Sunday, August 29, 2010

Repeating the New Deal, Inhibited Growth and Job Creation, Limitations of Monetary Policy and Financial Turbulence

Repeating the New Deal, Inhibited Growth and Job Creation, Limitations of Monetary Policy and Financial Turbulence

Carlos M. Pelaez

This post considers in (I) slower economic growth and job creation, repeating the New Deal in (II), inhibited growth and job creation in (III), limitations of monetary policy in (IV), financial turbulence in (V), interest rates in (VI) and brief conclusions in (VII). If you have difficulty in viewing the tables and illustrations go to: http://cmpassocregulationblog.blogspot.com/

I Slower Economic Growth and Job Creation. An accurate description of job stress in the US economy is provided by Fed Chairman Bernanke: “private-sector employment has grown only sluggishly, the small decline in the unemployment rate is attributable more to reduced labor force participation than to job creation, and initial claims for unemployment insurance remain high. Firms are reluctant to add permanent employees, citing slow growth of sales and elevated economic and regulatory uncertainty. In lieu of adding permanent workers some firms have increased labor input by increasing workweeks, offering full-time work to part-time workers, and making extensive use of temporary workers” (http://www.federalreserve.gov/newsevents/speech/bernanke20100827a.htm ). The “elevated economic and regulatory uncertainty” is paralyzing spending, investment and hiring decisions. Short-term economic indicators continue to disappoint. Initial seasonally adjusted (SA) jobless claims were 473,000 in the week ending Aug 21, declining by 31,000 relative to the prior week’s upwardly revised 504,000. Non-seasonally adjusted (NSA) initial claims fell by 23,613 to 380,935 in the week ending on Aug 21 from 404,548 in the prior week (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). Initial jobless claims stabilized at high levels in 2010 after declining through most of 2009. The index of existing-home sales of the National Association of Realtors fell 27.2 percent to an annual SA rate of 3.83 million units in Jul from the revised 5.14 million in Jun and 25.5 percent lower than 5.14 million in Jul 2009. Existing-home sales are the lowest since the index was started in 1999 and single-family sales are the lowest since May 1995 (http://www.realtor.org/press_room/news_releases/2010/08/ehs_fall ). In Jul 2010, sales of new homes in the US were at the SA annual rate of 276 thousand, 12.4 percent below the revised Jun rate of 315 thousand and 32.4 percent below the Jul 2009 rate of 408 thousand (http://www.census.gov/const/newressales_201007.pdf ). New house sales in Jan-July 2005 NSA were 801 thousand (http://www.census.gov/const/newressales_200507.pdf ) compared with 207 thousand NSA in Jan-Jul 2010 for a decline of 74.2 percent. New orders of manufactured durable goods rose by 0.3 percent in Jul after dropping 0.1 percent in Jun and 0.7 percent in May. Orders excluding transportation fell 3.8 percent and rose by 0.3 percent excluding defense (http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf ).

Growth in the expansion phase of the credit/dollar crisis and global recession is subpar relative to recoveries from past economic contractions. The proper comparison is with the similar contraction in 1981-1982 following another recession in 1979-1980, as shown in Table 1. In the first year of recovery in 1983, GDP grew at the SA annual equivalent rate of 5.1 percent in 1Q83 and then at rates of 9.3 percent, 8.1 percent and 8.5 percent in the three following quarters. After four quarters of growth beginning in 3Q09, GDP was revised to growth of 1.6 percent in 2Q10 with still weak demand (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&FirstYear=2009&LastYear=2010&Freq=Qtr ). The subpar rate of growth of the US economy in the current expansion phase perpetuates extremely high levels of unemployment and underemployment. The major cause of subpar growth is the combination of massive fiscal and monetary stimulus with radical changes in business models by legislative restructurings, regulatory shocks, mandates and expectations of taxation and higher interest rates because of a jump in government spending to 24.7 percent of GDP, which is a historical high after World War II.

Table 1, Quarterly Growth Rates of GDP, % Annual Equivalent SA

Quarter

1981

1982

1983

2008

2009

2010

I

8.6

-6.4

5.1

-0.7

-4.9

3.7

II

-3.2

2.2

9.3

0.6

-0.7

1.6

III

4.9

-1.5

8.1

-4.0

1.6

 

IV

-4.9

0.3

8.5

-6.8

5.0

 

Source: http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=1&Freq=Qtr&FirstYear=2008&LastYear=2010

II Repeating the New Deal. An interpretation of the New Deal is that fiscal stimulus must be massive in recovering growth and employment and that it should not be withdrawn prematurely to avoid a sharp second contraction as it occurred in 1937 (Christina Romer http://www.whitehouse.gov/assets/documents/Testimony_of_Christina_D.pdf ). Proposals for another higher dose of stimulus explain the current weakness by insufficient fiscal expansion and warn that failure to spend more can cause another contraction as in 1937. According to a different interpretation, private hours worked declined by 25 percent by 1939 compared with the level in 1929, suggesting that the economy fell to a lower path of expansion than in 1929 (works by Harold Cole and Lee Ohanian cited in Pelaez and Pelaez, Regulation of Banks and Finance, 215-7). Major real variables of output and employment were below trend by 1939: -26.8 percent for GNP, -25.4 percent for consumption, -51 percent for investment and -25.6 percent for hours worked. Surprisingly, total factor productivity increased by 3.1 percent and real wages by 21.8 percent (Ibid). The policies of the Roosevelt administration encouraged increasing unionization to maintain high wages with lower hours worked and high prices by lax enforcement of antitrust law to encourage cartels or collusive agreements among producers. The encouragement by the government of labor bargaining by unions and higher prices by collusion depressed output and employment throughout the 1930s until Roosevelt abandoned the policies during World War II after which the economy recovered full employment (Ibid). The fortunate ones who worked during the New Deal received higher real wages at the expense of many who never worked again. In a way, the administration behaved like the father of the unionized workers and the uncle of the collusive rich, neglecting the majority in the middle. Inflation-adjusted GDP increased by 10.8 percent in 1934, 8.9 percent in 1935, 13.0 percent in 1936 but only 5.1percent in 1937, contracting by -3.4 percent in 1938 (US Bureau of Economic Analysis cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 151, Globalization and the State, Vol. II, 206). The competing explanation is that the economy did not decline from 1937 to 1938 because of lower government spending in 1937 but rather because of the expansion of unions promoted by the New Deal and increases in tax rates (Thomas Cooley and Lee Ohanian http://professional.wsj.com/article/SB10001424052748703461504575443402028756986.html?mod=wsjproe_hps_MIDDLEFifthNews ). Government spending adjusted for inflation fell only 0.7 percent in 1936 and 1937 and could not explain the decline of GDP by 3.4 percent in 1938. In 1936, the administration imposed a tax on retained profits not distributed to shareholders according to a sliding scale of 7 percent for retaining 1 percent of total net income up to 27 percent for retaining 70 percent of total net income, increasing costs of investment that were mostly financed in that period with retained earnings (Ibid). The tax rate on dividends jumped from 10.1 percent in 1929 to 15.9 percent in 1932 and doubled by 1936. A recent study finds that “tax rates on dividends rose dramatically during the 1930s and imply significant declines in investment and equity values and nontrivial declines in GDP and hours of work” (Ellen McGrattan http://www.minneapolisfed.org/research/wp/wp670.pdf ), explaining a significant part of the decline of 26 percent in business fixed investment in 1937-1938. The National Labor Relations Act of 1935 caused an increase in union membership from 12 percent in 1934 to 25 percent in 1938. The alternative lesson from the 1930s is that capital income taxes and higher unionization caused increases in business costs that perpetuated job losses of the recession with current risks of repeating the 1930s (Cooley and Ohanian, op. cit.).

III Inhibited Growth and Job Creation. A case for draconian regulation of financial institutions and highest capital requirements, or regulatory view, is made by Sheila Bair, Chair of the Federal Deposit and Insurance Corporation (FDIC), by means of three arguments (http://www.ft.com/cms/s/0/a1dfbd02-aee8-11df-8e45-00144feabdc0.html ): (1) debt by leverage may be less expensive than equity capital but in comparison with a “properly” regulated world, debt holders would require a risk premium for eventual bank defaults; (2) the social costs of inadequate regulation and bank capital are measured by the waste of resources in housing, unemployment of humans and idle productive capacity instead of economic wellbeing that would have been promoted by allocating them to progress-creating energy, infrastructure and industry; and (3) financial reform must align the incentives for sound allocation and internalizing in banks the costs of leverage and risk-taking. The leitmotiv of this view is that bankers acting on their self-interest engage in excessive risk taking to obtain ever increasing profits that reward them with prodigal remuneration at the expense of their shareholders and society.

The argument of the regulatory view misses the critical role of policy in creating the credit/dollar crisis and global recession. The misallocation of resources and loss of employment was primarily caused by monetary policy jointly with housing policy considered in turn (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 interest rates to 1 percent between Jun 2003 and Jun 2004 with the objective of preventing deflation while simultaneously Treasury suspended the issue of 30-year Treasuries with the objective of increasing purchases of 30-year mortgage-backed securities to lower yields and stimulate housing. Policy is not very different currently except in much higher dimensions with the fed funds rate at 0 to 0.25 percent and a Fed portfolio of $1.98 trillion of long-term securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). Monetary policy created problems instead of reckless management of financial institutions as alleged by the regulatory view. The zero interest rates and the effort to reduce long-term interest rates created the impression that financial assets would never decline in value, encouraging high leverage, low liquidity, excessive risk and careless credit decisions. The wording of the Federal Open Market Committee (FMOC) “forward guidance” created the illusion of near-zero interest rates forever such that the Fed would prevent losses in financial exposures similar to a put option, or floor, on asset values written by the Fed. In fact, as it happens currently, Fed policy intended to encourage risk and spending to pump the economy by creating the illusion that brakes would not be applied indefinitely. Second, the near-zero interest rates and suspension of the issue of 30-year Treasuries merely magnified the effects of a yearly subsidy of housing measured in 2006 at $221 billion, policy of affordable housing, capital by Fannie and Freddie of $900 per $200,000 mortgage (Edward J. Pinto, The Future of Housing Finance, WSJ, Aug 17, 09 http://professional.wsj.com/article/SB10001424052748704407804575425231311880538.html) and acquisition or guarantee by Fannie and Freddie of $1.6 trillion of nonprime mortgages. Fannie and Freddie were under lax oversight by tax-creating political institutions compared with oversight by boards and internal controls of for-profit financial institutions. The audit, oversight and regulation of Fannie and Freddie was dominated by politics, creating the “too politically important to fail,” resulting in expensive bailouts paid with taxpayer funds. The regulatory view alleges that governance of financial institutions failed because of taking advantage in bailouts by the “too big to fail” doctrine. The fact is that investment banks failed and large commercial banks were restructured or sold, smaller banks were liquidated, TARP was imposed on banks that did not need capital, large private financial institutions repaid bailout capital with high interest, management of all levels in financial institutions lost large parts and some all of their net worth in holdings of stock in the companies where they worked and preservation of capital was a critical effort in private financial institutions but disregarded in Fannie and Freddie.

The proposal of the regulatory view is to strengthen Basel III capital requirements with: (1) elimination of hybrid instruments allegedly confusing debt and equity in counting Tier 1 capital; (2) capital buffers to prevent lending declines during crises; (3) higher capital charges on riskier derivatives and trading; and (4) an international leverage ratio (Bair op.cit.). The regulatory view chooses benign measurements of the impact of capital requirements on borrowing costs of financial institutions and global economic growth. Technical, timely, suggestive and pioneering works on measuring this impact encounter the difficulty in simulating the effects of policy because economic agents, such as borrowers and lenders, adjust their preferences in response to anticipation of policies while the models assume immutable preferences (works by Robert Lucas, Finn Kyndland and Edward Prescott cited in Pelaez and Pelaez, Regulation of Banks and Finance, 112-6). It is revealing to focus on specific segments of financial business, which is difficult because regulatory rules based on the Dodd-Frank bill are still not known. An important regulation already implemented is the Credit Card Accountability, Responsibility and Disclosure Act of 2009 (CARD) (http://www.whitehouse.gov/the_press_office/Fact-Sheet-Reforms-to-Protect-American-Credit-Card-Holders ). CARD was signed into law on May 22, 2009, and entered into effect on February 22, 2010. CARD harmed the credit card industry and its users who are nearly everybody. The WSJ quotes the Nilson Report (http://www.nilsonreport.com/ ) that credit card loans outstanding fell by 10 percent in 2009 to $772.2 billion (http://professional.wsj.com/article/SB10001424052748704094704575443402132987676.html?mod=wsjproe_hps_MIDDLEFifthNews ). An independent consultant estimates that regulation will reduce revenues of the credit card companies by $11 billion in the next five years but higher interest charges and fees will recover only 25 percent of that loss (Ibid). Credit card companies had nine months to lower credit volumes and increase interest rates. CARD caused what economists could call “Pareto harm,” as opposed to “Pareto improvement,” in that most users lost by higher interest rates and reduced credit limits in credit cards but no consumer gained except in costly fake transparency rules. In a vote along partisan lines, the Securities and Exchange Commission (SEC) changed proxy access rules to replace corporate directors to ease the capacity of groups of shareholders in changing the composition of corporate boards for their interests but not necessarily those of all shareholders and the economy. The measure could benefit actions by trade-union militants, advocates of shareholder rights, trial attorneys and government, as analyzed by a former SEC commissioner (http://professional.wsj.com/article/SB20001424052748703632304575451343422958522.html ). These firm and industry level regulatory shocks actually increase premiums required by investors, reducing capital in key segments of economic activity and spreading the uncertainty originating in the restructuring of the entire economy that frustrates current operating business models during an incipient recovery with high unemployment.

An interpretation of the Great Depression is that “in 1929, the collapse and extreme volatility of stock prices led consumers and firms to simply stop spending” (Romer, op. cit, 2). Investment and spending decisions by households and business have paused in 2010 because of inopportune legislative and regulatory shocks that have created “elevated” uncertainty about decisions in business models. A simple calculation of the fiscal projection for the next ten years by comparing the actual departing dates for 2009 relative to 2008 finds an increase in government spending of $4.4 trillion (http://professional.wsj.com/article/SB10001424052748704476104575439543402718272.html?mod=WSJ_hpp_RIGHTTopCarousel_3 ). The government spending curve was tilted upwardly. Forecast deficits keep on rising after every revision because of the uncertainty of future revenue depending on economic growth that is decelerating. There is doubt if the deficits will again be below one trillion dollars. Income and costs of business and households become uncertain because of the expectation of massive increases in taxes and abrupt reduction of expenditures in a debt crisis that can cause another economic contraction. The combined pressure of the deficit, the eventual unwinding of two trillion dollars of long-term securities held by the Fed and deep restructuring of business models inhibit growth and perpetuate 27 million persons unemployed, underemployed, marginally attached to the labor force or discouraged that they can find a job.

IV Limitations of Monetary Policy. In one of the most watched and expected speeches, Fed Chairman Bernanke outlined the available policies should the economy worsen significantly: “(1) conducting additional purchases of long-term securities, (2) modifying the Committee’s communication, and (3) reducing the interest paid on excess reserves” (http://www.federalreserve.gov/newsevents/speech/bernanke20100827a.htm ). These policies are discussed briefly in turn. Chairman Bernanke identified two difficulties in further easing by purchases of long-term securities: (1) the difficulty in quantifying or “calibrating” the purchases of securities and their structure because of lack of past experience and knowledge on the impact of the Fed’s portfolio on financial markets and the economy; and (2) the risks of unwinding of the portfolio even with the design and tests of exit instruments. Alan Blinder, who served as Vice Chairman of the Board of the Fed, provides perceptive analysis of the Fed’s options in an article for the WSJ (http://professional.wsj.com/article/SB10001424052748703846604575448022122679194.html?mod=wsjproe_hps_TopMoreNews

). The initial objective of long-term purchases of mortgage-backed securities was to lower their risk spread relative to Treasuries, which Blinder finds to have been highly successful in promoting stability in mortgage financing and thus in recovering the economy. A doubt on this success is that the survey of weekly mortgage applications of the Mortgage Bankers Association registers an increase in the refinancing index of 5.7 percent relative to the earlier week while the purchase index rose by only 0.6 percent. The unadjusted purchase index dropped 1.1 percent from the previous week and 38.8 percent from the same week a year earlier (http://www.mortgagebankers.org/NewsandMedia/PressCenter/73783.htm ). Lower mortgage rates, even if entirely attributed to Fed policy, have not resulted in increasing house purchases perhaps because of the “elevated” economic/regulatory uncertainty. There may be an effect of higher after-mortgage income of households because of refinancing that could improve consumption but weak labor markets and uncertainty about legislative restructurings and increases in taxes and interest rates may channel funds into precautionary savings instead of consumption. The new policy of reinvesting maturing securities in the Fed portfolio in long-term Treasuries acts to flatten the yield curve of Treasuries and may be harmful because of the already low yield of bonds in general. It may be added that lowering yields of high-duration securities creates major risks of capital losses in bond portfolios as discussed in the following section on financial turbulence. What securities will the Fed buy and what will the impact be on financial markets and the economy? Can the Fed manage effectively and with desired impact a diversified portfolio of asset-backed securities on corporate loans, credit-card receivables, auto loans and the like? Should the Fed interfere with the determination of risk spreads among asset classes? Changing the wording of the FOMC guidance on low rates may not help much because the statement and policy can change according to the unpredictable economic/financial environment. If economists and the Fed could predict accurately six months ahead, there would not be uncertainty, which is not the case in reality. Lowering the interest rates on bank reserves deposited at the Fed from the current 25 basis points to zero is not likely to have significant effects. Innovation in policy tools and analysis is indispensable but there may be limits as to what can be done in practice when interest rates are at the “zero bound” (http://www.federalreserve.gov/boarddocs/speeches/2004/200401033/default.htm ). The insistence on zero interest rates and forward guidance could merely repeat the distortion of risk/return decisions by business, household and government as in the earlier episode in 2003.

V Financial Turbulence. Financial turbulence continued in the week of Aug 27. Most major stock indexes shown in Table 2 lost value in the week with the low magnitudes masking significant fluctuations in thin markets partly because of vacations before the end of the summer in Europe and the US. Commodities fluctuated with a small gain in the week and oil moved toward the level of $75/barrel.

Table 2, Stocks, Commodities, Dollar and 10-Year Treasury

 

Peak

Trough

% Trough

% 8/27

Week 8/27

DJIA

26-Apr

2-Jul

-13.6

-9.4

-0.6

S&P 500

23-Apr

2-Jul

-16

-12.5

-0.7

NYSE Financial

15-Apr

2-Jul

-20.3

-16.3

-0.4

Dow Global

15-Apr

2-Jul

-18.4

-14.1

-1.0

Asia Pacific

15-Apr

2-Jul

-12.5

-8.5

-1.2

Shanghai

15-Apr

2-Jul

-24.7

-17.5

-1.2

Europe STOXX

15-Apr

2-Jul

-15.3

-9.7

-0.5

Dollar

25-Nov

25-Jun

22.3

18.5

-0.5

DJ USB Com

6-Jan

2-Jul

-14.5

-9.3

0.2

10 Year T

5-Apr

27-Aug

3.986

2.647

 

Source: http://online.wsj.com/mdc/page/marketsdata.html

The 10-year Treasury maturing in 08/2020 with coupon of 2.63 was priced on Aug 27 at a yield of 2.647 percent or equivalently at a price of 99.78 (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-270810 ). Bonds are trading at extremely low yields, raising concerns in a WSJ article by Jeremy Siegel and Jeremy Schwartz (http://professional.wsj.com/article/SB10001424052748704407804575425384002846058.html) If yields of the 10-year Treasury were to increase to 3.98 percent, the actual recent peak on Apr 5, the price for settlement on Monday Aug 30, 2010, would be 88.976, for a capital loss of 10.8 percent, reflecting the risk that Siegel and Schwartz label as “the great American bond bubble.” Increasing the existing Fed portfolio of long-term Treasuries could further lower yields, creating the possibility of a duration trap of major capital losses in bond portfolios that raises doubts on the painless exit from quantitative easing, which is merely a new term for printing money to buy long-term bonds. The Fed may have placed itself in a tough policy corner, failing to reignite mortgage purchases while creating exposure to major disorderly increases in all interest rates. To be sure, Treasury yields are not likely to backup immediately from 3.647 percent to 3.98 percent but jumps are quite likely as bond portfolio managers unload duration and leverage with fire-sale effects throughout all bond segments.

VI Interest Rates. The US yield curve shifted upward for the first time in weeks. The 10-year US Treasury traded at 2.65 percent on Aug 20, which was higher than 2.62 percent a week before but still much lower than 3 percent a month earlier. The 10-year government bond of Germany traded at 2.21 percent, for a high negative spread of 44 basis points relative to the US 10-year Treasury (http://markets.ft.com/markets/bonds.asp?ftauth=1283005655785 ). On Apr 4, the 10-year German government bond traded at a yield of 3 percent (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-040810 ). The price of the 10-year Treasury at the yield of 3.00 percent a month ago for settlement on Aug 30 would be 96.831, which would result in a capital loss of 3 percent relative to the price of 99.78 on Aug 27, causing an absurd loss with leverage of 10:1 common in Treasuries.

VII Conclusion. The joint massive fiscal/monetary stimulus and legislative restructurings and regulatory shocks have inhibited economic growth and job creation. The economy is slowing while 27 million people are unemployed or underemployed and declines in the jobless rate are mainly accounting exit of people from the labor force. Policy must be shifted to recover confidence that can reignite domestic demand by investment and consumption. (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)

http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )

Sunday, August 22, 2010

Flattening Economic Growth and Weakening Job Creation

 

Flattening Growth and Weakening Job Creation

Carlos M. Pelaez

The post documents in (I) flattening economic growth and in (II) weakening job creation. The causes of flattening growth/employment creation are analyzed in (III). Financial turbulence is discussed in (IV). Interest rates are covered in (V) and (VI) concludes. If you have difficulty in viewing the tables and illustrations go to: http://cmpassocregulationblog.blogspot.com/

I Flattening Growth. Short-term economic indicators continue to suggest deceleration of economic growth. Real estate and industry are considered in this section and employment in the following section. First, an important symptom of flattening growth is the continuing stress in construction and real estate markets, which has been erroneously blamed solely on reckless lending by financial institutions to camouflage the major role of government policy and justify draconian regulation. In Jan 2006, housing starts in the US were at an annual seasonally-adjusted (SA) rate of 2265 thousand (http://www.census.gov/const/newresconst_200701.pdf ). In Jul 2010, housing starts were at an annual SA rate of 546 thousand, higher by 1.7 percent above the Jun revised estimate of 537 thousand but 7.0 percent below the Jul 2009 rate of 587 thousand and 75.9 percent below the level of 2265 thousand in Jan 2006. Building permits for privately-owned housing units were at an annual SA rate of 565 thousand, which is 3.1 percent below the revised Jun rate of 583 thousand and 3.7 percent below the Jul 2009 estimate of 587 thousand (http://www.census.gov/const/newresconst.pdf ). The causes of the housing debacle began in the 1990s (Edward J. Pinto, The Future of Housing Finance, WSJ, Aug 17, 09 http://professional.wsj.com/article/SB10001424052748704407804575425231311880538.html ). The GSE Act of 1992 and HUD’s National Homeownership Strategy led to lax standards in national mortgage underwriting. While in 1990 only one in 200 government-insured loans to buy houses had down payments less than or equal to 3 percent, in 2006 about 30 percent of all home buyers had no down payments. Fannie and Freddie required only $900 of capital in backing a $200,000 mortgage (Ibid). An important cause of the real estate collapse and the recession was a yearly housing subsidy estimated in 2006 at $221 billion, composed of $37.9 billion in government spending for low-income housing, $156.5 billion in federal tax housing expenditures and $26.7 billion in credit subsidies for Fannie, Freddie and the Veteran’s administration (Dwight Jaffee and John Quigley cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 42-8, Regulation of Banks and Finance, 79-80). The housing subsidy was magnified by monetary policy that suspended the auctions of 30-year Treasuries to lower mortgage rates and fixed fed funds rates of 1 percent in 2003-2004 that encouraged financing of everything with short-dated funds, including adjustable rate mortgages (ARMS) to NINJA (no income, no job and no assets) borrowers (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). Housing and Fed monetary policies wrote an illusory, deceiving put option on house prices paid by taxpayers: if house prices collapsed below the mortgage debt, as they did, because of over construction, tax-payer funds would be used for bailing out Fannie, Freddie, mortgage banks, NINJA debtors and whatever failed. Three avenues for change of Fannie and Freddie would be: (1) return to shareholders of the retained portfolio of assets and relocation of Fannie and Freddie to another government agency; (2) maintenance of the Fannie and Freddie model but with stronger regulation to prevent unsound balance sheets and systemic risk; and (3) issue of covered bonds by the originating financial entities to promote sound mortgage origination (Dwight Jaffee cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 47-8). A minimum agenda of reform would be to eliminate the subsidy on housing and to explicitly incorporate any guarantees in the government budget instead of hiding them in the balance sheets of Fannie and Freddie. Unfortunately, the reform is being directed toward three avenues: (1) federal guarantees of a substantial proportion of mortgage-backed securities issued to finance US home mortgages; (2) taxes on these securities to finance low-income housing; and (3) requirements on the issuers of complying with mandates of affordable housing (Edward Pinto, op.cit.). Policymakers with professed aversion to derivatives have reinvented a new derivative on housing. The guarantees and “affordable” housing subsidies of the new system recreate a put option issued on the price of houses with the guarantee of tax payers’ money. That is, when housing prices collapse again after excessive construction driven by these new proposed subsidies, Fannie, Freddie, careless mortgage bankers, NINJA debtors and guaranteed mortgages will be bailed out again with taxpayer funds. Fannie and Freddie are in a new class of “too politically important to fail.”

Second, the deceleration of industry is less clear because two regional surveys by the New York and Philadelphia Federal Reserve Banks suggest deceleration into Aug and beyond while the national Fed survey finds higher growth in Jul. Industry fell before the beginning date of the recession by the NBER and recovered ahead of the economy, providing the highest optimism for sustained growth. The index of general business conditions of the Empire State Manufacturing Survey of the Fed of New York rose two points from Jul to reach 7.1 in Aug. The general business index suggests improvement “at a very modest pace.” The forward information is evidently negative and caught the attention of financial markets: “the future general business conditions index fell 6 points to 35.7, a reading well below the levels observed earlier this year. The future new orders index dipped 3 points to 31.4, and the future shipments index retreated 6 points to 25.7” (http://www.newyorkfed.org/survey/empire/empiresurvey_overviewexpand.html ). The release of the report on industrial production and capacity utilization by the Fed brought relief that the recovery was continuing. Total industrial production in the US grew 1.0 percent in Jul after dropping 0.1 percent in Jun; manufacturing grew by 1.1 percent after falling 0.5 percent in Jun; the rate of capacity utilization for total industry reached 74.8 percent, higher by 5.7 percentage points relative to a year earlier but still 5.8 percentage points below the average for 1972 to 2009; and total industry was 7.7 percent higher in Jul than a year earlier but still at 93.0 percent of the average for 2007. Production of motor vehicles and parts grew 10 percent, but manufacturing excluding motor vehicles and parts rose by 0.6 percent (http://www.federalreserve.gov/releases/g17/Current/default.htm ). The Aug Business Outlook Survey of the Philadelphia Fed contributed to the impression of deceleration. The broad index of current activity fell from 5.1 in Jul to -7.7 in Aug, which is the first monthly decline since Jul 2009. The forward indicators may be revealing uncertainty with the new orders index falling to -7.1, the shipment index becoming negative at -4.5 and weak indexes for delivery times and unfilled orders (http://www.philadelphiafed.org/research-and-data/regional-economy/business-outlook-survey/2010/bos0810.pdf ).

II Weakening Job Creation. Initial jobless claims SA rose by 12,000 in the week of Aug 14 to reach 500,000 from the Aug 7 revised level of 488,000. This is a significant increase over the fluctuation around 450,000 in 2010. Initial claims SA reached 575,000 a year ago. The four-week moving average SA new claims grew by 8000 to reach 482,500 in the week of Aug 14 compared with the revised 474,500 a week earlier. Non-seasonally adjusted (NSA) initial claims actually fell by 22,644 from 424,500 in the week of Aug 7 to 401,856 in the week of Aug 14 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). Economic growth is subpar in this expansion phase of the economy with resulting weakness in labor markets. The unemployment rate increased from 9.4 percent in Jul 2009 to 10.1 percent in Oct 2009, declining to 9.5 percent in Jul 2010 but the percentage of the adult noninstitutional (or civilian) population having a job declined steadily from 59.3 percent in Jul 2009 to 58.4 percent in Jul 2010 (http://www.bls.gov/web/empsit/cpseea3.pdf ). Many people willing and able to work are discouraged from seeking employment. There are 27 million people unemployed, working part-time because they do not find another occupation, marginally attached to the labor force or discouraged that there is no job for them.

III Causes of Flattening Growth/Employment Creation. US economic policy has consisted of a short-run strategy to revive the economy by stimulus and simultaneous structural change for alleged improvements in the long run. The short-run economic policy of the US has consisted of massive fiscal and monetary stimuli designed to drive growth and motivate job hiring. At the same time, policy has engaged in complex legislative restructuring of large segments of economic activity, draconian regulation and mandates. Growth is flattening and labor markets weakening because of the uncertainty of the impact of legislative restructurings on profits and business models and the fear of taxes and interest rate increases resulting from the stimulus. The fiscal stimulus of an effective $862 billion can be broken down into three categories: $296 billion in aid to states, unemployment and food stamps, $230 billion in infrastructure (of which $164 billion are unspent) and $336 billion in tax cuts, one-time payments and other finance provisions (http://online.wsj.com/public/resources/documents/stimulus0814.pdf ). From a long-term perspective, most of these projects have much lower present value of benefits less costs than those in the private sector from which the government obtained the funds by future taxation. Such a massive stimulus would have already driven economic activity and employment, creating doubts about the claims that the stimulus bill ARRA “has raised employment relative to what it otherwise would have been by between 2.5 and 3.6 million” and that “ARRA has raised the level of GDP as of the second quarter of 2010, relative to what it otherwise would have been by between 2.7 and 3.2 percent” (http://www.whitehouse.gov/files/documents/cea_4th_arra_report.pdf ). There are also doubts as to whether the monetary stimulus of the 0 to 0.25 percent rate on fed funds and the $2.3 trillion bloated Fed balance sheet (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ) have recovered the economy and saved or created jobs (see the analysis of monetary policy in Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-62, Regulation of Banks and Finance, 224-7). Flattening economic growth and weakening labor markets instead of V-shaped recovery and robust labor markets as in expansions after historical deep contractions appear to be a consequence of the uncertainty on business models created by the legislative restructurings, draconian regulation and mandates that have replaced private sector allocation with official allocation, creating uncertainty about the returns on investment and the costs of hiring. Table 1 shows another uncertainty in the form of a government deficit that has soared from 1.9 percent of GDP in 2006 to over 9 percent of GDP in 2009 and 2010. The forecast deficits keep on rising after every revision because of the uncertainty of future revenue depending on economic growth that is decelerating. There is doubt if the deficits will be again below one trillion dollars. The error was raising expenditures from 19.6 percent of GDP in 2007 to 24.7 percent of GDP in 2009 by an increase in expenditures of 18 percent while revenue fell 16.6 percent. Revenue fell to 14.8 percent of GDP in 2009 and 14.6 percent of GDP in 2010 because of the weak economy with poor prospects because of decelerating growth. Crises are not opportunities for spending away the future because of the costs of the current growth deceleration and weak employment in anticipation of major tax increases. Long-term government revenues in the US have remained historically below 20 percent of GDP so that the deficit and debt are in an expansion that may cause an adverse sudden stop of the economy in the future when taxes must be increased and expenditures contained. The unwinding of the Fed balance sheet by sale of $2 trillion long-term bonds and Treasuries may cause higher interest rates than required in an eventual upswing of the economy that could also contribute to flattening the growth curve.

Table 1, Government Revenues, Expenditures and Debt

 

2006

2007

2008

2009

2010

2011

2012

$ Billions

             

Revenue

2406

2568

2523

2105

2143

2648

2953

Expend

2655

2728

2982

3518

3485

3714

3618

Deficit

-249

-160

-459

-1413

-1342

-1066

-665

Net Debt

4828

5035

5803

7545

9031

10007

10790

% GDP

             

Revenue

18.2

18.5

17.5

14.8

14.6

17.5

18.7

Expend

20.1

19.6

20.7

24.7

23.8

24.5

23

Deficit

-1.9

-1.2

-3.2

-9.9

-9.1

-7.0

-4.2

Net Debt

36.5

36.2

40.2

53

61.6

66.1

68.5

Source: http://www.whitehouse.gov/sites/default/files/omb/budget/fy2011/assets/hist.pdf http://www.cbo.gov/ftpdocs/117xx/doc11705/08-18-Update.pdf

The Basel III capital accord appears to take final shape as some definitions crystallized on Jul 26 (http://www.bis.org/press/p100726/annex.pdf ) following considerable negotiation (http://www.ft.com/cms/s/0/ab02375c-aafb-11df-9e6b-00144feabdc0.html ). Major definitional issues have been approved on three important components of the agreement before final calibration. First, the definition of Tier 1 capital may include “significant investments in the common shares of unconsolidated financial institutions,” mortgage servicing rights and deferred tax assets but banks must deduct from common equity for Tier 1 capital the value that exceeds the aggregate of these three items by 15 percent of the common equity component of Tier 1 capital. Second, calibration of the agreement will consider a Tier 1 leverage ratio of 3 percent with transition period until 2018. Third, the definition of the liquidity coverage ratio, or liquidity required to withstand a crisis of 30 days, will be defined and calibrated to minimize distortions of the system while penalizing imprudent liquidity practices. The critical difference between the Basel III process and the US Dodd-Frank bill of financial regulation is the competent care by the Basel Committee on Banking Supervision in crafting prudential regulation and supervision on the basis of technical principles that preserve the functions of financial intermediation required for growth and employment creation. The rushed Dodd-Frank bill will make US banks uncompetitive relative to international banks, restricting the volume of credit and increasing the costs of borrowing, preventing the V-shaped recovery required to attain full employment. The consequence of the Dodd-Frank bill is an increase in borrowing costs of every activity by business and households while the financial system continues to be vulnerable to crises.

IV Financial Turbulence. Financial turbulence is returning as a result of the doubts on the world economy and global financial markets. Table 2 provides a summary of turbulence in stocks, commodities, the dollar and Treasury yields. The columns provide the dates of the recent peaks and troughs of financial variables and the percentage change from recent peak to trough, peak to Aug 20 and change in the week ending on Aug 20. Equity indexes fell in major stock exchanges, except China and Asia Pacific, with the Global Dow losing 0.9 percent. European and American stocks were particularly affected. The dollar appreciated to $1.2705/euro, reversing the depreciation of earlier weeks. Commodity prices fell and oil trended toward $73/barrel. The 10-year Treasury collapsed to 2.616 percent partly because of the use of highly-rated fixed income as safe haven in the flight out of risk exposures; perhaps the expectation of further quantitative easing also caused decline in yields.

Table 2, Stocks, Commodities, Dollar and 10-Year Treasury

 

Peak

Trough

% Trough

% 8/20

Week 8/20

DJIA

26-Apr

2-Jul

-13.6

-8.8

-0.9

S&P 500

23-Apr

2-Jul

-16

-12

-0.7

NYSE Fin

15-Apr

2-Jul

-20.3

-16

-1.2

Dow Glob

15-Apr

2-Jul

-18.4

-13.2

-0.9

Asia

15-Apr

2-Jul

-12.5

-7.4

0.5

China

15-Apr

2-Jul

-24.7

-16.5

1.4

Europe STOXX

15-Apr

2-Jul

-15.3

-9.3

-1.8

Dollar

25-Nov

25-Jun

22.3

19.1

0.4

DJ USB Com

6-Jan

2-Jul

-14.5

-9.4

-1

10 Year T

5-Apr

20-Aug

3.986

2.616

 

Source: http://online.wsj.com/mdc/page/marketsdata.html

The US Treasury with redemption date on 08/20/2020 with coupon of 2.63 percent was quoted at a yield of 2.61 percent or price of 100.13 on Aug 20 (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-200810 ). The price of that bond for settlement on 8/23/2010 at a yield of 3.98 percent would be 88.959 or a decrease of price by 11.2 percent [88.959/100.13 -1]100. In practice, such a backup of yields would not occur but it could happen over time as the 10-year Treasury yield fell from 3.986 percent on Apr 5 to 2.61 percent on Aug 20, that is, in just 138 days. Unloading of duration and leverage in professional bond portfolios could accentuate price decreases, which may occur when the Fed gives the first sign of unloading its portfolio of two trillion dollars of long-term securities. Professor Jeremy Siegel, of the Wharton School, and Jeremy Schwartz, of Wisdom Tree, analyze the risks of capital losses of positions in Treasuries with high duration in a must-read opinion article for the Wall Street Journal (http://professional.wsj.com/article/SB10001424052748704407804575425384002846058.html ). An increase in yields of 10-year Treasuries from 2.8 percent to the 4 percent almost reached in Apr would cause a capital loss exceeding three times the current yield of 10-year Treasuries (Ibid). Such an increase could occur as Siegel and Schwartz point out because of acceleration of the rate of growth of the economy. They quote data from the Investment Company Institute that from Jan 2008 to Jun 2010 the outflows from equity funds totaled $232 billion while $559 billion flowed into bond funds. There may be another but similar avenue for a rise in stocks compared to decline of bonds. Companies are holding $3 trillion in cash (http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aFzUwxN3LKsQ ). After all recessions and similar events, there is need for reorganizations in which companies change business models, selling entire divisions or lines of business to acquire others. The boom in takeovers at the turn of the 1990s was driven by the changes caused by the third industrial or technological revolution that created excess capacity by technological/organizational change, government policy and globalization; exit by the capital markets is value creating compared to alternative liquidation (Michael C. Jensen, The modern industrial revolution, exit and the failure of internal control systems, Journal of Finance 1993, cited in Pelaez and Pelaez, Globalization and the State Vol. I, 49-51, Government Intervention in Globalization, 46-7). Bloomberg estimates that $3.51 trillion of deals were announced in 2006 and $4.02 trillion in 2007 (http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aFzUwxN3LKsQ ). The cash-rich position of companies suggests that they can leverage to take opportunities of changing or improving their business models in what is necessary reorganization in economies worldwide. The other catalyst of stock markets could be a shift away from the policy of legislative restructurings and regulation in a new reality created after November that more adequately balances the role of the private sector in economic allocation and job creation. The combination of new consolidation via capital markets and inflow of funds into equities and away from bonds could trigger the realization of capital losses in bond positions with long duration. An accelerating fiscal deficit and rising interest rates as the Fed realizes there is no more ammunition to buy trillions of dollars of government bonds could hurt bond investments long in duration with high leverage.

V Interest Rates. The US yield curve continues to trend down to 2.62 percent on Aug 20 from 2.69 percent a week earlier and 2.89 percent a month earlier. Much the same has occurred with the 10-year government bond of Germany that traded at the yield of 2.27 percent on Aug 20 for a negative spread of 34 basis points to the comparable Treasury (http://markets.ft.com/markets/bonds.asp ). On Apr 4, the 10-year German government bond traded at a yield of 3 percent (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-040810 ). The common explanation for this downward trend of US and German government-bond yields is the flight of funds from riskier assets into the safe haven of government securities. Long-duration bonds have high risks of capital losses that may be amplified by a stampede out of the safe havens back into riskier assets. An inverted yield curve, or higher yields in short-term securities than in long-term securities, is commonly seen as a sign of recession while expansions are typically accompanied by upward sloping yield curves with yields of short-term securities below those of long-term securities (http://professional.wsj.com/article/SB10001424052748703321004575427822149953204.html?mod=wsjproe_hps_MIDDLEThirdNews). It is difficult to read much from the yield curve with the Fed working exotically on long, intermediate and short segments, maintaining short-term rates at zero and trying to control the rise of long-term yields. At some point the central bank will concede that it cannot fix the entire yield curve and that zero interest rates merely promote instability of financial variables by the carry trade from the dollar and yen into riskier futures and options on high-yielding currencies, commodities and equities (Pelaez and Pelaez, Globalization and the State, Vol. II, 203-4, Government Intervention in Globalization, 70-4). Targeting ceilings on long-term yields by expanding the Fed balance sheet is equivalent to the Fed writing an illusory put option or floor on prices of nearly all bonds that are priced to yield spreads over Treasuries. When the Fed put is discredited and abandoned, the selloff in bond markets will raise long-term interest rates in all segments. Declines in prices of mortgage-backed and asset-backed securities in general and haircuts in sale and repurchase agreements reduced funding capital of traders in the credit/global recession, causing common liquidity effects and flight to quality in multiple market segments as analyzed by Markus Brunnermeier and Lasse Pedersen (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 223). The fire sale of bonds and rise of interest rates analyzed by Siegel and Schwartz would spread to all segments of bond markets. Leverage and risks of the magnitudes assumed by Fannie, Freddie and the Fed have never been dreamed in private financial institutions, which are governed by nonpolitical, stricter and consistent oversight.

VI Conclusion. Economic growth is failing to show the V shape in expansions following past sharp contractions and labor markets are under unusual stress. Legislative restructuring combined with anticipations of increases in taxes and interest rates create uncertainty in economic recovery and job creation that causes financial turbulence. Major policy shifts are required to promote growth and create jobs by reducing uncertainty in economic and financial decisions by business and households. Government is a critical institution acting as delegated agent with coercion powers on behalf of the principal, which is society, such that its resources originating in taxpayer contributions should be used parsimoniously to allow room for the private sector to generate prosperity and jobs (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)

http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )

Sunday, August 15, 2010

Global Economic Slowing, Stimulus/Policy Doubts and Financial Turbulence

Global Economic Slowing, Stimulus/Policy Doubts and Financial Turbulence

Carlos M Pelaez

This post relates the slowing global economy to doubts on stimulus and structural policy shocks and financial turbulence. The global economic slowdown is discussed in (I) and deceleration of US growth in (II). Stimulus doubts are analyzed in (III). Financial turbulence is considered in (IV) and interest rates in (V). A brief conclusion is in (VI). If you have difficulty in viewing the tables and illustrations go to: http://cmpassocregulationblog.blogspot.com/

I Global Economic Slowdown. There is growing concern but only limited information of deceleration of the major regions in the world economy.

GDP growth rates may not capture the growth concerns because quarterly growth combines both earlier more rapid growth and only a tail of possible deceleration in 2Q10. Table 1 provides quarterly rates of growth of GDP in the past four quarters seasonally adjusted (SA) relative to the prior quarter and not-seasonally adjusted (NSA) relative to the same quarter in the prior year. The deceleration is more evident in the case of the US that jumped ahead of the other major advanced economies but began to decelerate earlier. The strength of recovery of the euro zone is significantly caused by the dynamism of the German economy that jumped 2.2 percent in 2Q10 and 3.7 percent relative to a year earlier.

Table 1, Quarterly Rates of Growth of GDP %

SA from Prior Quarter                               NSA from Prior Year

 

3Q09

4Q09

1Q10

2Q10

3Q09

4Q09

1Q10

2Q10

Euro Zone

0.4

0.1

0.2

1

-4.1

-2.1

0.6

1.7

Germany

0.7

0.3

0.5

2.2

-4.4

-2

2

3.7

France

0.3

0.6

0.2

0.6

-2.7

-0.5

1.2

1.7

USA

0.4

1.2

0.9

0.6

-2.7

0.2

2.4

3.2

Japan

0.1

1.1

1.2

na

-4.9

-1.4

4.2

na

Source: http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-13082010-BP/EN/2-13082010-BP-EN.PDF

There appears to be deceleration of industrial growth in the euro area in Jun relative to better performance in prior months with stronger performance in Germany than in the rest of the members of the euro area and the European Union. Industrial production in the euro area dropped 0.1 percent in Jun 2010 relative to May 2010 after increasing by 1.1 percent in May relative to Apr. In the 12 months ending in Jun 2010 industrial production grew by 8.2 percent in the euro area (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/4-12082010-AP/EN/4-12082010-AP-EN.PDF ). Germany’s industrial production dropped 0.5 percent from Jun relative to May but after increasing 3.3 percent in May, 1.1 percent in April and 2.6 percent in Mar. In the 12 months ending in Jun 2010, German industrial production grew 11.5 percent after 13.5 percent in May and 14.7 percent in Apr. France’s industrial production dropped 1.6 percent in Jun 2010 relative to May 2010 after increasing 1.9 percent in May and declining 0.4 percent in Apr. In the 12 months ending in Jun 2010, France’s industrial production grew 4.8 percent, declining from 8.5 percent in the prior two months. There were 23.1 million people unemployed in the European Union in Jun of whom 15.8 million in the euro area. The rate of unemployment of the euro area increased from 9.5 percent in Jun 2009 to 10.0 percent in Mar 2010, remaining at that level in Apr, May and Jun (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/3-30072010-AP/EN/3-30072010-AP-EN.PDF ).

Growth of world trade is critical in economic growth and reduction of unemployment. World recovery was apparently proceeding adequately as shown by excellent export data. Euro zone SA exports grew by 5.2 percent in Jun relative to May and imports by 4.3 percent (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/6-13082010-AP/EN/6-13082010-AP-EN.PDF ). Exports suggest strong world demand and imports rising internal demand. NSA exports of the euro area in Jan-Jun 2010 grew by 18 percent relative to the same period in 2009, which was also the rate of growth of imports.

The economy of China is also showing some signs of possible slowdown. The July trade surplus was $28.7 billion, higher than $20 billion in Jun. However, the rate of growth of exports fells from 43.9 percent in Jun to 38.1 percent in Jul and the rate of increase of imports fell from 34.1 percent in Jun to 22.7 percent in Jul, raising the possibility of less dynamic internal demand. The prices of houses in China’s 70 largest cities did not change relative to June and the yearly rate of increase fell from 11.4 percent in Jun to 10.3 percent in July (http://www.ft.com/cms/s/0/0d5d0d32-a43f-11df-abf7-00144feabdc0.html ). There were mild declines in yearly rates in Jul relative to Jun: industrial output growth fell from 13.7 in Jun to 13.4 percent in Jul, urban fixed asset investment from 25.5 percent in Jun to 24.9 percent in Jul and retail sales 17.9 percent in Jul relative to 18.3 percent in Jun. The consumer price index in China rose to 3.3 percent on a year-on-year basis (http://www.ft.com/cms/s/0/98f852a0-a4fa-11df-8d8c-00144feabdc0.html

http://www.stats.gov.cn/english/newsandcomingevents/t20100811_402664373.htm ). GDP growth eased from year-on-year growth of 11.9 percent in the first quarter to 11.1 percent in the second quarter (http://www.stats.gov.cn/english/statisticaldata/Quarterlydata/ ).

II Deceleration of US Growth. This section considers the information obtained from economic indicators that are released monthly or weekly. The subsections analyze the trade deficit (II A), manufacturing and sales (II B), unemployment (II C) and consumer prices (II D).

II A Trade Deficit. The indicator that perhaps influenced markets the most was the trade deficit equal to: (exports of goods and services) less (imports of goods and services). Exports of goods and services in Jun were $150.5 billion and imports $200.3 billion for a trade deficit of $49.9 billion, which is much higher than the May revised trade deficit of $42.0 billion. In Jan-Jun 2010, the trade deficit reached $247.5 billion, much higher by $76.6 billion than $170.9 billion in Jan-Jun 2009. The trade deficit rose by $22.8 billion from Jun 2009 to Jun 2010, with exports rising by $22.6 billion or 17.7 percent and imports by $45.3 billion or 29.2 percent. However, exports of goods and services fell by $2.0 billion or 1.3 percent from $152.4 billion in May and imports grew by $5.9 billion or 3.0 percent from $194.4 billion in May. The increase in imports of goods from May to June was across many categories: $3.1 billion in consumer goods, $1.3 billion in automotive vehicles, parts and engines, $0.6 billion in other goods and $0.5 billion in capital goods. The increase in imports of goods from Jun 2009 to Jun 2010 was also across many categories: $12.8 billion in industrial supplies and materials, $9.3 billion in automotive vehicles, parts and engines, $9.1 billion in capital goods, $9.0 billion in consumer goods and others (http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf ). There are two issues relating to the trade deficit: (1) the downward impact of the trade deficit in the revision of GDP growth; and (2) the deteriorating external imbalance of the US.

First, the much higher trade deficit for Jun may lower the revised second estimate of the 2Q10 GDP growth rate to be released by the Bureau of Economic Analysis (BEA) on Aug 27. The apprehension in the market is about a sharp downward revision. Gross Domestic Product or GDP “measures the value of final goods and services produced in the United States” at market prices (http://www.bea.gov/national/pdf/nipa_primer.pdf ). The accounting identity of GDP identifies “the final goods and services purchased by persons, business, government, and foreigners” (Ibid, 4):

GDP = C + I + G + (X-M) = C + I + G + B           (1)

C is consumption, I investment, G government spending, X exports of goods and services, M imports of goods and services and B is the trade balance or difference of X less M. Consumption, which represents about 70 percent of GDP in the US, is measured as personal consumption expenditures (PCE) of goods and services by households and nonprofit institutions serving households. Investment is measured as gross private domestic investment, consisting of “purchases of fixed assets (equipment, software, and structures) by private business that contribute to production and have a useful life of more than one year, of purchases of homes by households, and of private business investment in inventories” (Ibid, 8). Exports are goods and services that US residents transfer or sell overseas. Imports must be deducted as “the value of imports is already included in the other expenditure components of GDP, because market transactions do not distinguish the source of goods and services. Therefore, imports must be deducted in order to derive a measure of total domestic output” (Ibid, 8). Thus, imports have a negative sign in equation (1). Government measures expenditures and gross investment by Federal, state and local government.

The BEA provides SA changes in GDP from a quarter to the prior quarter converted to the equivalent annual percentage rate. Table 2 second row, “Total,” provides the BEA estimates of GDP as SA quarterly gross rates of GDP in annual equivalent percentage rates. Market participants were already concerned that GDP grew mostly because of changes in inventories instead of by private investment and PCEs or actual internal demand. Growth rates of GDP are lower than in the first four quarters in past recessions with persistent job stress of 27 million persons and the rate for 2Q10 of 2.4 percent could signal deceleration of growth of the economy. The remaining rows below Total provide the breakdown of the growth rates in percentage point contributions  by the various sectors. The row “net exports” of goods and services is the contribution in percentage points by the trade balance or in this case trade deficit of exports of goods and services less imports of goods and services. In 2Q10, the trade deficit was responsible for a decrease of the growth rate of GDP of 2.78 percentage points. The revised estimate for 2Q10 to be released on Aug 27 will include the sharp trade deficit in Jun and may lower the growth rate of GDP. The hopeful sign in GDP growth was an increase in spending on equipment and software in 2Q10 at the inflation-adjusted rate of 21.9 percent, following 20.4 percent in the first quarter. There are doubts if this investment is mainly because of business replacing depreciated equipment and implementing previously postponed plans to increase efficiency instead of deliberate increases in production and hiring (http://professional.wsj.com/article/SB10001424052748704164904575421403221676016.html?mod=wsjproe_hps_LEFTWhatsNews

). The revision of 2Q10 GDP growth could consolidate the view of a declining growth rate that will not alleviate job stress in weak US labor markets.

Table 2, Percentage Point Contributions to the Growth Rate of GDP

Segment

3Q09

4Q09

1Q10

2Q10

Total

1.6

5.0

3.7

2.4

PCE

1.41

0.69

1.33

1.15

Gross Investment

1.22

2.7

3.044

3.14

Fixed Investment

0.12

-0.12

0.39

2.09

Change Inventories

1.1

2.83

2.64

1.05

Net Exports

-1.37

1.9

-0.31

-2.78

Gov

0.33

-0.28

-0.32

0.88

Source: http://bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&FirstYear=2009&LastYear=2010&Freq=Qtr

Second, the trade deficit of the US improved significantly in 2009 but has deteriorated in 2010. The external imbalance of the US could place a growth constraint because of the need for simultaneous adjustment of an unsustainable internal debt and a deteriorating net international investment position or external indebtedness (on external imbalance in the US see Pelaez and Pelaez, International Financial Architecture, The Global Recession Risk and Globalization and the State, Vol. II, 182-210, Government Intervention in Globalization, 167-81).

II B Manufacturing and Sales. Short-term indicators continue to show weakness in sales and manufacturing. Sales of merchant wholesalers fell by 0.7 percent in Jun relative to May after declining by 0.5 percent in May relative to Apr but were higher by 12.9 percent from the level in Jun 2009 (http://www2.census.gov/wholesale/pdf/mwts/currentwhl.pdf ). Retail and goods services sales rose by 0.4 percent in Jul relative to Jun and stood 5.5 percent higher than in Jul 2009. The May/Apr estimate was lowered from -0.5 percent to -0.3 percent. The increase in sales was mostly due to an increase in motor vehicles and parts of 1.6 percent. Sales excluding motor vehicles and parts grew by only 0.2 percent from Jun to Jul after falling 0.1 percent from May to Jun (http://www.census.gov/retail/marts/www/marts_current.pdf ). The combined value of distributive trade sales and manufacturers’ shipment, adjusted for seasonal factors and differences in trading days, fell by 0.6 percent from May to Jun 2010, standing 9.2 percent above Jun 2009. Manufacturers’ and trade inventories rose by 0.3 percent from May into Jun because of declining sales (http://www.census.gov/mtis/www/data/pdf/mtis_current.pdf ).

II C Unemployment. The job market continues to show significant weakness when compared to sharp growth of GDP and employment creation after past sharp contractions. The information from the initial weekly claims for unemployment insurance is continuing job stress. In the week ending on Aug, SA initial claims for unemployment insurance rose by 2000 to reach 484,000 over the prior week’s revised number of 482,000. The four-week moving average rose by 14,250 to reach 473,500 relative to the prior week’s 459,250. The SA initial claims were 557,000 a year ago but have stabilized around 450,000 since the beginning of the year. NSA initial claims rose by 18,862 from 402,135 in the week of Jul 31 to 420,997 in the week of Aug 7. NSA initial claims stood at 564.500 a year ago (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). There is important analysis and data in a must-read essay by Henry Olsen in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052748704388504575419280283794598.html ). The unemployment rate increased from 9.4 percent in Jul 2009 to 10.1 percent in Oct 2009, declining to 9.5 percent in Jul 2010 but the percentage of the adult noninstitutional (or civilian) population having a job declined steadily from 59.3 percent in Jul 2009 to 58.4 percent in Jul 2010 (http://www.bls.gov/web/empsit/cpseea3.pdf ). Olsen argues that the unemployment rate measures those without a job who are actively seeking one but the civilian employment/population ratio is superior in detecting job stress because it measures the percentage of people with a job irrespective of whether they are searching for one. In a good economy more people search for jobs but a bad economy discourages job searches. Growth of the population requires more jobs for adults. A traumatic aspect of job stress is that the percent of employment of the civilian population ages 16 to 19 fell from 37.9 percent in Jul 2009 to 34.6 percent in Jul 2010 (http://www.bls.gov/web/empsit/cpseea3.pdf ). The media is full of anecdotal information of hard times with retirees returning to the labor force and competing with teenagers who are just beginning to seek a place in society. The civilian employment/population ratio was slightly above 63 percent in 2007 such that the decrease to 58.4 percent in Jul 2010 with 238 million working-age noninstitutionalized civilians leads to the conclusion that 12 million jobs were lost (http://professional.wsj.com/article/SB10001424052748704388504575419280283794598.html ). This drama conflicts with the design and claims that the stimulus “saved” or created millions of jobs. In the upswing after the recession of 1979-82, the employment ratio jumped from 57 to 63 percent in 1990. The policy shift requires focus on promoting the proper incentives for rapid job creation by the private sector (Ibid).

II D Consumer Prices.The SA consumer price index rose by 0.3 percent in Jul from Jun. The NSA adjusted increase in the 12 months ending in Jul was 1.2 percent (http://www.bls.gov/news.release/pdf/cpi.pdf ).

III Stimulus. The Federal Open market Committee (FOMC) on Aug 10 states that “the pace of economic recovery is likely to be more modest in the near term than had been anticipated” (http://www.federalreserve.gov/newsevents/press/monetary/20100810a.htm ). The FOMC maintained the fed funds target of 0 to 0.25 percent and stated that “economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period” (Ibid). In the effort to ensure recovery with price stability the FOMC “will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature” (Ibid). Variations of this policy together with the eventual need for unwinding the Fed’s balance sheet were revealed by the FOMC minutes of the Jun meeting (http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20100623.pdf ). Theoretical and empirical research develops a policy of quantitative easing or increases in the balance sheet of the central bank and its concentration in long-term securities to lower long-term interest rates (http://www.federalreserve.gov/pubs/feds/2004/200448/200448pap.pdf see Pelaez and Pelaez, The Global Recession Risk, 95-107, Pelaez and Pelaez, Regulation of Banks and Finance, 224-7, Financial Regulation after the Global Recession, 157-62). The value of the current balance sheet of the Fed is $2.3 trillion with a portfolio of $1.99 trillion of long-term securities, consisting of $712 billion of Treasury notes and bonds, $1119 billion of mortgage-backed securities and $159 billion of Federal agency debt securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). Quantitative easing can be interpreted as injecting huge amounts of bank reserves by purchasing long-term securities that could lead to lowering long-term interest rates as portfolios are rebalanced toward long-term fixed income securities, causing a decrease in their prices equivalent to lower yields. Policy would flatten the yield curve with long-term yields dropping toward the zero fed funds rate. This policy is almost identical to that before the credit crisis. The Fed lowered the fed funds rate to 1 percent in Jun 2003 and maintained it at that level with the forward guidance that it would remain at low levels indefinitely and kept it at 1 percent until Jun 2004. Treasury suspended the issue of 30-year bonds from 2001 to 2005 with the intention similar to quantitative easing of channeling duration-matching funds in pension funds from 30-year Treasuries to investment in mortgage-backed securities that would raise the price, equivalent to lowering the yield, to attain the elusive flat curve with all yields close to the zero bound. The $201 billion yearly subsidy of housing ensured continuing investment in long-term mortgage-backed securities. Fannie and Freddie jumped into the policy of affordable housing for all and purchased or guaranteed $1.6 trillion of nonprime mortgages. Monetary policy created the illusion of selling a put on wealth or equivalently a ceiling on interest rates. The combination of these policies eroded calculations of risk and return, increasing leverage, decreasing liquidity by encouraging financing of everything in overnight sale and repurchase agreements and mispricing credit and rate risk, causing the credit 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).

The repeated policy of fed funds interest rates of 0 to 0.25 percent combined with 11 credit facilities at the Fed and the more observable $2.3 trillion Fed balance sheet did not prevent another Great Depression and may have complicated world financial stability with the carry trade from zero US interest rates by shorting the dollar and simultaneously taking long positions in high-yielding currencies, commodity futures and equities (Pelaez and Pelaez, Globalization and the State, Vol. II, 203-4, Government Intervention in Globalization, 70-4). The instability of oil prices rising to $149/barrel and then collapsing below $60/barrel and fluctuating financial variables may have cancelled any beneficial effects of exotic monetary policy based on weak state of the art in analysis of current economic conditions and forecasting the future. Boldness is not an assurance of success. There is a new element of uncertainty that dooms bold monetary stimulus. Even if fiscal and monetary stimulus were successful in a different environment, they would fail in the present one because attempts to increase demand by stimulus are offset by uncertainty of business and households resulting from inopportune legislative restructuring of business models, regulatory shocks and mandates. The credit volume-reducing and rate-increasing effects of the Dodd-Frank financial regulation act cloud every business and personal decision with suffocating uncertainty on interest rates and access to credit. Monetary and fiscal stimulus only contributes to worse expectations about future increases in taxes and interest rates that can slow down spending and the economy by exacerbating uncertainty in financial and economic decisions.

IV Financial Turbulence. Financial turbulence is increasing again as a result of the doubts on the world economy and global financial markets. Table 3 provides a summary of turbulence in stocks, commodities, the dollar and Treasury yields. The columns provide the dates of the recent peaks and troughs of financial variables and the percentage change from recent peak to trough, peak to Aug 13 and change in the week ending on Aug 13. Equities indexes fell in all major stock exchanges with the Global Dow losing 4.2 percent. The dollar appreciated to $1.276/euro, reversing the depreciation of earlier weeks. Commodity prices fell and oil trended toward $75/barrel. The 10-year Treasury collapsed to 2.679 percent partly because of the use of highly-rated fixed income as safe haven in the flight out of risk exposures; perhaps the expectation of further quantitative easing also caused decline in yields.

Table 3, Stocks, Commodities, Dollar and 10-Year Treasury

 

Peak

Trough

% Trough

% 8/13

Week 8/13

DJIA

26-Apr

2-Jul

-13.6

-8.0

-3.3

S&P 500

23-Apr

2-Jul

-16

-11.3

-3.8

NYSE Fin

15-Apr

2-Jul

-20.3

-15.1

-5.3

Dow Global

15-Apr

2-Jul

-18.4

-12.4

-4.2

Asia Pacific

15-Apr

2-Jul

-12.5

-7.8

-3.5

Shanghai

15-Apr

2-Jul

-24.7

-17.6

-1.9

Europe

STOXX

15-Apr

2-Jul

-15.3

-7.7

-0.4

Dollar

25-Nov

25-Jun

22.3

18.6

4.1

USB Com

6-Jan

2-Jul

-14.5

-8.5

-1.9

10 Year T

5-Apr

6-Aug

3.986

2.679

 

Source: http://online.wsj.com/mdc/public/page/mdc_us_stocks.html?mod=topnav_2_3004

V Interest Rates. The US yield curve shifted downwardly with the 10-year Treasury declining to 2.68 percent from 2.82 percent a week earlier and 2.97 percent in the prior month (http://markets.ft.com/markets/bonds.asp?ftauth=1281886564580 ). Risk exposures moved also to the safe haven of the 10-year government bond of Germany that traded at 2.39 percent equivalent to a negative spread of 29 basis points relative to the comparable Treasury.

VI Conclusion. Monetary and fiscal stimulus merely causes expectations of future increases in taxes and interest rates. A policy shift encouraging growth and job creation by the private sector will be more effective in promoting wellbeing. There is significant value in the explanation of why there is not more hiring by the owner of a business employing 83 persons in New Jersey. The cost of hiring a high-school graduate, “Sally,” employed for 15 years in this entrepreneur’s business, is $74,000 per year of which the employee “Sally” receives gross pay of $59,000 and net pay after deductions of $44,000 (http://professional.wsj.com/article/SB10001424052748704017904575409733776372738.html

). The exotic stimulus and legislative restructurings and regulation ignore that their short-run effects are denying many people like this entrepreneur the opportunity to thrive in an innovative knowledge business and people like “Sally” the opportunity to enter into formal society with a high-school degree and millions of other people like “Sally” who lost their jobs and cannot find another one. The alleged long-term benefits of the restructurings cannot be measured but the short-term employment costs and personal stress are staggering. (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)

http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )