Change is coming.

The CBO put out its Long Term Budget projection a while back but the cover it worth pondering.  Both scenarios it has evaluated are non workable.  At lease they are being honest…let hope we can tackle our fiscal problems before they tackle us. 

Another interest note is that the recent spike in debt % of GDP matches (or reasonably closely) up with (with respect to change and velocity of change) WWI, the GD, and (only the first year) of WWII. 

Debt Distribution

The 10 yr bond has given some of us some anxiety over the past few days/weeks.  Admittedly a rally from low 2% to high 3% is big (at least on a change basis…debatable on a level basis, although it would be a high real yield if we descend into a deflation depression what that’s not the baseline expectation at this point).  All this being said what is causing the large fall in U.S. debt (remember a rising yield mean a falling bond price)?  The answer as far as I can tell is awkward auctions.  Where the price for new issuance is not coming in where the market expects them and it is shaking the confidence of debt buyers.  Some people have speculated that China has taken a breather from buying treasury debt to show that they don’t have to do so.  If that is the case, which doesn’t show up on a level basis in the custodial holdings (it could be done via a shift in maturity structure purchasing), and they want to keep their currency policy they have to buy other $ assets.  If they are unhappy with the risk of US treasury bonds its hard to imagine they are happier with – say – equities or corporate bonds.  That being said that could have rock the asset class or debt distribution boat for a few auctions to send a message. 

What would that message be?  In part ‘we want assurance about better fiscal policy/we want to be paid back’  but it is also about the type of debt that is being offered.  The U.S. treasury department has been issuing a lot more 3-5 yr issues instead of bills while bills have appeal to these hyper-risk adverse policy investors.  They are not being given the flavor that they want, thus the boat is rocked.  From the U.S. perspective you can push the 3/5 year debt and risk bumps but you have less roll over risk over the next few years.  I think this is a smart strategy (I’m assuming this is being done explicitly). 

This reality is illustrated in the following chart which show three snap shots of the Federal Debt Distribution (the portion that I’m talking about is the difference between Feb-09 and May-09…2000 is there for other reason). 

Rating Agency

After the last year or so it is a wonder that anyone subscribes to rating agencies anymore but they do.  In fact it is headline news when they come out and make tweaks on their outlooks like they did for UK soverign debt on 5/21.  S&P revised its outlook for the UK to negative from stables and affirmed the AAA long term rating and A-1+ short term rating.  This event makes me think about two things.  First (1) The rigidity of the investment community and (2) what do the ratings really mean? 

I’ve complained beforethe ability the rigidity of the investment community but the idea is that if everyone is looking at the same analysis the markets don’t function well because everyone wants to sell at the same time.  This will happen even if it just a descent sized group of people blindly following ‘guidelines’ about ratings, because the smart investors know that non-economic ‘guideline’ sellers will dump securities with a downgrade occurs and thus don’t buy until that flow is well underway.  For those of you who don’t know what I mean by guideline selling it means that a investment manager has a rule about what he can invest in and when that rule is broken he must sell the asset.  This creates a very inelastic (who doesn’t care about price) or what I call ‘non-economic’ seller.  We should be hoping that no one (the big reserve holder or big custodial banks) have a rule about British debt which would disrupt the markets. 

My second question is related to the rating itself.  What is AAA mean?  Low default risk?  If that is the case rating domestic sovereign debt (with a well run finance branch) seems a little odd; worse case it the Bank of England could buy the debt (print the money) and inflation away the debt.  (Yes, I’m ignoring what happen to Russia when they defaulted on their domestic debt but the idea that domestic default seems extremely unlikely is true).  Note: I’m under the impression that AAA for gov’t  and municipals vs corporates are two different scales (you can’t compare across them in a meaningful way only within a group…yes that is annoying).  Does it mean low real purchasing power risk?  If  this where the case then lowering the sovereign debt rating would require the lowering of all other debt (because it would be driven by a macro force: inflation or currency).  So as far as I can tell, AAA mean better than AA, which mean better than A and so on.  Even ignoring the rigidity that the rating agencies put into the system one would hope we (the investment community) could come up with a better (more meaningful) syntax…like probability of default (let use implied and just get rid of the rating agencies).

Be Confident that we don’t know…

In an era of fairly dire economic predictions it is, in a way, comforting to reflect that these prediction are by no means set in stone.  They are guesses, it could be better (although it could be worse).  Looking at some predictions about today from a decade ago illustrate how off we can be.  Look at the following IMF report (based on CBO projections) that the U.S. would have negative marketable debt (or have excess cash of debt) starting in 2006.  Now this projection was before the Bush tax cuts which would have altered these projections but even with that in mind the change in circumstances is incredible.  What is the take-away…be skeptical and operate knowing that we live in an uncertain world. 

Let the mailbox burn

Last week I went to a speech given by a major private equity firms COO.  He was highlighting the global economic crisis from his perspective.  (He noted that being a lawyer and not an economist he wasn’t sure why people wanted to hear him talk about it….he did a reasonable job).  But before the speech began I was discussing the new PPIP (public private investment partnership) program another attendee.  She argued that it would fail because there was bound to be fraud just like with RTC (resolution trust corporation) after the SNL crisis in the early 90s.  Given, she argued, that fraud was the underlying driver of the economic crisis, we could never get out of it by bring to life another program that would be rife with fraud.  I pointed out that although fraud facilities the crisis it was not the underlying cause (global economic imbalances) and that just because a program has a bad side affect it shouldn’t necessarily be scraped.  I noted that if the PPIP gets the financial system working so that credit is moving around (new balance sheet capacity) but some fraud occurs the net is positive.  She was insistent that this was not the case. 

To me she was letting the house burn and focusing on saving the mailbox.  Or according to Nietzsche she was engaged in the most common form of human stupidity; forgetting what one is trying to achieve. 

But she did, unknown to her, have a point.  The success of any public program, in a democratic society, that requires continuous support depends on at least the tacit support (or at least not the vehement opposition) of the program.  If fraud in PPIP undermines the federal government’s ability to respond to crisis it will have serious consequences.  To fix the analogy it would be as if the firefighters had the hose cut by an angry mob because the mailbox was burning.  Foolish but if the hose is cut the house will burn.  You could see some of this as an affect of the AIG bonus fiasco; we nearly let a few million dollars undermine the legal system which is part of foundations of a 15 trillion dollar economy.

Inflation is Your Friend!?

Inflation is a dirty word which – if you wish to increase your credibility – you will only say bad thing about it.  Here’s a small sample:

The best way to destroy the capitalist system is to debauch the currency.  By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.  – JM Keynes.

The first panacea for a mismanaged nation is inflation of the currency; the second is war.  -E Hemingway

Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man. – R Reagan

Althought these statements are fairly rhetorical, they are also reasonably true.  But, why is inflation bad?  (1) It can breakdown the price mechanism which is how resources are allocated and thus – in a sense – randomize the production system and (2) it can create transitional problem between nominal (money) and real prices which can destabilize society.  These problems emerge from having too low inflation (deflation debt spiral), or having a large change in inflation over a short period of time, or having a high (>8% annual inflation).  So the ideal of low stable inflation – which is what we shoot for – is a good middle ground. 

So why is the title of this post, ‘inflation is your friend.’  We’ll I could mean that inflation could help us get out of the real debt burden on the economy by increasing the nominal (money) price of the assets and thus decreasing leverage but what I am thinking about is inflation as a political buffer.  Consider that a large chunk of the most recent IMF recapitalization is going to go to Eastern Europe.  Why not just have Western European countries bail them out directly instead of through the IMF.  The IMF gives Western Europe political cover; the elected official in the West don’t have to answer to voters that they are bailing out Eastern Europe (which is what they are doing) instead they are sending money to the IMF.  Inflation can fill that role when it comes to the real size of government.  As long as spending grows slower than inflation (or slower than inflation and the growth of the economy) the real value (or % of GDP) value of government spending will decrease (in real terms).  Given it is pretty clear that we are incapable of shrinking (nominal) spending (would be nice but doesn’t appear that it will ever happen) because politicians view it as political suicide, inflation is our political cover. 

I’m not suggesting that we should target 10% inflation (playing with fire) but maybe we ultimately want 4/5% instead of 2%.  (There are also leverage discouraging side effect of this that may be beneficial). 

The Language of Market to Market

FASB recently adjusted the rules regarding to mark-to-market accounting.  This give a timely opportunity to reflex on why this matters.  On the surface it doesn’t.  Accounting is the measurement of businesses books in order for interested parties (manager, investors, clients, regulators, ….) to make better decisions.  And given that accounting is (if designed well) like the physics  experiments where the result differs based on observation (except in trivial ways – you have to pay the accountants).  Regardless of which way the language is taken the end users should be able to interpret the information and with that technical choice known and their conclusions should only change if the information is somehow better.  Mark to market (seems like) it should provide information about firms so wouldn’t it be better?  So what’s the big deal about market to market? 

Well, MTM is creating its own reality.  The clearest example is that losses that are being marked at banks are pushing their capital levels close to regulatory problematic levels.  If there was no mark to market the regulatory capital would not be a problem (the banks would hold the loans at historical cost and only market them down as losses were realized and thus quite possibly survive the downturn).  Now this suggests that due to MTM the same bank (in terms of risks, losses, and capital) would survive if they took risks through loans (no MTM) instead of securities (MTM).  This is the measurement of reality taking over reality due to a third party constraint (the regulators). 

I highly doubt that anyone discussed that bring on-line MTM was the equivalent of a large increase in economic capital requirement for banks, but in fact it was.  I’m inclined to argue that accountants should be conceptual instead of rules based and focusing on presenting reality; this makes me lean toward MTM.  Solving the problems created by MTM can be done by hiding reality but could be done better by improving the capital requirements (and investigating third party constraint that allow measurement to artificially inflict damage). 

Update/Side Comment: Now that banks can mark these assets to something other than market; the pressures to sell them off are lessened which makes the option to sell into the PPIPs less attractive.  This makes the question of will there be seller a little bit tougher. 

Democracy and The Rule of the Stupid

The word democracy makes people feel good.  Just like the ‘Axis of Evil’ sounds bad (however cartoonish).  But hopefully the reasons for our choice of societal organization is based on more then semantics and rhetoric.  I’m not going to try to provide the rational for why democracy is good (justice but also robustness) but I’d like to point out some of its weaknesses and why you should care about them in the context of the economic crisis.  

I’ve ranted about the fact that banks were giving back capital and that our bank bailout plan might retroactively fail because politicians were providing incentives for bankers to treat the capital as a short term loan instead of the equity injection that was needed.  Why would politicians do this?  They care about being elected and they want to keep their job (and increase thier power).  Thus they are pandering to what makes people feel good at the moment.  Which unfortunetly is beating up the financial system instead of fixing the problem.

So then the ignoble question is ‘are the legislator evil or stupid?’  Many politician basically understand the banking crisis (if not I’d be happy to explain it to them) and they know that paying back the capital is not entirely desirable.  If it all just about being elected how do they reconcile with thier conscious.  They tell themselves that if they are not reelected they won’t be able to do any good down the road and if they could just get a supermajority then they could do so much good.  So they justify foolishness now in order to allow them selves to do good in the future.  Of course it is important to note that they are nearly always in the short run and thus never get away from foolishness to go ‘good’.  But it seems weak to argue that politicians should not behave politically.  Politicans will be politicans. 

This policy vs. politics problem – the inability to do the right policy even when smart people agree about what it should be because of the political element – is always a popular conversation among wonks.  But it is not a new problem.  Aristotle wrote about the problem of the rule of the masses (or more bluntly the rule of the stupid) would be mitigated by the rule of the wealthy.  He also argued that one of the keys to a healthy democracy is a large middle class because they will be able to balance the rule of the stupid and the rule of the oligarch.  This could be because they view themselves as possibly being in each of those classes in the future and want the rules of the game (how society works) to be tolerable in both states of the world.  I tend to think that the truth to this argument is not about a large economic middle class but a large educated class.  Eduated voter use thier minds to make decisions based on reality and not a fantasy that a policitcan may be selling. 

From this educated middle class perspective some policy issues have a more substantial middle class than in other policy areas.  To be honest I suspect that people are more in tune with education, military, and health care issues than they are with macro economic issues.  Nearly everyone has experienced the education system, many people know someone who is in the military and most of us interact with the health care system.  And although I’m not a strong proponent that experience makes one an expert it does help increase understanding.  Many macro economic issue are simply not understood by the public and thus the rule of the stupid is risking poor policies that will compound the economic crisis. 

We’ve seen the enemy and he is us.

American Recovery and Reinvestment Act of 2009

I know I’m repeating myself (a lot here) but I think this is a better quick presentation of the numbers (and when we are spending 800 billion dollar I feel like I can abuse the topic twice).

A good source of information for government fiscal information is the CBO (Congressional Budget Office). They provide analysis on of the impact of bills from congress. They are designed to be non partisan and don’t offer proscriptions but rather just the facts. (admittedly the fact in a slightly odd way because they will show what is in the law rather than what is expect (eg. they assume continued AMT, even though it is regularly adjusted, but only for one year at a time). That being said they have put out on the table a report on the fresh off the presses stimulus package. Lets skip over the ugly details that hundreds of billions are essentially non stimulative programs (not temporarily, timely or targeted) but opportunistic spending that has piggy packed on a recovery bill and focus on the headline numbers. We see a few striking things: (1) It is big, 5% of GDP over 3 years, (2) its lasts for a while, having a non trivial impact into 2011, and (3) its peak isn’t until 2010.

	2009	2010	2011	2012	2013	2014	2015
Nominal GDP	14,138	14,421	14,709	15,445	16,217	17,028	17,879
Net Impact on the Deficit	184	399.4	134.4	36.1	27.6	22.4	4.7
% of GDP	1.30%	2.77%	0.91%	0.23%	0.17%	0.16%	0.03%
% of Stimulus Spent in Year	23%	49%	17%	4%	3%	3%	1%
Impact on GDP, assuming a 1.15 multiplier	1.50%	3.19%	1.05%	0.27%	0.20%	0.18%	0.04%

The package is far from good; but it better then nothing. The spending form is the most suspect while the size is likely the closest part of the package to being right. If we are experiencing, as I believe we are, the paradox of thrift – where everyone is trying to save more but in aggregate we save less because income fall – and the classical economic concepts of prices falling stimulates quantity demand is broken because of a shock that shifted the demand curve, then this stimulus may provide a source for saving that is not – in the short run – destructive.

Saving more is beneficial in the long run but if the savings rates increases so quickly that the economy can not adjust and the banking system is hobbled so it can’t intermediate that savings a downward spiral of economic activity may ensue. Will the stimulus package save us from a hard recession? No, we are already in one which will likely continue to hurt throughout 2009 and a recover is likely to be L shaped throughout 2010/2011. At that point hopefully HH (household) balance sheets and confidence have been repaired and the banking system is healthy enough (this is essential) that a private demand driven economy can return to steer the boat.

Krugman vs Hayek and the Cycle

The whys of the business cycle are complicated and fairly contentious – at least among economist. I don’t think we have a fully encapsulating explanatory theory but I tend to favor the Austrian Theory. Simply put that the cycle is driven my mal-investment (read: when expectations are off). The theory in a narrow sense argues that this poor investment is driven my non market (read central bank) driven monetary policy. If they hold rates to low a investment boom ensues which eventually, once the credit growth can no longer grow (we can’t leverage to infinity), credit slows and those poor investments fail. I have a small addition that I typical like to argue. Poor investment can be driven by over stimulative monetary policy (which provides low rate but also – and this is important – makes the environment less volatile) but they are more often driven by the inability of entrepreneurs and investors to see the future. So everything from disillusion expectations (IT investment) to shock to the economy (oil and gas in 80s) to innovation (investment in typewriter manufacturing capacity) can spark a transitional downturn where the old capacity is taken off line (which it should be because it is no longer valuable) and savings and investments build up new capacity. Monetary policy can dampen and extentuate the cycle and fiscal policy can help break downward spiral due to the paradox of thrift but until we can see the future the cycle will remain in one form or another. We can prepare ourselves for it and handle it better or worse but it is not going away.

I called this Krugman vs Hayek because I ran across an articleby Krugman where he attacked (something he enjoys doing) Hayek. His argument is that Austrians are taking the bleed the system approach advocated by Andrew Mellon at the start of the great depression.  He seems to suggest that ever letting productive capacity lay idle is a economic waste. I’m somewhere Mellon and Krugman in between and take a more nuanced view of the economic cycle. Letting the system bleed if it is entering a downward self perpetuating (deflationary/money supply contracting) spiral is a bad idea. The liberal capitalistic (Hayekian) system requires a functioning, as Smith put it, ‘civil’ society this requires that the bleeding not break the system. But on the other hand Krugman is wrong that leaving capacity idle is always a bad thing (he assume that we can tell which is productive and which is not). At the extreme if we keep capacity going we’d still be making typewriters and buggy whips instead of autos and computers. We have to let the system work through capital allocation decision because if we don’t the economy will become increasingly nationalized as no one want to buy the products that are produced and the government has to take over the unprofitable typewriter factories. Never letting Schumpeter’s forces of creative destruction function is a bad idea.

Now we are working off excess investment in housing but also have entered into an deflationary spiral and forces assets sales. So as I’ve argued before the fiscal stimulus – of the right size and form – is a good thing, but of the wrong size – too big or too small and of the wrong flavor – will hurt us both in the long and short run.  We have to tear the muscle so that it can rebuild but just not bleed the system white.