5 ducats

Prosperity After the War

We have been through years of economic decline and stagnation. Large government stimulus programs are over, though they did more to survive than prosper. Interest rates are at rock bottom, government debt has never been higher, unemployment remains high, and the dollar is strong largely because all other currencies are in trouble. The war is finally over. After years of foreclosures, people are buying homes in large numbers, and young people are going to college in droves.

The above paragraph could describe both 1945 and 2013. After WWII there was fear that the nation would fall back into depression. But we didn't. Partly it was because of the GI bill that enabled widespread investment in education and housing, and partly it was because private deleveraging had occurred. But I think it was mostly because of widespread optimism.

I see optimism returning today, I think because people see hope and are fatigued by prophesies of financial austerity and apocalypse. Good.

What remains to be seen is if inflation and interest rates will skyrocket as growth returns. If they do, then the banks are in trouble and their business model of borrowing short and lending long may even be untenable. Yet interest rates and inflation rose very gradually after WWII, and I bet that they will now too.

That is particularly true if you appreciate that the Fed's QE only created cash by purchasing bonds, and the Fed can remove the cash by selling those bonds if needed. Nor for that matter has our money stock (M2) increased at a faster rate since the financial crisis hit. Most QE fear mongers don't understand what money or the monetary base is. Ignore them.

We face many problems, and the next decade will not be utopia. But as I look back to the late 40's and 50's, I bet that the next decade will be a good one for the US.

The Next Mortgage Crisis

Mortgage debt is falling and house prices are rising. A new cycle has begun. Previously underwater borrowers are able to refinance to much lower payments and increase their disposable income. Foreclosure sales are avoided by improved expectations of the borrower, lender, and housing investors. General confidence and consumption rebounds. Lenders lower their loss reserves, increase lending, and even hold loans on their balance sheet. Inflation will rise and the Fed will unwind their massive balance sheet.

That cascade of change is good for almost everyone, but it will cause interest rates to rise in a couple of years, and someone will be exposed. That someone is probably mortgage REITs, who borrow short duration money in order to buy longer duration MBS and profit from the yield spread. Some mortgage REITs manage their risk by hedging interest rates with derivatives, and by buying adjustable rate mortgages rather than 30-yr fixed rates. But other REITs have spent little to manage their interest rate risk, which has allowed them to prosper greatly in a period of falling yields, and to grow into behemoths.

Higher interest rates reduce mortgage refinancing, which causes a REIT's interest revenue to remain at the old, lower mortgage interest rate while their cost of borrowing simultaneously rises. After prolonged prevarications, a particularly risky REIT or two will falter. Their funding will dry up, and they will no longer be able to buy MBS. This drop in MBS demand will cause mortgage yields to rise higher and slow prepayments even more, including on borrowers who would have otherwise moved to another house.

The prospect of a a giant REIT's MBS portfolio being forcibly liquidated will scare other MBS investors out of the market, which results in MBS prices falling more. The spreading fear causes funding to be pulled from even safer REITs, endangering their survival and promulgating a spiral of falling mortgage prices that will be unpleasant for all MBS investors, including banks, insurance companies, and fixed income funds (though a flight to Treasuries may create an offsetting gain for some). And the corresponding much higher mortgage interest rates won't be pretty for the housing market either.

Fannie and Freddie were the historical big buyers of MBS, but their portfolios are mandated to shrink. So will the Fed come to the rescue, or will they want to teach the market a lesson in self reliance? Ultimately the Fed's hand will be forced if there is systemic counterparty risk from the debt and derivatives traded with REITs, which could certainly be the case.

Virtuous cycles turn vicious, which is the contagious and cascading nature of risk. The next mortgage crisis shouldn't be as bad as the last, as long as the big bank's interest rate derivatives are secure. But it is probably only years away, not decades. It would be nice for regulators to mitigate that crisis ahead of time. As is usually the case, the answer if for regulators to preemptively and gradually reduce the leverage of the risky borrowers. Or at least make sure that tax payer insured and systemically important lenders aren't funding the concentrations of high risk.

How to Balance the Budget

First, we shouldn't balance the budget most years. During recessions we almost have to run a deficit due to higher unemployment benefits and lower income taxes, plus we need someone to borrow the money that households and businesses save (otherwise the economy continues to shrink). In the boom times the government should run a surplus in order to pay down the debt from earlier recessions, slow down an overheating economy, and reduce competition with private investors for savings.

Our long term average deficit should be less than or equal to our economic growth rate, which includes increases in population, productivity, and inflation (though inflation growth is often consumed by higher interest rates on the debt). As long as our future tax base increases by as much as our deficit, we can pay off that deficit without raising tax rates. Ideally, our deficits are spent on investments that increase productivity (infrastructure, education, research) that make it easy to repay. 

As US economic growth rate accelerates towards normal levels (3%?), the deficit will naturally shrink due to higher tax revenues and lower spending on unemployment benefits and SNAPS (food stamps). But there are two long term fiscal problems that won't easily be fixed with economic growth.

1. Top tax rates on ordinary, capital gains, dividend, estate, and business income are all near post-WWII lows.
2. Medicare and Medicaid spending is increasing much faster than reasonable economic growth.

We need to raise taxes back to something around what they were during the Clinton administration (when we ran a surplus, but before so many boomers retired). Everyone hates to pay higher taxes, and the ones with the most money are invariably the ones going to be tapped, yet they have the most lobbying power. Here are tit-for-tat tax ideas that may be more palatable:

• Tax capital gains as ordinary income, but allow capital gains to be reduced by an inflation index and eliminate the AMT.
• Tax dividends as ordinary income, but allow corporations to deduct dividend payments to US taxpayers as a business expense.
• Tax inheritance over 10 times the median income as ordinary income, but eliminate the estate tax.
• Implement a carbon tax and eliminate alternative energy credits, but reduce top corporate tax rate to 28% and make R&D tax credits permanent.
• Eliminate most itemized personal deductions, but replace them with non-refundable tax credits @ 15% of expense (regardless of tax bracket).

As for slowing the growth of medical expenses, maybe Obamacare will help. So much of health care spending is for insurance overhead (10%), insurance profits (10%), and provider billing (at least 15%). The size of these expenses don't make any sense. I don't have a solution of how to reduce them, but it would be easier to cut these than healthcare itself.

Bernanke Uncertainty

I'm suspicious that the market's uncertainty and hope on QE3 is harming the economy. Speculation in what the Fed will or won't do is messing with already pretty messy commodity and currency values. Uncertainty is almost always bad. I wish Bernanke would settle it by saying something short, direct, and then stop. Such as,

"We've done all we can to help the economy with the purchase of Treasuries and Agency MBS. Buying more won't help, so don't expect more. If we have a future emergency, maybe we'll find a way to buy non-traditional assets, but I'm not sure what those assets would be or how it would work at this time - it is all hpothetical right now and would be dictated by the type of emergency and market reaction at the time - so don't ask.

We commit to keeping interest rates low for the forseeable future, in other words for years. Hopefully this statement makes the market feel good, but the reality of US de-leveraging, and increasingly global de-leveraging, has created an excess of savings versus the demand for debt. The market equilibrium is already dictating very low interest rates for years.

This means that the US and most developed nation governments are looking at incredibly low borrowing rates for many years, often these rates are negative in real terms. So I advise them to borrow that cheap money and put it to work by investing in infrastructure, education, and research in ways that will not only stimulate current demand, but also increase future productivity. Surely governments can find public investments that will yield more than a 2% marginal return in national production. If they can't or won't, then citizens should vote in politicians who will.

The future of the economy depends much more on the public and private sectors investing their money in productive enterprises than if and when I make asset purchases. So stop wasting your time second guessing me, I promise you future interest rates will be near their current levels for the next three years. Now get back to investing, producing, and consuming - because that's what the economy is about, it isn't about me. If you are concerned about Europe or China's future, then focus your business in the US.

No more excuses, no more poppycock about a return to the gold standard, distractions about the value of the dollar, rumors of phantom inflation, or mis-statements about the money supply. Get back to work!

And to all you reporters - get off my lawn.  Now!"

No Wonder Paul Ryan

Rep. Paul Ryan doesn't believe in taxing investment income, and since that is almost the only kind of income that Romney receives, it would drop Romney's effective tax rate below 1%.  And because Romney's businesses route their income through nations that act as tax shelters, little to no corporate tax on the income was ever paid either. Ryan's nomination seems laughably self-serving for Romney, and it probably won't help Romney escape tax questions. Portman of Ohio was the better strategy, particularly since Ohio is the most important swing state.

But R&R's taxes should raise a more basic question. Should investment income receive a preferred tax rate? After all, production requires land, labor, capital, and entrepreneurship - not just capital investment. Providing capital (money) is not the same as entrepreneurship (innovation). Capital does take a risk by investing, but it gets rewarded for taking that risk by receiving higher aggregate returns.

Nor should we assume that the wealthy would not invest if they didn't have lower tax rates, because they still want to save for their retirement, their children's college, large purchases, and even the avarice of money for its own sake. Meanwhile the penalty of usually persistent inflation is a strong incentive for capital to not lay fallow.

What does it say about working for a living if only workers pay taxes? Karl Marx would laugh his ass off. We need people to work, and taxing it much higher than investment creates a terrible incentive to show up for work each day. Why not speculate in real estate, trade stocks, and create derivatives (and these have more social prestige as well)? By giving these activities tax incentives, we created an economy that is less productive, more volatile, and less equal. Ryan's plan would make it even worse.

The main problem with the US economy is not a lack of private non-real estate investment, though higher consumption and employment would certainly help. Private non-real estate investment has returned to its pre-recession level (though like the rest of the economy, not to the extrapolated trend), and the incredibly low bond yields on investment grade and even junk corporate bonds demonstrate that raising investment money is literally cheaper than ever. The large deficit is in real estate (fixed) investment due to the over building of the 2000's, though even that is recovering as the surplus is gradually absorbed. Government investments have also dropped, due to low tax revenues (note how relatively low Federal investment is in the bottom two lines).

China's current woes show that you can have too much investment and too little consumption. China's past growth with 50% of expenditures going to investment was only possible because a) there are a lot of obvious high-return investments when you start in the agrarian age, and b) they looked to exporting for consumption, which relied on what was an artificially low Yuan and low labor costs. China continues to develop real estate, build factories, use labor intensive processes, and buy industrial commodities even though no one uses the buildings, Europe doesn't buy the exports, and their labor isn't that cheap anymore. China is becoming yet another classic example of why central economies don't work in the long run (remember that the USSR was a superstar in the 50's and 60's).

We need a simple, progressive tax system that doesn't discriminate by the type of income. I think most Americans agree with this. If we really believe in a free market, then why do we continue to manipulate market behavior by preferring investment over consumption in our taxes? Because the rich and powerful have created an impossibly complex tax code that favors themselves rather than the free market that they supposedly adore.

Central Bankers Aren't Supposed to Fake Out Markets

I remember Greenspan saying that the Fed doesn't make surprise moves; it strongly hints at what it will do until the market gets it. So don't over analyze Fed guidance, the contrarians are by definition going to be wrong. There are all kinds of criticisms one can make about Greenspan's policy decisions, but this operational tactic makes a lot of sense.

Central banks want to reduce volatility and uncertainty, since those are things that cause losses, create bail-outs, and generally make the public angry at central bankers. Draghi's conflicting statements increased volatility and uncertainty; he made a bad situation worse. Bond traders clearly interpreted his "whatever it takes" comment as a strong hint that big action was coming. As soon as he realized that the markets had over read his comments, he should have immediately put out strong corrective hints. Instead the bond investors bought big, and today they lost big.

You may not care that bond investors over interpreted a comment and lost money. But governments need bond investors to finance debt, and the taxpayers needs low interest rates. If bond investors perceive the world as capricious then they will demand higher yields to buy debt. What Draghi did definitely makes the Euro debt and currency seem more capricious.

Furthermore, central banks can manage economies by changing lending rates, setting reserves, buying or selling securities, but quite often they also manage by offering guidance on their future actions (such as inflation targets). That only works if the market understands and believes what the central bank is saying. Markets will of course always closely listen to the ECB President, but going forward they will second guess, disagree, and discount Draghi's statements. Dragi has made the ECB weaker, and it wasn't strong to begin with.

Savings versus Investment

The common explanation for our economic woes is excessive debt. Then we blame whomever we don't like for it (government, banks, Federal Reserve, culture, etc.). The solution is then for the offender to wear sack cloth and ashes for seven years, or until the debt is paid down. Here's a different take...

During the boom our investment exceeded savings. During the bust our savings exceeded our investment. Economic models usually assume that Savings=Investment. But during the boom we had leverage built upon leverage due to low down payments and low capital ratios of non-banks. When the bust hit, savings surged as the private sector tried to regain solvency, and investment fell due to fear of not being repaid. Savings were so plentiful relative to investment demand that they reaped negative yields (real or nominal).

Many people think the negative yields are irrational. They explain that it is due to the manipulation of central banks, even though the low yields persist globally in every investment without default risk. Or they believe there is a speculative bond bubble, even though I don't think speculative bubbles in bonds are even possible since the principal repayment amount is contractually fixed and the possible appreciation due to market interest rates approaches zero as the YTM approaches zero.

Negative yields are rational when a) there is more risk of deflation than inflation, b) the world's second largest currency is in danger of breaking apart, c) the second and third largest economies are in a recession, and d) no major economy is doing well. In a deflationary environment, why wouldn't you want to hold cash with a zero yield, since it is worth more in the future and everything else is worth less? It isn't feasible to hold billions of currency, so you hold the next safest and liquid instrument you can find. If you can hold a foreign currency likely to appreciate versus your domestic currency, then a negative yield makes even more sense (i.e. you are in the Eurozone).

We can argue if we have too much savings or too few investments, but what matters most is that they are not in balance with each other. We can wait for things to work themselves out. If the population is growing, then eventually there will need to be new investment to support additional subsistence demand. That could take a very long time to work itself out. Here are some other options...

1. Just de-leverage - unfortunately deleveraging means a shrinking economy, which means higher defaults, which leads to either a destruction in private savings, or (more likely) a transfer of private debt to public debt.
2. Raise interest rates to increase incentive to invest - but if there is no expected consumption to repay the investment then the interest rate is irrelevant. Also, borrowers default more often.
3. Lower taxes on investments - lower consumption means that investors will lose money, lower taxes on profits are irrelevant if your investment has no profits. In the US these taxes are already historically very low.
4. Create inflation to effectively destroy excess savings and to penalize non-investment. For better or worse, central banks have been unable to create inflation because the expansion of the monetary base has not stimulated private lending.
5. Destroy excess savings with default or principal reduction. This leads to even more fear by savers, which causes higher savings but even lower investment.
6. Destroy excess capacity, which creates incentive for new investment. This sounds absurd and wasteful to me, but I didn't invent it. Included for completeness sake.
7. Lower saving by increasing consumption - Make people watch more advertisements and put Prozac in the water? Unfortunately, the debtors would likely be only ones who consume more.
8. Government taxes wealth in order to remove excess savings - would be unpopular and hard to implement. 
9. Government increases consumption by aiding the poor - unemployment, Medicaid, SNAP, etc. Is this economic stimulus or just subsistence?
10. Government lowers taxes on the poor to increase consumption (since they lack the capacity to save), and create an incentive for investment to capture that spending. But poor don't pay much in taxes to begin with.
11. Government increases investment in research, education, and infrastructure in order to put excess savings and labor to work, which hopefully leads to higher consumption and therefore higher private investment. But will government investment lead to higher productivity, and how long can higher government debt be sustained without credit risk?

These options range from distasteful to idiotic to terrible. By default we've done a lot of #1. As public policy we have so far tried #3, 9, 10, and #11, at least a little. The stimulus package had $750 billion of tax cuts and spending spread out over a couple of years in a $15 trillion economy. We've done #9 over more years with more money. These may not sound like great options, but they are less bad than the alternatives. 

Those who have savings (and political power) will particularly despise the ideas to raise inflation, taxes, or defaults. Those with debt positions will generally favor these very options. The savers will advocate lower investment taxes and higher interest rates to stimulate investment, even though without likely sales revenue to repay the investment, the tax and interest rate are moot in the business decision.

Employment Numbers

Employment numbers are important to monitor the trend of the economy (though I think consumer sales are a better leading indicator). Unemployment claim data is particularly nice because it isn't a survey, and it comes out weekly - unfortunately people tend to look at it so closely that they see trends that aren't there. The real world is a noisy place, particularly with floating holidays and such.

But the big numbers are in the the monthly BLS employment situation report, which comes from two different surveys - one of employers and one of households. The important employee count (but not unemployment rate) comes from the employer survey. This is considered the 'truth', while the ADP employment report is considered an estimation.

But why shouldn't we consider the ADP report to be as accurate an estimate as the BLS data for private payrolls? The ADP report comes from an incredibly rich data source of 344,000 employers and is determined by actual electronic payroll processing. There is some bias (for which they try to correct) based on which types of firms use ADP. But the BLS is also bedeviled by the bias of new businesses that get left out of their survey.

What makes me particularly suspicious is a graphical comparison of these two measures of employment. See this. The BLS line is a lot jumpier from month to month, which is a symptom of a smaller sized sample that creates more statistical noise. Remember that the BLS survey sample size is limted by their budget. And the BLS line tends to have more muted cyclical highs and lows, which I think also suggests that their data isn't as robust.

So who to believe, the BLS or ADP? At the very least, I wouldn't throw away the ADP data when the government data comes out. The ADP data has value. However the BLS data has lots of really cool stuff beyond employment count - things like hours worked, part-time, reason for part-time, and by many cohorts (which get even noiser as the sample size decreases). An overview of multiple data beats staring at a single graph until you imagine a trend. But that doesn't make good headlines.

Read this Der Spiegel "Imagining the Unthinkable"

Are the Germans in denial about the Euro? According to this must read Der Spiegel article, no.

• Investment experts at Deutsche Bank now feel that a collapse of the common currency is "a very likely scenario." 

• German companies are preparing themselves for the possibility that their business contacts in Madrid and Barcelona could soon be paying with pesetas again. 

• According to Credit Suisse, the market leader in Europe's largest economy [Deutsche Bank] ..., would face such heavy loses that it would suffer a capital shortfall of €35 billion.

• IT systems are being prepared for a Europe with multiple currencies.

• Economists with the Dutch bank ING have calculated that in the first two years following a collapse, the countries in the euro zone would lose 12 percent of their economic output... It would make the recession that followed the bankruptcy of investment bank Lehmann Brothers seem like a minor industrial accident by comparison.

• The German Finance Ministry's prognosis is even grimmer than that of the ING experts. According to their scenarios, in the first year following a euro collapse, the German economy would shrink by up to 10 percent and the ranks of the unemployed would swell to more than 5 million people. The officials were so horrified by their conclusions that they kept all of their analyses under lock and key, for fear that the costs of rescuing the euro could spin out of control.

• According to a scenario by the major Swiss bank UBS, if the financial risks resulting from the decline in exports, the necessary bank bailouts and the company bankruptcies are added together, the total cost to the German economy could amount to a quarter of Germany's gross domestic product -- well over €500 billion.

• Through this internal payment system in the euro zone, the Bundesbank has accumulated about €700 billion in claims against the central banks of countries like Greece, Spain and Italy. This is more than five times the Bundesbank's own capital.

Given these prominent German and Dutch prognostications, how could German leaders allow the Euro to fail? After all, they must know this information. I think that is explained earlier in the article...

• They [Southern Europe] would prefer to have the money without conditions. But the German government is unwilling to accept this, which puts Europe at its next impasse. Furthermore, the rescue strategists' resources are limited.

• But now even the ECB has largely exhausted its resources. It has already bought up so much of the sovereign debt of ailing countries that any additional shopping spree threatens to backfire, causing interest rates to explode instead of fall.

• The question is whether the economy in Southern Europe will recover before the euro rescuers' tools are exhausted, or whether it will be too late by the time the recovery arrives.

• It's a question of growth and the economy, but also of character. How willing are the Spaniards and Italians to accept reforms and hardship, and how willing, on the other hand, are the donor countries of the north to provide assistance and make sacrifices?

I would dispute some of these points, but what I think doesn't matter. Based on this, it sounds like German leaders have already accepted that the Euro will break apart. But the date of failure sounds distantly dependent on future periphery economic performance and political reforms, and has nothing to do with German decisions.

I too, think the break-up of the Euro (if not in name, then significantly in composition) is inevitable. But preparations must be made immediately for an orderly and amicable division. I don't hear any of this, only defiance and a bunker mentality (no double entendre intended).

If Germany has already accepted the break-up of the Euro, then at this Thursday's summit Germany will offer disingenuous solutions, which will be both impossible politically and inappropriate for the immediate market problems. The purpose will be to give the appearance of German support for the currency union, while in fact having confidence that it is doomed. This strategy will enrage other participants, and probably not just Southern Europe. And it will frighten markets whose hopes hang from increasingly dubious expectations of government and central bank rescue.

The begining of the Euro's end could be within a week. And that photo of Draghi being presented with a Prussian spiked helmet will go down in infamy.

An Alternative to Blame within the Eurozone

Nationalism and stereotypes have created a breakdown in communication within the Eurozone. Each side tells monologues of how they are the victim of so-and-so's vice of gluttony, greed, sloth, wrath, or envy. Perhaps some truth, but they are all guilty of pride. In this environment, an orderly resolution of the debt crisis is impossible.

I believe they need to share a non-judgemental historical explanation of the crisis. From that standpoint it is much easier to agree on mutual solutions. Here's how I would explain the development of the crisis - with no blame attached. As is usually the case, unsustainable virtuous cycles (low interest rates & trade imbalances) become vicious cycles.

Low Interest Rate Cycle:

1. Euro adoption caused periphery interest rates to fall in expectation of tighter monetary policy from the ECB than than they had from their individual periphery central banks.
2. The ECB lowered their benchmark interest rate from 4.75% in 2001, down to 2.0% in 2005. This was stimulative for Germany's 1% real GDP growth for that period, but was inflationary for Irish (21%), Greek (17%), and Spanish (13%) growth.
3. High perhiphery growth rates caused markets to underestimate long-term credit risk and price the periphery at the same low interest rates as the core.

Trade Imbalance Cycle:

1. The Euro gives periphery consumers a stronger currency, which makes imports from the core cheaper and creates years of trade deficits with the core.
2. Low interest rates and high inflation create a very favorable environment for real estate investment in the periphery.
3. Domestic investment is directed towards real estate and away from manufacturing, which makes the periphery even less competitive in manufacturing.
4. Higher inflation in the periphery causes employee compensation to rise faster than in the core, which makes the periphery even less competitive in manufacturing.
5. Core nations accumulate huge trade surpluses in the form of periphery IOU's, which they invest in perhiphery banks and core bank subsidaries in the periphery, where it is often invested in an asset with outstanding returns - real estate.

Imbalances Find Equilibrium:

1. Trade imbalances created poor private investment choices in the periphery, particularly in a real estate bubble. This threat was not recognized until the US financial crisis forced tighter credit and more appreciation of asset bubble risk.
2. As collateral prices fell, periphery banks became insolvent. Core nations withdrew their short-term lending to periphery banks. Large depositors fled perhiphery banks.
3. Sovereign and ECB lending replaced the private debt to periphery banks, which allowed core banks to recover some (but not all) of their periphery investments.
4. Employment and production rapidly fell in the periphery as private credit, consumption, investment, and government spending all fell.
5. The expense of bank bailouts and a shrinking tax base caused higher borrowing costs for periphery nations, which in trun caused even more fear of sovereign default.

The above is Christmas past and present, and what we should acknowledge it (though details vary from nation to nation). Below is Christmas future...

Resolution:

1. Widespread insolvency causes high interest rates, deflation, and cessation of trade (the opposite of virtuous cycle that started the debt crisis).
2. Core economies are dependent on trade, which plummets and rapidly shrinks their economy.
3. Large periphery sovereign(s) default and/or leave the Euro, which causes core banks to be insolvent (including some of largest banks in world). Core bank losses exceed their host's GDP.
4. After the first major nation withdraws from the Euro, there is a run on the ECB as other members threaten to leave the Euro to avoid the larger share of losses from ECB and Target 2 debts.
5. Core nations become insolvent due to smaller tax revenues and large bank bailout costs.
6. Ironically, the remaining core nations instruct the ECB to print trillions in Euros to prevent systemic collapse. 

The resolution section could be completely different, if the Euro members realize that blame will lead to mutually assured destruction - including for the core. The downside can be avoided with generous debt restructuring, ECB debt purchases, heterodox ECB money creation, and the orderly end of the Euro. The Euro never made sense. Europeans don't have enough common identity to be willing to help each other during times of economic crisis - particularly for the long run. In this case accepting a sad truth is better than believing a comfortable lie.

The US dollar works because the states share government revenue and spending between each other with ignorance and impunity rather than avarice and antagonism. I believe that a common currency across the Anglo nations would be more successful than within the Euro, because the people of the US, Canada, UK, Australia, and New Zealand share more in common culture than within the Eurozone. But no one is advocating an Anglo-wide currency because it is a silly idea (even between closer trading partners like the US and Canada or Australia and New Zealand). We all do fine with our own floating currency, thank you very much. And we don't want an even more behometh and remote central government.

Eurozone members should plan an orderly break-up of the Euro, and then hopefully focus more on wealth and less on money. May they have the wisdom to know the difference.

Timing a Crisis

I remember that the US financial crisis slowly developed for more than two years. Here's my recollection, of key events both from personal experience and news accounts.

• 4/2006 - I see data on new purchase contracts, Florida house prices are falling.
• 6/2007 - First payment and early defaults are so high on subprime and option ARM's that warehouse lines and originations start to collapse.
• 3/2008 - I hear anxious conversations from a broker dealer that they are hedging and/or severing transactions with Bear Stearns. (I then realized the problem was much bigger than mortgages).
• 9/2008 - Fannie & Freddie are put into conservatorship.
• 11/2008 - Lehman files bankruptcy. There is a run on money markets. Private lending stops.

What is surprising in retrospect is that it took 31 months from the first sign of distress until the apex of panic. For the first two years, most of the public and even financial experts were oblivious to the danger that already existed. Who would have expected money markets to be the achilles heal of a mortgage crisis?

In retrospect we tend to think of a crisis occuring at a single point in time due to a single catalyst. In reality a crisis can build for years, and the particular catalytic event (if any) is never forseen. That's what makes shorting so scary, because you can't time fear. Conversely, the fact that a systemic problem hasn't lead to a panic yet should not give us confidence that it won't happen in the future.

It is surreal how quickly we have reinvented history in our rememberence of the recent financial crisis, perhaps as a concious effort to not learn anything from it, and to protect the existing system. And so it is in Europe as well, even before their panic.

Debt Solution

Most of the economic problems in the developed world are due to high levels of private debt that purchased overpriced speculative assets. Many will add their own spin to blame somebody for it (governments, central banks, banks, lazy people, greedy people, etc.). If blame were a solution then our economies would have long ago recovered. 

There are several common reactions to a debt crisis:

1. Lower interest rate and/or extend term.
2. Forgive the borrowers.
3. Liquidate the borrowers.
4. Lend the creditors money from the government and/or central bank.

The traditional workout is the rate/term. Because of the fear of moral hazard there is a maddening amount of bureacracy and time to make sure the borrower really deserves/needs it. If the rate reductions do occur, they are often just enough to delay the default rather than cure.

The rate/term workout is increasingly forgotten in our politically polarized world, where many want to liquidate in order to punish the debtor, or forgive in order to punish the creditor. The problem with either ideology is that it would not only destroy most banks, but also destroy credit markets and collateral values for decades. For example in the mortgage industry ruthless foreclosures lead to a vicious cycle of falling house prices, more negative equity, and more defaults. And debt forgiveness would make lenders very reluctant to lend in the future. 

Since rate/term, liquidation, and forgiveness don't work on a large scale, debt crises soon end up with the delay tactic of lending from the government/central bank/IMF. Swapping one debt for another debt may solve short-term liquidity problems, but it isn't a cure unless the borrower's capacity to pay improves through income growth or collateral appreciation. Unfortunately, neither of those is likely in a balance sheet recession.

A controversial fourth way would be for the central bank to purchase bad debt after it has followed a stipulated restructuring. The restructuring itself would be traditional, the novel part is for the central bank to commit to purchase the restructured debt as a commodity. This gets quantitative easing directed to the heart of the solvency debt problem, rather than pushing more liquidity into excess bank reserves (which are at the central bank rather than flowing through the economy).

Eligible debt would be defined as debt that the market will not refinance (or requires an excessive premium to do so). The central bank would set restructuring policies that place costs on both the lender and borrower (contrary to popular opinion, both are often to blame for bad loans). Restructuring rules would generally be:

1. Interest rate is reduced to the rate for best credit.
2. Fixed-rate debt becomes floating rate indexed to 1-month risk free rate.
3. Lifetime interest rate ceiling is set to prevent large future rate shock, but borrower bears some interest rate risk (likely when economy recovers).
4. Principal reduction is possible, but discouraged.
5. For secured debt where the borrower has the capacity to pay (is current), the amortization term is shortened so that they pay down debt and achieve positive equity sooner.

The central bank gets creditors to realize their losses through large interest rate reductions to the borrower, and in return the central bank can directly subsidize a specific portion of those losses by paying up for the restructured assets in order to make the deal work. This quickly cleans up bank balance sheets and borrower income statements so that consumption, lending, and investing can increase at a normal pace.

The central bank would have no recourse to the government or bank that sells the restructured debt, so that the central bank would bear the full credit risk. However credit losses should be small if the restructuring works at a macro and micro sense. This approach could be applied to consumer, commercial, or government debt. Consumer and commercial restructured debt would be securitized for easy sale and administration for central banks.

Such purchases by central banks have many advantages:

1. Immediate, large reduction in borrower payments will stimulate consumption.
2. Removal of bad assets from balance sheets will increase bank capital and lending.
3. Higher consumption and easier credit will increase investment and absorb high savings.
4. By the central bank stipulating the restructuring terms it removes lengthy means testing and negotiations between the creditor and debtor.
5. Collateral values are supported by reducing liquidations and accelerating amortization.
6. By indexing restructured debt to short-term rates, central bank and/or markets can easily constrain consumption if inflation becomes a problem.

On the other hand, there are several possible problems with this proposal:

1. Central banks take credit risk, which is scary from a political perspective.
2. It could create inflation.
3. Moral hazard because banks think they will be bailed out in the future.

None of these objections are unique to this policy. Right now the ECB is holding lots of dubious assets as collateral; they take credit risk but won't admit it. And any policy that is stimulative could create inflation; but in a deflationary environment can't the central bank create money without much inflation? As far as moral hazard, we've amazingly already made government bonds subordinate to senior bank bonds in many situations.

In 2008 I would have thought this proposal was insane, but conventional policies haven't worked in the past 5 years of recession. Huge problems are building in Europe and China. The time for radical intervention is approaching, because what is the point of a healthy central bank at the expense of a destroyed economy? 

Too Much Saving?

Are the households of surplus nations (i.e. China, Japan, Germany) the ones that are saving so much, or is it more their businesses? It tends to be the latter. Are they are scared by previous economic or war traumas, do their tax laws favor savings over debt, do low interest rates exacerbate savings rates, or perhaps it is just cultural? I don't know the answer.

My guess is that savings is culturally more valued in geographies with harsh winters, because people learned that they had to stockpile food, fuel, and seed to survive. Savings did not equal a contemporaneous investment, but was hoarding for the certain future dearth. But there's more to it than that.

Many people view savings and debt as moral issues; savings is good and debt is bad. Never mind that if debt is a vice then it is only possible through the action of the saver (therefore savings must be bad?). Savings could be directed to equity investment rather than debt, but in spite of our capitalistic propaganda, most stock trading is speculation after the IPO. Ironically, higher stock prices enable corporate investment mostly by supporting a higher debt burden.

The problem with corporations is that they don't consume goods and services (except for executive perks), instead they invest their money. The same goes for state owned enterprises and central banks. If we ask them to consume then we are asking them to violate their charters. Corporations will invest in their business if either they have a technological breakthrough that allows them to expand their market, or if their market is organically growing (uncommon now). Typically one can expect markets to gradually expand simply through population growth and inflation - but Europe and Japan have neither (is a low inflation target incompatible with a declining population?). Nor has either invented new must-have consumer goods. So they have little internal corporate investment, and what they had was for Chinese capital equipment export (now gone).

Fortunately our modern financial system enables savings to immediately be transformed into an investment in the winter rather than waiting for spring. Unfortunately in the past decade bank loans and bonds have tended to invest savings into assets for speculative price appreciation rather than an investment to increase productivity. The inevitable resulting losses perversely create an incentive for more saving, but less investment. If we can't find more household consumption or corporate investment, then we need more shared investment (education, infrastructure, technology) to absorb savings.

A fascinating alternative is that we need less savings. We now produce so much food with 2% of the work force, and so many goods with 8% of the work force that we are obese and trip over our cluttered possessions. Goods no longer cost much, though assets (including land) do as we bid up their scarcity through our mal-investments. We need not save for the cold season, and in the Western world we have government pension provisions for old age. Relatively speaking, we don't need much savings, (but we are told that saving is wise and moral).

I think most households desire future income more than the savings themselves. But if we all buy annuities, then we just increase demand for scarce assets through an intermediary. One solution would be to change the tax law to incentivize corporations to pay out their profits in dividends rather than their current practice of hoarding their savings in high grade paper or equity buybacks (at yields below their core business operations). By turning most public companies into yield producers, the companies themselves become high quality assets for investment rather than hoarders of savings and scarce high quality investments.

The False Hope of Emergency Lending

Central banks can lend money at low interest rates to nations, either directly or indirectly (through banks, special funds, or international agencies). Markets love this stuff because they think that it is inflationary (in particular, asset prices), and that the poor country is saved. However both are usually false.

Emergency lending can only works if it isn't done at the last minute. Replacing more expensive debt with cheaper debt is nice because it reduces interest expenses (and therefore future borrowing costs), and it increases the liquidity (reducing the chance they will run out of cash). But remember, that the money we are seeing in Europe isn't a gift - it is still debt to be repaid.

If you wait until the market fears immenent default, then households and consumers hoard cash rather than consuming or investing. Which is to say tha that economic activity slows and tax revenue falls. It may also create deflation rather than inflation, since people hoard currency (including in another nation) rather than goods or assets. In order to counteract this hoarding one would have to lend so much money, so cheaply, that everyone knows the government is solvent (not merely liquid) for years to come.

But that isn't what happens. Emergency funds are dispensed in the same way that someone's head is held underwater until the moment that they are about to drown, then they are let up momentarily for one gasp of air, and then plunged underwater again.

Someday the markets will figure out that emergency lending isn't helping the debtor. In the meantime, the only one that it does help are the creditors (often banks and insurance companies), who get their risky private debts repaid through the expense of central banks and taxpayers issuing the new debt.

By now, the economies of many troubled nations are so screwed up that their debts are uncollectible because their tax base has been wrecked, and they weren't doing great beforehand. The only solution is a workout (a.k.a. 'default' to creditors) - unless one wants to hope that Prince Charming gives the money to the nations, rather than lending it. But neither Mario nor Angela look like the giving or forgiving type.

Think the Unthinkable

It used to be unthinkable that the Euro would break-up. Now the common question is not if, but when and how much. 

Another unthinkable is that China's economy will not only slow, but will shrink significantly. Even more unthinkable is that the Politboro's power will be challenged. The economic news from China looks to have turned into a vicious negative cycle. Yes, there is still hope by many that the government will manage a recovery, but I doubt that hope will survive the year. When hope is lost, it is difficult to regain and most stimulus projects become impotent because consumers don't consume and investors don't invest no matter how big the government incentives are. My crystal ball isn't clear enough to see if China's political system is overthrown; I doubt it, but again, it is thinking the unthinkable.

And so two of the largest economies in the world will retreat for a decade or two. Perhaps the US will become like Japan and have 25+ years of zero growth, zero inflation, and constant deficits. And who knows what will become of Japan - can they borrow forever? We study Greece too much and Japan too little.

Looking back, we will ask why it happened, and how it could have been avoided. The old self rightous vices of debt and sloth will be trotted out, with perhaps a bit of avarice and gluttony too.

But it was all avoidable, if we followed a few simple rules:

1. Bad debts are the responsibility of the lender more than the borrower, and are not the unlimited liability of the government or society. Our bailouts to date have benefitted the creditor more than the debtor, and in so doing create lenders with money who won't lend, borrowers who can't consume, and businesses who won't invest. Gradually liquidate insolvent lenders, and encourage new capital to new lenders.
2. Never give up your currency. It is your sovereignty. Don't share or peg currencies because it creates long-term inbalances that end in distaster.
3. Corruption destroys the state. It creates terrible investment decisions and breeds contempt and hopelessness. Corruption is obvious in Greece and China, but more shadowy in the West; particularly in the US where Congress spends most of its time asking for campaign contributions.

In the past decade the world has made many bad investment decisions. In almost every instance the loss is borne by taxpayers, the creditors are indirectly bailed out, and the debtors are slowly destroyed. This will be exacerbated in the future by global deflation.

Here in North Carolina, a recent vote on banning same-sex marriage brought guidance from this Leviticus 20 scripture, "If a man lies with a man as one lies with a woman, both of them has done what is detestable. They must be put to death, their blood will be on their own heads."

I don't want to live in a theocracy, but I wish equal attention was given to Leviticus 25, in particular: "If any of your fellow Israelites become poor and are unable to support themselves among you, help them as you would a foreigner and stranger, so they can continue to live among you. Do not take interest or any profit from them, but fear your God, so that they may continue to live among you. You must not lend them money at interest or sell them food at a profit." 

It sounds to me like the Bible directs an interest free work-out on hardship borrowers (read the whole chapter and you will see details on foreclosure and redemption rules). Maybe we should pay more attention to the passages that direct us to help each other, and less on the those that direct us to stone each other. Let's think the unthinkable.

End the Euro Now

A common currency is impossible across nations that don't share government spending,taxes or labor. The Eurozone isn't the United States of Europe because Germans would rather destroy Europe for a third time than pay money or forgive debts of Mediterraneans. Compare that to taxpayers on the East and West coasts of the US, who send large amounts to the Southern and Midwestern US without concern (or even knowledge). It is as simple as identity, Germans and Spaniards think of themselves as Germans and Spaniards, not as Europeans (indeed, not even all Spaniards would identify as Spaniards).

Periperal nations need to create their own floating currencies, with independent central banks that have clear instructions. And they need to let their banks fail - including allowing bond holders and foreign depositors to lose money, but they must also capitalize new banks to replace the old. With every institution that is destroyed they must immediately have a new and improved institution to replace it.

Europe continues to save banks, governments, and a currency while economies and even the fabric of society are destroyed. It is a terrible trade off.

When Deflation Comes

The economies of Europe, China, Brazil, and India are all rapidly shrinking, though it will take a while for the data to show it. The markets keep hoping for the governments to save the day, though there is no indication that any of them will do anything sustantive or helpful. Europe's governments have already postponed so long that the real economy has entered a vicious cycle of doom. China's government provided massive stimulus in 2009, but it was for even more investment in a nation that already had too much unproductive investment and too little consumption. 

Consumption and investment in at least half the world is falling, which will lead to a prolonged and dramatic plunge in most commodity prices. Labor prices may be sticky, but the price of most goods will fall. It may even infect the US, where the dollar will become much more valuable compared to other currencies. The downside to your dollar being worth more is that it means everything else is worth less. The lack of global investment opportunities and the fear of loss will drive ever more savings into cash, particularly when holding US currency becomes not only the safest, but also the highest return investment globally available. 

The deflation won't be a dramatic bust, but a slow and steady withering. We are looking at a global Japan, but worse than Japan. What is frightening is that 23 years later, Japan still has no solution. Their deflation hasn't been that bad, but there has been de minimus economic growth. And their government continues to borrow more money every year on a stagnant tax base. Is this what awaits the rest of the world?

The private sector is too afraid to consume and/or invest outside of the US. Most governments either won't or can't borrow money to invest on infrastructure, education, and technology - much less to spend on social benefits. Central banks create money, but they only provide it to banks, who then sit on the cash because they see no safe lending opportunities and need to preserve their capital for expected higher future credit losses.

Central banks must do what the public and private sector will not or cannot - they must make people spend. The last gasp of Monetarists is the call for central banks to create inflation by talking it up and raising  inflationary targets. But the fear of possible inflation is overwhelmed by the fear of certain default and deflation in a depression. All that raising inflationary targets through verbage will do is convince everyone that central banks are both impotent and absurd. Central banks like to calm markets, but now they need to scare them. This is a tough role for central bankers, who are known for being boring rather than scary. They will need radical action.  

Central banks must find a way to flood households with money, where it will be immediately spent since a) households have pent-up demand in a depression, and b) if enough money really is distributed then households will want to spend it before inflation lessens the value. If consumption is elevated for long then it will draw out private investment to collect the household spending and start a virtuous cycle of consumption and investment (then you can worry about inflation).

The trick is that most central banks can't just send households checks, instead they must buy assets. Large banks can sell bonds and other liquid securities to central banks, but what asset can most households sell? Their mortgaged house, their children, and their souls? There's the rub that will require creative policy and rule interpretation. We need central banks to buy mortgage and credit card debt, and then agree to either not collect on the debt and/or force the debt to be restructured so that the household's interest rate is set to the risk free rate (approximately zero in a deflationary environment). Central banks must take credit risk, and perhaps willingly take credit losses. And why not? They can make their own money, they aren't really a bank. They can afford to do what no one else can.

Central banks can go too far in printing money. Zimbabwe and Weimar Germany show why central banks should be independent, so that they don't go crazy making money for government operating expenses. That is what central banks fear today. I suspect it will take prolonged depression and deflation for  private creditors and central banks to realize that there are worse things than your returns being eaten away by inflation, such as debtors defaulting because their income falls even as their debt burdens remain, or central banks that are at best ignored and at worst abolished.

Hopefully we will appreciate the difference between currency (paper) and wealth (serving each other) before things get too bad. Otherwise we won't have much of either.

Europe Watching - Edition XXII

We wait for Europe's next announcement. Maybe they can pull this off a few more times. After all, Germany still wants to be repaid for a decade of exports on credit. Greece, Spain, et al still want a stable currency. All sides want the Euro to continue.

Too bad the Euro is doomed, all because.... well, the Euro is a bad idea. As I and others have said before, there's no way for money flows to balance across nations. Now they are in a doom loop. Money is leaving peripheral nation banks and heading for Germany. Investment and consumption is contracting in perhipheral Europe, thereby assuring they can't increase production to pay back their debt or sell more exports. In the future we will look back at a horrific graph of plummeting money supply in peripheral Europe.

The only hope is for both sides to realize that you can't squeeze blood from a turnip. Particularly in Spain, I think people are starting to realize that the common currency is hopeless. And Germans are starting to realize that not only will they not get paid back, but that every bailout increases the public's losses. If there is hope within the Euro, it would require debt forgivenss (at least interest forgiveness) and for Germany to buy goods and services from the periphery. This isn't about morality, it is about math. Maybe France can convince Germany.

Not gonna happen. So I guess Germans can wait for their banks to default and their exports to plummet (including all those luxury cars to China). Their money will flee to the US, just like it is now fleeing from Spain to Germany. Germany's final export to Spain will be Schadenfreude.

Maybe Europe can pull off a few bank bailouts, some QE, maybe a common bond or new emergency fund. But we are reaching the point where creditors (including the IMF and ECB) realize that this is good money after bad. They must already know it, but they haven't figured a way out (real or diplomatic).

All that's kind of a given, here's what I'm watching:

• Many have come to expect general asset appreciation after every bailout and QE event and try to time it. At first they expected inflation, now they are merely Pavlov's dog. Sometime this year the ECB will ring its bell, but asset prices will continue to fall. Who will be long and wrong?
• Which creditor will be the first to flinch, the ECB, Germany, or someone else?
• Will gold increase with the demise of the Euro, or will the US dollar become the new gold?
• Which US financial institution(s) will have European exposure? Or even just the uncertainty of exposure? This could include common place investments (interest rate swaps, money market).
• What will Putin do when the price of oil and consumption of gas falls, cutting off his money?
• What will China do as their biggest export market continues to shrink, while at the same time their real estate bubble falls hard?
• What will the BRICs do as their commodity exports, currency, and domestic credit collapse?
• Will the markets' perceived power of central banks plummet? And will that in turn cause central banks to lose even more of their soft expectations power?
• Is this the end of austerity and monetarism?

As for the last question, I fear the pendelum will swing too far at some point. Austerity and monetary policy both have their place, though they are the wrong medicine for this disease. Someday we will see asset bubbles, inflation, and money printing for political shenanigains (and no, that isn't what's been happening lately). "The boom, not the slump is the right time for austerity at the Treasury."

Why Should We Forgive Mortgage Principal?

If liberals, Democrats, the President, the FHA Secretary, and others really want to forgive principal then they can do so on many of the 707,863 FHA mortgages that are seriously delinquent. FHA now has more seriously delinquent mortgages than Fannie Mae (654,912), yet FHA is producing only a third as many modifications per month (5,553 for FHA vs 15,557 for Fannie). 

Jawboning continues on forgiveness of mortgage principal. Conservatives are against it and liberals are for it. Unfortunately I think many opinions are driven more by the desire to punish borrowers (make them stand up to their promise on a mortgage they were lucky to get to begin with) or to punish banks (their crooked underwriting and outrageous profits are to blame) than based on any theory of recovery.

The best reason for forgiveness of principal is to reduce the supply of distressed house sales, which will improve house prices, home equity, and growth to the general economy. And it will end a lot of personal suffering. The best reason for not forgiving principal is that it sets a dangerous precedent, so that whenever the economy is weak borrowers will want forgiveness again. And it seems unfair to everyone who didn't get debt forgiven.

As I have repeatedly stated for years, I think it is far preferable to modify and refinance borrowers into 1-month, 1-2% adjustable rate mortgages with low lifetime interest rate caps (5%), than to forgive principal. It is quid pro quo; lower rate in return for accepting limited interest rate risk. For current borrowrers, the 40% lower payment could be used to pay down principal faster.  That there is no interest in this, or really in any plausible workout plan, tells me that most principal forgiveness discussions are just political grandstanding. People in DC rarely resort to action (as opposed to rhetoric) unless you can provide large numbers of votes or campaign contributions.

In truth, many of the delinquent mortgages are so far gone, after missing literally years of payments, that I doubt that anything will bring them back. But for those who do want principal forgiveness, put it to the test on FHA loans.

Who Got Bailed Out?

Greek sovereign debt was restructured in March, and private bond investors suffered €100 billion in writeoffs. But before, during, and after the restructuring much of Greece's debt has been refinanced, purchased, or indirectly funded by pan-government agencies. Here are the big exposures: 

• ECB: €126 b,
• Euro interbank lending (TARGET2): €107 b,
• Euro Emergency Stability Fund: €73 b, 
• IMF: €22 b

After a couple of years of theater and over €300 billion of support, most private owners of Greek government debt have had time to sell their bonds to the ECB and friends. Banks with loand or bonds to Greek businesses have had time to build up reserves and/or create a supposed hedge for the risk. So most of the private risk of a Greek government default has been transferred to quasi-government institutions. I don't mind that, but when we say there was a Greek bailout, let's figure out who really gets bailed out.

Banks should be the safer for the bailouts (in time we may discover that some still gambled it away). But it looks like the ECB, Bundesbank, and others could take some big losses. That won't go over well with European voters - none of who got to vote on the officials of the quasi government entities.

If private lenders lost €100 billion, and the quasi-government entities end up losing another €100+, does that mean that Greece came out ahead? Greece's nominal GDP peaked in Q3, 2008. The cumulative GDP since then is €82 billion below what their GDP would have been if they had stayed at that high point 3.5 years ago. The shortfall will blow past €100 billion within the year.

No one is better off. This isn't a zero sum game. But people, including politicians and economists who should know better still tend to think that way. Greece can't just save money and thereby pay back its debtors. Remember that the whole problem is that Greece doesn't have Euros. They've run trade deficits, investment deficits, and government deficits for years (if there's another kind of deficit possible, they are probably running it too).

In order for Greece to pay back their accumulated debts they have to sell goods and services. Government cutbacks would only help that if the government had been crowding out private investment, but that isn't the case. Until the crisis, Greek businesses could borrow at much lower rates than they had seen before thanks to the easy credit that all Euro members got with the new currency.

Thanks to austerity, Greece is now even less capable than before to repay its debts - though repayments was dubious to begin with. Now it looks like Spain won't be able to repay either, but they weren't a basket case to begin with.

Austerity made sense if one was trying to solve the problem with microeconomics, finance, self-rightousness, or various political agendas. It never made any sense in macroeconomics. Unfortunately most business people and politicians know far more about finance than macroeconomics. 

The Euro is only money. They can always make more (and they will). But the cycle of fear has lead to falling consumption, bank runs, and a cessation of business lending and investment. If people don't have financial transactions then the money doesn't matter. The focus has to be on increasing wealth (goods and services), not currency.