02/why-did-the-unemployment-rate-drop-2/ ). There were 27 million people in job stress composed of: 14.6 million unemployed (of whom long-term unemployed of 6.8 million or 45.5 percent who have been unemployed more than 27 weeks), 8.6 million working part-time because they could not find a better job, 2.6 million marginally attached to the labor force (who wanted and were available for work and had search for work in the prior 12 months) and 1.2 million discouraged workers (who believe there is no job for them or had not searched for work in the prior four weeks). The most relevant period for comparison of the current situation is not with the Great Depression much the same as pointed out by Franco Modigliani relative to a speech in 1981 in which President Reagan “began by suggesting that ‘we are in the worst economic mess since the Great Depression,’ a statement than an objective review of the situation would find highly exaggerated” (Franco Modigliani, Reagan’s economic policies: a critique. Oxford Economic Papers 40 (3), 399). Modigliani’s arguments apply currently to exaggerated statements by government officials and others comparing the current crisis to the Great Depression (Pelaez and Pelaez, Regulation of Banks and Finance, 198-217). 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 problem is that the current rates of economic growth are not repeating those in the expansion after the 1980s contraction. US GDP increased in the current expansion at the annual seasonally-adjusted percentage rate of 2.2 in QIII09, 5.6 in QIV09 and 2.7 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. The quarterly annual rate of growth of -6.4 percent in QI82 was followed a year later by 9.3 percent in QII83 while the quarterly annual rate of growth of GDP of -6.4 percent in QI09 is followed a year later by only 2.7 percent in QI10.
II Failures of Economic Policy. The fiscal stimulus of over $1 trillion, the monetary stimulus of the Fed balance sheet of $2.3 trillion with the objective of reducing long-term interest rates (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ) and zero interest rates of fed funds since Dec 2008 have failed in recovering the economy and employment. The most effective redistributive policy during recessions is job creation and strong labor markets not the use of taxation and stimulus for redistribution of income and wealth that causes job losses and weak labor markets. The uncertainty shocks of restructuring major economic activities and future increases in taxes and interest rates are frustrating growth and job creation. Alan H. Meltzer finds that the stimulus has not worked as planned, resulting in low economic growth and high unemployment (http://professional.wsj.com/article/SB10001424052748704629804575325233508651458.html?mod=WSJ_hp_mostpop_read&mg=reno-wsj ). The fact that the administration is requesting another dose of stimulus constitutes an admission of the failure of the larger stimulus provided by the American Recovery and Reinvestment Act of 2009 (ARRA). The failure of the stimulus is attributed by Meltzer to two major factors. First, the administration did not calculate carefully the costs of finding long-term solutions to problems, resulting merely in wasteful spending of taxpayer money instead of stimulating the economy. Second, uncertainty in the costs of doing business by legislative restructurings in multiple sectors created adverse expectations that frustrated investment and job creation. A case against the administration’s fiscal stimulus is provided by Jeffrey Miron (Harvard Journal of Law and Public Policy 33 (2, Spring 2010)). There are three important issues in this analysis. First, the stimulus by government spending was $787 billion provided by ARRA. Government spending may occur too late to have an impact on recovery because of the delay in implementation and the lag in effect after disbursement. Second, government spending may be less effective than private investment that takes into account the discounted or present value of benefits net of costs. Private decisions may be more effective in allocating resources to activities that increase jobs in the private sector while also promoting long-term economic prosperity and employment. Martin Feldstein analyzes a variety of tax policies: introducing an investment tax credit to stimulate business investment; increasing the R&D tax credit to prevent decline in R&D expenditures; reducing the corporate tax to levels comparable to other countries to induce job-creating investment in the US; and maintaining low tax rates on capital gains to induce increases in stock prices that could recover consumer wealth, stimulating spending that would create jobs (Martin Feldstein, Rethinking the role of fiscal policy. American Economic Review 99 (2), 556-9). Meltzer and Miron consider alternative stimulus routes such as reductions in corporate income taxes during the Kennedy-Johnson administration and the Reagan administration that eliminate the double taxation of corporate profits first as profits in the balance sheets and then again as dividends in the returns of shareholders. The resulting business investment and spending would create new jobs. The type of stimulus may be more important than the size. ARRA used stimulus in “shovel ready” public works, energy efficiency and research that has very limited and short-lived impact in job creation. Third, spending was allocated to multiple restructurings of economic activities for alleged long-term benefits, which were also rushed and not based on their benefits relative to costs. The agenda focused on the restructurings, neglecting job creation. The prolonged period of job stress in the short and medium term erases the benefits of restructuring most of the economy for alleged long-term benefits.
The Wall Street Journal provides clear and informed analysis of the US fiscal situation (http://professional.wsj.com/article/SB10001424052748703426004575338991852947182.html ). The government increased expenditures sharply to 25 percent of GDP while tax revenue declined from 18.5 percent of GDP in 2007 to 14.8 percent of GDP in 2009, remaining at nearly the same level in 2010. The strategy for adjustment of the fiscal deficit is by increasing taxes such as a trial balloon of a value added tax and perhaps a federal energy tax. Another possibility is an increase of the tax on the income, dividends and gains from capital but it is possible that general tax revenue may fail to increase because the reductions in those taxes caused an increase in tax revenue of 44 percent between 2003 and 2007. At the very best the strategy would attain a balanced budget. There is vast literature on the effects of spending and taxes. A revealing essay by Olivier Blanchard and Roberto Perotti concludes that: “we find that private investment is consistently crowded out by both government spending and, to a lesser degree, by taxation; this implies a strong negative effect on private investment of balanced-budget fiscal expansion” (Quarterly Journal of Economics 117 (4), 1363). The “balanced-budget fiscal expansion” is popularly known as “tax to spend.” The problem of the restructurings of economic activities from the private sector to the government is the frustration, or crowding out, of private investment by government investment that is not typically based on sound cost/benefit criteria. The uncertainty generated by legislative restructurings is resulting in a slower US economy that will be less efficient and internationally uncompetitive in the long term. Nearly all employment creation in the US is created by the private sector. The continuing strategy of “tax to spend” may create permanent conditions of 27 million people in job stress. The unemployment rate will decline by people dropping from the civilian labor force. There is high need of reevaluating the economic policy of the US by eliminating the crowding out of private investment in order to generate required economic growth needed for employment creation and sustained prosperity. There is a critically important role for government intervention (Pelaez and Pelaez, Government Intervention in Globalization, 1-12) but this role has to be balanced more toward the government providing the structure of services and regulation required for investment in employment creation by the private sector. Large-scale spending on infrastructure financed with taxes crowds out the private investment required for job creation that can alleviate the plight of 27 million persons who are willing to work but cannot find employment and the rapidly growing number of those that are not counted in the labor force because they desisted in finding a job.
III Financial Regulation. John B. Taylor is the author of a must-read book on how government policies caused, deepened and prolonged the credit/dollar crisis and global recession (http://www.amazon.com/John-B.-Taylor/e/B001IQZHL2/ref=sr_tc_2_0?qid=1278096179&sr=1-2-ent ). Taylor’s analysis finds that the Dodd-Frank regulation threatens growth of the economy (http://professional.wsj.com/article/SB10001424052748703426004575338732174405398.html?mod=WSJ_Opinion_LEADTop&mg=reno-wsj ). The law will reduce bank capital and financing, raising interest rates and flattening the expansion path of the economy. The Dodd-Frank bill was already approved in the House and appears that will also be approved by the Senate. The complexity of the 2319 pages of the bill is as worrisome as the multiple sections and subsections (Ibid). An important deficiency found by Taylor is the misdiagnosis of the causes of the financial crisis. The various regulatory agencies had powers to avert the crisis and prevent its deepening by controlling the alleged causes of the crisis on which the Dodd-Frank bill is supposedly based. There is no sound argument for additional powers to agencies that did not use the existing ones in preventing and resolving the crisis by acting on the causal and propagation factors alleged in the erroneous crisis analysis of the architects of the bill. The Fed has superior staff and board members who have the knowledge in the frontiers of research on systemic risk such that the creation of a new office of research on systemic risk is a waste of taxpayer money. Bailouts are not eliminated but rather institutionalized in the powers given to the FDIC to liquidate companies. In fact, the bill sanctions the “too politically important to fail,” beginning with open-ended bailouts that may eventually cost one trillion dollars for Fannie and Freddie. The bill may make unviable currently viable individual financial entities and maybe the entire financial system. Overall, the Dodd-Frank bill will make the financial system more prone to crisis. The Bureau of Consumer Financial Protection may cause the same reduction of credit lines and increase of interest rates as the CARD (Credit Card Accountability, Responsibility and Disclosure) Act of May 2009. The chair of the board of directors of a savings and loan bank in Ohio finds that the Dodd-Frank bill will cause the end of community banking by arbitrarily preventing loans to creditworthy clients (http://professional.wsj.com/article/SB10001424052748703964104575334611037072320.html?mod=wsjproe_hps_LEFTWhatsNews ). The Dodd-Frank bill will restrict the financing of innovation by entrepreneurs that has been the major driver of US economic growth and prosperity, accentuating the vulnerability of the financial system to crises. There was a set of four government policies that interacted with each other in creating excessive risk, low liquidity, short-term financing, high leverage and unsound credit: (1) near zero interest rates of fed funds in 2003-2004; (2) suspension of auctions of 30-year Treasuries in 2001-2005 to lower mortgage rates; (3) housing subsidy of $221 billion per year; and (4) 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). The Dodd-Frank bill is not based on correct analysis of the causes of the credit crisis, rendering it worthless in its intent of preventing the repetition of another financial crisis. The valid parallel of the Dodd-Frank bill is with the rush to regulation in the form of the Banking Act of 1933 (12 U.S.C. § 371a) that prohibited payment of interest on demand deposits and imposed limits on interest rates paid on time deposits issued by commercial banks. The consequence of the Banking Act of 1933 and Regulation Q was the exporting of banking from New York to London (Pelaez and Pelaez, Financial Regulation after the Global Recession, 57-8).
IV Financial Turbulence. Major stock market indexes continue to fall (http://online.wsj.com/mdc/public/page/mdc_us_stocks.html?mod=topnav_2_3010 ). This is not typical behavior of equities during expansion phases of the business cycle. The percentage performance of major US indices was: DJIA -13.6 from the recent peak on Apr 26 to Jul 2 and -4.5 in the week; S&P 500 -16.0 from the recent peak on Apr 23 and -5.0 in the week; and NYSE Financial -20.3 since Apr 15 and -6.4 in the week. The percentage performance of major world stock markets from Apr 15 to Jul 2 was: Dow Global -18.4 and -6.7 in the week; Dow Asia Pacific TSM -12.5 and -3.1 in the week; Shanghai -24.7 and -6.7 percent in the week; and STOXX Europe 50 -15.3 and -4.3 in the week. The euro strengthened, trading at $1.2560/EUR on Jul 2. The dollar has gained 20.4 percent since the recent trough relative to the euro on Nov 25, 2009, but lost 1.5 percent in the week. The DJ UBS commodity index fell 14.5 percent since the recent peak on Jan 6 and lost 3.7 percent in the week. The European Central Bank (ECB) appears to have made the transition from the non-renewal of the one-year 1 percent facility to 90-day facilities (http://professional.wsj.com/article/SB10001424052748703426004575338334107767598.html?mod=wsjproe_hps_MIDDLEThirdNews ). The three-month dollar LIBOR is virtually unchanged at 0.5336 percent and the LIBOR-OIS spread, measuring willingness to lend among banks, was also stable at 33.63 basis points, much higher than before the financial turbulence but without further deterioration. The swap spread measures the difference between the swap rate of floating for fixed-interest payments and the 2-year Treasury yield, widened slightly by 0.87 basis points to 37.25 basis points (http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=a97fGOdOIyDU ). These critical indicators of financial risk climbed to higher levels during the financial turbulence but have remained stable in the week.
V Economic Indicators. The most encouraging information is about continuing expansion in industry but with an apparent slowdown. Conditions in housing markets continue under pressure. Employment continues softer than would be expected after three quarters of GDP growth. Personal income increased by 0.4 percent in May and personal consumption expenditures (PCE) by 0.2 percent; real disposable income increased by 0.5 percent in May and real PCE by 0.3 per cent (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm ). The business barometer index of the Chicago Institute of Supply Management (ISM) stood at 59.1 in Jun relative to 59.7 in May (https://www.ism-chicago.org/chapters/ism-ismchicago/files/ISM-C%20June%202010.pdf ). The ISM purchasing managers’ index (PMI) declined from 59.7 in May to 56.2 in Jun (http://www.ism.ws/ISMReport/MfgROB.cfm ). There may be some deceleration of global demand as suggested by the PMIs of various major economies (http://www.ft.com/cms/s/0/fa81dd7c-8536-11df-9c2f-00144feabdc0.html ). New orders of manufactured goods fell by 1.4 percent in May after eight consecutive months of increases (http://www.census.gov/manufacturing/m3/prel/pdf/s-i-o.pdf ). The pending home sales index of the National Association of Realtors (NAR) dropped by 30 percent on contracts signed in May after three consecutive monthly increases as buyers took advantage of the fiscal credit expiring in April (http://www.realtor.org/press_room/news_releases/2010/07/phs_drop ). Construction spending fell in May by 0.2 percent and was down by 8 percent relative to May 2009 (http://www.census.gov/const/C30/release.pdf ). The 10-city S&P Case-Shiller index of house prices is higher by 4.6 percent in Apr 2010 relative to Apr 2009 and the 20-city by 3.8 percent relative to a year earlier. Improvements in housing markets may only occur in 2011 (http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff--p-us---- ). Initial unemployment claims in the week ending on Jun 26 increased by 13 thousand to 472 thousand from the revised prior week’s 459 thousand (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
VI Interest Rates. The US yield curve continues to shift downwardly as investors exit risk and move funds to the temporary safe haven of Treasuries, other sovereign bonds and highly-rated mortgage-backed securities and corporate debt. The 10-year Treasury yield declined to 2.98 percent on Jul 2, substantially lower than 3.11 percent a week earlier and 3.35 percent a month earlier. The 10-year German government bond traded at 2.58 percent for a negative spread of 39 basis points relative to the 10-year Treasury (http://markets.ft.com/markets/bonds.asp?ftauth=1278151076312 ).
VII Conclusion. The most important issue in the agenda of the United States is alleviating the dramatic situation of 27 million people who are unemployed or underemployed involuntarily in part-time occupations. Many more are dropping from the labor force by stopping their job searches. The fiscal stimulus of $1 trillion, the Fed balance sheet of $2.3 trillion and the zero interest rate on fed funds since Dec 2008 are failing in promoting faster economic growth that can create jobs. Policy should be reoriented toward reducing the crowding out of private investment by government spending and reduction of uncertainty in business decisions. The most effective redistributive policy with this high level of 27 million people in job stress is inducing the private sector to create jobs. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
Carlos M Pelaez
The objective of this post is to analyze the job stress in the US that is increasingly being related to failures of economic policy. Section I considers the 27 million persons in job stress; II analyzes the failures of economic policy and III financial regulation; financial turbulence is documented in IV, economic indicators in V and interest rates in VI; VII concludes.
I The 27 Million in Job Stress. Economic policy appears to be failing at least in the most important task, which is employment creation, requiring more effective policy strategy. The nonfarm payroll survey finds 125,000 job losses in Jun with a decline of temporary workers employed in the Census 2010 by 225,000 and an increase in private-sector payroll employment of 83,000 (http://www.bls.gov/news.release/pdf/empsit.pdf ). The unemployment rate of the household survey stood at 9.5 percent while the civilian labor force fell by 625,000 because people desisted from finding a job. Thus, the unemployment rate fell not because more people found jobs but as a result of 625,000 people dropping out of the labor force by interrupting their job searches. In the past two months more than one million persons dropped out of the labor force, stopping the search for jobs because of various factors such as the end of unemployment benefits that forces them to engage in job-searching, returning to school to bridge the difficult times and so on while the US population increased by 361,000 (http://blogs.wsj.com/economics/2010/07/02/why-did-the-unemployment-rate-drop-2/ ). There were 27 million people in job stress composed of: 14.6 million unemployed (of whom long-term unemployed of 6.8 million or 45.5 percent who have been unemployed more than 27 weeks), 8.6 million working part-time because they could not find a better job, 2.6 million marginally attached to the labor force (who wanted and were available for work and had search for work in the prior 12 months) and 1.2 million discouraged workers (who believe there is no job for them or had not searched for work in the prior four weeks). The most relevant period for comparison of the current situation is not with the Great Depression much the same as pointed out by Franco Modigliani relative to a speech in 1981 in which President Reagan “began by suggesting that ‘we are in the worst economic mess since the Great Depression,’ a statement than an objective review of the situation would find highly exaggerated” (Franco Modigliani, Reagan’s economic policies: a critique. Oxford Economic Papers 40 (3), 399). Modigliani’s arguments apply currently to exaggerated statements by government officials and others comparing the current crisis to the Great Depression (Pelaez and Pelaez, Regulation of Banks and Finance, 198-217). 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 problem is that the current rates of economic growth are not repeating those in the expansion after the 1980s contraction. US GDP increased in the current expansion at the annual seasonally-adjusted percentage rate of 2.2 in QIII09, 5.6 in QIV09 and 2.7 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. The quarterly annual rate of growth of -6.4 percent in QI82 was followed a year later by 9.3 percent in QII83 while the quarterly annual rate of growth of GDP of -6.4 percent in QI09 is followed a year later by only 2.7 percent in QI10.
II Failures of Economic Policy. The fiscal stimulus of over $1 trillion, the monetary stimulus of the Fed balance sheet of $2.3 trillion with the objective of reducing long-term interest rates (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ) and zero interest rates of fed funds since Dec 2008 have failed in recovering the economy and employment. The most effective redistributive policy during recessions is job creation and strong labor markets not the use of taxation and stimulus for redistribution of income and wealth that causes job losses and weak labor markets. The uncertainty shocks of restructuring major economic activities and future increases in taxes and interest rates are frustrating growth and job creation. Alan H. Meltzer finds that the stimulus has not worked as planned, resulting in low economic growth and high unemployment (http://professional.wsj.com/article/SB10001424052748704629804575325233508651458.html?mod=WSJ_hp_mostpop_read&mg=reno-wsj ). The fact that the administration is requesting another dose of stimulus constitutes an admission of the failure of the larger stimulus provided by the American Recovery and Reinvestment Act of 2009 (ARRA). The failure of the stimulus is attributed by Meltzer to two major factors. First, the administration did not calculate carefully the costs of finding long-term solutions to problems, resulting merely in wasteful spending of taxpayer money instead of stimulating the economy. Second, uncertainty in the costs of doing business by legislative restructurings in multiple sectors created adverse expectations that frustrated investment and job creation. A case against the administration’s fiscal stimulus is provided by Jeffrey Miron (Harvard Journal of Law and Public Policy 33 (2, Spring 2010)). There are three important issues in this analysis. First, the stimulus by government spending was $787 billion provided by ARRA. Government spending may occur too late to have an impact on recovery because of the delay in implementation and the lag in effect after disbursement. Second, government spending may be less effective than private investment that takes into account the discounted or present value of benefits net of costs. Private decisions may be more effective in allocating resources to activities that increase jobs in the private sector while also promoting long-term economic prosperity and employment. Martin Feldstein analyzes a variety of tax policies: introducing an investment tax credit to stimulate business investment; increasing the R&D tax credit to prevent decline in R&D expenditures; reducing the corporate tax to levels comparable to other countries to induce job-creating investment in the US; and maintaining low tax rates on capital gains to induce increases in stock prices that could recover consumer wealth, stimulating spending that would create jobs (Martin Feldstein, Rethinking the role of fiscal policy. American Economic Review 99 (2), 556-9). Meltzer and Miron consider alternative stimulus routes such as reductions in corporate income taxes during the Kennedy-Johnson administration and the Reagan administration that eliminate the double taxation of corporate profits first as profits in the balance sheets and then again as dividends in the returns of shareholders. The resulting business investment and spending would create new jobs. The type of stimulus may be more important than the size. ARRA used stimulus in “shovel ready” public works, energy efficiency and research that has very limited and short-lived impact in job creation. Third, spending was allocated to multiple restructurings of economic activities for alleged long-term benefits, which were also rushed and not based on their benefits relative to costs. The agenda focused on the restructurings, neglecting job creation. The prolonged period of job stress in the short and medium term erases the benefits of restructuring most of the economy for alleged long-term benefits.
The Wall Street Journal provides clear and informed analysis of the US fiscal situation (http://professional.wsj.com/article/SB10001424052748703426004575338991852947182.html ). The government increased expenditures sharply to 25 percent of GDP while tax revenue declined from 18.5 percent of GDP in 2007 to 14.8 percent of GDP in 2009, remaining at nearly the same level in 2010. The strategy for adjustment of the fiscal deficit is by increasing taxes such as a trial balloon of a value added tax and perhaps a federal energy tax. Another possibility is an increase of the tax on the income, dividends and gains from capital but it is possible that general tax revenue may fail to increase because the reductions in those taxes caused an increase in tax revenue of 44 percent between 2003 and 2007. At the very best the strategy would attain a balanced budget. There is vast literature on the effects of spending and taxes. A revealing essay by Olivier Blanchard and Roberto Perotti concludes that: “we find that private investment is consistently crowded out by both government spending and, to a lesser degree, by taxation; this implies a strong negative effect on private investment of balanced-budget fiscal expansion” (Quarterly Journal of Economics 117 (4), 1363). The “balanced-budget fiscal expansion” is popularly known as “tax to spend.” The problem of the restructurings of economic activities from the private sector to the government is the frustration, or crowding out, of private investment by government investment that is not typically based on sound cost/benefit criteria. The uncertainty generated by legislative restructurings is resulting in a slower US economy that will be less efficient and internationally uncompetitive in the long term. Nearly all employment creation in the US is created by the private sector. The continuing strategy of “tax to spend” may create permanent conditions of 27 million people in job stress. The unemployment rate will decline by people dropping from the civilian labor force. There is high need of reevaluating the economic policy of the US by eliminating the crowding out of private investment in order to generate required economic growth needed for employment creation and sustained prosperity. There is a critically important role for government intervention (Pelaez and Pelaez, Government Intervention in Globalization, 1-12) but this role has to be balanced more toward the government providing the structure of services and regulation required for investment in employment creation by the private sector. Large-scale spending on infrastructure financed with taxes crowds out the private investment required for job creation that can alleviate the plight of 27 million persons who are willing to work but cannot find employment and the rapidly growing number of those that are not counted in the labor force because they desisted in finding a job.
III Financial Regulation. John B. Taylor is the author of a must-read book on how government policies caused, deepened and prolonged the credit/dollar crisis and global recession (http://www.amazon.com/John-B.-Taylor/e/B001IQZHL2/ref=sr_tc_2_0?qid=1278096179&sr=1-2-ent ). Taylor’s analysis finds that the Dodd-Frank regulation threatens growth of the economy (http://professional.wsj.com/article/SB10001424052748703426004575338732174405398.html?mod=WSJ_Opinion_LEADTop&mg=reno-wsj ). The law will reduce bank capital and financing, raising interest rates and flattening the expansion path of the economy. The Dodd-Frank bill was already approved in the House and appears that will also be approved by the Senate. The complexity of the 2319 pages of the bill is as worrisome as the multiple sections and subsections (Ibid). An important deficiency found by Taylor is the misdiagnosis of the causes of the financial crisis. The various regulatory agencies had powers to avert the crisis and prevent its deepening by controlling the alleged causes of the crisis on which the Dodd-Frank bill is supposedly based. There is no sound argument for additional powers to agencies that did not use the existing ones in preventing and resolving the crisis by acting on the causal and propagation factors alleged in the erroneous crisis analysis of the architects of the bill. The Fed has superior staff and board members who have the knowledge in the frontiers of research on systemic risk such that the creation of a new office of research on systemic risk is a waste of taxpayer money. Bailouts are not eliminated but rather institutionalized in the powers given to the FDIC to liquidate companies. In fact, the bill sanctions the “too politically important to fail,” beginning with open-ended bailouts that may eventually cost one trillion dollars for Fannie and Freddie. The bill may make unviable currently viable individual financial entities and maybe the entire financial system. Overall, the Dodd-Frank bill will make the financial system more prone to crisis. The Bureau of Consumer Financial Protection may cause the same reduction of credit lines and increase of interest rates as the CARD (Credit Card Accountability, Responsibility and Disclosure) Act of May 2009. The chair of the board of directors of a savings and loan bank in Ohio finds that the Dodd-Frank bill will cause the end of community banking by arbitrarily preventing loans to creditworthy clients (http://professional.wsj.com/article/SB10001424052748703964104575334611037072320.html?mod=wsjproe_hps_LEFTWhatsNews ). The Dodd-Frank bill will restrict the financing of innovation by entrepreneurs that has been the major driver of US economic growth and prosperity, accentuating the vulnerability of the financial system to crises. There was a set of four government policies that interacted with each other in creating excessive risk, low liquidity, short-term financing, high leverage and unsound credit: (1) near zero interest rates of fed funds in 2003-2004; (2) suspension of auctions of 30-year Treasuries in 2001-2005 to lower mortgage rates; (3) housing subsidy of $221 billion per year; and (4) 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). The Dodd-Frank bill is not based on correct analysis of the causes of the credit crisis, rendering it worthless in its intent of preventing the repetition of another financial crisis. The valid parallel of the Dodd-Frank bill is with the rush to regulation in the form of the Banking Act of 1933 (12 U.S.C. § 371a) that prohibited payment of interest on demand deposits and imposed limits on interest rates paid on time deposits issued by commercial banks. The consequence of the Banking Act of 1933 and Regulation Q was the exporting of banking from New York to London (Pelaez and Pelaez, Financial Regulation after the Global Recession, 57-8).
IV Financial Turbulence. Major stock market indexes continue to fall (http://online.wsj.com/mdc/public/page/mdc_us_stocks.html?mod=topnav_2_3010 ). This is not typical behavior of equities during expansion phases of the business cycle. The percentage performance of major US indices was: DJIA -13.6 from the recent peak on Apr 26 to Jul 2 and -4.5 in the week; S&P 500 -16.0 from the recent peak on Apr 23 and -5.0 in the week; and NYSE Financial -20.3 since Apr 15 and -6.4 in the week. The percentage performance of major world stock markets from Apr 15 to Jul 2 was: Dow Global -18.4 and -6.7 in the week; Dow Asia Pacific TSM -12.5 and -3.1 in the week; Shanghai -24.7 and -6.7 percent in the week; and STOXX Europe 50 -15.3 and -4.3 in the week. The euro strengthened, trading at $1.2560/EUR on Jul 2. The dollar has gained 20.4 percent since the recent trough relative to the euro on Nov 25, 2009, but lost 1.5 percent in the week. The DJ UBS commodity index fell 14.5 percent since the recent peak on Jan 6 and lost 3.7 percent in the week. The European Central Bank (ECB) appears to have made the transition from the non-renewal of the one-year 1 percent facility to 90-day facilities (http://professional.wsj.com/article/SB10001424052748703426004575338334107767598.html?mod=wsjproe_hps_MIDDLEThirdNews ). The three-month dollar LIBOR is virtually unchanged at 0.5336 percent and the LIBOR-OIS spread, measuring willingness to lend among banks, was also stable at 33.63 basis points, much higher than before the financial turbulence but without further deterioration. The swap spread measures the difference between the swap rate of floating for fixed-interest payments and the 2-year Treasury yield, widened slightly by 0.87 basis points to 37.25 basis points (http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=a97fGOdOIyDU ). These critical indicators of financial risk climbed to higher levels during the financial turbulence but have remained stable in the week.
V Economic Indicators. The most encouraging information is about continuing expansion in industry but with an apparent slowdown. Conditions in housing markets continue under pressure. Employment continues softer than would be expected after three quarters of GDP growth. Personal income increased by 0.4 percent in May and personal consumption expenditures (PCE) by 0.2 percent; real disposable income increased by 0.5 percent in May and real PCE by 0.3 per cent (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm ). The business barometer index of the Chicago Institute of Supply Management (ISM) stood at 59.1 in Jun relative to 59.7 in May (https://www.ism-chicago.org/chapters/ism-ismchicago/files/ISM-C%20June%202010.pdf ). The ISM purchasing managers’ index (PMI) declined from 59.7 in May to 56.2 in Jun (http://www.ism.ws/ISMReport/MfgROB.cfm ). There may be some deceleration of global demand as suggested by the PMIs of various major economies (http://www.ft.com/cms/s/0/fa81dd7c-8536-11df-9c2f-00144feabdc0.html ). New orders of manufactured goods fell by 1.4 percent in May after eight consecutive months of increases (http://www.census.gov/manufacturing/m3/prel/pdf/s-i-o.pdf ). The pending home sales index of the National Association of Realtors (NAR) dropped by 30 percent on contracts signed in May after three consecutive monthly increases as buyers took advantage of the fiscal credit expiring in April (http://www.realtor.org/press_room/news_releases/2010/07/phs_drop ). Construction spending fell in May by 0.2 percent and was down by 8 percent relative to May 2009 (http://www.census.gov/const/C30/release.pdf ). The 10-city S&P Case-Shiller index of house prices is higher by 4.6 percent in Apr 2010 relative to Apr 2009 and the 20-city by 3.8 percent relative to a year earlier. Improvements in housing markets may only occur in 2011 (http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff--p-us---- ). Initial unemployment claims in the week ending on Jun 26 increased by 13 thousand to 472 thousand from the revised prior week’s 459 thousand (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
VI Interest Rates. The US yield curve continues to shift downwardly as investors exit risk and move funds to the temporary safe haven of Treasuries, other sovereign bonds and highly-rated mortgage-backed securities and corporate debt. The 10-year Treasury yield declined to 2.98 percent on Jul 2, substantially lower than 3.11 percent a week earlier and 3.35 percent a month earlier. The 10-year German government bond traded at 2.58 percent for a negative spread of 39 basis points relative to the 10-year Treasury (http://markets.ft.com/markets/bonds.asp?ftauth=1278151076312 ).
VII Conclusion. The most important issue in the agenda of the United States is alleviating the dramatic situation of 27 million people who are unemployed or underemployed involuntarily in part-time occupations. Many more are dropping from the labor force by stopping their job searches. The fiscal stimulus of $1 trillion, the Fed balance sheet of $2.3 trillion and the zero interest rate on fed funds since Dec 2008 are failing in promoting faster economic growth that can create jobs. Policy should be reoriented toward reducing the crowding out of private investment by government spending and reduction of uncertainty in business decisions. The most effective redistributive policy with this high level of 27 million people in job stress is inducing the private sector to create jobs. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
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