Public Policy – Page 69 – The Aleph Blog

You Can’t Cheat an Honest Man

Posted on 27 February 2010 by David Merkel

An honest man knows that you can’t get something for nothing.? Discounts?? Sure, when warranted, but nothing is ever truly free.? Someone has to pay.

That is one reason why I have been skeptical about Greece and Goldman Sachs.? It would be really hard to trick an honest government into using derivatives in order to get into the EU.? Honesty requires full disclosure when the parties on the other side have asked for it, even if they are not checking too closely for their own reasons.

Which brings up another angle of the story.? If EU governments cared that much about the sanctity of the Euro, why did they not inquire more closely about derivatives?? Why is it a surprise now?? At the time when Greece entered the EU, the use of derivatives was well-known, why did the governments of the EU not challenge Greece, given its checkered history with respect to default.

Even if Goldman was marketing swaps to marginal European governments wanting to get into the EU, with many other investments banks imitating them, the governments weren’t dumb.? “What, we get to get into the EU, and all we have to do is pay a lot more 15-20 years from now?? That’s a deal.? (We will grow out of these promises.)”

Alas, but the growth does not come, but the debts come due.? As I often say, “you can’t cheat the cash flows.”? Income statements and balance sheets may lie, but it is hard to lie about cash flows.? Those are indisputable accounting entries.

Even if they did the swaps, I do not lay the major portion of the blame on Goldman Sachs, but on Greece.? Greece was the one in need, and they could have cut their budget, but would not do so for political reasons.? Now that trouble is back, bigger and badder than ever.

The same applies to Jefferson County, Alabama.? They played a variety of games to lower current costs, and assumed that it would be so for the future.? Fools.? You can’t get something for nothing.? You will either pay something in the future, or bear a risk that you do not understand.? Anyone who is mature enough to be a board member in the county had better be worldly wise enough to know that you can’t get something for nothing, and that advisors may have ulterior motives.

Did investment banks like Goldman Sachs take advantage of a bunch of rubes?? No.? They took advantage of politicians who were looking for a cheap deal, and were willing to cut corners in their due diligence.

You can’t cheat an honest man.? Honest men don’t cut corners, and they pay in full, on ordinary terms.? But those wishing for a low-cost way out of the political troubles on the cheap are great targets for those that want to cheat others.

More on Sovereign Risk and Semi-Sovereign Risk

Posted on 26 February 2010 by David Merkel

When does a sovereign or semi-sovereign government default?? I have seen three answers:

1) When debt is greater than future seniorage revenue (central bank profits) plus future debt repayments.? (Kind of a tautology, but what is implied is that if future debt repayments are onerous, a government would default.)

2) When the interest rate a government pays is greater than the likely growth rate of revenues. (I.e., if you are paying more than your revenue growth rate, the indebtedness will continue to grow without bounds?)

3) When the structural deficit is high, and total interest paid exceeds the size of the structural deficit.? (In that case, default would bring the budget into balance, at the cost of being shut out of the bond market.? But, given the situation, in the short run, being shut out of the bond market isn?t a problem.? There would be problems if the day comes when they need to borrow again; negotiations would begin over paying old debts.)

I will propose a fourth idea: governments can lay claim to a percentage of the GDP of their country/state/municipality.? How large that can be will vary by culture.? Beyond a certain point, attempts to take more than the natural limit for that culture will not result in higher revenues, because people will hide income, and/or leave the country/area.? When debts and unfunded obligations exceed the present value of maximum GDP extraction by the government, default is likely, the only question is when it will happen ? when does cash flow prove insufficient?? Perhaps the earlier three rules can help with that.

Tough Time to be a Municipality

Revenue is declining for almost all states and municipalities.? Given the need to run balanced budgets (on a cash basis), and not having a central bank to fall back on, the problems are much deeper for States and Municipalities than for the Federal Government.? This report from the Rockefeller Institute shows how widespread the loss of revenues is.

But what should larger governments do for smaller governments in this crisis?? Oddly, the best answer is nothing, and even some of the Europeans recognize this.? Smaller governments need to grasp that they have to solve their own problems, and not rely on the Federal government to help ? it has enough problems of its own.

So, if I had any great advice for strapped municipalities in California, or any other place in the US, one of the first things I would recommend is that you assume you aren?t going to get any help.? Those that could help you are in worse shape.? Such does the Pew Institute indicate.? Few states have their pension and retiree healthcare benefits funded.? They won?t have excess funds to aid municipalities, and my even compound the problem by reducing revenues shared with municipalities in order to stem their own budget shortfalls.

The Federal Government Won?t Be Much Help Either

The politics of the US are dysfunctional enough with opaque congressional earmarking benefiting local and special interests.? It will be yet more dysfunctional if states and municipalities ask the US Government for aid.? Besides, the US Government has issues of its own.? Tonight, it will release the 2009 Financial Report of the United States Government, somewhat behind schedule.? With all of the chaos, who could blame them for being late?? My suspicion is that when one adds up the explicit debts of the US Government and its unfunded obligations, it will add up to a figure near four times GDP.? If the US dollar were not the global reserve currency, we would have long ago slipped into chaos.

What would it take to make the US?s debt to GDP ratio stop rising permanently?? We would need to run surpluses of around 8% of GDP, if I understand the charts on page 5 right.? Absent some major shift in governing philosophy, that?s not even close to being on the table.

As I wrote in my seven part article, My Visit to the US Treasury, Part 5: After the meeting, I said to one Treasury staffer, ?One of the quiet casualties of this crisis is that you lost your last bit of slack from the entitlement systems.?

?What do you mean??

?Just this, prior to the crisis, Social Security and Medicare would produce cash flow surpluses for the Government until 2018.? Now the estimates are 2016, and my guess is more like 2014.? The existing higher deficit takes us out to the point where the entitlement systems go into permanent negative cash flow.? This means that the US budget is in a structural deficit for as far as the eye can see, fifty years or more, absent changes to entitlements.?

He looked at me and commented that it would be the job of a later administration.? No way to handle that now.? To me, the answer reminded me of what I say to myself when I go on a scary ride at Six Flags with my kids.? There is nothing we can do to change matters.? The only thing to adjust is attitude.? So, ignore the fact that you are afraid of heights, and enjoy the torture, okay?

Now, with interest rates so low on the short end, there is one further risk: that the Fed would keep rates low simply to keep? the US Government?s financing costs down.? As the Kansas City Fed?s President Hoenig said recently,

?Depending on your assumptions about the economy, that federal debt will grow at an unsustainable level starting immediately, or in a very few years,? Hoenig said. ?We do have significant private debt, so that?s in place, so what worries me about that [is] that puts pressure on the Fed to keep interest rates artificially low as you try to deal with that debt.?

The US Government is in a tough spot financially, and if inflation rises (which is not impossible, consider stagflation in the 70s), its ability to continue to finance itself cheaply will erode.? On the bright side, the US is still viewed as a safe haven, so if there are troubles in Europe or Japan, the US will benefit from additional liquidity in the short run.

Back to the States

For another summary of how tough things are at the states, consider this piece from the Center on Budget and Policy Priorities.? Because many state budgets assume a better economy than they actually got, and some were quite optimistic, the average state has a 6.6% gap to fill as a percentage of its 2010 budget.? The gap projected for 2011 is 17% of the 2010 budget.? Not pretty, and if you want to look at it from a bottom-up perspective, this article offers a lot of links to the various emerging troubles.

One further wrinkle in the matter is Vallejo, California, which is in Chapter 9 now.? In the past, muni bond investors and insurers felt assured that in defaults by cities and counties that they would eventually be paid back in full.? With Vallejo, that may not happen; bondholders may have to take a haircut.? If that happens, and it establishes a precedent for Chapter 9 cases, yields will rise for cities and counties that can file for Chapter 9, in order to reflect the increased risk of loss.? Higher future borrowing costs will further burden city and county budgets.? There is no free lunch in the muni bond market.? (For more good articles by Joe Mysak of Bloomberg, look here.)

Conclusion ? Why do I Write This?

This is a pretty gloomy assessment, but it is consistent with the deleveraging process that is rippling through the US economy.? All sorts of hidden leverage have been revealed including:

Reliance on optimistic economic assumptions in budgets.
Reliance on a robust housing sector.
Reliance on financial guarantee insurers.
Reliance on increasing leverage at banks, and sloppy underwriting of loans.
Reliance on Fannie and Freddie to absorb poorly underwritten mortgages.
Reliance on large pension and retiree healthcare promises to keep wages low, and not funding those promises to keep taxes low.
Reliance on high stock returns to pay for pensions.
Reliance on increasing debt levels in households.
Low bond yields make it difficult to invest for pensions.

And there may be other things we have relied on that may fail.? Banking crises often lead to financial crises, as is pointed out in the excellent book, This Time is Different.

The US government can always borrow more.
The Treasury and Federal Reserve can stimulate the economy out of any crisis.

My main message is that this is a serious situation almost everywhere in the US.? We have borrowed ourselves into a corner.? I write this so that all parties can understand the dynamics going on, so that when muni defaults happen, and the normal dynamics in the bond market shift, you won?t be surprised at the results.? Also, now you have links to a wide number of reports indicating how serious the problems are with Federal and State debts and unfunded liabilities, so that you can do your own digging on the topic.

Of Credit Ratings, Sovereign Risk and Semi-Sovereign Risk

Posted on 25 February 2010 by David Merkel

This post was prompted by Barry’s article Credit Rating Firms: Worthless in a Bull market, Damaging in a Bear Markets.

When I was a bond manager, we had a rule for our analysts — ignore the rating, but read the write-up.? The analysts at the rating agencies would give their true opinion in the write-up.? The buy side analysts usually found themselves in agreement with what was written, and would tell us what they thought the rating really should be.

After that, the portfolio managers were encouraged to ignore the rating, except to calculate the yield haircut for the incremental capital employed.? Those doing structured products developed their own models for benchmarking the risks of deals, ignoring the ratings, but reading the reports, because there was often really good information on the weak points of deals, including things not mentioned in the prospectus.

As managers, we knew we could always find seemingly cheap bonds for a given rating, but they were “cheap for a reason.”? We would avoid them.? Who would buy them?? Collateralized Debt Obligations [CDOs].? In CDOs were run by mechanical rules that relied on the ratings of the debts, among other things.

As such, they tended to fail.? After seeing the debacle 1999-2002 in CDOs, most insurers swore off CDOs — aside from AIG.? They were structurally weak securities with lousy collateral.

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The rating agencies have a hard task.? In the old days, they said that ratings were good for a full credit cycle.? Bond managers wanted stable ratings, and didn’t want to be bothered with ratings that were higher in the boom, and lower in the bust.

In 2001, after Enron, the rating agencies took several actions to be more proactive about ratings.? Result: a lot of ratings moved down rapidly, led to a collective screech from bond managers.? Result 2: the rating agencies stopped being proactive.

Barry is mostly right that in a bull market, ratings are worthless, and in a bear market, you don’t need them.? But they do have uses:

1)? Many bonds have no one analyzing them — particularly small deals.? A rating helps create a buyer base.

2)? The bread-and-butter corporate ratings are usually pretty accurate.

3) They summarize a lot of useful data in a small space.

4) What the analysts write is usually pretty good.? They are reasonably good at ranking credits within a given class against one another.

The corruption occurred higher up in the firms, because they mis-set the ratings for categories as a whole.? CDOs too high, subprime CDOs way too high, Munis too low, CPDOs ridiculous etc.? Part of the problem is inadequate thinking and risk aversion about new asset classes, because they don’t have loss data for assets that have been bought to securitize.

I’ve written too much, but I will give you one more key lesson of the period 1990-2008 regarding ratings, and this applies to sovereign issues today: Ratings that must be maintained in order to avoid a given result are dangerous, and good bond managers avoid investing in such bonds.

Examples:

1)? Insurers that made their Guaranteed Investment Contracts [GICs] putable on ratings downgrades.? (Fixed rate failure early 90s [Mutual Benefit], floating rate late 90s.? [General American / ARM Financial])

2) Enron-like structures that would force issuance of preferred stock on a downgrade (and some other triggers)

3) Reinsurance treaties callable on a downgrade.

4) Swap counterparty agreements requiring more capital on a downgrade.

5) Step-up bonds, where more interest is paid after a downgrade — not worth it…

It is perverse to want more out of a company when they are downgraded — often it leads to a collapse.? As a bondholder, it does not pay to stand near cliffs where a downgrade can change the creditworthiness of a company.

Sovereign governments are the same way.? You can’t make them pay; the only big penalty is getting shut out of the bond market — which means that in the future, their budget would have to be balanced on a cash basis.? So, I offer one simple insight on sovereign risk — I suspect that sovereigns default when the interest payments are more than structural budget deficit.? At that point, it would pay for a government to default.? Of course, this would have to be a situation where the structural budget deficit is high, and there is little hope of bringing it down politically.

Now one could just print their way out of the situation, and hand fresh currency to creditors — but at a cost of high interest rates and inflation, which could crush economic activity in real terms.? Partially inflating to do it, and borrowing to make interest payments would face a similar hurdle, because the borrowing would likely be at higher rates due to inflation.

But States of the US, municipalities whose States don’t allow them to file for Chapter 9, members of the EU, and other Semi-Sovereign credits that don’t have access to a printing press have it tougher, but I think the same test applies.? If the structural budget deficit is high, but less than interest payments, the odds of a default rise considerably, because if they cease paying the interest, the budget is balanced.? Being shut out of the bond market does not matter at that point.

Now, there are still costs to defaulting.? Rare would it be for a government to stop being profligate after a default.? They would need the bond market back at some point, and then the negotiation over past debts would begin.? There would also be seizures of assets abroad.? There might even be economic sanctions.? If the defaulting nation is big enough, it could cause some bank failures, leading to a broader set of crises.? At some level of crisis, war is not impossible, improbable as that may be.

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Coming back full circle, I am reminded that corporate credits don’t typically default because they can’t refinance, they typically default because they can’t make the interest payment.? My opinion is that it is the same for sovereign debts, except that is more sturm und drang around it because of currency, political, and solvency of financial institutions issues.

So, what would be a good next step?? Create a table of Sovereign and Semi-sovereign debtors, estimate their structural budget deficits and their interest payments.? My question: has anyone done this already?? Is there a good place to look where the data is summarized?? Let me know any ideas in the comments, and thanks.

Thoughts on my Last Two Posts

Posted on 24 February 2010 by David Merkel

Some follow-up on my last two posts.? I will be talking to those that suggested parties that would be willing to create a definitive bond blog.? But, others brought up a good point, which I am well aware of, but forgot for a moment.? The bond markets are mainly institutional.? Institutional bond investors have no lack of research sources to guide them.? Retail investors get ripped of, or are relegated to government bonds, ETFs, or mutual funds.? So, maybe creating a definitive bond blog would not be a good use of time?? Maybe, maybe not.

What is clear is that such a blog would have to be retail-focused.? It could not dwell on minutiae that would be valuable to institutional investors, but would have to deal with the hard problems that retail investors face with fixed income.

The alternative would be to try to do a blog for institutional investors and bright amateurs, and invite institutional investors to write pseudonymously — think of it as a Zero Hedge for fixed income, without so much attitude.? But would institutional investors read it?? They are inundated already.

Now, John Jansen himself has encouraged the idea, which I appreciate.? He did great work while he was at it.? Could we do as well or better?

Thoughts?? I am still game for this idea, write to me here.

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How long to the point of no return?? I don’t know.? In all of the time that I wrote at RealMoney, I tried to point at directions, but not give timetables.? Giving timing is a mug’s game.

But let me consider some of the commentary that I have received.? My last two posts generated so much traffic that people were not able to access my site for a time.

Promises, promises.? What is a promise to pay worth?? All I know is that the more promises there are outstanding, the less a promise is worth.? The same applies to the Federal Reserve, who issues small-denomination short-duration 0% CP, otherwise known as currency.

Some say that so long as a primary dealer can “repo previously issued govt bonds at the central bank to gain reserves to purchase the new issue bonds at a Treasury auction, that nation can never default, no matter what the level of debt to GDP ratio is….” The effect of that is to raise interest rates.? Higher rates will harm the economy.? As more long-term promises are issued, the safety/value of a promise diminishes.? The same is true of short-term promises, but the effect is more immediate.

Which reminds me that nations with a lot of debt to roll over are most at risk.? There are others in worse shape than the US.? The US Dollar may be the best among bad major currencies, as I have argued on many occasions.? Also, banking crises tend to lead to sovereign debt crises.? The nation absorbs the losses of the banks, and then some fail as a result.

In a true free market, no one would care about currency levels.? They would take spot and future currency rates and factor them in as a cost of doing business.

The Keynesian solutions assume that growth will occur as a result of government spending.? I disagree.? In Japan, there has been no end of such spending, and from what I have read, that spending has not resulted in additional productivity.? Additional productivity only comes from projects that yield more benefits than their costs, and Japan has had more than its share of white elephants.

Throwing a brick through the window and having the glass repairman do his work may raise GDP, but the net worth of society is diminished.? True growth comes from entrepreneurs competing for advantage, and finding places where there are needs to be met.

That is one reason why I say that the deficit spending of the US is destructive.? It does not reflect the needs of people, but the needs of politicians currying favor with interest groups.? We need to shrink the US Government, so that it cannot meddle with the details of our lives.? Let it focus on defense, justice, internal security, and public health, goals worthy of a government.? Let local governments deal with other issues.

The budget troubles will percolate down to all municipalities.? It cannot be otherwise.? Local governments will toss out less needed actors, such as social workers, and retain those more needed, like policemen.? On the whole, society will be better off, as we reduce unproductive actors.

Growth matters a lot.? We need to focus on eliminating things that constrain the growth of the economy, without sending the government budget into greater deficit.? Let the US government reduce corporate welfare.? Let them eliminate the deduction for employee health care expense — that will shrink the health care sector significantly.? My view is that we need to eliminate all tax preferences in the economy, and tax people/institutions in their increase in value every year.? Get the government out of the social engineering business.? Let’s have true tax reform.? Let government do what it does well, and leave the rest to the people.

I recognize that I have a point of view here.? My contention is (aside from ethical issues) that when there is a high level of debt in an economy, that efforts to stimulate fail.? Better not to stimulate at all, ever.? Rather, focus on constraining credit, so that speculation does not overcome the economy, whether personal or corporate.

As for now, let us encourage short sales, foreclosures and bankruptcies, which eliminate debt.? Prices will reset lower, but predominantly equity-financed businesses will not fail easily.? Once the Debt/GDP ratio gets below 1.5x, the economy will grow on a healthy basis again.

How Long, To The Point Of No Return?

Posted on 20 February 201021 February 2010 by David Merkel

Alea posted a paper, and The Big Picture a slideshow on sovereign debts, by the same author.? We have had a blessed period post-WWII, where there have been no defaults of major nations.? But that is not normal.? Nations default on their debts if they get too large, or they repudiate through inflation, or they raise taxes on a docile public.

The main point of the paper is that we are past the point of no return in most major nations, without significant changes that would diminish living standards for some time.? Add the implicit obligations to the explicit debt, and there is quite a mountain to climb.? Defaults are coming, the only question is what nations will default.

I often think that economists need to get out of the math ghetto, and study history.? Math is not capable of capturing nuances.? I write this as one who uses advanced statistical analyses regularly.? History is more robust than mathematical analyses.? Math occludes understanding in economics because it forces a numerical simplification of matters that have more dimensions than are admitted in the analysis.

Are there doubts about this?? Here are some simple tests: How well do macroeconomic models forecast, particularly at turning points?? On microeconomics, what kind of R-squared are they getting when they test the general equilibrium neoclassical model?? Are many of the testable hypotheses are not rejected?? When last I looked, R-squareds were in the percentage single digits, and most testable hypotheses were rejected.

So why do we think that developed nations could not default on their debts?? The book This Time is Different, should disabuse such notions.?? Major nations have often defaulted on their debts.? It is regrettable, sinful, but normal.

Personally, I think that all of the developed nations as a group have gotten lazy, and also do not realize the degree to which they are interconnected, particularly through their banks.? This is not a call for governments to reach out and help one another, but a yellow flag to say, “Don’t bail out other nations.? Focus on the effects on your own country; if you must do bailouts at all, focus on your local financial institutions, and then create risk-based capital rules that penalize foreign lending, and encourage diversification in what foreign lending is done.? This is logical in a credit-based system, because you only regulate one side of the transaction.

I am not arguing for isolationism in investing, but there is a tendency in the bull phase of the credit cycle to assume that nations don’t default, and so lending to sovereign credits that are weak becomes the trade of the moment.? Good regulation of financials limits the ability of those regulated to be yield hogs, particularly in the bull phase of the credit cycle.

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Nations are mortal.? They don’t last forever, historically, if they last 200 years, that is significant.? Even with nations that last so long, they can repudiate debts multiple times in their lives, though there is a cost — being shut out of the bond market for a time, until lenders forget.

So, what is the calculus on national default?? It is an option, but what influences the choice?

Willingness of public to accept more taxes.
Willingness of the public to accept reductions in services.
Strength of the economy.
Willingness of foreign creditors to buy more debt.
Willingness of locals to save through buying national debt.

Default happens when a nation gives up; they conclude that there is no way that they can pay off the debts incurred.

Nations have not given up so far, but unless economic growth increases significantly, there will be defaults in many places eventually.

A Question of Cultural Failure (II)

Posted on 17 February 2010 by David Merkel

Good cultures balance short and long-term goals.? Focusing too much on the long-term can lead to overinvestment, and problems like Japan still faces.? Focusing on the short-run can lead governments and companies to focus on manipulating budget and earnings numbers to fulfill their own selfish ends.

At present, we have no surplus of long-termism, but a surfeit of short-termism.??? Many economic players have decided that it is in their interest to play for time? — make things look good in the short run, and maybe a magical fix will appear for long run problems.

It seems that the EU thinks that if they can make Greece behave, that all will be right.? Well, tell that to those that protest in Greece.? Let each EU nation rather take a step back and ask, “What is cheaper in the long-run, bailing out Greece, or bailing out my banks with Greece exposure?”? The latter is probably cheaper, but not certainly so.? Given the lack of unanimity, the situation would lean toward bailing out domestic banks, because bailing out Greece requires the cooperation of separate nations, many of which have electorates that strongly oppose a bailout of Greece.

But, that could mean a virtual dissolution of the Eurozone.? Not necessarily.? You could end up with a lot of nations in default, and shut out of the bond markets (the PIIGS), while the rest do seemingly fine, as they quietly bail out their banks.

In that situation, the Euro would still exist, and might continue to be the currency of nations that are in default.? They just could not borrow any more at any rate in Euros, and perhaps not in any currency.

But the Eurozone itself would be in tatters, at least from a marketing standpoint.? What is good about being in the Eurozone?? Free trade?? Well Britain has that, even though they are a basket case, at least they control their own destiny, sort of.? The veneer that being in the Eurozone means that you are a high quality borrower is shattered.? Credit spreads over the German Euro benchmark will be high indeed for nations that have been undisciplined in their finances.

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People and governments like stasis.? No change.? Why?? It makes policy simple.? If something is in trouble, give it aid.? But — what if the trouble is an indication that people don’t want what is being produced by the one that is in trouble?? Capitalism is wonderful because it is dynamic. It can quickly adjust to changing conditions, unlike socialist bureaucrats.? Rather than volatility being a negative, with capitalism it is a positive.? It shows that the economy needs to change, that losses on prior bad investments should be recognized.? Failure to see things like this lessens the flexibility of the economy, and makes the eventual adjustments much larger than they would have to be if we did not interfere in the economy.

Now, this applies all over the world.? China is creating some of the biggest white elephants in history, so it seems.? Like Japan in the late 80s, they are building up useless industrial capacity.? Naive Keynesianism says that it does not matter what one spends money on, what matters is that the money gets spent, and quickly.

We may as well throw bricks at every window we see with that logic, knowing that GDP will record that glassman’s wages, but will not record the loss from a broken window.

Alas, we have too much automotive capacity, so we support automotive firms in the US.? We have too many bankers and too much capacity to build homes, so we support that as well.? Far better that we let firms fail, and let the assets be released to better uses.? Why waste your life or capital in an industry where there is not enough demand?

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In one sense, my claim of cultural failure boils down to not being willing to recognize losses.? In another sense, it is using the political process to invalidate economics.? Why should the government bail out company A and not company B?

The present political climate in the US could be summarized as a question of fairness.? Why should some benefit from bailouts, and not others?? There should be some answer here that doesn’t sound lame.? Lame answer: we were protecting the whole economy by protecting banks.? Better answer: we goofed in protecting the banks.? We should have let them fail, and bailed out depositors.? Don’t bail out anyone; let housing prices drop until ordinary people can afford them.? But if you must bail out, go down to the lowest level, and bail out those with mortgages, which will benefit not only them, but everyone above them.

This leaves aside moral hazard — all bailouts are a mistake.? Far better to let all fail, and let the system reset.? Run a hard culture where failure is punished.? That will cause people to avoid failure with greater assiduousness.

I will have more on this in the likely final segment for this topic.

A Question of Cultural Failure

Posted on 13 February 201014 February 2010 by David Merkel

I’ve said this before in different ways, but I will say it once more, “Governments are smaller than markets; markets are smaller than cultures.”? The reasoning is simple:

Governments can only control a fraction of what an economy or culture does.? Governments that are overbearing on an economy or culture may gain greater proportional control, but the size of the pie will shrink.? More of the economy or culture goes into hiding, away from the prying eyes of the government.
Markets only express a fraction of what mankind does.? They cover the tradeable aspects of what we do, but typically do not give us our deeper goals or desires for ourselves, and the culture as a whole.

When I look at the biggest economic problems facing the world today, many of them stem from deeper cultural problems.? Let’s start with the current poster child, or, canary in the coal mine, Greece.

Greece got into the Eurozone via subterfuge; they lied about the true status of their indebtedness, and Wall Street (with its counterparts in European investment banking) helped them do it.? So did a number of the other nations in the Eurozone that are presently under stress.

Now, the core members of the Eurozone wanted the Euro to grow as a currency — they were committed to an ever-wider and -deeper union.? The dream of a united Europe made them willfully blind to the low probability that the nations which were fiscal basket cases had genuinely changed.? The core should have been skeptical, and now they are paying the price, though not paying any money, yet.

The core nations that could pay or guarantee to help Greece are playing a tight game.? They act as an internal European IMF, insisting on reductions in the Greek budget deficit.? Greece does its part by saying it hasn’t asked for aid, which is unlikely.? At the same time, reductions in the Greek budget deficit bring the competing political factions inside Greece out in force.? Protests!? Strikes!? There are few arguing for what is best for Greece overall, and many arguing for a larger piece of what is a shrinking pie.? In a situation like this, it might be better for outsiders to let Greece fail,but they won’t do that.? Why?

The banks in the core nations can’t afford a default by Greece if by contagion it leads to defaults in Portugal, Spain, Italy, and Ireland.? A failure of the banking system does not conduce well to maintaining power for elites.

I have already talked about the perverse incentives for the core European nations to do anything to support Greece.? If Europe was rational, they would abandon the experiment now, or press for a Federal Europe akin to the US.? I don’t see either happening — I just see slow suffering for now, and futile playing for time.

Dubai is a place where anything can get done.? Anything indeed, but who pays the bills?? Dubai is a place of big ideas and little responsibility. ?? It is a moral flaw to bite off more than you can chew, particularly if you do so on behalf of others.

Many US States and Municipalities are in a world of hurt, because they compromised their long-term financial position to solve short-run budget crises.? That is the nature of the crises that we face today.

The same is true of the current US government — they fight for short term political advantage, rather than the long term good of the nation.? Who will favor the long-term and sacrifice for the greater good?

A simple summary statement here is “Greed is not good.”? Societies that are willing to sacrifice self interests have a much better probability of succeeding than societies that pursue self interest.

That’s all for now, I will pick this up in part II.

Ignore anyone who tells you that debt levels don’t matter.

Posted on 12 February 2010 by David Merkel

Debt levels in an economy matter.? They matter a lot.? An economy that is financed primarily by debt can be like a chain of dominoes.? If one fixed claim fails, and it is large enough, many other fixed claims that rely on the first claim could fail as well, triggering a chain of failures.? This is a reason why a fiat-money credit-based economy must limit leverage particularly in financial institutions.

Why financial institutions?? They borrow and lend.? They also lend to other financial institutions.? A? big move in the value of some assets can make many banks insolvent, and perhaps banks that lent to other banks.? The banks should have equity bases more than sufficient to absorb losses at a 99% probability level.? That means that leverage should be a lot lower than it is now.

Economies are more stable when they limit fixed claims and encourage financing via equity rather than debt.? Imagine what the economy would be like if interest was not deductible from taxable income, but dividends were deductible.

People would save money to buy homes, and would put more money down when they borrowed.
Corporations would lower their debt-to-equity ratios, and would pay more dividends.
Fewer people and corporations would go broke.

Pretty good, but in the short run, the economy would probably grow slower.? The debt bonanza from 1984-2006 pushed our economy to grow faster than it should have, where people and firms took more chances by borrowing more, and making the overall economy less resilient.? Debt-based economies lose resilience.

What was worse, the Federal Reserve in the Greenspan and Bernanke years facilitated the debt increases because the Fed never took away the stimulus fast enough, and offered stimulus too rapidly.? This led to a culture of unbridled debt and risk-taking.? If only:

Greenspan had been silent when the crash hit in October 1987.
Greenspan had not given into political pressure in late 1990, where he set up a process of cutting interest rates too much.
Greenspan had not cut rates in 1995.
Greenspan had not cut rates during the LTCM crisis.
Greenspan would have cut far less 2000-2002.
Instead of tightening 1/4% at a time 2004-6 , they would have raised the rate far more rapidly, completing the rise in one year.
Bernanke would not have let the fed funds rate go to zero, but would have limited fed funds to never go lower than 1% below the ten-year Treasury yield.? We never need more than that to stimulate, but some patience is necessary.

What’s that you say?? The economy would have grown more slowly?? Right, and the economy should have grown more slowly, rather than gunning the engine through the overaccumulation of debt.? As it is, the economy will grow more slowly for some time a la Japan, until we delever the economy enough that it can once again grow without stimulus.

The economy is at a fork in the road.? Do we:

Leave rates low and leave quantitative easing in until price inflation unfolds?
Let rates rise gradually and drain quantitative easing slowly?
Raise rates significantly and drain quantitative easing rapidly?

The third view is off the table.? No one wants to see any failure.? Bad decisions of the past must be grown out of, even if it takes a long time of subpar growth to do that.

When Eastern Europe left the Soviet orbit, the countries that did the best were the ones that freed their economies most rapidly.? Well, not in the short-run.? Letting companies fail is always a drag in the short run, but in the longer-run it leads to faster growth, because bad investments fail, and are replaced by better investments.

The same is true with monetary policy.? The US grew faster during periods where failures were reconciled and liquidated, rather than attempting to smooth the economic cycle — leading to fewer failures in the short run, much but bigger failures when the amount of debt became too large.

Before the crisis, when I was writing at RealMoney.com, I usually encouraged taking the less risky macroeconomic route, suggesting policies that would not increase debt levels.? The trouble was, that all of those ideas were losers in the short-run, and so they were not followed.? In the long run we are all dead, leaving the failures of short-run policies to our kids.

Personally, I would raise the Fed funds rate to 2% immediately, and let it shadow the 10-year rate less 1% thereafter.? But no one likes jolts, except when the Fed is loosening.? After that, I would rather the Fed allow inflation to raise collateral values and end the home and commercial mortgage crises.? But no, what we are likely to get is a Japan-style muddle-in-the-middle where they struggle with a slow raising of rates, and a slow end to quantitative easing, with a premature giving in when the economy has a negative burp before the removal of policy accommodation is complete.? I expect us to move in the direction of Japan.

What may change the story are sovereign defaults as government debt levels get too high.? In the short run, that may favor the dollar — it won’t fail rapidly.? But perhaps the euro might fail.? Even the yen might.? The era we are in is like the mid-1800s, when nations were constrained by their debt levels.

From the recent book “This Time is Different,” we know that countries with high debt levels grow more slowly, and defaul more frequently.? Ignore anyone who tells you that debt levels don’t matter.

The Rope Limit, Redux

Posted on 9 February 2010 by David Merkel

Sorry I haven’t written much recently.? The recent snowstorms have tossed me around, as I care for my family, and those around me.? It is amusing in a backwards way, to see Washington, DC frozen at a time when there is so much volatility in global finance.? Yo, Treasury, make sure the skeleton crew on international finance gets in, regardless.

The incentives are perverse in every way in Europe.? If Germany, France, and the Netherlands don’t bail out Greece, then what will become of Portugal and Spain?? And later, Italy and Ireland?? In aggregate, this is big.

But, if Germany, France, and the Netherlands do bail out Greece, then will Portugal and Spain be next in line?? And later, Italy and Ireland?? In aggregate, this is big.

Perverse, indeed, and I criticize my own thoughts on the Euro that I thought would die from inflation.? No such thing.? The Euro is strong –? So strong that marginal nations were able to borrow at rates lower than they ever dreamed imaginable.? The debts built up like mad, ignoring the day when the inevitable weakening in aggregate demand would come, and debts of marginal, overindebted nations would prove weak.? The EU is validating the idea that currency union requires political union.? We learned that in the US 200 years ago, but the youngsters in the EU have to learn that lesson the hard way.

This is an ugly situation, as ugly as China forcing exports into the rest of the world, or the US Government continuing to borrow with abandon.? What seems to have no limit may find the limit more rapidly than one anticipates.

Just be aware that sovereign volatility has negative impacts on asset prices.

Default, Inflation, Higher Taxes — Choose One

Posted on 7 February 2010 by David Merkel

When I look at the present economic environment, I am not encouraged.? But if you really want me to be discouraged, talk to me about politics.

For the last 40-80 years we have been borrowing, whether implicitly (pensions, retiree healthcare) or explicitly, deferring problems into the future, where they will be compounded with interest and survivorship (lifespans have lengthened, Kaiser, and sadly for those who pay, they want a high quality of life in their dotage).

So, at present, legislators are more partisan, whether in the states or at the federal level.? Why?? There is less slack.? Let’s start at the state level, because most of them have to balance their budgets, and can’t print money to help out.

Many states are screaming in pain.? As such, they tell their legislators in the Federal Congress to send back money.? But that toughens the debate on the Federal level.

With almost all state budgets fighting against a deficit, and some in deep trouble, it makes for interesting and ugly politics.? Much of this was created by optimistic assumptions of what could be earned from equities over the long run, much of which is now being slowly repudiated, as markets fail to live up to expectations.

The Federal budget is hopelessly out-of-whack, with 4-5% of GDP deficits out as far as the eye can see.? So, what do we do about it?

1) Raise Taxes.? I don’t like this idea, because the US Government has entered many areas where it should not be.? I would rather see the discretionary government shrink considerably.? Also, remember, Social Security and Medicare are not guaranteed.? Congress could wipe out all benefits tomorrow, and face a political firestorm.? But remember, in the Great Depression, that is just what they did.? This is why I don’t insist that rates must head higher.? It depends on society as a whole.

Raising taxes has the perverse result of slowing economic growth, which affects future taxes.

2) Inflate the currency.? Ugh.? Oppress the elderly, who cannot work to make up the difference?? Create a new inflation mindset that has all of us focusing on the short-term.? Inflationary economies by their nature become more and more short term.

3) Default on obligations.? There are several forms of this:

a) Total default: anyone with a Treasury Note is a sucker.? Global depression ensues.

b) External default: we do not honor external obligations, but honor internal ones.? Global depression ensues, but the US does relatively well.

c) Internal default: what, are you joking?? Why do we pay off the losers who lent to us?

As we look at Greece, Spain, and Portugal, we chuckle over the foolishness of the EU thinking that they could have monetary union without full political union.? It didn’t work under the Confederation, why should it work elsewhere?

But we should not chuckle.? After all, we have California, Illinois, and New York, and more waiting in the wings.? There is no bankruptcy code for the states.? I am not sure what happens if one state does not pay, aside from being shut out of the municipal bond market.

So, my point remains — what are we going to do?? Raise taxes, inflate the currency, or default?? Perhaps in a real crisis, we would slim down the government.? We might also decrease Social Security and Medicare benefits.? We might also amend ERISA, to allow for reductions in pension payments.? In a real crisis, nothing is fixed.

Or, we might tax a lot more — the depression was an example of that.? That is a reason that I am not a total bear on Treasuries.

The government has choices to make.? What should they do?? Offer your answers as best you can.