Wednesday, June 19, 2013

The U.S. Economy

The State Of The U.S. Economy
(Bloomberg website, August 11, 2010)

Laurence Kotlikoff, an economics professor at Boston University, talks about the state of the U.S. economy. Kotlikoff speaks with Erik Schatzker on Bloomberg Television's InsideTrack."

Let’s get real. The U.S. is bankrupt. Neither spending more nor taxing less will help the country pay its bills.  What it can and must do is radically simplify its tax, health-care, retirement and financial systems, each of which is a complete mess. But this is the good news. It means they can each be redesigned to achieve their legitimate purposes at much lower cost and, in the process, revitalize the economy.  Last month, the International Monetary Fund released its annual review of U.S. economic policy. Its summary contained these bland words about U.S. fiscal policy: “Directors welcomed the authorities’ commitment to fiscal stabilization, but noted that a larger than budgeted adjustment would be required to stabilize debt-to-GDP.”  

But delve deeper, and you will find that the IMF has effectively pronounced the U.S. bankrupt. Section 6 of the July 2010 Selected Issues Paper says: “The U.S. fiscal gap associated with today’s federal fiscal policy is huge for plausible discount rates.” It adds that “closing the fiscal gap requires a permanent annual fiscal adjustment equal to about 14 percent of U.S. GDP.”  The fiscal gap is the value today (the present value) of the difference between projected spending (including servicing official debt) and projected revenue in all future years.

To put 14 percent of gross domestic product in perspective, current federal revenue totals 14.9 percent of GDP. So the IMF is saying that closing the U.S. fiscal gap, from the revenue side, requires, roughly speaking, an immediate and permanent doubling of our personal-income, corporate and federal taxes as well as the payroll levy set down in the Federal Insurance Contribution Act.  Such a tax hike would leave the U.S. running a surplus equal to 5 percent of GDP this year, rather than a 9 percent deficit. So the IMF is really saying the U.S. needs to run a huge surplus now and for many years to come to pay for the spending that is scheduled. It’s also saying the longer the country waits to make tough fiscal adjustments, the more painful they will be.

Is the IMF bonkers?  No. It has done its homework. So has the Congressional Budget Office whose Long-Term Budget Outlook, released in June, shows an even larger problem.  Based on the CBO’s data, I calculate a fiscal gap of $202 trillion, which is more than 15 times the official debt. This gargantuan discrepancy between our “official” debt and our actual net indebtedness isn’t surprising. It reflects what economists call the labeling problem. Congress has been very careful over the years to label most of its liabilities “unofficial” to keep them off the books and far in the future.  For example, our Social Security FICA contributions are called taxes and our future Social Security benefits are called transfer payments. The government could equally well have labeled our contributions “loans” and called our future benefits “repayment of these loans less an old age tax,” with the old age tax making up for any difference between the benefits promised and principal plus interest on the contributions.  The fiscal gap isn’t affected by fiscal labeling. It’s the only theoretically correct measure of our long-run fiscal condition because it considers all spending, no matter how labeled, and incorporates long-term and short-term policy.

How can the fiscal gap be so enormous?  Simple. We have 78 million baby boomers who, when fully retired, will collect benefits from Social Security, Medicare, and Medicaid that, on average, exceed per-capita GDP. The annual costs of these entitlements will total about $4 trillion in today’s dollars. Yes, our economy will be bigger in 20 years, but not big enough to handle this size load year after year.  This is what happens when you run a massive Ponzi scheme for six decades straight, taking ever larger resources from the young and giving them to the old while promising the young their eventual turn at passing the generational buck. Herb Stein, chairman of the Council of Economic Advisers under U.S. President Richard Nixon, coined an oft-repeated phrase: “Something that can’t go on, will stop.” True enough. Uncle Sam’s Ponzi scheme will stop. But it will stop too late.

And it will stop in a very nasty manner. The first possibility is massive benefit cuts visited on the baby boomers in retirement. The second is astronomical tax increases that leave the young with little incentive to work and save. And the third is the government simply printing vast quantities of money to cover its bills. Most likely we will see a combination of all three responses with dramatic increases in poverty, tax, interest rates and consumer prices. This is an awful, downhill road to follow, but it’s the one we are on. And bond traders will kick us miles down our road once they wake up and realize the U.S. is in worse fiscal shape than Greece.

Some doctrinaire Keynesian economists would say any stimulus over the next few years won’t affect our ability to deal with deficits in the long run.   This is wrong as a simple matter of arithmetic. The fiscal gap is the government’s credit-card bill and each year’s 14 percent of GDP is the interest on that bill. If it doesn’t pay this year’s interest, it will be added to the balance.  Demand-siders say forgoing this year’s 14 percent fiscal tightening, and spending even more, will pay for itself, in present value, by expanding the economy and tax revenue.  My reaction? Get real, or go hang out with equally deluded supply-siders. Our country is broke and can no longer afford no- pain, all-gain “solutions.”

(Laurence J. Kotlikoff is a professor of economics at Boston University and author of “Jimmy Stewart Is Dead: Ending the World’s Ongoing Financial Plague with Limited Purpose Banking.” The opinions expressed are his own.)

Plausible deniability?
(Fox News website, by John R. Lott, Jr., 2008)

 The mortgage crisis has produced a massive case of political amnesia. That happens when one is trying to redirect blame for something that could cost up to $700 billion. Some who now claim that the mortgage crisis is the result of too little regulation saw things more clearly when so much wasn’t at stake.  The New York Times editorialized on Saturday that “This crisis is the result of a willful and systematic failure by the government to regulate and monitor the activities of bankers, lenders, hedge funds, insurers and other market players.” If you believe the Times or the Obama campaign, everything but government regulation is to blame for the crisis.  Yet, it is not just economists who were predicting these problems. For example, a September 30, 1999, article in the New York Times predicted exactly what has happened:

Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people . ''Fannie Mae has expanded home ownership for millions of families in the 1990's by reducing down payment requirements,'' said Franklin D. Raines, Fannie Mae's chairman and chief executive officer. ''Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.'' . . .  Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.  ''From the perspective of many people, including me, this is another thrift industry growing up around us,'' said Peter Wallison a resident fellow at the American Enterprise Institute. ''If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.'' . . .

Indeed, during the late 1990s, the Clinton administration and Fannie Mae bragged (Los Angeles Times, May 31 1999) about how they had lowered the standards required to borrow money for homes to increase borrowing by groups that otherwise wouldn’t qualify. Their goal of increasing minority ownership was surely a laudable one, but making others pay for the voters’ altruism has real costs.  As even the New York Times understood in 1999, as long as housing prices kept on going up there was no problem with this system. If someone couldn’t pay their mortgages, they could sell their property. There was no threat of default. However, a lack of down payments meant that people defaulted on their mortgages.  Unfortunately, these insights don’t fit the current political template. With just 43 days to the election, the New York Times and others want to be in sync with the Obama campaign’s attack on the Bush administration not having enough regulation. It particularly doesn’t fit the fact that McCain was criticizing Fannie Mae and Freddie Mac for years along the lines of the New York Times 1999 article.  Ironically, in other articles, the New York Times described the Democrats as “important political allies” of these two government-sponsored enterprises.  The New York Times is right that “Taxpayers have every right to be alarmed and angry.” But they should read their old news articles to see whom they should get angry at.

Is the proposed bailout bill the answer?  $700 billion for the bailout is a lot of money. The costs so far of the Iraq war are probably even a couple hundred billion dollars less than that. But if the $700 billion wasn’t bad enough, it is on top of the giant bailout just announced a couple of weeks ago for Fannie Mae and Freddie Mac. The costs are likely to grow further when Democrats add on their demands to subsidize homeowners.  The argument is that something has to be done now. We're in a panic, and mortgages supposedly can’t be sold for what they are really worth. The fear is that with the value of assets so low, financial institutions will try to sell off their mortgage-backed securities, driving down the price of those assets and making financial institutions insolvent that would otherwise be financially viable.  What the government proposes to do is buy these assets when they are low, when people are panicking, and resell them later once confidence has been restored. Supposedly, the government could actually make money.  There are some real problems with this argument. First, even if most people are behaving irrationally and don’t understand the true long-run value of these mortgages, just like the government is proposing to do, others can make money by buying these assets at fire sale prices and reselling themselves once the crisis is past. In fact, if this panic explanation is true, there is a strong reason to believe that this desire to make money, to see the chance to buy low and sell high, would actually keep the price from falling very much.  McCain’s proposal on Friday to provide bridge loans would let the companies themselves decide whether this panic explanation is true. 

If the government’s argument is right, one first has to assume that all those smart people in government are a lot smarter than people in the finance industries. Ironically, the government will be hiring private evaluators to determine how much the government should pay for these assets. Given that government regulation -- forcing mortgage companies to make loans that they didn’t want to make -- created this problem, it is not obvious why government officials should be so wise right now.  Increased stock prices after the bailout’s announcement isn’t necessarily evidence that the bailout is needed. Stock prices might also be rising simply because the government is promising to pay a lot for some worthless assets. If so, that is nice for stockholders of affected companies, but not so nice for the rest of us.  But for the sake of argument, let’s assume that only the government’s offer to purchase these mortgages can prevent panicked sellers from sending prices down. It still isn’t clear that you want to subsidize these companies. As the 1999 Times article noted and McCain has continued to point out, such subsidies create incentives for companies to take unjustified risks in the future. Imagine how your gambling behavior would change if the government promised to cover your losses and let you keep your winnings. 

The government may also end up managing or owning these companies. Political considerations, not efficiency, will end up being the goal. A simple demand might be what company managers can be paid. But private shareholders have a lot better incentive deciding the costs and benefits of motivating managers than political constituencies who have little at stake in whether the company makes the right decisions.  Some parts of the proposed legislation released over the weekend are also worrisome. For example, at least in the first draft, the proposed power given to the Secretary of the Treasury would be unlimited and unchecked.  It emphasizes the possible problems that can arise from drafting legislation too quickly:  “Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.”  Why do people put so much faith in government correctly solving this problem when the debate can’t even honestly discuss what caused it? With all the pressure to get things done quickly, it seems unlikely that things will be properly sorted out. With $700 billion at stake, let’s make sure that we really have a very good reason for spending the money.

What Caused The Financial Crisis? The Big Lie Goes Viral.
(By Barry Ritholtz, Washington Post, 5 November 2011)

I have a fairly simple approach to investing: Start with data and objective evidence to determine the dominant elements driving the market action right now. Figure out what objective reality is beneath all of the noise. Use that information to try to make intelligent investing decisions.  But then, I’m an investor focused on preserving capital and managing risk. I’m not out to win the next election or drive the debate. For those who are, facts and data matter much less than a narrative that supports their interests. One group has been especially vocal about shaping a new narrative of the credit crisis and economic collapse: those whose bad judgment and failed philosophy helped cause the crisis.

Rather than admit the error of their ways — Repent! — these people are engaged in an active campaign to rewrite history. They are not, of course, exonerated in doing so. And beyond that, they damage the process of repairing what was broken. They muddy the waters when it comes to holding guilty parties responsible. They prevent measures from being put into place to prevent another crisis.  Here is the surprising takeaway: They are winning. Thanks to the endless repetition of the Big Lie.

A Big Lie is so colossal that no one would believe that someone could have the impudence to distort the truth so infamously. There are many examples: Claims that Earth is not warming, or that evolution is not the best thesis we have for how humans developed. Those opposed to stimulus spending have gone so far as to claim that the infrastructure of the United States is just fine, Grade A (not D, as the we discussed last month), and needs little repair. 

Wall Street has its own version: Its Big Lie is that banks and investment houses are merely victims of the crash. You see, the entire boom and bust was caused by misguided government policies. It was not irresponsible lending or derivative or excess leverage or misguided compensation packages, but rather long-standing housing policies that were at fault.  Indeed, the arguments these folks make fail to withstand even casual scrutiny. But that has not stopped people who should know better from repeating them.  The Big Lie made a surprise appearance Tuesday when New York Mayor Michael Bloomberg, responding to a question about Occupy Wall Street, stunned observers by exonerating Wall Street: “It was not the banks that created the mortgage crisis. It was, plain and simple, Congress who forced everybody to go and give mortgages to people who were on the cusp.”

What made his comments so stunning is that he built Bloomberg Data Services on the notion that data are what matter most to investors. The terminals are found on nearly 400,000 trading desks around the world, at a cost of $1,500 a month. (Do the math — that’s over half a billion dollars a month.) Perhaps the fact that Wall Street was the source of his vast wealth biased him. But the key principle of the business that made the mayor a billionaire is that fund managers, economists, researchers and traders should ignore the squishy narrative and, instead, focus on facts. Yet he ignored his own principles to repeat statements he should have known were false.

Why are people trying to rewrite the history of the crisis? Some are simply trying to save face. Interest groups who advocate for deregulation of the finance sector would prefer that deregulation not receive any blame for the crisis.

Some stand to profit from the status quo: Banks present a systemic risk to the economy, and reducing that risk by lowering their leverage and increasing capital requirements also lowers profitability. Others are hired guns, doing the bidding of bosses on Wall Street.   They all suffer cognitive dissonance — the intellectual crisis that occurs when a failed belief system or philosophy is confronted with proof of its implausibility.  And what about those facts? To be clear, no single issue was the cause. Our economy is a complex and intricate system. What caused the crisis? Look:

1. Fed Chair Alan Greenspan dropped rates to 1 percent — levels not seen for half a century — and kept them there for an unprecedentedly long period. This caused a spiral in anything priced in dollars (i.e., oil, gold) or credit (i.e., housing) or liquidity driven (i.e., stocks).

2. Low rates meant asset managers could no longer get decent yields from municipal bonds or Treasurys. Instead, they turned to high-yield mortgage-backed securities. Nearly all of them failed to do adequate due diligence before buying them, did not understand these instruments or the risk involved. They violated one of the most important rules of investing: Know what you own.

3. Fund managers made this error because they relied on the credit ratings agencies — Moody’s, S&P and Fitch. They had placed an AAA rating on these junk securities, claiming they were as safe as U.S. Treasurys.

4. Derivatives had become a uniquely unregulated financial instrument. They are exempt from all oversight, counter-party disclosure, exchange listing requirements, state insurance supervision and, most important, reserve requirements. This allowed AIG to write $3 trillion in derivatives while reserving precisely zero dollars against future claims.

5.  The Securities and Exchange Commission changed the leverage rules for just five Wall Street banks in 2004. The “Bear Stearns exemption” replaced the 1977 net capitalization rule’s 12-to-1 leverage limit. In its place, it allowed unlimited leverage for Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns. These banks ramped leverage to 20-, 30-, even 40-to-1. Extreme leverage leaves very little room for error.

6. Wall Street’s compensation system was skewed toward short-term performance. It gives traders lots of upside and none of the downside. This creates incentives to take excessive risks.

7.  The demand for higher-yielding paper led Wall Street to begin bundling mortgages. The highest yielding were subprime mortgages. This market was dominated by non-bank originators exempt from most regulations. The Fed could have supervised them, but Greenspan did not.

8.  These mortgage originators’ lend-to-sell-to-securitizers model had them holding mortgages for a very short period. This allowed them to get creative with underwriting standards, abdicating traditional lending metrics such as income, credit rating, debt-service history and loan-to-value.

9.  “Innovative” mortgage products were developed to reach more subprime borrowers. These include 2/28 adjustable-rate mortgages, interest-only loans, piggy-bank mortgages (simultaneous underlying mortgage and home-equity lines) and the notorious negative amortization loans (borrower’s indebtedness goes up each month). These mortgages defaulted in vastly disproportionate numbers to traditional 30-year fixed mortgages.

10. To keep up with these newfangled originators, traditional banks developed automated underwriting systems. The software was gamed by employees paid on loan volume, not quality.

11. Glass-Steagall legislation, which kept Wall Street and Main Street banks walled off from each other, was repealed in 1998. This allowed FDIC-insured banks, whose deposits were guaranteed by the government, to engage in highly risky business. It also allowed the banks to bulk up, becoming bigger, more complex and unwieldy.

12. Many states had anti-predatory lending laws on their books (along with lower defaults and foreclosure rates). In 2004, the Office of the Comptroller of the Currency federally preempted state laws regulating mortgage credit and national banks. Following this change, national lenders sold increasingly risky loan products in those states. Shortly after, their default and foreclosure rates skyrocketed.

Bloomberg was partially correct: Congress did radically deregulate the financial sector, doing away with many of the protections that had worked for decades. Congress allowed Wall Street to self-regulate, and the Fed the turned a blind eye to bank abuses.  The previous Big Lie — the discredited belief that free markets require no adult supervision — is the reason people have created a new false narrative.  Now it’s time for the Big Truth.



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